1. © 2014 Cengage Learning. All Rights Reserved.
Learning Objective
LO1 Analyze an income statement using vertical analysis.
© 2014 Cengage Learning. All Rights Reserved.

2. Vertical Analysis Ratios
Lesson 17-1
Vertical Analysis Ratios
LO1
Vertical analysis ratios measure the relationship between one financial statement item and another item on the same financial statement.
On the income statement, vertical analysis ratios focus on the ability of a business to earn a profit.
A ratio that measures the ability of a business to generate income is called a profitability ratio.
Continued on the next slide.

3. Vertical Analysis Ratios
Lesson 17-1
Vertical Analysis Ratios
LO1
Vertical analysis ratios on an income statement are examples of profitability ratios.
Managers use vertical analysis ratios to help make business decisions.
For vertical analysis to be an effective tool, a business must set a target, or standard, for each ratio.
A standard used to compare financial performance is called a benchmark.

4. Factors Used to Determine Benchmark Ratios
Lesson 17-1
Factors Used to Determine Benchmark Ratios
LO1
Actual ratios from prior fiscal periods
Industry standards published by industry organizations
Business plans
Unexpected events

5. Analyzing Trends with Vertical Analysis
Lesson 17-1
Analyzing Trends with Vertical Analysis
LO1
Financial statements that provide information for multiple fiscal periods are called comparative financial statements.
An analysis of changes over time is called trend analysis.
Net income after federal income tax as a percent of net sales is called profit margin.

6. Analyzing Trends with Vertical Analysis
Lesson 17-1
Analyzing Trends with Vertical Analysis
LO1

7. Using Vertical Analysis to Analyze Gross Profit
Lesson 17-1
Using Vertical Analysis to Analyze Gross Profit
LO1
Gross profit as a percent of net sales is called gross margin.
This ratio is also referred to as gross profit margin.

8. Correcting an Unfavorable Gross Margin
Lesson 17-1
Correcting an Unfavorable Gross Margin
LO1
Increase unit sales prices
Decrease the unit cost of merchandise

9. Using Vertical Analysis to Analyze Operating Expenses
Lesson 17-1
Using Vertical Analysis to Analyze Operating Expenses
LO1
Income from operations as a percent of net sales is called the operating margin.
This ratio is also referred to as the rate of return on sales.
Total operating expenses as a percent of net sales is called the operating expense ratio.

10. Correcting an Unfavorable Operating Expense Ratio
Lesson 17-1
Correcting an Unfavorable Operating Expense Ratio
LO1
Reduce operating expenses
Modify the benchmark
Increase net sales

11. Lesson 17-1 Audit Your Understanding
1. Identify four factors that management can use to determine benchmark financial ratios.
ANSWER
1. Actual ratios from prior fiscal periods
2. Industry standards published by industry organizations
3. Business plans
4. Unexpected events

12. Lesson 17-1 Audit Your Understanding
2. Why should a business be cautious about increasing the markup on merchandise purchased for sale?
ANSWER
If the increase in markup is too large, a decrease in sales revenue could occur for two reasons: (1) the sales price may exceed what customers are willing to pay or (2) customers may elect to purchase from competing businesses having lower prices.

13. Lesson 17-1 Audit Your Understanding
3. What are two practices that can be used to reduce the cost of merchandise?
ANSWER
Purchase merchandise in larger quantities or from other vendors offering a lower cost

14. Lesson 17-1 Audit Your Understanding
4. Should managers interested in reducing operating expenses focus more on the operating expense ratio or the operating margin?
ANSWER
Operating expense ratio

15. Lesson 17-1 Audit Your Understanding
5. What are three possible actions to correct an unfavorable operating expense ratio?
ANSWER
Reduce operating expenses
Modify the benchmark
Increase net sales

16. © 2014 Cengage Learning. All Rights Reserved.
Learning Objectives
LO2 Perform vertical analysis of a balance sheet.
LO3 Analyze a balance sheet using vertical analysis.
© 2014 Cengage Learning. All Rights Reserved.

