Essentials of Financial Statement Analysis PDF

Essentials of Financial
Statement Analysis
An Introduction to
Financial Statement
Analysis
Gregory Mostyn, CPA
Worthy and James Publishing

www.worthyjames.com
Essentials of Financial Statement Analysis

An Introduction to Financial Statement Analysis
Published by
Worthy and James Publishing
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Table of Contents
Financial Statements Quick Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
GAAP Quick Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Trend Analysis Using a Reference Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Financial Ratios and Ratio Analysis Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis: Measures of Liquidity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis: Measures of Solvency. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis: Measures of Profitability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis: Measures of Investment Return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ratio Analysis: Measures of Productivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1
7
9
16
18
22
26
29
30
Analysis as an Outsider. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Quality of Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Potentially Hidden Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Big, Bad, Sudden Surprises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
32
34
39
44
Conclusions About Usefulness And Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Summary Table of Financial Ratios and Measurements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Quick Review and Vocabulary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Practice Questions and Problems. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Solutions to Questions and Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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55
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2008 Worthy and James Publishing. See front matter: Terms of Use.
iii
Financial Statements Quick Review

Balance Sheet
Purpose
The balance sheet is the most basic and essential financial statement. It is
described by the basic accounting equation: A = L + OE, (A means assets,
L means liabilities, and OE means owners equity.) The purpose of the
balance sheet is to show the wealth of a business (assets) and the two possible claims on that wealth, which are the creditors claims (liabilities) and
the owners claim (called owners equity, partners equity, or stockholders
equity.) at a given point in time. There are two main sources of owners
equity: investments by the owner(s) and the business operations.
Key Issues
Two key issues concerning a balance sheet are:

1. How items are classified on the balance sheet.
2. How the assets and liabilities are valued, which is to say, how the dollar
value is calculated. The dollar value is recorded initially at its original
transaction value, which is usually called historical cost. As time
passes, generally accepted accounting principles (GAAP) may require
valuation adjustments to the original value of some assets.
Example
The example below shows a balance sheet after the close of business on
June 30, 2008. The assets and liabilities are classified by type and by current
compared to long-term (longer than a year). This example shows total
business assets with a value of $410,120. Of that amount, creditors have a
claim of $173,850 and the residual amount of $236,270 is claimed by the
owner. If this were a partnership, owners equity would be called partners
equity and two or more owners names would be shown. If this were a
corporation, the equity would be called stockholders or shareholders
equity. The equity would then be subdivided into sections showing the
sources, such as paid-in capital from stock sold, and retained earnings
from operations.
continued
Balance Sheet, continued
Sioux City Enterprises

Balance Sheet
June 30, 2008
Assets
Current Assets
Cash
Short-term investments
Accounts receivable
Merchandise inventory
Office supplies
Total current assets
Property, Plant, and Equipment
Office equipment
Less: Accumulated depreciation
Store equipment
Total assets
$ 41,300
28,250
29,450
69,650
920
$169,570
25,800
6,850
314,500
92,900
Liabilities and Owners Equity

Current liabilities:
Wages payable
$ 3,200
Accounts payable
34,200
Interest payable
1,450
Current portion of long-term debt
3,200
Total current liabilities
Long-term liabilities
Notes payable
135,000
Less: current portion (above)
3,200
Total long-term liabilities
Total liabilities
Owners equity:
R. Chandra, capital
Total liabilities and Owners Equity
18,950
221,600
$410,120
$ 42,050
131,800
173,850
236,270
$410,120
Income Statement
Purpose
The income statement is a change statement that shows the change in

equity as a result of operating a business during a specific period of time.
The income statement shows the change in owners equity (or partners or
stockholders equity) that results from the sales made to customers (revenues) minus the resources consumed to operate the business (expenses).
When revenues exceed expenses (net income) assets increase and/or debt
decreases. When expenses exceed revenues (net loss) assets decrease and/or
debt increases.
Key Issues
The key issues concerning the income statement are the proper classification, correct amounts, and timing of revenues and expenses into the correct
accounting periods.
Example
The example below shows an income statement. The income statement

shows the revenues and expenses for the six months ended June 30, 2008.
This business has a net income of $40,150 for the period, which means
that the owners equity increased by that amount as a result of operating
the business. Notice the importance of recording in the correct period. If
some revenue or expense on this income statement were recorded in the
prior or the next period, this would change the results on income statements for two periods and change the trend in the revenue or expense,
and net income.
This example contains a detailed listing of expenses. These are sometimes
condensed into categories called operating expenses and other
expenses.
continued
Income Statement, continued
Sioux City Enterprises

Income Statement
For the Six Months Ended June 30, 2008
Revenues
Net sales
Rental Income
Total Revenue
Expenses
Cost of goods sold
Salaries and wages expense
Rent expense
Advertising expense
Utilities expense
Freight-out expense
Insurance expense
Depreciation expense
Interest expense
Total expenses
Net income
Articulation
$368,900
2,000
370,900
$266,000
45,200
4,000
3,880
3,200
2,960
2,150
1,550
1,450
330,390
$ 40,510
The income statement and balance sheet are closely connected to each
other. Revenues, expenses, and net income or loss on the income statement
affect what is reported on the balance sheet. This is called articulation.
Volume 1 of Basic Accounting Concepts, Principles, and Procedures provides detailed examples of articulation.
Statement of Owners Equity

Purpose
The statement of owners equity (or partners equity, or stockholders

equity) summarizes the changes to owners equity for a specific period of
time. This generally consists of: (1) the net income or net loss from the
income statement, (2) the total of the owner(s) investments in the business,
and (3) the total of the owner(s) withdrawal of assets from the business. In
a proprietorship or partnership, these items are usually limited and relatively easy to follow. In a large corporation, they can become more involved
and complex, and are reported in a statement of stockholders equity.
Statement of Cash Flows

Purpose
The statement of cash flows explains the change in cash for a specific
period of time. This usually corresponds to the same period of time used
for the income statement and statement of owners equity. The change in
cash is explained by three types of business activities: operating, investing,
and financing.
Key Issue
The key issue concerning the statement of cash flows is whether a transaction has been properly classified as an operating, investing, or financing
activity.
Operating Activities
Operating activities relate to the cash effects of the transactions that make
up net income. In effect, the cash flow from operating activities shows the
income statement on a cash basis instead of an accrual basis. Cash flow
from operating activities shows the cash results from the essential recurring operations of a business, and it is the most important part of the
statement of cash flows.
Investing Activities
Investing activities relate to the increases and decreases in cash from transactions that involve buying and selling long-term assets and activities that
involve buying and selling investments, including making and collecting
loans.
Financing Activities
Financing activities relate to the cash effects of the transactions that

involve obtaining and paying back sources of business capital, such as
loans and investments in the business. (This does not include short-term
debt related to operating activities.)
Format
The statement of cash flows presented below is shown in the most popular
format. The operating activities section begins with net income and makes
two types of adjustments to net income to convert it to a cash basis:
Add operating items that increase cash and are not part of the net
income calculation or items that reduced net income but did not use
cash.
Deduct operating items that use cash and are not part of the net
income calculation or items that increased net income but did not
increase cash.
Note: An alternative format is sometimes used. The point here is to
understand the essential components of the statement. The details of
formats and adjustments is a more advanced topic.
continued
Statement of Cash Flows , continued
Superior Office Supply Company

Statement of Cash Flows
Years Ended December 31
Cash flows from operating activities
Net income
Add: Items increasing cash or not reducing cash
Depreciation expense
Decreases in current operating assets
Increases in current operating liabilities
Less: Items reducing cash or not increasing cash
Increases in current operating assets
Decreases in current operating liabilities
Increase in cash from operating activities
Cash flows from investing activities
Expenditures on plant and equipment
Expenditures on intangible assets
Decrease in cash from investing activities
Cash flows from financing activities
Increase in non-trade short-term note payable
(Decrease) increase in long-term debt
Owner cash withdrawals
Decrease in cash from financing activities
Net increase in cash
Beginning cash balance
Ending cash balance
TIP
2008
$167,500
2007
$174,600
58,200
1,400
25,800
35,100
17,800
12,900
(67,400)
(29,800)
$155,700
(165,900)
(4,800)
$ 69,700
(45,000)
(10,000)
$ (55,000)
(5,000)
$ (5,000)
25,500
(30,200)
(55,000)
$ (59,700)
10,500
(40,000)
$ (29,500)
$ 41,000
414,200
$455,200
$ 35,200
379,000
$ 414,200
Dont be fooled. Depreciation is often incorrectly referred to as a

source of cash because it is a well-known adjustment that is added
back to net income as you see above. Depreciation is not literally a
source of cash. It is simply a non-cash expense deduction that reduces
net income but does not require the use of any cash. So, depreciation
is added back to net income to cancel out the deduction for the purpose of calculating the cash flow. In fact, the same add-back adjustment is made for amortization and for every other non-cash expense
(like using up supplies).
GAAP Review
GAAP (Generally Accepted Accounting Principles)
What Is GAAP?
In the United States, GAAP is a set of rules and standards that guide
accountants as to when and how to properly record transactions and how to
prepare proper financial statements. GAAP is not like unchanging laws of
physics. GAAP is designed to meet the needs of society. GAAP is always
evolving as the economic environment changes. Also, GAAP only refers to
rules of accounting in the United States. Different countries have different
rules for different purposes.
Broad GAAP
There are a few broad GAAP principles that provide general guidance and
that apply to all types of transactions. These are fundamental accounting
rules. These are like general traffic laws. Example: The historical cost
principle requires that all transactions be recorded at original transaction
value unless a specific GAAP rule creates an exception.
Specific GAAP
Specific GAAP rules offer specific direction for important kinds of

specific situations. As you continue your study of accounting and learn
how to record specific types of transactions, you will learn specific GAAP
rules.
Examples of some specific GAAP rules are:
GAAP Is Not Perfect
How uncollectible accounts receivable should be recorded

Acceptable methods for calculating inventory cost
Requirements for changing inventory values
How interest should be calculated on certain kinds of debt
Just as with other kinds of rules, GAAP is not perfect. GAAP is often subject to interpretation. Estimates are frequently required. The application
of different methods is allowed, which can make comparability difficult to
achieve. However, despite shortcomings, GAAP is essential to financial
reporting.
continued
GAAP (Generally Accepted Accounting Principles) , continued

Where Does GAAP
Come From?
There is no single source or listing of GAAP! There are a number of different sources, some more important than others.
Official Pronouncements: An official pronouncement is a formal and

authoritative document issued by the Financial Accounting Standards
Board (FASB), which is the standard-setting authority in the accounting
profession. The FASB is an independent organization that derives its
authority from the Federal Securities and Exchange Commission and
the fact that state licensing boards for accountants accept the FASB
pronouncements as highest authority.
The pronouncements of the FASB are called Statements of Financial
Accounting Standards (SFAS) . An SFAS prescribes how certain kinds
of transactions must be recorded, and presented and explained on
financial statements.
FASB Technical Guides: The next authoritative level below an SFAS is a

technical guide, usually dealing with narrow or very specific subject
matter.
Examples:
FASB Technical Bulletins
AICPA (American Institute of CPAs) Statements of Position and Practice Bulletins
EITF (Emerging Issues Task Force) Positions and Recommendations
International Standards
Industry Practice: Industry practice is a source of GAAP. Historically,

some industry practices have achieved wide acceptance over many
years. Sometimes this has created conflict and a lack of consistency
within GAAP because the practices serve the purposes of different
groups. To a diminished degree, this process continues today.
Other Accounting Literature: Research publications by educators, journal

articles, textbooks, professional association publications, and AICPA
technical practice aids are examples of this source of GAAP. These are
the least authoritative GAAP sources.
The International Accounting Standards Board (IASB) is an independent

organization with the goal of developing a single set of comprehensive
global accounting standards. The FASB currently has several major
projects underway with the IASB working towards uniform standards.
Trend Analysis Using a

Reference Base
Overview
Introduction:
Your New Business
We begin our discussion by assuming that you have just recently taken
over the management of your (imaginary) family business. The business is
a wholesale office supply store that primarily sells office supplies and office
equipment on account to retail merchants. One of the first things that you
need to do is to analyze the financial statements of the business to judge its
condition and to decide if you need to make any changes in the operations
and management.
A Reference Base
A reference base is simply a selected amount that is used to compare to

other numbers. The comparison is usually done by calculating the other
numbers as a percentage of the reference base amount.
Example
Suppose that you are given the following sales amounts:
Sales
2008
2007
2006
2005
$75,000
$48,000
$55,000
$50,000
Comparing totals: If you want to compare the total sales for each year to
the year 2005, then the 2005 sales of $50,000 is your reference base
amount. Divide each years sales by the base amount.
Sales
2008
2007
2006
2005
150%
96%
110%
100%
Example: The 2006 sales compared to 2005 is: $55,000/$50,000 = 110%.

Comparing changes: If you want to compare the change for each year to
the base amount, calculate the difference and divide by the base amount.
Sales
2008
2007
2006
2005
50%
(4%)
10%
Example: The 2006 percent change is: ($55,000 $50,000)/$50,000 = 10%.
10
Horizontal Analysis
Overview
Horizontal analysis is a comparison of financial statement information

over a period of time. Both dollar amounts and percentage amounts are
evaluated to identify changes and trends from the base year. Watching
trends over an extended time period is an extremely valuable analytical
procedure.
Balance Sheet
Example
The example below shows a two-year horizontal analysis of comparative

balance sheets for your business, with 2007 as the base year.
Condensed Balance Sheet
December 31
Increase or (decrease)
Amount
Percent
2008
2007
Assets
Current assets
Cash and cash equivalents
Accounts receivable, net
Inventory
Prepaid expenses
Property, plant, and equipment
Net property, plant, and equip.
Intangible assets
Total assets
$ 455,200
35,500
286,200
492,100
52,300
$1,321,300
$ 990,500
365,000
$ 625,500
110,000
$2,056,800
$ 414,200
36,900
255,800
456,900
50,500
$1,214,300
$ 945,500
306,800
$ 638,700
100,000
$1,953,000
$ 41,000
(1,400)
30,400
35,200
1,800
$107,000
$ 45,000
58,200
$ (13,200)
10,000
$103,800
9.9%
(3.8%)
11.9%
7.7%
3.6%
8.8%
4.8%
19.0%
(2.1%)
10.0%
5.3%

Current liabilities
Accounts payable
Short-term notes payable
Other current liabilities
Long-term debt
Total liabilities
$ 414,700
50,000
185,600
$ 650,300
551,400
$1,201,700
$ 388,900
24,500
215,400
$ 628,800
581,600
$1,210,400
$ 25,800
25,500
(29,800)
$ 21,500
(30,200)
$ (8,700)
6.6%
104.1%
(13.8%)
3.4%
(5.2%)
(0.7%)
$ 855,100
$2,056,800
$ 742,600
$1,953,000
$112,500
$103,800
15.1%
5.3%
Your Name, capital

Total liabilities and owners equity
11
Horizontal Analysis, continued

Income Statement
Example
The example below shows a two-year horizontal analysis of comparative

income statements, with 2007 as the base year.
Condensed Income Statement
Sales
Less: Returns and allowances
Net sales
Cost of goods sold
Gross profit
2008
$2,198,600
98,900
2,099,700
1,364,800
$ 734,900
2007
$2,114,100
90,900
2,023,200
1,294,800
$ 728,400
Increase or (decrease)
Amount
Percent
$ 84,500
4.0%
8,000
8.8%
76,500
3.8%
70,000
5.4%
$ 6,500
0.9%
Selling expenses
Administrative expenses
Total operating expenses
Operating income
252,000
283,500
$ 535,500
$ 199,400
222,600
293,400
$ 516,000
$ 212,400
29,400
(9,900)
$ 19,500
$ (13,000)
2,900
2,100
34,800
$ 167,500
39,900
$ 174,600
Other revenue and gains

