1. Financial Statement Analysis17
Financial Statement Analysis
Student Version

2. Describe basic financial statement analytical methods.1
Describe basic financial statement analytical methods.
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3. 1
Horizontal Analysis
The percentage analysis of increases and decreases in related items using comparative financial statements is called horizontal analysis.

4. 1 Exhibit 1 Comparative Balance Sheet—Horizontal Analysis
Difference $17,000
Base year (2009) $533,000
= 3.2%

5. 1 Comparative Schedule of Current Assets—Horizontal Analysis Exhibit 2
Difference $25,800
Base year (2009) $64,700
= 39.9%

6. 1 Comparative Income Statement—Horizontal Analysis Exhibit 3
Increase amount $296,500
Base year (2009) $1,234,000
= 24.0%

7. 1 Comparative Retained Earnings Statement—Horizontal Analysis
Exhibit 4
Horizontal Analysis:
Increase amount $37,500
Base year (2009) $100,000
= 37.5%

8. X – whatever you are comparing X to*
*also known as the “base”

9. Horizontal analysis shows trends over time.
Cautions about horizontal analysis
Many people will think of a simple linear regression when they see a trend, which is not always the case
Many people will make predictions based on too few observations, and their predictions may seem reasonable given their limited frame of reference

10. 1
Vertical Analysis
A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis.

11. Vertical Analysis of Balance Sheet1
Vertical Analysis of Balance Sheet
In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.

12. 1 Exhibit 5 Compar-ative Balance Sheet—Vertical Analysis
Current assets $550,000
Total assets $1,139,500
= 48.3%

13. Vertical Analysis of the Income Statement1
Vertical Analysis of the Income Statement
In a vertical analysis of the income statement, each item is stated as a percent of net sales.

14. 1 Comparative Income Statement—Vertical Analysis Exhibit 6
Selling expenses $191,000
Net sales $1,498,000
= 12.8%

15. Common-Size Statements1
Common-Size Statements
In a common-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with with industry percentages.

16. 1
Exhibit 7
Common-Sized Income Statement

17. Use financial statement analysis to assess the solvency of a business.2
Use financial statement analysis to assess the solvency of a business.
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18. So, solvency is a very important topic!
Measures of solvency are important to determine the ability of a business to pay its creditors.
If a business can’t pay it’s creditors, it is technically
BANKRUPT.
So, solvency is a very important topic!

19. 2
Working Capital
The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company’s ability to pay current liabilities.

20. Working Capital = Current Assets – Current Liabilities2
Working Capital = Current Assets – Current Liabilities
Current assets $550,000 $533,000
Current liabilities –210,000 –243,000
Working capital $340,000 $290,000
Indicates the ability to pay bills as they come due and pay for current operations.
Does not tell you what current expenses are.

21. 2
Current Ratio
The current ratio, sometimes called the working capital ratio or bankers’ ratio measures a company’s ability to pay its current liabilities.

22. 2
Current Assets
Current Liabilities
Current Ratio =
Shows the number of times assets could cover liabilities. Indicates likelihood of payment of liabilities.
Current assets $550,000 $533,000
Current liabilities $210,000 $243,000
Current ratio
$550,000
$210,000
$533,000
$243,000
Again, however, it does not address expenses.

23. 2
Quick Ratio
A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio or acid-test ratio.

24. 2
The quick ratio deducts inventory and uncollectible accounts allowances from assets to determine the cash available to repay debts.
Quick assets are cash and other current assets that can be quickly converted to cash.
Quick assets:
Cash $ 90,500 $ 64,700
Temporary Investments 75,000 60,000
Accounts receivable (net) 115, ,000
a. Total quick assets $280,500 $244,700
b. Current liabilities $210,000 $243,000
Quick ratio (a ÷ b)

25. Analysis Example Step 1: Descriptions
Select the facts that give the reader a
Comprehensive and fair view
of the company’s operations.
This section should be primarily descriptive. Write the narrative from an internal accountant’s perspective.

26. Lincoln Company had net sales of $1,480,000 in 2010, with operating expenses of $290,000.
Lincoln currently has $340,000 in working capital, an increase of $50,000 over last year.
Our current ratio has improved from 2.2 to 2.6, and our quick ratio has improved from 1.0 to 1.3.

27. Analysis Example Step 2: Comparisons
Make comparisons to other companies and industry.

28. Lincoln’s primary competitors are Madison Company, Sugarland Inc
Lincoln’s primary competitors are Madison Company, Sugarland Inc. and Bowland Ltd. The quick ratio for competitors and the industry overall are displayed in the table below.
Lincoln
Madison
Sugarland
Bowland
Industry
2009
1.0
3.0
.99
1.8
2010
1.3
6.0
1.2

29. Analysis Example Step 3: Discussion
Evaluate the result of your analysis and explain any differences (if you can) from media reports, competitor press releases, or general economic news.

