Garrisonch Chapter 14

BONUS Chapter 1 Managerial Accounting and the Business Environment
BC14–1
Chapter
14
BC14–1 Chapter 4 Systems Design: Process Costing
Learning
Objectives
After studying Chapter 14,
you should be able to: “HOW WELL AM I DOING?”
1. Explain the need for and
limitations of financial
statement analysis.
FINANCIAL STATEMENT
2. Prepare a trend and
ANALYSIS
common-size balance sheet
Business focus
and income statement. Tim Hortons Inc., 2006 Annual Report:
3. Compute and interpret the
Excerpts
financial ratios used by the
common shareholder. Tim Hortons became a separate public company again on September 29, 2006,
when Wendy’s spun off controlling interest by distributing the shares it owned
to its shareholders. Thus Tim’s provided its own annual report for the full year
4. Explain what is meant by the
term financial leverage and ended December 31, 2006.
show how financial leverage Tim Hortons’ reported revenues of $1.7 billion for 2006, an increase of
is measured. approximately 12% over 2005. They reported this increase was made up of an
increase in same store revenues, price increases and revenues of new restau-
5. Compute and interpret the rants. Operating income before tax and interest expense amounted to $379.2
financial ratios used by the million, a 30.7% increase over 2005. An analysis of the reasons is provided in
short-term creditor. their management discussion and analysis contained in the annual report.
Net income increased 35.8% in 2006 and amounted to $259.6 million.
6. Compute and interpret the They state that the increase in net income was less than the increase in operat-
financial ratios used by the ing income because of increases in interest expense and higher income taxes.
long-term creditor. The management discussion provides estimates of growth levels for 2007
and some of the risk factors expected in attempting to achieve this growth.
Two such factors are increased construction costs and labour shortages.
Many more facts and analyses can be found in the full annual report. The
quarterly financial reports provide more timely information than the annual report
but they are not as detailed and they are not audited. For example, a quarterly
report for March 31, 2007, is available providing a timely update on 2006.
The question addressed in the upcoming chapter is how investors and credi-
tors make sense of the many pages in the annual and quarterly reports. For man-
agement, the questions are: Have we satisfied the reporting regulations? How will
we be viewed by our investors? How do we compare to our competitors?
Source: Tim Hortons, 2006 Annual Report.

BC14–2 Chapter 14 “How Well Am I Doing?” Financial Statement Analysis
A ll financial statements are essentially historical

documents. They tell what has happened during a particular period of time. However,
most users of financial statements are concerned about what will happen in the future. For
example, shareholders are concerned with future earnings and dividends. Creditors are
concerned with the company’s future ability to repay its debts. Managers are concerned
with the company’s ability to finance future expansion and how statement users will view
their performance. Despite the fact that financial statements are historical documents,
they can still provide valuable information bearing on all of these concerns.
Financial statement analysis involves careful selection of data from financial
statements for the primary purpose of forecasting the financial health of the company.
This is accomplished by examining trends in key financial data, comparing financial data
across companies, and analyzing key financial ratios. In this chapter, we consider some
of the more important ratios and other analytical tools that analysts use in attempting to
predict the future course of events in business organizations.
Managers are also vitally concerned with the financial ratios discussed in this chapter.
First, the ratios provide indicators of how well the company and its business units are
performing. Some of these ratios would ordinarily be used in a balanced scorecard approach
as discussed in Chapter 11 in the textbook. The specific ratios selected depend on the
company’s strategy. For example, a company that wants to emphasize responsiveness to
customers may closely monitor the inventory turnover ratio discussed later in this chapter.
Second, since managers must report to shareholders and may wish to raise funds from
external sources, they must pay attention to the financial ratios used by external investors
to evaluate the company’s investment potential and creditworthiness.
Need for and Limitations of Financial Statement Analysis
Learning Objective 1 The Internal Use of Ratios

Explain the need for and From the perspective of top management, ratio analysis can serve as a useful tool for
limitations of financial performance evaluation; analysis of threats, constraints, and opportunities; and strategic
statement analysis. planning.
As was discussed in Chapter 11 in the textbook, ratios such as ROI combined with
other measures can aid in evaluating the performance of individual unit managers. Further,
ratios such as the current ratio and debt ratio can be calculated to determine whether
managers are operating in accordance with contractual agreements regarding restrictions
such as minimum working capital requirements and borrowing limitations.
Ratios are helpful in formulating policy and in developing an ongoing organizational
plan. A deeper awareness of the total business environment is essential for long‑term
growth and survival. Key business ratios of competitors, customers, and suppliers can
be calculated to provide input data for marketing strategy. Indeed, regular monitoring of
competitors may help to predict competitors’ reactions to pricing and production decisions.
Key ratios for customers can prove to be valuable in assessing their ability to honour their
purchase commitments. Ratios for suppliers can provide signals about their ability to meet
deadlines and other contractual provisions. In summary, ratios of competitors, customers,
and suppliers are of great potential value in the competitive struggle for business survival
and growth.
Benchmarking
Financial statements are not only historical documents but also are essentially static
documents. They speak only of the events of a single period of time. However, statement
users are concerned about more than just the present; they are also concerned about the
www.mcgrawhill.ca/olc/garrison
Chapter 14 “How Well Am I Doing?” Financial Statement Analysis BC14–3
trend of events over time. For this reason, financial statement analysis directed toward
a single period is of limited usefulness. The results of financial statement analysis for a
particular period are of greater value only when viewed in comparison with the results
of other periods (intrafirm analysis) and, in some cases, with the results of other firms
(interfirm analysis). It is only through comparison that one can gain insight into trends
and make intelligent judgements as to their significance.
Ratios of other firms in the same industry can serve as standards by which to make
comparisons. Industry ratios are available from a number of sources such as Statistics
Canada (CANSIM), which provides statistics for 14 key ratios. (See Exhibit 14–10 at
the end of this chapter for a list of sources.) Rather than industry averages, the ratios of
the most successful firms may be chosen as standards of comparison. This is known as
benchmarking, a process of continuously measuring a firm against the best firms in the Benchmarking
industry. In today’s increasingly competitive international environment, successful firms The process of measuring a firm
set benchmarks based on the highest industry standards. The most successful companies against the most successful firms
emphasize the highest standards in terms of cost efficiency, quality products and services, in the industry.
and customer focus.
Once industry benchmarks are chosen, a manager can make individual comparisons.
Depending on the direction and extent of any deviation from a ratio’s benchmark, a
judgement is made as to whether a particular ratio is good, bad, or satisfactory. Plans
should then be put in place by management to address any weak spots while maintaining
strengths. This requires looking beyond ratios and seeking out detailed information on what
best practices successful firms use. It is not always easy to obtain sensitive information
from competitors but much can be learned by visiting both competing and non-competing
firms and by keeping up to date with recent industry and trade publications and talking with
knowledgeable industry experts, discriminating customers, and discerning suppliers.
Industry benchmarks should be interpreted with caution. For example, structural or
technological change in an industry can cause a benchmark to become outdated and limit
its usefulness. Used properly, benchmarks should lead both production and service firms to
continuous quality improvements. The aim is to be the best in all value‑added activities in
terms of lower costs, better quality, and greater customer satisfaction. This may necessitate
major changes to value chain activities and the elimination of non‑value‑added activities.
Such major changes are referred to as re-engineering or restructuring.
Ratios should be interpreted in the context of management’s chosen competitive
strategy. If the chosen strategy is high turnover/low profit margin, benchmarks should
reflect the performance of companies with a similar strategic focus and may not be
comparable to firms that employ a lower turnover/high profit margin strategy. For example,
a successful company with a low turnover/high profit margin strategy would react with
less concern to ratios reflecting lower cost control, because it can recover its cost through
the relatively higher prices it charges for its goods or services. Customers are willing to
pay more because of real or perceived differences in the firm’s product or services. On the
other hand, a company with a high turnover/low profit margin strategy would be unable
to pass these costs on to customers. Such companies are no‑frill operations that attempt
to keep costs as low as possible. Successful companies using this strategy are profitable
as a consequence of their high sales volume. Even a small change in unit cost will make
a relatively large impact on total cost because many units are affected. High cost for a
firm following this strategy translates into lower profits and may severely threaten a firm’s
ability to compete.
Although financial statement analysis is a highly useful tool, it has two limitations
that we must mention before proceeding any further. These two limitations involve the
comparability of financial data between companies and the need to look beyond ratios.
Comparison of Financial Data

Comparisons of one company with another can provide valuable clues about the financial
health of an organization. Unfortunately, differences in accounting methods between
companies sometimes make it difficult to compare the companies’ financial data. For
example, if one firm values its inventories by the FIFO method and another firm by the
average cost method, then direct comparisons of financial data such as inventory valuations
and cost of goods sold between the two firms may be misleading. Sometimes enough
data is presented in footnotes to the financial statements to restate data on a comparable
basis. Otherwise, the analyst should keep in mind the lack of comparability of the data
before drawing any definite conclusions. Nevertheless, even with this limitation in mind,
comparisons of key ratios with other companies and with industry averages often suggest
avenues for further investigation.
The Need to Look Beyond Ratios

An inexperienced analyst may assume that ratios are sufficient in themselves as a basis
for judgements about the future. Nothing could be further from the truth. Conclusions
based on ratio analysis must be regarded as tentative in nature. Ratios should not be
viewed as an end, but rather they should be viewed as a starting point, as indicators of
what to pursue in greater depth. They raise many questions, but they rarely answer any
questions by themselves.
In addition to ratios, other sources of data should be analyzed in order to make
judgements about the future of an organization. The analyst should look, for example,
at industry trends, technological changes, changes in consumer tastes, changes in broad
economic factors, and changes within the firm itself. A recent change in a key management
position, for example, might provide a basis for optimism about the future, even though
the past performance of the firm (as shown by its ratios) may have been mediocre.
Statements
Statements in Comparative in Comparative and Common-Size Form
and Common-Size Form
Few figures appearing on financial statements have much significance standing by
Learning Objective 2
themselves. It is the relationship of one figure to another and the amount and direction of
Prepare a trend and common- change over time that are important in financial statement analysis. How does the analyst
size balance sheet and income key in on significant relationships? How does the analyst dig out the important trends and
statement. changes in a company? Three analytical techniques are widely used:
1. Dollar and percentage changes on statements.
2. Common-size statements.
3. Ratios.
The first and second techniques are discussed in this section; the third technique is discussed
in the next section. To illustrate these analytical techniques, we analyze the financial
statements of Example Company, a supplier of computer and cellphone components.
While Example Company is artificial and may differ from specific real companies,
it provides an opportunity to view the complete range of analysis. Thus after studying
Example Company, modifications of the illustrated analysis can be made to accommodate
the specifics of a real company.
Dollar and Percentage Changes on Statements

A good place to begin in financial statement analysis is to put statements in comparative
form. This consists of little more than putting two or more years’ data side by side.
Statements cast in comparative form underscore movements and trends and may give the
analyst valuable clues as to what to expect.
Examples of financial statements placed in comparative form are given in Exhibits
14–1 and 14–2. These statements of Example Company reveal the firm has been
experiencing substantial growth. The data on these statements are used as a basis for
discussion throughout the remainder of the chapter.
changes in dollar form helps the analyst focus on key factors that have affected profitability or financial position. For exam-
ple, observe in Exhibit 14–2 that sales for 2008 were up $4 million over 2007, but that this increase in sales was more than
negated by a $4.5 million increase in cost of goods sold.
EXAMPLE COMPANY
EXHIBIT 14–1
Exhibit 14–1 Comparative
Comparative
Comparative Balance Sheet
Balance Sheet
Balance Sheet
December 31, 2008 and 2007
(dollars in thousands)
Increase
(Decrease)
2008 2007 Amount Percent
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,200 $ 2,350 $(1,150) (48.9)%*
Accounts receivable, net . . . . . . . . . . . . 6,000 4,000 2,000 50.0%
Inventory . . . . . . . . . . . . . . . . . . . . . . . . 8,000 10,000 (2,000) (20.0)%
Prepaid expenses . . . . . . . . . . . . . . . . . 300 120 180 150.0%
Total current assets . . . . . . . . . . . . . . 15,500 16,470 (970) (5.9)%
Property and equipment:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 4,000 –0– –0–%
Buildings and equipment, net . . . . . . . . 12,000 8,500 3,500 41.2%
Total property and equipment . . . . . . 16,000 12,500 3,500 28.0%
Total assets . . . . . . . . . . . . . . . . . . . . . . . . $31,500 $28,970 $ 2,530 8.7%
Liabilities and Shareholders Equity

Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . $ 5,800 $ 4,000 $ 1,800 45.0%
Accrued payables . . . . . . . . . . . . . . . . . 900 400 500 125.0%
Notes payable, short term . . . . . . . . . . . 300 600 (300) (50.0)%
Total current liabilities . . . . . . . . . . . . 7,000 5,000 2,000 40.0%
Long-term liabilities:
Bonds payable, 8% . . . . . . . . . . . . . . . . 7,500 8,000 (500) (6.3)%
Total liabilities . . . . . . . . . . . . . . . . . 14,500 13,000 1,500 11.5%
Shareholders equity:
Preferred shares, $6 no par,
$100 liquidation value . . . . . . . . . . . . 2,000 2,000 –0– –0–%
Common shares, 500 no par . . . . . . . . . 7,000 7,000 –0– –0–%
Total paid-in capital . . . . . . . . . . . . . . 9,000 9,000 –0– –0–%
Retained earnings . . . . . . . . . . . . . . . . . 8,000 6,970 1,030 14.8%
Total shareholders equity . . . . . . . 17,000 15,970 1,030 6.4%
Total liabilities and
shareholders equity . . . . . . . . . . . . . . . $31,500 $28,970 $ 2,530 8.7%
*Since we are measuring the amount of change between 2007 and 2008, the dollar amounts for
2007 become the base figures for expressing these changes in percentage form. For example,
Cash decreased by $1,150 between 2007 and 2008. This decrease expressed in percentage form
is computed as follows: $1,150 � $2,350 � 48.9%. Other percentage figures in this exhibit and
Exhibit 14–2 are computed in the same way.
Horizontal Analysis Comparison of two or more years’ financial data is known

as horizontal analysis or trend analysis. Horizontal analysis is facilitated by show- Horizontal or trend analysis
ing changes between years in both dollar and percentage form, as has been done in Exhib- A side-by-side comparison of
its 14–1 and 14–2. Showing changes in dollar form helps the analyst focus on key factors two or more years’ financial
that have affected profitability or financial position. For example, observe in Exhibit statements.
14–2 that sales for 2008 were up $4 million over 2007, but that this increase in sales was
more than negated by a $4.5 million increase in cost of goods sold.
Exhibit
EXHIBIT 14–2
14–2 Comparative
Comparative
EXAMPLE COMPANY
Income
Income and Retained Earnings
Earnings Comparative Income Statement and Reconciliation
Statement
Statement of Retained Earnings
For the Years Ended December 31, 2008 and 2007
Increase
(Decrease)
2008 2007 Amount Percent
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000 $48,000 $4,000 8.3%

Cost of goods sold . . . . . . . . . . . . . . . . . . 36,000 31,500 4,500 14.3%
Gross margin . . . . . . . . . . . . . . . . . . . . . . 16,000 16,500 (500) (3.0)%
Operating expenses:
Selling expenses . . . . . . . . . . . . . . . . . . 7,000 6,500 500 7.7%
Administrative expenses . . . . . . . . . . . . 5,860 6,100 (240) (3.9)%
Total operating expenses . . . . . . . . . . 12,860 12,600 260 2.1%
Operating income . . . . . . . . . . . . . . . . . . . 3,140 3,900 (760) (19.5)%
Interest expense . . . . . . . . . . . . . . . . . . . . 640 700 (60) (8.6)%
Net income before taxes . . . . . . . . . . . . . . 2,500 3,200 (700) (21.9)%
Less income taxes (30%) . . . . . . . . . . . . . 750 960 (210) (21.9)%
Net income . . . . . . . . . . . . . . . . . . . . . . . . 1,750 2,240 $ (490) (21.9)%
Dividends to preferred shareholders,
$6 per share (see Exhibit 14–1) . . . . . . 120 120
Net income remaining for common
shareholders . . . . . . . . . . . . . . . . . . . . . 1,630 2,120
Dividends to common shareholders,
$1.20 per share . . . . . . . . . . . . . . . . . . . 600 600
Net income added to
retained earnings . . . . . . . . . . . . . . . . . 1,030 1,520
Retained earnings, beginning
of year . . . . . . . . . . . . . . . . . . . . . . . . . . 6,970 5,450
Retained earnings, end of year . . . . . . . . . $ 8,000 $ 6,970
Showing changes between years in percentage form helps the analyst to gain
Showing changes between years in percentage form helps the analyst to gain per-
perspective and to gain a feel for the significance of the changes that are taking place. A
spective and to gain a feel for the significance of the changes that are taking place. A
$1 million increase in sales is much more significant if the prior year’s sales were $2
$1 million increase in sales is much more significant if the prior year’s sales were $2 mil-
million than if the prior year’s sales were $20 million. In the first situation, the increase
lion than if the prior year’s sales were $20 million. In the first situation, the increase
would be 50%—undoubtedly a significant increase for any firm. In the second situation,
would be 50%—undoubtedly a significant increase for any firm. In the second situation,
the increase would be only 5%—perhaps just a reflection of normal growth.
the increase would be only 5%—perhaps just a reflection of normal growth.
S
Trend Percentages Horizontal
Trend Percentages Horizontal analysis of financial statements can also be carried out
analysis of financial statements can also be carried out
Trend percentages by computing trend percentages. Trend percentages state several years’ financial data
by computing trend percentages. Trend percentages state several years’ financial data in
The expression of several years’ in terms of a base year. The base year equals 100%, with all other years stated as some
terms of a base year. The base year equals 100%, with all other years stated as some per-
financial data in percentage form percentage of this base. To illustrate, consider Tim Hortons which vies with other fast
centage of this base. To illustrate, consider TELUS, which vies with BCE and Rogers for
in terms of a base year. food suppliers for a position the fast food field. Tim Hortons enjoyed tremendous growth
Trend percentages position in the communications field. TELUS enjoyed tremendous growth in the last
in the last number of years, as evidenced by the following data:
The expression of several years’ number of years, as evidenced by the following data:
financial data in percentage form Tim Hortons Inc.
TELUS Consolidated
in terms of a base year. Income Statement (millions) 2006 2005 2004
Income Statement (millions) 2003 2002 2001 2000 1999 1998
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,659.5 $1,482.0 $1,338.3
Operating revenues . . . . . . . . $7,146.0 $7,006.7 $7,202.6 $6,106.4 $5,588.9 $5,560.1
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . 379.2 290.0 319.3
Net income . . . . . . . . . . . . . . . 331.5 (229.0)
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 259.6 453.5 461.0
191.1 349.8 205.1
67.01
www.mcgrawhill.ca/college/garrison
By simply looking at these data, one can see that sales increased in nearly every
year since 2004. But how rapidly have sales been increasing and have the increases in
net income kept pace with the increases in sales? By looking at the raw data alone, it is
difficult to answer these questions. The increases in sales and the increases in net income
can be put into better perspective by stating them in terms of trend percentages, with 2004
as the base year. These percentages (all rounded) are given below:
Tim Hortons Inc.
Income Statement (millions) 2006 2005* 2004
Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124.0 110.7 100
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . 118.8 90.8 100
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126.6 93.2 100
*For 2005: $1,482.0/$1,338.3 = 1.107; 290.0/319.3 = .908; 191.1/205.1 = .932
The trend analysis is particularly striking when the data are plotted as shown in
Exhibit 14–3. Tim Hortons’ sales growth has been impressive since 2004, but the growth
in net income has been more sporadic.
Common-Size Statements
Key changes and trends can also be highlighted by the use of common-size statements. A Common-size statement
common-size statement is one that shows the items appearing on it in percentage form as A statement that shows the items
well as in dollar form. Each item is stated as a percentage of some total of which that item appearing on it in percentage
is a part. The preparation of common-size statements is known as vertical analysis. form as well as in dollar form.
Common-size statements are particularly useful when comparing data from different On the income statement, the
percentages are based on total
companies. For example, in a recent year Tim Hortons’ revenue was $1,659.5 million.
sales revenue; on the balance
Since there are few Canadian comparatives, you might look at Starbucks Corporation sheet, the percentages are based
for their 52 weeks ended October 1, 2006. Starbucks’ revenue was $7,786.9 million U.S. on total assets.
This comparison is somewhat misleading because of the dramatically different size but
a perspective may be gained by using operating income as a percentage of revenues: Vertical analysis
Tim Hortons 22.9% (379.2/1659.5); Starbucks 11.5% (893.9/7786.9). The common The presentation of a company’s
financial statements in common-
size comparison now favours Tim Hortons. The questions for further analyis is why the
size form.
difference.
The Balance Sheet One application of the vertical analysis idea is to state the separate
assets of a company as percentages of total assets. A common-size statement of this type
is shown in Exhibit 14–4 for Example Company.
Notice from Exhibit 14–4 that placing all assets in common-size form clearly shows
the relative importance of the current assets as compared to the non-current assets. It also
shows that significant changes have taken place in the composition of the current assets
over the last year. Notice, for example, that the receivables have increased in relative
importance and that both cash and inventory have declined in relative importance. Judging
from the sharp increase in receivables, the deterioration in the cash position may be a
result of an inability to collect from c ustomers.
Tim Hortons Trends Exhibit 14–3 Tim Hortons

150 Trend Analysis of Sales and Net
Income
Percentage
100
Change
Sales
Net Income
50
0
1 2 3
Years
EXHIBIT
Exhibit 14–4 Common
CommonSize
EXAMPLE COMPANY
Balance
Size SheetSheet
Balance Common-Size Comparative Balance Sheet
Common-Size
Percentages
2008 2007 2008 2007
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,200 $ 2,350 3.8%* 8.1%
Accounts receivable, net . . . . . . . . . . . . . . . 6,000 4,000 19.0% 13.8%
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 10,000 25.4% 34.5%
Prepaid expenses . . . . . . . . . . . . . . . . . . . . 300 120 1.0% 0.4%
Total current assets . . . . . . . . . . . . . . . . . 15,500 16,470 49.2% 56.9%

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 4,000 12.7% 13.8% Gross ma
Buildings and equipment, net . . . . . . . . . . . 12,000 8,500 38.1% 29.3%
Total property and equipment . . . . . . . . . 16,000 12,500 50.8% 43.1% A broad g
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,500 $28,970 100.0% 100.0%
Liabilities and Shareholders Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . $ 5,800 $ 4,000 18.4% 13.8%
Accrued payables . . . . . . . . . . . . . . . . . . . . 900 400 2.8% 1.4%
Notes payable, short term . . . . . . . . . . . . . . 300 600 1.0% 2.1%
Total current liabilities . . . . . . . . . . . . . . . 7,000 5,000 22.2% 17.3%
Bonds payable, 8% . . . . . . . . . . . . . . . . . . . 7,500 8,000 23.8% 27.6%
Total liabilities . . . . . . . . . . . . . . . . . . . . 14,500 13,000 46.0% 44.9%
Shareholders equity:
Preferred shares, $6 no par,
$100 liquidation value . . . . . . . . . . . . . . . 2,000 2,000 6.4% 6.9%
Common shares, 500 no par . . . . . . . . . . . . 7,000 7,000 22.2% 24.2%
Total paid-in capital . . . . . . . . . . . . . . . . . 9,000 9,000 28.6% 31.1%
Retained earnings . . . . . . . . . . . . . . . . . . . . 8,000 6,970 25.4% 24.0%
Total shareholders equity . . . . . . . . . . . 17,000 15,970 54.0% 55.1%
Total liabilities and
shareholders equity . . . . . . . . . . . . . . . . . . $31,500 $28,970 100.0% 100.0%
*Each asset account on a common-size statement is expressed in terms of total assets, and each
liability and equity account is expressed in terms of total liabilities and shareholders equity. For
example, the percentage figure above for Cash in 2008 is computed as follows: $1,200 
$31,500  3.8%.
The Balance
Income Sheet
Statement Another application
One application of the
of the vertical vertical
analysis ideaanalysis ideatheis separate
is to state to place
all items
assets of aoncompany
the income statement inofpercentage
as percentages total assets.form in terms of sales.
A common-size A common-size
statement of this type
statement of this type is shown in Exhibit
is shown in Exhibit 14–4 for Example Company. 14–5.
Notice
By placing
fromall items 14–4
Exhibit on thethat
income statement
placing inin
all assets common size inform
common-size termsclearly
of sales, it is
shows
possible to see at a glance how each dollar of sales is distributed among the various
the relative importance of the current assets as compared to the non-current assets. It also costs,
expenses,
shows thatand profits. changes
significant By placinghavesuccessive years’
taken place statements
in the side of
composition by the
side, it is easy
current to
assets
over the last year. Notice, for example, that the receivables have increased in relative
excludes fixed costs. When fixed costs are included in the cost of goods sold figure, the
gross margin percentage tends to increase and decrease with sales volume changes. With
EXAMPLE COMPANY
EXHIBIT 14–5
Exhibit 14–5 Common
CommonSize
Size
Common-Size Comparative Income Statement
Income Statement
Income
Common-Size
Percentages
2008 2007 2008 2007
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000 $48,000 100.0% 100.0%

