Financial Accounting 10

Using Finonciol Stotemenl Anolysis fo Evoluole Firm Performunce

Here's Where You've BeenYou leorned to construct o siotement of cosh flows from on income stotement ondcomporotive bolonce sheets.

When you are finished studying this chapter, you should be able to:

1. Recognize and explain the components of net income.

2. Perform and interpreJ a horizontal analysis and a vertical analysis of f,rnancialstatement information.

3. Perform a basic ratio analysis of a set of financial statements and explain what theratios mean.

4. Recognize the risks ofinvesting in stock and explain how to control those risks.

Here's Where You're Going\.-- You will leorn to use verticol onolysis, horizontol onolysis, ond rotio onolysis

{,aarniry Q&iecfluep

475

476 CHAPTER 1O . USING FINANCIAL STATEMENT ANALYSIS TO EVALUATE FIRM PERFORMANCE

#fAiesAccounting information is an important part of the financial infor-mation investors use to evaluate a firm's performance. As an in-vestor, you need to feel confident in a firm's reported earnings.When a firm has made an error, earnings may need to be restated.There were a record number of earnings restatements in 2005-around 1,200. The surpr is ing thing about this high number of re-statements is that only f ive were the result of an investor class-action

lawsuit against accounting firms. This is a sharp decline from previous years.According to Professor Joseph Grundfest of Stanford Law School, a former

SEC commissioneL one reason is the improved corporate governance after thepassage of the Sarbanes-Oxley Act. Even when a firm must restate its earnings,investors are beginning to real ize that honest f i rms are doing their best to pro-duce accurate f inancial statements.

lSource: "Legal Beat; Earnings Restated? Don't Blame a Lawsuit for l t ," by Stephen Labaton, IheNew York llmes. February 3, 2005.1

A Closer Look at the Income StatementYou have learned a great deal about the basic financial statements and how accountantsrecord, summarize, and report transactions. There is information you can easily see in the fi-nancial statement, but there is also information that is difficult to see. It is important to lookbeyond the size and source of the numbers to see what the numbers mean.We have been ex-amining the individual parts of the financial statements. Now we will examine all the partsof the four financial statements together to answer the following questions: What informa-tion do financial statements provide? What does the information mean? How can we use it?

Before beginning the detailed analysis of the financial statements, we need to take acloser look at some of the characteristics of the income statement. Because earnings-netincome-is the focus of financial reporting, companies worry about how current and po-tential investors will interpret the announcement of earnings each quarter. It is not uncom-mon for companies to be accused of manipulating their earnings to appear more profitablethan they actually are. In an effort to make the components of earnings clear and to repre-sent exactly what they should to financial statement users, the Financial Accounting Stan-dards Board (FASB) requires that two items be separated from the regular earnings of acompany. The major reason for segregating these items is that they should not be consid-ered as part of the ongoing earnings of the firm. Reported earnings is an amount used topredict future earnings, but these two items are not expected to be repeated in the future.

1. Discontinued operations2. Extraordinary items

Exhibit 10.1 shows the components of net income.

Discontinued OperationsIfyou pay attention to the financial news, you are bound to hear about a company selling offa division. In2004, Motorola, one of the largest communications firms in the world, discon-tinued operating its semiconductor business segment so that the segment could form its ownfirm, Freescale Semiconductor. The gains or losses from these kinds of transactions areshown separately on the income statement. Firms are always evaluating the contribution thatthe various divisions make to the profits of the firm. If a division is not profitable or no longerfits the strategy of the firm, a frrm may sell it to remain profitable or change the firm's focus.Parts of a company's operations that are eliminated are called discontinued operations.

L.()"rRecognize and explain thecomponents of net income.

Discontinued operationsThose parts of the firm that acompany has el iminated bysel l ing a div is ion.

CHAPTER 10 o A CLOSER LOOK AT THE INCOME STATEMENT 477

When a firm eliminates a division, the financial implications are shown separately

from the regular operations of the firm. Why would this separation be useful? Earnings is

an important number because it is used to evaluate the performance of a firm and to pre-

dict its future performance. To make these evaluations and predictions more meaningful,

it is important that one-time transactions be separated from recurring transactions. This

separation allows investors to see one-time transactions as exceptions to the normal oper-

ations of the firm. In addition to the gain or loss from the sale, the earnings or loss for the

accounting period for the discontinued operations must also be shown separately. We will

look at an example of a firm with discontinued operations. In 2007, Muzby Manufactur-

ing 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 divi-

sion. Both the current year's income or loss from the crate-production division and the gain

or loss from the sale of those operations are shown separately on the income statement'

Suppose:

L. Muzby Manufacturing's income from continuing operations before taxes was $395,600'

2. Taxes related to that income were $155,000.3. The discontinued segment contributed income of $12,000 during the year.

4. Taxes related to that contributed income were $1,900.5. The discontinued segment was sold for a gain of $63'000.6. The taxes related to the profit from that gain were $28'000.

Exhibit 10.2 shows how this information would be presented on the income statement for

Muzby Manufacturing.

Extraordinary ltemsYou have learned that discontinued operations are the first item that accountants disclose

separately on the income statement. The second item is the financial effect of any event that

is unusual in nature and infrequenl in occurrence. The financial effects of such events are

called extraordinary items. To qualify as extraordinary, the events must be abnormal and

must not be reasonably expected to occur again in the foreseeable future. There is a great

deal of judgment required to decide if an event should be considered extraordinary. Exam-

ples of occurrences that have been considered extraordinary include eruptions of a volcano,

a takeover of foreign operations by 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

considered in light of the environment in which the business operates.

Suppose Muzby Manufacturing has a factory in China, and the Chinese government

decides to take possession of all American businesses in the country. The value of the lost

factory is $200,000. U.S. tax law allows companies to write off this type of extraordinary

loss, which means the company receives a tax savings. Suppose the applicable tax savings

is $67,000. Exhibit 10.3 shows how Muzby Manufacturing would present the information

on its income statement for the year.

EXHIBIT 10.1

Componentsof Net lncomeIt's important for investors to see

the individual pieces of earnings.

Extraordinary items Eventsthat are unusual in natureand infrequent in occurrence.

478 CHAPTER 10 . USTNG FTNANcIAL STATEMENT ANALysts ro EVALUATE FIRM pERFoRMANcE

EXHIBIT 10.2

Showing Discont inued Operat ions on the Income StatementThe highlighted portion of the income statement shows how amounts related to discontinued operations are presented.

Muzby ManufacturingIncome Statement

For the year ended December 3I,2007

Income from continuing operations before income taxes . . $395,600Income tax expense 155,000Income from continuing operations 240,600Discontinued operations

Incomefromdiscontinuedcrate-productionsegment(netoftaxesof$1,900).. . $10,I00Gain on disposal of crate-production segment (net of taxes of $28,000) . . 35,000 45,700

Net income $28b.200

EXHtBtT 10.3

Showing Extraordinary l tems on the Income StatementThe highlighted portion of the income statement shows how amounts related to extraordinary items are presented.

Muzby ManufacturingIncome Statement

For the year ended December 3I,2007

Income from continuing operations before income taxes . . $395,600Income tax expense 155,000Income from continuing operations 240,600Discontinued operations

Income from discontinued crate-production segment (net of taxes of $1,900) . . . . $10,100Gain on disposal of crate-production segment (net of taxes of $28,000) . . 35,000 45,100

Income before extraordinary item $r85J00Loss on extraordinary item

Expropriation of foreign operation (net of taxes of $67,000) (133,000)Net income $1b2.200

IIIIl - r -

7

'heurs fhsAWas Huricane Katrina an extraordinary event?

Almost everyone would consider Hurricane Katrina an extraordinary event. That is,everyone except the Financial Accounting Standards Board. For firms that incurredlosses from the hurricane, their financial statements did not treat the losses as extraor-dinary. However, if any of the firms operating segments were lost or shut down, thelosses were segregated as discont inued operat ions. Check out Ruths Chris SteakHouse's income statement, which you can f ind on the firm's website, for the year endedDecember 31 , 2005. Included in operating costs, hurricane and relocation costsamounted to $2,660,000.

CHAPTER 10 . HORIZONTAL AND VERTICAL ANALYSIS OF FINANCIAL INFORMATION

Reporting TaxesIn general, firms report total revenues and expenses and then subtract the associated taxes.However, the hnancial effects of discontinued operations and extraordinary items areshown net of tax.

479

What does it mean for a company to show discontinued operations and extra-ordinary items net of taxT What is the alternative?

Horizontal and Vertical Analysisof Financial InformationNow that you are prepared to recognize extraordinary items and discontinued operationsthat may appear on the income statement, you are ready to analyze an entire statement orset of statements.

There are three primary ways to analyze financial information: horizontal analysis, ver-tical analysis, and ratio analysis.

Horizontal AnalysisHorizontal analysis is a technique for evaluating a financial statement item over a pe-riod of time. The purpose of a horizontal analysis is to express the change in a finan-cial statement item in percentages rather than in dollars. Financial statement users canspot trends more easily with horizontal analysis than by simply looking at the rawnumbers. Consider the cash flows for Wal-Mart. According to its past six statementsof cash flows, Wal-Mart made the following cash expenditures for property, plant, andequipment.

Wal-Mart Capital ExpendituresFor fiscaf years ended on January 31,2001-2006

(in mi l l ions of dol lars)

2006 2005 2004

$14,s83 12,893 10,308 9,245 8,285 8,042

Often, the analyst selects one ofthe years as the reference point. It is called the base year,and the amounts reported for the other years are expressed as a percentage of the chosenbase year. The difference between the amount of the financial statement item each year andthe base year is expressed as a percentage of the base year. Suppose we choose 2001 as thebase year. Then, we subtract the 2001 capital expenditures ($8,042) from 2002 capital ex-penditures ($8,285) and divide by the base year number ($8,0+Z;.

$8,28s - $8,042 $243 : 3.02Vo$8,042 $8,042

Our calculation shows that during the fiscal year ended January 31,2002, Wal-Mart in-creased capital expenditures byjust 3.02Vo ofthe base year's capital expenditures. The cal-culation is done the same way for each year. The percentage change from the base year to2003 is calculated as follows:

$9.245 - $8,042

Horizontal analysis Atechnique for evaluatingf inancial statement i temsacross t ime.

200120022003

_ $1,203$8,042

Your Turn l O-l

i , . { }" ;Perform and interpret ahor izontal analysis and avert ical analysis of f inancialstatement information.

$8,042: 15.070


Wal-MartCapital Expenditures Comparison-Base year 2001

(dol lars in mi l l ions)

2005 2004 2003 2002 20012006

Capital expenditures $14,583

% change 81 .3o/o

10,308 9,245 8,285 8,042

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

12,893

603%

Vert ical analysis A techniquefor comparing i tems on afinancial statement in whichal l i tems are expressed as apercent of a common amount.

There is more than one way to do a horizontal analysis. Frequently, the analysis is done bycomparing one year with the next, rather than using a fixed base year.

It is usually diffrcult to understand the significance ofa single item such as capital expen-ditures when viewing the raw numbers. To make trends more apparent, it may be useful to ex-press the changes in spending in percentage form. A horizontal analysis makes it clear thatWal-Mart continues to make a signihcant investment in its property, plant, and equipment.

Vertical AnalysisVertical analysis is similar to horizontal analysis, but the analysis involves items on a singleyear's financial statement. Each item on a financial statement is expressed as a percentage ofa selected base amount. For example, a vertical analysis of an income statement almost al-ways uses sales as the base amount because almost all of a firm's expenditures depend on thelevel of sales. Each amount on the statement is expressed as a percentage of sales. This typeof analysis can point out areas in which the costs might be too large or growing without anobvious cause. For example, if managers at Wal-Mart see that employee salaries, as a percent-age of sales, are increasing, they can investigate the increase and, if necessary, take action toreduce the fum's salaries expense. Vertical analysis also allows the meaningful comparison ofcompanies of different sizes. Exhibit 10.4 shows a vertical analysis for Wal-Mart's incomestatements for the years ended January 3I,2006, and January 31,2005.

Ratio AnalysisThroughout this book, you have learned that ratio analysis uses information in the financialstatements to formulate specific values that determine some measure of a company's finan-cial position. We will review all the ratios you have learned and then look at an additionalcategory of ratios.

