“How Well Am I Doing?”—
Financial Statement Analysis
LO1. Prepare and interpret financial statements in comparative form and common-size form.
LO2. Compute and interpret financial ratios that would be most useful to a common
LO3. Compute and interpret financial ratios that would be most useful to a short-term
LO4. Compute and interpret financial ratios that would be most useful to a long-term
New in this Edition
• The material dealing with preferred stock versus debt as a source of financial leverage has
• The wording in the chapter has been extensively reworked to improve readability.
• Many new Business Focus boxes have been added.
A. Importance of Statement Analysis. The purpose of financial statement analysis is to
assist statement users in assessing the financial condition of the company.
1. Importance of comparisons. Items from financial statements are usually not particularly
informative when viewed in isolation. They are informative only when viewed in
comparison with the results of other periods and, in some cases, with the results of other
companies. Three techniques are commonly used to make comparisons and to detect trends.
• Dollar and percentage changes in financial statement items.
• Common-size statements.
2. The need to look beyond comparisons. Although comparisons provide useful
information, even the best prepared comparative analysis should never be regarded as
conclusive in itself. Other sources of information should be used in order to make
judgments about the future and to assess the adequacy of current operations. And
unanticipated future events can always make even the best financial analysis largely
B. Statements in Comparative and Common-Size Form. (Exercises 17-1 and 17-7.)
Two basic approaches are often used to compare financial statements between companies or
between different years for the same company: horizontal (trend) analysis and vertical
1. Horizontal Analysis; dollar and percentage changes on statements. One approach to
financial statement analysis is to simply place financial statements side-by-side. Two types
of comparisons can then be made.
a. Trend percentages restate a time-series of financial data in terms of a base year.
Particularly when plotted against time, this approach allows the analyst to quickly
gauge the rate and direction of changes.
b. The difference (increase or decrease) between two statements can be shown in separate
columns in both dollar and percentage form. Showing changes in dollar form helps to
zero in on key factors that have materially affected profitability or financial position.
Showing changes in percentage form helps to gain a feel for how unusual the changes
2. Vertical Analysis; Common-size Statements. Key changes and trends can also be
highlighted by the use of common-size statements (sometimes called “vertical analysis”). A
common-size statement is one that shows each item as a percentage of a total rather than in
dollar form. These kinds of statements make it much easier to compare companies of
different sizes and to track balance sheet and income statement relationships within a
company over time as its size changes.
a. When preparing common-size statements for the balance sheet, the various items on the
balance sheet are typically stated as percentages of total assets.
b. When applying common-size techniques to the income statement, all items on the
income statement are usually stated as a percentage of total sales dollars.
3. Gross Margin Percentage. The gross margin percentage is defined to be the gross margin
as a percentage of sales revenue.
Gross margin percentage =
When a common-size income statement is created, the gross margin percentage will be
computed as a matter of course. However, it is important in its own right and is often
computed even when a common-size income statement is not produced. Interpretation of
the number can be tricky—particularly in manufacturing companies. Due to the presence of
fixed costs in cost of goods sold, the gross margin percentage can be expected to improve
as sales increase. This occurs because fixed manufacturing costs are spread across more
C. Ratio Analysis—The Common Stockholder. (Exercises 17-2, 7-5, and 17-9.) The
common stockholder has a residual claim on the profits and assets of a company after all creditor
and preferred stockholder claims have been satisfied.
1. Earnings Per Share. Earnings per share is closely monitored by investment analysts.
Indeed, the emphasis this figure is given by investors and hence by CEOs has been
criticized for many years. In particular, there is criticism of the perceived pressure to “turn
in ever-increasing quarterly earnings per share.” (Interestingly, careful capital markets
studies indicate that the stock market is far less focused on short-term earnings than CEOs
typically think.) At any rate, earnings per share is computed as follows:
Net income - Preferred dividends
Earnings per share =
Average number of shares outstanding
To keep things simple in the book, the average number of common shares outstanding is
assumed to be computed by simply taking the average of the number of shares at the
beginning of the year and at the end of the year.
