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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

ACC 3301, Managerial Accounting 2

UNIT x STUDY GUIDE Title

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

ACC 3301, Managerial Accounting 3

UNIT x STUDY GUIDE Title

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.