1. Financial Accounting, 3e Weygandt, Kieso, & Kimmel
John Wiley & Sons, Inc.
Prepared by
Gregory K. Lowry
Mercer University
Marianne Bradford
The University of Tennessee

2. CHAPTER 15 FINANCIAL STATEMENT ANALYSIS
After studying this chapter, you should be able to:
1 Discuss the need for comparative analysis.
2 Identify the tools of financial statement analysis.
3 Explain and apply horizontal analysis.
4 Describe and apply vertical analysis.

3. CHAPTER 15 FINANCIAL STATEMENT ANALYSIS
After studying this chapter, you should be able to:
5 Identify and compute ratios and describe their purpose and use in analyzing a firm’s liquidity, profitability, and solvency.
6 Understand the concept of earning power and indicate how material items not typical of regular operations are presented.
7 Recognize the limitations of financial statement analysis.

4. PREVIEW OF CHAPTER 15 FINANCIAL STATEMENT ANALYSIS
Need for comparative analysis
Tools of analysis
Basics of Financial Statement Analysis
Horizontal and Vertical Analysis
Balance sheet
Income statement
Retained earnings statement
Ratio Analysis
Liquidity
Profitability
Solvency
Summary
Earning Power and Irregular Items
Limitations of Financial Analysis
Estimates
Cost
Accounting methods
Atypical data
Diversification
Discontinued operations
Extraordinary items
Change in accounting principle
Comprehensive income

5. BASICS OF FINANCIAL STATEMENT ANALYSIS
Analyzing financial statements involves 3 characteristics of a company: 1 its liquidity, 2 its profitability, and 3 its solvency.
Every item reported in a financial statement has significance.
In order to obtain information as to whether the amount 1 represents an increase over prior years or 2 is adequate in relation to the company’s need for cash, the amount of cash must be compared with other financial statement data.
Comparisons can be made on several difference bases – 3 are illustrated in this chapter: 1 intracompany basis, 2 industry averages, and 3 intercompany basis.

6. TOOLS OF FINANCIAL STATEMENT ANALYSIS
Three commonly used tools are utilized to evaluate the significance of financial statement data.
1 Horizontal analysis (trend analysis) is a technique for evaluating a series of financial statement data over a period of time.
2 Vertical analysis is a technique for evaluating financial statement data that expresses each item in a financial statement in terms of a percent of a base amount.
3 Ratio analysis expresses the relationship among selected items of financial statement data.

7. ILLUSTRATION 15-1, 15-2 SEARS ROEBUCK’S NET SALES
SEARS, ROEBUCK AND CO.
(Net Sales Stated in Millions)
1998
1997
1996
1995
1994
$ 41,322
$ 41,296
$ 38,064
$ 34,835
$ 33,110
The purpose of horizontal analysis is to determine the increase or decrease that has taken place, expressed as either an amount or a percentage. The recent net sales figures of Sears, Roebuck and Co. are shown above. Given that 1994 is the base year, we can measure all percentage increases or decreases from this base period amount as shown below.
Change since base period =

8. ILLUSTRATION 15-4 HORIZONTAL ANALYSIS OF SEARS, ROEBUCK’S NET SALES
We can determine that net sales for Sears, Roebuck increased approximately 5.2% [($34,835 - $33,110) ÷ $33,110] from 1994 to We can also determine that net sales increased over 24.8% [($41,322 - $33,110) ÷ $33,110] from 1994 to The percentage of the base period for each of the 5 years, assuming 1994 as the base period, is shown below.
Sears, Roebuck and Co.
Net Sales (in Millions)
Base Period 1994
1998
1997
1996
1995
1994
$41,322
$ 41,296
$ 38,064
$ 34,835
$33,110
124.8%
124.7%
115%
105%
100%

9. ILLUSTRATION 15-5 HORIZONTAL ANALYSIS OF A BALANCE SHEET
The 2-year condensed balance sheet of Quality Department Store Inc. for 1998 and 1997 showing dollar and percentage changes is displayed on the right. In the asset section, plant assets (net) increased $167,500 or 26.5%. In the liabilities section, current liabilities increased $41,500 or 13.7%. In the stockholders’ equity section, retained earnings increased $202,600 or 38.6%. It appears the company expanded its asset base during 1998 and financed the expansion by retaining income in the firm.
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheet
December 31
Increase or (Decrease)
during 1998
Current assets
$ 1,020,000
$ ,000
7.9%
Intangible assets
17,500
( 2,500)
( 14.3%)
$ 1,835,000
Current liabilities
13.7%
487,500
Total liabilities
800,000
32,000
Stockholders’ Equity
5,400
2.0%
Retained earnings
1,003,000
208,000
Total liabilities and stockholders’ equity
1998
1997
Amount
Percentage
Assets
$ ,000
Plant assets (net)
800,000
632,500
167,500
26.5%
15,000
Total assets
$ 1,595,000
$ 240,000
15.0%
Liabilities
$ ,500
$ ,000
$ ,500
Long-term liabilities
497,000
( 9,500)
( 1.9%)
832,000
4.0%
Common stock, $1 par
275,400
270,000
727,600
525,000
202,600
38.6%
Total stockholders’ equity
795,000
26.2%
$ 1,835,000
$ 1,595,000
$ 240,000
15.0%