Interest and dividends
Other expenses and losses
Interest expense
Net income
Analysis
800
(5,100)
($ 7,100)
13.2%
(3.4%)
3.8%
(6.1%)
38.1%
(12.8%)
(4.1%)
Balance sheet: The comparative balance sheets show that some significant changes have occurred between 2007 and 2008. Total current
assets have increased by almost 9%, and Property, Plant, and Equipment increased by almost 5%. We also see that total liabilities have
decreased by almost 1%, so there was no net borrowing. This means
that the increase in total assets must be primarily the result of business
net income unless there were owner investments.
Income statement: Unfortunately, net income (although positive) has

decreased by 4%, and operating income has decreased by 6%. However,
gross profit increased by almost 1%! How could this happen? It appears
that gross profit has increased because sales have increased, but the
company did not control the selling expenses and cost of goods sold
tightly enough. These two expenses increased much faster than sales
revenue. As a manager, this will require you to create a system that controls expenses more carefully. You should also investigate the increased
rate of merchandise returns.
12
Vertical Analysis
Overview
Vertical analysis is a comparison of financial statement information

within a single financial statement. A reference base amount is selected
within the statement, and other related items in the statement are compared to this amount. So, instead of using a reference base amount to
make comparisons over time, items are compared to a reference base
amount within one financial statement.
Balance Sheet
Example
The balance sheet below shows a vertical analysis. Can you find the reference base amounts? They are the items that are 100%the total assets and
the total liabilities and owners equity.
Condensed Balance Sheet
December 31
2008
Assets
Current assets
Cash and cash equivalents
Accounts receivable, net
Inventory
Prepaid expenses
Property, plant, and equipment
Net property, plant, and equipment
Intangible assets
Total assets
Current liabilities
Accounts payable
Short-term notes payable
Other current liabilities
Long-term debt
Total liabilities
Your Name, capital
Total liabilities and owners equity
Percent
2007
Percent
$ 455,200
35,500
286,200
492,100
52,300
$1,321,300
$ 990,500
365,000
$ 625,500
110,000
$2,056,800
22.1%
1.7%
13.9%
23.9%
2.5%
64.2%
48.2%
17.7%
30.4%
5.3%
100.0%
$ 414,200
36,900
255,800
456,900
50,500
$1,214,300
$ 945,500
306,800
$ 638,700
100,000
$1,953,000
21.2%
1.9%
13.1%
23.4%
2.6%
62.2%
48.4%
15.7%
32.7%
5.1%
100.0%
$ 414,700
50,000
185,600
$ 650,300
551,400
$1,201,700
20.2%
2.4%
9.0%
31.6%
26.8%
58.4%
$ 388,900
24,500
215,400
$ 628,800
581,600
$1,210,400
19.9%
1.3%
11.0%
32.2%
29.8%
62.0%
$ 855,100
$2,056,800
41.6%
100.0%
$ 742,600
$1,953,000
38.0%
100.0%
13
Vertical Analysis, continued

Income Statement
Example
The income statement below shows an example of vertical analysis for

your business. When vertical analysis is done for an income statement, the
net sales number is always the 100% reference base amount.
Condensed Income Statement
Sales
Net sales
Cost of goods sold
Gross profit
2008
$2,198,600
98,900
2,099,700
1,364,800
$ 734,900
Percent
104.7%
4.7%
100.0%
65.0%
35.0%
2007
$2,114,100
90,900
2,023,200
1,294,800
$ 728,400
Percent
104.5%
4.5%
100.0%
64.0%
36.0%
Selling expenses
Operating income
252,000
283,500
$ 535,500
$ 199,400
12.0%
13.5%
25.5%
9.5%
222,600
293,400
$ 516,000
$ 212,400
11.0%
14.5%
25.5%
10.5%
2,900
0.1%
2,100
0.1%
34,800
$ 167,500
1.7%
8.0%
39,900
$ 174,600
2.0%
8.6%

Interest expense
Net income
Analysis
Balance sheet: The balance sheet shows a significant percentage of total

assets as current assets. In 2008, this is more than 64% of total assets.
Cash is a high percentage of total assets. In 2008, it is more than 22%.
The strong cash position indicates a high degree of short-term debtpaying ability and relative safety.
Income statement: The analysis confirms that the major portion of

business expense is cost of goods sold, which in 2008 was 65% of total
sales. Selling and administrative expense activities combine to about
equally share most of the other expenses.
14
Combined Horizontal and Vertical Analysis

Analysis
After the vertical percentages are calculated, it is very useful to compare

the percentages between years to see the changesagain, remember that
trend analysis is one of the most important tools of financial analysis.
Balance sheet: For example, on the balance sheet, it becomes clear that
current assets as a percentage of total assets have increased from about
62% to 64%. At first, this might seem to be a good thing, but notice that
the percentages for Accounts Receivable and Inventory are also increasing. Does this mean that your business is having some trouble collecting
receivables and also that too much inventory has been ordered and is
building up?
Income statement: Cost of goods sold, which is a large dollar amount,

has significantly increased as a percentage of sales from 64% to 65%,
thereby lowering the gross profit margin. This calls for immediate
investigation. It is also interesting to note that total operating expenses
remained constant at 25.5% of net sales; however, apparently you were
able to decrease administrative expenses but lost some control over selling expenses, which increased from 11% to 12% of sales. Also, for some
reason the percentage of returns has increased.
Common-Size Statements
Overview
A common-size financial statement is a statement that is presented as only

percentages. No dollar amounts are shown.
Three Important Benefits
Three important benefits are provided by common-size statements:
Common-size statements make it easy to see percentage trends. These

clearly highlight areas that may require further management investigation.
Common-size statements make it possible to meaningfully compare
companies of different sizes. Total dollar amounts are difficult to compare, but percentages all relate to 100% and are easily compared.
Common-size statements make it possible to compare an individual
companys results against industry average percentages. Industry percentages are reported in publications such as Annual Statement Studies
by Robert Morris Associates; Almanac of Business and Industrial Financial Ratios by Troy, and reports by Standard and Poors and by Dun and
Bradstreet. Also, trade magazines and internet financial sites can provide industry information.
15
Common-Size Statements, continued

Example
The example below shows a two-year common-size income statement

using only the percentage amounts from the previous income statement.
Common-Size Income Statement
Sales
Net sales
Cost of goods sold
Gross profit
Selling expenses
Operating income
Interest expense
Net income
2008
104.7%
4.7%
100.0%
65.0%
35.0%
2007
104.5%
4.5%
100.0%
64.0%
36.0%
12.0%
13.5%
25.5%
9.5%
11.0%
14.5%
25.5%
10.5%
0.1%
0.1%
1.7%
8.0%
2.0%
8.6%
MD&A
Overview
Definition
Management discussion and analysis, usually referred to as MD&A, is a

required management disclosure in the annual report for a publicly held
company.
Features
MD&A must include an explanation of major financial statement items

including liquidity (cash position), sources of investment and debt capital provided to the business, and operating results that includes an
analysis of sales and significant expenses.
The MD&A must include an analysis of major risks.
The MD&A must include managements opinion about the future performance of the company. However, one must read the analysis of future
performance cautiously, as it is sometimes used as an overly optimistic
promotional tool.
16
Ratio Analysis
Overview
Introduction
Ratio analysis is a means of analyzing selected financial statement items by

the use of ratios. A ratio is the comparison of one number to another by
showing the numbers as a fraction, with the answer expressed as the fraction, or converted to a percentage, a rate, or a proportion. (To review these
items, see the basic math reviews in the disks accompanying these volumes.)
A financial ratio is designed so that the two numbers used in the ratio are
connected in a meaningful way. As a result, the ratio should provide a useful
insight into some specific element of a companys condition or operations.
Ratios are designed to evaluate many different elements of a business.
Business Elements
Analyzed
A great deal of financial data is available that can be used for many possible ratio calculations. In this section, we look at some of the most important and useful ratios, which measure these key aspects of a business:
Liquidity: The ability to pay short-term debts as they come due

Solvency: The long-term survival of a business
Profitability: The success of a business as measured by net income
Investment return: Measures a company on its merit as an investment
Productivity: Measures the operating efficiency
Interpreting Financial Ratios

Overview
Mechanically calculating a ratio does not tell you muchyou need to be

able to interpret the answer you get. Lets take a look at how to interpret
the ratios we will calculate.
Research the
Company
First, find out enough about a company to have an understanding of what

has been happening to it. This makes the ratios more meaningful. If possible, talk to present and past managers and employees. For large companies,
read financial and trade newspapers, magazines, and reports to find out
about the company and its industry area. Search the Internet using the
companys name, including a visit to the companys home page and links
on the home page to sites that analyze the company.
17
Interpreting Financial Ratios, continued

Benchmarks
A benchmark is a norm or guideline used for the purpose of comparison.

The table below shows benchmarks that are used for financial ratio analysis.
Benchmark
Advantages
Company history: What are the

past results for our company?
Indicates trends within our

company.
Main competitors: What is

the performance of our
competition?
Compares our company

against the direct
competition.
Industry norms: What is the

average performance for
companies in the same
industry?
Provides a greater scope

of comparison and may
encourage deeper
analysis.
Disadvantages
Gives no point of reference
outside of our company.
Independent standards: Use

information from experts to
help set best performance
goals and best practice
methods
Raises standards and

shows what is possible.
The application of GAAP may

be different, making
comparison less useful.
What if norms are mediocre?
(At one time American auto
companies were the standard
until Japan improved norms.)
Data may be from operations
that are not fully comparable
because of size or other
factors.
There will be employee and

management resistance to
significantly higher standards
and new processes within the
company. Compensation system
may have to be changed.
General Indicators and

Limitations
Interpret ratios only as general indicatorsratios are more like warning

lights than precise gauges. Ratios act as early warning indicators that
direct you to do further analysis to clarify the exact nature of an issue.
Ratios limitations are: (1) different companies can use different GAAP
methods, (2) ratios are based on historical dataa rear-view mirror,
and (3) cause and effect is not always clear.
Use in Groups
Whenever possible, use several ratios together when analyzing an element

of a business. Doing this provides a more reliable indication and may
reveal something more subtle that a single ratio would miss.
Coming Up . . .
Analysis and Comparing
to Industry Data
We are now ready to continue our analysis of your business, Superior

Office Supply Company. For additional help, we will also compare results
to industry average benchmarks for companies of about the same level of
sales or assets. The sources for industry data are Robert Morris Associates,
Standard and Poors, Dun and Bradstreet, and Almanac of Business and
Industrial Ratios.
18
Measures of Liquidity
Overview
Liquidity means the ability to obtain cash needed to pay current liabilities
as they come due and to pay unexpected short-term obligations. If a business cannot pay these immediate obligations, it will cease to operate. Owners, managers, suppliers, and lenders are very concerned with liquidity. We
will examine the following ratios to evaluate liquidity condition: (1) current
ratio, (2) quick ratio, (3) receivables turnover ratio, and (4) inventory turnover ratio.
Current Ratio
The current ratio is a comparison of the amount of current assets to the

amount of current liabilities. Current assets are called liquid assets because
they provide cash to pay current liabilities or represent prepayments.
The current ratio is:
total current assets

---------------------------------------------------------total current liabilities
Example for Superior Office Supply Company

2008
2007
$1,321,300
----------------------- = 2.03
$650,300
Industry Average
$1,214,300
----------------------- = 1.93
$628,800
1.4
Interpretation
The current ratio has improved somewhat. At the end of 2008, about
$2.03 of current assets were available for every dollar of current liabilities. The ratio exceeds the industry average benchmark.
Quick Ratio
(Acid-Test Ratio)
The quick ratio is a measure of how well a business could pay current
liabilities if they all came due quickly. This ratio uses only highly liquid
assets (called quick assets) compared to current liabilities. The assets
used are cash, short-term investments, and all current receivables net of
allowances.
+ short term investments + current receivables (net)
The quick ratio is: cash
-----------------------------------------------------------------------------------------------------------------------------------------------total current liabilities

2008
$455,200 + $35,500
+ $286,200
------------------------------------------- = 1.19
$650,300
2007
$414,200 + $36,900
+ $255,800
------------------------------------------ = 1.12
$628,800
Industry Average
.5
19
Measures of Liquidity, continued

Interpretation
The quick ratio has remained relatively constant, and it is significantly
better than the industry average. Note: For most businesses, a quick
ratio of 1 is considered adequate, although some companies that manage inventory very efficiently and negotiate favorable credit terms
maintain lower ratios.
Receivables Turnover
Average Collection
Period
An important measure of operating efficiency and potential liquidity is

how quickly a company can collect its accounts receivable. Receivables
that are slow to be collected may indicate poor customer credit quality,
collection problems, and potential cash flow problems. Accounts receivable turnover is a rough measure of the number of times that receivables
are created and collected in a periodthe more the turnover, the faster
the collection. Receivables turnover is calculated by dividing net credit
sales by the average amount of net receivables. The easiest average to use is
the balance at the beginning of a period plus the balance at the end of the
period divided by two. Assume all sales are on account.
A more useful calculation is to use the same information to calculate the
average number of days that a receivable is outstanding before being
collected. The easiest way to do this is to divide the turnover into the
number of days in the period. Here we are using one-year periods, so we
use 365 days.
The accounts receivable turnover is:
net credit sales

--------------------------------------------------------------average net receivables

2008
$2,099,700
--------------------------------- = 7.75 times

($286,200
+ $255,800)/2
2007
$2,023,200
--------------------------------- = 8.5 times

($255,800
+ $222,500)/2
Industry Average
18 times
Note: A/R balance from 2006

balance sheet is $222,500.
Interpretation
Superior Office Supply Company is clearly having problems with its receivables collection. The turnover is getting worse and is clearly below the
industry norm. Lets calculate the average collection period to clarify this.
Note: If there is a significant seasonal variation in sales, the average should
be calculated based on quarterly or monthly Accounts Receivable balances.
continued
20
The average collection period is:
number of days in the period

-----------------------------------------------------------------------------accounts receivable turnover

2008
365 days
---------------------- = 47 days
7.75 times
2007
Industry Average
365 days
------------------- = 43 days
8.5 times
20 days
Interpretation
In 2008, Superior Office Supply required an average of 47 days to collect
current receivablesmore than twice the industry average. This makes the
current ratio and quick ratio now look much less favorable because of the
uncertainty of when the receivables will be collected and how many are bad.
Inventory Turnover
Average Days to Sell
Another important measure of operating efficiency and potential liquidity

is how quickly a company has been selling its inventory. Inventory that has
been slow to sell indicates potentially serious income and cash flow problems. Inventory turnover is a rough measure of how often inventory is
purchased and sold in a given period. The turnover is calculated by dividing cost of goods sold by the average amount of inventory in the period.
A more useful calculation is to use the same information to calculate the
average days needed to sell inventory, similar to our days of receivables
calculation.
The inventory turnover is:
cost of goods sold

