1. Financial and Managerial Accounting
In presentations for each chapter in this text, we will provide you with sound to go along with the material on your screen. There will be sound on every slide you view. Please make sure your computer speakers are setup properly when viewing the material. Good luck and we hope you enjoy this new format.
Wild, Shaw, and Chiappetta
Fourth Edition
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Analyzing Financial Statements
Chapter 13
Analyzing Financial Statements
This chapter is important to all business majors. We will look in detail at ways to analyze a set of financial statements to gain new perspectives on the performance and financial position of a company. Let’s get started.

3. Conceptual Learning Objectives
C1: Explain the purpose and identify the building blocks of analysis.
C2: Describe standards for comparisons in analysis.
Conceptual Learning Objectives:
C1: Explain the purpose and identify the building blocks of analysis.
C2: Describe standards for comparisons in analysis.
13-3

4. Analytical Learning Objectives
A1: Summarize and report results of analysis.
A2: Appendix 13A – Explain the form and assess the content of a complete income statement (see text for details).
Analytical Learning Objectives:
A1: Summarize and report results of analysis.
A2: Appendix 13A – Explain the form and assess the content of a complete income statement (see text for details).
13-4

5. Procedural Learning Objectives
P1: Explain and apply methods of horizontal analysis.
P2: Describe and apply methods of vertical analysis.
P3: Define and apply ratio analysis.
Procedural Learning Objectives:
P1: Explain and apply methods of horizontal analysis.
P2: Describe and apply methods of vertical analysis.
P3: Define and apply ratio analysis.
13-5

6. Building Blocks of Analysis
Ability to meet short-term obligations and to efficiently generate revenues
Ability to generate future revenues and meet long-term obligations
Liquidity and Efficiency
Solvency
We have many analytical tools we can use to analyze the financial statements of a company. These techniques help us to better understand the company, allows us to transform and analyze data, and also helps to reduce uncertainty associated with financial information.
Financial analysis is used by many people within the organization. Managers find financial analysis helpful in planning and controlling operations. External users of financial statements are also interested in the results of comprehensive financial analysis. Shareholders, creditors, and customers all want to learn as much as possible about the financial health of a company.
As we complete this chapter by showing you how to calculate key business ratios, we will organize the ratios into four unique groups. Measures of liquidity and efficiency are most important to short-term creditors. Measures of solvency help people assess the ability of the company to generate revenues in the long-run. These measures are especially important to long-term creditors. Measures of profitability are important to managers and outsiders as well. Everyone with an interest in the company is concerned about the long-term profitability of its operations. Market prospects are most important to owners of the company’s common shares.
Basic information for our analysis comes from the financial statements and the notes to those statements. In some cases, we may need to develop supplemental information to complete our analysis.
When we complete our analysis, it is essential to compare the results we obtained to those of our competitors, other companies in our same industry, and general financial market guidelines.
Ability to provide financial rewards sufficient to attract and retain financing
Ability to generate positive market expectations
Market Prospects
Profitability
13-6

7. Standards for Comparison
When interpreting measures, we need to decide whether the measures indicate good, bad, or average performance. We can use the following to make that judgment:
Intracompany
Competitor
Industry
Guidelines (rule of thumb)
When interpreting measures from financial statement analysis, we need to decide whether measures indicate good, bad, or average performance. To make such judgments, we need standards or benchmarks for comparisons that include the following:
Intracompany – The company under analysis can provide standards based on prior performance and relationships between financial statement items. Next, we can use competitor benchmarks for comparison purposes. One or more direct competitors can be analyzed for the comparison to see how the company measures up to others in their industry. We can also use industry statistics – such as those that are available from Dun and Bradstreet, Standard & Poor’s and Moody’s. Finally, we can use general rules of thumb to help assess performance. For example, we know that the level of 2:1 is generally a positive benchmark for the current ratio.
The more experience one gains in performing such analyses, the easier it becomes to interpret the results. Like anything else, practice goes a long way in this area.
13-7