10. ILLUSTRATION 15-6 HORIZONTAL ANALYSIS OF AN INCOME STATEMENT
The 2-year comparative income statement of Quality Department Store Inc. for 1998 and 1997 is shown in condensed form on the right. Horizontal analysis of the comparative income statement shows the following changes:
1 Net sales increased $260,000, or 14.2% ($260,000 ÷ $1,837,000).
2 Cost of goods sold increased $141,000, or % ($141,000 ÷ $1,140,000).
3 Total operating expenses increased $37,000, or % ($37,000 ÷ $320,000).

11. ILLUSTRATION 15-7 HORIZONTAL ANALYSIS OF A RETAINED EARNINGS STATEMENT
The 2-year comparative retained earnings statement of Quality Department Store Inc. for 1998 and 1997 is presented on the right. Analyzed horizontally:
1 Net income increased $55,300, or 26.5%.
2 Common dividends increased only $1,200, or 2%.
3 Ending retained earnings increased %.

12. ILLUSTRATION 15-8 VERTICAL ANALYSIS OF A BALANCE SHEET
Presented on the right is the 2-year comparative balance sheet of Quality Department Store Inc. for 1998 and 1997.
1 Current assets increased $75,000 from 1997 to 1998, they decreased from % to 55.6% of total assets.
2 Plant assets (net) increased from 39.7% to 43.6% of total assets, and
3 Retained earnings increased from 32.9% to 39.7% of total liabilities and stockholders’ equity.
These results reinforce earlier observations that Quality is financing its growth through retention of earnings.

13. ILLUSTRATION 15-9 VERTICAL ANALYSIS OF AN INCOME STATEMENT
Vertical analysis of the year comparative income statement of Quality Department Store Inc. for 1998 and 1997 is shown on the right.
1 Cost of goods sold as a percentage of net sales declined 1% (62.1% versus 61.1%).
2 Total operating expenses declined 0.4% (17.4% versus 17.0%).
3 Net income as a percent of net sales therefore increased from 11.4% to %.
Quality appears to be a profitable enterprise that is becoming more successful.

14. ILLUSTRATION 15-10 INTERCOMPANY INCOME STATEMENT COMPARISON
Vertical analysis enables you to compare companies of different sizes. Quantity’s major competitor is a Sears store in a town nearby town. Using vertical analysis, the small Quality Department Store Inc. can be meaningfully compared to the much larger Sears, as shown below. 1 Gross profit rates were somewhat comparable at 38.9% and 34%. 2 Income from operations percentages were significantly different at 21.9% and 7.9%. 3 Quality’s selling and administrative expenses percentage was much lower than Sears’ – 17% to 26.1%. 4 Sears’ net income as a percentage of sales was much lower than Quality’s: 2.5% to 12.6%.

15. RATIO ANALYSIS
Ratio analysis expresses the relationship among selected items of financial statement data.
A ratio expresses the mathematical relationship between one quantity and another.
A single ratio by itself is not very meaningful, in the upcoming illustrations we will use:
1 Intracompany comparisons covering 2 years for the Quality Department Store.
2 Industry average comparisons based on the Dun & Bradstreet’s median ratios for department stores and Robert Morris Associates’ median ratios for department stores.
3 Intercompany comparisons based on Sears, Roebuck and Co. as Quality Department Store’s principal competitor.

16. ILLUSTRATION 15-11 FINANCIAL RATIO CLASSIFICATIONS
Liquidity Ratios
Measures of short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash
Profitability Ratios
Measures of the income or operating success of an enterprise for a given period of time
Solvency Ratios
Measures of the ability of the enterprise to survive over a long period of time
Revenues
Expenses - =
Net Income
XYZ Co.

