Financial Statement Analysis (discussion) Select one type of creditor or investor from the list below: vendor (supplier of goods or products) bank pr

Financial Statement Analysis (discussion) Select one type of creditor or investor from the list below:

vendor (supplier of goods or products)
bank pr

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Financial Statement Analysis (discussion) Select one type of creditor or investor from the list below:

vendor (supplier of goods or products)
bank providing short-term financing
bank providing long-term loan (10 years or more)
bond investor
investor in common stock

Discuss at least three specific financial ratios that creditors or investors would be most interested in when analyzing financial statements, and why.Embed course material concepts, principles, and theories (requires supporting citations) along with at least one scholarly, peer-reviewed reference in supporting your answer. Keep in mind that these scholarly references can be found in the Saudi Electronic Library by conducting an advanced search specific to scholarly references.You are required to reply to at least two peer discussion question post answers to this weekly discussion question and/or your instructor’s response to your posting. These post replies need to be substantial and constructive in nature. They should add to the content of the post and evaluate/analyze that post answer. Normal course dialogue doesn’t fulfill these two peer replies but is expected throughout the course. Answering all course questions is also required. 

 Required:

Chapter 16 in Managerial Accounting
Ding, K., Peng, X., & Wang, Y. (2019). A machine learning-based peer selection method with financial ratios. Accounting Horizons, 33(3), 75–87.

Corporate Finance Institute (2015-2021). Analysis of financial statements: Guide to analyizing financial statements for financial analysts. https://corporatefinanceinstitute.com/resources/knowledge/finance/analysis-of-financial-statements/ Managerial Accounting
Fifteenth Edition
Chapter 16
Financial Statement Analysis

Copyright © 2019 Cengage. All Rights Reserved.

Copyright © 2019 Cengage. All Rights Reserved.

1

The Value of Financial Statement Information
General-purpose financial statements are distributed to a wide range of potential users, providing each group with valuable information about a company’s economic performance and financial condition.
Users typically evaluate this information along three dimensions:
Liquidity
Solvency
Profitability

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Liquidity
Short-term creditors such as banks and financial institutions are primarily concerned with whether a company will be able to repay short-term borrowings such as loans and notes.
As such, they are most interested in evaluating a company’s ability to convert assets into cash, which is called liquidity.

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Solvency
Long-term creditors, such as bondholders, loan money for long periods of time.
Thus, they are interested in evaluating a company’s ability to make its periodic interest payments and repay the face amount of debt at maturity, which is called solvency.

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Profitability
Investors, such as stockholders, are interested in evaluating the potential for the price of the company’s stock to increase.
As such, investors focus on evaluating a company’s ability to generate earnings, which is called profitability.

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Techniques for Analyzing Financial Statements (1 of 2)
Financial statement users rely on the following techniques to analyze and interpret a company’s financial performance and condition:
Analytical methods examine changes in the amount and percentage of financial statement items within and across periods.
Ratios express a financial statement item or set of financial statement items as a percentage of another financial statement item, in order to measure an important economic relationship as a single number.

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Techniques for Analyzing Financial Statements (2 of 2)
Both analytical methods and ratios can be used to compare a company’s financial performance over time or to another company.
Comparisons Over Time: The comparison of a financial statement item or ratio with the same item or ratio from a prior period often helps the user identify trends in a company’s economic performance, financial condition, liquidity, solvency, and profitability.
Comparisons Among Companies: The comparison of a financial statement item or ratio to another company in the same industry can provide insight into a company’s economic performance and financial condition relative to its competitors.

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Analytical Methods
Users analyze a company’s financial statements using a variety of analytical methods. Following are three such methods:
Horizontal analysis
Vertical analysis
Common-sized statements

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Horizontal Analysis
The analysis of increases and decreases in the amount and percentage of comparative financial statement items is called horizontal analysis.
Each item on the most recent statement is compared with the same item on one or more earlier statements in terms of the following:
Amount of increase or decrease
Percent of increase or decrease
When comparing statements, the earlier statement is normally used as the base year for computing increases and decreases.