------------------------------------------------average inventory

2008
$1,364,800
--------------------------------- = 2.88 times
($492,100
+ $456,900)/2
2007
Industry Average
$1,294,800
--------------------------------- = 3.29 times
($456,900
+ $329,700)/2
5.4 times
Note: Inventory balance from

2006 balance sheet is $329,700.
Interpretation
Superior Office Supply Company is having problems with inventory
buildup. The inventory has been overstocked, or for some reason it is
not selling well. To clarify the turnover time, lets calculate the average
days to sell.
21
The average days to sell is:

-----------------------------------------------------------------------------inventory turnover

2008
365 days
---------------------- = 127 days
2.88 times
2007
365 days
---------------------- = 111 days
3.29 times
Industry Average
66 days
Interpretation
In 2008, Superior Office Supply required an average of 127 days to sell
its inventorymore than twice the industry average. The good
current ratio looks more doubtful, because there is now some
question as to the time it will take to sell the inventory and the ability
to sell it at normal prices. Perhaps the cause is simply buying too
much inventory. As a manager, you will have to do some further
investigation by checking the number of units sold, the pricing, and
the inventory purchasing policy.
Caution: The inventory turnover ratio (and days to sell) gives different
answers for companies using different inventory methods such as
FIFO, LIFO, or average, even though the inventory is not actually
moving faster or slower. The current ratio, which includes inventory, is
also affected by the use of different inventory methods. This can make
company comparisons more difficult.
TIP
The Operating Cycle
Sometimes, measures of liquidity are referred to as measures of the

adequacy of working capital. Working capital is defined as current
assets minus current liabilities. Working capital is used as an indicator
of ability to pay current liabilities and to meet the needs of current
operations.
By adding the average days to sell inventory to the average days to collect accounts receivable, you can calculate the operating cycle, which is
the time it takes to convert inventory into cash. For Superior Office
Supply, the operating cycle in 2008 is: 47 + 127 = 174 days. Also, if
vendors require payment in a period that is significantly less than the
operating cycle (for example, 60 days), it may indicate potential cash
flow problems.
22
Measures of Solvency
Overview
Solvency is the ability to remain in business for a long period of time. This
mainly refers to the ability to pay all debts as they come due. It also involves
the ability to raise new capital and to adapt to changing conditions. The
ratios we will use to evaluate solvency are: (1) debt ratio, (2) times interest
earned ratio, (3) asset turnover ratio, (4) cash flow to debt ratio, and
(5) free cash flow.
Note: Profitability also affects solvency; however, we will discuss this in
the next topic when we look at measures of profitability.
Debt Ratio
(Leverage Ratio)
The debt ratio is a measure of the extent to which a company uses debt.
The debt ratio compares the amount of total debt to total assets. The use
of debt is often called financial leverage. Although leverage can be very
useful to a business, the use of leverage also involves danger. As a company incurs more debt, the danger grows, because debt requires regular
fixed payments and often a large principal payment when the debt is due.
Also, lenders may impose additional requirements and restrictions called
debt covenants that, if violated, create the risk of the full loan becoming
immediately due and payable.
The debt ratio is:
total debt
-----------------------------total assets

2008
2007
Industry Average
$1,201,700
----------------------- = .58
$2,056,800
$1,210,400
----------------------- = .62
$1,953,000
.70
Interpretation
The company has both reduced its total debt and increased total assets,
so the debt ratio has declined from 62% to 58%, indicating improved
solvency and a reduction of risk. However, the company is still using
substantial leverage, and the industry norm is also relatively high.
Generally, debt exceeding one-third of total assets should be considered
as substantial. (This can be seen in the bond ratings of large industrial
companies. The median debt ratio at which the ratings change from
investment grade to speculative grade is about 40%.)
It is especially important to know why a debt ratio increases. What was
the money needed forexpansion, operations, to pay old debt? This
can be a key indicator of a companys condition and strategy. The
ability of a company to manage its debt depends on the size and the
stability of its operating cash flow.
23
Measures of Solvency, continued

Times Interest
Earned Ratio
The times interest earned ratio is a measure of a companys ability to pay

interest payments. The ability to pay loan interest is very important because if
the payments are not made, the lender can force a company into bankruptcy.
The times interest earned ratio is calculated by dividing operating income
by interest expense. (If operating income is not given, it can be calculated
by adding back income tax expense and interest expense to net income,
excluding non-recurring special items.)
Although this ratio is typically calculated using operating income, interest
payments are not made with income. They are made with cash. (If you
want to review the difference, look at the cash flow statements for Superior Office Supply or review the discussion of cash basis income statements.) Therefore, a more reliable method is to use operating cash flow
instead of operating income.
The times interest earned ratio is:
operating income
----------------------------------------------interest expense
cash flow from

operating activities
--------------------------------------------------interest expense
or

2008
Operating Income
2007
Operating Cash Flow
Operating Income
Operating Cash Flow
$69,700
$212,400
$155,700
$199,400
------------------- = 5.73 times ------------------- = 4.47 times ------------------- = 5.32 times ----------------- = 1.75 times
$39,900
$39,900
$34,800
$34,800
Interpretation
Based on operating income, in 2008 the business shows a multiple of 5.7 times the
amount of interest expense, which shows a safe coverage and far exceeds the industry
average, which is about 2.2 times. However, 2007 demonstrates the importance of
using operating cash flow to calculate the ratio. The ratio based on operating cash flow
is much less favorable than the ratio based on operating income. Remember, it is the
cash that counts when it comes to making interest payments. (Note: In the statement of
cash flows, if interest paid is a subtraction item when calculating operating cash flow, it
should be added back to operating cash flow for the purposes of this calculation.)
TIP
To get an idea of a businesss coverage for all operating fixed payment

commitments (such as debt payments + lease payments + . . . and so
on), add total operating fixed payments to operating cash flow for the
numerator of the fraction. Then use total operating fixed payments for
the denominator.
continued
24

Asset Turnover
Ratio
The asset turnover ratio measures how many dollars of sales are created for
every dollar of total assets. This has a direct effect on profitability and is
also a measure of the efficiency of the use of company assets. Asset turnover ratios can vary greatly depending on the type of business. For example, an accounting firm would have a relatively low investment in assets
and a much higher asset turnover ratio than an airline. Also, some analysts
prefer to focus only on gross plant and equipment (excluding accumulated
depreciation) turnover as a measure of the efficient use of productive
assets.
net sales
----------------------------------------------------average total assets
The asset turnover ratio is:

2008
2007
Industry Average
$2,099,700
$2,023,200
--------------------------------------- = 1.05 times ------------------------------------- = 1.06 times
($2,056,800
($1,953,000
+ $1,953,000)/2
+ $1,870,100)/2
3.6
Note: Total assets from 2006

balance sheet is $1,870,100.
Interpretation
Superior Office Supply is creating only about $1.05 of net sales for every
dollar invested in company assets. This is clearly below the industry average of $3.60. Perhaps the company has over-invested in inventory and
in property, plant, and equipment.
Cash Flow to
Debt Ratio
The cash flow to debt ratio is a good measure of long-term solvency and
shows the ability of a company to pay debt using only the operating cash
flow. The ratio is calculated by dividing operating cash flow by average
total debt.
The cash flow to debt ratio is:
cash flow from

-----------------------------------------------------------average total liabilities

2008
$155,700
----------------------------------- = .13 times
($1,201,700
+ $1,210,400)/2
2007
Industry Average
$69,700
----------------------------------- = .06 times
($1,210,400
+ $1,155,300)/2
Note: Total liabilities from 2006
.3 times
25

Interpretation
In 2008, Superior Office Supply produced only $.13 of cash flow for
every dollar of debt, the year 2007 was much worse, and both years are
far below the industry average. This is an unfavorable long-term indication. Yet, the times interest earned ratio for 2008 seems adequate. This
is a good example of how cash flow and income can be very different.
This ratio is also useful as an estimate of how much time would be
required to pay off debt using current operating cash flow. In this
example, the 2008 annual operating cash flow of $155,700 would
require about 7.7 years to pay off the average debt balance of $1,206,050
(calculated as 1/.13 = 7.69).
Free Cash Flow
Free cash flow is a measure of how much operating cash flow is available
after paying necessary cash outlays for expansion and/or improvements. It
is a good measure of financial stability. Although there is no single definition of free cash flow, the most common definition is: operating cash flow
less capital expenditures.
Free cash flow is: cash flow from operating activities capital expenditures
2008
2007
$155,700 $55,000 = $100,700
$69,700 $5,000 = $64,700
Interpretation
Free cash flow has shown an increase in 2008 of $36,000, or about
56%. However, this may be somewhat misleading because perhaps
2007 was a low number. This should be evaluated against past results
for several years.
continued
26

EBITDA
EBITDA sounds like some kind of wild African animal, but it really means
Earnings Before Interest, Taxes, Depreciation, and Amortization. To calculate EBITDA, start with income from continuing operations and add back
depreciation and amortization to obtain an income amount that excludes
these four expenses.
EBITDA is supposed to be an estimate of cash flow from operations, and it
is often used in press releases, business news reports, and even in some
ratio calculations. This is unfortunate because it is a very inferior and misleading estimate for several reasons. I mostly ignore EBITDA and simply
look for cash flow from operating activities on the statement of cash flows.
Measures of Profitability
Overview
Profitability is the essential reason for operating a business. It is also a key

element in a companys success, or lack of it, in obtaining capital. Profitability information is widely used and reported to lenders, investors, and
other stakeholders. Profitability ratios can be calculated at different levels
of the income statement, such as net income, operating income, and gross
profit.
Profit Margin Ratio
The profit margin percentage shows what percent of every dollar of net
sales ends up as net income. This ratio is also sometimes called the rate of
return on net sales. This ratio is calculated as net income divided by net
sales, and is usually expressed as a percentage.
The profit margin ratio is:
net income
-----------------------------net sales

2008
$167,500
----------------------- = 8%
$2,099,700
2007
$174,600
----------------------- = 8.6%
$2,023,200
Industry Average
1.5%
Interpretation
For the last two years, Superior Office Supplys profit percentage has
been greatly in excess of the industry average. This could be good news
or bad news. It is possible the company has some kind of very unusual
advantage. Or it has either temporarily had an unusual amount of sales
or has not been spending enough on necessary expenses. Lets explore
further . . .
27
Measures of Profitability, continued

Gross Profit Ratio
The gross profit ratio is calculated by dividing gross profit by net sales. The
gross profit ratio shows what percentage of each dollar of sales ends up as
gross profit. For merchandising and manufacturing companies this is a
very important ratio because it is affected by some very important things:
the selling price per unit and the number of units sold (sales revenue) and
the cost per unit of the merchandise and the number of units sold (cost of
goods sold). These items have a very powerful effect on net income.
The gross profit ratio is:
gross profit
-----------------------------net sales

2008
2007
$734,900
----------------------- = 35%
$2,099,700
$728,400
----------------------- = 36%
$2,023,200
Industry Average
36%
Interpretation
The gross profit ratio is about the same as the industry norm. In 2008,
$.35 of every dollar remained as gross profit to cover operating expenses
and provide a net income.
So, back to our question: Why is the net income percentage so high? We
now know that the gross profit percentage is about normal, so that only
leaves one other major area on the income statementoperating
expenses. The operating expenses are unusually low. This may be good
if the company is very efficient, but it will not be good if the company is
avoiding necessary and important expenses, such as repairs and maintenance and the cost of high-quality management.
Caution: As discussed above with inventory turnover, FIFO, LIFO,
average, and other inventory methods give different results. This can
make cost of goods sold and gross profit comparisons less reliable.
Gross Profit and

Market Share
Market share refers to the sales of a company as a percentage of the total

sales for all companies in the same type of business. Market share is an
important measure of the ability of a company to attract new customers
and keep old customers. For large publicly traded companies, market
share information is widely available.
Gross profit percentage is often closely related to market share. If a companys market share is growing, it means that the company is attracting
new customers and/or taking customers from competing businesses. This
usually means that the company will be able to maintain current prices
and therefore will be able to maintain or improve the gross margin percentage. Conversely, if a companys market share is decreasing, it is often
an early indicator that the gross profit percentage of the company will also
decrease, as the company tries to keep customers by lowering prices.
28
Measures of Profitability , continued

Earnings Per Share
Earnings per share (often called EPS) is a calculation that is done only for
a corporation. The basic EPS calculation is:
net income preferred dividends
----------------------------------------------------------------------------------------weighted average number of
common shares outstanding
The EPS shows how much net income is potentially available for each share
of common stock. The EPS number is important because it is a scaling
method that allows the earnings of different size companies to be compared
on a per-share basis. Corporations that have publicly traded stock (stock
that is traded on exchanges like the New York Stock Exchange or Nasdaq
exchange) are required to show earnings per share. The ratio is also important to stock investors who use it as part of a calculation called the price
earnings ratio (PE ratio), which is the price per share divided by the earnings per share. The PE ratio is used as an indicator of relative stock value.
There is no good or bad EPS number; it is an amount that is watched over
time and compared to the EPS of other corporations and measured against
the price of the stock using the PE ratio. (Some analysts prefer to use operating cash flow or free cash flow instead of net income in the calculation.)
Rate of Return
on Total Assets
The rate of return on total assets is calculated by dividing net income (or
sometimes income before interest expense) by average total assets. This
ratio is an indicator of how much profit is being created for each dollar of
assets, usually expressed as a percentage.
The rate of return on total assets is:
net income

2008
2007
$167,500
----------------------------------- = 8.4%
($2,056,800
+ $1,953,000)/2
$174,600
----------------------------------- = 11.2%
($1,953,000
+ $1,155,300)/2
Industry Average
7.5%
Note: Total assets from 2006

Interpretation
In 2008, the business had an 8.4% return on assets That is, it had 8.4 of
profit for every dollar of assets. This is less than 2007 but still above the
industry average.
29
Measures of Investment Return

Return on Equity
Return on equity measures the percent profit as a return on the average

amount the owner has invested in the business. The owner can compare
this with other businesses and also with other possible investments.
The return on equity ratio is:
net income
-------------------------------------------------------------,
average owner s equity

2008
2007
$167,500
-------------------------------- = 21%
($855,100
+ $742,600)/2
Industry Average
$174,600
-------------------------------- = 26%
($742,600
+ $608,000)/2
11%
Note: Owners equity from 2006

balance sheet is $608,000.
Interpretation
The return on equity is about twice as much as the industry norm, and
that is primarily because the net income percentage is so high. So again,
we have to be very sure to explain the net income and investigate the
low operating expenses.
Return on Equity
for a Corporation
The rate of return for a corporation is usually calculated as the return on

the common stockholders equity. The formula is:
----------------------------------------------------------------------------------------------------,
average common stockholders equity
Dividend Ratio
The dividend ratio is usually calculated only for the common shareholders
of a corporation. The ratio measures the total common shareholder dividends as a percent of the average amount invested by the common shareholders over a designated period of time. The calculation is:
common stock cash dividends
----------------------------------------------------------------------------------------------------,
continued
30
Measures of Investment Return, continued

