Chapter 23 Financial Statement Analysis

Question 1

Teva Pharmaceutical www.tevapharm.com

Teva Pharmaceutical got its start in Jerusalem in 1901 as a small wholesale drug business that distributed medicines via a herd of camels and donkeys. Today, Teva is the world leader in generic pharmaceuticals and among the top 15 pharmaceutical companies in the world. Teva balances its portfolio with generic, innovative, and branded products, vertically integrating its pharmaceutical and active pharmaceutical ingredient (API) activities.

The balance appears to be working. Calculating some of the key financial ratios that indicate a company’s financial health generates some nice numbers for Teva including a current ratio of 1.8 (indicating assets are higher than liabilities) and a long-term debt-to-equity ratio of 0.30.

Answer 1

Teva Pharmaceutical www.tevapharm.com

Teva Pharmaceutical got its start in Jerusalem in 1901 as a small wholesale drug business that distributed medicines via a herd of camels and donkeys. Today, Teva is the world leader in generic pharmaceuticals and among the top 15 pharmaceutical companies in the world. Teva balances its portfolio with generic, innovative, and branded products, vertically integrating its pharmaceutical and active pharmaceutical ingredient (API) activities.

The balance appears to be working. Calculating some of the key financial ratios that indicate a company’s financial health generates some nice numbers for Teva including a current ratio of 1.8 (indicating assets are higher than liabilities) and a long-term debt-to-equity ratio of 0.30.

Question 2

Owners, managers, creditors, and other parties use financial statements to gather the information needed to make business decisions.

The Phases of Statement Analysis:
The two phases of financial statement analysis are (1) compute differences, percentages, and ratios; and (2) interpret the results.

Answer 2

Owners, managers, creditors, and other parties use financial statements to gather the information needed to make business decisions.

The Phases of Statement Analysis:
The two phases of financial statement analysis are (1) compute differences, percentages, and ratios; and (2) interpret the results.

Question 3

Vertical analysis:
is the relationship of each item on a financial statement to some base amount on the statement. On the income statement, each item is expressed as a percentage of net sales. On the balance sheet, each item is expressed as a percentage of total assets or total liabilities and stockholders’ equity.

Answer 3

Vertical analysis:
is the relationship of each item on a financial statement to some base amount on the statement. On the income statement, each item is expressed as a percentage of net sales. On the balance sheet, each item is expressed as a percentage of total assets or total liabilities and stockholders’ equity.

Question 4

Horizontal analysis:

is the percentage change for individual items in the financial statements from year to year.

Answer 4

Horizontal analysis:

is the percentage change for individual items in the financial statements from year to year.

Question 5

THE INTERPRETATION PHASE:

The second step in statement analysis, the interpretation phase, is the more difficult and important step. Financial statement interpretation requires an understanding of financial statements and knowledge of the operations of the business and the industry. In the interpretation phase, the analyst develops an understanding of the significance of the percentages and ratios computed. Analysts compare the ratios for the current year to prior years’ ratios, budgeted ratios, and industry averages.

Answer 5

THE INTERPRETATION PHASE:

The second step in statement analysis, the interpretation phase, is the more difficult and important step. Financial statement interpretation requires an understanding of financial statements and knowledge of the operations of the business and the industry. In the interpretation phase, the analyst develops an understanding of the significance of the percentages and ratios computed. Analysts compare the ratios for the current year to prior years’ ratios, budgeted ratios, and industry averages.

Question 6

Comparative Statements:
are financial statements presented side by side for two or more years. Figure 23.1 shows the comparative income statement of Special Products, Inc., for the years 2012 and 2013.

Answer 6

Comparative Statements:
are financial statements presented side by side for two or more years. Figure 23.1 shows the comparative income statement of Special Products, Inc., for the years 2012 and 2013.

Question 7

ABOUT
ACCOUNTING

NYSE:
The New York Stock Exchange (NYSE) lists more than 2,800 companies from all over the world whose collective worth at year-end 2007 was $27.1 trillion in global market capitalization.

Answer 7

ABOUT
ACCOUNTING

NYSE:
The New York Stock Exchange (NYSE) lists more than 2,800 companies from all over the world whose collective worth at year-end 2007 was $27.1 trillion in global market capitalization.

Question 8

Financial statements with items expressed as percentages of a base amount are called common-size statements. The last two columns in the comparative income statement are referred to as a comparative common-size statement.

Answer 8

Financial statements with items expressed as percentages of a base amount are called common-size statements. The last two columns in the comparative income statement are referred to as a comparative common-size statement.

Question 9

important!
Percentages:
In common-size statements, percentages (of net sales on the income statement and of total assets on the balance sheet) are shown instead of dollar amounts.

