FEATURE STORY Making Money the Old‐Fashioned Way

Li Ka‐shing likes things simple. He wears a basic electronic wristwatch, basic black dress shoes, and basic business suits. He lives by the philosophy that “If you keep a good reputation, work hard, be nice to people, keep your promises, your business will be much easier.” It seems to have worked for him. Business has been good. Li Ka‐shing is Asia’s richest man, with a net worth of over US$30 billion. That placed him in the top 20 on a recent list of the richest people in the world.

Li was not born rich. His family fled to Hong Kong from mainland China during the upheavals of war in 1940. His father died when Li was in his teens, forcing him to quit school and take a job at a plastics trading company. Within a few years, Li had started his own plastics company. One of his early businesses produced plastic flowers. He produced the parts for the flowers and then paid people to assemble the flowers in their homes. This saved him the cost of additional factory space (space being in short supply in Hong Kong).

Over the years, Li also invested in Hong Kong properties. One long‐time business associate recalls that Li was very disciplined when bidding on investments in businesses and properties. He didn’t like debt, and he would never bid above a predetermined number. He knew precisely what it would take for his investments to be profitable.

Today, Li’s business interests span many industries and virtually all parts of the world. His companies operate in 55 countries with approximately 250,000 employees. He owns ports, retail companies, electricity companies and energy interests such as oil sands in Canada, shipping companies, and telecom companies. He describes his criteria for doing business in a country as “rule of law, political stability that safeguards investments, ease of doing business and good tax structures.”

How can you enjoy similar success? There are no guarantees, but honing your financial analysis skills would be a start. A good way for you to begin your career as a successful investor is to master the fundamentals of financial analysis discussed in this chapter.

Sources: Tom Mitchell and Robin Kwong, “Breaking the Mould,” Financial Times Online (FT.com) (October 26, 2007); Michael Schuman, “The Miracle of Asia’s Richest Man,” Forbes.com (February 24, 2010).

PREVIEW OF CHAPTER 14

We can learn an important lesson from Li Ka‐shing: Study companies carefully if you wish to invest. Do not get caught up in fads but instead find companies that are financially healthy. Using some of the basic decision tools presented in this textbook, you can perform a rudimentary analysis on any company and draw basic conclusions about its financial health. Although it would not be wise for you to bet your life savings on a company’s shares relying solely on your current level of knowledge, we strongly encourage you to practice your new skills wherever possible. Only with practice will you improve your ability to interpret financial numbers.

Before unleashing you on the world of high finance, we will present a few more important concepts and techniques, as well as provide you with one more comprehensive review of corporate financial statements. We use all of the decision tools presented in this textbook to analyze a single company.

The content and organization of Chapter 14 are as follows.

Basics of Financial Statement Analysis

Learning Objective 1

Discuss the need for comparative analysis.

Analyzing financial statements involves evaluating three characteristics: a company’s liquidity, profitability, and solvency. A short‐term creditor, such as a bank, is primarily interested in liquidity—the ability of the borrower to pay obligations when they come due. The liquidity of the borrower is extremely important in evaluating the safety of a loan. A long‐term creditor, such as a bondholder, looks to profitability and solvency measures that indicate the company’s ability to survive over a long period of time. Long‐term creditors consider such measures as the amount of debt in the company’s capital structure and its ability to meet interest payments. Similarly, shareholders look at the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential of their investment.

Need for Comparative Analysis

Every item reported in a financial statement has significance. When Marks and Spencer plc (M&S) (GBR) reports cash and cash equivalents of £422.9 million on its statement of financial position, we know the company had that amount of cash on the report date. But, we do not know whether the amount represents an increase over prior years, or whether it is adequate in relation to the company’s need for cash. To obtain such information, we need to compare the amount of cash with other financial statement data.

Comparisons can be made on a number of different bases. Three are illustrated in this chapter.

1. Intracompany basis. Comparisons within a company are often useful to detect changes in financial relationships and significant trends. For example, a comparison of M&S’s current year’s cash amount with the prior year’s cash amount shows either an increase or a decrease. Likewise, a comparison of M&S’s year‐end cash amount with the amount of its total assets at year‐end shows the proportion of total assets in the form of cash.
2. Industry averages. Comparisons with industry averages provide information about a company’s relative position within the industry. For example, financial statement readers can compare M&S’s financial data with the averages for its industry compiled by financial rating organizations such as the U.S. companies Dun & Bradstreet, Moody’s, and Standard & Poor’s, or with information provided on the Internet by organizations such as Yahoo! on its financial site.
3. Intercompany basis. Comparisons with other companies provide insight into a company’s competitive position. For example, investors can compare M&S’s total sales for the year with the total sales of its competitors in retail, such as Carrefour (FRA).

Tools of Analysis

Learning Objective 2

Identify the tools of financial statement analysis.

We use various tools to evaluate the significance of financial statement data. Three commonly used tools are as follows.

• Horizontal analysis evaluates a series of financial statement data over a period of time.
• Vertical analysis evaluates financial statement data by expressing each item in a financial statement as a percentage of a base amount.
• Ratio analysis expresses the relationship among selected items of financial statement data.

Horizontal analysis is used primarily in intracompany comparisons. Two features in published financial statements and annual report information facilitate this type of comparison. First, each of the basic financial statements presents comparative financial data for a minimum of two years. Second, a summary of selected financial data is presented for a series of five to 10 years or more. Vertical analysis is used in both intra‐ and intercompany comparisons. Ratio analysis is used in all three types of comparisons. In the following sections, we explain and illustrate each of the three types of analysis.

Horizontal Analysis

Learning Objective 3

Explain and apply horizontal analysis.

Horizontal analysis also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place. This change may be expressed as either an amount or a percentage. For example, Illustration shows recent net sales figures of Dubois SA.

If we assume that 2015 is the base year, we can measure all percentage increases or decreases from this base period amount as follows.

For example, we can determine that net sales for Dubois increased from 2015 to 2016 approximately 6% [(€ 19,903 − € 18,781) ÷ € 18,781]. Similarly, we can determine that net sales increased from 2015 to 2017 approximately 5.7% [(19,860 − € 18,781) ÷ € 18,781].

Alternatively, we can express current year sales as a percentage of the base period. We do this by dividing the current year amount by the base year amount, as shown below.

Illustration 14-4 presents this analysis for Dubois for a three‐year period using 2015 as the base period.

Statement of Financial Position

To further illustrate horizontal analysis, we will use the financial statements of Quality Department Store, a fictional retailer. Illustration 14-5 presents a horizontal analysis of its two‐year condensed statements of financial position, showing euro and percentage changes.

The comparative statements of financial position in Illustration show that a number of significant changes have occurred in Quality Department Store’s financial structure from 2016 to 2017:

• In the assets section, plant assets (net) increased €167,500, or 26.5%.
• In the equity section, retained earnings increased €202,600, or 38.6%.
• In the liabilities section, current liabilities increased €41,500, or 13.7%.

These changes suggest that the company expanded its asset base during 2017 and financed this expansion primarily by retaining income rather than assuming additional long‐term debt.

Income Statement

Illustration 14-6 presents a horizontal analysis of the two‐year condensed income statements of Quality Department Store for the years 2017 and 2016. Horizontal analysis of the income statements shows the following changes:

• Net sales increased €260,000, or 14.2% €260,000 ÷ €1,837,000).
• Cost of goods sold increased €141,000, or 12.4% (€141,000 ÷ €1,140,000).
• Total operating expenses increased €37,000, or 11.6% (€37,000 ÷ €320,000).

Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorable.

•HELPFUL HINT Note that though the amount column is additive (the total is €55,300), the percentage column is not additive (26.5% is not the column total). A separate percentage has been calculated for each item.

Retained Earnings Statement

Illustration 14-7 presents a horizontal analysis of Quality Department Store’s comparative retained earnings statements. Analyzed horizontally, net income increased €55,300, or 26.5%, whereas dividends on the share capital—ordinary increased only €1,200, or 2%. We saw in the horizontal analysis of the statement of financial position that ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities.

Horizontal analysis of changes from period to period is relatively straightforward and is quite useful. But, complications can occur in making the computations. If an item has no value in a base year or preceding year but does have a value in the next year, we cannot compute a percentage change. Similarly, if a negative amount appears in the base or preceding period and a positive amount exists the following year (or vice versa), no percentage change can be computed.

> DO IT!

Horizontal Analysis

Summary financial information for Rosepatch NV is as follows.

Compute the amount and percentage changes in 2017 using horizontal analysis, assuming 2016 is the base year.

Action Plan

✓ Find the percentage change by dividing the amount of the increase by the 2016 amount (base year).

Solution

Related exercise material: BE14-2, BE14-3, BE14-6, BE14-7, E14-1, E14-3, E14-4, and DO IT! 14-1.

The Navigator

Vertical Analysis

Learning Objective 4

Describe and apply vertical analysis.

Vertical analysis also called common‐size analysis, is a technique that expresses each financial statement item as a percentage of a base amount. On a statement of financial position, we might say that current assets are 22% of total assets—total assets being the base amount. Or on an income statement, we might say that selling expenses are 16% of net sales—net sales being the base amount.

Statement of Financial Position

Illustration 14-8 presents the vertical analysis of Quality Department Store’s comparative statements of financial position. The base for the asset items is total assets. The base for the equity and liability items is total equity and liabilities.

Vertical analysis shows the relative size of each category in the statement of financial position. It also can show the percentage change in the individual asset, liability, and equity items. For example, we can see that current assets decreased from 59.2% of total assets in 2016 to 55.6% in 2017 (even though the absolute euro amount increased €75,000 in that time). Plant assets (net) have increased from 39.7% to 43.6% of total assets. Retained earnings have increased from 32.9% to 39.7% of total equity and liabilities. These results reinforce the earlier observations that Quality Department Store is choosing to finance its growth through retention of earnings rather than through issuing additional debt.

Income Statement

Illustration 14-8 shows vertical analysis of Quality Department Store’s income statements. Cost of goods sold as a percentage of net sales declined 1% (62.1% vs. 61.1%), and total operating expenses declined 0.4% (17.4% vs. 17.0%). As a result, it is not surprising to see net income as a percentage of net sales increase from 11.4% to 12.6%. Quality Department Store appears to be a profitable business that is becoming even more successful.

•HELPFUL HINT The formula for calculating these statement of financial position percentages is: Each item / Total assets = %

•HELPFUL HINT The formula for calculating these income statement percentages is: Each item on I/S / Net sales = %

An associated benefit of vertical analysis is that it enables you to compare companies of different sizes. For example, Quality Department Store’s main competitor is a Park Street store in a nearby town. Using vertical analysis, we can compare the condensed income statements of Quality Department Store (a small retail company) with Park Street (a giant global retailer), as shown in Illustration 14-10 (page 718).

