1. Financial Statement Analysis
Chapter Thirteen
Financial Statement Analysis
This chapter focuses on financial statement analysis which is used to assess the financial health of a company. It includes examining trends in key financial data, comparing financial data across companies, and analyzing financial ratios.

2. Learning Objective 1
Describe factors associated with communicating useful information.
Learning Objective One:
Describe factors associated with communicating useful information.

3. Factors in Communicating Useful Information
The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the following:
Users
Types of Decisions
The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the following:
The users
The types of decisions, and
Techniques for information analysis
Methods of Analysis

4. Learning Objective 2
Differentiate between horizontal and vertical analysis.
Learning Objective Two:
Differentiate between horizontal and vertical analysis.

5. Methods of Analysis Horizontal Analysis Vertical Analysis
This chapter discusses three categories of analysis methods: horizontal, vertical, and ratio.
Let’s look at the financial statements for Milavec for 2008 and We will refer to these financial statements in the examples of analysis techniques in this chapter.
Ratio Analysis

6. Milavec Company Financial Statements
Here are the comparative income statements and statements of retained earnings for Milavec Company.

7. Milavec Company Financial Statements
Here are the comparative balance sheets for Milavec Company.

8. Horizontal Analysis
Horizontal analysis (or trend analysis) refers to studying the behavior of individual financial statement items over several accounting periods.
Absolute Amounts
Percentage Analysis
Part One
Horizontal analysis (also known as trend analysis) involves analyzing financial data over several accounting periods.
Part Two
The absolute amounts of particular financial statement items have many uses. For example, financial statement users may use absolute amounts reported for research and development costs to judge whether a company is spending excessively or conservatively. However, it is difficult to judge the materiality of an absolute financial statement amount without considering the size of the company reporting it.
Part Three
Percentage analysis involves computing the percentage relationship between two amounts. In horizontal percentage analysis, a financial statement item is expressed as a percentage of the previous balance for the same item.

9. Milavec Company Horizontal Analysis
This exhibit presents a condensed version of Milavec’s income statement with horizontal percentages for each item. The percentages disclose that, even though Milavec’s net income is slightly more than total sales, products may be underpriced. Cost of goods sold increased much more than sales, resulting in a lower gross margin. Users would also want to investigate why operating expenses decreased substantially despite the increase in sales volume.

10. Milavec Company Trend Analysis
Percentage
Current Year Amount
Base Year Amount
100% = ×
Trend analysis is simply an extension of percentage analysis to cover several periods of time. To compute a trend percentage using a base year, first select the base year and then the data for all years are stated in terms of a percentage of that base year. Alternatively, a trend percentage can be calculated using the percentage of change from each preceding year.
The equation for computing a trend percentage is current year amount divided by base year amount times one hundred percent.

11. Vertical Analysis
Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.
Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. Horizontal analysis compares items over many time periods; vertical analysis compares many items within the same time period.
A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.

12. Vertical Analysis of Income Statement
In income statements, all items are usually expressed as a percentage of sales.
In income statements, all items are usually expressed as a percentage of sales.

13. Milavec Company Vertical Analysis
This exhibit presents Milavec’s income statements, along with vertical percentages, for 2008 and This analysis discloses that cost of goods sold increased significantly as a percentage of sales. Operating expenses and income taxes, however, decreased in relation to sales.

14. Vertical Analysis of Balance Sheet
In balance sheets, all items are usually expressed as a percentage of total assets.
In balance sheets, all items are usually expressed as a percentage of total assets.

15. Milavec Company Vertical Analysis
This exhibit presents Milavec’s balance sheets, along with vertical percentages, for 2008 and This analysis discloses few large percentage changes from the preceding year. Even small individual percentage changes, however, may represent substantial dollar increases. For example, Inventory has increased sixty-two point eight percent from 2007 to 2008, which may have unfavorable consequences. Careful analysis requires considering changes in both percentages and absolute amounts.

16. Learning Objective 3 Explain ratio analysis. Learning Objective Three:

17. Ratio Analysis
Ratio analysis involves studying various relationships between different items reported in a set of financial statements.
Ratio analysis involves studying various relationships between different items reported in a set of financial statements.

18. Learning Objective 4
Calculate ratios for assessing a company’s liquidity.
Learning Objective Four:
Calculate ratios for assessing a company’s liquidity.