2. Price-Earnings Ratio. The relation between the market price of a share of stock and the
stock’s current earnings per share is often stated in terms of a price-earnings ratio. This
ratio tends to be high in companies that have good future growth prospects. The price-
earnings ratio is computed as follows:
Market price per share
Price-earnings ratio =
Earnings per share
The price-earnings ratio is widely used by investors as a general guideline in gauging stock
values. If the ratio is unusually high or low for a company in relation to its industry, an
analyst may suspect that the stock is overvalued or undervalued.
3. Dividend Payout Ratio. The dividend payout ratio gauges the portion of current earnings
being paid out in dividends. This ratio is computed as follows:
Dividends per share
Dividend payout ratio =
Earnings per share
A high or low dividend payout ratio is neither good nor bad taken by itself. A low payout
ratio may be an indication that the company has excellent internal investment opportunities
and therefore foregoes paying dividends.
4. Dividend Yield Ratio. The dividend yield ratio is defined as follows:
Dividends per share
Dividend yield ratio =
Market price per share
The dividend yield ratio is primarily of interest to retirees and other stockholders who need
a steady stream of cash income from their investments. Such stockholders “buy dividends”
and compare dividend yields to the returns they could earn on bonds and other fixed
income securities. Historically some stocks’ dividends have been so reliable that investing
in the stock is believed to be almost as safe as putting money in the bank.
5. Return on Total Assets. The return on total assets is a measure of how profitably assets
have been employed. It is computed as follows:
Net income + Interest expense × ( 1 - Tax rate )
Return on total assets =
Average total assets
The return on total assets attempts to measure what the return on total assets would be if the
company had no long-term debt in its capital structure. The after-tax interest expense is
added back to net income to eliminate the interest expense associated with debt.
6. Return on Common Stockholders’ Equity. The return on common stockholders’ equity
is a measure of the success of a company in generating income for common stockholders.
Net income- Preferred dividends
Return on common stockholders' equity =
Average common stockholders' equity
Common stockholders’ equity is stockholders’ equity less preferred stock. Average
common stockholders’ equity is the average of the common stockholders’ equity at the
beginning and end of the year. Net income less preferred dividends is referred to as “net
income remaining for common stockholders” in the text.
7. Financial leverage. Financial leverage involves financing assets with funds that have been
provided by creditors or preferred stockholders at a fixed rate of return. If assets in which
the funds are invested earn a rate of return greater than the fixed rate of return required by
the suppliers of the funds, then financial leverage is positive and the common stockholders
benefit. The optimal capital structure of the company (that is, the optimal mix of common
stock, preferred stock, and debt) continues to be an unresolved issue in finance.
8. Book Value Per Share. The book value per share measures the amount that would be
distributed to holders of each share of common stock if all assets were sold at their balance
sheet carrying amounts and if all creditors were paid off. The book value per share is
computed as follows:
Common stockholders' equity
Book value per share =
Number of common shares outstanding
Because book values of assets can be quite out of date, this ratio is of limited use. The
denominator in this ratio is the number of common shares outstanding at the end of the year
rather than the average number of common shares outstanding. This is in contrast to the
earnings per share computation. The reason is that the numerator in the book value per
share is a balance sheet item (a stock) whereas the numerator in the earnings per share is an
income statement item (a flow). With stocks, the end of year figure is used in the
denominator. With flows, the average figure for the year is used in the denominator.
D. Ratio Analysis—The Short-term Creditor. (Exercises 17-3, 17-6, and 17-8.) A short-
term creditor is concerned with the ability of the company to make payments on its debts. Thus,
the short-term creditor is much more interested in cash flows and in working capital
management than in how much accounting net income a company reports.
1. Working Capital. The excess of current assets over current liabilities is known as working
capital. A large working capital balance provides some security to short-term creditors.
