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Course Project – Ratio Analysis on Financial Statements

Course Project – Ratio Analysis on Financial Statements

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Course Project – Ratio Analysis on Financial Statements In week twelve you selected a publicly traded company and found their annual report. Now that you have their financial information I would like you to perform a ratio analysis on the financial statements. Focus on the financial statement analysis chapter (PDF) you are reading this week. You will want to compute ratios for your company for the last two years. Do not compute each ratio you learned about for your company. There may be some that are not relevant. Rather focus on those eight ratios that you feel are the most important and relevant to analyze how your company is doing. Make sure to justify the ratios that you choose for your analysis. Compare how your company has done to the industry averages. Do you notice any trends that are positive or negative? Does anything look good or bad that is notable? Do you have any suggestions on things they could be doing to improve these ratios? Please analyze what you found for each of the eight ratios. Then organize your findings into a 15 minute presentation. Be sure to include some background on your company in your presentation.Submission Details: 

21
Analyzing Financial
Statements

Chapter Twenty-One

After completing this chapter, you should be able to:

1 Explain the objectives of financial statement analysis.

2 Describe and use the following four analytical techniques: horizontal analysis, trend
analysis, vertical analysis, and ratio analysis.

3 Explain the importance of comparisons and trends in financial statement analysis.

4 Prepare and interpret common-size financial statements.

5 Define and compute the various financial ratios discussed in the chapter.

Chicago, IL—Contemporary
Interiors, a Chicago tradition in
Scandinavian furniture and
contemporary design, has
announced a decision to go
national. Although Contempo-
rary Interiors has opened
stores throughout the Midwest
in recent years, the company
has remained a regional busi-
ness with the bulk of its sales
in the greater Chicago area.
Yesterday, however, a company
spokesman announced that
Contemporary Interiors’ Board
of Directors had decided the
time was right to make the

next move. Marc Janson,
spokesman for the firm’s pres-
ident and CEO, pointed to the
strong economy and consumer
confidence as being key to the
decision. “Disposable income
is up, and we’re seeing that in
our business,” said Janson.
“Even more important, though,
is our company’s strong finan-
cial position. The analysts tell
us that our financial state-
ments look good. Our working
capital, inventory turnover,
return on assets, and so forth
are all strong. This will be
important, because in order to

expand, the company’s going
to have to raise capital. And
the bankers and potential
investors are going to need to
see those strong financial indi-
cators. The board hasn’t
decided yet how much of our
new capital needs should be
debt and how much should be
in stock. I’m sure they’ll keep a
close eye on the debt-equity
ratio.” When asked where
Contemporary Interiors’ next
store would appear, Janson
replied that New York, Atlanta,
and San Francisco were all
under consideration.

CONTEMPORARY INTERIORS TO GO NATIONAL

Financial statements provide the primary means for managers to communicate about
the financial condition of their organization to outside parties. Managers, investors,
lenders, financial analysts, and government agencies are among the users of financial
statements. Substantial information is conveyed by financial statements about the
financial strength and current performance of an enterprise. Although financial state-
ments are prepared primarily for users outside an organization, managers also find their
organization’s financial statements useful in making decisions. As managers develop
operating plans, they think about how those plans will affect the performance of the
organization, as conveyed by the financial statements. In this chapter, we explore how
to analyze financial statements to glean the most information about an organization.

Overview of Financial Statements
There are four primary financial statements:

1. Balance sheet
2. Income statement
3. Retained earnings statement
4. Statement of cash flows

Exhibit 21–1 presents the basic structure of each of these statements and the relation-
ships between them. The balance sheet presents an organization’s financial position at
a point in time. It shows the balances in the organization’s assets, liabilities, and
owners’ equity, as of the balance sheet date.

The other three financial statements depicted in Exhibit 21–1 relate to a period of
time. The income statement reports the income for the period between two balance
sheet dates. The retained earnings statement shows how income and dividends for the
period have changed the organization’s retained earnings. The statement of cash flows
shows how cash was obtained during the period and how it was used.