A Review of All RatiosThere are four general categories of ratios, named for what they attempt to measure:

. Liquidity ratios: These ratios measure a company's ability to pay its current bills andoperating costs-obligations coming due in the next fiscal year.

. Solvency ratios: These ratios measure a company's ability to meet its long-termobligations, such as its long-term debt (bank loans), and to survive over a long pe-riod of time.

. Profitability ratios: These ratios measure the operating or income performance of acompany. Remember the goal of a business is to make a profit, so this type of ratio ex-amines how well a company is meeting that goal.

. Market indicators: These ratios relate the current market orice of the comoanv's stockto earnings or dividends.

The first part of Exhibit 10.5 reviews the three types of ratios you learned about in earlierchapters. Also, there are two new ratios provided.

Suppose Wal-Mart pays off a current liability with cash. What effect wouldthis have on the company's current ratio? What effect would the pay off haveon the company's working capital?

L"(}".lPerform a basic ratioanalysis of a set of f inancialstatements and explainwhat the ratios mean.

Liquidity rat ios Measure thecompany's abi l i ty to pay i tscurrent bi l ls and operatingcosts.

Solvency ratios Measure thecompany's abi l i ty to meet i tslong-term obl igations and tosurvive over a long period oft ime.

Profitability ratios Measurethe operating or incomeperformance of a company.

Market indicators Ratios thatrelate the current marketprice of the company's stockto earnings or dividends.

Your Turn I O-2Hfuws. $hssr #B

CHAPTER 10 . RATIO ANALYSIS 481

EXHtBtT 10.4

Vert ical AnalysisThe analysis for a single year provides some information, but the comparison of two years reveals more about what's going on with

Wal-Mart. The percentages look very consistent across these two years. What item(s) stands out in the analysis? The notes to the

financial statements are the first place to look for additional information whenever an analysis reveals something interesting or

susprcrous.

Wat-MaJt Stores, Inc.Consolidated Statements of Income

For the fiscal years ended( in mi l l ions)

January 31,2006 January 31, 2005

Net salesOther income, net . . .

Costs and expenses:Cost of salesSeIIing, general, and adm. expensesOperat ingprof i t . . . . .Interest expense (net) . . .Income from continuing operations beforeincome taxes and minority interestProvision for taxes (current and deferred)Income from continuing operations before minority interest . . .

Minority interestNet income

$3r2,4273,227

315,654

240,39L56,73318,5301,t72

17,3595,803

11,555(324)

$ 11,231

100.00%1.03%

76.940/ot8.t60/o5.93%0.38%

$285,2222,910

288,L32

100.00%L.02o/o

3.600/o

5.560/o 16,1051.860/o 5,5893.70o/o 10,5160.t0o/o (249)3.600/o $ 70,267

219,793 77.060/o

5L,248 17.97%

17,091 5.99o/o

986 0.35o/o

o.oD"/o

1.960/o3.690/o0.09%

Company A has a gross profit ratio of 30%, and Company B has a gross profitratio of 60%. Can you tell which company is more prof itable? Why or why not?

Your Turn I O-g\"'tlLtl,tlsttl''..\fli,us ^w''^ ult

Market lndicator RatiosThe market price of a share of stock is what an investor is willing to pay for the stock. There

are two ratios that use the current market price of a share of stock to help potential investorspredict 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 share of stock divided bythe company's current earnings per share.

P/E ratio : Market price per share

Earnings per share

Investors and financial analysts believe the P/E ratio indicates future earnings potential. A

high P/E ratio indicates that the company has the potential for significant growth. When anew firm has no earnings, the P/E ratio has no meaning because the denominator is zero.For the first several years ofbusiness, Amazon.com had no earnings but a rising stock price.

Analysts have varying opinions about the information contained in the P/E ratio.The other market indicator ratio is the dividend yield ratio. This ratio is the dividend

per share divided by the market price per share. You may find that the values for the dividend

Price-earnings (P/E) ratio Themarket price of a share ofstock divided by that stock'searnings per share.

Dividend yield rat io Dividendper share divided by thecurrent market price persna re.


EXHIBIT 10.5A

Common Ratios*Tumover ratios are often considered effrciencv ratios

| -

When pickinq an investment. you might get the advice to look for a frrm that offersI - - - - -\> oood sharehJlder value. But what is good shareholder value? Richard Berstein of Mer-

-7 ril l Lynch has suggested three qualities: a high dividend yield, strong dividend growth,

and a solid history of returning profits to investors by purchasing treasury stock.

lsource: "MarketValues; PickingtheCreamof theCream," byConrad DeAenl le, TheNewYorkTimes,March 4, 2006 l

r---- 'hewsfhsAt l

Ratio Definition How to use the ratio

Chapterwhere

youstudied

the ratio

,

Current ratioTotal current assets

Total current IiabilitiesTo measure a company's ability to pay currentliabilities with current assets. This ratio helpscreditors determine if a company can meet itsshort-term obligations.

2

Quick ratio (alsolmown as theacid-test ratio)

Cash + short-term + net accountsinvestment receivable

Total current liabilities

To measure a company's ability to meet its short-termobligations. This ratio is similar to the current ratio.However, by limiting the numerator to very liquidcurrent assets, it is a stricter test.

Working capital Current assets - curent liabilities

To measure a company's ability to meet its short-termobligations. Although technically not a ratio, workingcapital is often measured as part of financial statementanalysis.

J

Inventoryturnover ratio

To measure how quickly a company is selling itsinventory

Accountsreceivable

tumover ratio

Net credit salesAverage net accounts receivable

To measure how quicldy a company collects the cashfrom its credit customers.

6

SOLVENCY

Debt-to-equityratio

Total liabilitiesTotal shareholders' equity

To compare the amount of debt a company has withthe amount the owners have invested in the company.

7

Times-interest-eamedratio

Income from operationsInterest expense

To compare the amount of income that has beeneamed in an accounting period @efore interest) tothe interest obligation for the same period. If netincome is used in the numerator, be sure to add backinterest expense.

7

CHAPTER 10 . RATIO ANALYSIS 483

EXHIBIT 10.58

Retum on assets Net income + interest expenseAverage total assets

To measure a company's success in using its assets toearn income for owners and creditors, those who arefinancing the business. Because interest is part ofwhat has been eamed to pay creditors, it is oftenadded back to the numerator. Net income is theretum to the owners and interest expense is thereturn to the creditors. Average total assets are theaverage of begiruLing assets and ending assets for theyeax.

4

Asset turnoverrauo

Net salesAverage total assets

To measure how effrciently a company uses its assets. 4

Return on equity Net income - preferred dividends To measure how much income is eamed with thecommon shaxeholders' investment in the company.

8Average common shareholders' equity

Gross proflt ratio To measure a company's profltability. It is one of themost carefirlly watched ratios by managementbecause it describes the percentage ofthe sales price

that is gross profit. A small shift usually indicates abig change in the profitability of the company's sales.

Earnings pershare

Net income - preferred dividends To calcr-rlate net income per share of common stock. 8Weighted average number of shares

of common stock outstanding

Price-earningsratio

To calculate the market price for $1 of eamings. 10

Dividend yieldratio

Dividend per shareMarket price per share

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

10

yield ratio are quite low compared to the return an investor would expect on an investment.

Investors are willing to accept a low dividend yield when they anticipate an increase in 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 shows the earnings per share, the dividends per share, and the market price per

share for Google Inc. and for General Mills. Which stock would be a better buy for long-

term growth? Which would be best if you needed regular dividend income?

The types of stock that will appeal to an investor depend on the investors' preferences

for income and growth. A young investor, for example, will not need dividends from retire-

ment funds invested in stocks. These long-term investors would prefer to invest in compa-

nies 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

484 CHAPTER 10 . USTNG FTNANcTAL STATEMENT ANALysts ro EVALUATE FIRM pERFoRMANcE

EXHtBtT 10.6 Google, Inc. GeneralMiils

December 31, 2005 May 28, 2006For f iscal years endedPrice/Earnings andDividend Yield Rat ios Earnings per share $ 0.77

$ 0.00$49.3264.05n/a

$3.05$1.34

$51.7916.982.59o/o

Dividends per shareEnding market price per sharePrice/earnings ratioDividend yield ratio

16.98. A retiree who needs a dividend income for living expenses will be more concernedwith the size of the dividend yield of an investment and less concerned with the investment'slong-term growth. General Mills would be better than Google for dividends.

These two market-related ratios are very important to management and to investors be-cause analysts and investors use them in evaluating stocks. If you examine a company's an-nual report, you are likely to see these ratios reported, usually for the most recent 2 or 3 years.

Understanding RatiosA ratio by itself does not give much information. To be useful, a ratio must be compared tothe same ratios from previous periods, ratios of other companies in the industry, or indus-try averages. Keep in mind that, with the exception of earnings per share, the calculationsto arrive at a specific ratio may vary from company to company. There are no standard orrequired formulas to calculate a ratio. One company may calculate a debt ratio as debt toequity, whereas another company may calculate a debt ratio as debt to debt ptus equity.When interpreting and using any company's ratios, be sure you know how those ratios havebeen computed. When you are computing ratios, be sure to be consistent in your calcula-tions so you can make meaningful comparisons among them.

Even though the only ratio that must be calculated and presented as part of the finan-cial statements is EPS, managers typically include in their company's annual report manyof the ratios we have discussed in this chapter. When these ratios are not shown as part ofthe financial statements, they may be included in other parts of the annual report, often ingraphs depicting ratio trends over several years.

Any valuable financial statement analysis requires more than a cursory review of ra-tios. The analyst must look at trends, components of the values that are part of the ratios,and other information about the company that may not even be contained in the financialstatements.

Using Ratio AnalysisWe will compute some of the ratios shown in Exhibit 10.5 for J&J Snack Foods Corp. us-ing the company's 2005 annual report. Exhibit 10.7 shows the income statements for3 years, and Exhibit 10.8 shows the balance sheets for 2years.

Other information needed for the analysis:

' Market price per share at the close of fiscal year: approximately $55 per share at Sep-tember 24,2005 and$42 per share at September 25,2004.

' No dividends were paid by J&J Snack Foods corp. during the hscal year ended Sep-tember 25,2004. However, J&J Snack Foods Corp. paid dividends of $0.05 per shareduring the fiscal year ended September 24,2005.

All the ratios shown in Exhibit 10.9 are calculated for J&J Snack Foods Corp. for thefiscal years ended September24,2005, and September 25,2004. Even though 2years ofratios do not give us enough information for making decisions, use this as an opportunityto practice how to calculate the ratios. Exhibit 10.9 shows the computations.

CHAPTER 10 . FINANCIAL STATEMENT ANALYSIS-MORE THAN NUMBERS 485

EXHIBIT 10.7

Income Statements for J&J Snack Foods Corp.

J&I Snack Foods CorporationConsolidated Statement of Earnings

(in thousands, except per share data)

SePtember 24, 2005Fiscal year ended (b2 weerst

September 25, 2004(52 weeks)

September 27, 2003(52 weeks)

Net salesCost 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 shareWeighted average number of diluted shares

Earnings per diluted share

$457,112302,065r55,047r14,79840,2491,689(136)

41,802L5,759

$26,043

9,097$ 2.86

9,300$ 2.80

$416,588276,379140,209105,01735,L92

bOtl

(113)35,64512,936

$22,710

8,909$ 2.55

9,143$ 2.48

$364,567239,722124,U593,99830,847

362(113)

31,09611,194

$ 19,902

8,8002.26

9,0512.20

The accompanying notes are an integral part of these statements'

Financial Statement Analysis-More than NumbersYou have probably noticed the following sentence at the end ofevery actual financial state-

ment you have ever seen, "The accompanying notes are an integral part of these financial

statements." Some analysts believe there is more real information about the financial health

of a company in the notes than in the statements themselves. Go to the back of the book where

you will find the financial statements for Staples and Office Depot. Look at the detailed and

extensive notes that accompany the statements. The more you leam about analyzing and eval-

uating a company's performance, whether in subsequent courses or in actual business experi-

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 compared to those of another firm. For example, if one

company uses LIFO and another uses FIFO, an analyst would convert the LIFO values to

FIFO values using the disclosures required to be in the notes of firms that use LIFO.

