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CHAPTER 10
USING FINANCIAL STATEMENT ANALYSIS TO
EVALUATE FIRM PERFORMANCE
CHAPTER OVERVIEW
The chapter begins with a closer look at the income statement. Specifically, the discussion
centers on separately reported items on the income statement, including discontinued operations
and extraordinary items. The definition and accounting treatment for each of these items is
briefly covered.
The next part of the chapter presents analysis of financial information. Horizontal analysis and
vertical analysis is explained. Finally, ratio analysis is discussed. All of the ratios presented in
previous chapters are reviewed and segregated into liquidity ratios, solvency ratios, and
profitability ratios. Two new market indicator ratios are introduced (price-earnings ratio and
dividend-yield ratio) and explained. A full ratio analysis is then presented.
LEARNING OBJECTIVES
After completing Chapter 10, your students should be able to answer these questions:
1. Recognize and explain the components of net income.
2. Perform and interpret a horizontal analysis and a vertical analysis of financial
statement information.
3. Perform a basic ratio analysis of a set of financial statements and explain what the
ratios mean.
4. Recognize the risks of investing in stock and explain how to control those risks.
CHAPTER OUTLINE
Closer Look at the Income Statement (LO 1)
I. Earnings (net income) are the focus of financial reporting.
a. Not uncommon for firms to be accused of manipulating their earnings
b. GAAP defines two items that need to be separated from regular earnings of a
business:
i. Discontinued operations
ii. Extraordinary items
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 10-1
II. Discontinued operations are those parts of the firm that a company has eliminated by
selling a division.
a. Financial implications related to that segment are separated from the regular
operations of the firm.
i. Net income is used to evaluate the performance of a company and to predict
future performance.
ii. To make evaluations meaningful, one-time occurrences are separated out.
b. Financial implications of discontinuing a business segment are reported separately.
i. Gain or loss on disposal
ii. Earnings or loss of the segment for the accounting period
Teaching Tip
Use the example on pages 462-3 to illustrate the separate reporting of discontinued operations.
III. Extraordinary items are events that are unusual in nature and infrequent in occurrence.
a. Examples:
i. Eruption of a volcano
ii. Takeover of foreign operations by the foreign government
iii. Effects of new laws or regulations that result in a one-time cost for
compliance
b. Each situation is unique and must be considered in the environment in which the
company operates.
Teaching Tip
Explain how situations must be considered within the context of the company’s environment. For
example, in 2005 Hurricane Katrina caused considerable damage to property in Louisiana and
Mississippi. The loss incurred by companies located along the coast of Louisiana and Mississippi
would not be extraordinary because it was not unusual or infrequent. However, loss incurred by
companies located in Vicksburg, Mississippi (200 miles away from the coast) might be
extraordinary because hurricane damage in Vicksburg is both unusual and infrequent.
Teaching Tip
Use the example on page 463 to illustrate the separate reporting of extraordinary items.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 10-2
Teaching Tip
The issues surrounding the classification of an item as “extraordinary” came under scrutiny
following the terrorist attacks of September 11, 2001. Although accounting issues are trivial
compared to the human factors involved in these tragic events, an interesting debate arose.
Clearly, those businesses located in the World Trade Center suffered extraordinary losses (to the
extent that they did not have business interruption insurance). What about the businesses that
were not directly affected by the damage to structures? For example, the tourism industry ground
to a halt for a substantial period after the attacks. Should hotels, restaurants, theater companies,
airlines, travel agents, resorts in the Caribbean, etc., have been allowed to estimate the losses
they suffered as a result of September 11 and report them as extraordinary?
Teaching Tip
Have students give you examples of items they believe would be classified as extraordinary
losses. Use examples like earthquakes in California and tornadoes in Kansas to demonstrate
when natural disasters are not classified as extraordinary as it does not meet the infrequent and
unusual test.
Horizontal and Vertical Analysis of Financial Information (LO 2)
I. Horizontal analysis is a technique for evaluating financial statement amounts across
time.
a. Purpose is to express the change in an item in percentages, based on a specific past
year chosen as the base year
Teaching Tip
PepsiCo. Inc. reported the following information (in millions) for the years ended December 31,
20X3, 20X2, and 20X1.
