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Spiceland | Thomas | Herrmann
Financial Accounting
Financial
Statement
Analysis
Chapter 12
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objectives
• Perform vertical analysis
• Perform horizontal analysis
• Use ratios to analyze a company’s risk
• Use ratios to analyze a company’s profitability
• Distinguish persistent earnings from one-time
items
• Explain quality of earnings and distinguish
between conservative and aggressive accounting
practices
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Part A
Comparison of Financial Accounting Information
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Illustration 12.1—Three Types of
Comparisons
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Learning Objective 1
Perform vertical analysis
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Vertical Analysis
• Express each item in a financial statement as a
percentage of the same base amount
• Income statement items expressed as a
percentage of sales
• Balance sheet items expressed as a percentage
of assets
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Illustration 12.2—Common-Size
Income Statements
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Illustration 12.2—Common-Size
Balance Sheets
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Learning Objective 2
Perform horizontal analysis
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Horizontal Analysis
• Analyze trends in financial statement data for a
single company over time
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Illustration 12.4—Horizontal Analysis
of the Income Statement
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Illustration 12.5—Horizontal Analysis
of the Balance Sheet
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Part B
Using Ratios to Assess Risk and Profitability
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Learning Objective 3
Use ratios to analyze a company’s risk
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Illustration 12.7—Risk Ratios
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Receivables Turnover Ratio
• Measures how many times receivables are
collected during the year
• Low ratio indicates trouble collecting its accounts
receivable
• High ratio indicates quick collection of receivables
into cash
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Average Collection Period
• Days it takes to convert receivables into cash
• Shorter collection period is better
12-17
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Inventory Turnover Ratio
• Measures how many times average inventory is
sold during the year
• High ratio indicates that inventory is selling quickly
• Extremely high ratio might indicate lost sales due
to inventory shortages
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Average Days in Inventory
• Days it takes to sell inventory
• Lower is better
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Current Ratio
• Compares current assets to current liabilities
• High ratio indicates sufficient assets to cover
current liabilities
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Acid-Test Ratio
• More conservative measure of ability to pay
current liabilities
• Ignores current assets such as inventories and
prepaid expenses
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Debt to Equity Ratio
• Indicates the risk of bankruptcy
• Higher ratio indicates higher risk
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Times Interest Earned Ratio
• Compare interest payments with income available
to pay them
• Associated with long-term liabilities
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Learning Objective 4
Use ratios to analyze a company’s profitability
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Illustration 12.16—Profitability
Ratios
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Gross Profit Ratio
• Indicates the portion of each dollar of sales above
its cost of goods sold
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Return on Assets
• Measures the income the company earns on each
dollar invested in assets
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Profit Margin
• Measures the income earned on each dollar of
sales
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Asset Turnover
• Measures sales volume in relation to the
investment in assets
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Return on Equity
• Measures the income earned for each dollar in
stockholders’ equity
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Price-Earnings Ratio
• Compares a company’s share price with its
earnings per share
• Indication of investors’ expectations of future
earnings
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Part C
Earnings Persistence and Earnings Quality
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Learning Objective 5
Distinguish persistent earnings from one-time items
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Earnings Persistence and One-Time
Income Items
Earnings
Persistence
Current earnings that
will continue or persist
into future years
One-Time
Income Items
Certain items are part
of net income in the
current year but are not
expected to persist
Discontinued
operationsExtraordinary
items
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Discontinued Operations
• Sale or disposal of a significant component of a
company’s operations
• Any gains or losses on discontinued operations in
the current year are reported separately
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Illustration 12.24—Presentation of
a Discontinued Operation
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Extraordinary Items
• Gains or losses that do not reflect normal
operations and that are not likely to happen again
• Event that produces a gain or loss must meet two
conditions:
• Unusual in nature
• Infrequent in occurrence
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Illustration 12.25—Presentation of
an Extraordinary Item
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Illustration 12.26—Comparison of
Extraordinary Items with Other Revenues and
Expenses
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Learning Objective 6
Explain quality of earnings and distinguish between
conservative and aggressive accounting practices
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Quality of Earnings
• Ability of reported earnings to reflect true earnings
• Usefulness of reported earnings to predict future
earnings
Result in
reporting lower
income, lower
assets, and
higher liabilities
Result in
reporting higher
income, higher
assets, and
lower liabilities
Conservative
Accounting Practices
Aggressive
Accounting Practices
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Illustration 12.27—Financial
Statements Prepared by Mr. Nadal
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Illustration 12.27—(continued)
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Mr. Djokovic's Proposed Changes
• Decrease estimate of bad debts
• Reverse write-down of inventory
• Increase asset’s useful life changing depreciation
estimate
• Remove loss contingency
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Illustration 12.29—Income
Statement Revised by Mr. Djokovic
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Illustration 12.30—Balance Sheet
Revised by Mr. Djokovic
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Illustration 12.31—Statement of
Cash Flows Revised by Mr. Djokovic
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Symbolism Revealed
• Mr. Nadal represents conservative accounting
practices
• Mr. Djokovic represents aggressive accounting
practices
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End of Chapter 12
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