Firm Using Finonciol Anolysis Stotemenl foEvoluole Performunce

Here's Been WhereYou've

Youleorned construct siotement coshflowsfromon income to stotement ond o of comporotive bolonce sheets.

Here's WhereYou're Going

\.-Youwill leorn useverticol to horizontol onolysis, onolysis, rotioonolysis ond

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When you are finished studying this chapter, you should be able to: 1. Recognizeand explain the componentsof net income. 2. Perform and interpreJ a horizontal analysis and a vertical analysis of f,rnancial statementinformation. and explain what the 3. Perform a basic ratio analysisof a set of financial statements ratios mean. 4. Recognizethe risks ofinvesting in stock and explain how to control those risks.

475

476

T F CHAPTER . USI NGFI NANCI AL 1O STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E A

#fAies
Accountinginformation is an important part of the financialinforuse to evaluatea firm's performance. an inmation investors As vestor,you need to feel confident in a firm's reported earnings. When a firm hasmade an error,earningsmay needto be restated. There were a record number of earningsrestatements 2005in The surprising around 1,200. thing about this high number of restatements that only f ivewere the resultof an investor is class-action years. firms.Thisis a sharpdeclinefrom previous lawsuitagainstaccounting JosephGrundfestof Stanford Law School, former Accordingto Professor a governance is one after the SEC commissioneL reason the improvedcorporate passage the Sarbanes-Oxley Evenwhen a firm must restateits earnings, Act. of investors beginning realize to that honestfirmsare doing their bestto proare financialstatements. duce accurate
Restated? Don't Blamea Lawsuitfor lt," by StephenLabaton,Ihe "Legal Beat;Earnings lSource: New York llmes. February3, 2005.1

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R ec ogniz e and ex p l a i nth e co m ponent s ne t i n c o m e . of

A Closer Lookat the Income Statement

You have learned a great deal about the basic financial statementsand how accountants record, summarize,and report transactions. There is information you can easily seein the financial statement, there is also information that is difficult to see.It is important to look but beyond the size and sourceof the numbersto seewhat the numbersmean.We havebeenexamining the individual parts of the financial statements. Now we will examine all the parts together to answer the following questions:What informaof the four financial statements provide? What doesthe information mean?How can we use it? tion do financial statements Before beginning the detailed analysis of the financial statements,we need to take a closer look at some of the characteristicsof the income statement.Becauseearnings-net income-is the focus of financial reporting, companies worry about how current and potential investorswill interpret the announcementof earningseach quarter.It is not uncommon for companiesto be accusedof manipulating their earningsto appearmore profitable than they actually are. In an effort to make the componentsof earningsclear and to represent exactly what they should to financial statementusers,the Financial Accounting Standards Board (FASB) requires that two items be separatedfrom the regular earnings of a company.The major reason for segregatingthese items is that they should not be considered as part of the ongoing earnings of the firm. Reported earnings is an amount used to predict future earnings,but thesetwo items are not expectedto be repeatedin the future. 1. Discontinued operations 2. Extraordinary items of Exhibit 10.1 showsthe components net income.

Discontinued Operations
Ifyou pay attentionto the financial news,you arebound to hear about a company selling off a division. In2004, Motorola, one of the largestcommunicationsfirms in the world, discontinued operatingits semiconductorbusinesssegmentso that the segmentcould form its own firm, FreescaleSemiconductor.The gains or losses from these kinds of transactionsare Firms are always evaluatingthe contribution that shown separatelyon the income statement. the various divisions make to the profits of the firm. If a division is not profitable or no longer fits the strategyof the firm, a frrm may sell it to remain profitable or changethe firm's focus. Partsof a company'soperationsthat are eliminated are called discontinued operations.

Discontinuedoperations Those parts of the firm that a companyhaseliminatedby sellinga divisio n.

L 1 C H A P T E R0 o A C L O S E R O O K A T T H E I N C O M ES T A T E M E N T

477

EXHIBIT10.1 Components of Net lncome

It's important for investorsto see the individual pieces of earnings.

When a firm eliminates a division, the financial implications are shown separately from the regular operations of the firm. Why would this separationbe useful? Earnings is an important number becauseit is used to evaluatethe performance of a firm and to predict its future performance. To make these evaluations and predictions more meaningful, it is important that one-time transactionsbe separatedfrom recurring transactions.This separationallows investorsto seeone-time transactionsas exceptionsto the normal operations of the firm. In addition to the gain or loss from the sale, the earnings or loss for the We will accounting period for the discontinued operationsmust also be shown separately. look at an example of a firm with discontinued operations.In 2007, Muzby Manufacturing sold off a major business segment, the crate-production division, because the firm wanted to focus its operations on its core business,which did not include the crate division. Both the current year's income or loss from the crate-productiondivision and the gain or loss from the sale of those operations are shown separatelyon the income statement' Suppose: L. 2. 3. 4. 5. 6. Muzby Manufacturing's income from continuing operationsbefore taxeswas $395,600' Taxesrelatedto that income were $155,000. The discontinued segmentcontributed income of $12,000 during the year. Taxesrelated to that contributed income were $1,900. The discontinued segmentwas sold for a gain of $63'000. The taxes related to the profit from that gain were $28'000.

Exhibit 10.2 shows how this information would be presentedon the income statementfor Muzby Manufacturing.

ltems Extraordinary
You have learned that discontinued operations are the first item that accountantsdisclose The seconditem is the financial effect of any event that separatelyon the income statement. is unusual in nature and infrequenl in occurrence.The financial effects of such events are called extraordinary items. To qualify as extraordinary,the eventsmust be abnormal and must not be reasonablyexpectedto occur again in the foreseeablefuture. There is a great deal of judgment required to decide if an event should be consideredextraordinary.Examthat havebeen consideredextraordinary include eruptions of a volcano, ples of occurrences a takeover of foreign operationsby the foreign government,and the effects of new laws or regulations that result in a one-time cost to comply. Each situation is unique and must be consideredin light of the environment in which the businessoperates. SupposeMuzby Manufacturing has a factory in China, and the Chinese government in decidesto take possessionof all American businesses the country. The value of the lost factory is $200,000. U.S. tax law allows companiesto write off this type of extraordinary loss, which meansthe company receivesa tax savings.Supposethe applicable tax savings is $67,000. Exhibit 10.3 shows how Muzby Manufacturing would presentthe information on its income statementfor the year.

Extraordinaryitems Events that are unusualin nature and infrequentin occurrence.

478

CHAPTER . USTNG 10 FTNANc I AL STATEM E N T N A L y s t s r o E V A L U A T E I R M p E R F o R M A N c E A F

EXHIBIT10.2 Showing DiscontinuedOperationson the Income Statement

The highlighted portion of the income statementshows how amounts related to discontinued operations are presented.

Muzby Manufacturing Income Statement For the year ended December 3I,2007
Income from continuing operations before income taxes . . Income tax expense Income from continuing operations Discontinued operations Incomefromdiscontinuedcrate-productionsegment(netoftaxesof$1,900)... $10,I00 Gain on disposal of crate-production segment (net of taxes of $28,000) .. 35,000 Net income

$395,600 155,000 240,600

45,700 $28b.200

E XHtBtT .3 10
Showing Extraordinaryltems on the Income Statement
The highlighted portion of the income statementshows how amounts related to extraordinary items are presented.

Muzby Manufacturing Income Statement For the year ended December 3I,2007
Income from continuing operations before income taxes . . Income tax expense Income from continuing operations Discontinued operations Income from discontinued crate-production segment (net of taxes of $1,900) . . . . Gain on disposal of crate-production segment (net of taxes of $28,000) .. Income before extraordinary item Loss on extraordinary item Expropriation of foreign operation (net of taxes of $67,000) Net income

$395,600 155,000 240,600 $10,100 35,000

45,100 $r85J00

(133,000)
$1b2.200

I I I I
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7
WasHuricane Katrina extraordinary an event? Almost everyone wouldconsider Hurricane Katrina extraordinary an event. Thatis, everyone except the Financial Accounting Standards Board. firmsthat incurred For losses the hurricane, financial from their statements nottreatthe losses extraordid as dinary. However, anyof the firms operating if segments werelostor shutdown,the losses were segregated discontinued as operations. Check out RuthsChrisSteak you House's income statement, which canf indon thefirm's website, theyear for ended December , 2005. Included operating 31 in costs,hurricane and relocation costs amounted $2,660,000. to

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479

Reporting Taxes
In general,firms report total revenuesand expenses and then subtractthe associatedtaxes. However, the hnancial effects of discontinued operations and extraordinary items are shown net of tax.

What does it mean for a companyto show discontinuedoperationsand extraordinary items net of taxT What is the alternative?

Your Turn l O-l

Horizontal Vertical Analysis and of Financial Information

Now that you are preparedto recognize extraordinary items and discontinued operations that may appearon the income statement,you are ready to analyzean entire statementor set of statements. There are threeprimary ways to analyzefinancial information: horizontal analysis,vertical analysis, and ratio analysis.

i ,.{ }" ; Performand interpret a hori zontalanal ysi s and a verti calanal ysi s fi na ncial of statementinformation.

Horizontal Analysis
Horizontal analysis is a technique for evaluating a financial statementitem over a period of time. The purpose of a horizontal analysis is to expressthe change in a financial statementitem in percentages rather than in dollars. Financial statementusers can spot trends more easily with horizontal analysis than by simply looking at the raw numbers. Consider the cash flows for Wal-Mart. According to its past six statements of cash flows, Wal-Mart made the following cash expendituresfor property, plant, and equipment.
Horizontal analysisA techniquefor evaluating f inancial statementitems across time.

Wal-Mart Capital Expenditures Forfiscafyearsendedon January 31,2001-2006 (in millions dollars) of 2006 $14,s83 2005
12,893

2004 10,308

2003 9,245

2002 8,285

2001 8,042

Often, the analyst selectsone ofthe years as the referencepoint. It is called the baseyear, and the amounts reported for the other years are expressedas a percentageof the chosen baseyear.The difference betweenthe amount of the financial statementitem eachyear and the baseyear is expressed a percentageof the baseyear. Supposewe choose2001 as the as base year. Then, we subtractthe 2001 capital expenditures($8,042) from 2002 capital expenditures($8,285)and divide by the baseyear number ($8,0+Z;.

$8,28s - $8,042 $8,042

$243 $8,042

: 3.02Vo

Our calculation shows that during the fiscal year ended January 31,2002, Wal-Mart increasedcapital expendituresbyjust 3.02Voofthe baseyear's capital expenditures.The calculation is done the same way for each year. The percentagechangefrom the baseyear to 2003 is calculated as follows:

$9.245- $8,042_ $1,203 $8,042 $8,042

15.070

480

T F CHAPTER . USI NGFI NANCI AL 1O STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E A

Wal-Mart CapitalExpenditures Comparison-Baseyear 2001 (dol l ars n mi l l i ons) i

2006
Capitalexpenditures $14,583 % change 81.3o/o

2005
12,893 603%

2004
10,308

2003
9,245

2002 2001
8,285 8,042

28.2o/o 15.Oo/o 3.0o/o 100o/o

There is more than one way to do a horizontal analysis.Frequently,the analysisis done by comparing one year with the next, rather than using a fixed baseyear. the It is usually diffrcult to understand significanceofa singleitem suchas capital expenditures when viewing the raw numbers. To make trends more apparent,it may be useful to expressthe changesin spendingin percentage form. A horizontal analysismakes it clear that Wal-Mart continuesto make a signihcant investmentin its property,plant, and equipment.

VerticalAnalysis
Verticalanalysis technique A for comparingitemson a financialstatementin which all itemsare expressed a as percentof a common amount.

Vertical analysis is similar to horizontal analysis,but the analysisinvolves items on a single year's financial statement. Each item on a financial statement expressed a percentage is as of a selectedbase amount. For example,a vertical analysisof an income statementalmost alalmost all of a firm's expenditures ways usessalesas the baseamountbecause dependon the is level of sales.Each amount on the statement expressed a percentage sales.This type as of of analysiscan point out areasin which the costsmight be too large or growing without an at obviouscause.For example,if managers Wal-Mart seethat employeesalaries, a percentas age of sales,are increasing,they can investigatethe increaseand, if necessary, take action to Vertical analysisalso allows the meaningful comparisonof reducethe fum's salariesexpense. companiesof different sizes.Exhibit 10.4 shows a vertical analysisfor Wal-Mart's income for statements the yearsendedJanuary3I,2006, and January31,2005.

L"(}".l Performa basicratio a n aly s is a s et of fi n a n c i a l of statements and explain what the ratios mean.
Liquidityratios Measure the company's ability to pay its current billsand operating costs. Solvencyratios Measurethe company's abilityto meet its long-termobligations and to survive over a long period of time. Profitability ratios Measure the operatingor income performance a company. of Market indicators Ratiosthat relatethe current market priceof the company's stock to earnings dividends. or

Analysis Ratio
Throughout this book, you have learnedthat ratio analysisusesinformation in the financial statements formulate specific valuesthat determine somemeasureof a company's finanto cial position. We will review all the ratios you have learned and then look at an additional category of ratios.

