Chapter 17 Financial Statement Analysis Accounting, 21 st Edition Warren Reeve Fess PowerPoint Presentation by Douglas Cloud Professor Emeritus of Accounting Pepperdine University © Copyright 2004 South-Western, a division of Thomson Learning. All rights reserved. Task Force Image Gallery clip art included in this electronic presentation is used with the permission of NVTech Inc.

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1.List the basic financial statement analytical procedures. 2.Apply financial statement analysis to assess the solvency of a business. 3.Apply financial statement analysis to assess the profitability of a business. 4.Summarize the uses and limitations of analytical measures. 5.Describe the contents of corporate annual reports. ObjectivesObjectives After studying this chapter, you should be able to:

Horizontal Analysis What is horizontal analysis?

Horizontal Analysis It’s an analysis of the percentage increases and decreases of related items in comparative financial statements.

Lincoln Company Comparative Balance Sheet December 31, 2006 and 2005 Assets Current assets$ 550,000$ 533,000$ 17, % Long-term investments95,000177,500(82,500)(46.5%) Fixed assets (net)444,500470,000(25,500)(5.4%) Intangible assets50,00050,000— Total assets $1,139,500$1,230,500$ (91,000)(7.4%) Liabilities Current liabilities$ 210,000$ 243,000$ (33,000)(13.6%) Long-term liabilities100,000200,000(100,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000)(30.0%) Stockholders’ Equity Preferred 6% stock, $100 par$ 150,000$ 150,000— Common stock, $10 par500,000500,000— Retained earnings179,500137,500$42, % Total stockholders’ equity $ 829,500$ 787,500$42, % Total liab. & SE $1,139,500$1230,500$(91,000)(7.4%) AmountPercent Balance Sheet Increase (Decrease)

Assets Current assets$ 550,000$ 533,000$ 17, % Long-term investments95,000177,500(82,500)(46.5%) Fixed assets (net)444,500470,000(25,500)(5.4%) Intangible assets50,00050,000— Total assets $1,139,500$1,230,500$ (91,000)(7.4%) Liabilities Current liabilities$ 210,000$ 243,000$ (33,000)(13.6%) Long-term liabilities100,000200,000(100,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000)(30.0%) Stockholders’ Equity Preferred 6% stock, $100 par$ 150,000$ 150,000— Common stock, $10 par500,000500,000— Retained earnings179,500137,500$42, % Total stockholders’ equity $ 829,500$ 787,500$42, % Total liab. & SE $1,139,500$1230,500$(91,000)(7.4%) Horizontal Analysis: Horizontal Analysis: Lincoln Company Comparative Balance Sheet December 31, 2006 and 2005 Difference$17,000 Base year (2005)$533,000 = 3.2% AmountPercent Increase (Decrease)

Assets Current assets$ 550,000$ 533,000$ 17, % Long-term investments95,000177,500(82,500)(46.5%) Fixed assets (net)444,500470,000(25,500)(5.4%) Intangible assets50,00050,000— Total assets $1,139,500$1,230,500$ (91,000)(7.4%) Liabilities Current liabilities$ 210,000$ 243,000$ (33,000)(13.6%) Long-term liabilities100,000200,000(100,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000)(30.0%) Stockholders’ Equity Preferred stock, $100 par$ 150,000$ 150,000— Common stock, $10 par500,000500,000— Retained earnings179,500137,500$42, % Total stockholders’ equity $ 829,500$ 787,500$42, % Total liab. & SE $1,139,500$1230,500$(91,000)(7.4%) Horizontal Analysis: Horizontal Analysis: Difference$(82,500) Base year (2005)$177,500 = (46.5%) Lincoln Company Comparative Balance Sheet December 31, 2006 and AmountPercent Increase (Decrease)

Assets Current assets$ 550,000$ 533,000$ 17, % Long-term investments95,000177,500(82,500)(46.5%) Fixed assets (net)444,500470,000(25,500)(5.4%) Intangible assets50,00050,000— Total assets $1,139,500$1,230,500$ (91,000)(7.4%) Liabilities Current liabilities$ 210,000$ 243,000$ (33,000)(13.6%) Long-term liabilities100,000200,000(100,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000)(30.0%) Stockholders’ Equity Preferred 6% stock, $100 par$ 150,000$ 150,000— Common stock, $10 par500,000500,000— Retained earnings179,500137,500$42, % Total stockholders’ equity $ 829,500$ 787,500$42, % Total liab. & SE $1,139,500$1230,500$(91,000)(7.4%) Horizontal Analysis: Horizontal Analysis: Difference? Base year (2005)? = ? Lincoln Company Comparative Balance Sheet December 31, 2006 and AmountPercent Increase (Decrease) Okay, go to the next slide and calculate the percentage change for fixed assets.

