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CHAPTER 14
Financial Statement Analysis
LEARNING OBJECTIVES
1. DISCUSS THE NEED FOR COMPARATIVE ANALYSIS.
2. IDENTIFY THE TOOLS OF FINANCIAL STATEMENT
ANALYSIS.
3. EXPLAIN AND APPLY HORIZONTAL ANALYSIS.
4. DESCRIBE AND APPLY VERTICAL ANALYSIS.
5. IDENTIFY AND COMPUTE RATIOS USED IN ANALYZING
A FIRM’S LIQUIDITY, PROFITABILITY, AND SOLVENCY.
6. UNDERSTAND THE CONCEPT OF EARNING POWER,
AND INDICATE HOW IRREGULAR ITEMS ARE
PRESENTED.
7. UNDERSTAND THE CONCEPT OF QUALITY OF
EARNINGS.
CHAPTER REVIEW
Need for Comparative Analysis
1. Financial statement analysis enables the financial statement user to make informed decisions
about a company.
2. When analyzing financial statements, three major characteristics of a company are generally
evaluated: (a) liquidity, (b) profitability, and (c) solvency.
3. (L.O. 1) Comparative analysis may be made on a number of different bases.
a. Intracompany basis—Compares an item or financial relationship within a company in the
current year with the same item or relationship in one or more prior years.
b. Industry averages—Compares an item or financial relationship of a company with industry
averages.
c. Intercompany basis—Compares an item or financial relationship of one company with the
same item or relationship in one or more competing companies.
Tools of Financial Analysis
4. (L.O. 2) There are three basic tools of analysis: (a) horizontal, (b) vertical, and (c) ratio.
Horizontal Analysis
5. (L.O. 3) Horizontal analysis, also called trend analysis, is a technique for evaluating a series
of financial statement data over a period of time to determine the increase or decrease that has
taken place, expressed as either an amount or a percentage. In horizontal analysis, a base year
is selected and changes are expressed as percentages of the base year amount.
Vertical Analysis
6. (L.O. 4) Vertical analysis, also called common-size analysis, expresses each item within a
financial statement as a percent of a base amount. Generally, the base amount is total assets for
the balance sheet, and net sales for the income statement. For example, it may be determined
that current assets are 22% of total assets, and selling expenses are 15% of net sales.
Ratio Analysis
7. (L.O. 5) A ratio expresses the mathematical relationship between one quantity and another as
either a percentage, rate, or proportion. Ratios can be classified as:
a. Liquidity ratios—measures of the short-term debt-paying ability.
b. Profitability ratios—measures of the income or operating success of an enterprise for a given
period of time.
c. Solvency ratios—measures of the ability of the enterprise to survive over a long period of time.
8. There are four liquidity ratios: the current ratio, the acid-test ratio, accounts receivable turnover,
and inventory turnover.
9. The current ratio expresses the relationship of current assets to current liabilities. It is a widely
used measure for evaluating a company’s liquidity and short-term debt paying ability. The formula
for this ratio is:
Current Ratio
=
Current Assets
Current Liabilities
10. The acid-test or quick ratio relates cash, short-term investments, and net receivables to current
liabilities. This ratio indicates a company’s immediate liquidity. It is an important complement to the
current ratio. The formula for the acid-test ratio is:
Acid-Test Ratio
=
Cash + Short-Term Investments + Accounts
Receivable (net)
Current Liabilities
11. The accounts receivable turnover is used to assess the liquidity of the accounts receivable. This
ratio measures the number of times, on average, receivables are collected during the period. The
formula for the ratio is:
Accounts Receivable
Turnover
=
Net Credit Sales
Average Net Accounts Receivable
Average net accounts receivable can be computed from the beginning and ending balances of the
net accounts receivable. A popular variant of the accounts receivable turnover is to convert it into
an average collection period in terms of days. This is done by dividing the accounts receivable
turnover into 365 days.
