12.8: Summary of Chapter 12 Learning Objectives

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Henry Dauderis and David Annand
Athabasca University via Lyryx Learning

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LO1 – Describe ratio analysis, and explain how the liquidity, profitability, leverage, and market ratios are used to analyze and compare financial statements.

Ratio analysis measures the relative magnitude of two selected numerical values taken from a company's financial statements and compares the result to prior years and other similar companies. Financial ratios are an effective tool for measuring: (a) liquidity (current ratio, acid-test ratio, accounts receivable collection period, and number of days of sales in inventory); (b) profitability (gross profit ratio, operating profit ratio, net profit ratio, sales to total assets ratio, return on total assets, and return on equity); (c) leverage (debt ratio, equity ratio, debt to equity ratio, and times interest earned ratio); and (d) market ratios (earnings per share, price-earnings ratio, and dividend yield ratio). Ratios help identify the areas that require further investigation.

LO2 – Describe horizontal and vertical trend analysis, and explain how they are used to analyze financial statements.

Horizontal analysis involves the calculation of percentage changes from one or more years over the base year dollar amount. The base year is typically the oldest year and is always 100%. Vertical analysis requires that numbers in a financial statement be restated as percentages of a base dollar amount. For income statement analysis, the base amount used is sales. For balance sheet analysis, total assets, or total liabilities and equity, are used as the base amounts. When financial statements are converted to percentages, they are called common-size financial statements.

Discussion Questions

Ratios need to be evaluated against some base. What types of information can be used to compare ratios against?
Explain what liquidity means. When a corporation is illiquid, what are the implications for shareholders? ...for creditors?
How is it possible that a corporation producing net income each year can be illiquid?
What ratios can be calculated to evaluate liquidity? Explain what each one indicates.
1. Define working capital. Distinguish between the current ratio and the acid-test ratio.
2. "The current ratio is, by itself, inadequate to measure liquidity." Discuss this statement.
Two firms have the same amount of working capital. Explain how it is possible that one is able to pay off short-term creditors, while the other firm cannot.
Management decisions relating to accounts receivable and inventory can affect liquidity. Explain.
What is one means to evaluate the management of accounts receivable? ...inventory?
Discuss the advantages and disadvantages of decreasing number of days of sales in inventory.
What is the revenue operating cycle? How is its calculation useful in evaluating liquidity?
1. Identify and explain six ratios (and any associated calculations) that evaluate a corporation's profitability.
2. What does each ratio indicate?
Why are analysts and investors concerned with the financial structure of a corporation?
Is the reliance on creditor financing good or bad? Explain its impact on net income.
Discuss the advantages and disadvantages of short-term debt financing compared to long-term debt financing.
Identify and explain ratios that evaluate financial returns for investors.
Distinguish between horizontal and vertical analyses of financial statements.