To better appreciate the role of accounting information in business, look at a business

plan. A business plan is a detailed analysis of what it would take to start and maintain the

operation of a successful business. Anyone writing a business plan includes a sales forecast,

expense estimates, and prospective financial statements. These are "what-if" financial

statements, forecasts that are part of the business plan. Banks often require these statements

before they will lend money to a new firm.Because accounting is such an integral part of business, accounting principles will

continue to change as business changes. 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 usefulness and reliability of the accounting data from electronic transactions,

446 CHAPTER 1O o USING FINANCIAL STATEMENT ANALYSIS TO EVALUATE FIRM PERFoRMANCE

EXHIBtT 10.8

Balance Sheets of J&J Snack Foods Corp.

J&I Snack Foods CorporationConsolidated Balance Sheets

(in thousands, except share amounts)

September 24,2005

September 25,2004

AssetsCurrent Assets

Cash and cash equivalentsMarketable securities available for saleReceivables

Ttade, Iess allowances of $1,054 and $1,104, respectivelyOther .

InventoriesPrepaid expenses and otherDeferred income taxes

Total current assets

Property, plant and equipment, at costLess accumr:Iated depreciation and amortization . . .

Other AssetsGoodwillOther intan$ble assets, netOther .

Liabilities and Stockholder's EquityCurrent Liabilities

Accountspayable .. . .Accrued liabilitiesDMdendspayable

Total current liabilities

Deferred income taxesOther long-term liabilities

Stockholder's EquityPreferred 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 respectivelyAccumulated other comprehensive lossRetainedeamings .. . .

$ 15,79554,225

46,267oou

33,6841,2L52.393

L54,233

326,143237,09889,045

53,6227,0431,981

62,646$305.924

$ 37,029L4,7311,T42

52,902

17,987273

36,091(1,918)

200,589234,762

$305,924

$ t9,6oo36,500

47,753233

29,587r,3543,385

L38,4r2

314,880225,40689,474

46,4771,9041,257

49,538$277,424

$ 34,497L3,149

47,646

19,153529

33,069(2,061)

179,088210,096

$277,424

CHAPTER 10 . FINANCIAL STATEMENT ANALYSIS-MORE THAN NUMBERS 447

EXHIBIT 10.9A

Ratio Analysis for J&J Snack Foods Corp.As you evaluate the 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 appear to 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 Definition Computation Computation Interpretation

LIQUIDITY For FYE Sept 2005

Cunent ratio Total current assetsTotal current

liabilities

1 K/ OQQ

Kt ont

t38.412+ t ,o4o

This is an excellentcurrent ratio. Avalue over 2 isconsidered good.Industry average forthis industry-processed andpackaged goods-is1.9.

Acid-test ratio(also Imown asthe quick ratio)

Cash + short-terminvestments +net accounts

receivableTotal current liabilities

-r9n

19,600+47,753+36,50047,646

- t 1a

This is a very highacid-test ratio.Industry average is0.8.

Working capital(technically nota ratio, but stilla measure of

liquidity)

Total current assets -Total current liabilities

754,233 - 62,902 = $101,331(in thousands)

138,412 - 47,646 = $90,766(in thousands)

This arnountsupports the strongliquidity of the firm,

Inventorytumover ratio

Cost of goods soldAverage inventory

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

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

= 10.47

The company isturning over itsinventory 10 timeseach year. Industryaverage is 10.6.

Accountsreceivabletumover

ratio

Net salesAverage net

accounts receivable

467,rr2@idi@ffi6=o 'o

* From the 2003 balance sheetnot shown here

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

The company istuming over itsreceivables over 9times each year. Ifyou divide 366 daysby 9.72, you'll seethat it takes thecompany about 38days to collect itsrecerables. Theindustry average is34 days.

SOLVENCY

Debt to equity Total liabilitiesTotal equity

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

The company doesnot have excessivedebt. The indus@average is 0.51.

Times interesteamed

Net income +rnterest expenseInterest expense

22,710 + ll3 ^^.-

ll3 =

'vaThis company hasno problem meetingits interestobligation Theindustry average is64.

488 cHAprER 10 . usrNc FtNANctAL STATEMENT ANALysts ro EVALUATE FIRM pERFoRMANCE

EXHIBIT 10.98

PROFITABILITY

Retum on assets Net income

interest expenseAverage 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 balancesheet

This is a goodreturn on assets.The industryaverage is 4.60/o.

Return on equity Net income -preferred dividendsAverage common

shareholders' equity

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

= ll.7o/o = 1L.570/o

*From the 2003 balancesheet

22,710 - 0(210,096 + 1.82,564*)/2

Most investorswould be happy toeaJn an l1%o returnon their investment.The industryaverage is 10%0.

Gross profltratio

Gross profltSales

L40,209 no a^/4lo,Ddd

The gross profitshows that forevery dollar ofproduct thecompany sells,approximately$0.66 is the cost ofthe item to J&ISnack Foods. Theindustry averagegross profitpercentage is 36.8%.

Earnings pershare

Net income -preferred dividends

Number ofshares of commonstock outstanding

26,043-0 ^^^^g$g7* - = DZ'do

+Disclosed on the incomestatement.

*Disclosed on the incomestatement.

A two-year trend isnot veryinformative.However, for thetwo years shown,the ratio is certainlymoving in the rightdirection.

Price-earningsratio

Market price percommon share

Earnings per shaxe

$55 _ 10,aThis PE ratio is abit lower than theindustry average of19.8.

Dividend yield Dividend per shareMarket price

per shareffi=o.ox

o -n$42.00 - "This firm did notpay dividends in2004.In 2005, thefirm paid $0.50,which is a little lessthan lo/o of the stockprrce.

rJ Fd il) ffi ffi,ruT,re hi ffi $ ru #usine s sWhat is EBITDA?

lf you read much about financial statements and earnings,you will eventually come across the expression "EBITDA"(pronounced iba duh). lt is an acronymfor earning beforeinterest, taxes, depreciation, and amortization. EBITDAcan be calculated from information on the income state-ment (earnings, taxes, and interest) and the statement ofcash flows (deoreciation and amortization-added backto net income when calculating cash from operatinq activ-ities). Eliminating these items-because they involve man-

agement discretion and estimates--<an make it easter tocompare the financial health of various firms. Because it is

a result of management's financing choices (debt ratherthan equity), eliminating interest takes away the effect ofa firm's caoital structure.

Even though EBITDA has became a popular mea-sure of a firm's performance, it does not tell the whole

CHAPTER 10 . BU5INESS Rl5K, CONTROL, AND ETHICS 489

story. According to lnvestopidia.com, there are at leastfour reasons to be wary of EBITDA.

1 . There is no substitute for cash flows. No matterwhat EBITDA is, a firm can not operate without suf-f ic ient cash.

2. The i tems that are el iminated from earnings are notavoidable. so ignoring them can be misleading.

3. EBITDA ignores the qual i ty of earnings. You wi l llearn more about that in Chapter 1 1.

4. Using EBITDA to calculate a price-earnings ratiocould make a f i rm look cheaper than i t actual ly is.

The bottom line: EBITDA is useful, but it is only one of

many measures of a firm's performance. Rememberthat EBITDA is NOT defined by GAAP, so firms may mea-

sure EBITDA different wavs.

e-business, and real-time access to financial data. As competition takes on new dimensions,

particularly due to new technology, the scrutiny of a firm's financial information will in-

crease. Together with the influence of the financial scandals of the early 2000s, the finan-

cial information needed for good decision making will continue to grow in importance.

Business Risk, Control, and EthicsWe already discussed, in Chapter 1, the risks associated with starting a business. Now we

will take the perspective of an investor. After all, you are very likely to buy stock in a pub-

licly traded company sometime in your life. Many working people have money in retire-

ment funds that are invested in the stock of publicly traded companies. Additionally, the

movement of the stock market affects a large number of firms and individual investors. How

should you, as an investor, minimize the risks associated with stock ownership? That risk,

of course, is losing your moneylFirst, you should be diligent about finding a financial advisor or financial analyst to help

you, or you should become an expert from your own study and analysis of available stocks.

You also need to know and understand some financial accounting and financial statement

analysis, which you have been exposed to in this course. However, being knowledgeable or

consulting an expert does not give an investor complete protection against losses.

That leads to the second and most effective way to minimize the risks associated with

stock ownership: Diversify. In everyday usage, to diversify means to vary or expand. In the

language of investment, diversify means to vary the investments you make-to expand be-

yond a narrow set of investments. Diversification means not putting all of your eggs in one

basket. A diversified set of investments allows an investor to earn a higher rate of return for

a given amount of risk.

L"{)"4Recognize the risks ofinvest ing in stock andexolain how to controlthose risks.

490 CHAPTER 1O . USING FINANCIAL STATEMENT ANALYSIS TO EVALUATE FIRM PERFoRMANCE

There is no way to eliminate all of the risks of stock ownership, but having many dif-ferent types of investments will help you minimize your risk or, equivalently, increase yourreturn for a given amount of risk. According to Bank One, 'A diversified portfolio does notconcentrate in one or two investment categories. Instead, it includes some investmentswhose returns zig while the returns of other investments zag."

Chapter Summary Points

' Components of net income include income from continuing operations, discontinued op-erations, and extraordinary items. Gains and losses from discontinued operations and fromextraordinary items are segregated from other revenues and expenses so that an investorcan easily separate these nonrecurring items from those expected to reoccur in the future.

' Horizontal analysis compares a specific financial statement item across time, oftenwith reference to a chosen base year. A vertical analysis, also know as common sizestatements, shows every item on a single year's financial statement as a percentage ofone of the other financial statement items. Most often, a vertical analysis of the incomestatement calculates all items as a percentage of sales.

' Ratio analysis is a tool used by anyone who wants to evaluate a firm's financial state-ments. Remember that a ratio is meaningful only when it is compared to another ratio.

' Investing in a firm as an owner, by purchasing a firm's stock, can create risks. Thebiggest risk is that the firm will not do well and its stock price will decrease. The bestprotection for an investor is to have a diversified portfolio. That is, buy a variety ofstocks so that a decrease in the price of one stock may be offset by an increase in theprice of another. Also, do not put all of your investment money in stock ownership. In-vest in a variety of assets, such as stocks, bonds, and real estate.

Chapter Summary ProblemsInstructionsUse the information in the annual report provided in the back of the textbook and the otherfrom the textbook's website to perform a ratio analysis on the most recent fiscal years ofboth office Depot and Staples. Use Exhibit 10.9 as a model. comment on your results.

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CHAPTER 10 . ANSWERS TO YOUR TURN QUESTIONS 493

Key Terms for Chapter 10Discontinued operations

@.416)Dividend yield ratio (p. a81)Extraordinary items (p. 477)Horizontal analysis (p. a79)

Liquidity ratios (p. 480)Market indicators (p. 480)Price-earnings (PE) ratio

(p.481)

Profitability ratios (p. 480)Solvency ratios (p. 480)Vertical analysis (p. 480)

Answers to YOUR TURN Quest ionsChapter 10Your Turn 10-1Those items must be shown after the tax consequences have been subtracted because thismethod of reporting the items net of taxes keeps the tax implications of these items sepa-rate from the company's regular tax expense. The alternative is to show the items before thetax implications and then to include the tax savings or tax increases in the company's reg-ular tax expense.

Your Turn 10-2This payoff would increase the current ratio. We can use a simple example to illustratewhy: Suppose current assets were $500 million and current liabilities were $250 million.The current ratio would be 2. Now suppose $50 million worth of current liabilities werepaid off with current assets. Then current assets would be $450 million, and current lia-bilities would be $200 million. The current ratio is now 2.25. When both the numeratorand the denominator of a fraction are reduced by the same amount, the value of the frac-tion will increase. Working capital will remain unchanged. It started at $500 million mi-nus $250 million in the example. After $50 million worth of liabilities is paid off withcash, the current assets will be $450 million and the current liabilities will be $200 mil-lion. The difference is still $250 million.

Your Turn 10-3No, the gross profit ratio does not tell which company is more profitable because onecompany may have higher sales than the other. For example 30Vo of alarge number isbetter than 60Vo of a small number. Also, the amount of costs the companies must coverbeyond the cost of goods sold is unknown. The gross profit ratio is most useful for com-paring companies in the same industry or evaluating performance of a single companyacross time.

Your Turn Appendix 10AThe FASB wants to make the changes to shareholders'equity that do not affect net incomemore apparent to financial statement users.