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Vertical Analysis
The percentage analysis of the relationship of each component in a financial statement to a total within the statement is called vertical analysis.
In a vertical analysis of the balance sheet, the percentages are computed as follows:
Each asset item is stated as a percent of the total assets.
Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.
In a vertical analysis of the income statement, each item is stated as a percent of sales.

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Common-Sized Statements
In a common-sized statement, all items are expressed as percentages, with no dollar amounts shown.
Common-sized statements are often useful for comparing one company with another or for comparing a company with industry averages.

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Analyzing Liquidity
Liquidity analysis evaluates the ability of a company to convert current assets into cash.
Liquidity ratios and measures focus upon a company’s current position (current assets and liabilities), accounts receivable, and inventory.

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Current Position Analysis
Current position analysis evaluates a company’s ability to pay its current liabilities.
This information helps short-term creditors determine how quickly they will be repaid.
This analysis includes the following:
Working capital
Current ratio
Quick ratio

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Current Position Analysis: Working Capital
A company’s working capital is computed as follows:
Working Capital = Current Assets – Current Liabilities
The working capital is used to evaluate a company’s ability to pay current liabilities.
A company’s working capital is often monitored monthly, quarterly, or yearly by creditors and other debtors.
However, it is difficult to use working capital to compare companies of different sizes.

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Current Position Analysis: Current Ratio
The current ratio, sometimes called the working capital ratio, is computed as follows:

The current ratio is a more reliable indicator of a company’s ability to pay its current liabilities than is working capital, and it is much easier to compare across companies.

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Current Position Analysis: Quick Ratio
A ratio that measures the “instant” debt-paying ability of a company is the quick ratio, sometimes called the acid-test ratio.
The quick ratio is computed as follows:

The current ratio is a more reliable indicator of a company’s ability to pay its current liabilities than is working capital, and it is much easier to compare across companies.

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Accounts Receivable Analysis
A company’s ability to collect its accounts receivable is called accounts receivable analysis.
Accounts receivable analysis includes the computation and analysis of the following:
Accounts receivable turnover
Number of days’ sales in receivables
Collecting accounts receivable as quickly as possible does the following:
Improves a company’s liquidity
Provides cash to improve or expand operations
Reduces the risk of uncollectible accounts

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Accounts Receivable Analysis: Accounts Receivable Turnover
The accounts receivable turnover is computed as follows:

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Accounts Receivable Analysis: Number of Days’ Sales in Receivables (1 of 2)
The number of days’ sales in receivables is computed as follows:

where

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Accounts Receivable Analysis: Number of Days’ Sales in Receivables (2 of 2)
The number of days’ sales in receivables is an estimate of the time (in days) that the accounts receivable have been outstanding.
The number of days’ sales in receivables is often compared with a company’s credit terms to evaluate the efficiency of the collection of receivables.

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Inventory Analysis (1 of 2)
A company’s ability to manage its inventory effectively is evaluated using inventory analysis.
Inventory analysis includes the computation and analysis of the following:
Inventory turnover
Number of days’ sales in inventory

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Inventory Analysis (2 of 2)
Excess inventory does the following:
Decreases liquidity by tying up funds (cash) in inventory
Increases insurance expense, property taxes, storage costs, and other related expenses
Increases the risk of losses because of price declines or obsolescence of the inventory

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Inventory Analysis: Inventory Turnover
The inventory turnover is computed as follows:

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Inventory Analysis: Number of Days’ Sales in Inventory (1 of 2)
The number of days’ sales in inventory is computed as follows:

where

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Inventory Analysis: Number of Days’ Sales in Inventory (2 of 2)
The number of days’ sales in inventory is a rough estimate of the length of time it takes to purchase, sell, and replace the inventory.

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Analyzing Solvency
Solvency analysis evaluates a company’s ability to pay its long-term debts.