17. ILLUSTRATION 15-12 CURRENT RATIO Quality Department Store
The current ratio (working capital ratio) is a widely used measure for evaluating a company’s liquidity and short-term debt-paying ability. It is calculated by divided current assets by current liabilities and is a more dependable indicator of liquidity than working capital. The current ratios for Quality Department Store and comparative data are shown below.
CURRENT ASSETS CURRENT RATIO = ——————————— CURRENT LIABILITIES
Quality Department Store

18. ILLUSTRATION 15-13 CURRENT ASSETS OF QUALITY DEPARTMENT STORE

19. ILLUSTRATION 15-14 ACID-TEST RATIO Quality Department Store
The acid-test ratio (quick ratio) is a measure of a company’s short-term liquidity and is calculated by dividing the sum of cash, marketable securities, and net receivables by current liabilities. The acid-test ratios for Quality Department Store and comparative data are shown below.
CASH + MARKETABLE SECURITIES + RECEIVABLES (NET) ACID-TEST RATIO = ———————————————————————————— CURRENT LIABILITIES
Quality Department Store
Industry average
Sears, Roebuck and Co.
————————
———————————
1.3:1
1.3:1

20. [ ] [ ] ILLUSTRATION 15-15 CURRENT CASH DEBT COVERAGE RATIO
The current cash debt coverage ratio usually provides a superior representation of liquidity since it uses not cash provided by operating activities rather than a balance at a point in time. Quality Department Store’s current cash debt coverage ratios for 1998 and 1997 are calculated below.
CURRENT CASH DEBT NET CASH PROVIDED BY OPERATING ACTIVITIES COVERAGE RATIO = ———————————————————————— AVERAGE CURRENT LIABILITIES
Quality Department Store [ ] [ ]

21. ILLUSTRATION 15-16 RECEIVABLES TURNOVER Quality Department Store
The receivables turnover ratio is used to assess the liquidity of the receivables. It measures the number of times, on average, receivables are collected during the period. The ratio is calculated by dividing net credit sales by average net receivables during the year. The receivables turnover ratio and comparative data for Quality Department Store for 1998 and 1997 are calculated below.
NET CREDIT SALES RECEIVABLES TURNOVER = ——————————————— AVERAGE NET RECEIVABLES
Quality Department Store [ ] [ ]

22. ILLUSTRATION 15-17 INVENTORY TURNOVER Quality Department Store
The inventory turnover ratio measures the number of times, on average, the inventory is sold during the period – which measures the liquidity of the inventory. It is calculated by dividing cost of goods sold by average inventory during the year. The inventory turnover ratio and comparative data for Quality Department Store for 1998 and 1997 are calculated below.
COST OF GOODS SOLD INVENTORY TURNOVER = ———————————— AVERAGE INVENTORY
Quality Department Store [ ] [ ]
Industry average
Sears, Roebuck and Co.
————————
———————————
3.4 times
5.5 times

23. ILLUSTRATION 15-18 PROFIT MARGIN RATIO Quality Department Store
The profit margin ratio is a measure of the percentage of each dollar of sales that results in net income. It is calculated by dividing net income by net sales for the period. The profit margin ratios and comparative data for Quality Department Store for 1998 and 1997 are calculated below.
NET INCOME PROFIT MARGIN ON SALES = —————— NET SALES
Quality Department Store
Industry average
Sears, Roebuck and Co.
————————
———————————
3.6%
2.5%

24. ILLUSTRATION 15-19 CASH RETURN ON SALES RATIO Quality Department Store
The cash basis counterpart of the profit margin ratio is the cash return on sales ratio which uses net cash provided by operating activities as the numerator and net sales as the denominator. Using net cash provided by operating activities of $404,000 in 1998 and $340,000 in 1997, Quality Department Store’s cash return on sales ratios are calculated and evaluated below.
NET CASH PROVIDED BY OPERATING ACTIVITIES CASH RETURN ON SALES RATIO = ————————————————————————— NET SALES
Quality Department Store
Industry average
Sears, Roebuck and Co.
————————
———————————
6.2%
7.5%

25. ILLUSTRATION 15-20 ASSET TURNOVER Quality Department Store
The asset turnover ratio measures how efficiently a company uses its asset to generate sales. It is determined by dividing net sales by average assets for the period. Quality Department Store’s cash return on sales ratios are calculated and evaluated below.
NET SALES ASSET TURNOVER = ————————— AVERAGE ASSETS
Quality Department Store [ ] [ ]

26. ILLUSTRATION 15-21 RETURN ON ASSETS Quality Department Store
An overall measure of profitability is the return on assets ratio. It is calculated by dividing net income by average assets for the period. Quality Department Store’s return on assets ratios for 1998 and 1997 are calculated and evaluated below.
NET INCOME RETURN ON ASSETS = ————————— AVERAGE ASSETS
Quality Department Store [ ] [ ]
Industry average
Sears, Roebuck & Co.
————————
———————————
3.4%
2.7%