A Reviewof All Ratios

There are four generalcategoriesof ratios, named for what they attempt to measure: . Liquidity ratios: Theseratios measurea company's ability to pay its current bills and operating costs-obligations coming due in the next fiscal year. . Solvency ratios: These ratios measurea company's ability to meet its long-term obligations, such as its long-term debt (bank loans), and to survive over a long period of time. . Profitability ratios: These ratios measurethe operating or income performance of a company.Rememberthe goal of a businessis to make a profit, so this type of ratio examineshow well a company is meeting that goal. . Market indicators: Theseratios relate the current market orice of the comoanv's stock to earningsor dividends. The first part of Exhibit 10.5 reviews the three types of ratios you learned about in earlier chapters.Also, there are two new ratios provided.

Your Turn I O-2

Hfuws. #B $hssr

SupposeWal-Mart pays off a current liability with cash.What effect would this have on the company'scurrent ratio? What effect would the pay off have on the company'sworking capital?

10 CHAPTER . RATIOANALYSIS

481

E XH tBtT 0 .4 1
VerticalAnalysis
The analysis for a single year provides some information, but the comparison of two years reveals more about what's going on with look very consistentacrossthesetwo years.What item(s) standsout in the analysis?The notes to the Wal-Mart. The percentages financial statementsare the first place to look for additional information whenever an analysis reveals something interesting or susprcrous.

Wat-MaJtStores, Inc. Consolidated Statements of Income For the fiscal years ended
( i n m i l l i ons )

J anuar y31,2006

J anuar y31,2005

Net sales Other income, net . . .

$3r2,427 3,227 315,654

100.00% 1.03%

$285,222 2,910 288,L32

219,793 5L,248 17,091 986 16,105 5,589 10,516 (249) $ 70,267

100.00% L.02o/o

Costs and expenses: 240,39L Cost of sales 56,733 SeIIing,general, and adm. expenses 18,530 Ope ratin gp rof it . . . . . 1,t72 (net) . . . Interest expense Income from continuing operations before income taxes and minority interest 17,359 Provision for taxes (current and deferred) 5,803 11,555 Income from continuing operations before minority interest . . . (324) Minority interest $ 11,231 Net income

76.940/o t8.t60/o 5.93% 0.38%

5.560/o 1.860/o 3.70o/o 0.t0o/o 3.600/o

77.060/o 17.97% 5.99o/o 0.35o/o

o.oD"/o

1.960/o 3.690/o 0.09%

3.600/o

profit B A Company hasa grossprofit ratioof 30%,and Company hasa gross Whyor why not? is ratioof 60%.Canyoutell whichcompany moreprofitable? ult \"'tlLtl,tlsttl''..\fli,us ^w''^ Market lndicatorRatios
The market price of a shareof stock is what an investor is willing to pay for the stock. There are two ratios that use the current market price of a shareof stock to help potential investors predict what they might earn by purchasing that stock. One ratio is the price-earnings (P/E) ratio. This ratio is defined by its name: It is the price of a shareof stock divided by the company's current earningsper share. P/E ratio : Market price per share Earnings per share Investorsand financial analystsbelieve the P/E ratio indicates future earnings potential. A high P/E ratio indicates that the company has the potential for significant growth. When a new firm has no earnings,the P/E ratio has no meaning becausethe denominator is zero. For the first severalyearsofbusiness,Amazon.com had no earningsbut a rising stock price. Analysts have varying opinions about the information containedin the P/E ratio. The other market indicator ratio is the dividend yield ratio. This ratio is the dividend per sharedivided by the market price per share. You may find that the valuesfor the dividend

Your Turn I O-g

Price-earnings(P/E)ratio The market priceof a shareof stockdivided by that stock's p earnings er share.

Dividendyield ratio Dividend per sharedivided by the current market priceper re. sna

482

F T A STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E CHAPTER O . USI NGFI NANCI AL 1

EXHIBIT10.5A Common Ratios

*Tumover ratios are often consideredeffrciencv ratios

Ratio

Definition

How to use the ratio

Chapter where you studied the ratio

,
Current ratio Total current assets Total current Iiabilities To measure a company's ability to pay current liabilities with current assets. This ratio helps creditors determine if a company can meet its short-term obligations. To measure a company's ability to meet its short-term obligations. This ratio is similar to the current ratio. However, by limiting the numerator to very liquid current assets, it is a stricter test. To measure a company's ability to meet its short-term obligations. Although technically not a ratio, working capital is often measured as part of financial statement analysis. To measure how quickly a company is selling its inventory Net credit sales Average net accounts receivable To measure how quicldy a company collects the cash from its credit customers. 6
J

Quick ratio (also lmown as the acid-test ratio)

Cash + short-term + net accounts investment receivable Total current liabilities

Working capital

Current assets - curent liabilities

Inventory turnoverratio
Accounts receivable tumover ratio

SOLVENCY
Debt-to-equity ratio Times-interesteamed ratio Total liabilities Total shareholders' equity Income from operations Interest expense To compare the amount of debt a company has with the amount the owners have invested in the company. To compare the amount of income that has been eamed in an accounting period @efore interest) to the interest obligation for the same period. If net income is used in the numerator, be sure to add back interest expense.

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"M si h " D , ls our c e: ar k et Val u eP ; c k i n g t h e C r e a mto fe C r e a m , b y C o n r a d e A e n l l eT h e N e w Y o r k Ti m e s, March 2006l 4,

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10 CHAPTER . RATIOANALYSIS

483

EXHIBIT10.58

Retum on assets

Net income + interest expense Average total assets

To measure a company's success in using its assets to earn income for owners and creditors, those who are financing the business. Because interest is part of what has been eamed to pay creditors, it is often added back to the numerator. Net income is the retum to the owners and interest expense is the return to the creditors. Average total assets are the average of begiruLing assets and ending assets for the yeax. To measure how effrciently a company uses its assets.

Asset turnover rauo Return on equity

Net sales Average total assets Net income - preferred dividends Average common shareholders' equity

To measure how much income is eamed with the common shaxeholders' investment in the company. To measure a company's profltability. It is one of the most carefirlly watched ratios by management becauseit describesthe percentageofthe salesprice that is gross profit. A small shift usually indicates a big change in the profitability of the company's sales.

Gross proflt ratio

Earnings per share

Net income - preferred dividends Weighted average number of shares of common stock outstanding

net To calcr-rlate income per share of common stock.

Price-earnings ratio Dividend yield ratio Dividend per share Market price per share

To calculate the market price for $1 of eamings.

10

To calculate the percentage return on the investment in a share of stock via dividends.

10

yield ratio are quite low comparedto the return an investor would expect on an investment. Investorsare willing to accepta low dividend yield when they anticipatean increasein the price ofthe stock. Stocks with low growth potential, however,may need to offer a higher dividend yield to attract investors, Dividend yield ratio Dividend per share Market price per share

Exhibit 10.6 showsthe earningsper share,the dividends per share,and the market price per sharefor Google Inc. and for General Mills. Which stock would be a better buy for longterm growth? Which would be best if you neededregular dividend income? The types of stock that will appealto an investor dependon the investors' preferences for income and growth. A young investor,for example,will not need dividends from retirement funds investedin stocks.These long-term investorswould prefer to invest in companies with high growth potential, no matter what the dividend yield. Google might be more attractive, with its high P/E ratio of 64.05, than General Mills, with its lower P/E ratio of

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CHAPTER 0 . USTNG 1 FTNANc TAL STATEM E N T N A L y s t s r o E V A L U A T E I R M p E R F o R M A N c E A F

Google,Inc.
For fiscal years ended

EXH tBtT 0 .6 1
Price/Earnings and Dividend Yield Ratios
Earnings per share Dividends per share Ending market price per share Price/earnings ratio Dividend yield ratio

December 2005 31,

General Miils May 28, 2006

$ 0.77 $ 0.00 $49.32 64.05 n/a

$3.05 $1.34 $51.79 16.98 2.59o/o

16.98.A retiree who needsa dividend income for living expenses will be more concerned with the size of the dividend yield of an investmentand lessconcernedwith the investment's long-term growth. General Mills would be better than Google for dividends. Thesetwo market-relatedratios are very important to managementand to investorsbecauseanalystsand investorsuse them in evaluatingstocks.If you examine a company's annual report, you arelikely to seetheseratios reported,usually for the most recent2 or 3 years.

Understanding Ratios
A ratio by itself doesnot give much information. To be useful, a ratio must be comparedto the sameratios from previous periods, ratios of other companiesin the industry, or industry averages. Keep in mind that, with the exception of earningsper share,the calculations to arrive at a specific ratio may vary from company to company.There are no standardor required formulas to calculate a ratio. One company may calculate a debt ratio as debt to equity, whereas another company may calculate a debt ratio as debt to debt ptus equity. When interpreting and using any company'sratios, be sureyou know how thoseratios have been computed.When you are computing ratios, be sure to be consistentin your calculations so you can make meaningful comparisonsamong them. Even though the only ratio that must be calculated and presentedas part of the financial statementsis EPS, managerstypically include in their company's annual report many of the ratios we have discussedin this chapter.When theseratios are not shown as part of the financial statements, they may be included in other parts of the annual report, often in graphs depicting ratio trends over severalyears. Any valuable financial statementanalysis requires more than a cursory review of ratios. The analyst must look at trends, componentsof the values that are part of the ratios, and other information about the company that may not even be contained in the financial statements.

Using Ratio Analysis

We will compute some of the ratios shown in Exhibit 10.5 for J&J Snack Foods Corp. using the company's 2005 annual report. Exhibit 10.7 shows the income statementsfor 3 years,and Exhibit 10.8 showsthe balancesheets 2years. for Other information neededfor the analysis: ' Market price per shareat the close of fiscal year: approximately $55 per shareat September24,2005 and$42 per shareat September 25,2004. No dividends were paid by J&J Snack Foods corp. during the hscal year ended Sep' tember25,2004. However,J&J SnackFoodsCorp. paid dividendsof $0.05 per share during the fiscal year endedSeptember 24,2005. All the ratios shown in Exhibit 10.9 are calculated for J&J Snack Foods Corp. for the fiscal yearsendedSeptember24,2005, and September 25,2004. Even though 2years of ratios do not give us enough information for making decisions,use this as an opportunity to practice how to calculatethe ratios. Exhibit 10.9 shows the computations.

A S 10 CHAPTER . F I N A N C I A L T A T E M E N T N A L Y S I S - M O R ET H A N N U M B E R S

485

EXHIBIT10.7 Income Statementsfor J&J SnackFoodsCorp. J&I Snack Foods Corporation Consolidated Statement of Earnings
(in thousands, exceptper sharedata) 24, SePtember 2005 (b2weerst September 25, 2004 (52 weeks) September27, 2003 (52weeks)

year ended Fiscal

Net sales Cost ofgoods sold . . . Gross proflt Selling, general and administrative expenses Operating proflt Investment income. . . lrterest expense and other Eamings before taxes . . Income taxes Net earnings Weighted average number of basic shares Eamings per basic share Weighted average number of diluted shares Earnings per diluted share

$457,112 302,065 r55,047 r14,798 40,249 1,689 (136) 41,802 L5,759 $26,043 9,097 2.86 9,300 $ 2.80 $

$416,588 276,379 140,209 105,017 35,L92

bOtl

(113) 35,645 12,936 $22,710 8,909 2.55 9,143 $ 2.48 $

$364,567 239,722 124,U5 93,998 30,847 362 (113) 31,096 11,194 $ 19,902 8,800 2.26 9,051 2.20

The accompanying notes are an integral part of these statements'

than Numbers Analysis-More Financial Statement

You have probably noticed the following sentenceat the end ofevery actual financial statement you have ever seen,"The accompanyingnotes are an integral part of these financial statements."Some analysts believe there is more real information about the financial health Go themselves. to the back of the book where of a companyin the notesthan in the statements for you will find the financial statements Staplesand Office Depot. Look at the detailedand extensivenotes that accompanythe statements.The more you leam about analyzing and evalexpericoursesor in actualbusiness uating a company'sperformance,whetherin subsequent ence, the more you will understand the information in the notes to the financial statements. When you are comparing two or more firms, you need to know the accounting choices those frrms have made-such as depreciation and inventory methods-to make valid comparisons. Often, analysts compute new amounts using a different method than the one the firm used so that amounts can be meaningfully comparedto those of anotherfirm. For example,if one company uses LIFO and another uses FIFO, an analyst would convert the LIFO values to requiredto be in the notesof firms that use LIFO. FIFO valuesusing the disclosures To better appreciatethe role of accounting information in business,look at a business plan. A businessplan is a detailed analysis of what it would take to start and maintain the Anyone writing a businessplan includes a salesforecast, operationof a successfulbusiness. expense estimates, and prospective financial statements.These are "what-if" financial statements, forecaststhat are part of the businessplan. Banks often require thesestatements before they will lend money to a new firm. Because accounting is such an integral part of business, accounting principles will continue to changeas businesschanges.Each year, the FASB and the SEC add and change the rules for valuing items on the financial statements.FASB is also concerned with the continued usefulnessand reliability of the accounting data from electronic transactions,

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CHAPTER O o USI NGFI NANCI AL 1 STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F o R M A N C E A T F

EXHIBtT10.8 BalanceSheetsof J&J SnackFoodsCorp. J&I Snack Foods Corporation Consolidated Balance Sheets
(in thousands, exceptshareamounts)

September24, 2005

September25, 2004

Assets Current Assets Cash and cash equivalents Marketable securities available for sale Receivables Ttade, Iess allowances of $1,054and $1,104,respectively Other . Inventories Prepaid expenses and other Deferred income taxes Total current assets Property, plant and equipment, at cost Less accumr:Iated depreciation and amortization

$ 15,795 54,225 46,267 oou 33,684 1,2L5 2.393 L54,233 326,143 237,098 89,045 53,622 7,043 1,981 62,646 $305.924

$ t9,6oo 36,500 47,753 233 29,587 r,354 3,385 L38,4r2 314,880 225,406 89,474 46,477 1,904 1,257 49,538 $277,424

...

