661 CHAPTER 15 FINANCIAL STATEMENT ANALYSIS CLASS DISCUSSION QUESTIONS 1. Horizontal analysis is the percentage analy-sis of increases and decreases in corre-sponding statements. The percent change in the cash balances at the end of the preced-ing year from the end of the current year is an example. Vertical analysis is the percent-age analysis showing the relationship of the component parts to the total in a single statement. The percent of cash as a portion of total assets at the end of the current year is an example. 2. Comparative statements provide information as to changes between dates or periods. Trends indicated by comparisons may be far more significant than the data for a single date or period. 3. Before this question can be answered, the increase in net income should be compared with changes in sales, expenses, and assets devoted to the business for the current year. The return on assets for both periods should also be compared. If these comparisons in-dicate favorable trends, the operating per-formance has improved; if not, the apparent favorable increase in net income may be off-set by unfavorable trends in other areas. 4. You should first determine if the expense amount in the base year (denominator) is significant. A 100% or more increase of a very small expense item may be of little con-cern. However, if the expense amount in the base year is significant, then over a 100% increase may require further investigation. 5. Generally, the two ratios would be very close, because most service businesses sell services and hold very little inventory. 6. The amount of working capital and the change in working capital are just two indica-tors of the strength of the current position. A comparison of the current ratio and the quick ratio, along with the amount of working capi-tal, gives a better analysis of the current po-sition. Such a comparison shows: Current Preceding Year Year Working capital....... $42,500 $37,500 Current ratio............ 2.0 2.5 Quick ratio .............. 0.8 1.2 It is apparent that, although working capital has increased, the current ratio has fallen from 2.5 to 2.0, and the quick ratio has fallen from 1.2 to 0.8. 7. The bulk of Wal-Mart sales are to final cus-tomers that pay with credit cards or cash. In either case, there is no accounts receivable. Procter and Gamble, in contrast, sells al-most exclusively to other businesses, such as Wal-Mart. Such sales are “on account,” and thus, create accounts receivable that must be collected. A recent financial state-ment showed Wal-Mart’s accounts receiv-able turning 109 times, while Procter and Gamble’s turned only 13 times. 8. No, an accounts receivable turnover of 6 with sales on a n/30 basis is not satisfactory. It indicates that accounts receivable are col-lected, on the average, in one-sixth of a year, or approximately 60 days from the date of sale. Assuming that some customers pay within the 30-day term, it indicates that other accounts are running beyond 60 days. It is also possible that there is a substantial amount of past-due accounts of doubtful col-lectibility on the books. 9. a. A high inventory turnover minimizes the amount invested in inventories, thus freeing funds for more advantageous use. Storage costs, administrative ex-penses, and losses caused by obsoles-cence and adverse changes in prices are also kept to a minimum. b. Yes. The inventory turnover could be high because the quantity of inventory on hand is very low. This condition might result in the lack of sufficient goods on hand to meet sales orders.662 c. Yes. The inventory turnover relates to the “turnover” of inventory during the year, while the number of days’ sales in inventory relates to the amount of inven-tory on hand at the end of the year. Therefore, a business could have a high inventory turnover for the year, yet have a high number of days’ sales in inventory at the end of the year. 10. The ratio of fixed assets to long-term liabili-ties increased from 2 for the preceding year to 2.5 for the current year, indicating that the company is in a stronger position now than in the preceding year to borrow additional funds on a long-term basis. 11. a. Due to leverage, the rate on stockhold-ers’ equity will often be greater than the rate on total assets. This occurs be-cause the amount earned on assets ac-quired through the use of funds provided by creditors exceeds the interest charges paid to creditors. b. Higher. The concept of leverage applies to preferred stock as well as debt. The rate earned on common stockholders’ equity ordinarily exceeds the rate earned on total stockholders’ equity because the amount earned on assets acquired through the use of funds provided by preferred stockhold-ers normally exceeds the dividends paid to preferred stockholders. 12. The earnings per share in the preceding year were $20 per share ($40/2), adjusted for the stock split in the latest year. 13. A share of common stock is currently selling at 10 times current annual earnings. 14. The dividend yield on common stock is a measure of the rate of return to common stockholders in terms of cash dividend dis-tributions. Companies in growth industries typically reinvest a significant portion of the amount earned in common stockholders’ equity to expand operations rather than to return earnings to stockholders in the form of cash dividends. 15. During periods when sales are increasing, it is likely that a company will increase its in-ventories and expand its plant. Such situa-tions frequently result in an increase in cur-rent liabilities out of proportion to the in-crease in current assets and thus lower the current ratio.663 EXERCISES Ex. 15–1 a. HOME-MATE APPLIANCE CO. Comparative Income Statement For the Years Ended December 31, 2006 and 2005 2006 2005 Amount Percent Amount Percent Sales............................................ $500,000 100.0% $450,000 100.0% Cost of goods sold..................... 275,000 55.0 234,000 52.0 Gross