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 36,000 31,500 69.2% 65.6%
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 16,500 30.8% 34.4%
Operating expenses:
Selling expenses . . . . . . . . . . . . . . . . . . . . . . 7,000 6,500 13.5% 13.5%
Chapter 15 “How Well Am I Doing?” Financial Statement Analysis BC15-9
Administrative expenses . . . . . . . . . . . . . . . . 5,860 6,100 11.3% 12.7%
Total operating expenses . . . . . . . . . . . . . 12,860 12,600 24.7% 26.2%
importance
Operatingand that both
income . . . . cash
. . . . .and
. . . .inventory
. . . . . . . . .have
. declined
3,140 in3,900
relative importance.
6.0% Judg-
8.1%
ing from the sharp increase in receivables, the
Interest expense . . . . . . . . . . . . . . . . . . . . . . . .deterioration
640 in the
700cash position
1.2% may be a
1.5%
resultNet
of income
an inability to collect from customers.
before taxes . . . . . . . . . . . . . . . . . 2,500 3,200 4.8% 6.7%
Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . 750 960 1.4% 2.0%
The Net
Income
incomeStatement
. . . . . . . . . . . .Another
. . . . . . . .application
. . . . . . . . $of1,750
the vertical analysis3.4%
$ 2,240 idea is to4.7%
place
all items on the income statement in percentage form in terms of sales. A common-size
statement of this
*Note that type is shown
the percentage figuresinfor
Exhibit 14–5.
each year are expressed in terms of total sales for the year.
By placing all items on the income statement sold
For example, the percentage figure for cost of goods in common
in 2008 issize in terms
computed of sales, it is
as follows:
$36,000 $52,000 69.2%
possible to see at a glance how each dollar of sales is distributed among the various costs,
� �
expenses, and profits. And by placing successive years’ statements side by side, it is easy
to spot interesting trends. For example, as shown in Exhibit 14–5, the cost of goods sold
as a percentage of sales increased from 65.6% in 2007 to 69.2% in 2008. Or looking at
this from a different viewpoint, the gross margin percentage declined from 34.4% in 2007
tospot
30.8% in 2008.trends.
interesting Managers
For and investment
example, analysts
as shown often pay
in Exhibit 14–5,close
theattention to the sold
cost of goods grossas
margin percentage because it is considered a broad gauge of profitability.
a percentage of sales increased from 65.6% in 2007 to 69.2% in 2008. Or looking at this The gross mar-
gin percentage
from a differentis viewpoint,
computed as thefollows:
gross margin percentage declined from 34.4% in 2007
to 30.8% in 2008. Managers and investment analysts often pay close attention to the
gin percentage Gross margin percentage
gross margin percentage because it is considered a broad gauge of profitability. The gross
margin percentage is computed as follows: A broad gauge of profitability,
auge of profitability, calculated by dividing sales into the gross margin. calculated by dividing sales into
Gross margin the gross margin.
Gross margin percentage �
Sales
TheThegross
grossmargin
marginpercentage
percentagetendstendstotobebemore
morestable
stablefor
forretailing
retailingcompanies
companiesthanthanfor
for
otherservice
other servicecompanies
companiesandandfor
formanufacturers
manufacturerssincesincethe
thecost
costofofgoods
goodssold
soldininretailing
retailing
excludesfixed
excludes fixedcosts.
costs.When
Whenfixed
fixedcosts
costsare
areincluded
includedininthe
thecost
costofofgoods
goodssold
soldfigure,
figure,the
the
grossmargin
gross marginpercentage
percentagetends
tendstotoincrease
increaseandanddecrease
decreasewithwithsales
salesvolume
volumechanges.
changes.With
With
increases in sales volume, the fixed costs are spread across more units and the gross
margin percentage improves.
While a higher gross margin percentage is generally considered to be better than a
lower gross margin percentage, there are exceptions. Some companies purposely choose
EXHIBIT 14–5 Common Size
a strategy emphasizing low prices (and hence
EXAMPLE low gross margins). An increasing gross
COMPANY
Income Statement
margin in such a company might Comparative
Common-Size be a sign that the company’s
Income Statement strategy is not being
effectively implemented.
Common-size statements are (dollars
also in thousands)
very helpful in pointing out efficiencies and
inefficiencies that might otherwise go unnoticed. To illustrate, in 2008, Example Company’
Common-Size
selling expenses increased by $500,000 over 2007. A glance at the common-size Percentages income
statement shows, however, that on a relative basis, selling expenses were no higher in
2008 than in 2007. In each year, they represented 200813.5% of 2007
sales. 2008 2007
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000 $48,000 100.0% 100.0%

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 36,000 31,500 69.2% 65.6%
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000 16,500 30.8% 34.4%
Operating expenses:
Earnings per Share
An investor buys a share in the hope of realizing a return in the form of either dividends
BC14–10 or future 14
Chapter increases
“How in theAm
Well value of theFinancial
I Doing?” share. Since earnings
Statement form the basis for dividend
Analysis
payments, as well as the basis for future increases in the value of shares, investors are
always interested in a company’s reported earnings per share. Probably no single statis-
Ratio Analysis—The Common tic Ratioor Analysis—The
is more widelyShareholder
quoted relied on by investors thanCommon Shareholder
earnings per share, although it has
some inherent limitations, as discussed below.
Earnings
A number per share
of financial is computed
ratios are used toby dividing
assess net income
how well available
the company for common
is doing from the
Learning Objective 3 shareholders
standpoint ofby thethe average number
shareholders. Theseofratios
common shares
naturally outstanding
focus duringdividends,
on net income, the year. “Net
and
Compute and interpret the income available
shareholders’ for common shareholders” is net income less dividends paid to the own-
equities.
financial ratios used by the ers of the company’s preferred shares.1
common shareholder.
Earnings per Share
1.
AnAnother complication
investor can arise
buys a share when
in the a company
hope has issued
of realizing securities
a return in such as executive
the form stockdividends
of either options or
warrants that can be converted into common shares. If these conversions were to take place, the same earn-
or ings
future increases in the value of the share. Since earnings form the basis for dividend
would have to be distributed among a greater number of common shares. Therefore, a supplemental
payments, asshare
earnings per wellfigure,
as the basis
called for earnings
diluted future increases in the
per share, may havevalue of shares, investors are
to be computed.
always interested in a company’s reported earnings per share. Probably no single statistic
Earnings per share is more widely quoted or relied on by investors than earnings per share, although it has
some inherent limitations, as discussed below.
Earnings
Netper share available for
income Earnings per share is computed by dividing net income available for common
Net income available
common for common
shareholders dividedshareholders by the average number of common shares outstanding during the year. “Net
shareholders
by the divided
averageby the of common
number shares
income outstanding
available during the
for common year.
shareholders” is net income less dividends paid to the
average number of common owners of the company’s preferred shares.1
shares outstanding during the
year. Net income � Preferred dividends
Chapter
Earnings per share � 15 “How Well Am I Doing?” Financial Statement Analysis
Average number of common shares outstanding
Using the data in Exhibits 14–1 and 14–2, we see that the earnings per share for
Example Company for 2008 would be computed as follows:
$1,750,000 � $120,000
� $3.26 (1)
(500,000 shares � 500,000 shares)/2
Note that the denominator in the earnings per share formula uses the weighted-
average number of of common
common sharessharesoutstanding
outstandingforforthe
theyear.
year.Using
Usinga weighted
a weightedaverage
averageis
appropriate
is appropriatebecause
becauseit itrecognizes
recognizesthatthatcommon
commonshareholders
shareholders may
may contribute
contribute varying
amounts of capital for varying amounts of time. A weighted-average number of shares
reflects earnings per
reflects pershare
shareduring
duringthetheperiod andand
period is not a measure
is not of entitlement
a measure to earn-
of entitlement to
ings at period-end.
earnings Assume
at period‑end. Assumethat athat
company beganbegan
a company operations on January
operations 2, 2003,
on January by issu-
2, 2007, by
ing 10,000
issuing common
10,000 common shares, andand
shares, onon
October
October1,1,2003,
2007,ananadditional
additional10,000
10,000 shares were
issued. The company obviously has 20,000 shares outstanding at year‑end. year-end. However, the
weighted-average number of shares outstanding for the year is calculated as follows:
10,000 shares 3
� 9 months 5
� 90,000 share months
3 3 months �
20,000 shares � 5 60,000 share months
12
12 150,000 share months
The 10,000 shares issued on January 2 were outstanding for nine months before before any
any new
shares were issued. On October 1, another 10,000 shares were issued, bringing the total
outstanding toto 20,000
20,000for
forthe
thelast
lastthree months
three months of of
thethe
year. TheThe
year. weighted average
weighted can now
average can
be determined
now be determinedby dividing
by dividingthe the
number
numberof ofshare
sharemonths
months(150,000)
(150,000)by bythe
the number
number of
months in a year (12) to give a weighted average of 12,500 shares.
complicationscan
Two complications canarise
arise in connection
in connection withwith the computation
the computation of earnings
of earnings per
per share.
share.
The The
first firstwhenever
arises arises whenever an extraordinary
an extraordinary gain or lossgain or loss
appears appears
as part of netasincome.
part ofThe
net
income.arises
second The second
wheneverarises wheneverhas
a company a company
convertiblehassecurities
convertible
on securities
its balanceonsheet.
its balance
These
sheet. These complications
complications are discussedare discussed
in the in the
following following paragraphs.
paragraphs.
Extraordinary Items and Earnings per Share

1. Another complication can arise when a company has issued securities such as executive stock options
Extraordinary items are items resulting from transactions or events that have all of the fol-
or warrants that can be converted into common shares. If these conversions were to take place, the same
lowing characteristics:
earnings would have to be distributed among a greater number of common shares. Therefore, a supple-
mentalare
1. They earnings per share figure,
not expected calledfrequently
to occur diluted earnings
overper may have to be computed.
share, years.
several
2. They do not typify the normal business activities of the entity.
3. They do not depend primarily on the decisions of management or determinations by
management or owners.
Extraordinary Items and Earnings per Share

Extraordinary items are items resulting from transactions or events that have all of the
following characteristics:
1. They are not expected to occur frequently over several years.
2. They do not typify the normal business activities of the entity.
3. They do not depend primarily on the decisions of management or determinations by
management or owners.
If a company has extraordinary gains or losses appearing as part of net income, two earnings
per share figures must be computed—one showing the earnings per share resulting from
normal operations and one showing the earnings per share impact of the extraordinary
items. This approach to computing earnings per share accomplishes three things. First,
it helps statement users to recognize extraordinary items for what they are—unusual
events that probably will not recur. Second, it eliminates the distorting influence of the
extraordinary items from the basic earnings per share figure. Third, it helps statement
users to assess properly the trend of normal earnings per share over time. Since one would
not expect the extraordinary or unusual items to be repeated year after year, they should
be given less weight in judging earnings performance than is given to profits resulting
from normal operations.
In addition to reporting extraordinary items separately, the accountant also reports
them net of their tax effect. This means that whatever impact the extraordinary item has
on income taxes is deducted from the extraordinary item on the income statement. Only
the net, after‑tax gain or loss is used in earnings per share computations.
To illustrate these ideas, let us assume that Amata Company has suffered a fire loss
of $6,000 and that management is wondering how the loss should be reported on the
company’s income statement. The correct and incorrect approaches to reporting the loss
are shown in Exhibit 14–6.
As shown under the correct approach in the exhibit, the $6,000 loss is reduced to only
$4,200 after tax effects are taken into consideration. The reasoning behind this computation
is as follows: The fire loss is fully deductible for tax purposes. Therefore, this deduction will
reduce the firm’s taxable income by $6,000. If taxable income is $6,000 lower, then income
taxes will be $1,800 (30% 3 $6,000) less than they otherwise would have been. In other
words, the fire loss of $6,000 saves the company $1,800 in taxes that otherwise would have
been paid. The $1,800 savings in taxes is deducted from the loss that caused it, leaving a net
loss of only $4,200. This same $4,200 figure could have been obtained by multiplying the
original loss by the formula (1 2 Tax rate): [$6,000 3 (1 2 0.30) 5 $4,200].
This same procedure is used in reporting extraordinary gains. The only difference is
that extraordinary gains increase taxes; thus, any tax resulting from such a gain must be
deducted from it, with only the net gain reported on the income statement.
To continue our illustration, assume that the company in Exhibit 14–6 has 2,000
common shares outstanding. Earnings per share would be reported as follows:
Earnings per share on common stock:
On net income before extraordinary item ($7,000 4 2,000 shares) . . . . . . . . . $ 3.50

On extraordinary item, net of tax ($4,200 4 2,000 shares) . . . . . . . . . . . . . . . . (2.10)
Net earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.40

In summary, clearly segregating extraordinary items as we have done above is

necessary to avoid misunderstanding a company’s normal income‑producing ability.
Reporting only the flat $1.40 per share figure would be misleading and perhaps cause
investors to regard the company less favourably than they should.
Fully Diluted Earnings per Share

A problem sometimes arises in trying to determine the number of common shares to use
in computing earnings per share. Until recent years, the distinctions between common
EXHIBIT 14–6 Reporting
Exhibit Reporting Conversio
Incorrect Approach
Extraordinary Items Net of Their

Sales . . . . . . . . . . . . . . . . . . . . . . $100,000
Tax Effects A preferre
Cost of goods sold . . . . . . . . . . . 60,000 Extraordinary gains and
some futu
Gross margin . . . . . . . . . . . . . . . 40,000 losses should not be included
Operating expenses: with normal items of revenue
Selling expenses . . . . . . . . . . . $18,000 and expense. This distorts a
Administrative expenses . . . . . 12,000 firm s normal income-producing
Fire loss . . . . . . . . . . . . . . . . . . 6,000 36,000 ability.
Net income before taxes . . . . . . . 4,000

Income taxes (30%) . . . . . . . . . . 1,200

Net income . . . . . . . . . . . . . . . . . $ 2,800
Correct Approach
Sales . . . . . . . . . . . . . . . . . . . . . . $100,000
Cost of goods sold . . . . . . . . . . . 60,000
Reporting the extraordinary
Gross margin . . . . . . . . . . . . . . . 40,000 item separately and net of its
Operating expenses: tax effect leaves the normal Fully dilu
Selling expenses . . . . . . . . . . . $18,000 items of revenue and expense per share
Administrative expenses Chapter
. . . . . 1512,000
“How Well Am I Doing?”
30,000 Financial Statement Analysis
unaffected.
Operating income . . . . . . . . . . . . 10,000
ed stock or bond feature that allows the purchaser to convert preferred3,000
Income taxes (30%) . . . . . . . . . . shares or bonds into common shares at An earnin

re time. Net income before
When convertible
extraordinary item .securities
. . . . . . . . .are present in the financial
7,000 structure
Original loss of
. . .a. firm, the ques-
. . . . $6,000
Extraordinary item: Less reduction in
tion arises as to whether these securities should be retained in their unconverted form or taxes
Fire
treated asloss, net of shares
common tax . . .in
. . computing
.... earnings4,200
per share.atThe
a 30% rate . . .accepted
generally . . . 1,800
posi-
tionNetis income
that convertible
. . . . . . . . securities
. . . . . . . . . should be treated
$ 2,800both in their
Loss, netpresent
of tax . and
. . . . prospective
. $4,200
forms. This requires the presentation of two earnings per share figures, one showing earn-
ings per share assuming no conversion into common shares and the other showing full
conversion into common shares. The latter figure is known as the fully diluted earnings
shares,
per share. preferred shares, and debt were quite clear. However, these distinctions have
become murkier due to a growing tendency to issue convertible securities of various types.
Rather than simply issuing common shares, firms today often issue preferred shares or
Conversion feature bonds that carry a conversion feature allowing the purchaser to convert the preferred
A preferred shares or bond shares or bonds into common shares at some future time.
feature that allows the purchaser When convertible securities are present in the financial structure of a firm, the question
utedshares
to convert preferred earnings
or arises as to whether these securities should be retained in their unconverted form or treated
bonds into common shares at as common shares in computing earnings per share. The generally accepted position is
some future time.
that convertible securities should be treated both in their present and prospective forms.
er the correct approach in the exhibit, the $6,000This lossrequires
is reduced thetopresentation
only $4,200ofafter twotax effectsper
earnings areshare
takenfigures,
into consideration.
one showingThe reasoning
earnings per
utation is as follows: The firegsloss
perisshare
fullyfigure
deductible
showing for tax
full purposes.
conversion Therefore,
into common this deduction
shares. will reduce
share assuming no conversion into common shares and the other showing full conversion the firm’s taxable income by
ncome is $6,000 lower, then income
Fully diluted earnings taxes will be $1,800 (30%  $6,000) less than they otherwise would have
into common shares. The latter figure is known as the fully diluted earnings per share. been. In other words, the fire
es the company $1,800 in taxes that otherwise would
per share To Tohave
illustrate
illustrate the computation
been paid.
the computation
The $1,800 savings of aa company’s
of company’s fully
in taxes isfully dilutedfrom
deducted
diluted earnings
the loss
earnings perthat
per share, let us
caused
share, let us
it,
of only $4,200. This same $4,200 figure
An earnings per share figure could assume
have been that the
obtained preferred
by shares
multiplying of
the Example
original Company
loss by the in Exhibit
formula
assume that the preferred shares of Example Company in Exhibit 14–1 are convertible into (1  14–1
Tax are
rate): convertible
[$6,000 
00]. showing full conversion into into common
common shares shares
on theonbasis the basis
of fiveofshares
five shares of common
of common for eachforshare
each ofshare of preferred.
preferred. Since
cedure is used in reporting
common Since
shares.extraordinary gains. 20,000
The only20,000 preferred
difference is shares
that are
extraordinaryoutstanding,
gains conversion
increase would
taxes;
preferred shares are outstanding, conversion would require issuing an additional require
thus, any issuing
tax resultingan addi-
from
be deducted from it, with only the net gain reported tional on100,000
the common
income shares.
statement. Earnings per share on a fully
100,000 common shares. Earnings per share on a fully diluted basis would be computed diluted basis would be com-
ur illustration, assume that the company in Exhibit puted
as as follows:
14–6
follows: has 2,000 common shares outstanding. Earnings per share would be reported as
Net income Fully diluted
re on common stock: �
(Weighted-average number of common shares outstanding earnings per share
before extraordinary item ($7,000  2,000 shares) . . . . . . . . . $ 3.50
� Potential shares issued on convertible securities)
ry item, net of tax ($4,200  2,000 shares) . . . . . . . . . . . . . . . . (2.10)
Net income $1,750,000
share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.40
� � $2.92 (2)
(500,000 shares outstanding 600,000 shares
clearly segregating extraordinary items as we have done above
� 100,000 common is converted
necessaryshares)
to avoid misunderstanding a company’s normal
g ability. Reporting only the flat $1.40 per share figure would be misleading and perhaps cause investors to regard the company less
ey should. In comparing equation (2) with equation (1), we can note that the earnings per share
figure has dropped by 34 cents. Although the impact of full dilution is relatively small in
this case, it can be very significant in situations where large amounts of convertible secu-
Earnings per Share rities are present.
mes arises in trying to determine the number of commonIn summary,

shares tofully diluted
use in earnings
computing per share
earnings permitUntil
per share. the user to see
recent thethe
years, impact on
distinc- Price-earnings ra
figure has dropped by 34 cents. Although the impact of full dilution is relatively small
in this case, it can be very significant in situations where large amounts of convertible
securities are present.
In summary, fully diluted earnings per share permit the user to see the impact on
earnings per share of share issues that would dilute the earnings attributable to each com-
mon share if they were to happen. For example, the issue of 100,000 common shares in
addition to the 500,000 weighted-average number of shares existing for the basic earn-
ings per share would require at least 100,000 3 $3.26 or $326,000 of new earnings to
avoid diluting the earnings to common shareholders. In our example, earnings to com-
mon shareholders increased only $120,000 [($1,750,000 – $120,000) – $1,750,000] for
the 100,000 new shares. The $1.20 for the new shares is below the $3.26 needed to avoid
dilution. To illustrate, if earnings increased by $206,000 ($326,000 – $120,000), then no
dilution would have occurred:
($1,750,000 + $206,000)/600,000 = $3.26
Earnings per Share and Profitability

