1. Analysis of Financial Statements
Chapter 17
Chapter 17: Analysis of Financial Statements

2. Building Blocks of Analysis
Liquidity and efficiency
Solvency
Financial statement analysis focuses on one or more elements of a company’s financial condition or performance. These four areas are considered the building blocks of financial statement analysis:
■ Liquidity and efficiency—ability to meet short-term obligations and to efficiently generate revenues.
■ Solvency—ability to generate future revenues and meet long-term obligations.
■ Profitability—ability to provide financial rewards sufficient to attract and retain financing.
■ Market prospects—ability to generate positive market expectations.
Profitability
Market prospects

3. Standards for Comparison
When we interpret our analysis, it is essential to compare the results we obtained to other standards or benchmarks.
Intracompany
Competitors
Industry
Guidelines
These include
■ Intracompany—The company under analysis can provide standards for comparisons based on its own prior performance.
■ Competitors—One or more direct competitors of the company being analyzed can provide standards for comparisons.
■ Industry—Industry statistics can provide standards of comparisons. Such statistics are available from services such as Dun & Bradstreet, Standard & Poor’s, and Moody’s.
■ Guidelines (rules of thumb)—General standards of comparisons can develop from experience.
All of these comparison standards are useful when properly applied, yet measures taken from a selected competitor or group of competitors are often best.

4. Tools of Analysis Horizontal Analysis Vertical Analysis Ratio 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.
Three of the most common tools of financial statement analysis are:
1. Horizontal analysis, which 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.
2. Vertical analysis, which is the process of comparing a company’s financial condition and results of operation in reference to a base amount. For example, we may wish to know the percentage of each expense account to sales revenue for the period.
3. Ratio analysis, which involves the use of key ratios to evaluate the strengths and weaknesses of a company.
Ratio Analysis
Measurement of key relations between financial statement items.

5. Horizontal Analysis
P 1
Horizontal analysis refers to examination of financial statement data across time. The term horizontal analysis arises from the left-to-right (or right-to-left) movement of our eyes as we review comparative financial statements across time. Comparing amounts for two or more successive periods often helps in analyzing financial statements.
This comparison of the asset section of the Balance Sheet for Polaris Industries Inc. illustrates horizontal analysis.

6. Common-Size Statements
Vertical Analysis
P 2
Common-Size Statements
Common-size
Percent
Analysis Amount
Base Amount × =
100
Financial Statement Base Amount
Balance Sheet Total Assets
Income Statement Revenues
Vertical analysis is a tool to evaluate individual financial statement items or a group of items in terms of a specific base amount. We usually define a key aggregate figure as the base, which for an income statement is usually revenue and for a balance sheet is usually total assets. The term vertical analysis arises from the up-down (or down-up) movement of our eyes as we review common-size financial statements. Vertical analysis is also called common-size analysis.

7. Common-Size Balance Sheet
P 2
($325,336 ÷ $1,228,024) × 100 = 26.5%
Here is the asset section of the comparative balance sheets of Polaris Industries Inc. For common-size analysis of the Balance Sheet, set total assets equal to 100 percent and express all other items as a percentage of total assets.
To illustrate, calculate the percentage that cash and cash equivalents are of total assets. Divide the total cash and cash equivalents for 2011 by the total assets for 2011, and multiply the result by 100 percent. At the end of 2011, cash and cash equivalents made up 26.5% of total assets. For 2010, the percentage was 37.1%. Each line item is expressed as a percentage of total assets.
($393,927 ÷ $1,061,647) × 100 = 37.1%
Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

8. Liquidity and efficiency
Ratio Analysis
P 3
Liquidity and efficiency
Solvency
Ratios are among the more widely used tools of financial analysis because they provide clues to, and symptoms of, underlying conditions. A ratio can help us uncover conditions and trends difficult to detect by inspecting individual components making up the ratio. Ratios, like other analysis tools, are usually future oriented; that is, they are often adjusted for their probable future trend and magnitude, and their usefulness depends on skillful interpretation.
A ratio expresses a mathematical relation between two quantities. It can be expressed as a percent, rate, or proportion. For instance, a change in an account balance from $100 to $250 can be expressed as (1) 150%, (2) 2.5 times, or (3) 2.5 to 1.
The ratios are organized into the four building blocks of financial statement analysis: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects.
Profitability
Market prospects

9. Liquidity and Efficiency
P 3
Current
Ratio
Inventory Turnover
Acid-test
Ratio
Days’ Sales Uncollected
Accounts Receivable Turnover
Liquidity refers to the availability of resources to meet short-term cash requirements. It is affected by the timing of cash inflows and outflows along with prospects for future performance. Analysis of liquidity is aimed at a company’s funding requirements. Efficiency refers to how productive a company is in using its assets. Efficiency is usually measured relative to how much revenue is generated from a certain level of assets.
Days’ Sales in Inventory
Total Asset Turnover

10. Current Ratio Current Assets Current Ratio = Current Liabilities
P 3
Current Ratio =
Current Assets
Current Liabilities
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.
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. A higher current ratio suggests a strong liquidity position and an ability to meet current obligations.
This ratio measures the short-term debt-paying ability of the company. A higher current ratio suggests a strong liquidity position.

11. Pledged Assets to Secured Liabilities
Solvency
P 3
Debt
Ratio
Equity
Ratio
Pledged Assets to Secured Liabilities
Solvency refers to a company’s long-run financial viability and its ability to cover long-term obligations. One of the most important components of solvency analysis is the composition of a company’s capital structure. Capital structure refers to a company’s financing sources.
Times Interest Earned

12. Debt-to-equity ratio =
P 3
Debt-to-equity ratio =
Total liabilities
Total equity
This ratio measures what portion of a company’s assets are contributed by creditors. A larger debt-to-equity ratio implies less opportunity to expand through use of debt financing.
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. A larger debt-to-equity ratio implies less opportunity to expand through use of debt financing.

13. Return on Common Stockholders’ Equity
Profitability
P 3
Profit
Margin
Return on Total Assets
Profitability refers to a company’s ability to generate an adequate return on invested capital. Return is judged by assessing earnings relative to the level and sources of financing. Key profitability measures are profit margin, return on total assets, and return on common stockholders’ equity.
Return on Common Stockholders’ Equity

14. Profit Margin Profit margin = Net income Net sales
Net sales
This ratio describes a company’s ability to earn net income from each sales dollar.
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.
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. Return on total assets measures how well assets have been employed by the company’s management.

15. Market Prospects Price-Earnings Ratio Dividend Yield P 3
Market measures are useful for analyzing corporations with publicly traded stock. These market measures use stock price, which reflects the market’s (public’s) expectations for the company. This includes expectations of both company return and risk—as the market perceives it. Key measures of market prospects include the price-earnings ratio and dividend yield.

16. Price-Earnings Ratio Price-earnings ratio =
Market price per common share
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.
Once we know the earnings per share, we can calculate the price-earnings ratio, or PE ratio. We will divide the closing market price per share of a company’s common stock by earnings per share. The ratio is used as an indicator of the future growth and risk of a company’s earnings as perceived by the stock’s buyers and sellers.

17. Summary of Ratios
This chart and Exhibit in your textbook summarizes the major financial statement analysis ratios illustrated in this chapter and throughout the book. This summary includes each ratio’s title, its formula, and the purpose for which it is commonly used.

18. End of Chapter 17
End of Chapter 17.