19. Liquidity Ratios
Liquidity ratios indicate a company’s ability to pay short-term debts. They focus on current assets and current liabilities.
Working Capital
Current Ratio
Quick Ratio
Accounts Receivable Ratios
Inventory Ratios
Liquidity ratios indicate a company’s ability to pay short-term debts. They focus on current assets and current liabilities.
The liquidity ratios we will review are:
Working capital
Current ratio
Quick ratio
Accounts receivable ratios, and
Inventory ratios

20. Working Capital
The excess of current assets over current liabilities is known as working capital.
Working capital is current assets minus current liabilities. Current assets include assets most likely to be converted into cash in the current operating period. Current liabilities represent debts that must be satisfied in the current period. Working capital therefore measures the excess funds the company will have available for operations, excluding any new funds it generates during the year.
Milavec’s working capital dramatically increased from 2007 to 2008, but the numbers themselves say little without also considering Milavec’s size, industry, and other economic factors.

21. The current ratio measures a company’s short-term debt paying ability.
Current Assets
Current Liabilities =
The current ratio measures a company’s short-term debt paying ability.
The current ratio is computed as shown.
It measures a company’s short-term debt paying ability.
It must be interpreted with care. For example, a declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories or other stagnant current assets.
A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories.

22. Current Ratio
To illustrate using the current ratio for comparisons, consider Milavec’s current position relative to Laroque’s, a larger firm with current assets of five hundred thousand dollars and current liabilities of three hundred seventy eight thousand dollars.
There is no single ideal current ratio that suits all companies. In recent years the average current ratio of the thirty companies that comprise the Dow Jones Industrial Average was around one point three five to one; the individual company ratios, however, ranged from point three seven to one to four point two two to one.

23. Quick (Acid-Test) Ratio
Quick Assets
Current Liabilities =
Acid-Test
Ratio
Quick assets include Cash,
Current Marketable Securities, and Accounts Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory.
The quick or acid-test ratio is computed as shown.
It is a conservative variation of the current ratio because it only includes cash, receivables, and current marketable securities.
It measures a company’s ability to meet its obligations without having to liquidate its inventory.

24. Quick (Acid-Test) Ratio
Here are Milavec Company’s current ratios and quick ratios for 2008 and 2007.

25. Accounts Receivable Turnover
Net Credit Sales
Average Accounts Receivable
Accounts Receivable
Turnover =
This ratio measures how many times a company converts its receivables into cash each year.
The accounts receivable turnover is calculated as shown.
It measures how quickly credit sales are converted to cash.

26. Accounts Receivable Turnover
Milavec’s accounts receivable turnover is presented here. The 2008 ratio of sixteen point nine eight indicates that Milavec collected its average receivables almost seventeen times that year. The higher the turnover, the faster the collection.

27. Average Days to Collect Receivables
Average Collection Period =
365 Days
Accounts Receivable Turnover
= 21 days
Average Collection Period =
365 Days
16.98 Times
A related measure called the average days to collect receivables is computed as shown.
It measures how many days, on average, it takes to collect an accounts receivable.
It should be interpreted relative to the credit terms offered to customers.
For 2008, Milavec’s average collection period was twenty-one days.
This ratio measures, on average, how many days it takes to collect an account receivable.

28. Inventory Turnover
Cost of Goods Sold
Average Inventory
Inventory
Turnover =
This ratio measures how many times a company’s inventory has been sold and replaced during the year.
The inventory turnover is computed as shown.
It measures how many times a company’s inventory has been sold and replaced during the year.

29. Inventory Turnover
Here is the inventory turnover for Milavec. Generally, the higher turnover indicates that merchandise is being handled more efficiently. Trying to compare firms in different industries, however, can be misleading. Inventory for grocery stores and many retail outlets is higher than inventory turnover for appliance and jewelry stores.

30. Average Days to Sell Inventory
Average Sale Period =
365 Days
Inventory Turnover
= 34 days
Average Sale Period =
365 Days
10.80 Times
A related measure called the average days to sell inventory is computed as shown.
It measures the number of days being taken, on average, to sell the entire inventory one time.
In 2008, Milavec’s average days to sell inventory was thirty-four days.
This ratio measures how many days, on average, it takes to sell the inventory.

31. Learning Objective 5
Calculate ratios for assessing a company’s solvency.
Learning Objective Five:
Calculate ratios for assessing a company’s solvency.

32. Solvency Ratios
Solvency ratios are used to analyze a company’s long-term debt-paying ability and its financing structure.
Debt to Assets Ratio
Debt to Equity Ratio
Number of Times Interest Earned
Plant Assets to Long-Term Liabilities
Solvency ratios are used to analyze a company’s long-term debt-paying ability and its financing structure.
The solvency ratios we will look at are:
Debt to assets ratio
Debt to equity ratio
Number of times interest earned, and
Plant assets to long-term liabilities

33. Debt to Assets Ratio
Total Liabilities
Total Assets
Debt to Assets Ratio =
This ratio measures the percentage of a company’s assets that are financed by debt.
The debt to assets ratio is computed as shown.
This ratio measures the percentage of a company’s assets that are financed by debt.

