CHAPTER18

Financial Statement
Analysis

18-1
 PreviewofCHAPTER18

18-2
 Basics of Financial Statement Analysis

Analyzing financial statements involves:

Comparison Tools of
Characteristics
Bases Analysis

 Liquidity  Intracompany  Horizontal

 Profitability  Industry  Vertical
 Solvency averages  Ratio
 Intercompany

SO 1 Discuss the need for comparative analysis.

18-3
SO 2 Identify the tools of financial statement analysis.
 Horizontal Analysis

Horizontal analysis, also called trend analysis, is a

technique for evaluating a series of financial statement data
over a period of time.

 Purpose is to determine the increase or decrease that

has taken place.

 Commonly applied to the balance sheet, income

statement, and statement of retained earnings.

18-4 SO 3 Explain and apply horizontal analysis.

 Horizontal Analysis
Illustration 18-5
Horizontal analysis of
balance sheets

Changes suggest
that the company
expanded its asset
base during 2009
and financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.

18-5 SO 3 Explain and apply horizontal analysis.

 Horizontal Analysis
Illustration 18-6
Horizontal analysis of
Income statements

Overall, gross profit

and net income were
up substantially.
Gross profit
increased
17.1%, and net
income, 26.5%.
Quality’s profit trend
appears favorable.

18-6 SO 3 Explain and apply horizontal analysis.

 Horizontal Analysis

Illustration 18-7
Horizontal analysis of In the horizontal analysis of the balance sheet the ending
retained earnings
statements retained earnings increased 38.6%. As indicated earlier, the
company retained a significant portion of net income to
finance additional plant facilities.

18-7 SO 3 Explain and apply horizontal analysis.

 Vertical Analysis

Vertical analysis, also called common-size analysis, is a

technique that expresses each financial statement item as
a percent of a base amount.

 On an income statement, we might say that selling

expenses are 16% of net sales.

 Vertical analysis is commonly applied to the balance

sheet and the income statement.

18-8 SO 4 Describe and apply vertical analysis.

 Vertical Analysis
Illustration 18-8
Vertical analysis of
balance sheets

These results
reinforce the earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.

18-9 SO 4 Describe and apply vertical analysis.

 Vertical Analysis
Illustration 18-9
Vertical analysis of
Income statements

Quality appears
to be a profitable
enterprise that is
becoming even
more successful.

18-10 SO 4 Describe and apply vertical analysis.

 Vertical Analysis
Enables a comparison of companies of different sizes.

Illustration 18-10
Intercompany income
statement comparison

18-11 SO 4 Describe and apply vertical analysis.

 Ratio Analysis

Ratio analysis expresses the relationship among selected

items of financial statement data.

Financial Ratio Classifications

Liquidity Profitability Solvency

Measures short- Measures the Measures the

term ability of the income or ability of the
company to pay its operating success company to
maturing of a company for a survive over a long
obligations and to given period of period of time.
meet unexpected time.
needs for cash.
SO 5 Identify and compute ratios used in analyzing a
18-12
firm’s liquidity, profitability, and solvency.
 Ratio Analysis

A single ratio by itself is not very meaningful.

The discussion of ratios will include the

following types of comparisons.

SO 5 Identify and compute ratios used in analyzing a

18-13
firm’s liquidity, profitability, and solvency.
 Ratio Analysis

Liquidity Ratios

Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for cash.

 Short-term creditors such as bankers and suppliers are

particularly interested in assessing liquidity.

 Ratios include the current ratio, the acid-test ratio,

receivables turnover, and inventory turnover.

SO 5 Identify and compute ratios used in analyzing a

18-14
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Liquidity Ratios

1. Current Ratio Illustration 18-12

Ratio of 2.96:1 means that for every dollar of current liabilities,

Quality has $2.96 of current assets.
SO 5 Identify and compute ratios used in analyzing a
18-15
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Liquidity Ratios

2. Acid-Test / Quick Ratio

Illustration 18-13

SO 5 Identify and compute ratios used in analyzing a

18-16
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Liquidity Ratios

2. Acid-Test Ratio
Illustration 18-14

Acid-test ratio measures immediate liquidity.

SO 5 Identify and compute ratios used in analyzing a

18-17
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Liquidity Ratios

3. Receivables Turnover
Illustration 18-15

Measures the number of times, on average, the company collects

receivables during the period.
18-18 SO 5
 Ratio Analysis Liquidity Ratios

Receivables Turnover
$2,097,000
= 10.2 times
($180,000 + $230,000) / 2

A variant of the receivables turnover ratio is to convert it to

an average collection period in terms of days.

365 days / 10.2 times = every 35.78 days

Receivables are collected on average every 36 days.

SO 5 Identify and compute ratios used in analyzing a

18-19
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Liquidity Ratios

4. Inventory Turnover
Illustration 18-16

Measures the number of times, on average, the inventory is sold

during the period.
18-20 SO 5
 Ratio Analysis Liquidity Ratios

$1,281,000 Inventory Turnover

= 2.3 times
($500,000 + $620,000) / 2

A variant of inventory turnover is the days in inventory.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among

industries.

SO 5 Identify and compute ratios used in analyzing a

18-21
firm’s liquidity, profitability, and solvency.
 Ratio Analysis

Profitability Ratios

Measure the income or operating success of a company for a

given period of time.
 Income, or the lack of it, affects the company’s ability to
obtain debt and equity financing, liquidity position, and the
ability to grow.
 Ratios include the profit margin, asset turnover, return
on assets, return on common stockholders’ equity,
earnings per share, price-earnings, and payout ratio.

SO 5 Identify and compute ratios used in analyzing a

18-22
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Profitability Ratios

5. Profit Margin
Illustration 18-17

Measures the percentage of each dollar of sales that results in

net income.
SO 5 Identify and compute ratios used in analyzing a
18-23
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Profitability Ratios

6. Asset Turnover
Illustration 18-18

Measures how efficiently a company uses its assets to generate

sales.
SO 5 Identify and compute ratios used in analyzing a
18-24
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Profitability Ratios

7. Return on Asset
Illustration 18-19

An overall measure of profitability.

SO 5 Identify and compute ratios used in analyzing a

18-25
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Profitability Ratios

8. Return on Common Stockholders’ Equity

Illustration 18-20

Shows how many dollars of net income the company earned for
each dollar invested by the owners.
18-26 SO 5
 Ratio Analysis Profitability Ratios

9. Earnings Per Share (EPS)

Illustration 18-22

A measure of the net income earned on each share of common

stock.

18-27 SO 5
 Ratio Analysis Profitability Ratios

10. Price-Earnings Ratio

Illustration 18-23

Measures the net income earned on each share of common stock.

18-28 SO 5
 Ratio Analysis Profitability Ratios

11. Payout Ratio

Illustration 18-24

Measures the percentage of earnings distributed in the form of

cash dividends.
18-29 SO 5
 Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company to survive

over a long period of time.
 Debt to Total Assets and
 Times Interest Earned

are two ratios that provide information about debt-paying

ability.

SO 5 Identify and compute ratios used in analyzing a

18-30
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Solvency Ratios

12. Debt to Total Assets Ratio

Illustration 18-25

Measures the percentage of the total assets that creditors provide.

18-31 SO 5
 Ratio Analysis Solvency Ratios

13. Times Interest Earned

Illustration 18-26

Provides an indication of the company’s ability to meet interest

payments as they come due.
18-32 SO 5
 Ratio Analysis

Summary of Ratios
Illustration 18-27

18-33 SO 5
 Summary of Ratios
Illustration 18-27

18-34 SO 5