Chapter 15 “How Well Am I Doing?” Financial Statement Analysis
Earnings per share can be a misleading measure of profitability. To illustrate, assume
that Simyar Company has 100,000 shares outstanding over a three‑year period. Simyar
Company has total assets for year 2006 of $1 million and it is company policy to pay out
of its after-tax income as dividends. Note from the following data that earnings per share
50% of its after‑tax income as dividends. Note from the following data that earnings per
increased each period. This increase may be misinterpreted as improved operating per-
share increased each period. This increase may be misinterpreted as improved operating
formance when in fact it is totally attributable to Simyar Company reinvesting 50% of its
performance when in fact it is totally attributable to Simyar Company reinvesting 50% of
earnings. Return on investment has actually remained at 10%. For this illustration, it is
its earnings. Return on investment has actually remained at 10%. For this illustration, it is
assumed that ROI is calculated on total assets at the beginning of the year.
assumed that ROI is calculated on total assets at the beginning of the year.
Earnings Available Return on Earnings
Earnings Available Return on Earnings
Year Assets for Common Shareholders Investment per Share
Year Assets for Common Shareholders Investment per Share
2006 . . . . . . . . . . . . . .
2006 . . . . . . . . . . . . . . $1,000,000
$1,000,000 $100,000
$100,000 10%
10% $1.0000
$1.0000
2007 . . . . . . . . . . . . . .
2007 . . . . . . . . . . . . . . 1,050,000
1,050,000 105,000
105,000 10%
10% 1.0500
1.0500 Dividend
2008 . . . . . . . . . . . . . .
2008 . . . . . . . . . . . . . . 1,102,500
1,102,500 110,250
110,250 10%
10% 1.1025
1.1025 Shows the
Price-Earnings
Price-EarningsRatio
Ratio
relationship between
The relationship betweenthethemarket
marketprice
priceofof a share
a share andand
the the share’s
share’s current
current earnings
earnings per
per share
share is often
is often quoted
quoted in terms of aofprice-earnings
in terms a price-earningsratio.
ratio.IfIfwe
weassume
assume that
that the
the current
current
Example Company’
market price for Example Company’ shares is $40 $40 each,
each, the
the company’s
company’s price-earnings
price-earnings
ratio would be computed as follows:
Market price per share
Price-earnings ratio �
Earnings per share
$40
� 12.3
$3.26
The price-earnings ratio is 12.3; that is, the shares are selling for about 12.3 times times
current earnings.
The price-earnings ratio is widely used by investors as a general guideline in gauging
share values. AAhigh
highprice-earnings
price-earningsratio
ratiomeans that
means investors
that areare
investors willing to pay
willing to apay
premium
a pre-
for thefor
mium company’s shares—presumably
the company’s shares—presumably because the company
because is expected
the company to havetohigher
is expected have
than average
higher future earnings
than average growth.growth.
future earnings Conversely, if investors
Conversely, believebelieve
if investors a company’s future
a company’s
earnings
future growth
earnings prospects
growth are limited,
prospects thethe
are limited, company’s
company’sprice-earnings
price-earningsratio
ratio would
would be
relatively low.
DividendPayout
Dividend Payoutand
andYield
Yield Ratios
Ratios
Investors hold
Investors hold shares
shares in
in aa company
company because
because they
they anticipate
anticipate an
an attractive
attractive return.
return. The
The return
return
sought is not always dividends. Many investors prefer not to receive dividends. Instead,
sought is not always dividends. Many investors prefer not to receive dividends. Instead,
they prefer to have the company retain all earnings and reinvest them internally in order
to support growth. The shares of companies that adopt this approach, loosely termed
growth shares, often enjoy rapid upward movement in market price. Other investors pre-
they prefer to have the company retain all earnings and reinvest them internally in order to
support growth. The shares of companies that adopt this approach, loosely termed growth
shares, often enjoy rapid upward movement in market price. Other investors prefer to
have a dependable, current source of income through regular dividend payments. Such
investors seek out shares with consistent dividend records and payout ratios.
Dividend payout ratio The Dividend Payout Ratio The dividend payout ratio gauges the portion of cur-
An index showing whether a rent earnings being paid out in dividends. Investors who seek growth in market price would
company pays out most of its like this ratio to be small, whereas investors who seek dividends prefer it to be large. This
earnings in dividends or reinvests ratio is computed by relating dividends per share to earnings per share for common stock:
the earnings internally.
Dividends per share
Dividend payout ratio � Dividends per share
Dividend payout ratio Earnings per share
Earnings per share
Fortend
assets Example
to have Company,
low payout theratios,
dividend payoutpayout
whereas ratio for
ratios2008 tend is computed
to be high as in follows:
findustries
ollows:
For Example Company, the dividend payout ratio for 2008 is computed as follows:
with limited reinvestment opportunities. $1.20 (see Exhibit 14–2)
$1.20 (see Exhibit 14–2) � 36.8%
36.8%
assets tend to have low payout ratios,$3.26 whereas payout ratios tend to be high in industries
$3.26
TheThere
with Dividend
limited Yieldthing
isreinvestment
no such Ratio as a The
opportunities.
“right” dividend
payoutyield ratio,ratio
evenisthoughobtained by dividing
it should be noted the cur-
that
There
rentratio
the dividends is noper
tends such thing
share byas the a current
“right” payout
market ratio,aper
price even thoughindustry.
share: it shouldIndustries
be noted with that
There is notosuch be similar
thing as for companies
a “right” payout within particular
ratio, even though it should be noted that
the
ampleratio tends to be for
opportunities similar
growth for at companies
high rateswithin of returna particular
on assetsindustry. tend to have Industries
low payout with
the ratio tends to be similar for companies within a particular industry. Industries with
ample
The opportunities
Dividend
ratios, opportunities
whereas payoutYield for growth
Ratio
ratios tend at
The high rates
dividend
to be highof return
yield ratioon
in industries assets
is obtained
withtend to
by have
dividing low payout
the cur-
ample for growth at high rates of return on assets tendlimited
to havereinvestment
low payout
yield ratio ratios,
rent whereasperpayout
dividends share by ratiosthe tend
current to be highprice in industries
per share: with limited reinvestment
opportunities.
ratios, whereas payout ratios tend to market be high in industries with limited reinvestment
opportunities.
e return in terms of cash dividends being provided by a share.
opportunities.
yield ratio Dividends per share
Dividend yield ratio The Dividend Yield Dividend
Ratioyield The ratio �
dividend yield ratio is obtained by dividing the
Shows the returnein
return
termsinofterms The
cashof cash Dividend
dividends
current dividends Yield
being Ratio
The Dividend Yield Ratio The dividend yield ratio
provided
per share byby The
a
the dividend
share.
current
Market
market yieldprice priceisper
ratio peris share:
share by dividing the cur-
obtained
obtained by dividing the cur-
dividends being provided by a rent dividends per share by the current market price per share:
rent dividends
The marketper share
price forbyExample
the current marketDividends
price per share:per share
share. Dividend yieldCompany’
ratio � shares is $40 each, so the dividend yield is
computed as follows: Market price per share
yield ratio $1.20
yield ratio � 3.0%
e return in terms of cash The
The market
dividends market price
being for
for Example
provided
price by a share.
Example $40 shares
Company’
Company’ shares isis $40
$40 each,
each, so so the
the dividend
dividend yield yield isis
e return in terms of cash dividends being provided by a share.
computed as
computed as follows:follows:
The dividend yield ratio measures $1.20the rate Dividends
of returnper (inshare
the form of cash dividends
Dividend yield ratio �� Dividends
3.0% per share
Dividend
only) that would be earned by an investor yield ratio
$40 who Market price per share
Market price per share shares at the current
buys the common
market price. A low dividend yield ratio is neither bad nor good by itself. As discussed
above,
Theadividend
The dividend
market
company yield
price
yield
may ratio
forpayExample
ratio out measures
veryCompany’
measures theinrate
the
little rate of return
shares
of
dividends return
is $40 (ineach,
(in the
the form
so
it form the ofdividend
of cash
cash dividends
yield is
dividends
The market price for Example Company’ shares isbecause
$40 each, has ample
so the opportunities
dividend yield is
only)
computed
only) that
that
for reinvesting would
as
wouldfollows:be
be earned
earned byby an
an investor
investor
funds within the company at high rates of return. who
who buys
buys the
the common
common shares
shares at
at the
the current
current
computed as follows: $1.20
market price.
market price. A A low
low dividend
dividend yield yield ratioratio is
is neither
neither
$1.20 � 3.0% bad
bad nor
nor good
good by
by itself.
itself. As
As discussed
discussed
above, aa company
company may may paypay out out very
very little $40in
little 3.0% because
above,
Return on Total Assetsthe $40in dividends
dividends because itit has has ample
ample opportunities
opportunities
for
for reinvesting
reinvesting funds within
funds within the company
company at at high
high rates
rates of
of return.
return.
The dividend yield ratio measures the rate of return (in the form of cash dividends
Managers have both
The dividend yield ratio measures
financing and operating the rateresponsibilities.
of return (in the Financing
form of responsibilities
cash dividends
only) that would be earned by an investor who buys the common shares at the current
relate
only)
Return to
that how
would one
onTotal be earned
obtains the funds needed to provide
Assetsyield ratio is neither bad nor good by itself. atAs
by an investor who buys thefor the
common assets in
shares an organization.
the current
Return
market on
price. ATotal Assets
low dividend discussed
Operating
market responsibilities
price. A low dividend relate to how
yield ratioone uses thebad
is neither assetsnoroncegoodthey by have
itself.been obtained.
As discussed
above,
Managers
Managers a company
havetoboth
have may
both pay
financing out very
and little
operatingin dividends because
responsibilities. it has
Financing ample opportunities
responsibilities
Both are
above, vital
a company may pay outand
financing
a well-managed very operating
firm. However,
little responsibilities.
in dividends care must
because Financing
be taken
it hasnot ampletoresponsibilities
confuse
opportunitiesor mix
for reinvesting
relate
relate to when
to how one
how funds
one within
obtains the
the the company
funds
funds needed
needed at high rates of
tomanager.
provide forreturn.
the assets in anan organization.
the reinvesting
for two obtains
assessing
funds withinthe performance
the company at to
of ahighprovide
rates offor
That theis,assets
return. whether in organization.
funds have been Return on comm
Operating
Operating
obtained from responsibilities
responsibilities
creditors or relate
relate
fromto toshareholders
how one
how one uses
usesshouldthe assets
the assets
not onceonce
be they have
they
allowed have been obtained.
been
to influence obtained.
one’s Return on comm
shareholders’ equ
Both
Return
Both are
are
assessment vital
on
vital to
ofTotal
to aa well-managed
how well Assets
well-managed firm. However, care must
the assets have been employed since being received by theor
firm. However, care must bebe taken
taken not
not to
to confuse
confuse orfirm.
mix
mix shareholders’ equ
When compared t
Return
the two
the two whenon
when Total
assessing
assessing Assets
the
the performance
performance of
of a
a manager.
manager.
The return on total assets is a measure of operating performance that shows how That
That is,
is, whether
whether funds
funds have
have been
been When compared
total assets, meas
Managers
obtained havecreditors
from both financing and operating responsibilities. Financing responsibilities total assets, meas
obtained
well assets
Managers from havecreditors
have or
beenfinancing
both or from
employed. from and shareholders
shareholders
It is defined as
operating should
should
follows: not be
not
responsibilities. be allowed
allowed
Financing to influence
to influence
responsibilities one’s
one’s to which financial
to which financial
relate
assessment
assessment to how of
of one
how
how obtains
well
well the
the the funds
assets
assets have
have needed
been
been to provide
employed
employed for
since
since the assets
being
being in
received
received an organization.
by
by the
the firm.
firm. working for or aga
relate to how one obtains the funds needed to provide for the assets in an organization. working for or aga
Return on total assets Operating
The responsibilities
return
The return on total relate to
total assets
assets is ahow one uses
a measure
measure the assets once
of operating
operating they havethat
performance been obtained.
n total assets Operating on
responsibilities relate is to how one uses of the assets once they havethat
performance been shows
shows how
how
obtained. shareholders.
shareholders.
Measure of how well assets
of how wellhave Both
well
assets have
well are
assets
been
assets vital
haveto
employed
have a well-managed
been
been by employed.
management.
employed. firm.
It
It is
is However,
defined
defined as
as care must
follows:
follows: be taken not to confuse or mix
Both are vital to a well-managed firm. However, care must be taken not to confuse or mix
been employed by management. the two when assessing the performance of a manager. That is, whether funds have been
the two when assessing the performance Net income of �a manager.
[Interest That is, whether
expense � (1 �toTax funds have been
rate)]*
n total assets obtained Returnfromoncreditors
total assets or from
� shareholders should not be allowed influence one’s
obtained from creditors or from shareholders should not be allowed to influence one’s
of how well assets haveassessment
been employed of how well the assets have been Average
employed total
since assets
being received by the firm.
assessment of howby wellmanagement.
the assets have been employed since being received by the firm.
The return on istotal assetscalledis anopat.measure of operating performance that shows how
The return on total assets
*This numerator commonly
Net is income
a measure of operating
� [Interest expense performance
� (1 � Tax thatrate)]*
shows how
well assets
Returnhavehave been
on total employed.
assets � It is defined as follows:
well Adding
assets been employed.
interest expense back to net income It is defined as follows:
results total
in anassets
adjusted earnings figure that
Average
shows what earnings would Net been
have income if � [Interest
the assets expense
had been � (1 � Tax
acquired solelyrate)]*
by selling
Return
*This on total
numerator Net
assets � called nopat.
is commonly income [Interest expense (1 Tax rate)]*
Return on total assets
shares. With this adjustment, the return on total Average assets can total
be assets for companies with
compared
Average total assets
Adding interest expense back to net income results in an adjusted earnings figure that
shows what earnings would have been if the assets had been acquired solely by selling
shares. With this adjustment, the return on total assets can be compared for companies
with differing amounts of debt or over time for a single company that has changed its mix
of debt and equity. Thus, the measurement of how well the assets have been employed is
not influenced by how the assets were financed. Notice that the interest expense is placed
on an after-tax basis by multiplying it by the factor (1 2 Tax rate).
The return on total assets for Example Company for 2008 would be computed as
follows (from Exhibits 14–1 and 14–2):
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,750,000

Assets,
Add end of year
back interest expense:. . . . $640,000
. . . . . . . .3. . (1
. .2. . 0.30) . . . . . . . .
. . . . . . . . . . . . . .
. 31,500,000
448,000

Total
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$. 2,198,000
(nopat) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,470,000
(a)

Average
Assets, total assets:
beginning of year$60,470,000 � 2 . . . . . . . . . . . . . . . . $28,970,000
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,235,000 (b)
Return on total assets, (a) � (b) . . . . . . . . . . . . . . . . . . . . . . .
Assets, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,500,000 7.3%

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example Company has earned a return of 7.3% on average $60,470,000
assets employed over the

last year.
Average total assets: $60,470,000 4 2 . . . . . . . . . . . . . . . . . . $30,235,000 (b)
Return on total assets, (a) 4 (b) . . . . . . . . . . . . . . . . . . . . . . . . 7.3%
Return on Common Shareholders’ Equity
Example Company has earned a return of 7.3% on average assets employed over the
One of the primary reasons for operating a corporation is to generate income for the ben-
last year.
efit of the common shareholders. One measure of a company’s success in this regard is the
return on common shareholders’ equity, which divides the net income remaining for
Return
commonon Common
shareholders by Shareholders’
the average commonEquity
shareholders’ equity for the year. The for-
mula is as follows:
One of the primary reasons for operating a corporation is to generate income for the
benefit of the common shareholders. One measure of a company’s success in this regard
n on common shareholders’ equity
is the return on common shareholders’ equity, which divides the net income remaining
compared to the return on total assets, measures the extent to which financial leverage is working for or against Return on common
on shareholders. for common shareholders by the average common shareholders’ equity for the year. The shareholders’ equity
formula is as follows: Measures the income as a
percentage of average common
Return on common Net income � Preferred dividends shareholders’ investment in the
�
shareholders’ equity Average common shareholders equity ’ company.
where
Average common
shareholders’ equity � {
Average total shareholders’ equity
� Average preferred shares }
ForForExample
ExampleCompany,
Company,the
thereturn
return on common shareholders’
on common shareholders’equity
equityis is 11.3%
11.3% forfor
2008
2008 as shown below:
as shown below:
NetNet income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$. 1,750,000
income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,750,000
Deduct
Deduct preferred
preferred dividends . . . . . . . . . . . . . . . . . . . . . . . . . .
dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
120,000

NetNet income
income remaining
remaining forfor common
common shareholders . . . . . . . . . $. 1,630,000
shareholders . . . . . . . . . . $ 1,630,000
(a) (a)

Average
Average shareholders
shareholders’ equity
equity . . . . . . . . . . . . . . . . . . . . . . . . $16,485,000*
. . . . . . . . . . . . . . . . . . . . . . . . . . $16,485,000*
†
Deduct
Deduct average
average preferred
preferred shares
shares . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . 2,000,000
2,000,000
†

Average
Average common
common shareholders
shareholders’ equity . . . . . . . . . . . . . . . . . $14,485,000
equity . . . . . . . . . . . . . . . . . . . $14,485,000 (b) (b)

Return
Return on on common
common shareholders
shareholders’ equity,
equity, (a)(a)
4� (b) . . . . . . . . . 11.3%
(b) . . . . . . . . . 11.3%
*$15,970,000
*$15,970,000 � $17,000,000
1 $17,000,000 � $32,970,000;
5 $32,970,000; $32,970,000
$32,970,000 4 2�52$16,485,000.
� $16,485,000.
†
† $2,000,000
$2,000,000 � $2,000,000
1 $2,000,000 � $4,000,000;
5 $4,000,000; $4,000,000
$4,000,000 4 2�52$2,000,000.
� $2,000,000.
Compare the return on common shareholders’ equity in the preceding (11.3%) with
theCompare thetotal
return on return on common
assets computedshareholders’
previously equity
(7.3%).inWhythe preceding (11.3%)
is the return with
on common
theshareholders’
return on total assets computed previously (7.3%). Why is the return on common
equity so much higher? The answer lies in the principle of financial lever-
age. Financial so much
leverage higher? The
is discussed in answer lies in the
the following principle of financial leverage.
paragraphs.
Financial leverage is discussed in the following paragraphs.
Financial Leverage
LEARNING OBJECTIVE 4
Explain what is meant by the term financial leverage and show how financial leverage
Financial Leverage Financial Leverage

