Introduction to Financial Accounting

Chapter 12
Financial Statement Analysis

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 Chapter 12 Learning Objectives

LO1 – Ratio Analysis – Liquidity, Profitability, leverage, and Market

LO2 – Horizontal and Vertical Trend Analysis

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 Financial Statement Analysis
LO1 – Ratio Analysis – Liquidity, Profitability, leverage, and Market

• Various stakeholders such as shareholders, creditors,

potential investors, and others will analyze a
corporation’s liquidity, profitability, and financial
structure over more than one year and will compare the
results to industry benchmarks.
• A common way to evaluate financial statements is
through ratio analysis. A ratio is a stated relationship
between two numbers of the same kind. A financial
ratio is a measure of magnitude between two selected
numbers taken from a financial statement.
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 Ratio Analysis
•Gross profit ratio – the relationship between gross profit (the
numerator) and sales (denominator):

–The gross profit ratio is $700/3,200 = 22%

–Another way to state the ratio is 22:1.
–For every $1 in sales, the company earns, on average, $.022 after cost of
goods sold, to cover expenses.
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 Ratio Analysis
• Financial ratios are effective tools because they provide a
common basis or context for evaluation:
– Company A, B, and C all have different gross profit and sales
amounts, but the gross profit ratio allows for an evaluation of all
three, due to all sharing the same context:

A B C

– The gross profit ratio for each is:

Co. B and C have a higher 700 650 540
gross profit than Co. A 3,200 2,800 2,340
22% 23% 23%
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 Ratio Analysis

• The gross profit ratio has provided a common basis

for evaluation of three separate businesses, provided
they are from the same industry and have a similar
product mix.
• Ratio analysis alone will not provide a definitive
financial evaluation. It is an analytic tool that, when
combined with professional judgement, offers insight
into the financial performance of a business.

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 Ratio Analysis
• Qualitative factors such as possessing an adequate
capacity or the necessary equipment for ongoing
production also provides valuable insights. Notes to
the financial statement are a good source.
• One of the main purposes of ratio analysis is to
highlight areas that require further analysis and
investigation.

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 Ratio Analysis
• There are four major types of financial ratios:
– Liquidity ratios – measure the ability to pay
current liabilities as they are due.
– Profitability ratios – measures the ability to
generate an adequate return on assets employed,
and shareholder investment.
– Leverage ratios – measures the business’s relative
debt and its long-term financial viability.
– Market ratios – measures financial returns to
shareholders and market perceptions of its value.

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 Ratio Analysis
• Liquidity Ratios: Analyzing Short-term Cash Needs
– Net profit does not mean cash in the bank. Profitable
companies without sufficient cash are at risk of not
meeting their short-term obligations.
– First, let’s look at working capital:

Current
Assets Working
Capital Current Liabilities
(Debt)

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 Ratio Analysis
• Working capital is the $-value difference between a
company’s current assets and current liabilities at a
point in time.

• Between 2019 and 2021, working capital has

decreased by $158 ($336 – 178) from the previous
year.

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 Ratio Analysis
• Liquidity Ratios: Current ratio – expresses working
capital as a ratio: __Current Assets__
Current Liabilities

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 Ratio Analysis
• Current ratio:

• Usually, the higher this ratio, the better (to a point).

• The overall decline from 1.91:1 to 1.14:1 may be
cause for concern.

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 Ratio Analysis
• Current ratio: Is a 2:1 benchmark enough?
• Composition of the current assets is important:

• Which of these two companies can pay their current

debt most easily?
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 Ratio Analysis
• Liquidity Ratios: Acid-test ratio – addresses the
weakness found in the current ratio:
Cash + Short-Term Investments + Accounts Receivable
Current Liabilities

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 Ratio Analysis
• Acid-Test Ratio: Also called the quick ratio, it
excludes the accounts that cannot be converted into
cash quickly:

Cash + Short-Term Investments + Accounts Receivable

Current Liabilities

OR
Current Assets – Inventory – Prepaid Expenses
Current Liabilities

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 Ratio Analysis

• What is a good benchmark for an acid-test ratio?