8. Horizontal Analysis Vertical Analysis
Tools of Analysis
C 1
Horizontal Analysis
Comparing a company’s financial condition and performance across time.
Vertical Analysis
Comparing a company’s financial condition and performance to a base amount.
Horizontal analysis can be extremely helpful in learning more about a company. It is the process of properly preparing financial data in dollar and percentage formats. This information is usually shown side-by-side.
Vertical analysis is the process of comparing a company’s financial condition and results of operation in reference to a base amount.
Over time, the business community has developed several key ratios that are considered important when evaluating the strengths and weaknesses of a company. We will cover many of these key ratios in this chapter.
Measurement of key relations between financial statement items
Ratio Analysis
13-8

9. Comparative Statements
Calculate Change in Dollar Amount
Dollar
change
Analysis period
amount
Base period
amount – =
Since we are measuring the amount of the change between 2011 and 2010, the dollar amounts for 2010 become the “base” period amounts.
The first task that we face is establishing the base year and then calculating changes in reference to the base.
In horizontal analysis, we use the oldest year shown as the base year and determine the dollar change between the base year and the current year. For Clover Corporation 2010 is the base year.
Once we establish the base year, we may calculate the percentage change by dividing the dollar change by the base year amount and multiplying by one hundred. With this background, let’s get started with our work on the Clover Corporation’s comparative balance sheet.
Calculate Change as a Percent
Percent
change
Dollar change
Base period amount = ×
100
13-9

10. CLOVER CORPORATION
Comparative (partial) Balance Sheet
December 31, 2011
2011
2010
Dollar
Change
Percent
Change*
Assets
Current assets:
Cash and equivalents
12,000 $
23,500
(11,500)
(48.9)
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
1,800
Total current assets
155,000
164,700
Property and equipment:
Land -
0.0
Buildings and equipment, net
120,000
85,000
Total property and equipment
160,000
125,000
Total assets
315,000
289,700
* Percent rounded to first decimal point.
P 1
$12,000 – $23,500 = $(11,500)
Here is a comparative balance sheet of Clover Corporation. For the dollar change in cash, we subtract the base year amount of twenty-three thousand, five hundred dollars from the current year amount of twelve thousand dollars, and determine the change in cash was a negative eleven thousand, five hundred dollars.
We know the percentage change will be negative. To determine the percentage change, we divide the dollar change of eleven thousand, five hundred dollars by the base year balance of twenty-three thousand, five hundred, and multiply by one hundred percent. The percentage change is a decrease in cash of forty eight point nine percent. Why don’t you take a few minutes and see if you can calculate the dollar and percentage changes for accounts receivable and inventory. When you are done, go to the next slide.
($11,500 ÷ $23,500) × 100 = 48.9%
13-10

11. Comparative (Partial) Balance Sheet December 31, 2011
CLOVER CORPORATION
Comparative (Partial) Balance Sheet
December 31, 2011
2011
2010
Dollar
Change
Percent
Change*
Assets
Current assets:
Cash and equivalents
12,000 $
23,500
(11,500)
(48.9)
Accounts receivable, net
60,000
40,000
20,000
50.0
Inventory
80,000
100,000
(20,000)
(20.0)
Prepaid expenses
3,000
1,200
1,800
150.0
Total current assets
155,000
164,700
(9,700)
(5.9)
Property and equipment:
Land -
0.0
Buildings and equipment, net
120,000
85,000
35,000
41.2
Total property and equipment
160,000
125,000
28.0
Total assets
315,000
289,700
25,300
8.7
* Percent rounded to first decimal point.
P 1
How did you do? We can see that, overall, our assets increased by eight point seven percent, but our current assets decrease by five point nine percent. The decrease in current assets may impact some of the ratios that we calculate later in the presentation.
13-11

12. Comparative Income Statements For the Years Ended December 31, 2011
CLOVER CORPORATION
P 1
Comparative Income Statements
For the Years Ended December 31, 2011
Dollars
Percent
2011
2010
Change
Change
Revenues
$520,000
$480,000
$40,000
8.3%
Costs and expenses:
Cost of sales
360,000
315,000
45,000
14.3%
Selling and admin.
128,600
126,000
2,600
2.1%
Interest expense
6,400
7,000
(600)
(8.6%)
Income before taxes
$25,000
$32,000
($7,000)
(21.9%)
Let’s compare years using the income statement. Now let’s look at trend analysis which helps us analyze changes in financial information over a number of years. The change is usually stated in percentage terms.
Income taxes (30%)
7,500
9,600
(2,100)
(21.9%)
Net income
$17,500
$22,400
($4,900)
(21.9%)
Net income per share
$0.79
$1.01
Avg. # common shares
22,200
22,200
Percent changes rounded to first decimal point.
13-12

