Financial Statement Analysis

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Chapter 14

Financial Statement Financial Statement

AnalysisAnalysis

Financial Accounting, Seventh Edition

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Balance Balance sheetsheet

Income Income statementstatement

Retained Retained earnings earnings statementstatement

Basics of Basics of Financial Financial Statement Statement AnalysisAnalysis

Basics of Basics of Financial Financial Statement Statement AnalysisAnalysis

Horizontal and Horizontal and Vertical Vertical AnalysisAnalysis

Horizontal and Horizontal and Vertical Vertical AnalysisAnalysis

Ratio AnalysisRatio AnalysisRatio AnalysisRatio AnalysisEarning Power Earning Power and Irregular and Irregular

ItemsItems

Earning Power Earning Power and Irregular and Irregular

ItemsItems

Quality of Quality of EarningsEarningsQuality of Quality of EarningsEarnings

Need for Need for comparative comparative analysisanalysis

Tools of Tools of analysisanalysis

LiquidityLiquidity

ProfitabilityProfitability

SolvencySolvency

SummarySummary

Discontinued Discontinued operationsoperations

Extraordinary Extraordinary itemsitems

Changes in Changes in accounting accounting principleprinciple

ComprehensiveComprehensive incomeincome

Alternative Alternative accounting accounting methodsmethods

Pro forma Pro forma incomeincome

Improper Improper recognitionrecognition

Financial Statement AnalysisFinancial Statement AnalysisFinancial Statement AnalysisFinancial Statement Analysis

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Analyzing financial statements involves:

Basics of Financial Statement Basics of Financial Statement AnalysisAnalysisBasics of Financial Statement Basics of Financial Statement AnalysisAnalysis

CharacteristicsComparison

BasesTools 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.

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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.

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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

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Illustration 14-5

Overall, gross profit and net income were up substantially. Gross profit increased17.1%, 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

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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 appearsto 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 14-10Intercompany 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 AnalysisRatio AnalysisRatio AnalysisRatio Analysis

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.

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The discussion of ratios will include the following types of comparisons.

A single ratio by itself is not very meaningful.

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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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Ratio Analysis Ratio Analysis Ratio Analysis Ratio Analysis

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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Ratio Analysis Ratio Analysis Ratio Analysis Ratio Analysis

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=


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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=


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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=


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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

=


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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=


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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=


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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.

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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

=


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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

=


Financial Statement Analysis

Business

trend analysis

commonsize analysis

financial statement

penneys net income

summary financial information

net sales

retention of earnings

additional debt