CHAPTER 12 STUDY GUIDE

Preparing a Horizontal Analysis

(Current year account balance ‒ Previous year account balance) / Previous year account balance -Horizontal analysis is an approach that takes into consideration the changes in account balances over time. Requires financial statements for at least two years. Percentage changes are calculated which express the dollar change relative to the previous year's balance.

Preparing the Common-Size Balance Sheet

(Individual Asset, Liability, or Equity Account Balance) / Total Assets --Common-size statements or vertical analysis helps users examine changes in the relative size of account balances within a single statement. All account balances are expressed as a percentage of total assets.

Preparing the Common-Size Income Statement

(Individual Revenue or Expense Account Balance) / Net Sales -- All revenue and expense accounts are expressed as a percentage of net sales revenue.

Limitations of Financial Statement Analysis

1. Investors and analysts should a. Be very reserved about reading too much into ratios b. Be very careful to consider comparable industry information 2. The choice of accounting policies must be considered when comparing two or more companies. 3. A single ratio for a single year is not a sufficient indicator of a company's financial health.

Industry Statistics

1. Many organizations keep statistics on industry information. a. U.S. government—the U.S. Census Bureau b. Professional research and consulting organizations c. Investment firm analysts 2. Important understandings about companies to enhance financial analysis a. Understanding a company's competitive environment b. Understanding the size of a potential market c. Understanding who a company's competitors are

Interpreting Leverage Ratios

1. Multiple leverage ratios must be evaluated rather than using any one ratio by itself. 2. Creditors prefer to see lower debt ratios as they indicate a lower level of risk. 3. Some debt may not be reported on the balance sheet such as financing arrangements, leases, and purchase commitments.

Interpreting Profitability Ratios

1. Profitability ratios evaluate a company at its most important level: how well it generates profit. 2. If the return on common stockholders' equity is higher than the return on assets, the company has positive financial leverage.

Published Industry Ratio Analysis

1. Several published sources offer ratio analyses of particular industries. a. Risk Management Association b. Dun & Bradstreet 2. The Standard Industrial Classification (SIC) and the North American Industry Classification System (NAICS) codes categorize industry information.

Interpreting Liquidity Ratios

1. The quality of assets is assessed through the turnover ratios. 2. Factoring results when a company sells its receivables for quicker access to cash which increases liquidity. 3. The average collection period should be compared to the company's credit policy. 4. Higher inventory turnover and higher accounts receivable turnover rates are preferable in most cases.

Use the information in question 3. Suppose cash from operations was used to buy a company's own stock during the year. What result would appear in the common-size statements? A. Cash would decrease as a percentage of total assets, and equity would decrease for the cost of the treasury stock. B. Long-term debt as a percentage of total debt and equity would increase and equity would decrease. C. Cash would decrease as part of total assets and equity would increase as a percentage of total debt and equity. D. No changes would occur.

A. Cash would decrease as a percentage of total assets, and equity would decrease for the cost of the treasury stock. -- Treasury stock increases when a company buys its own stock. Since treasury stock is a contra account, this increase will cause total equity to decrease. Cash would also decline due to payment to acquire the stock, causing total assets to decline as well.

Susan Ellis is a successful banker for Third Ninth Bank. She is analyzing a current client that has had some issues with inventory management in the past. What is the most relevant ratio for Susan to use to analyze this problem? A. Inventory turnover B. Average sales period C. Return on assets D. Inventory elimination ratio

A. Inventory turnover -- Inventory turnover ratios are the principal way to determine the effectiveness of inventory management.

Bill's Landscaping Services experienced a banner sales year during 2012. Sales have increased by 20% and gross margin has increased by 10% from the prior year. Bill's CPA has some concerns about Bill's results that are best stated in which of the following responses? A. It appears that Bill has largely been contracting work that is less profitable than in the past. B. Bill's Landscaping Services has performed well with these changes. C. A gross margin decrease is to be expected with a sales increase. D. Landscaping services should not have significant increases between years.