Your Turn Appendix 1081. The securities will be shown in the current asset section ofthe balance sheet at a

value of $52,000. The write-up will be balanced with a $2,000 unrealized gain on thelncome statement.

2. The securities will be shown in either the current asset or the long-term asset sectionof the balance sheet (depending on a firm's intent) at a value of $52,000. The write-up will be balanced with a $2,000 unrealized gain that will go directly to equity, aspart of accumulated other comprehensive tncome.

3. The securities will be shown at their cost of $50,000 in the long-term asset section ofthe balance sheet (unless the debt securities are maturing in the coming year, inwhich case they would be current assets).

494 CHAPTER , IO o USING FINANCIAL STATEMENT ANALYSIS To EVALUATE FIRM PERFoRMANCE

Questions1. Dehne the items that the Financial Accounting Standards Board requires a frrm to re-

port separately on the income statement. Why is this separation useful?2. What criteria must be met for an event to be considered extraordinary? Give an exam-

ples of events that would be considered to be extraordinary.3. What does it mean to show an item net of tax?4. What is horizontal analysis? What is the purpose of this method of analysis?5. What is vertical analysis? What is the purpose of this method of analysis?6. What is liquidity? Which ratios are useful for measuring liquidity and what does each

measure?7. What is solvency? Which ratios are useful for measuring solvency and what does each

measure?8. What is profitability? Which ratios are useful for measuring profitability and what does

each measure?9. What are market indicators? Which ratios are market indicators and what does each

measure?L0. How are financial ratios used to determine how successfully a company is operating?

Multiple-Choice Questions1. Suppose a firm had an extraordinary loss of $300,000. If the frrm's tax rate is 35%, 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 loss of $195,000b. On the income statement as part of the calculation of income from operations,

before taxes, for a loss of $300,000c. As supplementary information in the notes to the financial statementsd. As a cash outflow from financing on the statement of cash flows

2. Current assets for Kearney Company are $120,000 and total assets are $600,000. Cur-rent liabilities are $80,000 and total liabilities are $300.000. What is the current rario?a. 2.00b. 2.50c. 1.90d. 1.50

3. Ritchie Company sold some fixed assets for a gain of $100,000. The firm's taxrate is 25Vo. How would Ritchie Company report this transaction on its financialstatements?a. On the income statement as part of the calculation of income from continuing

operations, net of tax, in the amount of $75,000b. As an extraordinary item, net of tax, in the amount of $75,000c. As discontinued operations, net of tax, in the amount of $75,000d. On the income statement as part of the calculation of income from continuing

operations at the before tax amount of $100,0004. Gerard Company reported sales of $300,000 for 2006, $330,000 for 200'7, and

$360,000 for 2008. Ifthe company uses 2006 as the base year, what were the percent-age increases for 2001 and 2008 compared to the base year?a. l jVofor200'l andljTo for2008b. l20Vo for 2007 and 1207o for 2008c. 11,07ofor2001 andll j7o for2008d. l j%ofor2007 and2}Va for2008

5. On June 30, Star Radio reported total current assets of $45,000, total assets of$200,000, total current liabilities of $42,000, and total liabilities of $80,000. Howmuch working capital did Star Radio have on this date?a. $87,000b. $200,000c. $3,000d. $123.000

CHAPTER 10 . SHORT EXERCISES 495

6. Talking Puppet Company reported aPlE ratio of 50 on the last day of the fiscal year.If the company reported earnings of $2.50 per share, how much was a share of the com-pany's stock trading for at that time?a. $20 per shareb. $125 per sharec. $50 per shared. $47.50 per share

7. Singleton Company had sales of $2,000,000, cost of sales of $1,200,000, and averageinventory of $400,000. What was the company's inventory turnoverratio for the period?a. 3.00b. 4.00c. 5.00d. 0.33

8. Suppose a firm had an inventory turnover ratio of 20. Suppose the hrm considers a yearto be 360 days. How many days, on average, does an item remain in the inventory?a. 5.56 daysb. 18 daysc. 20 daysd. 360 days

9. Suppose a new company is trying to decide whether to use LIFO or FIFO in a periodof rising inventory costs. The CFO suggests using LIFO because it will give a higherinventory turnover ratio. Is he correct?a. Yes, the average inventory will be lower (the ratio's denominator) and the cost of

goods sold (the ratio's numerator) will be higher than if FIFO were used.b. No, the average inventory would be the same because purchases are the same no

matter which inventory method is 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 $ 1 00,000 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.

Short ExercisesSE10-1. Discontinued operations. (LO 1)In 2006, Earthscope Company decided to sell its satellite sales division, even though the di-vision had been profitable during the year. During 2006, the satellite division earned$54,000 and the taxes on that income were $12,500. The division was sold for a gain of$750,000, and the taxes on the gain amounted to $36,700. How would these amounts be re-ported on the income statement for the year ended December 31, 2006?

SE10-2. Discontinued operations. (LO 1)In 2007, Office Products decided to sell its furniture division because it had been losingmoney for several years. During 2007,the furniture division lost $140,000. The tax savingsrelated to the loss amounted to $25,000. The division was sold at a loss of $350,000, andthe tax savings related to the loss on the sale was $50,000. How would these amounts be re-ported on the income statement for the year ended December 31,2007?

SE10-3. Discontinued operations. (LO 1)After the terrorist attacks on the World Trade Center in 2001, Congress passed a lawrequiring new security devices in airports. One airport security firm had to get rid of anentire segment of the business that produced the old devices, and they suffered a sig-nificant loss on the disposal of the segment. The loss amounted to $320,000, with a re-lated tax benefit of I07o of the loss. How would this be reported on the firm's incomestatement?

" " : 496 CHAPTER 10 . USING FINANCIAL STATEMENT ANALYSIS TO EVALUATE FIRM PERFORMANCE

SE10-4. Extraordinary item. (LO l)Sew and Save Company suffered an extraordinary loss of $30,000 last year. The relatedtax 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 incomestatement.

(in thousands) 2007 2006 2005

Revenues $6,400 $4,575 $3,850

Cost of sales 3,900 2,650 2,050

Perform a horizontal analysis of revenues and cost of sales in both dollar amounts and inpercentages for2007 and2006, using 2005 as the base year.

SE10-6. Horizontal analysis. (LO 2)Use the following information about the capital expenditures of Andes Company to performa horizontal analysis, with2004 as the base year. What information does this provide aboutAndes Company?

(in mill ions) 2007 2006 2005 2004

Capitalexpenditures $41,400 545,575 $43,850 $50,600

SE10-7. Vertical analysis. (LO 2)Bessie's Quilting Company reported the following amounts on its balance sheet at Decem-ber 31,2007.

CashAccounts receivable, netInventoryEquipment, netTotal assets

$ s,00040,00035,000

120,000$200,000

Perform a vertical analysis of the assets of Bessie's Quilting Company. Use total assets asthe base. What information does the analysis provide?

SE10-8. Vertical analysis. (LO 2)Perform a vertical analysis on the following income statement, with sales as the baseamount. What other information would you need to make this analysis meaningful?

Sales $35,000Cost of goods sold 14,000Gross margin 21,000Other expenses 7,000Net income $14.000

SE10-9. Ratio analysis. (LO 2)Fireworks reported current assets of $720,000 and a current ratio of 1.2. What were currentliabilities? What was working capital?

SE10-10. Ratio analysis. (LO 3)A 5-year comparative analysis of Low Light Company's current ratio and quick ratio follows.

2004 200s 2006 2007 2008

current rat io 1.19 1.85 2.50 3.40 4.02

Acid-test rat io 1. i 5 1.02 0.98 0.72 0.50

a. What has been happening to the liquidity of Low Light Company over the5 years presented?

CHAPTER 10 . EXERCISES

b. Considering both ratios, what does the trend indicate about what has happened tothe makeup of Low Light's current assets over the 5-year period?

SE10-11. Ratio analysis. (LO 3)A company's debt-to-equity ratio has been increasing for the past 4 years. Give at least twocompany actions that might have caused this increase.

SE10-12. Ratio analysis. (LO 3)The following is a 5-year comparative analysis of Accent Company's return on assets andreturn on equity.

2005Return on assets 8o/oReturn on equity 20o/o

a. What does this analysis tell you about the overall profitability of AccentCompany over the S-year period?

b. What does this analysis tell you about what has happened to Accent's amount ofdebt over the past 5 years?

SE10-13. Ratio analysis. (LO 3)Earnings for Archibold Company have been fairly constant over the past 6 months, but theP/E ratio has been climbing steadily. How do you account for this climb? What does it tellyou about the market's view of the company's future?

SE10-14. Risk and control. (LO 4)Suppose you are the financial advisor to AHA Company, a local software developmentcompany. The CFO suggests the firm invest all of its extra cash in technology stocks. Hethinks that will demonstrate the company's confidence in that sector of the market. Whatadvice would you give him and why?

SE10-15. Appendix 10A: Comprehensive income.Give an example of a gain or loss that would be excluded from the income statement andshown directly on the balance sheet as part of accumulated other comprehensive income.

SE10-16. Appendix I 0B : Investments.Convey Company had some extra cash and purchased the stock of various companies withthe objective of making a prof,rt in the short run. The cost of Convey's portfolio was $79,450at December 31, 2008. On that date, the market value of the portfolio was $85,200. Howwould this increase in value be reflected in Convev's financial statements for the year endedDecember 31, 2008?

Exercises-Set AE10-1A. Discontinued operations. (LO 1)Use the following information to construct a partial income statement beginning with in-come from continuing operations.

497

2006 2007 20087.5o/o 7.12o/o 6.540/o

21o/o 21.8o/o 22.2%

20096o/o

23o/o

$230,00050,0008,500

138,50041,000

Income from continuing operationsLoss during the year from operating discontinued operationsTax benefit of lossLoss from sale of discontinued operationsTax savings from loss on the sale

E10-2A. Extraordinary item. (LO l)Devon's Central Processing Agency suffered a $560,000 loss due to a disaster that qualifiesas an extraordinary item for financial statement purposes. The tax beneht of the lossamounts to $123,000. If income from continuing operations (net of tax) amounted to$1,300,500, what is net income?

CHAPTER 10 . USING FINANCIAL STATEMENT ANALYSIS TO EVALUATE FIRM PERFORMANCE

E10-3A. Horizontal analysis. (LO 2)Jones Furniture reported the following amounts for its sales during the past 5 years. Using2OO4 as the base year, perform a horizontal analysis. What information does the analysisprovide that was not apparent from 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 September 30,2OO7

Sales revenue

Cost of goods sold

Gross profit

Operating expenses:

Depreciat ion-bui ld ings and equipment

Other sel l ing and administrat ive

Total expenses

lncome before interest and taxes

Interest expense

Income before taxes

Income taxes

Net income

E10-5A. Current ratio and working capital. (LO 3)Calculate the current ratio and the amount of working capital for Albert's Hotels for theyears given in the following comparative balance sheets. Although 2 yearc is not much of a

trend, what is your opinion of the direction of these ratios?

Albert' Hotels Inc.Balance Sheet

At December 31, 2008 and 2007

2008

Current assets;

Cash

Accounts receivable, net

Inventory

Prepaid expenses


Equipment, net

Total assets

Total current l iabi l i t ies

Long-term l iabi l i t ies

Total l iabi l i t ies

Common stockholders' equity

Retained earnings

Total l iabil i t ies and stockholders' equity

$ 1002,500

$ ga,ooo1 10,000170,00018,000

396,000184,000

$s8o,ooo$206,0001 19,000325,00090,000

155,000

$10,2285,75' l

$ q,qtt

2,600

$ 1,877350

$ t ,szt150

$ 1,377

2007

$ 90,0001 16,000160,00016,000

382,0001 60,000

$s42,000$223,0001 17,000340,00090,000

1 12,000

$s42,000$s80,000

E'10-6A'. Debt-to-equity ratio. (LO 3)Use the balance sheets from Alberl's Hotels in E10-5A to compute the debt-to-equity ratiofor 2008 and 2001 . Suppose you calculated a debt ratio using debt plus equity as the de-nominator. Which ratio-debt to equity or debt to debt plus equity-seems easiest to inter-pret? As an investor, do you view the "trend" in the debt-to-equity ratio as favorable orunfavorable? Why?

E10-7A. Ratio analysis. (LO 3)Zap Elecftonics reported the following for the fiscal years ended January 31,2007 , andJanuarv 3 l . 2006.