17. Calculating Vertical Analysis Ratios on a Balance Sheet
Lesson 17-2
Calculating Vertical Analysis Ratios on a Balance Sheet
LO2
Asset Amounts Divided by Total Assets 1
Liability and Stockholders’ Equity Amounts Divided by Total Assets 2

18. Evaluating Vertical Analysis Asset Ratios
Lesson 17-2
Evaluating Vertical Analysis Asset Ratios
LO3

19. Evaluating Vertical Analysis Liability Ratios
Lesson 17-2
Evaluating Vertical Analysis Liability Ratios
LO3
A ratio that measures the ability of a business to pay its long-term liabilities is called a solvency ratio.
Total liabilities divided by total assets is called the debt ratio.

20. Evaluating Vertical Analysis Liability Ratios
Lesson 17-2
Evaluating Vertical Analysis Liability Ratios
LO3

21. Lesson 17-2 Audit Your Understanding
1. Why do many retailers perform vertical analysis on the Accounts Receivable and Merchandise Inventory accounts?
ANSWER
First, these are typically two of the largest asset accounts for a retail merchandising business.
Second, industry standards are available for these accounts.

22. Lesson 17-2 Audit Your Understanding
2. What may cause a vertical analysis ratio for accounts receivable to be below the target range?
ANSWER
A ratio below the target range may indicate that a company is restricting customers’ ability to purchase on account. This action may have a negative effect on sales.

23. Lesson 17-2 Audit Your Understanding
3. What may cause a vertical analysis ratio for merchandise inventory to be below the target range?
ANSWER
The business may not be stocking an adequate supply or variety of merchandise.

24. Lesson 17-2 Audit Your Understanding
4. What should a company do if the vertical analysis ratio for merchandise inventory is above the target range?
ANSWER
The company should prepare a list of the inventory items having the largest cost. The company should assess whether the proper quantity of each item is available for sale. Future inventory purchases should ensure that the optimal quantity on hand is maintained.

25. Lesson 17-2 Audit Your Understanding
5. Why is it risky for a business to have too many liabilities?
ANSWER
The business must be able to pay its liabilities on a timely basis. If sales decline during difficult financial times, a business may be unable to make its monthly payments.

26. © 2014 Cengage Learning. All Rights Reserved.
Learning Objectives
LO4 Perform horizontal analysis on an income statement.
LO5 Perform horizontal analysis on a balance sheet.
© 2014 Cengage Learning. All Rights Reserved.

27. Analyzing Trends with Horizontal Analysis
Lesson 17-3
Analyzing Trends with Horizontal Analysis
LO4
A comparison of one item on a financial statement with the same item on a previous period’s financial statement is called horizontal analysis.
Current Period −
Prior Period =
Increase (Decrease)
$242,584.00 −
$221,489.00 =
$21,095.00
Increase
(Decrease) ÷
Prior Period =
Horizontal Analysis Ratio
$21,095.00 ÷
$221,489.00 =
9.5%

28. Horizontal Analysis of an Income Statement
Lesson 17-3
Horizontal Analysis of an Income Statement
LO4
Current Year Less Prior Year 1
Difference Amount Divided by Prior Year 2

29. Horizontal Analysis of a Balance Sheet
Lesson 17-3
Horizontal Analysis of a Balance Sheet
LO5

30. Lesson 17-3 Audit Your Understanding
1. How could a 2.0% decrease in supplies expense be an unfavorable trend?
ANSWER
If management took actions that should have decreased supplies expense by significantly more than 2.0%, then only a 2% decrease would be unfavorable.

31. Lesson 17-3 Audit Your Understanding
2. How does a publicly held corporation use horizontal analysis when reporting to the Securities and Exchange Commission?
ANSWER
The document filed with the Securities and Exchange Commission contains a section titled Management’s Discussion and Analysis of Financial Condition and Results of Operations and Results of Operations. Management often uses these ratios to explain the current year’s results of operations compared to previous years.

