1-1

Analyzing Financial
Statements
Chapter 17
Electronic Presentations in Microsoft® PowerPoint® to accompany
Fundamental Accounting Principles, 17ce
Prepared by
Regula Lewis

© 2022 McGraw Hill Ltd.

 1-2

Learning Objectives

1. Describe financial statement analysis and identify its focus, standards

of comparison, and tools. (LO1)
2. Describe and apply methods of horizontal analysis. (LO2)
3. Describe and apply methods of vertical analysis. (LO3)
4. Define and apply ratio analysis. (LO4)

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Vignette
Flow Beverage Corp—IPO Fuels Growth Strategy to Bring Sustainable Water and
Wellness to the World

Nicholas Reichenbach has been on an entrepreneurial journey since he was 16 years old, with
experience launching 11 different businesses in fields from retail to technology to hospitality and
entertainment. His latest business venture came to him after attending Burning Man Festival in
2013. He was “stunned by the mountain of plastic created by 70,000 people over 7 days” and felt
compelled to provide the planet with a more eco-friendly alternative. After discussing the idea
with his wife, she came up with the name Flow, inspired by a book she had been reading.

• Video Links: https://youtu.be/822bAFKGBig and https://youtu.be/2pweJTyrlL0

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Critical Thinking Challenge

What is another name for the return on capital ratio?

Explain what it means and why a corporation like Flow would want to
maximize it.

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LO1: Basics of Analysis 1

• Financial statement analysis is the application of analytical tools to

general-purpose financial statements and related data for making
business decisions.
• It involves transforming data into useful information.
• Financial statement analysis reduces our reliance on hunches, guesses,
and intuition.
• It reduces our uncertainty in decision making as an external financial
statement user.

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Basics of Analysis 2

• Macro environmental analysis incorporates factors such as the

political, economic, social, and technological issues impacting the
business (PEST analysis(political, economic, social, and
technological)) and is effective in understanding the industry
landscape.
• A SWOT (strengths, weaknesses, opportunities, and threats)analysis
investigates the internal corporate strengths and weaknesses against
external opportunities and threats.
• Porter’s Five Forces is another industry analysis tool designed to
conduct an analysis from a more global perspective. These five
forces are:
– Threat of new entrants, Bargaining power of buyers,
Bargaining power of suppliers, Threat of new substitutes, and
Competitive rivalry

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Purpose of Analysis

Financial statement analysis helps internal and external users make better
business decisions.
Goals of financial analysis include the evaluation of:
1. Past and current performance
2. Current financial position
3. Future performance and risk

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Four Key Building Blocks of Financial

Statement Analysis
• Liquidity and Efficiency – ability to meet current obligations and
to generate revenues efficiently.
• Solvency – ability to generate future revenues and meet long-
term obligations.
• Profitability – ability to provide financial rewards sufficient to
attract and retain financing.
• Market – ability to generate positive market expectations.

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Information for Analysis

• Financial reporting refers to the communication of relevant

financial information to decision makers.
• General-purpose financial statements are part of financial
reporting.
• They include:
1) Income statement
2) Balance sheet
3) Statement of changes in equity
4) Statement of cash flows

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Standards for Comparisons

To make these judgments, we need standards for comparison, which can

include:
• Intracompany – The company under analysis provides standards for
comparisons based on prior performance and relationships between its
financial items.
• Competitor (or intercompany) – One or more direct competitors of the
company under analysis can provide standards of comparison.
• Industry – Industry statistics can provide standards of comparison.
• Guidelines (rules of thumb) – General standards of comparison can
develop from past experiences.

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CHECKPOINT

1. Who are the intended users of general-purpose financial statements?

2. What statements are usually included in general-purpose financial
statements published by corporations?
3. Which of the following are least useful as a basis for comparison
when analyzing ratios and turnovers? (a) companies operating in a
different economy; (b) past experience; (c) rule-of-thumb standards;
(d) averages within a trade or industry.
4. What basis of comparison for ratios is usually best?

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Tools of Analysis

Three of the most common tools are:

• Horizontal analysis – Comparison of a company’s financial condition and
performance across time
• Vertical analysis – Comparison of a company’s financial condition and
performance to a base amount
• Ratio analysis – Determination of key relationships among financial
statement items

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LO2: Horizontal Analysis

• Horizontal analysis is a tool to evaluate the important relationships and

changes between the items in financial statements across time.
• Comparative financial statements show financial amounts in side-by-
side columns on a single statement and facilitate the comparison of
amounts for two or more successive periods.