January 31( in thousands)

Accounts receivable

lnventory

Current assets

Current l iabi l i t ies


Shareholders 'equi ty

Sales

Cost of goods sold

Interest expense

Net income

Assume all sales are on credit and the firm has no preferred stock outstandins. Calculatethe following ratios.

a. Current ratio (for both years)b. Accounts receivable turnover 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 these ratios suggest problems for the company?

E10-8A. Ratio analysis. (LO 3)Evans Family Grocers reported the following for the two most recent fiscal years.

December 31

Cash

Receivables (net)

Merchandise inventory

Plant assets

Total assets

Accounts payable

Long-term notes payable

Common stock

Retained earnings

280,000 260,000

Total Liabil it ies and Shareholders' Equity $420,000 $380,000Net income for the year ended 12131108 $ ZS,OOO

2007 2006

$ 35,184 $ 24,306

106,754 113,875

174,369 124,369

71,616 68,001

12,315 35,200

121,851 198,935

712,855 580,223

483,463 400,126

335 709

1 1,953 4,706

2008

cHAPTER 1o o EXERCTsES 4gg t-tt, l :

;r';.',..r11.;r..,ifr

Sales (all sales were on account)

Cost of goods sold

Interest expense

2007

$ 2s,000 $ 20,00060,000 70,00055,000 30,000

$4?9p99 $380,99945,000 52,00075,000 100,000

135,000 122,000165,000 96,000

4s0,000210,000

1,500

Calculate the following for the year ended December 31,2008.a. Current ratiob. Working capital

c. Accounts receivable turnover ratiod. Inventory turnover ratioe. Return on assetsf. Return on equity

E10-9A. Ratio analysis. (LO 3)Furniture Showcase reported the following for its fiscal year ended June 30, 2008.

Sales $530,000Cost of sales 300,000Gross margin 230,000Expenses* 113,000Net income $117,000*Included in the expenses was

$12,000 of interest expense.Assume no income tax expense.

At the beginning of the year, the company had 50,000 shares of common stock outstand-ing. At the end of the year, there were 40,000 shares outstanding. The market price of thecompany's stock at year-end was $20 per share. The company declared and paid $80,000of dividends near year-end.

Calculate earnings per share, the price-earnings ratio, and times-interest-earned ratiofor Furniture Showcase.

Use the balance sheet and income statement for The Talbots Inc. for E10-10A throuehE10-13A..

E10-10A. Horizontal analysis. (LO 2)Use the statement of earnings for Talbots to perform a horizontal analysis for each item re-ported for the year from January 29,2005, to January 28,2006. What does your analysistell you about the operations of Talbots for the year?

E10-11A. Vertical analysis. (LO 2)Use the statement of earnings for Talbots to perform a vertical analysis for each item re-ported for the last two fiscal years using net sales as the base. What does your analysis tellyou about the operations for the years reported?

EI0-12A, Liquidity ratios. (LO 3)Use the financial statements for Talbots to calculate the following liquidity ratios for FYEJanuary 28,2006. What information does this provide about the firm's liquidity?

a. Cunent ratiob. Acid-test ratioc. Working capitald. Inventory turnover ratioe. Accounts receivable turnover ratio (Assume all sales are credit sales.)

E10-13A. Solvency and profitability ratios. (LO 3)Use the financial statements for Talbots to calculate the following solvency and profitabil-ity ratios for FYE January 28,2006. What information does this provide about the firm'ssolvency and profitability ?

a. Debt-to-equityratiob. Times-interest-earned ratioc. Return on assetsd. Return on equitye. Gross margin percentage


The Talbots,Inc. and SubsidiariesConsolidated Balance Sheets

(Amounts in thousands except share data)

January 28,2006

January 29,2005

501

AssetsCurrent Assets:

Cash and cash equivalents . . . .Customeraccountsreceivable-net .Merchandise inventoriesDeferred catalog costsDue from affiliatesDeferred income taxesPrepaid and other current assets

Tota] current assetsPropertyandequipment-net . . . . .Deferred income taxesGoodwill-netTfademarks-netOther assetsTotal Assets

Liabilities and Stockholder's EquityCurrent Liabilities:

Accounts payableAccrued income taxesAccrued liabilities

Total current liabilitiesLong-term debtDeferred rent under lease commitments . . . . .Deferred income taxes .Other liabilitiesCommitments

Stocldrolder's Equrty:Common stock, $0.01 par value; 200,000,000 authorized;

77,861,L28 shares and 76,940,134 shares issued,respectively, and 53,359,556 shares and 54,123,667shares outstanding, respectively

Additional paid-in capitalRetained earningsAccumulated other comprehensive lossDeferred compensationTleasury stock, at cost; 24,501,572 and22,816,467

shares, respectivelyTotal stockholder's equity

Total Liabilities and Stockholder's Equity

$ 103,020209,749246,707

6,0217,892

14,lr533,157

620,661387,536

6,40735,51375,88420,r43

$l,L46,tM

$ 85,34337,909

LzL,205244,457100,000110,864

63,855

$ 31,811199,256238,544

5,1 189,073

14,00629,589

527,397405,rL4

35,51375,884L8,222

$1p94qq

$ 65,07027,196

110,372202,638100,000109,946

5,67055,288

779455,22L783,397(16,682)(13,403)

7AO

432,9L2715,580(r7,r42)(11,821)

See notes to consolidated financial statements.

502 CHAPTER 10 . USING FINANCIAL STATEMENT ANALYSIS TO EVALUATE FIRM PERFORMANCE

The Talbots, Inc. and SubsidiariesConsolidated Statements of Earnings

(Amounts in thousands except per share data)

Year ended

Jmuary 28,2006

Jmuary 29, January 31,2005 2004

1,093,023 995,765462,705 432,424r42,rt5 166,601

Net salesCosts and Expenses

Cost of sales, buying and occupancySeIIing, general and administrative

Operating IncomeInterest

Interest expenseInterest income

$1,808,606 $1,697,843 $1,594,790

Interest expense-netIncome Before TaxesIncome taxesNet incomeNet income per share

Basic .Diluted

Weighted Average Number of Shares ofCommon Stock Outstandins

Basic

1,153,734502,724I52,r48

4,480r,3743,106

r49,04255,891

$ 93,151

$ 1.76$ r.72

2,6L6506

2,1 10140,005

$ 1.73$ 1.70

2,402307

2,095164,50661,615

$ 102,891

56.53157,901Di luted . . . . 54,103

E10-14A. Risk and control. (LO 4)Often a firm will contribute its own shares of 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.Omicron Corporation invested $125,000 of its extra cash in securities. Under each of the

following independent scenarios, (a) calculate the amount at which the investments would

be valued for the year-end balance sheet, and (b) indicate how the effect ofthese scenarios

should be reported on the other financial statements, if at all.

1. All the securities were debt securities, with a maturity date in 2 years. Omicron will

hold the securities until they mature. The market value of the securities at year-end was

$123,000.2. Omicron purchased the securities for trading, hoping to make a quick profit. At year-

end the market value of the securities was $120,000.3. Omicron is uncertain about how long it will hold the securities. At year-end the mar-

ket value of the securities is $126,000.

E10-16A. Appendix I 0B : Investments.During 2007, Nike has invested $200,000 of extra cash in securities. Of the total amount in-

vested, $75,000 was invested in bonds that 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 invested in the stock of various com-

CHAPTER 10 . EXERCISES 503

panies that Nike intends to trade to make a short-term profit. At the end of the year, the mar-ket value of the held-to-maturity securities was $80,000; the market value of the trading se-curities was $75,000; and the market value of the available-for-sale securities was $55,000.Use the accounting equation to record all adjustments required at year-end, and indicatehow the effects of each group of securities will be reported on the financial statements.

Exercises-Set BE10-18. Discontinued operations. (LO 1)Use the following information to construct a partial income statement beginning with in-come from continuing operations.

Income from continuing operations $310,000Loss during the year from operation of discontinued operations 75,000

E10-28. Extraordinary items. (LO l)Tropical Vacations suffered a $1,070,000 loss due to a tsunami, which qualifies as an extra-ordinary item for financial statement purposes. The tax benefit of the loss amounts to$155,000. If income from continuing operations (net of tax) amounted to $1,861,250, whatis net income?

E10-38. Horizontal analysis. (LO 2)Making Every Day Sunny Umbrellas reported the following amounts for sales during thepast 5 years. Using 2006 as the base year, perform a horizontal analysis. What informationdoes the analysis provide that was not apparent from the raw numbers?

2010 2009 2008 2007 2006

$27,925 $30,400 $33,525 $ZS,ZSO $30,300

E1-0-48. Vertical analysis. (LO 2)Use the income statement from Designers Discount Inc. to perform a vertical analysis withsales as the base.

Tax benefit of lossLoss from sale of discontinued operationsTax savinss from loss on the sale

Designers Discount Inc.Income Statement

For the year ended March 28, 2008

Sales revenue

Cost of goods sold

Gross profit on sales

Operating expenses:

Depreciat ion-bui ld ings and equipment $ ZASOther sel l ing and administrat ive

Total expenses

Income before interest and taxeslnterest expense

Income before taxes

lncome taxes

Net income

3,750

19,400105,75032.000

$16,374

7,985

$ 8,389

4,015

$ q,ztq

254

$ 4,1201,236

$ 2,884

E10-58. Current ratio and working capital. (LO 3)Calculate the current ratio and the amount of working capital for Mike & Kat Racing Com-pany for the years given in the following comparative balance sheets. Although 2 years willnot show a signihcant trend, what is your opinion of the direction of these ratios?


Mike & Kat Racing CompanyBalance Sheet


2008

Current assets:

Cash


lnventory

Prepaid expenses


Equipment, net

Total assets

Total current l iabil i t ies


Total l iabil i t ies

Shareholders" equity

Retained earnings

Total l iabil i t ies and shareholders' equity

$ 1 86,00094,000

185,00017,000

482,000215,000

$697,000$257,000185,000452,000163,75081,250

$697,000

2007

$ 192,00085,000

1 70,50014,000

461,50019s,000

$656,500

2007

$ t:,goz47,682

155,71672,26317,85258,03570,22352,7s0

43.21,006

$259,0001 90,000459,000148,25049,250

$6s6,s00

E10-68. Debt-to-equity ratio. (LO 3)Use the balance sheets from Mike & Kat Racing Company in E10-5B to compute a debt-

to-equity ratio for 2008 and 2007. Suppose you calculated a debt ratio using debt plus eq-

uity as the denominator. Which ratio-debt to equity or debt to debt plus equity- seems

easiest to interpret? As an investor, do you view the "trend" in the debt to equity ratio as fa-

vorable or unfavorable? Why?

E10-7B. Ratio analysis. (LO 3)Crystal Cromartie's Frozen Foods reported the following for the fiscal years ended Septem-ber 30,2008, and September 30,2007.

September 30(in mi l l ions)Accounts receivableInventoryCurrent assetsCurrent liabilitiesLong-term liabilitiesShareholders' equitySalesCost of goods soldInterest expenseNet income

Assume there is no outstanding preferred stock and all sales are credit sales. Calculate the

following ratios.a. Current ratio (for both years)b. Accounts receivable turnover 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 these ratios suggest problems for the company?

2008

$ zt,zas45,692

185,7't6

80,9s415,25121,87188,45560,463

21.51,842

CHAPTER 10 r EXERCISES 505

E10-88. Ratio analysis. (LO 3)Hutson Coffee Shops reported the following for the two most recent fiscal years.

December 31

Cash

Receivables (net)


Fixed assets

Total assets

Accounts payable

Long-term notes payable

Common stock

Retained earnings

Total l iabi l i t ies and shareholders ' equi tyNet income for the year ended 1213111O

Sales (al l sales were on account)

Cost of goods sold

Interest expense

201 0

$ 34,0008s,00074,000

365,000

$ss8,00065,00082,000

1 75,00023s,000

$s58,000$11s,000620,000284,000

3,000

2009

$ 17,00080,00048,000

324,O00

$469.00083,000

1 12,000144,000130,000

$469,000

Calculate the following for the year ended December 31,2010.a. Current ratiob. Working capitalc. Accounts receivable turnover ratiod. Inventory turnover ratioe. Return on assetsf. Return on equity

E10-98. Ratio analysis. (LO 3)International Imports Corporation reported the following for itsJune 30, 2007.

fiscal year ended

SalesCost of salesGross marginExpenses*Net income

$640,000470,000170,00094,000

$ 76,000

xlncluded in the expenses were $9,000of interest expense and $14,000of income tax expense.