Financial leverage (often called leverage for short) involves acquiring assets with funds
that have been obtained from creditors or from preferred shareholders at a fixed rate of
Explain what is meant by the return. If the assets in which the funds are invested are able to earn a rate of return greater
term financial leverage than the fixed rate of return required by the funds’ suppliers, then we have positive
and show how financial financial leverage and the common shareholders benefit.
leverage is measured. For example, suppose that CTV is able to earn an after-tax return of 12% on its
broadcasting assets. If the company can borrow from creditors at a 10% interest rate
Financial leverage in order to expand its assets, then the common shareholders can benefit from positive
Acquiring assets with funds leverage. The borrowed funds invested in the business will earn an after-tax return of
that have been obtained from 12%, but the after-tax interest cost of the borrowed funds will be only 7% [10% interest
creditors or from preferred rate 3 (1 2 0.30) 5 7%]. The difference will go to the common shareholders.
shareholders at a fixed rate of We can see this concept in operation in the case of Example Company. Notice from Exhibit
return. 14–1 that the company’s bonds payable bear a fixed interest rate of 8%. The after-tax interest
cost of these bonds is only 5.6% [8% interest rate 3 (1 2 0.30) 5 5.6%]. The company’s assets
Positive financial leverage are generating an after-tax return of 7.3%, as we computed earlier. Since this return on assets
A situation in which the fixed
is greater than the after-tax interest cost of the bonds, leverage is positive, and the difference
return to a company’s creditors
and preferred shareholders
accrues to the benefit of the common shareholders. This explains in part why the return on
is less than the return on total common shareholders’ equity (11.3%) is greater than the return on total assets (7.3%).
assets. In this situation, the return Unfortunately, leverage is a two-edged sword. If assets are unable to earn a high
on common shareholders’ equity enough rate to cover the interest costs of debt, or to cover the preferred dividend due to the
will be greater than the return on preferred shareholders, then the common shareholder suffers. Under these circumstances,
total assets. we have negative financial leverage.
Negative financial leverage The Impact of Income Taxes Debt and preferred shares are not equally efficient in
A situation in which the fixed generating positive leverage. The reason is that interest on debt is tax-deductible, whereas
return to a company’s creditors preferred dividends are not. This usually makes debt a much more effective source of
and preferred shareholders is positive leverage than preferred shares.
greater than the return on total
To illustrate this point, suppose that Hotel Corporation is considering three ways of
assets. In this situation, the return
on common shareholders’ equity
financing a $100-million expansion of its chain of hotels:
will be less than the return on total 1. $100 million from an issue of common shares.
assets. 2. $50 million from an issue of common shares, and $50 million from an issue of
preferred shares bearing a dividend rate of 8%.
3. $50 million from an issue of common shares, and $50 million from an issue of bonds
bearing an interest rate of 8%.
Assuming that Hotel Corporation can earn an additional $15 million each year before
interest and taxes as a result of the expansion, the operating results under each of the three
alternatives are shown in Exhibit 14–7.
If the entire $100 million is raised from an issue of common shares, then the return to
the common shareholders will be only 10.5%, as shown under alternative 1 in the exhibit.
If half of the funds are raised from an issue of preferred shares, then the return to the
common shareholders increases to 13%, due to the positive effects of leverage. However,
if half of the funds are raised from an issue of bonds, then the return to the common
shareholders jumps to 15.4%, as shown under alternative 3. Thus, long-term debt is much
more efficient in generating positive leverage than are preferred shares. The reason is
that the interest expense on long-term debt is tax-deductible, whereas the dividends on
preferred shares are not.
The Desirability of Leverage Because of leverage, having some debt in the capital
structure can substantially benefit the common shareholder. For this reason, most com-
panies today try to maintain a level of debt that is considered to be normal within the
industry. Many companies, such as commercial banks and other financial institutions,
rely heavily on leverage to provide an attractive return on their common shares.
$50,000,000
$50,000,000 $50,000,000
$50,000,000
Alternative 1:
Alternative 1: Common
Common Shares;
Shares; Common
Common Shares;
Shares;
$100,000,000
$100,000,000 $50,000,000
$50,000,000 $50,000,000
$50,000,000
Common
Chapter 14 “How Well Am I Doing?”
Common Shares
Financial Preferred
SharesStatement Shares
Analysis
Preferred Shares Bonds
Bonds BC14–17
Chapter 15 “How Well Am I Doing?” Financial Statement Analysis BC15-17
Earnings
Earnings before
before interest
interest and
and taxes
taxes .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. $ 15,000,000
$ 15,000,000 $15,000,000
$15,000,000 $15,000,000
$15,000,000
Exhibit
Deduct 14–7
interest Leverage
expense (8% from
 Preferred
$50,000,000)
Deduct interest expense (8% � $50,000,000) . . . . . . . . .
Shares
. . . . . . and
. . . Long-Term
—
—
Debt —
— 4,000,000
4,000,000
EXHIBIT 14–7 Leverage from Preferred Shares and Long-Term Debt
Net
Net income
income before
before taxes
taxes .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 15,000,000
15,000,000 15,000,000
15,000,000 11,000,000
11,000,000
Deduct Alternatives: $100,000,000 Issue of Securities
Deduct income taxes (30%)
income taxes (30%) .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 4,500,000
4,500,000 4,500,000
4,500,000 3,300,000
3,300,000
Net
Net income
income .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. 10,500,000
10,500,000
Alternative 2:
10,500,000
10,500,000 7,700,000
Alternative 3:
7,700,000
Deduct
Deduct preferred
preferred dividends
dividends (8% (8%  � $50,000,000)
$50,000,000) .. .. .. .. .. .. .. —
4,000,000
$50,000,000
—
4,000,000 —
$50,000,000
—
Net
Net income
income remaining
remaining for
for common
common (a) (a) .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. Alternative
$
$ 10,500,000
10,500,0001: Common
$ Shares;
$ 6,500,000
6,500,000 Common
$ Shares;
$ 7,700,000
7,700,000
$100,000,000 $50,000,000 $50,000,000
Common
Common shareholders
shareholders equity
equity (b)
(b) .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. $100,000,000
$100,000,000 $50,000,000
$50,000,000 $50,000,000
$50,000,000
Common Shares Preferred Shares Bonds
Return on common shareholders equity (a)
Return on common shareholders equity (a) � (b) . . . . . .  (b) . . . . . . 10.5%
10.5% 13.0%
13.0% 15.4%
15.4%
The
The Desirability
Desirability
Earnings of Leverage
of
before interest and taxes . .Because
Leverage . . . . . . . .of
Because of. . leverage,
leverage,
...... having
having some
some debt
$ 15,000,000 debt in
in the
the capital
capital
$15,000,000 $15,000,000
structure can substantially
Deduct interest
structure expense (8%
can substantially benefit the
� $50,000,000)
benefit common
the common shareholder.
. . . shareholder.
...... For this reason, most compa-
For—this reason, most compa-
— 4,000,000
nies
nies today try to
to maintain a level of debt that is considered
considered to to be
be normal
normal within
within the indus-
Nettoday
incometrybefore
maintain
taxes . .a. level
. . . . .of
. . debt
. . . . .that
. . . is
........ 15,000,000 the indus-
15,000,000 11,000,000
try.
try. Many
Many companies,
companies, such
such as
as commercial
commercial banks
banks
Deduct income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . .
and
and other
other financial
financial
4,500,000
institutions,
institutions, rely
rely
4,500,000 3,300,000
heavily
heavily on
on leverage
leverage to
to provide
provide an
an attractive
attractive return
return on
on their
their common
common shares.
shares.
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500,000 10,500,000 7,700,000
Deduct preferred dividends (8% � $50,000,000) . . . . . . . — 4,000,000 —
Book
Book Value
Value
Net income per
per Share
Share
remaining for common (a) ............... $ 10,500,000 $ 6,500,000 $ 7,700,000
Another
Commonstatistic
Another frequently
shareholders
statistic equityused
frequently (b) . .in
used in. . attempting
. . . . . . . . . . to
attempting . . .assess
to ..
assess the
the well-being
well-being of
$100,000,000 of the common
the$50,000,000
common $50,000,000
shareholder
shareholder
Return on commonis book value
is book shareholders per
value per share.share.
equity The
The book
(a)book
� (b) value value
. . . . . per per
. share
share 10.5%measures the amount
measures the amount 13.0%that
that 15.4%
would
would be be distributed
distributed to to holders
holders of of each
each commoncommon share share if if allall assets
assets were
were sold
sold at
at their
their bal-
bal-
ance
ance sheet
sheet carrying
carrying amounts
amounts (i.e., (i.e., book
book values)
values) and and if if all all creditors
creditors were were paid
paid off.
off. Thus,
Thus,
book
book value per share is based entirely on historical costs. The formula for computing it
value per share is based entirely on historical costs. The formula for computing it is
is
Book
as
as follows:
follows: Value per Share
ue Another statistic frequently used in attempting to assess the well-being of the common
ue per
per share
share shareholder is book value per share. The book value per share measures the amount that Book value per share
the woulddistributed
be distributedholders to holderscommonof each common share if allwere assets were sold at their balance Measures the amount that
the amount
amount that
that would
would be be distributed to to holders of of common shares shares ifif all all assets
assets were sold sold at at their
their balance
balance sheet
sheet would be distributed to holders
amounts sheet carrying amounts (i.e., book values) and if all creditors were paid off. Thus, book value
amounts and
and ifif all
all creditors
creditors werewere paid
paid off.
off. of common shares if all assets
per share is based entirely on historical costs. The formula for computing it is as follows:
were sold at their balance sheet
n in which the fixed return to a company’s creditors and preferred
Common
Common shareholders
shareholders’
shareholders’ is greater
equity
equitythan
(Total
(Total
the return on total carrying amounts and if all
this situation, the return on common shareholders’ equity shareholders’
will be less thanequity
the return � Preferred
 Preferred shares)
shares)
on total assets. creditors were paid off.
Book value per share 
Book value per share � Number of common shares outstanding
Number of common shares outstanding
The Impact Total of Income Taxes Debt and preferred ..shares are not equally efficient in
Total shareholders
Total shareholders’equity
shareholders equity(see
equity (seeExhibit
(see Exhibit14–1)
Exhibit 14–1) . . .
14–1) .. .. .. $17,000,000
$17,000,000
$17,000,000
generating positive Deduct leverage.
preferred The reason
shares (see isExhibit
that interest
14–1) .on debt is tax-deductible, whereas
Deduct
Deduct
preferred shares
preferred shares (see (see Exhibit 14–1) . . . . . . . . 2,000,000
. . . 2,000,000
2,000,000
preferred dividends Common
are not. This
shareholders
usually
equity
makes debt a much more effective source of pos-
.. .. .. .. .. .. .. .. .. .. .. .. .. .. .. $15,000,000
itive leverage than Common
Common shareholders’
shareholders
preferred equity . . . . . . . . . . . . . .
shares. equity $15,000,000
$15,000,000
The To
book illustrateper thisshare
point, suppose that Hotel Corporation is considering three follows:
ways of
The book avalue
financing value per share
$100-million share of of Example
of Example
ExampleofCompany’
expansion
Company’
Company’
its chain of
common
common
common hotels:shares
shares
sharesisis computed
computedasas
iscomputed asfollows:
follows:
$15,000,000
$15,000,000  $30
1. $100 million from an issue of500,000 commonshares shares.� $30
500,000 shares
2.
If $50 million
If this
this book from
book value
value is an issue
is compared of
compared with common
with the the $40$40shares, market and
value $50 million from
of Example an issue
Company of
shares,
If this
preferred book value
shares is
bearingcompared
a with
dividend the
rate $40of market
market
8%. value
value of
of Example
Example Company
Company shares,
shares,
then the
then theshares
sharesappear
appeartoto be be somewhat overpriced. However, asdiscussed
we discussed earlier,
then
3. the million
$50
market shares reflect
prices appear
from an be somewhat
toissue somewhat
expectationsof common about
overpriced.
overpriced.
shares,
future
However,
However,
and
earnings $50 million as
as we
and we discussed
from
dividends,
earlier,
earlier,
an issue
whereas
mar-
mar-
of bonds
book
ket
ket prices
prices
bearing reflect
reflect
an expectations
expectations
interest rate of about
about
8%. future
future earnings
earnings and
and dividends,
dividends, whereas
whereas book
book value
value
value largely
largely reflects reflects
the the results
results of that
events that occurred in the past. Ordinarily, the market
largely
value reflects
of a share results of
theexceeds ofitsevents
events
book that
value.
occurred
occurred
For
in
in the
example, the past.past. in
Ordinarily,
Ordinarily,
a recent
the
the market
year, market
Canadian
value
value of
of
Tire
aa share
share exceeds
Assuming
exceeds its
that
its book value.
Hotelvalue.
book Corporation can earn an additional $15 million each year before
Corporation Limited traded on the stock market at 2.2 times its book value per share and
interest and taxes as a result of the expansion, the operating results under each of the three
15.90 times its earnings per share.
alternatives are shown in Exhibit 14–7.
If the entire $100 million is raised from an issue of common shares, then the return to
the common shareholders will be only 10.5%, as shown under alternative 1 in the exhibit.
Ratio Analysis—TheRatio
If half of the funds are raised from an issue of preferred shares, then the return to the com-
mon shareholders increases to 13%, due to the positive
Short-Term
effectsAnalysis—The
Creditor
of leverage. However, ifShort-Term Creditor
half of the funds are raised from an issue of bonds, then the return to the common share-
Short-term creditors, such as suppliers, want to be repaid on time. Therefore, they focus
holders jumps to 15.4%, as shown under alternative 3. Thus, long-term debt is much more
on the company’s cash flows and on its working capital since these are the company’s
efficient in generating positive leverage than are preferred shares. The reason is that the
primary sources of cash in the short run.
interest expense on long-term debt is tax-deductible, whereas the dividends on preferred
shares are not.
The excess of current assets over current liabilities is known as working capital. The
working
working capital
capital for
for Example
Example Company
Company is is computed
computed below:
below:
Working
Working capital
capital
Measures the company’s ability to repay current liabilities using only current assets.
Measures the company’s ability to repay current liabilities using only current assets.
Working Capital
Working
Working capital  Current
capital � Current assets  Current
assets � Current liabilities
liabilities
Compute and interpret the The excess of current assets over current liabilities 2008 is known2007
as working capital. The
2008 2007
financial ratios used by the working capital for Example Company is computed below:
Current assets . . . . . . . . . . $15,500,000 $16,470,000
Current assets . . . . . . . . . . $15,500,000 $16,470,000
short-term creditor. Current liabilities . . . . . . . . 7,000,000 5,000,000
Current liabilities
Working capital.5 . . Current
..... 7,000,000
assets 5,000,000
2 Current liabilities
Working capital . . . . . . . . . $ 8,500,000 $11,470,000
Working capital . . . . . . . . . $ 8,500,000 $11,470,000
Working capital 2008 2007
Measures the company’s ability to The
repay current liabilities using only The amount
amount of working
Current
of working capital
capital available
assets . . . . . . . . . .
available to
to aa firm
firm is
$15,500,000 is of considerable
considerable interest
of$16,470,000 interest toto short-
short-
term creditors, because
term creditors, because it represents
Current itliabilities
represents assets
. . . . assets financed
. . . . financed
7,000,000 from long-term
5,000,000 capital sources that
from long-term capital sources that
current assets.
do
do not
not require
require near-term
Working capital
near-term repayment. Therefore,
. . . . . . . . .
repayment. $ 8,500,000
Therefore, the
the greater the
$11,470,000
greater the working
working capital,
capital, the
the
greater
greater is the cushion of protection available to short-term creditors and the greater is the
is the cushion of protection available to short-term creditors and the greater is the
assurance
assurance that
that short-term
short-term debts
debts will
will be
be paid
paid when
when due.
due.
The amount of working capital available to a firm is of considerable interest to short-
termAlthough
creditors,itit is
Although is always
always it
because comforting
representsto
comforting short-term
to assets
short-term creditors
creditors
financed fromto see
see aa large
to long-term working
large capital capital
workingsources
capital
balance,
balance, a
a large
large balance
balance by
by itself
itself is
is no
no assurance
assurance that
that debts
debts
that do not require near-term repayment. Therefore, the greater the working capital, the will
will be
be paid
paid when
when due.
due. Rather
Rather
than
than being
greaterbeing aa sign
is the sign of
of strength,
cushion strength, aa large
of protection working
largeavailable
working to capital
capital balance
balance
short-term may
may simply
creditors simply mean
mean
and the that
that obso-
greater obso-
is the
lete
lete inventory
inventory is
is being
being accumulated.
accumulated.
assurance that short-term debts will be paid when due. Therefore,
Therefore, to
to put
put the
the working
working capital
capital figure
figure into
into
proper
proper perspective,
perspective, it
it must
must be
be supplemented
supplemented with
with other
other analytical
analytical
Although it is always comforting to short-term creditors to see a large working capital work.
work. The
The following
following four
four
ratios
ratios
balance,(the
(thea current
current ratio,
ratio, the
large balance by acid-test
the acid-test
itself is no ratio,
ratio, the
the accounts
assurance accounts
that debtsreceivable
will beturnover,
receivable turnover,
paid when and the
anddue. inven-
the Rather
inven-
tory
tory turnover)
turnover) should
should all
all be
be used
used in
in connection
connection with
with
than being a sign of strength, a large working capital balance may simply mean thatan
an analysis
analysis of
of working
working capital.
capital.
obsolete inventory is being accumulated. Therefore, to put the working capital figure into
Current Ratio
proper perspective,
Current Ratio it must be supplemented with other analytical work. The following
four ratios (the current ratio, the acid-test ratio, the accounts receivable turnover, and the
The
The elements
elements
inventory involved
involved
turnover) in
in the
should allcomputation
the computation of
of working capital
workingwith
be used in connection capital are
are frequently
frequently
an analysis expressed
expressed
of working in
in
capital.
ratio form. A company’s current assets divided by its current liabilities is known
ratio form. A company’s current assets divided by its current liabilities is known as theas the
current
current ratio:
ratio:
Current Ratio
Current
Current ratio
ratio The elements involved in the computation of working capital are frequently expressed in
Test of short-term debt-paying ability.
Test of short-term debt-payingratio
ability.
form. A company’s current assets divided by its current liabilities is known as the
Current ratio current ratio:
Test of short-term debt-paying Current
Current Current assets
assets
ability. Current ratio
ratio �
 Current liabilities
Current liabilities
ForFor Example
Example Company,
Company, the
the current
current ratios
ratios for
for 2007
2007 and
and 2008
2008 would
would be
be computed
computed as
as
follows:
follows:
2008
2008 2007
2007
$15,500,000
$15,500,000 � 2.21 to 1 $16,470,000
$16,470,000 � 3.29 to 1
$7,000,000  2.21 to 1 $5,000,000  3.29 to 1
$7,000,000 $5,000,000
Although
Although widely
Although widely regarded
widely regarded as
regarded as aaa measure
as measure of
measure of short-term
of short-term debt-paying
short-term debt-paying ability,
debt-paying ability, the
ability, the current
the ccurrent
urrent
ratio
ratio must be interpreted with great care. A declining ratio, as above, might be a sign of
ratio must
must be
be interpreted
interpreted with
with great
great care.
care. A
A declining
declining ratio,
ratio, as
as above,
above, might
might be
be aa sign
sign of aaa
of
deteriorating
deteriorating financial
financial condition.
condition. On
On the
the other
other hand,
hand, it
it might
might
deteriorating financial condition. On the other hand, it might be the result of eliminating be
be the
the result
result of
of eliminating
eliminating
obsolete
obsolete inventories
obsolete inventoriesor
inventories ororother
otherstagnant
other stagnant
stagnant current assets.
current
current assets.assets.An
An improving
An improving
improving ratio might
ratio ratio
mightmightbe
be the
thebe result
the
result
of an
resultunwise
of an stockpiling
unwise of
stockpiling inventory,
of or it
inventory, might or indicate
it might an improving
indicate
of an unwise stockpiling of inventory, or it might indicate an improving financial situation. an financial
improving situation.
financial
In
In short,
short, the
situation. In current
the ratio
short, the
current is
is useful,
current
ratio ratiobut
useful, tricky
tricky to
is useful,
but butinterpret.
to tricky toTo
interpret. avoid
avoid aa blunder,
Tointerpret. To avoidthe
blunder, analyst
a blunder,
the analyst
must
the take
analyst a hard
must look
take at
a the
hard individual
look at theassets and
individual
must take a hard look at the individual assets and liabilities involved. liabilities
assets involved.
and liabilities involved.
TheThe general
The generalrule
general rule ofofthumb
ruleof thumbcalls
thumb calls
calls for aa current
forfor a current
current ratio
ratio of
of 22of
ratio to
to21. This
1.to
This rule
rule is
1. This subject
isrule to
to many
is subject
subject many to
exceptions,
many depending
exceptions, on
depending the industry
on the and
industry the firm
and involved.
the firm
exceptions, depending on the industry and the firm involved. Some industries can operate Some
involved. industries
Some can
industries operate
can
quite
quite successfully
operate on
on aa current
quite successfully
successfully current on ratio
aratio of
currentof slightly
ratio of
slightly over
over 11 to
slightly 1. The
The adequacy
1.over 1adequacy
to 1. The of aa current
current ratio
of adequacy
towww.mcgrawhill.ca/college/garrison of a
ratio
depends www.mcgrawhill.ca/college/garrison
depends heavily on the composition of the assets involved. For example, as we see in the
current heavily
ratio on
depends the composition
heavily on the of the assets
composition involved.
of the For
assets example,
involved. as
For we see
example, in as
the
table
we below,
see in theboth
table Worthington
below, both Corporation
Worthington and Greystone,
Corporation and
table below, both Worthington Corporation and Greystone, Inc. have current ratios of 2 toInc. have
Greystone, current
Inc. ratios
have of 2
current to
11ratios
H
H of 2 tohh1. However, ii they arebl blnotfi ii ll
fiin comparable di
di ii financial
G
G ii lik
lik ll Greystone
condition. hh dif difis
likely to have difficulty meeting its current financial obligations, since almost all of its
current assets consist of inventory rather than more liquid assets such as cash and accounts
receivable.
Worthington Greystone,
Corporation Inc.
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . $ 25,000 $ 2,000

Accounts receivable, net . . . . . Worthington
60,000 Greystone,
8,000

Inventory . . . . . . . . . . . . . . . . . Corporation
85,000 Inc.
160,000
Prepaid expenses . . . . . . . . . . 5,000 5,000
Current assets:
Total current assets . . . . . . . $175,000 $175,000 (a)
Cash . . . . . . . . . . . . . . . . . . . . $ 25,000 $ 2,000
Accounts receivable, net . . . .
Current liabilities . . . . . . . . . . . . . 60,000
$ 87,500 8,000(b)
$ 87,500
Inventory . . . . . . . . . . . . . . . . . 85,000 160,000
Current ratio,expenses . . . . . . . . . .
Prepaid (a) � (b) . . . . . . . . 2 to5,000
1 2 to5,000
1

Total current assets . . . . . . $175,000 $175,000 (a)

Acid-Test Current
(Quick)
Ratio
liabilities . . . . . . . . . . . . . $ 87,500 $ 87,500 (b)
The acid-testCurrent ratio, (a) 4 (b) . . . . . . . .

(quick) ratio is a much more rigorous 2 to 1 2 to 1
test of a company’s ability to meet
its short-term debts. Inventories and prepaid expenses are excluded from total current
assets, leaving only the more liquid (or “quick”) assets to be divided by current liabilities.
Acid-Test (Quick) Ratio
quick) ratio The acid-test (quick) ratio is a much more rigorous test of a company’s ability to meet its Acid-test (quick) ratio
rt-term debt-paying ability without having to rely on inventory.
short-term debts. Inventories and prepaid expenses are excluded from total current assets, Test of short-term debt-paying
leaving only the more liquid (or “quick”) assets to be divided by current liabilities. ability without having to rely on
inventory.
Cash � Temporary Investments � Current receivables*
Acid-test ratio � Current liabilities
*Current receivables include both accounts receivable and any short-term notes receivable.
TheTheacid-test
acid-testratio
ratio is
is designed
designed to tomeasure
measurehow howwell
wella company
a company can meet
can meetits its
obligations
obliga-
without having to liquidate or depend too heavily on its inventory. Since
tions without having to liquidate or depend too heavily on its inventory. Since inventory inventory may
be difficult to sell in times of economic stress, it is generally felt that to
may be difficult to sell in times of economic stress, it is generally felt that to be properly be properly
protected,each
protected, eachdollar
dollarofofliabilities
liabilitiesshould
shouldbebebacked
backedbybyatatleast
least$1
$1ofofquick
quickassets.
assets.Thus
Thus,
,
an acid-test ratio of 1 to 1 is broadly viewed as being adequate in
an acid-test ratio of 1 to 1 is broadly viewed as being adequate in many firms. many firms.
TheTheacid-test
acid-testratios
ratiosfor
forExample
ExampleCompany
Companyfor for2007
2007and and2008
2008arearecomputed
computedbelow:below:
2008
2008 2007
2007
Cash(see
Cash (seeExhibit
Exhibit14–1)
14–1) . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . $1,200,000
$1,200,000 $2,350,000
$2,350,000
Accounts

Accounts receivable (see Exhibit 14–1) . . . . .
receivable (see Exhibit 14–1) . . . . 6,000,000 6,000,000 4,000,000
4,000,000
Total
Total quick assets . . . . . . . . . . . . . . . . . . . . . $7,200,000 $6,350,000 (a)
quick assets . . . . . . . . . . . . . . . . . . . . . $7,200,000 $6,350,000 (a)

Currentliabilities
Current liabilities(see
(seeExhibit
Exhibit14–1)
14–1) .. .. .. .. .. .. .. $7,000,000
$7,000,000 $5,000,000
$5,000,000 (b)
(b)

Acid-testratio,
Acid-test ratio,(a)
(a)�4(b)
(b) . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . 1.03
1.03toto11 1.27toto11
1.27
Although
AlthoughExample
ExampleCompany
Company hashas an acid-test
an acid-test ratio ratio for that
for 2008 2008 that is the
is within within the
accept-
acceptable range, an analyst might be concerned about several disquieting trends
able range, an analyst might be concerned about several disquieting trends revealed in the revealed
in the company’s
company’s balance balance sheet.inNotice
sheet. Notice Exhibitin14–1
Exhibit
that14–1 that short-term
short-term debts while
debts are rising, are rising,
the
cash position seems to be deteriorating. Perhaps the weakened cash position is a resultposition
while the cash position seems to be deteriorating. Perhaps the weakened cash of the
is a result
greatly of thevolume
expanded greatly of
expanded
accountsvolume of accounts
receivable. One wondersreceivable.
why theOne wonders
accounts why the
receivable
accounts receivable have been allowed to increase so
have been allowed to increase so rapidly in so brief a time. rapidly in so brief a time.
InInshort,
short,asaswith
withthe
thecurrent
currentratio,
ratio,the
theacid-test
acid-testratio
ratioshould
shouldbebeinterpreted
interpretedwith
withoneone
eye on its basic components.
eye on its basic components.
AccountsReceivable
Accounts Receivable Turnover
Turnover
The accountsreceivable
Theaccounts receivable turnover
turnover isis aarough
roughmeasure
measureofofhowhowmany
manytimes
timesa acompany’s
company’s Accounts receivable turnover
accounts receivable have been turned into cash during the year. It is frequently usedinin A rough measure of how many
accounts receivable have been turned into cash during the year. It is frequently used
conjunction with an analysis of working capital, since a smooth flow from accounts receivable times a company’s accounts
conjunction with an analysis of working capital, since a smooth flow from accounts
into cash isintoan cash
important receivable have been turned into
receivable is an indicator
importantofindicator
the “quality”
of theof“quality”
a company’s
of aworking
company’scapital and is
working cash during the year.
critical to its ability to operate. The accounts receivable turnover is computed by dividing sales
on account (i.e., credit sales) by the average accounts receivable balance for the year.
BC15-20 Chapter 15 “How Well Am I Doing?” Financial Statement Analysis Average
Assuming that all sales for the year were on account, the accounts receivable turnover Averagesas
for Example Company for 2008 would be computed as follows:
Measure
Measureo
Sales on account
BC15-20
BC14–20
BC15-20 Chapter
Chapter Accounts
Chapter 15
15 “How
14 “HowWell
“How Sales
WellAm
Well Amon
receivable account
turnover
I IDoing?”
Doing?” �

Financial
Financial
$52,000,000
Statement
Statement Analysis
Analysis
Analysis
Average� accounts
 � 10.4balance
receivable
 times
Average accounts receivable balance $5,000,000*
Assuming that all sales for the year were on account, the accounts receivable turnover
*$4,000,000  � $6,000,000  Sales
� $10,000,000; $10,000,000 
Sales�on2
on�account
$5,000,000 average.
account
for Example Company
Accounts for
receivable2008 would
turnover �be computed as follows:
Accounts receivable turnover �Average accounts receivable balance
The turnover figure can then be divided Average
into 365accounts receivable
to determine balance
the average number of
days being taken
Assuming
Assuming to
that Sales
collect
all sales on
an
for account
account
the year (known
were onas $52,000,000
the average
account, the collection
accounts period).
receivable turnover
Assuming that
thatall
allsales
salesforforthe
theyear
yearwere
wereon �
onaccount,

account, the �
theaccounts10.4 times
accountsreceivable
 receivableturnover
turnover
for ExampleAverage
Company accounts
for 2008receivable
would balance
be computed $5,000,000*
as follows:
for
forExample
ExampleCompany
Companyfor for2008
2008wouldwouldbe becomputed
computedasasfollows:
follows:
*$4,000,000 �
 $6,000,000 �
 $10,000,000; $10,000,000 �
2�
 $5,000,000 average.
Average collection period Sales
Saleson onaccount
account $52,000,000
$52,000,000
Measure of the average number ofThe turnover
days taken tofigure can
collect an then be divided
account into�
receivable. 365 to determine��
�$5,000,000* 10.4
10.4
the times
timesnumber of
average
Average accounts receivable balance
Average accounts receivable balance $5,000,000*
days being taken to collect an account (known as the average collection period).
*$4,000,000 ��$6,000,000 $10,000,000; 365 days
Average
*$4,000,000 collection
$6,000,000�� period � $10,000,000

$10,000,000; $10,000,000��2 2��$5,000,000 $5,000,000average.
average.
Accounts receivable turnover
The Theturnover
The turnoverfigure
turnover figurecan
figure canthen
can thenbe
then bedivided
be dividedinto
divided into365
into 365to
365 totodetermine
determinethe
determine theaverage
the averagenumber
average numberof
number of
of
Average collection period days The average
being collection
taken to period
collect an for
account Example (known Company
as the for
average 2008collection
is computed as follows:
period).
AverageMeasure
collection period days
days being
being taken
taken to
to collect
collect
of the average number of days taken to collect an account receivable.
an
an account
account (known
(known asas the
the average
average collection
collection period).
period).
Measure of the average number 365
of days taken to collect an � 35 days
 365 days
accountAverage collection
receivable. period Average collection 10.4 period times�

