1. Financial Statement Analysis
Chapter 15
Financial Statement Analysis

2. Financial Statement Analysis
To make informed decisions about a company
Helpful in managing the company
Comparison with competition
Charting a company’s progress, measure performance
Establish financial health
Used for investment decisions
Generally based on comparative financial data
From one year to the next
With a competing company
With the industry as a whole.

3. Financial Statement Analysis
Three main ways to analyze financial statements
Horizontal analysis
Vertical analysis
Using industry averages

4. Horizontal Analysis
The study of percentage changes in comparative statements
Compute dollar changes
Compute percentage changes

5. Example: Income Statement
Step 1
Step 2

6. Example: Balance Sheet (partial)

7. Trend Percentages Form of horizontal analysis
Select a period of three to five years
Base year, earliest year, is selected and set equal to 100%
Subsequent years expressed as a percentage of the base period

8. E15-13: Horizontal analysis—income statement
Data for Mariner Designs, Inc., follow:
1. Prepare a horizontal analysis of the comparative income statement of Mariner Designs, Inc. Round percentage changes to one decimal place.
MARINER DESIGNS, INC.
Comparative Income Statement
Years Ended December 31, 2012 and 2011
2011
2012
Net sales revenue
$ 431,000
$ 372,350
Expenses:
Cost of goods sold
$ 200,000
$ 187,550
Selling and general expenses
99,000
91,050
Other expense
8,350
6,850
Total expenses
$ 307,350
$ 285,450
Net income
$ 123,650
$ 86,900

9. E15-13: Horizontal Analysis—Income Statement
MARINER DESIGNS, INC.
Comparative Income Statement
Years Ended December 31, 2012 and 2011
Increase (Decrease)
2011
2012
Amount
Percent
Net sales revenue
$ 431,000
$ 372,350
$ 58,650
15.8 %
Expenses:
Cost of goods sold
$ 200,000
$ 187,550
$ 12,450
6.6 %
Selling and general expenses
99,000
91,050
7,950
8.7 %
Other expense
8,350
6,850
1,500
21.9 %
Total expenses
$ 307,350
$ 285,450
21,900
7.7 %
Net income
$ 123,650
$ 86,900
$ 36,750
42.3 %

10. E15-13: Horizontal analysis—income statement
Data for Mariner Designs, Inc., follow:
2. Why did 2012 net income increase by a higher percentage than net sales revenue?
Revenues increase at a higher rate than total expenses.

11. Vertical Analysis
Shows relationship of each item to a base amount on financial statements
Income statement–each item expressed as percentage of net sales
Balance sheet–each item expressed as percentage of total assets or total liabilities and equity.

12. Example: Income Statement
Base amount
Percentage of the base amount

13. Example: Balance Sheet
Base amount
Percentage of base

14. Prepare a vertical analysis of Tri-State assets for 2012 and 2011.
S15-3 : Vertical analysis
Tri-State Optical Company reported the following amounts on its balance sheet at December 31, 2012 and 2011:
Prepare a vertical analysis of Tri-State assets for 2012 and 2011.
2012
2011
Cash and receivables
$ 54,530
$ 46,860
Inventory
42,435
32,670
Property, plant, and equipment, net
108,035
85,470
Total assets
$ 205,000
$ 165,000
2012
% of
total
2011
Cash and receivables
$ 54,530
$ 46,860
Inventory
42,435
32,670
Property, plant, and equipment, net
108,035
85,470
Total assets
$ 205,000
$ 165,000
26.6
20.7
52.7
100.0
28.4
19.8
51.8
100.0

15. Common-Size Statements
Common-size statements compare one company to another

16. Benchmarking Comparing a company with another leading company
Two main types:
Against a key competitor
Against the industry average

17. S15-4 :Common-size income statement
Data for Martinez, Inc., and Rosado, Corp., follow: 1. Prepare common-size income statements.
Martinez
Rosado
Net sales
$ 10,600
$ 18,600
Cost of goods sold
6,455
13,522
Other expenses
3,541
4,185
Net income $ $
Martinez
Rosado
Net sales
100 %
Cost of goods sold
60.9 %
72.7 %
Other expenses
33.4 %
22.5 %
Net income
5.7 %
4.8 %

18. S15-4 :Common-size income statement
(Continued) 2. Which company earns more net income? 3. Which company’s net income is a higher percentage of its net sales?
Martinez
Rosado
Net sales
100 %
Cost of goods sold
60.9 %
72.7 %
Other expenses
33.4 %
22.5 %
Net income
5.7 %
4.8 %
Rosado
Martinez

19. Financial Ratios No single ratio tells the whole picture
Different ratios explain different aspects

20. Ability to Pay Current Liabilities
Working capital
Working capital = Current assets – Current liabilities
Current ratio
Current assets
Current liabilities
Current ratio =

21. Ability to Pay Current Liabilities
Acid-test ratio
Cash + Short-term investments + Net current receivables
Current liabilities
Acid-test Ratio =

22. Ability to Sell Inventory and Collect Receivables
Inventory turnover ratio
Formula
Inventory turnover =
Cost of goods sold
Average inventory

23. Ability to Sell Inventory and Collect Receivables
Days in inventory ratio
Formula
Days in inventory =
365 days
Inventory turnover ratio

24. Ability to Sell Inventory and Collect Receivables
Gross profit percentage
Formula
Gross profit percentage =
Gross profit Net sales

25. Ability to Sell Inventory and Collect Receivables
Accounts receivable turnover ratio
Formula
Accounts receivable turnover =
Net credit sales
Average net accounts receivable

26. Ability to Sell Inventory and Collect Receivables
Days’ sales in receivables ratio
Formula
Days’ sales in
average accounts = receivable
365 days
Accounts receivable
turnover ratio