For the Years Ending
Dec. 31, 20X3 Dec. 31, 20X2 Dec. 31, 20X1
Sales $26,971 $25,112 $23,512
Net Income 3,568 3,000 2,400
Compute percentage changes for Sales and Net Income for 20X3.
% change in Sales = $26,971 – 25,112 = $1,859 = 7.4% increase
$25,112 $25,112
% change in Net income = $3,568 – 3,000 = $568 = 18.9% increase
$3,000 $3,000
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 10-3
Vertical analysis is a technique for comparing items in a financial statement in which all items
are expressed as a percent of a common amount.
b. Similar to horizontal analysis, but involves items on a financial statement for a single
year
c. Common-sizing involves converting all amounts on a financial statement to a
percentage of a chosen value on that statement, also known as vertical analysis.
d. Each item in the financial statement is expressed as a percentage of a selected item on
the statement.
i. Sales are the common amount or base for income statement items.
ii. Total assets are the common amount or base for balance sheet items.
Teaching Tip
Common size statements are simply vertical analysis statements presented without the
percentage signs and with no dollar amounts provided. Common-size analysis is helpful when
comparing different size companies, because all amounts are stated in percentages.
Teaching Tip
Use the information in the earlier Teaching Tip for PepsiCo. Inc., to compute the vertical analysis
percentage for net income.
For the Years Ending
Dec. 31, 20X3 Dec. 31, 20X2 Dec. 31, 20X1
Vertical analysis % = $ 3,568 = 13.2% $ 3,000 = 11.9% $2,400 = 10.2%
$26,971 $25,112 $23,512
Net income was 10.2% of every sales dollar in 20X1 but rose to 13.2% of every sales dollar in
20X3.
Teaching Tip
Exhibit 10.2 provides a vertical analysis for General Mills, Inc.
Ratio Analysis (LO 3)
I. Liquidity ratios measure the company’s ability to pay its current bills and operating
costs.
a. Current ratio
i. Current assets divided by current liabilities
ii. This ratio was first presented in Chapter 2.
b. Cash from operations to current liabilities
i. Net cash from operating activities divided by current liabilities
ii. This ratio measures a company's ability to meet its short-term obligation.
c. Inventory turnover ratio
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i. Cost of goods sold divided by average inventory
ii. This ratio was first presented in Chapter 5.
d. Accounts receivable turnover ratio
i. Net credit sales divided by average net accounts receivable
ii. This ratio was first presented in Chapter 4.
II. Solvency ratios measure the company’s ability to meet its long-term obligations and to
survive over a long period of time.
a. Debt-to-equity
i. Total liabilities divided by total shareholders’ equity
ii. This ratio was first presented in Chapter 7.
III. Profitability ratios measure the operating or income performance of a company.
a. Profit margin
i. Net income divided by net sales
ii. This ratio was first presented in Chapter 3.
b. Return on assets
i. Net income + interest expense divided by average total assets
ii. This ratio was first presented in Chapter 6.
c. Asset turnover ratio
i. Net sales divided by average total assets
ii. This ratio was first presented in Chapter 6.
d. Return on equity
i. Net income minus preferred dividends divided by average common
stockholders’ equity
ii. This ratio was first presented in Chapter 8.
e. Gross profit ratio
i. Gross profit divided by net sales
ii. This ratio was first presented in Chapter 8.
f. Earnings per share (EPS)
i. Net income minus preferred dividends divided by weighted average number
of shares of common stock outstanding
ii. This ratio was first presented in Chapter 8.
IV. Market indicator ratios are ratios that relate the current market price of the company’s
stock to earnings or dividends.
a. Price-earnings ratio (P/E)
i. Market price of a share of stock divided by the current EPS
ii. Indicates the return an investor might earn by purchasing the stock
iii. Gives an indication of future earnings
iv. An extremely high P/E ratio might indicate an overpriced stock.
v. A very low P/E ratio might indicate an underpriced stock.
b. Dividend-yield ratio
i. Dividend per share divided by the market price per share
ii. Investors are willing to accept a low dividend yield when they anticipate an
increase in the price of the stock.
iii. Stocks with low growth potential may offer a higher dividend yield.
V. Understanding ratios
a. A ratio by itself does not give much information.
b. To be useful, a ratio must be compared with:
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 10-5
i. Ratios from prior years
ii. Ratios of other companies in the same industry
iii. Industry average ratios
iv. No standard formulas for computing ratios (except for EPS)
c. Be consistent in calculating ratios so comparisons will be meaningful.
d. Look for trends, components in the values that are part of the ratios, and other
information about the company that may not even be contained in the financial
statements.
e. Financial statements are only one source of information.
f. Ratio analysis is only one tool for analyzing financial statements.
