Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Spiceland | Thomas | Herrmann Financial Accounting Financial Statement Analysis Chapter 12

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objectives Perform vertical analysis Perform horizontal analysis Use ratios to analyze a company’s risk Use ratios to analyze a company’s profitability Distinguish persistent earnings from one-time items Explain quality of earnings and distinguish between conservative and aggressive accounting practices 12-2

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Part A Comparison of Financial Accounting Information 12-3

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 1 Perform vertical analysis 12-4

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Vertical Analysis Express each item in a financial statement as a percentage of the same base amount Income statement items expressed as a percentage of sales Balance sheet items expressed as a percentage of assets 12-5

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 2 Perform horizontal analysis 12-6

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Horizontal Analysis Analyze trends in financial statement data for a single company over time 12-7

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Part B Using Ratios to Assess Risk and Profitability 12-8

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 3 Use ratios to analyze a company’s risk 12-9

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Receivables Turnover Ratio Measures how many times receivables are collected during the year Low ratio indicates trouble collecting its accounts receivable High ratio indicates quick collection of receivables into cash 12-10

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Average Collection Period Days it takes to convert receivables into cash Shorter collection period is better 12-11

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Inventory Turnover Ratio Measures how many times average inventory is sold during the year High ratio indicates that inventory is selling quickly Extremely high ratio might indicate lost sales due to inventory shortages 12-12

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Average Days in Inventory Days it takes to sell inventory Lower is better 12-13

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Current Ratio Compares current assets to current liabilities High ratio indicates sufficient assets to cover current liabilities 12-14

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Acid-Test Ratio More conservative measure of ability to pay current liabilities Ignores current assets such as inventories and prepaid expenses 12-15

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Debt to Equity Ratio Indicates the risk of bankruptcy Higher ratio indicates higher risk 12-16

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Times Interest Earned Ratio Compare interest payments with income available to pay them Associated with long-term liabilities 12-17

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 4 Use ratios to analyze a company’s profitability 12-18

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Gross Profit Ratio Indicates the portion of each dollar of sales above its cost of goods sold 12-19

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Return on Assets Measures the income the company earns on each dollar invested in assets 12-20

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Profit Margin Measures the income earned on each dollar of sales 12-21

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Asset Turnover Measures sales volume in relation to the investment in assets 12-22

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Return on Equity Measures the income earned for each dollar in stockholders’ equity 12-23

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Price-Earnings Ratio Compares a company’s share price with its earnings per share Indication of investors’ expectations of future earnings 12-24

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Part C Earnings Persistence and Earnings Quality 12-25

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 5 Distinguish persistent earnings from one-time items 12-26

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Earnings Persistence and One-Time Income Items Earnings Persistence Current earnings that will continue or persist into future years One-Time Income Items Certain items are part of net income in the current year but are not expected to persist Discontinued operations Extraordinary items 12-27

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Discontinued Operations Sale or disposal of a significant component of a company’s operations Any gains or losses on discontinued operations in the current year are reported separately 12-28

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Extraordinary Items Gains or losses that do not reflect normal operations and that are not likely to happen again Event that produces a gain or loss must meet two conditions: Unusual in nature Infrequent in occurrence 12-29

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objective 6 Explain quality of earnings and distinguish between conservative and aggressive accounting practices 12-30

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Quality of Earnings Ability of reported earnings to reflect true earnings Usefulness of reported earnings to predict future earnings Result in reporting lower income, lower assets, and higher liabilities Result in reporting higher income, higher assets, and lower liabilities Conservative Accounting Practices Aggressive Accounting Practices 12-31

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Mr. Djokovic's Proposed Changes Decrease estimate of bad debts Reverse write-down of inventory Increase asset’s useful life changing depreciation estimate Remove loss contingency 12-32

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Symbolism Revealed Mr. Nadal represents conservative accounting practices Mr. Djokovic represents aggressive accounting practices 12-33

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. End of Chapter