Assets Current assets$ 550,000$ 533,000$ 17, % Long-term investments95,000177,500(82,500)(46.5%) Fixed assets (net)444,500470,000(25,500)(5.4%) Intangible assets50,00050,000— Total assets $1,139,500$1,230,500$ (91,000)(7.4%) Liabilities Current liabilities$ 210,000$ 243,000$ (33,000)(13.6%) Long-term liabilities100,000200,000(100,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000)(30.0%) Stockholders’ Equity Preferred 6% stock, $100 par$ 150,000$ 150,000— Common stock, $10 par500,000500,000— Retained earnings179,500137,500$42, % Total stockholders’ equity $ 829,500$ 787,500$42, % Total liab. & SE $1,139,500$1230,500$(91,000)(7.4%) Lincoln Company Comparative Balance Sheet December 31, 2006 and 2005 (5.4%) AmountPercent Increase (Decrease)

Sales$1,530,500$1,234,000$296, % Sales returns32,50034,000(1,500)(4.4%) Net sales$1,498,000$1,200,000$298, % Cost of goods sold1,043,000820,000223, % Gross profit $ 455,000$ 380,000$ 75, % Selling expenses$ 191,000$ 147,000$ 44, % Administrative expenses104,00097,4006, % Total operating expenses$ 295,000$ 244,400$ 50, % Operating income$ 160,000$ 135,600$ 24, % Other income8,50011,000(2,500)(22.7%) $ 168,500$ 146,600$ 21, % Other expense6,00012,000(6,000)(50.0%) Income before income tax$ 162,500$ 134,600$ 27, % Income tax71,50058,10013, % Net income$ 91,000$ 76,500$ 14, % Lincoln Company Comparative Income Statement December 31, 2006 and AmountPercent Increase (Decrease) Income Statement

Sales$1,530,500$1,234,000$296, % Sales returns32,50034,000(1,500)(4.4%) Net sales$1,498,000$1,200,000$298, % Cost of goods sold1,043,000820,000223, % Gross profit $ 455,000$ 380,000$ 75, % Selling expenses$ 191,000$ 147,000$ 44, % Administrative expenses104,00097,4006, % Total operating expenses$ 295,000$ 244,400$ 50, % Operating income$ 160,000$ 135,600$ 24, % Other income8,50011,000(2,500)(22.7%) $ 168,500$ 146,600$ 21, % Other expense6,00012,000(6,000)(50.0%) Income before income tax$ 162,500$ 134,600$ 27, % Income tax71,50058,10013, % Net income$ 91,000$ 76,500$ 14, % Horizontal Analysis: Horizontal Analysis: Increase amount$296,500 Base year (2005) $1,234,000 = 24.0% 24.0% Lincoln Company Comparative Income Statement December 31, 2006 and AmountPercent Increase (Decrease)

Sales$1,530,500$1,234,000$296, % Sales returns32,50034,000(1,500)(4.4%) Net sales$1,498,000$1,200,000$298, % Cost of goods sold1,043,000820,000223, % Gross profit $ 455,000$ 380,000$ 75, % Selling expenses$ 191,000$ 147,000$ 44, % Administrative expenses104,00097,4006, % Total operating expenses$ 295,000$ 244,400$ 50, % Operating income$ 160,000$ 135,600$ 24, % Other income8,50011,000(2,500)(22.7%) $ 168,500$ 146,600$ 21, % Other expense6,00012,000(6,000)(50.0%) Income before income tax$ 162,500$ 134,600$ 27, % Income tax71,50058,10013, % Net income$ 91,000$ 76,500$ 14, % Horizontal Analysis: Horizontal Analysis: Increase amount$298,000 Base year (2005) $1,200,000 = 24.8% 24.8% Lincoln Company Comparative Income Statement December 31, 2006 and AmountPercent Increase (Decrease)

Vertical Analysis A percentage analysis can be used to show the relationship of each component to a total within a single statement.