Teaching Tip
Students should be aware that not all ratios apply to all companies. For example, inventory
turnover would not be applicable to a service company.
Teaching Tip
Have students give examples of pairs of companies that could be benchmarked against each
other. Coke and Pepsi would be a good start. If time permits, obtain the information needed and
complete the analysis.
Teaching Tip
Call a company that issues annual reports and ask them to send you enough copies of their
annual report for your class to use, or copy the annual report of the company from the Internet.
Use a copy of Robert Morris and Associates’ (RMA) Annual Statement Studies, and select an
appropriate industry category for comparison. Use this annual report to help illustrate the
calculations, and then compare your results to the industry averages. In some cases, the ratios
are calculated differently than in the text.
Teaching Tip
Use the example that begins on page 470 to demonstrate how to use ratio analysis.
Financial Statement Analysis – More than Numbers (LO 3)
I. The notes are an integral part of the financial statements.
a. Some analysts believe there is more real information about the health of a company in
the notes to the financial statements than in the statements themselves.
II. A business plan is a detailed analysis of what it would take to start and maintain the
operation of a successful business.
a. It should include a sales forecast, total expenses estimated, and prospective
financial statements.
b. Banks often require these prior to lending money to new firms.
III. Because accounting is such an integral part of business, accounting principles will
continue to change as business changes.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 10-6
a. Each year the FASB and other standard-setting bodies add and changes rules for
including, excluding, and valuing items in the financial statements.
b. The accounting profession will be increasingly concerned with electronic
transactions, e-business, and real-time access to financial data.
Business Risk, Control, and Ethics (LO 4)
I. There are risks with owning stock.
II. How do you minimize those risks?
a. Be diligent about finding a financial advisor or financial analyst to help you.
i. Become an expert in the analysis of available stock.
ii. Know some financial accounting and financial statement analysis.
b. Diversify.
i. This means to vary or expand.
ii. Don’t put all your eggs in one basket.
iii. This allows you to earn a higher rate of return for a given amount of risk.
III. You cannot eliminate all the risks of stock ownership.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 10-7
CHAPTER 10 NAME ___________________________________
TEN-MINUTE QUIZ Section _____________ Date____________
_____________________________________________________________________________
_
_____ 1. Items separated from the regular earnings of a company include:
a. Discontinued operations
b. Extraordinary items
c. Loss on sale of equipment
d. Two of the above
_____ 2. To be reported as an extraordinary item, the event must be:
a. Unusual and infrequent
b. Unusual and frequent
c. Normal and infrequent
d. Part of continuing operations
_____ 3. When using horizontal analysis, the base year is normally:
The current year
The earliest year presented
The latest year presented
The year with the highest revenues
_____ 4. Jacksonville Company reported cost of goods sold of $80,000 in 20X5 and
$92,000 in 20X6. The percentage change is:
12%
13%
15%
None of the above
_____ 5. A method of financial statement analysis that must use two or more years of
financial statements is known as:
Horizontal
Diagonal
Ratio
All of the above
_____ 6. What type of ratios measure the company’s ability to pay its current bills and
operating costs?
Liquidity
Solvency
Profitability
Market indicator
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 10-8
_____ 7. Liquidity ratios include all of the following, except:
a. Return on assets
b. Current ratio
c. Working capital
d. Acid test
_____ 8. Which of the following types of ratios measure the ability of a company to
survive over a long period of time?
a. Liquidity ratios
b. Solvency ratios
c. Profitability ratios
d. Market indicators
_____ 9. An extremely high price-earnings ratio may indicate:
a. That the stock is underpriced
b. That the stock is overpriced
c. That the investment is low risk
d. That the company pays high dividends
_____ 10. Dividend-yield ratio is calculated by:
a. Dividing dividend per share by market price per share
b. Dividing market price per share by dividend per share
c. Subtracting the dividend per share from the earnings per share
d. Dividing the dividend per share by the earnings per share
ANSWER KEY - CHAPTER 10 – TEN-MINUTE QUIZ
D
A
B
C
A
A
A
B
B
A
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