13. Analysis period amount
Trend Analysis
P 1
Trend analysis is used to reveal patterns in data covering successive periods.
To calculate the trend percentage, we divide the current period amount by the base period amount and multiply by one hundred. All values will be expressed as a percentage increase or decrease from the base period. The base period is usually the oldest period shown.
Trend
percent
Analysis period amount
Base period amount
100 = ×
13-13

14. Trend Analysis 2007 is the base period so its amounts will equal 100%.
Berry Products
Income Information
For the Years Ended December 31,
Item
2011
2010
2009
2008
2007
Revenues
400,000 $
355,000
320,000
290,000
275,000
Cost of sales
285,000
250,000
225,000
198,000
190,000
Gross profit
115,000
105,000
95,000
92,000
85,000
We have developed some income information for Berry Products for the years 2007 through Let’s analyze this information using trend analysis.
2007 is the base period so its amounts will equal 100%.
13-14

15. For the Years Ended December 31,
Trend Analysis
P 1
Berry Products
Income Information
For the Years Ended December 31,
Item
2011
2010
2009
2008
2007
Revenues
400,000 $
355,000
320,000
290,000
275,000
Cost of sales
285,000
250,000
225,000
198,000
190,000
Gross profit
115,000
105,000
95,000
92,000
85,000
Item
2011
2010
2009
2008
2007
Revenues
105%
100%
Cost of sales
104%
Gross profit
108%
The base period will be the year Now we convert all the dollars shown to percentages using year 2007 amounts as one hundred percent.
To determine the percentage increase in sales for 2008, we divide 2008 sales of two hundred ninety thousand dollars by 2007 sales of two hundred seventy five thousand dollars, and multiply by one hundred percent. Sales for 2008 are one hundred five percent of 2007 sales. We follow similar calculations for cost of goods sold and gross margin. Next, we complete the remaining years on our table. Before going to the next slide see if you can calculate the 2009 sales percent.
13-15

16. Trend Analysis How would this trend analysis look on a line graph?
Berry Products
Income Information
For the Years Ended December 31,
Item
2011
2010
2009
2008
2007
Revenues
400,000 $
355,000
320,000
290,000
275,000
Cost of sales
285,000
250,000
225,000
198,000
190,000
Gross profit
115,000
105,000
95,000
92,000
85,000
Item
2011
2010
2009
2008
2007
Revenues
145%
129%
116%
105%
100%
Cost of sales
150%
132%
118%
104%
Gross profit
135%
124%
112%
108%
How did you do in your calculation? Now that the table is complete we can see that cost of goods sold is increasing faster than the increase in sales, so gross margin is increasing slowly. Better cost control would lead to a more rapid increase in gross margins.
How would this trend analysis look on a line graph?
13-16

17. Trend Analysis
P 1
We can use the trend percentages to construct a graph so we can see the trend over time.
Some managers prefer to review trend information in chart form. Using Excel is an easy way to develop charts from our data. Here is the chart of the trend percentages for Berry Products. You can see the slow growth of gross margins clearly.
13-17

18. Common-Size Statements
P 2
Calculate Common-size Percent
Common-size
percent
Analysis amount
Base amount × =
100
Financial Statement Base Amount
Balance Sheet Total Assets
Income Statement Revenues
Now, let’s move from horizontal analysis to vertical analysis.
Common size financial statements are prepared for a single period. We express all items on the statement in terms of a one component of that statement. For the income statement, we normally express all items as a percent of total revenues. For the balance sheet, we generally express all items as a percent of total assets.
13-18

