chapter
15(14)
Financial Statement
Analysis
______________________________________________
OPENING COMMENTS
This chapter presents techniques for analyzing financial statements and the contents of annual reports.
The techniques for analyzing financial statements include horizontal analysis, vertical analysis, and ratio
analysis. Since an analytical technique has been presented at the end of most chapters, some of the
material presented in Chapter 15(14) will be a review. The appendix presents unusual items on the
income statement.
When covering this chapter, you should guard against getting bogged down in the calculations
surrounding ratio analysis. Try to spend at least as much class time interpreting ratios as calculating them.
Emphasize that computing ratios is only the starting point for assessing the performance of a business. To
be meaningful, current-year ratios must be compared with ratios from prior years and ratios of other
companies in the same industry. The influence of the general economic and business environment should
be considered. Finally, sound financial judgment should be applied.
After studying the chapter, your students should be able to:
2. Use financial statement analysis to assess the solvency of a business.
4. Describe the contents of corporate annual reports.
KEY TERMS
accounts receivable analysis
accounts receivable turnover
290 Chapter 15(14) Financial Statement Analysis
common-sized statement
current position analysis
current ratio
dividend yield
dividends per share
earnings per share on common stock
extraordinary item
horizontal analysis
inventory analysis
inventory turnover
leverage
liquidity
Management’s Discussion and Analysis (MD&A)
number of days’ sales in inventory
number of days’ sales in receivables
number of times interest charges are earned
price-earnings (P/E) ratio
profitability
quick assets
quick ratio
STUDENT FAQS
• Do we have to memorize all these formulas?
• Which formulas are the most important?
• What are the top five formulas?
• Should we use these formulas to tell how a company is doing before we invest in it?
• These are hard since I did not learn some of this information earlier. What do you suggest I do?
• What do these formulas really tell us about the company?
• How do I know if a ratio of fixed assets to long-term liabilities of 3.8 is good or bad?
• Is vertical or horizontal analysis better?
• How are some of these ratios related? If a company’s accounts receivable turnover is poor, then won’t
the numbers of days’ sales in receivables be poor too?
• How much emphasis should I put on unusual items in a company’s income statement when evaluating
its financial condition?
Chapter 15(14) Financial Statement Analysis 291
OBJECTIVE 1
Describe basic financial statement analytical methods.
SYNOPSIS
Three methods to analyze a company’s financial statements are horizontal analysis, vertical analysis, and
common-size statements. To complete a horizontal analysis, a minimum of two financial statements is
used. Each item on the most recent statement is compared with the same item on an earlier statement in
terms of the amount of increase or decrease and the percent of increase or decrease. Exhibits 1, 2, 3, and 4
show the horizontal comparison of various financial statements. The percentage analysis of the
Key Terms and Definitions
• Common-Sized Statement – A financial statement in which all items are expressed only in
relative terms.
• Horizontal Analysis – Financial analysis that compares an item in a current statement with the
same item in prior statements.
• Vertical Analysis – An analysis that compares each item in a current statement with a total
amount within the same statement.
Relevant Example Exercises and Exhibits
• Example Exercise 15(14)-1 Horizontal Analysis
• Example Exercise 15(14)-2 Vertical Analysis
• Exhibit 1 – Comparative Balance Sheet—Horizontal Analysis
• Exhibit 2 – Comparative Schedule of Current Assets—Horizontal Analysis
SUGGESTED APPROACH
The basic financial statement analytical procedures are horizontal analysis, vertical analysis, and ratio
analysis. Ratio analysis is covered under Objectives 2 and 3.
292 Chapter 15(14) Financial Statement Analysis
DEMONSTRATION PROBLEM—Horizontal Analysis
Ask your students to turn to the annual report for Nike in Appendix C at the end of the text. Specifically,
direct them to the Consolidated Statements of Income. Ask your students to compute the dollar increase
in sales (Gross Margin) between fiscal year 2010 and fiscal year 2011. (Answer: $708 million, or
$708,000,000)
Most likely, a few students will have 7.4 percent as an answer. These students have compared the $708
million increase in sales to sales in fiscal year 2011. Remind them that a percentage change in a financial
statement item is computed by comparing the change in dollars to the base year amount. The base year is
the starting point—fiscal year 2010 in this case.