At the beginning of the year, the company had 40,000 shares of common stock out-standing and no preferred stock. At the end of the year, there were 25,000 common sharesoutstanding and no preferred stock. The market price of the company's stock at year-endwas $15 per share. The company declared and paid $46,000 ofdividends near year-end.

Calculate earnings per share, the price-earnings ratio, and times-interest-earned ratiofor International Imports.

E10-108. Horizontal analysis. (LO 2)Use the statement of income for Wendy's to perform a horizontal analysis for each item re-ported for the year from January 2,2005, to January l,2006. What does your analysis tellyou about the operations of Wendy's for the years reported?

E10-118. Vertical analysis. (LO 2)Use the statement of income for Wendy's to perform a vertical analysis for each item re-ported for 2005 and 2004 using sales and other operating revenues as the base. What doesyour analysis tell you about the operations of Wendy's for the years reported?


Wendy's International, Inc. and Subsidiaries-Consolidated Balance Sheets

January 1, 2006 and Jamary 2,20052005 2004(Dollars in thousand,s)

AssetsCurrent assets

Cash andcashequivalents . . . . .Accounts receivable, net , . .Notes receivable, netDeferred income taxes .Inventories and otherAdvertising fund restricted assets .Assets held for disPosition

Total current assetsProperty and equipment, netNotes receivable, netGoodwillDefened income taxesIntangible assets, netOther assets.

Total assetsLiabilities and Shareholder's Equity

Current liabilitiesAccounts payableAccrued expenses

Salaries and wagesTaxesInsuranceOther

Advertising fund restricted liabilitiesCurrent portion of long-term obligations

Total current liabilitiesLong-term obligations

Term debtCapital leases

Total long-term obligationsDeferred income taxesOther long-term liabilitiesCommitments and contingenciesShareholder's equity

Preferred stock, Authorized: 250,000 shares

Accumulated other comprehensive income (expense):Cumulative translation a{iustments and otherPension liability

Tleasury stock, at cost: 7,681,000 and 5,681,000shares, respectively

Uneamed compensation-restricted stockTotal shareholder's equityTotal liabilities and shareholder's equity

$ 393,241138,99911,74629,04362,86853,86666,803

756,5662,325,888

14,796128,808

6,6234L,757

$ 176,749127,15811,62627,28056,01060,021

0458,844

2,349,820t2,652

166,9986,772

41,787165,880 160,671

$3,440,318 $3,197,544

$ 188,481 $ 197,247

51,184 46,971116,920 108,02558,t47 53,16090,263 92,83868,929 60,0219,428 130,125

583,352 688,387

559,097 538,05556,736 55,552

615,833 593,60778,206 109,674

104,338 90,187

Common stock, $.10 stated value per share, Authorized: 200'000'000 shares.Issued: 125,490,000 and 118,090,000 shares, respectively 12,549

Capital in excess ofstatedvalue 405,588Retained earnings 1,858,743

11,8091l 1,286

r,700,813

Lr5,252 102,950(1,0e6) (913)

2,391,036 1,925,945

(294,669) (195,124)(37,778) (15,132)

2,058,589 1,715,689q#4qfl8 wgj44

See accompanying Notes to the Consolidated Financial Statements.


Wendy's International, Inc. and SubsidiariesConsolidated Statements of brcome

(In thousonds, effiept per shnre d,ata)

RevenuesRetail salesFranchise revenues

Total revenuesCosts and expensesCost of salesCompany restaurant operating costs . . . .Operating costsDepreciation of property and equipmentGeneral and administrative expensesGoodwill impairmentOther (income) exlpense, net . . .

Total costs and expensesOperating income

Interest expenseInterest income

Income before income taxesIncome taxesNet incomeBasic eamings per common shareDiluted earnings per common shareDividends per common shareBasic sharesDiluted shares

YearBnded YearEnded YearEndedJanuary1,2006 Janrary2,2005 December28,2003

2005 2004 2003

$3,028,4r4754,733

3,783,t47

2,003,804682,505171,919199,680321,51836,141(9,603)

3,405,964377,L83(46,405)

7,286338,064113,997

$ 224,067-$135-

1,900,635668,948168,492L78,394283,72I190,00018,644

3,408,834226,604(46,950)

4,409184,063132,028

$ 52,035:ffi

1,618,002550,643135,332163,481261,070

0r,942

2,730,4704r9,442(45,773)

4,929377,598141,599

$ 235,999ffi

$2,935,899 fi2,534,t35699,539 614,777

3,635,438 3,r48,9r2

$1.92$0.58

LL4,945116,819

$0.45 $2.05$0.48 $0.24

113,832 113,966115,685 115,021

See accompanying Notes to the Consolidated Financial Statements.

E10-12B. Liquidity ratios. (LO 3)Use the financial statements forWendy's to calculate the following liquidity ratios for 2005.What do these ratios tell about the firm?

a. Current ratiob. Acid-test ratioc. Working capita.

E10-13B. Solvency and profitability ratios. (LO 3)Use the financial statements for Wendy's to calculate the following solvency ratios andprofitability for 2005 and provide an interpretation for each ratio.

a. Debt-to-equityratiob. Times-interest-earned ratioc. Return on assetsd. Return on equitye. 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 thoserisks? Why are you willing to take risks like these?

E10-15B. Appendix I 0B : Investments.Kinsey Scales invested $164,000 of its extra cash in securities. Under each of the followingindependent scenarios, (a) calculate the amount at which the investments would be valued for

508 CHAPTER 1O o USING FINANCIAL STATEMENT ANALYSIS TO EVALUATE FIRM PERFORMANCE

the year-end balance sheet, and (b) indicate how these scenarios should be reported on theother financial statements, if at all.

1. Al1 the securities were debt securities, with a maturity date in 2 years. Kinseywill hold the securities until they mature. The market value of the securities atyear-end was $158,000.

2. Kinsey purchased the securities for trading, hoping to make a quick profit. Atyear-end the market value of the securities was $162,000.

3. Kinsey is uncertain about how long it will hold the securities. At year-end themarket value of the securities is $167,000.

810-168. Appendix I 0B : Investments.During 2009, Arctic Fans & Blowers has invested $245,000 of extra cash in securities. Of thetotal amount invested, $115,000 was invested in bonds that Arctic plans to hold until maturity(the bonds were issued at par); $55,000 was invested in various equity securities that Arcticplans to hold for an indefinite period of time; and $75,000 was invested in the stock of vari-ous companies that Arctic intends to trade to make a short-term profit. At the end of the year,the market value of the held-to-maturity securities was $108,000, the market value of the trad-ing securities was $52,000, and the market value of the available-for-sale securities was$85,000. Use the accounting equation to record all adjustments required at year-end and in-dicate how the effects of each group of securities will be reported on the financial statements.

Problems-Set A

P10-1A. Discontinued operations and extraordinary item. (LO 1)Each of the following items was found on the financial statements for Hartsfield Companyfor the year ended December 31,2007.

Net income from continuing operations $136,500Gain on the sale of a discontinued segment, net of taxes of $42,000 140,000Loss from operation of discontinued segment, net of taxes of $24,000 (80,000)Gain on sale of land 65,000Extraordinary loss, net of taxes of $6,000 (20,000)

Requireda. For the items listed, indicate the financial statement and appropriate section,

where applicable, on which each would appear.b. Provide a description of each item and give as many details of each item's

financial statement presentation as possible.c. Based on the data provided, what is Hartsfield Company's tax rate?

P10-24. Prepare qn income statement. (LO I)The Pops Corporation had the following for the year ended December 3 I , 2008.

SalesCost of goods soldInterest incomeGain on sale of equipmentSelling and administrative expensesInterest expenseExtraordinary gainLoss from discontinued segment operationsGain on disposal of discontinued segment

$s75,000230,00010,0009,000

12,0005,000

15,000(10,500)28,000

RequiredAssume the corporation is subject to a 30Vo tax rate. Prepare an income statement for theyear ended December 31, 2008.

CHAPTER 10 . PROBLEMS

P10-3A. Prepare an income statement. (LO 1)The following balances appeared in the general ledger for Hacky Sak Corporation at fiscalyear end September 30, 2008:

509

Selling and administrative expensesOther revenues and gainsOperating expensesCost of goods soldNet salesOther expenses and losses

In addition, the following occurred throughout the year.

1. On April 10, a tornado destroyed one of the company's manufacturing plants resultingin an extraordinary loss of $55,000.

2. On July 31, the company discontinued one of its unprofitable segments. The loss fromoperations was $25,000. The assets of the segment were sold at a gain of $15,000.

Requireda. Assume Hacky Sak's income tax rate is 40Vo; prepare the income statement for

the year ended September 30, 2008.b. Calculate the earnings per share the company would report on the income

statement assuming Hacky Sak had a weighted average of 200,000 shares ofcommon stock outstanding during the year and paid preferred dividends of$s,000.

P10-4A. Prepare horizontal and vertical analysis. (LO 2)Given the followins income statements:

Year ended December 31,( in thousands)

$ 2s,00050,00075,000

135,000375,000

15,000

Net sales

Cost of goods sold

Gross profit

Sel l ing, general , and administrat iveexpenses

Operat ing income

Interest exoense

Interest and net investmentexpense (income)

Other expense-net

Income before income taxes

Income taxes

Net income

2008 2007

$4,934,430 $4,881,1032,804,459 2,784,3922,129,971 2,096,711

2009

$5,003,8372,7s5,3232,248,514

1,673,449 1,598,333 1,573,510575,065 531,638 523,20161 , 1 68 71 ,97 1 80,837

(s,761)

29,540

(8,278)

23,355

(6,482)

26,046

490,118 440,103 427,277

185,258 167,239 166,663

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

Required

a. For each of the years shown, prepare a vertical analysis, using sales as the base.Write a paragraph explaining what the analysis shows.

b. Using 2007 as the base year, prepare a horizontal analysis for sales and cost ofgoods sold. What information does this analysis give you?


P10-5A. Calculate and analyze financial ratios. (LO 3)Given the information below from a ftrm's financial statement:

Net sales (all on account)

Cost of goods sold

Gross profit

Interest expense

Income taxes

Net income

Cash and cash equivalents

Accounts receivable, less allowance


Total assets

Total current I iabil i t ies


Total shareholders' equity**The firm has no preferred stock.

Required

Year ended December 31,(in thousands)

2009 2008 2007

$s,003,837 $4,934,4302,755,323 2,804,459

2,248,514 2,129,971

61,168 71,971't86,258 167,239

[_4r,899 W$ 18,623 $ rg,r3g $ 3,s30

606,046 604,516 546,3141,597 ,377 1,547,290 1,532,2534,0s2,090 4,065,462 4,03s,8011,189,862 1,111,973 44,5391,153,595 1,237,s491,698,532 1,715,940 1,592,180

a. Calculate the followine ratios for 2009 and 2008:1. Current ratio2. Acid-test ratio (assume no short-term investments)3. Working capital4. Accounts receivable turnover ratio5. Debt-to-equity ratio6. Times-interest-earned ratio7. Return on equity8. Gross profit percentage

b. Suppose the changes from 2008 to 2009 in each of these ratios were consistentwith the direction and size ofthe change for the past several years. For eachratio, explain what the trend in the ratio would indicate about the company.

CHAPTER 10 o PROBLEMS 511

P10-6A. Calculate and analyze financial ratios. (LO 3)The following information was taken from the 2008 annual report of Presentations.

At December 31,( in thousands)

2008 2007ASSETS

Current assets

Cash

Accounts receivable

Merchandise inventorv

Prepaid expenses

Total current assetsPlant and equipment:

Bui ld ings, net

Equipment, net

Total p lant and equipmentTotal assets

LIABILITIES

Current l iabi l i t ies

Accounts payable

Notes payable

Total current l iabi l i t iesLong-term l iabi l i t ies


STOCKHOLDERS' EQUITYCommon stock, no par valueRetained earnings

Total stockholders' equ ityTotal l iabi l i t ies and stockholders, equi ty

Sales revenue

Cost of goods soldGross profit on salesOperating expenses:

Depreciat ion-bui ld ings and equipmentOther sel l ing and administrat ive

Total expenses

Income before interest and taxesInterest expenseIncome before taxes

Income taxes

Net income

$ 1,6171,9252,070

1885,800

$ q,qst

1,293

$ s,zso$t t ,sso

$ t ,st z900

2,7173,s006,217

3,3901,943s,333

!r_u!g$12,228

8,7513,477

1022,667

$1,2203,112

966149

5,447

$2,9s21,045

$4,037

v484

$ 1,68s1,1002,7852,0004,795

3,0421,6574,699

59,484

2,769

708

168

540' t14

$ qzo

Requireda. Calculate the following ratios for 200g and 2007 whenever possible.