Park Street’s net sales are 8,372 times greater than the net sales of relatively tiny Quality Department Store. But vertical analysis eliminates this difference in size. The percentages show that Quality’s and Park Street’s gross profit rates were comparable at 38.9% and 39.4%. However, the percentages related to income from operations were significantly different at 21.9% and 3.8%. This disparity can be attributed to Quality’s selling and administrative expense percentage (17%), which is much lower than Park Street’s (35.6%). Although Park Street earned net income more than 951 times larger than Quality’s, Park Street’s net income as a percentage of each sales euro (1.4%) is only 11% of Quality’s (12.6%).

Ratio Analysis

Learning Objective 5

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

Ratio analysis expresses the relationship between selected financial statement data. expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. The relationship is expressed in terms of either a percentage, a rate, or a simple proportion. To illustrate, in 2013, Marks and Spencer plc (M&S) had current assets of £1,267.9 million and current liabilities of £2,238.3 million. We can find the relationship between these two measures by dividing current assets by current liabilities. The alternative means of expression are:

To analyze the primary financial statements, we can use ratios to evaluate liquidity, profitability, and solvency. Illustration 14-11 describes these classifications.

Ratios can provide clues to underlying conditions that may not be apparent from individual financial statement components. However, a single ratio by itself is not very meaningful. Thus, in the discussion of ratios we will use the following types of comparisons.

1. Intracompany comparisons for two years for Quality Department Store.
2. Industry average comparisonsbased on median ratios for department stores.
3. Intercompany comparisons based on Park Street as Quality Department Store’s principal competitor.

Sometimes, relationships between numbers can be used by companies to detect fraud. The numeric relationships that can reveal fraud can be such things as financial ratios that appear abnormal, or statistical abnormalities in the numbers themselves. For example, the fact that WorldCom’s (USA) line costs, as a percentage of either total expenses or revenues, differed very significantly from its competitors should have alerted people to the possibility of fraud. Or, consider the case of a bank manager, who cooperated with a group of his friends to defraud the bank’s credit card department. The manager’s friends would apply for credit cards and then run up balances of slightly less than $5,000. The bank had a policy of allowing bank personnel to write off balances of less than $5,000 without seeking supervisor approval. The fraud was detected by applying statistical analysis based on Benford’s Law. Benford’s Law states that in a random collection of numbers, the frequency of lower digits (e.g., 1, 2, or 3) should be much higher than higher digits (e.g., 7, 8, or 9). In this case, bank auditors analyzed the first two digits of amounts written off. There was a spike at 48 and 49, which was not consistent with what would be expected if the numbers were random.

THE MISSING CONTROL

Independent internal verification. While it might be efficient to allow employees to write off accounts below a certain level, it is important that these write‐offs be reviewed and verified periodically. Such a review would likely call attention to an employee with large amounts of write‐offs, or in this case, write‐offs that were frequently very close to the approval threshold.

Source: Mark J. Nigrini, “I’ve Got Your Number,” Journal of Accountancy Online (May 1999).

Liquidity Ratios

Liquidity ratios measure the short‐term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short‐term creditors such as bankers and suppliers are particularly interested in assessing liquidity. The ratios we can use to determine the company’s short‐term debt‐paying ability are the current ratio, the acid‐test ratio, accounts receivable turnover, and inventory turnover.

1. CURRENT RATIO

The current ratio is a widely used measure for evaluating a company’s liquidity and short‐term debt‐paying ability. The ratio is computed by dividing current assets by current liabilities. Illustration 14-12 shows the 2017 and 2016 current ratios for Quality Department Store and comparative data.

What does the ratio actually mean? The 2017 ratio of 2.96:1 means that for every euro of current liabilities, Quality has €2.96 of current assets. Quality’s current ratio has decreased in the current year. But, compared to the industry average of 1.70:1, Quality appears to be very liquid. Park Street has a current ratio of 2.05:1, which indicates it has adequate current assets relative to its current liabilities.

•HELPFUL HINT Any company can operate successfully without working capital if it has very predictable cash flows and solid earnings. A number of U.S. companies (e.g., Whirlpool, American Standard, and Soup) are pursuing this goal as less money tied up in working capital means more money to invest in the business.

The current ratio is sometimes referred to as the working capital ratio. Working capital is current assets minus current liabilities. The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have significantly different current ratios.

The current ratio is only one measure of liquidity. It does not take into account the composition of the current assets. For example, a satisfactory current ratio does not disclose the fact that a portion of the current assets may be tied up in slow‐moving inventory. A euro of cash would be more readily available to pay the bills than a euro of slow‐moving inventory.

Investor Insight

How to Manage the Current Ratio

The apparent simplicity of the current ratio can have real‐world limitations because adding equal amounts to both the numerator and the denominator causes the ratio to decrease.

Assume, for example, that a company has $2,000,000 of current assets and $1,000,000 of current liabilities; its current ratio is 2:1. If it purchases $1,000,000 of inventory on account, it will have $3,000,000 of current assets and $2,000,000 of current liabilities; its current ratio decreases to 1.5:1. If, instead, the company pays off $500,000 of its current liabilities, it will have $1,500,000 of current assets and $500,000 of current liabilities; its current ratio increases to 3:1. Thus, any trend analysis should be done with care because the ratio is susceptible to quick changes and is easily influenced by management.

Q How might management influence a company’s current ratio?(See page 759.)

2. ACID‐TEST RATIO

The acid-test (quick) ratio is a measure of a company’s immediate short‐term liquidity. We compute this ratio by dividing the sum of cash, short‐term investments, and net accounts receivable by current liabilities. Thus, it is an important complement to the current ratio. For example, assume that the current assets of Quality Department Store for 2017 and 2016 consist of the items shown in Illustration 14-13.

Cash, short‐term investments, and accounts receivable (net) are highly liquid compared to inventory and prepaid expenses. The inventory may not be readily saleable, and the prepaid expenses may not be transferable to others. Thus, the acid‐test ratio measures immediate liquidity. The 2017 and 2016 acid‐test ratios for Quality Department Store and comparative data are as follows.

The ratio has declined in 2017. Is an acid‐test ratio of 1.02:1 adequate? This depends on the industry and the economy. When compared with the industry average of 0.70:1 and Park Street’s of 1.05:1, Quality’s acid‐test ratio seems adequate.

3. ACCOUNTS RECEIVABLE TURNOVER

We can measure liquidity by how quickly a company can convert certain assets to cash. How liquid, for example, are the accounts receivable? The ratio used to assess the liquidity of the receivables is the accounts receivable turnover.It measures the number of times, on average, the company collects receivables during the period. We compute the accounts receivable turnover by dividing net credit sales (net sales less cash sales) by the average net accounts receivable. Unless seasonal factors are significant, average net accounts receivable can be computed from the beginning and ending balances of the net accounts receivable¹.

Assume that all sales are credit sales. The balance of net accounts receivable at the beginning of 2016 is €200,000. Illustration 14-15 shows the accounts receivable turnover for Quality Department Store and comparative data. Quality’s accounts receivable turnover improved in 2017. The turnover of 10.2 times is substantially lower than Park Street’s 37.2 times, and is also lower than the department store industry’s average of 46.4 times.

AVERAGE COLLECTION PERIOD A popular variant of the accounts receivable turnover is to convert it to an average collection period in terms of days. To do so, we divide the accounts receivable turnover into 365 days. For example, the accounts receivable turnover of 10.2 times divided into 365 days gives an average collection period of approximately 36 days. This means that accounts receivable are collected on average every 36 days, or about every 5 weeks. Analysts frequently use the average collection period to assess the effectiveness of a company’s credit and collection policies. The general rule is that the collection period should not greatly exceed the credit term period (the time allowed for payment).

4. INVENTORY TURNOVER

Inventory turnover measures the number of times, on average, the inventory is sold during the period. Its purpose is to measure the liquidity of the inventory. We compute the inventory turnover by dividing cost of goods sold by the average inventory. Unless seasonal factors are significant, we can use the beginning and ending inventory balances to compute average inventory.

Assuming that the inventory balance for Quality Department Store at the beginning of 2016 was €450,000, its inventory turnover and comparative data are as shown in Illustration 14-16 Quality’s inventory turnover declined slightly in 2017. The turnover of 2.3 times is low compared with the industry average of 4.3 and Park Street’s 3.1. Generally, the faster the inventory turnover, the less cash a company has tied up in inventory and the less chance a company has of inventory obsolescence.

DAYS IN INVENTORY A variant of inventory turnover is the days in inventory. We calculate it by dividing the inventory turnover into 365. For example, Quality’s 2017 inventory turnover of 2.3 times divided into 365 is approximately 159 days. An average selling time of 159 days is also high compared with the industry average of 84.9 days (365 ÷ 4.3) and Park Street’s 117.7 days (365 ÷ 3.1).

Inventory turnovers vary considerably among industries. For example, grocery store chains have a turnover of 17.1 times and an average selling period of 21 days. In contrast, jewelry stores have an average turnover of 0.80 times and an average selling period of 456 days.

Profitability Ratios

Profitability ratios measure the income or operating success of a company for a given period of time. Income, or the lack of it, affects the company’s ability to obtain debt and equity financing. It also affects the company’s liquidity position and the company’s ability to grow. As a consequence, both creditors and investors are interested in evaluating earning power—profitability. Analysts frequently use profitability as the ultimate test of management’s operating effectiveness.

5. PROFIT MARGIN

Profit margin is a measure of the percentage of each euro of sales that results in net income. We can compute it by dividing net income by net sales. Illustration 14-17 shows Quality Department Store’s profit margin and comparative data.

•Alternative Terminology Profit margin is also called the rate of return on sales.

Quality experienced an increase in its profit margin from 2016 to 2017. Its profit margin is unusually high in comparison with the industry average of 8% and Park Street’s 1.4%.

High‐volume (high inventory turnover) businesses, such as grocery stores and discount stores, generally experience low profit margins. In contrast, low‐volume businesses, such as jewelry stores or airplane manufacturers, have high profit margins.

6. ASSET TURNOVER

Asset turnover measures how efficiently a company uses its assets to generate sales. It is determined by dividing net sales by average total assets. The resulting number shows the euros of sales produced by each euro invested in assets. Unless seasonal factors are significant, we can use the beginning and ending balance of total assets to determine average total assets. Assuming that total assets at the beginning of 2016 were €1,446,000, the 2017 and 2016 asset turnover for Quality Department Store and comparative data are shown in Illustration 14-18 (page 724).

Asset turnover shows that in 2017 Quality generated sales of approximately €1.20 for each euro it had invested in assets. The ratio changed very little from 2016 to 2017. Quality’s asset turnover is below both the industry average of 1.4 times and Park Street’s ratio of 1.4 times.

Asset turnovers vary considerably among industries. For example, a large utility company might have a ratio of 0.4 times, and a large grocery chain might have a ratio of 3.4 times.

7. RETURN ON ASSETS

An overall measure of profitability is return on assets. We compute this ratio by dividing net income by average total assets. The 2017 and 2016 return on assets for Quality Department Store and comparative data are shown below.

Quality’s return on assets improved from 2016 to 2017. Its return of 15.4% is very high compared with the department store industry average of 8.9% and Park Street’s 2.4%.

