Kimmel, Weygandt, Kieso, Trenholm Financial Accounting: Tools for Business Decision-Making, Canadian Edition S U M M A RY O F D E C I S I O N T O O L K I T S

Decision Checkpoints CHAPTER 1 (p 29) Are the companys operations profitable? Info Needed for Decision Statement of earnings Tool to Use for Decision The statement of earnings reports on the success or failure of the companys operations by reporting its revenues and and expenses. How to Evaluate Results If the companys revenue exceeds its expenses, it will report net earnings; otherwise it will report a net loss.

What is the companys policy toward dividends and growth? Does the company rely primarily on debt or shareholders equity to finance its assets?

Statement of retained earnings How much of this year s earnings A company striving for did the company pay out in rapid growth will pay a low dividends to shareholders? dividend. Balance sheet The balance sheet reports the companys resources and claims to those resources. There are two types of claims: liabilities and shareholders equity. Compare the amount of debt versus the amount of shareholders equity to determine whether the company relies more on creditors or owners for for its financing. Compare the amount of cash provided by operating activities with the amount of cash used by investing activities. Any deficiency in cash from operating activities must be made up with cash from financing activities. Higher value suggests favourable efficiency (use of assets). Higher value suggests favourable return on each each dollar of sales. Higher amount indicates liquidity. Higher ratio indicates favourable liquidity. A higher ratio indicates liquiditythat the company is generating cash sufficient to meet its short-term needs. Lower value indicates favourable solvency. A higher ratio indicates solvencythat the company is generating cash sufficient to meet its long-term needs.

Does the company generate sufficient cash from operating activities to fund its investing activities?

Statement of cash flows

The statement of cash flows shows the amount of cash provided or used by operating activities, investing activities, and financing activities.

CHAPTER 2 (p 79) Is the company using its assets effectively? Is the company maintaining an adequate margin between sales and expenses?

Net earnings and average assets Return on assets ratio Net earnings and net sales Profit margin ratio

Net earnings Average assets Net earnings Net sales

Can the company meet Current assets and current its short-term obligations? liabilities

Working capital Current ratio

Current assets minus Current liabilities Current assets Current liabilities Cash provided (used) by operating activities Average current liabilities Total liabilities Total assets Cash provided (used) by operating activities Average total liabilities

Current liabilities and cash provided (used) by operating activities

Cash current debt coverage ratio Debt to total assets ratio Cash total debt coverage ratio

Can the company meet its Total debt and total assets long-term obligations? Total liabilities and cash provided (used) by operating activities

CHAPTER 3 (p 139) Has an accounting transaction occurred?

Details of the event

Accounting equation

Determine the effect, if any, on assets, liabilities, and shareholders equity.

Decision Checkpoints How do you determine that debits equal credits?

Info Needed for Decision All account balances

Tool to Use for Decision Trial balance

How to Evaluate Results List the account titles and their balances; total the debit and credit columns; verify equality. Recognizing revenue too early overstates current period revenue; recognizing it too late understates current period revenue. Recognizing expenses too early overstates current period expense; recognizing it too late understates current period expense. Higher ratio suggests the average margin between selling price and inventory cost is increasing. Too high a margin may result in lost sales.

CHAPTER 4 (p 202) At what point should the Need to understand the natur e Revenue should be recorded company record revenue? of the companys business when earned. For a service business, revenue is earned when service is performed. At what point should the Need to understand the natur e Expenses should follow company record expenses? of the companys business revenuesthat is, the effor t (expense) should be matched with the result (revenue). CHAPTER 5 (p 259) Is the price of goods Gross profit and net sales keeping pace with changes in the cost of inventory?

Gross profit rate

Gross profit Net sales

Is management controllingNet sales and operating operating costs? expenses

Operating expenses to sales ratio

Higher value should be Operating expenses investigated to determine Net sales whether cost cutting is necessary. Depends on objective. In a period of rising prices, earnings and inventory are higher under FIFO. LIFO provides opposite results. Average cost can moderate the impact of changing prices. A higher inventory turnover ratio or lower average days in inventory suggests that management is reducing the amount of inventory on hand, relative to sales.