27. [ ] [ ] ILLUSTRATION 15-22 RETURN ON COMMON STOCKHOLDERS’ EQUITY
A ratio that measures profitability from the viewpoint of the common stockholder is return on common stockholders’ equity. It is calculated by dividing net income by average common stockholders’ equity for the period. Quality Department Store’s return on common stockholders’ equity for 1998 and 1997 are calculated and evaluated below.
RETURN ON COMMON NET INCOME STOCKHOLDERS’ EQUITY = ——————————————————————— AVERAGE COMMON STOCKHOLDERS’ EQUITY
Quality Department Store [ ] [ ]
Industry average
Sears, Roebuck and Co.
————————
———————————
12.9%
17.6%

28. ILLUSTRATION 15-23 RETURN ON COMMON STOCKHOLDERS’ EQUITY WITH PREFERRED STOCK
When preferred stock is present, preferred dividend requirements are deducted from net income to determine income available to common stockholders. The par value of preferred stock (or call price – if applicable) must be deducted from total stockholders’ equity to arrive at the amount of common stockholders’ equity used in this ratio. The ratio then appears as shown below.
RATE OF RETURN ON COMMON NET INCOME – PREFERRED DIVIDENDS STOCKHOLDERS’ EQUITY = ——————————————————————— AVERAGE COMMON STOCKHOLDERS’ EQUITY

29. ILLUSTRATION 15-24 EARNINGS PER SHARE Quality Department Store
Earnings per share (EPS) of common stock is a measure of net income earned on each share of common stock. It is calculated by dividing net income by the number of weighted average common shares outstanding during the year. Quality Department Store’s EPS for 1998 and 1997 are calculated and evaluated below.
EARNINGS NET INCOME PER SHARE = ———————————————————————————— WEIGHTED AVERAGE COMMON SHARES OUTSTANDING
Quality Department Store [ ]

30. ILLUSTRATION 15-25 PRICE-EARNINGS RATIO Quality Department Store
The price-earnings (PE) ratio measures the ratio of the market price of each share of common stock to the earnings per share. It is calculated by dividing the market price per share of common stock by earnings per share. Quality Department Store’s PE ratios for 1998 and 1997 are calculated and evaluated below.
MARKET PRICE PER SHARE OF COMMON STOCK PRICE-EARNINGS RATIO = ————————————————————————— EARNINGS PER SHARE
Quality Department Store
Industry average
Sears, Roebuck and Co.
————————
———————————
28 times
18 times

31. ILLUSTRATION 15-26 PAYOUT RATIO Quality Department Store
The payout ratio measures the percentage of earnings distributed in the form of cash dividends. It is calculated by dividing cash dividends by net income. Quality Department Store’s payout ratios for 1998 and 1997 are calculated and evaluated below.
CASH DIVIDENDS PAYOUT RATIO = ————————— NET INCOME
Quality Department Store
1998
1997
$61,200
$60,000
————— = 23.2%
————— = 28.8%
$263,800
$208,500
Industry average
Sears, Roebuck and Co.
————————
———————————
N/A
34.3%

32. ILLUSTRATION 15-27 DEBT TO TOTAL ASSETS Quality Department Store
The debt to total assets ratio measures the percentage of total assets provided by creditors, indicating the degree of leveraging. It is calculated by dividing total debt by total assets. Quality Department Store’s total debt to total assets ratios for 1998 and 1997 are calculated and evaluated below.
TOTAL DEBT DEBT TO TOTAL ASSETS = ———————— TOTAL ASSETS
Quality Department Store
Industry average
Sears, Roebuck and Co.
————————
———————————
38.0%
84%

33. ILLUSTRATION 15-28 TIMES INTEREST EARNED Quality Department Store
The times interest earned ratio provides an indication of the company’s ability to meet interest payments as they come due. It is calculated by dividing income before income taxes and interest expense by interest expense. Quality Department Store’s times interest earned ratios for 1998 and 1997 are calculated and evaluated below.
TIMES INTEREST INCOME BEFORE INCOME TAXES AND INTEREST EXPENSE EARNED = ————————————————————————————— INTEREST EXPENSE
Quality Department Store
Industry average
Sears, Roebuck and Co.
————————
———————————
2.7 times
2.27 times