OtherAssets Goodwill
Other intan$ble assets, net Other .

Liabilities and Stockholder's Equity Current Liabilities Accountspayable .... Accrued liabilities DMdendspayable Total current liabilities Deferred income taxes Other long-term liabilities Stockholder's Equity Preferred stock, $1 par value; authorized, 5,000,000 shares;none issued . . . . Common stock, no par value; authorized, 25,000,000 shares;issued and outstanding, 9,136,000 and 9,006,000 respectively Accumulated other comprehensive loss Retainedeamings....

$ 37,029 L4,731 1,T42 52,902 17,987 273

$ 34,497 L3,149 47,646 19,153 529

36,091 (1,918) 200,589 234,762 $305,924

33,069 (2,061) 179,088 210,096 $277,424

S A 10 CHAPTER . F I N A N C I A L T A T E M E N T N A L Y S I S - M O R ET H A N N U M B E R S

447

EXHIBIT10.9A Ratio Analysisfor J&J SnackFoodsCorp.

As you evaluatethe ratios, keep in mind that even two years' worth of ratios is rarely enough information to come to any conclusions. Most annual reports provide the data for ten years' worth of ratios. For J&J Snack Foods Corp., almost all of the ratios appearto be moving in the right direction. Often, ratio analysis is useful for identiffing potential problem areas.None is obvious for J&J Snack Foods Corp. from this analysis.
Ratio LIQUIDITY Cunent ratio Total current assets Total current liabilities Definition Computation For FYE Sept 2005
1 K/ OQQ Kt ont

Computation

Interpretation

t38.412
+ t,o4o

This is an excellent current ratio. A value over 2 is consideredgood. Industry average for this industryprocessedand packagedgoods-is 1.9.

Acid-test ratio (also Imown as the quick ratio)

Cash + short-term investments + net accounts receivable Total current liabilities Total current assets Total current liabilities

This 19,600+47,753+36,500 is a very high acid-test ratio. 47,646 -r9n

- t 1a

Industry average is 0.8.

Working capital (technically not a ratio, but still a measure of liquidity) Inventory tumover ratio

= 754,23362,902 $101,331 138,412 47,646= $90,766 This arnount (in thousands) supports the strong (in thousands)
liquidity of the firm,

Cost of goods sold Average inventory

302.065 (29,587 33,684)/2 "' "" +

276,379 (29,587 +23,202*)2 = 10.47

The company is turning over its inventory 10 times each year. Industry averageis 10.6. The company is tuming over its receivablesover 9 times each year. If you divide 366 days you'll see by 9.72, that it takes the company about 38 days to collect its recerables. The industry average is 34 days.

Accounts receivable tumover ratio

Net sales Average net accounts receivable

467,rr2 @idi@ffi6=o

'o

z_oaR

(47,753+ 37,645*)/2- " ' "

* From the 2003balancesheet not shown here

SOLVENCY The company does not have excessive debt. The indus@ averageis 0.51.

Debt to equity

Total liabilities Total equity

47,646+ 19,682= ---ITolb$6 u'oo

Times interest eamed

Net income + rnterest expense Interest expense

22,710+ ll3 = ^^. ll3 'va

This company has no problem meeting its interest obligation The industry average is 64.

488

c HA pr E R 0 . u s rN c F tN A N c tAL A T EME N T A Lysts E V A LU A TE M R FoR MA N C E 1 ST AN ro FIR pE

EX HI B I T 10. 98

PROFITABILITY
Retum on assets Net income interest expense Average total assets

26,043 136 + (305,924 277,424)/2 + = 8.98o/o

22,710 1.I3 +
(277,424 +239,478*)/2 = 8.830/o *Flom the 2003 balance sheet

This is a good return on assets. The industry average is 4.60/o.

Return on equity

Net income preferred dividends Average common shareholders' equity

26,043 0 (234,762 210,096)/2 +

= ll.7o/o

Most investors 22,710 0 (210,096 1.82,564*)/2 would be happy to + = 1L.570/o *From the 2003 balance sheet eaJn an l1%o return on their investment. The industry average is 10%0.

Grossproflt ratio

Gross proflt Sales

L40,209 4l o,D dd

no a^/

The gross profit shows that for every dollar of product the company sells, approximately $0.66is the cost of the item to J&I Snack Foods. The industry average gross profit percentage is 36.8%. A two-year trend is not very informative. However, for the two years shown, the ratio is certainly moving in the right direction.

Earnings per share

Net income preferred dividends Number of shares of common stock outstanding

2 6,043-0 =
g$g7* -

^^^^ DZ'do

+ Disclosed the i ncome on statement.

*D i scl osed the i ncome on statement.

Price-earnings ratio

Market price per common share Earnings per shaxe

$55 _ 10,a

This PE ratio is a bit lower than the industry average of 19.8.

Dividend yield

Dividend per share Market price per share

ffi=o.ox

o -n $42.00"

This firm did not pay dividends in 2004.In 2005,the firm paid $0.50, which is a little less than lo/oof the stock prrce.

, R 1 C H A P T E R0 . B U 5 I N E S S l 5 K , C O N T R O L A N D E T H I C S

489

ffiru ffi hi $ #usine Fd rJ il)ffi,ruT,re

What is EBITDA?
and statements earnings, financial much about lf youread "EBITDA" youwill eventually the comeacross expression (pronounced duh).lt isan acronymfor before earning iba EBITDA and interest, taxes,depreciation, amortization. stateon from canbe calculated information the income of (earnings, and taxes, interest) the statement and ment (deoreciation amortization-added back and cashflows activcash whencalculating fromoperatinq to netincome manthey Eliminating items-because involve these ities). to make andestimates--<an it easter discretion agement it is Because firms. of health various the compare financial (debtrather financing choices a result management's of of takes awaythe effect interest thanequity), eliminating firm's structure. a caoital meaa has Even thoughEBITDA became popular performance, it doesnot tellthe whole sureof a firm's

ss

there According lnvestopidia.com, areat least to story. to four reasons be waryof EBITDA. for 1. Thereis no substitute cashflows.No matter withoutsufis, what EBITDA a firmcannot operate ficient cash. are from that 2. Theitems areeliminated earnings not themcanbe misleading. soignoring avoidable. You of the ignores quality earnings. will 3. EBITDA 1 about thatin Chapter1. learn more ratio a to 4. UsingEBITDA calculate price-earnings is. than lookcheaper it actually make firm a could but is Thebottomline:EBITDA useful, it is onlyoneof Remember a firm'sperformance. of manymeasures so by defined GAAP, firmsmaymeais thatEBITDANOT wavs. different sureEBITDA

to and real-time access financial data.As competition takeson new dimensions, e-business, particularly due to new technology, the scrutiny of a firm's financial information will increase.Together with the influence of the financial scandalsof the early 2000s, the financial information neededfor good decision making will continue to grow in importance.

and Risk, Business Control, Ethics

We already discussed,in Chapter 1, the risks associatedwith starting a business.Now we will take the perspectiveof an investor.After all, you are very likely to buy stock in a publicly traded company sometime in your life. Many working people have money in retirement funds that are invested in the stock of publicly traded companies.Additionally, the movementof the stock market affects a large number of firms and individual investors.How should you, as an investor, minimize the risks associatedwith stock ownership?That risk, of course,is losing your moneyl First, you shouldbe diligent about finding a financial advisor or financial analystto help you, or you should become an expert from your own study and analysisof availablestocks. You also need to know and understandsome financial accounting and financial statement analysis,which you have been exposedto in this course.However,being knowledgeableor consulting an expert does not give an investor completeprotection againstlosses. That leads to the secondand most effective way to minimize the risks associatedwith stock ownership: Diversify. In everydayusage,to diversify meansto vary or expand.In the languageof investment,diversify meansto vary the investmentsyou make-to expandbeyond a narrow set of investments.Diversification meansnot putting all of your eggsin one basket.A diversified set of investmentsallows an investor to earn a higher rate of return for a given amount of risk.

L"{)"4 the risksof Recognize i i nvesti ng n stockand exolain how to control those risks.

490

CHAPTER O . USI NGFI NANCI AL 1 STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F o R M A N C E A T F

There is no way to eliminate all of the risks of stock ownership, but having many different types of investmentswill help you minimize your risk or, equivalently,increaseyour return for a given amount of risk. According to Bank One, 'A diversified portfolio doesnot concentrate in one or two investment categories. Instead, it includes some investments whose returns zig while the returns of other investmentszag."

Chapter Summary Points

of discontinuedop' Components net income include income from continuing operations, erations, extraordinary and items.Gainsandlosses from discontinued operations from and extraordinary items are segregated from other revenuesand expensesso that an investor can easily separate thesenonrecurringitems from thoseexpectedto reoccurin the future. ' Horizontal analysis compares a specific financial statement item across time, often with referenceto a chosenbase year. A vertical analysis, also know as common size statements, shows every item on a single year's financial statementas a percentageof one of the other financial statementitems. Most often, a vertical analysisof the income statementcalculatesall items as a percentageof sales. Ratio analysis is a tool used by anyone who wants to evaluatea firm's financial state' ments. Rememberthat a ratio is meaningful only when it is comparedto anotherratio. ' Investing in a firm as an owner, by purchasing a firm's stock, can create risks. The biggest risk is that the firm will not do well and its stock price will decrease. The best protection for an investor is to have a diversified portfolio. That is, buy a variety of stocks so that a decreasein the price of one stock may be offset by an increasein the price of another. Also, do not put all of your investment money in stockownership.Invest in a variety of assets, suchas stocks,bonds,and real estate.

Chapter Summary Problems

Instructions
Use the information in the annual report provided in the back of the textbook and the other from the textbook's website to perform a ratio analysis on the most recent fiscal years of both office Depot and Staples. Use Exhibit 10.9as a model. comment on your results.

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1 C H A P T E R0 . A N S WE R S O Y O U R T U R N Q U E S T I O N S T

493

KeyTerms Chapter for 10

Discontinued operations Liquidity ratios (p. 480) Market indicators (p. 480) @.416) Dividend yield ratio(p. a81) Price-earnings (PE) ratio (p .4 8 1 ) Extraordinary items(p. 477) (p. Horizontalanalysis a79)
Profitability ratios (p. 480) Solvencyratios (p. 480) Vertical analysis(p. 480)

Answers YOUR to TURN Questions

Chapter 10 YourTurn 10-1
Those items must be shown after the tax consequences have been subtractedbecausethis method of reporting the items net of taxes keeps the tax implications of these items separate from the company'sregular tax expense. The alternativeis to show the items before the tax implications and then to include the tax savingsor tax increasesin the company's regular tax expense.

Your Turn 10-2

This payoff would increasethe current ratio. We can use a simple example to illustrate why: Supposecurrent assets were $500 million and current liabilities were $250 million. The current ratio would be 2. Now suppose$50 million worth of current liabilities were paid off with current assets. Then current assets would be $450 million, and current liabilities would be $200 million. The current ratio is now 2.25. When both the numerator and the denominatorof a fraction are reducedby the sameamount,the value of the fraction will increase. Working capital will remain unchanged. startedat $500 million miIt nus $250 million in the example.After $50 million worth of liabilities is paid off with cash,the current assets will be $450 million and the current liabilities will be $200 million. The differenceis still $250 million.

YourTurn 10-3
No, the gross profit ratio does not tell which company is more profitable becauseone company may have higher salesthan the other. For example 30Voof alarge number is better than 60Voof a small number.Also, the amount of coststhe companiesmust cover beyond the cost of goods sold is unknown. The grossprofit ratio is most useful for comparing companiesin the same industry or evaluatingperformanceof a single company acrosstime.

Your TurnAppendix 10A

The FASB wants to make the changesto shareholders'equitythat do not affect net income more apparentto financial statementusers.

Your TurnAppendix 108

1. The securities will be shownin the currentassetsectionofthe balancesheetat a value of $52,000.The write-up will be balanced with a $2,000unrealizedgain on the lncome statement. 2. The securitieswill be shown in either the current assetor the long-term assetsection of the balance sheet(dependingon a firm's intent) at a value of $52,000.The writeup will be balancedwith a $2,000 unrealized gain that will go directly to equity, as part of accumulatedother comprehensivetncome. 3. The securities will be shownat their cost of $50,000in the long-termassetsectionof the balance sheet(unlessthe debt securitiesare maturing in the coming year, in which casethey would be current assets).