Average collection period Accounts receivable turnover
Measure
Measureofofthetheaverage
averagenumber
numberThisofofdays
daystaken
simply means
taken totocollect
that onan
collect account
average
an account it receivable.
takes 35 days to collect on a credit sale. Whether the
receivable.
The average
The
averageaverage collection
of 35collection
days taken period
periodto collectfor Example
for Example
an account Company
Company is goodfor for 2008depends
or 2008
bad is computed
is computedon theas ascredit
follows:
follows: terms
365
365 days
days
Example Company Average
Average collection
is offering
collection period
its customers.
period � If the credit
365 Accounts receivable turnover
� terms are 30 days, then a 35-day
average collection period would 10.4 usually be � 
viewed 35 days
Accounts asreceivable
very good.turnover Most customers will
times
The
tend average
to withhold collection
payment period for for
as Example
long
The average collection period for Example Company for 2008 is computed as the Company
credit termsfor 2008
will is
allow computed
and mayas asfollows:
even go over
follows:
This fewsimply
aThis days. means
simply means
This factor,that
that ononadded average
average to ititever-present
takes
takes 35
35 days
days to
to
problems collect
collect on
on
with aaacredit
credit
few sale.
sale. Whether
Whether
slow-paying the
the
cus-
average of 365
365 �is35good
average can
tomers, of 35 35 days
daysthe
cause taken
takenaverageto
to collect
collect an
an account
collection account
period is good
to
� 35 days days
exceed or
or bad
bad depends
depends
normal crediton
on the
the
terms credit
credit
by a terms
terms
week
Example 10.4
10.4times timesIf
so andCompany
Example
or should notis
Company offering
iscause
offering great its customers.
itsalarm.
customers. If the
the credit
credit termsterms are are 30 30 days,
days, thenthen aa 35-day
35-day
average
average collection period would usually be viewed as very good. Most customers will
ThisThis simply means that on average it takes 35 days to collect on a credit sale. Whetherwill
simply
On collection
the means
other period
that
hand, on
if would
average
the usually
company’sit takes be
35
creditviewed
days terms to as
collect
are very
10 ongood.
a
days, Most
credit
then sale.
a customers
Whether
35-day average the
the
tend
tend
average to
to
collection withhold
withhold
of 35 days
period payment
payment
istaken to
worrisome. for
for as long
as
collect long
The an as
as thecredit
the
account
long creditis
collection terms
terms
good or will
will
bad
period allow
allow
depends
may and
and may
may
on
result the
from even
even goover
go
credit
many over
olda
terms
average of 35 days taken to collect an account is good or bad depends on the credit terms
aunpaid
fewdays.
few
Example days. This
CompanyThis offactor,
factor, is added added toits to ever-present
ever-present orproblems problemsbewith with
a few aslow-paying
fewdays,
slow-paying customers,cus-
Example accounts
Company isoffering
doubtful
offering itscustomers.
collectability,
customers. IfIf
itthe may
the credit
credit aterms
result
terms are
of
are 30
poor then
day-to-day
30 days, then aa35-day
credit
35-day
tomers,
can
average cause can the cause
average the average
collection collection
period to period
exceed tonormal
exceed normal
credit termscreditby terms
a week byoraso weekand
average collection period would usually be viewed as very good. Most customerswill
management. collection The period
firm may would
be usually
making be
sales viewed
with as
inadequate very good.
credit Most
checks customers
on customers, will
or
tend
or so
shouldtoand
perhaps not should
withholdcause
no not
great
payment
follow-ups cause
alarm. aregreat
for as
beingalarm.
long madeas theon credit
slow terms
accounts. will allow and may even go over
tend to withhold payment for as long as the credit terms will allow and may even go over
a afew On the
Ondays.the other
other hand, ififadded
the company’s credit
credit terms are
are 10 days, then aa 35-day
35-day average
few days. Thishand,
This factor,
factor, the
added company’s
totoever-present
ever-present terms
problems
problems 10 days,
with
with then
aafewfewslow-paying
slow-paying average
cus-
cus-
collection
collection
tomers, can period
period
cause is
is
the worrisome.
worrisome.
average The
The
collection long
long collection
collection
period to exceed period
period may
normalmay result
result
credit from
from
terms many
bymany
a weekold
old
tomers,
Inventory can cause
Turnover the average collection period to exceed normal credit terms by a week
unpaid
or unpaid
so andaccounts
accounts
should of
of
not doubtful
doubtful
cause collectability,
greatcollectability,
alarm. or
or itit may
may be
be aa result
result ofof poor
poor day-to-day
day-to-day credit
credit
or so and should not cause great alarm.
management.
inventory
management.
On The firm
firm may
turnover
The ififratio
may be
be making
making sales sales with
with inadequate
inadequate credit
credit checks
checks on
on customers,
customers,
The Onthe theotherother hand,
hand, thethe company’s
measures
company’s credit
how
creditmany terms
terms are
times are10a10 days,
days,then
company’s then aa35-day
inventory
35-day average
has been
average
oror perhaps
perhaps
collection no
no follow-ups
follow-ups are
are being
being made
made on
on slow
slow accounts.
accounts.
collection period is worrisome. The long collection period may result from manyold
sold and period
replaced is worrisome.
during the year. TheIt is long
computed collection by period
dividing may
the result
cost of from
goods many
sold by the
old
unpaid
average accounts
level of of doubtful
inventory on collectability,
hand: or it may
unpaid accounts of doubtful collectability, or it may be a result of poor day-to-day credit be a result of poor day-to-day credit
management.
Inventory
management.Turnover The
Thefirm firmmay maybe bemaking
makingsales saleswithwithinadequate
inadequatecredit creditchecks
checkson oncustomers,
customers,
Inventory turnover ratio Inventory
ororperhaps no
Turnover
follow-ups are being made on slow accounts.
perhaps no follow-ups are being made on slow accounts.
Inventory turnover ratio The inventory
The inventory turnover turnover ratio ratio measures
measures how how manymany times times aa company’s
company’s inventoryinventory has has been
been
MeasureMeasure manya times asold
of howtimes
of how many and
and replaced
company’s
sold inventory
replaced during
duringhas the the year.
been soldIt
year. is
is computed
Itduring the year.
computed by
by dividing
dividing the the cost
cost ofof goods
goods sold sold by by the
the
company’s inventory has been Inventory
Inventory
average
average level
level of
Turnover
Turnover
of inventory
inventory on on hand:
hand:
sold during the year. The Theinventory
inventoryturnover turnoverratio ratiomeasures
measureshow howmany Cost times
many of goods
times aacompany’s
sold
company’s inventory
inventoryhas hasbeenbeen
Inventory turnover ratio sold and replaced Inventory
during the turnover
year. It is 
�
computed by dividing the cost of goods sold by the
sold and replaced during the year. It is computed by dividing
Average inventory balance the cost of goods sold by the
average
average level
level ofofinventory
inventory on on hand:
hand:
Measure of how many times a company’s inventory has been soldisduring the year.
The average average inventory
inventory figure
figure isthe theaverage
average of ofthethe beginning
beginning andand endingendinginventory
inventory fig-
Inventory turnover ratio
Inventory turnover ratio ures.
figures. SinceSince Example
Example Company Company has ahasbeginning
a beginning inventory of
inventory $10,000,000
of $10,000,000and an ending
and an
inventory
ending inventory of $8,000,000,of $8,000,000, its average its inventory
average inventoryfor
Cost theofyear forwould
goods thesold
year be would
$9,000,000. The com-
be $9,000,000.
Inventory turnover �
 the
Measure
Measureofofhowhowmany timesaapany’s
manytimes company’s
The inventory
company’s
company’s inventory turnover
inventory
inventory has
hasbeen for 2008
sold
turnover
been would
soldduring
for
during2008 be
the computed
year.
would
Average as follows:
be computed
year.inventory balance as follows:
The average inventory Cost of goods
figure is thesoldaverage of$36,000,000 the beginningand ending inventory fig-

�CostCost ofofgoods
goods � 4 times
sold
sold
ale period ures. Since Example Average Company
Inventory inventory
Inventoryturnover has a beginning
balance
turnover��Average inventory balanceinventory
$9,000,000 of $10,000,000 and an ending
inventory of $8,000,000, its average inventory for theinventory
Average year would be $9,000,000. The com-
balance
of the average number ofThe
pany’s The number
inventory
days taken to ofselldays
turnover the for being2008
inventory taken
would to
oneaverage sell
be
time. the
computed entire as inventory
follows: one time (calledfig- the
averageTheaverage
average
sale
inventory
period) inventory
can
figure
be figure is
computed isthethe by average
dividing
ofofthe the beginning
365 beginning
by the
and
andending
inventory ending inventory
inventory
turnover
fi fig-
gure:
Average sale period ures. Since Example Company Chapterhas 15aabeginning
“How Well inventory
Am I Doing?” Financial
ofof$10,000,000 Statement
and an Analysis
ending
Measure of the average number
ures. Since Example Company
Cost of goods has sold beginning inventory
$36,000,000 $10,000,000 and an ending
inventory
inventoryofof$8,000,000,
$8,000,000, itsitsaverage
averageinventoryinventory� forforthe year
the365 year would
would
days �
be 4betimes
$9,000,000.
$9,000,000.The Thecom-com-
of days taken to sell the inventory Average Average inventory sale balance
period � $9,000,000
pany’s inventory turnover for
pany’s inventory turnover for 2008 would be computed 2008 would be computed as
Inventoryasturnover follows:
follows:
one time.
Cost
Costofofgoods
goodssold
365
sold $36,000,000
$36,000,000 � 4 times
��
911⁄4 days � 4 times
Average inventory balance
4 times
Average inventory balance $9,000,000
$9,000,000
The average sale period varies from industry to industry. Grocery stores tend to turn
over their inventory very quickly, perhaps as often as every 12 to 15 days. On the other
hand, jewellery stores tend to turn over their inventory very slowly, perhaps only a couple
365 days
Average sale period �
Inventory turnover
Chapter 14 365
“How �
Well
91Am
1 I Doing?” Financial Statement Analysis
⁄4 days BC14–21
4 times
The average sale period varies from industry to industry. Grocery stores tend to turn
over their inventory very quickly, perhaps as often as every 12 to 15 days. On the other other
hand, jewellery stores tend to turn over their inventory very slowly, perhaps only a couple
of times each year.
If a firm
firm has a turnover that is much slower than the average for its industry, then then it
it
may have
have obsolete
obsolete goods on hand,
hand, or
or its
its inventory
inventory may
may be be needlessly
needlessly high.
high. Excessive
Excessive
inventories tie up funds that could be used elsewhere in operations. Managers sometimes
argue that they must buy in veryvery large
large quantities
quantities to take
take advantage
advantage of the
the best
best discounts
discounts
being offered. But these discounts must be carefully weighed against the added costs of
insurance, taxes, financing, and risks of obsolescence
obsolescence and deterioration
deterioration that result from
from
carrying added inventories.
Inventory turnover has been increasing in recent years as as companies
companies have
have adopted
adopted
just-in-time (JIT) methods. Under JIT, inventories are purposely kept low, and thus athus
just-in-time (JIT) methods. Under JIT, inventories are purposely kept low, and com-a
company utilizing JIT methods may have a very high inventory turnover
pany utilizing JIT methods may have a very high inventory turnover when compared to when compared
to other
other companies.
companies. Indeed,
Indeed, oneone of the
of the goalsgoals of JIT
of JIT is toisincrease
to increase inventory
inventory turnover
turnover by
by sys-
systematically reducing the amount of inventory
tematically reducing the amount of inventory on hand. on hand.
Cash Flow
Cash FlowRatios
Ratios
In analyzing
analyzing the thefirm’s
firm’sshort-term
short‑termliquidity
liquidityrisk,
risk,the
themanager
managermay may find
find it useful
it useful to refer
to refer to
the statement of cash flows in conjunction with a firm’s balance sheet and incomeincome
to the statement of cash flows in conjunction with a firm’s balance sheet and state-
statement
ment to compute
to compute various various
ratios.ratios. Theofratio
The ratio cashofflow
cashfrom
flowoperations
from operations
(CFO) to (CFO)
currentto
current liabilities can provide valuable clues to management
liabilities can provide valuable clues to management on how best to finance business on how best to finance
business operations.
operations. This ratioThis
is anratio is anof
indicator indicator of the
the amount of amount
cash theoffirmcash
hasthe firm has
derived fromderived
oper-
from operations after meeting current debt and working capital obligations.
ations after meeting current debt and working capital obligations. In calculating this ratio, In calculating
itthis ratio,toituse
is best is cash
best toflowusefrom
cashcontinuing
flow fromoperations
continuingsooperations
as not to besomisled
as notby tounusual
be misled
or
by unusual or non-recurring items. A ratio of .40 or more
non-recurring items. A ratio of .40 or more is considered good for a manufacturingis considered good forora
manufacturing
retailing firm. or retailing firm.
In addition
additiontotoshort-term
short‑termratioratio analysis,
analysis, a manager
a manager maymayalsoalso
find find it useful
it useful to do to do a
a trend
trend analysis comparing net income over several periods with cash
analysis comparing net income over several periods with cash flow from operations. To flow from operations.
To reduce
reduce the the effect
effect of of non-cash
non-cash items,
items, suchasasdepreciation
such depreciationand andaccruals
accrualsof of revenue
revenue and
expenses, one could use the following ratio:
CFO before interest and taxes

Operating income before interest,
taxes, and depreciation
Any evidence of the CFO and operating income not moving in parallel could signal
Any evidence of the CFO and operating income not moving in parallel could signal
trouble and the cause should be investigated in time to take corrective action.
trouble and the cause should be investigated in time to take corrective action.
Other cash flow ratios may also be of interest. In assessing the quality of earnings,
Other cash flow ratios may also be of interest. In assessing the quality of earnings, for
for example, insight can be gained by dividing cash flow from operations by sales. A high
example, insight can be gained by dividing cash flow from operations by sales. A high
ratio signals high‑quality earnings. Cash flow from operations is used in lieu of operating
ratio signals high-quality earnings. Cash flow from operations is used in lieu of operating
income because the latter is subject to more judgement regarding cost allocation and
income because the latter is subject to more judgement regarding cost allocation and rev-
revenue recognition. Another indicator of quality of earnings is cash flow from operations
enue recognition. Another indicator of quality of earnings is cash flow from operations
divided by operating income. Because of non-cash expenses such as depreciation and
divided
Chapter by 15 operating
“How Well income. Because of non-cash expenses such as depreciation and
non-cash revenues suchAm I Doing?”
as credit Financial
sales Statement
or the recognitionAnalysis
of previously deferred revenue,
non-cash revenues such as credit sales or the recognition of previously deferred revenue,
a substantial difference may exist between CFO and operating income.
a substantial difference may exist between CFO and operating income.
In addition to assessing quality quality of earnings,
earnings, CFO
CFO can also be used to com compute
pute
In addition to assessing quality of earnings, CFO can also be used to compute
other ratios of interest to management. A manager may be interested, for exam exampple,
le, in
other ratios of interest to management. A manager may be interested, for example, in
ddetermining
etermining the firm’s ability to make capital expenditures from internally generated
determining the firm’s ability to make capital expenditures from internally generated
funds. A helpful ratio is CFO divided by capital asset acquisitions. Dividends are usually
funds. A helpful ratio is CFO divided by capital asset acquisitions. Dividends are usually
deducted from CFO under the assumption that current dividends will not be cut.
deducted from CFO under the assumption that current dividends will not be cut.
CFO � Dividends
CFO � Dividends
Cash paid for capital assets
www.mcgrawhill.ca/college/garrison Cash paid for capital assets
Although
Although it is likely that aa firm
it is likely that firm will
will seek
seek long-run
long‑run sources
sources of
of financing
financing for major
for major
AlthoughCFO
acquisitions, it is has
likely that a firm will seek long-run sources of as
financing for major
acquisitions, CFO has information content. CFO can be interpreted as an indicator of the
information content. CFO can be interpreted an indicator of the
i iti CFO h i f ti t t CFO b i t t d i di t f th
firm’s ability to service debt. However, this ratio does have limitations, as do cash flow
ratios generally. Because managers often have considerable discretion regarding capital
asset decisions, the CFO to capital expenditures ratio can easily be manipulated. One
firm’s ability to service debt. However, this ratio does have limitations, as do cash flow
ratios generally. Because managers often have considerable discretion regarding capital
asset decisions, the CFO to capital expenditures ratio can easily be manipulated. One
should look for trends and seek explanations for changes in these trends.
Caution should be exercised in the use and interpretation of all cash flow ratios.
Cash flow ratios, for example, should not be interpreted as a measure of the firm’s
ability to distribute cash. This is because cash flow ratios do not include some critical
information that has future cash flow effects. Cash flow ratios, for example, do not
include provision for asset replacement or for contingencies. When used in conjunction
with other ratios, however, cash flow ratios may provide useful insights for managerial
decisions.
Cash Burn Rate

Cash burn rate A cash flow ratio developed to look at Internet companies is called the cash burn rate.
The monthly rate of cash use. The cash burn rate is computed from the cash flow statement as follows:
Cash burn rate = (Cash flow from operations + Cash used for capital assets acquisi-
tions + Cash used to purchase going-concern businesses) ÷ Number of
months presented in the statement (that is 3, 6, 9, 12, depending on the
specific set of statements)
Months to burn out A variation to assist interpretation is the months to burn out. This amount is com-
The time needed to use up cash puted as follows:
and liquid assets.
Months to burn out = (Cash and cash equivalents
+ Temporary investments) ÷ Cash burn rate
Application of the above ratios assumes that the numerator of the cash burn rate is
negative (a cash outflow). However, the use of the burn rate is positive because the cash
and its equivalents amounts are positive; otherwise, insolvency is likely.
To illustrate the sign issue, the following is taken from Exhibit 14–8 (page BC14–26).
Here, the cash flow from operations was $5,520 inflow, while $5,000 was paid for invest-
ments. Thus, the net inflow was $520 ($5,520 – $5,000). The statement was for 12 months,
so the inflow per month was $43.33, the opposite of a burn. Thus, with $1,470 of cash and
equivalents on hand, this balance should grow instead of being consumed as implied if the
cash from operations was negative. If the $43.33 amount was negative (an outflow), then
the $1,470 would be burned out in 33.9 months.
Ratio Analysis—The Long-Term Creditor