GROUP LEARNING ACTIVITY—Horizontal Analysis
Divide your class into small groups. Ask them to perform the horizontal analysis requested on
Transparency Master (TM) 15(14)-1 using the financial statements. The correct answers are displayed on
TM 15(14)-2.
GROUP LEARNING ACTIVITY—Vertical Analysis
Under vertical analysis, all financial statement items are shown as a percentage of a significant total on
the statement. On an income statement, all items are shown as a percentage of sales. On a balance sheet,
all items are shown as a percentage of total assets.
Chapter 15(14) Financial Statement Analysis 293
OBJECTIVE 2
Use financial statement analysis to assess the solvency of a business.
SYNOPSIS
Users of financial statements are interested in the ability of a company to maintain liquidity, solvency,
and profitability. The ability of a company to convert assets into cash is called liquidity, and the ability to
pay its debts is called solvency. Current position analysis concerns a company’s ability to pay its current
liabilities; it includes working capital, current ratio, and quick ratio. Working capital is computed as
working capital = current assets – current liabilities and is used to evaluate a company’s ability to pay
Accounts receivable analysis assesses a company’s ability to collect the money due from customers. It
includes accounts receivable turnover and number of days’ sales in receivables. Accounts receivable
turnover is calculated as accounts receivable turnover = sales/average accounts receivable. Number of
days’ sales in receivables is computed as number of days’ sales in receivables = average accounts
receivable/average daily sales and is an estimate of the time (in days) that the accounts receivable have
been outstanding.
Inventory analysis analyzes the company’s ability to manage its inventory and includes inventory
turnover and number of days’ sales in inventory. Excess inventory ties up cash and increases insurance
The ratio of fixed assets to long-term liabilities provides a measure of whether note holders or
bondholders will be paid. Calculated as ratio of fixed assets to long-term liabilities = fixed assets (net)/
long-term liabilities. A related ratio, the ratio of liabilities to stockholders’ equity, measures how much of
the company is financed by debt and equity. It is computed as ratio of liabilities to stockholders’ equity =
total liabilities/total stockholders’ equity. The fixed charge coverage ratio is also known as the number of
times interest charges are earned and measures the risk that interest payments will not be made if earnings
decrease. It is computed as number of times interest charges are earned = (income before income tax +
interest expense)/interest expense. The higher the ratio, the more likely payments will be made.
Key Terms and Definitions
• Accounts Receivable Analysis – A company’s ability to collect its accounts receivable.
• Accounts Receivable Turnover – The relationship between sales and accounts receivable,
computed by dividing the sales by the average net accounts receivable; measures how frequently
294 Chapter 15(14) Financial Statement Analysis
• Inventory Turnover – The relationship between the volume of goods sold and inventory,
computed by dividing the cost of goods sold by the average inventory.
• Liquidity – The ability to convert assets into cash.
• Number of Days’ Sales in Inventory – The relationship between the volume of sales and
• Quick Ratio – A financial ratio that measures the ability to pay current liabilities with quick
assets (cash, marketable securities, accounts receivable).
• Ratio of Fixed Assets to Long-Term Liabilities – A leverage ratio that measures the margin of
safety of long-term creditors, calculated as the net fixed assets divided by the long-term liabilities.
• Ratio of Liabilities to Owner’s (Stockholders’) Equity – A comprehensive leverage ratio that
measures the relationship of the claims of creditors to stockholders’ equity.
• Solvency – The ability of a firm to pay its debts as they come due.
• Working Capital – The excess of the current assets of a business over its current liabilities.
Relevant Example Exercises and Exhibits
• Example Exercise 15(14)-3 Current Position Analysis
SUGGESTED APPROACH
Solvency, which is a company’s ability to pay debts as they become due, is assessed through ratio
analysis. TM 15(14)-4 lists the ratios that measure a firm’s solvency.
Use the following group learning activities to give your students the opportunity to practice ratio analysis
as it relates to solvency.
