1 of 52Visit UMT online at © South-Western 2004 Survey of Accounting, 2/eChapter 9, ACCT125 ACCOUNTING FUNDAMENTALS FOR MANAGERS University

1 of 52Visit UMT online at www.umtweb.edu© South-Western 2004Survey of Accounting, 2/e Chapter 9, ACCT125

ACCOUNTING ACCOUNTING FUNDAMENTALS FOR FUNDAMENTALS FOR

MANAGERSMANAGERS

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Visit UMT online at www.umtweb.edu 2 of 52Chapter 9, ACCT125

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3 of 52Visit UMT online at www.umtweb.edu© South-Western 2004Survey of Accounting, 2/e Chapter 9, ACCT125

Chapter 9Chapter 9

Financial Statement AnalysisFinancial Statement Analysis


After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

After studying this After studying this chapter, you should chapter, you should

be able to:be able to:

Learning ObjectivesLearning Objectives

1. Describe basic financial statement analytical procedures.

2. Apply financial statement analysis to assess the solvency of a business.

3. Apply financial statement analysis to assess the profitability of a business.

4. Summarize the uses and limitations of analytical measures.

5. Describe the contents of corporate annual reports.


1Describe basic financial statement analytical procedures.

Learning ObjectiveLearning Objective


Lincoln CompanyLincoln CompanyComparative Balance SheetComparative Balance SheetDecember 31, 2004 and 2003December 31, 2004 and 2003

AssetsCurrent assets $ 550,000 $ 533,000 $ 17,000 3.2%Long-term investments 95,000 177,500 (82,500) (46.5%)Fixed assets (net) 444,500 470,000 (25,500) (5.4%)Intangible assets 50,000 50,000 —

$1,139,500 $1,230,500 $ (91,000) (7.4%) LiabilitiesCurrent liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)Long-term liabilities 100,000 200,000 (100,000) (50.0%)

$ 310,000 $ 443,000 $(133,000) (30.0%) Stockholders’ EquityPreferred stock, $100 par $ 150,000 $ 150,000 — Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500 $42,000 30.5%

$ 829,500 $ 787,500 $42,000 5.3% $1,139,500 $1230,500 $(91,000) (7.4%)

Increase (Decrease)2004 2003 Amount Percent


Lincoln CompanyLincoln CompanyComparative Balance SheetComparative Balance SheetDecember 31, 2004 and 2003December 31, 2004 and 2003

AssetsCurrent assets $ 550,000 $ 533,000 $ 17,000 3.2%Long-term investments 95,000 177,500 (82,500) (46.5%)Fixed assets (net) 444,500 470,000 (25,500) (5.4%)Intangible assets 50,000 50,000 —

$1,139,500 $1,230,500 $ (91,000) (7.4%) LiabilitiesCurrent liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)Long-term liabilities 100,000 200,000 (100,000) (50.0%)

$ 310,000 $ 443,000 $(133,000) (30.0%) Stockholders’ EquityPreferred stock, $100 par $ 150,000 $ 150,000 — Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500 $42,000 30.5%

$ 829,500 $ 787,500 $42,000 5.3% $1,139,500 $1230,500 $(91,000) (7.4%)


Horizontal Analysis: Horizontal Analysis:

Current year (2004) $550,000Base year (2003) $533,000

= 103.2%

Increase amount $17,000Base year (2003) $533,000

= 3.2%


Lincoln CompanyLincoln CompanyComparative Income StatementComparative Income StatementDecember 31, 2004 and 2003December 31, 2004 and 2003

Sales $1,530,500 $1,234,000 $296,500 24.0%Sales returns 32,500 34,000 (1,500) (4.4%)Net sales $1,498,000 $1,200,000 $298,000) 24.8%Cost of goods sold 1,043,000 820,000 223,000 27.2% Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%Administrative expenses 104,000 97,400 6,600 6.8% Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7%Operating income $ 160,000 $ 135,600 $ 24,400 18.0%Other income 8,500 11,000 (2,500) (22.7%) $ 168,500 $ 146,600 $ 21,900 14.9%Other expense 6,000 12,000 (6,000) (50.0%)Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%Income tax 71,500 58,100 13,400 23.1%Net income $ 91,000 $ 76,500 $ 14,500 19.0%



Lincoln CompanyLincoln CompanyComparative Income StatementComparative Income StatementDecember 31, 2004 and 2003December 31, 2004 and 2003

