2. Financial Statement Analysis
Chapter 23
Financial Statement Analysis
Section 1: Vertical Analysis
Section Objectives
Chapter 22 completed the discussion of corporate accounting by explaining long-term bonds. Chapter 23 introduces financial reporting and analysis. The chapter will demonstrate different techniques to analyze financial statements including horizontal and vertical analysis. Section one explains how to use Vertical Analysis.
Use vertical analysis techniques to analyze a comparative income statement and balance sheet.
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3. Phases of Statement Analysis
Computation Phase:
Vertical analysis
Horizontal analysis
Ratio analysis
Interpretation Phase: Comparison of ratios
Budgeted ratios
Industry Averages
Analyzing financial statements is a capstone activity in the accounting cycle process because owners and managers need to know the financial strengths and weaknesses of the business in order to stay competitive.
Lenders, prospective investors, and suppliers are also interested in the analysis. There are two phases in statement analysis: The Computation Phase and the Interpretation Phase. In the Computation Phase, there are three basic calculations used: vertical, horizontal, and trend analysis. In the Interpretation Phase comparisons are made using ratios, percentages from prior years, budgets, and industry averages.

4. Cost of goods sold Net Sales
Use vertical analysis techniques to analyze a comparative income statement and balance sheet
Objective 1
Each item is expressed as a percentage of the net sales figure.
Cost of goods sold Net Sales =
$1,752,500
$2,969,000
= 59.0%
Selling expenses
Net Sales =
$526,425
$2,969,000
= 17.7%
Let’s see how to perform a vertical analysis on a comparative set of income statements and balance sheets. Based on Figure 23-1 in your book for Household Product, Inc., we will calculate a few key components of a vertical analysis.
In vertical analysis, every item on the income statement is divided by the net sales figure. Here we see that cost of goods sold can be expressed as 59.0 percent of net sales during the year. Selling expenses are 17.7 percent of net sales and net income after taxes is 1.9% of net sales.
Net income after taxes
Net Sales =
$55,563
$2,969,000
= 1.9%

5. Comparative Statement
Household Products, Inc.
Comparative Income Statement
Year Ended December 31, 2010 and 2009
Amounts Percent of Net Sales
Revenue
Sales ,104, ,825,
Less Sales Returns and Allowances , ,
Net Sales ,969, ,700,
Net Income After Income Taxes , ,
Comparative Income Statements show amounts and percentages for TWO consecutive years.
A set of comparative statements for 2009 and 2010 are shown here. These two years will be compared and significant differences can be evaluated.

6. Common-size Statement
Household Products, Inc.
Comparative Income Statement
Year Ended December 31, 2010 and 2009
Amounts Percent of Net Sales
Revenue
Sales ,105, ,850,
Less Sales Returns and Allowances , ,
Net Sales ,970, ,725,
Net Income After Income Taxes , ,
Household Products, Inc.
Comparative Income Statement
Year Ended December 31, 2010 and 2009
Amounts Percent of Net Sales
Revenue
Sales ,104, ,825,
Less Sales Returns and Allowances , ,
Net Sales ,969, ,700,
Net Income After Income Taxes , ,
When financial statement items are expressed as percentages of a base amount then the statement is called a common-size statement.
Using the comparative income statements for 2009 and 2010 we can convert the items on the income statements to be expressed as percentages of each year’s net sales. For example, for the year 2010, net income after taxes is expressed as $55,563/$2,969,000=1.9 % of net sales.

7. Vertical Analysis of the Balance Sheet
Each item is expressed as either a percentage of total assets or of total liabilities plus stockholders’ equity.
Cash
Total assets
$115,231
$555,711 =
= 20.7%
Accounts payable
total liabilities plus stkhldrs’ equity.
A comparative Balance Sheet can be viewed in Figure When we perform a vertical analysis on the balance sheet, each item is expressed as either a percentage of total assets or of total liabilities plus stockholders’ equity. For example, here we see that of total assets of $555,711, the cash balance makes up 20.7%. The accounts payable balance of $71,000 is 12.8% of total liabilities and stockholders’ equity and the total stockholder’s equity represents 56.9& of the total liabilities and stockholder’s equity.
$ 71,000
$ 555,711 =
= 12.8%
Total stockholders’ equity
total liabilities plus stkhldrs’ equity. =
$316,306
$ 555,711
= %

