CHAPTER 13

Financial Analysis: The Big Picture

Study Objectives

1. Understand the concept of sustainable income.

2. Indicate how irregular items are presented.

3. Explain the concept of comprehensive income.

4. Describe and apply horizontal analysis.

5. Describe and apply vertical analysis.

6. Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.

7. Understand the concept of quality of earnings.

Chapter Outline

Study Objective 1 - Understand the Concept of Sustainable Income

The value of a company is a function of its future cash flows.

When analysts use this year’s net income to estimate future cash flows, they must make sure that this year’s net income does not include irregular (out of the ordinary) revenues, expenses, gains or losses.

Net income adjusted for irregular items is referred to as sustainable income.

Sustainable income is the most likely level of income to be obtained in the future. Sustainable income differs from actual net income by the amount of irregular revenues,

expenses, gains, and losses included in this year’s net income. Users are interested in sustainable income because it helps them derive an estimate of future

earnings without the “noise” of irregular items.

Study Objective 2 - Understand How Irregular Items are Presented

Irregular items are identified by type on the income statement. Two types of irregular items are reported - discontinued operations and extraordinary items. Irregular items are reported net of income taxes. Income tax expense is computed for the

income before irregular items. Then, income tax expense is computed for each individual irregular item.

Discontinued operations refers to the disposal of a significant component of a business, such as the elimination of a major class of customers or an entire activity. When the disposal of a significant component occurs, the income statement should report the

gain (or loss) from discontinued operations, net of tax. To illustrate, assume that Rozek Inc. has revenues of $2.5 million and expenses of $1.7 million

from continuing operations in 2012. The company therefore has income before income taxes of $800,000. During 2012, the company discontinued and sold its unprofitable chemical division. The loss on disposal of the chemical operations (net of $90,000 taxes) was $210,000. Assuming a 30% tax rate on income before income taxes, the income statement presentation would be as follows:

ROZEK INC.Income Statement (partial)

For the Year Ended December 31, 2012

Income before income taxes.............................................. $800,000Income tax expense........................................................... 240,000Income before irregular items............................................ 560,000Discontinued operations

Loss from disposal of chemical division, net of $90,000 income tax saving.............................. (210,000)

Net Income......................................................................... $350,000

Extraordinary items are events and transactions that meet two conditions: They are unusual in nature and infrequent in occurrence. To be considered unusual, the item should be abnormal and only incidentally related to

customary activities of the entity. To be regarded as infrequent, the event or transaction should not be reasonably expected to

recur in the foreseeable future. Both criteria must be evaluated in terms of the environment in which the entity operates.

Extraordinary items are reported net of tax in a separate section of the income statement immediately below discontinued operations.

Assume that in 2012 a revolutionary foreign government expropriated property held as an investment by Rozek Inc. If the loss is $70,000 before applicable income taxes of $21,000, the income statement presentation will show a deduction of $49,000, as illustrated below:

ROZEK INC.Partial Income Statement

For the Year Ended December 31, 2012

Income before income taxes.............................. $800,000Income tax expense........................................... 240,000Income before irregular items............................ 560,000Discontinued operations: Loss from

disposal of chemical division, net of $90,000 income tax savings .................... (210,000)

Extraordinary item: Expropriation of investment, net of $21,000 income tax savings.................................................. (49,000)

Net income......................................................... $301,000

If a transaction or event meets one but not both of the criteria for an extraordinary item, it should be reported in a separate line item in the upper portion of the income statement, rather than being reported in the bottom portion as an extraordinary item. Transactions or events meeting only one criteria are usually reported under “Other

revenues and gains” or “Other expenses and losses” at their gross amount (not net of tax).

In summary, in evaluating a company, it generally makes sense to eliminate all irregular items in estimating future sustainable income.

Changes in accounting principle For ease of comparison, financial statements are expected to be prepared on a basis

consistent with that used for the preceding period. A change in accounting principle occurs when the principle used in the current year is

different from the one used in the preceding year.

A change is permitted when management can show that the new principle is preferable to the old principle. An example is a change in inventory costing methods (such as FIFO to average-cost).

A change in accounting principle is reported retroactively, to improve comparability. Companies report both the current period and previous periods reported on the face of the

statements using the new principle. As a result, the same principle applies in all periods.