1. Debt-to-equity ratio2. Gross margin percentage3. Currenl ratio4. Acid-test ratio5. Times-interest-earned ratio

b. What do the ratios indicate about the success of Presentations? What additionalinformation would help you analyze the overall performance of this company?


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

At June 30,2007

$ 17,000

10,00054,00075,00016,000

172,000

$140,000

June 30, June 30,2005 2005

Balance sheet:

Cash

Investments (in tradingsecu rit ies)

Accounts receivable (net)

Inventory

Prepaid expenses



$ 12,000

16,000s0,00070,00012,000

1 60,000

$ 9o,ooo

$380,000225,000

$ 14,000

20,00048,00073,00010,000

1 65,000

$ 7s,000

Income statement for the June 30, 2007: June 30 2006:year ended

Net credit sales

Cost of goods sold

$420,000250,000

Requireda. Compute the following ratios for the years ended June 30,2007 , and whenever

possible for the year ended June 30, 2006. For each, indicate ifthe direction isfavorable or unfavorable for the company.

1. Current ratio2. Accounts receivable turnover3. Inventory turnover ratio4. Gross profit percentage

b. Suppose the industry average for similar retail stores for the current ratio is 1.7.Does this information help you evaluate For the Kitchen's liquidity?

P10-8A. Calculate and analyze financial ratios, (LO 3)You are interested in investing in Reese Company, and you have obtained the balance sheetsfor the company for the past 2 years.

Reese CompanyBalance Sheet

AtJune 30,2007 and 2005

Current assets:

Cash


Inventory

Prepaid rent


Equipment, net

Total assets

Total current I iabil i t ies




Retained earnings


2007

$1 98,000210,000270,000

15,000693,000280,000

$973,000$306,000219,00052s,0001 50,000298,000

2005

$ eo,ooo1 16,0001 60,00016,000

382,000250,000

$642,000$223,0001 17,000340,00090,000

212,O00

$642,000$973,000

CHAPTER 10 . PROBLEMS 513

year endedThe following amounts were reportedJune 30, 2007.

SalesCost of goods soldInterest expenseNet income

Required

a. Compute as many of the financial statement ratios you have studied as possiblewith the information provided for Reese Company. Some ratios can be computedfor both years and others can be computed for only 1 year.

b. Would you invest in Reese Company? Why or why not? What additionalinformation would be helpful in making this decision?

Problems-Set B

P10-18. Discontinued operations and extraordinary item. (LO I)Each of the following items was found on the financial statements for Logan Company forthe year ended December 31,2008.

Income from continuing operations 85,000Gain on the sale of discontinued segment, net of taxes $9,000 30,000Loss from operation of discontinued segment, net of taxes of $9,750 (32,500)

Gain on sale of equipment 12,000Extraordinary loss from earthquake, net oftaxes $45,000 (150,000)

Requireda. For each item listed, indicate the financial statement and appropriate section, if

applicable, on which each would appear.b. Provide a description of each item and give as many details of each item's

financial statement presentation as possible.c. Based on the data provided, what is Logan Company's tax rate?

P10'2B. Prepare an income statement. (LO 1)The Blues Corporation had the following for the year ended December 31,2007 .

on the income statement for the

$450,000215,000

7,50080,000

SalesCost of goods soldInterest incomeGain on sale of equipmentSelling and administrative expensesInterest expenseExtraordinary gainLoss from discontinued segment operationsGain on disposal of discontinued segment

$425,000185,000

8,0004,000

18,0003,000

25,000(e,s00)36,000

RequiredAssume the corporation is subject to a 40Vo tax rate. Prepare an income statement for theyear ended December 31,2007 .

P10-3B. Prepare an income statement (LO 1)The following balances appeared in the general ledger for Ski Daddle Corporation at fiscalyear-end December 3I, zOOi .

Selling and administrative expensesOther revenues and gainsOperating expensesCost of goods soldNet salesOther expenses and losses

$ 4s,00080,000

110,000185,000325,000

8,000


In addition, the following occurred throughout the year.

1. On August2}, afire destroyed one of the company's warehouses resulting in an extra-ordinary loss of $35,000.

2. On October 31, the company discontinued one of its unprofitable segments. The lossfrom operations was $35,000. The assets of the segment were sold ata gainof $19,000.

Requireda. Assume Ski Daddle Corporation's income tax rate is 307o; prepare the income

statement for the year ended December 31, 2001 .b. Calculate the earnings per share the company would report on the income

statement assuming Ski Daddle had 100,000 shares of common stockoutstanding during the year and paid preferred dividends of $15,000.

P10-4B. Perform horizontal and vertical analysis. (LO 2)Here are the income statements from a frrm's recent annual reDort.

Year ended December 31,( in mi l l ions)

2008 2007 2006

526,971 $2s,112 $ZZ,StZ12,379 11,497 10,750

Net revenue

Cost of sales

Sel l ing, general , and administrat iveexpenses

Amortization of intangible assets

Other exoenses

Operating profit

Income from investments

Interest exoense

Interest income

Income before income taxes

Income taxes

Net income

9,460

145

204

4,783

323

(1 63)

51

4,994

1,424

$ g,szo

8,9s8138224

8,574

165

3s53,667

160(21e)

67

4,295280(1 78)

364,4331,433

$ 3,000

3,675

1,244

$ 2,431

Requireda. For each ofthe years shown, perform a vertical analysis, using sales as the base.

Write a paragraph explaining what the analysis shows.b. Using 2006 as the base year, perform a horizontal analysis for net revenue and

cost of sales. What information does this analysis give you?

CHAPTER 10 . PROBLEMS 515

Consolidated Statement of IncomeRadioShack Corporation and Subsidiaries

2,025.5349.9

5.9(44.s)

10.2321.551.6

39.86.90.1(0.8)

0.2

Year Ended December 31,

2005 2004

(ln millions, exceptper share amounts)

Net sales and operatingrevenues

Cost of products soldGross profit

Operating expenses:Sel l ing, general and

administrativeDepreciation and

amortizationTotal operating expensesOperating incomelnterest incomeInterest expenseOther income, netIncome before income taxesProvision for income taxesIncome before cumulative

effect of change inaccounting principle

Cumulative effect of changein accounting principle, netof $1.8 mi l l ion tax benef i t

Net income

%otDollars Revenues

o/o ofDollars Revenues

$4,841.22,406.72,434.5

1,774.8

101.41,876.2

558.311.4

(2s.6)

2.0542.1 11.2204.9 4.2

337.2 7.0

$ 337.2 7.00/o

$5,081.72,706.32,375.4

1,901.7

123.8

100.0o/o53.346.7

37.4

2.4

100.0%49.7s0.3

36.7

2.138.81 1.50.2(0.s)

6.41.0

269.9 5.4

(2.s) (0.1)

5 ZAI.O 5.3o/o


Consolidated Balance SheetsRadioShack Corporation and Subsidiaries

December 31,

(ln mill ions, except for share amounts) 2005

Assets

Current assets:

Cash and cash equivalents

Accounts and notes receivable, net

Inventories, net

Other current assets


Property, plant and equipment, net

Other assets, net

Total assets

Liabil it ies and Stockholders' Equity

Current l iabi l i t ies:

Short-term debt, including current maturit iesof long-term debt

Accounts payable

Accrued expenses and other currentl iabi l i t ies

Income taxes payable

Total current l iabil i t ies

Long-term debt, excluding currentmaturit ies

Other non-current l iabi l i t ies

Total l iabil i t ies

Commitments and cont ingent l iabi l i t ies(see Notes 11 and 12)

Stockholders' equity:

Preferred stock, no par value,1,000,000 shares authorized:

Ser ies A junior part ic ipat ing,300,000 shares designated and none issued

Series B convertible, 100,000 sharesauthor ized and non issued

Common stock, $1 par value,650,000,000 shares authorized;1 91,033,000 shares issued

Addit ional paid- in capi ta l

Retained earnings

Treasury stock, at cost; 56,071,000and 32,835,000 shares, respectively

Unearned compensation

Accumu lated other comorehensiveincome (loss)

Total stockholders' equity


$ zzq.o309.4964.9

129.0

1,627 .3

476.2

101.6

$ 2,20s.1

$ +o.g490.9

379.575.0

2004

$ 437.9

241.O

1,003.7

92.5' t ,775.1

652.089.6

5 2,s15.7

$ ss.o442.2

342.1117.5957.4986.3

494.9 s05.9135.1 130.3

1,515.3 1,594.6

191.0 1 91.0

88.2 82.7

1,741.4 1,508.1

(1,431.6) (8se.4)

(0.s)

0.3 (0.3)

588.8 922.1$ 2,20sj $ 2,s16.7

The accompanying notes are an integral part of these consolidated financialstatements.

CHAPTER 10 ' PROBLEMS 517

P10-5B. Calculate and analyze financial ratios. (LO 3)

The information given in P10-4B was taken from Radio Shack's financial statements. Even

though you did not study all of the items on the statements, you should recognize most of them.

Requireda. Calculate the following ratios for 2005.

1. Current ratio2. Acid-test ratio3. Working capital4. Accounts receivable turnover ratio (Assume all sales are credit sales.)

5. Debt-to-equity ratio6. Times-interest-earned ratio7. Return on equitY

b. Notice that Radio Shack provides a vertical analysis of the income statement.

Comment on the changes between the 2 years shown.

P10-68. Calculate and analyze financial ratios. (LO 3)

The following information was taken from the annual report of ROM'

At December 31,( in thousands)

2008

ASSETS:

Current assets:

Cash

Accounts receivable


Prepaid expenses


Plant and equipment:

Bui ld ings, net

Equipment, net

Total p lant and equipment

Total assets

LIABILITIES:

Current l iabi l i t ies:

Accounts payable

Notes payable

Total current I iabi l i t ies



STOCKHOLDERS' EQUITY

Common stock, no par value

Retained earnings

Total stockholders' equitY


Sales for the year

Cost of goods sold

Total assets at Dec. 31,2007

Total l iabi l i t ies at Dec. 31,2007

Total stockholders' equity at Dec. 31 , 2007

$ 1,2203,112

966149

5,447

2,9921,0454,037

$_s,484

$ 1,68s1,1002,78s2,0004,785

3,0421,6574,699

!_2,4e!$ 10,200

6,750

8,980

4,535

4,445

518 CHAPTER 1O o USING FINANCIAL STATEMENT ANALYSIS TO EVALUATE FIRM PERFORMANCE

Required

a. Calculate the following ratios for 2008:1. Debt-to-equity ratio2. Gross profrt percentage3. Current ratio4. Acid-test ratio

b. What do the ratios indicate about the success of ROM? What additionalinformation would be useful to help you analyze the overall performance of thiscompany?

P10-7B. Calculate and analyze financial ratios. (LO 3)The f,rnancial statements of Builder Bob's include the followins items.

Accounts receivable (net) 44,000

At

Balance sheet:

Cash

I nvestments (short-term)

Inventory

Prepaid rent



Sept. 30, 2008

$ zz,ooo15,000

85,0005,000

$1 77,000

$1 20,000

$320,000150,000

Sept. 30, 2007

$ zz,ooo12,00040,00075,0002,000

$1 51 ,ooo$ 8o,ooo

Income statement for the year ended September 30, 2008:

Net credit salesCost of goods sold

Requireda. Compute the following ratios for the year ended September 30, 2008, and

September 30,2007 . For each, indicate if the direction is favorable orunfavorable for the company.

1. Current ratio2. Quick ratio3. Accounts receivable turnover (2008 only)4. Inventory turnover ratio (2008 only)5. Gross margin percentage (2008 only)

b. Which financial statement users would be most interested in these ratios?c. Suppose the industry average for similar retail stores for the current ratio is 1.2.

Does this information help you evaluate Builder Bob's liquidity?