In this chapter, we will concentrate on analyzing the data conveyed by the balance
sheet, the income statement, and the retained earnings statement. In the preceding
chapter, we explored how the statement of cash flows is prepared and used.

Objectives of Financial Statement Analysis
Financial statements are based on historical accounting information, which
reflects the transactions and other events that have affected the firm.
Managers and other users of the firm’s financial statements are interested in

the future. The objective of financial statement analysis is to use historical accounting
data to help in predicting how the firm will fare in the future. The aspects of an organi-
zation’s future performance that are of most interest depend on the needs of the user. A
manager in the firm would be interested in the company’s overall financial strength, its
income and growth potential, and the financial effects of pending decisions. A potential
lender, such as a bank loan officer, would be concerned primarily about the firm’s
ability to pay back the loan. Potential investors would be interested not only in the
company’s ability to repay its loan obligations, but also its future profit potential.
Potential customers would want to assess the firm’s ability to carry out its operations
effectively and meet delivery schedules. Thus, the needs of the analyst dictate the sort
of financial statement analysis that is most appropriate.

Analytical Techniques Used
Four analytical tools are in widespread use in analyzing financial statements:

1. Horizontal analysis
2. Trend analysis

44 Chapter 21 Analyzing Financial Statements

Overview of Financial Statements

Objectives of Financial Statement Analysis
LO 1 Explain the objectives of financial

statement analysis.

LO 2 Describe and use the following
four analytical techniques: horizontal

analysis, trend analysis, vertical
analysis, and ratio analysis.

3. Vertical analysis
4. Ratio analysis

Each of these techniques is defined, discussed, and illustrated in the following sections
of the chapter.

Importance of Comparisons and Trends
No single measure of a company’s financial condition or performance can
tell us much. The single most important point to remember about financial
statement analysis is that every financial measure should be compared
across time and across other companies to be meaningful. For example, an
airline’s profit for the current year should be compared with the same
company’s profit for several previous years. Moreover, the company’s profit should
be compared with the profit reported by other airlines of similar size and operational

Chapter 21 Analyzing Financial Statements 45

BALANCE SHEET

12/31/x0

� �

Liabilities

Owner’s Equity

Assets

BALANCE SHEET

12/31/x1

� �

Liabilities

Owner’s Equity

Assets

INCOME STATEMENT

For the Year Ended 12/31/x1

Revenues

� Expenses

� Gains

� Losses

Income

RETAINED EARNINGS STATEMENT

For the Year Ended 12/31/x1

Retained earnings on 12/31/x0

� Income

� Dividends

Retained earnings on 12/31/x1

STATEMENT OF CASH FLOWS

For the Year Ended 12/31/x1

Cash inflows during 20×1

� Cash outflows during 20×1

Change in cash during 20×1

These three state-
ments refer to a
period of time, the
year 20×1. They help
reconcile the
account balances on
the balance sheets
as of 12/31/x0 and
12/31/x1.





























12/31/x0 12/31/x1
Time

Exhibit 21–1

Overview of Financial
Statements

LO 3 Explain the importance of com-
parisons and trends in financial
statement analysis.

characteristics. Comparing key financial data with industry norms also adds meaning
to the reported profit for the company being analyzed.

To reemphasize the point, every financial measure discussed in this chapter should
be compared with other analogous measures to be meaningful.

Sources of Data
Published financial statements provide the primary source of data about any organi-
zation’s financial condition and performance. A company’s annual report, quarterly
reports, and financial news releases provide a wealth of information about the firm.