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Calculation of Dollar Changes and Percentage

Changes 1

When analyzing a set of financial statements, it is helpful to investigate four

key issues:
1. Large dollar changes
2. Large percentage changes
3. Unusual line items
4. Unexpected relationships

We calculate the dollar change for a financial statement item as:

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Calculation of Dollar Changes and Percentage

Changes 2

We calculate the percentage change by dividing the dollar change by the base
period amount, and then multiplying this quantity by 100%:

OR

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Calculation of Dollar Changes and Percentage

Changes 3

We must be aware of a few issues in working with percentage changes. To

illustrate, let’s look at four separate cases in the chart below:

Change Analysis
Case Base Period Analysis Dollar Percent
Period
A $ (4,500) $1,500 $6,000 ---
B 2,000 (1,000) (3,000) ---
C --- 8,000 8,000 ---
D 10,000 -0- (10,000) (100%)

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Comparative Balance Sheet

• One of the most useful comparative statements is the comparative

balance sheet.
• It consists of amounts from two or more balance sheet dates arranged
side by side.
• The usefulness of comparative financial statements is often improved
by also showing each item’s dollar change and percentage change.
• This type of presentation highlights large dollar and percentage changes
for decision makers.

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Comparative Income Statement

• A comparative income statement is prepared similarly to the

comparative balance sheet.
• Amounts for two or more periods are placed side-by-side, with
additional columns for dollar and percentage changes.

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Trend Analysis 1

• Trend analysis, also called trend percent analysis or index number trend
analysis, is used to reveal patterns in data covering successive periods.
• This method of analysis is a variation on the use of percentage changes
for horizontal analysis.
• The difference is that trend analysis does not subtract the base period
amount in the numerator.
• To calculate trend percentages we need to:
1. Select a base period and assign each item for the base period
statement a weight of 100%.
2. Express financial numbers from other periods as a percentage of
the base period number.

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Trend Analysis 2

• To illustrate trend analysis, we use selected financial data of Nature’s

Playground as shown in Exhibit 17.3.
Revenue and Expenses
2023 2022 2021 2020 2019
Net Sales $164,313 $105,027 $67,515 $52,242 $29,230

Cost of goods sold 35,940 24,310 19,459 7,735 6,015

Gross profit $128,373 $80,717 $48,056 $44,507 $23,215

• Trend Percentages of Revenues and Expenses

2023 2022 2021 2020 2019
Net Sales 562.1% 359.3% 231.0% 178.7% 100%

Cost of goods sold 597.5 404.2 323.5 128.6 100

EXHIBIT 17.3
Gross profit 553.0 347.7 207.0 191.7 100
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Trend Analysis 3

Trend Percentages of Revenues and Expenses

2023 2022 2021 2020 2019

Net Sales 562.1% 359.3% 231.0% 178.7% 100%

Cost of goods sold 597.5 404.2 323.5 128.6 100

Gross profit 553.0 347.7 207.0 191.7 100

EXHIBIT 17.4
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Trend Analysis 4

A line graph can help us identify trends and detect changes in direction or
magnitude.

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EXHIBIT 17.5
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Trend Analysis 5

Revenues and Total Assets Data

Trend
Percent
2023 2019 2023 vs.
2019
Net Sales $264.3 $29.2 562.7%

Total assets (fiscal year-end) 191.4 41.9 456.8

EXHIBIT 17.6
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CHECKPOINT

5. Analyze the following information for Lighting.com, an online direct-

to-designer lighting store (expressed in millions of dollars) and
identify whether the trend in accounts receivable is favourable or
unfavourable when compared to the trend in net sales.

2023 2022 2021

Net sales $50.0 $40.0 $39.0
Accounts receivable 13.0 8.8 7.8

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LO3: Vertical (or Common-Size) Analysis

• Used to evaluate individual financial statement items or groups of items

in terms of a specific base amount.
• The base amount is usually defined as 100%.
• Income statement items are expressed as a percentage of revenues.
• Balance sheet items are expressed as a percentage of total assets.