CHAPTER 10 . CRITICALTHINKING PROBLEMS 519

P10-8B. Calculate and analyze financial ratios. (LO 5)You are interested in investing in Apples and Nuts Company, and you have obtained the bal-ance sheets for the company for the past 2 years.

Apples and Nuts CompanyBalance Sheet


2008

Current assets

Cash


Inventory

Prepaid rent


Equipment, net

Total assets





Retained earnings

Total l iabi l i t ies and stockholders ' equi ty

$873,000

Net income for the year ended December 3L, 2008 was $ 100,000.

Requireda. Compute as many of the financial statement ratios 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?

Crit ical Thinking ProblemsRisk and Control

Think about the risks of investing in a company and about the information provided by thefinancial ratios you studied in this chapter. Which financial ratios do you believe might giveyou information about the risk of investing in a company? Comment on those ratios fromStaples and Office Depot, which you calculated at the end of the chapter in the ChapterSummary Problem.

EthicsAtlantis Company sells computer components and plans on borrowing some money to ex-pand. After reading a lot about earnings management, Andy, the owner of Atlantis, has de-cided he should try to accelerate some sales to improve his frnancial statement ratios. Hehas called his best customers and asked them to make their usual January purchases by De-cember 31. Andy told the customers he would allow them until the end of February to payfor the purchases, just as if they had made their purchases in January.

a. What do you think are the ethical implications of Andy's actions?b. Which ratios will be imoroved bv acceleratine these sales?

Group AssignmentIn groups, try to identify the type of company that is most likely indicated by the ratios shownbelow. The four types of companies represented are: retail grocery, heavy machinery,

$ 98,000310,000275,00010,000

693,0001 80,000

$206,000219,000425,000250,0001 98,000

$873,000

2007

$ go,ooo

216,000170,000

5,000482,000258,000

$740,000$223,000217,000440,0001 90,0001 10,000

$740,ooo

520 CHAPTER 10 o USTNG FtNANcTAL STATEMENT ANALysrs ro EVALUATE FIRM pERFoRMANCE

restaurant, and drug manufacturer. Make notes on the arguments to support your position sothat you can share them in a class discussion.

AccountsGross (Long-term) Receivable Inventory

Margin Debt-to- Turnover Turnover Return onRat io Equi ty Rat io Rat io Rat io Equi ty

1 82.9o/o 25o/o 5.5 times 1.5 times 22.9%

2 33.7o/o 134o/o 49.3 t imes 11.2 t imes 3.6%

3 25.3% 147% 2.3 t imes 5.0 t imes 5.0o/o

4 37.4o/o 620/o 34.9 times 32.9 times 15.7o/o

Internet Exercise: Papa John's Internat ionalPapa John's has surpassed Little Caesars to become the number three pizza chain, behindonly number onePizza Hut and number two Domino's Pizza.PapaJohn's 2,800 restaurants(about11%o are franchised) are scattered across the United States and 10 other countries.Examine how Papa John's compares with its competition.

IE 10-1. Go to www.papajohns.com and explore "Papa John's Story" and "Ow PizzaStory." What differentiates Papa John's from its competition?

lEI0-2. Go to http://moneycentral.msn.com and get the stock quote forPZZA, Papa John'sstock symbol. Identify the current price-to-earnings ratio and dividend yield ratio. What dothese market indicators mean for Papa John's?

IE 10-3. Select "Financial Results" and then "Key Ratios."a. Select "Financial Condition." Calculate the current ratio and quick (acid-test)

ratio for Papa John's and the industry. Who would find these ratios of primaryinterest? Identify the debt-to-equity ratio and interest coverage ratio (anothername for times-interest-earned ratio) for Papa John's and the industry. Is PapaJohn's primarily financed by debt or equity? How can you tell? Does Papa John'shave the ability to pay its interest obligations? Explain why or why not.

b. Select "Investment Returns." Identify return on equity and return on assets forPapa John's and the industry. What do these ratios measure?

c. Select "Ten-Year Summary." Review the information provided for return onequity and return on assets. What additional information is revealed about PapaJohn's financial position? Is this information helpful?

IE 10-4. Review the information recorded earlier. Does Papa John's compare favorablywith industry averages? Support your judgment with at least two observations.

Please note: Internet Web sites are constantly being updated. Therefore, if the informationis not found where indicated, please explore the Web site further to find information.

Appendix l0A

Comprehensive IncomeIn the chapter, you learned that the Financial Accounting Standards Board (FASB) has de-fined two items that companies need to separate from regular earnings on financialstatements: discontinued operations and extraordinary items. There is a third item-comprehensive income.

Even though most transactions that affect shareholders'equity are found on the incomestatement-revenues and expenses-there are a small number of transactions that affectshareholders'equity that are excluded from the calculation of net income. We already knowabout two of them:

1.. Owners making contributions (paid-in capital)2. Owners receiving dividends

In addition to these two, there are several other transactions that affect equity withoutgoing through the income statement. The most common examples of these transactions are( 1) unrealized gains and losses from foreign currency translations nd (2) unrealized gainsand losses on certain investments. Rather than including either of these kinds of gains andlosses on the income statement, they are reported as a direct adjustment to equity. The rea-son is that these items do not really reflect a firm's performance, so firms have lobbied tohave them kept out of the calculation of earnings. To keep these transactions from gettinglost among all the financial statement numbers, the FASB requires the reporting of net in-come plus these other transactions that affect shareholders' equity in an amount called com-prehensive income. Comprehensive income includes all changes in shareholders' equityduring a period except those changes in equity resulting from contributions by sharehold-ers and distributions to shareholders. There are two parts of comprehensive income: net in-come and other comprehensive income. We know what types of transactions are includedin net income-revenues, expenses, discontinued operations, and extraordinary items.Items included in other comprehensive income include unrealized gains and losses fromforeign currency translation and unrealized gains and losses on certain types ofinvestments.Exhibit 10A.1 shows all of the items that affect shareholders' equity.

What is the purpose of having a statement of comprehensive incomerather than a simple income statement?

Comprehensive income Thetotal of al l i tems that affectshareholders' equity excepttransactions with the owners;comorehensive income hastwo oarts: net income andother comprehensive income.

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

521

522 CHAPTER 10

EXHIBIT 1O.A1

Comprehensive IncomeThe items in the left columnappear on the financialstatements in the equityclassifications shown in the riehtcolumn.

. USING FINANCIAL STATEMENT ANALYSIS TO EVALUATE FIRM PERFORMANCE

Items that Affect Shareholders' Equiff

Appendix l0B

Investments in SecuritiesYou have learned that certain gains and losses related to investments may be included inother comprehensive income. We will take a closer look at how a firm accounts for its in-vestments in the securities of another firm. You will see how gains and losses on some ofthese investments are reported as part of comprehensive income.

When interest rates are low, a company's extra cash-cash not immediately needed-may earn more in the stock market or bond market than it would in a bank savings accountor certificate of deposit. That is when a company buys stocks and bonds of other compa-nies with its extra cash. For entities such as banks and insurance companies, investing cashin other companies is a crucial pafi of managing their assets. As you learned in previouschapters, stocks are equity securities and bonds are debt securities. Both may be purchasedwith a company's extra cash. When a company buys another company's debt securities orless than 207o of its equity securities, the accounting rules require firms to classify their in-vestments in securities into one of three categories: held to maturity, trading, and availablefor sale.

Held-to-Maturity SecuritiesSometimes a company purchases debt securities and intends to keep them until they mature.Recall that all bonds have a maturity date, but equity securities do not. If a company has theintention of keeping the securities until maturity and their financial condition indicates thatthey should be able to do this, the securities will be classified as held-to-maturity securities.Such investments are recorded at cost, and they are reported at that same amount on the bal-ance sheet-plus or minus any unamoftized discount or premium. No matter how muchheld-to-maturity investments are worth on the market, a company will always report them atamortized cost when preparing its balance sheet.

Trading SecuritiesIf a company buys the securities solely to trade them and make a short-term profit, the com-pany will classify them as trading securities. The balance sheet shows trading securities attheir market value. A company obtains the current value of the investments from The WallStreet Journal or a similar source of market prices. Those values are then shown on the bal-ance sheet. Updating the accounting records to show the securities at their market value iscalled marking to market.If the securities' cost is lower than market value, then the com-pany will record the difference as an unrealized gain. If the securities' cost is higher thanmarket value, then the company will record the difference as an unrealized loss. Remem-be1, realizing means actually getting something. Any gain or loss on an investment the com-pany is holding (holding mears not selling) is something the company does not get (a gain)or does not give up (a loss) until the company sells the securities. Unrealized gains orlosses are gains or losses on securities that have not been sold. Such a gain or loss may alsobe called a holding gain or /oss. The unrealized gains and losses from trading securities arereported on the income statement.

Held-to-maturity securitiesInvestments in debt securit iesthat the company plans tohold unti l they mature.

Trading securities Investmentsin debt and equity securit iesthat the company haspurchased to make a short-term orofit.

Unreal ized gain or loss Anincrease or decrease in themarket value of a company'sinvestments in securit ies isrecognized either on theincome statement-fortrading securit ies-or in othercomprehensive income in theequity section of the balancesheet-for avai lable-for-salesecurit ies-when the f inancialstatements are prepared, eventhough the securit ies have notbeen sold.

523


Avai lable-for-sale secu ritiesInvestments the company mayhold or sel l ; the company'sintention is not clear enoughto use one of the othercategories-he I d to m atu rityor trading.

Your Tarn, " i , . ,1 ' t

For example, suppose Avia Company has invested $130,000 of its extra cash insecurities-stocks and bonds traded on the stock and bond markets. At the end of theyear, the securit ies that cost Avia $130,000 have a market value of $125,000. On theincome statement for the year, Avia will show an unrealized loss of $5,000. The lossis recorded in an adjustment made before the financial statements are prepared.

The securities'new value of $125,000 (originally $130,000 minus loss of $5,000) hasreplaced their original cost. Now, $125,000 will be the "cost" and will be compared to themarket value on the date of the next balance sheet. Remember, the company purchasedthese trading securities as investments to trade in the short run, so the firm's investmentportfolio is likely to look very different at the next balance sheet date.

Available-for-Sa le SecuritiesSometimes a company is not sure how long it will keep the debt or equity securities it haspurchased. Ifthe company does not intend to sell the securities in the short term for a quickprofit or does not intend to hold them until maturity, the company will classify the securi-ties as available for sale. Every year, when it is time to prepare the annual balance sheet,the cost of this group of securities is compared to the market value at the balance sheet date.The book value of the securities is then adjusted to market value, and the correspondinggain or loss is reported in shareholders' equity. Such a gain or loss is called an unrealizedor holding gain or loss, just as it is called for trading securities. But these gains and lossesdo not go on the income statement. Instead, they are included as part of accumulated othercomprehensive income in the shareholders' equity section of the balance sheet.

A corporation has invested $50,000 in the securities of other companies. Atthe end of the yeaI that corporation's portfolio has a market value of $52,000.Describe where these securities would be shown on the annual financialstatements and at what amount under each of the conditions described.

1. The investment is classified as trading securities.2. The investment is classified as available for sale.3. The investment is classified as held to maturity.

Suppose Avia Company classified its portfolio of securities that cost $ 130,000 as avail-able for sale. Ifthe market value ofthe securities is $125,000 at the date ofthe balance sheet,the securities must be shown on the balance sheet at the lower amount. In this case, the un-realized loss will nol be shown on the income statement. Instead of going through net in-come to retained earnings, the loss will go through comprehensive income to accumulatedother comprehensive income in the shareholders' equity section of the balance sheet. Theloss will be shown after retained earnings, either alone-and labeled as an unrealized lossfrom investments in securities-or combined with other nonincome statement sains andlosses-and labeled as accumulated other comprehensive income.

Selling the Securit iesWhen a firm sells any of these securities-trading, available for sale, and held to maturity-the gain or loss on the sale is calculated like other accounting gains and losses. The bookvalue of the security at the time of the sale is compared to the selling price. The selling priceis often called the proceeds from the sale. If the book value is greater than the proceeds, thefirm will record a loss on the sale. If the book value is less than the proceeds, the firm willrecord a gain on the sale. Gains and losses from the actual sale of the securities are bothrealized-the sale has actually happened-and recognized-the relevant amounts areshown on the income statement.

Financial Accounting 10

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