8. RETURN ON ORDINARY SHAREHOLDERS’ EQUITY

Another widely used profitability ratio is return on ordinary shareholders’ equity. It measures profitability from the ordinary shareholders’ viewpoint. This ratio shows how many euros of net income the company earned for each euro invested by the owners. We compute it by dividing net income available to ordinary shareholders by average ordinary shareholders’ equity. When a company has preference shares, we must deduct preference dividend requirements from net income to compute income available to ordinary shareholders. Similarly, we deduct the par value of preference shares (or call price, if applicable) from total equity to determine the amount of ordinary shareholders’ equity used in this ratio. Assuming that ordinary shareholders’ equity at the beginning of 2016 was €667,000, Illustration 14-20 shows the 2017 and 2016 ratios for Quality Department Store and comparative data.

Quality’s rate of return on ordinary shareholders’ equity is high at 29.3%, considering an industry average of 18.3% and a rate of 6.4% for Park Street.

Note also that Quality’s rate of return on ordinary shareholders’ equity (29.3%) is substantially higher than its rate of return on assets (15.4%). The reason is that Quality has made effective use of leverage. Leveraging or trading on the equity at a gain means that the company has borrowed money at a lower rate of interest than it is able to earn by using the borrowed money. Leverage enables Quality Department Store to use money supplied by non‐owners to increase the return to the owners. A comparison of the rate of return on total assets with the rate of interest paid for borrowed money indicates the profitability of trading on the equity. Quality Department Store earns more on its borrowed funds than it has to pay in the form of interest. Thus, the return to shareholders exceeds the return on the assets, due to benefits from the positive leveraging.

9. EARNINGS PER SHARE (EPS)

Earnings per share (EPS) is a measure of the net income earned on each ordinary share. It is computed by dividing net income available to ordinary shareholders by the number of weighted‐average ordinary shares outstanding during the year. A measure of net income earned on a per share basis provides a useful perspective for determining profitability. Assuming that there is no change in the number of outstanding shares during 2016 and that the 2017 increase occurred midyear, Illustration 14-21 shows the net income per share for Quality Department Store for 2017 and 2016.

Note that no industry or specific competitive data are presented. Such comparisons are not meaningful because of the wide variations in the number of shares outstanding among companies. The only meaningful EPS comparison is an intracompany trend comparison. Here, Quality’s earnings per share increased 20 cents per share in 2017. This represents a 26% increase over the 2016 earnings per share of 77 cents.

The terms “earnings per share” and “net income per share” refer to the amount of net income applicable to each ordinary share. Therefore, in computing EPS, if there are preference dividends declared for the period, we must deduct them from net income to determine income available to the ordinary shareholders.

10. PRICE‐EARNINGS RATIO

The price-earnings (P-E) ratio is a widely used measure of the ratio of the market price of each ordinary share to the earnings per share. The price‐earnings (P‐E) ratio reflects investors’ assessments of a company’s future earnings. We compute it by dividing the market price per share by earnings per share. Assuming that the market price of Quality Department Store shares is €8 in 2016 and €12 in 2017, the price‐earnings ratio computation is as follows.

In 2017, each Quality Department Store share sold for 12.4 times the amount that the company earned on each share. Quality’s price‐earnings ratio is lower than the industry average of 21.3 times, and also lower than the ratio of 17.2 times for Park Street.

11. PAYOUT RATIO

The payout ratio measures the percentage of earnings distributed in the form of cash dividends. We compute it by dividing cash dividends declared on ordinary shares by net income. Companies that have high growth rates generally have low payout ratios because they reinvest most of their net income into the business. The 2017 and 2016 payout ratios for Quality Department Store are computed as shown in Illustration 14-23.

Quality’s payout ratio is higher than the industry average payout ratio of 16.1%. Park Street’s ratio is very high because its net income in 2017 was quite low.

Solvency Ratios

Solvency ratios measure the ability of a company to survive over a long period of time. Long‐term creditors and shareholders are particularly interested in a company’s ability to pay interest as it comes due and to repay the face value of debt at maturity. Debt to assets and times interest earned are two ratios that provide information about debt‐paying ability.

12. DEBT TO ASSETS RATIO

The debt to assets ratio measures the percentage of the total assets that creditors provide. We compute it by dividing total liabilities (both current and non‐current liabilities) by total assets. This ratio indicates the company’s degree of leverage. It also provides some indication of the company’s ability to withstand losses without impairing the interests of creditors. The higher the percentage of total liabilities to total assets, the greater the risk that the company may be unable to meet its maturing obligations. The 2017 and 2016 ratios for Quality Department Store and comparative data are as follows.

A ratio of 45.3% means that creditors have provided 45.3% of Quality Department Store’s total assets. Quality’s 45.3% is above the industry average of 34.2%. It is considerably below the high 62.0% ratio of Park Street. The lower the ratio, the more equity “buffer” there is available to the creditors. Thus, from the creditors’ point of view, a low ratio of debt to assets is usually desirable.

The adequacy of this ratio is often judged in the light of the company’s earnings. Generally, companies with relatively stable earnings (such as public utilities) have higher debt to assets ratios than cyclical companies with widely fluctuating earnings (such as many high‐tech companies).

13. TIMES INTEREST EARNED

Times interest earned provides an indication of the company’s ability to meet interest payments as they come due. We compute it by dividing the sum of net income, interest expense, and income tax expense by interest expense. Illustration 14-25 (page 728) shows the 2017 and 2016 ratios for Quality Department Store and comparative data. Note that times interest earned uses net income before interest expense and income tax expense. This represents the amount available to cover interest. For Quality Department Store, the 2017 amount of €468,000 is computed by taking net income of €263,800 and adding back the €36,000 of interest expense and the €168,200 of income tax expense.

• Alternative Terminology Times interest earned is also called interest coverage.

Quality’s interest expense is well covered at 13 times. It is less than the industry average of 16.1 times but significantly exceeds Park Street’s 2.9 times.

Summary of Ratios

Illustration 14-26 summarizes the ratios discussed in this chapter. The summary includes the formula and purpose or use of each ratio.

> DO IT!

Ratio Analysis

The condensed financial statements of John Cully Company, for the years ended June 30, 2017 and 2016, are presented below.

Compute the following ratios for 2017 and 2016.

1. Current ratio.
2. Inventory turnover. (Inventory on 6/30/15 was €599.0.)
3. Profit margin.
4. Return on assets. (Assets on 6/30/15 were €3,349.9.)
5. Return on ordinary shareholders’ equity. (Equity on 6/30/15 was €1,795.9.)
6. Debt to assets ratio.
7. Times interest earned.

Action Plan

✓ Remember that the current ratio includes all current assets. The acid‐test ratio uses only cash, short‐term investments, and net accounts receivable.

✓ Use average balances for turnover ratios like inventory, accounts receivable, as well as return on assets.

Solution

Related exercise material: BE14-9, BE14-10, BE14-11, BE14-12, BE14-13, E14-5, E14-6, E14-7, E14-8, E14-9, E14-10, E14-11, and DO IT! 14-2.

The Navigator

Earning Power and Unusual Items

Learning Objective 6

Understand the concept of earning power, and how discontinued operations are presented.

Users of financial statements are interested in the concept of earning power. Earning power means the normal level of income to be obtained in the future. Earning power differs from actual net income by the amount of unusual revenues, expenses, gains, and losses. Users are interested in earning power because it helps them derive an estimate of future earnings without the “noise” of unusual items.

For users of financial statements to determine earning power or regular income, discontinued operations are separately identified on the income statement. Discontinued operations are reported net of income taxes. That is, the income statement first reports income tax on the income before discontinued operations. Then, the amount of tax for discontinued operations is computed. The general concept is “let the tax follow income or loss.”

Discontinued Operations

Discontinued operations refers to the disposal of a significant component of a business, such as the elimination of a major class of customers or an entire activity. For example, to downsize its operations, General Dynamics Corp. (USA) sold its missile business to Hughes Aircraft Co. (USA) for $450 million. In its income statement, General Dynamics reported the sale in a separate section entitled “Discontinued operations.”

Following the disposal of a significant component, the company should report on its income statement both income from continuing operations and income (or loss) from discontinued operations. The income (loss) from discontinued operations consists of two parts: the income (loss) from operations and the gain (loss) on disposal of the component.

To illustrate, assume that during 2017 Acro Energy Ltd. has income before income taxes of NT$800,000. During 2017, Acro discontinued and sold its unprofitable chemical division. The loss in 2017 from chemical operations (net of NT$60,000 taxes) was NT$140,000. The loss on disposal of the chemical division (net of NT$30,000 taxes) was NT$70,000. Assuming a 30% tax rate on income, Illustration 14-27 shows Acro’s income statement presentation.

• HELPFUL HINT Observe the dual disclosures: (1) the results of operations of the discontinued division must be eliminated from the results of continuing operations, and (2) the company must also report the disposal of the operation.

Note that the statement uses the caption “Income from continuing operations” and adds a new section “Discontinued operations.” The new section reports both the operating loss and the loss on disposal net of applicable income taxes. This presentation clearly indicates the separate effects of continuing operations and discontinued operations on net income.

Investor Insight

What Does “Non‐Recurring” Really Mean?

Procter & Gamble Co. (USA)

Many companies incur restructuring charges as they attempt to reduce costs. They often label these items in the income statement as “non‐recurring” charges to suggest that they are isolated events which are unlikely to occur in future periods. The question for analysts is, are these costs really one‐time, “non‐recurring” events, or do they reflect problems that the company will be facing for many periods in the future? If they are one‐time events, they can be largely ignored when trying to predict future earnings.

But some companies report “one‐time” restructuring charges over and over again. For example, toothpaste and other consumer‐goods giant Procter & Gamble Co. (USA) reported a restructuring charge in 12 consecutive quarters. Motorola (USA) had “special” charges in 14 consecutive quarters. On the other hand, other companies have a restructuring charge only once in a five‐ or ten‐year period. There appears to be no substitute for careful analysis of the numbers that comprise net income.

Q If a company takes a large restructuring charge, what is the effect on the company’s current income statement versus future ones? (See page 759.)

Changes in Accounting Principle

For ease of comparison, users of financial statements expect companies to prepare such statements on a basis consistent with the preceding period. A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year. Accounting rules permit a change when management can show that the new principle is preferable to the old principle. An example is a change in inventory costing methods (such as FIFO to average‐cost).

Companies report most changes in accounting principle retroactively. That is, they report both the current period and previous periods using the new principle. As a result the same principle applies in all periods. This treatment improves the ability to compare results across years.

Comprehensive Income

The income statement reports most revenues, expenses, gains, and losses recognized during the period. However, over time, specific exceptions to this general practice have developed. Certain items now bypass income and are reported directly in equity.

Companies do not include in income any unrealized gains and losses on non‐trading securities. Instead, they report such gains and losses in the statement of financial position as adjustments to equity, called accumulated other comprehensive income. Why are these gains and losses on non‐trading securities excluded from net income? Because disclosing them separately (1) reduces the volatility of net income due to fluctuations in fair value, yet (2) informs the financial statement user of the gain or loss that would be incurred if the securities were sold at fair value. Similarly, in Chapter 9 you learned that companies that employ revaluation accounting do not include the revaluation surplus in income. It also is closed out to accumulated other comprehensive income.

