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CHAPTER TWELVE
Financial Statement Analysis
Financial statement analysis involves the application of analytical tools to
financial statements and supplemental data included with the financial
statements to enhance the ability of decision makers to make optimal decisions.
Key Concepts
• Ratio analysis provides additional information necessary to enhance
the decision-making ability of the users of the information.
• Liquidity ratios assess a company’s ability to meet its short-term
financial obligations.
• Solvency ratios assess the extent to which a company must borrow
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Learning Objectives
LO1— Explain why decision makers analyze financial statements and recognize
the limitations of financial statement analysis.
Lecture Outline
A. Introduction
o Decision makers need a variety of information in the
or for a company.
B. Why Analyze Financial Statements? (LO1)
1. Limitations of Financial Statement Analysis
Key Concept
Ratio analysis provides additional information necessary to enhance the
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o Financial statements are prepared using GAAP. If
2. The Impact of Inflation on Financial Statement Analysis
o Financial statements are prepared using historical costs and
C. Horizontal Analysis (LO2)
o Horizontal analysis refers to analyzing financial statements
D. Vertical Analysis (LO3)
Key Concept
Rather than focus on a single ratio, decision makers need to evaluate a
company by comparing ratios to those of previous years, budgeted
amounts, and industry standards.
Key Concept
Vertical analysis uses common-size financial statements to remove size
Instructor’s Manual
o When comparing companies of different sizes, it is useful to
standardize the statements.
E. Ratio Analysis—Liquidity Ratios (LO4)
o Financial statement ratios simply refer to a relationship
between two financial statement amounts stated as a
percentage
1. Current Ratio
2. Acid-Test Ratio
o The quick ratio is a stricter test of a company’s ability to pay
3. Cash Flow from Operations to Current Liabilities Ratio
o Cash flow from operations to current liabilities ratio = Net
Key Concept
Liquidity ratios assess a company’s ability to meet its short-term
financial obligations.
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4. Accounts Receivable Analysis
o The accounts receivable turnover ratio is one of the best
5. Inventory Analysis
o Inventory turnover ratio = Cost of goods sold / Average
6. Cash-to-Cash Operating Cycle Ratio
o Cash-to-cash operating cycle ratio = Number of days in
inventory + Number of days in receivables
F. Ratio Analysis—Solvency Ratios (LO5)
o Solvency refers to a company’s ability to remain in business
1. Debt-to-Equity Ratio
o Debt-to-equity ratio = Total liabilities ÷ Total stockholders’
2. Times-Interest-Earned Ratio
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o Times-interest-earned measures a company’s ability to meet
3. Debt Service Coverage Ratio
o Measures the amount of cash generated from operating
4. Cash Flow from Operations to Capital Expenditures Ratio
o This ratio measures a company’s ability to use cash flow
G. Ratio Analysis—Profitability Ratios (LO6)
1. Return on Assets (ROA)
o ROA considers the return to investors on all assets invested
2. Return on Common Stockholders’ Equity (ROCSE)
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o ROCSE measures the return to common stockholders (net
3. Earnings Per Share (EPS)
o Current stockholders and potential investors use earnings
number of common shares outstanding
4. Price Earnings Ratio
o A company’s P/E ratio tells us how much an investor is
End-of-Chapter Material
The problems and questions for this chapter are mostly intended to be
computational and not decision oriented. Any of the problems can be
Key Concept
Profitability ratios provide measures of how effectively a company is
using its assets.
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