Financial Statement

18 Analysis

Learning Objectives
Apply horizontal and vertical analysis to financial
1 statements.

2 Analyze a company’s performance using ratio analysis.

3 Apply the concept of sustainable income.

18-1
LEARNING Apply horizontal and vertical analysis to
1
OBJECTIVE financial statements.

Analyzing financial statements involves:

Comparison Tools of
Characteristics
Bases Analysis

 Liquidity  Intracompany  Horizontal

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

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 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.
 Commonly applied to the
► balance sheet,
► income statement, and
► statement of retained earnings.

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 Horizontal Analysis
Illustration 18-5
Horizontal analysis of
balance sheets

Changes suggest that

the company
expanded its asset
base during 2013 and
financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.

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 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.

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LO 1
 Horizontal Analysis

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

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 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
► income statement.

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 Vertical Analysis
Illustration 18-8
Vertical analysis of
balance sheets

Quality is choosing to
finance its growth
through retention of
earnings rather than
through issuing
additional debt.

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 Vertical Analysis
Illustration 18-9
Vertical analysis of
Income statements

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

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 Vertical Analysis

Enables a comparison of companies of different sizes.

Illustration 18-10
Intercompany income statement comparison
18-10 LO 1
 DO IT! 1 Horizontal Analysis

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 Particular Interest
What would be important to you in studying a company's financial
statements?

Short-term creditors, such as banks, are primarily interested in the

ability of the firm to pay its currently maturing obligations. In that case,
you would examine the current assets and their relation to short-term
liabilities to evaluate the short-run solvency of the firm.
Bondholders, on the other hand, look more to long-term indicators, such
as the enterprise's capital structure, past and projected earnings, and
changes in financial position.
Stockholders, present or prospective, also are interested in many of the
features considered by a long-term creditor. As a stockholder, you would
focus on the earnings picture, because changes in it greatly affect the
market price of your investment. You also would be concerned with the
financial position of the firm, because it affects indirectly the stability of
earnings.

18-12
 LEARNING Analyze a company’s performance using
2
OBJECTIVE ratio analysis.

Ratio analysis expresses the relationship among selected

items of financial statement data.
Financial Ratio Classifications

Liquidity Profitability Solvency

Measures short-term Measures the Measures the ability

ability of the company income or operating of the company to
to pay its maturing success of a survive over a long
obligations and to company for a given period of time.
meet unexpected period of time.
needs for cash.

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 Ratio Analysis

A single ratio by itself is not very meaningful.

The discussion of ratios include the following types of

comparisons.
1. Intracompany comparisons for two years for Quality
Department Store.

2. Industry average comparisons based on median ratios

for department stores.

3. Intercompany comparisons based on Macy’s, Inc. as

Quality Department Store’s principal competitor.

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 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,
accounts receivable turnover, and inventory
turnover.
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 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Balance Sheet (partial)
For the Years Ended December 31
2013 2012 2013 2012

Illustration 18-12

18-16 LO 2
 Ratio Analysis Liquidity Ratios

1. CURRENT RATIO
Illustration 18-12

2013 2012

1.52:1

Ratio of 2.96:1 means that for every dollar of current liabilities, Quality
has $2.96 of current assets.

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 Investor Insight
How to Manage the Current Ratio

The apparent simplicity of the current ratio can have real-world limitations
because adding equal amounts to both the numerator and the denominator
causes the ratio to decrease.

Assume, for example, that a company has $2,000,000 of current assets

and $1,000,000 of current liabilities. Thus, its current ratio is 2:1. If the
company purchases $1,000,000 of inventory on account, it will have
$3,000,000 of current assets and $2,000,000 of current liabilities. Its current
ratio therefore decreases to 1.5:1. If, instead, the company pays off
$500,000 of its current liabilities, it will have $1,500,000 of current assets
and $500,000 of current liabilities. Its current ratio then increases to 3:1.
Thus, any trend analysis should be done with care because the ratio is
susceptible to quick changes and is easily influenced by management.
18-18 LO 2
 Ratio Analysis Liquidity Ratios

2. ACID-TEST RATIO
Illustration 18-13

2013 2012

18-19 LO 2
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial) Balance Sheet (partial)

2013 2012 2013 2012

Illustration 18-12

18-20 LO 2
 Ratio Analysis Liquidity Ratios

2. ACID-TEST RATIO
Illustration 18-14

2013 2012

0.47:1

Acid-test ratio measures immediate liquidity.