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Common-Size Statements

• The comparative statements in Exhibits 17.1 and 17.2 show how each
item has changed over time, but they do not emphasize the relative
importance of each item.
• We use common-size financial statements to reveal changes in the
relative importance of each financial statement item.
• A common-size percentage is measured by taking each individual
financial statement amount under analysis and dividing it by its base
amount:

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Common-Size Balance Sheet

• Common-size statements express each item as a percentage of a base

amount.
• Common-size analysis enables an analyst to pay close attention to
financial statement line items that are increasing or decreasing at a
different pace than the growth of the company as a whole.
• The base amount for a common-size balance sheet is usually total
assets. It is assigned a value of 100%.
• The total amount of liabilities plus equity equals 100% since this amount
equals total assets.

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Common-Size Income Statement

• The amount of net sales is the base amount and it is assigned a value of
100%.
• Each common-size income statement item appears as a percentage of
revenues.
• Analyzing differences in common-size percentages from one year to the
next on the income statement can highlight problems with overall cost
management.
• One of the advantages of calculating common-size percentages for
successive income statements is in helping us uncover potentially
important changes in a company’s expenses.

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Data Analytics: Common-Size Graphics 1

• An income statement readily lends itself to common-size graphical

analysis.
• Revenues affect nearly every item in an income statement.
• It is also usually helpful for our analysis to know what portion of
revenues various geographical regions take up.
• Common-size financial statements are useful in comparing different
companies because the focus is changed from dollars (which can vary
significantly between companies of different sizes) to percentages
(which are always expressed as X out of 100; the base is constant).

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Data Analytics: Common-Size Graphics 2

Common-Size Graphic of Nature’s Playground’s Sales by Geographic

Region

EXHIBIT 17.9
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CHECKPOINT

6. On common-size comparative statements, which of the following is

true? (a) Each item is expressed as a percentage of a base amount; (b)
Total assets are assigned a value of 100%; (c) Amounts from two or
more successive periods are placed side-by-side; (d) All of the above
are true.
7. What is the difference between the percentages sshown on a
comparative income statement and those shown on a common-size
comparative income statement?
8. Trend percentages are (a) shown on the comparative income
statement and the comparative balance sheet; (b) shown on
common-size comparative statements; or (c) also called index
numbers.
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LO4: Ratio Analysis

• Ratios are among the most popular and widely used tools of financial
analysis.
• They provide us with clues and symptoms of underlying conditions.
• Ratios, properly interpreted, identify areas requiring further
investigation.
• A ratio can help us uncover conditions and trends that are difficult to
detect by inspecting individual components making up the ratio.
• Usefulness of ratios depends on how skillfully we interpret them, and
interpretation is the most challenging aspect of ratio analysis.

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Liquidity and Efficiency

Liquidity:
Refers to the availability of resources to meet short-term cash
requirements. A company’s short-term liquidity is affected by the timing
of cash inflows and outflows, along with prospects for the future
performance.

Efficiency:
Refers to how well a company uses its assets and is usually measured
relative to how much revenue is generated for a certain level of assets.
Efficiency is usually measured relative to how much revenue is generated
for a certain level of assets. Inefficient use of assets can cause liquidity
problems.
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Working Capital and Current Ratio 1

• The amount of current assets less current liabilities is called working

capital or net working capital.
• A company needs an adequate amount of working capital to meet
current cash needs: debts, carry sufficient inventories, and take
advantage of cash discounts.
• A company that runs low on working capital is less likely to meet
current obligations or continue operating.

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Working Capital and Current Ratio 2

• When evaluating a company’s working capital, we must look beyond

the dollar amount of current assets less current liabilities.
• We also need to consider the relationship between the amounts of
current assets and current liabilities.
• The current ratio describes a company’s ability to pay its current
obligations.
• The current ratio relates current assets to current liabilities as follows:

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Working Capital and Current Ratio 3

Working Capital and Current Ratio

(in thousands) Nov. 30, 2023 Nov. 30, 2022

Current assets $153,233 $103,685
Current liabilities 24,139 18,864
Working capital $129,094 $84,821
Current ratio:
$153,233/$23,139 6.35 to 1
$103,685/$18,864 5.50 to 1

EXHIBIT 17.10
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Working Capital and Current Ratio 4

• A high current ratio suggests a strong liquidity position.

