1. “How Well Am I Doing?” Financial Statement Analysis
Chapter 17
“How Well Am I Doing?” Financial Statement Analysis

2. Limitations of Financial Statement Analysis
Differences in accounting methods between companies sometimes make comparisons difficult.
We use the LIFO method to value inventory.
We use the FIFO method to value inventory.

3. Limitations of Financial Statement Analysis
Changes within the firm
Industry trends
Consumer tastes
Technological changes
Economic factors
Analysts should look beyond the ratios.

4. Statements in Comparative and Common-Size Form
Dollar and percentage
changes on statements
Analytical techniques used to examine relationships among financial statement items
Common-size
statements
Ratios

5. Dollar and Percentage Changes on Statements
Comparing statements underscores movements and trends and may provide valuable clues about what to expect in the future.
Horizontal analysis
Trend
analysis

6. Horizontal Analysis
Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

7. Horizontal Analysis Example
The following slides illustrate a horizontal analysis of Clover Corporation’s December 31, 2004 and 2003 comparative balance sheets and comparative income statements.

8. Horizontal Analysis

9. Horizontal Analysis Calculating Change in Dollar Amounts Dollar Change
Current Year
Figure
Base Year
Figure = –
The dollar amounts for 2003 become the “base” year figures.

10. Calculating Change as a Percentage
Horizontal Analysis
Calculating Change as a Percentage
Percentage
Change
Dollar Change
Base Year Figure × =
100%

11. Horizontal Analysis $12,000 – $23,500 = $(11,500)
($11,500 ÷ $23,500) × 100% = 48.9%

12. Horizontal Analysis

13. Horizontal Analysis
We could do this for the liabilities & stockholders’ equity, but now let’s look at the income statement accounts.

14. Horizontal Analysis

15. Sales increased by 8.3% yet net income decreased by 21.9%.
Horizontal Analysis
Sales increased by 8.3% yet
net income decreased by 21.9%.

16. Horizontal Analysis
There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

17. Trend Percentages
Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.

18. Trend Analysis × Trend Percentage Current Year Amount Base Year Amount
100% = ×

19. Trend Analysis Example
Look at the income information for Berry Products for the years 2000 through We will do a trend analysis on these amounts to see what we can learn about the company.

20. For the Years Ended December 31
Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
The base
year is 2000, and its amounts
will equal 100%.

21. For the Years Ended December 31
Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
2001 Amount ÷ 2000 Amount × 100%
( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%

22. For the Years Ended December 31
Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.

23. Trend Analysis
We can use the trend percentages to construct a graph so we can see the trend over time.

24. Common-Size Statements
Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis.

25. Common-Size Statements
Example
Let’s take another look at the information from the comparative income statements of Clover Corporation for 2004 and 2003.
This time let’s prepare common-size statements.

26. Common-Size Statements
Net sales is usually the base and is expressed as 100%.

27. Common-Size Statements
2004 Cost ÷ 2004 Sales × 100%
( $360,000 ÷ $520,000 ) × 100% = 69.2%
2003 Cost ÷ 2003 Sales × 100%
( $315,000 ÷ $480,000 ) × 100% = 65.6%

28. Gross Margin Percentage
Sales =
This measure indicates how much
of each sales dollar is left after deducting the cost of goods sold to cover expenses and a profit.

29. Common-Size Statements
What conclusions can we draw?

30. Quick Check 
Which of the following statements describes horizontal analysis?
a. A statement that shows items appearing on it in percentage and dollar form.
b. A side-by-side comparison of two or more years’ financial statements.
c. A comparison of the account balances on the current year’s financial statements.
d. None of the above.

31. Quick Check 
Which of the following statements describes horizontal analysis?
a. A statement that shows items appearing on it in percentage and dollar form.
b. A side-by-side comparison of two or more years’ financial statements.
c. A comparison of the account balances on the current year’s financial statements.
d. None of the above.
Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

32. Now, let’s look at Norton Corporation’s 2004 and 2003 financial statements.

36. Now, let’s calculate some ratios based on Norton Corporation’s financial statements.

37. Ratio Analysis – The Common Stockholder
Use this information to calculate ratios to measure the well-being of the common stockholders of Norton Corporation.

38. Average Number of Common Shares Outstanding
Earnings Per Share
Earnings per Share
Net Income – Preferred Dividends
Average Number of Common Shares Outstanding =
Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

39. Average Number of Common Shares Outstanding
Earnings Per Share
Earnings per Share
Net Income – Preferred Dividends
Average Number of Common Shares Outstanding =
Earnings per Share
$53,690 – 0
(17, ,400)/2 =
= $2.42
This measure indicates how much
income was earned for each share of common stock outstanding.

40. Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share
Earnings Per Share =
Price-Earnings
Ratio
$20.00
$2.42 =
= 8.26 times
This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth.

41. Dividend Payout Ratio Dividend Payout Ratio Dividends Per Share
Earnings Per Share =
Dividend
Payout Ratio
$2.00
$2.42 =
= 82.6%
This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking current income would like this ratio to be large.

42. Dividend Yield Ratio Dividend Yield Ratio Dividends Per Share
Market Price Per Share =
Dividend
Yield Ratio
$2.00
$20.00 =
= 10.00%
This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

43. Net Income + [Interest Expense × (1 – Tax Rate)]
Return on Total Assets
Return on
Total Assets
Net Income + [Interest Expense × (1 – Tax Rate)]
Average Total Assets =
Return on
Total Assets
$53,690 +[7,300 × (1 – .30)]
($300,000 + $346,390) ÷ 2 =
= %
This ratio measures how well assets have been employed.

44. Return on Common Stockholders’ Equity
Net Income – Preferred Dividends
Average Stockholders’ Equity =
Return on Common
Stockholders’ Equity
$53,690 – 0
($180,000 + $234,390) ÷ 2 =
= 25.91%
This measure indicates how well the company employed the owners’ investments to earn income.

45. Financial Leverage
Financial leverage involves acquiring assets with funds at a fixed rate of interest.
Return on investment in assets
>
Fixed rate of return on borrowed funds
Positive financial leverage =
Return on investment in assets
<
Fixed rate of return on borrowed funds
Negative financial leverage =

46. Quick Check  Which of the following statements is true?
a. Negative financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets.
b. Positive financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets.
c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year.

47. Quick Check  Which of the following statements is true?
a. Negative financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets.
b. Positive financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets.
c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year.

48. Impact of Income Taxes
Debt is more efficient in generating positive financial leverage than preferred stock.

49. Common Stockholders’ Equity Number of Common Shares Outstanding
Book Value Per Share
Book Value per Share
Common Stockholders’ Equity
Number of Common Shares Outstanding =
= $ 8.55
Book Value per Share
$234,390
27,400 =
This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.

50. Ratio Analysis – The Short– Term Creditor
Use this information to calculate ratios to measure the well-being of the short-term creditors for Norton Corporation.

51. Working Capital

52. Current Ratio Current Ratio Current Assets Current Liabilities =
$65,000
$42,000 =
1.55 : 1
This ratio measures the ability
of the company to pay current
debts as they become due.

53. Acid-Test (Quick) Ratio
Quick Assets
Current Liabilities =
Acid-Test
Ratio
Quick assets are Cash,
Marketable Securities, Accounts Receivable and
current Notes Receivable.
Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000.

54. Acid-Test (Quick) Ratio
Quick Assets
Current Liabilities =
Acid-Test
Ratio
$50,000
$42,000 =
1.19 : 1
Acid-Test
Ratio
This ratio is like the current
ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash.

55. Accounts Receivable Turnover
Sales on Account
Average Accounts Receivable
Accounts Receivable
Turnover =
= times
$500,000
($17,000 + $20,000) ÷ 2
Accounts Receivable
Turnover =
This ratio measures how many times a company converts its receivables into cash each year.

56. Average Collection Period=
365 Days
Accounts Receivable Turnover
= days
Average Collection Period =
365 Days
27.03 Times
This ratio measures, on average, how many days it takes to collect an account receivable.

57. Inventory Turnover Cost of Goods Sold Average Inventory Inventory=
= times
$140,000
($10,000 + $12,000) ÷ 2
Inventory
Turnover =
This ratio measures the number
of times merchandise inventory
is sold and replaced during the year.

58. Average Sale Period Average Sale Period = 365 Days Inventory Turnover
12.73 Times
This ratio measures how many days, on average, it takes to sell the inventory.

59. Ratio Analysis – The Long– Term Creditor
Use this information to calculate ratios to measure the well-being of the long-term creditors for Norton Corporation.
This is also referred to as net operating income.

60. Times Interest Earned Ratio
Earnings before Interest Expense
and Income Taxes
Interest Expense
Times Interest Earned =
Times Interest Earned
$84,000
7,300 =
11.5 times
This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor.

61. Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity Debt–to–=
$112,000
$234,390
Debt–to–
Equity Ratio =
= to 1
This ratio measures the amount of assets being provided by creditors for each dollar of assets being provided by the owners of the company.

63. End of Chapter 17