Study Objective 3 – Explain the Concept of Comprehensive Income

Comprehensive Income - Most revenues, expenses, gains, and losses are included in net income. However, certain gains and losses now bypass net income. Instead these items are recorded as direct adjustments to stockholders’ equity.

Many analysts have expressed concern about this practice because they believe it reduces the usefulness of the income statement. To address this concern, the FASB now requires companies to report not only net income but

also comprehensive income. Comprehensive income includes all changes in stockholders’ equity during a period except

those changes resulting from investments by stockholders and distributions to stockholders.

For example, unrealized gains or losses on available-for-sale securities are excluded from net income. Instead they are reported as part of “Other comprehensive income.”

Illustration of comprehensive income: Accounting standards require that most investments in stocks and bonds be adjusted up or

down to their market value at the end of each accounting period. For example, assume that during 2012, Stassi Company purchased IBM stock for $10,000 as

an investment. At the end of 2012, Stassi was still holding the investment, but the stock’s market value was now $8,000. In this case, Stassi is required to reduce the recorded value of its IBM investment by $2,000. The $2,000 difference is an unrealized loss.

Should Stassi include this $2,000 unrealized loss in net income? It depends on whether the IBM stock is classified as a trading security or an available-for-sale security. A trading security is bought and held primarily for sale in the near term to generate

income on short-term price differences. Unrealized losses on trading securities are reported in the “Other expenses and losses” section of the income statement.

Available-for-sale securities are held with the intent of selling them sometime in the future. Unrealized gains and losses on available-for-sale securities are not included in the determination of net income. Instead, they are reported as part of “Other comprehensive income.”

Format: One format for reporting comprehensive income is to report a combined statement of income

and comprehensive income.

STASSI CORPORATIONCombined Statement of Income and

Comprehensive Income (partial)

Net Income................................................................... $300,000Unrealized loss on available-for-sale securities............ 2,000Comprehensive income................................................ $298,000

The unrealized loss on available-for-sale securities is also reported as a separate component of stockholders’ equity.

STASSI CORPORATIONBalance Sheet (partial)

Stockholders’ equityCommon stock........................................................ $3,000,000Retained earnings................................................... 1,500,000

Total paid-in capital and retained earnings..... 4,500,000Less: Unrealized loss on available-for-sale

securities.................................................... (2,000)Total stockholders’ equity............................................. $4,498,000

Note that the presentation of the loss is similar to the presentation of the cost of treasury stock in the stockholders’ equity section. An unrealized gain is added to this section of the balance sheet.

Reporting the unrealized gain or loss in the stockholders’ equity section serves two important purposes:1. It reduces the volatility of net income due to fluctuations in fair value.2. It informs the financial statement user of the gain or loss that would occur if the securities

were sold at fair value.

Complete Income Statement - The following income statement for Pace Corporation presents the types of items found on this statement and shows how the irregular items are reported.

PACE CORPORATIONIncome Statement and

Statement of Comprehensive IncomeFor the Year Ended December 31, 2012

Net sales....................................................................... $440,000Cost of goods sold........................................................ 260,000Gross profit................................................................... 180,000

Operating expenses................................................ 110,000Income from operations.......................................... 70,000Other revenues and gains....................................... $ 5,600Other expenses and losses..................................... (9,600) (4,000)Income before income taxes................................... 66,000Income tax expense ($66,000 x 30%)..................... 19,800Income before irregular items.................................. 46,200

Discontinued operations: Gain on disposal of Plastics Division, net of $15,000

income taxes ($50,000 x 30%).............................. 35,000Extraordinary item: Tornado loss, net

of income tax savings $18,000 ($60,000 x 30%)...................................................... (42,000)

Net Income.................................................................. 39,200Add: Unrealized gain on

available-for-sale securities.................................. 10,000Comprehensive income............................................. $ 49,200

Concluding remarks – The computation of the correct net income number can be elusive. In assessing the future prospects of a company, some investors focus on income from

operations and therefore ignore all irregular and other items. Others use measures such as net income, comprehensive income, or some modified version

of one of these amounts.

Study Objective 4 – Describe and Apply Horizontal Analysis

In assessing the financial performance of a company, investors are interested in the core or sustainable earnings of a company. Investors are also interested in making comparisons from period to period.