A. It appears that Bill has largely been contracting work that is less profitable than in the past. -- Bill's CPA has a valid concern that in the long-term, this could significantly begin to impact Bill's business. Gross margin trends are usually important to external parties such as banks and external investors.

Frank Farmer is evaluating his company's June financial statements. Payroll expense increased from 4% to 5% of total expenses, while wages and salaries expense increased from 15% to 17% during June. What would not cause this change? A. Some employees were laid off during the month of June. B. Employees were hired in June. C. Several employees received raises at the beginning of June. D. Several employees received bonuses during June.

A. Some employees were laid off during the month of June. -- All changes except for answer choice A will cause payroll expense to go up because payroll expense is based on the amount of wages and salaries. When more wages and salaries expenses are incurred, payroll taxes are expected to increase as well.

(USE STARTING INFO) Accounts receivable turnover -- a measure of the liquidity of a company's accounts receivable. It measures how many times, on average, a company's receivables balance is collected during the year.

Accounts receivable turnover = Net credit sales/Average accounts receivable balance 17.3 = $650,000 / ($35,000 + $40,000)/2

(USE STARTING INFO) Acid-test (quick) ratio -- a more stringent measure of liquidity than the current ratio. It excludes inventory and prepaid expenses because they do not quickly convert into cash.

Acid-test ratio = Cash + Cash equivalents + Accounts receivable 0.80 = $3,900 + $40,000

(USE STARTING INFO) Average collection period -- reveals how many days, on average, the company takes to collect cash from a credit sale.

Average collection period = 365 Days in a year/Accounts receivable turnover 21.1 = 365/17.3

Rhonda Billings was using trend analysis for her financial statements for her general store. If the base year (2011) was $200,000 in sales and the current year (2013) sales were $250,000, what result would the trend analysis display for this change? A. 25% B. 125% C. 100% D. 80%

B. 125% -- Using trend analysis with 2011 as a base year, the result would be 125% = ($250,000 ÷ $200,000).

Bill Zane is a star analyst for Silverman Bank. He is reviewing earnings per share for two different entertainment companies. Which of the following is a crucial step that Bill should perform in this analysis? A. Ensure that the shares outstanding are from the end of year only B. Be sure to deduct preferred stock dividends from net income in the numerator C. Make sure the company has enough operating cash flow D. Deduct interest expense from debt

B. Be sure to deduct preferred stock dividends from net income in the numerator -- Bill must deduct preferred dividends from net income to arrive at the correct amount of earnings per share because EPS represents the amount of profit the company has earned for each share of common stock outstanding.

Use the information from the previous question, one of the entertainment companies has a 0.75 current ratio and a 40% gross margin (company A). The other company (company b) has a 1.25 current ratio and a 30% gross margin. Which company is more liquid and why? A. Company A, since it has a higher gross margin B. Company B, since it has a higher current ratio C. Company A, since it has a lower current ratio D. Company B, since it has a lower gross margin

B. Company B, since it has a higher current ratio -- Larger current ratios are better because high ratios point to greater liquidity. A current ratio of less than 1.0 should give rise to liquidity issues. The company has only 75% of the current assets needed to pay it current debts on time. Gross margin measures profitability, not liquidity.

Ben Storm is focused on his new job as accounts receivable manager for a large corporation. He is asked to evaluate accounts receivable. Ben determined that the company's accounts receivable turnover ratio is 8.4 times compared to 11.4 times for the industry. Which of the following is a valid diagnosis to the problem? A. Not enough customers purchased on account B. The company is not collecting amounts due as quickly as other companies in the industry. C. The company is not granting credit freely enough. D. The company is not aggressive enough in recording bad debt expense.

B. The company is not collecting amounts due as quickly as other companies in the industry. -- Certain customers are likely causing the turnover number to be low. Those customers should be identified and given more restrictive credit or possibly no credit at all. Lower turnover amounts indicate collections have slowed.

Use the information in question 1. Jim noticed that prepaid expenses increased by 5% and cash declined by 1%. What is one possible explanation for this change? A. A vendor issued a debit memo for damaged inventory. B. A large write off of accounts receivable was recorded. C. An annual insurance policy was paid in advance. D. A line of credit was utilized.