19. CLOVER CORPORATION
Comparative (Partial) Balance Sheet
December 31, 2011
Common-size
Percents*
2011
2010
Assets
Current assets:
Cash and equivalents
12,000 $
23,500
3.8%
8.1%
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
Total current assets
155,000
164,700
Property and equipment:
Land
12.7%
Buildings and equipment, net
120,000
85,000
Total property and equipment
160,000
125,000
Total assets
315,000
289,700
* Percent rounded to first decimal point.
P 2
($12,000 ÷ $315,000) × 100 = 3.8%
Here is the asset section of the comparative balance sheet of Clover Corporation. We want to express all line-items on the financial statement in terms of total assets, so we set total assets equal to one hundred percent.
We calculate the percentage of total assets made up of cash and cash equivalents. We divide the total cash and cash equivalents for 2011 by the total assets for 2011, and multiply the result by one hundred percent. At the end of 2011, cash and cash equivalents made up three point eight percent of total assets. The same measure shows the percentage for 2010 to be eight point one percent.
Why don’t you try and calculate the percent of total assets for accounts receivable and inventory before going to the next screen. The practice will be helpful to you.
($23,500 ÷ $289,700) × 100 = 8.1%
13-19

20. Comparative (Partial) Balance Sheet December 31, 2011 Common-size
CLOVER CORPORATION
Comparative (Partial) Balance Sheet
December 31, 2011
Common-size
Percents*
2011
2010
Assets
Current assets:
Cash and equivalents
12,000 $
23,500
3.8%
8.1%
Accounts receivable, net
60,000
40,000
19.0%
13.8%
Inventory
80,000
100,000
25.4%
34.5%
Prepaid expenses
3,000
1,200
1.0%
0.4%
Total current assets
155,000
164,700
49.2%
56.9%
Property and equipment:
Land
12.7%
Buildings and equipment, net
120,000
85,000
38.1%
29.3%
Total property and equipment
160,000
125,000
50.8%
43.1%
Total assets
315,000
289,700
100.0%
* Percent rounded to first decimal point.
P 2
Here are the completed computations. How did you do? You can see that accounts receivable made up nineteen percent of total assets in 2011, and thirteen point eight percent in There has been a drop in total current assets, and an increase in property and equipment from 2010 to 2011.
13-20

21. Comparative (Partial) Balance Sheets December 31, 2011 Common-size
CLOVER CORPORATION
Comparative (Partial) Balance Sheets
December 31, 2011
Common-size
Percents*
2011
2010
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable
67,000 $
44,000
21.3%
15.2%
Notes payable
3,000
6,000
1.0%
2.1%
Total current liabilities
70,000
50,000
22.2%
17.3%
Long-term liabilities:
Bonds payable, 8%
75,000
80,000
23.8%
27.6%
Total liabilities
145,000
130,000
46.0%
44.9%
Shareholders' equity:
Preferred stock
20,000
6.3%
6.9%
Common stock
60,000
19.0%
20.7%
Additional paid-in capital
10,000
3.2%
3.5%
Total paid-in capital
90,000
28.6%
31.1%
Retained earnings
69,700
25.4%
24.1%
Total shareholders' equity
170,000
159,700
54.0%
55.1%
Total liabilities and shareholders' equity
315,000
289,700
100.0%
* Percent rounded to first decimal point.
P 2
Here is our vertical analysis for the liabilities and equity side of the balance sheet. Check a few of the percentages to see if we agree.
13-21

22. Comparative Income Statements For the Years Ended December 31, 2011
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2011
Common-size
Percents*
2011
2010
Revenues
520,000 $
480,000
100.0%
Costs and expenses:
Cost of sales
360,000
315,000
69.2%
65.6%
Selling and admin.
128,600
126,000
24.7%
26.3%
Interest expense
6,400
7,000
1.2%
1.5%
Income before taxes
25,000
32,000
4.8%
6.7%
Income taxes (30%)
7,500
9,600
1.4%
2.0%
Net income
17,500
22,400
3.4%
4.7%
Net income per share
0.79
1.01
Avg. # common shares
22,200
* Rounded to first decimal point.
P 2
Let’s go back and look at the comparative income statements of Clover Corporation and complete our common size calculations.
We will express all line-items on the income statement as a percent of total sales. We begin by setting total sales equal to one hundred percent.
We begin the calculation by determining the cost of goods sold percentages. For 2011, divide cost of goods sold of three hundred sixty thousand dollars by sales of five hundred twenty thousand dollars, and multiply by one hundred percent. For 2011, cost of goods sold was sixty nine point two percent of total sales. Before moving to the next slide, calculate the gross margin percent for each year as well as the percentages for the other line items. It will be good practice.
13-22