34. ILLUSTRATION 15-29 CASH DEBT COVERAGE RATIO Quality Department Store
The ratio of net cash provided by operating activities to average total liabilities is the cash debt coverage ratio and is a measure of solvency. Quality Department Store’s cash debt coverage ratios for 1998 and 1997 are calculated and evaluated below.
NET CASH PROVIDED BY OPERATING ACTIVITIES CASH DEBT COVERAGE RATIO = ————————————————————————— AVERAGE TOTAL LIABILITIES
Quality Department Store [ ] [ ]
Industry average
Sears, Roebuck and Co.
————————
———————————
.38 times
.096 times

35. ILLUSTRATION 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS

36. ILLUSTRATION 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS

37. ILLUSTRATION 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS

38. ILLUSTRATION 15-30 SUMMARY OF LIQUIDITY, PROFITABILITY, AND SOLVENCY RATIOS

39. EARNING POWER AND IRREGULAR ITEMS
For users of financial statements to determine earning power or regular income, the irregular items are separately identified on the income statement.
3 types of irregular items are reported:
1 Discontinued operations,
2 Extraordinary items, and
3 Changes in accounting principle.

40. DISCONTINUED OPERATIONS
Discontinued operations constitutes the disposal of a significant segment of a business.
The income (loss) from discontinued operations consists of
1 the income (loss) from operations and
2 the gain (loss) on disposal of the segment.

41. ILLUSTRATION 15-31 STATEMENT PRESENTATION OF DISCONTINUED OPERATIONS
Acro Energy Inc. has revenues of $2.5 million and expenses of $1.7 million from continuing operations in The company therefore has income before income taxes of $800,000. The company discontinued and sold its unprofitable chemical division during The 2001 loss from chemical operations was $140,000 (net of $60,000 in income taxes), and the loss on disposal of the chemical division (net of $30,000 in income taxes), was $70,000. Given a 30% income tax rate, the partial income statement presentation is shown below.

42. EXTRAORDINARY ITEMS
Extraordinary items are events and transactions that meet two conditions: they are
1 unusual in nature and
2 infrequent in occurrence.
Extraordinary items are reported net of taxes in a separate section of the income statement immediately below discontinued operations.

43. ILLUSTRATION 15-32 EXAMPLES OF EXTRAORDINARY AND ORDINARY ITEMS
CONDEMNED
SALE

44. ILLUSTRATION 15-33 STATEMENT PRESENTATION OF EXTRAORDINARY ITEMS
In 2001 a revolutionary foreign government expropriated property held as an investment by Acro Energy Inc. If the loss is $70,000, before applicable income taxes of $21,000, the partial income statement presentation will show a deduction of $49,000 – as shown below.

45. CHANGE IN ACCOUNTING PRINCIPLE
To make them comparable, financial statements are expected to be prepared on a basis consistent with that used in the preceding period.
A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year.
A change is permitted when
1 management can show that the new principle is preferable to the old principle and
2 the effects of the change are clearly disclosed in the income statement.

46. CHANGE IN ACCOUNTING PRINCIPLE
When a change in accounting principle has occurred,
1 the new principle should be used in reporting the results of operations of the current year and
2 the cumulative effect of the change on all prior year income statements should be disclosed net of applicable income taxes in a special section immediately preceding net income.

47. ILLUSTRATION 15-34 STATEMENT PRESENTATION OF CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE
At the beginning of 2001, Acro Energy Inc. changes from the straight-line method of depreciation to the declining-balance method for equipment purchased on January 1, Assuming a 30% income tax rate the net of income tax effect of the change is $16,800 ($24,000 X 70%). The partial income statement presentation is shown below.

48. LIMITATIONS OF FINANCIAL ANALYSIS
You should be aware of some of the limitations of the three analytical tools illustrated in the chapter and of the financial statements on which they are based.
1 Estimates Financial statements contain numerous estimates; to the extent that these estimates are inaccurate, the financial ratios and percentages are inaccurate.
2 Cost Traditional financial statements are based on cost and are not adjusted for price-level changes Comparisons of unadjusted financial data from different periods may be rendered invalid by significant inflation or deflation.

49. LIMITATIONS OF FINANCIAL ANALYSIS
3 Alternative Accounting Methods Variations among companies in the application of GAAP may hamper comparability. Although differences in accounting methods might be detectable from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is difficult, if not impossible, in some cases.
4 Atypical Data Fiscal year-end data may not be typical of the financial condition during the year. Firms often establish a fiscal year-end that coincides with the low point in operating activity or in inventory levels. Thus, certain account balances may not be representative of the account balances during the year.
5 Diversification of Firms Diversification in American industry also restricts the usefulness of financial analysis. Many firms today are too diversified to be classified by industry, while others appear to be comparable when they are not.

50. COPYRIGHT
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programs or from the use of the information contained herein.

51. CHAPTER 15 FINANCIAL STATEMENT ANALYSIS