1. Financial Statement Analysis
Chapter 15

2. Learning Objectives
Describe basic financial statement analytical methods.
Use financial statement analysis to assess the solvency of a business.
Use financial statement analysis to assess the profitability of a business.
Describe the contents of corporate annual reports.

3. Learning Objective 1
Describe basic financial statement analytical methods.

4. Basic Analytical Methods
Users analyze a company’s financial statements using a variety of analytical methods. Three such methods are as follows:
Horizontal analysis
Vertical analysis
Common-sized statements

5. Horizontal Analysis
The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis.

6. Horizontal Analysis

7. Horizontal Analysis Horizontal Analysis: Difference $17,000
Base year (2013) $533,000
= 3.2%

8. Horizontal Analysis

9. Horizontal Analysis Horizontal Analysis: Difference $25,800
Base year (2013) $64,700
= 39.9%

10. Horizontal Analysis

11. Horizontal Analysis Horizontal Analysis: Difference $296,500
Base year (2013) $1,234,000
= 24.0%

12. Horizontal Analysis

13. Horizontal Analysis Horizontal Analysis: Difference $37,500
Base year (2013) $ 100,000
= 37.5%

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

15. Vertical Analysis
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.

16. Vertical Analysis

17. Vertical Analysis Vertical Analysis: Current Assets $550,000
Total Assets $ 1,139,500
= 48.3%

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

19. Vertical Analysis

20. Vertical Analysis Vertical Analysis: Selling expenses $191,000
Net sales $1,498,000
= 12.8%

21. Common-Sized Statements
In a common-sized statement, all items are expressed as percentages with no dollar amounts shown.
Common-sized statements are useful for comparing the current period with prior periods, individual businesses with one another, or one business with industry averages.

22. Common-Sized Statements

23. Learning Objective 2
Use financial statement analysis to assess the solvency of a business.

24. Solvency Analysis
All users of financial statements are interested in the ability of a company to do the following:
Meet its financial obligations (debts), called solvency.
Earn income, called profitability.

25. Solvency Analysis
Solvency analysis focuses on the ability of a business to pay its current and noncurrent liabilities.
Solvency and profitability are interrelated. A company that cannot pay its debts will have difficulty obtaining credit, which can decrease its profitability.

26. Current Position Analysis
A company’s ability to pay its current liabilities is called current position analysis. It is of special interest to short-term creditors.

27. Working Capital
The excess of current assets over current liabilities is called working capital. Working capital is often used to evaluate a company’s ability to pay current liabilities.
Working capital is computed as follows:
Working Capital = Current Assets – Current Liabilities

28. Current Ratio
The current ratio, sometimes called the working capital ratio, also measures a company’s ability to pay its current liabilities.
The current ratio is computed as follows:
Current Ratio =
Current Assets
Current Liabilities

29. Current Ratio The current ratio for Lincoln Company is computed below.
Current assets $550,000 $533,000
Current liabilities $210,000 $243,000
Current ratio
$550,000
$210,000
$533,000
$243,000

30. Quick Ratio
A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio, or acid-test ratio. It is computed as follows:
Quick Ratio =
Quick Assets
Current Liabilities
Quick assets are cash and other assets that can be easily converted to cash.

31. Quick Assets The quick ratio for Lincoln Company is computed below.
Quick assets:
Cash $ 90,500 $ 64,700
Temporary Investments 75,000 60,000
Accounts receivable (net) , ,000
Total quick assets $280,500 $244,700
Current liabilities $210,000 $243,000
Quick ratio
$280,500
$210,000
$244,700
$243,000

32. Accounts Receivable Turnover
The relationship between sales and accounts receivable may be stated as accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a company’s solvency.
The accounts receivable turnover is computed as follows:
Accounts Receivable Turnover =
Net Sales
Average Accounts Receivable

33. Accounts Receivable Turnover
The accounts receivable turnover for Lincoln Company is computed below.
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
$1,498,000
$117,500
$1,200,000
$130,000

