The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin CHAPTER 13 Financial Statement Analysis.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin

CHAPTER 13

Financial Statement Analysis

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13-2

Learning Objective

LO1LO1

To describe factors associated with communicating

useful information

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13-3Factors in Communicating Useful Information

Users

Types of Decisions

Means of Analysis

The primary objective of accounting is to provide information useful for decision making. To provide

information that supports this objective, accountants must consider the following:

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Learning Objective

LO2LO2

To differentiate between horizontal

and vertical analysis

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Methods of Analysis

Horizontal Analysis

Vertical Analysis

Ratio Analysis

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13-6Milavec Company Financial Statements

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13-7Milavec Company Financial Statements

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13-8

Horizontal Analysis

Horizontal analysis (or trend analysis) refers to studying the behavior of

individual financial statement items over several accounting periods.

Absolute Amounts

Percentage Analysis

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13-9Milavec Company Horizontal Analysis

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13-10

Vertical Analysis

Vertical analysis Vertical analysis uses uses percentages to compare percentages to compare individual components of individual components of

financial statements to a key financial statements to a key statement figure. Astatement figure. A common- common-

sizesize financial statement is a vertical analysis in which each

financial statement item is expressed as a percentage.

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Vertical Analysis of Income Statement

In income statements, all

items are usually

expressed as a percentage of

sales.

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13-12Milavec Company Vertical Analysis

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Vertical Analysis of Balance Sheet

In balance sheets, all items

are usually expressed as a percentage of total assets.

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Learning Objective

LO3LO3

To explain ratio analysis

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Ratio Analysis

Ratio analysis involves studying

various relationships

between different items reported in a

set of financial statements.

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Learning Objective

LO4LO4

To calculate ratios for assessing a

company’s liquidity

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Liquidity Ratios

Liquidity ratios indicate a company’s ability to pay short-

term debts. They focus on current assets and current

liabilities.

1. Working Capital

2. Current Ratio

3. Quick Ratio

4. Accounts Receivable Ratios

5. Inventory Ratios

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Working CapitalThe excess of current assets

over current liabilities is known as working capital.

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Current Ratio

The current ratio measures a company’s short-term debt

paying ability.

A declining ratio may be a sign of deteriorating

financial condition, or it might result from eliminating

obsolete inventories.

CurrentRatio

Current Assets Current Liabilities

=

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Current Ratio

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Quick (Acid-Test) Ratio

Quick Assets Current Liabilities

=Acid-Test

Ratio

Quick assets include Cash,Current Marketable Securities, and

Accounts Receivable. This ratio measures a company’s ability

to meet obligations without having to liquidate inventory.

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Quick (Acid-Test) Ratio

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13-24Accounts Receivable Turnover

Net Credit Sales Average Accounts Receivable

Accounts ReceivableTurnover

=

This ratio measures how many times a company converts its

receivables into cash each year.

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13-25Accounts Receivable Turnover

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Average Days to Collect Receivables

Average Collection

Period=

365 Days Accounts Receivable Turnover

This ratio measures, on average, how many days it takes to collect

an accounts receivable.

= 21 daysAverage

Collection Period

= 365 Days 16.98 Times

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Inventory Turnover

Cost of Goods Sold Average Inventory

InventoryTurnover

=

This ratio measures how many times a company’s inventory has been

sold and replaced during the year.

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Inventory Turnover

INSERT Insert 20, p.

543, Text Box here

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Average Days to Sell Inventory

Average Sale Period

= 365 Days Inventory Turnover

This ratio measures how many days, on average, it takes to sell

the inventory.

= 34 daysAverage

Sale Period=

365 Days 10.80 Times

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Learning Objective

LO5LO5

To calculate ratios for assessing a

company’s solvency

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Solvency Ratios

Solvency ratios are used to analyze a company’s long-term debt-

paying ability and its financing structure.

1. Debt to Assets Ratio

2. Debt to Equity Ratio

3. Number of Times Interest Earned

4. Plant Assets to Long-Term Liabilities

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Debt to Assets Ratio

This ratio measures the percentage of a company’s assets that are financed by

debt.

Total Liabilities Total Assets

Debt to Assets Ratio

=

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Debt to Equity Ratio

This ratio indicates the relative proportions of debt to equity on a

company’s balance sheet.

Stockholders like a lot of debt if the company can

take advantage of positive financial

leverage.

Total Liabilities Stockholders’ Equity

Debt to Equity Ratio

=

Creditors prefer less debt and more equity

because equity represents a buffer of

protection.

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Debt to Assets and Debt to Equity Ratios

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Number of TimesInterest is Earned Ratio

This is the most common measure of a company’s ability

to provide protection for its long-term creditors.

Times Interest Earned

Earnings before Interest Expense and Income TaxesInterest Expense=

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Number of Times Interest Earned Ratio

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Plant Assets to Long-Term Liabilities

This ratio suggests how well long-term debt is managed to

finance long-term assets.

Plant Assets to Long-Term

Liabilities

Net Plant AssetsLong-Term Liabilities=

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Plant Assets to Long-Term Liabilities

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Learning Objective

LO6LO6

To calculate ratios for assessing

company management’s effectiveness

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Profitability Ratios

Profitability ratios measure a company’s ability to generate

earnings.

1. Net Margin (or Return on Sales)

2. Asset Turnover Ratio

3. Return on Investment

4. Return on Equity

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Net Margin

This measure describes the percent remaining of each sales dollar after

subtracting other expenses as well as cost of goods sold.

Net Margin

Net Income Net Sales

=

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Net Margin

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Asset Turnover Ratio

Net Sales Average Total Assets

AssetTurnover

=

This ratio measures how many sales dollars were generated

for each dollar of assets invested.

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Asset Turnover Ratio

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Return on Investment (ROI)

This is the ratio of wealth generated (net income) to the amount invested

(average total assets).

Return on

Investment

Net Income

Average Total Assets=

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Return on Investment (ROI)

* The computation of average assets is calculated as

beginning assets plus ending assets divided by 2.

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Return on Equity

This measure is often used to measure the profitability of the stockholders’

investment.

Return on Equity

Net IncomeAverage Total Stockholders’

Equity

=

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Return on Equity

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Learning Objective

LO7LO7

To calculate ratios for assessing a

company’s position in the stock market

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Stock Market Ratios

Stock market ratios analyze the earnings and dividends of a

company.

1. Earnings Per Share

2. Book Value

3. Price-Earnings (PE) Ratio

4. Dividend Yield

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Earnings Per Share

Earnings per

Share

Net Earnings Available for Common Stock Average Number of Outstanding Common

Shares

=

This measure indicates how muchincome was earned for each share of

common stock outstanding.

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Earnings Per Share

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Book Value Per Share

This ratio measures the amount that would be distributed to holders of each share of common

stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.

Book Value per Share

Stockholders’ Equity - Preferred Dividends Outstanding Common Shares

=

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Book Value Per Share

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Price-Earnings Ratio

Price-EarningsRatio

Market Price Per Share Earnings Per Share

=

This ratio compares the earnings of a company to the market price for a share

of the company’s stock.

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Dividend Yield

DividendYield

Dividends Per Share Market Price Per Share

=

This ratio identifies the return, in terms of cash dividends, on the current

market price of the stock.

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Learning Objective

LO8LO8

To explain the limitations of

financial statement analysis

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13-58Limitations of Financial Statement Analysis

Different Industries

Changing Economic

Environment

Accounting Principles

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End of Chapter 13