Trading on Equity
Trading on equity refers to the effect that financial leverage (see the debt
ratio discussion) has on the return on equity. The effect of trading on
equity can be seen by comparing the rate of return on total assets of 8.4%
in 2008 with the return on the owners equity in 2008 of 21%. The positive
difference that exceeds the return on total assets happens when a business
borrows money at an interest rate that is less than the rate that the business is able to earn when it uses the borrowed money. Using borrowed
funds (leverage) also means that less of the owners money is needed to
acquire assets. The borrowed money is being put to work to buy assets that
create additional income and that do not require the use of owners
money. If the borrowed money more than pays for itself, this profitability
is a boost that adds directly to net income.
Trading on equity should be used cautiously. The attempt to trade on
equity may result in a much worse rate of return to owners if the situation
reverses and a company cannot earn a rate of return on the borrowed
money that is equivalent to the interest cost. Furthermore, increased debt
always means increased risk. In our discussion of the debt ratio, we saw
that the median level at which debt ratings change from investment to
speculative grade is about 40%. Although many companies in fact operate
at a debt ratio higher than 40%, it does not lessen the increased cash flow
risk and opportunity cost risk when large, sudden, and negative financial
events occur.
Measures of Productivity
Overview
Measures of productivity show the level of efficiency at which a company

is using and obtaining its resources. There are many measures of productivity. The measure used should relate to an important resource. Some
typical examples are shown below.
Revenue (or Gross Profit)

Per Unit of Resource
Revenue (or gross profit) per unit of resource shows the amount of revenue (gross profit) created per unit of scarce resource used. Examples:
Revenue per square foot of floor space (used by retail stores)

Revenue per employee or per dollar of wages expense
Revenue per seat per mile (used by airlines)
Asset turnover ratio. The asset turnover ratio previously discussed can
also be interpreted as an overall measure of how effectively the investment in assets is used to create revenue.
31
Measures of Productivity, continued

Cost Per Unit
of Resource
Cost per unit of resource shows the cost incurred to obtain or use a unit of
a particular resource. Examples:
Other Good
Indicators
Wage expense per employee or per hour worked

Rent expense per square foot
Cost of inventory per item
Other indicators of productivity focus on designated activities. Examples:
Plant and equipment turnover: This is an indicator of the amount of

revenue created for every dollar invested in the plant and equipment
(productive) assets. This is similar to total asset turnover, except that
the denominator used is the average gross cost of plant and equipment.
Inventory turnover: The inventory turnover ratio previously discussed
shows how quickly a business is able to sell inventory. Also, the number
of days of inventory on hand can be a good early warning of an inventory buildup.
Accounts receivable turnover: As previously discussed, this also relates to
the efficiency of collecting receivables and the management of credit policy.
Accounts receivable compared to sales: Compare the percentage change
in the age of accounts receivable to the percentage change in net sales.
(The accounts receivable turnover ratio acts as a similar indicator of the
ability to actually collect what is reported as revenue.)
Percent of past-due or uncollectible receivables per sales dollar: This is an
indicator of the credit policy applied and collectibility of reported sales.
Cost of goods sold as a percentage of revenue
Percent of returned merchandise per sales dollar
Variances between actual costs and budgeted or standard costs
32
Analysis as an Outsider
Overview
Insider As Primary
User of Financial
Information
Until this point, our discussion about financial statement analysis has
been from the point of view of someone who has the ability to influence or
control the managementan insider. For example, we analyzed the financial statements of Superior Office Supply Company as if you were assuming management of your own family-owned business. Therefore, the
financial information was primarily for your use, as an insider, to analyze
and improve your business.
As an insider and primary user you want financial statements to be as
accurate and as honestly representative of the real situation as possible.
Your analysis of these statements improves your understanding of what is
happening to the business and improves your decision making, which in
turn results in better profits and cash flow. Your good decisions increase
the value of the business. Moreover, if necessary, the business will be able to
obtain cheaper outside capital (lower interest on loans and lower required
rate of return on new investment money), because the business is secure
and profitable.
Notice the priorities here for use of financial statement information:
(1) create better understanding and decision making, which results in (2) an
increase in real business value, and finally (3) a cheaper cost of capital.
Outsiders As Users
of Financial
Information
Outsiders are people who do not have authority to manage a company. The
most important outsiders are providers of capital: (1) investors, (2) lenders,
and (3) suppliers. For some businesses, outsiders may be a significant and
regular source of capital. This is usually the situation with large corporations. Outsiders are also financial statement users and, of course, want
statements that are reliable and accurate. However, outsiders must rely on
the financial statements that have been prepared by the insidersthe top
management.
Different Priorities
As an outsider, you naturally would like to believe that the financial information priorities of the management are the same as yours, which is to first
create reliable financial statements that result in good decision making.
Then business value increases and cost of capital decreases. Sometimes it
happens this way.
Often however, when outsiders begin to provide a significant amount of
capital, the managements financial information priorities become reversed:
(1) maximize short-term business value and obtain the cheapest possible
capital and (2) create better understanding and decision making.
33
Overview, continued
Be Skeptical
Maximum business value and low-cost capital happen primarily as the

result of high reported profits. When high reported profits become a compelling first priority that supersedes effective management, the financial
statements become a tool for reporting favorable information rather than
for showing reliable and accurate information for decision making. The
business begins to look more valuablenot because management has
actually made it more valuable but because the financial statements are
used as a shortcut to make the business appear more valuable.
As an outsider, it is always wise to maintain the following skeptical attitude: A company that (1) needs significant capital from outsiders and/or
(2) provides significant rewards to top management based on profitability
will (3) have a management that is highly motivated to create financial
statements that make a business appear as profitable as possible.
Finding Information
Full Disclosure
For publicly traded companies, the law requires that information disclosures to outside parties be made available simultaneously to all outside
parties. Therefore, even as an outsider, you have access to very useful
information, and no other outsider legally has better access to information
than you do.
SEC
Probably the single best source of detailed company information for publicly traded companies is the SEC (Securities and Exchange Commission)
website at www.sec.gov. You can type in a company name (or its trading
ticker symbol) to locate the company and its reports. The key financial
information items to look for are reports 10-K (annual report) and 10-Q
(quarterly report) and 8-K (disclosure of material events).
Annual Reports
Company annual reports are available at the investor relations page of a

company website. Some other sites that provide annual reports are
www.annualreportservice.com and www.reportgallery.com.
Conference Calls
When publicly traded companies release annual reports, top management

will present a public question-and-answer session called a conference call.
You can listen to this discussion on the Internet! Written transcripts of the
call are also available on the Internet. This is often very useful information
because analysts participating in the session ask very insightful questions.
34
Quality of Earnings
Overview
Overview
At various times in this volume and in Volume 1, we have referred to the

important topic of event analysis. We defined event analysis as the analytical procedure used to identify and properly record transactions. The
key elements of event analysis are: (1) classification, (2) valuation, and
(3) timing (recognition).
The quality of earnings issue is really a discussion about proper event
analysis in the context of how the event analysis affects the income statement. Specifically, on the income statement the reported income or loss is
a direct result of how revenue and gain events and expense and loss events
are analyzed.
Definition
Although there is no single definition of quality of earnings, the general

idea is the extent to which a companys operating and net income honestly portray what has really happened. More specifically, quality of earnings refers to these issues:
1. Does income accurately measure the change in a companys wealth that
has resulted from the current period operations?
2. Does income accurately represent the recurring and repeatable operations of a company so that the reported income has predictive usefulness?
Earnings
Management
Whenever a company intentionally uses GAAP for the purpose of manipulating the results shown on the income statement, the company is doing
earnings management. This is a major cause of low quality of earnings.
Earnings Management
Example
Smith Corporation is aggressive and wants to favorably impress investors

so that the price of its stock will increase. Smith uses every accounting
method that it can for the express purpose of reporting higher net income.
For example, it records all revenue regardless of the financial condition of
its customers, it uses the straight-line depreciation method, and it uses
FIFO in an industry in which prices are regularly increasing. Smith is said
to have a low quality of earnings because there is a good chance that its
selection of methods, all biased toward showing higher income, overstates
the wealth actually resulting from operations. Also, outsiders are likely to
be misled into believing that the favorable results come from recurring
operations that will continue into future periods.
35
Earnings Management, continued

Revenues should result in an increase in valuable resources, and expenses
should result in a decrease in valuable resources. Thus, operating income
(and net income) should be a measure of the change in valuable resources
(wealth) resulting from the operations. Ideally, the methods used to analyze these events should be consistent at all times if fair, accurate, and fully
comparable financial statements are to be achieved.
Why Is Earnings
Management
Possible?
However, GAAP permits: (1) the use of different methods and (2) the use
of estimates. Whenever transaction (event) analysis is subject to choices
and estimates, the opportunity will always exist for earnings management.
Not the Same
As Fraud
Earnings management is not the same as fraudulent reporting, although

the ethics of earnings management is in many cases questionable. Fraud is
an outright violation or ignoring of GAAP with the intent to deceive.
Earnings management falls into a gray area because GAAP is not ignored
or violated; rather, GAAP is selectively applied to create biased financial
statements. The aspect of deception, however, is often still present and, if
sufficiently excessive, can result in legal action by the SEC, federal prosecutors, and state attorneys general.
Revenue
Management
There are many opportunities for managing revenue. It is also a frequent form of financial fraud. The table below shows several common
methods of revenue management with descriptions. (Remember: Revenue
either increases assets or decreases liabilities, so revenue management
affects both the balance sheet and the income statement. See revenue recognition principle.)
Method
Description
Doubtful-credit sales
Sales knowingly made to customers who may not have the ability to pay.
Sales returns understated
Seller estimates sales returns at a low amount.
Percentage of
completion manipulated
Activities occurring over a long time period such as construction projects

and extended service contracts recognize revenue as the work is done
based on percentage of completion. Seller manipulates this estimate.
Related-party sales
A sale is made to a division, subsidiary, or other related party who can

be compelled to buy. Disclosure of the relationship is minimal.
Offsetting sales
Two companies make equivalent sales to each other really for the
purpose of increasing reported revenues.
Channel stuffing
Channel stuffing means pressuring customers to make large purchases

much sooner than they normally would. This process may involve either
threats or excessive discounts. It usually happens at year end. This is
not really a GAAP application; however, it is revenue management.
continued
36

Compared to Fraud
The examples below illustrate revenue fraud. Notice that they involve
clear GAAP violation or outright fictitious revenue transactions.
Method
Description
Revenue with excessive

probability of return
Revenue is recorded for sales transactions with terms that will cause the
merchandise to probably be returned and that allow the customer to
easily return merchandise with no penalty.
Fake revenue
Revenue is recorded for sales transactions that never happened.
Wrong period
The books are held open at the end of a period to intentionally record
sales from the next period into the current period.
Misclassification
Non-recurring sales of plant and equipment are recorded as sales revenue.
Early shipment
Goods are prematurely shipped and revenue is recorded before title

passes to buyer.
Bill-and-hold sales
Seller bills the customer but delays shipment to the customer (title does
not pass to buyer) thereby recording revenue but not cost of goods sold.
Expense Management
There are also many ways to manage expenses. The table below shows
some common methods. (Remember: An expense either decreases assets
or increases liabilities, so expense management affects the balance sheet as
well as the income statement. Also see the matching principle.)
Method
Uncollectible receivables underestimated
Control depreciation
(and amortization)
Control cost of goods
sold
Description
The estimate of bad receivables is intentionally understated, which
reduces uncollectible account expense (and overstates assets). Different
estimating methods are also available.
Unrealistically long time periods are used. Unrealistically large residual values are used. Different depreciation methods are available.
Different inventory methods are available. LIFO purchase decisions
are made at year end. Subjective inventory write-down replacement
costs are used.
Accrued expenses
underestimated
Examples: Accrued warranty expenses Accrued environmental

cleanup liability Employee benefits liabilities
Capitalizing expenditures instead of recording them as expenses
GAAP permits discretion in recording some expenditures as assets rather

than as expenses. Examples: Capitalizing software development
depends upon when management decides the software is technically
feasible. Oil exploration expenditures are allowed to be capitalized.
There is discretion in using estimates for capitalizing lease payments.
Expense timing
A business can decide to incur or not incur expenses in any given period,
for example, repairs and maintenance. When earnings management is
involved, this decision is influenced more by how the income statement will
appear than by business necessities or efficient management.
37

Compared to Fraud
The examples below illustrate expense fraud. Notice that they involve
clear GAAP violation or outright fictitious transactions.
Method
Description
Capitalize operating
expenses
Expenditures that are clearly operating expenses, such as payroll, repairs,

maintenance, and so on, are recorded as the purchase of assets.
Misclassification
An expense is spread around in small amounts to various accounts.
Unrecorded accruals
Accrued expenses are intentionally ignored.
Wrong period
Expenses are intentionally recorded in the wrong periods.
Important financial warning signs:
Collection of receivables becomes slower. The accounts receivable

turnover ratio decreases and the average number of days to collect
increases.
Inventory is selling more slowly. The inventory turnover ratio

decreases, the number of days to sell becomes greater, and the
average inventory balance increases.
Liquidity becomes a problem. Continued or significant decreases

in the current ratio, the quick ratio, and operating cash flow are all
warning signs.
Debt becomes excessive and repayment becomes more difficult.

The cash flow to debt ratio begins to decline. The debt ratio begins
to increase. More debt means more risk.
The gross profit percentage is decreasing. The company is selling

its goods for lessoften a sign of increased competitionand
also may be paying more for its inventory.
Any significant increases or decreases in gross profit percentages

should be carefully investigated.
Interim press releases use amounts that do not conform to GAAP

(even though GAAP amounts are disclosed).
TIP
continued
38

Other Methods
Numerous other methods for earnings management do not require showing greater revenues or smaller expenses. Here are some examples:
Method
The big bath
Income smoothing and

the cookie jar
(also called secret
reserves)
Description
After many periods of overstating net income, a company fixes everything by correcting the cumulative overstatement in the current year.
That often involves writing off unproductive (impaired) assets and/or
incurring restructuring costs all in a single year. This results in a very
bad year, which the company knows that most investors will soon forget
because the next year will look much better in comparison.
Companies know that investors like to see a smoothly increasing
income. To achieve this, a company will overstate expenses or understate revenues in good years.
Examples:
Misleading press
releases
Repeated nonrecurring losses
Pension plans
In a good year, uncollectible accounts expense, sales returns,

warranty expense, etc., is overstated to create an excessive balance in
an allowance (or liability) account. When a bad year arrives, the excessive balance reduces the amount of expense needed.
In a good year, the amount of unearned revenue earned is understated, so in a bad year, more can be recorded as earned.
Large companies sometimes publish misleading press releases using

non-GAAP amounts that greatly overstate income. This usually happens
at the time of quarterly earnings reports and may include misleading
non-GAAP terminology such as pro forma income or core income.
Although these companies have reported income to the SEC on a correct GAAP basis, the press releases receive much more attention
because they are widely reported by financial news services and television media. Solution: Use Edgar on the SEC website at www.sec.gov/
and ignore the press releases. (Or use only the GAAP data in the
releases and the reconciliation of the non-GAAP data to the GAAPbased data.)
Companies know that most investors/lenders tend to ignore nonrecurring or special items and instead focus on income from
continuing operations because it is perceived as a predictor of what is
likely to happen next period. Some companies try hard to classify as
much expense as possible as non-recurring(and one-time gains as
part of continuing operations).
GAAP allows companies to report their own assumed rate of return for
pension plan investments regardless of actual plan gains or losses. This
results in an income smoothing effect as well as non-realized (cash not
received) assumed gains. The amount of cash actually set aside for pension payments is often unrelated to the stated value of the pension plan.
39
Potentially Hidden Liabilities