34. Number of Days’ Sales in Receivables
The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. It is computed as follows:
Number of Days’ Sales in Receivables
Average Accounts Receivable
Average Daily Sales =
Net Sales
365

35. Number of Days’ Sales in Receivables
The number of days’ sales in receivables for Lincoln Company is computed below.
Average accounts receivable
(Total accounts receivable ÷ 2) $ 117,500 $ 130,000
Net sales $1,498,000 $1,200,000
Average daily sales
(Net sales ÷ 365) $ ,104 $ ,288
Number of days’ sales in receivables
$117,500
$4,104
$130,000
$3,288

36. 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 a firm in managing its inventory.
The inventory turnover is computed as follows:
Inventory Turnover =
Cost of Goods Sold
Average Inventory

37. Inventory Turnover
Lincoln’s inventory balance at the beginning of is $311,000.
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
$1,043,000
$273,500
$820,000
$297,000

38. 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.
The number of days’ sales in inventory is computed as follows:
Number of Days’ Sales in Inventory
Average Inventory
Average Daily Cost of Goods Sold =
Cost of Goods Sold
365

39. Number of Days’ Sales in Inventory
The number of days’ sales in inventory for Lincoln Company is computed below.
Average Inventory $273,500 $297,000
$547,000 ÷ 2
$594,000 ÷ 2
(continued)

40. Number of Days’ Sales in Inventory
The number of days’ sales in inventory for Lincoln Company is computed below.
Average Inventory $273,500 $297,000
Average daily cost of goods sold $2,858 $2,247
$1,043,000 ÷ 365
$820,000 ÷ 365
Number of days’ sales in inventory
$273,500
$2,858
$297,000
$2,247

41. 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 note-holders or bondholders. It also indicates the ability of the business to borrow additional funds on a long- term basis.
The ratio is computed as follows:
Ratio of Fixed Assets to Long-Term Liabilities
Fixed Assets (net)
Long-Term Liabilities =

42. Ratio of Fixed Assets to Long-Term Liabilities
To illustrate, the ratio of fixed assets to long- term liabilities for Lincoln Company is computed below.
Fixed assets (net) $444,500 $470,000
Long-term liabilities $100,000 $200,000
Ratio of fixed assets to
long-term liabilities
$444,500
$100,000
$470,000
$200,000

43. Ratio of Liabilities to Stockholders’ Equity
The relationship between the total claims of the creditors and the owners—the ratio of liabilities to stockholders’ equity—is a solvency measure that indicates the margin of safety for creditors.
The ratio is computed as follows:
Ratio of Liabilities to Stockholders’ Equity
Total Liabilities
Total Stockholders’ Equity =

44. Ratio of Liabilities to Stockholders’ Equity
The ratio of liabilities to stockholders’ equity for Lincoln Company is computed below.
Total liabilities $310,000 $443,000
Total stockholders’ equity $829,500 $787,500
Ratio of liabilities to
stockholders’ equity
$310,000
$829,500
$443,000
$787,500

45. 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 debt- holders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio.

46. Number of Times Interest Charges Earned
It is computed as follows:
Number of Times Interest Charges Are Earned
Income Before Income Tax + Interest Expense
Interest Expense =

47. Number of Times Interest Charges Earned
The number of times interest charges are earned for Lincoln Company is computed below.
Income before income tax $162,500 $134,600
Add interest expense , ,000
Amount available to meet
interest charges $168,500 $146,600
Number of times interest
charges earned
$146,600
$12,000
$168,500
$6,000

48. Number of Times Interest Charges Earned
The number of times interest charges are earned can be adapted for use with dividends on preferred stock.
The number of times preferred dividends are earned is computed as follows:
Number of Times Preferred Dividends Are Earned
Net Income
Preferred Dividends =

49. Learning Objective 3
Use financial statement analysis to assess the profitability of a business.

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

51. Ratio of Net Sales to Assets
The ratio of net sales to assets is a profitability measure that shows how effectively a company utilizes its assets.
The ratio is computed as follows:
Ratio of Net Sales to Assets
Net Sales
Average Total Assets
(excluding long-term investments) =

