1. Chapter 13 Financial Statement Analysis
Using Financial Accounting Information:
The Alternative to Debits and Credits, 6th by
Gary A. Porter and Curtis L. Norton
Copyright © 2009 South-Western, a part of Cengage Learning.

2. Financial Statement Analysis
Creditors
Will I
be paid?
How
good is our
investment?
How are we
performing?
Stockholders
Management

3. Limitations of Financial Statement Analysis
Use of different accounting methods
Changes in accounting methods
LIFO
FIFO
LO1

4. Limitations of Financial Statement Analysis
????
Failure to recognize trends in ratios
Difficulty of making industry comparisons (i.e., conglomerates)

5. Limitations of Financial Statement Analysis
Nonoperating items on income statement
Effects of inflation
Oranges
Apples =

6. Horizontal Analysis % $
A comparison of financial statement items over a period of time
Read right to left to compare one year’s results with the next as a dollar amount of change and as a percentage of change from year to year % $
LO2

7. Horizontal Analysis December 31 Increase (Decrease)
Dollars Percent
Cash $ $1, $(1,030) (76)%
Accounts receivable , , ,
Inventory , , ,
Prepaid insurance (50) (25)
Total current assets $10,720 $8, $ 1,
Dollar change from
year to year
Percentage change
from one year to
the next year

8. Tracking items over a series of years
Trend Analysis
Wm. Wrigley Jr. Company
23% % % %
Return on
Average Equity
Tracking items over a series of years

9. Vertical Analysis
Common-size statements recast items as a percentage of a selected item
Allows comparisons of companies of different size
Compares percentages across years to identify trends % % %
LO3

10. Vertical Analysis December 31, 2008 December 31, 2007
Dollars Percent Dollars Percent
Cash $ % $ 1, %
Accounts receivable , ,
Inventory , ,
Prepaid insurance
Total current assets $10, % $8, %
Compare percentages
across years to spot
year-to-year trends

11. Liquidity Analysis Nearness to cash
Ability to pay debts as they become due
LO4

12. – Working Capital Excess of current assets over current liabilities
Lacks meaningful comparisons for companies of different size –

13. Current Ratio Measure of short-term financial health
Consider composition of current assets
Rule of thumb
2:1

14. Acid-Test (Quick) Ratio
Stricter test of ability to pay debts
Excludes inventories and prepaid assets
Quick Assets
Current Liabilities

15. Cash Flow from Operations to Current Liabilities
Focuses on cash only
Can be used to indicate the flow of cash during the year to cover the debts due
Net Cash Provided by Operating Activities
Average Current Liabilities

16. Accounts Receivable Turnover Ratio
Net Credit Sales
Average Accounts Receivable
Indicates how quickly a company is collecting (i.e., turning over) its receivables

17. Number of Days’ Sales in Receivables
Number of Days in the Period
Accounts Receivable Turnover
Represents the average number of days
an account is outstanding

18. Number of Days’ Sales in Receivables
Example:
360 days
4.8 times
= 75 days
If this company’s credit terms are net 30, what would this tell you about the efficiency of the collection process?

19. Inventory Turnover Ratio
Cost of Goods Sold
Average Inventory
Represents the number of times per period inventory is turned over (i.e., sold).

20. Number of Days’ Sales in Inventory
Number of Days in the Period
Inventory Turnover
Represents the average number of days
inventory is on hand before it’s sold

21. Cash Operating Cycle Number of Days’ Sales in Inventory +
Time between the purchase of merchandise and the collection of the from the sale
Number of Days’ Sales in Inventory +
Number of Days’ Sales in Receivables
Collection of
Accounts
Receivable
Purchase of
Inventory

22. Solvency Analysis Ability to stay in business over the long-term Times
Interest
Earned
Debt-to-Equity
Ratio
Cash Flow
from Operations
to Capital
Expenditures
Debt
Service
Coverage
LO5

23. How much have creditors contributed compared to owners?
Debt-to-Equity Ratio
How much have creditors contributed compared to owners?
Total Liabilities
Total Stockholders’ Equity

24. For every dollar contributed by owners, creditors have loaned $.89
Debt-to-Equity Ratio
For every dollar contributed by owners, creditors have loaned $.89
Total Liabilities
Total Stockholders’ Equity
= .89

25. Net Income + Interest Expense + Income Tax Expense
Times Interest Earned
Measures ability to meet current interest payments
The greater the coverage the better
Net Income + Interest Expense + Income Tax Expense
Interest Expense

26. Debt Service Coverage
Measures amount of cash from operating activities available to “service” the debt
Cash Flow from Operations Before
Interest and Tax Payments
Interest and Principal Payments

27. Cash Flow from Operations to Capital Expenditures Ratio
Measures company’s ability to use operations (vs. creditors and owners) to finance its acquisitions of productive assets
Cash Flow from Operations – Total Dividends Paid
Cash Paid for Acquisitions

28. Profitability Analysis
Rate of Return on Assets
Return on Common Stockholders’ Equity
Earnings per Share
Price/Earnings Ratio
Dividend Ratios
LO6

29. Net Income + Interest Expense, Net of Tax
Return on Assets Ratio
Measures return to all providers of capital (creditors and owners)
Net Income + Interest Expense, Net of Tax
Average Total Assets

30. Return on Common Stockholders’ Equity
Net Income – Preferred Dividends
Average Common Stockholders’ Equity
The owners
earned 15%
on their investment
in ABC Co...
Not bad!

31. Earnings per Share Presents profits on a per-share basis
Net Income – Preferred Dividends
Weighted Average Number of
Common Shares Outstanding

32. Price/Earnings Ratio Current Market Price Earnings per Share
Relates earnings to the market price of the stock
Current Market Price
Earnings per Share
very high P/E
very low P/E
possibly overpriced
possibly underpriced

33. Price/Earnings Ratio
Both companies have earnings of $2 per share. So why the different P/E ratios?
P/E Ratios
Co. A = 9 to 1
Co. B = 8 to 1

34. Common Dividends per Share
Dividend Payout Ratio
Common Dividends per Share
Earnings per Share
We need to
decide what percentage of the firm’s income we can return to owners

35. Common Dividends per Share
Dividend Yield Ratio
Investors willing to forgo dividends in lieu of price appreciation
Common Dividends per Share
Market Price per Share
usually
< 5% =

36. Accounting Tools: Reporting and Analyzing Other Income Statement Items
Appendix
Accounting Tools: Reporting and Analyzing Other Income Statement Items

37. Common Characteristics
All such items are reported after income from continuing operations
Reported separately
Shown net of tax effects
Most analysts ignore these items, since they are not likely to reoccur
LO7

38. Discontinued Operations
Any gain or loss from disposal of a division or segment of the business
Any net income or loss from operating this portion until the date of disposal

39. Extraordinary Items Gain or loss due to an event that is
Unusual in nature AND
Infrequent in occurrence

40. End of Chapter 13