• A high ratio means a company should be able to meet its current
obligations. But a company also can have a current ratio that is too high.
• An excessively high ratio means the company has invested too much in
current assets compared to its current obligations.
• Since current assets do not normally generate much additional revenue,
an excessive investment in current assets is not an efficient use of
funds.

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Working Capital and Current Ratio 5

• Many users apply a guideline of 2 to 1 for the current ratio in helping

evaluate the debt-paying ability of a company.
• A company with a 2 to 1 or higher current ratio is generally thought to
be a good credit risk in the short run.
• But this analysis is only one step in our process of assessing a
company’s debt-paying ability.
• We also need to analyze at least three additional factors:
1. Type of business
2. Composition of current assets
3. Turnover rate of current asset components

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Type of Business 1

• The type of business a company operates affects our assessment of its

current ratio.
• The importance of the type of business to our analysis implies that an
evaluation of a company’s current ratio should include a comparison
with ratios of other successful companies in the same industry.
• We must recognize that the current ratio is affected by a company’s
accounting methods, especially choice of inventory method.

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Type of Business 2

Current ratio 1.6:1 Times interest earned 50 times

Quick ratio 1.1:1 Profit margin 14%
Accounts receivable turnover 16 times Gross profit ratio 18%

Days’ sales uncollected 21 days Return on total assets 20%

Inventory turnover 5 times Return on common shareholders’ 32.7%
equity
Days’ sales in inventory 70 days Book value per common share $8.63
Total asset turnover 2.3 times Book value per preferred share $15.00
Accounts payable turnover 4 times Earnings per share $1.79
Debt ratio 35% Price-earnings per share 18.2
Equity ratio 65% Dividend yield $0.35
Pledged assets to secured liabilities 1.4:1

EXHIBIT 17.11
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Composition of Current Assets

• The composition of a company’s current assets is important to our

evaluation of short-term liquidity.
• Current receivables normally are more liquid than inventory.
• An excessive amount of receivables and inventory lessens a company’s
ability to pay current liabilities.
• One way to take account of the composition of current assets is to
evaluate the quick ratio.

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Quick Ratio 1

• The quick ratio, also called the acid-test ratio, is a more rigorous test of
a company’s ability to pay its current debts.
• Inventory and prepaid expenses are excluded and only quick assets are
included.
• Quick assets are cash, investments (current), accounts receivable, and
notes receivable. These are the most liquid types of current assets.
• We calculate the quick ratio as:

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Quick Ratio 2

EXHIBIT 17.12
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Quick Ratio 3

• A common rule of thumb for an acceptable quick ratio is 1 to 1.

• It is important to assess what the acceptable range for the industry
is.
• We need to consider other factors. For instance, the working capital
requirements of a company are affected by how frequently the
company converts its current assets into cash.

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Accounts Receivable Turnover 1

• Accounts receivable turnover is more precise if credit sales are used

for the numerator.
• Net sales (or revenues) are usually used by external users because
information about credit sales is typically not reported.
• Average accounts receivable is estimated by averaging the
beginning and the ending receivables for the period.
• Ending accounts receivable is sometimes substituted for the average
balance in calculating accounts receivable turnover.
• Some users prefer using gross accounts receivable (before
subtracting the allowance for doubtful accounts).

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Accounts Receivable Turnover 2

Nature’s Playground’s 2023 accounts receivable turnover is calculated

as:

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Accounts Receivable Turnover 3

• If accounts receivable are collected quickly, then accounts

receivable turnover is high.
• A high turnover is favourable because it means the company does
not have a large amount of resources tied up in accounts
receivable.
• An accounts receivable turnover can be too high, as it can signal an
issue with credit terms being so restrictive that they negatively
affect sales volume.

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Days’ Sales Uncollected 1

• Days’ sales uncollected, defined as:

• This formula places accounts receivable in the numerator with sales

in the denominator.
• Any current notes receivable from customers are also normally
included in the numerator.