Overview
Importance of
Knowing Liabilities
The importance of identifying all liabilities cannot be overstated. Liabilities are a claim on a companys present and future wealth. Furthermore,
many liabilities are created by expenses that significantly impact the
amount of income reported on the income statement and thereby affect
the earnings. The analysis guidelines of classification, valuation, and timing must be applied to all liabilities.
Identifying Liabilities
Some liabilities are easy to identify because they have been recorded as the
result of completed transactions such as the receipt of cash from a bank
loan or by properly recording an adjusting entry for an expense accrual.
These are the liabilities that regularly appear on a balance sheet. But, can
there be liabilities that do not appear the balance sheet? Yes!
Liabilities Not on
the Balance Sheet
Two kinds of liabilities have the potential to disappear from the balance
sheet. These liabilities are:
Contingent liabilities
Off-balance-sheet financing
Contingent Liabilities
Definition
A contingent liability is a potential liability that will become an actual liability only if some other event occurs first.
This contingent liability . . .
. . . becomes an actual (recorded) liability if . . .
Product warranty
the customer wants a defective item repaired or replaced.
IRS audit
the IRS assesses a deficiency.
Activity impacting the environment
environmental damage has occurred.
Potentially dangerous product
damages are awarded or settlement is agreed.
Defendant in a lawsuit
the lawsuit results in damages awarded or settlement agreed.
Issuance of coupons
a customer uses coupons.
Guarantee a debt
the borrower does not repay the debt.
Frequent-flier miles
non-paying passengers replace paying passengers.

continued
40
Contingent Liabilities, continued

Contingent Liability
Classifications
When you look at the list of examples, it becomes clear that not all the contingencies are equally likely to happen. For example, product warranties
require some future expenditures and can be estimated from past experience.
However, the outcome of a lawsuit is very unpredictable. GAAP classifies
contingent liabilities into three categories:
Probable
The amount can be reasonably estimated: Accrue the expense and
liability on the financial statements (use the estimate to debit an
expense and credit a liability).
The amount cannot be reasonably estimated: Disclose in footnotes.
Reasonably Possible: Disclose in footnotes.
Remote: Depending on item, disclose in footnotes or no disclosure
required.
The items that are disclosed in footnotes will be recorded on financial

statements only if and when the contingency happens.
What Is the Potential
Problem?
The classifications probable, reasonably possible, and remote are subjective

descriptions. Only items in the probable category that can be reasonably
estimated such as warranty expenses or coupon expenses will show up as
accrued expenses on the financial statements.
But what should be done in the case of potential environmental damage or
potentially dangerous products? These items could be very large amounts
for some companies. Another example is airline frequent-flier miles, for
which there is no consistent treatment.
Also, there is great variety in footnote disclosures. Sometimes disclosures
are clear and easy to understand. Sometimes they are vague or quite complex and difficult to interpret.
If an aggressive management can convince auditors that an item should
not appear on the financial statements or that disclosure should be vague
or even eliminated by classifying an item as remote, then a contingent liability has the potential to result in a very unpleasant surprise. In a company with a high quality of earnings, contingent liabilities are fully and
obviously disclosed, and expense or loss provisions are recorded as necessary, based on a conservative management attitude.
41
Contingent Liabilities, continued

Examples of Probable
Liabilities That Can
Be Estimated
Warranty liabilities
Coupons issued to customers
Unused refundable tickets sold to customers
All of the items above (1) create probable liabilities and (2) can be estimated based on a companys past experience. Therefore a journal entry is
made to record the liability and to match the related expense against current period revenue to which the liability is related. For example:
Warranty Expense
Estimated Warranty Liability
20,000
20,000
When a customer returns and wants the product repaired:

Estimated Warranty Liability
Parts Inventory
Wages Payable
Actual Liabilities That

Must Be Estimated
1,000
300
700
There is a difference between an actual liability that must be estimated and

a contingent liability that can be estimated. Remember that a contingent
liability, even though it might be probable, does not exist unless some
event happens.
An actual liability is one that already exists. Sometimes an actual liability
needs to be estimated. Examples: Property taxes that have not yet been
determined, estimated income taxes, and employee vacation pay.
Off-Balance-Sheet Financing
Definition
Off-balance-sheet financing means incurring debt or the equivalent of debt

in such a way that it does not appear as a liability on the balance sheet.
Why It Is Done
Off-balance-sheet financing is done because:
Assets are obtained for use but no debt is recorded, making the balance
sheet appear more favorable to investors, lenders, and suppliers.
New debt may violate loan covenants on existing debt.
Off-balance-sheet financing generally lowers the quality of earnings and the

quality of financial reporting. There are many ways to create off-balancesheet financing. Two common examples are described below.
continued
42
Off-Balance-Sheet Financing, continued

Example 1: Leases
A company acquires a long-term asset, but instead of buying the asset by

paying cash or signing a loan agreement, the company signs a long-term
lease. Because a lease is a rental agreement, no debt (and no asset) is
recorded. By keeping the new asset and the new debt off the balance sheet,
the companys debt ratio does not increase. This makes the company
appear stronger.
GAAP response: This kind of lease is characterized as a capital lease and
requires the lessee (the entity using the asset) to record the leased item as
an asset and to record debt on the balance sheet for a calculated value of
the total lease payments. However, this requirement is based on a fourpart test. If the answer is yes to any of the following items, the arrangement is a capital lease:
1. Does the lease transfer ownership to the lessee?
2. Is there an option to purchase the asset at a bargain (unusually low)
price?
3. Is the lease term at least 75% of the assets useful life?
4. Does the present value (a calculated value) of payments exceed 90% of
the assets initial value?
GAAP weakness: Because the numerical amounts of the test are not really
very demanding, it is extremely easy to manipulate a lease agreement into
a normal (operating) lease (rather than a capital lease) that keeps the liability for future payments off the balance sheet. As one example, the lease
term could be set at 74.9% of the asset life. At the present time, many millions of dollars of future lease payment obligations disappear from balance
sheets because of lease manipulation. As well, ratios such as the debt ratio
become unusable. Required footnote disclosures are often obscure and
difficult to interpret.
This is another example of a problem created when GAAP permits the use
of flexible alternatives, although here flexibility is not the result of direct
alternatives but rather the use of two not very demanding rules that create
an opportunity for manipulation.
43
Off-Balance-Sheet Financing, continued

Example 2: Variable
Interest Entities
If a company wants to finance and operate a specific activity, the company

is able keep the activitys related debt off its balance sheet by creating a
new entity (a corporation, partnership, etc.) with a very small investment
of its own money. Other investors may also be involved. The new entity is
financed mostly by debt, while the company creating the entity directly or
indirectly guarantees up to 50% of the debt repayment (and may share up
to the same percentage profits). The assets of the new entity are also used
as security for the debt. This type of high-debt entity is called a variable
interest entity (V.I.E.) because the company creating it has an interest
in the entity that varies, depending upon the amount of the gains or losses
that it shares, while maintaining a very small equity investment. Essentially, the company that creates the V.I.E. is using a combination of its
good credit plus the V.I.E. assets to create the V.I.E.
For example, Enron engaged in many activities that were very speculative,
risky, and used primarily debt financing. Enron formed numerous partnerships with highly leveraged debt to operate and finance these activities
off-balance sheet while earning fees for managing the partnerships, plus
sharing in some potential profits (which usually never happened). Eventually the partnerships failed and Enron could not fulfill its guarantees to the
V.I.E. lenders.
Large banks and investment companies such as Citigroup, Bear Stearns,
and Merrill Lynch provide another example. These companies made
investments that included high yielding but very risky (called subprime) adjustable rate long-term mortgages. A company would create a
V.I.E. and sell the investments to the V.I.E. This turned the long-term
investments back into cash; also, the company received substantial fees.
In many of these cases, the V.I.E. was entirely financed by short-term debt
(6 months or less) and wealthy investors, with no investment or guarantee
by the bank or investment company. However, the reputation of the company creating the V.I.E. implied that it would make sure that the lenders
would not lose money.
The investors and lenders were happy as long at they continued to receive
payments from the mortgages; however, a perfect storm soon appeared
that changed everything. At about the same time, real estate values
severely declined and the interest rates on the mortgage loans started to
adjust up. Many homeowners lost or abandoned their homes. Soon, the
payments decreased, losses were incurred, lenders became frightened, and
the short-term financing became impossible to renew. Even in cases where
they had made no contractual guarantees, the implicit guarantees and
importance of financial reputation were so essential to the banks and
investment companies that they incurred huge losses in order to pay off
the V.I.E. lenders (but not the investors).
44
Big, Bad, and Sudden Surprises

The Nature of the Surprises
Overview
If you are an outsider and a stakeholder in a business, you are going to be

subject to many different kinds of financial risks. Many of these risks are of
the kind that can be spotted by using the tools that we have discussed so far.
Discovering other operating risks such as poor earnings quality may
require more accounting training and especially keen observation of the
financial statements and footnote disclosures. So far, so goodbut unfortunately, these do not come close to covering all the dangerous possibilities.
Where They Appear
The subject of financial risk is huge; we cannot even begin to describe all
the possibilities here. However, what we can still do is have some idea of the
general direction that risks will be coming from, and this can be useful. Of
course, what we are most concerned with are not small losses or the losses
we can see coming. What we are most worried about are those big losses
that take us by surprise. (Big unexpected surprises are sometimes called
Black Swans. A very useful, entertaining, and best-selling book on this
subject is The Black Swan by Nassim Taleb.) So where do we direct our
watchful eyes? We return to balance sheet: we are concerned with sudden
decreases in assets or surprise increases in liabilities.
As you know, the owners claim (Owners Equity) on the wealth of a
business is calculated by the basic accounting equation of A = L + OE. You
can see from this simple equation that a net decrease in assets (A) or net
increase in liabilities (L) will make owners equity decrease.
Note: A material decrease in an asset value that is not recoverable is
called impairment. The word is usually used in connection with longterm tangible assets, but may by used to describe any unrecoverable
asset value loss. Accountants measure and record impairment losses on
financial statements, but by the time this happens, the damage has
already been done.
45
Sudden Asset Decreases

Know Your Assets
When you look at a balance sheet, do you understand the assets? Understanding assets means two key things: 1. Do you know what the assets
are? 2. Do you understand how the assets are valued?
When you can answer these two questions, you will have a general sense of
how quickly the assets could change value, the subjectivity of their values
that appear on the balance sheet, and their utility to the business. The
more that you learn about the asset types the better feel for them you
will develop.
In general, physical assets are usually easier to understand and value than
intangible assets and financial assets. For example, it would probably be
easier to understand and to estimate likely values for a truck and some
merchandise inventory than for a retained interest in a securitized loan or
for an exotic financial market derivative. Especially when complex assets
are a substantial portion of total assets, we need to be extra careful.
Look at the Notes
Look at the disclosure in notes to the financial statements in either the

annual report or the SEC reports (10-Q or 10-K) that discuss the assets. If
you can understand the notes and understand what they say about valuation, then you are reducing your possible surprises. What do you think
about this actual example:
The market for MSRs (Mortgage Loan Servicing Rights) is not sufficiently liquid to provide participants with quoted market prices. Therefore, the Company uses an optionadjusted spread valuation approach to determine the fair value of MSRs. This approach
consists of projecting servicing cash flows under multiple interest rate scenarios, and discounting these cash flows using risk adjusted discount rates. The key assumptions used in
the valuation of MSRs include mortgage prepayment speeds and discount rates. The
model assumptions and the MSRs fair value estimates are compared to observable trades of
similar MSR portfolios and interest-only security portfolios, as well as to MSR broker valuations and industry surveys. The cash flow model and underlying prepayment and interest rate models used to value these MSRs are subject to validation in accordance with the
Companys model validation policies. Refer to key assumptions at June 30, 2007 on page 65
for the key assumptions used in the MSR valuation process. (Citigroup June 30, 2007 10-Q)
Do you understand what these assets are, the reliability of the value measurement, and what could happen to the values? The more complex the assets
are, probably the more complex the business operations are. Remember the
investment method of the famous investor Warren Buffet (who is one of the
richest men in the world). He repeatedly states that if he does not completely
understand a company, he will not invest in it. This is a good basic principle
for all kinds of stakeholders.
46
Sudden Liability Increases

Overview
If you think that analyzing assets can be difficult, then predicting unforeseen
liabilities is almost off the scale! This is where real surprises can happen.
Nevertheless a thoughtful analysis can still provide benefits.
Contingent
Liabilities
Review the contingent liabilities. Take a careful look at the notes that relate
to the contingent liabilities. Regardless of what assurances the notes might
provide, what events could increase the contingent liabilities that are
shown on the balance sheet or create new liabilities from possible events
that are described in the notes?
Look at the Notes
Just as with the assets, read the notes that relate to the liabilities. Do you
understand the liabilities that are recorded on the balance sheet and their
descriptions on the footnotes? Do you understand how amounts could
increase? Here is another actual example:
The Company may provide various products and services to the VIEs. It may provide
liquidity facilities, may be a party to derivative contracts with VIEs, may provide loss
enhancement in the form of letters of credit and other guarantees to the VIEs, may be the
investment manager, and may also have an ownership interest or other investment in certain
VIEs. In general, the investors in the obligations of consolidated VIEs have recourse only
to the assets of the VIEs and do not have recourse to the Company, except where the
Company has provided a guarantee to the investors or is the counterparty to a derivative
transaction involving the VIE. In addition to the VIEs that are consolidated in accordance
with FIN 46-R, the Company has significant variable interests in certain other VIEs that
are not consolidated because the Company is not the primary beneficiary. These include
multi-seller finance companies, collateralized debt obligations (CDOs), structured finance
transactions, and numerous investment funds. In addition to these VIEs, the Company
issues preferred securities to third party investors through trust vehicles as a source of
funding and regulatory capital, which were deconsolidated during the 2004 first quarter.
The Companys liabilities to the deconsolidated trust are included in long-term debt.
(Citigroup 10Q June 30, 2007)
This complexity should make us all think twice.