Working capital = Current assets – Current liabilities
2. Current Ratio. The current ratio is another way to express the relation between current
assets and current liabilities. It is computed as follows:
Current ratio =
A current ratio of less than 1 may be considered unacceptable since in that case current
liabilities would exceed current assets—a warning that there may soon be a cash flow
3. Acid-Test Ratio. The acid-test ratio is a more rigorous test of a company’s ability to meet
its short-term debts than the current ratio since it excludes less liquid current assets such as
inventories and prepaid expenses. The acid-test ratio is computed as follows:
Cash + Marketable securities + Current receivables
Acid-test ratio =
Note that “current receivables” includes any notes receivable as well as accounts
4. Accounts Receivable Turnover. Accounts receivable turnover is a measure of how
quickly accounts receivables are turned into cash. In its most intuitive form, the turnover
figure is typically divided into 365 days and shown as the average number of days to
collect an account (known as the average collection period). This ratio is used to evaluate
credit management and account collection practices.
Sales on account
Accounts receivable turnover =
Average accounts receivable balance
Average collection period =
Accounts receivable turnover
An increase in the accounts receivable turnover (and a decrease in the average collection
period) would usually be considered favorable.
5. Inventory Turnover. The inventory turnover ratio measures how quickly inventory is
converted into sales. In its most intuitive form, the average number of days required to sell
inventory (the average sale period) is computed by dividing 365 days by the inventory
turnover figure. This ratio is used to evaluate inventory management.
Cost of goods sold
Inventory turnover =
Average inventory balance
Average sale period =
An increase in the inventory turnover (and a decrease in the average sale period) would
usually be considered favorable.
E. Ratio Analysis—The Long-term Creditor. (Exercises 17-4 and 17-8.) The long-term
creditor is concerned with both the near-term and the long-term ability of a company to meet its
commitments. Long-term creditors are usually protected to some degree by restrictive covenants,
or rules, in loan agreements that restrict the company’s ability to take actions that are not in the
best interests of the creditors. Before entering into a loan agreement, creditors very carefully
examine the company’s financial condition and pay particular attention to the following two
1. Times Interest Earned. The times interest earned ratio indicates the relation between
interest payments and the earnings that are available to make those interest payments. This
ratio is computed as follows:
Earnings before interest expense and income taxes
Times interest earned =
Creditors would like to see a high times interest earned ratio. Note: Earnings before interest
expense and income taxes is also referred to as “net operating income” in the text.
2. Debt-to-Equity Ratio. Long-term creditors would like a reasonable balance between the
capital provided by creditors and the capital provided by stockholders. This balance is
measured by the debt-to-equity ratio:
Debt-to-equity ratio =
Creditors would like the debt-to-equity ratio to be relatively low. Stockholders’ equity
represents the excess of the book value of assets over the book value of liabilities. This is a
safety margin for creditors and they would like this safety margin (i.e., stockholders’
equity) to be as large as possible relative to the size of the liabilities.
Level of Suggested
Assignment Topic Difficulty Time
Exercise 17-1 Common-size income statement......................................... Basic 15 min.
Exercise 17-2 Financial ratios for common stockholders.......................... Basic 30 min.
Exercise 17-3 Financial ratios for short-term creditors.............................. Basic 30 min.
Exercise 17-4 Financial ratios for long-term creditors............................... Basic 15 min.
Exercise 17-5 Selected financial ratios for common stockholders............. Basic 15 min.
Exercise 17-6 Selected financial measures for short-term creditors.......... Basic 15 min.
Exercise 17-7 Trend percentages............................................................... Basic 15 min.
Exercise 17-8 Selected financial ratios...................................................... Basic 30 min.
Exercise 17-9 Selected financial ratios for common stockholders............. Basic 20 min.
Exercise 17-10 Selected financial ratios for common stockholders............. Basic 20 min.
Problem 17-11 Effects of transactions on various ratios............................. Basic 30 min.
Problem 17-12 Common-size statements and financial ratios for creditors. Basic 60 min.
Problem 17-13 Financial ratios for common stockholders.......................... Basic 45 min.
Problem 17-14 Comprehensive ratio analysis............................................. Medium 90 min.
Problem 17-15 Common-size financial statements..................................... Medium 30 min.
Problem 17-16 Interpretation of financial ratios.......................................... Medium 30 min.
Problem 17-17 Effects of transactions on various financial ratios............... Medium 45 min.