The total, or 100% item, on the balance sheet is “total assets.” Vertical Analysis

Lincoln Company Comparative Balance Sheet Assets Current assets$ 550, %$ 533, % Long-term investments95, , Property, plant, & equip. (net)444, , Intangible assets50, , Total assets$1,139, %$1,230, % Liabilities Current liabilities$ 210, %$ 243, % Long-term liabilities100, , Total liabilities$ 310, %$ 443, % Stockholders’ Equity Preferred stock, 6%, $100 par$ 150, %$ 150, % Common stock, $10 par500, , Retained earnings179, , Total stockholders’ equity$ 829, %$ 787, % Total liab. & SE$1,139, %$1,230, % December 31, 2006 December 31, 2005 AmountPercentAmountPercent Vertical Analysis: Vertical Analysis: Current assets $550,000 Total assets $1,139,500 = 48.3% 48.3%BalanceSheetBalanceSheet

Lincoln Company Comparative Balance Sheet Assets Current assets$ 550, %$ 533, % Long-term investments95, , Property, plant, & equip. (net)444, , Intangible assets50, , Total assets$1,139, %$1,230, % Liabilities Current liabilities$ 210, %$ 243, % Long-term liabilities100, , Total liabilities$ 310, %$ 443, % Stockholders’ Equity Preferred 6% stock, $100 par$ 150, %$ 150, % Common stock, $10 par500, , Retained earnings179, , Total stockholders’ equity$ 829, %$ 787, % Total liab. & SE$1,139, %$1,230, % Vertical Analysis: Vertical Analysis: Current assets $533,000 Total assets $1,230,500 = 43.3% 43.3% December 31, 2006 December 31, 2005 AmountPercentAmountPercent

Lincoln Company Comparative Balance Sheet Assets Current assets$ 550, %$ 533, % Long-term investments95, , Property, plant, & equip. (net)444, , Intangible assets50, , Total assets$1,139, %$1,230, % Liabilities Current liabilities$ 210, %$ 243, % Long-term liabilities100, , Total liabilities$ 310, %$ 443, % Stockholders’ Equity Preferred 6% stock, $100 par$ 150, %$ 150, % Common stock, $10 par500, , Retained earnings179, , Total stockholders’ equity$ 829, %$ 787, % Total liab. & SE$1,139, %$1,230, % December 31, 2006 December 31, 2005 AmountPercentAmountPercent

Sales$1,530, % $1,234, % Sales returns32, , Net sales$1,498, %$1,200, % Cost of goods sold1,043, , Gross profit $ 455, %$ 380, % Selling expenses$ 191, %$ 147, % Administrative expenses104, , Total operating expenses$ 295, %$ 244, % Income from operations$ 160, $ 135, % Other income8, , $ 168, %$ 146, % Other expense6, , Income before income tax$ 162, %$ 134, % Income tax expense71, , Net income$ 91,0006.1%$ 76,5006.4% Amount Percent Amount Percent Net sales is 100.0% Lincoln Company Comparative Income Statement For the Years Ended December 31, 2006 and 2005 IncomeStatementIncomeStatement

Sales$1,530, % $1,234, % Sales returns32, , Net sales$1,498, %$1,200, % Cost of goods sold1,043, , Gross profit $ 455, %$ 380, % Selling expenses$ 191,000 Selling expenses$ 191, %$ 147, % Administrative expenses104, , Total operating expenses$ 295, %$ 244, % Income from operations$ 160, $ 135, % Other income8, , $ 168, %$ 146, % Other expense6, , Income before income tax$ 162, %$ 134, % Income tax expense71, , Net income$ 91,0006.1%$ 76,5006.4% Amount Percent Amount Percent Vertical Analysis: Vertical Analysis: Selling expenses $191,000 Net sales $1,498,000 = 12.8% 12.8%

Sales$1,530, % $1,234, % Sales returns32, , Net sales$1,498, %$1,200, % Cost of goods sold1,043, , Gross profit $ 455, %$ 380, % Selling expenses$ 191, %$ 147, % Administrative expenses104, , Total operating expenses$ 295, %$ 244, % Income from operations$ 160, $ 135, % Other income8, , $ 168, %$ 146, % Other expense6, , Income before income tax$ 162, %$ 134, % Income tax expense71, , Net income$ 91,0006.1%$ 76,5006.4% Amount Percent Amount Percent Lincoln Company Comparative Income Statement For the Years Ended December 31, 2006 and 2005

Sales$1,530, % $1,234, % Sales returns32, , Net sales$1,498, %$1,200, % Cost of goods sold1,043, , Gross profit $ 455, %$ 380, % Selling expenses$ 191, %$ 147, % Administrative expenses104, , Total operating expenses$ 295, %$ 244, % Income from operations$ 160, $ 135, % Other income8, , $ 168, %$ 146, % Other expense6, , Income before income tax$ 162, %$ 134, % Income tax expense71, , Net income$ 91,0006.1%$ 76,5006.4% Amount Percent Amount Percent Lincoln Company Comparative Income Statement For the Years Ended December 31, 2006 and 2005

Common Size Statements Vertical analysis with both dollar and percentage amounts is also useful in comparing one company with another or with industry averages. Such comparisons are easier to make with the use of common-size statements in which all items are expressed in percentages.