Answer 9

important!
Percentages:
In common-size statements, percentages (of net sales on the income statement and of total assets on the balance sheet) are shown instead of dollar amounts.

Question 10

To find the percentage of increase, divide the increase by the amount for the base year. The base year is always the earlier year. The percentage of increase for gross sales is 9.9 percent.

Answer 10

To find the percentage of increase, divide the increase by the amount for the base year. The base year is always the earlier year. The percentage of increase for gross sales is 9.9 percent.

Question 11

important!
Base Year:
In preparing horizontal percentage analyses, the earlier year is used as the base for computing the percentage of change.

Answer 11

important!
Base Year:
In preparing horizontal percentage analyses, the earlier year is used as the base for computing the percentage of change.

Question 12

important!
Adding It Up:
In horizontal analysis, the amounts in the Increase or Decrease columns can be added or subtracted vertically, but the percentages cannot be.

Answer 12

important!
Adding It Up:
In horizontal analysis, the amounts in the Increase or Decrease columns can be added or subtracted vertically, but the percentages cannot be.

Question 13

Horizontal analysis is especially useful in identifying items that need further investigation. For example, the increase in net sales was 10.0 percent, but the increase in cost of goods sold was 11.3 percent. An alert manager would want to determine the reasons for the increase in cost of goods sold.

Management would also be interested in learning why freight increased 36.8 percent during 2013 while purchases increased only 9.0 percent.

Keep in mind that percentages of increase or decrease can be misleading when small amounts are involved. For example, total other income decreased 65.3 percent. However, in terms of actual dollars, the amount is relatively small, from $16,700 to $5,800. On the other hand, a small percentage change is important for items involving large dollar amounts.

Answer 13

Horizontal analysis is especially useful in identifying items that need further investigation. For example, the increase in net sales was 10.0 percent, but the increase in cost of goods sold was 11.3 percent. An alert manager would want to determine the reasons for the increase in cost of goods sold.

Management would also be interested in learning why freight increased 36.8 percent during 2013 while purchases increased only 9.0 percent.

Keep in mind that percentages of increase or decrease can be misleading when small amounts are involved. For example, total other income decreased 65.3 percent. However, in terms of actual dollars, the amount is relatively small, from $16,700 to $5,800. On the other hand, a small percentage change is important for items involving large dollar amounts.

Question 14

trend analysis: which compares selected ratios and percentages over a period of time. Often the time period is five years.

Answer 14

trend analysis: which compares selected ratios and percentages over a period of time. Often the time period is five years.

Question 15

Managerial Implications:
COMPARATIVE STATEMENTS:
Statement analysis is extremely important to managers in detecting areas of strength and weakness in a business.

Comparison of current data with the data of prior years indicates favorable and unfavorable trends.

Managers compare percentages from year to year and with industry averages in order to detect variations that require prompt investigation.

Management must consider certain factors when using industry averages.

Answer 15

Managerial Implications:
COMPARATIVE STATEMENTS:
Statement analysis is extremely important to managers in detecting areas of strength and weakness in a business.

Comparison of current data with the data of prior years indicates favorable and unfavorable trends.

Managers compare percentages from year to year and with industry averages in order to detect variations that require prompt investigation.

Management must consider certain factors when using industry averages.

Question 16

Recall:
Consistency Principle:
The consistency principle permits comparisons between years. Using the same methods allows meaningful comparisons.

Answer 16

Recall:
Consistency Principle:
The consistency principle permits comparisons between years. Using the same methods allows meaningful comparisons.

Question 17

The financial ratios and percentages that reflect averages for similar companies are called Industry averages. These data are converted to a uniform presentation, usually in common-size statements arranged by company size (based on sales volume or total assets). Income statement items are expressed as a percentage of net sales and balance sheet items as a percentage of total assets. Common-size statements can be presented for one year or for several years. Individual companies compare their results to industry averages.

Answer 17

The financial ratios and percentages that reflect averages for similar companies are called Industry averages. These data are converted to a uniform presentation, usually in common-size statements arranged by company size (based on sales volume or total assets). Income statement items are expressed as a percentage of net sales and balance sheet items as a percentage of total assets. Common-size statements can be presented for one year or for several years. Individual companies compare their results to industry averages.

Question 18

In comparing to industry averages, keep in mind the following:

Different businesses keep different types of accounts and do not classify items in the same manner.

No two businesses are exactly alike. There are differences in the merchandise sold, the type of customers, and the method of financing (owners’ equity versus borrowed funds). Some businesses buy fixed assets while others lease all or some of the fixed assets.

The industry figures could include data from corporations, partnerships, and sole proprietorships. The different business entities might report salary allowances, benefits for owners, and other items in very different ways.