8. Financial Statement Analysis
Chapter 23
Financial Statement Analysis
Section 2: Horizontal Analysis
Section Objectives
Use horizontal analysis techniques to analyze a comparative income statement and balance sheet.
Use trend analysis to evaluate financial statements.
Interpret the results of statement analyses by comparison with industry averages.
In section 2 we will see how to use horizontal analysis and trend analysis to evaluate financial statements.
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9. Use horizontal analysis techniques to analyze a comparative income statement and balance sheet
Objective 2
Horizontal Analysis
Evaluates financial statements for two or more periods.
Compares items in each line to determine the change in dollar amounts.
Uses the same method for both the income statement and the balance sheet.
Our second technique for analyzing financial statements is a horizontal analysis.
Remember that horizontal analysis refers to comparing one year’s numbers to the next year’s numbers on a straightline. It is useful in calling attention to relationships that bear further investigation.
Usually accountants want to know by how much and by what percentage an item changed from one year to the next.
A percentage change can be shown by using the earlier figure as the base.

10. Horizontal Analysis of the
Income Statement
Sales for $3,104,450
Sales for – 2,825,625
Increase $ 278,825
Earlier year is the base year.
Using horizontal analysis, the percentage change from the base year is calculated. This is done by dividing the amount of the change by the amount of the base year. In this example there was an increase in sales of $278,825 from 2009 to If we divide this increase of $278,825 by the 2009 base year amount of $2,825,625 then we get a change (increase) of 9.9%
Increase in sales
Sales for base year =
$ 278,825
$2,825,625
9.9% =

11. Horizontal Analysis of the
Balance Sheet
Current liabilities 12/31/ $ 75,905
Current liabilities 12/31/ – 88,240
$ (12,335)
Decrease in current liabilities
Current liabilities in base year =
$ (12,335)
$ 88,240
– 14.0% =
Horizontal analysis of items on the balance sheet involves calculating the amount of change in each line item as well as the percentage of change. Here there was a decrease in current liabilities of $12,335. The decrease amount is divided by the base year amount of $88,240 to calculate a percentage change of -14.0%. Any significant changes shown in the Comparative Balance Sheets will be evaluated.
When trying to interpret the percentage changes and dollar amount changes from the base year and whether the change is significant or requires additional investigation it is easier if some basis of comparison is available. For example comparing your results with the company budget or with industry averages.
A decrease is expressed as a negative percentage.

12. Often the time period is five years.
Objective 3
Use trend analysis to evaluate financial statements
QUESTION:
What is trend analysis?
Trend analysis compares selected ratios and percentages over a period of time.
ANSWER:
Another analysis tool is a trend analysis. The word “trend” indicates a general direction in which something tends to move. Trend analysis compares selected ratios and percentages over several years to show a general tendency or inclination in company business.
Often the time period is five years.

13. Trend Analysis
Net Sales 2,055,600 2,223,240 2,587,500 2,700,000 2,969,000
Cost of goods sold 1,059,900 1,234,560 1,495,642 1,574,721 1,752,500
Gross profit on sales , ,680 1,091,858 1,125, ,216,500
Percentage of
gross profit to net sales
In this trend analysis, we can see that percentage of gross profit to net sales increased from 41.0% to 41.7% during the last two years. An increase in the gross profit percentage is a positive trend. If it was negative, it should be investigated by management.
The increase in the percentage of gross profit to net sales is positive for the company.

14. Using Industry Averages
Interpret the results of the statement analyses by comparison with industry averages
Objective 4
Using Industry Averages
Trade associations survey their members to obtain financial information and other data.
Data is converted to a uniform presentation, usually in common-size statements arranged by company size.
Individual companies compare their results to industry averages.
Industry averages are obtained by trade associations who survey their members to obtain financial information and other data. Common-size statements are important to managers in comparing their operations to other firms of similar size in their industry. When comparing your figures to the industry averages, one must keep in mind the following:
Different businesses keep different types of accounts and do not classify items in the same manner.
Many things influence comparisons of financial statements: size of the business, types of customers, merchandise sold, leased or purchased long-term assets, financial accounting methods applied, etc..