GROUP LEARNING ACTIVITY—Computing Solvency Measures
The ratios that assess solvency are listed in the text in the first section of Exhibit 10. Calculating these
ratios using real-life financial statements is a challenge for most students, due to the differences in
terminology used by companies. For example, a company may use the term “plant assets” or “property,
Chapter 15(14) Financial Statement Analysis 295
GROUP LEARNING ACTIVITY—Analyzing Solvency Measures
TM 15(14)-5 shows solvency ratios for Ace Company over a two-year period. The TM also presents
industry averages for the solvency ratios. Ask your students to analyze the data related to Ace Company
1. For each solvency ratio, state whether or not Ace has improved from the prior year.
3. Comment on any significant items noticed when reviewing the solvency ratios and Ace’s overall
solvency.
Possible response: The table below provides a summary of the questions listed above:
Ratio
Ace Prior Year
Ace vs. Industry
Current Ratio
Improved
Better
Quick Ratio
Unchanged
Better
turnover
in receivables
Inventory turnover
Worse
Worse
Number of days’ sales
in inventory
Improved
Better
Ratio of fixed assets to
long-term liabilities
Unchanged
No significant difference
Ratio of liabilities to
stockholders’ equity
Improved
Better
Number of times
interest charges earned
Improved
Worse
Comments: 1) The accounts receivable turnover and number of days’ sales in receivables show higher
OBJECTIVE 3
Use financial statement analysis to assess the profitability of a business.
SYNOPSIS
Profitability analysis focuses on a company’s ability to earn profits. Eight different ratios are used to
analyze profit and both the income statement and the balance sheet are utilized. The ratio of sales to assets
per share on common stock, and it is a ratio that measures a company’s future earnings prospects.
Dividends per share measures the extent to which earnings are being distributed to common shareholders.
It is computed as dividends per share = dividends on common stock/shares of common stock outstanding.
The dividend yield on common stock measures the rate of return to common stockholders from cash
dividends. It is computed as dividend yield = dividends per share of common stock/market price per share
• Price-Earnings (P/E) Ratio – The ratio of the market price per share of common stock, at a
specific date, to the annual earnings per share.
Chapter 15(14) Financial Statement Analysis 297
• Rate Earned on Common Stockholders’ Equity – A measure of profitability computed by
dividing net income, reduced by preferred dividend requirements, by common stockholders’
equity.
Relevant Example Exercises and Exhibits
• Example Exercise 15(14)-8 Sales to Assets
• Example Exercise 15(14)-9 Rate Earned on Total Assets
• Example Exercise 15(14)-10 Common Stockholders’ Profitability Analysis
• Example Exercise 15(14)-11 Earnings per Share and Price-Earnings Ratio
• Exhibit 8 – Effect of Leverage
• Exhibit 9 – Dividends and Earnings per Share of Common Stock
• Exhibit 10 – Summary of Analytical Measures
SUGGESTED APPROACH
Profitability, which is a company’s ability to earn income, is also assessed through ratio analysis. TM
15(14)-6 lists the ratios that measure a firm’s profitability.
Use the Group Learning Activities below to give your students the opportunity to practice ratio analysis
as it relates to profitability.
GROUP LEARNING ACTIVITY—Computing Profitability Measures
The ratios that assess profitability are listed in the text in the second part of Exhibit 10. Ask your students
to calculate each of the profitability ratios (items i through m) for the Nike Inc. Financial Statement
GROUP LEARNING ACTIVITY—Analyzing Profitability Measures
TM 15(14)-7 shows profitability ratios for Ace Company over a two-year period. The TM also presents
industry averages for the profitability ratios.
1. For each profitability ratio, state whether or not Ace has improved from the prior year.
298 Chapter 15(14) Financial Statement Analysis
3. Comment on any significant items noticed when reviewing the profitability ratios and Ace’s overall
profitability.
Possible response: The table below provides a summary of the questions listed above:
Ratio
Ace Prior Year
Ace vs. Industry
Ratio of sales to assets
Improved
Better
Rate earned on total assets
No change
No significant difference
Rate earned on stockholders’
equity
Improved
Better
Earnings per share on common
stock
Improved
No comparison
Price earnings ratio
Worse
Worse
Dividend yield
No Change
Better
OBJECTIVE 4
Describe the contents of corporate annual reports.
SYNOPSIS
The annual report of a corporation contains financial statements, accompanying notes, and several other
requirements. The Securities and Exchange Commission (SEC) requires that annual reports include the
management’s analysis of current operations and their plans for the future. The Sarbanes-Oxley Act of
Key Terms and Definitions
• Management’s Discussion and Analysis (MD&A) – An annual report disclosure that provides
management’s analysis of the results of operations and financial condition.
