Chapter 17 – Analysis of Financial Statements
CHAPTER 17
ANALYSIS OF FINANCIAL STATEMENTS
Related Assignment Materials
Student Learning Objectives Questions
Quick
Studies* Exercises* Problems*
Beyond the
Numbers
Conceptual objectives:
C1. Explain the purpose and identify
the building blocks of analysis.
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C2. Describe standards for
comparisons in analysis.
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Analytical objectives:
A1 Summarize and report results of
analysis.
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A2A Explain the form and assess the
content of a complete income
statement.
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Procedural objectives:
P1. Explain and apply methods of
horizontal analysis.
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P2. Describe and apply methods of
vertical analysis.
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P3. Define and apply ratio analysis. 4, 5, 6, 7, 8, 9,
10, 11, 12,,
14,15, 16, 17
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*See additional information on next page that pertains to these quick studies, exercises and problems.
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Chapter 17 – Analysis of Financial Statements
Additional Information on Related Assignment Material
Corresponding problems in set B (in text), also relate to learning objectives identified in grid on
previous page. The Serial Problem for Success Systems continues in this chapter
Connect reproduces assignments online, in static or algorithmic mode, which allows instructors to
monitor, promote, and assess student learning. It can be used for practice, homework, or exams.
Synopsis of Chapter Revisions
Motley Fool: Revised opener with new entrepreneurial assignment
New companies –Apple, Google, and Samsung –throughout the chapter, exhibits, and
illustrations
New boxed discussion on the role of financial statement analysis to fight and prevent
fraud
Enhanced horizontal, vertical, ratio analysis using new companies and industry data
New analysis for segment data
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Education.
Chapter 17 – Analysis of Financial Statements
Chapter Outline Notes
I. Basics of Analysis—Transforming data into useful
information.
A. Purpose of Analysis
To help users (both internal and external) make better business
decisions.
1. Internal users (managers, officers, internal auditors,
consultants, budget officers, and market researchers) make the
strategic and operating decisions of a company. Purposes for
these users is to provide strategic information to improve
company efficiency and effectiveness in providing products
and services.
2. External users (shareholders, lenders, directors, customers,
suppliers, regulators, lawyers, brokers, and the press) rely on
financial statement analysis to make decisions in pursuing
their own goals.
3. The common goal of all users is to evaluate:
a. Past and current performance.
b. Current financial position.
c. Future performance and risk.
B. Building Blocks of Analysis
The four areas of inquiry or building blocks are:
1. Liquidity and efficiency—ability to meet short-term
obligations and to efficiently generate revenues.
2. Solvency—ability to generate future revenues and meet
long-term obligations.
3. Profitability—ability to provide financial rewards sufficient to
attract and retain financing.
4. Market prospects—ability to generate positive market
expectations.
C. Information for Analysis
Most users rely on general purpose financial statements that
include:
1. Income statement
2. Balance sheet
3. Statement of stockholders’ equity (or statement of retained
earnings)
4. Statement of cash flows
5. Notes related to the statements
6. Other useful financial data—10K/other SEC filings, news
releases, shareholders’ meetings, forecasts, management
letters, auditor’s report, and analyses published in annual
reports.
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Chapter 17 – Analysis of Financial Statements
Chapter Outline Notes
D. Standards for Comparisons
Used to determine if analysis measures suggest good, bad, or
average performance. Standards (benchmarks) can include the
following types of comparisons:
1. Intracompany—based on own prior performance and
relationships between its financial items.
2. Competitor—compared to one or more direct competitors.
(often best)
3. Industry—published industry statistics (available from
services like Dun & Bradstreet, Standard and Poor’s, and
Moody’s).
4. Guidelines (rules-of-thumb)—general standards developed
from experience.
E. Tools of Analysis
1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis
II. Horizontal Analysis—Tool to evaluate changes in financial statement
data across time. This analysis utilizes:
A. Comparative Statements
1. Reports where financial amounts for more than one period are
placed side by side in columns on a single statement.
2. Dollar changes and percentage changes—usually shown in
line items.
a. Dollar change = Analysis period amount minus Base
period amount.
b. Percent change = (Analysis period amount minus Base
period amount) divided by Base period amount multiplied
by 100. Note:
(1) When a negative amount appears in the base period
and a positive amount in the analysis period (or vice
versa) a meaningful percentage change cannot be
computed.
(2) When there is no value in the base period—percentage
change is not computable.
(3) When an item has a value in the base period and zero
in the next period—the decrease is 100 percent.
3. Comparative Balance Sheets—balance sheets from two or
more periods arranged side-by-side. Dollar and percentage
changes are often shown. Analysis focuses on large changes.
4. Comparative Income Statements—also compares two or more
periods presented side-by side with dollar and percentage
changes.
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Chapter 17 – Analysis of Financial Statements
Chapter Outline Notes
B. Trend analysis (also called trend percent analysis or index number
trend analysis)
1. A form of horizontal analysis used to reveal patterns in data
across successive periods.
2. Involves computing trend percents (or index number) as
follows: Analysis period amount divided by base period
amount) multiplied by 100.