Ratio Analysis—The Long-Term Creditor
The position of long-term creditors differs from that of short-term creditors in that they
are concerned with both the near-term and the long-term ability of a firm to meet its
Compute and interpret the commitments. They are concerned with the near term since the interest they are entitled
financial ratios used by the to is normally paid on a current basis. They are concerned with the long term since they
long-term creditor. want to be fully repaid on schedule.
Since the long-term creditor is usually faced with greater risks than the short-term
creditor, firms are often required to agree to various restrictive covenants, or rules, for
the long-term creditor’s protection. Examples of such restrictive covenants include the
maintenance of minimum working capital levels and restrictions on payment of dividends
to common shareholders. Although these restrictive covenants are in widespread use,
they must be viewed as a poor second to adequate future earnings from the point of
view of assessing protection and safety. Creditors do not want to go to court to collect
their claims; they would much prefer staking the safety of their claims for interest
and eventual repayment of principal on an orderly and consistent flow of funds from
operations.
repayment of principal on an orderly and consistent flow of funds from operations.
the long-term
repayment of principal theantimes
creditor ison interest
orderly earned ratio.
and consistent flow Itofisfunds
computed by dividing earn-
from operations.
ings before interest expense and income taxes (i.e., operating income) by the yearly inter-
Times
est Interest
charges Earned
that must be met: Ratio
Times Interest Earned Ratio
terest earned ratio TheThe most common measure of the ability of a firm’s operations to provide protection to
the to most common
long-term measure
creditor of theinterest
is the times ability of a firm’s
earned operations
ratio. to provide
It is computed protection
by dividing to
earn-
of the company’s ability make interest payments.
Times
the long-term
ings before InterestcreditorEarned
is
interest expense the times
andRatio interest earned ratio. It is computed by
income taxes (i.e., operating income) by the yearly inter- dividing earn-
ings
est before interest
charges that mustexpense
be met: andEarnings
income taxesbefore(i.e.,
interest expense
operating and income
income) by the taxes
yearly inter-
The Times
most interest earned � of the ability of a firm’s operations to provide protection
common
est charges that mustmeasure
be met: Interest expense
to the long-term creditor is the times interest earned ratio. It is computed by dividing Times interest earned ratio
terest earned ratio For Example Company, the times interesttaxes
earned ratio for 2008 would by be the
computed
terest
of the earned
earnings
ratioability
company’s
before interest
to make interest payments.
expense and income (i.e., operating income) yearly Measure of the company’s ability
as
of the company’s ability follows:
interest
to make charges thatpayments.
interest must be met: to make interest payments.
Earnings before interest expense and income taxes
Times interest earned � Earnings $3,140,000 before interest expense and income taxes
Times interest earned � � 4.9Interest
timesexpense
$640,000 Interest expense
For Example Company, the times interest earned ratio for 2008 would be computed
Earnings
as follows:
For Example before income taxes
Company, mustinterest
the times be usedearned
in the computation,
ratio for 2008since would interest expense
be computed
deductions
as follows: come before income taxes are computed. Creditors have first claim on earn-
ings. Only those earnings remaining $3,140,000
after all interest
$3,140,000 � 4.9 times charges have been provided for are
subject to income taxes. $640,000 � 4.9 times
$640,000
Generally,before
Earnings earningsincome are viewed
taxes as adequate
must be used to the
in protect long-termsince
computation, creditors if the
interest times
expense
Earnings before
interest
Earnings before income
income taxes taxes must
must be be used
used in inthe
thecomputation,
computation, since sinceinterest
interest expense
expense
deductions earned
come ratio is 2 or more.
income Before
taxes aremaking
computed. a final judgement,
Creditors have however, it would be
deductionscome
deductions
necessary to look
before
comebefore
beforeincome
at a
incometaxes
firm’s
taxes
long-run are are computed.
computed.
trend of
Creditors
Creditors
earnings and have firstfirst
have
evaluate
first claim
claim
how
claim on
on earn-
on earnings.
vulnerable
earn-
the
ings.
Only Only
Only those
ings. those those earnings
earningsearnings
remaining remaining
remaining
after after
after
all all
all interest
interest chargescharges
interest charges
have been have
have been
been provided
provided provided for
for are
for are subject are
firm is
subject to
to cyclical
income changes
taxes. in the economy.
subject
to income to taxes.
income taxes.
Generally, earnings
Generally, earnings
Generally, earnings are are viewed
are viewed
viewed as as adequate
as adequate
adequate to to protect
to protect long-term
protect long-term creditors
long-term creditors
creditors if ifif the
the times
the times
times
interest earned
Debt-to-Equity
interest earned
interest ratio
earned ratio is 2
Ratio
ratio is or
is 22 or more.
or more. Before
more. Before making
Before making a final
making aa final judgement,
final judgement, however,
judgement, however, it would
however, itit would
would be be
be
necessary
necessary to
necessary to look
to look at
look at a firm’s
at aa firm’s long-run
firm’s long-run trend
long-run trend of
trend of earnings
of earnings
earnings and and evaluate
and evaluate how
evaluate how vulnerable
how vulnerable
vulnerable the the
the
Long-term
firm is to creditors
cyclical are also
changes in concerned
the economy. with keeping a reasonable balance between the
firm is
firm is to
to cyclical
cyclical changes
changes in in the
the economy.
economy.
portion of assets provided by creditors and the portion of assets provided by the share-
holders of a firm. This balance is measured by the debt-to-equity ratio:
Debt-to-Equity
Debt-to-Equity Ratio
Debt-to-Equity Ratio
Ratio
Long-term
Long-term creditors
Long-term creditors are
are also
are alsoconcerned
also concernedwith
concerned withkeeping
with keeping
keepingaa reasonable
reasonable
a reasonablebalance
balance between
between
balance the
the
between
equity ratio portion of assets provided by creditors and the portion of assets provided by the share-
portion
the of
portion assets
of provided
assets by
provided creditors
by and
creditors the
and portion
the of
portionassets
of provided
assets
of the amount of assets being provided by creditors for each dollar of assets being provided by the by the
provided share-
by the
ders.
holders
holders of
of aa firm.
shareholders firm. This
This balance
of a firm. balance
This is
is measured
balancemeasured by
by the
is measured bydebt-to-equity
the debt-to-equity ratio:
ratio:ratio:
the debt-to-equity Debt-to-equity ratio
Measure of the amount of assets
Total liabilities being provided by creditors
equity Debt-to-equity ratio �
equity ratio
ratio Shareholders’ equity for each dollar of assets being
of
of the
the amount
amount of
of assets
assets being
being provided
provided by
by creditors
creditors for
for each
each dollar
dollar of
of assets
assets being
being provided
provided by
by the
the provided by the shareholders.
ders. 2008
2008 2007
2007
ders.
Total liabilities . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . $14,500,000
Total $13,000,000 (a)
Total liabilities
Debt-to-equity Total liabilities
$14,500,000
liabilities$13,000,000 (a)
Shareholders’ . . . . . . . . .ratio
Debt-to-equity
equity ....�
Shareholders equity . . . . . . . . . . . . . . . . .
ratio .� . 17,000,000
. . Shareholders’
17,000,000 equity 15,970,000 (b)
15,970,000 (b)
Debt-to-equity ratio, (a)
Debt-to-equity ratio, (a) �4 (b) . . . . . . . . . .Shareholders’
(b) . . . . . . . . . . 0.85
0.85 to 1 equity
to 1 0.81
0.81 to
to 11
The 2008 2007
The debt-to-equity
debt-to-equity ratio ratio indicates
indicates the the amount amount of 2008
of assets
assets being
being provided
2007
provided by
by creditors
creditors
for
for each
each dollar
dollar
Total of
of assets
assets
liabilities . . being
being
. . . . . provided
provided
. . . . . . . . .by
by
. . .the
the
. . .owners
owners of
of
$14,500,000 aa company.
company. In
In
$13,000,000 2007,
2007,
(a) creditors
creditors of
of
Total liabilities . . . . . . . . . . . . . . . . . . . . . . $14,500,000 $13,000,000 (a)
Example Company
ExampleShareholders
Company were
equity
were providing
. .
providing . . . . . 81
.
81. .cents
.
cents. .
Shareholders equity . . . . . . . . . . . . . . . . . 17,000,000 . .of
of. . assets for
17,000,000
assets for each
each $1
$1 of assets
15,970,000
of assets
15,970,000 (b)
being
(b)
being provided
provided
by
by shareholders;
shareholders; the
the figure
Debt-to-equity
Debt-to-equity ratio,
ratio, (a)
figure increased
�� (b)
increased
(a) (b) .. ..only
.. .. .. .. slightly
only .slightly to
. .. .. .. 0.85to 85
0.85 tocents
to
85 11
cents by 2008.
by0.81 to
2008.
0.81 to 11
Creditors
Creditors would
would like
like the
the debt-to-equity
debt-to-equity ratio
ratio to
to be
be relatively
relatively low.
low. The
The lower
lower the
the ratio,
ratio,
The
The debt-to-equity
debt-to-equity ratio
ratio indicates
indicates the
the amount
amountby of assets
of the
assets being
beingofprovided
provided by
by creditors
creditors
the
the greater
greater the
the amount
amount of
of assets
assets being
being provided
provided by the owners
owners of aa company
company and
and the
the
for
for each
eachisdollar
dollar of
of assets
assets being
being providedprovided by
by the the owners
owners of
of aa company.
company. In
In 2007,
2007, creditors
creditors of
of
greater
greater is the
the buffer
buffer of
of protection
protection to
to creditors.
creditors By
By contrast,
contrast common
common shareholders
shareholders would
would
Example
Example Company
Company were
were providing
providing 81
81 cents
cents of
of assets
assets for
for each
each $1
$1 of
of assets
assets being
being provided
provided
like the ratio to be relatively high, because through leverage, common shareholders can
by
by shareholders;
shareholders; the
the figure
figure increased only slightly
slightly to to 85
85 cents
cents by
by 2008.
benefit from the assets
beingincreased
providedonly by creditors. 2008.
Creditors would like the debt-to-equity ratio to be relatively low. The lower
lower the ratio,
In most industries, norms have developed over the years that serveThe
Creditors would like
www.mcgrawhill.ca/college/garrison the debt-to-equity ratio to be relatively low. as guides the ratio,
to firms
the
the greater
greater the
the amount
amount of
of assets
assets being
being provided
provided by
by the
the owners
owners of
of a
a company
company and
and the
the
in their decisions as to the “right” amount of debt to include in the capital structure.
greater
greater is
is the
the buffer
buffer of
of protection
protection to
to creditors.
creditors By
By contrast,
contrast common
common shareholders
shareholders would
would
Different industries face different risks. For this reason, the level of debt that is appropriate
like the ratio to be relatively high because through leverage common shareholders can
for firms in one industry is not necessarily a guide to the level of debt that is appropriate
for firms in a different industry.
Monitoring Productivity
Monitoring Productivity
The importance of productivity has increased among Canadian business firms. In the
manufacturing sector, Canadian firms have not kept pace with other competitors. To help
MONITORING PRODUCTIVITY
The importance
reverse this trend,ofmanagement
productivitymust has increased
be alert to among Canadiantechniques
new production business firms. In the
that result in
manufacturing
long‑term productivitysector, Canadian
gains and firms have not
must make kept
use of pace with other
measurement methodscompetitors.
that help theTo
help reverseitsthis
firm assess trend,position.
relative management must be
Long‑term alert to new
productivity production
gains can resulttechniques
from the earlythat
result
adoption in long-term productivity
of more efficient gains and
production must make
techniques. Theuse of measurement
development methods that
and application of
help the firm
knowledge assess
and its relative
new ideas are theposition.
primary Long-term productivity Improved
drivers of productivity. gains canproductivity
result from
the
mayearly adoption
manifest itselfofinmore
savingsefficient production
in materials, techniques.
labour, capital, andThe development
energy and appli-
costs. Productivity
cation
benefitsofcould
knowledge and new
also include ideas are
improved the or
quality primary drivers faster
more variety, of productivity.
cycle time, Improved
faster and
productivity
more efficientmay manifest
production itself
runs, andinbetter
savings in materials,
customer service. labour, capital, and energy
costs.
ToProductivity
management, benefits could productivity
improving also include can improved
mean quality
obtainingor more
highervariety, faster
profitability
cycle time, faster
and greater and more
assurance efficient
of survival in production
an ever more runs,competitive
and better customer service.
business environment.
The To management,
management improving
accountant canproductivity can meanrole
play an important obtaining
in the higher profitability
assessment and
of a firm’s
greater assurance of survival in an ever more competitive business environment. The man-
productivity.
agement accountant
Productivity cancan play an important
be determined roleofinsome
as a ratio the assessment
measure ofof a firm’s
output productivity.
to some measure
Productivity
of input. Outputscan canbebedetermined
expressedas inaphysical
ratio of some
units measure of output
or by dollar valuestocorresponding
some measure of to
input. Outputs
the firm’s can be Inputs
objectives. expressed in physical
consist units labour,
of materials, or by dollar valuesand
overhead, corresponding to the
capital. Corporate
firm’s
annualobjectives. Inputs consist
reports typically of materials,
provide physicallabour,
data overhead,
useful for andmeasuring
capital. Corporate annual
a company’s
reports typically provide physical data useful for measuring a company’s productivity.
productivity.
Numerous methods methodscan canbe beused
usedtoto measure
measure productivity.
productivity. TheyThey
rangerange
fromfrom sophisti-
sophisticated
cated
computercomputer
models models that perform
that perform sensitivity
sensitivity analysis
analysis on productivity
on productivity (profitability)
(profitability) as
as any
any
or allorofallthe
of elements
the elements of the
of the inputinput
mixmix are are changed,
changed, to the
to the simple
simple utilization
utilization of finan-
of financial
cial
datadata readily
readily available
available fromfrom the firm’s
the firm’s existing
existing accounting
accounting system.
system. BothBoth performance
performance and
and productivity
productivity of invested
of invested capitalcapital
can be canmeasured
be measured by calculating
by calculating financial
financial ratiosratios that
that help
help to relate
to relate production
production inputs inputs to production
to production outputs.outputs.
One measurement ratio useful in assessing productivity is the return on investment investment
formula calculated in Chapter 11 as follows:
Operating income Sales Operating income
ROI � � �
Sales Average operating assets Average operating assets
Other financial
financialratios
ratiosthat may
that mayhelphelp
assess productivity
assess include
productivity such ratios
include such as manu-
ratios as
facturing
manufacturingcost tocost to selling
sales, cost to cost
sales, selling sales,toand administrative
sales, cost to sales.
and administrative cost toMore detailed
sales. More
productivity analysis can
detailed productivity be extended,
analysis can be for example,
extended, fortoexample,
analyze the to individual
analyze thecomponents
individual
of manufacturing
components cost. Separate
of manufacturing ratios
cost. can beratios
Separate computedcan beforcomputed
raw materials,
for rawlabour, and
materials,
manufacturing overhead as percentages
labour, and manufacturing overhead asofpercentages
the market valueof theofmarket
productionvalue(manufacturing
of production
cost times the ratio
(manufacturing costoftimes
salesthe
to cost
ratioofofsales).
sales to cost of sales).
Other partial measures of productivity can be computed by expressing components
of the balance sheetsheet as
aspercentages
percentagesofofsales.sales.TheThelower
lowerthe theinvestment
investment forfor a given
a given level
level of
of sales,
sales, thethe
moremore productive
productive is the
is the business
business in the
in the utilization
utilization of of
its its resources.
resources. ForFor exam-
example,
ple,
takingtaking the ratio
the ratio of capital
of capital assetsassets to the
to sales, sales, the higher
higher the salesthethat
sales
canthat can be generated
be generated for each
for each
dollar dollarininvested
invested in capital
capital assets, assets, is
the greater thethegreater is the productivity
productivity of theassets.
of the firm’s fixed firm’s
fixed
The assets.
management accountant should be cautious, however, in interpreting productivity
TheThe
ratios. management accountant
interrelationships shouldthe
among be various
cautious,measures
however,of in interpreting
productivity productiv-
and their
ity ratios.effect
ultimate The oninterrelationships among must
the firm’s profitability the various
be clearlymeasures of productivity
understood. For example, andlabour
their
ultimate effect on theasfirm’s
may be decreasing profitability
a percentage must be clearly
of manufacturing understood.
cost as a resultFor of example, labour
the purchase of
may be decreasing as a percentage of manufacturing cost as a result of the purchase of
higher‑quality raw materials. Careful analysis may reveal that increased productivity
labour was more
higher-quality rawthan offset Careful
materials. by the increased
analysis may cost reveal
of thethatrawincreased
materials.productivity
Nevertheless,of
partial productivity ratios can provide information on how output is affected by a given
input factor, and changes in these ratios can serve as a signal for investigation that might
otherwise go unnoticed.
Productivity analysis is as important to service industries as it is to manufacturing firms.
Measures such as the number of customers served per day or the number of transactions
completed per week for a given staff complement are examples of productivity measures
for service industries.
In spite of the fact that productivity can be measured for any input factor, labour‑hours have
been the most commonly used input in measuring productivity. Productivity measures derived
from labour no doubt can be useful to management in assessing learning curve effects and the
motivational level of employees. However, as firms face stiffer competition both nationally
stiffer competition both nationally and internationally, it seems prudent for management
to assess the interrelationships among several productivity measures. This is especially
true in the new manufacturing environment where costs are mostly fixed. Even the direct
labour
that remains can be interpreted as fixed
Chapter 14 “Howin theAm
Well sense that employee
I Doing?” Financialskills are essen-
Statement Analysis BC14–25
tial to a firm’s success. The amount invested in training and development may be a criti-
cal performance measure in this environment in assessing current position and as an
and internationally, it seems prudent for management to assess the interrelationships among
indicator of future productivity. Since workers need multiple skills in the high-tech envi-
several productivity measures. This is especially true in the new manufacturing environment
ronment, a measure such as percent cross-trained could be a revealing statistic in moni-
where costs are mostly fixed. Even the direct labour that remains in this modern environment
toring productivity. Other useful measures could include number of defects, percentage
can be interpreted as fixed in the sense that employee skills are essential to a firm’s success.
passing first inspection, work in process turnover, scrap as a percentage of output, and
The amount invested in training and development may be a critical performance measure
percentage of on-time shipments.
in this environment in assessing current position and as an indicator of future productivity.
What is measured and reported should be determined by the measure’s relationship
Since workers need multiple skills in the high‑tech environment, a measure such as percent
to the firm’s operating and strategic goals. For example, if a major objective of a company
cross‑trained could be a revealing statistic in monitoring productivity. Other useful measures
is to increase market share, measures of delivery and quality improvements may provide
could include number of defects, percentage passing first inspection, work in process turnover,
useful strategic information. By using productivity ratios and new performance indica-
scrap as a percentage of output, and percentage of on‑time shipments.
tors to help understand key interrelationships, management may be able to more quickly
What is measured and reported should be determined by the measure’s relationship
adopt cost-reducing innovations that lead to improvements in total productivity and to
to the firm’s operating and strategic goals. For example, if a major objective of a company
increased long-term profitability.
is to increase market share, measures of delivery and quality improvements may provide
ratios useful strategic information. By using productivity ratios and new performance indicators Productivity ratios
to help understand key interrelationships, management may be able to more quickly adopt Ratios that measure output in
cost‑reducing innovations thatsuch
leadas
todirect
improvements in total productivity and to increased relation to some measure of input,
easure output in relation to some measure of input, labour charges.
long‑term profitability. such as direct labour charges.
RATIOS AND PROFIT PLANNING

Ratios and Profit Planning
Profit
Profit planning
planning and and
the the projection
projection of budgeted
of budgeted financial
financial statements
statements werewere discussed
discussed in in
Chapter 9 in the textbook. Ratios can be linked to the budgeting process
Chapter 9 in the textbook. Ratios can be linked to the budgeting process to help project to help project
financial
financial statement
statement account
account balances
balances as wellasaswell as toinassist
to assist in estimating
estimating cash
cash flows. In flows.
addi- In
addition, using ratios in the forecasting process allows a complete articulation
tion, using ratios in the forecasting process allows a complete articulation of the balance of the
balance sheet, income statement, and statement
sheet, income statement, and statement of cash flows. of cash flows. For example consider the
\ following two ratios.
Sales on account
Accounts receivable turnover �
Accounts receivable
Sales on account
Accounts receivable �
Accounts receivable turnover
Budgeted
Budgetedaccounts
accounts receivable can,can,
receivable therefore, be estimated
therefore, by dividing
be estimated by dividingprojected
projected salessales
on account
on account by the
by accounts
the accounts receivable turnover.
receivable For For
turnover. example, if projected
example, salessales
if projected for 2008
for 2008
for Example
for Example Company,
Company, fromfrom
Exhibit 14–2,
Exhibit is $52,000
14–2, is $52,000and and
if the accounts
if the receivable
accounts receivable
turnover is forecasted
turnover is forecasted to beto8.67, thenthen
be 8.67, estimated
estimatedaccounts receivable
accounts for 2008
receivable is $6,000
for 2008 is $6,000
($52,000/8.67
($52,000/8.67 rounded).
rounded).
Chapter
Similarly, 15inventory
Similarly, “How Well
inventory for Am
for I2008
2008 Doing?”
can can Financial Statement
be projected
be projected Analysis
by manipulating
by manipulating the inventory turnover
the inventory turnover
formula. Recall
formula. that:that:
Recall
Cost
Cost ofof goods
goods sold
sold
Inventory
Inventory turnover
turnover � � Inventory
Inventory
Then:
Chapter 15 “How Well Am I Doing?” Financial Statement Analysis
Then: Cost
Cost of of goods
goods sold
sold
Inventory
Inventory � � Inventory turnover
Inventory turnover
If If the
If the cost
the cost
cost of
of goods
goods soldsold is estimated
is estimated
estimated at at 69%
69% of of sales
sales and
and the
the inventory turnover
inventory turnover
turnover is is
is
expected
expected to
to be
be 4.5,
4.5, then
then inventory
inventory is
is projected
projected to
to be
be 7,973
7,973 [($52,000
[($52,000
expected to be 4.5, then inventory is projected to be 7,973 [($52,000 � 0.69)/4.5]. 3� 0.69)/4.5].
0.69)/4.5].
Accounts
Accounts payable
Accounts payable
payable can can
can bebe projected
be projected
projected by by linking
by linking budgeted
linking budgeted purchases
budgeted purchases
purchases to to
to aaa new
new ratio
new ratio
ratio
called
called the
the accounts
accounts payable
payable
called the accounts payable turnover. turnover.
turnover.
Purchases
Purchases on on account
account
Accounts
Accounts payable
payable turnover
turnover � � Accounts payable
Accounts payable
Therefore:
Therefore: Purchases
Purchases on on account
account
Accounts
Accounts payable
payable � � Accounts payable turnover
Accounts payable turnover
However,
However, because
because purchases
www.mcgrawhill.ca/olc/garrison purchases on on account
account is is not
not disclosed,
disclosed, it
it too
too must
must bebe estimated.
estimated. A A
convenient
convenient way to project purchases is through the algebraic manipulation of the
way to project purchases is through the algebraic manipulation of the cost
cost ofof
goods
goods sold
sold (CGS)
(CGS) formula.
formula.
However, because purchases on account is not disclosed, it too must be estimated. A

convenient way to project purchases is through the algebraic manipulation of the cost of
goods sold (CGS) formula.
Beginning inventory 1 Purchases 2 Ending inventory 5 CGS
Therefore:
BC15-26 Chapter 15 Purchases 5 CGS
“How Well Am 2 Beginning
I Doing?” Financial inventory
Statement1 Ending inventory
Analysis
5 $35,880 2 $10,000 1 $7,973
5 $33,853
If 5.8 times is the accounts payable turnover, then accounts payable is projected to
equal $5,837 ($33,853/5.8).
A full integration of the sales forecast for 2008 is presented in Exhibit 14–8, which
incorporates the following additional assumptions. Prepaid expenses are projected to be
$300 at December 31, 2008. The Land account balance is expected not to change, and
buildings and equipment are forecasted at $12,000 net of depreciation. The expected
balance of accrued payables is $900; $500 will be used to retire bonds and $300 to pay
short-term notes. Where amounts in Exhibit 14–8 differ with corresponding items in
Exhibits 14–1 and 14–2, it is a result of rounding.
Exhibit 14–8 Estimated Estimated Income Statement*

Financial Statements Sales revenue (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,880
Gross margin on sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,120
Operating expenses:
Selling expenses (13.5%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Administrative expenses (11.2%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,860
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,860
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,260
Interest expense (1.2%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 640
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,620
Income tax (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 786
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,834
Estimated Statement of Cash Flows

Operating activities:
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,834
Increase in accounts receivable (52,000/8.67 � 4,000) . . . . . . . . . . . (1,998)
Decrease in inventory (35,880/4.5 � 10,000) . . . . . . . . . . . . . . . . . . . 2,027
Increase in prepaid expenses (given) . . . . . . . . . . . . . . . . . . . . . . . . . (180)
Depreciation expense (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Increase in accounts payable (33,853/5.8 � 4,000) . . . . . . . . . . . . . . 1,837
Increase in accrued payable (900 given � 400) . . . . . . . . . . . . . . . . . 500
Cash flow from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,520
Financing activities:
Retired bonds (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (500)
Retired short-term notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (300)
Paid dividends (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (600)
Investing activities:
Purchased equipment (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (5,000)
Net change in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . (880)
Cash balance 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,350
Balance of cash and cash equivalents 2008 . . . . . . . . . . . . . . . . . . . . . . $ 1,470
*Assumes depreciation of $1,500 is included in selling and administrative expenses.
Exhibit
EXHIBIT 14–8 Estimated
Estimated
Estimated Balance Sheet, December 31, 2008
Financial
Financial Statements
Statements
Assets (concluded)
(concluded)
Current Assets:
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,470
Accounts receivable (52,000  8.67) . . . . . . . . . . . . . . . . . . . . . . . . . 5,998
Inventory (35,880  4.5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,973
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,741
Capital assets:
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Buildings and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,741
Liabilities
Accounts payable (33,853  5.8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,837
Accrued payables (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900
Notes payable, short-term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,037
Bonds payable, 8% (8,000  500) . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,537
Shareholders Equity
Preferred shares, $100 liquidation value $6 no par . . . . . . . . . . . . . . . . . 2,000
Common shares 500 no par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Total contributed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000
Retained earnings (6,970  1,834  600 given) . . . . . . . . . . . . . . . . . . 8,204
Total shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,204
Total liabilities and shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . . $31,741
Proforma Earnings Proforma Earnings

Management will discuss the company’s earnings performance in the annual report to
shareholders and in press releases to the news media. Obviously, it is to the company’s
advantage to present results in a manner that creates the most favourable image. If the
results are bad relative to expectations, then a “big bath” may be called for—the presenta-
tion of results even more unfavourably than warranted by the actual circumstances. The
reason for this is to enable the future to be better by placing costs that belong to the future
in the current period, the period of the “bath.”
Alternatively, management may present results according to the practice of proforma
reporting, presenting “proforma earnings” in an “if then” context: “If we did not have
these non-cash charges, then our earnings would have been $xxx.” “If we did not have
these non-cash accounting expenses from amortization, then our earnings would have
been $yyy.” “If we did not have debt charges, then our income would have been $zzz.”
Common proforma income results would be EBIT (earnings before interest and taxes) or
EBITDA (earnings before interest, taxes, depreciation and amortization). Because these
proforma income/earnings do not include all legitimate costs, expenses, and losses, and
because they are not GAAP, the users of such results can be misled.
What management must be concerned about with this type of reporting is the reputation
they generate for themselves or their firm by the use of such numbers. For example, Telus
reported in its 2006 annual report that they had a 9% increase in EBITDA, excluding restruc-
turing, over 2005. EBITDA excludes $1,575.6 million of depreciation, $504.7 million for
interest, and $351.0 million for income taxes. These three matters account for 28% of revenue
for 2006. Will the statement user be misled by the comments about the EBITDA increase or
will they believe the 9% represents the increase in core business operations? Management
believes that the 9% increase is a key reflection of their operations.
Summary of Ratios and Sources of Comparative Ratio Data

Exhibit 14–9 contains a summary of the ratios discussed in this chapter. The formula for
each ratio and a summary comment on each ratio’s significance are included in the exhibit.
Exhibit 14–10 contains a listing of some sources that provide comparative ratio
data organized by industry. These sources are used extensively by managers, investors,
and analysts in doing comparative analyses and in attempting to assess the well-being
of companies. The Internet also contains a wealth of financial and other data. A search
engine such as Google can be used to track down information on individual companies.
Many companies have their own web sites on which they post their latest financial reports
and news of interest to potential investors. the Sedar and EDGAR databases listed in
Exhibit 14–10 are particularly rich sources of data. They contain copies of all reports filed
by companies with the agencies since about 1995—including U.S. annual reports filed as
form 10-K.
Exhibit 14–9 Summary of Ratios
Ratio Formula Significance