Sales $1,530,500 $1,234,000 $296,500 24.0%Sales returns 32,500 34,000 (1,500) (4.4%)Net sales $1,498,000 $1,200,000 $298,000) 24.8%Cost of goods sold 1,043,000 820,000 223,000 27.2% Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%Administrative expenses 104,000 97,400 6,600 6.8% Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7%Operating income $ 160,000 $ 135,600 $ 24,400 18.0%Other income 8,500 11,000 (2,500) (22.7%) $ 168,500 $ 146,600 $ 21,900 14.9%Other expense 6,000 12,000 (6,000) (50.0%)Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%Income tax 71,500 58,100 13,400 23.1%Net income $ 91,000 $ 76,500 $ 14,500 19.0%


Horizontal Analysis: Horizontal Analysis:

Current year (2004) $1,498,000Base year (2003) $1,200,000

= 124.8%

Increase amount $298,000Base year (2003) $1,200,000

= 24.8%


Lincoln CompanyLincoln CompanyComparative Balance SheetsComparative Balance Sheets

AssetsCurrent assets $ 550,000 48.3% $ 533,000 43.3%Long-term investments 95,000 8.3 177,500 14.4Fixed assets (net) 444,500 39.0 470,000 38.2Intangible assets 50,000 4.4 50,000 4.1

$1,139,500 100.0% $1,230,500 100.0% LiabilitiesCurrent liabilities $ 210,000 18.4% $ 243,000 19.7%Long-term liabilities 100,000 8.8 200,000 16.3

$ 310,000 27.2% $ 443,000 36.0% Stockholders’ EquityPreferred stock, $100 par $ 150,000 13.2% $ 150,000 12.2% Common stock, $10 par 500,000 43.9 500,000 40.6Retained earnings 179,500 15.7 137,500 11.2

$ 829,500 72.8% $ 787,500 64.0% $1,139,500 100.0% $1230,500 100.0%

December 31, 2004 December 31, 2003 Amount Percent Amount Percent





$310,000 27.2% $ 443,000 36.0% Stockholders’ EquityPreferred stock, $100 par $ 150,000 13.2% $ 150,000 12.2% Common stock, $10 par 500,000 43.9 500,000 40.6Retained earnings 179,500 15.7 137,500 11.2

$829,500 72.8% $787,500 64.0% $1,139,500 100.0% $1230,500 100.0%

December 31, 2004 December 31, 2003 Amount Percent Amount Percent

Vertical Analysis: Vertical Analysis:

Current liabilities $210,000Total assets $1,139,500

= 18.4%





$310,000 27.2% $ 443,000 36.0% Stockholders’ EquityPreferred stock, $100 par $ 150,000 13.2% $ 150,000 12.2% Common stock, $10 par 500,000 43.9 500,000 40.6Retained earnings 179,500 15.7 137,500 11.2

$829,500 72.8% $787,500 64.0% $1,139,500 100.0% $1230,500 100.0%

December 31, 2004 December 31, 2003 Amount Percent Amount PercentCommon-Size StatementsCommon-Size Statements


2Apply financial statement analysis to assess the solvency of a business.



Solvency AnalysisSolvency Analysis

Solvency is the ability of a business to meet its financial obligations (debts) as they are due.

Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities.

This ability is normally assessed by examining balance sheet relationships.


Solvency Measures — The Short-Term CreditorSolvency Measures — The Short-Term Creditor

Current assets $550,000 $533,000Current liabilities 210,000 243,000

Working Capital and Current RatioWorking Capital and Current RatioWorking Capital and Current RatioWorking Capital and Current Ratio

2004 2003




Use: To indicate the ability to meet currently maturing obligations.


2004 2003Current assets $550,000 $533,000Current liabilities 210,000 243,000Working capitalWorking capital $340,000$340,000 $290,000$290,000



Current assets $550,000 $533,000Current liabilities 210,000 243,000Working capital $340,000 $290,000

Current ratioCurrent ratio 2.6 2.6 2.2 2.2




Divide current

assets by current

liabilities

Divide current

assets by current

liabilities

2004 2003



Quick assets:Cash $ 90,500 $ 64,700Marketable securities 75,000 60,000Accounts receivable (net) 115,000 120,000 Total $280,500 $244,700

Current liabilities $210,000 $243,000

Acid-Test RatioAcid-Test RatioAcid-Test RatioAcid-Test Ratio

2004 2003



Acid-Test RatioAcid-Test RatioAcid-Test RatioAcid-Test Ratio

Use: To indicate instant debt-paying ability.Use: To indicate instant debt-paying ability.

2004 2003Quick assets:

Cash $ 90,500 $ 64,700Marketable securities 75,000 60,000Accounts receivable (net) 115,000 120,000 Total $280,500 $244,700

Current liabilities $210,000 $243,000Acid-test ratioAcid-test ratio 1.3 1.3 1.0 1.0



Accounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable Turnover

Net sales on account $1,498,000 $1,200,000Accounts receivable (net):

Beginning of year $ 120,000 $ 140,000End of year 115,000 120,000Total $ 235,000 $ 260,000

Average $ 117,500 $ 130,000

2004 2003



Accounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable Turnover

Use: To assess the efficiency in collecting receivables and in the management of credit.