15. Financial Statement Analysis
Chapter 23
Financial Statement Analysis
Section 3: Ratios
Section Objectives
Compute and interpret financial ratios that measure profitability, operating results, and efficiency.
Compute and interpret financial ratios that measure financial strength.
Compute and interpret financial ratios that measure liquidity
Recognize shortcomings in financial statement analysis.
We continue discussion on the financial reporting and analysis by discussing the analysis of comparable financial statements. We will look at ratios that measure profitability, financial strength, and liquidity. We will also look at some shortcomings in financial statement analysis.
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16. Ratio Analysis Financial ratios have three classifications:
Profitability, operating results, and efficiency
Financial strength
Liquidity
Ratio analysis is much like the dissecting process in a biology class. The financial statements are broken down into smaller pieces, analyzing them with ratios.
Some financial ratios examine profitability and operating results, while others evaluate efficiency.

17. Ratios Measuring Profitability, Operating Results, and Efficiency
Compute and interpret financial ratios that measure profitability, operating results, and efficiency
Objective 5
Ratios Measuring Profitability, Operating Results, and Efficiency
Rate of return on sales.
Rate of return on common stockholders’ equity.
Earnings per share of common stock (EPS).
Price-earnings ratio.
Yield on common stock.
Rate of return on total assets.
Asset turnover.
Here are the ratios which measure Profitability, Operating Results, and Efficiency.
We will start with Rate Of Return On Sales.

18. Rate of Return on Sales
Measures what percentage of each sales dollar is net income.
Formula:
Net income
Net sales
= Rate of return on net sales
Example:
This is a measure of operating efficiency and profitability. Once again, referring to Figure 23.3, we can discuss some ratios based on income data for Household Products.
The calculation is (Net Income ÷ Net Sales) In this example, the rate of return is 1.9%
The higher the rate of return on sales, the more satisfactory the operation of the business. Management should look for and investigate unfavorable trends.
$ 55,563
$ 2,969,000
= %
The higher the rate of return on net sales, the more satisfactory are the business operations.

19. Rate of Return on Common Stockholders’ Equity
Measures how well the corporation is making a profit for its shareholders.
Formula:
Income available to common stockholders
Common stockholders’ equity
Return on
common
stockholders’
equity =
Procedure:
The next ratio we will want to calculate is Rate of Return on Common Stockholders’ Equity. This is a key measure of how well a business is making a profit for the shareholders. The calculation is (Net Income Available to Common Stockholders ÷ Total equity of common stock)
Step 1: Compute income available to common stockholders.
Step 2: Compute the common stockholders’ equity.
Step 3: Divide the income available to common stockholders by the common stockholders’ equity.

20. Rate of Return on Common Stockholders’ Equity
Step 1: Compute income available to common stockholders.
Net income after income taxes $55,563
Less dividend requirements on preferred stock ,000
The first step is to calculate the income which is available to common stockholders. Remember that net income after taxes is reduced by any preferred dividend requirements. In this example, the preferred shareholders were entitled to $4,000 in dividends so the income available to common stockholders is $51,563.
Income available to common
stockholders $51,563

21. Rate of Return on Common Stockholders’ Equity
Step 1: Income available to common stockholders = $51,563
Step 2: Compute the common stockholders’ equity.
Total stockholders’ equity $316,306
In step 1 we determined the income available to common stockholders and now in step 2 we need to compute the common stockholders’ equity. If total stockholders’ equity is $316,306 and we subtract the preferred stockholders’ equity of $50,000, then common stockholders’ equity is $266,306 for the current year.
Preferred stockholders’ equity ,000
Common stockholders’ equity $266,306

22. Rate of Return on Common Stockholders’ Equity
Step 1: Income available to common stockholders = $51,563
Step 2: Common stockholders’ equity = $266,306
Step 3: Divide the income available to common stockholders by the common stockholders’ equity.
In step 3 we divide the income available to common stockholders by the common stockholder’s equity. Our rate of return on stockholders’ equity is 19.4%. Household Products’ rate of return on common stockholder’s equity shows that, for 2010, each dollar of common stockholder’ equity earned 19.4 cents.
$51,563
$266,306
= %

23. Earnings per Share of Common Stock
Measures the profit accruing to each share of common stock owned.
Formula:
Earnings per share =
Income available to common stockholders
Average number of shares of common stock outstanding during year
Our next ratio, earnings per share of common stock measures the profit accruing to each share of common stock owned. It is computed by dividing income available to common stockholders by the average number of shares of common stock outstanding during the year.
Analysts, stockholders, and creditors watch the earnings per share measurement very closely.