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Days’ Sales Uncollected 2

• The days’ sales uncollected figure on November 30, 2023, is:

• Days’ sales uncollected is more meaningful if we know the

company’s credit terms.
• A rough guideline is that days’ sales uncollected should not exceed
one and one-third times the days in its: (a) credit period, if
discounts are not offered; or (b) discount period, if discounts are
offered.
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Inventory Turnover 1

• Working capital (current assets minus current liabilities)

requirements are affected by how long a company holds inventory
before selling it.
• One measure of this effect is the turnover.
• It provides a measure of a firm’s liquidity and how quickly it can
convert inventory to cash.
• Inventory turnover is defined as:

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Inventory Turnover 2

• Nature’s Playground’s inventory turnover for 2023 is:

• Average inventory is estimated by averaging the beginning and the

ending inventories for the period.
• If the beginning and ending inventories do not represent the
amount normally on hand, an average of quarterly or monthly
inventories may be used if available.
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IMPORTANT TIP

An important tip is a high turnover ratio is typically better;

however, it is important to assess prior-year comparatives and
competitors in the industry to ensure resources are utilized
efficiently.

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 1-53

Days’ Sales in Inventory 1

• Days’ sales in inventory is a useful measure in evaluating the

liquidity of a company’s inventory.
• Days’ sales in inventory is linked to inventory in a similar manner
as days’ sales uncollected is linked to receivables.
• Days’ sales in inventory is calculated as:

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 1-54

Days’ Sales in Inventory 2

• We calculate days’ sales in inventory as:

• Rule of thumb: a lower days’ sales in inventory is better. A

business selling perishables such as meat or produce’s days’ sales
in inventory would be very low (one or two days) as compared to a
retailer selling slower-moving inventory such as jewellery.

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 1-55

Total Asset Turnover 1

• Total asset turnover describes the ability of a company to use its

assets to generate sales.
• This ratio is calculated as:

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Total Asset Turnover 1

• This calculation is:

• Rule of thumb: the higher the asset turnover, the better the
company is managing its cash resources.

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 1-57

Accounts Payable Turnover 1

• The accounts payable turnover describes how much time it takes

for a company to meet its obligations to its suppliers.
• It is calculated as:

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Accounts Payable Turnover 2

• We calculate the ratio as:

• Rule of thumb: typically, a company that manages its payables well

has an accounts payable turnover ratio above 6 times or below 60
days.

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 1-59

CHECKPOINT

9. The following information is from the December 31, 2023 balance

sheet of Westfield Sports Corp: cash, $820,000; accounts
receivable, $240,000; inventories, $470,000; PPE assets,
$910,000; accounts payable, $350,000; and income taxes
payable, $180,000. Calculate the (a) current ratio, and (b) quick
ratio.
10. On December 31, 2023, Westfield Sports Corp. (in Checkpoint 9)
had accounts receivable of $290,000 and inventories of $530,000.
During 2023, net sales amounted to $2,500,000 and cost of goods
sold was $750,000. Calculate the (a) accounts receivable turnover,
(b) days’ sales uncollected, (c) inventory turnover, and (d) days’
sales in inventory.
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 1-60

Solvency

• Refers to a company’s long-run financial viability and its ability to cover

long-term obligations.
• All business activities of a company—financing, investing, and operating
—affect a company’s solvency.
• One of the most important components of solvency analysis is the
composition of a company’s capital structure, its sources of financing:
shares and/or debt.
• Analysis of solvency is long term and uses less precise but more
encompassing measures.
• Analysis of capital structure is one key in evaluating solvency.

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Debt and Equity Ratios 1

• One element of solvency analysis is to assess the portion of a

company’s assets contributed by its owners and the portion
contributed by creditors.
• This relation is reflected in the debt ratio.
• The debt ratio expresses total liabilities as a percentage of total
assets.
• The equity ratio provides complementary information by expressing
total equity as a percentage of total assets.

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 1-62

Debt and Equity Ratios 2

Nature’s Playground’s debt and equity ratios are calculated as:

Nov. 30, 2023 Ratios

Total liabilities $26,469 13.8% [Debt Ratio]
Total equity 164,953 86.2 [Equity Ratio]
Total liabilities and
equity $191,422 100%

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 1-63

Pledged Assets to Secured Liabilities 1

• The ratio of pledged assets to secured liabilities is used to evaluate the

risk faced by secured creditors of companies failing to meet their
principal and interest payments.
• This ratio also is relevant to unsecured creditors. The ratio is calculated
as:

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Pledged Assets to Secured Liabilities 2

• The information needed to calculate this ratio is not usually reported in

published financial statements.
• This means that people who have the ability to obtain information
directly from the company (such as bankers and certain lenders)
primarily use the ratio.
• A generally agreed minimum value for this ratio is about 2 to 1.
• The ratio needs careful interpretation because it is based on the book
value of pledged assets.
• Creditors prefer that a debtor be able to pay with cash generated by
operating activities rather than with cash obtained by liquidating assets.