12. Inventory turnover measures the number of times, on average, the inventory is sold during the
period. It indicates the liquidity of the inventory. The formula for the ratio is:
Inventory Turnover
=
Cost of Goods Sold
Average Inventory
Average inventory can be computed from the beginning and ending inventory balances. A variant
of inventory turnover is to compute the average days to sell the inventory. This is done by
dividing the inventory turnover into 365 days.
13. The profitability ratios are explained in review points 14 to 23.
14. The profit margin ratio is a measure of the percentage of each sales dollar that results in net
income. The formula is:
Profit Margin
=
Net Income
Net Sales
15. Asset turnover measures how efficiently a company uses its assets to generate sales. The
resulting number shows the dollars of sales produced by each dollar invested in assets. The formula
for this ratio is:
Asset Turnover
=
Net Sales
Average Assets
16. Return on assets is an overall measure of profitability. It measures the rate of return on each dollar
invested in assets. The formula is:
Return on Assets
=
Net Income
Average Assets
17. Return on common stockholders’ equity measures profitability from the common stockholders’
viewpoint. The ratio shows the dollars of income earned for each dollar invested by the owners.
The formula is:
Return on Common
Stockholders’ Equity
=
Net Income
Average Common Stockholders’ Equity
a. When preferred stock is present, preferred dividend requirements are deducted from net income
to compute income available to common stockholders. Similarly, the par value of preferred
stock (or call price, if applicable) must be deducted from total stockholders’ equity to arrive at
the amount of common stock equity used in this ratio.
b. Leveraging or trading on the equity at a gain means that the company has borrowed money
through the issuance of bonds or notes at a lower rate of interest than it is able to earn by
using the borrowed money. A comparison of the rate of return on total assets with the rate of
interest paid for borrowed money indicates the profitability of trading on the equity.
18. Earnings per share measures the amount of net income earned on each share of common stock.
The formula is:
Earnings per Share
=
Net Income
Weighted-Average Common
Shares Outstanding
Any preferred dividends declared for the period must be subtracted from net income.
19. The price-earnings ratio measures the ratio of market price per share of common stock to earnings
per share. It is an oft-quoted statistic that reflects investors’ assessments of a company’s future
earnings. The formula for the ratio is:
Price-Earnings Ratio
=
Market Price per Share of Stock
Earnings per Share
20. The payout ratio measures the percentage of earnings distributed in the form of cash dividends.
The formula is:
Payout Ratio
=
Cash Dividends
Net Income
Companies with high growth rates generally have low payout ratios because they reinvest most of
their income into the business.
21. There are two solvency ratios: debt to assets and times interest earned.
22. The debt to assets ratio measures the percentage of total assets provided by creditors. The
formula for this ratio is:
Debt to Assets Ratio
=
Total
Liabilities
Total Assets
The adequacy of this ratio is often judged in the light of the company’s earnings. Companies with
relatively stable earnings, such as public utilities, have higher debt to assets ratios than cyclical
companies with widely fluctuating earnings, such as many high-tech companies.
23. Times interest earned measures a company’s ability to meet interest payments as they
become due. The formula is:
Times Interest
Earned
=
Income before Income Taxes
and Interest Expense
Interest Expense
Discontinued Operations
24. (L.O. 6) Discontinued operations refers to the disposal of a significant component of a business,
such as eliminating an entire activity or eliminating a major class of customers.
a. When the disposal occurs, the income statement should report both income from continuing
operations and income (loss) from discontinued operations.
b. The income (loss) from discontinued operations consists of (1) income (loss) from operations
and (2) gain (loss) on disposal of the segment.
c. Both components are reported net of applicable taxes in a section entitled Discontinued
Operations, which follows income from continuing operations.
Extraordinary Items
25. Extraordinary items are events and transactions that meet two conditions: (a) unusual in nature
and (b) infrequent in occurrence.
a. To be “unusual,” the item should be abnormal and only incidentally related to customary
activities of the entity.
b. To be “infrequent,” the item should not be reasonably expected to recur in the foreseeable
future.
c. Extraordinary items are reported net of taxes in a separate section of the income statement
immediately below discontinued operations.