CHAPTER 6 (p 314) What is the impact of the choice of inventory costing method?

Are prices increasing, or are they decreasing?

Statement of earnings and balance sheet effects

How long is an item in inventory?

Cost of goods sold; beginning and ending inventory. Inventory turnover ratio

Cost of goods sold Average Inventory 365 days Inventory turnover ratio

Days in inventory CHAPTER 7 (p 378) Are the companys financial statements supported by adequate internal controls?

Auditors report, statement of management responsibility, management discussion and analysis, articles in financial press

The required measures of If any indication is given internal control are to that these or other controls (1) establish responsibility, (2) are lacking, the financial segregate duties, (3) document statements should be used procedures, (4) employ physical with caution. or automated controls, and (5) use independent internal verification. Does the company repor t any cash as being restricted? A restriction on the use of cash limits managements ability to use those resources for general obligations. This might be considered when assessing liquidity.

Is all of the companys cash available for general use?

Balance sheet and notes to financial statements

Decision Checkpoints Will the company be able to meet its projected cash needs?

Info Needed for Decision

Tool to Use for Decision

How to Evaluate Results Two issues: (1) Are managements projections reasonable? (2) If outside sources ar e needed, are they available? A low measure should be investigated. If this measure is low, additional financing may be necessary. Free cash flow allows a company to buy additional investments, reduce its debts, or add to its liquidity. The greater the free cash flow, the greater its options. Accounts in the older categories require follow-up: letters, phone calls, e-mails, and possible renegotiation of terms. Increase in ratio may suggest increased credit risk, requiring evaluation of credit policies. If a material loss appears likely, the potential negative impact of that loss on the company should be carefully evaluated, along with the adequacy of the allowance for doubtful accounts. Average collection period should be consistent with corporate credit policy. An increase may suggest a decline in financial health of customers.

Cash budget (typically The cash budget shows available only to management) projected sources and uses of cash. If cash uses exceed internal cash sources, then the company must look for outside sources. Cash and cash equivalents, average daily expenses Cash to daily cash expenses ratio Cash and cash equivalents Average daily cash expenses

Does the company have adequate cash to meet its daily needs? Does the company have any discretionary cash available?

Net cash provided by operating Free activities, capital expenditures, cash and cash dividends flow

Net cash provided by operating activities minus capital expenditures minus cash dividends

CHAPTER 8 (p 437) Is the amount of past due accounts increasing? Which accounts require managements attention? Is the companys credit risk increasing?

List of outstanding receivables and their due dates

Prepare an aging schedule showing the receivables in various stages: outstanding 0-30 days, 31-60 days, 61-90 days, 91-120 days, and over 120 days. Credit risk ratio Allowance for doubtful accounts Accounts receivable

Allowance for doubtful accounts and accounts receivable Note to the financial statements on concentrations of credit risk

Does the company have significant concentrations of credit risk?

If risky credit customers ar e identified, the financial health of those customers should be evaluated to gain an independent assessment of the potential for a material credit loss. Receivables turnover ratio Average collection period Net credit sales Average net receivables 365 days Receivables turnover ratio

Are collections being Net credit sales and average made in a timely fashion? receivables balance

CHAPTER 9 (p 495) Is the companys estimated Estimated useful life of capital useful life for amortization assets from notes to financial reasonable? statements of this company and its competitors

If the companys estimated useful life significantly exceeds that of competitors, or does not seem reasonable in light of the circumstances, the reason for the difference should be investigated. If notes do not provide sufficient detail, average useful life can be estimated as follows Average useful life Average cost of property, plant, and equipment Amortization expense

Too high an estimated useful life will result in understating amortization expense and overstating net earnings.

This tool can also be used to assess the average age of intangible assets, substituting the average cost of intangible assets for property, plant, and equipment in the formula.

