CH 13 Revised with Solutions
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Title Page
Chapter Title: Analysis of Financial Statements
Authors: Wild and Shaw
Relevant Edition: 9th Edition
Copyright: McGraw Hill LLC, 2022
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Learning Objectives
Conceptual Objectives
C1: Define the building blocks of analysis and the standards for comparisons.
Analytical Objectives
A1: Summarize and report results of analysis.
A2: Explain the form and assess the content of a complete income statement (Appendix 13A).
Procedural Objectives
P1: Explain and apply methods of horizontal analysis.
P2: Describe and apply methods of vertical analysis.
P3: Define and apply ratio analysis.
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Defining Analysis
Learning Objective C1
Focus on building blocks of analysis and standards of comparisons.
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Purpose of Financial Statement Analysis
Common Goals:
Evaluate company performance and financial condition.
Assist in evaluating:
Past and current performance.
Current financial position.
Future performance and risk.
Users of Analysis:
Internal Users: Managers, Officers, Internal Auditors.
External Users: Shareholders, Lenders, Suppliers.
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Building Blocks of Analysis
Key Areas:
Liquidity and Efficiency
Solvency
Profitability
Market Prospects
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Information for Analysis
General-purpose Financial Statements Include:
Income Statement
Balance Sheet
Statement of Stockholders’ Equity
Statement of Cash Flows
Notes to the Financial Statements
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Standards for Comparison
Importance of Standards: Essential to interpret analysis results.
Types of Standards:
Intracompany
Competitor Analysis
Industry Benchmarks
Guidelines
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Tools of Analysis
Types of Analysis:
Horizontal Analysis: Comparing financial condition and performance across time.
Vertical Analysis: Comparing financial condition and performance to a base amount.
Ratio Analysis: Measurement of key relations between financial statement items.
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Methods of Horizontal Analysis
Learning Objective P1
Focus on explanation and application of horizontal analysis methods.
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Overview of Horizontal Analysis
Definition: Review of financial statement data across time.
Learning Objective P1
Emphasis on horizontal analysis methods.
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Comparative Statements: Dollar Change
Process for Measuring Changes:
Compare analysis period against base period.
Analysis period: Current financial statements.
Base period: Financial statements for comparison.
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Comparative Statements: Percent Change
Calculation Method:
Divide the dollar change by the base period amount, then multiply by 100.
Note: Four cases require additional analysis.
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Comparative Balance Sheets
Example: Exhibit 13.1 (Refer to text for visual).
Learning Objective P1
Reinforcement of horizontal analysis methods.
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Trend Analysis: Equation
Purpose: Reveal patterns in data across periods.
Learning Objective P1
Application of trend analysis in interpretation.
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Trend Analysis: Illustration
Step-by-step method for identifying trend percents by comparing current years to a base year.
Exhibit 13.3: Calculation and data presentation.
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Exercise 13-3: Computing and Analyzing Trend Percents
Objective: Compute trend percents for specific accounts.
Data from 2017 as base year for comparison across 2018-2021.
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Exercise 13-3 Analysis Results
Summary of Trends:
Sales Trend: Favorable (increase).
Cost of Goods Sold Trend: Unfavorable (increase outpaces sales).
Accounts Receivable Trend: Unfavorable (increase exceeds sales growth).
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Learning Objective P2
Overview
Focus on describing and applying methods of vertical analysis.
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Vertical Analysis Overview
Definition: Creation of common-size statements for comparison.
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Common-Size Balance Sheet
Example: Exhibit 13.8 (Refer to text for details).
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Data Visualizations
Significance of visuals in understanding financial statement data.
Exhibits on common-size graphics demonstrated with income statements and assets.
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Exercise 13-4: Computing Common-Size Percents
Task: Compute common-size percents from comparative income statements.
Analysis of item impacts on net income decline.
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Exercise 13-4 Analysis Results
Findings:
Increase in Cost of Goods Sold is primary reason for net income decline.
Current year net income percent vs. prior year indicates substantial decline.
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Exercise 13-5: Income Effect Analysis
Task: Use common-size and trend percents to determine income changes over three years.
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Exercise 13-5 Supporting Calculations
Analyzed common-size net income percent.
Net income has decreased over three years.
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Learning Objective P3
Overview
Focus on defining and applying ratio analysis techniques.