23. P 2
Common-Size Graphics
This is a graphical analysis of Clover Corporation’s common-size income statement for 2011.
This graph shows a common size income statement for All percentages are expressed in term of sales revenue. For example, cost of sales was sixty nine point two percent of total sales in Some business managers prefer to view charts rather than the raw numbers. We constructed this chart using Excel.
13-23

24. Liquidity and Efficiency
Ratio Analysis
P 3
Liquidity and Efficiency
Solvency
Profitability
Market Prospects
Ratio Analysis
On the next three slides we will present financial information from Norton Corporation’s 2010 and 2011 financial statements. We will use this information to prepare a ratio analysis for the company. You may want to print these three screens so you can refer to them as we compute the ratios.
Let’s use the following financial statements for Norton Corporation for our ratio analysis.
13-24

25. Accounts receivable, net 17,000 Inventory 12,000 10,000
NORTON CORPORATION
Balance Sheet
December 31, 2011
2011
2010
Assets
Current assets:
Cash
30,000 $
20,000
Accounts receivable, net
17,000
Inventory
12,000
10,000
Prepaid expenses
3,000
2,000
Total current assets
65,000
49,000
Property and equipment:
Land
165,000
123,000
Buildings and equipment, net
116,390
128,000
Total property and equipment
281,390
251,000
Total assets
346,390
300,000
P 3
Here is the asset section of Norton’s comparative balance sheets.
13-25

26. Liabilities and Shareholders' Equity Current liabilities:
NORTON CORPORATION
Balance Sheet
December 31, 2011
2011
2010
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable
39,000 $
40,000
Notes payable, short-term
3,000
2,000
Total current liabilities
42,000
Long-term liabilities:
Notes payable, long-term
70,000
78,000
Total liabilities
112,000
120,000
Shareholders' equity:
Common stock, $1 par value
27,400
17,000
Additional paid-in capital
158,100
113,000
Total paid-in capital
185,500
130,000
Retained earnings
48,890
50,000
Total shareholders' equity
234,390
180,000
Total liabilities and shareholders' equity
346,390
300,000
P 3
With this slide, we complete the presentation of the company’s balance sheet by providing the liabilities and stockholders’ equity sections.
13-26

27. Net income before taxes 76,700 66,000 Less income taxes (30%) 23,010
NORTON CORPORATION
Income Statement
For the Years Ended December 31
2011
2010
Revenues
494,000 $
450,000
Cost of sales
140,000
127,000
Gross margin
354,000
323,000
Operating expenses
270,000
249,000
Net operating income
84,000
74,000
Interest expense
7,300
8,000
Net income before taxes
76,700
66,000
Less income taxes (30%)
23,010
19,800
Net income
53,690
46,200
P 3
Finally, we have Norton’s comparative income statements for 2010 and 2011.
13-27

28. Liquidity and Efficiency
P 3
Current
Ratio
Inventory Turnover
Acid-test
Ratio
Days’ Sales Uncollected
Accounts Receivable Turnover
Now that we have the basic information we need, let’s calculate some of the company’s important ratios. On the next slide, we provide supplemental information that we will need.
Days’ Sales in Inventory
Total Asset Turnover
13-28

29. Liquidity and Efficiency
P 3
Use this information to calculate the liquidity and efficiency ratios for Norton Corporation.
We will turn our attention to ratios that provide measures of the liquidity and efficiency for Norton Corporation. Some additional information is provided to help us complete this analysis.
13-29

30. Working Capital Dec. 31, 2011 Current assets 65,000 $
Working capital represents current assets financed from long-term capital sources that do not require near-term repayment.
Dec. 31, 2011
Current assets
65,000 $
Current liabilities
(42,000)
Working capital
23,000
Working capital is defined as current assets minus current liabilities. It is a critical measure for all types of businesses. Positive working capital means the company will have enough assets converted into cash within the next year to pay its current obligations.
13-30