Answer 18

In comparing to industry averages, keep in mind the following:

Different businesses keep different types of accounts and do not classify items in the same manner.

No two businesses are exactly alike. There are differences in the merchandise sold, the type of customers, and the method of financing (owners’ equity versus borrowed funds). Some businesses buy fixed assets while others lease all or some of the fixed assets.

The industry figures could include data from corporations, partnerships, and sole proprietorships. The different business entities might report salary allowances, benefits for owners, and other items in very different ways.

Question 19

> >

5. OBJECTIVE Compute and interpret financial ratios that measure profitability, operating results, and efficiency.

Ratio analysis is used to assess a company’s profitability, financial strength, and liquidity. Ratio analysis investigates a relationship between two items either as a ratio (2 to 1 or 2:1) or as a rate (percentage).

Financial ratios have three classifications:

1. Profitability, operating results, and efficiency
2. Financial strength
3. Liquidity

Answer 19

> >

5. OBJECTIVE Compute and interpret financial ratios that measure profitability, operating results, and efficiency.

Ratio analysis is used to assess a company’s profitability, financial strength, and liquidity. Ratio analysis investigates a relationship between two items either as a ratio (2 to 1 or 2:1) or as a rate (percentage).

Financial ratios have three classifications:

1. Profitability, operating results, and efficiency
2. Financial strength
3. Liquidity

Question 20

Profitability is measured by net income. However, a dollar amount of net income is not a sufficient yardstick. Net income of $150,000 might be excellent for a small firm but unsatisfactory for a large corporation. A number of ratios are used to determine the adequacy of a company’s profit.

Answer 20

Profitability is measured by net income. However, a dollar amount of net income is not a sufficient yardstick. Net income of $150,000 might be excellent for a small firm but unsatisfactory for a large corporation. A number of ratios are used to determine the adequacy of a company’s profit.

Question 21

important!
Rate of Return on Sales:
The rate of return on sales measures what part of each sales dollar remains as net income. It measures operating efficiency and profitability.

Answer 21

important!
Rate of Return on Sales:
The rate of return on sales measures what part of each sales dollar remains as net income. It measures operating efficiency and profitability.

Question 22

Profitability Ratios:
RATE OF RETURN ON SALES:
The rate of return on sales is a measure of managerial efficiency and profitability. It is computed as follows:

Net Income / Net Sales = Rate of return on net sales

Answer 22

Profitability Ratios:
RATE OF RETURN ON SALES:
The rate of return on sales is a measure of managerial efficiency and profitability. It is computed as follows:

Net Income / Net Sales = Rate of return on net sales

Question 23

Some companies use income before taxes to calculate the percentage because income taxes depend on factors not related to sales. Special Products, Inc., uses net income after income taxes to calculate the rate.

Answer 23

Some companies use income before taxes to calculate the percentage because income taxes depend on factors not related to sales. Special Products, Inc., uses net income after income taxes to calculate the rate.

Question 24

Return on common stockholders’ equity: is a key measure of how well the corporation is making a profit for its shareholders. It is computed as follows:

Income available to common stockholders / Common stockholders’ equity = Return on Common stockholders’ equity

Answer 24

Return on common stockholders’ equity: is a key measure of how well the corporation is making a profit for its shareholders. It is computed as follows:

Income available to common stockholders / Common stockholders’ equity = Return on Common stockholders’ equity

Question 25

The increase in the 2013 rate of return on common stockholders’ equity is caused primarily by the increase in net income. As net income increases, you should expect this ratio to improve. As a common stock shareholder, you would want to monitor this ratio yearly.

Answer 25

The increase in the 2013 rate of return on common stockholders’ equity is caused primarily by the increase in net income. As net income increases, you should expect this ratio to improve. As a common stock shareholder, you would want to monitor this ratio yearly.

Question 26

Earnings per share of common stock measures the profit accruing to each share of common stock owned. It is computed as follows:
Income available to common stockholders / Average number of shares of common stock outstanding during year = Earnings per share

Answer 26

Earnings per share of common stock measures the profit accruing to each share of common stock owned. It is computed as follows:
Income available to common stockholders / Average number of shares of common stock outstanding during year = Earnings per share

Question 27

Analysts, stockholders, and creditors watch the earnings per share measurement very closely. Comparing earnings per share for the same company for several years could show a trend. Keep in mind that changes in the number of shares outstanding might distort this measurement.

Answer 27

Analysts, stockholders, and creditors watch the earnings per share measurement very closely. Comparing earnings per share for the same company for several years could show a trend. Keep in mind that changes in the number of shares outstanding might distort this measurement.