49 4

, CHAPTER I O o USI NGFI NANCI AL T STATEM E N T N A L Y S I S o E V A L U A T E I R M P E R F o R M A N C E A F

Questions 1. Dehne the items that the Financial Accounting StandardsBoard requires a frrm to report separatelyon the income statement.Why is this separationuseful? 2. What criteria must be met for an event to be consideredextraordinary?Give an examples of eventsthat would be consideredto be extraordinary. 3. What does it mean to show an item net of tax? 4. What is horizontalanalysis? What is the purposeof this methodof analysis? 5. What is vertical analysis?What is the purpose of this method of analysis? 6. What is liquidity? Which ratios are useful for measuringliquidity and what does each measure? 7. What is solvency?Which ratios are useful for measuringsolvency and what doeseach measure? 8. What is profitability? Which ratios are useful for measuringprofitability and what does eachmeasure? 9. What are market indicators? Which ratios are market indicators and what does each measure? L0. How are financial ratios used to determine how successfullya company is operating?

Multiple-Choice Questions 1. Suppose had extraordinary of $300,000. frrm's rate 35%, afirm an loss If the tax is how
will the loss be shown in the financial statements? a. On the income statement,below income from operations,net of tax savings,for a net lossof $195,000 b. On the income statementas part of the calculation of income from operations, beforetaxes,for a loss of $300,000 c. As supplementaryinformation in the notes to the financial statements d. As a cash outflow from financing on the statementof cash flows Currentassets KearneyCompanyare $120,000and total assets $600,000. for are Current liabilities are $80,000and total liabilities are $300.000. What is the currentrario? a. 2.00 b . 2 .5 0 c . 1 .9 0 d . 1 .5 0 Ritchie Company sold some fixed assetsfor a gain of $100,000.The firm's tax rate is 25Vo.How would Ritchie Company report this transaction on its financial statements? a. On the income statementas part of the calculation of income from continuing operations, of tax, in the amountof $75,000 net b. As an extraordinary item, net of tax, in the amount of $75,000 c. As discontinued operations, of tax, in the amountof $75,000 net d. On the income statementas part of the calculation of income from continuing operationsat the before tax amount of $100,000 Gerard Company reported sales of $300,000 for 2006, $330,000 for 200'7, and $360,000for 2008. Ifthe companyuses2006 as the baseyear,what were the percentage increasesfor 2001 and 2008 comparedto the baseyear? a. ljVofor200'l andljTo for2008 b. l20Vo for 2007 and 1207ofor 2008 c. 11,07ofor2001 andllj7o for2008 d. lj%ofor2007 and2}Vafor2008 On June 30, Star Radio reported total current assetsof $45,000, total assetsof $200,000,total current liabilities of $42,000,and total liabilities of $80,000.How much working capital did Star Radio have on this date? a. $87,000 b. $200,000 c. $3,000 d . $ 1 2 3 .0 0 0

2.

3.

4.

5.

C H A P TE R . S H OR T X E R C IS E S 495 10 E 6. Talking Puppet Company reported aPlE ratio of 50 on the last day of the fiscal year. If the companyreportedearningsof $2.50 per share,how much was a shareof the company's stock trading for at that time? a. $20 per share b. $125 per share c. $50 per share d. $47.50per share 7. SingletonCompanyhad salesof $2,000,000, cost of salesof $1,200,000, and average inventory of $400,000.What was the company'sinventory turnoverratio for the period? a. 3.00 b. 4.00 c. 5.00 d. 0. 33 8. Supposea firm had an inventory turnover ratio of 20. Supposethe hrm considersa year to be 360 days. How many days, on average,does an item remain in the inventory? a. 5.56days b. 18 days c. 20 days d. 360 days 9. Supposea new company is trying to decide whether to use LIFO or FIFO in a period of rising inventorycosts.The CFO suggests it using LIFO because will give a higher inventory turnover ratio. Is he correct? a. Yes, the averageinventory will be lower (the ratio's denominator) and the cost of goodssold (the ratio's numerator)will be higher than if FIFO were used. b. No, the averageinventory would be the samebecausepurchasesare the sameno matterwhich inventorymethodis chosen. c. The inventory method has no effect on the inventory turnover ratio. d. Without specific inventory amounts,it is not possible to predict the effect of the inventory method. 10. If a firm has $ I 00,000 debt and $ 100,000 equity, then a. The return on equity ratio is 1. b. The debt-to-equity ratio is 1. c. The return on assets ratio is 0.5. d. The firm has too much debt.

ShortExercises
SE10-1.Discontinuedoperations. (LO 1) In 2006,Earthscope Companydecidedto sell its satellitesales division,eventhoughthe division had been profitable during the year. During 2006, the satellite division earned $54,000 and the taxeson that income were $12,500.The division was sold for a gain of and the taxeson the gain amounted $36,700.How would theseamountsbe reto $750,000, ported on the income statementfor the year endedDecember 31, 2006? SE10-2.Discontinuedoperations.(LO 1) In 2007, Office Products decided to sell its furniture division becauseit had been losing moneyfor several years.During 2007,thefurnituredivision lost $140,000. The tax savings relatedto the loss amountedto $25,000.The division was sold at a loss of $350,000,and the tax savings relatedto the loss on the salewas $50,000.How would theseamounts rebe ported on the income statementfor the year endedDecember 31,2007? SE10-3.Discontinuedoperations.(LO 1) After the terrorist attacks on the World Trade Center in 2001, Congresspasseda law requiring new security devicesin airports. One airport security firm had to get rid of an entire segmentof the businessthat produced the old devices, and they suffered a significant loss on the disposal of the segment.The loss amountedto $320,000,with a related tax benefit of I07o of the loss. How would this be reported on the firm's income statement?

"

":

496

T F A CHAPTER 0 . USI NGFI NANCI AL 1 STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E

SE10-4.Extraordinaryitem. (LO l) Sew and Save Company suffered an extraordinary loss of $30,000 last year. The related tax savings amounted to $5,600. How would this tax savings be reported on the income statement? SE10-5.Horizontal analysis.(LO 2) Olin Copy Corporation reported the following amounts on its 2007 comparative income statement. (in thousands) Revenues Costof sales 2007 $6,400 3,900 2006 $4,575 2,650 2005 $3,850 2,050

Perform a horizontal analysis of revenuesand cost of salesin both dollar amounts and in percentages for2007 and2006,using 2005 as the baseyear. SE10-6.Horizontal analysis.(LO 2) Use the following information about the capital expendituresof Andes Company to perform a horizontal analysis,with2004 as the baseyear.What information doesthis provide about Andes Company? (in millions) Capitalexpenditures 2007 $41,400 2006 545,575 2005 $43,850 2004 $50,600

SE10-7. Verticalanalysis.(LO 2) Bessie'sQuilting Companyreportedthe following amountson its balancesheetat December 31,2007. Cash net Accountsreceivable, Inventory Equipment, net Total assets

$ s,000 40,000 35,000 120,000 $200,000

as of Perform a vertical analysisof the assets Bessie'sQuilting Company.Use total assets the base.What information does the analysisprovide? SE10-8. Verticalanalysis.(LO 2) Perform a vertical analysis on the following income statement, with sales as the base amount. What other information would you need to make this analysis meaningful? Sales Cost of goodssold Grossmargin Other expenses Net income $35,000 14,000 21,000 7,000 $14.000

SE10-9.Ratio analysis.(LO 2) Fireworks reported current assetsof $720,000 and a current ratio of 1.2.What were current liabilities? What was working capital? SE10-10.Ratio analysis.(LO 3) A 5-yearcomparativeanalysisof Low Light Company'scurrentratio and quick ratio follows. 2004 c u rre n t ra t i o Ac i d -te s t rati o 1.19 1.i 5 200s 1.85 1.02 2006 2.50 0.98 2007 3.40 0.72 2008 4.0 2 0.5 0

a. What has been happeningto the liquidity of Low Light Company over the 5 years presented?

C H A P TE R . E X E R C IS E S 497 10 b. Considering both ratios, what doesthe trend indicate about what has happenedto the makeup of Low Light's current assetsover the 5-year period? SE10-11.Ratio analysis.(LO 3) A company's debt-to-equity ratio has been increasingfor the past 4 years.Give at least two company actions that might have causedthis increase. SE10-12.Ratio analysis.(LO 3) The following is a 5-year comparativeanalysis of Accent Company's return on assetsand return on equity.

Returnon assets Return equity on

2005 8o/o 20o/o

2006
7.5o/o 21o/o

2007
7.12o/o 21.8o/o

2008
6.540/o 22.2%

2009
6o/o 23o/o

a. What does this analysistell you about the overall profitability of Accent Company over the S-yearperiod? b. What does this analysistell you about what has happenedto Accent's amount of debt over the past 5 years? SE10-13.Ratio analysis.(LO 3) Earnings for Archibold Company have been fairly constantover the past 6 months, but the P/E ratio has been climbing steadily.How do you accountfor this climb? What does it tell you about the market's view of the company's future? SE10-14. Riskand control. (LO 4) Supposeyou are the financial advisor to AHA Company, a local software development company.The CFO suggeststhe firm invest all of its extra cash in technology stocks. He thinks that will demonstratethe company's confidence in that sector of the market. What advice would you give him and why? SE10-15.Appendix10A: Comprehensive income. Give an example of a gain or loss that would be excluded from the income statementand shown directly on the balance sheetas part of accumulatedother comprehensiveincome. SE10-16. Appendix I 0B: Investments. Convey Company had some extra cash and purchasedthe stock of various companieswith the objective of making a prof,rtin the short run. The cost of Convey's portfolio was $79,450 at December 31, 2008. On that date, the market value of the portfolio was $85,200. How would this increasein value be reflected in Convev's financial statements the year ended for December31, 2008?

Exercises-Set A
E10-1A. Discontinuedoperations.(LO 1) Use the following information to construct a partial income statementbeginning with income from continuing operations. Income from continuing operations Loss during the year from operating discontinued operations Tax benefit of loss Loss from sale of discontinued operations Tax savingsfrom loss on the sale

$230,000 50,000 8,500 138,500 41,000

E10-2A. Extraordinaryitem. (LO l) Devon's Central ProcessingAgency suffereda $560,000loss due to a disasterthat qualifies as an extraordinary item for financial statement purposes. The tax beneht of the loss amounts to $123,000. If income from continuing operations (net of tax) amounted to what is net income? $1,300,500,

F T A STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E CHAPTER 0 . USI NGFI NANCI AL 1

E10-3A. Horizontal analysis.(LO 2) JonesFurniture reported the following amountsfor its salesduring the past 5 years. Using 2OO4as the base year, perform a horizontal analysis.What information does the analysis provide that was not apparentfrom the raw numbers?

2008 $30,000

2007 $28,400

2006 $26,300

2005 $24,200

2004 $2s,4oo

E10-4A. Vertical analysis. (LO 2) Use the income statement from Color Copy to perform a vertical analysis with sales as the base. Color Copy Inc. lncome Statement For the year ended September30,2OO7 revenue Sales Costof goods sold Grossprofit Operatingexpenses: l D e p re c i ati on-bui di ngsand equi pment Oth e r s e l l i ngand admi ni strati ve Total expenses lncome before interestand taxes Interestexpense Incomebefore taxes Incometaxes Net income

$10,228 5,75'l $ q,qtt $ 100 2,500 2,600 $ 1,877 350

$ t , s zt
150 $ 1,377

E10-5A. Current ratio and working capital. (LO 3) Calculate the current ratio and the amount of working capital for Albert's Hotels for the years given in the following comparativebalancesheets.Although 2 yearcis not much of a trend, what is your opinion of the direction of theseratios?

Albert' Hotels Inc. Balance Sheet and 2007 At December 2008 31, 2008
Currentassets; Cash net Accountsreceivable, Inventory Prepaidexpenses Total current assets Eq u i p m e n t net , Total assets T o ta lc u rre ntl i abi l i ti es l L o n g -te rm i abi l i ti es T o ta l l i a b i l iti es equity Commonstockholders' R e ta i n e d arni ngs e equity Total liabilitiesand stockholders'

2007 $ 90,000 116,000 160,000 16,000 382,000 160,000 $s42,000 $223,000 117,000 340,000 90,000 112,000 $s42,000

$ ga,ooo
110,000 170,000 18,000 396,000 184,000 $s8o,ooo $206,000 119,000 325,000 90,000 155,000 $s80,000

t-tt,l: cHAPTER o EXERCTsES 4gg 1o E'10-6A'. Debt-to-equityratio. (LO 3) Use the balance sheetsfrom Alberl's Hotels in E10-5A to compute the debt-to-equity ratio for 2008 and 2001. Supposeyou calculated a debt ratio using debt plus equity as the denominator.Which ratio-debt to equity or debt to debt plus equity-seems easiestto interpret? As an investor, do you view the "trend" in the debt-to-equity ratio as favorable or unfavorable?Why? E10-7A. Ratio analysis.(LO 3) Zap Elecftonics reported the following for the fiscal years ended January 31,2007 , and Ja n uar v l. 2006. 3 J anuar y 31 ( in t hous ands ) Accountsreceivable lnventory Currentassets Cur r entliabiliti e s Long- t er m liab i l i ti e s S har eholder s' e q u i ty S ales Costof goods sold Interestexpense Net inc om e

;r';.',..r11

2007
$ 35,184 106,754 174,369 7 1 ,6 16 12,315 121,851 712,855 483,463 335 11 ,9 5 3

2006
$ 24,306 113,875 124,369 68,001 35,200 198,935 580,223 400,126 709 4,706

Assume all sales are on credit and the firm has no preferred stock outstandins. Calculate the following ratios. a. Current ratio (for both years) b. Accounts receivableturnover ratio (for 2007) c. Inventory turnover ratio (for 2007) d. Debt-to-equity ratio (for both years) e. Return on equity ratio (for 2007) Do any of theseratios suggestproblems for the company? E10-8A. Ratio analysis.(LO 3) Evans Family Grocers reported the following for the two most recent fiscal years. Dec em ber 31 Cash (net) Receivables M er c handis e v e n to ry in Plant assets Total assets Accountspayable Long-termnotes payable Commonstock Ret ained ni n g s ear Total Liabilities and Shareholders' Equity Net incomefor the year ended 12131108 (all Sales sales were on account) Costof goods sold Interestexpense

2008 $ 2s,000 60,000 55,000 280,000

2007 $ 20,000 70,000 30,000 260,000

$4?9p99
45,000 75,000 135,000 165,000
$420,000 $ ZS,OOO

$380,999
52,000 100,000 122,000 96,000
$380,000

4s0,000 210,000 1,500

Calculate the following for the year endedDecember 31,2008. a. Current ratio b. Working capital

c. d. e. f.