Assurances
In general, of course, one should always be cautious about assurances in

the financial statements notes such as maximum losses are unlikely;
this is particularly true when financial instruments and entities are complex and not easily understood.
47
Sudden Liability Increases, continued

What Kind of
Activities?
Review the nature of the business activities. For example, some activities
may be inherently more prone to lawsuits, such as selling prescription
drugs or selling tobacco products. Potential liabilities for some activities
can be very difficult to predict. For example, the note above indicates that
in general investors in the consolidated V.I.E. debt had access only to V.I.E.
assets and not to the Company creating the V.I.E. However, as we discussed
in the previous section about V.I.E.s, despite the fact that when there were
no loan guarantees to V.I.E. lenders, in many cases major losses were still
incurred in order to pay off the lenders simply to preserve a companys
good name and credit standing.
Other Issues
Fraud
When people think of sudden, negative financial surprises, what often

comes to mind is fraud. Fraudulent financial reporting is sometimes
detectable by financial statement analysis. Auditors, of course, perform
tests that can detect fraudulent activities. However, sometimes fraud can
be difficult to detect and may persist until its cumulative negative effect is
suddenly revealed. Often just the rumor or possibility of fraud is enough
to significantly impact both credit availability and investment values. The
decrease in asset values or sudden appearance of new liabilities can be devastating, but at this point a stakeholder will have few, if any, good options.
Direct Equity
Events That
Affect Investor
Stakeholders
Apart from an awareness of possible sudden changes in assets and liabilities,

a person who is an investor stakeholder also needs to be concerned about
events that can directly and negatively affect the market value of investments. These can include items such as surprise news events of various
kinds, the issuance of new stock and stock options and the creation of
other kinds of equity dilution, changes in debt ratings, and changes in
management. As well, various kinds of operational issues can affect equity
value both by decreased earnings and market valuation losses. These are
the kinds of issues that relate most directly to equity investors.
48
Conclusions
Financial Statement Usefulness
GAAP Does Matter
GAAP is important. GAAP provides the essential standards for maintaining the integrity of accounting information and financial reporting.
Therefore, you should not conclude from our discussion that GAAP does
not matter. On the contrary, GAAP is the best means presently available
for communicating accounting information.
High Earnings
Quality Is
Not Assured
However, the very flexibility and complexity of GAAP that is intended to

encourage accurate reporting enables companies to manipulate and bias
the results of financial statements, creating the definite possibility of low
quality of earnings. Because estimates often must be used, and because
alternative methods are frequently permitted for measuring particular
kinds of transactions, the meaning of financial statements can become
subjective. The qualities of usefulness and relevance can be easily compromised.
Therefore, you should retain your skepticism even when you are using
GAAP-based, audited financial statements. This advice is reinforced by the
fact that many investment professionals no longer attribute major importance to GAAP net income or even income from continuing operations,
but instead they prefer to base much of their analysis on the statement of
cash flows, particularly operating cash flows, which are much less subject
to manipulation. This is a rather sad commentary, considering the great
efforts that have gone into developing the GAAP that measures and
reports income. Nevertheless, given human nature, you should conclude
that GAAP cannot be relied upon to assure high quality of earnings.
49
The Public Response

Sarbanes-Oxley
In 2002, Congress created the Sarbanes-Oxley Act. Sarbanes-Oxley was

a response to the ever-increasing investor distrust of public company
financial reporting and to the concerns that unreliable reporting would
damage the American capital markets.
This distrust was later vindicated by securities and accounting fraud
charges filed against numerous large public companies such as Adelphia,
Health South, Sunbeam, WorldCom, Global Crossing, and Enron, all of
which had published audited financial statements that aggressively
reported inflated earnings and gave little or no indication of serious
financial problems. The last straw was the sudden collapse and bankruptcy of Enron and then WorldCom, which was the largest bankruptcy
ever filed. These two financial shocks were quickly followed by the license
revocation and collapse of the auditor involved with both businesses,
Arthur Andersen Company.
The cumulative effect of all these events was a public outcry that the
accounting profession had become unable to adequately regulate its
auditors because of the conflict of interest created by the large audit and
consulting fees received from the clients being audited. The result was
Sarbanes-Oxley.
The Sarbanes-Oxley law applies generally to publicly traded companies
and has the following broad objectives:
Reporting: Make financial reporting fair, understandable, and independent.
Auditing and internal control: Enforce and improve auditing standards and internal control analysis by CPA firms. Significantly
improve internal control procedures used by the reporting companies.
Corporate responsibility: Require personal accountability by top executives (chief executive officer and chief financial officer) for what is
reported on financial statements of their companies. Corporate audit
committees cannot be part of management and must have membership on the board of directors.
Penalties: Enact severe criminal and civil penalties for top executives,
board members, and auditors who knowingly act or fail to act in ways
that cause shareholders and other stakeholders to be defrauded.
50
The Public Response, continued

The Public Company
Accounting Oversight
Board (PCAOB)
A potentially very significant development for improving the quality of

earnings for public companies is the Public Company Accounting Oversight Board (PCAOB). The PCAOB is a private-sector, non-profit organization that was created by the Sarbanes-Oxley Act.
The main purpose of the PCAOB is to assure the implementation of two
of the Sarbanes-Oxley goals:
Make financial reporting fair, understandable, and independent.

Enforce and improve high-quality auditing and internal control standards.
The Sarbanes-Oxley Act removed the final authority over audit and internal control standards and enforcement from the public accounting profession and placed this authority under the control of the PCAOB for all
publicly traded companies.
The PCAOB makes proposals for auditing and reporting rule changes and
submits these proposals to the Securities and Exchange Commission. In
turn, the Commission must approve each proposal for it to become effective as a PCAOB rule. The PCAOB rules serve to implement existing
GAAP and to create improved auditing, internal control, and reporting
standards and, hopefully, to improve the quality of earnings.
To perform audits of public companies, CPA firms must register with the
PCAOB. The PCAOB has broad investigative and disciplinary authority
over these CPA firms. The PCAOB actively investigates potential violations and solicits information and complaints about potential violations.
The Future?
GAAP is always evolving and responding to the economic, social, and

political environment. For example, the accounting profession continues
to clarify the objectives of the conceptual framework of accounting GAAP
is also being integrated with international accounting standards. Perhaps
in the future, a consensus may develop that the many rules attempting
analytical precision have exceeded limits beyond which the unintended
results of complexity and manipulation cancel out any subtle measurement benefits.
Perhaps the concept of single reasonable point of reference might be
acknowledged as often more useful to stakeholders than current flexibility
and the selective accuracy that are often the result. And for quality of earnings, hopefully the PCAOB oversight will result in continuing improvement.
However, you can at least be certain of this: In the financial world, regardless of where your future leads, a good understanding of accounting will
always serve you very well.
Summary of Financial Ratios and Measurements

Ratio
Computation
Interpretation
Measures of Liquidity
Current ratio
total current assets

---------------------------------------------------------total current liabilities
Quick (acid-test) ratio
cash + short term + current

investments receivables (net)
---------------------------------------------------------------------------------------------total current liabilities
Receivables turnover
net credit sales

----------------------------------------------------------------average net receivables
Average days to
collect
Inventory turnover
Average days to sell

-----------------------------------------------------------------------------accounts receivable turnover
cost of goods sold
------------------------------------------------average inventory
-----------------------------------------------------------------------------inventory turnover
Shows the ability to pay current

liabilities by using current assets
A more conservative measure of the
ability to pay current liabilities
The number of times in a period
the average level of receivables is
collectedshows ability to collect
Average collection time in days
The number of times in a period the
average level of inventory is sold
Average selling time in days
Measures of Solvency
Debt ratio
(leverage ratio)
Times-interest earned
total debt
-----------------------------total assets
operating income
----------------------------------------------Interest expense
or
Asset turnover ratio

Cash flow to debt
ratio
Free cash flow
Shows the percentage of assets that

must be used to repay debt
How many times the operating
income covers interest expense (not
a measure of cash flow coverage)
cash flow from

+ interest paid
--------------------------------------------------interest expense
How many times the cash flow from

operations before interest covers
interest expense (shows cash flow
coverage)
net sales
Dollars of sales generated for every

dollar invested in assets
cash flow from

-----------------------------------------------------------average total liabilities
The ability of a company to repay

debt using only operating cash flow
(cash flow from operating activities) (capital expenditures)
How much operating cash flow

remains after paying for capital
expenditures
51
52
Summary of Financial Ratios and Measurements, continued

Ratio
Computation
Interpretation
Profit margin ratio
net income
-----------------------------net sales
Percent of sales that becomes profit
Gross profit
ratio
gross profit
-----------------------------net sales
Percent of sales that becomes

gross profit (for merchandising
companies)
Measures of Profitability
Earnings per share

----------------------------------------------------------------------------------------weighted average number of
common shares outstanding
Return on total assets
For corporations, the net income

allocable to each common share
of stock
net income
The percent profit created for each

dollar invested in assets
net income
-------------------------------------------------------------,
average owner s equity
The percentage net income for the

average amount of owners equity
or
The percentage net income for the

average amount of common stockholders equity in a corporation
Measures of Investment Return

Return on equity

-----------------------------------------------------------------------------------------------------,
Dividend ratio
common stock cash dividends

-----------------------------------------------------------------------------------------------------,
The percentage cash dividends for

the average amount of common
stockholders equity in a corporation
Revenue (or gross

profit) per unit of
resource
revenue (or gross profit)

--------------------------------------------------------------------------------------units of important resource used
Measures the ratio of revenue/gross

profit that is being created for units
of a scarce resource being used
Cost per unit of

resource
cost
--------------------------------------------------------------------------------------units of important resource used
Measures the ratio of cost that is

incurred for units of a scarce
resource used
Plant and equipment turnover

Inventory turnover
Receivables turnover (or
average age)
Percent of past-due
receivables
Cost of goods sold
percentage
Percent of merchandise
returns
Standard cost variances
Designed to highlight key measures

that are considered important to an
operation. (Note that many of these
are also related to liquidity or
solvency as well as productivity.)
Standard cost measures the amount
of input needed for the output
produced.
Measures of Productivity
Other measures
QUICK REVIEW
The essential financial statements are the

balance sheet, income statement, statement of
owners (or partners or stockholders) equity,
and the statement of cash flows. The balance
sheet shows financial condition as wealth and
claims on wealth. The income statement
shows changes in owners equity that result
from operations, the statement of owners
equity shows all changes in owners equity,
and the statement of cash flows explains the
change in the cash balance as operating
activities, investing activities, and financing
activities.
Horizontal analysis compares amounts over
a selected time period to a reference base
amount at the beginning the time period.
Vertical analysis is a comparison of amounts
within a financial statement to a designated
amount in the statement. Vertical and
horizontal analysis can be combined.
Ratio analysis analyzes important financial
relationships by use of a ratio, which is the
comparison of one number to another, usually
displayed as a fraction. Ratio analysis focuses
on the elements of liquidity, solvency, profitability, investment return, and productivity.
These ratios are summarized on pages 882
and 883.
Analyzing a business as an outsider always

requires skepticism and caution. Careful
analysis of 10-K (annual financial statements),
10-Q (quarterly financial statements), and 8-K
(significant event) reports filed with the SEC
(Securities and Exchange Commission), of
annual reports, and of conference calls is
essential. All of these resources are available
on the Internet.
Quality of earnings affects the usefulness

of financial reports and can be impaired by
both revenue and expense management.
Off-balance-sheet financing understates
total obligations and makes a companys
financial condition appear more secure and
favorable.
The Sarbanes-Oxley Act of 2002 was a response

to increasing distrust of financial reporting by
publicly traded companies. The purpose of the
act is to: (1) improve the reliability and quality
of financial reporting, (2) improve auditing
standards and internal control, (3) increase
corporate responsibility, and (4) impose
significant penalties for violations. The Public
Company Accounting Oversight Board
(PCAOB) was created by Sarbanes-Oxley to
implement the first two goals of the act.
53
54
VO C A B U L A RY
Benchmark: a norm or guideline used for the
purpose of comparison
Operating cycle: the time required to convert

inventory back into cash
Capital lease: a financed asset purchase

disguised as a long-term lease
PCAOB: the Public Company Accounting

Oversight Board
Common-size financial statement: a financial

statement shown in percentages
Price earnings ratio: stock price per share

divided by earnings per share; used by investors in
the stock of publicly traded companies to gauge
relative value of a stock
Contingent liability: a potential liability that

will become an actual liability only if some other
event occurs first
Debt covenants: requirements and restrictions
imposed by lenders
Earnings management: the use of GAAP to
manipulate reported income
EBITDA: Earnings Before Interest, Taxes,
Depreciation, and Amortization
Financial leverage: the use of debt
Free cash flow: cash flow from operating
activities minus capital expenditures
Productivity: the level of efficiency at which a

business operates
Publicly traded: stock that can be bought and
sold on stock exchanges
Quality of earnings: an evaluation as to
whether the reported income accurately
represents the true change in wealth and the
recurring nature of business operations
Quick assets: highly liquid assets (cash, shortterm investments, and net short-term receivables)
used to calculate the quick ratio
Impairment: an unrecoverable decrease in asset

value
Sarbanes-Oxley: a federal law that controls

auditing standards for publicly traded companies
and imposes personal liability on the top
executives of such companies for the reliability of
financial statements
Liquidity: the ability to pay current liabilities as

they become due
Solvency: the ability to remain in business for a

long period of time
Liquid assets: assets quickly convertible into

cash
Trading on equity: the effect on return on

equity when a business incurs debt
Market share: a companys sales as a percentage

of total sales for all companies in the same
industry or type of business
Vertical analysis: comparing financial statement

information within a statement
Horizontal analysis: comparing financial

statement information over time
MD&A: Management discussion and analysis
Working capital: current assets minus current

liabilities
Off-balance-sheet financing: incurring debt

in such a way that it does not appear as a liability
on the balance sheet
P RAC T I C E
Use these questions and problems to practice what you have learned.
Multiple Choice
Select the best answer.
1. To evaluate the solvency of a business, which primary measurements would you select?
a. debt ratio, accounts receivable turnover ratio, and times-interest earned
b. gross profit ratio, return on equity ratio, and current ratio
c. quick ratio, inventory turnover ratio and earnings per share
d. debt ratio, asset turnover ratio, and cash flow to debt ratio.
2. To evaluate the profitability of a business, which primary measurements would you select?
a. quick ratio, free cash flow, and asset turnover ratio
b. current ratio, average days to sell inventory, and gross profit ratio
c. free cash flow, return on total assets, and debt ratio
d. earnings per share, gross profit ratio, and return on total assets ratio
3. To evaluate the liquidity of a business, which primary measurements would you select?
a. current ratio, quick ratio, and cash flow to debt ratio
b. current ratio, average days to sell inventory, and average days to collect receivables
c. current ratio, average days to sell inventory, and asset turnover ratio
d. times interest earned ratio, gross profit ratio, and return on total assets ratio
4. Earnings per share is used by investors in what important calculation?
a. price earnings ratio
b. profit ratio
c. return on equity ratio
d. dividend ratio
5. Quality of earnings refers to:
a the reliability of the change in wealth indicated on the income statement.
b. the reliability of the income statement as an indicator of recurring operations.
c. the assurance that properly applied GAAP means unbiased financial statements.
d. both a and b.
6. If Company X is an accounting firm and Company Y is an airline:
a. Company X probably will have a higher gross profit ratio.
b. Company Y probably will have a lower inventory turnover ratio.
c. Company X probably will have a higher asset turnover ratio.
d. Company Y probably will have a higher profit ratio.
7. A large corporation has new management that has promised to quickly stop losses and make
the company profitable. Which earnings management technique would they be most tempted
to immediately use?
a. income smoothing using the cookie jar
b. the big bath
c. capitalizing operating expenses
d. expense timing
8. Two ratios that can be used as measures of potential liquidity as well as operating efficiency are:
a. gross profit and return on total assets ratios.
b. quick and current ratios.
c. accounts receivable turnover and inventory turnover ratios.
d. current and cash flow to debt ratios.
55
56
P RA CTI C E
9. If sales on account have been overstated, what calculation is most likely to detect it?
a. inventory turnover ratio or average days to sell calculation
b. current ratio
c. free cash flow calculation
d. accounts receivable turnover ratio or average days to collect receivables calculation
10. If a company changes from LIFO to FIFO in a period of rising prices, the inventory turnover
ratio:
a. will suddenly look better.
b. will suddenly look worse.
c. will not be affected.
d. cannot be calculated.
11. When analyzing a change in the debt ratio:
a. an increase is usually bad, and a decrease is usually good.
b. an increase usually creates more risk, and a decrease usually reduces risk.
c. When a debt ratio increases, it is essential to know the reason as this can be a good indicator
of a companys condition or strategy; when the ratio decreases, it is usually an indicator of
improvement in financial strength.
d. both b and c.
12. An important audit rule-setting and compliance enforcement organization requiring
registration by accountants who wish to audit publicly traded companies is the:
a. Public Company Accounting Oversight Board (PCAOB).
b. Securities and Exchange Commission (SEC).
c. Financial Accounting Standards Board (FASB).
d. American Institute of Certified Public Accountants (AICPA).
13. Which of the following does not represent a contingent liability?
a. a product that has a 1-year warranty
b. coupons issued by a grocery store
c. an oil tanker that does not have a double hull.
d. a long-term lease-purchase structured so that no debt appears on the balance sheet
14. A problem with contingent liability classification is that:
a. contingent liabilities may be difficult to calculate.
b. it is subjective and sometimes can be easily manipulated.
c. it is difficult to identify a contingent liability.
d. the classification does not apply to all types of companies.
15. If a company is using debt to acquire assets, then the business:
a. will have a high asset turnover ratio.
b. is said to be trading on equity.
c. will usually increase the rate of return on owners equity.
d. both b and c.
16. The federal law that resulted from years of aggressive financial reporting and the sudden
collapse of Enron and Worldcom is:
a. the PCAOB.
b. the Securities and Exchange Commission (SEC).
c. Sarbanes-Oxley.
d. FASB.
P RAC T I C E
Reinforcement Problems
1. Identifying the ratios.