24. Earnings per Share of Common Stock
Step 1: Compute income available to common stockholders.
Step 2: Determine the average number of shares of common stock outstanding during the year.
Step 3: Divide the income available to common stockholders by the average number of shares of common stock outstanding.
The steps to calculate the Earnings Per Share of Common Stock is outlined step by step here. Let’s see how step 1 and step 2 is determined using the next slide.

25. Earnings per Share of Common Stock
Step 1: Income available to common stockholders = $51,563
Step 2: Determine the average number of shares of common stock outstanding during the year.
7,000 shares x 12 months = 7,000 shares
12 months
1,000 shares x 3 months = shares
Remember, that income available to common stockholders was determined earlier to be $51,563. In Step 2, the average number of shares of common stock outstanding during the year must be calculated. An analysis of the common stock account reveals that 7,000 shares were outstanding throughout 2009 and most of In October of 2010, 1000 additional shares were issued. The weighted average number of shares outstanding for 2010 was 7,250 as shown in this slide.
Weighted Average ,250 shares
number of shares

26. Earnings per Share of Common Stock
Step 1: Income available to common stockholders = $51,563
Step 2: Average number of shares outstanding = 7,250
Step 3: Divide the income available to common stockholders by the average number of shares of common stock outstanding
In step 3 we divide the income available to common stockholders by the average number of shares of common stock outstanding. Earnings per share were $7.11 in 2010.
The Accounting Principles Board requires that publicly traded companies report earnings per share (EPS) information on the front of the income statement, just below reported net income.
The complexity of the EPS calculation depends on the company’s capital structure. A company that has bonds, stock, or stock options has a complex capital structure. The formula shown in the textbook is based on a simple capital structure. The formula for a complex structure would include converting bonds, stock, and stock options to common stock, which would affect the formula’s denominator.
$51,563
7,250 shares
= $7.11
Earnings per share were $7.11.

27. Price-Earnings Ratio
Compares the current market value of common stock with the earnings per share of that stock.
Formula:
Price-earnings ratio
Market price per share
Earnings per share =
Example: 12
$144
$ 12 =
The Price-Earnings Ratio compares the market value of common stock with the earnings per share of that stock. It is computed as Market Price per share/ Earnings per share. This ratio indicates the attractiveness of the stock as an investment at its current market value. In this example, the stock is selling for 12 times its earnings per share.
PE ratio = 12 to 1
The price-earnings ratio is an indicator of the attractiveness of a stock as an investment.

28. Yield on Common Stock
Relationship between the dividends received by the stockholders and the market value of each share.
Formula:
Yield on Common Stock
Dividend per share Market price per share =
For a publicly held corporation, the relationship between the dividends received by the stockholders and the market value of each share is important. The yield on common stock is computed as Dividend per share/ Market price per share. In this example, an investor in a share of common stock received 10% on its investment during the year.
Example:
10%
$ 6
$ 60 =

29. Rate of Return on Total Assets
Measures the rate of return on the assets used by the company.
Formula:
Rate of return on total assets
Income before interest expense and income taxes Total assets =
Example:
Income before income taxes $ 79,375
The rate of return on total assets is computed as: Income before interest expense and income taxes/ Total assets. The numerator (net income before interest expense and income taxes) is also know as EBIT. The “E” stands for “earnings. The rate of return for Household Products, Inc., is 16.4% in The results are meaningful only if compared with rates of prior years and with the industry average.
Add back interest expense ,500
Income before interest and taxes $ 90,875
Total assets $555,711
16.4%
$90,875
$555,711 =

30. Rate of Return on Total Assets
This rate helps the analyst to:
judge managerial performance,
measure the effectiveness of the assets used,
evaluate proposed capital expenditures.
Only income from normal business operations is considered.
The rate of return on total assets measures the rate of return on the assets used by a company. This rate helps the analyst to judge managerial performance, measure the effectiveness of the assets used, and evaluate proposed capital expenditures.

31. Asset Turnover Net sales Total assets
Measures effective use of assets in making sales.
Formula:
Asset Turnover
Net sales Total assets =
Example:
5.3 to 1
$ 2,969,000
$ ,711 =
The Asset Turnover ratio measures the effectiveness of management to use assets to generate sales. It is calculated by (Net sales ÷ Total assets)
Keep in mind, that assets not used in producing sales should be excluded from this calculation. “Do you think a high or low asset turnover is preferable?” A High ratio is preferred because a low asset turnover compared to the industry average shows that the business uses more assets to generate the same sales volume as its competitors.
The higher the asset turnover, the more effectively the assets of the company are being used.