Net sales on account $1,498,000 $1,200,000Accounts receivable (net):


Average $ 117,500 $ 130,000

Accts. receivable turnoverAccts. receivable turnover 12.7 12.7 9.2 9.2

2004 2003



Number of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in Receivables



2004 2003Accounts receivable (net)

end of year $ 115,000 $ 120,000Net sales on account $1,498,000 $1,200,000Average daily sales on

on account (sales 365) $ 4,104 $ 3,288

Number of days’ sales in Number of days’ sales in

receivablesreceivables 28 28 36.5 36.5



Inventory TurnoverInventory TurnoverInventory TurnoverInventory Turnover

2004 2003Cost of goods sold $1,043,000 $ 820,000Inventories:


Average $ 273,500 $ 297,000



Inventory TurnoverInventory TurnoverInventory TurnoverInventory Turnover

Use: To assess the efficiency in the management of inventory.


2004 2003Cost of goods sold $1,043,000 $ 820,000Inventories:


Average $ 273,500 $ 297,000

Inventory turnoverInventory turnover 3.8 3.8 2.8 2.8



Number of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in Inventory



2004 2003Inventories, end of year $ 264,000 $283,000Cost of goods sold $1,043,000 $820,000Average daily cost of

goods sold (COGS 365) $ 2,858 $ 2,247

Number of days’ sales Number of days’ sales

in inventoryin inventory 92.4 92.4 125.9 125.9


Solvency Measures — The Long-Term CreditorSolvency Measures — The Long-Term Creditor

Ratio of Plant Assets to Long-Term LiabilitiesRatio of Plant Assets to Long-Term LiabilitiesRatio of Plant Assets to Long-Term LiabilitiesRatio of Plant Assets to Long-Term Liabilities

Fixed assets (net) $444,500 $470,000Long-term liabilities $100,000 $200,000

2004 2003



Use: To indicate the margin of safety to long-term creditors.

Use: To indicate the margin of safety to long-term creditors.

2004 2003

Fixed assets (net) $444,500 $470,000Long-term liabilities $100,000 $200,000

Ratio of fixed assets toRatio of fixed assets to

long-term liabilitieslong-term liabilities 4.4 4.4 2.4 2.4

Ratio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term Liabilities



Ratio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ Equity

2004 2003

Total liabilities $310,000 $443,000Total stockholders’ equity $829,500 $787,500



Ratio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ Equity

Use: To indicate the margin of safety to creditors.Use: To indicate the margin of safety to creditors.

2004 2003

Total liabilities $310,000 $443,000Total stockholders’ equity $829,500 $787,500Ratio of liabilities toRatio of liabilities to

stockholders’ equitystockholders’ equity 0.37 0.37 0.56 0.56



Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned

2004 2003

Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000



Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned

Use: To assess the risk to debtholders in terms of number of times interest charges were earned.

Use: To assess the risk to debtholders in terms of number of times interest charges were earned.

2004 2003

Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000

Number of times earnedNumber of times earned 4.0 4.0 4.2 4.2


3Apply financial

statement analysis to

assess the profitability

of a business.



Profitability AnalysisProfitability Analysis

Profitability is the ability of an entity to earn profits.

This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available.

Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet.


Profitability Measures — The Common StockholderProfitability Measures — The Common Stockholder

Ratio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to Assets

2004 2003Net sales $1,498,000 $1,200,000Total assets:

Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000

Average $1,048,750 $1,031,500 Excludes long-term investmentsExcludes long-term investments



Ratio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to Assets

Use: To assess the effectiveness of the use of assets.

Use: To assess the effectiveness of the use of assets.

2004 2003Net sales on account $1,498,000 $1,200,000Total assets:

Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000

Average $1,048,750 $1,031,500

Ratio of net sales to assetsRatio of net sales to assets 1.4 1.4 1.2 1.2



Rate Earned on Total AssetsRate Earned on Total AssetsRate Earned on Total AssetsRate Earned on Total Assets

2004 2003Net income $ 91,000 $ 76,500Plus interest expense 6,000 12,000

Total $ 97,000 $ 88,500Total assets:

Beginning of year $1,230,500 $1,187,500End of year 1,139,500 1,230,500Total $2,370,000 $2,418,000Average $1,185,000 $1,209,000



Rate Earned on Total AssetsRate Earned on Total AssetsRate Earned on Total AssetsRate Earned on Total Assets

Use: To assess the profitability of the assets.Use: To assess the profitability of the assets.