Many analysts have expressed concern over the significant increase in the number of items that bypass the income statement. They feel that such reporting has reduced the usefulness of the income statement. To address this concern, in addition to reporting net income, a company must also report comprehensive income. Comprehensive income is therefore the sum of net income plus other comprehensive income items. In other words, it includes all changes in equity during a period except those resulting from investments by shareholders and distributions to shareholders.

To illustrate, assume Stassi AG has ordinary shares of €3,000,000, retained earnings of €1,500,000, and accumulated other comprehensive loss of €2,000. Illustration 14-28 shows the statement of financial position presentation of the unrealized loss.

Note that the presentation of the accumulated other comprehensive loss is similar to the presentation of the cost of treasury shares in the equity section. (An unrealized gain would be added in this section of the statement of financial position.) Reporting the unrealized gain or loss in the equity section serves two important purposes: (1) it reduces the volatility of net income due to fluctuations in fair value, and (2) it informs the financial statement user of the gain or loss that would occur if the company sold the securities at fair value.

COMPLETE STATEMENT OF COMPREHENSIVE INCOME

In earlier chapters, we presented other comprehensive income items in a separate comprehensive income statement. Alternatively, companies can present other comprehensive income items and net income in a combined statement of comprehensive income. The statement of comprehensive income for Pace AG in Illustration 14-29 presents the types of items found on this statement, such as net sales, cost of goods sold, operating expenses, and income taxes. In addition, it shows how companies report discontinued operations and other comprehensive income (highlighted in red).

> DO IT!

Unusual Items

In its proposed 2017 income statement, AIR plc reports income before income taxes £400,000, loss on operation of discontinued flower division £50,000, and loss on disposal of discontinued flower division £90,000. The income tax rate is 30%. Prepare a correct income statement, beginning with “Income before income taxes.”

Action Plan

✓ Disclose the income tax effect of each component of income, beginning with income from continuing operations.

Solution

Related exercise material: BE14-14, BE14-15, E14-12, E14-13, and DO IT! 14-3.

The Navigator

Quality of Earnings

Learning Objective 7

Understand the concept of quality of earnings.

In evaluating the financial performance of a company, the quality of a company’s earnings is of extreme importance to analysts. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements.

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

Alternative Accounting Methods

Variations among companies in the application of IFRS may hamper comparability and reduce quality of earnings. For example, one company may use the average‐cost method of inventory costing, while another company in the same industry may use FIFO. If inventory is a significant asset to both companies, it is unlikely that their current ratios are comparable.

In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization. Although these differences in accounting methods might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is often difficult, if not impossible.

Pro Forma Income

Companies whose shares are publicly traded are required to present their income statement following IFRS. Some companies also report a second measure of income, called pro forma income. Pro forma income usually excludes items that the company thinks are unusual or non‐recurring.

To compute pro forma income, companies generally can exclude any items they deem inappropriate for measuring their performance. Many analysts and investors are critical of the practice of using pro forma income because these numbers often make companies look better than they really are. As the financial press noted, pro forma numbers might be called EBBS, which stands for “earnings before bad stuff.” Companies, on the other hand, argue that pro forma numbers more clearly indicate sustainable income because they exclude unusual and non‐recurring expenses.

Accounting regulators have provided guidance on how companies should present pro forma information. Stay tuned: Everyone seems to agree that pro forma numbers can be useful if they provide insights into determining a company’s sustainable income. However, many companies have abused the flexibility that pro forma numbers allow and have used the measure as a way to put their companies in a good light.

Improper Recognition

Because some managers have felt pressure from some analysts to continually increase earnings, they have manipulated the earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue. One practice that companies are using is channel stuffing: Offering deep discounts on their products to customers, companies encourage their customers to buy early (stuff the channel) rather than later. This lets the company report good earnings in the current period, but it often leads to a disaster in subsequent periods because customers have no need for additional goods. To illustrate, Bristol‐Myers Squibb (USA) at one time indicated that it used sales incentives to encourage wholesalers to buy more drugs than needed to meet patients’ demands. As a result, the company had to issue revised financial statements showing corrected revenues and income.

Another practice is the improper capitalization of operating expenses. The classic case is WorldCom (USA). It capitalized over $7 billion of operating expenses so that it would report positive net income. In other situations, companies fail to report all their liabilities. Enron (USA) had promised to make payments on certain contracts if financial difficulty developed, but these guarantees were not reported as liabilities. In addition, disclosure was so lacking in transparency that it was impossible to understand what was happening at the company.

> DO IT!

Quality of Earnings, Financial Statement Analysis

Match each of the following terms with the phrase that best describes it.

1. —Measures the ability of the company to survive over a long period of time.
2. —Usually excludes items that a company thinks are unusual or non‐recurring.
3. —Includes all changes in equity during a period except those resulting from investments by shareholders and distributions to shareholders.
4. — Indicates the level of full and transparent information provided to users of the financial statements.
5. — The disposal of a significant component of the business.
6. — Expresses each item within a financial statement as a percentage of a base amount.

Action Plan

✓ Develop a sound understanding of basic methods used for financial reporting.

✓ Understand the use of fundamental analysis techniques.

Solution

1. Solvency ratio: Measures the ability of the company to survive over a long period of time.
2. Pro forma income: Usually excludes items that a company thinks are unusual or non‐recurring.
3. Comprehensive income: Includes all changes in equity during a period except those resulting from investments by shareholders and distributions to shareholders.
4. Quality of earnings: Indicates the level of full and transparent information provided to users of the financial statements.
5. Discontinued operations: The disposal of a significant component of the business.
6. Vertical analysis: Expresses each item within a financial statement as a percentage of a base amount.

Related exercise material: DO IT! 14-4.

The Navigator

 GLOSSARY REVIEW

Accounts receivable turnover

A measure of the liquidity of accounts receivable; computed by dividing net credit sales by average net accounts receivable. (p. 721).

Acid-test (quick) ratio

A measure of a company’s immediate short-term liquidity; computed by dividing the sum of cash, short-term investments, and net accounts receivable by current liabilities. (p. 721).

Asset turnover

A measure of how efficiently a company uses its assets to generate sales; computed by dividing net sales by average total assets. (p. 723).

Change in accounting principle

The use of a principle in the current year that is different from the one used in the preceding year. (p. 732).

Comprehensive income

The sum of net income plus other comprehensive income items; it therefore includes all changes in equity during a period except those resulting from investments by shareholders and distributions to shareholders. (p. 732).

Current ratio

A measure used to evaluate a company’s liquidity and short-term debt-paying ability; computed by dividing current assets by current liabilities. (p. 720).

Debt to assets ratio

Measures the percentage of assets provided by creditors; computed by dividing total liabilities by total assets. (p. 727).

Discontinued operations

The disposal of a significant component of a business. (p. 731).

Earnings per share (EPS)

The net income earned on each ordinary share; computed by dividing net income minus preference dividends (if any) by the number of weighted-average ordinary shares outstanding. (p. 725).

Horizontal analysis

A technique for evaluating a series of financial statement data over a period of time, to determine the increase (decrease) that has taken place, expressed as either an amount or a percentage. (p. 713).

Inventory turnover

A measure of the liquidity of inventory; computed by dividing cost of goods sold by average inventory. (p. 722).

Leveraging

See Trading on the equity. (p. 725).

Liquidity ratios

Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. (p. 719).

Payout ratio

Measures the percentage of earnings distributed in the form of cash dividends; computed by dividing cash dividends declared on ordinary shares by net income. (p. 726).

Price-earnings (P-E) ratio

Measures the ratio of the market price of each ordinary share to the earnings per share; computed by dividing the market price per share by earnings per share. (p. 726).

Profitability ratios

Measures of the income or operating success of a company for a given period of time. (p. 723).

Profit margin

Measures the percentage of each currency unit of sales that results in net income; computed by dividing net income by net sales. (p. 723).

Pro forma income

A measure of income that usually excludes items that a company thinks are unusual or non-recurring. (p. 735).

Quality of earnings

Indicates the level of full and transparent information provided to users of the financial statements. (p. 734).

Ratio

An expression of the mathematical relationship between one quantity and another. The relationship may be expressed either as a percentage, a rate, or a simple proportion. (p. 718).

Ratio analysis

A technique for evaluating financial statements that expresses the relationship between selected financial statement data. (p. 718).

Return on assets

An overall measure of profitability; computed by dividing net income by average total assets. (p. 724).

Return on ordinary shareholders’ equity

Measures the currency units of net income earned for each currency unit invested by the owners; computed by dividing net income minus preference dividends (if any) by average ordinary shareholders’ equity. (p. 724).

Solvency ratios

Measures of the ability of the company to survive over a long period of time. (p. 727).

Times interest earned

Measures a company’s ability to meet interest payments as they come due; computed by dividing the sum of net income, interest expense, and income tax expense by interest expense. (p. 727).

Trading on the equity

Borrowing money at a lower rate of interest than can be earned by using the borrowed money. (p. 725).

Vertical analysis

A technique for evaluating financial statement data that expresses each item within a financial statement as a percentage of a base amount. (p. 716).

PRACTICE MULTIPLE-CHOICE QUESTIONS

(LO 1)

1. Comparisons of data within a company are an example of the following comparative basis:

   1. Industry averages

   2. Intracompany.

   3. Intercompany.

   4. Both (b) and (c).

(LO 3)

2. In horizontal analysis, each item is expressed as a percentage of the:

   1. net income amount.

   2. equity amount.

   3. total assets amount.

   4. base year amount.

(LO 3)

3. Sammy plc reported net sales of £300,000, £330,000, and £360,000 in the years, 2015, 2016, and 2017, respectively. If 2015 is the base year, what is the trend percentage for 2017?

   1. 77%.

   2. 108%.

   3. 120%.

   4. 130%.

(LO 4)

4. The following schedule is a display of what type of analysis?

   	Amount	Percent
   Property, plant, and equipment	€600,000	75%
   Current assets	200,000	25%
   Total assets	€800,000

   1. Horizontal analysis.

   2. Differential analysis.

   3. Vertical analysis.

   4. Ratio analysis.

(LO 4)

5. In vertical analysis, the base amount for depreciation expense is generally:

   1. net sales.

   2. depreciation expense in a previous year.

   3. gross profit.

   4. fixed assets.

(LO 5)

6. Which of the following measures is an evaluation of a firm’s ability to pay current liabilities?

   1. Acid-test ratio.

   2. Current ratio.

   3. Both (a) and (b).

   4. None of the above.

(LO 5)

7. A measure useful in evaluating the efficiency in managing inventories is:

   1. inventory turnover.

   2. days in inventory.