32. Ratios Measuring Financial Strength
Objective 6
Compute and interpret financial ratios that measure financial strength
Ratios Measuring Financial Strength
Number of times bond interest earned.
Ratio of stockholders’ equity to total equities.
Ratio of stockholders’ equity to total liabilities.
Book value per share of stock.
A company’s financial strength can be measured using ratio analysis. In general, the higher the ratio the stronger the company.
The four common ratios which measure financial strength are:
Number of times bond interest earned
Ratio of stockholders’ equity to total equities
Ratio of stockholders’ equity to total liabilities
Book value per share of stock

33. Number of Times Bond Interest Earned
Measures the ability of net income to cover the required bond interest payments.
Formula:
Income before bond interest and income taxes
Bond interest cash requirement
Times bond interest earned =
Procedure:
Step 1: Compute the income before bond interest and income taxes.
Step 2: Compute the cash required to pay bond interest.
Step 3: Compute the ratio.
The Number of Times Bond Interest Earned is a ratio that measures the margin of safety that net income provides for required bond interest payments.
The calculation of this measurement is: (income before bond interest and income taxes ÷ bond interest cash requirement).
Let’s try following the steps listed here to calculate this number. . .

34. Number of Times Bond Interest Earned
Step 1: Compute income before bond interest and income taxes.
Income before tax $79,375
Add bond interest expense ,500
In Step 1, we compute income before bond interest and income taxes. For Household Products, Inc. it is $88,875
Available for bond interest $88,875

35. Number of Times Bond Interest Earned
Step 1: Income before bond interest and income taxes = $88,875
Step 2: Compute the cash required to pay bond interest.
In step 2: we compute the cash required to pay annual bond interest. For Household Products, Inc. that number is $10,000.
$100,000 x
$ 10,000

36. Number of Times Bond Interest Earned
Step 1: Income before bond interest and income taxes = $88,875
Step 2: Cash required to pay bond interest = $10,000
Step 3: Compute the ratio.
Finally, in step 3, we can compute the ratio. At 8.9 times, the income of California Product, Inc. easily covers the required annual bond payments.
$ 88,875
$ 10,000
= 8.9 times
The income of Household Products, Inc. easily covers required bond payments.

37. Ratio of Stockholders’ Equity to Total Equities
Measures the portion of total capital provided by the stockholders and indicates the protection afforded creditors against possible losses.
Formula:
Stockholders’ equity
Total equities
Ratio of stockholders’ equity to total equities =
Example:
Recall the basic equation Total Assets = Total Equities.
The sum of a corporation’s liabilities and stockholder’s equity is referred to as its total equities.
The ratio of Stockholders’ Equity to Total Equities measures the portion of total capital provided by stockholders and indicates protection afforded creditors against losses.
The formula is: (stockholders’ equity ÷ Total equities). For Household Products, Inc. the measure is .57 to 1. This means that in the current year, the stockholders of the company provided 57 cents of each dollar of total equities. This ratio varies widely from industry to industry. A comparison with the industry average is important in determining a desirable ratio for a particular business.
$316,306
$555,711 =
0.57 to 1
A comparison with the industry average is important in determining a desirable ratio for a particular business.

38. Ratio of Stockholders’ Equity to Total Liabilities
Also known as the ratio of owned capital to borrowed capital.
Formula:
Stockholders’ equity
Total liabilities
Ratio of stockholders’ equity to total liabilities =
Example:
This ratio is another way to express the stockholders’ equity to total equity ratio.
The calculation is: = Stockholders equity
Total liabilities
Emphasize that a low ratio here can be risky. The corporation might not be able to make interest and principal payments on its debts.
$316,306
$239,405 =
1.32 to 1

39. Book Value per Share of Stock
Measures the financial strength underlying each share of stock.
Formula:
Common stockholders’ equity
Number of common shares
Book value per share of stock =
Procedure:
Step 1: Compute the claims of preferred shareholders.
Step 2: Compute the claims of common stockholders.
Step 3: Divide the total claims of common stockholders by the number of shares outstanding.
Book Value per share of stock is a measure of the financial strength of a business that underlies each share of stock.
To calculate this measurement: (common stockholders’ equity ÷ number of common shares).
Let’s follow these steps to calculate book value per share for Household Products, Inc. . .

