ILLUSTRATIVE ACCOUNTING APPLICATION PROBLEM
656 Chapter 14 Financial Statement Analysis
LeverageThe amount of debt used by the firm to finance its
assets; causes the rate earned on stockholders’ equity to vary
from the rate earned on total assets because the amount earned
on assets acquired through the use of funds provided by cred-
itors varies from the interest paid to these creditors.Leverage formulaA formula that states the rate earned on
stockholders’ equity as the product of the rate earned on to-
tal assets and the ratio of the average total assets divided by
average stockholders’ equity, or leverage.Management Discussion and Analysis (MDA)An an-
nual report disclosure that provides an analysis of the results
of operations and financial condition.Number of days’ sales in inventoryThe relationship be-
tween the volume of sales and inventory, computed by di-
viding the inventory at the end of the year by the average
daily cost of goods sold.Number of days’ sales in receivablesThe relationship
between sales and accounts receivable, computed by dividing
the net accounts receivable at the end of the year by the av-
erage daily sales.Number of times interest charges are earnedA ratio
that measures creditor margin of safety for interest payments,
calculated as income before interest and taxes divided by in-
terest expense.Price-earnings (P/E) ratioThe ratio of the market price
per share of common stock, at a specific date, to the annual
earnings per share.Profit marginA measure of the amount earned on each dol-
lar of sales, calculated as the ratio of net income to net sales.Quick assetsCash and other current assets that can he
quickly converted to cash, such as cash, marketable securities,
and receivables.Quick ratioThe ratio of the sum of cash, receivables, and
marketable securities to current liabilities.Rate earned on stockholders’ equityA measure of prof-
itability computed by dividing net income by total stock-
holders’ equity.Rate earned on total assetsA measure of the profitabil-
ity of assets, without regard to the equity of creditors and
stockholders in the assets, calculated as the net income di-
vided by average total assets.Ratio of fixed assets to long-term liabilitiesA lever-
age ratio that measures the margin of safety of long-term
creditors, calculated as the net fixed assets divided by the
long-term liabilities.Ratio of liabilities to stockholders’ equityA compre-
hensive leverage ratio that measures the relationship of the
claims of creditors to that of owners, calculated as total lia-
bilities divided by total stockholders’ equity.Vertical analysisThe percentage analysis of component
parts in relation to the total of the parts in a single financial
statement.Rainbow Paint Co.’s comparative financial statements for the years ending December 31,
2007 and 2006, are as follows. The market price of Rainbow Paint Co.’s common stock
was $30 on December 31, 2006, and $25 on December 31, 2007.Rainbow Paint Co.
Comparative Retained Earnings Statement
For the Years Ended December 31, 2007 and 20062007 2006
Retained earnings, January 1 $723,000 $581,800
Add net income for year 245,000 211,200
Total $968,000 $793,000
Deduct dividends:
On preferred stock $ 40,000 $ 40,000
On common stock 45,000 30,000
Total $ 85,000 $ 70,000
Retained earnings, December 31 $883,000 $723,000