Common-Size Income Statement

Solvency Analysis  Solvency is the ability of a business to meet its financial obligations (debts) as they are due.  Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities.  This ability is normally assessed by examining balance sheet relationships.

Current Position Analysis Current assets $550,000$533,000 Current liabilities 210, ,000 Working capital$340,000$290,000 Current ratio Working Capital and Current Ratio Use:To indicate the ability to meet currently maturing obligations Divide current assets by current liabilities

Quick Ratio Use:To indicate instant debt-paying ability Quick assets: Cash$ 90,500$ 64,700 Marketable securities 75,00060,000 Accounts receivable (net)115,000120,000 Total$280,500$244,700 Current liabilities$210,000$243,000 Quick ratio Current Position Analysis

Accounts Receivable Turnover Net sales on account$1,498,000$1,200,000 Accounts receivable (net): Beginning of year$ 120,000$ 140,000 End of year 115,500120,000 Total$ 235,000$ 260,000 Average (Total ÷ 2)$ 117,500$ 130, Accounts Receivable Analysis Net sales on account Average accounts receivable Net sales on account Average accounts receivable

Use:To assess the efficiency in collecting receivables and in the management of credit. Net sales on account$1,498,000$1,200,000 Accounts receivable (net): Beginning of year$ 120,000$ 140,000 End of year 115,500120,000 Total$ 235,000$ 260,000 Average$ 117,500$ 130,000 Accounts receivable turnover Accounts Receivable Analysis Accounts Receivable Turnover

Number of Days’ Sales in Receivables Accounts receivable (net), end of year$ 115,000$ 120,000 Net sales on account$1,498,000$1,200,000 Average daily sales on account (sales ÷ 365)$ 4,104$ 3, Accounts Receivable Analysis Accounts receivable, end of year Average daily sales on account Accounts receivable, end of year Average daily sales on account

Number of Days’ Sales in Receivables Use:To assess the efficiency in collecting receivables and in the management of credit. Number of days’ sales in receivables receivables Accounts receivable (net), end of year$ 115,000$ 120,000 Net sales on account$1,498,000$1,200,000 Average daily sales on account (sales ÷ 365)$ 4,104$ 3, Accounts Receivable Analysis

Inventory Turnover Cost of goods sold$1,043,000$ 820,000 Inventories: Beginning of year$ 283,000$ 311,000 End of year 264,000283,000 Total$ 547,000$ 594,000 Average (Total ÷ 2)$ 273,500$ 297,000 Inventory Analysis Cost of goods sold Average inventory Cost of goods sold Average inventory Inventory turnover =

Inventory Turnover Use:To assess the efficiency in the management of inventory Cost of goods sold$1,043,000$ 820,000 Inventories: Beginning of year$ 283,000$ 311,000 End of year 264,000283,000 Total$ 547,000$ 594,000 Average (Total ÷ 2)$ 273,500$ 297,000 Inventory turnover Inventory Analysis

Number of Days’ Sales in Inventory Inventories, end of year$ 264,000$283,000 Cost of goods sold$1,043,000$820,000 Average daily cost of goods sold (COGS ÷ 365)$ 2,858$ 2,247 Inventory Analysis Inventories, end of year Average daily cost of goods sold Inventories, end of year Average daily cost of goods sold Number of Days’ Sales in Inventory =

Use:To assess the efficiency in the management of inventory. Inventories, end of year$ 264,000$283,000 Cost of goods sold$1,043,000$820,000 Average daily cost of goods sold (COGS ÷ 365)$ 2,858$ 2,247 Number of days’ sales in inventory Inventory Analysis

Use:To indicate the margin of safety to long-term creditors Fixed assets (net)$444,500$470,000 Long-term liabilities$100,000$200,000 Ratio of fixed assets to long-term liabilities Ratio of Fixed Assets to Long-Term Liabilities Long-Term Creditors

Ratio of Liabilities to Stockholders’ Equity Use:To indicate the margin of safety to creditors. Total liabilities$310,000$443,000 Total stockholders’ equity$829,500$787,500 Ratio of liabilities to stockholders’ equity Long-Term Creditors

Number of Times Interest Charges Earned Income before income tax$ 900,000$ 800,000 Add interest expense 300, ,000 Amount available for interest$1,200,000$1,050,000 Long-Term Creditors Income before income tax + interest expense Interest expense Income before income tax + interest expense Interest expense Number of Times Interest Charges Earned =

Use:To assess the risk to debtholders in terms of number of times interest charges were earned Income before income tax$ 900,000$ 800,000 Add interest expense 300, ,000 Amount available for interest$1,200,000$1,050,000 Number of times earned Long-Term Creditors

Profitability Analysis  Profitability is the ability of an entity to earn profits.  This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available.  Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet.