Question 28

important!
Price-Earnings Ratio:
The price-earnings ratio depends in large part on expectations of future profitability, which cause stock prices to increase or decrease.

Answer 28

important!
Price-Earnings Ratio:
The price-earnings ratio depends in large part on expectations of future profitability, which cause stock prices to increase or decrease.

Question 29

The price-earnings ratio: compares the market value of common stock with the earnings per share of that stock. It is computed as follows:

Market price per share / Earnings per share = Price-earnings ratio

If a corporation’s common stock sells for $144 per share and its earnings are $12 per share, the price-earnings ratio is 12 to 1 ($144 ÷ $12).

The price-earnings ratio is an indicator of the attractiveness of the stock as an investment at its present market value. The amount investors are willing to pay for stock is based on expectations for the future. The price-earnings ratio is not computed for privately held companies because there is no readily available market value for the shares.

Answer 29

The price-earnings ratio: compares the market value of common stock with the earnings per share of that stock. It is computed as follows:

Market price per share / Earnings per share = Price-earnings ratio

If a corporation’s common stock sells for $144 per share and its earnings are $12 per share, the price-earnings ratio is 12 to 1 ($144 ÷ $12).

The price-earnings ratio is an indicator of the attractiveness of the stock as an investment at its present market value. The amount investors are willing to pay for stock is based on expectations for the future. The price-earnings ratio is not computed for privately held companies because there is no readily available market value for the shares.

Question 30

YIELD ON COMMON STOCK:

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 follows:

Dividend per share / Market price per share = Yield on common stock

For example, if the price of a share of common stock is $60 and the corporation is paying an annual dividend of $6, the yield is 10 percent ($6 ÷ $60).

Answer 30

YIELD ON COMMON STOCK:

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 follows:

Dividend per share / Market price per share = Yield on common stock

For example, if the price of a share of common stock is $60 and the corporation is paying an annual dividend of $6, the yield is 10 percent ($6 ÷ $60).

Question 31

RATE OF RETURN ON TOTAL ASSETS

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. The rate is computed as follows:

Income before interest expense and income taxes / Total assets = Rate of return on total assets

Income before interest and taxes is used to measure how effectively management utilized the assets, regardless of how the assets were financed. If nonoperating revenue amounts (such as dividend and interest income) are large, they should not be included in income. This ensures that only income from normal business operations is considered. For Special Products, Inc., income is computed by adding interest expense to income before income taxes.

Answer 31

RATE OF RETURN ON TOTAL ASSETS

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. The rate is computed as follows:

Income before interest expense and income taxes / Total assets = Rate of return on total assets

Income before interest and taxes is used to measure how effectively management utilized the assets, regardless of how the assets were financed. If nonoperating revenue amounts (such as dividend and interest income) are large, they should not be included in income. This ensures that only income from normal business operations is considered. For Special Products, Inc., income is computed by adding interest expense to income before income taxes.

Question 32

important!
Asset Turnover:
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.

Answer 32

important!
Asset Turnover:
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.

Question 33

ASSET TURNOVER:
The ratio of net sales to total assets measures the effective use of assets in making sales. This ratio is usually called asset turnover. It is computed as follows:

Net Sales / Total Assets = Asset turnover

Assets that are not used in producing sales, primarily investments, are excluded. Assets may be measured as end-of-year totals, average of beginning and ending totals, or average of monthly totals. Special Products, Inc., uses net sales and total assets at the end of the year.

Answer 33

ASSET TURNOVER:
The ratio of net sales to total assets measures the effective use of assets in making sales. This ratio is usually called asset turnover. It is computed as follows:

Net Sales / Total Assets = Asset turnover

Assets that are not used in producing sales, primarily investments, are excluded. Assets may be measured as end-of-year totals, average of beginning and ending totals, or average of monthly totals. Special Products, Inc., uses net sales and total assets at the end of the year.

Question 34

The higher the asset turnover, the more effectively the assets of the company are being used. The trend of this ratio is important because it indicates whether asset growth is accompanied by corresponding sales growth. If sales increase proportionately more than total assets, the ratio increases, which is a favorable indicator.

Answer 34

The higher the asset turnover, the more effectively the assets of the company are being used. The trend of this ratio is important because it indicates whether asset growth is accompanied by corresponding sales growth. If sales increase proportionately more than total assets, the ratio increases, which is a favorable indicator.

