Financial Statement Analysis

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Chapter 14
Financial StatementFinancial Statement
AnalysisAnalysis
Financial Accounting,
Seventh Edition

2
BalanceBalance
sheetsheet
IncomeIncome
statementstatement
RetainedRetained
earningsearnings
statementstatement
Basics ofBasics of
FinancialFinancial
StatementStatement
AnalysisAnalysis
Basics ofBasics of
FinancialFinancial
StatementStatement
AnalysisAnalysis
Horizontal andHorizontal and
VerticalVertical
AnalysisAnalysis
Horizontal andHorizontal and
VerticalVertical
AnalysisAnalysis
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
EarningEarning
Power andPower and
Irregular ItemsIrregular Items
EarningEarning
Power andPower and
Irregular ItemsIrregular Items
Quality ofQuality of
EarningsEarnings
Quality ofQuality of
EarningsEarnings
Need forNeed for
comparativecomparative
analysisanalysis
Tools ofTools of
analysisanalysis
LiquidityLiquidity
ProfitabilityProfitability
SolvencySolvency
SummarySummary
DiscontinuedDiscontinued
operationsoperations
ExtraordinaryExtraordinary
itemsitems
Changes inChanges in
accountingaccounting
principleprinciple
ComprehensiveComprehensive
incomeincome
AlternativeAlternative
accountingaccounting
methodsmethods
Pro formaPro forma
incomeincome
ImproperImproper
recognitionrecognition
Financial Statement AnalysisFinancial Statement AnalysisFinancial Statement AnalysisFinancial Statement Analysis

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Analyzing financial statements involves:
Basics of Financial Statement AnalysisBasics of Financial Statement AnalysisBasics of Financial Statement AnalysisBasics of Financial Statement Analysis
Characteristics
Comparison
Bases
Tools of
Analysis
Liquidity
Profitability
Solvency
Intracompany
Industry
averages
Intercompany
Horizontal
Vertical
Ratio
SO 1 Discuss the need for comparative analysis.
SO 2 Identify the tools of financial statement analysis.

4
SO 3 Explain and apply horizontal analysis.
Horizontal AnalysisHorizontal AnalysisHorizontal AnalysisHorizontal Analysis
Horizontal analysis, also called trend analysis, is a
technique for evaluating a series of financial
statement data over a period of time.
Its purpose is to determine the increase or decrease
that has taken place.
Horizontal analysis is commonly applied to the balance
sheet, income statement, and statement of retained
earnings.

5
Illustration 14-5
These changes
suggest that the
company expanded
its asset base
during 2007 and
financed this
expansion primarily
by retaining income
rather than
assuming additional
long-term debt.
Balance
Sheet

6
Illustration 14-5
Overall, gross
profit and net
income were up
substantially. Gross
profit increased
17.1%, and net
income, 26.5%.
Quality’s profit
trend appears
favorable.
Income
Statement
Illustration 14-6

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We saw in the horizontal analysis of the balance sheet that ending retained
earnings increased 38.6%. As indicated earlier, the company retained a
significant portion of net income to finance additional plant facilities.
Retained
Earnings
Statement Illustration 14-7

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Illustration: Summary financial information for
Rosepatch Company is as follows.
Compute the amount and percentage changes in 2011 using
horizontal analysis, assuming 2010 is the base year.
Solution on notes page
Solution
SO 4 Describe and apply horizontal analysis.
2011

9
SO 4 Describe and apply vertical analysis.
Vertical AnalysisVertical AnalysisVertical AnalysisVertical Analysis
Vertical analysis, also called common-size analysis, is
a technique that expresses each financial statement
item as a percent of a base amount.
On an income statement, we might say that selling
expenses are 16% of net sales.
Vertical analysis is commonly applied to the balance
sheet and the income statement.

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These results
reinforce the
earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.
Balance
Sheet
Illustration 14-8

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Quality appears
to be a profitable
enterprise that is
becoming even
more successful.
Income
Statement
Illustration 14-9

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Enables a comparison of companies of different sizes.
Illustration 14-10
Intercompany income
statement comparison
J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C.
Penney’s net income as a percent of each sales dollar (5.6%) is only 4% of
Quality’s (12.6%).

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SO 5 Identify and compute ratios used in analyzing
a firm’s liquidity, profitability, and solvency.
Ratio analysis expresses the relationship among
selected items of financial statement data.
LiquidityLiquidity ProfitabilityProfitability SolvencySolvency
Measures short-
term ability of
the company to
pay its maturing
obligations and to
meet unexpected
needs for cash.
Financial Ratio Classifications
Measures the
income or
operating success
of a company for
a given period of
time.
Measures the
ability of the
company to
survive over a
long period of
time.

14
The discussion of ratios will
include the following types of
comparisons.
A single ratio by itself is not very meaningful.