C. An annual insurance policy was paid in advance. -- An insurance policy paid in advance creates a prepaid expense while the cash payment causes cash to decrease.

Rodeo Star Company is a public company in the agriculture business. The CFO has been studying the dividend payout ratio for the last couple of years. For the current year, the company is expecting to pay dividends of 10 cents per share with an earnings per share of $1.50. Net income is $33,900 for the year. If Rodeo Star's Board of Directors does not want to exceed 7%, is the dividend payout in excess of their mandate? A. No, the result is only 3% and within compliance. B. Yes, the result is at 10% and outside compliance. C. No, the result is only 6.7% and within compliance. D. No, the result is less than 1% and within compliance.

C. No, the result is only 6.7% and within compliance. -- The dividend payout ratio is the dividend payment for the current year divided by earnings per share: $0.10 ÷ $1.50 = 6.67%, which is less than the mandate of 7%.

Jim Barber is reviewing common-size financial statements for his business, Dog Kennels International. During the year, equity increased and debt decreased as a percentage of total debt and equity. What could be a viable explanation for this change? A. The business took out a loan with the local bank. B. The business generated less cash from operations. C. The business paid off a loan with cash it obtained from issuing stock. D. The business defaulted on a loan.

C. The business paid off a loan with cash it obtained from issuing stock. -- A decrease in debt is caused by the company paying off some obligations. An increase in equity is caused by an issuance of stock or generating significant net income for the period. Generating cash from operations does not always mean the company earned significant net income.

Which one of the following is the least important in the process of understanding companies as part of enhancing financial analysis? A. Understanding a company's competitive environment B. Understanding the size of a potential market C. Understanding the number of employees working for a company D. Understanding who a company's competitors are

C. Understanding the number of employees working for a company -- The number of employees provides very little insight into evaluating a company.

(USE STARTING INFO) Current ratio -- the most common measure of short-term liquidity. It measures a company's ability to pay current debts as they become due.

Current ratio = Current assets/Current liabilities 3.10 = $170,010/$54,900

Preparing a Trend Analysis

Current year account balance / Base year account balance -- Trend analysis is a type of horizontal analysis that takes each year's account balance expressed as a percentage of the base year's percentage. Base year is usually the earliest year in the analysis. Uses of trend analysis are analyze information reported in corporate annual reports and compare changes in related accounts.

Jim Walker is using horizontal analysis for his company, Walker's Pet Supplies. When comparing July to August, cash is up 10% and accounts receivable is down 10%. What is the most likely reason for this change? A. Accrued payroll was paid to employees. B. The company issued stock. C. A vendor was paid for a service performed in July. D. A customer with a large account balance made a payment.

D. A customer with a large account balance made a payment. -- With cash increasing and accounts receivable decreasing, the most likely cause is from a large payment from a customer.

Alfred Baker is interpreting a set of comparative financial statements furnished to him by his CPA for 2010 and 2011. He notices that accounts receivable as a percent of total assets has decreased from 15% to 9%, while bad debt expense has increased as a percentage of total revenue from 3% to 8%. What concern should Alfred have about this trend? A. Alfred should be concerned that bad debt expense may be too small since it is only 8% of revenue, while receivables are 9% of total assets. B. Alfred should be concerned that accounts receivable may become too small to maintain liquidity. C. Alfred should not be concerned because accounts receivable appears on a different financial statement than bad debt expense. D. Alfred should be concerned of why the decrease in accounts receivable and the amount of bad debt expense moved in opposite directions.

D. Alfred should be concerned of why the decrease in accounts receivable and the amount of bad debt expense moved in opposite directions. -- Bad debt expense should largely be driven by the increase of the accounts receivable balance in terms of accruing for uncollectible accounts. Bad debt expense should likely increase when accounts receivable increases because when customers owe larger balances, it is likely that more of this amount will not be collectible.

