Mangerial Accounting VIII

ACC 3301, Managerial Accounting 1

Course Learning Outcomes for Unit VIII

Upon completion of this unit, students should be able to:

7. Analyze problems in managerial decision-making regarding cost planning and control.
7.1 Describe how the concepts of sustainable income and quality of earnings play a role in

managerial decision-making.
7.2 Explain how ratio analysis, horizontal analysis, and vertical analysis impact managerial

decision-making.

Required Unit Resources

Chapter 14: Financial Analysis: The Big Picture—Read the following sections:

• Sustainable Income and Quality of Earnings
• Horizontal Analysis and Vertical Analysis
• Ratio Analysis

In order to access the following resources, click the links below.

Chapter 14 PowerPoint Presentation
PDF of Chapter 14 Presentation

Unit Lesson

Introduction

In Unit VII, we examined cash flows and the use of capital budgeting techniques to determine the best project
and opportunity for a firm. In Unit VIII, we will dive into financial analysis and how it assists managers in
decision-making.

Making Comparisons

Comparisons between companies can provide helpful clues about the financial health of an organization.
Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare
their financial data. For instance, if a firm uses the Last In, First Out (LIFO) method to value its inventory while
another firm uses the First In, First Out (FIFO) method, then comparisons of their financial data, such as cost
of goods sold or inventory balances and totals, would be misleading.

Managers should not use ratios as an end but rather as a beginning point in analysis. Ratios raise many
questions and point to opportunities for further analysis; however, they rarely answer any questions by
themselves. In addition to ratios, the manager should evaluate industry trends, economic factors,
technological changes, internal changes within the firm, and shifts in consumer trends.

Financial ratios are classified into three distinct groups, as shown in Chapter 14 of the textbook. From the
graphic below, we can identify these categories as the following.

UNIT VIII STUDY GUIDE
Financial Analysis

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View the following interactive tutorial by accessing the Unit VIII Additional Unit Resources folder in the unit.

For more information about how a company’s performance can be determined using ratio analysis, please
view the Interactive Tutorial: Learning Objective 14.3. Each statement captures a small part of a firm’s
operations and represents its performance. For more information about how a company’s performance can be
determined using ratio analysis, please view the interactive tutorial below. Closed-captioning is available at
the bottom of the screen

Quality of Earnings

While profits are the lifeblood of a business, no company can survive for long and accomplish its other goals
unless it is profitable. Continuous losses drain assets from the business and leave the company at the mercy
of its creditors. In assessing the prospects of a company, managers are interested not only in the total amount
of earnings but also in the rate of earnings on sales, total assets, and owners’ equity. Further, managers must
look at the stability and source of those earnings. An inconsistent earnings performance over a period of
years, for instance, is less desirable than a steady level of earnings. A history of increasing earnings is
preferable to a flat earnings record.

A breakdown of sales and earnings by major product lines may be beneficial in evaluating the future
performance of a firm. Publicly owned companies include a supplementary schedule with their financial
statements that shows sales and profits by product line and by geographical area. These schedules assist
managers in forecasting the effect of changes in consumer demand for specific types of products.

Managers often express the opinion that the earnings of one company are higher quality than the earnings of
other similar companies. This concept arises because each company’s management can choose from a
variety of accounting principles and methods, all of which are considered generally acceptable. A company’s
management often is under heavy pressure to report rising earnings, and accounting policies may be tailored
toward this goal. In evaluating the quality of earnings, the manager should consider whether the accounting
principles and methods used will lead to a conservative measurement of earnings or tend to inflate reported
earnings.

Company Performance

Comparing financial information for a current period with similar information for prior years provides some
basis for judging whether the condition of the business is improving or worsening. This comparison of data
over time is called horizontal analysis. It expresses the idea of reviewing data for a number of consecutive

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periods. It is different from vertical analysis, which refers to the review of the financial information within a
single accounting period.

In addition to determining whether the situation is improving or becoming worse, horizontal analysis may aid
in making estimates of future prospects. Since changes may reverse their direction at any time, projecting
past trends into future ones always involves a level of risk. A weakness of horizontal analysis is that
comparison with the past does not lead to any basis for evaluation in absolute terms. The fact that net income
was 4% of sales last year and 5% of sales this year indicates improvement. However, if there is evidence that
net income should be 8% of sales, the record for both years is considered unfavorable.

Suggested Unit Resources

View the following video by accessing the Unit VIII Additional Unit Resources folder in the unit.

The Applied Skills Video: How to Prepare Horizontal and Vertical Analyses video will explain how to use
specific tools (horizonal analysis and vertical analysis) to evaluate the significance of financial statement data,
including income statements. Once you click on the link, closed-captioning can be accessed by clicking the
“CC” button on the bottom right of the video window, and a transcript can be accessed by clicking the “T”
button next to the “CC” button.