Other sources of financial information also are available, both for individual com-
panies and for entire industries. The Securities and Exchange Commission requires that
every publicly held company file a detailed financial report with the commission
annually. These reports are available to the public. The financial press, such as The Wall
Street Journal, Barron’s, Business Week, Fortune, Forbes, and various industry trade
publications, provides in-depth coverage of specific companies and industries. Other
important sources of financial data include financial advisory services, such as Dun &
Bradstreet, Moody’s Investors Service, Dow Jones, Standard & Poor’s, and Robert
Morris Associates. A wealth of financial information is also available on the Internet.

Doing a good job of financial statement analysis is not a trivial task. It requires a
solid knowledge of accounting, familiarity with the analytical techniques to be dis-
cussed in this chapter, and substantial research using data from a variety of sources.

Comparative Financial Statements
To illustrate each of the techniques used in analyzing financial statements, we will
focus on a retail business. Contemporary Interiors, Inc., headquartered in Chicago,
operates a chain of furniture stores in the Midwest. The company specializes in con-
temporary furniture, much of it imported from the Scandinavian countries. The firm
also sells handcrafted furnishings, such as ceramic lamps and handwoven wall
hangings.

Contemporary Interiors’ balance sheets for December 31, 20×0 and 20×1, are dis-
played in Exhibit 21–2. The company’s income statements and retained earnings state-
ments for 20×0 and 20×1 are presented in Exhibit 21–3.

Horizontal Analysis
Exhibits 21–2 and 21–3 display comparative financial statements, which
show the company’s financial results for two successive years. These state-
ments highlight the change in each financial item between 20×0 and 20×1.
For example, Exhibit 21–2 shows that Contemporary Interiors’ cash balance
increased by $100,000 between December 31, 20×0, and December 31,
20×1. Notice that the changes highlighted in Exhibits 21–2 and 21–3 are

shown in both dollar and percentage form. Thus, Contemporary Interiors’ $100,000
increase in cash represents an increase of 14.3 percent of the December 31, 20×0,
amount (14.3% � $100,000 � $700,000).

Comparative financial statements and change data enable managers and financial
analysts to do horizontal analysis, which is an analysis of the year-to-year change in
each financial statement item. The purpose of horizontal analysis is to determine how
each item changed, why it changed, and whether the change is favorable or unfa-
vorable. This is a tall order, and it requires substantial additional information. Suppose,
for example, that a business periodical recently published a story about a growing
demand for Danish furniture. A glance at Contemporary Interiors’ comparative balance

46 Chapter 21 Analyzing Financial Statements

Comparative Financial Statements

LO 2 Describe and use the following
four analytical techniques: horizontal

analysis, trend analysis, vertical
analysis, and ratio analysis.

Comparative financial
statements show the
company’s financial
results for two successive
years and highlight
changes.

Horizontal analysis is an
analysis of the year-to-
year change in each
financial statement item.

sheet reveals that its cash, accounts receivable, and inventory have all increased during
20×1. These changes are consistent with expanded operations in response to increased
demand for the company’s goods. The comparative income statement helps to confirm
this supposition, since sales and cost of goods sold increased from 20×0 to 20×1.

Thus the analyst’s job is like putting together a jigsaw puzzle. The analyst first
gathers all the puzzle pieces (financial data) and then tries to fit them together to create
a meaningful picture (the firm’s financial condition and performance).

Chapter 21 Analyzing Financial Statements 47

Contemporary Interiors, Inc.
Comparative Balance Sheets
December 31, 20×1 and 20×0

(in thousands)

Year Increase or
(Decrease)

Assets 20×1 20×0 Amount Percentage
Current assets:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 800 $ 700 $ 100 14.3

Marketable securities . . . . . . . . . . . . . . . . . . . . . . 450 300 150 50.0

Accounts receivable, net . . . . . . . . . . . . . . . . . . . . 12,000 11,000 1,000 9.1

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 17,000 3,000 17.6

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . 250 300 (50) (16.7)

Total current assets . . . . . . . . . . . . . . . . . . . . . . $ 33,500 $ 29,300 $4,200 14.3