Problem 17-18 Ethics and the manager....................................................... Difficult 45 min.
Problem 17-19 Incomplete statements; analysis of ratios............................ Difficult 60+ min.
Problem 17-20 Comprehensive problem—Part I: Financial ratios for
common stockholders.................................................... Difficult 60 min.
Problem 17-21 Comprehensive problem—Part II: Creditor ratios.............. Difficult 45 min.
Problem 17-22 Comprehensive problem—Part III: Common-size Difficult 30 min.
Essential Problems: Problem 17-11, Problem 17-12 and Problem 17-13, Problem 17-14 and
Problem 17-15, Problem 17-17.
Supplementary Problems: Problem 17-16, Problem 17-20 and Problem 17-21 and Problem
17-22, Problem 17-18, Problem 17-19.
Helpful Hint: Before beginning the lecture, show
students the 20th segment from the third tape of the
McGraw-Hill/Irwin Managerial/Cost Accounting video
library. This segment introduces students to many of
the concepts discussed in chapter 17. The lecture notes
reinforce the concepts introduced in the video.
Chapter theme: This chapter focuses upon financial
statement analysis which is used to assess the financial
1 health of a company. It includes examining trends in key
financial data, comparing financial data across
companies, and analyzing financial ratios.
I. Limitations of financial statement analysis
A. Comparison of financial data
i. Differences in accounting methods between
companies sometimes make it difficult to
compare their financial data. For example:
1. If one company values its inventory using
the LIFO method and another uses the
2 average cost method, then direct
comparisons of financial data such as
inventory valuations and cost of goods sold
may be misleading.
a. Even with this limitation in mind,
comparing financial ratios with other
companies or industry averages can
provide useful insights.
A. The need to look beyond ratios
ii. Ratios should not be viewed as an end, but
rather as a starting point. They raise many
questions and point to opportunities for
further analysis, but they rarely answer
3 questions by themselves.
1. In addition to ratios, other sources of data
should also be considered such as industry
trends, technological changes, changes in
consumer tastes, changes in broad
economic factors, and changes within the
Helpful Hint: Some skepticism is healthy when dealing
with financial statement analysis. Reinforce the
limitations of relying on financial statements by
identifying events that would make the financial
statements doubtful as a predictor of the future. Such
an event would be a change in oil prices that occurs
after the financial statements are issued. An increase in
oil prices would be favorable for companies with large
stocks of petroleum and unfavorable for companies that
use large quantities of petroleum feedstocks in their
I. Statements in comparative and common-size form
B. Key concept
iii. An item on a balance sheet or income
statement has little meaning by itself. The
meaning of the number can be enhanced by
drawing comparisons. This chapter
discusses three such means of enabling
1. Dollar and percentage changes on
statements (horizontal analysis).
2. Common-size statements (vertical
C. Dollar and percentage changes on statements
iv. Horizontal analysis (also known as trend
analysis) involves analyzing financial data
5 1. Quantifying dollar changes over time
serves to highlight the changes that are the
most important economically.
2. Quantifying percentage changes over time
serves to highlight the changes that are the
6 v. Clover Corporation – an example
7 8 9
10 11 12
13 14 15
16 17 18
1. Assume the comparative asset account
7 balances from the balance sheet as shown.
a. The dollar change in account balances
8 is calculated as shown. Notice:
• 2004 serves as the base year.
b. The percentage change in account
9 balances is calculated as shown.
c. The dollar ($11,500) and percentage
10 (48.9%) changes in the cash account
are computed as shown.
d. The dollar and percentage changes for
11 the remaining asset accounts are as
2. We could do this for the liabilities and
12 stockholder’s equity, but instead let’s look at
the income statement.
a. Assume Clover has the comparative
income statement amounts as shown.
b. The dollar and percentage changes for
14 each account are as shown. Notice:
• Sales increased by 8.3% yet net
15 income decreased by 21.9%.
• There were increases in cost of
goods sold (14.3%) and
16 operating expenses (2.1%) that
offset the increase in sales.
vi. Horizontal analysis can be even more useful
17 when data from a number of years are used to
compute trend percentages.
