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Chapter 15
Lecture Notes
Chapter theme: This chapter focuses upon financial
I. Limitations of financial statement analysis
A. Comparing financial data across companies
i. Differences in accounting methods between
companies sometimes make it difficult to
compare their financial data. For example:
B. Looking beyond ratios
i. Ratios should not be viewed as an end, but
rather as a starting point. They raise many
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1. In addition to ratios, other sources of data
should also be considered such as industry
trends, technological changes, changes in
consumer tastes, changes in broad
economic factors, and changes within the
company itself.
Helpful Hint: Reinforce the limitations of relying on
II. Statements in comparative and common-size form
Learning Objective 1: Prepare and interpret financial
statements in comparative and common-size form.
A. Key concept
i. An item on a balance sheet or income
statement has little meaning by itself. The
meaning of the number can be enhanced by
drawing comparisons. This chapter
discusses three types of comparisons.
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B. Dollar and percentage changes on statements
i. Horizontal analysis (also known as trend
analysis) involves analyzing financial data
over time.
ii. Clover Corporation – an example
1. Assume the comparative asset account
balances from the balance sheet as shown.
a. The dollar change in account balances
is calculated as shown. Notice, last
shown.
2. We could do this for the liabilities and
stockholders’ equity, but instead let’s look at
the income statement.
a. Assume Clover has the comparative
income statement amounts as shown.
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when data from a number of years are used to
compute trend percentages.
1. To compute a trend percentage, a base year
is selected and the data for all years are
stated in terms of a percentage of that
base year.
iv. Berry Products – an example
1. Assume the financial results as shown for
2007-2011. Notice:
a. The base year is 2007 and its amounts
will equal 100%.
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C. Common-size statements
i. Vertical analysis focuses on the relations
among financial statement items at a given
point in time. A common-size financial
statement is a vertical analysis in which each
financial statement item is expressed as a
percentage.
1. In income statements, all items are usually
expressed as a percentage of sales.
a. Managers often pay close attention to
2. In balance sheets, all items are usually
expressed as a percentage of total assets.
3. Common-size financial statements are
particularly useful when comparing data
from different companies. For example:
a. In 2008, Burger King’s net income
was $190 million, whereas
McDonald’s was $4,313 million. This
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performance compares favorably
with Burger King’s.
ii. Clover Corporation – an example
1. Let’s revisit the comparative income
statements as shown. Notice:
a. As previously mentioned, sales is
Quick Check – horizontal versus vertical analysis
III. Norton Corporation − data for calculating ratios
A. We are going to examine ratios that are useful to
common stockholders, short-term creditors, and
long-term creditors.
i. To facilitate our discussion, we are going to
use financial data for this year and last year
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Helpful Hint: To exercise students’ understanding of
ratios, after defining each ratio, ask students whether
IV. Ratio analysis − the common stockholder
Learning Objective 2: Compute and interpret financial
ratios that would be useful to a common stockholder.
i. Earnings per share
1. Earnings per share is computed as shown.
a. The average number of common
shares outstanding is computed by
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2. Norton Corporation’s earnings per share for
this year ($2.42) is computed as shown.
ii. Price-earnings ratio
1. The price-earnings ratio is computed as
shown.
2. Norton Corporation’s price-earnings ratio
for this year (8.26 times) is computed as
shown.
iii. Dividend payout ratio
1. The dividend payout ratio is computed as
shown.
a. Investors who seek market price
iv. Dividend yield ratio
1. The dividend yield ratio is computed as
shown.
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2. Norton Corporation’s dividend yield ratio
for this year (10%) is computed as shown.
v. Return on total assets
1. The return on total assets is computed as
shown.
a. Adding interest expense back to net
2. Norton Corporation’s return on assets for
this year (18.19%) is computed as shown.
vi. Return on common stockholders’ equity
1. The return on common stockholders‘ equity
is computed as shown.
vii. Financial leverage
1. Financial leverage results from the
difference between the rate of return the
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a. Positive financial leverage exists if
the rate of return on the company’s
assets exceeds the rate of return the
by having debt in the capital structure.
Quick Check – financial leverage
viii. Book value per share
1. The book value per share is computed as
shown.
a. It measures the amount that would be
distributed to holders of each share
entirely on historical cost.
2. Norton Corporation’s book value per share
at the end of this year ($8.55) is computed as
shown. Notice:
a. The book value per share of $8.55
does not equal the market value per
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dividends, whereas the book value
per share is based on historical cost.
V. Ratio analysis – the short-term creditor
Learning Objective 3: Compute and interpret financial
ratios that would be useful to a short-term creditor.
A. Short-term creditors, such as suppliers, want to be paid
i. Working capital
1. The excess of current assets over current
liabilities is known as working capital.
a. Working capital is not free. It must be
financed with long-term debt and
equity. Therefore, managers often seek
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ii. Current ratio
1. The current ratio is computed as shown.
a. It measures a company’s short-term
debt paying ability.
2. Norton Corporation’s current ratio of 1.55 is
calculated as shown.
iii. Acid-test (quick) ratio
1. The acid-test ratio is computed as shown.
a. It is a more rigorous measure of
short-term debt paying ability because
2. Norton Corporation’s acid-test (quick) ratio
of 1.19 is computed as shown.
a. Each dollar of liabilities should be
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iv. Accounts receivable turnover
1. The accounts receivable turnover is
calculated as shown.
2. A related measure called the average
collection period is computed as shown.
a. It measures how many days, on
average, it takes to collect an
v. Inventory turnover
1. The inventory turnover is computed as
shown.
a. It measures how many times a
company’s inventory has been sold
and replaced during the year.
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(1). If a company’s inventory turnover
is less than its industry average, it
2. A related measure called the average sale
period is computed as shown.
a. It measures the number of days being
taken, on average, to sell the entire
inventory one time.
VI. Ratio analysis – the long-term creditor
Learning Objective 4: Compute and interpret financial
ratios that would be useful to a long-term creditor.
A. Long-term creditors are concerned with a company’s
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i. Times interest earned ratio
1. The times interest earned ratio is calculated
as shown.
a. It is the most common measure of a
2. Norton Corporation’s times interest earned
ratio of 11.5 times is computed as shown.
ii. Debt–to-equity ratio
1. The debt-to-equity ratio is computed as
shown.
a. It indicates the relative proportions of
debt and equity on a company’s
balance sheet.
represents a buffer of protection.
c. In practice, debt-to-equity ratios
from 0.0 to 3.0 are common.
2. Norton Corporation’s debt–to-equity ratio of
0.48 is computed as shown.
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VII. Summary of ratios and sources of comparative ratio
data