Long-term investments . . . . . . . . . . . . . . . . . . . . . . . $ 500 $ 550 $ (50) (9.1)

Property, furnishings, and equipment:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000 $ 6,000 $ –0– –0–

Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 52,000 3,000 5.8

Equipment and furnishings, net . . . . . . . . . . . . . . . 25,000 23,000 2,000 8.7

Total property, furnishings, and equipment . . . . . $ 86,000 $ 81,000 $5,000 6.2

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000 $110,850 $9,150 8.3

Liabilities and Stockholders’ Equity
Current liabilities:

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,500 $ 7,050 $ 450 6.4

Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . 2,200 2,100 100 4.8

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 3,200 (200) (6.3)

Total current liabilities . . . . . . . . . . . . . . . . . . . . $ 12,700 $ 12,350 $ 350 2.8

Long-term liabilities:

Bonds payable ($1,000 face value; 10%) . . . . . . . . 37,300 35,700 1,600 4.5

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000 $ 48,050 $1,950 4.1

Stockholders’ equity:

Preferred stock ($100 par value; 8%) . . . . . . . . . . . $ 6,000 $ 6,000 $ –0– –0–

Common stock ($10 par value)* . . . . . . . . . . . . . . . 25,000 24,000 1,000 4.2

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . 4,000 3,800 200 5.3

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 29,000 6,000 20.7

Total stockholders’ equity . . . . . . . . . . . . . . . . . $ 70,000 $ 62,800 $7,200 11.5

Total liabilities and stockholders’ equity . . . . . . . . . . . $120,000 $110,850 $9,150 8.3

*100,000 shares of common stock were issued on January 1, 20×1. Since these shares were outstanding during the entire year, the
weighted-average number of shares outstanding in 20×1 was 2,500,000 shares.

Exhibit 21–2

Comparative Balance Sheets

Trend Analysis
The comparative financial statements in Exhibits 21–2 and 21–3 allow a
comparison of only two years’ data. When the comparison is extended to
three or more years, the technique is called trend analysis. Trends can be
shown in both dollar and percentage form by designating the first year in the
sequence as the base year. Then the amounts in subsequent years are shown

as a percentage of the base-year amount. Exhibit 21–4 displays a trend analysis of
Contemporary Interiors’ sales and net income data over a six-year period.

Contemporary Interiors’ sales and net income both have risen steadily over the six-
year period. However, the growth in sales has been greater than the growth in net
income. The increase in income between year 5 and year 6 is quite small, despite a
large increase in sales. The relationship between the trend in sales and the trend in net
income could be cause for concern. Why has Contemporary Interiors’ management
been unable to convert a relatively larger growth in sales into an equally large growth
in net income? While the trend analysis does not answer this question, it does serve an
attention-directing role for the analyst. An alert financial analyst will delve more
deeply into this issue and try to come up with an explanation.

Vertical Analysis
Horizontal and trend analyses focus on the relationships between the
amounts of each financial item across time. In contrast, vertical analysis
concentrates on the relationships between various financial items on a par-
ticular financial statement. To show these relationships, each item on the

48 Chapter 21 Analyzing Financial Statements

Contemporary Interiors, Inc.
Comparative Income and Retained Earnings Statements

For the Years Ended December 31, 20×1 and 20×0
(in thousands)

Year Increase or
(Decrease)

20×1 20×0 Amount Percentage
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $87,000 $82,000 $5,000 6.1

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,930 56,350 4,580 8.1

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $26,070 $25,650 $ 420 1.6

Operating expenses:

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 $ 4,600 $ 400 8.7

Administrative expenses . . . . . . . . . . . . . . . . . . . . 2,000 2,100 (100) (4.8)

Total operating expenses . . . . . . . . . . . . . . . . . . $ 7,000 $ 6,700 $ 300 4.5

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,070 $18,950 $ 120 .6

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,030 3,890 140 3.6

Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . $15,040 $15,060 $ (20) (.1)

Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . 3,760 3,800 (40) (1.1)

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,280 $11,260 $ 20 .2

Dividends on preferred stock . . . . . . . . . . . . . . . . . . . 480 480 –0– –0–

Net income available to common stockholders . . . . . . $10,800 $10,780 $ 20 .2

Dividends on common stock . . . . . . . . . . . . . . . . . . . 4,800 4,600 200 4.3

Net income added to retained earnings . . . . . . . . . . . . $ 6,000 $ 6,180 $ (180) (2.9)

Retained earnings, January 1 . . . . . . . . . . . . . . . . . . . 29,000 22,820 6,180 27.1

Retained earnings, December 31 . . . . . . . . . . . . . . . . $35,000 $29,000 $6,000 20.7

Exhibit 21–3

Comparative Income and
Retained Earnings Statements

LO 2 Describe and use the following
four analytical techniques: horizontal

analysis, trend analysis, vertical
analysis, and ratio analysis.

LO 2 Describe and use the following
four analytical techniques: horizontal

analysis, trend analysis, vertical
analysis, and ratio analysis.

Trend analysis is a
comparison of three or
more years’ data.

Vertical analysis
concentrates on the
relationships between
various financial items on
a financial statement.

statement is expressed as a percentage of a base item that also appears on the statement.
On the balance sheet, each item is expressed as a percentage of total assets. On the
income statement, each item is stated as a percentage of sales. Financial statements
prepared in terms of percentages of a base amount are called common-size financial
statements. Contemporary Interiors’ common-size balance sheets and income state-
ments for 20×0 and 20×1 are displayed in Exhibits 21–5 and 21–6.

Financial analysts use vertical analysis to gain insight into the relative importance
or magnitude of various items on the financial statements. Using common-size state-
ments, prepared in a comparative format, analysts can discern changes in a firm’s
financial condition and performance from year to year.

To illustrate, notice that Contemporary Interiors’ composition of current
assets remained quite stable from 20×0 to 20×1. Although the various asset
amounts changed, each asset represents roughly the same proportion of total
assets on December 31, 20×1, as on December 31, 20×0. The largest change
is in inventory, which increased from 15.3 percent to 16.7 percent of total assets. This
could be merely a reflection of increased sales, and the required working capital.
Alternatively, it could indicate overstocking.

Ratio Analysis: The Balance Sheet
The balance sheet is like a snapshot. It records the company’s financial
position at an instant in time. Several key relationships between the balance
sheet items can help an analyst gain insight into the strength of a business.

Working Capital
Current assets are assets that, under normal business operations, will be converted into
cash within a reasonably short time period, usually a year. Contemporary Interiors’
current assets include cash, marketable securities, accounts receivable, inventory, and
prepaid expenses. The expectation is that the inventory will be sold within a year, the
accounts receivable will be collected within a year, and so forth. Current liabilities are
obligations due within a year.

A key financial measure is a company’s working capital, which is defined as
follows:

Working capital � Current assets � Current liabilities

Contemporary Interiors’ working capital as of December 31, 20×1, amounts to
$20,800,000 ($33,500,000 � $12,700,000). Working capital is a key concept in oper-
ating a business. It is important to keep a reasonable amount of working capital to

Chapter 21 Analyzing Financial Statements 49

Year 6 Year 5 Year 4 Year 3 Year 2 Year 1
A. Trend Analysis in Dollars

(Measured in Thousands)

Sales . . . . . . . . . . . . . . $87,000 $82,000 $78,000 $74,800 $73,000 $72,000

Net income . . . . . . . . . . 11,280 11,260 11,000 10,500 10,200 9,900

Year 6 Year 5 Year 4 Year 3 Year 2 Year 1
B. Trend Analysis in Percentages

Sales . . . . . . . . . . . . . . 121* 114† 108 104 101 100

Net income . . . . . . . . . . 114 114 111 106 103 100

*121% � $87,000 � $72,000
†114% � $82,000 � $72,000

Exhibit 21–4

Trend Analysis: Contemporary
Interiors, Inc.