Question 35

Financial Strength Ratios

NUMBER OF TIMES BOND INTEREST EARNED:
A corporation’s bondholders and stockholders want to know if net income is sufficient to cover the required bond interest payments. Times bond interest earned measures this. It is computed as follows:

Income before bond interest and income taxes / Bond interest cash requirement = Times bond interest earned

Answer 35

Financial Strength Ratios

NUMBER OF TIMES BOND INTEREST EARNED:
A corporation’s bondholders and stockholders want to know if net income is sufficient to cover the required bond interest payments. Times bond interest earned measures this. It is computed as follows:

Income before bond interest and income taxes / Bond interest cash requirement = Times bond interest earned

Question 36

Bond Premium:

The excess of the price paid over the face value of a bond is known as bond premium.

Answer 36

Bond Premium:

The excess of the price paid over the face value of a bond is known as bond premium.

Question 37

The sum of a corporation’s liabilities and stockholders’ equity is referred to as its total equities. The ratio of stockholders’ equity to total equities measures the portion of total capital provided by the stockholders. It indicates the protection afforded creditors against possible losses. The more capital provided by the stockholders, the greater the protection to creditors. The ratio of stockholders’ equity to total equities is computed as follows:

Stockholders’ Equity / Total Equity = Ratio of stockholders’ equities to total equities

Answer 37

The sum of a corporation’s liabilities and stockholders’ equity is referred to as its total equities. The ratio of stockholders’ equity to total equities measures the portion of total capital provided by the stockholders. It indicates the protection afforded creditors against possible losses. The more capital provided by the stockholders, the greater the protection to creditors. The ratio of stockholders’ equity to total equities is computed as follows:

Stockholders’ Equity / Total Equity = Ratio of stockholders’ equities to total equities

Question 38

The ratio of stockholders’ equity to total liabilities is known as the ratio of owned capital to borrowed capital. It is computed as follows:
Stockholders’ equity / Total liabilities = Ratio of stockholders’ equity to total liabilities

Answer 38

The ratio of stockholders’ equity to total liabilities is known as the ratio of owned capital to borrowed capital. It is computed as follows:
Stockholders’ equity / Total liabilities = Ratio of stockholders’ equity to total liabilities

Question 39

important!
Stockholders’ Equity:
A low ratio of stockholders’ equity to total liabilities can be risky. The corporation might not be able to make interest and principal payments on its debts.

Answer 39

important!
Stockholders’ Equity:
A low ratio of stockholders’ equity to total liabilities can be risky. The corporation might not be able to make interest and principal payments on its debts.

Question 40

In a Leveraged buyout, the purchasers of a business buy the stock, having the corporation agree to pay the sellers. The result is that the debt created by the purchase is a debt of the corporation. In many cases, the debt, usually with a high interest rate, makes up a large part of the total equities of the corporation. In the mid-1980s to early 1990s, many corporations went bankrupt because they could not meet the interest and principal payments on the debts. The balance sheets of these corporations would reflect a very low ratio of stockholders’ equity to total liabilities.

Answer 40

In a Leveraged buyout, the purchasers of a business buy the stock, having the corporation agree to pay the sellers. The result is that the debt created by the purchase is a debt of the corporation. In many cases, the debt, usually with a high interest rate, makes up a large part of the total equities of the corporation. In the mid-1980s to early 1990s, many corporations went bankrupt because they could not meet the interest and principal payments on the debts. The balance sheets of these corporations would reflect a very low ratio of stockholders’ equity to total liabilities.

Question 41

important!
Book Value per Share:
Book value and fair market value often are quite different. Book value per share does not indicate how much the stockholder would receive if the assets were sold and the corporation liquidated.

Answer 41

important!
Book Value per Share:
Book value and fair market value often are quite different. Book value per share does not indicate how much the stockholder would receive if the assets were sold and the corporation liquidated.

Question 42

BOOK VALUE PER SHARE OF STOCK:
Book value per share measures the financial strength underlying each share of stock. It is frequently reported in financial publications. It represents the amount that each share would receive in case of liquidation if the assets were sold for book value.

Answer 42

BOOK VALUE PER SHARE OF STOCK:
Book value per share measures the financial strength underlying each share of stock. It is frequently reported in financial publications. It represents the amount that each share would receive in case of liquidation if the assets were sold for book value.

Question 43

When there is one class of stock outstanding, the book value of each share is total stockholders’ equity divided by the number of shares outstanding. If more than one class of stock is outstanding, the rights of the various classes of stock are considered. The book value of preferred stock is computed first. Then the remaining balance of stockholders’ equity is divided by the number of common shares. Special treatment is given to dividends in arrears on cumulative preferred stock. In case of liquidation, the owner of a share of preferred stock will receive its par value. The Book value per share of common stock is computed as follow:

Common stockholders’ equity / Number of common shares = Book value per share of common stock

Answer 43

When there is one class of stock outstanding, the book value of each share is total stockholders’ equity divided by the number of shares outstanding. If more than one class of stock is outstanding, the rights of the various classes of stock are considered. The book value of preferred stock is computed first. Then the remaining balance of stockholders’ equity is divided by the number of common shares. Special treatment is given to dividends in arrears on cumulative preferred stock. In case of liquidation, the owner of a share of preferred stock will receive its par value. The Book value per share of common stock is computed as follow:

Common stockholders’ equity / Number of common shares = Book value per share of common stock

Question 44

Liquidity measures the ability of a business to pay its debts when due. Many businesses fail because they cannot pay their debts, even though they are profitable and have long-term financial strength.