34. Debt to Equity Ratio
Total Liabilities
Stockholders’ Equity
Debt to Equity Ratio =
This ratio indicates the relative proportions of debt to equity on a company’s balance sheet.
The debt to equity ratio is computed as shown.
This ratio indicates the relative proportions of debt to equity on a company’s balance sheet.
Creditors and stockholders have different views when defining the optimal debt to equity ratio.
Stockholders like a lot of debt if the company can take advantage of positive financial leverage.
Creditors prefer less debt and more equity because equity represents a buffer of protection.
Stockholders like a lot of debt if the company can take advantage of positive financial leverage.
Creditors prefer less debt and more equity because equity represents a buffer of protection.

35. Debt to Assets and Debt to Equity Ratios
Here are the debt to assets ratio and the debt to equity ratio for Milavec for 2008 and Each year less than one-third of the company’s assets were financed with debt. The amount of liabilities per dollar of stockholders’ equity declined by zero point zero six.

36. Number of Times Interest Earned Ratio
Earnings before Interest Expense
and Income Taxes
Interest Expense
Times Interest Earned =
This is the most common measure of a company’s ability to provide protection for its long-term creditors.
The number of times interest earned ratio is calculated as shown.
It is the most common measure of a company’s ability to protect its long-term creditors.
It is based on earnings before interest and income taxes because that is the amount of earnings that is available for making interest payments.

37. Number of Times Interest Earned Ratio
Here is the number of times interest earned ratio for Milavec for 2008 and Obviously interest is paid only once, but the more times it could be paid, the bigger the company’s safety net.

38. Plant Assets to Long-Term Liabilities
Net Plant Assets
Long-Term Liabilities =
This ratio suggests how well long-term debt is managed to finance long-term assets.
Companies often pledge plant assets as collateral for long-term liabilities. This ratio suggests how well long-term debt is managed to finance long-term assets.

39. Plant Assets to Long-Term Liabilities
Here are the plant assets to long-term liabilities ratios for Milavec for 2008 and 2007.

40. Learning Objective 6
Calculate ratios for assessing company management’s effectiveness.
Learning Objective Six:
Calculate ratios for assessing company management’s effectiveness.

41. Profitability Ratios
Profitability ratios measure a company’s ability to generate earnings.
Net Margin (or Return on Sales)
Asset Turnover Ratio
Return on Investment
Return on Equity
Profitability ratios measure a company’s ability to generate earnings.
The profitability ratios we will look at are:
Net Margin (or Return on Sales)
Asset Turnover Ratio
Return on Investment, and
Return on Equity

42. Net Margin Net Margin Net Income Net Sales =
This measure describes the percent remaining of each sales dollar after subtracting other expenses as well as cost of goods sold.
Net margin is calculated as shown.
This measure describes the percent remaining of each sales dollar after subtracting other expenses as well as cost of goods sold.

43. Net Margin
Here are the net margin calculations for Milavec for 2008 and Milavec has maintained approximately the same net margin. Obviously, the larger the percentage, the better.

44. Asset Turnover Ratio
Net Sales
Average Total Assets
Asset
Turnover =
This ratio measures how many sales dollars were generated for each dollar of assets invested.
The asset turnover ratio is calculated as shown.
This ratio measures how many sales dollars were generated for each dollar of assets invested.

45. Asset Turnover Ratio
Here are the asset turnover ratios for Milavec for 2008 and As with most ratios, the implications of a given asset turnover ratio is affected by other considerations. Asset turnover will be high in an industry that requires only minimal investment to operate, such as real estate sales companies. On the other hand, industries that require large investments in plant and machinery, like the auto industry, are likely to have lower asset turnover ratios.

46. Return on Investment (ROI)
Net Income
Average Total Assets =
This is the ratio of wealth generated (net income) to the amount invested (average total assets).
The return on investment is computed as shown.
This is the ratio of wealth generated (net income) to the amount invested (average total assets).

47. Return on Investment (ROI)
For Milavec, ROI was as follows:
Here are Milavec’s return on investment ratios for 2008 and Generally, higher returns on investment suggest better performance.

48. Average Total Stockholders’ Equity
Return on Equity
Return on Equity
Net Income
Average Total Stockholders’ Equity =
This measure is often used to measure the profitability of the stockholders’ investment.
The return on common stockholder’s equity is computed as shown.
This measure is often used to measure the profitability of the stockholders’ investment.