40. Book Value per Share of Stock
Step 1: Compute the claims of preferred stockholders.
For Household Products, Inc. the book value of preferred stock is the same as the par value, $100 per share. $
x shares outstanding
$50,000
In step 1, we compute the claims of preferred stockholders. Since there are no cumulative dividends or special liquidation provisions for the preferred stock of the company, the book value is the same as the par value, $100 per share. If we multiply the $100 x the 500 shares outstanding we get total claims for preferred shareholders of $50,000.

41. Book Value per Share of Stock
Step 1: Claims of preferred stockholders = $50,000
Step 2: Compute the claims of common stockholders.
Stockholders’ equity $316,306
Next, we need to compute the claims of common stockholders. To do this, we deduct the claims of preferred stockholders from total stockholders’ equity. This amount is $266,306.
Less preferred stock equity ,000
Claims of common stockholders $266,306

42. Book Value per Share of Stock
Step 1: Claims of preferred stockholders = $50,000
Step 2: Claims of common stockholders = $266,306
Step 3: Divide the total claims of common stockholders by the number of shares outstanding.
Finally, we divide the total claims of common stockholders by the number of shares of common stock outstanding. The book value of each share of stock is $ Since market value of stock or current value may not be readily available to financial statement users, book value per share is used to measure the financial strength of stock. (Book value per share is based on asset cost, not market or liquidation value.)
Let’s move on to liquidity ratios.
$266,306
8,000 shares =
$33.29

43. Ratios Measuring Liquidity
Objective 7
Compute and interpret financial ratios that measure liquidity
Ratios Measuring Liquidity
Working capital
Current ratio
Acid-test ratio
Inventory turnover
Accounts receivable turnover
Liquidity ratios measure the ability of a business to pay its debts when they are due.
Common ratios which measure liquidity are:
Working capital
Current ratio
Acid-test ratio
Inventory turnover
Accounts receivable turnover

44. Working Capital – Current liabilities – 75,905
Measures the ability of a company to meet its current obligations.
Formula:
Current assets
– Current liabilities
Working capital
Example:
Working capital represents the margin of security afforded short-term creditors. Working capital, sometimes called net working capital, is computed as:
Current assets – Current liabilities = Working Capital. In the current year, Household Products Inc. had working capital of $348,026.
$423,931
– ,905
$348,026

45. Current Ratio
Measures the ability of a business to pay its debts using current assets.
Formula:
Current assets ÷ Current liabilities = Current ratio
Example:
$423,931
$ 75,905
= 5.59:1
The current ratio is the key measure in determining a firm’s ability to pay current debts and adequacy of working capital.
The calculation of the ratio is: (current assets ÷ current liabilities).
Remember, assets are considered current if they will be converted to cash or used within one year.
From a creditor’s viewpoint, the higher the current ratio, the better. In retail and manufacturing businesses, a popular guideline is a current ratio of at least 2 to 1.
A high current ratio may also indicate that excess current assets may be on hand that are not earning income. (This may be caused by large Accts. Rec. balances, or excess inventory.)
In retail and manufacturing businesses, a desired guideline is a current ratio of at least 2 to 1.

46. Quick assets are cash, receivables, and marketable securities.
Acid-Test Ratio
Measures immediate liquidity.
Formula:
Quick assets ÷ Current liabilities = Acid-test ratio
Quick assets are cash, receivables, and marketable securities.
Example:
Cash $115,231
Receivables ,000
Marketable securities – 0 –
$ 217,231
The acid-test ratio measures immediate liquidity by comparing “near cash” assets to current liabilities. To calculate the Acid-test ratio: Quick assets / Current liabilities.
Quick assets are cash, receivables, and marketable securities. (The company could pay off all of its current debt right away if it needed to.) For Household Products, Inc., the acid-test ratio is 2.86 to 1. In general, this ratio should be at least 1 to 1.
$217,231
$ 75,905
= 2.86:1
A general guideline is that the acid-test ratio should be at least 1 to 1.