15
Liquidity RatiosLiquidity Ratios
Measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for
cash.
 Short-term creditors such as bankers and suppliers are
particularly interested in assessing liquidity.
 Ratios include the current ratio, the acid-test ratio,
receivables turnover, and inventory turnover.

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Compute the Current Ratio for 2007.
The ratio of 2.96:1 means that for every dollar of
current liabilities, Quality has $2.96 of current assets.
Current Assets
Current Liabilities
= Current Ratio
$1,020,000
$344,500
= 2.96 : 1

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Compute the Acid-Test Ratio for 2007.
Illustration 14-13

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Compute the Acid-Test Ratio for 2007.
The acid-test ratio measures immediate liquidity.
Cash + Short-Term Investments + Receivables (Net)
Current Liabilities
Acid-Test
Ratio
$100,000 + $20,000 + $230,000
$344.500
= 1.02 : 1
=

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Compute the Receivables Turnover ratio for 2007.
It measures the number of times, on average, the
company collects receivables during the period.
$2,097,000
($180,000 + $230,000) / 2
= 10.2 times
Net Credit Sales
Average Net Receivables
Receivables
Turnover
=

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A variant of the receivables turnover ratio is to convert
it to an average collection period in terms of days.
This means that receivables are collected on average
every 36 days.
$2,097,000
($180,000 + $230,000) / 2
= 10.2 times
365 days / 10.2 times = every 35.78 days
Receivables Turnover

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Compute the Inventory Turnover ratio for 2007.
Inventory turnover measures the number of times, on
average, the inventory is sold during the period.
$1,281,000
($500,000 + $620,000) / 2
= 2.31 times
Cost of Good Sold
Average Inventory
Inventory
Turnover
=

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A variant of inventory turnover is the days in inventory.
Inventory turnover ratios vary considerably among
industries.
365 days / 2.3 times = every 159 days
$1,281,000
($500,000 + $620,000) / 2
= 2.3 times
Inventory Turnover

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Profitability RatiosProfitability Ratios
Measure the income or operating success of a company for
a given period of time.
 Income, or the lack of it, affects the company’s ability to
obtain debt and equity financing, liquidity position, and the
ability to grow.
 Ratios include the profit margin, asset turnover, return
on assets, return on common stockholders’ equity,
earnings per share, price-earnings, and payout ratio.

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Compute the Profit Margin ratio for 2007.
Measures the percentage of each dollar of sales that
results in net income.
$263,800
$2,097,000
= 12.6%
Net Income
Net Sales
Profit
Margin
=

25
Compute the Asset Turnover ratio for 2007.
Measures how efficiently a company uses its assets to
generate sales.
$2,097,000
($1,95,000 + $1,835,000) / 2
= 1.22 times
Net Sales
Average Assets
Asset
Turnover
=

26
Compute the Return on Assets ratio for 2007.
An overall measure of profitability.
$263,800
($1,595,000 + $1,835,000) / 2
= 15.4%
Net Income
Average Assets
Return
on Assets
=

27
Compute the Return on Common Stockholders’
Equity ratio for 2007.
Shows how many dollars of net income the company
earned for each dollar invested by the owners.
$263,000 - $0
($795,000 + $1,003,000) / 2
= 29.3%
Net Income – Preferred Dividends
Average Common Stockholders’ Equity
Return on
Common
Stockholders’
Equity
=

28
Compute the Earnings Per Share for 2007.
A measure of the net income earned on each share of
common stock.
$263,800
270,000 + 275,400 / 2
= $0.97 per share
Net Income
Weighted Average Common
Shares Outstanding
Earnings
Per Share
=

29
Compute the Price Earnings Ratio for 2007.
The price-earnings (PE) ratio reflects investors’
assessments of a company’s future earnings.
$12.00
$0.97
= 12.4 times
Market Price per Share of Stock
Earnings Per Share
Price
Earnings
Ratio
=

30
Compute the Payout Ratio for 2007.
Measures the percentage of earnings distributed in the
form of cash dividends.
$61,200
$263,800
= 23.2%
Cash Dividends
Net Income
Payout
Ratio
=
*
* From analysis of retained earnings.

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Solvency RatiosSolvency Ratios
Solvency ratios measure the ability of a company to survive
over a long period of time.
 Debt to total assets and times interest earned are two
ratios that provide information about debt-paying ability.

32
Compute the Debt to Total Assets Ratio for 2007.
Measures the percentage of the total assets that
creditors provide.
$832,000
$1,835,000
= 45.3%
Total Debt
Total Assets
Debt to
Total Assets
Ratio
=

33
Compute the Times Interest Earned ratio for 2007.
Provides an indication of the company’s ability to meet
interest payments as they come due.
$468,000
$36,000
= 13 times
Income before Income Taxes and
Interest Expense
Interest Expense
Times
Interest
Earned
=

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