Chapter 15(14) Financial Statement Analysis 299
SUGGESTED APPROACH
The text presents information on the Management Discussion and Analysis section of the annual report
plus the Independent Auditor’s Report. You may want to briefly mention other components of the annual
report. TM 15(14)-8 lists several sections typically included in a corporate annual report. Briefly review
these sections and their content with your students, using the notes below.
1. Financial Highlights—presents selected financial data that summarize operations for the past year or
two.
3. Financial Statements
4. Notes to the Financial Statements—presents supplemental information needed to interpret the
6. Management Report—affirms management’s responsibility for internal controls and the accuracy of
financial statements; usually signed by the company’s CFO.
8. Historical Summary—presents key financial data for the past five to ten years.
Ask your students to look through the financial statements of Nike and locate as many of these sections as
possible.
Use the following Group Learning Activity to cover the independent auditors’ report and the management
report in more detail.
GROUP LEARNING ACTIVITY—Independent Auditors’ Report
Obtain copies of several different annual reports. Divide the class into small groups; give each group an
annual report. Ask each group to locate the independent auditors’ report. Next, instruct the groups to
outline the auditors’ report by briefly describing the main point(s) in each paragraph. Ask two or more
300 Chapter 15(14) Financial Statement Analysis
INTERNET ACTIVITY—Annual Reports
It is possible to find the annual reports of many companies by searching the Internet. Ask your students to
WRITING EXERCISE—Historical Summary
Ask your students to write an answer to the following question [TM 15(14)–10]:
Many annual reports include a Historical Summary section, which shows key financial data for the past
five to ten years. Why would information that is five to ten years old be presented in an annual report?
APPENDIX—UNUSUAL ITEMS ON THE
INCOME STATEMENT
SYNOPSIS
GAAP requires that unusual items be reported separately on the income statement. Without separate
reporting on the income statement, users of financial statements might be misled. Unusual items either
affect the current period or affect a prior period. Extraordinary item include those that are unusual in
nature and infrequent in occurrence. Earnings per share are usually included with the income statement
but are only required in the report for continuing operations and net income.
Key Terms and Definitions
• Extraordinary Item – An event or a transaction that is both (1) unusual in nature and (2)
infrequent in occurrence.
Relevant Example Exercises and Exhibits
Chapter 15(14) Financial Statement Analysis 301
SUGGESTED APPROACH
The text presents unusual items in two sections, those affecting the current period income statement
(discontinued operations and extraordinary items) and those affecting a prior period income statement
LECTURE AID—Unusual Income Statement Items
1. Fixed Asset Impairments: A fixed asset impairment occurs when the carrying amount (book value) of
2. Restructuring Charges: These are costs associated with involuntarily terminating employees,
terminating contracts, consolidating facilities, or relocating employees. For example, assume a
restaurant chain decides to close several of its unprofitable locations. Closing the restaurants may
create the following costs: severance packages for managers, fees associated with breaking a lease, or
fees paid to an employment agency to help workers find other jobs. The company may be willing to
incur these costs because the short-term restructuring costs are less than the long-term costs of
running unprofitable restaurants.
3. Discontinued Operations: This section contains information concerning any component of a business
(such as a division, department, or product line) that is sold or closed during the year. The amount
displayed in this section is calculated as follows:
4. Extraordinary Items: These are revenues or expenses that result from events that are “unusual and
infrequent.” Examples include natural disasters (flood, earthquake, fire) and condemnation of land or
5. Changes in Accounting Principles: This section shows the effect of changing from one accepted
accounting principle to another. For example, a corporation might choose to change its depreciation
method from the straight-line to the declining-balance method. That corporation would need to re–
compute depreciation for all of its assets under the new method (declining-balance) for any prior
WRITING EXERCISE—Below-the-Line Items Reported on the Income
Statement
Ask your students to write a response to the following questions found on TM 15(14)-11:
1. Why are the results of discontinued operations and extraordinary items shown in separate sections at
the bottom of the income statement?
2. Why are discontinued operations and extraordinary items shown net of tax?