Accounts receivableturnover ratio Inventory turnover ratio Return on assets Return on equity

E10-9A. Ratio analysis. (LO 3) Furniture Showcasereported the following for its fiscal year endedJune 30, 2008. Sales $530,000 300,000 Cost of sales 230,000 Grossmargin 113,000 Expenses* Net income $117,000 *Included in the expenses was $12,000of interestexpense. Assumeno income tax expense. At the beginning of the year, the company had 50,000 sharesof common stock outstanding. At the end of the year, there were 40,000 sharesoutstanding.The market price of the company's stock at year-end was $20 per share.The company declared and paid $80,000 of dividends near year-end. ratio Calculate earnings per share,the price-earnings ratio, and times-interest-earned for Furniture Showcase. Use the balance sheet and income statement for The Talbots Inc. for E10-10A throueh E 1 0 -1 3 A.. E10-10A. Horizontal analysis.(LO 2) Use the statementof earningsfor Talbots to perform a horizontal analysisfor eachitem reported for the year from January 29,2005, to January 28,2006. What does your analysis tell you about the operationsof Talbots for the year? E10-11A. Verticalanalysis.(LO 2) Use the statementof earnings for Talbots to perform a vertical analysis for each item reportedfor the last two fiscal yearsusing net salesas the base.What doesyour analysistell you about the operationsfor the years reported? EI0-12A, Liquidity ratios. (LO 3) Use the financial statementsfor Talbots to calculate the following liquidity ratios for FYE January 28,2006. What information does this provide about the firm's liquidity? a. Cunent ratio b. Acid-test ratio c. Working capital d. Inventoryturnoverratio e. Accounts receivableturnover ratio (Assume all salesare credit sales.) and profitability ratios. (LO 3) E10-13A. Solvency for Use the financial statements Talbots to calculate the following solvency and profitability ratios for FYE January 28,2006. What information does this provide about the firm's solvency and profitability ? a. Debt-to-equityratio ratio b. Times-interest-earned c. Return on assets d. Return on equity e. Gross margin percentage

C H A P T E R0 . E X E R C I S E S 1

501

The Talbots,Inc. and Subsidiaries Consolidated Balance Sheets

(Amounts in thousandsexcept share data)

January 28, 2006

January 29, 2005

Assets Current Assets: Cash and cash equivalents . . . . Customeraccountsreceivable-net Merchandise inventories Deferred catalog costs Due from affiliates Deferred income taxes Prepaid and other current assets

Tota] current assets

Propertyandequipment-net ..... Deferred income taxes Goodwill-net Tfademarks-net Other assets Total Assets Liabilities and Stockholder's Equity Current Liabilities: Accounts payable Accrued income taxes Accrued liabilities Total current liabilities Long-term debt Deferred rent under lease commitments . . . . . Deferred income taxes . Other liabilities Commitments Stocldrolder's Equrty: Common stock, $0.01par value; 200,000,000 authorized; 77,861,L28 shares and 76,940,134 shares issued, respectively, and 53,359,556 shares and 54,123,667 shares outstanding, respectively Additional paid-in capital Retained earnings Accumulated other comprehensive loss Deferred compensation Tleasury stock, at cost; 24,501,572and22,816,467 shares, respectively Total stockholder's equity Total Liabilities and Stockholder's Equity

$ 103,020 209,749 246,707 6,021 7,892 14,lr5 33,157 620,661 387,536 6,407 35,513 75,884 20,r43 $l,L46,tM

31,811 199,256 238,544 5,1 18 9,073 14,006 29,589 527,397 405,rL4 35,513 75,884 L8,222

$1p94qq
$ 65,070 27,196 110,372 202,638 100,000 109,946 5,670 55,288

85,343 37,909 LzL,205 244,457 100,000 110,864 63,855

779 455,22L 783,397 (16,682) (13,403)

7AO

432,9L2 715,580

(r7,r42)
(11,821)

See notes to consolidated financial statements.

502

F T A STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E 10 CHAPTER . USI NGFI NANCI AL

The Talbots, Inc. and Subsidiaries Consolidated Statements of Earnings

(Amounts in thousandsexcept per share data)

Year ended

Jmuary 28, 2006

Jmuary 29, 2005

January 31, 2004

Net sales Costs and Expenses Cost of sales,buying and occupancy SeIIing, general and administrative Operating Income Interest Interest expense Interest income Interest expense-net Income Before Taxes Income taxes Net income Net income per share Basic . Diluted Weighted Average Number of Shares of Common Stock Outstandins Basic

$1,808,606 $1,697,843 $1,594,790 1,153,734 502,724 I52,r48 4,480 r,374 3,106 r49,042 55,891 $ 93,151 $ 1.76 $ r.72 1,093,023 462,705 r42,rt5 2,6L6 506 2,1 10 140,005 995,765 432,424 166,601 2,402 307 2,095 164,506 61 , 615 $ 102,891

$ 1.73 $ 1.70 56.531 57,901

D i l u te d

....

54,103

E10-14A. Riskand control. (LO 4) Often a firm will contribute its own sharesof stock to its pension fund rather than cash. What problem could this cause?How could it be avoided?Have you heard of any firm that did this and the result was a disaster? 810-15A. Appendix I 0B : Investments. Under each of the Omicron Corporationinvested$125,000of its extra cashin securities. following independentscenarios,(a) calculate the amount at which the investmentswould be valued for the year-endbalance sheet,and (b) indicate how the effect ofthese scenarios if should be reported on the other financial statements, at all. 1. All the securitieswere debt securities,with a maturity date in 2 years. Omicron will hold the securitiesuntil they mature.The market value of the securitiesat year-endwas $ 1 2 3 ,0 0 0 . 2. Omicron purchasedthe securitiesfor trading, hoping to make a quick profit. At yearend the market value of the securitieswas $120,000. 3. Omicron is uncertain about how long it will hold the securities.At year-endthe maris ket value of the securities $126,000. E10-16A. Appendix I 0B: Investments. During 2007, Nike has invested$200,000of extra cashin securities.Of the total amount invested,$75,000was investedin bondsthat Nike plans to hold until maturity (the bonds were issued at par value); $65,000 was invested in various equity securities that Nike plans to hold for an indefinite period of time; and $60,000 was investedin the stock of various com-

C H A P TE R . E X E R C IS E S 503 10 paniesthat Nike intendsto trade to make a short-termprofit. At the end of the year,the market value of the held-to-maturity securitieswas $80,000;the market value of the trading securities was $75,000; and the market value of the available-for-salesecuritieswas $55,000. Use the accounting equation to record all adjustmentsrequired at year-end, and indicate how the effects of each group of securitieswill be reported on the financial statements.

Exercises-Set B
E10-18. Discontinuedoperations.(LO 1) Use the following information to construct a partial income statementbeginning with income from continuing operations. Income from continuing operations Loss during the year from operation of discontinued operations Tax benefit of loss Loss from sale of discontinued operations Tax savinss from loss on the sale

$310,000
75,000

19,400 105,750 32.000

E10-28. Extraordinaryitems.(LO l) Tropical Vacationssuffereda $1,070,000loss due to a tsunami, which qualifies as an extraordinary item for financial statement purposes. The tax benefit of the loss amounts to If (net of tax) amounted $1,861,250, $155,000. income from continuingoperations to what is net income? E10-38. Horizontal analysis. (LO 2) Making Every Day Sunny Umbrellas reported the following amounts for salesduring the past 5 years.Using 2006 as the baseyear, perform a horizontal analysis.What information does the analysisprovide that was not apparentfrom the raw numbers? 2010 $27,925 2009 $30,400 2008 $33,525 2007 $ZS,ZSO 2006 $30,300

E1-0-48. Vertical analysis. (LO 2) Use the income statementfrom DesignersDiscount Inc. to perform a vertical analysiswith salesas the base. Designers DiscountInc. IncomeStatement Forthe year ended March 28, 2008 Sales revenue Costof goods sold Grossprofit on sales Operatingexpenses: Depr ec iat io n -b u i l d i n g s n d e q u i p me n t a O t her s ellinga n d a d mi n i s tra ti v e Total expenses Incomebefore interestand taxes lnterestexpense Incomebefore taxes lncometaxes Net inc om e $ ZA S $16,374 7,985 $ 8,389

3,750 4,015 $ q,ztq 254 $ 4,120 1,236 $ 2,884

E10-58. Current ratio and working capital. (LO 3) Calculatethe current ratio and the amount of working capital for Mike & Kat Racing Company for the years given in the following comparativebalancesheets. Although 2 years will not show a signihcant trend, what is your opinion of the direction of theseratios?

504

T F A STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E 10 CHAPTER . USI NGFI NANCI AL

Mike & Kat RacingCompany BalanceSheet At December31, 2008 and 2007 2008 Current assets: Cash net Accountsreceivable, lnventory Prepaidexpenses Total current assets Equipment,net Total assets Total current liabilities li L o n g -te rm abi l i ti es Total liabilities equity Shareholders" R e ta i n e d a rni ngs e equity Total liabilitiesand shareholders'

2007 $192,000 85,000 170,500 14,000 461,500 19s,000 $656,500 $259,000 190,000 459,000 148,250 49,250

$186,000 94,000 185,000 17,000 482,000 215,000 $697,000 $257,000 185,000 452,000 163,750 81,250 $697,000

$6s6,s00

E10-68. Debt-to-equityratio. (LO 3) Use the balance sheetsfrom Mike & Kat Racing Company in E10-5B to compute a debtto-equity ratio for 2008 and 2007. Supposeyou calculated a debt ratio using debt plus equity as the denominator.Which ratio-debt to equity or debt to debt plus equity- seems easiestto interpret?As an investor,do you view the "trend" in the debt to equity ratio as favorable or unfavorable?Why? E10-7B. Ratio analysis. (LO 3) Crystal Cromartie's Frozen Foodsreportedthe following for the fiscal years endedSeptem-

30,2007. and ber30,2008, September 30 September (in millions) Accounts receivable Inventory Current assets liabilities Current liabilities Long-term equity Shareholders' Sales sold Cost goods of Interest expense Netincome 2008 2007

$ zt,zas
45,692 185,7't6

$ t:,goz
47,682 155,716 72,263 17,852 58,035 70,223 52,7s0 43.2 1,006

80,9s4 15,251 21,871 88,455 60,463 21.5 1,842

Assume there is no outstandingpreferred stock and all salesare credit sales.Calculate the following ratios. a. Current ratio (for both years) b. Accounts receivableturnover ratio (for 2008) c. Inventory turnover ratio (for 2008) d. Debt-to-equity ratio (for both years) e. Return on equity (for 2008) Do any of theseratios suggestproblems for the company?

C H A P T E R0 r E X E R C I S E S 505 1

E10-88. Ratio analysis.(LO 3) Hutson Coffee Shopsreported the following for the two most recent fiscal years. Dec em ber 31 Cash (net) Receivables Merchandise inventory Fixedassets Total assets Accountspayable Long-termnotes payable Commonstock Ret ained ni n g s ear T ot al liabilit ies n d s h a re h o l d e rs 'q u i ty a e Net incomefor the year ended 1213111O ( S ales all s ales e re o n a c c o u n t) w Costof goods sold Interestexpense

201 0 $ 34,000 8s,000 74,000 365,000 $ss8,000 65,000 82,000 175,000 23s,000 $s58,000 $11s,000 620,000 284,000 3,000

2009 $ 17,000 80,000 48,000 324,O00 $469.000 83,000 112,000 144,000 130,000 $469,000

Calculate the following for the year endedDecember 31,2010. a. Current ratio b. Working capital c. Accounts receivableturnover ratio d. Inventory turnover ratio e. Return on assets f. Return on equity E10-98. Ratio analysis.(LO 3) International Imports Corporation reported the following for its fiscal year ended June30, 2007.