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 1-65

Times Interest Earned 1

• The times interest earned ratio is used to reflect the riskiness of

repayments with interest to creditors.
• The amount of profit before the deduction of interest charges and
income taxes is the amount available to pay interest charges.
• We calculate this ratio as:

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 1-66

Times Interest Earned 2

• Nature’s Playground’s times interest earned ratio for 2023 is calculated

as:

• The larger this ratio, the less risky is the company for lenders.
• A guideline for this ratio is that creditors are reasonably safe if the
company earns its fixed interest charges two or more times each year.

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 1-67

CHECKPOINT

11. Which ratio best reflects the ability of a company to meet immediate
interest payments? (a) debt ratio; (b) equity ratio; (c) times interest
earned; (d) pledged assets to secured liabilities.

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 1-68

Profitability

• We are especially interested in the ability of a company to use its assets

efficiently to produce profits (and positive cash flows).
• Profitability refers to a company’s ability to generate an adequate
return on invested capital.
• Return is judged by assessing earnings relative to the level and sources
of financing.
• Profitability is also relevant to solvency.

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 1-69

Profit Margin 1

• The profit margin reflects a company’s ability to earn a profit from

sales.
• Profit margin gives an indication of how sensitive profit is to changes in either
prices or costs.
• It is measured by expressing profit as a percentage of revenues (sales
and revenues are similar terms).
• We can use the information in Exhibit 17.2 to calculate Nature’s
Playground’s 2023 profit margin as:

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 1-70

Profit Margin 2

• An improved profit margin could be due to more efficient operations

resulting in lower cost of goods sold and reduced expenses.
• It could also be due to higher prices received for products sold.
• Rule of thumb: the higher the profit margin the better. To evaluate the
profit margin of a company, we must consider the industry in which it
operates. For instance, a publishing company might be expected to
have a profit margin of between 10% and 15%, while a retail
supermarket might have a normal profit margin of 1% or 2%.

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 1-71

Gross Profit Ratio 1

• Gross profit, also called gross margin, is the relation between sales and
cost of goods sold.
• A merchandising company needs sufficient gross profit to cover operating
expenses or it will likely fail.
• To help us focus on gross profit, users often calculate a gross profit ratio.
• Rule of thumb: the higher the gross profit ratio, the better a company is at
managing its inventory and sales to customers. The gross profit ratio, or
gross margin ratio, is defined as:

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Gross Profit Ratio 2

• The gross profit ratios of Nature’s Playground for the years 2023 and
2022 were:
2023 2022
Net sales $164,313 $105,027
Cost of goods sold 35,940 24,310
Gross profit from sales $128,373 $80,717
Gross profit ratio 78.13% 76.85%
Calculated as $128,373/$164,313) x ($80,717/$105,027) x
100% 100%

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 1-73

Return on Total Assets 1

• The two basic components of operating efficiency—profit margin and

total asset turnover—are used to calculate a summary measure, return
on total assets, calculated as:

• Nature’s Playground’s 2023 return on total assets is:

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Return on Total Assets 2

• The following calculation shows the relationship between profit margin,

total asset turnover, and return on total assets:

OR

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Return on Total Assets 3

• Notice that both profit margin and total asset turnover contribute to
overall operating efficiency, as measured by return on total assets.
• Rule of thumb: the higher the return on total assets, the better a
company is able to manage its resources to generate profit.
• If we apply this formula to Nature’s Playground, we get:

Profit Margin x Total Assets Turnover

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Return on Common Shareholders’ Equity 1

• Perhaps the most important goal in operating a company is to earn

profit for its owners. The return on common shareholders’ equity
measures the success of a company in reaching this goal. We calculate
this return measure as:

• We determine Nature’s Playground’s return as follows:

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Return on Common Shareholders’ Equity 2

• In the numerator, the dividends on cumulative preferred shares must

be subtracted whether they are declared or are in arrears.
• If preferred shares are non-cumulative, the dividends are subtracted
only if declared.
• Rule of thumb: the higher the return on equity, the better the company
is generating profit for the owners of the company. Nature’s
Playground’s return on common shareholders’ equity of 23.5% is
unfavourable when compared to the industry average of 32.7%. This
indicates that Nature’s Playground’s competitors are earning more
profit for their owners than Nature’s Playground is.

