1. Chapter 15 Financial Statement Analysis Student Version
These slides should be viewed using the presentation mode (left click your mouse on the icon).

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

3. LO 1
Horizontal Analysis
The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis.

4. Horizontal Analysis LO 1 Horizontal Analysis: Difference $17,000
Lincoln
Horizontal Analysis:
Difference $17,000
Base year (2011) $533,000
= 3.2%

5. Horizontal Analysis LO 1 Horizontal Analysis: Difference $25,800
Lincoln
Horizontal Analysis:
Difference $25,800
Base year (2011) $64,700
= 39.9%

6. Horizontal Analysis LO 1 Horizontal Analysis: Difference $296,500
Lincoln
Horizontal Analysis:
Difference $296,500
Base year (2011) $1,234,000
= 24.0%

7. Horizontal Analysis LO 1 Horizontal Analysis: Difference $37,500
Lincoln
Horizontal Analysis:
Difference $37,500
Base year (2011) $ 100,000
= 37.5%

8. LO 1
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.
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.

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

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

11. Common-Sized Statements
LO 1
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.

12. Learning Objective 2
Use financial statement analysis to assess the liquidity and solvency of a business.

13. Liquidity and Solvency Analysis
LO 2
Liquidity and Solvency Analysis
All users of financial statements are interested in the ability of a company to do the following:
Maintain liquidity and solvency.
Earn income, called profitability.

14. Current Position Analysis
LO 2
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 and includes the computation and analysis of the following:
Working capital
Current ratio
Quick ratio

15. LO 2
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

16. LO 2
Current Ratio
The current ratio, sometimes called the working capital ratio or bankers’ 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

17. 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

18. LO 2
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.

19. 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

20. Accounts Receivable Turnover
LO 2
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 liquidity.
The accounts receivable turnover is computed as follows:
Accounts Receivable Turnover =
Net Sales
Average Accounts Receivable

21. Accounts Receivable Turnover
LO 2
Accounts Receivable Turnover
Lincoln
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

22. Number of Days’ Sales in Receivables
LO 2
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

23. Number of Days’ Sales in Receivables
LO 2
Number of Days’ Sales in Receivables
Lincoln
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

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

25. LO 2
Inventory Turnover
Lincoln
Lincoln’s inventory balance at the beginning of 2011 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

26. Number of Days’ Sales in Inventory
LO 2
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

27. Number of Days’ Sales in Inventory
LO 2
Number of Days’ Sales in Inventory
Lincoln
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

28. Long-Term Liabilities
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 =

29. 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.
Lincoln
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

30. Ratio of Liabilities to Stockholders’ Equity
LO 2
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:
Lincoln
Ratio of Liabilities to Stockholders’ Equity
Total Liabilities
Total Stockholders’ Equity =

31. Ratio of Liabilities to Stockholders’ Equity
LO 2
Ratio of Liabilities to Stockholders’ Equity
The ratio of liabilities to stockholders’ equity for Lincoln Company is computed below.
Lincoln
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

32. Number of Times Interest Charges Earned
LO 2
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.

33. Number of Times Interest Charges Earned
LO 2
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 =

34. Number of Times Interest Charges Earned
LO 2
Number of Times Interest Charges Earned
The number of times interest charges are earned for Lincoln Company is computed below.
Lincoln
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

35. Number of Times Preferred Dividends Are Earned
LO 2
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 =

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

37. Profitability Analysis
LO 3
Profitability Analysis
Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business.

38. Ratio of Net Sales to Assets
LO 3
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) =

39. Ratio of Net Sales to Assets
LO 3
Ratio of Net Sales to Assets
Lincoln
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

40. Rate Earned on Total Assets
LO 3
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 =

41. Rate Earned on Total Assets
LO 3
Rate Earned on Total Assets
Lincoln
This ratio for Lincoln Company is computed below. Total assets are $1,187,500 at the beginning of 2011.
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

42. Rate Earned on Stockholders’ Equity
LO 3
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 =

43. Rate Earned on Stockholders’ Equity
LO 3
Rate Earned on Stockholders’ Equity
The rate for Lincoln Company is computed below. Total stockholders’ equity is $750,000 at the beginning of 2011.
Lincoln
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

44. Rate Earned on Stockholders’ Equity
LO 3
Rate Earned on Stockholders’ Equity
The difference between the rate earned on stockholders’ equity and the rate earned on total assets is called leverage.
For Lincoln Company, the effect of leverage is computed as follows:
Lincoln
Rate earned on stockholders’ equity 11.3% 10.0%
Less rate earned on total assets
Effect of leverage 3.1% 2.7%

45. Rate Earned on Common Stockholders’ Equity
LO 3
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 =

46. Rate Earned on Common Stockholders’ Equity
LO 3
Rate Earned on Common Stockholders’ Equity
Lincoln Company had $150,000 of 6% preferred stock outstanding on December 31, 2012 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:
Lincoln
(continued)

47. Rate Earned on Common Stockholders’ Equity
LO 3
Rate Earned on Common Stockholders’ Equity
Lincoln
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

48. Earnings per Share on Common Stock
LO 3
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 =

49. Earnings per Share on Common Stock
LO 3
Earnings per Share on Common Stock
Lincoln
Earnings per share 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

50. LO 3
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 =

51. LO 3
Price-Earnings Ratio
Lincoln
The price-earnings 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

52. LO 3
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)

53. Shares of Common Stock Outstanding
LO 3
Dividends per Share
Lincoln
Dividends per Share
Dividends
Shares of Common Stock Outstanding =
The dividends per share for Lincoln Company are computed below.
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

54. LO 3
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 =

55. LO 3
Dividend Yield
Lincoln
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

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

57. Corporate Annual Reports
LO 4
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

58. Report on Internal Control
LO 4
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.

59. Report on Fairness of Financial Statements
LO 4
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.

60. Financial Statement Analysis
The End