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Ratio of Fixed Assets to Long-Term Liabilities
The ratio of fixed assets to long-term liabilities provides a measure of how much fixed assets a company has to support its long-term debt.
This measures a company’s ability to repay the face amount of debt at maturity and is computed as follows:

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Ratio of Liabilities to Stockholders’ Equity
The ratio of liabilities to stockholders’ equity measures how much of the company is financed by debt and equity. It indicates the margin of safety for creditors.
The ratio of liabilities to stockholders’ equity is computed as follows:

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Times Interest Earned
The times interest earned, sometimes called the coverage ratio, measures the risk that interest payments will not be made if earnings decrease.
The times interest earned is computed as follows:

The higher the ratio, the more likely interest payments will be paid if earnings decrease.

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Profitability Analysis
Profitability analysis evaluates the ability of a company to generate future earnings.
This ability depends on the relationship between the company’s operating results and the assets the company has available for use in its operations.
Thus, the relationship between income statement and balance sheet items is used to evaluate profitability.

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Asset Turnover
The asset turnover measures how effectively a company uses its assets.
The asset turnover is computed as follows:

Note that long-term investments are excluded in computing asset turnover because long-term investments are unrelated to normal operations and sales.

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Return on Total Assets (1 of 3)
The return on total assets measures the profitability of total assets, without considering how the assets are financed.
In other words, this rate is not affected by the portion of assets financed by creditors or stockholders.
The return on total assets is computed as follows:

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Return on Total Assets (2 of 3)
By adding interest expense to net income, the effect of whether the assets are financed by creditors (debt) or stockholders (equity) is eliminated.
Because net income includes any income earned from long-term investments, the average total assets includes long-term investments and the net operating assets.
The return on operating assets is sometimes computed when there are large amounts of nonoperating income and expense.

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Return on Total Assets (3 of 3)
The return on operating assets is computed as follows:

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Return on Stockholders’ Equity (1 of 2)
The return on stockholders’ equity measures the rate of income earned on the amount invested by the stockholders.
The return on stockholders’ equity is computed as follows:

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Return on Stockholders’ Equity (2 of 2)
The return on stockholders’ equity is normally higher than the return on total assets.
This is because of the effect of leverage.
Leverage involves using debt to increase the return on an investment.

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Return on Common Stockholders’ Equity
The return on common stockholders’ equity measures the rate of profits earned on the amount invested by the common stockholders.
The return on common stockholders’ equity is computed as follows:

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Earnings per Share on Common Stock (1 of 2)
Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock.
EPS must be reported in the income statement.
EPS on common stock is computed as follows:

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Earnings per Share on Common Stock (2 of 2)
Many corporations have complex capital structures with various types of equity securities outstanding, such as convertible preferred stock, stock options, and stock warrants.
In such cases, the possible effects of such securities on the shares of common stock outstanding are reported separately as earnings per common share assuming dilution or diluted earnings per share.

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Price-Earnings Ratio
The price-earnings (P/E) ratio on common stock measures a company’s future earnings prospects.
The price-earnings ratio is computed as follows:

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Dividends per Share (1 of 2)
Dividends per share measures the extent to which earnings are being distributed to common shareholders.
Dividends per share is computed as follows:

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Dividends per Share (2 of 2)
Comparing dividends per share and earnings per share indicates the extent to which earnings are being retained for use in operations.

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Dividend Yield
The dividend yield on common stock measures the rate of return to common stockholders from cash dividends.
It is of special interest to investors whose objective is to earn revenue (dividends) from their investment.
The dividend yield is computed as follows:

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Summary of Analytical Measures (1 of 3)

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Summary of Analytical Measures (2 of 3)

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Summary of Analytical Measures (3 of 3)

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Corporate Annual Reports
In addition to the financial statements and the accompanying notes, corporate annual reports normally include the following sections:
Management discussion and analysis
Report on internal control
Report on fairness of the financial statements

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Management Discussion and Analysis (1 of 2)
Management’s Discussion and Analysis (MD&A) is required in annual reports filed with the Securities and Exchange Commission.
It includes management’s analysis of current operations and its plans for the future.
Typical items included in the MD&A are as follows:
Management’s analysis and explanations of any significant changes between the current and the prior years’ financial statements.