Three types of comparisons have been shown in the text to improve the decision usefulness of financial information:

1. Intracompany basis. Comparisons within a company are often useful to detect changes in financial relationships and significant trends. A comparison of Kellogg’s current year’s cash amount with the prior year’s cash amount shows either an increase or a decrease. Likewise, a comparison of Kellogg’s year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash.

2. Intercompany basis. Comparisons with other companies provide insight into a company’s competitive position. Kellogg’s total sales for the year can be compared with the total sales of its competitors in the breakfast cereal area, such as General Mills.

3. Industry averages. Comparisons with industry averages provide information about a company’s relative position within the industry. Kellogg’s financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody’s, and Standard & Poor’s, or with information provided on the Internet by organizations such as Yahoo! on its financial site.

Three basic tools are used in financial statement analysis to highlight the significance of financial statement data:1. Horizontal analysis2. Vertical analysis3. Ratio analysis

Horizontal analysis, also known as trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place. The increase or decrease can be expressed as either an amount or a percentage.

TEACHING TIP

Horizontal analysis is just that—horizontal. One looks across the page.

To illustrate horizontal analysis, the most recent net sales figures (in thousands) of Chicago Cereal Company are given:

2009 2008 2007 2006 2005     $11,776 $10,907 $10,177 $9,614 $8,812

If we assume that 2005 is the base year, we can measure all percentage increases or decreases from this base-period amount with the following formula:

Change Since Base Period

For example, we can determine that net sales for Chicago Cereal Company increased approximately 9.1% [($9,614 - $8,812) / $8,812] from 2005 to 2006.

Alternatively, we can express current-year sales as a percentage of the base period by dividing the current-year amount by the base-year amount:

Current Results in Relation to Base Period = Current-Year AmountBase Year Amount

Current-period sales expressed as a percentage of the base-period for each of the five years, assuming 2005 as the base period is:

2009 2008 2007 2006 2005       $11,776 $10,907 $10,177 $9,614 $8,812

133.64% 123.77% 115.49% 109.10% 100%

The financial statements of Chicago Cereal Company are used to further illustrate horizontal analysis:

CHICAGO CEREAL COMPANY, INC.Condensed Balance Sheets

December 31(In thousands)

Increase (Decrease) during 2009                

Assets                                   2009       2008 Amount PercentCurrent assets $ 2,717 $ 2,427 $290 11.9Plant assets (net) 2,990 2,816 174 6.2Other assets 5,690 5,471 219 4.0Total assets $11,397 $10,714 $683 6.4

Liabilities and Stockholders’ EquityCurrent liabilities $ 4,044 $ 4,020 $ 24 0.6Long-term liabilities 4,827 4,625 202 4.4 Total liabilities 8,871 8,645 226 2.6Stockholders’ equity Common stock 493 397 96 24.2 Retained earnings 3,390 2,584 806 31.2 Treasury stock (cost) (1,357) (912) (445) 48.8 Total stockholders’ equity 2,526 2,069 457 22.1Total liabilities and stockholders’ equity $11,397 $10,714 $683 6.4

The comparative balance sheet shows a number of changes from 2008 to 2009. Current assets increased $290,000 or 11.9% ($290/$2,427). Property assets (net) increased $174,000 or 6.2%. Other assets increased $219,000 or 4.0%. Current liabilities increased $24,000 or 0.6% while long-term liabilities increased $202,000, or

4.4%. Retained earnings increased $806,000 or 31.2%.

TEACHING TIP

Impress upon students the importance of the percentage figures. The percentages allow us to see the relevance of the increase or decrease.

A 2-year comparative income statement of Chicago Cereal Company for 2009 and 2008 is given in condensed format:

CHICAGO CEREAL COMPANY, INC.Condensed Income Statement

For the Years Ended December 31(In thousands)

Increase (Decrease) during 2009                    

2009 2008 Amount PercentNet sales $11,776 $10,907 $869 8.0Cost of goods sold 6,597 6,082 515 8.5Gross profit 5,179 4,825 354 7.3Selling and administrative expenses 3,311 3,059 252 8.2Income from operations 1,868 1,766 102 5.8Interest expense 319 307 12 3.9Other income (expense), net (2 ) 13 (15) (115.4)Income before income taxes 1,547 1,472 75 5.1Income tax expense 444 468 (24) (5.1)Net income $ 1,103 $ 1,004 $ 99 9.9