Common-size financial
statements are prepared
in percentages of a base
amount.

Working capital is
current assets minus
current liabilities.

LO 4 Prepare and interpret common-
size financial statements.

LO 5 Define and compute the various
financial ratios discussed in the chapter.

ensure that short-term obligations can be paid on time, opportunities for volume
expansion can be seized, and unforeseen circumstances can be handled easily.
Contemporary Interiors has a comfortable balance of working capital.

Current Ratio
Another way of viewing a company’s working capital position is in terms of the
current ratio, defined as follows:

Current ratio �
Current assets

Current liabilities

50 Chapter 21 Analyzing Financial Statements

Contemporary Interiors, Inc.
Common-Size Balance Sheets
December 31, 20×1 and 20×0

Common-Size Statements

Assets 20×1 20×0
Current assets:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 .6

Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 .3

Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.0 9.9

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.7 15.3

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 .3

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28.0 26.4

Long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 .5

Property, furnishings, and equipment:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.0 5.4

Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45.8 47.0

Equipment and furnishings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20.8 20.7

Total property, furnishings, and equipment . . . . . . . . . . . . . . . . . 71.6 73.1

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100.0 100.0

Liabilities and Stockholders’ Equity

Current liabilities:

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.3 6.3

Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.8 1.9

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5 2.9

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.6 11.1

Long-term liabilities:

Bonds payable ($1,000 face value; 10%) . . . . . . . . . . . . . . . . . . . . 31.1 32.2

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.7 43.3

Stockholders’ equity:

Preferred stock ($100 par value; 8%) . . . . . . . . . . . . . . . . . . . . . . . 5.0 5.4

Common stock ($10 par value) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20.8 21.7

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 3.4

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29.2 26.2

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58.3 56.7

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . 100.0 100.0

Exhibit 21–5

Common-Size Balance Sheets

Contemporary Interiors’ current ratio as of December 31, 20×1, is computed below:

Current ratio (12/31/x1) � � 2.64, or 2.64 to 1

A popular rule of thumb is that a company’s current ratio should be at least 2 to 1.
Thus, Contemporary Interiors’ current ratio is quite healthy. Indeed, it may be too
large, once again indicating a possible excess of inventory. It is naïve and somewhat
dangerous to place too much faith in a rule of thumb such as “Keep a current ratio of 2
to 1.” The appropriate magnitude for this ratio (and all financial ratios) varies widely
among industries, companies, and the specific circumstances of individual firms.

Limitation of the Current Ratio The current ratio does not tell the whole story of a
company’s ability to meet its short-term obligations. Consider the following balance
sheet data for Contemporary Interiors and its chief competitor, Trends in Teak.

Contemporary Trends
Interiors in Teak

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 800 $ 100

Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 150

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 2,950

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 30,000

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 300

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $33,500 $33,500

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,700 $12,700

Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.64 to 1 2.64 to 1

Each of these companies exhibits a current ratio of 2.64 to 1. However, are the two
firms in equally strong positions regarding payment of their current obligations? The
answer is no. Trends in Teak has most of its current assets tied up in inventory, which
may take close to a year to convert into cash through normal business operations. In
contrast, Contemporary Interiors can cover all of its current debts with cash, mar-
ketable securities, and accounts receivable, which typically will be converted to cash
more quickly than inventory.

$33,500,000

$12,700,000

Chapter 21 Analyzing Financial Statements 51

Contemporary Interiors, Inc.
Common-Size Income Statements

For the Years Ended December 31, 20×1 and 20×0

Common-size Statements

20×1 20×0
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100.0 100.0

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70.0 68.7

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30.0 31.3

Operating expenses:

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.8 5.6

Administrative expenses . . . . . . . . . . . …

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