The NAICS codes were a joint product of the United States, Canada, and Mexico to A. Replace data generated by the U.S. Census Bureau. B. Classify companies based on liquidity. C. Classify companies based on profitability. D. Provide information on ratio analysis based on industry.

D. Provide information on ratio analysis based on industry. -- The consortium was developed to provide average ratios by industry for comparison purposes.

Jerry Tines wants to assess how management uses assets for use in the business. On what ratio should Jerry focus? A. Return on common stockholder's equity B. Price/earnings ratio C. Gross margin percentage D. Return on assets

D. Return on assets -- Return on assets measures how well assets have been employed in conducting business.

(USE STARTING INFO) Debt ratio -- measures the proportion of assets financed through debt

Debt ratio = Total liabilities/Total assets 0.35 = $149,900/$426,010

(USE STARTING INFO) Debt-to-equity ratio -- measures the amount of financing provided by creditors (debt) relative to the amount provided by owners (equity).

Debt-to-equity ratio = Total liabilities/Total stockholders' equity 0.54 = $149,900/$276,110

(USE STARTING INFO) Dividend payout ratio -- measures how much of earnings per share is returned to common stockholders in the form of dividends.

Dividend payout ratio = Dividends per share/Earnings per Share 32.5% = $0.80/$2.46

(USE STARTING INFO) Earnings per share -- represents how much of a company's current net income was earned for each share of common stock held by an investor.

Earnings per share = Net income ‒ preferred dividends/Average number of shares outstanding $2.46 = $123,110/50,000

(T/F) If all else remains constant, a 10% drop in gross margin will lead to a 10% increase in net income.

F -- Both gross margin and net income are profit amounts. When no other changes exist, any change in net income will follow the change in gross margin.

(T/F) Profitability ratios focus on being able to pay bills as they come due.

F -- Liquidity ratios focus on the ability of a company to pay obligations as they come due.

(T/F) SIC codes or NAICS codes capture all businesses that exist in the United States today.

F -- SIC codes or NAICS codes have limitations in that certain businesses are too diversified to be classified.

(T/F) Times interest earned focuses on ensuring a company can make interest payments out of its current year's sales.

F -- Times interest earned focuses on earnings before interest and taxes (cash flow) versus sales in terms of the ability to make interest payments.

(T/F) Trend analysis is the process of using one numerator for a base year and trending that over several years.

F -- Trend analysis uses a base year as the denominator over multiple years, not a numerator.

Leverage Ratios

Financial leverage refers to the use of borrowed capital to finance a business or project. High levels of debt pose a risk for companies.

(USE STARTING INFO) Gross margin percentage -- shows how much of each sales dollar is available to cover operating expenses and provide a profit after the cost of goods sold has been covered.

Gross margin percentage = Gross margin/Net sales revenue 49.2% = $320,000/$650,000

Interpreting a Horizontal Analysis

Interpreting the results is a key component of performing horizontal analysis. Large percentage changes should be questioned.

Interpreting the Common-Size Financial Statements

Managers must consider the fact that if a company grows, its account balances will also.

(USE STARTING INFO) Price/earnings ratio -- indicates what multiple of current earnings investors are willing to pay for a share of stock.

Price/earnings ratio = Market price per share/Earnings per Share 6.5 times = $16.10/$2.46

Profitability ratios

Profitability ratios indicate a company's ability to generate profit.

(USE STARTING INFO) Return on assets -- measures how well assets have been employed in conducting the business.

Return on assets ratio = Net income + interest expense x (1 ‒ tax rate)/Average total assets 33.9% = $123,110 + [$5,600 × (1‒35%)]/($320,900 + $426,010) ÷ 2

(USE STARTING INFO) Return on common stockholders' equity -- measures how well the funds provided by common stockholders have been used to generate a return for the company.

Return on common equity = Net income - Preferred dividends/Average common stockholders' equity 57.4% = $123,110/($153,000 + $276,110) ÷2

Interpreting Market Measure Ratios

Stock valuation is tied closely to two key principles, growth and profitability

(T/F) An acid-test ratio is a good measure to determine the amount of highly liquid assets a company possesses.