Horizontal analysis of the income statements shows these changes: Net sales increased $869,000 or 8.0% ($869 ÷ $10,907). Cost of goods sold increased $515,000 or 8.5% ($515 ÷ $6,082). Selling and administrative expenses increased $252,000, or 8.2% ($252 ÷ $3,059). Overall, gross profit increased by 7.3% and net income increased by 9.9%. The increase in net income can be attributed to the increase in net sales and a decrease in

Income tax expense. When using horizontal analysis, if an item has no value in a base year or preceding year and a

value in the next year, no percentage change can be computed. And if a negative amount appears in the base or preceding period and a positive amount exists in the following year, no percentage change can be computed.

Study Objective 5 - Describe and Apply Vertical Analysis

Vertical analysis, also called common-size analysis, is a technique for evaluating financial statement data that expresses each item in a financial statement as a percentage of a base amount. On a balance sheet one might say that current assets are 22% of total assets (total assets

being the base amount.) On an income statement one might say that selling expenses are 16% of net sales (net sales

being the base amount.)

Presented below is the comparative balance sheet of Chicago Cereal for 2009 and 2008, analyzed vertically.

CHICAGO CEREAL COMPANY, INC.Condensed Balance Sheets

December 31(In thousands)

2009 2008 Assets                                             Amount Percent* Amount Percent*Current assets $ 2,717 23.8 $ 2,427 22.6Property assets (net) 2,990 26.2 2,816 26.3Other assets 5,690 50.0 5,471 51.1Total assets $11,397 100.0 $10,714 100.0

Liabilities and Stockholders’ EquityCurrent liabilities $4,044 35.5 $ 4,020 37.5Long-term liabilities 4,827 42.4 4,625 43.2 Total liabilities 8,871 77.9 8,645 80.7 Stockholders’ equity Common stock 493 4.3 397 3.7 Retained earnings 3,390 29.7 2,584 24.1 Treasury stock (cost) (1,357) (11.9) (912) (8.5) Total stockholders’ equity 2,526 22.1 2,069 19.3Total liabilities and stockholders’ equity $11,397 100.0 $10,714 100.0

*Numbers have been rounded to total 100%.

In addition to showing the relative size of each category on the balance sheet, vertical analysis may show the percentage change in the individual asset, liability, and stockholders’ equity items. Chicago Cereal’s current assets increased $290,000 from 2008 to 2009 and they increased

from 22.6% to 23.8% of total assets. Property assets (net) decreased from 26.3% to 26.2% of total assets. Other assets decreased from 51.1% to 50.0% of total assets. Retained earnings increased by $806,000 from 2008 to 2009, and total stockholders’ equity

increased from 19.3% to 22.1% of total liabilities and stockholders’ equity. This switch to a higher percentage of equity financing has two causes: First, while total liabilities increased by $226,000 the percentage of liabilities declined from 80.7% to 77.9% of total liabilities and stockholders’ equity. Second, retained earnings increased by $806,000. Thus, the company shifted toward a heavier reliance on equity financing both by using less debt and by increasing the amount of retained earnings.

Vertical analysis of the comparative income statements of Chicago Cereal, shown below reveals that: Cost of goods sold as a percentage of net sales increased from 55.8% to 56.0%. Selling and administrative expenses increased from 28.0% to 28.1%. Net income as a percentage of net sales increased from 9.1% to 9.4%. The decline in net income as a percentage of sales is due primarily to the decrease in interest

expense and income tax expense as a percentage of sales.

CHICAGO CEREAL COMPANY, INC.Condensed Income Statement

For the Years Ended December 31(In thousands)

2009 2008Amount Percent* Amount Percent*

Net sales $11,776 100.0 $10,907 100.0Cost of goods sold 6,597 56.0 6,082 55.8Goss profit 5,179 44.0 4,825 44.2Selling and admin. expenses 3,311 28.1 3,059 28.0Income from operations 1,868 15.9 1,766 16.2Interest expense 319 2.7 307 2.8Other income (expense), net (2) 0 13 0Income before income taxes 1,547 13.2 1,472 13.4Income tax expense 444 3.8 468 4.3Net income $ 1,103 9.4 $ 1,004 9.1*Numbers have been rounded to total 100%.