47. Inventory Turnover
Measures the number of times the inventory is replaced during the period.
Formula:
Cost of goods sold ÷ Average inventory = Inventory turnover
Procedure:
Step 1: Compute the average inventory.
Step 2: Divide the cost of goods sold by the average inventory.
It is important that a business sell its inventory rapidly so that excess working capital is not tied up in merchandise.
The inventory turnover ratio measures the times the average inventory had to be replaced during the period. The calculation is: (cost of goods sold ÷ average inventory)
Let’s use the steps indicated to figure how many times inventory turned over during the year for Household Products, Inc.

48. Inventory Turnover Inventory, Jan. 1 $ 225,000
Step 1: Compute the average inventory.
Inventory, Jan $ 225,000
Inventory, Dec ,000
Totals $ 430,000 ÷
In step 1, we compute the average inventory during the year. The average inventory balance is $215,000.
Average inventory $ 215,000

49. The inventory turnover ratio varies widely by industry.
Step 1: Average inventory = $215,000
Step 2: Divide the cost of goods sold by the average inventory.
$1,752,500
$ 215,000
= times
In step 2, we divide the cost of goods sold by the average inventory. For Household Products, Inc., their inventory turned over 8.15 times during the year.
The higher the ratio (turnover), the shorter the time between the purchase and sale of the inventory. The inventory turnover ratio varies widely by industry. Inventory turnover for a bakery is almost daily. A vendor of construction equipment might turn inventory just twice a year.
The inventory turnover ratio varies widely by industry.

50. Accounts Receivable Turnover
Measures the speed with which sales on account are collected.
Formula:
Net credit sales ÷ Average receivables = Accounts receivable turnover
Procedure:
Step 1: Compute average accounts receivable.
Step 2: Divide net credit sales by average accounts receivable.
The accounts receivable turnover measures the speed with which sales on account are collected. We want accounts receivable to be turned over many times throughout the year. The calculation of this ratio is (net credit sales ÷ average receivables). Remember that accounts receivable represents unpaid sales, or credit sales. Net credit sales, therefore, must be part of the calculation of the accounts receivable turnover ratio.
Let’s use the steps illustrated to calculate the accounts receivable turnover for Household Products, Inc. . .

51. Accounts Receivable Turnover
Step 1: Compute average accounts receivable.
Accounts receivable, Jan $ 73,500
Accounts receivable, Dec ,000
Totals $175,500 ÷
In step 1, we compute the average accounts receivable balance for the year. The average balance is $87,750.
Average accounts receivable $ 87,750

52. Accounts Receivable Turnover
Step 1: Average accounts receivable = $87,750
Step 2: Divide net credit sales by average accounts receivable.
$2,700,000
$ ,750
= times
In step 2 we divide net credit sales by average accounts receivable. During the year, the accounts receivable balance turned over 30.8 times. The accounts receivable turnover can be used to determine the average collection period of accounts receivable.
The accounts receivable turnover can be used to determine the average collection period of accounts receivable.

53. Accounts receivable turnover
QUESTION:
What is the average collection period?
The average collection period is the number of days’ sales in receivables.
ANSWER:
The accounts receivable turnover can be used to determine the average collection period of accounts receivable, or number of days’ sales in receivables. The average collection period is computed by the formula: 365 days / Accounts receivable turnover.
365 days
Accounts receivable turnover
Average collection period
Formula: =

54. Precautionary Notes on Statement Analysis
Objective 8
Recognize shortcomings in financial statement analysis
Precautionary Notes on Statement Analysis
Financial statements use book values.
Book value depends on accounting policies and procedures.
Businesses have choices about certain things, such as depreciation methods and useful lives.
Financial statements assume that the dollar is a stable monetary unit.
No two companies are exactly the same:
Different legal entities
Different product mixes
Different financing methods
Objective 8 is to recognize shortcomings in financial statement analysis. Financial statement analysis is useful only if certain limitations are understood. One limitation is that different companies use different financing methods, classify expenses differently, have different policies, and operate as different types of entities. These differences must be clearly understood to evaluate financial statements properly.
Another limitation of ratio analysis is that financial statements are prepared assuming that the dollar is a stable monetary unit however, the amounts on financial statements do not necessarily represent dollars with today’s purchasing power.
Financial statement analysis is useful only if these limitations are understood.

55. College Accounting, 12th Edition
Thank You
for using
College Accounting, 12th Edition
Price • Haddock • Farina