1. Financial Statement Analysis
Chapter 19
HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

2. Objectives
1. Perform a horizontal analysis of comparative financial statements
2. Perform vertical analysis of financial statements
3. Prepare common size financial statements
4. Calculate the standard financial ratios used for decision-makers
5. Use ratios in decision-making
6. Measure economic value added by a company’s operations

3. The Annual Report Usually Contains ...
financial statements.
footnotes to the financial statements.
a summary of accounting methods used.
management discussion and analysis of the financial results.
an auditor’s report.
comparative financial data for series of year.

4. analysis of comparative
Objective 1
Perform a horizontal
analysis of comparative
financial statements.

5. Horizontal Analysis Increase/(Decrease) 2004 2003 Amount Percent
Sales $41,500 $37,850 $3, %
Expenses 40, , , %
Net profit , %

6. Horizontal Analysis 2004 2003 Difference Sales $41,500 $37,850 $3,650

7. Trend % = Any year $ ÷ Base year $
Trend Percentages...
are calculated by selecting a base year whose amounts are set equal to 100%.
The amounts of each following year are expressed as a percentage of the base amount.
Trend % = Any year $ ÷ Base year $

8. What are the trend percentages?
Year
Revenues $27,611 $24, $21,718
Cost of sales , , ,049
Gross profit $12, $ 9, $ 8,669
2002 is the base year.
What are the trend percentages?

9. Trend Percentages These percentages were calculated by
Year
Revenues % 111% 100%
Cost of sales 117% 113% 100%
Gross profit % 110% 100%
These percentages were calculated by
dividing each item by the base year.

10. Perform a vertical analysis of financial statements.
Objective 2
Perform a vertical analysis
of financial statements.

11. Vertical Analysis...
compares each item in a financial statement to a base number set to 100%.
Every item on the financial statement is then reported as a percentage of that base.

12. Vertical Analysis 2004 % Revenues $38,303 100.0%
Revenues $38,
Cost of sales ,
Gross profit $18,
Total operating expenses ,
Operating profit $ 5,
Other income ,
Income before taxes $ 7,
Income taxes ,
Net profit $ 4,

13. Vertical Analysis Assets 2004 % Current assets: Cash $ 1,816 4.7
Receivables net ,
Inventories ,
Prepaid expenses ,
Total current assets $21,
Plant and equipment, net ,
Other assets ,
Total assets $38,

14. Objective 3
Prepare common-size
financial statements.

15. Common-size Statements
On the statement of financial performance, each item is expressed as a percentage of net sales.
On the statement of financial position, the common size is the total on each side of the accounting equation.
Common-size statements are used to compare one company to other companies, and to the industry average.

16. Benchmarking Percent of Net Sales Technology Limited
Enterprise Limited
 Cost of goods sold  Operating expenses
 Income tax  Net profit

17. Calculate the standard
Objective 4
Calculate the standard
financial ratios used
by decision-makers.

18. Ratio Classification Measuring ability to pay current liabilities
Measuring ability to sell inventory and collect receivables
Measuring ability to pay long-term debt
Measuring profitability
Analysing shares as an investment

19. The Data (Exhibit 19-1 Lucent Technology 20X7)
Net sales (Year 2004) $858,000
Cost of goods sold ,000
Gross profit $345,000
Total operating expenses ,000
Plus Interest revenue ,000
Interest expense (24,000)
Profits before taxes $ 81,000
Income tax ,000
Net profits $ 48,000

20. The Data (Exhibit 19-2 Lucent Technology 20X7 and 20X6)
Assets
Current assets:
Cash $ 29,000 $ 32,000
Receivables net , ,000
Inventories , ,000
Prepaid expenses , ,000
Total current assets $262,000 $236,000
Long-term investments , ,000
Plant and equipment, net , ,000
Total assets $787,000 $644,000

21. The Data (Exhibit 19-2 Lucent Technology 20X7 and 20X8)
Liabilities
Current liabilities:
Bills payable $ 42,000 $ 27,000
Accounts payable , ,000
Accrued liabilities , ,000
Total current liabilities $142,000 $126,000
Long-term debt , ,000
Total liabilities $431,000 $324,000