31. This ratio measures the short-term debt-paying ability of the company.
Current Ratio
P 3
Current
ratio
Current assets
Current liabilities =
Current
ratio
$65,000 $42,000 =
1.55 : 1
Perhaps the most significant measure of a company’s ability to pay current obligations is the current ratio. It is merely current assets divided by current liabilities.
At Norton, the current ratio is one point five five to one. This means that for every dollar of current liability that falls due we will have one dollar and fifty- five cents to pay that obligation.
As a short-term creditor, you would be vitally interested in a company’s current ratio. If the ratio continues to lower over time, you may be less likely to be paid in full.
This ratio measures the short-term debt-paying ability of the company.
13-31

32. Quick assets Current liabilities
Acid-Test Ratio
P 3
Quick assets Current liabilities =
Acid-test
ratio
Quick assets are Cash, Short-Term Investments, and Current Receivables.
$50,000
$42,000 =
1.19 : 1
Acid-test
ratio
The acid-test ratio is a more stringent measure than the current ratio. We calculate the ratio by dividing quick assets by current liabilities. Quick assets include cash, marketable securities, current accounts and notes receivable. You can see that Norton’s only quick assets are cash and accounts receivable.
The acid test ratio at Norton is one point one nine to one. The acid test ratio is generally lower than the current ratio because we have reduced the numerator. We have removed accounts from the numerator that generally require a period of time to convert into cash. For example, for some companies inventories may take a significant amount of time to be converted into cash.
This ratio is like the current
ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash.
13-32

33. Accounts Receivable Turnover
P 3
Net sales
Average accounts receivable/net
Accounts receivable
turnover =
= times
$494,000
($17,000 + $20,000) ÷ 2
Accounts receivable
turnover =
We calculate accounts receivable turnover by dividing our net credit sales, or sales on account, by average accounts receivable. This is yet another example of a ratio that contains an income measure in the numerator and a balance sheet measure in the denominator. Remember, in this type of ratio we always use an average amount in the denominator.
At Norton, accounts receivable turnover is twenty-six point seven times. This means, that on average, accounts receivable turns over completely about twenty seven times per year.
This ratio helps us get a feel for the number of times per year a company can convert its accounts receivable into cash. For any company, the higher the turnover, the faster the cash collection on accounts receivable.
This ratio measures how many times a company converts its receivables into cash each year.
13-33

34. Inventory Turnover Cost of goods sold Average inventory Inventory
P 3
Cost of goods sold
Average inventory
Inventory
turnover =
= times
$140,000
($10,000 + $12,000) ÷ 2 =
Inventory
turnover
Like receivables turnover, we can also calculate the inventory turnover. Inventory turnover is calculated by dividing cost of goods sold for the period by the average inventory.
At Norton, inventory turnover is twelve point seven three times. So, inventory is turned over about thirteen times per year.
The inventory turnover ratio measures the number of times inventory is sold and replaced during the year. Higher inventory turnover helps protect a company from obsolete inventory items.
This ratio measures the number
of times merchandise is sold and
and replaced during the year.
13-34

35. Days’ Sales Uncollected
P 3
A/R, net
Net sales
Days’ sales uncollected =
´ 365
Days’ sales uncollected
$20,000
$494,000 =
´ = days
Days sales uncollected is calculated by dividing ending accounts receivable by net sales, and multiplying this amount by three hundred sixty-five days. At Norton, the days sales uncollected is fourteen point eight days. If Norton offers a two-ten, net thirty cash discount, most customers would pay off the receivable balance close to the ten day discount period and reduce the days sales uncollected.
This ratio measures the liquidity of receivables.
13-35

36. Days’ Sales in InventoryP3
Days’ sales in inventory =
Ending inventory
Cost of goods sold
´ 365
Days’ sales in inventory =
$12,000
$140,000
´ = days
We can also calculate the days sales in inventory by dividing ending inventory by cost of goods sold, and multiplying this amount by three hundred sixty five days.
At Norton, the days sales in inventory is thirty one point two nine days. Inventory is sold completely about once a month.
This ratio measures the liquidity of inventory.
13-36

37. Total Asset Turnover Total asset turnover = Net sales
P 3
Total asset turnover =
Net sales
Average total assets
= 1.53 times
$494,000
($300,000 + $346,390) ÷ 2 =
Total asset
turnover
Total asset turnover is equal to net sales divided by average total assets. At Norton, asset turnover was one point five three times. Asset turnover is a measure of how efficiently management is using the available assets to generate sales.
This ratio measures the efficiency of assets in producing sales.
13-37