52. Ratio of Net Sales to Assets
The ratio of net sales to assets for Lincoln Company is computed below.
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
Average (Total ÷ 2) $1,048,750 $1,031,500
Excludes long-term investments
(continued)

53. Ratio of Net Sales to Assets
The ratio of net sales to assets for Lincoln Company is computed below.
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
Average (Total ÷ 2) $1,048,750 $1,031,500
Ratio of net sales to assets
$1,498,000
$1,048,750
$1,200,000
$1,031,500

54. Rate Earned on Total Assets
The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed.
It is computed as follows:
Rate Earned on Total Assets
Net Income Interest Expense
Average Total Assets =

55. Rate Earned on Total Assets
This ratio for Lincoln Company is computed below. Total assets are $1,187,500 at the beginning of 2013.
Net income $ ,000 $ ,500
Plus interest expense , ,000
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
Average (Total ÷ 2) $1,185,000 $1,209,000
Rate earned on total assets % %
$97,000
$1,185,000
$88,500
$1,209,000

56. Rate Earned on Stockholders’ Equity
The rate earned on stockholders’ equity measures the rate of income earned on the amount invested by the stockholders.
It is computed as follows:
Rate Earned on Stockholders’ Equity
Net Income
Average Total Stockholders’ Equity =

57. Rate Earned on Stockholders’ Equity
The rate for Lincoln Company is computed below. Total stockholders’ equity is $750,000 at the beginning of 2013.
Net income $ ,000 $ ,500
Stockholders’ equity:
Beginning of year $ 787,500 $ 750,000
End of year , ,500
Total $1,617,000 $1,537,500
Average (Total ÷ 2) $ 808,500 $ 768,750
Rate earned on stockholders’
equity % %
$91,000
$808,500
$76,500
$768,750

58. Rate Earned on Stockholders’ Equity
The difference between the rate earned on stockholders’ equity and the rate earned on total assets is called leverage.

59. Rate Earned on Stockholders’ Equity
For Lincoln Company, the effect of leverage is computed as follows:
Rate earned on stockholders’ equity 11.3% 10.0%
Less rate earned on total assets
Effect of leverage 3.1% 2.7%

60. Rate Earned on Stockholders’ Equity

61. Rate Earned on Common Stockholders’ Equity
The rate earned on common stockholders’ equity measures the rate of profits earned on the amount invested by the common stockholders.
It is computed as follows:
Rate Earned on Common Stockholders’ Equity
Net Income – Preferred Dividends
Average Common Stockholders’ Equity =

62. Rate Earned on Common Stockholders’ Equity
Lincoln Company had $150,000 of 6% preferred stock outstanding on December 31, and Thus, preferred dividends of $9,000 ($150,000 x 6%) are deducted from net income. Lincoln’s common stockholders’ equity is determined as follows:
(continued)

63. Rate Earned on Common Stockholders’ Equity
Net income $ ,000 $ ,500
Less preferred dividends , ,000
Total $ ,000 $ ,500
Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000
End of year , ,500
Total $1,317,000 $1,237,500
Average (Total ÷ 2) $ 658,500 $ 618,750
Rate earned on common
stockholders’ equity % %
$82,000
$658,500
$67,500
$618,750

64. Earnings per Share on Common Stock
Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock. GAAP requires the reporting of earnings per share in the income statement.
It is computed as follows:
Earnings per Share (EPS) on Common Stock
Net Income – Preferred Dividends
Shares of Common Stock Outstanding =

65. Earnings per Share on Common Stock
EPS for Lincoln Company is computed below.
Net income $91,000 $76,500
Less preferred dividends 9, ,000
Total $82,000 $67,500
Shares of common stock 50,000 50,000
Earnings per share on common stock $ $1.35
$82,000
50,000
$67,500
50,000

66. Price-Earnings Ratio
Another profitability measure quoted by the financial press is the price-earnings (P/E) ratio on common stock. The price-earnings ratio on common stock measures a company’s future earnings prospects.
The price-earnings ratio is computed as follows:
Price-earnings (P/E) ratio
Market Price per Share of Common Stock
Earnings per Share on Common Stock =