27. Ability to Pay Long-Term Debt
Debt ratio
Formula
Average debt ratio ranges from 57% to 67%
Debt ratio =
Total liabilities
Total assets

28. Ability to Pay Long-Term Debt
Debt to equity ratio
Formula
Debt to equity =
Total liabilities
Total equity

29. Ability to Pay Long-Term Debt
Times-interest-earned ratio
Formula
Times-interest earned ratio =
Earnings Before Interest and Taxes
Interest expense

30. Measuring Profitability
Return on net sales
Formula
Rate of return
on net sales =
Net income
Net sales

31. Measuring Profitability
Return on total assets
Formula
Rate of return
on total assets =
Net income + Interest expense
Average total assets

32. Measuring Profitability
Asset turnover ratio
Formula
Asset turnover ratio =
Net sales
Average total assets

33. Measuring Profitability
Return on common stockholders’ equity
Formula
Rate of return on common
stockholders’ equity =
Net income – Preferred dividends
Average common stockholders’ equity

34. Leverage Trading on the equity Increases profits during goods times
Compounds losses during bad times

35. Measuring Profitability
Earnings per share
Formula
Earnings per share of common stock =
Net income – Preferred Dividends
Number of shares of common stock outstanding

36. Analyzing Stock Investments
Price/earnings ratio (P/E)
Formula
P/E ratio =
Market price per share of common stock
Earnings per share

37. Analyzing Stock Investments
Dividend yield
Formula
Dividend yield on common stock =
Annual dividends per share of common stock
Market price per share of common stock

38. Analyzing Stock Investments
Dividend Payout
Formula
Dividend Payout =
Annual dividends per share
Earnings per share

39. Analyzing Stock Investments
Book value
Formula
Book value per share of common stock =
Total stockholders’ equity – Preferred equity
Number of shares of common stock outstanding

40. S15-5: Evaluating current ratio
Win’s Companies, a home improvement store chain, reported the following summarized figures:

41. S15-5 : Evaluating current ratio
(Continued)
Compute Win’s Companies’ current ratio at May 31, 2012 and 2011.
2. Did Win’s Companies’ current ratio improve, deteriorate, or hold steady during 2012?
Current assets
Current liabilities
Current ratio =
- $ 54,300,000/$ 33,000,000 = 1.65
$ 25,200,000/$ 13,100,000 =
Win’s Companies current ratio deteriorated.

42. S15-6: Computing inventory, gross profit, and receivables ratios
Use the Win’s Companies data in Short Exercise 15-5 to complete the following requirements.
Compute the rate of inventory turnover, days in inventory, and gross profit percentage for 2012.
Inventory turnover =
Cost of goods sold
Average inventory
$ 28,400,000/($6,900,000 + $8,200,000)/2 = 3.76
Days in inventory =
365 days
Inventory turnover ratio
365/3.76 = 97 days
Gross profit percentage =
Gross profit Net sales
$21,800,000/$50,200,000 = %

43. S15-6 : Computing inventory, gross profit, and receivables ratios
(Continued)
2. Compute days’ sales in average receivables during Round dollar amounts to three decimal places.
Days’ sales in
average accounts = receivable
365 days
Accounts receivable
turnover ratio
Accounts receivable turnover =
Net credit sales
Average net accounts receivable
365/($ 50,200,000/($7,400,000 + $5,300,000)/2 ) = 46 days

44. S15-7: Measuring ability to pay liabilities
Use the financial statements of Win’s Companies in Short Exercise 15-5.
Compute the debt ratio and the debt to equity ratio at May 31, 2012.
2. Is Win’s ability to pay its liabilities strong or weak? Explain your reasoning.
Debt ratio =
Total liabilities
Total assets
$ 45,300,000 / $ 88,300,000 = 51.3
Debt to equity =
Total liabilities
Total equity
$ 45,300,000 / $ 43,000,000 = 1.05
The company’s ability to pay its liabilities is strong since the debt ratio is low.

45. S15-8 : Measuring profitability
Use the financial statements of Win’s Companies in Short Exercise 15-5 to complete the following profitability measures for 2012.
1. Compute the rate of return on net sales.
2. Compute the rate of return on total assets.
3. Compute the asset turnover ratio.
Rate of return
on net sales =
Net income
Net sales
$ 15,500,000 / $ 50,200,000 = 30.9%
Rate of return
on total assets =
Net income + Interest expense
Average total assets
$ 15,500, ,000 / ($ 88,300,000 + $ 51,200,000)/2 = 22.9%
Asset turnover ratio =
Net sales
Average total assets
$ 50,200,000 / ($ 88,300,000 + $ 51,200,000)/2 = 0.72

46. S15-8 : Measuring profitability
(Continued)
4. Compute the rate of return on common stockholders’ equity.
5. Are these rates of return strong or weak? Explain your reasoning.
Rate of return on common
stockholders’ equity =
Net income – Preferred dividends
Average common stockholders’ equity
$ 15,500,000 – 0 / ($ 43,000,000 + $ 27,500,000) /2 = 44.0 %
These rates of return are strong considering that average companies present much lower rates of return.

47. S15-9 : Computing EPS and P/E ratio
Use the financial statements of Win’s Companies in Short Exercise Win’s has 500,000 common shares outstanding during 2012.
Compute earnings per share (EPS) for Win’s. Round to the nearest cent.
2. Compute Win’s Companies’ price/earnings ratio. The market price per share of Win’s stock is $68.50.
Earnings per share of common stock =
Net income – Preferred Dividends
Number of shares of common stock outstanding
$ 15,500,000 – 0/500,000 = $31.00
P/E ratio =
Market price per share of common stock
Earnings per share
$68.50/$31.00 = 2.2 times