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 1-78

Book Value Per Share 1

• Book value can be calculated per common share and per preferred
share.
• Book value per common share is the recorded amount of equity
applicable to common shares divided by the number of common shares
outstanding.

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Book Value Per Share 2

• Nature’s Playground has no preferred shares, so we calculate only book

value per common share. For November 30, 2023, this ratio is
calculated as:

• The book value can be used as the starting point in share valuation
methods or for merger negotiations.
• It is important to note that book values are used as a rough estimate.
• Actual asset values can deviate substantially from reported book values
in the event of a liquidation.

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 1-80

Book Value Per Share 3

• To calculate book value when both common and preferred shares are
outstanding, we must first allocate total equity between these two
kinds of shares. The book value per preferred share is calculated first,
and its calculation is:

*Stated another way, the numerator could be described as: Call price of preferred shares
plus dividends in arrears or, if there is no call price, then: Paid-in capital from preferred
shares plus dividends in arrears.

• The equity applicable to preferred shares equals the preferred shares’

call price (or average paid-in amount if the preferred shares are not
callable) plus any cumulative dividends in arrears. The remaining
equity is the portion applicable to common shares.
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 1-81

Earnings Per Share

• Earnings per share was introduced in Chapter 13. Nature’s Playground’s
earnings per share figure was given in Exhibit 17.8. It was calculated as:

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 1-82

Market Measures

• Market measures are useful when analyzing corporations having

publicly traded shares.
• These market measures use share price in their calculation.
• Share price reflects what the market (public) expectations are for the
company.
• This includes both the return and risk characteristics of a company as
currently perceived by the market.

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 1-83

Price-Earnings Ratio 1

• The price–earnings ratio is the most widely quoted measure of

company performance. It measures how investors judge the company’s
future performance and is calculated as:

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Price-Earnings Ratio 2

• Predicted earnings per share for the next period is often used in the
denominator of this calculation.
• Reported earnings per share for the most recent period is also
commonly used.
• In both cases, the ratio is an indicator of the future growth of and risk
related to a company’s earnings as perceived by investors who establish
the market price of the shares.

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 1-85

Price-Earnings Ratio 3

• Using Nature’s Playground’s $0.63 earnings per share that was reported
at the end of 2023, we calculate its price–earnings ratios using both the
low and high share prices:

• Nature’s Playground’s ratios, which are higher than the industry average
of 18.2, reflect the expectation of investors that the company will
continue to grow at a faster rate than its competitors.

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 1-86

Dividend Yield 1

• We use dividend yield as a means of comparing the dividend-paying

performance of different investment alternatives. Dividend yield is
calculated as:

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 1-87

Dividend Yield 2

• A low dividend yield is neither bad nor good by itself.

• Some companies decide not to declare dividends because they prefer
to reinvest the cash.
• Nature’s Playground, for instance, does not pay cash dividends on its
common shares, but its competitors pay $0.35 per common share on
average.

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 1-88

ETHICAL IMPACT 1

Balancing Objectives: Social Media Reporting

You recently accepted a position with a nationwide property developer that
focuses on designing innovative urban communities geared toward young
professionals looking for fitness, healthy eating, advanced connectivity, and
social connections. Last week in your orientation, the President and CEO
mentioned to the group of new employees that an exciting future is ahead.
The company is planning to go public in the next year and is hoping to raise
$300 million to enable the company to meet its aggressive expansion plans
into the cities of Montreal, Victoria, and St. John’s. You are excited to hear
that you will participate in preparing accounting disclosures and records for
this new phase of corporate development.