Changes in Accounting Principle
26. A change in an accounting principle occurs when the principle used in the current year is different
from the one used in the preceding year. Companies report most changes in accounting principle
retroactively. That is, they report both the current period and previous periods using the new principle.
Income Statement with Irregular Items
27. A partial income statement showing the additional sections and the material items not typical of
regular operations is as follows:
Income Statement (partial)
Income before income taxes ................................................................ $XXX
Income tax expense ............................................................................. XXX
Income from continuing operations ...................................................... XXX
Discontinued operations:
Loss from operations of discontinued division,
net of $XXX income tax savings ................................................ $XXX
Gain on disposal of division, net of $XXX income taxes ................. XXX XXX
Income before extraordinary item ........................................................ XXX
Extraordinary item:
Gain or loss, net of $XXX income taxes ................................... XXX
Net Income .......................................................................................... $XXX
28. Comprehensive income includes all changes in stockholders’ equity during a period
except those resulting from investments by stockholders and distributions to stockholders. Certain
items bypass income and are reported directly in stockholders’ equity
Quality of Earnings
29. (L.O. 7) In evaluating the financial performance of a company, the quality of a company’s earnings
is of extreme importance to analysts. A company that has a high quality of earnings provides full
and transparent information that will not confuse or mislead users of financial statements.
30. Variations among companies in the application of generally accepted accounting principles—
alternative accounting methods—may hamper comparability and reduce quality of earnings.
31. In recent years, many companies have been also reporting a second measure of income called
pro forma income—which excludes items that the company thinks are unusual or nonrecurring.
Because many companies have abused the flexibility that pro forma numbers allow, it is an area
that will probably result in new rule-making.
LECTURE OUTLINE
A. Basics of Financial Statement Analysis.
1. Analyzing financial statements involves evaluating three characteristics:
a company’s liquidity, profitability, and solvency.
a. A short-term creditor (a bank) is primarily interested in liquidity—the
ability of the borrower to pay obligations when they come due.
b. A long-term creditor (a bondholder) looks to profitability and solvency
measures that indicate the company’s ability to survive over a long
period of time.
c. Stockholders look at the profitability and solvency of the company.
They want to assess the likelihood of dividends and the growth
potential of the stock.
2. Comparison of financial information can be made on a number of different
bases.
a. Intracompany basis: compares an item or financial relationship within
a company in the current year with the same item or relationship in
prior years.
b. Industry averages: compares an item or financial relationship of
a company with industry averages (norms) published by Dun &
Bradstreet, Moody’s, and Standard & Poor’s.
c. Intercompany basis: compares an item or financial relationship of
one company with the same item or relationship in one or more
competing companies.
B. Tools of Financial Statement Analysis.
1. Horizontal analysis (trend analysis) is a technique for evaluating a series
of financial statement data over a period of time to determine the increase
or decrease that has taken place, expressed as either an amount or a
percentage.
2. Vertical analysis (common-size analysis) is a technique that expresses
each financial statement item as a percent of a base amount. A benefit
of vertical analysis is that it enables one to compare companies of
different sizes.
3. Ratio analysis expresses the relationship among selected items of finan-
cial statement data. The relationship is expressed in terms of either a
percentage, a rate, or a simple proportion.
4. Ratios can be classified as follows:
a. Liquidity ratios: measure the short-term ability of the enterprise to
pay its maturing obligations and to meet unexpected needs for
cash.
b. Profitability ratios: measure the income or operating success of a
company for a given period of time.
c. Solvency ratios: measure the ability of a company to survive over a
long period of time.
5. Liquidity ratios.
a. The current ratio is a widely used measure for evaluating a company’s
liquidity and short-term debt paying ability. It is computed by dividing
current assets by current liabilities.
b. The acid-test (quick) ratio is a measure of a company’s immediate
short-term liquidity. This ratio is computed by dividing the sum of
cash, short-term investments, and net receivables by current liabilities.