32. © 2014 Cengage Learning. All Rights Reserved.
Learning Objectives
LO6 Calculate earnings per share.
LO7 Calculate and interpret market ratios.
LO8 Calculate and interpret liquidity ratios.
© 2014 Cengage Learning. All Rights Reserved.

33. Lesson 17-4
Earnings per Share
LO6
Net income after federal income tax divided by the number of outstanding shares of stock is called earnings per share.
Earnings per share is often abbreviated as EPS.
Net Income after Federal Income Tax
$ 79,896.57
Number of Shares Outstanding
÷ 7,500
÷ 75,000
Earnings per Share
$ 10.65
$ 1.07

34. Lesson 17-4
Market Ratios
LO7
A ratio that measures a corporation’s financial performance in relation to the market value of its stock is called a market ratio.

35. Lesson 17-4
Dividend Yield
LO7
The relationship between dividends per share and market price per share is called the dividend yield.
Dividends per Share ÷
Market Price per Share =
Dividend Yield
$2.00 ÷
$228.75 =
0.87%

36. Lesson 17-4
Price-Earnings Ratio
LO7
The relationship between the market value per share and earnings per share of a stock is called the price-earnings ratio.
It is often referred to as the P/E ratio.
Market Price per Share ÷
Earnings per Share =
Price-Earnings Ratio
$228.75 ÷
$10.65 =
21.5

37. Lesson 17-4
Liquidity Ratios
LO8
A ratio that measures the ability of a business to pay its current financial obligations is called a liquidity ratio.

38. Lesson 17-4
Working Capital
LO8
The amount of current assets less current liabilities is called working capital.
Current Assets −
Current Liabilities =
Working Capital
$185,322.90 −
$32,251.78 =
$153,071.12

39. Lesson 17-4
Current Ratio
A ratio that measures the relationship of current assets to current liabilities is called the current ratio.
The current ratio measures a company’s ability to pay its current liabilities when due.
Current Assets ÷
Current Liabilities =
Current Ratio
$185,322.90 ÷
$32,251.78 =
5.75

40. Lesson 17-4
Quick Ratio
Cash and other current assets that can be quickly converted into cash are called quick assets.
Quick assets are also referred to as liquid assets.
A ratio that measures the relationship of quick assets to current liabilities is called the quick ratio.

41. Quick Ratio Cash + Accounts Receivable = Quick Assets $54,444.34 +
Lesson 17-4
Quick Ratio
Cash +
Accounts Receivable =
Quick Assets
$54,444.34 +
$17,872.56 =
$72,316.90
Quick Assets ÷
Current Liabilities =
Quick Ratio
$72,316.90 ÷
$32,251.78 =
2.24

42. Lesson 17-4 Audit Your Understanding
1. Why can one corporation’s earnings per share not be compared to the EPS of other corporations?
ANSWER
Each corporation’s EPS is a unique number because corporations can issue any number of shares. As a result, the earnings of each corporation are divided by a different number of shares.

43. Lesson 17-4 Audit Your Understanding
2. What group is the primary user of market ratios?
ANSWER
Investors

44. Lesson 17-4 Audit Your Understanding
3. Do income stocks typically have low or high dividend yields?
ANSWER
High

45. Lesson 17-4 Audit Your Understanding
4. Do growth stocks typically have low or high price-earnings ratios?
ANSWER
High

46. Lesson 17-4 Audit Your Understanding
5. What is the primary source of data to calculate liquidity ratios?
ANSWER
Balance sheet

47. Lesson 17-4 Audit Your Understanding
6. What does working capital measure?
ANSWER
Working capital is a measure of the financial resources available for the daily operations of the business.

48. Lesson 17-4 Audit Your Understanding
7. Why is the current ratio a useful measure of financial strength?
ANSWER
The current ratio permits a business to compare itself to its industry or to provide a convenient relative measurement from year to year regarding the company’s ability to pay current liabilities when due.