Vertical analysis enables you to compare companies of different sizes. Shown below is a comparison of the income statements of Chicago Cereal and General Mills:

CONDENSED INCOME STATEMENTSFor the Year Ended December 31, 2009

(In thousands)

Chicago Cereal. General Mills, Inc.Amount Percent* Amount Percent*

Net sales $11,776 100.0 $14,691 100.0Cost of goods sold 6,597 56.0 9,458 64.4Gross profit 5,179 44.0 5,233 35.6Selling and admin. expenses 3,311 28.1 2,954 20.1Nonrecurring charges 0 — (43) 0.3Income from operations 1,868 15.9 2,322 15.8Other expense and revenues   (including income taxes) 765 6.5 1,0108 6.9Net income $ 1,103 9.4 $ 1,304 8.9*Numbers have been rounded to total 100%

Although Chicago Cereal’s net sales are less than the net sales of General Mills, vertical analysis eliminates the impact of the size difference for the analysis.

Chicago Cereal’s has a higher gross profit, 44.0%, compared to 35.6% for General Mills, but Chicago Cereal’s selling and administrative expenses are 28.1% of net sales, while those of General Mills are 20.1% of net sales.

Chicago Cereal’s and General Mills report similar percentages for income from operations as a percentage of net sales, 9.4% compared to 8.9%, respectively.

Study Objective 6 - Identify and Compute Ratios Used in Analyzing a Company’s Liquidity, Solvency, and Profitability

For analysis of the primary financial statements, ratios can be classified into three types:1. Liquidity ratios measure the short-term ability of the company to pay its maturing obligations

and to meet unexpected needs for cash.2. Solvency ratios measure the ability of the company to survive over a long period of time.3. Profitability ratios measure the income or operating success of a company for a given period

of time.

TEACHING TIP

Review the summary listing on pages 700-701 of ratios presented in previous chapters. A comprehensive illustration of ratio analysis is presented in the Appendix at the end of the chapter.

Study Objective 7 – Understand the Concept of Quality of Earnings

A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of financial statements.

The issue of quality of earnings has taken on increasing importance because recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business.

Some of the factors affecting quality of earnings include the following: Alternative accounting methods – Variations among companies in the application of

generally accepted accounting principles may hamper comparability and reduce quality of earnings. For example, one company may use the FIFO method of inventory costing, while another

company in the same industry may use LIFO. If inventory is a significant asset to both companies, it is unlikely that their current ratios

are comparable. Differences also exist in reporting such items as depreciation and amortization. Although

these differences in accounting methods might be detected from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is often difficult, if not impossible.

Pro forma income – Companies whose stock is publicly traded are required to present their income statement following generally accepted accounting principles (GAAP). In recent years, many companies have been also reporting a second measure of income,

called pro forma income. Pro forma income is a measure that usually excludes items that the company thinks are

unusual or non-recurring. There are no rules as to how to prepare pro forma earnings. Companies generally can

exclude any items they deem inappropriate for measuring their performance. Many analysts are critical of the practice of using pro forma income because these

numbers often make companies look better then they really are. Companies, on the other hand, argue that pro forma numbers more clearly indicate

sustainable income because unusual and non-recurring expenses are excluded.

Recently, the SEC provided some guidance on how companies should present pro forma information.

Everyone seems to agree that pro forma numbers can be useful if they provide insights into determining a company’s sustainable income. However, many companies have abused the flexibility that pro forma numbers allow and have used the measure as a way to put their companies in a more favorable light.

Improper recognition – Because some managers have felt pressure to continually increase earnings, they have manipulated the earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue. One practice that companies are using is called channel stuffing. Offering deep discounts

on their products to customers, companies encourage their customers to buy early (stuff the channel) rather than later.

This lets the company report good earnings in the current period, but it often leads to a disaster in subsequent periods because customers have no need for additional goods.

Another practice is the improper capitalization of operating expenses. The classic case is WorldCom which capitalized over $7 billion of operating expenses to ensure that it would report positive net income.

