CHAPTER 14
Financial Statement Analysis
LEARNING OBJECTIVES
1. APPLY HORIZONTAL AND VERTICAL ANALYSIS TO
FINANCIAL STATEMENTS.
2. ANALYZE A COMPANY’S PERFORMANCE USING RATIO
ANALYSIS.
3. APPLY THE CONCEPT OF SUSTAINABLE INCOME.
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.
Tools of Financial Analysis
4. There are three basic tools of analysis: (a) horizontal, (b) vertical, and (c) ratio.
Horizontal Analysis
5. Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial
Vertical Analysis
6. 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. 2) A ratio expresses the mathematical relationship between one quantity and another as
either a percentage, rate, or proportion. Ratios can be classified as:
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:
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
=
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
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
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
Return on Assets
=
Net Income
Average Total
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
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
Earnings per Share
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
Discontinued Operations
24. (L.O. 3) 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.
Other Comprehensive Income
25. Other Comprehensive income includes all changes in stockholders’ equity during a period
except those changes resulting from investments by stockholders and distributions to
26. A partial statement of comprehensive income showing discontinued operations and other
comprehensive income is as follows:
Statement of Comprehensive Income (partial)
Income before income taxes ………………………………………………………. $XXX
Income tax expense …………………………………………………………………. XXX
Income from continuing operations ……………………………………………… XXX
Discontinued operations:
Loss from operation of discontinued division,
net of $XXX income tax savings ………………………………………… $XXX
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. 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.
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.
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.
INVESTOR INSIGHT
The apparent simplicity of the current ratio can have real-world
limitations because adding equal amounts to both the numerator
and the denominator causes the ratio to decrease. Conversely,
decreasing both the numerator and the denominator by equal
amounts causes the ratio to increase.
How might management influence a company’s current ratio?
Answer: Management can affect the current ratio by speeding up
or withholding payments on accounts payable just before the
c. Accounts receivable turnover is used to assess the liquidity of
accounts receivable. Companies compute this ratio by dividing net
credit sales by the average net accounts receivable during the year.
6. Profitability ratios.
a. Profit margin is a measure of the percentage of each dollar of sales
that results in net income. It is computed by dividing net income by
net sales.
b. Asset turnover measures how efficiently a company uses its assets
to generate sales. It is computed by dividing net sales by average
total assets.
c. An overall measure of profitability is return on assets. This ratio is
computed by dividing net income by average total assets.
d. Return on common stockholders’ equity shows how many dollars of
net income the company earned for each dollar invested by the
owners. Companies compute it by dividing net income by average
common stockholders’ equity.
(1) When a company has preferred stock, it must deduct preferred
dividend requirements from net income to compute income
available to common stockholders.
e. Earnings per share is a measure of the net income earned on each
share of common stock. It is computed by dividing net income by
the number of weighted-average common shares outstanding during
the year.
f. The price-earnings ratio is a measure of the ratio of the market
price of each share of common stock to the earnings per share. It is
computed by dividing the market price per share of the stock by
earnings per share.
7. Solvency ratios.
a. The debt to assets ratio measures the percentage of the total
assets that creditors provide. It is computed by dividing total
liabilities (both current and long-term liabilities) by total assets.
C. Sustainable Income.
Sustainable income is the most likely level of income to be obtained by a
company in the future. An income statement provides information on
sustainable income, but also information on discontinued operations and
other comprehensive income.
1. Discontinued operations refers to the disposal of a significant component
of a business. Examples involve stopping an entire activity or eliminating
a major class of customers.
a. The income (loss) from discontinued operations consists of the
income (loss) from operations and the gain (loss) on disposal of the
segment.
2. Comprehensive income includes all changes in stockholders’ equity
during a period except those changes resulting from investments by
stockholders and distributions to stockholders.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. Intercompany comparison refers to comparison with other companies to provide insight into
competitive position.
True False
2. Vertical analysis determines the percentage increase or decrease that has taken place over a
period of time.
True False
3. A base year is determined when performing horizontal analysis.
True False
4. Liquidity ratios measure the ability of an enterprise to survive over a long period of time.
True False
5. Accounts receivable turnover, inventory turnover, and asset turnover are all common measures
of liquidity.
True False
6. Profit margin, return on assets, and return on common stockholders’ equity are profitability ratios.
True False
7. The formula for computing times interest earned is income before income taxes and
interest expense divided by interest expense.
True False
8. The debt to assets ratio measures the percentage of total assets provided by long-term creditors.
True False
9. The discontinued operation section reports both the operating loss for discontinued operations
and the loss on disposal of a compound net of income taxes.
True False
10. One format for reporting other comprehensive income is to report a statement of comprehensive
income.
True False
Multiple Choice
1. Sales (in millions) for a three year period are: Year 1 $6, Year 2 $6.9, and Year 3 $7.5.
Using Year 1 as the base year the percentage increase in sales in Years 2 and 3 are,
respectively
a. 115% and 125%.
b. 115% and 109%.
c. 115% and 130%.
d. 87% and 80%.
2. An incorrect formula is
a. current ratio = current assets ÷ current liabilities.
b. accounts receivable turnover = net credit sales ÷ average net accounts receivable.
c. asset turnover = net income ÷ average assets.
d. payout ratio = cash dividends ÷ net income.
3. The acid-test ratio
a. is a solvency ratio.
b. measures immediate short-term liquidity.
c. includes inventory in the numerator of the formula.
d. includes total liabilities in the denominator of the formula.
4. The ratio that measures the overall profitability of assets is
a. profit margin.
b. asset turnover.
c. return on common stockholders’ equity.
d. return on assets.
5. Other comprehensive income includes unrealized gains and losses on
a. available-for-sale securities only.
b. trading securities only.
c. both available-for-sale and trading securities.
d. neither available-for-sale nor trading securities.
ANSWERS TO QUIZ
True/False
1. True 6. True
Multiple Choice
1. a.