Ratio of Net Sales to Assets Net sales $1,498,000$1,200,000 Total assets: Beginning of year$1,053,000$1,010,000 End of year 1,044,5001,053,000 Total$2,097,500$2,063,000 Average (Total ÷ 2)$1,048,750$1,031,500 The Common Stockholder Excludes long-term investments

The Common Stockholder Use:To assess the effectiveness of the use of assets. Ratio of net sales to assets Ratio of net sales to assets Ratio of Net Sales to Assets Net sales $1,498,000$1,200,000 Total assets: Beginning of year$1,053,000$1,010,000 End of year 1,044,5001,053,000 Total$2,097,500$2,063,000 Average (Total ÷ 2)$1,048,750$1,031,500

Rate Earned on Total Assets Use:To assess the profitability of the assets Rate earned on total assets 8.2% 7.3% Rate earned on total assets 8.2% 7.3% Net income$ 91,000$ 76,500 Plus interest expense6,00012,000 Total$ 97,000$ 88,500 Total assets: Beginning of year$1,230,500$1,187,500 End of year 1,139,5001,230,500 Total$2,370,000$2,418,000 Average (Total ÷ 2)$1,185,000$1,209,000 The Common Stockholder

Rate Earned on Stockholders’ Equity Use:To assess the profitability of the investment by stockholders. Rate earned on stockholders’ equity 11.3% 10.0% Net income$ 91,000$ 76,500 Stockholders’ equity: Beginning of year$ 787,500$ 750,000 End of year 829,500787,500 Total$1,617,000$1,537,500 Average (Total ÷ 2)$ 808,500$ 768, The Common Stockholder

Rate Earned on Common Stockholders’ Equity The Common Stockholder Net income$ 91,000$ 76,500 Less preferred dividends9,0009,000 Remainder—common stock$ 82,000$ 67,500 Common stockholders’ equity: Beginning of year $ 637,500$ 600,000 End of year 679,500637,500 Total$1,317,000$1,237,500 Average (Total ÷ 2)$ 658,500$ 618,750

Use:To assess the profitability of the investment by common stockholders Rate earned on common Rate earned on common stockholders’ equity 12.5% 10.9% stockholders’ equity 12.5% 10.9% Net income$ 91,000$ 76,500 Less preferred dividends9,0009,000 $ 82,000$ 67,500 Remainder—common stock$ 82,000$ 67,500 Common stockholders’ equity: Beginning of year$ 637,500$ 600,000 End of year 679,500637,500 Total$1,317,000$1,237,500 $ 658,500$ 618,750 Average (Total ÷ 2)$ 658,500$ 618,750 The Common Stockholder Rate Earned on Common Stockholders’ Equity

Earnings Per Share on Common Stock Earnings per share on common stock $1.64 $1.35 Earnings per share on common stock $1.64 $1.35 Net income$ 91,000$ 76,500 Less preferred dividends9,0009,000 Remainder—common stock$ 82,000$ 67,500 Shares of common stock50,00050,000 Use:To assess the profitability of the investment by common stockholders. The Common Stockholder

Price-Earnings Ratio Use:To indicate future earnings prospects, based on the relationship between market value of common stock and earnings Price-earnings ratio on common stock Price-earnings ratio on common stock Market price per share of common$41.00$27.00 Earnings per share on common÷ 1.64÷ 1.35 The Common Stockholder

Dividend Yield on Common Stock Use:To indicate the rate of return to common stockholders in terms of dividends Dividend yield on common stock 1.95% 2.22% Dividend yield on common stock 1.95% 2.22% Dividends per share of common$ 0.80$ 0.60 Market price per share of common÷ ÷ The Common Stockholder

Corporate Annual Reports In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report. The MDA includes an analysis of the results of operations and discusses management’s opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition.

Corporate Annual Reports In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report. Before issuing annual statements, all publicly held corporations are required to have an independent audit of their financial statements. The CPAs who conduct the audit render an opinion as to the fairness of the statements.

The End Chapter 17