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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 company’s 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 company’s operations by reporting its revenues and and expenses. How to Evaluate Results If the company’s revenue exceeds its expenses, it will report net earnings; otherwise it will report a net loss.

What is the company’s 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 company’s 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 liquidity—that the company is generating cash sufficient to meet its short-term needs. Lower value indicates favourable solvency. A higher ratio indicates solvency—that 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.

management discussion and analysis. and (5) use independent internal verification. verify equality. Is all of the company’s cash available for general use? Balance sheet and notes to financial statements . Average cost can moderate the impact of changing prices. or are they decreasing? Statement of earnings and balance sheet effects How long is an item in inventory? Cost of goods sold. 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. Higher ratio suggests the average margin between selling price and inventory cost is increasing. relative to sales. Recognizing revenue too early overstates current period revenue. A higher inventory turnover ratio or lower average days in inventory suggests that management is reducing the amount of inventory on hand. earnings and inventory are higher under FIFO. CHAPTER 4 (p 202) At what point should the Need to understand the natur e Revenue should be recorded company record revenue? of the company’s business when earned.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. At what point should the Need to understand the natur e Expenses should “follow” company record expenses? of the company’s business revenues—that is. This might be considered when assessing liquidity. the financial segregate duties. (3) document statements should be used procedures. or automated controls. CHAPTER 6 (p 314) What is the impact of the choice of inventory costing method? Are prices increasing. In a period of rising prices. Recognizing expenses too early overstates current period expense. revenue is earned when service is performed. beginning and ending inventory. the effor t (expense) should be matched with the result (revenue). Inventory turnover ratio Cost of goods sold Average Inventory 365 days Inventory turnover ratio Days in inventory CHAPTER 7 (p 378) Are the company’s financial statements supported by adequate internal controls? Auditor’s report. For a service business. LIFO provides opposite results. Too high a margin may result in lost sales. recognizing it too late understates current period expense. recognizing it too late understates current period revenue. statement of management responsibility. (2) are lacking. total the debit and credit columns. (4) employ physical with caution. 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. Depends on objective. Does the company repor t any cash as being restricted? A restriction on the use of cash limits management’s ability to use those resources for general obligations.

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 management’s projections reasonable? (2) If outside sources ar e needed. . and equipment Amortization expense Too high an estimated useful life will result in understating amortization expense and overstating net earnings. the greater its options. The greater the free cash flow. then the company must look for outside sources. and over 120 days. phone calls. 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 management’s attention? Is the company’s 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. If notes do not provide sufficient detail. Increase in ratio may suggest increased credit risk. Average collection period should be consistent with corporate credit policy. capital expenditures. plant. Cash and cash equivalents. and possible renegotiation of terms. and equipment in the formula. additional financing may be necessary. are they available? A low measure should be investigated. This tool can also be used to assess the average age of intangible assets. If cash uses exceed internal cash sources. average useful life can be estimated as follows Average useful life Average cost of property. Cash budget (typically The cash budget shows available only to management) projected sources and uses of cash. substituting the average cost of intangible assets for property. Accounts in the older categories require follow-up: letters. If this measure is low. 31-60 days. 61-90 days. Free cash flow allows a company to buy additional investments. or does not seem reasonable in light of the circumstances. along with the adequacy of the allowance for doubtful accounts. An increase may suggest a decline in financial health of customers. 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 company’s 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 company’s estimated useful life significantly exceeds that of competitors. If a material loss appears likely. requiring evaluation of credit policies. or add to its liquidity. the potential negative impact of that loss on the company should be carefully evaluated. 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. reduce its debts. e-mails. 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. 91-120 days. the financial health of those customers should be evaluated to gain an independent assessment of the potential for a material credit loss. the reason for the difference should be investigated. plant.

light of the particular but they suffer from additional circumstances taxes. If negative outcomes are possible. evaluate liquidity ratios. these obligations should not be ignored in analysis. If liquidity ratios are low. or that they may be in need of replaceIndicates the sales dollars generated per dollar of assets. High ratio indicates sufficient earnings available to cover annual interest payments. accounts receivable. 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. High ratio indicates sufficient cash available to cover annual interest payments. easier capital raising costs and benefits in light ability. government regulations. . and professional managers. growth expectations. 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. Acidtest ratio CHAPTER 10 (p 555) Can the company meet its current obligations? Cash. type of business. How effective is the company at generating sales from its assets? Net sales and average total assets Asset turnover ratio Is the company’s Estimated useful life of amortization of intangibles intangibles from notes to reasonable? financial statements of this company and its competitors If the company’s estimated useful life significantly exceeds that of competitors or does not seem reasonable in light of the circumstances. 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. 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. determine the probability. then lines of credit should be high to compensate. A high value suggests the company is effective in using its resources to generate sales. the amount of loss. 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. and other highly liquid assets. Also. the reason for the difference should be investigated. Are the company’s capital Amortization expense and assets possibly outdated accumulated amortization or in need of replacement? ment. and separation of ownership from management.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 company’s assets are not as efficient. and the potential impact on financial statements. High ratio indicates good Current liabilities liquidity. short-term investments. If ratios differ significantly after including unrecorded obligations. Too high an estimated useful life will result in understating amortization expense and overstating net earnings. CHAPTER 11 (p 618) Should the company incorporate? Capital needs.

Decision Checkpoints What level of return can be earned on the company’s 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. the measure would use cash spent to maintain the flow current level of operations. What is the company’s 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. Values should not be compared across companies. 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. but that is rarely available. A high value suggests good liquidity. although it also may suggest shares are over-valued. A higher measure suggests improved performance. although the number is subject to manipulation. CHAPTER 13 (p 731) How much cash did the company generate to either expand operations or pay dividends? Cash provided by operating activities. Since the numerator contains a “flow” measure. 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. cash (Ideally. that is. it will meet its obligations in the long term. It may indicate that the company is in the matur e or declining phase of the corporate life cycle. it provides a good supplement to the current ratio. including any gains and losses. A high value suggests the company is solvent. to see total potential variation. 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 . Significant free cash flow indicates greater potential to finance new investment and pay additional dividends.) 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. A user should evaluate a company’s earnings as reported. CHAPTER 12 (p 662) Is the company window -dressing its results by manipulating its investment portfolio? Balance of gains and losses. and cash dividends. A high measure suggests strong earnings performance from common shareholders’ perspective. How does the company’s 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 company’s 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. cash spent on capital Free assets.

atypical data. percentage of total assets (total liabilities and shareholders’ equity). alternative accounting methods. and significant differences over a series of years should be investigated. These percentages should be investigated for differences.Decision Checkpoints Are differences between cash and accrual accounting reasonable? Info Needed for Decision Cash provided by operating activities. These items should usually be ignored in estimating future net earnings. If a major business line has been discontinued. its results in the current period should not be included in estimates of future net earnings. the analysis should be relied upon with caution. How do the company’s 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 year’s 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 . Changes in each line item relative to the base year should be presented both by amount and by percentage. and not determined by management. companies should be and each line item on the balance investigated to determine sheet should be presented as a the cause. If any of these factors is significant. during the current year. This is called vertical analysis. either across years in the same company. 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. 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. Each line item on the statement Any differences either of earnings should be presented across years or between as a percentage of net sales. The primary limitations of financial analysis are estimates. unusual. 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. This is called horizontal analysis. or in the same year across different companies. 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 diversification. sales. reported being the base year. cost. 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.