Answer 44

Liquidity measures the ability of a business to pay its debts when due. Many businesses fail because they cannot pay their debts, even though they are profitable and have long-term financial strength.

Question 45

Working capital is a measure of the ability of a company to meet its current obligations. It represents the margin of security afforded short-term creditors. Working capital, sometimes called net working capital, is computed as follows:
Current assets - Current liabilities = Working capital

Answer 45

Working capital is a measure of the ability of a company to meet its current obligations. It represents the margin of security afforded short-term creditors. Working capital, sometimes called net working capital, is computed as follows:
Current assets - Current liabilities = Working capital

Question 46

The current ratio measures the ability of a business to pay its current debts using current assets. The current ratio is computed as follows:
Current assets / Current liabilities = Current ratio

Answer 46

The current ratio measures the ability of a business to pay its current debts using current assets. The current ratio is computed as follows:
Current assets / Current liabilities = Current ratio

Question 47

The current ratio varies widely among industries and even from company to company within an industry. A popular guideline is that a current ratio of at least 2 to 1 is desirable in retail and manufacturing businesses. This guideline is not applicable, however, to all businesses.

Answer 47

The current ratio varies widely among industries and even from company to company within an industry. A popular guideline is that a current ratio of at least 2 to 1 is desirable in retail and manufacturing businesses. This guideline is not applicable, however, to all businesses.

Question 48

Current Assets:

Assets are considered current if they will be converted to cash or used within one year.

Answer 48

Current Assets:

Assets are considered current if they will be converted to cash or used within one year.

Question 49

From the viewpoint of a short-term creditor, the higher the current ratio, the greater the amount of protection afforded. However, the current ratio can be too high. A very high current ratio indicates that excess current assets are on hand and are not earning income. A high current ratio could be caused by large sums of money tied up in accounts receivable that might be uncollectible. A high current ratio could also be caused by obsolete inventory or an inventory level higher than required to conduct normal operations.

Answer 49

From the viewpoint of a short-term creditor, the higher the current ratio, the greater the amount of protection afforded. However, the current ratio can be too high. A very high current ratio indicates that excess current assets are on hand and are not earning income. A high current ratio could be caused by large sums of money tied up in accounts receivable that might be uncollectible. A high current ratio could also be caused by obsolete inventory or an inventory level higher than required to conduct normal operations.

Question 50

The acid-test ratio is a measure of immediate liquidity; the ratio of quick assets to current liabilities measures immediate liquidity. This ratio uses quick assets Cash, receivables, and marketable securities.

Cash + Receivables + Marketable securities / Current liabilities = Acid-test ratio

Answer 50

The acid-test ratio is a measure of immediate liquidity; the ratio of quick assets to current liabilities measures immediate liquidity. This ratio uses quick assets Cash, receivables, and marketable securities.

Cash + Receivables + Marketable securities / Current liabilities = Acid-test ratio

Question 51

The acid-test ratio shows that in 2013, Special Products, Inc., had $2.86 of quick assets for each dollar of current liabilities. In 2012, the acid-test ratio was 1.75. This dramatic increase should be investigated.

Answer 51

The acid-test ratio shows that in 2013, Special Products, Inc., had $2.86 of quick assets for each dollar of current liabilities. In 2012, the acid-test ratio was 1.75. This dramatic increase should be investigated.

Question 52

Acid-test ratios vary widely from industry to industry. A general guideline is that the acid-test ratio should be at least 1 to 1. The due dates of current liabilities, composition of quick assets, and various operating factors are considered when evaluating the adequacy of the ratio. Comparisons with the industry average and with the company’s ratio in prior years can be helpful.

Answer 52

Acid-test ratios vary widely from industry to industry. A general guideline is that the acid-test ratio should be at least 1 to 1. The due dates of current liabilities, composition of quick assets, and various operating factors are considered when evaluating the adequacy of the ratio. Comparisons with the industry average and with the company’s ratio in prior years can be helpful.