   3. Both (a) and (b).

   4. None of the above.

      	2017	2016
      Inventory	£ 54,000	£ 48,000
      Current assets	81,000	106,000
      Total assets	382,000	326,000
      Current liabilities	27,000	36,000
      Total liabilities	102,000	88,000
      Share capital—preference	40,000	40,000
      Ordinary shareholders’ equity	240,000	198,000
      Net sales	784,000	697,000
      Cost of goods sold	306,000	277,000
      Net income	134,000	90,000
      Income tax expense	22,000	18,000
      Interest expense	12,000	12,000
      Dividends paid to preference shareholders	4,000	4,000
      Dividends paid to ordinary shareholders	15,000	10,000

(LO 5)

8. Compute the days in inventory for 2017.

   1. 64.4 days.

   2. 60.8 days.

   3. 6 days.

   4. 24 days.

(LO 5)

9. Compute the current ratio for 2017.

   1. 1.26:1.

   2. 3.0:1.

   3. 0.80:1.

   4. 3.75:1.

(LO 5)

10. Compute the profit margin for 2017.

    1. 17.1%.

    2. 18.1%.

    3. 37.9%.

    4. 5.9%.

(LO 5)

11. Compute the return on ordinary shareholders’ equity for 2017.

    1. 47.9%.

    2. 51.7%.

    3. 61.2%.

    4. 59.4%.

(LO 5)

12. Compute the times interest earned for 2017.

    1. 11.2 times.

    2. 65.3 times.

    3. 14.0 times.

    4. 13.0 times.

(LO 6)

13. In reporting discontinued operations, the statement of comprehensive income should show in a special section:

    1. gains and losses on the disposal of the discontinued component.

    2. gains and losses from operations of the discontinued component.

    3. Both (a) and (b).

    4. None of the above.

(LO 6)

14. Scout Ltd. has income before taxes of £400,000, loss on operation of a discontinued division of £40,000, and a £60,000 loss on disposal of a division. If the income tax rate is 25% on all items, the statement of comprehensive income should show income from continuing operations and discontinued operations, respectively, of:

    1. £400,000 and £100,000.

    2. £400,000 and £75,000.

    3. £300,000 and £100,000.

    4. £300,000 and £75,000.

(LO 7)

15. Which situation below might indicate a company has a low quality of earnings?

    1. The same accounting principles are used each year.

    2. Revenue is recognized when goods are provided or services are performed.

    3. Maintenance costs are expensed as incurred.

    4. The company is continually reporting pro forma income numbers.

Solutions

1. (b) Comparisons of data within a company are called intracompany comparisons, not (a) industry averages, (c) intercompany comparisons, or (d) both intracompany and intercompany comparisons. Intercompany comparisons are among companies.
2. (d) Horizontal analysis converts each succeeding year’s balance to a percentage of the base year amount, not (a) net income amount, (b) equity amount, or (c) total assets amount.
3. (c) The trend percentage for 2017 is 120% (£360,000/£300,000), not (a) 77%, (b) 108%, or (d) 130%.
4. (c) The data in the schedule is a display of vertical analysis because the individual asset items are expressed as a percentage of total assets. The other choices are therefore incorrect. Horizontal analysis is a technique for evaluating a series of data over a period of time.
5. (a) In vertical analysis, net sales is used as the base amount for income statement items, not (b) depreciation expense in a previous year, (c) gross profit, or (d) fixed assets.
6. (c) Both the acid‐test ratio and the current ratio measure a firm’s ability to pay current liabilities. Choices (a) and (b) are correct but (c) is the better answer. Choice (d) is incorrect because there is a correct answer.
7. (c) Both inventory turnover and days in inventory measure a firm’s efficiency in managing inventories. Choices (a) and (b) are correct but (c) is the better answer. Choice (d) is incorrect because there is a correct answer.
8. (b) Inventory turnover = Cost of goods sold/Average inventory [£306,000/(£54,000 + £48,000/2)] = 6 times. Thus, days in inventory = 60.8 (365/6), not (a) 64.4, (c) 6, or (d) 24 days.
9. (b) Current ratio = Current assets/Current liabilities (£81,000/£27,000) = 3.0 : 1, not (a) 1.26:1, (c) 0.80:1, or (d) 3.75:1.
10. (a) Profit margin = Net income/Net sales (£134,000/£784,000) = 7.1%, not (b) 18.1%, (c) 37.9%, or (d) 5.9%.
11. (d) Return on ordinary shareholders’ equity = Net income (£134,000)− Preference dividends (£4,000)/Average ordinary shareholders’ equity [(240,000 + £198,000)/2] = 59.4%, not (a) 47.9%, (b) 51.7%, or (c) 61.2%.
12. (c) Times interest earned = Net income + Interest expense + Income tax expense divided by Interest expense [(£134,000 + 12,000 + £22,000)/£12,000] = 14.0 times, not (a) 11.2, (b) 65.3, or (d) 13.0 times.
13. (c) Gains and losses on the disposal of the discontinued component and gains and losses from operations of the discontinued component are shown in the special section titled discontinued operations. Other comprehensive income items are reported in a separate section after net income on the statement of comprehensive income. Choices (a) and (b) are therefore correct but (c) is the better answer. Choice (d) is incorrect as there is a correct answer.
14. (d) Income tax expense = 25% × £400,000 = £100,000; therefore, income from continuing operations = £400,000 − £ 100,000 = £300,000. The loss on discontinued operations is shown net of tax, (£60,000 + £ 40,000) × 75% = £75,000. The other choices are therefore incorrect.
15. (d) By continually reporting pro forma income numbers, the company appears to be interested in diverting attention away from IFRS‐based results. Choices (a), (b), and (c) all describe situations where the company is reporting as required by IFRS.

PRACTICE EXERCISES

Prepare horizontal and vertical analysis.

(LO 3, 4)

1. The comparative condensed statements of financial position of Roadway Ltd. are presented below.

Instructions

1. Prepare a horizontal analysis of the statement of financial position data for Roadway Ltd. using 2016 as a base.
2. Prepare a vertical analysis of the statement of financial position data for Roadway Ltd. in columnar form for 2017.

Solution

Compute ratios.

(LO 5)

2. Rondo plc’s comparative statements of financial position are presented below.

Rondo’s 2017 income statement included net sales of £120,000, cost of goods sold of £70,000, and net income of £14,000.

Instructions

Compute the following ratios for 2017.

1. Current ratio.

2. Acid-test ratio.

3. Accounts receivable turnover.

4. Inventory turnover.

5. Profit margin.

6. Asset turnover.

7. Return on assets.

8. Return on ordinary shareholders’ equity.

9. Debt to assets ratio.

Solution

1. (a) (£5,300 + £21,200 + £ 9,000)/£10,370 = 3.42

2. (b) (£5,300 + £21,200)/£10,370 = 2.56

3. (c) £120,000/[(£21,200 + £23,400)/2] = 5.38

4. (d) £70,000/[(£9,000 + £7,000)/2] = 8.8

5. (e) £14,000/£120,000 = 11.7%

6. (f) £120,000/[(£110,500 + £120,100)/2] = 1.04

7. (g) £14,000/[(£110,500 + £120,100)/2] = 12.1%

8. (h) £14,000/[(£100,130 + £89,000)/2] = 14.8%

9. (i) £10,370/£110,500 = 9.4%

PRACTICE PROBLEM

Prepare a statement of comprehensive income.

(LO 6)

The events and transactions of Dever SA for the year ending December 31, 2017, resulted in the following data.

Cost of goods sold	R$2,600,000
Net sales	4,400,000
Other income and expense	(4,000)
Selling and administrative expenses	1,100,000
Income from operations of plastics division	70,000
Gain from disposal of plastics division	500,000
Unrealized loss on non-trading securities	60,000

Analysis reveals that:

1. All items are before the applicable income tax rate of 30%.
2. The plastics division was sold on July 1.
3. All operating data for the plastics division have been segregated.

Instructions

Prepare a statement of comprehensive income for the year.

Solution

WileyPLUS

Brief Exercises, DO IT! Review, Exercises, and Problems, and many additional resources are available for practice in WileyPLUS.

QUESTIONS

1. 1. Kurt Gibson believes that the analysis of financial statements is directed at two characteristics of a company: liquidity and profitability. Is Kurt correct? Explain.
   2. Are short-term creditors, long-term creditors, and shareholders interested primarily in the same characteristics of a company? Explain.
2. 1. Distinguish among the following bases of comparison: (1) intracompany, (2) industry averages, and (3) intercompany.
   2. Give the principal value of using each of the three bases of comparison.
3. Two popular methods of financial statement analysis are horizontal analysis and vertical analysis. Explain the difference between these two methods.
4. 1. If Nimoy SA had net income of €350,000 in 2016 and it experienced a 22.4% increase in net income for 2017, what is its net income for 2017?
   2. If five cents of every euro of Nimoy revenue is net income in 2016, what is the euro amount of 2016 revenue?
5. What is a ratio? What are the different ways of expressing the relationship of two amounts? What information does a ratio provide?
6. Name the major ratios useful in assessing (a) liquidity and (b) solvency.
7. Maribel Ortiz is puzzled. Her company had a profitmargin of 10% in 2017. She feels that this is an indication that the company is doing well. Gordon Liddy, her accountant, says that more information is needed to determine the firm’s financial well-being. Who is correct? Why?
8. What do the following classes of ratios measure? (a) Liquidity ratios. (b) Profitability ratios. (c) Solvency ratios.
9. What is the difference between the current ratio and the acid-test ratio?
10. Monte Company, a retail store, has an accounts receivable turnover of 4.5 times. The industry average is 12.5 times. Does Monte have a collection problem with its accounts receivable?

11. Which ratios should be used to help answer the following questions?

    1. How efficient is a company in using its assets to produce sales?
    2. How near to sale is the inventory on hand?
    3. How many dollars of net income were earned for each dollar invested by the owners?
    4. How able is a company to meet interest charges as they fall due?
12. The price-earnings ratio of General Motors (USA) (automobile builder) was 8, and the price-earnings ratio of Microsoft (USA) (computer software) was 38. Which company did the securities market favor? Explain.
13. What is the formula for computing the payout ratio? Would you expect this ratio to be high or low for a growth company?

14. Holding all other factors constant, indicate whether each of the following changes generally signals good or bad news about a company.

    1. Increase in profit margin.
    2. Decrease in inventory turnover.
    3. Increase in the current ratio.
    4. Decrease in earnings per share.
    5. Increase in price-earnings ratio.
    6. Increase in debt to assets ratio.
    7. Decrease in times interest earned.
15. The return on assets for Miller Limited is 7.6%. During the same year, Miller’s return on ordinary shareholders’ equity is 12.8%. What is the explanation for the difference in the two rates?

