Chapter 15 – Lecture Notes
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Chapter 15
Lecture Notes
Chapter theme: This chapter focuses on financial
statement analysis which managers use to assess the
financial health of their companies. It includes examining
trends in key financial data, comparing financial data
across companies, and analyzing financial ratios.
I. Limitations of financial statement analysis
A. Comparing financial data across companies
i. Differences in accounting methods between
companies sometimes make it difficult to
compare their financial data. For example:
1. If one company values its inventory using
the LIFO method and another uses the
average cost method, then direct
comparisons of financial data such as
inventory valuations and cost of goods sold
may be misleading.
a. Even with this limitation in mind,
comparing financial ratios with other
companies or industry averages can
provide useful insights.
B. Looking beyond ratios
i. Ratios should not be viewed as an end, but
rather as a starting point. They raise many
questions and point to opportunities for
further analysis, but they rarely answer
questions by themselves.
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1. In addition to ratios, other sources of data
should also be considered such as industry
trends, technological changes, changes in
consumer tastes, changes in broad
economic factors, and changes within the
company itself.
Helpful Hint: Reinforce the limitations of relying on
financial statements by identifying events that would
make financial statements doubtful as a predictor of the
future. Such an event would be a change in oil prices
that occurs after the financial statements are issued. An
increase in oil prices would be favorable for companies
with large stocks of petroleum and unfavorable for
companies that use large quantities of petroleum
feedstocks in their manufacturing processes.
II. Statements in comparative and common-size form
Learning Objective 1: Prepare and interpret financial
statements in comparative and common-size form.
A. Key concept
i. An item on a balance sheet or income
statement has little meaning by itself. The
meaning of the number can be enhanced by
drawing comparisons. This chapter
discusses three types of comparisons.
1. Dollar and percentage changes on
statements (horizontal analysis).
2. Common-size statements (vertical
analysis).
3. Ratios.
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B. Dollar and percentage changes on statements
i. Horizontal analysis (also known as trend
analysis) involves analyzing financial data
over time.
1. Quantifying dollar changes over time
serves to highlight the changes that are the
most important economically.
2. Quantifying percentage changes over time
serves to highlight the changes that are the
most unusual.
ii. Clover Corporation – an example
1. Assume the comparative asset account
balances from the balance sheet as shown.
a. The dollar change in account balances
is calculated as shown. Notice, last
year serves as the base year.
b. The percentage change in account
balances is calculated as shown.
c. The dollar ($11,500) and percentage
(48.9%) changes in the cash account
are computed as shown.
d. The dollar and percentage changes for
the remaining asset accounts are as
shown.
2. We could do this for the liabilities and
stockholders’ equity, but instead let’s look at
the income statement.
a. Assume Clover has the comparative
income statement amounts as shown.
b. The dollar and percentage changes for
each account are as shown. Notice:
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i. Sales increased by 8.3% yet net
income decreased by 21.9%.
ii. There were increases in cost of
goods sold (14.3%) and
operating expenses (2.1%) that
offset the increase in sales.
iii. Horizontal analysis can be even more useful
when data from a number of years are used to
compute trend percentages.
1. To compute a trend percentage, a base year
is selected and the data for all years are
stated in terms of a percentage of that
base year.
a. The equation for computing a trend
percentage is as shown.
iv. Berry Products – an example
1. Assume the financial results as shown for
2010–2014. Notice:
a. The base year is 2010 and its amounts
will equal 100%.
2. The 2011 results restated in trend
percentages would be computed as shown.
3. The trend percentages for the remaining
years would be as shown. Notice:
a. Cost of goods sold is increasing
faster than sales.
4. The trend percentages can also be used to
construct a graph as shown.
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C. Common-size statements
i. Vertical analysis focuses on the relations
among financial statement items at a given
point in time. A common-size financial
statement is a vertical analysis in which each
financial statement item is expressed as a
percentage.
1. In balance sheets, all items are usually
expressed as a percentage of total assets.