3. Often aided by graphical depiction.
III. Vertical Analysis—(also called common-size analysis) Comparing
financial condition and performance to a base amount. The analysis
tools include:
A. Common-Size Statements—reveal changes in the relative
importance of each financial statement item by redefining each in
terms of common-size percents.
1. Base amount is commonly defined as 100%. Usually a key
aggregate figure is the base (Examples: revenue is the income
statement base and total assets is the balance sheet base).
2. Sum of individual items is 100%.
3. Common-size percentage equals (Analysis amount divided by
Base amounts) multiplied by 100.
B. Common-Size Graphics
Graphical analysis (Ex. pie charts and bar charts) of common-size
statements that visually highlight comparison information.
IV. Ratio Analysis—widely used analysis tool that express key
relationships among financial statement items. Ratios are organized
into the four (A to D below) building blocks of analysis:
A. Liquidity and Efficiency
1. Liquidity refers to the availability of resources to meet
short-term cash requirements.
2. Efficiency refers to how productive a company is in using its
assets. Efficiency is usually measured relative to how much
revenue is generated for a certain level of assets.
3. Ratios in this block:
a. Working capital—the excess of current assets less current
liabilities.
b. Current ratio—current assets divided by current liabilities;
describes a company’s ability to pay its short-term
obligations.
c. Acid-test ratio—similar to current ratio but focuses on
quick assets (i.e., cash, short-term investments, current
receivables, and notes receivable) rather than current
assets. Calculated as quick assets divided by current
liabilities.
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Chapter 17 – Analysis of Financial Statements
Chapter Outline Notes
d. Accounts receivable turnover—net sales or credit sales
divided by average accounts receivable; a measure of how
long it takes a company to collect its accounts.
e. Inventory turnover—cost of goods sold divided by
average inventory; the number of times a company’s
average inventory is sold during an accounting period.
f. Days’ sales uncollected—(accounts receivable divided by net
credit sales) multiplied by 365 days; measures how
frequently a company collects its accounts receivable.
g. Days’ sales in inventory—(ending inventory divided by
cost of goods sold) multiplied by 365; measures how
many days it will take to convert the inventory on hand at
the end of the period into accounts receivable or cash.
h. Total asset turnover—net sales divided by average total
assets; describes the ability to use assets to generate sales.
B. Solvency
1. Solvency refers to a company’s long-run financial viability and
its ability to cover long-term obligations. Capital structure is
one of the most important components of solvency analysis.
2. Capital structure refers to a company’s sources of financing.
3. Ratios in this block:
a. Debt ratio—total liabilities divided by total assets.
b. Equity ratio—total stockholders’ equity divided by total
assets; compliment of debt ratio.
c. Debt-to-equity ratio—total liabilities divided by total
equity.
Note: A company is considered less risky if its capital structure
(equity and long-term debt) is composed more of equity.
Financial leveraging, the inclusion of debt, can increase return
to stockholders.
d. Times interest earned—income before interest expense
and income taxes divided by interest expense; reflects the
risk of repayments with interest to creditors.
C. Profitability
1. Profitability refers to a company’s ability to generate an
adequate return on invested capital.
2. Return is judged by assessing earnings relative to the level
and sources of financing.
3. Profitability is also relevant to solvency.
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Chapter 17 – Analysis of Financial Statements
Chapter Outline Notes
4. Ratios in this block:
a. Profit margin—net income divided by net sales;
describes the ability to earn a net income from sales.
b. Return on total assets—net income divided by average
total assets; a summary measure of operating
efficiency, comprises profit margin and total asset
turnover.
c. Return on common stockholders’ equity—net income
less preferred dividends divided by average common
stockholders’ equity; measures the success of a
company in earning net income for its owners.
D. Market Prospects
1. Market measures are useful for analyzing corporations with
publicly traded stock.
2. Market measures use stock price in their computation.
3. Ratios in this block:
a. Price-earnings ratio—market price per share of common
stock divided by earnings per share; used to evaluate the
profitability of alternative common stock investments.
b. Dividend yield—annual cash dividends paid per share of
stock divided by market price per share; used to compare
the dividend paying performance of different investment
alternatives.
E. Summary of Ratios
Exhibit 17.16 on p. 737 of text sets forth the names of each of the
common ratios by category, and includes the formula and a
description of what is measured by each ratio.
V. Global View—Compares U.S. GAAP to IFRS
A. Horizontal and vertical analyses help eliminate many differences
between U.S. GAAP and IFRS when analyzing and interpreting
financial statements. Percentages are consistently applied across
and within periods. However, where reporting rules differ, users
should exercise caution in drawing conclusions.
B. Ratio analysis has many of the advantages and disadvantages of
horizontal and vertical analysis as mentioned above.
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Education.