1:1 is usually reasonable
• Big Dog Corp.’s declining acid-test ratios over
three years are worrisome.
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 Ratio Analysis
• Liquidity Ratios: Accounts Receivable Collection
Period – measures management’s effectiveness
regarding its trade accounts receivable.
• Measures the average number of days needed to
collect an amount due, compared to the collection
period (i.e. net 30 means due within 30 days).

Average Accounts Receivable

Net Credit Sales X 365

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 Ratio Analysis
Accounts Receivable Collection Period:

Average accounts receivable $544 + 420 = $482 $420 + 257 = $338.5

2 2
Average Accounts Receivable X 365 = $482 X 365 = 55 days $338.5
X 365 = 44 days
Net Credit Sales 3,200 2,800

The company’s collection period is increasing and exceeds the n/30 credit period.

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 Ratio Analysis
• Liquidity Ratios: Number of days of sales in
inventory – measures the number of days that can
be serviced by existing inventory levels.
• Measures the average number of days needed to
collect an amount due, compared to the collection
period (i.e. net 30 means due within 30 days).

Average Merchandise Inventory

Cost of Goods Sold X 365

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 Ratio Analysis
Number of Days of Sales in Inventory:

Average inventory $833 + 503 = $668 $503 + 361 = $432

2 2
Average Merchandise Inventory $668 $432 X 365 = 73 days
X 365 = 98 days
Cost of Goods Sold 2,500 2,150
The company is investing significantly more in inventory than previously
which should be investigated.
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 Ratio Analysis
• Number of days to complete the revenue
operating cycle:

2021 2020
Average number of days sales in inventory 98 days 73 days
Average number of days to collect receivables 55 days 44 days
Number of days to complete revenue cycle 153 days 117 days

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 Ratio Analysis
• The number of days to complete the revenue
operating cycle has significantly increased from 117
days to 153 days. This is a 30% increase in the
number of days, from the previous year!
• If accounts payable terms are n/60 days, the
company will not be able to pay their suppliers,
because the number of days in the cycle exceeds the
60-day terms.
• Summary: It appears that Big Dog Carworks Corp. is
growing less liquid. Current assets, especially quick
assets, are declining relative to current liabilities and
the revenue operating cycle is increasing.

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 Ratio Analysis
• Profitability Ratios: Gross profit ratio – percentage of
sales revenue left after cost of goods sold:
Gross Profit
Net Sales

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 Ratio Analysis
• Gross profit ratios:

• This ratio has not changed significantly over the

three years but a small decline as a percentage can
affect net income, because gross profit is a large
component of the income statement.

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 Ratio Analysis
• Profitability Ratios: Operating profit ratio –
percentage of sales revenue left after cost of goods
sold and operating expenses: Income from operations
Net Sales

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 Ratio Analysis
• Operating profit ratios:

• Despite both increasing sales and income from operations, the

operating profit ratios are relatively flat.

+9% +34%

• Sales is not keeping pace with increases in cost of goods sold and
operating expenses, resulting in a significant deceleration of
increases from 34% to 9%.
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 Ratio Analysis
• Profitability Ratios: Net profit ratio – percentage of
sales revenue retained after all expenses:
Net Income
Net Sales

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 Ratio Analysis
• Net profit ratios:

• Net income is relatively flat over the three years due to

increasing interest expenses from increasing liabilities.

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 Ratio Analysis
• Profitability Ratios: Sales to total assets ratio – sales
earned relative to assets invested:
_____Net Sales_____
Average Total Assets

Assets

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 Ratio Analysis
• Sales to total assets ratios:

• Both sales and average total assets have increased, but sales
has weakened relative to the amount of assets invested each
year.
• Assets are not producing revenue as effectively as in the past,
so further investigation is required.
• Industry averages would be useful.

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 Ratio Analysis
• Profitability Ratios: Return on total assets ratio
(ROA) – efficiency of assets used to produce income
from operations: Income from Operations
Average Total Assets

Assets

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 Ratio Analysis
• Return on total assets ratios:

• Both income from operations and average total assets have

increased, but income from operations has weakened relative
to the amount of assets invested each year.
• Assets are not being used as efficiently as in the past, so
further investigation is required.
• More information about the company’s plans and projections
would be useful.