67. Price-Earnings Ratio
The P/E ratio for Lincoln Company is computed below.
Market price per share of
common stock $41.00 $27.00
Earnings per share on common
stock ÷ $1.64 ÷ $1.35
Price-earnings ratio on
common stock

68. Dividends per Share
Dividends per share can be reported with earnings per share to indicate the relationship between dividends and earnings.
Comparing these two per-share amounts measures the extent to which earnings are being distributed to common shareholders. The ratio for dividends per share is at the top of the next slide.
(continued)

69. Shares of Common Stock Outstanding
Dividends per Share
The dividends per share for Lincoln Company are computed below.
Dividends per Share
Dividends
Shares of Common Stock Outstanding =
Dividends on common stock $40,000 $30,000
Shares of common stock outstanding ÷ 50,000 ÷ 50,000
Dividends per share of common stock $ $0.60

70. Dividends and Earnings per Share

71. Dividend Yield
The dividend yield on common stock measures the rate of return to common stockholders from cash dividends.
It is of special interest to investors whose objective is to earn dividends from their investment. It is computed as follows:
Dividend Yield
Dividends per Share of Common Stock
Market Price per Share of Common Stock =

72. Dividend Yield
The dividend yield for Lincoln Company is computed below.
Dividends per share of
common stock $ $ 0.60
Market price per share of
common stock $41.00 $27.00
Dividend yield on common stock % %
$0.80
$41
$0.60
$27

73. Summary of Analytical Measures
(continued)

74. Summary of Analytical Measures
(concluded)

75. Learning Objective 4
Describe the contents of corporate annual reports.

76. Corporate Annual Reports
In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections:
Management discussion and analysis
Report on internal control
Report on fairness of the financial statements

77. Management Discussion and Analysis
Management’s Discussion and Analysis (MD&A) is required in annual reports filed with the SEC.
It contains management’s analysis of current operations and its plans for the future.
Typical items included in the MD&A are:
Management’s analysis and explanations of any significant changes between the current and prior year’s financial statements.
(continued)

78. Management Discussion and Analysis
Important accounting principles or policies that could affect interpretation of the financial statements.
Management’s assessment of the company’s liquidity and the availability of capital to the company.
Significant risk exposures that might affect the company.
Any “off-balance-sheet” arrangements such as leases not included directly in the financial statements.

79. Report on Internal Control
The Sarbanes-Oxley Act of 2002 requires a report stating management’s responsibility for establishing and maintaining internal control. In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report.
It also requires a public accounting firm to verify management’s conclusions on internal control.

80. Report on Fairness of Financial Statements
All publicly held corporations are required by the Sarbanes-Oxley Act of 2002 to have an independent audit (examination) of their financial statements. The CPA firm that conducts the audit renders an opinion on the fairness of the statements.

81. Unusual Items on the Income Statement
Appendix
Unusual Items on the Income Statement

82. Unusual Items on the Income Statement
Unusual items affecting the current period’s income statement include the following:
Discontinued operations
Extraordinary items

83. Discontinued Operations
A company may discontinue a segment of its operations by selling or abandoning the segment’s operations.
A note accompanying the income statement should describe the operations sold, including such details as the date operations were discontinued, the assets sold, and the effect (if any) on current and future operations.

84. Discontinued Operations
Jones Corporation produces and sells electrical products, hardware supplies, and lawn equipment. Because of lack of profits, Jones discontinues its electrical products operation and sells the remaining inventory and other assets at a loss of $100,000. Exhibit 11 (next slide) illustrates the reporting of the loss on the discontinued operations.

85. Discontinued Operations

86. Extraordinary Items
An extraordinary item is defined as an event or transaction with both of the following characteristics:
Unusual in nature
Infrequent in occurrence

87. Extraordinary Items

88. Reporting Earnings per Share

89. Financial Statement Analysis
The End