Chapter 17 – Analysis of Financial Statements
Chapter Outline Notes
VI. Decision Analysis—Analysis Reporting
Goal of financial statement analysis report is to reduce uncertainty
through rigorous and sound evaluation. A good analysis report usually
consists of six sections:
1. Executive summary
2. Analysis overview
3. Evidential matter
4. Assumptions
5. Key factors
6. Inferences
VI. Sustainable Income—Appendix 17A—When a revenue and expense
transactions are from normal, continuing operations, a simple income
statement is adequate. When activities include events that are not
normal, it must disclose this information by separating the income
statement into different sections as follows (A-D):
A. Continuing Operations
Reports the revenues, expenses, and income generated by the
company’s continuing operations.
B. Discontinued Segments
1. A business segment is a part of a company’s operations that
serves a particular line of business or class of customers.
2. Section reports:
a. Income (loss) from operating the discontinued business
segment for the current period prior to disposal (net of
taxes).
b. Gain or loss on disposal of the segment (net of related
income tax effects).
C. Extraordinary Items—reports extraordinary gains and losses that
are both unusual and infrequent.
1. An unusual gain or loss is abnormal or otherwise unrelated to
the company’s regular activities and environment.
2. An infrequent gain or loss is not expected to recur given the
company’s operating environment.
3. Items that are unusual or infrequent, but not both, are reported
in the income statement as part of continuing operations but
below the normal revenues and expenses.
D. Earnings per Share
1. Final section of income statement
2. Reports EPS for three subcategories of income (continuing
operations, discontinued segments, and extraordinary items).
EPS discussed in chapter 13
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Chapter 17 – Analysis of Financial Statements
Chapter Outline Notes
E. Changes in Accounting Principles
1. The consistency principle directs a company to apply the same
accounting principle across periods. Changes from one
accounting principles to another (Example: LIFO to FIFO) are
acceptable if justified as improvements in financial reporting.
2. A footnote would describe change and why it is an
improvement.
3. Requires retrospective application (application of new
accounting principle to prior periods as if that principle had
always been used).
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Education.
Chapter 17 – Analysis of Financial Statements
Alternate Demonstration Problem
Chapter Seventeen
Following are data from the statements of two companies selling similar
products:
Current Year-End Balance Sheets
Sled
Company
Zip
Company
Cash………………………………………………………...…. $ 11,900 $ 20,000
Notes receivable—short-term............................. 7,700 3,200
Accounts receivable, net……..…………................. 42,000 64,000
Inventory……………………...................................... 58,800 87,680
Prepaid expenses………….................................... 1,680 3,520
Plant and equipment, net..…………………………….. 232,120 274,400
Total assets…………………………............................ $354,200 $452,800
Current liabilities………………………………………….. $ 56,000 $ 80,000
Mortgage payable…..……..................................... 70,000 80,000
Common stock, $10 par value..……..……….......... 140,000 160,000
Retained earnings……………………………............... 88,200 132,800
Total liabilities and stockholders’ equity............ $354,200 $452,800
Data from the Current Year’s Income Statement
Sales….…………..………………………........................ $672,000 $880,000
Cost of goods sold……………………………………….. 528,080 699,840
Interest expense…………………………………………… 4,200 5,600
Net income………………………................................ 23,373 28,896
Beginning-of-Year Data
Inventory……………………...................................... $ 53,200 $ 85,120
Total assets…………………………............................ 345,800 443,200
Stockholders’ equity…..……..……………................ 217,000 285,120
Required:
1. Calculate current ratios, acid-test ratios, inventory turnovers, and days’ sales
uncollected for the two companies. Then state which company you think is
the better short-term credit risk and why.
2. Calculate return on total assets employed and return on stockholders’
equity. Then, under the assumption that each company’s stock can be
purchased at book value, state which company’s stock you think is the
better investment and why.
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Chapter 17 – Analysis of Financial Statements
Solution: Alternate Demonstration Problem
Chapter Seventeen
Part 1
Sled Company Zip Company
Current ratio: $122,080
$ 56,000
= 2.18 to 1 $178,400
$ 80,000
= 2.23 to 1
Acid-test ratio: $ 61,600
$ 56,000
= 1.10 to 1 $ 87,200
$ 80,000
= 1.09 to 1
Inventory
turnover:
$528,080
$ 56,000
= 9.4 times $669,840
$ 86,400
= 7.8 times
Days’ sales
uncollected:
$ 42,000
$672,000
x 365 = 22.8 $ 64,000
$880,000
x 365 = 26.5
Sled Company and Zip Company have almost equal current and acid-test
ratios, so near the same that the differences are not significant. However,
Sled Company turns its inventory and collects its accounts receivable
more rapidly than Zip Company; and on this basis it appears to be a better
short-term credit risk.
Part 2
Return on total assets: $ 23,373
$350,000 = 6.68% $ 28,896
$448,000 = 6.45%
Return on stockholders’
equity:
$ 23,373
$222,600 = 10.5% $ 28,896
$288,960 = 10.0%
Assuming that the stock of each company could be purchased at book
value, Sled Company’s stock seems to be the better investment. This
conclusion is based on Sled’s slightly better return on stockholders’ equity
(or return on the investment) of 10.5% compared with 10% for Zip. In
addition, the better inventory turnover, days’ sales uncollected, and return
on total assets employed indicate that Sled Company might be the better
managed company. This information reinforces the conclusion as to which
stock is the better investment.
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