Learning Objective LO 1 Analyze an income statement

Lesson 17 -1 Vertical Analysis Ratios LO 1 ● Vertical analysis ratios measure the relationship between one financial statement item and another item on the same financial statement. ● On the income statement, vertical analysis ratios focus on the ability of a business to earn a profit. ● A ratio that measures the ability of a business to generate income is called a profitability ratio. Continued on the next slide. © 2014 Cengage Learning. All Rights Reserved. SLIDE 2

Lesson 17 -1 Vertical Analysis Ratios LO 1 ● Vertical analysis ratios on an income statement are examples of profitability ratios. ● Managers use vertical analysis ratios to help make business decisions. ● For vertical analysis to be an effective tool, a business must set a target, or standard, for each ratio. ● A standard used to compare financial performance is called a benchmark. © 2014 Cengage Learning. All Rights Reserved. SLIDE 3

Factors Used to Determine Benchmark Ratios Lesson 17 -1 LO 1 ● Actual ratios from prior fiscal periods ● Industry standards published by industry organizations ● Business plans ● Unexpected events © 2014 Cengage Learning. All Rights Reserved. SLIDE 4

Lesson 17 -1 Analyzing Trends with Vertical Analysis LO 1 ● Financial statements that provide information for multiple fiscal periods are called comparative financial statements. ● An analysis of changes over time is called trend analysis. ● Net income after federal income tax as a percent of net sales is called profit margin. © 2014 Cengage Learning. All Rights Reserved. SLIDE 5

Lesson 17 -1 Analyzing Trends with Vertical Analysis © 2014 Cengage Learning. All Rights

Lesson 17 -1 Using Vertical Analysis to Analyze Gross Profit LO 1 ● Gross profit as a percent of net sales is called gross margin. ● This ratio is also referred to as gross profit margin. © 2014 Cengage Learning. All Rights Reserved. SLIDE 7

Lesson 17 -1 Correcting an Unfavorable Gross Margin LO 1 ● Increase unit sales

Lesson 17 -1 Using Vertical Analysis to Analyze Operating Expenses LO 1 ● Income from operations as a percent of net sales is called the operating margin. ● This ratio is also referred to as the rate of return on sales. ● Total operating expenses as a percent of net sales is called the operating expense ratio. © 2014 Cengage Learning. All Rights Reserved. SLIDE 9

Lesson 17 -1 Correcting an Unfavorable Operating Expense Ratio LO 1 ● Reduce operating

Lesson 17 -1 Audit Your Understanding 1. Identify four factors that management can use to determine benchmark financial ratios. ANSWER 1. Actual ratios from prior fiscal periods 2. Industry standards published by industry organizations 3. Business plans 4. Unexpected events © 2014 Cengage Learning. All Rights Reserved. SLIDE 11

Lesson 17 -1 Audit Your Understanding 2. Why should a business be cautious about increasing the markup on merchandise purchased for sale? ANSWER If the increase in markup is too large, a decrease in sales revenue could occur for two reasons: (1) the sales price may exceed what customers are willing to pay or (2) customers may elect to purchase from competing businesses having lower prices. © 2014 Cengage Learning. All Rights Reserved. SLIDE 12

Lesson 17 -1 Audit Your Understanding 3. What are two practices that can be used to reduce the cost of merchandise? ANSWER Purchase merchandise in larger quantities or from other vendors offering a lower cost © 2014 Cengage Learning. All Rights Reserved. SLIDE 13

Lesson 17 -1 Audit Your Understanding 4. Should managers interested in reducing operating expenses focus more on the operating expense ratio or the operating margin? ANSWER Operating expense ratio © 2014 Cengage Learning. All Rights Reserved. SLIDE 14

Lesson 17 -1 Audit Your Understanding 5. What are three possible actions to correct an unfavorable operating expense ratio? ANSWER • Reduce operating expenses • Modify the benchmark • Increase net sales © 2014 Cengage Learning. All Rights Reserved. SLIDE 15

Learning Objectives LO 2 Perform vertical analysis of a balance sheet. LO 3 Analyze