1. To compute a trend percentage, a base year
18 is selected and the data for all years are
stated in terms of a percentage of that
18 a. The equation for computing a trend
percentage is as shown.
19 vii. Berry Products – an example
1. Assume the financial results as shown for
20 a. The base year is 2000 and its amounts
will equal 100%.
2. The 2001 results restated in trend
percentages would be computed as shown.
3. The trend percentages for the remaining
years would be as shown. Notice:
a. Cost of goods sold is increasing
faster than sales.
4. The trend percentages can also be used to
23 construct a graph as shown.
D. Common-size statements
viii. Vertical analysis focuses on the relations
among financial statement items at a given
24 point in time. A common-size financial
statement is a vertical analysis in which each
financial statement item is expressed as a
1. In income statements, all items are usually
25 expressed as a percentage of sales.
a. Managers often pay close attention to
the gross margin percentage, which
is computed as shown.
• The gross margin percentage
26 tends to be more stable for
retailing companies because
cost of goods sold excludes
“In Business Insights”
Managers and investors pay close attention to the gross
margin percentage. For example:
“Gross Margins Can Make the Difference” (page 793)
• After announcing a 42% increase in quarterly
profits, Dell Computer Corp.’s shares fell over
• According to the Wall Street Journal, investors
focused on the company’s eroding profit margins.
“Analysts…said that a decline in gross margins
was larger than they had expected and indicated
a difficult pricing environment. Gross margins
fell nearly a full percentage point to 21.5% of
sales, from 22.4%.”
• Dell had cut its prices to increase its market
share, which worked, but at the cost of lowered
2. In balance sheets, all items are usually
27 expressed as a percentage of total assets.
3. Common-size financial statements are
28 particularly useful when comparing data
from different companies. For example:
a. In 2002, Wendy’s net income was
$219 million, whereas McDonald’s
was $893 million. This comparison is
misleading because of the different
sizes of the two companies.
28 • Wendy’s net income as a
percent of sales was about 8%
and McDonald’s was about
5.8%. In this light, McDonald’s
performance does not compare
favorably with Wendy’s.
29 ix. Clover Corporation – an example
1. Let’s revisit the comparative income
statements as shown. Notice:
30 a. As previously mentioned, sales is
usually the base and is expressed as
2. The cost of goods sold as a percentage of
31 sales for 2004 (65.6%) and 2005 (69.2%)
are calculated as shown.
3. The common-size percentages for the
32 remaining items on the income statement are
33-34 Quick Check – horizontal versus vertical analysis
I. Norton Corporation – data for calculating ratios
E. We are going to examine ratios that are useful to
35 common stockholders, short-term creditors, and
x. To facilitate our discussion, we are going to
35 use 2004 and 2005 financial data from Norton
36 1. The asset side of Norton’s balance sheets is
37 2. The liabilities and stockholder’s equity side
of Norton’s balance sheets is as shown.
38 3. Norton’s income statements are as shown.
Helpful Hint: To exercise students’ understanding of
ratios, after defining each ratio, ask students whether
an increase in the ratio would generally be consider
good news or bad news and why.
Helpful Hint: Impress on students that the ratios
discussed in this chapter cannot be analyzed in a
vacuum. Comparisons with industry averages and prior
years are essential as is reading the notes to the
financial statements to determine management’s
I. Ratio analysis – the common stockholder
F. The ratios that are of the most interest to stockholders
include those ratios that focus on net income,
39 dividends, and stockholder’s equities. The
information shown for Norton Corporation will be used
to calculate ratios of interest to common stockholders.
xi. Earnings per share
1. Earnings per share is computed as shown.
40 a. The average number of common
shares outstanding is computed by
adding the shares outstanding at the
beginning of the year to the shares
outstanding at the end of the year and
40 dividing by two.
b. Investors are interested in this ratio
because earnings form the basis for
dividend payments and future
increases in the value of shares of
2. Norton Corporation’s earning per share for
41 2005 ($2.42) is computed as shown.
xii. Price-earnings ratio
1. The price-earnings ratio is computed as
a. A higher price-earnings ratio means
42 that investors are willing to pay a
premium for a company’s stock
because of its optimistic future
2. Norton Corporation’s price earnings ratio
for 2005 (8.26 times) is computed as shown.
xiii. Dividend payout ratio
1. The dividend payout ratio is computed as
a. Investors who seek market price
43 growth would like this ratio to be
small, whereas investors who seek
dividends prefer it to be large.