Profitability
Gross margin percentage Gross margin 4 Sales A broad measure of profitability
Earnings per share (of common (Net income 2 Preferred dividends) Tends to have an effect on the
shares) 4 Average number of common shares market price per share, as reflected
outstanding in the price-earnings ratio
Price-earnings ratio Market price per share 4 Earnings An index of whether a share is
per share cheap or relatively expensive in relation to
current earnings
Dividend payout ratio Dividends per share 4 Earnings An index showing whether a
per share company pays out most of its earnings in
dividends or reinvests the earnings internally
Dividend yield ratio Dividends per share 4 Market price Shows the return in terms of cash
per share dividends being provided by a share
Return on total assets {Net income 1 [Interest expense 3 Measure of how well assets have
(1 2 Tax rate)]} 4 Average total been employed by management
assets
Return on common shareholders’ (Net income 2 Preferred dividends) When compared to the return on
equity 4 Average common shareholders’ total assets, measures the extent
equity (Average total shareholders’ to which financial leverage is
equity 2 Average preferred shares) working for or against common
shareholders
Book value per share Common shareholders’ equity (Total Measures the amount that would
shareholders’ equity 2 Preferred be distributed to holders of
shares) 4 Number of common common shares if all assets were
shares outstanding sold at their balance sheet carrying amounts
and if all creditors were paid off
Liquidity
Working capital Current assets 2 Current liabilities Measures the company’s ability to
repay current liabilities using only current
assets.
Current ratio Current assets 4 Current liabilities Test of short-term debt-paying ability
Acid-test (quick) ratio (Cash 1 Temporary Investments 1 Current Test of short-term debt-paying ability
receivables) 4 Current liabilities without having to rely on inventory
(continued)
Exhibit 14–9 Summary of Ratios (concluded)
Ratio Formula Significance

Accounts receivable turnover Sales on account 4 Average accounts A rough measure of how many times
receivable balance a company’s accounts receivable have been
turned into cash during the year
Average collection period 365 days 4 Accounts receivable turnover Measure of the average number of
(age of receivables) days taken to collect an account receivable
Inventory turnover Cost of goods sold 4 Average inventory Measure of how many times a company’s
balance inventory has been sold during the year
Average sale period (turnover in days) 365 days 4 Inventory turnover Measure of the average number of
days taken to sell the inventory one time
Solvency
Times interest earned Earnings before interest expense and Measure of the company’s ability
income taxes 4 Interest expense to make interest payments
Debt-to-equity ratio Total liabilities 4 Shareholders’ equity Measure of the amount of assets
being provided by creditors for each dollar of
assets being provided by the shareholders
Cash burn rate (Cash flow from operations + Capital asset Determines the rate of cash use for
acquisitions + Cash used to purchase operating decisions
going concerns) ÷ Number of months in
statements
Months to burn out Cash and cash equivalents + Short-term Assesses the ability to sustain
marketable securities ÷ Burn rate the current burn rate
Exhibit 14–10 Sources of Financial Information
Source Content
Internet Resources
http://www.hemscott.com This is a British service where financial reports and other news are available.
http://www.hoovers.com/ This is an extensive site for reviews and summary financial information, including for international
companies.
http://www.ic.gc.ca/ Industry Canada publishes studies of various industry groups. They also provide a benchmarking
service.
http://www.rmahq.org/ This site was formerly maintained by Robert Morris Associates. It is now the Risk Management
Association site and contains extensive financial studies of industries; these studies must be
purchased.
http://www.sec.gov/ or These sites provide a source of financial information that companies must file with the Securities
http://www.freeedgar.com/ and Exchange Commission in the United States. The commonly used SEC forms for annual and
quarterly financial filings are the 10-K and 10-Q forms, r espectively.
http://www.sedar.com/ This database provides the annual and quarterly accounting reports for Canadian public
companies. This site is similar to the SEC site except that filings are not in a specified form.
http://www.statscan.ca/ Various series contain survey information about industry groups in terms of prospects and ratios.
Library Internet Resources

Public libraries and university libraries often have access to some or all of the following services where financial or background
information can be found:
ABIGlobal A reference source for topical and company literature.

CBCA A Canadian business reference source.
EBSCO Provides an extensive database of references and journal articles.
(continued)
Exhibit 14–10 Sources of Financial Information (concluded)
Source Content
Financial Post Corporate Reports A wide-ranging resource for Canadian financial and market information, including graphical
capabilities.
Mergent online Moody’s Mergent is a source of financial information on companies and their industries.
LexisNexis An extensive database of legal, regulatory, and financial information is provided by this source.
Compustat An analyis database of a large number of North American and worldwide companies.
DevelopmentsDevelopments
in Generally Accepted Accounting
in Generally Principles
Accepted Accounting Principles
Generally accepted accounting principles (GAAP) in Canada are specified in the Hand-
book published by the Accounting Standards Board (AcSB) of the Canadian Institute
of Chartered Accountants. Membership of the AcSB consists of members of the three
accounting professions in Canada and is overseen by the Accounting Standards Oversight
Council (AcSOC) from the year 2000. AcSOC is a creature of CICA but it has a represen-
tative membership from the financial community in Canada. Authority for the Handbook
of AcSB comes from the Securities Acts of the Canadian provinces and territories, and the
various companies’ Acts that authorized limited companies.
Canadian GAAP is in a process of change whereby it is being harmonized with
the International Financial Reporting Standards (IFRS) published by the International
Accounting Standards Board (IASB). The harmonization of GAAP for public companies
in Canada has a deadline of 2011 for its completion. This harmonization process is helped
by the 2002 agreement of the Financial Accounting Standards Board to move toward har-
monizing with the IFRS’s, an important factor given the extensive financing of Canadian
companies in the United States.
During the next few years, changes will be frequent and numerous. Certainly an analyst
or accountant interested in financial reporting should obtain a copy of the CICA Handbook
and follow the developments on various web sites.2 Without such study, numerous errors are
possible because differences exist currently in a wide variety of areas. Some examples of the
areas of difference include inventories, revenue, shareholders’ equity, and depreciation.
In BUSINESS
XBRL: The Next Generation of Financial Reporting
The Securities and Exchange Commission (SEC) in the United States and securities commis-
sions in Canada encourage companies to submit financial reports using a computer code
known as Extensible Business Reporting Language, or XBRL for short. XBRL is a “financial
reporting derivation of Extensible Markup Language, or XML—a framework that establishes
individual ‘tags’ for elements in structured documents, allowing specific elements to be imme-
diately accessed and aggregated.”
XBRL dramatically improves the financial reporting process in two ways. First, data are
tagged in accordance with a generally accepted framework. This simplifies the process of
making apples-to-apples comparisons of financial results across companies. For example,
2. Sources for details about harmonization changes can be found at the following: www.cica.ca;
www.iasb.org; www.iasplus.com (published by Deloitte); www.pwc.com/ifrs (published by
PricewaterhouseCooper). A recent summary article is Michel Blanchette, IFRS in Canada: Evolution or
Revolution, “CMA Management, May 2007, pp. 22–26.
“many of the components of a ‘property, plant, and equipment’ listing on a balance sheet . .
. may be described differently by different companies, but when tagged in XBRL, a straight
comparison becomes much simpler.”
Second, XBRL simplifies the exchange of financial data. Without XBRL, a company’s
financial data are typically stored in a format that is unique to that company’s specific financial
software application and that cannot be easily read by other financial software. This problem is
overcome with XBRL because the tagged data become “independent of the originating applica-
tion and can readily be shared with any application that recognizes XBRL. This feature of XBRL
makes the markup language very attractive for government regulators and financial analysts.”
Sources: Glenn Cheney, “U.S. gets its XBRL in gear: SEC, FDIC OK tagged data,” Accounting Today, March
14–April 3, 2005, pp. 26–27; Neal Hannon, “XBRL Fundamentals,” Strategic Finance, April 2005, pp. 57–58;
Ghostwriter, “From Tags to Riches,” CFO-IT, Spring 2005, pp. 13–14; www.xbrl.ca; www.sedar.com.
Summary Summary
The data contained in financial statements represent a quantitative summary of a firm’s
operations and activities. Someone who is skilful at analyzing these statements can learn
much about a company’s strengths, weaknesses, emerging problems, operating efficiency,
profitability, and so forth.
Many techniques are available to analyze financial statements and to assess the direc-
tion and importance of trends and changes. In this chapter, we have discussed three such
analytical techniques—dollar and percentage changes in statements, common-size state-
ments, and ratio analysis. Refer to Exhibit 14–9 for a detailed listing of the ratios. This
listing also contains a brief statement as to the significance of each ratio.
Extensive supplementary reporting is being distributed by companies to demonstrate
aspects such as governance and sustainability that extend the information typically con-
tained in financial statements.
Glossary
Visit the Online Learning Centre at http://www.mcgrawhill.ca/olc/garrison/ for a review of key
terms and definitions.
Questions
14–1 What three basic analytical techniques are used in financial statement analysis?
14–2 Distinguish between horizontal and vertical analysis of financial statement data.
14–3 What is the basic purpose for examining trends in a company’s financial ratios and other
data? What other kinds of comparisons might an analyst make?
14–4 Why does the financial analyst compute financial ratios rather than simply studying raw
financial data? What dangers are there in the use of ratios?
14–5 Assume that two companies in the same industry have equal earnings. Why might these
companies have different price-earnings ratios? If a company has a price-earnings ratio of
20 and reports earnings per share for the current year of $4, at what price would you expect
to find the share selling on the market?
14–6 Armcor, Inc. is in a rapidly growing technological industry. Would you expect the company
to have a high or low dividend payout ratio?
14–7 Distinguish between a manager’s financing and operating responsibilities. Which of these
responsibilities is the return on total assets ratio designed to measure?
14–8 What is meant by the dividend yield on a common share investment?
14–9 What is meant by the term financial leverage?

14–10 The president of a medium-sized plastics company was recently quoted in a business
journal as stating, “We haven’t had a dollar of interest-paying debt in over 10 years. Not
many companies can say that.” As a shareholder in this firm, how would you feel about its
policy of not taking on interest-paying debt?
14–11 Why is it more difficult to obtain positive financial leverage from preferred shares than
from long-term debt?
14–12 If a share’s market value exceeds its book value, then the share is overpriced. Do you
agree? Explain.
14–13 Weaver Company experiences a great deal of seasonal variation in its business activities.
The company’s high point in business activity is in June; its low point is in January. During
which month would you expect the current ratio to be highest?
14–14 A company seeking a line of credit at a bank was turned down. Among other things, the
bank stated that the company’s 2 to 1 current ratio was not adequate. Give reasons why a
2 to 1 current ratio might not be adequate.
14–15 If you were a long-term creditor of a firm, would you be more interested in the firm’s long-
term or short-term debt-paying ability? Why?
14–16 A young university student once complained to one of the authors, “ The reason that
corporations are such big spenders is that the federal income tax department always picks
up part of the tab.” What did he mean by this statement?
14–17 What pitfalls are involved in computing earnings per share? How can these pitfalls be
avoided?
14–18 What is meant by reporting an extraordinary item on the income statement net of its tax
effect? Give an example of both an extraordinary gain and an extraordinary loss net of its
tax effect. Assume a tax rate of 30%.
14–19 “Earnings per share this year is higher than last year. Profitability is definitely improving.”
Comment.
14–20 How can cash flow ratios be used to access earnings quality? Explain.
Exercises
S
EXERCISE 14–1 Common-Size Income Statement [LO2]
A comparative income statement is given below for Ryder Company:
Ryder Company
Comparative Income Statement
This Year Last Year
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000,000 $4,000,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . 3,160,000 2,400,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,840,000 1,600,000
Selling and administrative expenses:
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . 900,000 700,000
Administrative expenses . . . . . . . . . . . . . . . . . . 680,000 584,000
Total selling and administrative expenses . . . . . . 1,580,000 1,284,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . 260,000 316,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 40,000
Net income before taxes . . . . . . . . . . . . . . . . . . . $ 190,000 $ 276,000
The president is concerned that net income is down even though sales have increased during
the year. The president is also concerned that administrative expenses have increased because the
company made a concerted effort to cut “fat” out of the organization.
Required:
1. Express each year’s income statement in common-size percentages. Carry computations to
one decimal place.
2. Comment briefly on the changes between the two years.
S
EXERCISE 14–2 Financial Ratios for Common Shareholders [LO3]
Comparative financial statements for Heritage Antiquing Services for the fiscal year ending
December 31 appear below and on the next page. The company did not issue any new common or
preferred shares during the year. A total of 600,000 common shares were outstanding. The interest
rate on the bond payable was 14%, the income tax rate was 40%, and the dividend per common
share was $0.75. The market value of the company’s common shares at the end of the year was
$26. All of the company’s sales are on account.
Heritage Antiquing Services

This Year Last Year
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,080 $ 1,210
Accounts receivable, net . . . . . . . . . . . . . . . . . 9,000 6,500
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 10,600
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . 600 500
Total current assets . . . . . . . . . . . . . . . . . . . . . . . 22,680 18,810
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 9,000
Buildings and equipment, net . . . . . . . . . . . . . 36,800 38,000
Total property and equipment . . . . . . . . . . . . . . . 45,800 47,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $68,480 $65,810
Liabilities and Shareholders’ Equity

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . $18,500 $17,400
Accrued payables . . . . . . . . . . . . . . . . . . . . . . 900 700
Notes payable, short term . . . . . . . . . . . . . . . . — 100
Total current liabilities . . . . . . . . . . . . . . . . . . . . . 19,400 18,200
Bonds payable . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 8,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,400 26,200
Shareholders’ equity:
Preferred shares . . . . . . . . . . . . . . . . . . . . . . . . 1,000 1,000
Common shares . . . . . . . . . . . . . . . . . . . . . . . . 6,000 6,000
Total paid-in capital . . . . . . . . . . . . . . . . . . . . . 7,000 7,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . 34,080 32,610
Total shareholders’ equity . . . . . . . . . . . . . . . . . . 41,080 39,610
Total liabilities and shareholders’ equity . . . . . . . $68,480 $65,810
Required:
Compute the following financial ratios for common shareholders for this year:
1. Gross margin percentage.
2. Earnings per common share.
3. Price-earnings ratio.
4. Dividend payout ratio.
5. Dividend yield ratio.
6. Return on total assets.
7. Return on common shareholders’ equity.
8. Book value per common share.
Heritage Antiquing Services

Comparative Income Statement and Reconciliation
This Year Last Year
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $66,000 $64,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,000 42,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000 22,000
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,500 11,000
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . 7,400 7,000
Total selling and administrative expenses . . . . . . . . . . . . . . 18,900 18,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,100 4,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 800
Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,300 3,200
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,320 1,280
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,980 1,920
Dividends to preferred shareholders . . . . . . . . . . . . . . . . . . 60 400
Net income remaining for common shareholders . . . . . . . . . 1,920 1,520
Dividends to common shareholders . . . . . . . . . . . . . . . . . . . 450 450
Net income added to retained earnings . . . . . . . . . . . . . . . . 1,470 1,070
Retained earnings, beginning of year . . . . . . . . . . . . . . . . . 32,610 31,540
Retained earnings, end of year . . . . . . . . . . . . . . . . . . . . . . . $34,080 $32,610
S
EXERCISE 14–3 Financial Ratios for Short-Term Creditors [LO5]
Refer to the data in Exercise 14–2 for Heritage Antiquing Services.
Required:
Compute the following financial data for short-term creditors for this year:
1. Working capital.
2. Current ratio.
3. Acid-test ratio.
4. Accounts receivable turnover. (Assume that all sales are on account.)
5. Average collection period.
6. Inventory turnover.
7. Average sale period.
S
EXERCISE 14–4 Financial Ratios for Long-Term Creditors [LO6]
Refer to the data in Exercise 14–2 for Heritage Antiquing Services.
Required:
Compute the following financial ratios for long-term creditors for this year:
1. Times interest earned ratio.
2. Debt-to-equity ratio.
S
EXERCISE 14–5 Trend Percentages [LO2]
Starkey Company’s sales, current assets, and current liabilities (all in thousands of dollars) have
been reported on the next page over the last five years (Year 5 is the most recent year):
Required:
1. Express all of the asset, liability, and sales data in trend percentages. (Show percentages for
each item.) Use Year 1 as the base year, and carry computations to one decimal place.
2. Comment on the results of your analysis.
Year 5 Year 4 Year 3 Year 2 Year 1
Sales . . . . . . . . . . . . . . . . . . . $5,625 $5,400 $4,950 $4,725 $4,500

Current assets:
Cash . . . . . . . . . . . . . . . . . . $ 64 $ 72 $ 84 $ 88 $ 80
Accounts receivable . . . . . 560 496 432 416 400
Inventory . . . . . . . . . . . . . . 896 880 816 864 800
Total current assets . . . . . . . . $1,520 $1,448 $1,332 $1,368 $1,280
Current liabilities . . . . . . . . . . $ 390 $ 318 $ 324 $ 330 $ 300
S
EXERCISE 14–6 Selected Financial Ratios for Common Shareholders [LO3, LO4]
Selected financial data from the September 30 year-end statements of Kosanka Company are given
below:
Total assets . . . . . . . . . . . . . . . . . . . . . . . $5,000,000
Long-term debt (12% interest rate) . . . . $750,000
Preferred shares, 8,000, $7 no par . . . . . $800,000
Total shareholders’ equity . . . . . . . . . . . . $3,100,000
Interest paid on long-term debt . . . . . . . . $90,000
Net income . . . . . . . . . . . . . . . . . . . . . . . $470,000
Total assets at the beginning of the year were $4,800,000; total shareholders’ equity was
$2,900,000. There has been no change in preferred shares during the year. The company’s tax rate is
30%.
Required:
1. Compute the return on total assets.
2. Compute the return on common shareholders’ equity.
3. Is the company’s financial leverage positive or negative? Explain.
S
EXERCISE 14–7 Selected Financial Measures for Short-Term Creditors [LO5]
Rightway Products had a current ratio of 2.5 on June 30 of the current year. On that date, the com-
pany’s assets were as follows:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000
Accounts receivable, net . . . . . . . . . . . . . . . 460,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000
Prepaid expenses . . . . . . . . . . . . . . . . . . . . 10,000
Plant and equipment, net . . . . . . . . . . . . . . 1,900,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $3,200,000
Required:
1. What was the company’s working capital on June 30?
2. What was the company’s acid-test ratio on June 30?
3. The company paid an account payable of $100,000 immediately after June 30.
a. What effect did this transaction have on working capital? Show computations.
b. What effect did this transaction have on the current ratio? Show computations.
S
EXERCISE 14–8 Selected Financial Ratios [LO5, LO6]
Recent financial statements for Madison Company are given on the next page.
Account balances at the beginning of the company’s fiscal year were: accounts receivable,
$140,000; and inventory, $260,000. All sales were on account.
Required:
Compute financial ratios as follows:
1. Gross margin percentage.
2. Current ratio.
3. Acid-test ratio.
Madison Company
Balance Sheet
June 30
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21,000
Accounts receivable, net . . . . . . . . . . . . . . . . 160,000
Merchandise inventory . . . . . . . . . . . . . . . . . . 300,000
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 9,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . 490,000
Property and equipment, net . . . . . . . . . . . . . . . 810,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,300,000

Liabilities:
Current liabilities . . . . . . . . . . . . . . . . . . . . . . $ 200,000
Bonds payable, 10% . . . . . . . . . . . . . . . . . . . 300,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
Common shares, 20,000 no par . . . . . . . . . . $100,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . 700,000
Total shareholders’ equity . . . . . . . . . . . . . . . . . 800,000
Total liabilities and shareholders’ equity . . . . . . $1,300,000
Madison Company
Income Statement
For the Year Ended June 30
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,100,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . 1,260,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . 840,000
Selling and administrative expenses . . . . . . 660,000
Operating income . . . . . . . . . . . . . . . . . . . . . 180,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . 30,000
Net income before taxes . . . . . . . . . . . . . . . 150,000
Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . 45,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 105,000
4. Average collection period.

5. Average sale period.
6. Debt-to-equity ratio.
7. Times interest earned.
8. Book value per share.
S
EXERCISE 14–9 Selected Financial Ratios for Common Shareholders [LO3]
Refer to the financial statements for Madison Company in Exercise 14–8. In addition to the data in
these statements, assume that Madison Company paid dividends of $3.15 per share during the year.
Also assume that the company’s common shares had a market price of $63 per share on June 30
and there was no change in the number of outstanding common shares during the fiscal year.
Required:
Compute the following:
1. Earnings per share.
2. Dividend payout ratio.
3. Dividend yield ratio.
4. Price-earnings ratio.
S
EXERCISE 14–10 Selected Financial Ratios for Common Shareholders [LO3, LO4]
Refer to the financial statements for Madison Company in Exercise 14–8. Assets at the beginning
of the year totalled $1,100,000, and the shareholders’ equity totalled $725,000.
Required:
Compute the following:
1. Return on total assets.
2. Return on common shareholders’ equity.
3. Was financial leverage positive or negative for the year? Explain.
Problems Problems
S
PROBLEM 14–11 Common-Size Statements and Financial Ratios for Creditors [LO2, LO5,
LO6]
Modern Building Supply sells various building materials to retail outlets. The company has just
approached Linden Bank requesting a $300,000 loan to strengthen the Cash account and to pay
certain pressing short-term obligations. The company’s financial statements for the most recent
two years are shown below and on the next page.
During the past year, the company has expanded the number of lines that it carries in order x
e cel
to stimulate sales and increase profits. It has also moved aggressively to acquire new customers.
Sales terms are 2/10, n/30. All sales are on account.
Modern Building Supply

This Year Last Year
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 90,000 $ 200,000
Temporary investments . . . . . . . . . . . . . . . . . 0 50,000
Accounts receivable, net . . . . . . . . . . . . . . . . 650,000 400,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000 800,000
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 20,000 20,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . 2,060,000 1,470,000
Plant and equipment, net . . . . . . . . . . . . . . . . . 1,940,000 1,830,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000,000 $3,300,000

Liabilities:
Current liabilities . . . . . . . . . . . . . . . . . . . . . . $1,100,000 $ 600,000
Bonds payable, 12% . . . . . . . . . . . . . . . . . . . 750,000 750,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 1,850,000 1,350,000
Preferred shares, 4,000, $4 no par . . . . . . . . 200,000 200,000
Common shares, 50,000, no par . . . . . . . . . . 500,000 500,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . 1,450,000 1,250,000
Total shareholders’ equity . . . . . . . . . . . . . . . . . 2,150,000 1,950,000
Total liabilities and shareholders’ equity . . . . . . $4,000,000 $3,300,000
Modern Building Supply

This Year Last Year
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,000,000 $6,000,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 5,400,000 4,800,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,600,000 1,200,000
Selling and administrative expenses . . . . . . . . . 970,000 710,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . 630,000 490,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . 90,000 90,000
Net income before taxes . . . . . . . . . . . . . . . . . 540,000 400,000
Income taxes (40%) . . . . . . . . . . . . . . . . . . . . . . 216,000 160,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 324,000 240,000
Dividends paid:
Preferred dividends . . . . . . . . . . . . . . . . . . . . 16,000 16,000
Common dividends . . . . . . . . . . . . . . . . . . . . 108,000 60,000
Total dividends paid . . . . . . . . . . . . . . . . . . . . . 124,000 76,000
Net income retained . . . . . . . . . . . . . . . . . . . . . 200,000 164,000
Retained earnings, beginning of year . . . . . . . . 1,250,000 1,086,000
Retained earnings, end of year . . . . . . . . . . . . . $1,450,000 $1,250,000
Assume that the following ratios are typical of companies in the building supply industry:
Current ratio . . . . . . . . . . . . . . . 2.5