2. In income statements, all items are usually
expressed as a percentage of sales.
ii. Clover Corporation – an example
1. Let’s revisit the comparative income
statements as shown. Notice:
a. As previously mentioned, sales is
usually the base and is expressed as
100%.
2. The operating costs (or selling and
administrative expenses) as a percentage
of sales for last year (26.2%) and this year
(24.8%) are calculated as shown.
3. The common-size percentages for the
remaining items on the income statement are
as shown.
Quick Check – horizontal versus vertical analysis
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III. Norton Corporation − data for calculating ratios
A. We are going to examine ratios that managers use to
better understand organizational performance.
i. To facilitate our discussion, we are going to
use financial data for this year and last year
from Norton Corporation:
1. The asset sides of Norton’s balance sheets
are as shown.
2. The liabilities and stockholders’ equity sides
of Norton’s balance sheets are as shown.
3. Norton’s income statements are as shown.
Helpful Hint: To exercise students’ understanding of
ratios, after defining each ratio, ask students whether
an increase in the ratio would generally be considered
good news or bad news and why.
Helpful Hint: Impress on students that the ratios
discussed in this chapter cannot be analyzed in a
vacuum. Comparisons with industry averages and prior
years are essential.
IV. Ratio analysis – assessing liquidity
Learning Objective 2: Compute and interpret financial
ratios that managers use to assess liquidity.
A. The data and ratios that managers use to assess
liquidity include working capital, the current ratio,
and the acid-test (quick) ratio. The information
shown for Norton Corporation will be used to calculate
the aforementioned liquidity ratios.
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i. Working capital
1. The excess of current assets over current
liabilities is known as working capital.
a. Working capital is not free. It must be
financed with long-term debt and
equity. Therefore, managers often seek
to minimize working capital.
b. A large and growing working capital
balance may not be a good sign. For
example, it could be the result of
unwarranted growth in inventories.
2. Norton Corporation’s working capital
($23,000) is calculated as shown.
ii. Current ratio
1. The current ratio is computed as shown.
a. It measures a company’s short-term
debt paying ability.
b. It must be interpreted with care. For
example, a declining ratio may be a
sign of deteriorating financial
condition, or it might result from
eliminating obsolete inventories or
other stagnant current assets.
2. Norton Corporation’s current ratio of 1.55 is
calculated as shown.
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iii. Acid-test (quick) ratio
1. The acid-test ratio is computed as shown.
a. It is a more rigorous measure of
short-term debt paying ability because
it only includes cash, marketable
securities, accounts receivable, and
current notes receivable.
b. It measures a company’s ability to
meet its obligations without having to
liquidate its inventory.
2. Norton Corporation’s acid-test (quick) ratio
of 1.19 is computed as shown.
a. Each dollar of liabilities should be
backed by at least $1 of quick assets.
Norton satisfies this condition.
V. Ratio analysis – asset management
Learning Objective 3: Compute and interpret financial
ratios that managers use for asset management
purposes.
A. Managers compute a variety of ratios for asset
management purposes. The information shown for
Norton Corporation will be used to calculate the asset
management ratios.
i. Accounts receivable turnover
1. The accounts receivable turnover is
calculated as shown.
a. It measures how quickly credit sales
are converted to cash.
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b. Norton Corporation’s accounts
receivable turnover of 26.7 times is
computed as shown.
2. A related measure called the average
collection period is computed as shown.
a. It measures how many days, on
average, it takes to collect an
account receivable. It should be
interpreted relative to the credit
terms offered to customers.
b. Norton Corporation’s average
collection period of 13.67 days is
computed as shown.
ii. Inventory turnover
1. The inventory turnover is computed as
shown.
a. It measures how many times a
company’s inventory has been sold
and replaced during the year.
b. It should increase for companies that
adopt just-in-time methods.
c. It should be interpreted relative to a
company’s industry. For example,
grocery stores turn their inventory over
quickly, whereas jewelry stores tend
to turn their inventory over slowly.
(1). If a company’s inventory turnover
is less than its industry average, it
either has excessive inventory or
the wrong sorts of inventory.
d. Norton Corporation’s inventory
turnover of 12.73 times is computed as
shown.
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