16. Which two ratios do you think should be of greatest interest to:

    1. A pension fund considering the purchase of 20-year bonds?
    2. A bank contemplating a short-term loan?
    3. An ordinary shareholder?
17. Why must preference dividends be subtracted from net income in computing earnings per share?
18. 1. What is meant by trading on the equity?
    2. How would you determine the profitability of trading on the equity?
19. Tillman SA has net income of R$160,000, weightedaverage ordinary shares outstanding of 50,000, and preference dividends for the period of R$30,000. What is Tillman’s earnings per share? Pat Tillman, the president of Tillman SA, believes the computed EPS of the company is high. Comment.
20. Why is it important to report discontinued operations separately from income from continuing operations?
21. You are considering investing in Cherokee Transportation. The company reports 2017 earnings per share of €6.50 on income from continuing operations and €4.75 on net income. Which EPS figure would you consider more relevant to your investment decision? Why?
22. MRT Ltd. reported 2016 earnings per share of £3.20 and had no discontinued operations. In 2017, EPS on income from continuing operations was £2.99, and EPS on net income was £3.49. Is this a favorable trend?
23. Identify and explain factors that affect quality of earnings.

BRIEF EXERCISES

Follow the rounding procedures used in the chapter.

Discuss need for comparative analysis.

(LO 1)

BE14-1 You recently received a letter from your Uncle Liam. A portion of the letter is presented below.

You know that I have a significant amount of money I saved over the years. I am thinkingabout starting an investment program. I want to do the investing myself, based on my ownresearch and analysis of financial statements. I know that you are studying accounting, soI have a couple of questions for you. I have heard that different users of financial statementsare interested in different characteristics of companies. Is this true, and, if so, why?Also, some of my friends, who are already investing, have told me that comparisons involvinga company’s financial data can be made on a number of different bases. Can youexplain these bases to me?

Instructions

Write a letter to your Uncle Liam which answers his questions.

BE14-2 Maria Fierro SpA reported the following amounts in 2015, 2016, and 2017.

Identify and use tools of financial statement analysis.

(LO 2, 3, 4, 5)

	2015	2016	2017
Current assets	€220,000	€230,000	€240,000
Current liabilities	€160,000	€170,000	€184,000
Total assets	€500,000	€600,000	€630,000

Instructions

(a) Identify and describe the three tools of financial statement analysis. (b) Perform each of the three types of analysis on Maria Fierro’s current assets.

Prepare horizontal analysis.

(LO 3)

BE14-3 Using the following data from the comparative statements of financial position of Dotte NV, illustrate horizontal analysis.

	December 31, 2017	December 31, 2016
Inventory	€ 840,000	€ 500,000
Accounts receivable	€ 520,000	€ 350,000
Total assets	€2,500,000	€3,000,000

Prepare vertical analysis.

(LO 4)

BE14-4 Using the same data presented above in BE14-3 for Dotte NV, illustrate vertical analysis.

Calculate percentage of change.

(LO 3)

BE14-5 Net income was €550,000 in 2015, €500,000 in 2016, and €525,000 in 2017. What is the percentage of change from (a) 2015 to 2016 and (b) 2016 to 2017? Is the change an increase or a decrease?

Calculate net income.

(LO 3)

BE14-6 If Valdamorte plc had net income of £560,000 in 2017 and it experienced a 40% increase in net income over 2016, what was its 2016 net income?

Calculate change in net income.

(LO 3)

BE14-7 Horizontal analysis (trend analysis) percentages for Kemplar Company’s sales revenue, cost of goods sold, and expenses are shown below.

Horizontal Analysis	2017	2016	2015
Sales revenue	97.8	103.3	100.0
Cost of goods sold	103.0	96.0	100.0
Expenses	105.2	99.3	100.0

Did Kemplar’s net income increase, decrease, or remain unchanged over the 3-year period?

Calculate change in net income.

(LO 4)

BE14-8 Vertical analysis (common size) percentages for Dagman Company’s sales revenue, cost of goods sold, and expenses are shown below.

Vertical Analysis	2017	2016	2015
Sales revenue	100.0	100.0	100.0
Cost of goods sold	59.2	62.4	64.5
Expenses	25.0	25.6	27.5

Did Dagman’s net income as a percentage of sales increase, decrease, or remain unchanged over the 3-year period? Provide numerical support for your answer.

Calculate liquidity ratios.

(LO 5)

BE14-9 Selected condensed data taken from a recent statement of financial position of Morino Ltd. are as follows.

What are the (a) working capital, (b) current ratio, and (c) acid-test ratio?

Calculate profitability ratios.

(LO 5)

BE14-10 Huntsinger SE has net income of €12.76 million and net revenue of €88 million in 2017. Its assets are €14 million at the beginning of the year and €18 million at the end of the year. What are Huntsinger’s (a) asset turnover and (b) profit margin?

Evaluate collection of accounts receivable.

(LO 5)

BE14-11 The following data are taken from the financial statements of Gladow Company

	2017	2016
Accounts receivable (net), end of year	€ 550,000	€ 520,000
Net sales on account	3,680,000	3,000,000
Terms for all sales are 1/10, n/60.

(a) Compute for each year (1) the accounts receivable turnover and (2) the average collection period. At the end of 2015, accounts receivable (net) was €480,000.

(b) What conclusions about the management of accounts receivable can be drawn from these data?

Evaluate management of inventory.

(LO 5)

BE14-12 The following data are from the income statements of Charles A.Ş.

	2017	2016
Sales revenue	6,420,000	6,420,000
Beginning inventory	980,000	860,000
Purchases	4,440,000	4,720,000
Ending inventory	1,020,000	980,000

(a) Compute for each year (1) the inventory turnover and (2) the days in inventory.

(b) What conclusions concerning the management of the inventory can be drawn from these data?

(LO 5)

BE14-13 Feng Company has equity of HK$4,000,000 and net income of HK$680,000. It has a payout ratio of 22% and a return on assets of 16%. How much did Feng pay in cash dividends, and what were its average assets?

(LO 6)

BE14-14 An inexperienced accountant for Ming Limited showed the following in the income statement: income before income taxes and discontinued operations £400,000, income from operation of discontinued retail division (before taxes) £10,000, and loss from disposal of discontinued retail division (before taxes) £80,000. The applicable tax rate is 30%. Prepare a correct income statement.

(LO 6)

BE14-15 On June 30, Blevins ASA discontinued its operations in Europe. During the year, the operating loss was €320,000 before taxes. On September 1, Blevins disposed of its European facilities at a pretax loss of €150,000. The applicable tax rate is 30%. Show the discontinued operations section of the income statement.

(LO 6)

BE14-16 An inexperienced accountant for Silva AG showed the following in the income statement: income before income taxes €450,000 and unrealized gain on non-trading securities (before taxes) €70,000. The unrealized gain on non-trading securities and income before income taxes are both subject to a 25% tax rate. Prepare a correct partial statement of comprehensive income, beginning with income before income taxes.

> DO IT!  REVIEW

Prepare horizontal analysis.

(LO 3)

DO IT! 14-1 Summary financial information for Rapture Limited is as follows.

	December 31, 2017	December 31, 2016
Plant assets	£ 821,000	£750,000
Current assets	188,000	225,000
Total assets	£1,009,000	£975,000

Compute the amount and percentage changes in 2017 using horizontal analysis, assuming 2016 is the base year.

Compute ratios.

(LO 5)

DO IT! 14-2 The condensed financial statements of Soule SpA for the years 2016 and 2017 are presented as follows.

Compute the following ratios for 2017 and 2016.

1. Current ratio.

2. Inventory turnover. (Inventory on 12/31/15 was €326.)

3. Profit margin.

4. Return on assets. (Assets on 12/31/15 were €2,100.)

5. Return on ordinary shareholders’ equity. (Equity on 12/31/15 was €960.)

6. Debt to assets ratio.

7. Times interest earned.

Prepare income statement.

(LO 6)

DO IT! 14-3 In its proposed 2017 income statement, Grinders Limited reports income before income taxes £500,000, income taxes £160,000 (not including unusual items), loss on operation of discontinued music division £60,000, and gain on disposal of discontinued music division £50,000, and unrealized loss on non-trading securities of £30,000. The income tax rate is 32%. Prepare a correct partial statement of comprehensive income beginning with income before income taxes.

Match terms relating to quality of earnings and financial statement analysis.

(LO 3, 5, 6, 7)

DO IT! 14-4 Match each of the following terms with the phrase that best describes it.

Quality of earnings	Pro forma income
Current ratio	Discontinued operations
Horizontal analysis	Comprehensive income

1. —A measure used to evaluate a company’s liquidity
2. —Usually excludes items that a company thinks are unusual or non-recurring.
3. —Indicates the level of full and transparent information provided to users of the financial statements.
4. —The disposal of a significant component of a business.
5. —Determines increases or decreases in a series of financial statement data.
6. —Includes all changes in equity during a period except those resulting from investments by shareholders and distributions to shareholders.

EXERCISES

Follow the rounding procedures used in the chapter.

Prepare horizontal analysis.

(LO 3)

E14-1 Financial information for Gallup SA is presented below.

	December 31, 2017	December 31, 2016
Plant assets	€396,000	€320,000
Current assets	128,000	110,000
Share capital—ordinary, €1 par	159,000	115,000
Retained earnings	135,300	150,000
Non-current liabilities	138,700	95,000
Current liabilities	91,000	70,000

Instructions

Prepare a schedule showing a horizontal analysis for 2017 using 2016 as the base year.

Prepare vertical analysis.

(LO 4)

E14-2 Operating data for Conard Limited are presented below.

	2017	2016
Net sales	£750,000	£600,000
Cost of goods sold	480,000	408,000
Selling expenses	105,000	84,000
Administrative expenses	75,000	54,000
Income tax expense	36,000	18,000
Net income	54,000	36,000

Instructions

Prepare a schedule showing a vertical analysis for 2017 and 2016.

Prepare horizontal and vertical analyses.

(LO 3, 4)

E14-3 The comparative condensed statements of financial position of Garcia SLU are presented below.

Instructions

1. Prepare a horizontal analysis of the statement of financial position data for Garcia using 2016 as a base.
2. Prepare a vertical analysis of the statement of financial position data for Garcia in columnar form for 2017.

Prepare horizontal and vertical analyses.

(LO 3, 4)

E14-4 The comparative condensed income statements of Hendi A.Ş. are shown below.

Instructions

1. Prepare a horizontal analysis of the income statement data for Hendi using 2016 as a base. (Show the amounts of increase or decrease.)
2. Prepare a vertical analysis of the income statement data for Hendi in columnar form for both years.

Compute liquidity ratios and compare results.

(LO 5)

E14-5 Nordstrom, Inc. (USA), operates department stores in numerous states. Selected financial statement data for the year ending February 1, 2014, are shown below.

For the year, net sales were $12,166 and cost of goods sold was $7,737 (in millions).

Instructions

1. Compute the four liquidity ratios at the end of the year.
2. Using the data in the chapter, compare Nordstrom’s liquidity with (1) that of Park Street, and (2) the industry averages for department stores.

Perform current and acid-test ratio analysis.

(LO 5)

E14-6 Bennis SA had the following transactions occur involving current assets and current liabilities during February 2017.

Feb.	3	Accounts receivable of R$15,000 are collected.
	7	Equipment is purchased for R$28,000 cash.
	11	Paid R$3,000 for a 3-year insurance policy.
	14	Accounts payable of R$12,000 are paid.
	18	Cash dividends of R$5,000 are declared.