T -- An acid-test ratio focuses on only those assets that can be converted to cash very quickly.

(T/F) An increase in a common-size percentage for total debt as compared to total debt plus equity could lead to concerns with a company's banker.

T -- Bankers are especially concerned with a change in total debt that could decrease the company's ability to pay back loan obligations.

(T/F) Debt-to-equity ratios are very common for assessing the viability of acquiring additional debt.

T -- Bankers very commonly look at debt ratios to determine the amount of financing a company can take on.

(T/F) A common-size financial statement analysis is best used by comparing two different sized companies together.

T -- Comparability is the strongest benefit of using common-size financial statements since two different size companies would look substantially different comparing amounts, but can be reasonably compared on a relative, percentage basis.

(T/F) Comparative financial statements are a requirement of GAAP.

T -- GAAP requires comparative statements that facilitate horizontal analysis. The SEC requires public companies to present three years of income statements.

(T/F) Horizontal analysis should not be used as an analysis in isolation.

T -- Horizontal analysis is just one tool in financial statement analysis and should not be used in isolation.

(T/F) One of the key requirements for horizontal analysis is that line items on financial statements must be comparable between years.

T -- If line items have been adjusted due to additions or deletions of groupings or actual general ledger accounts, comparability and usefulness of horizontal analysis is significantly impacted.

(T/F) SIC code stands for Standard Industrial Classification.

T -- SIC codes are an important part of classifying various types of businesses.

(T/F) The price-to-earnings ratio measures the market worth of an individual stock as compared to earnings.

T -- The price-to-earnings ratio is critical when evaluating a stock's value compared to a company's earnings and to its peers.

(T/F) Industry analyses are best conducted using data from a company's comparative financial statements.

T -- They are best conducted using horizontal, vertical, and ratio analysis based on a company's financial statements.

(T/F) Inventory turnover is a common ratio that can flag situations in which inventory may be obsolete.

T -- Turnover is important for inventory since the fewer times the value of inventory is sold during the year, the more likely that inventory could be obsolete.

(T/F) If current assets are increasing as a percentage of total assets, and liabilities have no change, working capital increases.

T -- Working capital is calculated as current assets less current liabilities. It will increase when current assets increase more than an increase in current liabilities. With no change in current liabilities, there will be a net increase in working capital.

Standard Industrial Classification (SIC) codes are available through the Security and Exchange Commission's EDGAR database at: http://www.sec.gov/edgar/searchedgar/companysearch.html Identify the Standard Industrial Classification (SIC) codes for the following companies using the EDGAR database. Include both the name and the number for each SIC code. · Target · Home Depot · Lender Processing Services · Wells Fargo · Cummins · United Airlines (UAL)

Target - 5331- Retail Variety Stores Home Depot - 5211- Retail-Lumber & Other Building Materials Lender Processing Services - 7389 - Services-Business services Wells Fargo - 6021 - National Commercial Banks Cummins, Inc - 3510 - Engines and Turbines United Airlines (UAL) - 4512 -- Air Transportation Scheduled

(USE STARTING INFO) Times interest earned ratio -- measures a company's ability to make interest payments out of current earnings.

Times interest earned ratio = Earnings before interest expense and taxes/Interest expense 3.48 times = $195,000/$5,600

Liquidity

a firm's ability to pay its obligations (bills) as they come due and to meet any unforeseen needs or cash.

Ratio analysis

a tool that is used to examine the relationships among the financial statement accounts. Account relationships must be meaningful.

Inventory turnover

measures how many times, on average, a company's inventory "turns over," or is sold, during the year. Inventory turnover = (Cost of Goods Sold/ Average Inventory Balance)

Market Measure Ratios

primarily focus on how to value stock of a company

Average days to sell inventory

reveals how many days elapse from the receipt of inventory to its sale to customers. Average days to sell inventory = (365 Days in a Year/Inventory Turnover)

Working capital

the amount of current assets available to pay current debts as they come due. (Current assets ‒ Current liabilities) = Working capital