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Ratio Analysis Overview
Key areas of focus:
Liquidity and Efficiency
Solvency
Profitability
Market Prospects
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Liquidity and Efficiency Ratios
Important Ratios:
Working Capital
Current Ratio
Acid-test Ratio
Accounts Receivable Turnover
Inventory Turnover
Days’ Sales Uncollected
Days’ Sales in Inventory
Total Asset Turnover
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Working Capital
Definition: Current assets minus current liabilities.
Importance: Indicates liquidity and ability to meet obligations.
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Current Ratio
Definition: Measures short-term debt-paying ability.
Implication: A higher ratio indicates stronger ability to meet obligations.
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Acid-Test Ratio
Definition: Similar to current ratio but excludes certain current assets.
Purpose: Measures liquidity more conservatively.
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Accounts Receivable Turnover
Definition: Indicates how many times receivables are converted into cash within a period.
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Inventory Turnover
Definition: Measures how long inventory is held before sales occur.
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Days’ Sales Uncollected
Definition: How frequently accounts receivable are collected.
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Days’ Sales in Inventory
Definition: Measures the liquidity of inventory.
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Total Asset Turnover
Definition: Assesses how effectively a company utilizes its assets for generating sales.
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E13-6/8 Data Overview
Showcases Simon Company’s assets, liabilities, and equity over three years.
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Exercise 13-7: Analyzing Liquidity
Task: Compute current and acid-test ratios for Simon Company.
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Exercise 13-7 Current Ratio Analysis
Results:
Current Ratio:
Current Year: 1.88:1 (worsened).
1 Year Ago: 2.52:1.
2 Yrs Ago: 2.87:1.
Analysis: Liquidity deteriorated over three years.
Acid-Test Ratio Analysis
Current Year: 0.93:1 (worsened).
Previous years' ratios confirmed decline in short-term liquidity.
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Exercise 13-8: Analyzing and Interpreting Liquidity
Tasks and Goals:
Compute various ratios regarding liquidity for Simon Company and determine their trends.
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Exercise 13-8 Results
Analytical Outcomes:
Days' Sales Uncollected: Increased (worsened).
Accounts Receivable Turnover: Decreased (worsened).
Inventory Turnover: Decreased (worsened).
Days' Sales in Inventory: Increased (worsened).
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Solvency Ratios
Types of Ratios:
Debt Ratio
Equity Ratio
Debt-to-Equity Ratio
Times Interest Earned
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Debt Ratio and Equity Ratio
Debt Ratio: Measures total liabilities as a percent of total assets.
Equity Ratio: Measures total equity as a percent of total assets.
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Debt-to-Equity Ratio
Indicates the proportion of a company's assets financed by creditors.
A higher ratio implies less opportunity for expansion using debt.
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Times Interest Earned Ratio
Most common measure of a company's ability to pay interest expenses.
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Exercise 13-9: Analyzing Risk and Capital Structure
Tasks:
Compute debt ratio, equity ratio, debt-to-equity ratio, and times interest earned for Simon Company.
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Exercise 13-9 Analysis and Results
Findings:
Debt and Equity Ratios: Improved.
Debt-to-Equity Ratio: Increased (more debt).
Times Interest Earned: Improved; company less risky for creditors.
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Profitability Ratios
Key Ratios:
Profit Margin
Return on Equity
Return on Total Assets
Gross Margin Ratio
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Gross Margin Ratio
Measures percent of gross margin in relation to net sales.
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Profit Margin Ratio
Assesses a company's ability to earn net income from sales.
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Return on Total Assets
Evaluates how efficiently assets generate profit.
Relation between profit margin, total asset turnover, and return on total assets discussed.
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Exercise 13-10: Analyzing Efficiency and Profitability
Tasks:
Compute various ratios for both current and prior years.
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Exercise 13-10 Results and Analysis
Profit Margin: Declined (worsened).
Total Asset Turnover: Slight increase.
Return on Total Assets: Decreased (worsened).
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Return on Equity
Indicates how well the company earns income for its shareholders.
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Market Prospects Ratios
Key Ratios:
Price-Earnings Ratio
Dividend Yield
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Price-Earnings Ratio
Measures market expectations for future growth potential.
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Dividend Yield
Assesses dividend-paying performance for investment comparisons.
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Exercise 13-11: Analyzing Profitability
Tasks:
Calculate various profitability ratios.
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Exercise 13-11 Results
Findings:
Return on Equity: Computed for current vs prior year.
Dividend Yield: Slight increase.
Price-Earnings Ratio: Increased; analysis reflects higher market expectations.
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Summary of Ratios
Exhibit 13.16 provides visual reference of various financial ratios.
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Conclusion
Recognition of the transformative impact of learning on financial analysis.