Decision Checkpoints

Info Needed for Decision

Tool to Use for Decision Average age Accumulated amortization Amortization expense Net sales Average total assets

How to Evaluate Results A high average age relative to competitors might suggest that the companys assets are not as efficient, or that they may be in need of replaceIndicates the sales dollars generated per dollar of assets. A high value suggests the company is effective in using its resources to generate sales. Too high an estimated useful life will result in understating amortization expense and overstating net earnings.

Are the companys capital Amortization expense and assets possibly outdated accumulated amortization or in need of replacement? ment. How effective is the company at generating sales from its assets? Net sales and average total assets

Asset turnover ratio

Is the companys Estimated useful life of amortization of intangibles intangibles from notes to reasonable? financial statements of this company and its competitors

If the companys estimated useful life significantly exceeds that of competitors or does not seem reasonable in light of the circumstances, the reason for the difference should be investigated. Acidtest ratio

CHAPTER 10 (p 555) Can the company meet its current obligations?

Cash, accounts receivable, short-term investments, and other highly liquid assets, and current liabilities Available lines of credit from notes to the financial statements EBIT and interest expense

Cash Short-term investments Ratio should be compared Net receivables to others in same industry. High ratio indicates good Current liabilities liquidity. If liquidity ratios are low, then lines of credit should be high to compensate. High ratio indicates sufficient earnings available to cover annual interest payments. High ratio indicates sufficient cash available to cover annual interest payments. If negative outcomes are possible, determine the probability, the amount of loss, and the potential impact on financial statements. If ratios differ significantly after including unrecorded obligations, these obligations should not be ignored in analysis.

Can the company obtain short-term financing when necessary? Is the company generating sufficient earnings to cover annual interest payments?

Compare available lines of credit to current liabilities. Also, evaluate liquidity ratios. Times EBIT interest Interest expense earned ratio Cash interest coverage ratio

Is the company EBITDA and interest expense generating sufficient cash to repay its interest? Does the company have Knowledge of events with any contingent liabilities? uncertain negative outcomes

EBITDA Interest expense

Notes to financial statements and financial statements

Does the company have significant unrecorded lease obligations?

Schedule of minimum lease payments from lease note

Compare liquidity and solvency ratios with and without unrecorded obligations included.

CHAPTER 11 (p 618) Should the company incorporate?

Capital needs, growth expectations, type of business, tax status

What portion of its Net earnings and total cash earnings does the company dividends paid on common pay out in dividends? shares

Corporations have limited Must carefully weigh the liability, easier capital raising costs and benefits in light ability, and professional managers;light of the particular but they suffer from additional circumstances taxes, government regulations, and separation of ownership from management. Total cash dividends Payout declared on A low ratio suggests that ratio common shares the company is retaining Net earnings its earnings for investment in future growth.

Decision Checkpoints What level of return can be earned on the companys dividends?

Info Needed for Decision Market price of shares and dividends paid per common share

Tool to Use for Decision Dividend yield Dividends declared per common share Share price at year end

How to Evaluate Results A high yield is attractive to investors looking for a steady investment earnings stream rather than share price appreciation. A higher measure suggests improved performance, although the number is subject to manipulation. Values should not be compared across companies.

How does the companys earnings performance compare with that of previous years?

Net earnings available to common shareholders and average common shares outstanding

Earnings per share

Net earnings Preferred share dividends Average common shares outstanding

How does the market perceive the companys prospects for future earnings?

Earnings per share and market price per share

Priceearnings ratio

Market price A high ratio suggests the per share market has favourable Earnings per share expectations, although it also may suggest shares are over-valued. A high measure suggests strong earnings performance from common shareholders perspective.

What is the companys Earnings available to common return on common shareholders and average shareholders investment? common shareholders equity

Net earnings Return on Preferred share common dividends shareAverage common holders equity ratio shareholders equity A company can window-dress by selling winners and holding losers to increase reported earnings, or do the opposite to reduce reported earnings Mis-classification of investments as short-term or long-term allows companies to time (advance or defer) the recognition of losses.