49. Return on Equity
Here are Milavec’s return on equity ratios for 2008 and 2007.
The slight decrease in Milavec’s return on equity is due primarily to the increase in common stock.

50. Learning Objective 7
Calculate ratios for assessing a company’s position in the stock market.
Learning Objective Seven:
Calculate ratios for assessing a company’s position in the stock market.

51. Stock Market Ratios
Stock market ratios analyze the earnings and dividends of a company.
Earnings Per Share
Book Value
Price-Earnings (PE) Ratio
Dividend Yield
Stock market ratios analyze the earnings and dividends of a company.
The stock market ratios we will look at are:
Earnings Per Share
Book Value
Price-Earnings (PE) Ratio, and
Dividend Yield

52. Average Number of Outstanding Common Shares
Earnings Per Share
Earnings per Share
Net Earnings Available for Common Stock
Average Number of Outstanding Common Shares =
This measure indicates how much
income was earned for each share of common stock outstanding.
Earnings per share is computed as shown.
The average number of outstanding common shares is computed by adding the shares outstanding at the beginning of the year to the shares outstanding at the end of the year and dividing by two.
This measure indicates how much income was earned for each share of common stock outstanding.

53. Earnings Per Share Milavec’s 2008 EPS is calculated as follows:
Here are Milavec’s earnings per share for Investors attribute a great deal of importance to this ratio. However, there are numerous opportunities to manipulate this ratio. Prudent investors consider this in deciding how much weight to attach to earnings per share.

54. Stockholders’ Equity - Preferred Dividends Outstanding Common Shares
Book Value Per Share
Book Value per Share
Stockholders’ Equity - Preferred Dividends
Outstanding Common Shares =
This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.
The book value per share is computed as shown.
It measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off. This measure is based entirely on historical cost.

55. Book Value Per Share Book value per share for 2008
Here is Milavec’s book value per share ratio for 2008.

56. Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share
Earnings Per Share =
This ratio compares the earnings of a company to the market price for a share of the company’s stock.
The price-earnings ratio is computed as shown.
This ratio compares the earnings of a company to the market price for a share of the company’s stock.
In general, a higher price-earnings ratio indicates the market is more optimistic about a company’s growth potential than it is about a company with a lower price-earnings ratio.

57. Dividend Yield Dividend Yield Dividends Per Share
Market Price Per Share =
This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
The dividend yield ratio is computed as shown.
There are two ways to profit from a stock investment. One, investors can sell the stock for more than they paid to purchase it (if the stock price rises). Two, the company that issued the stock can pay cash dividends to the shareholders. Most investors view rising stock prices as the primary reward for investing in stock. The importance of receiving dividends, however, should not be overlooked.
This ratio measures the rate of return (in the form of cash dividends only) that would be earned by an investor who buys common stock at the current market price.

58. Learning Objective 8
Identify different forms for presenting analytical data.
Learning Objective Eight:
Identify different forms for presenting analytical data.

59. Presentation of Analytical Relationships
To communicate with users, companies present analytical information in endless different ways in annual reports. Common types presented include bar charts, pie charts, and line graphs. The next few slides show examples of these forms.
This slide illustrates a bar chart of the type you might see in an annual report.

60. Presentation of Analytical Relationships
This slide illustrates a pie chart of the type you might see in an annual report.

61. Presentation of Analytical Relationships
This slide illustrates a line graph of the type you might see in an annual report.

62. Learning Objective 9
Explain the limitations of financial statement analysis.
Learning Objective Nine:
Explain the limitations of financial statement analysis.

63. Limitations of Financial Statement Analysis
Different Industries
Changing Economic Environment
Accounting Principles
Part One
External users can rely on financial statement analysis only as a general guide to the potential of a business. Many factors must be considered simultaneously before making any judgments.
For example, different industries may be affected by unique social policies, special accounting procedures, or other individual industry attributes.
Part Two
When comparing firms, analysts must be alert to changes in general economic trends from year to year.
Part Three
Financial statement analysis is only as reliable as the data on which it is based. Although most firms follow generally accepted accounting principles, a wide variety of acceptable accounting methods is available from which to choose, including different inventory and depreciation methods, different schedules for recognizing revenue, and different ways to account for oil and gas exploration costs. Analysts must keep these differences in mind when comparing companies.

64. End of Chapter Thirteen
In this chapter we focused on financial statement analysis. We looked at how to examine trends in key financial data, compare financial data across companies, and analyze financial ratios.