30. Our current ratio of 1.3 is average compared to our competitors and industry standards.
Madison Company has been selling off its real estate holdings resulting in large inflows of cash for the last two years, resulting in a higher than normal current ratio.

31. Lincoln Company had net sales of $1,480,000 in 2010, with operating expenses of $290,000.
Lincoln currently has $340,000 in working capital, an increase of $50,000 over last year.
Our current ratio has improved from 2.2 to 2.6, and our quick ratio has improved from 1.0 to 1.3.

32. Describe options available to improve the ratios.
Analysis Example
Step 4: Options
Describe options available to improve the ratios.

33. In order to improve our quick ratio, we could also sell off some of our fixed assets, as Madison is doing.
We may also consider: ?????
Brainstorming

34. Accounts Receivable Turnover2
Accounts Receivable Turnover
The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a company’s solvency.

35. Average Accounts Receivable2
Accounts Receivable Turnover =
Net Sales
Average Accounts Receivable
a. Net sales $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year , ,000
Total $ 235,000 $ 260,000
Average (Total ÷ 2) $ 117,500 $ 130,000
Accounts receivable turnover
(a ÷ b)

36. If available, it is better to use credit sales rather than net sales as the numerator. This gives a more accurate picture of accounts receivable turnover.

37. Average Collection Period2
Average Collection Period
The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding.
Number of Days’ Sales in Receivables
Average Accounts Receivable
Average Daily Sales =
Net Sales
365

38. 2 2010 2009 Average accounts receivable (Total accounts
Average accounts receivable
(Total accounts
receivable ÷ 2) $ 117,500 $ 130,000
Net sales $1,498,000 $1,200,000
Average daily sales
(Sales ÷ 365) $ ,104 $ ,288
Number of days’ sales in
receivables (a ÷ b)

39. The accounts receivables measures are helpful in determining how quickly the accounts receivables will generate cash.
These measures are used to evaluate the effectiveness of the sales, credit, and collections policies and procedures of a company.
To improve effectiveness in this area, changes to those areas may need attention.

40. Days Payables Outstanding
The number of days’ payables outstanding is an estimate of the length of time (in days) the accounts payables have been outstanding.

41.
Average accounts payable
(Total accounts
payable ÷ 2) $ 117,500 $ 130,000
Cost of goods $1,498,000 $1,200,000
Average cost of goods
(cogs ÷ 365) $ ,104 $ ,288
Number of days’ cogs in
Payables (a ÷ b)

42. To adjust the accounts payable cycle, what strategies might management consider?

43. 2
Inventory Turnover
The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory.

44. 2 Cost of Goods Sold Average Inventory Inventory Turnover = 2010 2009
a. Cost of goods sold $1,043,000 $ 820,000
Inventories:
Beginning of year $ 283,000 $ 311,000
End of year , ,000
Total $ 547,000 $ 594,000
Average (Total ÷ 2) $ 273,500 $ 297,000
Inventory turnover (a ÷ b)

45. Number of Days’ Sales in Inventory2
Number of Days’ Sales in Inventory
The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory.

46. Average Daily Cost of Goods Sold2
Average Inventory
Average Daily Cost of Goods Sold
Number of Days’ Sales in Inventory =
Cost of Goods Sold
365
a. Average inventory (Total ÷ 2) $ 273,500 $ 297,000
Cost of goods sold $1,043,000 $ 820,000
Average daily cost of goods
sold (COGS ÷ 365 days) $2,858 $2,247
Number of days’ sales in
inventory (a ÷ b)

47. In order to improve the inventory measures, management may implement changes in product mix or inventory management. Further information would be needed to determine the correct course of action.
Possible actions include:
Offering more frequent sales promotions
Discounting obsolete inventory
Implementing just-in-time inventory practices
Adjusting re-order points
. . . More???

48. The next three ratios measure the ability of the company to obtain long-term financing for fixed assets.

49. Ratio of Fixed Assets to Long-Term Liabilities2
Ratio of Fixed Assets to Long-Term Liabilities
The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis “Collateral”

50. Long-Term Liabilities2
Ratio of Fixed Assets to Long-Term Liabilities
Fixed Assets (net)
Long-Term Liabilities =
a. Fixed assets (net) $444,500 $470,000
b. Long-term liabilities $100,000 $200,000
Ratio of fixed assets to
long-term liabilities (a ÷ b)

51. Debt-to-Capital Ratio2
Debt-to-Capital Ratio
The relationship between the total claims of the creditors and owners—the ratio of liabilities to stockholders’ equity—is a solvency measure that indicates the margin of safety for creditors.

52. Total Stockholders’ Equity2
Total Liabilities
Total Stockholders’ Equity
Ratio of Liabilities to Stockholders’ Equity =
a. Total liabilities $310,000 $443,000
b. Total stockholders’ equity $829,500 $787,500
Ratio of liabilities to
stockholders’ equity ( a÷ b)

53. Number of Times Interest Charges Earned2
Number of Times Interest Charges Earned
Corporations in some industries normally have high ratios of debt to stockholders’ equity. For such corporations, the relative risk of the debtholders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio.