38. Pledged Assets to Secured Liabilities
Solvency
P 3
Debt
Ratio
Equity
Ratio
Pledged Assets to Secured Liabilities
Let’s focus now on solvency ratios.
Times Interest Earned
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39. Solvency
P 3
Use this information to calculate the solvency ratios for Norton Corporation.
This screen contains some new supplemental information that will help us calculate the ratios that follow. One quick note; income before interest and taxes is often referred to as net operating income.
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40. Debt Ratio Total liabilities = Debt ratio Total assets $112,000
P 3
Total liabilities =
Total assets
Debt ratio
$112,000 =
$346,390
Debt ratio
= 32.3%
The debt ratio is determined by dividing total liabilities of the company by total assets.
At Norton, the debt ratio is thirty two point three percent. This means that just over thirty cents of every dollar of assets was provided by creditors of the company.
This ratio measures what portion of a company’s assets are contributed by creditors.
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41. Equity Ratio Total equity Equity ratio = Total assets $234,390
P 3
Total equity =
Total assets
Equity ratio
$234,390 =
$346,390
Equity ratio
= 67.7%
The equity ratio is determined by dividing total equities of the company by total assets.
At Norton, the equity ratio is sixty seven point seven percent. This means that about sixty eight cents of every dollar of assets was contributed by owners of Norton.
This ratio measures what portion of a company’s assets are contributed by owners.
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42. Debt-to-equity-ratio Debt-to-equity-ratio
P 3
Total liabilities =
Total equity
Debt-to-equity-ratio
$ 112,000 $ 346,390 =
Debt-to-equity-ratio
The debt-to-equity ratio is designed to measure the solvency of a company. A calculation above one indicates the company has more liabilities than equity. The lower the calculation, the more solvency the company has.
= 32%
This ratio measures the solvency of companies.
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43. Income before interest expense
Times Interest Earned
P 3
Times interest earned
Income before interest expense
and income taxes
Interest expense =
Times interest earned
$84,000
$7,300 = =
Long-term creditors are particularly interested in the ability of a company to meet periodic interest payments. Times interest earned is a ratio that would be important to you. The ratio is calculated by dividing income before interest and taxes by interest expense for the period.
At Norton, interest was earned eleven point five times during the year.
This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor.
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44. Profitability Profit Margin Basic Earnings per Share Gross Margin
Book Value per Common Share
The next category of ratios deals with profitability measures.
Return on Total Assets
Return on Common Stockholders’ Equity
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45. Profitability
P 3
Use this information to calculate the profitability ratios for Norton Corporation.
Here is some supplemental information about Norton that we will need to calculate our profitability ratios.
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46. Profit Margin Profit margin Net income Net sales = = 10.87% Profit
$53,690
$494,000 =
Profit margin tells us how effective the company is at producing bottom line net income. The ratio is determined by dividing net income by net sales.
At Norton, after all expenses and taxes have been paid, the company was able to produce a profit margin of ten point eighty seven percent.
This ratio describes a company’s ability to earn a net income from sales.
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47. Net sales - Cost of sales
Gross Margin
P 3
Gross
margin
Net sales - Cost of sales
Net sales =
= 71.66%
Gross
margin
$494,000 - $140,000
$494,000 =
Our gross margin percentage is an extremely important measure in business. The percentage indicates how much of each sales dollar is left to cover operating expenses, taxes and profit.
Gross margin is equal to net sales less cost of goods sold divided by net sales for the period.
At Norton, the gross margin is seventy one point sixty-six percent. This is a relatively high margin and indicates that, with effective cost control, the company will be able to produce net income.
This ratio measures the amount remaining from $1 in sales that is left to cover operating expenses and a profit after considering cost of sales.
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48. Return on Total Assets Return on total assets Net income
P 3
Return on
total assets
Net income
Average total assets =
= 16.61%
$53,690
($300,000 + $346,390) ÷ 2 =
Return on total assets
We can determine the return a company earns on its total assets. To calculate this ratio, we divide net income by the average total assets for the period.
Norton is able to earn a return on its total assets of sixteen point sixty-one percent. Please spend a few minutes going over the calculation of this ratio. Return on total assets measures how well assets have been employed by the management of Norton.
This ratio is generally considered
the best overall measure of a
company’s profitability.
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49. Return on Common Stockholders’ Equity
P 3
Return on common
stockholders’ equity
Net income - Preferred dividends Average common stockholders’ equity =