Question 53

INVENTORY TURNOVER:
It is important that a business sell its inventory rapidly so that excess working capital is not tied up in merchandise. Inventory turnover measures the number of times the inventory is replaced during the period. The higher the turnover, the shorter the time between the purchase and sale of the inventory. Inventory turnover is computed as follows:

Cost of goods sold / Average inventory = Inventory turnover

Ideally, average inventory is computed using month-end balances. However, these amounts are not available to analysts outside the business. Therefore, year-end balances are often used, but they might not be typical of the inventory levels during the year. Inventory is often at its lowest level at year-end.

Answer 53

INVENTORY TURNOVER:
It is important that a business sell its inventory rapidly so that excess working capital is not tied up in merchandise. Inventory turnover measures the number of times the inventory is replaced during the period. The higher the turnover, the shorter the time between the purchase and sale of the inventory. Inventory turnover is computed as follows:

Cost of goods sold / Average inventory = Inventory turnover

Ideally, average inventory is computed using month-end balances. However, these amounts are not available to analysts outside the business. Therefore, year-end balances are often used, but they might not be typical of the inventory levels during the year. Inventory is often at its lowest level at year-end.

Question 54

important!
Inventory Turnover:
A high inventory turnover indicates tight control over the level of inventory on hand.

Answer 54

important!
Inventory Turnover:
A high inventory turnover indicates tight control over the level of inventory on hand.

Question 55

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. A business must compare its inventory turnover with prior years and with the industry average.

Answer 55

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. A business must compare its inventory turnover with prior years and with the industry average.

Question 56

accounts receivable turnover:
A measure of the speed with which sales on account are collected; the ratio of net credit sales to average receivables:

Net credit sales / Average receivables = Accounts receivable turnover

Answer 56

accounts receivable turnover:
A measure of the speed with which sales on account are collected; the ratio of net credit sales to average receivables:

Net credit sales / Average receivables = Accounts receivable turnover

Question 57

It is desirable to use monthly balances to compute the average receivables. However, since these amounts are not available to analysts outside the business, year-end balances are often used. Outside analysts normally use net sales since they cannot determine net credit sales. For Special Products, Inc., accounts receivable on January 1, 2012, were $71,500. Net credit sales were $2,700,000 in 2013 and $2,500,000 in 2012.

Answer 57

It is desirable to use monthly balances to compute the average receivables. However, since these amounts are not available to analysts outside the business, year-end balances are often used. Outside analysts normally use net sales since they cannot determine net credit sales. For Special Products, Inc., accounts receivable on January 1, 2012, were $71,500. Net credit sales were $2,700,000 in 2013 and $2,500,000 in 2012.

Question 58

The accounts receivable turnover can be used to determine the average collection period The ratio of 365 days to the accounts receivable turnover; also called the number of days’ sales in receivables of accounts receivable, or number of days’ sales in receivables. The average collection period is computed as follows:

365 days / Accounts Receivable turnover

Answer 58

The accounts receivable turnover can be used to determine the average collection period The ratio of 365 days to the accounts receivable turnover; also called the number of days’ sales in receivables of accounts receivable, or number of days’ sales in receivables. The average collection period is computed as follows:

365 days / Accounts Receivable turnover

Question 59

Managerial Implication:
INTERPRETING FINANCIAL STATEMENTS:

1. It is important that managers understand the relationships among the items on the financial statements. Understanding these relationships will help management run the business effectively.
2. Managers use statement analysis to identify areas of operations that are weak and need attention.
3. It is essential that management know how to compute and interpret financial ratios. For example, a low inventory turnover compared with the industry average might reflect obsolete goods, excess merchandise, poor purchasing procedures, or other operating inefficiencies.
4. Effective managers recognize the key role the accountant plays in financial statement analysis and interpretation. Accountants understand what each line on the financial statements represents and can assist management in analyzing and understanding accounting reports.

Answer 59

Managerial Implication:
INTERPRETING FINANCIAL STATEMENTS:

1. It is important that managers understand the relationships among the items on the financial statements. Understanding these relationships will help management run the business effectively.
2. Managers use statement analysis to identify areas of operations that are weak and need attention.
3. It is essential that management know how to compute and interpret financial ratios. For example, a low inventory turnover compared with the industry average might reflect obsolete goods, excess merchandise, poor purchasing procedures, or other operating inefficiencies.
4. Effective managers recognize the key role the accountant plays in financial statement analysis and interpretation. Accountants understand what each line on the financial statements represents and can assist management in analyzing and understanding accounting reports.

Question 60

Special Products, Inc., collected accounts receivable in 2013 in about 12 days and about 11 days in 2012. As a general rule, the average collection period should not exceed the net credit period plus one-third. The credit terms for customers of Special Products, Inc., are net 15 days. The collection period should be 20 days or less [15 + (1/3 × 15)]. For both years, the collection period for Special Products, Inc., is much less than the guideline.

