© 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater Analyzing Financial Statements Analyzing Financial Statements Chapter 22

Learning Objective 1 Preparing comparative balance sheets Using horizontal and vertical analysis techniques © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-1

Comparative Balance Sheet Current and past financial reports covering two or more successive periods that place data in single columns side by side © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-1

Horizontal Analysis Amounts of items compared on the same line of comparative financial reports Comparing two figures across columns, from one period to another Percentage of increase/decrease: Amount of Change/Base (old year) © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-1

Learning Objective 2 Preparing comparative balance sheets Using horizontal and vertical analysis techniques © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-2

Trend Analysis Type of horizontal analysis Deals with percentage changes in items on the financial reports for several years Uses a base year to calculate the percentage change of each item © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-2

© 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater Problem 22B-1(a) LO-1,2

Vertical Analysis Comparing items in a financial report by expressing each item as a percentage of a certain base total On the income statement each item is calculated as a percentage of net sales On a balance sheet, a percentage of total assets, liabilities or owner’s equity is used © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-1, 2

© 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-1,2 Problem 22B-1 (b)

© 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-1,2 Problem 22B-2(a)

© 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater Problem 22B-2 (b) LO-1,2

Common-size Statements Comparative reports in which each item is expressed as a percentage of a base amount without dollar amounts Can be used to compare companies of different sizes © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-1

© 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-1 Problem 22B-1 (c)

Learning Objective 3 Calculating the four different types of ratios ◦ Liquidity ratios ◦ Asset management ratios ◦ Debt management ratios ◦ Profitability ratios © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Ratio Analysis Examination of relationship between two numbers or sets of numbers on financial reports Can indicate how well a company conducts its business We will use Problem 22B-3 to apply these concepts. © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Liquidity Ratios Measure a company’s ability to meet short-term obligations ◦ Current Ratio ◦ Acid Test Ratio © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Current Ratio Indicates a company’s ability to pay its short-term debt Current Assets Current Liabilities © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Current Ratio – Problem 22B-3 Current Assets Current Liabilities © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater $28,850 / $13,600 = 2.12:1 LO-3

Acid Test Ratio Indicates a company’s ability to pay its short-term debt Includes only assets that are easily converted into cash (quick assets) Current Assets – Inventory – Prepaid Expenses Current Liabilities © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Acid Test Ratio Current Assets – Inventory – Prepaid Expenses Current Liabilities © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater ($28,850 – 14,500 – 1,200) / $13,600 =.97 LO-3

Asset Management Ratios Measure how effectively a company is using its assets ◦ Accounts Receivable Turnover ◦ Average Collection Period ◦ Inventory Turnover ◦ Asset Turnover © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Accounts Receivable Turnover Indicates number of times Accounts Receivables are converted to cash within a given period Indication of effectiveness of company’s credit policy Net Credit Sales Average Accounts Receivable* *Avg. A/R = Beginning balance + ending balance 2 © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Accounts Receivable Turnover Net Credit Sales Average Accounts Receivable* © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 99,000 / ((9, ,700)/2) = times *Avg. A/R = Beginning balance + ending balance 2 LO-3

Average Collection Period Calculates the number of days it takes to collect Accounts Receivable Shows how quickly moneys owed are received from customers Measures how effectively a company collects its Accounts Receivable 365 days Accounts Receivable Turnover © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Average Collection Period 365 days Accounts Receivable Turnover © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 365 / = 34 days LO-3

Inventory Turnover Indicates how quickly inventory moves off the shelf How well a company sells its products Cost of Goods Sold Average Inventory © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Inventory Turnover Cost of Goods Sold Average Inventory © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 50,500 / [(14, ,900)/2] = 3.4 times LO-3

Asset Turnover Indicates how efficiently a company uses its assets to generate sales Helps measure the overall efficiency Net Sales Total Assets © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Asset Turnover Net Sales Total Assets © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 99,000 / 43,750 = 2.26 times LO-3

Debt Management Ratios Measure how well a company is using debt versus its equity position ◦ Debt to Total Assets ◦ Debt to Stockholders’ Equity ◦ Times Interest Earned © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Debt to Total Assets Indicates how much of a company’s assets are financed by creditors Total Liabilities Total Assets © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Debt to Total Assets Total Liabilities Total Assets © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 23,600 / 43,750 = 53.9% LO-3

Debt to Stockholders’ Equity Measures the risk creditors run in comparison with stockholders Total Liabilities Stockholders’ Equity © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Debt to Stockholders’ Equity Total Liabilities Stockholders’ Equity © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 23,600 / 20,150 = 117.1% LO-3

Times Interest Earned Indicates the degree of risk to lenders that a company will default on its interest payments (interest coverage ratio) Income Before Taxes and Interest Expense Interest Expense © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Times Interest Earned Income Before Taxes and Interest Expense Interest Expense © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 17,900 / 4,550 = 3.9 times LO-3

Profitability Ratios Measure a company’s ability to earn profits ◦ Gross Profit Rate ◦ Return on Sales ◦ Rate of Return on Total Assets ◦ Rate of Return on Common Stockholders’ Equity © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Gross Profit Rate Indicates how well net sales cover administrative and selling expenses Gross Profit Net Sales © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Gross Profit Rate Gross Profit Net Sales © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 48,500 / 99,000 = 49% LO-3

Return on Sales Shows the relationship of Net Income Before Taxes to Net Sales Indicates the effectiveness of a company’s pricing policy Net Income Before Taxes Net Sales © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Return on Sales Net Income Before Taxes Net Sales © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 13,350 / 99,000 = 13.5% LO-3

Rate of Return on Total Assets Measures how wisely a company has invested in and manages its assets Two ways to compute: Net Income before Interest and Taxes Total Assets Return on Sales x Total Asset Turnover © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Rate of Return on Total Assets Net Income before Interest and Taxes Total Assets © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 17,900 / 43,750 = 40.9% LO-3

Rate of Return on Common Stockholders’ Equity Indicates how well a company is managing debt financing to earn a profit for holders of Common Stock Net Income Before Taxes- Preferred Dividends Common Stockholders’ Equity © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater LO-3

Rate of Return on Common Stockholders’ Equity Net Income Before Taxes- Preferred Dividends Common Stockholders’ Equity © 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater 13,350 /20,150 = 66.3% LO-3

© 2010 Prentice Hall Business Publishing, College Accounting: A Practical Approach, 11e by Slater End of Chapter 22