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Management Discussion and Analysis (2 of 2)
Important accounting principles or policies that could affect interpretation of the financial statements, including the effect of changes in accounting principles or the adoption of new accounting principles.
Management’s assessment of the company’s liquidity and the availability of capital to the company.
Significant risk exposures that might affect the company.
Any “off-balance-sheet” arrangements such as leases not included in the financial statements.

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Report on Internal Control
The Sarbanes-Oxley Act of 2002 requires a report on internal control by management.
The report states management’s responsibility for establishing and maintaining internal control.
In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report.
Sarbanes-Oxley also requires a public accounting firm to verify management’s conclusions on internal control.
Thus, two reports on internal control, one by management and one by a public accounting firm, are included in the annual report.

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Report on Fairness of the Financial Statements
All publicly held corporations are required to have an independent audit (examination) of their financial statements.
The Certified Public Accounting (CPA) firm that conducts the audit renders an opinion, called the Report of Independent Registered Public Accounting Firm, on the fairness of the statements.
An opinion stating that the financial statements present fairly the financial position, results of operations, and cash flows of the company is said to be an unmodified opinion, sometimes called a clean opinion.
Any report other than an unmodified opinion raises a “red flag” for financial statement users and requires further investigation as to its cause.

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Appendix 1: Unusual Items on the Income Statement
Generally accepted accounting principles require that unusual items be reported separately on the income statement.
This is because such items do not occur frequently and are typically unrelated to current operations.
Unusual items on the income statement are classified as one of the following:
Affecting the current period income statement
Affecting a prior period income statement

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Appendix 1: Unusual Items Affecting the Current Period’s Income Statement
Discontinued operations are an unusual item that affect the current period’s:
income statement presentation.
earnings per share presentation.
Discontinued operations are reported separately on the income statement for any period in which they occur.

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Appendix 1: Unusual Items Affecting the Current Period’s Income Statement—Income Statement Presentation
A company may discontinue a component of its operations by selling or abandoning the component’s operations.
If the discontinued component is (1) the result of a strategic shift and (2) has a major effect on the entity’s operations and financial results, any gain or loss on discontinued operations is reported on the income statement as a Gain (or loss) from discontinued operations.
A note to the financial statements should describe the operations sold, including the date operations were discontinued, and details about the assets, liabilities, income, and expenses of the discontinued component.

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Appendix 1: Unusual Items Affecting the Current Period’s Income Statement—Earnings per Share
Earnings per common share should be reported separately for discontinued operations.

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Appendix 1: Unusual Items Affecting the Prior Period’s Income Statement
An unusual item may occur that affects a prior period’s income statement.
Two such items are as follows:
Errors in applying generally accepted accounting principles
Changes from one generally accepted accounting principle to another

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Appendix 2: Fair Value
Fair value is the price that would be received for selling an asset if it were sold today.
This differs from historical cost, in that the amount reported on the balance sheet changes each period to reflect the asset’s fair (current) value at the balance sheet date.
The change in an asset’s fair value from one period to the next is recorded in the financial statements as either:
a gain or loss on the income statement, or
an increase or decrease in stockholders’ equity reported as other comprehensive income.

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Appendix 2: Comprehensive Income (1 of 3)
When a change in an asset’s fair value is not recorded as a gain or a loss on the income statement, it is recorded as an element of other comprehensive income.
These include changes in the fair value of certain investment securities, foreign currency exposures, and pension assets.
The elements of other comprehensive income are included in the computation of comprehensive income, which is defined as all changes in stockholders’ equity during a period, except those resulting from dividends and stockholders’ investments.

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Appendix 2: Comprehensive Income (2 of 3)
Comprehensive income is determined as follows:

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Appendix 2: Comprehensive Income (3 of 3)
Companies must report comprehensive income in the financial statements either:
on the income statement, directly below net income, or
in a separate statement of comprehensive income.

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Appendix 2: Reporting Accumulated Other Comprehensive Income on the Balance Sheet
The cumulative effect of the elements of other comprehensive income is reported on the balance sheet as accumulated other comprehensive income.

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