Additional information:

1. As of February 1, 2017, current assets were R$140,000, and current liabilities were R$50,000.
2. As of February 1, 2017, current assets included R$10,000 of inventory and R$5,000 of prepaid expenses.

Instructions

1. Compute the current ratio as of the beginning of the month and after each transaction.
2. Compute the acid-test ratio as of the beginning of the month and after each transaction.

Compute selected ratios.

(LO 5)

E14-7 Willingham Company Ltd. has the following comparative statements of financial position data.

Additional information for 2017:

1. Net income was £28,000.
2. Sales on account were £418,000. Sales returns and allowances were £22,000.
3. Cost of goods sold was £190,000.

Instructions

Compute the following ratios at December 31, 2017.

1. Current ratio.
2. Acid-test ratio.
3. Accounts receivable turnover.
4. Inventory turnover.

Compute selected ratios.

(LO 5)

E14-8 Selected comparative statement data for Molini Products Company are presented below. All statement of financial position data are as of December 31.

	2017	2016
Net sales	£700,000	£680,000
Cost of goods sold	480,000	400,000
Interest expense	7,000	5,000
Net income	42,000	34,000
Accounts receivable	120,000	100,000
Inventory	85,000	75,000
Total assets	580,000	540,000
Total ordinary shareholders’ equity	425,000	325,000

Instructions

Compute the following ratios for 2017.

1. Profit margin.
2. Asset turnover.
3. Return on assets.
4. Return on ordinary shareholders’ equity.

Compute selected ratios.

(LO 5)

E14-9 The income statement for Christiansen, A/S, appears below.

Additional information:

1. The weighted-average ordinary shares outstanding in 2017 were 32,000 shares.
2. The market price of Christiansen, A/S was €10.80 per share in 2017.
3. Cash dividends of €20,000 were paid, €5,000 of which were to preference shareholders.

Instructions

Compute the following ratios for 2017.

1. Earnings per share.
2. Price-earnings ratio.
3. Payout ratio.
4. Times interest earned.

Compute amounts from ratios.

(LO 5)

E14-10 Rees Company experienced a fire on December 31, 2017, in which its financial records were partially destroyed. It has been able to salvage some of the records and has ascertained the following balances.

	December 31, 2017	December 31, 2016
Inventory	€200,000	€180,000
Accounts receivable (net)	73,000	126,000
Cash	30,000	10,000
Share capital—ordinary, €100 par	400,000	400,000
Retained earnings	134,000	122,000
Accounts payable	50,000	90,000
Notes payable	30,000	60,000

Additional information:

1. The inventory turnover is 3.4 times.
2. The return on ordinary shareholders’ equity is 25%.
3. The accounts receivable turnover is 8.8 times.
4. The return on assets is 20%.
5. Total assets at December 31, 2016, were €650,000.

Instructions

Compute the following for Rees Company.

1. Cost of goods sold for 2017.
2. Net sales (credit) for 2017.
3. Net income for 2017.
4. Total assets at December 31, 2017.

Compute ratios.

(LO 5)

E14-11 Yadier NV’s comparative statements of financial position are presented below.

Yadier’s 2017 income statement included net sales of €100,000, cost of goods sold of €60,350, and net income of €14,000.

Instructions

Compute the following ratios for 2017.

1. Current ratio.
2. Acid-test ratio.
3. Accounts receivable turnover.
4. Inventory turnover
5. Profit margin.
6. Asset turnover.
7. Return on assets.
8. Return on ordinary shareholders’ equity.
9. Debt to assets ratio.

Prepare a correct income statement

(LO 6)

E14-12 For its fiscal year ending October 31, 2017, Douglas Limited reports the following partial data shown below.

Income before income taxes	£550,000
Income tax expense (30% × £400,000)	120,000
Income before discontinued operations	430,000
Loss on discontinued division	150,000
Net income	£280,000

The loss on discontinued division consists of £60,000 loss from operations of the division and £90,000 loss on disposal of the division. The income tax rate is 30% on all items.

Instructions

1. Prepare a correct income statement, beginning with income before income taxes.

2. Explain in memo form why the income statement data are misleading.

Prepare statement of comprehensive income.

(LO 6)

E14-13 Trayer plc has income from continuing operations of £290,000 for the year ended December 31, 2017. It also has the following items (before considering income taxes).

1. An unrealized loss of £80,000 on non-trading securities.
2. A gain of £30,000 on the discontinuance of a division (comprised of a £10,000 loss from operations and a £40,000 gain on disposal).
3. A correction of an error in last year’s financial statements that resulted in a £20,000 understatement of 2016 income before income taxes.

Assume all items are subject to income taxes at a 20% tax rate.

Instructions

Prepare a statement of comprehensive income, beginning with income from continuing operations.

PROBLEMS

Follow the rounding procedures used in the chapter.

Prepare vertical analysis and comment on profitability.

(LO 4, 5)

P14-1 Comparative statement data for Lionel Company and Barrymore Company, two competitors, appear below. All statement of financial position data are as of December 31, 2017, and December 31, 2016.

Instructions

1. Prepare a vertical analysis of the 2017 income statement data for Lionel Company and Barrymore Company in columnar form.

2. Comment on the relative profitability of the companies by computing the return on assets and the return on ordinary shareholders’ equity for both companies.

Compute ratios from statement of financial position and income statement.

(LO 5)

P14-2 The comparative statements of Larker Tool SA are presented below.

All sales were on account.

Instructions

Compute the following ratios for 2017. (Weighted-average ordinary shares in 2017 were 60,000.)

1. Earnings per share.
2. Return on ordinary shareholders’ equity.
3. Return on assets.
4. Current ratio.
5. Acid-test ratio.
6. Accounts receivable turnover.
7. Inventory turnover.
8. Times interest earned.
9. Asset turnover.
10. Debt to assets ratio.

Perform ratio analysis, and evaluate financial position and operating results.

(LO 5)

P14-3 Condensed statement of financial position and income statement data for Clarence Limited appear below.

Additional information:

1. The market price of Clarence’s ordinary shares was £4.00, £5.00, and £7.00 for 2015, 2016, and 2017, respectively.
2. All dividends were paid in cash.

Instructions

1. Compute the following ratios for 2016 and 2017.
   1. Profit margin.
   2. Asset turnover.
   3. Earnings per share. (Weighted-average ordinary shares in 2017 were 32,000 and in 2016 were 31,000.)
   4. Price-earnings ratio.
   5. Payout ratio.
   6. Debt to assets ratio.

2. Based on the ratios calculated, discuss briefl y the improvement or lack thereof in financial position and operating results from 2016 to 2017 of Clarence Limited.

Compute ratios, and comment on overall liquidity and profitability.

(LO 5)

P14-4 Financial information for Ernie Bishop Company is presented below.

Additional information:

1. Inventory at the beginning of 2015 was €118,000.
2. Total assets at the beginning of 2015 were €632,000.
3. No ordinary share transactions occurred during 2015 or 2016.
4. All sales were on account.
5. Accounts receivable (net) at the beginning of 2015 were €88,000.
6. Notes payable are classified as a current liability.

Instructions

1. Indicate, by using ratios, the change in liquidity and profitability of Ernie Bishop Company from 2015 to 2016. (Note: Not all profitability ratios can be computed.)
2. Given below are three independent situations and a ratio that may be affected. For each situation, compute the affected ratio (1) as of December 31, 2016, and (2) as of December 31, 2017, after giving effect to the situation. Net income for 2017 was €50,000. Total assets on December 31, 2017, were €700,000.

Situation	Ratio
(1) 18,000 ordinary shares were sold at par on July 1, 2017.	Return on ordinary shareholders’ equity
(2) All of the notes payable were paid in 2017. The only change in liabilities was that the notes payable were paid.	Debt to assets ratio
Market price of ordinary shares was €9 on December 31, 2016, and €12.50 on December 31, 2017.	Price-earnings ratio

Compute selected ratios, and compare liquidity, profitability, and solvency for two companies.

(LO 5)

P14-4 Selected financial data of Target (USA) and Wal-Mart Stores, Inc. (USA) for a recent year are presented below (in millions).

Instructions

1. For each company, compute the following ratios.
   1. Current ratio.
   2. Accounts receivable turnover.
   3. Average collection period.
   4. Inventory turnover.
   5. Days in inventory.
   6. Profit margin.
   7. Asset turnover.
   8. Return on assets.
   9. Return on ordinary shareholders’ equity.
   10. Debt to assets ratio.
   11. Times interest earned.
2. Compare the liquidity, profitability, and solvency of the two companies.

Compute numerous ratios.

(LO 5)

P14-6 The comparative statements of Beulah Company Limited are presented below.

Additional data:

The ordinary shares recently sold at £19.50 per share.

Instructions

Compute the following ratios for 2017.

1. Current ratio.
2. Acid-test ratio.
3. Accounts receivable turnover.
4. Inventory turnover.
5. Profit margin.
6. Asset turnover.
7. Return on assets.
8. Return on ordinary shareholders’ equity.
9. Earnings per share.
10. Price-earnings ratio.
11. Payout ratio.
12. Debt to assets ratio.
13. Times interest earned.

Compute missing information given a set of ratios.

(LO 5)

P14-7 Presented below is an incomplete income statement and incomplete comparative statements of financial position of Bondi ASA.

Additional information:

1. The accounts receivable turnover for 2017 is 8 times.
2. All sales are on account.
3. The profit margin for 2017 is 14.5%.
4. Return on assets is 20% for 2017.
5. The current ratio on December 31, 2017, is 2.5.
6. The inventory turnover for 2017 is 4.9 times.

Instructions

Compute the missing information given the ratios above. Show computations. (Note: Start with one ratio and derive as much information as possible from it before trying another ratio. List all missing amounts under the ratio used to find the information.)

Prepare statement of comprehensive income with discontinued operations.

(LO 6)

P14-8 Violet Bick SA owns a number of cruise ships and a chain of hotels. The hotels, which have not been profitable, were discontinued on September 1, 2017. The 2017 operating results for the company were as follows.

Operating revenues	€12,900,000
Operating expenses	8,700,000
Operating income	€ 4,200,000

Analysis discloses that these data include the operating results of the hotel chain, which were operating revenues €2,000,000 and operating expenses €2,500,000. The hotels were sold at a gain of €300,000 before taxes. This gain is not included in the operating results. During the year, the company had an unrealized gain on non-trading securities of €150,000. In 2017, the company had other expense of €200,000, which is not included in the operating results. The corporation is in the 30% income tax bracket.

Instructions

Prepare a condensed statement of comprehensive income.

Prepare statement of comprehensive income.

(LO 6)

P14-9 The ledger of Gower Limited at December 31, 2017, contains the following summary data.

Net sales	£1,580,000	Cost of goods sold	£1,100,000
Selling expenses	70,000	Administrative expenses	90,000
Other income and expense	(6,000)

Your analysis reveals the following additional information that is not included in the above data.

1. The entire puzzles division was discontinued on August 31. The income from operations for this division before income taxes was £15,000. The puzzles division was sold at a loss of £74,000 before income taxes.
2. The company had an unrealized gain on non-trading securities of £120,000 before income taxes for the year.
3. The income tax rate on all items is 30%.