Lesson 17 -2 Calculating Vertical Analysis Ratios on a Balance Sheet LO 2 1 Asset Amounts Divided by Total Assets 2 Liability and Stockholders’ Equity Amounts Divided by Total Assets © 2014 Cengage Learning. All Rights Reserved. SLIDE 17

Lesson 17 -2 Evaluating Vertical Analysis Asset Ratios © 2014 Cengage Learning. All Rights

Lesson 17 -2 Evaluating Vertical Analysis Liability Ratios LO 3 ● A ratio that measures the ability of a business to pay its long-term liabilities is called a solvency ratio. ● Total liabilities divided by total assets is called the debt ratio. © 2014 Cengage Learning. All Rights Reserved. SLIDE 19

Lesson 17 -2 Evaluating Vertical Analysis Liability Ratios © 2014 Cengage Learning. All Rights

Lesson 17 -2 Audit Your Understanding 1. Why do many retailers perform vertical analysis on the Accounts Receivable and Merchandise Inventory accounts? ANSWER First, these are typically two of the largest asset accounts for a retail merchandising business. Second, industry standards are available for these accounts. © 2014 Cengage Learning. All Rights Reserved. SLIDE 21

Lesson 17 -2 Audit Your Understanding 2. What may cause a vertical analysis ratio for accounts receivable to be below the target range? ANSWER A ratio below the target range may indicate that a company is restricting customers’ ability to purchase on account. This action may have a negative effect on sales. © 2014 Cengage Learning. All Rights Reserved. SLIDE 22

Lesson 17 -2 Audit Your Understanding 3. What may cause a vertical analysis ratio for merchandise inventory to be below the target range? ANSWER The business may not be stocking an adequate supply or variety of merchandise. © 2014 Cengage Learning. All Rights Reserved. SLIDE 23

Lesson 17 -2 Audit Your Understanding 4. What should a company do if the vertical analysis ratio for merchandise inventory is above the target range? ANSWER The company should prepare a list of the inventory items having the largest cost. The company should assess whether the proper quantity of each item is available for sale. Future inventory purchases should ensure that the optimal quantity on hand is maintained. © 2014 Cengage Learning. All Rights Reserved. SLIDE 24

Lesson 17 -2 Audit Your Understanding 5. Why is it risky for a business to have too many liabilities? ANSWER The business must be able to pay its liabilities on a timely basis. If sales decline during difficult financial times, a business may be unable to make its monthly payments. © 2014 Cengage Learning. All Rights Reserved. SLIDE 25

Learning Objectives LO 4 Perform horizontal analysis on an income statement. LO 5 Perform

Lesson 17 -3 Analyzing Trends with Horizontal Analysis LO 4 ● A comparison of one item on a financial statement with the same item on a previous period’s financial statement is called horizontal analysis. Current Period − Prior Period = Increase (Decrease) $242, 584. 00 − $221, 489. 00 = $21, 095. 00 Increase (Decrease) ÷ Prior Period = Horizontal Analysis Ratio $21, 095. 00 ÷ $221, 489. 00 = 9. 5% © 2014 Cengage Learning. All Rights Reserved. SLIDE 27

Lesson 17 -3 Horizontal Analysis of an Income Statement Current Year 1 Less Prior

Lesson 17 -3 Horizontal Analysis of a Balance Sheet © 2014 Cengage Learning. All

Lesson 17 -3 Audit Your Understanding 1. How could a 2. 0% decrease in supplies expense be an unfavorable trend? ANSWER If management took actions that should have decreased supplies expense by significantly more than 2. 0%, then only a 2% decrease would be unfavorable. © 2014 Cengage Learning. All Rights Reserved. SLIDE 30

Lesson 17 -3 Audit Your Understanding 2. How does a publicly held corporation use horizontal analysis when reporting to the Securities and Exchange Commission? ANSWER The document filed with the Securities and Exchange Commission contains a section titled Management’s Discussion and Analysis of Financial Condition and Results of Operations. Management often uses these ratios to explain the current year’s results of operations compared to previous years. © 2014 Cengage Learning. All Rights Reserved. SLIDE 31

Learning Objectives LO 6 Calculate earnings per share. LO 7 Calculate and interpret market