2. Norton Corporation’s dividend payout ratio
for 2005 (82.6%) is computed as shown.
xiv. Dividend yield ratio
1. The dividend yield ratio is computed as
a. This ratio measures the rate of return
(in the form of cash dividends only)
that would be earned by an investor
who buys common stock at the
current market price.
2. Norton Corporation’s dividend yield ratio
for 2005 (10%) is computed as shown.
xv. Return on total assets
1. The return on total assets is computed as
a. Adding interest expense back to net
income enables the return on assets to
45 be compared for companies with
different amounts of debt or over time
for a single company that has changed
its mix of debt and equity.
2. Norton Corporation’s return on assets for
2005 (18.19%) is computed as shown.
xvi. Return on common stockholder’s equity
46 1. The return on common stockholder’s equity
is computed as shown.
a. This measure indicates how well the
company used the owners’ investments
to earn net income.
46 2. Norton Corporation’s return on common
stockholder’s equity for 2005 (25.91%) is
computed as shown.
“In Business Insights”
Comparing return on assets and return on common
stockholder’s equity across companies can be
insightful. For example:
“Comparing Banks” (page 797)
• Deutsche Bank, the German banking giant, fares
poorly in comparisons with its global rivals. Its
return on assets is only 0.26%, while its peers
such as Citigroup and Credit Suisse have ratios
of up to 0.92%.
• Its return on equity is only 10%, whereas the
return on equity of almost all of its peers is in the
14% to 16% range.
• One reason for Deutsche Bank’s anemic
performance is its bloated payroll. Deutsche
Bank’s earnings average about $23,000 per
employee. At HSBC (Hong Kong and Shanghai
Banking Corporation), the figure is $32,000 per
employee and at Credit Suisse it is $34,000.
xvii. Financial leverage
1. Financial leverage results from the
47 difference between the rate of return the
company earns on investments in its own
assets and the rate of return that the
company must pay its creditors.
a. Positive financial leverage exists if
the rate of return on the company’s
assets exceeds the rate of return the
company pays its creditors.
• In this case, having some debt
in a company’s capital structure
can benefit its shareholders.
47 b. Negative financial leverage exists if
the rate of return on the company’s
assets is less than the rate of return the
company pays its creditors.
• In this case, the common
stockholder suffers by having
debt in the capital structure.
48-49 Quick Check – financial leverage
xviii. Book value per share
1. The book value per share is computed as
a. It measures the amount that would be
distributed to holders of each share
of common stock if all assets were
sold at their balance sheet carrying
amounts and if all creditors were
• This measure is based entirely
on historical cost.
2. Norton Corporation’s book value per share
at the end of 2005 ($8.55) is computed as
a. The book value per share of $8.55
51 does not equal the market value per
share of $20. This is because the
market price reflects expectations
51 about future earnings and
dividends, whereas the book value
per share is based on historical cost.
I. Ratio analysis – the short-term creditor
G. Short-term creditors, such as suppliers, want to be paid
on time. Therefore, they focus on the company’s cash
52 flows and on its working capital. The information
shown for Norton Corporation will be used to calculate
ratios of interest to short-term creditors.
xix. Working capital
1. The excess of current assets over current
liabilities is known as working capital.
a. Working capital is not free. It must be
financed with long-term debt and
equity. Therefore, managers often seek
53 to minimize working capital.
b. A large and growing working capital
balance may not be a good sign. For
• It could be the result of
unwarranted growth in
2. Norton Corporation’s working capital
54 ($23,000) is calculated as shown.
xx. Current ratio
1. The current ratio is computed as shown.
a. It measures a company’s short-term
debt paying ability.
b. It must be interpreted with care. For
• A declining ratio may be a sign
of deteriorating financial
condition, or it might result
from eliminating obsolete
inventories or other stagnant
2. Norton Corporation’s current ratio of 1.55 is
56 calculated as shown.
xxi. Acid-test (quick) ratio
1. The acid-test ratio is computed as shown.
a. It is a more rigorous measure of
short-term debt paying ability because
it only includes cash, marketable
securities, accounts receivable, and
current notes receivable.