CHAPTER 12 (p 662) Is the company window -dressing its results by manipulating its investment portfolio?

Balance of gains and losses; classification of investments

Window-dressing and misclassification is not easy to spot: It is difficult for an outsider to determine why companies chose to either sell or hold a security. A user should evaluate a companys earnings as reported, including any gains and losses, to see total potential variation. Significant free cash flow indicates greater potential to finance new investment and pay additional dividends.

CHAPTER 13 (p 731) How much cash did the company generate to either expand operations or pay dividends?

Cash provided by operating activities, cash spent on capital Free assets, and cash dividends. cash (Ideally, the measure would use cash spent to maintain the flow current level of operations, but that is rarely available.)

Cash provided by operating activities minus Capital expenditures minus Dividends paid

Can the company finance Cash provided by operating its capital expenditures activities and cash spent on with cash provided by on capital assets (capital operating activities? expenditures)

Capital expenditure ratio

Cash provided by operating activities Capital expenditures Cash provided by operating activities Average current liabilities Cash provided by operating activities Average total liabilities

A high value indicates no need for outside financing. It may indicate that the company is in the matur e or declining phase of the corporate life cycle. A high value suggests good liquidity. Since the numerator contains a flow measure, it provides a good supplement to the current ratio. A high value suggests the company is solvent; that is, it will meet its obligations in the long term.

Is the company generating Cash provided by operating sufficient cash provided activities and average current by operating activities to liabilities meet its current obligations? Is the company generating Cash provided by operating sufficient cash provided activities and average total by operating activities to liabilities meet its long-term obligations?

Cash current debt coverage ratio Cash total debt coverage ratio

Decision Checkpoints Are differences between cash and accrual accounting reasonable?

Info Needed for Decision Cash provided by operating activities, sales, and profit margin ratio

Tool to Use for Decision Cash return on sales ratio Cash provided by operating activities Net sales

How to Evaluate Results Cash return on sales ratio should be compared to profit margin ratio, and significant differences over a series of years should be investigated.

CHAPTER 14 (p 797) Has the company sold any Discontinued operations major lines of business? section of statement of earnings

Anything reported in this section indicates that the company has discontinued a major line of business.

If a major business line has been discontinued, its results in the current period should not be included in estimates of future net earnings. These items should usually be ignored in estimating future net earnings.

Has the company experienced any extraordinary events or transactions?

Extraordinary item section of statement of earnings

Anything reported in this section indicates that the company experienced an event that was infrequent, unusual, and not determined by management.

Has the company changed Cumulative effect of change any of its accounting in accounting principle in principles? statement of retained earnings

Anything reported in this section Financial statements are indicates that the company has restated using new principle changed an accounting principle for comparability. during the current year. Comparative financial statements A significant change should should be prepared over at least be investigated to determine 2 years, with the first year the reason for the change. reported being the base year. Changes in each line item relative to the base year should be presented both by amount and by percentage. This is called horizontal analysis. Each line item on the statement Any differences either of earnings should be presented across years or between as a percentage of net sales, companies should be and each line item on the balance investigated to determine sheet should be presented as a the cause. percentage of total assets (total liabilities and shareholders equity). These percentages should be investigated for differences, either across years in the same company, or in the same year across different companies. This is called vertical analysis. The primary limitations of financial analysis are estimates, cost, alternative accounting methods, atypical data, and diversification. If any of these factors is significant, the analysis should be relied upon with caution.

How do the companys Statement of earnings and financial position and balance sheet operating results compare with those of previous period?

How do the relationships Statement of earnings and between items in this balance sheet years financial statements compare with last year s relationships or those of competitors?

Are efforts to evaluate the company significantly hampered by any of the common limitations of financial analysis?

Financial statements as well as a general understanding of the company and its business