Sales Costof sales Grossmargin Expenses* Net income

$640,000 470,000 170,000 94,000 $ 76,000

xlncluded in the expenses were $9,000 of interestexpenseand $14,000 of income tax expense. At the beginning of the year, the company had 40,000 sharesof common stock outstanding and no preferred stock. At the end of the year, there were 25,000 common shares outstanding and no preferred stock. The market price of the company's stock at year-end was $15 per share. The companydeclaredand paid $46,000ofdividends nearyear-end. Calculate earnings per share,the price-earnings ratio, and times-interest-earned ratio for International Imports. E10-108. Horizontal analysis.(LO 2) Use the statementof income for Wendy's to perform a horizontal analysisfor each item reportedfor the year from January2,2005, to Januaryl,2006. What doesyour analysistell you about the operationsof Wendy's for the years reported? E10-118. Verticalanalysis.(LO 2) Use the statementof income for Wendy's to perform a vertical analysis for each item reported for 2005 and 2004 using salesand other operating revenuesas the base.What does your analysistell you about the operationsof Wendy's for the years reported?

50 6

F T A STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E 10 CHAPTER . USI NGFI NANCI AL

Wendy's International, Inc. and SubsidiariesConsolidated Balance Sheets

(Dollars

in thousand,s)

January1, 2006and Jamary 2,2005 2005 2004

Assets Current assets Cashandcashequivalents..... Accounts receivable, net , . . Notes receivable, net Deferred income taxes . Inventories and other Advertising fund restricted assets . Assets held for disPosition Total current assets Property and equipment, net Notes receivable, net Goodwill Defened income taxes Intangible assets,net Other assets. Total assets Liabilities and Shareholder's Equity Current liabilities Accounts payable Accrued expenses Salaries and wages Taxes Insurance Other Advertising fund restricted liabilities Current portion of long-term obligations Total current liabilities Long-term obligations Term debt Capital leases Total long-term obligations Deferred income taxes Other long-term liabilities Commitments and contingencies Shareholder's equity Preferred stock, Authorized: 250,000shares Common stock, $.10 stated value per share, Authorized:

$ 393,241 138,999 11,746 29,043 62,868 53,866 66,803 756,566 2,325,888 14,796 128,808 6,623 4L,757 165,880 $3,440,318 $ 188,481 51,184 116,920 58,t47 90,263 68,929 9,428 583,352 559,097 56,736 615,833 78,206 104,338

$ 176,749 127,158 11,626 27,280 56,010 60,021 0 458,844 2,349,820 t2,652 166,998 6,772 41,787 160,671 $3,197,544 $ 197,247 46,971 108,025 53,160 92,838 60,021 130,125 688,387 538,055 55,552 593,607 109,674 90,187

200'000'000shares.

shares, respectively 12,549 and Issued:125,490,000 118,090,000 405,588 ofstatedvalue Capitalin excess 1,858,743 Retained earnings
Accumulated other comprehensive income (expense): Cumulative translation a{iustments and other Pension liability and 5,681,000 Tleasury stock, at cost: 7,681,000 shares, respectively Uneamed compensation-restricted stock Total shareholder's equity Total liabilities and shareholder's equity

11,809 1l 1,286 r,700,813 102,950 (913) 1,925,945 (195,124) (15,132) 1,715,689

Lr5,252 (1,0e6) 2,391,036 (294,669) (37,778) 2,058,589

q#4qfl8

wgj44

See accompanying Notes to the Consolidated Financial Statements.

C H A P T E R0 . E X E R C I S E S 1

Wendy's International, Inc. and Subsidiaries Consolidated Statements of brcome

(In thousonds,

effiept per shnre d,ata)

YearBnded January1,2006 2005

YearEnded YearEnded Janrary2,2005 December28,2003 2004 2003

Revenues Retail sales Franchise revenues Total revenues Costs and expenses Cost of sales Company restaurant operating costs . . . . Operating costs Depreciation of property and equipment General and administrative expenses Goodwill impairment Other (income) exlpense,net . . . Total costs and expenses Operating income Interest expense Interest income Income before income taxes Income taxes Net income Basic eamings per common share Diluted earnings per common share Dividends per common share Basic shares Diluted shares

$3,028,4r4 754,733 3,783,t47 2,003,804 682,505 171,919 199,680 321,518 36,141 (9,603) 3,405,964 377,L83 (46,405) 7,286 338,064 113,997 $ 224,067 -$135$ 1 . 92 $0.58 LL4,945 1 1 6 ,819

$2,935,899 699,539 3,635,438 1,900,635 668,948 168,492 L78,394 283,72I 190,000 18,644 3,408,834 226,604 (46,950) 4,409 184,063 132,028 $ 52,035 :ffi $0.45 $0.48 113,832 115,685

fi2,534,t35 614,777 3,r48,9r2 1,618,002 550,643 135,332 163,481 261,070 0 r,942 2,730,470 4r9,442 (45,773) 4,929 377,598 141,599 $ 235,999

ffi

$2.05 $0.24 113,966 115,021

See accompanying Notes to the Consolidated Financial Statements.

E10-12B. Liquidity ratios. (LO 3) Use the financial statements forWendy's to calculatethe following liquidity ratios for 2005. What do theseratios tell about the firm? a. Current ratio b. Acid-test ratio c. Working capita. E10-13B. Solvencyand profitability ratios. (LO 3) Use the financial statementsfor Wendy's to calculate the following solvency ratios and profitability for 2005 and provide an interpretation for each ratio. a. Debt-to-equityratio b. Times-interest-earned ratio c. Return on assets d. Return on equity e. Gross margin percentage 810-14B. Risk and control. (LO 4) Describe the risks of investing your money in the stock market. How can you reduce those risks? Why are you willing to take risks like these? E10-15B. Appendix I 0B: Investments. Kinsey Scalesinvested$164,000of its extra cashin securities.Under each of the following (a) independent scenarios, calculatethe amountat which the investments would be valuedfor

508

CHAPTER O o USI NGFI NANCI AL 1 T STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E A F

the year-endbalance sheet,and (b) indicate how these scenariosshould be reported on the other financial statements, at all. if 1. Al1 the securitieswere debt securities,with a maturity date in 2 years. Kinsey will hold the securitiesuntil they mature. The market value of the securitiesat year-endwas $158,000. 2. Kinsey purchasedthe securitiesfor trading, hoping to make a quick profit. At year-endthe market value of the securitieswas $162,000. 3. Kinsey is uncertain about how long it will hold the securities.At year-endthe market value of the securities $167,000. is 810-168. Appendix I 0B: Investments. During 2009, Arctic Fans& Blowers hasinvested$245,000of extra cashin securities. the Of total amountinvested,$115,000was investedin bondsthat Arctic plans to hold until maturity (the bonds were issuedat par); $55,000 was investedin various equity securitiesthat Arctic plans to hold for an indefinite period of time; and $75,000 was investedin the stock of various companiesthat Arctic intendsto trade to make a short-termprofit. At the end of the year, the market value of the held-to-maturitysecuritieswas $108,000,the market value of the trading securities was $52,000, and the market value of the available-for-salesecuritieswas required at year-endand in$85,000.Use the accountingequationto record all adjustments dicatehow the effectsof eachgroup of securitieswill be reportedon the financial statements. Problems-Set A P10-1A. Discontinuedoperationsand extraordinaryitem. (LO 1) Each of the following items was found on the financial statements Hartsfield Company for for the year endedDecember31,2007. Net income from continuingoperations Gain on the saleof a discontinued segment, of taxesof $42,000 net Loss from operationof discontinued segment, of taxesof $24,000 net Gain on saleof land Extraordinaryloss,net of taxesof $6,000 $136,500 140,000 (80,000) 65,000 (20,000)

Required
a. For the items listed, indicate the financial statementand appropriatesection, where applicable, on which each would appear. b. Provide a description of each item and give as many details of each item's presentation possible. financial statement as c. Basedon the dataprovided,what is HartsfieldCompany'stax rate? (LO I) P10-24. Prepareqn incomestatement. The Pops Corporation had the following for the year ended December 3 I , 2008. Sales Cost of goodssold Interest income Gain on sale of equipment Selling and administrative expenses Interest expense Extraordinary gain Loss from discontinued segmentoperations Gain on disposal of discontinued segment

$s75,000 230,000 10,000 9,000 12,000 5,000 15,000 (10,500) 28,000

Required
Assume the corporation is subject to a 30Votax rate. Preparean income statementfor the year endedDecember31, 2008.

C H A P TE R . P R OB LE MS 509 10 P10-3A. Prepare an income statement.(LO 1) The following balancesappearedin the generalledger for Hacky Sak Corporation at fiscal year end September 2008: 30, Selling and administrative expenses Other revenuesand gains Operating expenses Cost of goodssold Net sales Other expensesand losses

$ 2s,000 50,000 75,000 135,000 375,000 15,000

In addition, the following occurred throughout the year. 1. On April 10, a tornado destroyedone of the company's manufacturing plants resulting in an extraordinary loss of $55,000. 2. On July 31, the company discontinuedone of its unprofitable segments. The loss from operations was $25,000.The assets the segment of were sold at a gainof $15,000.

Required
a. Assume Hacky Sak's income tax rate is 40Vo;preparethe income statementfor the year endedSeptember 2008. 30, b. Calculate the earningsper sharethe company would report on the income statementassumingHacky Sak had a weighted averageof 200,000 sharesof common stock outstandingduring the year and paid preferred dividends of

$s,000.
P10-4A. Preparehorizontaland vertical analysis.(LO 2) Given the followins income statements:

Year ended December 31, (inthousands) 2008 2007 $4,934,430$4,881,103 $5,003,837 2,7s5,323 2,804,459 2,784,392 2,248,514 2,129,971 2,096,711 2009

Net s ales Costof goodssold profit Gross

gener a l , n d a d m i n i s tra ti v e S elling, a expenses 1,673,449 1,598,333 1,573,510 O per at inginc o m e Interestexoense Interestand net investment (income) expense Other expense-net Incomebefore incometaxes Incometaxes Net inc om e Required a. For each of the years shown, preparea vertical analysis,using salesas the base. Write a paragraphexplaining what the analysis shows. b. Using 2007 as the baseyear, prepare a horizontal analysisfor salesand cost of goods sold. What information does this analysis give you?

575,065 61 168 , (s,761) 29,540

490,118 185,258

531,638 71 1 ,97
(6,482) 26,046 440,103 167,239

523,201 80,837 (8,278) 23,355

427,277 166,663

$ :o:,aso 5 ztz,a'q $ zao,au

510

T A F CHAPTER 0 . USI NGFI NANCI AL 1 STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E

P10-5A. Calculate and analyzefinancial ratios. (LO 3) Given the information below from a ftrm's financial statement: Y earended D ecember 31, (in thousands) 2009 Net sales(all on account) Costof goods sold Grossprofit Interestexpense Incometaxes Net income C a s h n d c ashequi val ents a less Accountsreceivable, allowance Total current assets Total assets Total current Iiabilities L o n g -te rml i abi l i ti es Total shareholders' equity* *The firm has no preferredstock. 2008 2007 $s,003,837 $4,934,430 2,755,323 2,804,459 2,248,514 2,129,971 61,168 't86,258 71,971 167,239

[_4r,899W
$ 18,623$ rg,r3g $ 3,s30 606,046 604,516 546,314 1,597 ,377 1,547,290 1,532,253 4,0s2,090 4,065,462 4,03s,801 1,189,862 1,111,973 44,539 1,153,595 1,237,s49 1,698,532 1,715,940 1,592,180

Required
a. Calculate the followine ratios for 2009 and 2008: 1. Current ratio 2. Acid-test ratio (assumeno short-term investments) 3. Working capital 4. Accounts receivableturnover ratio 5. Debt-to-equity ratio ratio 6. Times-interest-earned 7. Return on equity 8. Gross profit percentage b. Supposethe changesfrom 2008 to 2009 in each of theseratios were consistent with the direction and size ofthe changefor the past severalyears.For each ratio, explain what the trend in the ratio would indicate about the company.

C H A P T E R0 o P R O B L E M S 1

511

P10-6A. Calculate and analyzefinancial ratios. (LO 3) The following information was taken from the 2008 annual report of Presentations. A t D ecember 31, (i n thousands)

2008
ASSETS Currentassets Cas h Accountsreceivable M er c hand i s en v e n to rv i Prepaidexpenses Total current assets P lantand equ i p m e n t: B uildingsn e t , E quipm en t, e t n T ot al pla n t a n d e q u i p me n t Total assets LIABILITIES Cur r entliabil i ti e s Accountspayable Notespayable Total current liabilities Long- t er m b i l i ti e s lia T ot al liabilit i e s STOCKHOLDERS' EQUITY Com m ons t o c k ,n o p a r v a l u e Ret ained rn i n g s ea Total stockholders' ity equ T ot al liabili ti e s n d s to c k h o l d e rs ,q u i ty a e S ales ev enue r Costof goods sold profit on sales Gross Operatingexpenses: Depr ec iat i o n -b u i l d i n g s n d e q u i p me n t a O t her s ellin ga n d a d m i n i s tra ti v e Total expenses Incomebefore interestand taxes Interestexpense Incomebefore taxes Incometaxes Net inc om e

2007

$ 1,617 1,925 2,070 188 5,800 $ q,qst 1,293

$1,220 3,112 966 149 5,447 $2,9s2 1,045 $4,037

$ s,zso $tt,sso

v484
$1,68s 1,100 2,785 2,000 4,795 3,042 1,657 4,699 59,484

z $ t,st
900 2,717 3,s00 6,217 3,390 1,943 s,333

!r_u!g
$12,228 8,751 3,477 102 2,667
2,769 708 168 540 ' t14

$ qzo

Required
a. Calculate the following ratios for 200g and 2007 wheneverpossible. 1. Debt-to-equityratio 2. Grossmargin percentage 3. Currenl ratio 4. Acid-test ratio 5. Times-interest-earned ratio b. What do the ratios indicate about the successof Presentations? What additional information would help you analyze the overall performance of this company?