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 Ratio Analysis
• Profitability Ratios: Return on equity ratio (ROE) –
measures the return to shareholders in the form of
net income earned for the owners:
__Net Income__
Average Equity

Equity

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 Ratio Analysis
• Return on equity ratios:

• Net income has weakened relative to the amount of equity

invested by shareholders over the two-year period.
• Industry averages would be useful. For example, if the
industry average was 5%, then the company’s ratios would be
considered to be “favourable”, or a positive indicator.

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 Ratio Analysis
• Leverage Ratios: Analyzing Financial Structure
• Both shareholders and creditors have claims to a
portion of the company’s assets:
Assets = Liabilities + Equity
= Creditors + Shareholders
$2,486 = $1,255 + $1,231

• The accounting equation expresses a relationship

between assets owned by an entity and the claims
against those assets (creditors and shareholders).
• Together, creditor and shareholder capital form the
financial structure of the corporation.
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 Ratio Analysis
• Leverage Ratios: Debt ratio – measures the
proportion of assets financed by debt:
Total Liabilities
Total Assets

Liabilities

Debt ratio $1,255/2,486 $917/2,112 $369/1,417

Debt ratio 0.5048:1 or 50.48% 0.4342:1 or 43.42% 0.2604:1 or 26.01%

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 Ratio Analysis

• In 2019, the company’s assets were financed by 26% debt and

74% (100% − 26%) equity.
• In 2021, the company’s assets were financed by 50% debt and
50% equity (100% − 50%).

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 Ratio Analysis
• The equity ratio can also be calculated directly:
Total Equity
Total Assets

Equity ratio $1,231/2,486 $1,195/2,112 $1,048/1,417

Equity ratio 0.4952:1 or 49.52% 0.5658:1 or 56.58% 0.7396:1 or 73.96%

• Generally, this is considered to be an unfavourable trend

because as debt financing increases, equity financing must be
decreasing.
• The greater the debt financing, the greater the risk because
principal and interest payments are part of debt financing.
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 Ratio Analysis
• Leverage Ratios: Debt to equity ratio – measures the
proportion of creditors’ to shareholders’ claims:
Total Liabilities
Equity
Liabilities

Debt to equity ratio $1,255/1,231 $917/1,195 $369/1,048

Debt to equity ratio 1.02:1 0.77:1 0.35:1
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 Ratio Analysis

Debt to equity ratio $1,255/1,231 $917/1,195 $369/1,048

Debt to equity ratio 1.02:1 0.77:1 0.35:1

• The proportion of debt to equity is increasing. In

2019, the debt to equity ratio was $0.35 of liability
for each dollar of equity. In 2021, the ratio has
increased to $1.02 of liability for each dollar of
equity. This is cause for concern.

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 Ratio Analysis
• Debt – Pros:
– Management’s reliance on creditor financing can be good because
issuing more shares to investors may weaken the percentage of
ownership and control of the existing shareholders.
– Existing shareholders may see creditor financing as a good decision if the
company can earn more with borrowed funds than the interest paid on
the debt.
• Debt – Cons:
– Management’s increasing reliance on creditor financing increases risk
because interest and principal must be paid.
– Interest rates can rise causing net income to decrease.
• Overall:
– There is no single most appropriate debt to equity ratio. There are
techniques to determine this, but this is beyond the scope of this course.

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 Ratio Analysis
• Leverage Ratios: Times interest earned ratio – indicates the
company’s ability to pay interest to long-term creditors:
Income from Operations
Interest Expense

• The larger the ratio, the better creditors are protected.

• The company’s ratio is decreasing, so interest expense is
increasing at a greater rate than income from operations.
• Creditors need to assess the company’s plans and projections.
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 Ratio Analysis
• Market Ratios: Analyzing Financial Returns to
Investors
• These ratios help investors decide whether to invest
or divest in shares of a corporation.