22. The Data (Exhibit 19-1 Lucent Technology 20X7 and 20X8)
Shareholders’ Equity
Ordinary shares (93,000) $186,000 $186,000
Retained earnings , ,000
Total shareholders’ equity $356,000 $320,000
Total liabilities and
shareholders’ equity $787,000 $644,000

23. Measuring Ability to Pay Current Liabilities
The current ratio measures
the company’s ability to pay
current liabilities with current assets.
Current ratio =
Total current assets ÷ Total current liabilities

24. Measuring Ability to Pay Current Liabilities
Lucent’s current ratio:
2003: $236,000 ÷ $126,000 = 1.87
2004: $262,000 ÷ $142,000 = 1.85
If the industry average is 1.80.
What does this tell us?
The current ratio decreased slightly during 2004 but it is still slightly higher than the industry average.

25. Measuring Ability to Pay Current Liabilities
The acid-test ratio shows the company’s
ability to pay all current liabilities
if they come due immediately.
Acid-test ratio =
(Cash + Short-term investments
+ Net current receivables)
÷ Total current liabilities

26. Measuring Ability to Pay Current Liabilities
Lucent’s acid-test ratio:
2003: ($32,000 + $85,000) ÷ $126,000 = .93
2004: ($29,000 + $114,000) ÷ $142,000 = 1.01
If the industry average is .60.
The company’s acid-test ratio improved considerably during 2004 and is well above the industry average.

27. Measuring Ability to Sell Inventory
Inventory turnover is a measure
of the number of times the average
level of inventory is sold during a year.
Inventory turnover = Cost of goods sold
÷ Average inventory

28. Measuring Ability to Sell Inventory
Inventory turnover:
2004: $513,000 ÷ $112,000* = 4.58
If the industry average is 2.70.
A high number indicates an ability to quickly sell inventory, but it might indicate stock-outs!
* Average inventory ($113,000 + $111,000) ÷ 2

29. Measuring Ability to Collect Receivables
Accounts receivable turnover measures a company’s
ability to collect cash from credit customers.
Accounts receivable turnover =
Net credit sales ÷ Average accounts receivable

30. Measuring Ability to Collect Receivables
Lucent’s accounts receivable turnover:
2004: $858,000 ÷ $99,500 = 8.62 times
If the industry average is 22.2 times.
Lucent’s receivable turnover is much lower than the industry average.
If the company is a rural store that sells to local people who tend to pay their bills over a lengthy period of time – then?

31. Measuring Ability to Collect Receivables
Days’ sales in receivable ratio measures how
many day’s sales remain in Accounts Receivable.
One day’s sales = Net sales ÷ 365 days
Days’ sales in Accounts Receivable =
Average net Accounts Receivable ÷ One day’s sales

32. Measuring Ability to Collect Receivables
Days’ sales in Accounts Receivable for 2004:
One day’s sales:
$858,000 ÷ 365 = $2,351
Days’ sales in Accounts Receivable:
$99,500 ÷ $2,351 = 42 days
What is the industry average - 365/22.2

33. Measuring Ability to Pay Debt
The debt ratio indicates the proportion
of assets financed with debt.
Total liabilities ÷ Total assets

34. Measuring Ability to Pay Debt
Lucent’s debt ratio:
2003: $324,000 ÷ $644,000 = 0.50
2004: $431,000 ÷ $787,000 = 0.55
Industry average 0.61.
Lucent expanded operations during 2004 by financing through borrowing – but it is still lower than the industry.

35. Measuring Ability to Pay Debt
Times-interest-earned ratio measures the
number of times profits before both
interest and tax can cover interest expense.
Times-interest-earned
= Net Profits plus (interest expense and tax)
÷ Interest expense

36. Measuring Ability to Pay Debt
Times-interest-earned ratio:
2004: ($81,000 + $24,000*) ÷ $24,000 = 4.37
The industry average is 2.00.
This is a favorable sign.
* Profits before tax are $81,000 (or $48,000 +
$33,000) and if we paid no interest of
$24,000 profits would be $105,000.

