Horngrens Financial and

Horngren's Financial and Managerial Accounting, The Financial Chapters Instructor's Solution Manual Tracie and Brenda Horngren's Financial & Managerial Accounting (The Financial Chapters) 8th Edition, Global Edition Miller-Nobles Tracie, Mattison Brenda,

Financial Chapters Arranged Reverse: 15-1 1 / 4

15-1 Chapter 15 Financial Statement Analysis

Review Questions

• What are the three main ways to analyze financial statements?

The three main ways to analyze financial statements are horizontal analysis, vertical analysis, and ratio analysis.

• What is an annual report? Briefly describe the key parts of the annual report.

An annual report (10-K) is a report required by the Securities and Exchange Commission that provides information about a company’s financial condition. The annual report includes the

following:

 An overview of the business  Management’s discussion and analysis of financial conditions and operations  The report of an independent registered public accounting firm  Financial statements  Notes to financial statements

• What is horizontal analysis, and how is a percentage change computed?

The horizontal analysis is the study of percentage changes in line items from comparative financial statements. The percentage change is calculated using this formula: (Dollar amount of change / Base period amount) × 100.

• What is trend analysis, and how does it differ from horizontal analysis?

The trend analysis is a form of horizontal analysis in which percentages are computed for line items by selecting a base period as 100% and expressing amounts for following periods as a percentage of the base period amount. (Any period amount / Base period amount) × 100.

• What is vertical analysis? What item is used as the base for the income statement? What item is used as the base for the balance sheet?

The vertical analysis of a financial statement shows the relationship of each line item to its base amount, which is the 100% figure. Every other item on the statement is then reported as a percentage of the base. For the income statement, net sales revenue is the base. For the balance sheet, total assets is the base.

• Describe a common-size statement and how it might be helpful in evaluating a company.

A common-size statement reports only percentages—the same percentages that appear in a vertical analysis. By only reporting percentages, it removes dollar value bias when comparing one company to another company.

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15-2

• What is benchmarking, and what are the two main types of benchmarks in financial statement

analysis?

Benchmarking is the practice of comparing a company’s performance with its prior performance or with best practices from other companies. The two main types of benchmarking in financial statement analysis are: benchmarking against a key competitor and benchmarking against the industry average.

• Briefly describe the ratios that can be used to evaluate a company’s ability to pay current liabilities.

The financial measures that are used to evaluate the ability of a company to pay its current liabilities are:

 Working capital: Current assets – Current liabilities

 Cash ratio: (Cash + Cash equivalents) / Total current liabilities

 Acid-Test (or Quick) ratio: (Cash + Short-term investments + Net current receivables) / Total current liabilities

 Current ratio: Current assets / Total current liabilities

• Briefly describe the ratios that can be used to evaluate a company’s ability to sell merchandise

inventory and collect receivables.

The ratios that are used to evaluate a company’s ability to sell merchandise inventory and collect receivables are:  Inventory turnover—measures the number of times a company sells its average level of merchandise inventory during a period. Cost of goods sold/ Average merchandise inventory. Days’ sales in inventory measures the average number of days merchandise inventory is held by

the company: 365 days / Inventory turnover

 Gross profit percentage measures the profitability of each net sales dollar above the cost of goods sold and is computed as: Gross profit / Net sales revenue. Accounts receivable turnover measures the number of times the company collects the average receivables balance in a year: Net credit sales / Average net accounts receivable. Days’ sales in receivables is also called the collection period. This ratio indicates how many days it takes to collect the average level of receivables: 365 days / Accounts receivable turnover.

• Briefly describe the ratios that can be used to evaluate a company’s ability to pay long-term debt.

The ratios that can be used to evaluate a company’s ability to pay long-term debt are:  Debt ratio—Shows the proportion of assets financed by debt: Total liabilities / Total assets. Debt to Equity ratio—Shows the proportion of total debt to equity: Total liabilities / Total equity. Times-Interest-Earned ratio—Evaluates the business’s ability to pay interest expense. It is calculated as: EBIT (Net income + Income tax expense + Interest expense) / interest expense.

• Briefly describe the ratios that can be used to evaluate a company’s profitability.

The ratios that can be used to evaluate a company’s profitability are:

 Profit margin ratio—Shows how much net income is earned on every dollar of sales: Net income / Net sales revenue.

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15-3  Rate of return on total assets—Measures the success a company has in using its assets to earn

income: (Net income + Interest expense) / Average total assets.

 Asset turnover ratio—Measures how efficiently a business uses its average total assets to

generate sales: Net sales revenue / Average total assets.

 Rate of return on common stockholder’s equity—Shows the relationship between net income available to common stockholders and their average common equity invested in the company: (Net income – Preferred dividends) / Average common stockholder’s equity. Earnings per share—Measures the amount of a company’s net income (loss) for each share of its outstanding common stock: (Net income – Preferred dividends) / Weighted average number of common shares outstanding.

• Briefly describe the ratios that can be used to evaluate a company’s stock as an investment.

The ratios that can be used to evaluate a company’s stock as an investment are:  Price / earnings ratio—The market price of a share of common stock in relation to the company’s earnings per share. It measures the value that the stock market places on $1 of a company’s earnings: Market price per share of common stock / Earnings per share. Dividend yield—The ratio of annual dividends per share of stock to the stock’s market price per share. It measures the percentage of a stock’s market value that is returned annually as dividends to stockholders: Annual dividend per share / Market price per share. Dividend payout—The ratio of dividends declared per common share relative to the earnings per

share of the company: Annual dividend per share / Earnings per share.

• What are some common red flags in financial statement analysis?

Some of the common red flags in financial statement analysis are:

 Unexpected or inconsistent movements among sales, merchandise inventory, and receivables  Earnings problems  Decreased cash flow  Too much debt  Inability to collect receivables  Buildup of merchandise inventory

Short Exercises

S-F:15-1

Explaining financial statements The three main tools to analyze financial statements are horizontal analysis, vertical analysis, and ratio analysis. Explain each method.

 A horizontal analysis provides a year-to-year comparison of a company’s performance in different periods. A vertical analysis provides a way to compare different companies...

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