512

T A F CHAPTER . USI NGFI NANCI AL 10 STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E

P10-7A. Calculate and analyzefinancial ratios. (LO 3) The financial statementsof For the Kitchen include the followins items.

At June 30, 2007

Ba l a n c e h eet: s Cash (in Investments trading rities) secu (net) Accountsreceivable Inventory Prepaidexpenses Total current assets T o ta lc u rre n tl i abi l i ti es Incomestatementfor the y e a r e n d ed Net credit sales Costof goods sold

June 30, 2005 $ 12,000 16,000 s0,000 70,000 12,000 160,000

June 30, 2005 $ 14,000 20,000 48,000 73,000 10,000 165,000 $ 7s,000

$ 17,000 10,000 54,000 75,000 16,000 172,000 $140,000

June 30, 2007:

$ 9o,ooo
June 30 2006:

$420,000 250,000

$380,000 225,000

Required
a. Compute the following ratios for the years endedJune 30,2007 , and whenever possible for the year ended June 30, 2006. For each, indicate ifthe direction is favorable or unfavorablefor the company. 1. Currentratio 2. Accounts receivableturnover 3. Inventory turnover ratio 4. Gross profit percentage b. Supposethe industry averagefor similar retail storesfor the current ratio is 1.7. Does this information help you evaluateFor the Kitchen's liquidity? P10-8A. Calculateand analyze financial ratios, (LO 3) You are interestedin investing in ReeseCompany,and you have obtainedthe balancesheets for the company for the past 2 years. Reese Company Balance Sheet AtJune 30,2007 and 2005

2007
Currentassets: Cash net Accountsreceivable, Inventory Prepaidrent Total current assets Eq u i p m e n t net , Total assets Total current Iiabilities L o n g -te rml i abi l i ti es T o ta l l i a b i l i t i es Commonstockholders' equity R e ta i n e d arni ngs e Total liabilitiesand stockholders' equity

2005

98,000 $1 210,000 270,000 15,000 693,000 280,000 $973,000 $306,000 219,000 52s,000 150,000 298,000 $973,000

$ eo,ooo
116,000 160,000 16,000 382,000 250,000 $642,000 $223,000 117,000 340,000 90,000 212,O00 $642,000

C H A P T E R0 . P R O B L E M S 1

513

for The following amounts were reported on the income statement the year ended June 30, 2007.
Sales Cost of goodssold Interest expense Net income Required a. Compute as many of the financial statementratios you have studied as possible with the information provided for ReeseCompany. Some ratios can be computed for both years and others can be computed for only 1 year. b. Would you invest in ReeseCompany?Why or why not? What additional information would be helpful in making this decision? Problems-Set B P10-18. Discontinued operations and extraordinary item. (LO I) for Each of the following items was found on the financial statements Logan Company for the year endedDecember31,2008. Income from continuing operations net Gain on the saleof discontinued segment, of taxes$9,000 Loss from operationof discontinued net segment, of taxesof $9,750 Gain on saleof equipment Extraordinaryloss from earthquake, oftaxes $45,000 net 85,000 30,000 (32,500) 12,000 (150,000)

$450,000 215,000 7,500 80,000

Required
a. For each item listed, indicate the financial statementand appropriatesection, if applicable, on which each would appear. b. Provide a description of each item and give as many details of each item's financial statementpresentationas possible. c. Basedon the dataprovided,what is Logan Company'stax rate? (LO 1) P10'2B. Preparean incomestatement. The Blues Corporation had the following for the year endedDecember 31,2007 . Sales Cost of goodssold Interest income Gain on sale of equipment Selling and administrative expenses Interest expense Extraordinary gain Loss from discontinued segmentoperations Gain on disposal of discontinued segment

$425,000 185,000 8,000 4,000 18,000 3,000 25,000

36,000

(e,s00)

Required
Assume the corporation is subject to a 40Votax rate. Preparean income statementfor the year endedDecember31,2007. P10-3B. Prepare an income statement (LO 1) The following balancesappearedin the generalledger for Ski Daddle Corporation at fiscal year-endDecember 3I, zOOi. Selling and administrative expenses Other revenuesand gains Operating expenses Cost of goodssold Net sales Other expensesand losses

$ 4s,000 80,000 110,000 185,000 325,000 8,000

514

T CHAPTER 0 . USI NGFI NANCI AL 1 A F STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E

In addition, the following occurred throughout the year. resulting in an extra1. On August2}, afire destroyedone of the company's warehouses ordinary loss of $35,000. 2. On October 31, the company discontinued one of its unprofitable segments.The loss The assets the segment from operations was $35,000. of were sold ata gainof $19,000.

Required
a. Assume Ski Daddle Corporation's income tax rate is 307o;preparethe income statementfor the year endedDecember 31, 2001. b. Calculate the earningsper sharethe company would report on the income statementassumingSki Daddle had 100,000 sharesof common stock outstandingduring the year and paid preferred dividends of $15,000. P10-4B. Perform horizontal and vertical analysis. (LO 2) Here are the income statementsfrom a frrm's recent annual reDort.

Year ended December 31, (in millions) 2008 2007 2006

Net revenue Costof sales Se l l i n g g e n eral , , and admi ni strati ve expenses Amortization of intangibleassets Other exoenses Operating profit Incomefrom investments Interestexoense Interestincome Incomebefore incometaxes Incometaxes Net income

526,971 12,379
9,460 145 204 4,783 323 (163) 51 4,994 1,424

$2s,112 11,497 8,9s8 138 224 4,295 280 (178) 36 4,433 1,433 $ 3,000

$ZZ,StZ 10,750
8,574 165

3s5
3,667 160 (21e) 67
3,675 1,24 4 $ 2,431

$ g,szo

Required
using salesas the base. a. For eachofthe yearsshown,perform a vertical analysis, Write a paragraphexplaining what the analysis shows. b. Using 2006 as the baseyear, perform a horizontal analysis for net revenueand cost of sales. What information doesthis analysisgive you?

C H A P T E R0 . P R O B L E M S 1

515

Consolidated Statement of Income RadioShack Corporation and Subsidiaries 31, Year EndedDecember 2005 2004
o/oof Revenues

(ln millions, except pershare amounts)

%ot Dollars Revenues

Dollars

Netsales operating and revenues $5,081.7 Costof products 2,706.3 sold profit Gross 2,375.4 Operating expenses: general Selling, and administrative 1,901.7 Depreciation and 123.8 amortization Totaloperating 2,025.5 expenses Operating income 349.9 lnterest income 5.9 (44.s) Interest expense Otherincome, net 10.2 Income beforeincome taxes 321.5 Provision income for taxes 51.6 Income beforecumulative effectof changein principle accounting 269.9 Cumulative effectof change principle, in accounting net (2.s) of $1.8 million benefit tax Net income 5 ZAI.O

100.0o/o $4,841.2 100.0% 2,406.7 49.7 53.3 46.7 2,434.5 s0.3

37.4 2 .4

1,774.8 101.4 1,876.2 558.3 11.4 (2s.6) 2.0 542.1 204.9

36.7 2.1 38.8 11.5 0.2

39.8 6.9 0.1 (0.8) 0.2 6.4 1.0

(0.s)
11.2 4.2

5.4

337.2

7.0

(0.1)
5.3o/o $ 337.2 7.00/o

516

CHAPTER . USI NGFI NANCI AL 10 T STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E A F

Consolidated Balance Sheets RadioShack Corporationand Subsidiaries December 31, (ln millions,exceptfor shareamounts) Assets Currentassets: C a s h n d cashequi val ents a Accountsand notes receivable, net Inventories, net Other current assets Total current assets plant and equipment,net Property, Other assets, net Total assets Equity Liabilities and Stockholders' C u rre n tl i a bi l i ti es: Short-termdebt, includingcurrent maturities of long-termdebt Accountspayable Accruedexpenses and other current l i a b i l i ti es Incometaxespayable Totalcurrent liabilities Long-termdebt, excludingcurrent maturities Oth e r n o n -currenti abi l i ti es l Total liabilities C o m m i tme nts and conti ngentl i abi l i ti es (s e eN o te s11 and 12) Stockholders' equity: Preferredstock,no par value, 1,000,000 shares authorized: S e ri e s j uni or parti ci pati ng, A 300,000 shares designatedand none issued Series convertible,100,000 B shares a u th ori zed and non i ssued Commonstock,$1 par value, 650,000,000 shares authorized; 19 1 ,0 3 3 ,000 i shares ssued p ai d-i ncapi tal Ad d i ti o n a l R e ta i n e d a rni ngs e Treasury stock,at cost;56,071,000 respectively and 32,835,000 shares, Unearnedcompensation lated other comorehensive Accumu income(loss) Total stockholders' equity Total liabilitiesand stockholders' equity 2005

2004

$ zzq.o 309.4
964.9 129.0 1,627 .3 476.2 101.6 $ 2,20s.1

437.9 241.O 1,003 . 7 92.5

't,775.1 652.0 89.6 2,s15.7 5

+o.g
490.9 379.5 75.0
986.3

$ ss.o
442.2 342.1 117.5 957.4 s05.9 130.3 1,594.6

494.9 135.1 1,515.3

191.0 88.2 1,741.4 (1,431.6)

191.0 82.7 1,508. 1 (8se. 4)

(0.s)
0.3
588.8

(0.3) 922.1 $ 2,s16.7

$ 2,20sj

The accompanying notes are an integral part of theseconsolidated financial statements.

10 C H A P TE R ' P R OB LE MS 517 P10-5B. Calculateand analyze financial ratios. (LO 3) Even The information given in P10-4B was taken from Radio Shack'sfinancial statements. most of them. you thoughyou did not studyall of the items on the statements, shouldrecognize

Required
a. Calculate the following ratios for 2005. 1. Currentratio 2. Acid-test ratio 3. Working capital 4. Accounts receivableturnover ratio (Assume all salesare credit sales.) 5. Debt-to-equity ratio ratio 6. Times-interest-earned 7. Returnon equitY b. Notice that Radio Shack provides a vertical analysis of the income statement. Comment on the changesbetween the 2 years shown. P10-68. Calculateand analyze financial ratios. (LO 3) The following information was taken from the annual report of ROM'

31, At December (inthousands) 2008

ASSETS: Currentassets: Cash Accountsreceivable inventory Merchandise Prepaidexpenses Total current assets P lantand equ i p m e n t: B uildingsne t , n E quipm ent, e t T ot al plan t a n d e q u i p m e n t Total assets LIABILITIES: Cur r entliabili ti e s : Accountspayable Notespayable T ot alc ur r e n tIi a b i l i ti e s l Long- t er m i a b i l i ti e s T ot al liabili ti e s EQUITY STOCKHOLDERS' Commonstock,no par value Ret ained rn i n g s ea equitY Total stockholders' equity Total liabilitiesand stockholders' S alesor t he ye a r f Costof goods sold Total assets Dec.31,2007 at a T ot al liabilit ie s t D e c .3 1 ,2 0 0 7 equity at Dec.31, 2007 Total stockholders'

$ 1,220 3,112 966 149 5,447 2,992 1,045 4,037 $_s,484

$ 1,68s 1,100 2,78s 2,000 4,785 3,042 1,657 4,699

!_2,4e!
$ 10,200 6,750 8,980 4,535 4,445

518

CHAPTER o USI NGFI NANCI AL 1O STATEM E N A N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E T T F

Required a. Calculate the following ratios for 2008: 1. Debt-to-equity ratio 2. Gross profrt percentage 3. Current ratio 4. Acid-test ratio b. What do the ratios indicate about the successof ROM? What additional information would be useful to help you analyzethe overall performanceof this company? P10-7B. Calculate and analyzefinancial ratios. (LO 3) The f,rnancialstatementsof Builder Bob's include the followins items. At Ba l a n c e h e et: s Cash (short-term) Investments (net) Accountsreceivable Inventory Prepaidrent Total current assets T o ta lc u rre n tl i abi i ti es l

Sept. 2008 30,

Sept. 2007 30,

$ zz,ooo
15,000
44,000

$ zz,ooo
12,000 40,000 75,000 2,000 51 $1 ,ooo $ 8o,ooo

85,000 5,000 77,000 $1 20,000 $1

Income statementfor the year ended September30, 2008:

Net creditsales Costof goods sold Required

$320,000 150,000

a. Compute the following ratios for the year ended September30, 2008, and September30,2007 . For each, indicate if the direction is favorable or unfavorablefor the company. 1. Current ratio 2. Quick ratio 3. Accounts receivableturnover (2008 only) 4. Inventory turnover ratio (2008 only) 5. Gross margin percentage(2008 only) b. Which financial statementusers would be most interestedin theseratios? c. Supposethe industry averagefor similar retail storesfor the current ratio is 1.2. Does this information help you evaluateBuilder Bob's liquidity?