37. Measuring Profitability
Rate of return on net sales shows the percentage
of each sales dollar earned as net profits.
Rate of return on net sales =
Net profits ÷ Net sales

38. Measuring Profitability
Lucent’s rate of return on sales:
2003: $26,000 ÷ $803,000 = 0.032
2004: $48,000 ÷ $858,000 = 0.056
The industry average is
The increase is significant in itself and also because it is much better than the industry average.

39. Measuring Profitability
Rate of return on total assets measures
how profitably a company uses its assets.
Rate of return on total assets =
(Net profits + income tax + interest expense)
÷ Average total assets

40. Measuring Profitability
Rate of return on total assets for 2004:
$105,000 ÷ $715,500* = 0.147
What if the industry average is
How does Lucent compare to the industry?
* ($644,000 + $787,000) ÷ 2 = $715,500

41. Measuring Profitability
Shareholders equity includes any additional
issued ordinary shares and retained profits.
Rate of return on ordinary shareholders’ equity
= (Net profits – preferred dividends)
÷ Average ordinary shareholders’ equity

42. Measuring Profitability
Lucent’s rate of return on ordinary shareholders’ equity for 2004:
($48,000 – $0) ÷ $338,000* = 0.142
Why is this ratio larger than the return on total assets (.101)?
Because Lucent uses leverage or gearing.
* ($356,000 + $320,000) ÷ 2 = $338,000

43. Gearing Example I borrow $90 (at 5%) and I put in $10
Invest $100 and earn 10% on it
Revenue $ ($100 x 10%)
Expenses $ ($90 x 5%)
Profit $ 5.50
Not bad on the $10 I put in.
But what if the assets only earned say 2%
Loss of $2.50
Gearing is RISKY !

44. Measuring Profitability
Earnings per share (EPS)
= (Net profits – Preferred dividends)
÷ Number of ordinary shares issued

45. Measuring Profitability
Lucent’s earnings per share:
2004: ($48,000 – $0) ÷ 93,000 = $0.52
EPS is important because it is becoming common to express the profit in this form rather than large dollar amounts.
Only important in comparison to previous EPS not other companies EPS.
Why?

46. Analysing Shares as an Investment
Price/earning ratio is the ratio of market price per share ($5) to earnings per share.
2004: $5 ÷ $0.52 = 9.6
Given Lucent’s 2004 P/E ratio of 9.6, we would say that the company’s shares are selling at 9.6 times earnings.
P/E ratios are commonly provided for listed companies.

47. Analysing Shares as an Investment
Dividend yield shows the percentage
of a share’s market value returned as
dividends to shareholders each period.
Dividend per ordinary share
÷ market price per ordinary shares

48. Analysing Shares as an Investment
Dividend yield on Lucent’s ordinary shares:
2004: $0.12 ÷ $5.00 = .024 (2.4%)
An investor who buys Lucent’s ordinary shares for $5 may expect to receive 2.4% of the investment annually in the form of cash dividends.

49. Analysing Shares as an Investment
Book value per ordinary share
= (Total ordinary shareholders’ equity)
÷ Number of ordinary shares issued

50. Analysing Shares as an Investment
Book value per share of Lucent’s ordinary shares:
2003: ($320,000) ÷ 93,000 = $3.44
2004: ($356,000) ÷ 93,000 = $3.83
Book value bears no relationship to market value.

51. Use ratios in decision making.
Objective 5
Use ratios in decision making.

52. Limitations of Financial Analysis
Business decisions are made in a world of uncertainty.
No single ratio or one-year figure should be relied upon to provide an assessment of a company’s performance.

53. Measure economic value added.
Objective 6
Measure economic value added.

54. Economic Value Added (EVA®)
Economic value added (EVA®) combines accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth.
EVA® = Net profits + Interest expense – Capital charge

55. End of Chapter 19