Price-earnings ratio – In order to make a meaningful comparison of market values and earnings across firms, investors calculate the price-earnings (P-E) ratio. The P-E ratio, divides the market price of a share of common stock by earnings per share. The P-E ratio reflects investors’ assessment of a company’s future earnings. Higher P-E ratios are associated with a greater willingness of investors to pay more per

share of stock, because they believe the company will have substantial earnings in the future

A low price-earnings ratio often signifies that investors think the company’s future earnings will not be strong or that it has poor-quality earnings.

Appendix – Comprehensive Illustration of Ratio Analysis

Many ratios used for evaluating the financial health and performance of a company are presented in the text. This appendix provides a comprehensive review of those ratios, discusses some important relationships among them, and focuses on their interpretation.

As indicated in the chapter, for analysis of the primary financial statements, ratios can be classified into three types:1. Liquidity ratios: Measures of the short-term ability of the company to pay its maturing

obligations and to meet unexpected needs for cash.2. Solvency ratios: Measures of the ability of the company to survive over a long period of time.3. Profitability ratios: Measures of the income or operating success of a company for a given

period of time.

Go over the information presented in Illustrations 13A-1 through 13A-4.

Ratios can provide clues to underlying conditions that may not be apparent from an inspection of the individual components of a particular ratio.

A single ratio by itself is not very meaningful.

The discussion on ratios uses the following comparisons:1. Intracompany comparisons covering two years for Chicago Cereal Company.

2. Intercompany comparisons using General Mills as one of Chicago Cereal’s principal competitors.

3. Industry average comparisons based on MSN.com median ratios for manufacturers of flour and other grain mill products and comparisons with other sources.

Liquidity ratios measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors, such as bankers and suppliers, are particularly interested in assessing

liquidity. The measures that can be used to determine the enterprise’s short-term debt-paying ability are

the current ratio, the current cash debt coverage ratio, the receivables turnover ratio, the average collection period, the inventory turnover ratio, and the average days in inventory.

1. The current ratio expresses the relationship of current assets to current liabilities, computed by dividing current assets by current liabilities. The current ratio is widely used for evaluating a company’s liquidity and short-term debt-

paying ability. Review the information in Illustration 13A-5.

2. Current cash debt coverage ratio is the ratio of cash provided by operating activities to average current liabilities. A disadvantage of the current ratio is that it uses year-end balances of current asset and

current liability accounts. Those year-end balances may not be representative of the company’s current position

during most of the year. Because it uses cash provided by operating activities rather than a balance at one point in

time, the current cash debt coverage ratio may provide a better representation of liquidity. Review the information in Illustration 13A-6.

3. The receivables turnover ratio measures liquidity by determining how quickly certain assets can be converted to cash. The receivables turnover ratio measures the number of times, on average, receivables are

collected during the period. The receivables turnover ratio is computed by dividing net credit sales (net sales less cash

sales) by average net receivables during the year. Review the information in Illustration 13A-7.

4. The average collection period is a popular variant of the receivables turnover ratio. The average collection period converts the receivables turnover into an average collection

period expressed in days. The ratio is computed by dividing the receivables turnover ratio into 365 days. The general rule is that the collection period should not greatly exceed the credit term

period. Review the information in Illustration 13A-8.

TEACHING TIP

Ask students to try not to memorize the information in this chapter. Ask them to think about the information that is available and about what they are trying to compute. The receivables turnover ratio tells us how many times receivables are turning over a year. Therefore, if we divide the receivables turnover ratio into the number of days in a year, we will find the number of days, on average, accounts receivable are outstanding.

5. The inventory turnover ratio measures the number of times on average the inventory is sold during the period. The purpose of this ratio is to measure the liquidity of the inventory. The inventory turnover ratio is computed by dividing the cost of goods sold by the average

inventory during the period. Review the information in Illustration 13A-9.

6. Days in inventory is a variant of the inventory turnover ratio. The days in inventory measures the average number of days inventory is held. It is computed by dividing the inventory turnover ratio into 365 days. Review the information in Illustration 13A-10.

Solvency ratios – measure the ability of the enterprise to survive over a long period of time. Long-term creditors and stockholders are interested in a company’s long-run solvency,

particularly its ability to pay interest as it comes due and to repay the face value of debt at maturity.

The debt to total assets ratio, the times interest earned ratio, and the cash debt coverage ratio provide information about debt-paying ability.