Acid-test ratio . . . . . . . . . . . . . . 1.2
Average collection period . . . . . 18 days
Average sale period . . . . . . . . . 50 days
Debt-to-equity ratio . . . . . . . . . 0.75
Times interest earned . . . . . . . . 6.0
Return on total assets . . . . . . . . 10%
Price-earnings ratio . . . . . . . . . . 9
Net income margin . . . . . . . . . . . 4%
Required:
1. Linden Bank is uncertain whether the loan should be made. To assist it in making a decision,
you have been asked to compute the following amounts and ratios for both this year and last
year:
a. Working capital.
b. Current ratio.
c. Acid-test ratio.
d. Average collection period. (The accounts receivable at the beginning of last year totalled
$350,000.)
e. Average sale period. (The inventory at the beginning of last year totalled $720,000.)
f. Debt-to-equity ratio.
g. Times interest earned.
2. For both this year and last year (carry computations to one decimal place):
a. Present the balance sheet in common-size form.
b. Present the income statement in common-size form down through net income.
3. From your analysis in (1) and (2) above, what problems or strengths do you see for Modern
Building Supply? Make a recommendation as to whether the loan should be approved.
S
PROBLEM 14–12 Financial Ratios for Common Shareholders [LO3, LO4]
Refer to the financial statements and other data in Problem 14–11. Assume that you have just
inherited several hundred shares of Modern Building Supply. Not being acquainted with the com-
pany, you decide to do some analytical work before making a decision about whether to retain or
sell the shares you have inherited.
Required:
1. You decide first to assess the well-being of the common shareholders. For both this year and
last year, compute the following:
a. The earnings per share.
b. The dividend yield ratio for common shares. The company’s common shares are cur-
rently selling for $45 per share; last year they sold for $36 per share.
c. The dividend payout ratio for common shares.
d. The price-earnings ratio. How do investors regard Modern Building Supply as compared
to other companies in the industry? Explain.
e. The book value per common share. Does the difference between market value and book
value suggest that the shares at their current price are too high? Explain.
2. You decide next to assess the company’s rate of return. Compute the following for both this
year and last year:
a. The return on total assets. (Total assets at the beginning of last year were $2,700,000.)
b. The return on common shareholders’ equity. (Shareholders’ equity at the beginning of
last year was $1,786,000.)
c. Is the company’s financial leverage positive or negative? Explain.
3. Based on your analytical work (and assuming that you have no immediate need for cash),
would you retain or sell the shares you have inherited? Explain.
PROBLEM 14–13 Effects of Transactions on Various Ratios [LO5]

Selected amounts from Reingold Company’s balance sheet from the beginning of the year follow:
Cash $70,000
Temporary investments $12,000
Accounts receivable, net $350,000
Inventory $460,000
Prepaid expenses $8,000
Plant and equipment, net $950,000
Accounts payable $200,000
Accrued liabilities $60,000
Notes due within one year $100,000
Bonds payable in five years $140,000
During the year, the company completed the following transactions:

x. Purchased inventory on account, $50,000.
a. Declared a cash dividend, $30,000.
b. Paid accounts payable, $100,000.
c. Collected cash on accounts receivable, $80,000.
d. Purchased equipment for cash, $75,000.
e. Paid a cash dividend previously declared, $30,000.
f. Borrowed cash on a short-term note with the bank, $60,000.
g. Sold inventory costing $70,000 for $100,000, on account.
h. Wrote off uncollectible accounts in the amount of $10,000 reducing the accounts receiv-
able balance accordingly.
i. Sold temporary investments costing $12,000 for cash, $9,000.
j. Issued additional common shares for cash, $200,000.
k. Paid off all short-term notes due, $160,000.
Required:
1. Compute the following amounts and ratios as of the beginning of the year:
a. Working capital.
b. Current ratio.
c. Acid-test ratio.
2. Indicate the effect of each of the transactions given above on working capital, the current ratio,
and the acid-test ratio. Give the effect in terms of increase, decrease, or none. Item (x) is given
as an example of the format to use:
The Effect on
Working Current Acid-Test
Transaction Capital Ratio Ratio
(x) Purchased inventory on account . . . . . None Decrease Decrease
x
e cel PROBLEM 14–14 Comprehensive Ratio Analysis [LO3, LO4, LO5, LO6]
You have just been hired as a loan officer at Fairfield Bank. Your supervisor has given you a file contain-
ing a request from Hedrick Company, a manufacturer of auto components, for a $1,000,000 five-year
loan. Financial statement data on the company for the last two years are given on the following page.
Marva Rossen, who just two years ago was appointed president of Hedrick Company, admits
that the company has been “inconsistent” in its performance over the past several years. But Rossen
argues that the company has its costs under control and is now experiencing strong sales growth,
as evidenced by the more than 25% increase in sales over the last year. Rossen also argues that
investors have recognized the improving situation at Hedrick Company, as shown by the jump
in the price of its common shares from $20 per share last year to $36 per share this year. Rossen
believes that with strong leadership and with the modernized equipment that the $1,000,000 loan
will permit the company to buy, profits will be even stronger in the future.
Anxious to impress your supervisor, you decide to generate all the information you can
about the company. You determine that the following ratios are typical of companies in Hedrick’s
industry:
Current ratio . . . . . . . . . . . . . . . 2.3

Acid-test ratio . . . . . . . . . . . . . . 1.2
Average collection period . . . . . 31 days
Average sale period . . . . . . . . . 60 days
Return on assets . . . . . . . . . . . . 9.5%
Debt-to-equity ratio . . . . . . . . . . 0.65
Times interest earned . . . . . . . . 5.7
Price-earnings ratio . . . . . . . . . . 10
Required:
1. You decide first to assess the rate of return that the company is generating. Compute the fol-
lowing for both this year and last year:
a. The return on total assets. (Total assets at the beginning of last year were $4,320,000.)
b. The return on common shareholders’ equity. (Shareholders’ equity at the beginning of
last year totalled $3,016,000. There has been no change in preferred or common shares
over the last two years.)
c. Is the company’s financial leverage positive or negative? Explain.
2. You decide next to assess the well-being of the common shareholders. For both this year and
last year, compute:
a. The earnings per share.
b. The dividend yield ratio for common shares.
c. The dividend payout ratio for common shares.
d. The price-earnings ratio. How do investors regard Hedrick Company as compared to
other companies in the industry? Explain.
e. The book value per common share. Does the difference between market value per
share and book value per share suggest that the shares at their current price are a bar-
gain? Explain.
f. The gross margin percentage.
Hedrick Company
This Year Last Year
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 320,000 $ 420,000
Temporary investments . . . . . . . . . . . . . . . . . 0 100,000
Accounts receivable, net . . . . . . . . . . . . . . . . 900,000 600,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000 800,000
Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 80,000 60,000
Total current assets . . . . . . . . . . . . . . . . . . . . . . 2,600,000 1,980,000
Plant and equipment, net . . . . . . . . . . . . . . . . . 3,100,000 2,980,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,700,000 $4,960,000

Liabilities:
Current liabilities . . . . . . . . . . . . . . . . . . . . . . $1,300,000 $ 920,000
Bonds payable, 10% . . . . . . . . . . . . . . . . . . . 1,200,000 1,000,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500,000 1,920,000
Preferred shares, 20,000, $2.40 no par value 600,000 600,000
Common shares, 50,000, no par . . . . . . . . . . 2,000,000 2,000,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . 600,000 440,000
Total shareholders’ equity . . . . . . . . . . . . . . . . . 3,200,000 3,040,000
Total liabilities and shareholders’ equity . . . . . . $5,700,000 $4,960,000
Hedrick Company
This Year Last Year
Sales (all on account) . . . . . . . . . . . . . . . . . . . . $5,250,000 $4,160,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 4,200,000 3,300,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,050,000 860,000
Selling and administrative expenses . . . . . . . . 530,000 520,000
Operating income . . . . . . . . . . . . . . . . . . . . . . . 520,000 340,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . 120,000 100,000
Net income before taxes . . . . . . . . . . . . . . . . . 400,000 240,000
Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . 120,000 72,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 280,000 168,000
Dividends paid:
Preferred shares . . . . . . . . . . . . . . . . . . . . . . 48,000 48,000
Common shares . . . . . . . . . . . . . . . . . . . . . . 72,000 36,000
Total dividends paid . . . . . . . . . . . . . . . . . . . . . 120,000 84,000
Net income retained . . . . . . . . . . . . . . . . . . . . . 160,000 84,000
Retained earnings, beginning of year . . . . . . . . 440,000 356,000
Retained earnings, end of year . . . . . . . . . . . . . $ 600,000 $ 440,000
3. You decide, finally, to assess creditor ratios to determine both short-term and long-term debt
paying ability. For both this year and last year, compute:
a. Working capital.
b. The current ratio.
c. The acid-test ratio.
d. The average collection period. (The accounts receivable at the beginning of last year
totalled $520,000.)
e. The average sale period. (The inventory at the beginning of last year totalled $640,000.)
f. The debt-to-equity ratio.
g. The times interest earned.
4. Make a recommendation to your supervisor as to whether the loan should be approved.
PROBLEM 14–15 Common-Size Financial Statements [LO2]

Refer to the financial statement data for Hedrick Company given in Problem 14–14.
Required:
For both this year and last year:
1. Present the balance sheet in common-size format.
2. Present the income statement in common-size format down through net income.
3. Comment on the results of your analysis.
PROBLEM 14–16 Effects of Transactions on Various Financial Ratios [LO3, LO5, LO6]
In the right-hand column below, certain financial ratios are listed. To the left of each ratio is a busi-
ness transaction or event relating to the operating activities of Graham Company.
1. Inventory was sold for cash at a profit. Debt-to-equity ratio
2. Land was purchased for cash. Earnings per share
3. Inventory was sold on account at cost. Acid-test ratio
4. Some accounts payable were paid off. Working capital
5. A customer paid an overdue bill. Average collection period
6. A cash dividend was declared, but not yet paid. Current ratio
7. A previously declared cash dividend was paid. Current ratio
8. The company’s common share price increased. Book value per share
9. The company’s common share price increased. Dividend yield ratio
Earnings per share remained unchanged.
10. Property was sold for a profit. Return on total assets
11. Obsolete inventory was written off as a loss. Inventory turnover ratio
12. Bonds were sold with an interest rate Return on common shareholders’ equity
less than the company’s return on assets.
13. The company’s common share price decreased. Dividend payout ratio
The dividend paid per share remained the same.
14. The company’s net income decreased, but Times interest earned
long-term debt remained unchanged.
15. An uncollectible account was written off Current ratio
against the Allowance for Bad Debts.
16. Inventory was purchased on credit. Acid-test ratio
17. The company’s common share price increased. Price-earnings ratio
Earnings per share remained unchanged.
18. The company paid off some accounts payable. Debt-to-equity ratio
Required:
Indicate the effect that each transaction or event would have on the ratio listed opposite to it. State
the effect in terms of increase, decrease, or no effect on the ratio involved, and give the reason for
your choice. In all cases, assume that the current assets exceed current liabilities both before and
after the event or transaction. Use the following format for your answers:
Effect on Ratio Reason for Increase, Decrease, or No Effect
1.
2.
Etc.
S
PROBLEM 14–17 Interpretation of Financial Ratios [LO3, LO4, LO5]
Being a prudent investor, Sally Perkins always investigates a company thoroughly before purchas-
ing its shares for investment. Ms. Perkins is interested in the common shares of Plunge Enterprises.
The following data are available for the company:
Year 3 Year 2 Year 1
Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . 2.8 2.5 2.0

Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . 0.7 0.9 1.2
Accounts receivable turnover . . . . . . . . . . . . . 8.6 9.5 10.4
Inventory turnover . . . . . . . . . . . . . . . . . . . . . . 5.0 5.7 6.8
Sales trend . . . . . . . . . . . . . . . . . . . . . . . . . . . 130.0 118.0 100.0
Dividends paid per share* . . . . . . . . . . . . . . . . $2.50 $2.50 $2.50
Dividend yield ratio . . . . . . . . . . . . . . . . . . . . . 5% 4% 3%
Dividend payout ratio . . . . . . . . . . . . . . . . . . . 40% 50% 60%
Return on total assets . . . . . . . . . . . . . . . . . . . 13.0% 11.8% 10.4%
Return on common shareholders’ equity . . . . 16.2% 14.5% 9.0%
*There were no changes in common shares outstanding over the three-year period.
Ms. Perkins would like answers to a number of questions about the trend of events over the
last three years in Plunge Enterprises. Her questions are as follows:
a. Is the market price of the company’s shares going up or down?
b. Is the earnings per share increasing or decreasing?
c. Is the price-earnings ratio going up or down?
d. Is the company employing financial leverage to the advantage of the common shareholders?
e. Is it becoming easier for the company to pay its bills as they come due?
f. Are customers paying their bills at least as fast now as they did in Year 1?
g. Is the total of the accounts receivable increasing, decreasing, or remaining constant?
h. Is the level of inventory increasing, decreasing, or remaining constant?
Required:
Answer each of Ms. Perkins’ questions and explain how you arrived at your answer.
PROBLEM 14–18 Ethics and the Manager [LO5]

Mountain Aerosport was founded by Jurgen Prinz to produce a ski he had designed for doing
aerial tricks. Up to this point, Jurgen has financed the company with his own savings and with
cash generated by his business. However, Jurgen now faces a cash crisis. In the year just ended,
an acute shortage of a vital tungsten steel alloy developed just as the company was beginning
production for the Christmas season. Jurgen had been assured by his suppliers that the steel
would be delivered in time to make Christmas shipments, but the suppliers had been unable to
fully deliver on this promise. As a consequence, Mountain Aerosport had a large inventory of
unfinished skis at the end of the year and had been unable to fill all of the orders that had come
in from retailers for the Christmas season. Consequently, sales were below expectations for the
year, and Jurgen does not have enough cash to pay his creditors.
Well before the accounts payable were due, Jurgen visited a local bank and inquired about
obtaining a loan. The loan officer at the bank assured Jurgen that there should not be any problem
getting a loan to pay off his accounts payable—providing that on his most recent financial state-
ments the current ratio was above 2.0, the acid-test ratio was above 1.0, and operating income
was at least four times the interest on the proposed loan. Jurgen promised to return later with a
copy of his financial statements.
Jurgen would like to apply for a $120 thousand six-month loan bearing an interest rate of 10%
per year. The unaudited financial reports of the company appear on the next page.
Required:
1. Based on the above unaudited financial statements and the statement made by the loan officer,
would the company qualify for the loan?
2. Last year Jurgen purchased and installed new, more efficient equipment to replace an older
heat-treating furnace. Jurgen had originally planned to sell the old equipment but found that it
is still needed whenever the heat-treating process is a bottleneck. When Jurgen discussed his
cash flow problems with his brother-in-law, he suggested to Jurgen that the old equipment be
sold or at least reclassified as inventory on the balance sheet since it could be readily sold. At
present, the equipment is carried in the Property and Equipment account and could be sold for
its net book value of $68 thousand. The bank does not require audited financial statements.
What advice would you give to Jurgen concerning the machine?
Mountain Aerosport
As of December 31, This Year and Last Year
(in thousands of dollars)
This Year Last Year
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $105 $225
Accounts receivable, net . . . . . . . . . . . . . . 75 60
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . 240 150
Prepaid expenses . . . . . . . . . . . . . . . . . . . 15 18
Total current assets . . . . . . . . . . . . . . . . . . . . 435 453
Property and equipment . . . . . . . . . . . . . . . . 405 270
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . $840 $723
Accounts payable . . . . . . . . . . . . . . . . . . . $231 $135
Accrued payables . . . . . . . . . . . . . . . . . . . 15 15
Total current liabilities . . . . . . . . . . . . . . . . . . 246 150
Long-term liabilities . . . . . . . . . . . . . . . . . . . 0 0
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . 246 150
Common shares . . . . . . . . . . . . . . . . . . . . . 150 150
Retained earnings . . . . . . . . . . . . . . . . . . . 444 423
Total shareholders’ equity . . . . . . . . . . . . . . . 594 573
Total liabilities and shareholders’ equity . . . . $840 $723
Mountain Aerosport
Income Statement
For the Year Ended December 31, This Year
(in thousands of dollars)
Sales (all on account) . . . . . . . . . . . . . . . . . . . . $630

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 435
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
Selling expenses . . . . . . . . . . . . . . . . . . . . . . 63
Administrative expenses . . . . . . . . . . . . . . . . 102
Total selling and administrative expenses . . . . 165
Operating income . . . . . . . . . . . . . . . . . . . . . . . 30
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . 0
Net income before taxes . . . . . . . . . . . . . . . . . 30
Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . 9
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21
x
e cel PROBLEM 14–19 Incomplete Statements; Analysis of Ratios [LO1, LO3, LO5, LO6]
Incomplete financial statements for Tanner Company are given on the next page. The following
additional information is available about the company:
a. Selected financial ratios computed from the statements given.
Current ratio . . . . . . . . . . . . . . . . . . 2.40

Acid-test ratio . . . . . . . . . . . . . . . . . 1.12
Accounts receivable turnover . . . . 15.0
Inventory turnover . . . . . . . . . . . . . . 6.0
Debt-to-equity ratio . . . . . . . . . . . . 0.875
Times interest earned . . . . . . . . . . . 7.0
Earnings per share . . . . . . . . . . . . . $4.05
Return on total assets . . . . . . . . . . . 14%
Tanner Company
Income Statement
For the Year Ended December 31
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,700,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . ?
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . ?
Selling and administrative expenses . . . . . . ?
Operating income . . . . . . . . . . . . . . . . . . . . . ?
Interest expense . . . . . . . . . . . . . . . . . . . . . . 45,000
Net income before taxes . . . . . . . . . . . . . . . ?
Income taxes (40%) . . . . . . . . . . . . . . . . . . . ?
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $ ?
Tanner Company
Balance Sheet
December 31
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ?
Accounts receivable, net . . . . . . . . . . . . . . . . ?
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Total current assets . . . . . . . . . . . . . . . . . . . . . . ?
Plant and equipment, net . . . . . . . . . . . . . . . . . ?
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ ?
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . $250,000

Bonds payable, 10% . . . . . . . . . . . . . . . . . . . . . ?
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . ?
Common shares, 40,000 no par . . . . . . . . . . . 100,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . ?
Total shareholders’ equity . . . . . . . . . . . . . . . . . ?
Total liabilities and shareholders’ equity . . . . . . $ ?
b. All sales during the year were on account.

c. The interest expense on the income statement relates to the bonds payable; the amount of
bonds outstanding did not change throughout the year.
d. There were no changes in the number of common shares outstanding during the year.
e. Selected balances at the beginning of the current year (January 1) were as follows:
Accounts receivable . . . . . . $160,000

Inventory . . . . . . . . . . . . . . . $280,000
Total assets . . . . . . . . . . . . . $1,200,000
Required:
Compute the missing amounts on the company’s financial statements. (Hint: You may find it help-
ful to think about the difference between the current ratio and the acid-test ratio.)
x
e cel PROBLEM 14–20 Forecast Financial Statements: Computer Spreadsheet [LO1, LO3, LO5,
LO6]
AC Company has just prepared the annual financial statements for 2007 given below:
AC COMPANY
Income Statement
For the Years Ended
2008 2007
Sales revenue (one half on credit for 2007) . . . . . . . . . . . $98,000 $95,000

Cost
of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,000
Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,000
Expenses
(including $3,000 interest expense each year) 33,000
Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16,000
Income tax on operations (19%) . . . . . . . . . . . . . . . . . . .
3,040
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,960

AC COMPANY
Balance Sheet
At December 31, 2008 and 2007
2008 2007
Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000
Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Capital assets (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
100,000
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $190,000

Liabilities
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000
Income tax payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Note payable, long‑term . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Shareholders’ Equity
Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Retained
earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34,000
Total liabilities and shareholders’ equity . . . . . . . . . . . . . $190,000

Additional information: Depreciation expense was $20,000 in 2007; depreciation rate for 2008
based on the beginning account balance, .20; long-term note payments expected at the end of
2008, $2,000; unpaid taxes expected at the end of 2008, $1,200; dividends expected to be paid
in 2008, $7,000; additions to capital assets in 2008, $10,000; credit sales as a percentage of total
sales for 2008, .60; $10,000 was in inventory, January 1, 2007.
Required:
Using a computer spreadsheet, prepare forecasts of the 2008 income statement, statement of cash
flows, and December 31, 2008 balance sheet. (Hint: Use 2007 turnovers as estimates for 2008.)
Research Research
R 14–21 Harmonization [LO3, LO5, LO6]
Using the CICA web site, www.cica.ca, and the International Accounting Standards Board site,
www.iasb.org, describe the changes that may be made to the disclosure of income statement matters.
Consider if these proposed changes would simplify or make more complicated the interpretation
of income performance.
R 14–22 Governance [LO1, LO3]

Governance refers to the overall management of the organization. Shareholders, directors, and
senior managers are involved in governance activities.
a. Examine the shareholder relations tab of the web site for Tim Hortons or Canadian Tire for
their discussion of ethics and governance.
b. Explain the elements they consider as part of their governance practices.
R 14–23 XBRL [LO1, LO3, LO5, LO6]

Using the web, sites www.xbrl.ca, or www.xbrl.org describe the potential benefits of XBRL use for
the analysis of financial statements.

Garrisonch Chapter 14

Enviado por

Dados do documento

Descrição original:

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

Garrisonch Chapter 14

Enviado por

Direitos autorais:

Formatos disponíveis

BONUS Chapter 1 Managerial Accounting and the Business Environment

Source: Tim Hortons, 2006 Annual Report.

A ll financial statements are essentially historical

Need for and Limitations of Financial Statement Analysis

Learning Objective 1 The Internal Use of Ratios

Comparison of Financial Data

The Need to Look Beyond Ratios

Dollar and Percentage Changes on Statements

2008 2007 Amount Percent

Property and equipment:

Liabilities and Shareholders Equity

Horizontal Analysis Comparison of two or more years’ financial data is known

2008 2007 Amount Percent

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000 $48,000 $4,000 8.3%

Tim Hortons Trends Exhibit 14–3 Tim Hortons

2008 2007 2008 2007

Property and equipment:

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,500 $28,970 100.0% 100.0%

Liabilities and Shareholders Equity

Chapter 14 “How Well Am I Doing?” Financial Statement Analysis BC14–9

2008 2007 2008 2007

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000 $48,000 100.0% 100.0%

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000 $48,000 100.0% 100.0%

Extraordinary Items and Earnings per Share

Extraordinary Items and Earnings per Share

In summary, clearly segregating extraordinary items as we have done above is

Fully Diluted Earnings per Share

Net income before taxes . . . . . . . 4,000

mes arises in trying to determine the number of commonIn summary,

Earnings per Share and Profitability

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,750,000

Financial Leverage Financial Leverage

The acid-testCurrent ratio, (a) 4 (b) . . . . . . . .

CFO before interest and taxes

Cash Burn Rate

Ratio Analysis—The Long-Term Creditor

RATIOS AND PROFIT PLANNING

However, because purchases on account is not disclosed, it too must be estimated. A

Exhibit 14–8 Estimated Estimated Income Statement*

Estimated Statement of Cash Flows

*Assumes depreciation of $1,500 is included in selling and administrative expenses.

Proforma Earnings Proforma Earnings

Summary of Ratios and Sources of Comparative Ratio Data

Exhibit 14–9 Summary of Ratios

Ratio Formula Significance

Exhibit 14–9 Summary of Ratios (concluded)

Ratio Formula Significance

Exhibit 14–10 Sources of Financial Information

Library Internet Resources

ABIGlobal A reference source for topical and company literature.

Exhibit 14–10 Sources of Financial Information (concluded)

14–9 What is meant by the term financial leverage?

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000,000 $4,000,000

Heritage Antiquing Services

Liabilities and Shareholders’ Equity

Heritage Antiquing Services

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $66,000 $64,000

Year 5 Year 4 Year 3 Year 2 Year 1

Sales . . . . . . . . . . . . . . . . . . . $5,625 $5,400 $4,950 $4,725 $4,500

Liabilities and Shareholders’ Equity

4. Average collection period.

Modern Building Supply

Liabilities and Shareholders’ Equity

ABIGlobal A reference source for topical and company literature.