18-21 LO 2
 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Balance Sheet (partial)
For the Years Ended December 31
2013 2012 2013 2012

18-22 LO 2
 Ratio Analysis Liquidity Ratios

3. ACCOUNTS RECEIVABLE TURNOVER

Illustration 18-15

2013 2012

69.1 times

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

receivables during the period.
18-23 LO 2
 Ratio Analysis Liquidity Ratios

3. ACCOUNTS RECEIVABLE TURNOVER

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

A variant of the accounts receivable turnover ratio is to convert it

to an average collection period in terms of days.

365 days / 10.2 times = every 35.78 days

Accounts receivable are collected on average every 36 days.

18-24 LO 2
 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Balance Sheet (partial)
For the Years Ended December 31
2013 2012 2013 2012

Illustration 18-12

18-25 LO 2
 Ratio Analysis Liquidity Ratios

4. INVENTORY TURNOVER
Illustration 18-16

2013 2012

3.1 times

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

during the period.
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 Ratio Analysis Liquidity Ratios

4. INVENTORY TURNOVER

$1,281,000
= 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.

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 Ratio Analysis

Profitability Ratios

Measure the income or operating success of a company for a

given period of time.
 Income affects the company’s ability to obtain debt and
equity financing, their liquidity position, and their ability to
grow.
 Ratios include the profit margin, asset turnover, return
on assets, return on common stockholders’ equity,
earnings per share, price-earnings ratio, and payout
ratio.
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 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012

18-29 LO 2
 Ratio Analysis Profitability Ratios

5. PROFIT MARGIN
Illustration 18-17

2013 2012

5.3%

Measures the percentage of each dollar of sales that results in

net income.

18-30 LO 2
 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012

Illustration 18-12

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 Ratio Analysis Profitability Ratios

6. ASSET TURNOVER
Illustration 18-18

2013 2012

1.3 times

Measures how efficiently a company uses its assets to generate

sales.
18-32 LO 2
 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012

Illustration 18-12

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 Ratio Analysis Profitability Ratios

7. RETURN ON ASSETS
Illustration 18-19

2013 2012

7.0%

An overall measure of profitability.

18-34 LO 2
 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012

Illustration 18-12

18-35 LO 2
 Ratio Analysis Profitability Ratios

8. RETURN ON COMMON STOCKHOLDERS’

EQUITY Illustration 18-20

2013 2012

24.2%

Shows how many dollars of net income the company earned for each
dollar invested by the owners.
18-36 LO 2
 Ratio Analysis Profitability Ratios

8. RETURN ON COMMON STOCKHOLDERS’

EQUITY
With Preferred Stock
 Deduct preferred dividend requirements from net income.

Illustration 18-21
Return on common stockholders’
equity with preferred stock

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 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012

Illustration 18-12

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 Ratio Analysis Profitability Ratios

9. EARNINGS PER SHARE (EPS)

Illustration 18-22

2013 2012

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

18-39 LO 2
 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012

Illustration 18-12

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 Ratio Analysis Profitability Ratios

10. PRICE-EARNINGS RATIO

Illustration 18-23

2013 2012

13.5 times

Reflects investors’ assessments of a company’s future earnings.

18-41 LO 2
 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012

Illustration 18-12

18-42 LO 2
 Ratio Analysis Profitability Ratios

11. PAYOUT RATIO

Illustration 18-24

2013 2012

24.2%

Measures the percentage of earnings distributed in the form of cash

dividends.
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 Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company to survive

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

are two ratios that provide information about debt-paying

ability.