Lesson 17 -4 Earnings per Share LO 6 ● Net income after federal income tax divided by the number of outstanding shares of stock is called earnings per share. ● Earnings per share is often abbreviated as EPS. Net Income after Federal Income Tax $ Number of Shares Outstanding Earnings per Share $ 79, 896. 57$ ÷ 7, 500 10. 65$ © 2014 Cengage Learning. All Rights Reserved. 79, 896. 57 ÷ 75, 000 1. 07 SLIDE 33

Lesson 17 -4 Market Ratios LO 7 ● A ratio that measures a corporation’s financial performance in relation to the market value of its stock is called a market ratio. © 2014 Cengage Learning. All Rights Reserved. SLIDE 34

Lesson 17 -4 Dividend Yield LO 7 ● The relationship between dividends per share and market price per share is called the dividend yield. Dividends per Share $2. 00 Market Price ÷ = per Share ÷ $228. 75 = © 2014 Cengage Learning. All Rights Reserved. Dividend Yield 0. 87% SLIDE 35

Lesson 17 -4 Price-Earnings Ratio LO 7 ● The relationship between the market value per share and earnings per share of a stock is called the price-earnings ratio. ● It is often referred to as the P/E ratio. Market Price ÷ per Share $228. 75 ÷ Earnings per Share $10. 65 Price-Earnings = Ratio = © 2014 Cengage Learning. All Rights Reserved. 21. 5 SLIDE 36

Lesson 17 -4 Liquidity Ratios LO 8 ● A ratio that measures the ability of a business to pay its current financial obligations is called a liquidity ratio. © 2014 Cengage Learning. All Rights Reserved. SLIDE 37

Lesson 17 -4 Working Capital LO 8 ● The amount of current assets less current liabilities is called working capital. Current Assets − $185, 322. 90 − Current Liabilities $32, 251. 78 = Working Capital = $153, 071. 12 © 2014 Cengage Learning. All Rights Reserved. SLIDE 38

Lesson 17 -4 Current Ratio ● A ratio that measures the relationship of current assets to current liabilities is called the current ratio. ● The current ratio measures a company’s ability to pay its current liabilities when due. Current Assets ÷ Current Liabilities = $185, 322. 90 ÷ $32, 251. 78 = © 2014 Cengage Learning. All Rights Reserved. Current Ratio 5. 75 SLIDE 39

Lesson 17 -4 Quick Ratio ● Cash and other current assets that can be quickly converted into cash are called quick assets. ● Quick assets are also referred to as liquid assets. ● A ratio that measures the relationship of quick assets to current liabilities is called the quick ratio. © 2014 Cengage Learning. All Rights Reserved. SLIDE 40

Lesson 17 -4 Quick Ratio Cash $54, 444. 34 + + Accounts Receivable $17, 872. 56 = = Quick Assets $72, 316. 90 ÷ ÷ Current Liabilities $32, 251. 78 = = Quick Ratio 2. 24 © 2014 Cengage Learning. All Rights Reserved. SLIDE 41

Lesson 17 -4 Audit Your Understanding 1. Why can one corporation’s earnings per share not be compared to the EPS of other corporations? ANSWER Each corporation’s EPS is a unique number because corporations can issue any number of shares. As a result, the earnings of each corporation are divided by a different number of shares. © 2014 Cengage Learning. All Rights Reserved. SLIDE 42

Lesson 17 -4 Audit Your Understanding 2. What group is the primary user of

Lesson 17 -4 Audit Your Understanding 3. Do income stocks typically have low or

Lesson 17 -4 Audit Your Understanding 4. Do growth stocks typically have low or

Lesson 17 -4 Audit Your Understanding 5. What is the primary source of data

Lesson 17 -4 Audit Your Understanding 6. What does working capital measure? ANSWER Working capital is a measure of the financial resources available for the daily operations of the business. © 2014 Cengage Learning. All Rights Reserved. SLIDE 47

Lesson 17 -4 Audit Your Understanding 7. Why is the current ratio a useful measure of financial strength? ANSWER The current ratio permits a business to compare itself to its industry or to provide a convenient relative measurement from year to year regarding the company’s ability to pay current liabilities when due. © 2014 Cengage Learning. All Rights Reserved. SLIDE 48