Instructions: Write the name of each ratio or measure and its formula for each of the following
analysis categories:
a. Liquidity
b. Solvency
c. Profitability
d. Investment return
e. Productivity
2. Horizontal analysis.
Instructions: Prepare a horizontal analysis that shows both the dollar and percent changes in 2007
from 2006 and also in 2008 from 2007 using the income statement shown below. Why did net
income increase by a higher percentage than sales in 2007? Why did net income increase by a
lower percentage than sales in 2008?
Grand Forks Company
Comparative Income Statement
Years Ended December 31, 2008, 2007, 2006
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income from operations. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2008
$605,000
358,000
247,000
165,000
82,000
2,000
$ 80,000
2007
$489,000
276,000
213,000
140,000
73,000
1,000
$ 72,000
2006
$418,000
251,000
167,000
126,000
41,000
2,000
$ 39,000
3. Calculate ratios. Assets and liabilities and selected other financial information from the
financial statements of Ketchikan Corporation are shown below.
Instructions: Compute the following for 2008:
Current ratio
Inventory turnover
Rate of return on total assets
Quick Ratio
Accounts receivable turnover

Debt ratio
Rate of return on equity
Profit margin ratio
Average collection period

Cash flow to debt ratio
Earnings Per Share
57
58
P RA CTI C E
3, continued
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventories, yearend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term mortgage payable. . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment, net of depreciation. . . . . . . .
Accounts receivable, year end . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net cash flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock shares issued and outstanding . . . . . . . . . . . .
(amounts shown were outstanding all year)
2008
$312,000
210,000
24,300
11,000
15,500
14,000
98,700
2,500
278,000
15,700
36,300
12,500
355,000
37,600
210,000
2007
$285,000
195,500
37,800
7,200
16,900
15,200
110,200
1,900
237,500
24,800
25,200
(18,600)
325,700
31,300
150,000
4. How transactions affect ratios.

Instructions: Consider the separate transactions shown below as they would affect the calculations in
problem 3 above. What effect would each transaction have on the ratios indicated? Recompute the
indicated ratios for each transaction. (Tip: First visualize which accounts are being debited and credited
in the transaction, then visualize if the numerator and/or denominator in the ratio are affected.)
Transaction
What is the effect on the . . .?
1. Paid $10,000 of the accrued liabilities
a. current ratio
b. debt ratio
2. Purchased $20,000 of inventory on account
a. current ratio
b. inventory turnover ratio
3. Borrowed $50,000 using a long-term note payable.
a. debt ratio
b. cash flow to debt ratio
4. Sold inventory costing $10,000 at a sales price of

$19,000. The sale is on account.
a.
b.
c.
d.
5. A $500 sales discount was taken by a customer on

$7,500 of accounts receivable. (Sale was made on
account.)
a. current ratio
b. accounts receivable turnover ratio
6. A sales return of $10,000 was made by a customer.

(Sale was made on account.) The cost of the
merchandise was $6,000.
a. current ratio
c. inventory turnover ratio
7. The adjusting entry for estimated uncollectible

accounts expense is $2,000.
a. rate of return on equity

current ratio
accounts receivable turnover ratio
inventory turnover ratio
rate of return on equity
P RAC T I C E
5. Analysis for a loan decision. Melanie Davenport, the owner of Hilo Enterprises, has come to
your bank for a $70,000 loan. Hilo Enterprises has been a long-time customer of the bank. You
are a member of the loan committee reviewing the loan application. The loan officer dealing with
the customer is recommending that the full $70,000 loan be made because the business has
been consistently profitable, maintains a good amount of working capital, has good current and
acid-test ratios, and because Melanie Davenport is a long-term customer of the bank.
Instructions: Use the measures you think are relevant to evaluate the loan application. Do you
agree with the loan officers recommendation? Do you want any other data?
Hilo Enterprises
Years Ended May 31
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
General and administrative . . . . . . . . . . . . . . . . . . . . . . .
Income from operations. . . . . . . . . . . . . . . . . . . . . . . . . . . .
Loss on sale of land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2008
$456,000
214,000
242,000
2007
$397,000
188,000
209,000
2006
$344,000
158,000
186,000
37,000
161,000
44,000
2,000
1,000
$ 41,000
28,000
141,000
40,000
24,000
124,000
38,000
2,000
$ 38,000
1,000
$ 37,000
2008
2007
2006
$ 37,000
119,000
2,000
127,000
285,000
125,000
44,000
$ 86,000
49,000
3,000
51,000
189,000
118,000
12,000
10,000
$305,000
$ 97,000
48,000
160,000
$305,000
Hilo Enterprises
Comparative Balance Sheet
May 31
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment. . . . . . . . . . . . . . . . . . . . . .
Less: Accumulated depreciation . . . . . . . . . . . . . . . . . . . .
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$366,000
$ 70,000
62,000
2,000
78,000
212,000
125,000
28,000
10,000
$319,000
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Long-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . .
Melanie Davenport, capital . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and owners equity . . . . . . . . . . . . . . . . . . .
$123,000
47,000
196,000
$366,000
$106,000
58,000
155,000
$319,000
59
60
P RA CTI C E
6. Analysis for an investment decision. De Kalb Decor, Inc. is a small privately held home
remodeling and interior-decorating company that opened in 2005 and sells to both retail and
contractor customers. It is about to sell additional shares of its stock to a limited group of
investors for the purpose of obtaining cash to fund an expansion of its operations and to pay off
half of the short-term debt. You have the opportunity to purchase some of the shares being
offered, and the company provided the audited financial statements that you see below.
Instructions:
a. Prepare a 3-year comparative common-size income statement.
b. Analyze liquidity, solvency, profitability, and investment return.
c. Is there any other important information that you would like to have?
d. Does the investment interest you?
De Kalb Decor, Inc.
Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . .
General and administrative. . . . . . . . . . . . . . . . . . . . . . .
Income (loss) from operations . . . . . . . . . . . . . . . . . . . . . .
Other revenues and gains and expenses and losses:
Other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Loss on sale of short-term investments . . . . . . . . . . . . . . .
Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . .
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2008
$1,046,000
607,000
439,000
2007
$865,000
519,000
346,000
159,000
241,000
39,000
137,000
205,000
4,000
95,000
170,000
(25,000)
4,000
(24,000)
(31,000)
(12,000)
0
($12,000)
23,000
(17,000)
12,000
(5,000)
10,000
2,000
$ 8,000
2006
$721,000
481,000
240,000
(18,000)
0
$(18,000)
P RAC T I C E
6, continued
De Kalb Decor, Inc.
December 31
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Supplies and prepaid expenses . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment. . . . . . . . . . . . . . . . . . . . . .
Less: Accumulated depreciation . . . . . . . . . . . . . . . . . . . .
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Stockholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and owners equity . . . . . . . . . . . . . . . . .
2008
$152,000
25,000
107,000
104,000
13,000
401,000
415,000
95,000
$721,000
$133,000
164,000
297,000
424,000
$721,000
2007
$105,000
68,000
111,000
120,000
10,000
414,000
375,000
54,000
$735,000
$137,000
128,000
265,000
470,000
$735,000
2006
$ 64,000
42,000
84,000
101,000
9,000
300,000
315,000
20,000
$595,000
$ 58,000
75,000
133,000
462,000
$595,000
2008
2007
2006
($12,000)
$8,000
$(18,000)
41,000
12,000
20,000
34,000
20,000
79,000
15,000
10,000
De Kalb Decor, Inc.

Comparative Statement of Cash Flows
Cash flows from operating activities
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Add: Items increasing cash or not reducing cash
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Proceeds from sale of short-term investments. . . . . . . .
Decreases in current operating assets . . . . . . . . . . . . . . .
Increases in current operating liabilities. . . . . . . . . . . . .
Loss on sale of short-term investments . . . . . . . . . . . . .
Less: Items reducing cash or not increasing cash
Increases in current operating assets . . . . . . . . . . . . . . .
Decreases in current operating liabilities
Increase in cash from operating activities . . . . . . . . .
Cash flows from investing activities
Expenditures on plant and equipment. . . . . . . . . . . .
Cash flows from financing activities
Increase (decrease) in long-term debt
Dividends to shareholders . . . . . . . . . . . . . . . . . . . . . . . .
Increase in cash from financing activities . . . . . . . . .
Net increase (decrease) in cash . . . . . . . . . . . . . . . . . . . . . .
Beginning cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ending cash balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
31,000
(3,000)
(4,000)
85,000
(73,000)
48,000
(17,000)
10,000
(40,000)
(60,000)
(92,000)
53,000
30,000
36,000
(34,000)
2,000
47,000
105,000
$152,000
53,000
41,000
64,000
$105,000
30,000
(52,000)
116,000
$64,000
61
62
P RA CTI C E
7. Analysis for an investment decision. Financial information for Bedford and Buford companies
is shown below. You are a value investor, so you are interested in purchasing the stock of a
company that has the lowest price earnings ratio and is also in good financial condition. Which
company would you select?
Current year income statement information:
Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bedford, Inc.
$550,000
315,000
235,000
3,000
35,000
95,000
Buford, Inc.
$420,000
273,000
147,000
4,000
15,000
72,000
Bedford, Inc.
$55,000
8,000
42,000
110,000
5,000
590,000
131,000
159,000
100,000 shares
$17.20
Buford, Inc.
$44,000
15,000
28,000
75,000
4,000
432,000
77,000
133,000
100,000 shares
$16.40
Bedford, Inc.
$51,000
99,000
542,000
336,000
Buford, Inc.
$37,000
81,000
409,000
227,000
Year-end balance sheet and other information:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Short-term investments . . . . . . . . . . . . . . . . . . . . . . . .
Accounts and short-term notes receivable, net . . . . .
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prepaid expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common stock issued and outstanding. . . . . . . . . . .
Current market price of stock . . . . . . . . . . . . . . . . . . .
Beginning of the year information:
Accounts and short-term notes receivable

Inventory
Total assets
Stockholders equity
Use the following ratios for each company:

Current ratio
Quick ratio
Inventory turnover
Debt ratio
Asset turnover
Profit margin ratio
Receivables turnover
Gross profit ratio
Return on equity
P RAC T I C E
8. Use ratios to calculate financial statement values. The condensed income statement and balance
sheet for Mystery Company are shown below. Calculate the values for items, A through R.
Mystery Company
Income Statement
Year Ended June 30, 2008
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling and marketing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
General and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income (loss) from operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(A)
(B)
(C)
55,000
127,500
(D)
1,500
(11,250)
(E)
Mystery Company
June 30
2008
2007
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . .
Less: accumulated depreciation . . . . . . . . . . . . . . . . . . . .
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
44,000
63,000
3,250
101,000
211,250
286,000
76,000
100,000
(N)
(F)
67,000
3,000
(G)
(H)
246,500
54,000
100,000
(I)

Long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
John Xxx, capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total liabilities and owners equity. . . . . . . . . . . . . . . . . . . .
(O)
278,500
(P)
(Q)
(R)
130,000
(J)
(K)
(L)
(M)
Other information:
The current ratio on June 30, 2008 is 2.6:1.

The 2008 gross profit percentage is 40%
The 2008 accounts receivable turnover ratio is 12 times.
The 2008 inventory turnover ratio is 4.5 times.

The debt ratio on June 30, 2007 is 65%.
The acid-test on June 30, 2007 is .8:1.
63
64
SO L U T ION S
Multiple Choice
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
d
d
b
a Earnings per share is also used directly for comparing profitability on a per-share basis.
d
c An airline would have a much greater investment in property, plant, and equipment assets
than an accounting firm. Therefore, the denominator in the fraction will be much bigger,
making the answer for turnover much smaller. A much bigger asset investment is needed
to create a dollar of revenue in an airline. An accounting firm and an airline are service
businesses and do not have merchandise inventory or cost of goods sold.
b First, this focuses blame on the old management. Second, future years results will now look
better when compared to the current large loss year in which the big bath was recorded.
c Both ratios relate to potential near-term cash flow and are also indicators of management
efficiency.
d If sales on account are overstated, the average balance of accounts receivable will also be
overstated. Also, these overstated receivables will remain uncollected. The denominator in
the ratio calculation will increase, which reduces the turnover and increases the days.
Example: Assume correct amounts are: sales 100, beginning A/R 14, and ending A/R 10.
Answer: [100/(14 + 10)]/2 = 8.33. Now assume sales overstated by 20. Answer: [120/(14 + 30)]/
2 = 5.45 (lower turnover). (Note: The gross profit ratio will also provide a clue as it begins to
increase above historical averages.)
b Changing from LIFO to FIFO in a period of rising prices reduces cost of goods sold, and the
numerator of the ratio becomes smaller. As well, the ending inventory becomes greater,
which increases the average inventory in the denominator. These changes decrease the
inventory turnover answer, although items are not actually being sold any slower. Be careful
when comparing companies using different inventory methods!
d
a This organization was created by the Sarbanes-Oxley Act in 2002.
d This is an off-balance sheet financing technique. All the other items represent potential
liability of varying degrees of probability.
b
b Trading on equity can result in either better returns or worse returns and increased risk.
c
SO L U T I O N S
Reinforcement Problems
1. See the table on pages 51 and 52.
2. Grand Forks Company

2008 changes
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses. . . . . . . . . . . . . . . . . . . .
Income from operations . . . . . . . . . . . . . . .
Interest expense. . . . . . . . . . . . . . . . . . . . . . .
Net income . . . . . . . . . . . . . . . . . . . . . . . . . .
$116,000
82,000
34,000
25,000
9,000
1,000
$ 8,000
23.7%
29.7
16.0
17.9
12.3
100.0
11.1%
2007 changes
$71,000
25,000
46,000
14,000
32,000
(1,000)
$33,000
16.9%
10.0
27.5
11.1
78.0
(50.0)
84.6%
In 2007, net income increased by a greater percentage than sales because total expenses increased
by a lower percentage than sales. As the biggest expense item, cost of goods sold had the biggest
effect. In 2008, net income increased by a lower percentage than sales because the total expenses
increased by a higher percentage than sales. Cost of goods sold again had the greatest effect, as
operating expenses actually increased by a lesser percentage than sales.
3. Ketchikan Company
Current ratio: 2.13:1
(14,000 + 15,700 + 24,300 + 2,500)/(11,000 + 15,500)
Accounts receivable turnover: 15.4 times per year