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ETHICAL IMPACT 2

Today in your one-on-one with the VP of Finance, Mia Kruner, she mentioned
she wants you to be responsible for releasing financial information through
social media to help reach their established group of followers to get them
excited for the upcoming IPO investment opportunity. In order to build up the
IPO demand, she has asked you to put together a plan for the types of
information they can release that will help boost their share price. You are
concerned about developing an appropriate social media policy to ensure
your plan does not negatively impact the reputation of the company,
especially in the eyes of Canadian securities regulators. What will you do to
ensure your plan meets these objectives? Do you have any concerns with
Mia’s request?

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 1-90

CHECKPOINT

12. Which ratio measures the success of a company in earning profit for
its owners? (a) Profit margin; (b) Return on common shareholders’
equity; (c) Price-earnings ratio; (d) Dividend yield.
13. If a company has net sales of $8,500,000, profit of $945,000, and total
asset turnover of 1.8 times, what is its return on total assets?

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 1-91

Summary of Ratios 1

• Standards of comparison may include:

• Ratios of other firms in the same industry
• Past performance
• Budgeted performance
• Subjective standards
• All of the foregoing comparison measures involve elements that
challenge direct comparability.
• Another limitation is that management may engage in year-end
transactions that temporarily improve certain ratios. This is an unethical
activity called window dressing.

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 1-92

Summary of Ratios 2

• A ratio that is significantly higher or lower than standard merely

indicates that something may be wrong and should be investigated, but
ratios do not provide definitive answers.
• Ratio analysis is based on current or past performance, but a user may
be more interested in future performance.
• Any conclusions are therefore tentative and must be interpreted in the
light of future expectations.
• Ratio analysis is, however, the beginning of a process of financial
analysis and can help describe the financial condition of a company and
help a user piece together a story about the relative strength and future
potential financial health.
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 1-93

Summary of Ratios 3

User Primary Interest Key Ratios Emphasized

Short-term creditor Assess ability of firm to Liquidity and efficiency
meet cash commitments ratios
in the near term
Long-term creditor Assess both short-term Solvency ratios
and long-term ability to
meet cash commitments
of interest payments
and debt repayment
schedules
Investor Assess the firm’s ability Profitability ratios and
to make profits, pay market ratios
dividends, and realize
share price increases

EXHIBIT 17.13
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 1-94

Critical Thinking Challenge

Refer to the Critical Thinking Challenge questions at the

beginning of the chapter.

Did your answers change after reading the chapter?

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 1-95

Summary 1

1. Describe financial statement analysis and identify its focus, standards

of comparison, and tools.
The purpose of financial statement analysis is to help users make better
business decisions using the tools of horizontal, vertical, and ratio analysis to
evaluate (1) past and current performance, (2) current financial position, and
(3) future performance and risk. The four building blocks of analysis are (1)
liquidity and efficiency–ability to meet current obligations and generate
revenues efficiently; (2) solvency–ability to generate future revenues and
meet long-term obligations; (3) profitability–ability to provide financial
rewards sufficient to attract and retain financing; and (4) market–ability to
generate positive market expectations. To make conclusions from analysis we
need standards for comparisons including (1) intracompany; (2) competitor;
(3) industry; and (4) guidelines (rules of thumb).
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 1-96

Summary 2

2. Describe and apply methods of horizontal analysis.

Horizontal analysis is a tool to evaluate changes in financial statement
data across time. Two important tools of horizontal analysis are
comparative statements and trend analysis. Comparative statements show
amounts for two or more successive periods, often with changes disclosed
in both absolute and percentage terms. Trend analysis is used to reveal
important changes occurring from one period to the next.

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Summary 3

1. Describe and apply methods of vertical analysis.

In common-size statements, each item is expressed as a percentage of a
base amount. The base amount for the balance sheet is usually total
assets, and the base amount for the income statement is usually net sales.
Vertical analysis is a tool to evaluate each financial statement item or
group of items in terms of a specific base amount. This base amount is
commonly defined as 100%. Two important tools of vertical analysis are
common-size statements and graphical analyses.

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 1-98

Summary 4

1. Describe and apply ratio analysis.

Ratio analysis provides clues and symptoms of underlying conditions.
Ratios, properly interpreted, identify areas requiring further investigation.
A ratio expresses a mathematical relation between two quantities;
examples are a percentage, a rate, or a proportion. Selected ratios are
organized into the building blocks of analysis: (1) liquidity and efficiency,
(2) solvency, (3) profitability, and (4) market.

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 1-99

End of Chapter

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