Accounting for Engineers Chapter 15

Business Overview

Discusses the industry the company is in, its growth strategy, and an overview of the company's brands. It also often discusses the company's competitors and the risks related to the company's business.

Horizontal Analysis vs Trend Analysis

Horizontal analysis allows a company to see the percentage change from one year to the next. Trend analysis shows the percentage change from a base year forward to determine whether the trend in net sales revenue, for example, is positive or negative over a longer period of time.

Report of Independent Registered Public Accounting Firm (Auditor's Report)

The audit report attests to the fairness of the presentation of the financial statements and states whether the financial statements are presented in accordance with Generally Accepted Accounting Principles (GAAP). This report is prepared by an independent external auditor who has performed an audit on the financial statements. In addition, the external auditor is responsible for assessing the effectiveness of the company's internal controls. Most audit reports have unqualified opinions, which means that the financial statements are presented fairly, in all material respects. A qualified opinion might be issued if the financial statements include a departure from GAAP. If the auditor finds that the financial statements are not represented fairly, an adverse opinion would be given. Decisions

Management's Discussion and Analysis of Financial Condition and Results of Operations

This section of the annual report is intended to help investors understand the results of operations and the financial condition of the company. It is important to realize that this section is written by the company and could present a biased view of the company's financial condition and results. This section of the report is the company's attempt to explain its financial statements and to discuss its performance. The MD&A section is of interest to investors, though, because it often contains information that is not found in the financial data. Such information might include how a company is planning to spend its cash during the next year for property, plant, and equipment or whether significant changes are expected to occur that would cause revenue or expenses to increase or decrease in the future. This section often provides forward-looking information that can be useful to investors who are trying to estimate what future earnings will be for the company.

Horizontal Analysis

compares the change in each financial statement item from one year to the next. Computing a percentage change in comparative statements requires two steps: ompute the dollar amount of the change in a line item from the earlier period to the later period. Divide the dollar amount of change by the earlier period amount, and multiply by 100. We call the earlier period the base period.

Cash Ratio

helps to determine a company's ability to meet its short-term obligations and is calculated as cash plus cash equivalents divided by total current liabilities. Notice that the cash ratio includes cash and cash equivalents. As a reminder, cash equivalents are highly liquid investments that can be converted into cash in three months or less. Examples of cash equivalents are money-market accounts and investments in U.S. government securities. This ratio is the most conservative valuation of liquidity because it looks at only cash and cash equivalents, leaving out other current assets such as merchandise inventory and accounts receivable. Having a cash ratio below 1.0 is a good thing. A cash ratio above 1.0 might signify that the company has an unnecessarily large amount of cash supply. This cash could be used to generate higher profits or be distributed as dividends to stockholders. However, a very low ratio doesn't send a strong message to investors and creditors that the company has the ability to repay its short-term debt.

Trend Analysis

is a form of horizontal analysis. Trend percentages indicate the direction a business is taking. For example, how have sales changed over a five-year period? What trend does net income show? These questions can be answered by trend analysis over a period, such as three to five years. Trend analysis percentages are computed by selecting a base period (for example, the earliest year). The base period amounts are set equal to 100%. The amounts for each subsequent year are expressed as a percentage of the base amount. To compute trend analysis percentages, we divide each item for the following years by the base period amount and multiply by 100.

Dollar value bias

is the bias one sees from comparing numbers in absolute (dollars) rather than relative (percentage) terms. For us, $1 million seems like a large number. For some large companies, it is immaterial.

Benchmarking

is the practice of comparing a company's performance with best practices from other companies. It often uses the common-size percentages in a graphical manner to highlight differences. There are two main types of benchmarks in financial statement analysis: benchmarking against a key competitor and benchmarking against the industry average.

Working Capital

measures the ability to meet short-term obligations with current assets. defined as current assets minus current liabilites

Vertical Analysis

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

Annual Report

provides information about a company's financial condition. These reports help investors make informed investment decisions. Consists of a business overview, management's discussion and analysis of financial condition and results of operations, report of independent registered public accounting firm, 4 basic financial statements, notes to financial statements

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.

Acid-Test or Quick Ratio

tells us whether a company could pay all its current liabilities if they came due immediately. we add cash and cash equivalents, short-term investments (those that may be sold in the next 12 months or the business operating cycle, whichever is longer), and net current receivables (accounts receivable and notes receivable, net of allowances) and divide this sum by total current liabilities. Merchandise inventory and prepaid expenses are not included in the acid-test ratio because they are the least-liquid current assets.