312,000/[(15,700 + 24,800)/2] = 15.4
Average collection period: 24 days

(312,000)/[(15,700 + 24,800)/2] = 15.4
365/15.4 = aprox. 24 days
Inventory turnover: 6.76 times per year

210,000/[(24,300 + 37,800)/2] = 6.76
Debt ratio: 35.3%

(11,000 + 15,500 + 98,700)/355,000 = .353
Cash flow to debt ratio: 28%

36,300/[(125,200 + 134,300)/2] = .279
Rate of return on total assets: 11%

37,600/[(355,000 + 325,700)/2] = .11
Rate of return on equity: 17.9%

37,600/[(229,800 + 191,400)/2] = .1785
Earnings per share: $.18 per common share

37,600/210,000 = .179
Quick ratio: 1.12

($14,000 + $15,700)/$26,500 = 1.12
Profit margin ratio: .12 (about 12%)

$37,600/$312,000 = .12
(Note: No preferred stock or dividends in this problem.)
4.
1a. The current ratio improves! (Current assets and current liabilities each decrease by $10,000.)
The new ratio is 2.8:1.
1b. The debt ratio also improves. (Total debt and total assets each decrease by $10,000.) The new
ratio is 33.3%.
65
66
SO L U T ION S
4, continued
2a. The current ratio decreases. (Current assets and current liabilities each increase by $20,000.)
The new ratio is approximately 1.165:1.
2b. The inventory turnover ratio decreases as more inventory is added. (Average inventory
increases.) The new ratio is 5.1 times per year.
3a. The debt ratio increases. (Total assets and total debt each increase by $50,000.) The new ratio
is 43%.
3b. The cash flow to debt percentage decreases. (Operating cash flow is unchanged, but total debt
increases by $50,000.) The new ratio is 23%.
4a. The current ratio increases. (Two items affect the current ratio here! Accounts receivable
increases by $19,000; inventory decreases by $10,000 so there is a net increase in current
assets of $9,000.) The new ratio is 2.47:1.
4b. The accounts receivable turnover ratio decreases as another account receivable is added.
(Accounts receivable and sales increase by $19,000.) The new ratio is 11 times per year.
4c. The inventory turnover ratio increases because cost of goods sold increases $10,000 and
average inventory decreases by $5,000. The new ratio is 8.45 times per year.
4d. The rate of return on equity increases because the sale increases net income by $9,000. The
new ratio is 22%.
5a. The current ratio decreases because less cash is received. The new current ratio is 2:1.
5b. The ratio increases. Normally a discount taken means that a receivable is paid more quickly,
so we can assume that net sales decrease by $500 and ending accounts receivable decrease by
$7,500. The new ratio is 18.9.
6a. The current ratio decreases as follows: current assets decrease by $10,000 for Accounts
Receivable decrease, but current assets increase by $6,000 for inventory returned. This is a net
$4,000 decrease in current assets and the new ratio is 1.98:1.
6b. The accounts receivable turnover ratio is affected as follows: net sales decrease to $302,000 and
average accounts receivable decrease to $15,250. The new ratio increases to 19.8 times per year!
A somewhat misleading result caused only by a return of merchandise. However, the result on
the income statement will be a decrease in net income due to the decrease in net sales.
6c. Average inventory increases by $3,000 and cost of goods sold decreases by $6,000. The new
inventory turnover ratio decreases to 6 times.
7a. The rate of return on equity is reduced because uncollectible accounts expense is debited and
reduces the net income. The rate decreases to 16.9%.
7b. The accounts receivable turnover will actually increase! (Because Allowance for Uncollectible
Accounts is credited, which increases the account, thereby decreasing the net accounts
receivable.) The changed accounts receivable turnover ratio would be 16.2 times per year.
5. Hilo Enterprisesanalysis: The primary concern of a lender is to be paid back the principal and
interest on a loan. Therefore, the primary focus of most loan evaluations will be on liquidity and
cash flow and solvency. The loan officer is correct: Operating and net income have been
increasing, the working capital as of 2008 is $162,000 ($285,000 $123,000), and the current
ratio is good and from 2007 to 2008 has improved from 1.95:1 to 2.3:1. The 2008 acid-test ratio is
good at 1.27:1 and is stable. However, unfortunately the loan officer has not focused on the cash
balance. An essential question is: Why is cash decreasing if the company is profitable?
SO L U T I O N S
5, continued
A further analysis shows that there has been a build-up in both accounts receivable and inventory.
These are unfavorable warning signs that the recorded sales are not easily being collected (or
worsethey are questionable sales) and that much of the inventory being purchased is not being
sold, which ties up cash and also carries the risk of inventory write-offs. The accounts receivable
turnover in 2007 is $397,000/($49,000 + $62,000)/2 = 7.15 times per year, which is about 51 days
average wait for collection. In 2008 this worsened to $456,000/($62,000 + $119,000)/2 = 5.04,
which is about 72 days. The inventory turnover in 2007 is $188,000/($51,000 + $78,000)/2 = 2.92
times per year, which is about 125 days to sell the average level of inventory. In 2008 this worsened
to $214,000/($78,000 + $127,000)/2 = 2.09, which is about 175 days to sell inventory. Liquidity is
definitely worsening. Considering this, it is also interesting that land was sold in 2008. To obtain
cash? The debt ratio trend is 48%, 51%, and 46% in 2006, 2007, and 2008. Although relatively
stable, the ratio is substantial.
Risks: (1) There may be significant losses because of write-offs of accounts receivable and
inventory next year, and (2) the indicators above are early warnings signs that business is
worsening, with unfavorable future cash flow and solvency implications.
Recommendation: (1) Obtain a statement of cash flows to confirm operating cash flow concerns
and also to calculate the solvency measures of cash flow to debt, cash basis times interest earned
and free cash flow. (2) Discuss the situation with the owner and ask about her business plan.
(3) A secured loan at a higher interest rate probably will be justified, as will a reduced loan
amount.
6.
De Kalb Decor, Inc.
Comparative Common-Size Income Statement
Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Operating expenses:
Selling and marketing . . . . . . . . . . . . . . . . . . . . . . . . .
General and administrative . . . . . . . . . . . . . . . . . . . . .
Income (loss) from operations . . . . . . . . . . . . . . . . . . . .
Other revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest expense
Loss on sale of short-term investments . . . . . . . . . . . . .
Income before income taxes . . . . . . . . . . . . . . . . . . . . . .
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net income (loss) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2008
100%
58
42
2007
100%
60
40
2006
100%
67
33
15
23
4
16
24
13
23
(3)
0
(2)
(3)
(1)
(1%)
3
(2)
2
(1)
1%
(2)
(2%)
67
68
SO L U T ION S
6, continued
Ratio
2008
2007
2006
Interpretation
3:1
3:1
5.2:1
Above-average and stable current ratio means company

has substantial current assets to meet short-term
liabilities (if receivables and inventory are good).
Quick Ratio
2.1:1
2.1:1
3.3:1
Very strong quick ratio indicates substantial very liquid

assets available to pay short-term liabilities.
A/R days to
collect
38 days
41 days
Collection time is satisfactory for typical sales on

account and is also improving. Industry norms would
be useful.
Inventory days
turnover
67 days
78 days
Company appears to sell inventory relatively quickly,

and the average time on hand is decreasing noticeably.
Industry norm is needed for comparison.
41%
36%
22%
Cash basis
times-interest
earned
3.5
2.8
2.0
The availability of cash flow for interest payments is

now very good; despite increase in debt the ability to
service (make payments on) the debt has actually
improved.
Asset turnover
1.4
1.3
For every dollar of assets, about $1.40 of sales revenue is

created. Industry norm is needed for comparison.
30%
24%
If operating cash flow were applied entirely to debt, flow

is sufficient to pay off 30% of total existing debt per year
or about 3.3 years to pay off all debt (1/.30 = 3.3).
$45,000
($12,000)
($82,000)
Measures the cash available after paying for long-term

asset acquisitions and replacements.
Profit margin
(1%)
1%
(2.5%)
Gross profit
42%
40%
33%
Liquidity Ratios
Current Ratio
Solvency Ratios
Debt ratio
Cash flow to
debt
Free cash flow
Debt is significantly increasing as a percent of total

assets. Why is this happening? What is the money
needed for?
Profitability Ratios
Earnings per
share
No net incomeslight loss.

Gross profit percentage of sales revenue is increasing
probably now above average but industry norm is
needed for comparison.
We need to know the number of shares outstanding;
however, we know earnings per share will be minimal or
negative by looking at the net income.
Investment Return Ratios

Return on
equity
Dividend ratio
(2.7%)
1.7%
No recent return on equity.
7.6%
0%
Probably not important for a new growing company.
SO L U T I O N S
6, continued
Analysis: If you were to focus only on the bottom linethe minimal net income and the net losses
of this companyyou would overlook the information that indicates that this appears to be a well
managed and vigorously growing company. Revenue has increased each year and 45% over the last
two years, whereas the cost of goods sold percentage has been decreasing. This is a powerful
combination. Operating expenses have been increasing substantially but have not changed as a
percentage of revenue. In the meantime, the company is handling receivables and inventory efficiently
as indicated by good and improving turnover ratios.
Liquidity and cash flow are good and improving. The company appears to have been financing
much of its growth by increased borrowing; however, the solvency indicators remain strong. These
will also improve if the business uses some of the new cash to pay down liabilities. Consistently
good and improving cash flow also tends to indicate minimal earnings management. Recent net
income and rate of return measures are not really meaningful for a new companyespecially for
one that appears to be coming into profitability. I would be very interested in this company;
however, before reaching a final decision, I would want to obtain more information about industry
norms for comparison. Some detailed productivity data also would be useful.
7. Bedford and Bufdord Companies

Bedford, Inc.
Inventory turnover: 3 times
Asset turnover: .97
Buford Inc.
Inventory turnover: 3.5 times
Asset turnover: 1.0
Quick ratio: .8:1

Debt ratio: 27%
Profit margin ratio: 17%
Quick ratio: 1.1:1

Debt ratio: 31%
Profit margin ratio: 17%
Receivables turnover: 12 times

Gross profit ratio: 43%
Return on equity: 25%
Receivables turnover: 13 times

Gross profit ratio: 35%
Return on equity: 27%
Analysis: This is not an easy choice. Buford has better liquidity ratios and is managing the
receivables and inventory more efficiently. On the other hand, Bedford has a lower debt ratio and
higher gross profit percentage, which indicate better solvency. Buford apparently has better
control of operating expenses, because it has the same net income profit margin percentage as
Bedford at 17%, even though Bedford has the higher gross profit percentage.
The deciding factor may be the price earnings ratio. Although the stock price of Buford is lower at
$16.50 per share, it is more expensive (higher price earnings ratio) relative to the earnings per
share (probably because of Bufords higher return on equity).
Calculation of PE ratios:
Bedford price earnings ratio: ($17.20 stock price per share)/($.95 earnings per share) = 18 times
Buford price earnings ratio: ($16.40 stock price per share)/($.72 earnings per share) = 23 times
69
70
SO L U T ION S
8. Mystery Company
A. Using accounts receivable turnover: ($63,000 + $67,000)/2 = $65,000 average balance 12 =
$780,000.
B. Using the gross profit percentage: A 40% gross profit means a 60% cost of goods sold.
Therefore, $780,000 .6 = $468,000
C. $780,000 .4 = $312,000
D. $312,000 ($55,000 + $127,500) = $129,500
E. $129,500 + $1,500 $11,250 = $119,750
F. Use acid-test ratio for total quick assets: x/$130,000 = .8 Cash is: $104,000 $67,000 =
$37,000
G. Using the inventory turnover ratio, write the ratio and what it equals in an equation form and
then use some algebra to solve for G in the equation:
[(G + $101,000)/2] 4.5 = $468,000 To solve for G,
[1/2(G) + 1/2($101,000)] 4.5 = $468,000 then,
[1/2 (G) + 50,500] 4.5 = $468,000 then,
2.25 (G) + 227,250 = $468,000 then,
2.25 (G) = $240,750 Therefore, G = $107,000.
H. $37,000 (from F) + $67,000 + $3,000 + $107,000 = $214,000
I. Total assets = H + ($246,500 54,000) + 100,000 = $506,500
J. Calculate (K) first. Then, $329,225 $130,000 = $199,225
K. Total liabilities, using the debt ratio: $506,500 .65 = $329,225
L. Owners equity is total assets total liabilities: $506,500 $329,225 = $177,275
M. M = I = $506,500
N. $211,250 + (286,000 $76,000) + $100,000 = $521,250
O. Using the current ratio: $211,250/x = 2.6 Result: x = $81,250
P. $81,250 + $278,500 = $359,750
Q. $521,250 (from N) $359,750 (from P) = $161,500 (Notice that the owners equity decreased
from 2006 to 2007, even though the business had net income. This means there were owner
withdrawals during 2007.)
R. R = N = $521,250

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Essentials of Financial

Gregory Mostyn, CPA

Worthy and James Publishing

Essentials of Financial Statement Analysis

Conclusions About Usefulness And Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Essentials of Financial Statement Analysis

Financial Statements Quick Review

Two key issues concerning a balance sheet are:

Essentials of Financial Statement Analysis

Balance Sheet, continued

Sioux City Enterprises

Liabilities and Owners Equity

Essentials of Financial Statement Analysis

The income statement is a change statement that shows the change in

The example below shows an income statement. The income statement

Essentials of Financial Statement Analysis

Income Statement, continued

Sioux City Enterprises

Statement of Owners Equity

The statement of owners equity (or partners equity, or stockholders

Essentials of Financial Statement Analysis

Statement of Cash Flows

Financing activities relate to the cash effects of the transactions that

Essentials of Financial Statement Analysis

Statement of Cash Flows , continued

Superior Office Supply Company

Dont be fooled. Depreciation is often incorrectly referred to as a

Essentials of Financial Statement Analysis

Specific GAAP rules offer specific direction for important kinds of

GAAP Is Not Perfect

How uncollectible accounts receivable should be recorded

Essentials of Financial Statement Analysis

GAAP (Generally Accepted Accounting Principles) , continued

Official Pronouncements: An official pronouncement is a formal and

FASB Technical Guides: The next authoritative level below an SFAS is a

Industry Practice: Industry practice is a source of GAAP. Historically,

Other Accounting Literature: Research publications by educators, journal

The International Accounting Standards Board (IASB) is an independent

Essentials of Financial Statement Analysis

Trend Analysis Using a

A reference base is simply a selected amount that is used to compare to

Suppose that you are given the following sales amounts:

Example: The 2006 sales compared to 2005 is: $55,000/$50,000 = 110%.

Example: The 2006 percent change is: ($55,000 $50,000)/$50,000 = 10%.

Essentials of Financial Statement Analysis

Horizontal analysis is a comparison of financial statement information

The example below shows a two-year horizontal analysis of comparative

Liabilities and Owners Equity

Your Name, capital

Essentials of Financial Statement Analysis

Horizontal Analysis, continued

The example below shows a two-year horizontal analysis of comparative

Other revenue and gains

Income statement: Unfortunately, net income (although positive) has

Essentials of Financial Statement Analysis

Vertical analysis is a comparison of financial statement information

Essentials of Financial Statement Analysis

Vertical Analysis, continued

The income statement below shows an example of vertical analysis for

Other revenue and gains

Balance sheet: The balance sheet shows a significant percentage of total

Income statement: The analysis confirms that the major portion of

Essentials of Financial Statement Analysis