57 b. It measures a company’s ability to
meet its obligations without having to
liquidate its inventory.
2. Norton Corporation’s acid-test (quick) ratio
of 1.19 is computed as shown.
a. Each dollar of liabilities should be
backed by at least $1 of quick assets.
Norton satisfies this condition.
“In Business Insights”
In some cases, a company may actually accumulate too
much cash in the eyes of some stakeholders. For
“Too Much Cash?” (page 800)
• Microsoft has accumulated an unprecedented
hoard of cash and cash equivalents – over $49
billion at the end of fiscal year 2003 and this cash
hoard is growing at the rate of about $1 billion
• Critics argue that Microsoft is stockpiling too
much cash and they claim that the company
should payout a higher dividend.
• Microsoft counters that the cash hoard is
necessary to fund anti-trust lawsuits and that it
enables the company to pursue risky but
potentially rewarding new market opportunities
such as the Xbox game console.
xxii. Accounts receivable turnover
1. The accounts receivable turnover is
calculated as shown.
a. It measures how quickly credit sales
are converted to cash.
b. Norton Corporation’s accounts
receivable turnover of 26.7 times is
computed as shown.
2. A related measure called the average
collection period is computed as shown.
59 a. It measures how many days, on
average, it takes to collect an
• It should interpreted relative to
the credit terms offered to
59 b. Norton Corporation’s average
collection period of 13.67 days is
computed as shown.
xxiii. Inventory turnover
1. The inventory turnover is computed as
a. It measures how many times a
company’s inventory has been sold
and replaced during the year.
b. It should increase for companies that
adopt just-in-time methods.
c. It should be interpreted relative to a
company’s industry. For example:
60 • Grocery stores turn their
inventory over quickly,
whereas jewelry stores tend to
turn their inventory over
1. If a company’s inventory
turnover is less than its
industry average, it either
has excessive inventory or
the wrong sorts of
d. Norton Corporation’s inventory
61 turnover of 12.73 times is computed as
2. A related measure called the average sale
period is computed as shown.
a. It measures the number of days being
taken, on average, to sell the entire
62 inventory one time.
b. Norton Corporation’s average sale
period of 28.67 days is computed as
Helpful Hint: Ask students to intuitively answer what
happens to the turnover ratios when accounts
receivable or inventory increase. Stress that
understanding the ratio is preferred to memorizing the
I. Ratio analysis – the long-term creditor
H. Long-term creditors are concerned with a company’s
ability to repay its loans over the long-run. Creditors
often seek protection by requiring that borrowers agree
63 to various restrictive covenants, or rules. The
information shown for Norton Corporation will be used
to calculate ratios of interest to long-term creditors.
ii. Times interest earned ratio
3. The times interest earned ratio is calculated
64 a. It is the most common measure of a
company’s ability to protect its long-
b. It is based on earnings before interest
and income taxes because that is the
amount of earnings that is available for
making interest payments.
64 c. A ratio of less than 1 is inadequate.
4. Norton Corporation’s times interest earned
ratio of 11.5 times is computed as shown.
xxiv. Debt-to equity ratio
1. The debt-to-equity ratio is computed as
a. It indicates the relative proportions of
debt and equity on a company’s
b. Creditors and stockholders have
different views when defining the
optimal debt-to-equity ratio.
• Stockholders like a lot of debt
if the company can take
advantage of positive financial
• Creditors prefer less debt and
more equity because equity
represents a buffer of
c. In practice, debt-to-equity ratios
from 0.0 to 3.0 are common.
2. Norton Corporation’s debt-to-equity ratio of
66 0.48 is computed as shown.
I. Summary of ratios and sources of comparative ratio