= 25.9%
$53,
($180,000 + $234,390) ÷ 2 =
Return on common stockholders’ equity
We may calculate the return on common stockholders’ equity. The numerator is net income available to common shareholders, that is net income less preferred dividends, divided by average common stockholders’ equity.
The return on common stockholders’ equity at Norton is twenty five point nine percent. The return on equity is higher than the return on total assets.
This measure indicates how well the company employed the owners’ investments to earn income.
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50. Book Value per Common Share
Shareholders’ equity applicable to common shares
Number of common shares outstanding =
Book value per share is calculated by dividing common stockholders’ equity by the number of common shares outstanding. Remember, we are including only common stockholders’ equity in the numerator. If your company has preferred shares outstanding, the total dollar amount will be removed to determine the stockholders’ equity relating to the common shareholders.
This ratio measures liquidation at reported amounts.
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51. Basic Earnings per Share
Net income - Preferred dividends
weighted-average common shares outstanding =
Basic earnings
per
share
$53,
27,400 =
= $1.96 per share
Earnings per share is equal to net income less preferred stock dividends divided by the average number of common shares outstanding. The numerator of the equation is sometimes referred to as income available to common shareholders.
Earnings per share is one dollar and ninety six cents per common share. Notice that we had no preferred dividends to impact our numerator.
Earnings per share is one of the most widely quoted financial ratios calculated. It is a measure of the company’s ability to produce income for each common share outstanding. As an investor, we will want to track this ratio carefully.
This measure indicates how much
income was earned for each share of common stock outstanding.
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52. Market Prospects
P 3
Use this information to calculate the market ratios for Norton Corporation.
As a shareholder, we often need information about the market prospects of our investment. Good ratios to look at for this purpose are the price earnings ratio and the dividend yield.
Here is some supplemental information we will need to calculate the market prospect ratios. The supplemental information includes information about the closing market price of the common stock and the annual cash dividend.
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53. Price-Earnings Ratio Market price per common share =
Earnings per share =
Price-earnings
ratio
$15.00
$1.96 =
= 7.65 times
Once we know the earnings per share, we can calculate the price-earnings ratio, or PE ratio. We will divide the closing market price of the Norton’s common stock by earnings per share.
For Norton, the PE ratio is seven point sixty-five times. This means that the stock is selling for seven point sixty-five times its current earnings per share.
This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth.
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54. Annual cash dividends per share
Dividend Yield
P 3
Dividend
yield
Annual cash dividends per share
Market price per share =
$2.00
$15.00
= 13.3%
If you are an investor who required current income; you will want to look for companies with high dividend payout ratios. If you believe that a company can invest its funds and earn a higher return than you would be able to earn, you might look for a company with high growth and a low payout ratio.
To determine the dividend yield ratio, we divide the annual cash dividend per share by the closing market price per share of the company’s common stock.
At Norton, the dividend yield is thirteen point three percent. If we purchase the stock today for fifteen dollars per share and receive an annual dividend of two dollars, we will earn a return of thirteen point three percent on our investment.
This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
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55. A1
Summarizing Results
A financial statement analysis report helps by directly assessing the building blocks of analysis and by identifying weaknesses in inference and by requiring explanation. It usually consists of six sections:
Executive summary
Analysis overview
Evidential matter
Assumptions
Key Factors
Inferences
Understanding the purpose of financial statement analysis is crucial to the usefulness of any analysis. This understanding leads to efficiency of effort, effectiveness in application, and relevance of focus. The purpose of most financial statement analyses is to reduce uncertainty in business decisions through a rigorous and sound evaluation. It also serves as a communication link with readers and helps to reevaluate evidence and refine conclusions on key building blocks. A good analysis usually consists of the six sections shown in this slide.
It’s also important to take out irrelevant information and details. In addition, writing style and knowledge is important. Mistakes in grammar and errors of fact compromise the report’s credibility.
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56. End of Chapter 13
We think the material in this chapter will help you when you enter into a management position or begin to invest in stocks and bonds of companies.
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