PR G C H A P TE R . C R ITIC A LTH IN K INOB LE MS 519 10 P10-8B. Calculate and analyzefinancial ratios. (LO 5) You are interestedin investing in Apples and Nuts Company,and you have obtainedthe balance sheetsfor the company for the past 2 years. Apples and Nuts Company Balance Sheet At December 2008 and 2007 31, 2008 Currentassets Cash Accountsreceivable, net Inventory P r epaid ent r Total current assets E quipm ent ne t , Total assets T ot alc ur r entl i a b il i ti e s Long- t er mlia b i l i ti e s T ot al liabilit ie s Commonstockholders' equity Ret ained n i n g s ear T ot al liabilit ie s n d s to c k h o l d e rs 'q u i ty e a

2007 $ go,ooo 216,000 170,000 5,000 482,000 258,000 $740,000 $223,000 217,000 440,000 190,000 110,000 $740,ooo

$ 98,000 310,000 275,000 10,000 693,000 180,000 $873,000 $206,000 219,000 425,000 250,000 198,000 $873,000

Net income for the year endedDecember3L, 2008 was $ 100,000.

Required
a. Compute as many of the financial statementratios you have studied as possible with the information from Apples and Nuts Company. (Compute 2008 ratios.) b. Would you invest in this company?Why or why not? What additional information would be helpful in making this decision?

Critical Thinking Problems

Risk and Control Think about the risks of investing in a company and about the information provided by the financial ratios you studiedin this chapter.Which financial ratios do you believe might give you information about the risk of investing in a company? Comment on those ratios from Staples and Office Depot, which you calculated at the end of the chapter in the Chapter Summary Problem.

Ethics
Atlantis Company sells computer componentsand plans on borrowing some money to expand. After reading a lot about earningsmanagement, Andy, the owner of Atlantis, has decided he should try to acceleratesome salesto improve his frnancial statementratios. He by has called his best customersand askedthem to make their usual Januarypurchases December 31. Andy told the customershe would allow them until the end of February to pay just as if they had made their purchasesin January. for the purchases, a. What do you think are the ethical implications of Andy's actions? b. Which ratios will be imoroved bv acceleratinethese sales?

Group Assignment
In groups,try to identify the type of companythat is most likely indicatedby the ratios shown below. The four types of companies representedare: retail grocery, heavy machinery,

520

CHAPTER 0 o USTNG NANc TAL 1 Ft A STATEM E N T N A L y s r s r o E V A L U A T E I R M p E R F o R M A N C E F

restaurant,and drug manufacturer.Make notes on the argumentsto supportyour position so that you can sharethem in a class discussion. Gross Margin R a ti o 1 2 3 4 82.9o/o 3 3 .7 o/o 2 5 .3 % 37.4o/o (Long-term) Debt-toE qui tyR ati o 25o/o 134o/o 147% 620/o Accounts Receivable Turnover R ati o 5.5times 49.3ti mes 2.3 ti mes 34.9times Inventory Turnover R ati o 1.5times 11.2ti mes 5.0ti mes 32.9times

Returnon E qui ty 22.9% 3.6% 5.0o/o 15.7o/o

Internet Exercise: Papa John's International

PapaJohn's has surpassed Little Caesarsto become the number three pizza chain, behind only number onePizzaHut and numbertwo Domino's Pizza.PapaJohn's 2,800restaurants (about11%oare franchised) are scatteredacrossthe United Statesand 10 other countries. Examine how PapaJohn's compareswith its competition. IE 10-1. Go to www.papajohns.com and explore "Papa John's Story" and "Ow Pizza Story." What differentiates PapaJohn's from its competition? lEI0-2. Go to http://moneycentral.msn.com get the stockquoteforPZZA, PapaJohn's and stock symbol. Identify the current price-to-earningsratio and dividend yield ratio. What do thesemarket indicators mean for PapaJohn's? IE 10-3. Select"FinancialResults"and then "Key Ratios." a. Select "Financial Condition." Calculate the current ratio and quick (acid-test) ratio for PapaJohn's and the industry. Who would find theseratios of primary interest?Identify the debt-to-equity ratio and interest coverageratio (another name for times-interest-earned ratio) for PapaJohn's and the industry. Is Papa John'sprimarily financedby debt or equity?How can you tell? Does PapaJohn's have the ability to pay its interest obligations? Explain why or why not. b. Select "Investment Returns." Identify return on equity and return on assetsfor PapaJohn's and the industry. What do theseratios measure? c. Select "Ten-Year Summary." Review the information provided for return on equity and return on assets. What additional information is revealedabout Papa John's financial position? Is this information helpful? IE 10-4. Review the information recorded earlier. Does Papa John's compare favorably with industry averages? Support your judgment with at least two observations. Pleasenote: Internet Web sites are constantly being updated.Therefore, if the information is not found where indicated, pleaseexplore the Web site further to find information.

Appendix l0A
Comprehensive Income
In the chapter,you learned that the Financial Accounting StandardsBoard (FASB) has defined two items that companies need to separate from regular earnings on financial statements: discontinued operations and extraordinary items. There is a third itemcomprehensive income. Even though most transactionsthat affect shareholders'equityare found on the income statement-revenues and expenses-there are a small number of transactionsthat affect shareholders'equitythat are excludedfrom the calculation of net income. We alreadyknow about two of them: 1.. Owners making contributions (paid-in capital) 2. Owners receiving dividends In addition to thesetwo, there are severalother transactionsthat affect equity without going through the income statement.The most common examplesof thesetransactionsare ( 1) unrealized gains and lossesfrom foreign currency translationsnd (2) unrealized gains and losseson certain investments.Rather than including either of thesekinds of gains and losseson the income statement,they are reported as a direct adjustmentto equity. The reason is that these items do not really reflect a firm's performance,so firms have lobbied to have them kept out of the calculation of earnings.To keep thesetransactionsfrom getting lost among all the financial statementnumbers,the FASB requires the reporting of net inequity in an amount called comcome plus theseother transactionsthat affect shareholders' prehensive income. Comprehensiveincome includes all changes in shareholders'equity during a period except those changesin equity resulting from contributions by shareholdThere are two parts of comprehensiveincome: net iners and distributions to shareholders. come and other comprehensiveincome. We know what types of transactionsare included in net income-revenues, expenses,discontinued operations, and extraordinary items. Items included in other comprehensiveincome include unrealized gains and losses from foreign currency translationand unrealizedgains and losseson certain types ofinvestments. Exhibit 10A.1 shows all of the items that affect shareholders'equity.

Comprehensiveincome The total of all itemsthat affect shareholders' equity except transactions with the owners; comorehensive incomehas two oarts:net incomeand other comprehensive income.

income What is the purposeof having a statementof comprehensive ratherthan a simpleincome statement?

Your Turn
$"-'h.ru,N*ww'$lh.$,e.,w'm

521

522

CHAPTER . USI NGFI NANCI AL 10 T STATEM E N T N A L Y S I S O E V A L U A T E I R M P E R F O R M A N C E A F

Items that Affect Shareholders' Equiff

EXHIBIT 1O.A1
Comprehensive Income
The items in the left column appear on the financial statements in the equity classifications shown in the rieht column.

Appendix l0B
Investments Securities in
You have learned that certain gains and lossesrelated to investmentsmay be included in other comprehensiveincome. We will take a closer look at how a firm accountsfor its investmentsin the securitiesof another firm. You will seehow gains and losseson some of theseinvestmentsare reported as part of comprehensiveincome. When interest rates are low, a company's extra cash-cash not immediately neededmay earn more in the stock market or bond market than it would in a bank savingsaccount or certificate of deposit. That is when a company buys stocks and bonds of other companies with its extra cash.For entities such as banks and insurancecompanies,investing cash in other companies is a crucial pafi of managing their assets.As you learned in previous chapters,stocks are equity securitiesand bonds are debt securities.Both may be purchased with a company's extra cash.When a company buys another company's debt securitiesor less than 207oof its equity securities,the accountingrules require firms to classify their investmentsin securitiesinto one of three categories:held to maturity, trading, and available for sale.

Held-to-Maturity Securities
Sometimesa companypurchases debt securitiesand intendsto keep them until they mature. Recall that all bonds have a maturity date,but equity securitiesdo not. If a companyhas the intention of keeping the securitiesuntil maturity and their financial condition indicatesthat they shouldbe ableto do this, the securitieswill be classifiedasheld-to-maturity securities. Such investmentsare recordedat cost, and they are reported at that sameamount on the balance sheet-plus or minus any unamoftized discount or premium. No matter how much held-to-maturity investmentsare worth on the market, a company will always report them at amortized cost when preparing its balancesheet.

Held-to-maturity securities Investments debt securities in that the companyplansto hold until they mature.

Trading Securities
If a companybuys the securitiessolely to trade them and make a short-termprofit, the company will classify them as trading securities. The balancesheetshowstrading securitiesat their market value. A company obtains the current value of the investmentsfrom The Wall StreetJournal or a similar sourceof market prices. Those values are then shown on the balance sheet.Updating the accounting records to show the securitiesat their market value is called marking to market.If the securities' cost is lower than market value, then the company will record the difference as an unrealized gain. If the securities' cost is higher than market value, then the company will record the difference as an unrealized loss. Remembe1,realizing meansactually getting something.Any gain or loss on an investmentthe company is holding (holding mears not selling) is somethingthe company doesnot get (a gain) or does not give up (a loss) until the company sells the securities. Unrealized gains or losses are gains or losseson securitiesthat have not been sold. Such a gain or loss may also be called a holding gain or /oss.The unrealizedgains and lossesfrom trading securitiesare reported on the income statement.

Trading securitiesInvestments in debt and equity securities that the companyhas purchased make a shortto term orofit. gain or lossAn Unrealized increase decrease the or in market value of a company's investments securities in is recognized either on the income statement-for trading securities-or in other comprehensive incomein the equity sectionof the balance sheet-for available-for-sale securities-whenthe financial statements prepared, are even though the securities havenot been sold.

523

524

CH A P TER . USINGFI NANCI AL 1O STATEM ENT ANALY S I S O E V A L U A T E I R M P E R F O R M A N C E T F

For example, supposeAvia Company has invested $130,000 of its extra cash in securities-stocks and bonds traded on the stock and bond markets. At the end of the year, the securitiesthat cost Avia $130,000have a market value of $125,000.On the income statementfor the year, Avia will show an unrealized loss of $5,000. The loss is recorded in an adjustment made before the financial statementsare prepared. The securities'newvalue of $125,000(originally $130,000minus loss of $5,000)has replaced their original cost. Now, $125,000 will be the "cost" and will be comparedto the market value on the date of the next balance sheet. Remember, the company purchased these trading securities as investmentsto trade in the short run, so the firm's investment portfolio is likely to look very different at the next balance sheetdate.

Available-for-Sa le Securities
Sometimesa company is not sure how long it will keep the debt or equity securitiesit has purchased.Ifthe company doesnot intend to sell the securitiesin the short term for a quick profit or does not intend to hold them until maturity, the company will classify the securities as available for sale. Every year, when it is time to prepare the annual balance sheet, the cost of this group of securitiesis comparedto the market value at the balancesheetdate. The book value of the securities is then adjusted to market value, and the corresponding gain or loss is reported in shareholders'equity. Such a gain or loss is called an unrealized or holding gain or loss,just as it is called for trading securities.But thesegains and losses do not go on the income statement.Instead,they are included as part of accumulatedother comprehensiveincome in the shareholders'equity section of the balance sheet.

Available-for-sale securities Investments companymay the hold or sell;the company's intention is not clearenough to useone of the other categories-he Id to m atu rity or trading.

Your Tarn
,"i, . ,1' t

A corporation invested has in of $50,000 the securities other companies. At portfoliohasa market the endof the yeaI that corporation's valueof $52,000. Describe where these securities would be shown on the annualfinancial statements at what amountundereachof the conditions and described. 1. Theinvestment classified tradingsecurities. is as 2. Theinvestment classified available sale. is as for 3. Theinvestment classified heldto maturity. is as
Avia Company classifiedits portfolio of securitiesthat cost $ 130,000as availSuppose ablefor sale.Ifthe marketvalueofthe securities $125,000at the dateofthe balance is sheet, the securitiesmust be shown on the balance sheetat the lower amount. In this case,the unrealized loss will nol be shown on the income statement.Instead of going through net income to retained earnings,the loss will go through comprehensiveincome to accumulated other comprehensiveincome in the shareholders'equity section of the balance sheet.The loss will be shown after retained earnings,either alone-and labeled as an unrealized loss from investmentsin securities-or combined with other nonincome statement sains and losses-and labeled as accumulatedother comprehensiveincome.

Selling Securities the

When a firm sells any of thesesecurities-trading, availablefor sale,and held to maturitythe gain or loss on the sale is calculated like other accounting gains and losses.The book value of the security at the time of the saleis comparedto the selling price. The selling price is often called the proceedsfrom the sale.If the book value is greaterthan the proceeds,the firm will record a loss on the sale.If the book value is less than the proceeds,the firm will record a gain on the sale. Gains and lossesfrom the actual sale of the securities are both realized-the sale has actually happened-and recognized-the relevant amounts are shown on the income statement.