54. 2 Income Before Income Tax + Interest Expense
Number of Times Interest Charges Earned =
Income before income tax $162,500 $134,600
a. Add interest expense , ,000
Amount available to meet
interest charges $168,500 $146,600
Number of times interest
charges earned (b ÷ a)

55. The three measures taken together tell creditors:
Long-term loans can be secured by fixed assets
Owners are “invested” in the assets
Earnings will cover interest payments
In order to improve the ability to secure long-term loans, managers may:
Provide additional equity
Increase earnings
Offer additional fixed assets to secure the loan

56. Sometimes, creditors will accept preferred stock to secure their loans
Sometimes, creditors will accept preferred stock to secure their loans. In that case they will use the following calculation:

57. Number of Times Preferred Dividends Are Earned2
Number of Times Preferred Dividends Are Earned
The number of times interest charges are earned can be adapted for use with dividends on preferred stock.
Number of Times Preferred Dividends Are Earned
Net Income
Preferred Dividends =

58. 3
Use financial statement analysis to assess the profitability of a business.
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59. The purpose of a business is to earn a profit
The purpose of a business is to earn a profit. If the investment in a business is not earning at least as much as the same amount of money invested in a certificate of deposit or other investment vehicle, why work so hard?
The next set of measures help to determine whether the business is profitable, and how it could be made more profitable.

60. Profitability Analysis3
Profitability Analysis
Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business.

61. Before we get started, let’s look at:
Net Sales: Sales after sales discounts and returns
&
Net Income: Generally, income after cost of goods and operating expenses and before interest, taxes, and depreciation and amortization (EBITDA, EBITD, EBIT, etc.)

62. Ratio of Net Sales to Assets3
Net Sales
Average Total Assets
Ratio of Net Sales to Assets =
a. Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044, ,053,000
Total $2,097,500 $2,063,000
b. Average (Total ÷ 2) $1,048,750 $1,031,500
Ratio of net sales to assets (a ÷ b)

63. This measure shows how well assets are being used to generate sales
This measure shows how well assets are being used to generate sales. Specific industries use variations of this measure, such as:
Sales per square foot
Sales per room (hotel)
Sales per employee

64. 3 Net Income + Interest Expense Average Total Assets
Rate Earned on Total Assets =
Net income $ ,000 $ ,500
Plus interest expense , ,000
a. Total $ ,000 $ ,500
Total assets:
Beginning of year $1,230,500 $1,187,500
End of year 1,139, ,230,500
Total $2,370,000 $2,418,000
b. Average (Total ÷ 2) $1,185,000 $1,209,000
Rate earned on total
assets (a ÷ b) % %

65. Market Measures of Profitability for Public Corporations

66. 3 Net Income Rate Earned on Stockholders’ Equity
Average Total Stockholders’ Equity
Rate Earned on Stockholders’ Equity =
a. Net income $ ,000 $ ,500
Stockholders’ equity:
Beginning of year $ 787,500 $ 750,000
End of year , ,500
Total $1,617,000 $1,537,500
b. Average (Total ÷ 2) $ 808,500 $ 768,750
Rate earned on stockholders’
equity (a ÷ b) % %

67. 3 Net Income – Preferred Dividends Average Common Stockholders’ Equity
Rate Earned on Common Stockholders’ Equity =
Net income $ ,000 $ ,500
Less preferred dividends , ,000
a. Remainder—common stock $ ,000 $ ,500
Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000
End of year , ,500
Total $1,317,000 $1,237,500
b. Average (Total ÷ 2) $ 658,500 $ 618,750
Rate earned on common
stockholders’ equity (a ÷ b) % %

68. 3 Net Income – Preferred Dividends Shares of Common Stock Outstanding
Earnings per Share (EPS) on Common Stock =
Net income $91,000 $76,500
Preferred dividends 9, ,000
Remainder—identified with
common stock $82,000 $67,500
b. Shares of common stock 50,000 50,000
Earnings per share on common
stock (a ÷ b) $ $1.35

69. 3 Market Price per Share of Common Stock
Earnings per Share on Common Stock
Price-earnings (P/E) ratio =
Market price per share of
common stock $41.00 $27.00
Earnings per share on common
stock ÷ ÷ 1.35
Price-earnings ratio on
common stock

70. Shares of Common Stock Outstanding3
Dividends
Shares of Common Stock Outstanding
Dividends per Share =
a. Dividends $40,000 $30,000
b. Shares of common stock outstanding 50,000 50,000
Dividends per share of common stock
(a ÷ b) $ $0.60

71. 3 Dividend yield on Dividends per Share of Common Stock
Market Price per Share of Common Stock
Dividend Yield =
a. Dividends per share of
common stock $ 0.80 $ 0.60
b. Market price per share of
common stock
Dividend yield on
common stock % %