Answer 60

Special Products, Inc., collected accounts receivable in 2013 in about 12 days and about 11 days in 2012. As a general rule, the average collection period should not exceed the net credit period plus one-third. The credit terms for customers of Special Products, Inc., are net 15 days. The collection period should be 20 days or less [15 + (1/3 × 15)]. For both years, the collection period for Special Products, Inc., is much less than the guideline.

Question 61

OTHER RATIOS:

The number of ratios that could be developed from financial statements is almost limitless. Analysts use their preferred ratios. Financial writers use many more ratios than those presented in this chapter. Depending on the industry, some ratios are more important than others. The ratios in this chapter are those most often used by accountants.

Answer 61

OTHER RATIOS:

The number of ratios that could be developed from financial statements is almost limitless. Analysts use their preferred ratios. Financial writers use many more ratios than those presented in this chapter. Depending on the industry, some ratios are more important than others. The ratios in this chapter are those most often used by accountants.

Question 62

SOME PRECAUTIONARY NOTES ON STATEMENT ANALYSIS:

There are limits to the benefits of financial statement analysis. Financial statements use book values. Book value depends on accounting procedures and policies. Different accounting policies and procedures make it difficult to compare financial results across companies. One firm, for example, might record a purchase as an asset and another firm could record it as an expense. Businesses also have many choices regarding depreciation methods, useful lives, and salvage value.

Another limitation of financial statement analysis is that financial statements are prepared assuming that the dollar is a stable monetary unit; this is far from correct. The amounts reported do not necessarily represent dollars with today’s purchasing power.

Finally, it is difficult to compare financial results of businesses that use different financing methods, classify expenses differently, have different policies for paying owner-employees, and operate as different types of business entities. Financial statement analysis is useful only if these limitations are clearly understood.

Answer 62

SOME PRECAUTIONARY NOTES ON STATEMENT ANALYSIS:

There are limits to the benefits of financial statement analysis. Financial statements use book values. Book value depends on accounting procedures and policies. Different accounting policies and procedures make it difficult to compare financial results across companies. One firm, for example, might record a purchase as an asset and another firm could record it as an expense. Businesses also have many choices regarding depreciation methods, useful lives, and salvage value.

Another limitation of financial statement analysis is that financial statements are prepared assuming that the dollar is a stable monetary unit; this is far from correct. The amounts reported do not necessarily represent dollars with today’s purchasing power.

Finally, it is difficult to compare financial results of businesses that use different financing methods, classify expenses differently, have different policies for paying owner-employees, and operate as different types of business entities. Financial statement analysis is useful only if these limitations are clearly understood.

Question 63

SOME PRECAUTIONARY NOTES ON STATEMENT ANALYSIS:

There are limits to the benefits of financial statement analysis. Financial statements use book values. Book value depends on accounting procedures and policies. Different accounting policies and procedures make it difficult to compare financial results across companies. One firm, for example, might record a purchase as an asset and another firm could record it as an expense. Businesses also have many choices regarding depreciation methods, useful lives, and salvage value.

Another limitation of financial statement analysis is that financial statements are prepared assuming that the dollar is a stable monetary unit; this is far from correct. The amounts reported do not necessarily represent dollars with today’s purchasing power.

Finally, it is difficult to compare financial results of businesses that use different financing methods, classify expenses differently, have different policies for paying owner-employees, and operate as different types of business entities. Financial statement analysis is useful only if these limitations are clearly understood.

Answer 63

SOME PRECAUTIONARY NOTES ON STATEMENT ANALYSIS:

There are limits to the benefits of financial statement analysis. Financial statements use book values. Book value depends on accounting procedures and policies. Different accounting policies and procedures make it difficult to compare financial results across companies. One firm, for example, might record a purchase as an asset and another firm could record it as an expense. Businesses also have many choices regarding depreciation methods, useful lives, and salvage value.

Another limitation of financial statement analysis is that financial statements are prepared assuming that the dollar is a stable monetary unit; this is far from correct. The amounts reported do not necessarily represent dollars with today’s purchasing power.

Finally, it is difficult to compare financial results of businesses that use different financing methods, classify expenses differently, have different policies for paying owner-employees, and operate as different types of business entities. Financial statement analysis is useful only if these limitations are clearly understood.

Question 64

Cost Basis Principle:
Accounts reflect historical costs, not current market values. This must be considered when analyzing financial statements. Book value rarely reflects fair market value.

Answer 64

Cost Basis Principle:
Accounts reflect historical costs, not current market values. This must be considered when analyzing financial statements. Book value rarely reflects fair market value.