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 Ratio Analysis
• Market Ratios: Earnings-per-Share (EPS) – measures
shareholders’ returns on a per-share basis:
_Net Income – preferred share dividends_
Number of Common Shares Outstanding

• The company has no preferred shares.

• EPS remains relatively stable over the three years
because the number of common shares issued has not
changed.
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 Ratio Analysis
• Market Ratios: Price-earnings (PE) ratio – market
expectations of future profitability:
Market price per share
Earnings per Share

• The stock market price is one of the most important

measures of a company’s financial performance.
• The earnings performance, often expressed as a PE
ratio, is increasing for this company, which is favourable.
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 Ratio Analysis
• The rising PE ratio suggests that investors expect that
future profits will be good in the coming years.
• Investors are often willing to pay more for for this
company’s common shares.
• This must be because future financial prospects are
anticipated to be better than in the past three years.

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 Ratio Analysis
• Market Ratios: Dividend Yield – short-term cash
return expected from an investment in the
company’s shares:
__Dividend per share__
Market Price per Share

• Some investors hold shares in order to realize an

increasing market price of the shares.
• Other investors want to maximize the dividend
revenue from share investments. The dividend yield
helps this investor know how much dividend they can
expect to receive.
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 Ratio Analysis
• Market Ratios: Dividend Yield:

• Investors have received decreasing amounts of dividends

relative to the market price, which could be cause for concern
for those investors expecting steady cash returns.

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 Ratio Analysis
• Note that dividends declared increased over the past
three years, even though net income has remained
relatively flat and despite the company’s poor
liquidity position. Investors might ask why such high
levels of dividends are being paid in this situation.

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 Ratio Analysis
• Overall Analysis:
• Ratio analysis is more useful if accompanied by overall
industry performance ratios, general economy indicators,
financial ratios from prior years, analysts’ opinions and
management’s plans.
• Although sales are increasing, net income has not kept
up.
• Gross profits are stable, but operating expenses appear to
be an issue.
• Income from operations has not kept up with the
increases in the asset base, including increases in current
assets.
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 Ratio Analysis
• Shortage of working capital and poor liquidity is an
immediate concern. The company should review its
credit policies and monitor its inventory levels to
ensure that these stay in line with sales.
• The plant expansion caused an increase in current
liabilities due to increased borrowings. As a result,
its ability to meet its debt obligations is weakening.
• The ability of income to cover interest expense has
also weakened.

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 Ratio Analysis
• The company should investigate alternatives to short-
term borrowings, such as converting some to long-
term debt, and/or issuing additional share capital to
retire some of its short-term debt obligations.
• Despite the shortcomings above, the stock market
price indicates that it expects the company to
continue to increase its profits in the future. Perhaps
the negative ratios are only temporary or easily
rectifiable by management.

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 Chapter 12 Learning Objectives
LO2 – Horizontal and Vertical Trend Analysis

• Trend analysis is the evaluation of financial

performance based on a re-statement of financial
statement dollar amounts to percentages.
• Horizontal analysis starts with the oldest base year
as 100%. All subsequent years are expressed as an
increase or decrease from the base year.

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 Financial Statement Analysis

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 Horizontal Analysis
• Alternatively, horizontal analysis is to calculate the
percentage change between two years:

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 Vertical Analysis
• Vertical analysis requires the financial statement to
be restated as percentages of a base dollar amount.
• For income statement analysis, sales is the base
dollar amount as 100%. For balance sheet analysis,
total assets, total liabilities and equity are used as
the base amounts.
• When financial statements are converted to
percentages, they are called common-size financial
statements.

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 Vertical Analysis

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 References
All clip-art was retrieved from http://openclipart.org on
Sept 6, 2016.

Slide 6: https://openclipart.org/detail/78121/apple
Slide 6: https://openclipart.org/detail/202259/green-apple
Slide 6: https://openclipart.org/detail/88669/orange
Slide 7: https://openclipart.org/detail/202768/puzzle-pieces-with-magnifying-glass
Slide 9: https://openclipart.org/detail/70183/mortgage
Slide 14: https://openclipart.org/detail/169757/check-and-cross-marks

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