Chapter 13 – Analyzing and Interpreting Financial Statements
Chapter 13
Analyzing and Interpreting Financial Statements
Student Learning Objectives and Related Assignment Materials*
Student Learning Objectives
Discussion
Questions
Quick
Studies
Exercises
Problems
(A &B set)**
Beyond the
Numbers
Conceptual objectives:
C1. Explain the purpose and identify
the building blocks of analysis.
1, 2, 3
13-1
13-1
HTR
C2. Describe standards for
comparisons in analysis.
13-5, 13-9
13-2
CA
Analytical objectives:
A1. Summarize and report
results of analysis.
13-7
13-6
13-2, 13-5
RIA, EC, CIP,
ED, GD
A2. Explain the form and assess the
content of a complete income
statement. (Appendix 13A)
13
13-8
13-13, 13-14
13-6
Procedural objectives:
P1. Explain and apply
methods of horizontal analysis.
13-2, 13-4
13-3, 13-4
13-1, 13-2
RIA, TIA, ED
P2. Describe and apply
methods of vertical analysis.
13-3
13-4, 13-5,
13-7
13-1
RIA, CA,
TIA, ED
P3. Define and apply ratio analysis.
4, 5, 6, 7, 8, 9,
10, 11, 12, 14,
15, 16, 17
13-6
13-8, 13-9,
13-10, 13-11,
13-12, 13-15
13-1, 13-3,
13-4, 13-5
CIP, TTN,
TIA, ED,
HTR
* Assignment materials that can be completed by students using:
Chapter 13 – Analyzing and Interpreting Financial Statements
13-2
Synopsis of Chapter Revisions
• Morgan Stanley: NEW opener with new entrepreneurial assignment
• New companies— Apple, Google, and Samsung—data 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 of segment data
• Streamlined global view section
PowerPoint® Show Slides
Chapter Learning Objective
PowerPoint® Slides
C1
3, 5
C2
4
P1
6-14
P2
15-20
P3
21-51
A1
52
Chapter 13 – Analyzing and Interpreting Financial Statements
13-3
Chapter Outline
Notes
I. Basics of Analysis—Transforming data into useful information for
decision making.
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.
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
1. Most users rely on general purpose financial statements that
include:
a. Income statement
b. Balance sheet
c. Statement of changes in stockholders’ equity (or statement
of retained earnings)
d. Statement of cash flows
e. Notes related to the statements
2. Financial reporting—is the communication of financial
information useful for making investment, credit, and other
business decisions. Includes information from SCE 10-K or
other filings, press releases, shareholders’ meetings, forecasts,
management letters, auditor’s reports, and Webcasts.
Chapter 13 – Analyzing and Interpreting Financial Statements
13-4
Chapter Outline
Notes
D. Standards for Comparisons
Used to determine if analysis measures suggest good, bad, or
average performance. Standards can include the following types of
comparisons:
1. Intracompany—based on 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 past experiences.
E. Tools of Analysis – includes horizontal, vertical and ratio analysis.
II. Horizontal Analysis—Tool to evaluate changes in financial statement
data across time. This analysis utilizes:
A. Comparative Statements—reports financial amounts for more
than one period placed side by side in columns on a single
statement.
1. Computation of 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 times
100.
Notes:
(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.
2. Comparative balance sheets
a. Consist of balance sheet amounts from two or more
balance sheet dates arranged side by side.
b. Usefulness is improved by showing each item’s dollar
change and percent change to highlight large changes.
3. Comparative income statements
a. Amounts for two or more period are placed side by side.
b. Additional columns are included for dollar and percent
changes.
Chapter 13 – Analyzing and Interpreting Financial Statements
13-5
Chapter Outline
Notes
B. Trend Analysis—used to reveal patterns in data across successive
periods. Involves computing trend percents (or index number) as
follows:
1. Select a base period and assign each item in the base period a
weight of 100%.
2. Express financial numbers as a percent of their base period
number.
3. Trend percent equals analysis period amount divided by base
period amount times 100.
III. Vertical 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. All amounts are
redefined in terms of common-size percents.
1. Common-size percentage equals analysis amount divided by
base amounts multiplied by 100.
2. Common-size balance sheets—base amount is usually total
assets.
3. Common-size income statements—base amount is usually
revenues.
B. Common-Size Graphics
Graphical analysis (e.g., pie charts and bar charts) of common-size
statements that visually highlight comparison information.
IV. Ratio Analysis—Using key relationships among financial statement
items. Ratios organized into the four (items A through D below)
building blocks of analysis:
A. Liquidity and Efficiency
1. Liquidity refers to the availability of resources to meet short-
term cash requirement.
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 over 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 and current
receivables) rather than current assets. Calculated as quick
assets divided by current liabilities.
Chapter 13 – Analyzing and Interpreting Financial Statements
13-6
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.
Note: A company is considered less risky if its capital
structure (equity and long-term debt) is composed more of
equity.
c. Debt-to-Equity Ratio – total liabilities divided by total
equity; measure of solvency. A larger debt-to–equity ratio
implies greater risk.
d. Times interest earned—income before interest expense
and income taxes divided by interest expense; reflects the
risk of loan 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.