18-44 LO 2
 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012

Illustration 18-12

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 Ratio Analysis Solvency Ratios

12. DEBT TO TOTAL ASSETS RATIO

Illustration 18-25

2013 2012

71.1%

Measures the percentage of the total assets that creditors provide.

18-46 LO 2
 QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012

Illustration 18-12

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 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.
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 Ratio Analysis

Summary of Ratios
Illustration 18-27

18-49 LO 2
 Summary of Ratios
Illustration 18-27

18-50 LO 2
 LEARNING Apply the concept of sustainable
3
OBJECTIVE income.

Sustainable income is the most likely level of income to be

obtained by a company in the future. It differs from actual net
income by the amount of unusual revenues, expenses,
gains, and losses included in the current year’s income.

Information on unusual items such as gains or losses on

discontinued items and components of other comprehensive
income are disclosed.

These unusual items are reported net of income taxes.

18-51 LO 3
 DO IT! 3 Unusual Items

In its proposed 2017 income statement, AIR Corporation

reports income before income taxes $400,000, unrealized gain
on available-for-sale securities $100,000, income taxes
$120,000 (not including unusual items), loss from operation of
discontinued flower division $50,000, and loss on disposal of
discontinued flower division $90,000. The income tax rate is
30%.
Prepare a correct statement of comprehensive income,
beginning with “Income before income taxes.”

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 DO IT! 3 Unusual Items

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18-54
 BALANCE SHEET INCOME STATEMENT
Cash 1 A/P 8 Sales 200
A/R 10 Longterm loan 70 COGS (150)
Inventory 20 Gross profit 50
Equipment 100 Equity 53 Operating expense (20)
131 131 Profit 30

ROE 57%
Gearing 247%
ROA 23%
Profit margin 15%
Asset turnover 1.5
A/R turnover 20.0
Inventory turnover 7.5
A/P turnover 18.8
Liquidity ratio 3.9
Quick ratio 1.4

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 Financial ratios

 Profitability
 Sales margin
 Earnings per share (EPS)
 Profitability and return: the return on capital employed (ROCE)
 Analyzing profitability and return in more detail: the
secondary ratios
 Liquidity
 current ratio
 quick ratio
 accounts receivable payment period
 inventory turnover period
 accounts payable payment period
 Gearing
 Financial Gearing
 Operating gearing
18-56
 Suggested format of a ratio
analysis

18-57
 How it has changed

increased/decreased sharply by x% from 20x1 to

20x2

risen/fallen significantly over three

years
doubled/halved much
improved/worse slightly
remained high/low at x%

18-58
 Why it has changed & Comments

Due to, because, as,

since more
less cash
It is because receivables
The main reason is

The company is showing a healthy

The increase is not large and the level is satisfactory
needs to pay attention to working capital/ investigate
It is difficult to draw conclusions without knowing

18-59
A puzzle is a game, problem, or toy that tests a person's
ingenuity or knowledge. In a puzzle, the solver is expected
to put pieces together in a logical way, in order to arrive at
the correct solution of the puzzle.

18-60
 A company is doing business in Vietnam

 Vietnamese accounting is moving to IFRS

 Understand accounting information in
Vietnamese context (qualitative information)
 The gap between Vietnamese accounting
regulation and IFRS
 Benefit your working in the Vietnamese context
 Be aware of the limitation in your discussion

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 Basic Limitations of Ratio Analysis
The ratios are only as good as the data upon which they are based and
the information with which they are compared.
 Data
• They are based on historical cost, which can lead to distortions in
measuring performance. 
• Where estimated items (such as depreciation and amortization) are
significant, income ratios lose some of their credibility
• Reliability of data
• Weak regulation
• Gap between Vietnamese standards vs IFRS (e.g. Goodwill, Noncurrent assets)
 Comparison
The difficult problem of achieving comparability among firms in a
given industry because of basic differences in accounting (e.g.
Depreciation methods)

18-62
 Vietnamese accounting standards vs IFRS

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