Instructions

Prepare a statement of comprehensive income for the year ended December 31, 2017. Use the format illustrated in the Practice Problem (page 741).

MATCHA CREATIONS

(Note: This is a continuation of the Matcha Creations problem from Chapters 1–13.)

MC14 Mei-ling and Curtis have comparative statements of financial position and income statements for Matcha & Coffee Creations. They have been told that they can use these financial statements to prepare horizontal and vertical analyses, to calculate financial ratios, to analyze how their business is doing, and to make some decisions they have been considering.

Go to the book’s companion website, www.wiley.com/college/weygandt, to see the completion of this problem.

BROADENING YOUR PERSPECTIVE

■ Financial Reporting and Analysis

Financial Reporting Problem: TSMC, Ltd. (TWN)

BYP14-1 Your parents are considering investing in TSMC ordinary shares. They ask you, as an accounting expert, to make an analysis of the company for them. TSMC’s financial statements are presented in Appendix A. The complete annual report, including the notes to the financial statements, is available in the Investors section of the company’s website at www.tsmc.com.

Instructions

(Follow the approach in the chapter for rounding numbers.)

1. Compute for 2013 and 2012 the (1) profit margin, (2) asset turnover, (3) return on assets, and (4) return on ordinary shareholders’ equity. How would you evaluate TSMC’s profitability?
2. Compute for 2013 and 2012 the (1) debt to assets ratio and (2) times interest earned. How would you evaluate TSMC’s long-term solvency?
3. What information outside the annual report may also be useful to your parents in making a decision about TSMC?

Comparative Analysis Problem:
Nestlé SA (CHE) vs. Petra Foods Ltd. (SGP)

BYP14-2 Nestlé’s financial statements are presented in Appendix B. Financial statements for Petra Foods are presented in Appendix C.

Instructions

1. Based on the information contained in these financial statements, determine each of the following for each company for the most recent fiscal year shown.
   1. The percentage increase (decrease) in (i) net sales and (ii) net income.
   2. The percentage increase in (i) total assets and (ii) total ordinary shareholders’ equity.
2. What conclusions concerning the two companies can be drawn from these data?

■Critical Thinking

Decision-Making Across the Organization

BYP14-3 As the chartered public accountant for Bonita Ltd., you have been asked to develop some key ratios from the comparative financial statements. This information is to be used to convince creditors that the company is solvent and will continue as a going concern. The data requested and the computations developed from the financial statements follow

	2017	2016
Current ratio	3.4 times	2.1 times
Acid-test ratio	.8 times	1.3 times
Asset turnover	2.6 times	2.2 times
Net income	Up 32%	Down 9%
Earnings per share	$3.30	$2.50

Instructions

With the class divided into groups, complete the following.

Bonita Ltd. asks you to prepare a list of brief comments stating how each of these items supports the solvency and going-concern potential of the business. The company wishes to use these comments to support its presentation of data to its creditors. You are to prepare the comments as requested, giving the implications and the limitations of each item separately. Then prepare a collective inference that may be drawn from the individual items about Bonita’s solvency and going-concern potential.

Communication Activity

BYP14-4 Kyle Benson is the CEO of McCarty’s Electronics. Benson is an expert engineer but a novice in accounting. He asks you to explain (1) the bases for comparison in analyzing McCarty’s financial statements, and (2) the factors affecting quality of earnings.

Instructions

Write a letter to Kyle Benson that explains the bases for comparison and factors affecting quality of earnings.

Ethics Case

BYP14-5 Robert Turnbull, president of Turnbull Industries, wishes to issue a press release to bolster his company’s image and maybe even its share price, which has been gradually falling. As controller, you have been asked to provide a list of 20 financial ratios along with some other operating statistics relative to Turnbull Industries’ first quarter financials and operations.

Two days after you provide the ratios and data requested, Perry Jarvis, the public relations director of Turnbull, asks you to prove the accuracy of the financial and operating data contained in the press release written by the president and edited by Perry. In the press release, the president highlights the sales increase of 25% over last year’s first quarter and the positive change in the current ratio from 1.5:1 last year to 3:1 this year. He also emphasizes that production was up 50% over the prior year’s first quarter.

You note that the press release contains only positive or improved ratios and none of the negative or deteriorated ratios. For instance, no mention is made that the debt to assets ratio has increased from 35% to 55%, that inventories are up 89%, and that while the current ratio improved, the acid-test ratio fell from 1:1 to .5:1. Nor is there any mention that the reported profit for the quarter would have been a loss had not the estimated lives of Turnbull’s plant and machinery been increased by 30%. Perry emphasizes, “The prez wants this release by early this afternoon.”

Instructions

1. Who are the stakeholders in this situation?
2. Is there anything unethical in president Turnbull’s actions?
3. Should you as controller remain silent? Does Perry have any responsibility?

Answers to Insight and Accounting Across the Organization Questions

p. 720 How to Manage the Current Ratio Q: How might management infl uence a company’s current ratio? A: Management can affect the current ratio by speeding up or withholding payments on accounts payable just before the statement of financial position date. Management can alter the cash balance by increasing or decreasing non-current assets or long-term debt, or by issuing or purchasing ordinary shares.

p. 732 What Does “Non-Recurring” Really Mean? Q: If a company takes a large restructuring charge, what is the effect on the company’s current income statement versus future ones? A: The current period’s net income can be greatly diminished by a large restructuring charge. The net incomes in future periods can be enhanced because they are relieved of costs (e.g., depreciation and labor expenses) that would have been charged to them.

A Look at U.S. GAAP

Learning Objective 8

Compare financial statement analysis and income statement presentation under IFRS and U.S. GAAP.

The tools of financial analysis are the same throughout the world. Techniques such as vertical and horizontal analysis, for example, are tools used by analysts regardless of whether GAAP- or IFRSrelated financial statements are being evaluated. In addition, the ratios provided in the textbook are the same ones that are used globally.

■Key Points

• The tools of financial statement analysis covered in this chapter are universal and therefore no significant differences exist in the analysis methods used.
• The basic objectives of the income statement are the same under both GAAP and IFRS. As indicated in the textbook, a very important objective is to ensure that users of the income statement can evaluate the earning power of the company. Earning power is the normal level of income to be obtained in the future. Thus, both the IASB and the FASB are interested in distinguishing normal levels of income from unusual items in order to better predict a company’s future profitability
• The basic accounting for discontinued operations is the same under GAAP and IFRS.
• The accounting for changes in accounting principles and changes in accounting estimates are the same for both GAAP and IFRS.
• Both IFRS and GAAP follow the same approach in reporting comprehensive income. The statement of comprehensive income can be prepared under the one-statement approach or the twostatement approach.

  Under the one-statement approach, all components of revenue and expense are reported in a statement of income. This combined statement of comprehensive income first computes net income or loss, which is then followed by components of other comprehensive income or loss items to arrive at comprehensive income. An example appears below.

  

  Under the two-statement approach, all the components of revenues and expenses are reported in a traditional income statement except for other comprehensive income or loss. In addition, a second statement (the comprehensive income statement) is then prepared, starting with net income and followed by other comprehensive income or loss items to arrive at comprehensive income. An example of the two-statement approach, using the same data as that used above for Walter Company, is as follows.

  

• The issues related to quality of earnings are the same under both GAAP and IFRS. It is hoped that by adopting a more principles-based approach, as found in IFRS, many of the earnings quality issues will disappear.

■Looking to the Future

The FASB and the IASB are working on a project that would rework the structure of financial statements. One part of this project addresses the issue of how to classify various items in the income statement. A main goal of this new approach is to provide information that better represents how businesses are run. In addition, the approach draws attention away from one number—net income.

■GAAP Practice

GAAP Self-Test Questions

1. The basic tools of financial analysis are the same under both GAAP and IFRS except that:
   1. horizontal analysis cannot be done because the format of the statements is sometimes different.
   2. analysis is different because vertical analysis cannot be done under GAAP.
   3. the current ratio cannot be computed because current liabilities are often reported before current assets in GAAP statements of position.
   4. None of the above.
2. Under GAAP:
   1. the reporting of discontinued items is different than IFRS.
   2. the reporting of other comprehensive income is prohibited.
   3. the reporting of changes in accounting principles is different than under IFRS.
   4. None of the above.
3. Presentation of comprehensive income must be reported under GAAP in:
   1. the statement of stockholders’ equity.
   2. the income statement before net income.
   3. the notes to the financial statements.
   4. a statement of comprehensive income.
4. Parmalane reports the following information:

   Sales revenue	$500,000
   Cost of goods sold	200,000
   Operating expense	40,000
   Unrealized loss on non-trading securities	10,000

   Parmalane should report the following under the two-statement approach using GAAP:

   1. net income of $260,000 and comprehensive income of $270,000.
   2. net income of $270,000 and comprehensive income of $260,000.
   3. other comprehensive income of $10,000 and comprehensive income of $270,000.
   4. other comprehensive loss of $10,000 and comprehensive income of $250,000.
5. Assuming the same information as in Question 4, Parmalane should report the following using a one-statement approach under GAAP:
   1. net income of $260,000 and comprehensive income of $270,000.
   2. net income of $270,000 and comprehensive income of $260,000.
   3. other comprehensive income of $10,000 and comprehensive income of $270,000.
   4. other comprehensive loss of $10,000 and comprehensive income of $250,000.

GAAP Exercises

GAAP14-1 Chen Company reports the following information for the year ended December 31, 2017: sales revenue $1,000,000, cost of goods sold $700,000, operating expenses $200,000, and an unrealized gain on non-trading securities of $75,000. Prepare a statement of comprehensive income using the one-statement approach.

GAAP14-2 Assume the same information for Chen Company as in GAAP14-1. Prepare the income statement and comprehensive income statement using the two-statement approach.

GAAP Financial Reporting Problem: Apple Inc.

GAAP14-3Your parents are considering investing in Apple common stock. They ask you, as an accounting expert, to make an analysis of the company for them. The financial statements and the notes to the financial statements from a recent annual report of Apple are presented at http://investor.apple.com.

Instructions

1. Make a 3-year trend analysis, using 2011 as the base year, of (1) net sales and (2) net earnings. Comment on the significance of the trend results.
2. Compute for 2013 and 2012 the (1) debt to assets ratio and (2) times interest earned. (See Note 6 for interest expense.) How would you evaluate Apple’s long-term solvency?
3. Compute for 2013 and 2012 the (1) profit margin, (2) asset turnover, (3) return on assets, and (4) return on common stockholders’ equity. How would you evaluate Apple’s profitability? Total assets at September 24, 2011 were $116,371 million, and total stockholders’ equity at September 24, 2011, was $76,615 million.
4. What information outside the annual report may also be useful to your parents in making a decision about Apple?

Answers to GAAP Self-Test questions

1. d
2. d
3. d
4. d
5. d

The Navigator

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Remember to go back to the Navigator box on the chapter opening page and check off your completed work.

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