In addition free cash flow provides information about the company’s solvency and its ability to pay additional dividends or invest in new projects.

7. The debt to total asset ratio measures the percentage of total assets provided by creditors. It is computed by dividing total liabilities (both current and long-term) by total assets. This ratio indicates the degree of financial leveraging and provides some indication of the

company’s ability to withstand losses without impairing the interests of its creditors. The higher the percentage of debt to total assets, the greater the risk that the company

may be unable to meet its maturing obligations. The lower the ratio, the more equity “buffer” is available to creditors if the company

becomes insolvent. Review the information in Illustration 13A-11.

8. The times interest earned ratio, also called interest coverage, indicates the company’s ability to meet interest payments as they come due. The ratio is computed by dividing income before interest expense and income taxes by

interest expense. Review the information in Illustration 13A-12.

TEACHING TIP

Emphasize that income before interest expense and income tax expense is the amount used in the formula because that is the amount available for paying interest payments. Again, stress to students to think about what they are trying to compute rather than trying to memorize the formulas.

9. The cash debt coverage ratio is the ratio of cash provided by operating activities to average total liabilities. This ratio is a cash-basis measure of solvency. The cash debt coverage ratio indicates a company’s ability to repay its liabilities from cash

generated from operating activities without having to liquidate the assets used in its operations.

Review the information in Illustration 13A-13.

10.Free cash flow is an indication of a company’s solvency and its ability to pay dividends or expand operations. Free cash flow is the amount of excess cash generated after investing in capital

expenditures and paying dividends. Review the information in Illustration 13A-14.

Profitability ratios – measure the income or operating success of an enterprise for a given period of time. A company’s income or lack of it, affects its ability to obtain debt and equity financing, its

liquidity position, and its ability to grow. Profitability is frequently used as the ultimate test of management’s operating effectiveness.

11.Return on common stockholders’ equity ratio is a widely used measure of profitability from the common stockholder’s viewpoint. The ratio shows how many dollars of net income were earned for each dollar invested by

the owners. Return on common stockholders’ equity ratio is computed by dividing net income minus any

preferred stock dividends—that is, income available to common stockholders—by average common stockholders’ equity.

Review the information in Illustration 13A-16.

12.The return on assets ratio measures the overall profitability of assets in terms of the income earned on each dollar invested in assets. The return on common stockholders’ equity ratio is affected by two factors: the return on

assets ratio and the degree of leverage. The return on assets ratio is computed by dividing net income by average total assets. Review the information in Illustration 13A-17.

13.The profit margin ratio, or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income. The return on assets ratio is affected by two factors, the first of which is the profit margin

ratio. The profit margin ratio is computed by dividing net income by net sales for the period. Review the information in Illustration 13A-18.

14.The asset turnover ratio measures how efficiently a company uses its assets to generate sales. The asset turnover ratio is the other factor that affects the return on assets ratio. The ratio is determined by dividing net sales by average total assets for the period. The resulting number shows the dollar of sales produced by each dollar invested in assets. Review the information in Illustration 13A-19.

15.The gross profit rate indicates a company’s ability to maintain an adequate selling price above its cost of goods sold. The profit margin ratio is strongly influenced by the gross profit rate. The gross profit rate is found by dividing gross profit (net sales less cost of goods sold) by

net sales. Review the information in Illustration 13A-21.

16.Earnings per share (EPS) is a measure of the net income earned on each share of common stock. Expressing net income earned on a per share basis provides a useful perspective for

determining profitability. Earnings per share is computed by dividing net income by the average number of common

shares outstanding during the year. When one uses “net income per share” or “earnings per share,” it refers to the amount of

net income applicable to each share of common stock. Review the information in Illustration 13A-22.

17.The price-earnings (P-E) ratio measures the ratio of the market price of each share of common stock to the earnings per share. The price-earnings ratio is a reflection of investors’ assessments of a company’s future

earnings. It is computed by dividing the market price per share of the stock by earnings per share. Review the information in Illustration 13A-23.

18.The payout ratio measures the percentage of earnings distributed in the form of cash dividends. Companies that have high growth rates are characterized by low payout ratios because

they reinvest most of their net income in the business. The payout ratio is computed by dividing cash dividends declared on common stock by net

income. Review the information in Illustration 13A-24.