1. Financial Statement Analysis
Chapter 15
Financial Statement Analysis

2. Answer: Financial Statement Analysis
Introduction
How can we determine:
The ability of an organization to pay loans?
Whether we are earning a fair return on our investment?
The adequacy of cash flow to pay operating expenses?
How to improve the overall performance of the company?
Answer: Financial Statement Analysis

3. Why Analyze Financial Statements?
Ratio analysis provides additional information necessary to enhance the decision-making ability of the users of the information.

4. Limitations of Financial Statement Analysis
When comparing companies and interpreting financial statement analysis, differences in accounting methods and cost flow assumptions need to be considered.

5. Limitations of Financial Statement Analysis
Rather than focus on a single ratio, decision makers need to evaluate a company by comparing ratios to those of previous years, budgeted amounts, and industry standards.

6. Horizontal Analysis
Horizontal analysis is used to analyze changes in accounts occurring between years.

7. Vertical Analysis
Vertical analysis uses common-size financial statements to remove size as a relevant variable in ratio analysis.

8. Vertical Analysis
Working Capital = Current Assets – Current Liabilities
Measure of an entity’s LIQUIDITY, or its ability to meet its immediate financial obligations
More useful if we have information concerning the makeup of Working Capital

9. Vertical Analysis Common-Size Comparative Income Statements
Percentages are based on NET sales
The gross profit percentage is usually closely watched

10. Current Ratio or Working Capital Ratio
Current Assets
Current Ratio =
Current Liabilities
Measures the entity’s liquidity.
This ratio tells us the amount of current assets for every dollar of current liabilities.
What is considered to be a good Current Ratio?

11. Number of Days’ Sales in Receivables
Number of Days in the Period
Accounts Receivable Turnover
This ratio is the average number of days to collect a credit sale.
This ratio varies according to the credit policy of the particular business and the industry standards.
This ratio has an impact on Return On Investment.

12. Inventory Turnover Ratio
Cost of Goods Sold
Average Inventory
Determines how many times during the period the cost of the inventory was sold.
Determining what is good is dependent on the industry and company standards.
For example, grocery stores would have a much higher expected turnover than car dealerships.

13. Net Income + Interest Expense (net of tax)
Return on Assets
Net Income + Interest Expense (net of tax)
Average Total Assets
Considers the return to investors on all assets invested in the company.
Interpretation is based on the company’s required return on assets, industry standards, and trends.

14. Price Earnings Ratio
Current Market Price
EPS
Important for investors because of the relationship of earnings to dividends and the market price of a company’s stock.
P/E ratio is very dependent on the industry.