2004 2003Net income $ 91,000 $ 76,500Plus interest expense 6,000 12,000

Total $ 97,000 $ 88,500Total assets:

Beginning of year $1,230,500 $1,187,500End of year 1,139,500 1,230,500Total $2,370,000 $2,418,000Average $1,185,000 $1,209,000

Rate earned on total assetsRate earned on total assets 8.2% 8.2% 7.3% 7.3%



Rate Earned on Stockholders’ EquityRate Earned on Stockholders’ EquityRate Earned on Stockholders’ EquityRate Earned on Stockholders’ Equity

2004 2003Net income $ 91,000 $ 76,500Stockholders’ equity:

Beginning of year $ 787,500 $ 750,000End of year 829,500 787,500Total $1,617,000 $1,537,500Average $ 808,500 $ 768,750



Rate Earned on Stockholders’ EquityRate Earned on Stockholders’ EquityRate Earned on Stockholders’ EquityRate Earned on Stockholders’ Equity

Use: To assess the profitability of the investment by stockholders.

Use: To assess the profitability of the investment by stockholders.

Net income $ 91,000 $ 76,500Stockholders’ equity:


Rate earned on equityRate earned on equity 11.3% 11.3% 10.0% 10.0%

2004 2003



Rate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ Equity

2004 2003Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Remainder—common stock $ 82,000 $ 67,500Common stockholders’ equity:




Rate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ Equity

Use: To assess the profitability of the investment by common stockholders.


2004 2003Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Remainder—common stock $ 82,000$ 82,000 $ 67,500$ 67,500Common stockholders’ equity:

Beginning of year $ 637,500 $ 600,000End of year 679,500 637,500Total $1,317,000 $1,237,500Average $ 658,500$ 658,500 $ 618,750$ 618,750

Rate earned on common equityRate earned on common equity 12.5% 12.5% 10.9% 10.9%



Earnings Per Share on Common StockEarnings Per Share on Common StockEarnings Per Share on Common StockEarnings Per Share on Common Stock

2004 2003Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Remainder—common stock $ 82,000 $ 67,500Shares of common stock 50,000 50,000



Earnings Per Share on Common StockEarnings Per Share on Common StockEarnings Per Share on Common StockEarnings Per Share on Common Stock

2004 2003Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Remainder—common stock $ 82,000 $ 67,500Shares of common stock 50,000 50,000

Earnings per share on commonEarnings per share on common $1.64 $1.64 $1.35 $1.35





Price-Earnings RatioPrice-Earnings RatioPrice-Earnings RatioPrice-Earnings Ratio

2004 2003Market price per share of common $20.50 $13.50Earnings per share on common $ 1.64 $ 1.35



Price-Earnings RatioPrice-Earnings RatioPrice-Earnings RatioPrice-Earnings Ratio

Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings.

Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings.

2004 2003Market price per share of common $20.50 $13.50Earnings per share on common $ 1.64 $ 1.35

Price-earnings ratio on commonPrice-earnings ratio on common 12.5 12.5 10.0 10.0



Dividend YieldDividend YieldDividend YieldDividend Yield

2004 2003Dividends per share of common $ 0.80 $ 0.60Market price per share of common $20.50 $13.50


4Summarize the uses

and limitations of

analytical measures.



Solvency measuresSolvency measuresSolvency measuresSolvency measures

Working Capital

Current ratio

Acid-test ratio

Accounts receivable turnover

Number of days’ sales in receivables

Inventory turnover

Number of days’ sales in inventory

Ratio of fixed assets to long-term liabilities

Ratio of liabilities to stockholders’ equity

Number of times interest charges earned

Summary of Analytical MeasuresSummary of Analytical Measures


Profitability measuresProfitability measuresProfitability measuresProfitability measures

Ratio of net sales to assets

Rate earned on total assets

Rate earned on stockholders’ equity

Rate earned on common stockholders’ equity

Earnings per share on common stock

Price earnings ratio

Dividends per share of common stock

Dividend yield

Summary of Analytical MeasuresSummary of Analytical Measures


5Describe the contents

of corporate annual

reports.




Dividend YieldDividend YieldDividend YieldDividend Yield

Use: To indicate the rate of return to common stockholders in terms of dividends.

Use: To indicate the rate of return to common stockholders in terms of dividends.

2004 2003Dividends per share of common $ 0.80 $ 0.60Market price per share of common $41.00 $27.00

Dividend yield on common stockDividend yield on common stock 1.95%1.95% 2.23%2.23%


Corporate Annual ReportsCorporate Annual Reports

1. Financial Highlights2. President’s Letter to the Stockholders3. Management Report4. Independent Auditors’ Report5. Historical Summary

In addition to financial statements, the annual report includes:

Documents

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