1. Financial statement analysis and interpretation
What is financial statement analysis?
Examining the financial statements from a users’ perspective and looking at relationships in the accounting information

2. Financial statement analysis and interpretation
Who analyzes financial statements?
Internal users (i.e., management)
External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors

3. Financial statement analysis and interpretation
What do internal users use it for?
Planning, evaluating and controlling company operations
What do external users use it for?
Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management

4. Financial statement analysis and interpretation
Information is available from
Published annual reports
Financial statements
Notes to financial statements
Letters to stockholders
Auditor’s report (Independent accountants)
Management’s discussion and analysis
Reports filed with governments

5. Financial statement analysis and interpretation
Information is available from
Other sources
Newspapers
Periodicals
Financial information organizations
Other business publications

6. Methods of financial statement analysis
Horizontal analysis
Vertical analysis
Ratio analysis
Common-size statements
Trend percentages

7. Horizontal analysis
Using comparative financial statements to calculate currency or percentage changes in a financial statement item from one period to the next

8. Vertical analysis
For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

9. Ratio analysis
Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

10. Common-size statements
Financial statements that show only percentages and no absolute currency amounts

11. Trend percentages
Show changes over time in given financial statement items (can help evaluate financial information of several years)

12. Horizontal analysis example
The management of Example Company provides you with comparative balance sheets of the years ended December 31, 2012 and Management asks you to prepare a horizontal analysis on the information

13. Horizontal analysis example

14. Horizontal analysis example
Calculating change in currency amounts
Money
amount
change
Current year
figure
Previous year
figure = –

15. Horizontal analysis example
Calculating change as a percentage
Percentage
change
Money amount change
Previous year figure × =
100%

16. Horizontal analysis example

17. Horizontal analysis example
(11,500 ÷ 23,500) × 100% = 48.9%

18. Horizontal analysis example

19. Horizontal analysis example
Let’s apply the same
procedures to the
liability and stockholders’ equity sections of the balance sheet

23. Sales increased by 8.3% while net income decreased by 21.9%.

24. There were increases in both cost of goods sold (14
There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

25. Vertical analysis example
The management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company

26. Vertical analysis example

27. Vertical Analysis Example
82,000 ÷ 483,000 = 17% rounded
30,000 ÷ 387,000 = 8% rounded

28. Vertical analysis example

29. Vertical analysis example
76,000 ÷ 483,000 = 16% rounded

30. Ratios CAUTION! Ratios can be expressed in different ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of $2.25)
CAUTION!
Using ratios and percentages without considering the underlying causes may
lead to incorrect conclusions

31. Categories of ratios Liquidity ratios
Indicate a company’s short-term debt-paying ability
Debt & Equity ratios (Long-term Solvency)
Show relationship between debt and equity financing in a company
Profitability ratios & tests
Relate income to other variables
Market ratios & tests
Help assess relative merits of stocks in the marketplace

32. Liquidity ratios Current (working capital) ratio
Quick ratio (‘acid test’)
Liquid (cash) ratio
Accounts receivable turnover
Number of days sales in accounts receivable
Inventory turnover
Total assets turnover

33. Debt & Equity ratios (long-term Solvency) Debt to Equity ratio
or Debt to TOTAL ‘long term’ funds (D+E)
Equity ratio (stockholders’ equity)

34. Profitability ratios & tests
Return on capital employed ROCE (ie. return on ‘operating assets’
Net income to net sales (return on sales or ‘net profit margin’)
Gross profit percentage
Return on equity ROE (ie. common stockholders equity)

35. Market ratios & tests Earnings per share Times interest earned
Times preferred dividends earned
Earnings yield on common stock
Price-earnings ratio
Payout ratio on common stock
Dividend yield on common stock
Dividend yield on preferred stock
Cash flow per share of common stock

36. Ratios
Now, let’s look at Aspect Corporation’s 2012 and 2011 financial statements

40. to calculate liquidity ratios for Aspect Co.
This
Information
will be used
to calculate liquidity ratios for Aspect Co.

41. Working Capital* The excess of current assets
over (ie. minus) current liabilities
While this is not a ratio, it does give an indication of a company’s liquidity

42. of the company to pay current debts as they become due
Current ratio
Current
Ratio
Current Assets
Current Liabilities =
Current
Ratio
65,000
42,000 =
1.55 : 1
Measures the ability
of the company to pay current
debts as they become due

43. Current Assets - Inventory
Quick ratio
Current Assets - Inventory
Current Liabilities =
Quick
Ratio
65,
42,000 =
1.26 : 1
Quick
Ratio
53,000
42,000 =
1.26 : 1
Quick
Ratio
This ratio is often and confusingly also referred to
as the “acid-test”

44. Liquid (‘acid-test’) ratio
Liquid Assets
Current Liabilities =
Acid-test
ratio
30,000
42,000 =
.71 : 1
Liquid
Ratio
Liquid assets are cash,
and current marketable securities

45. Accounts receivable turnover
Net, credit sales
Average, net accounts receivable
Sales on Account
Average accounts receivable
Accounts receivable
turnover =
= times
494,000
(17, ,000) ÷ 2
Accounts receivable
turnover =
This ratio measures how many times a company converts its receivables into cash each year

46. Number of days in accounts receivable
days sales
in accounts
receivables
365 Days
Accounts receivable turnover =
= days =
365 days
26.70 times
days sales
in accounts
receivables
Measures, on average, how many days it takes to collect an account receivable
What would be a desirable number of days for collection of accounts receivable ?

47. Measures the number of times replaced during the year
Inventory turnover
Cost of Goods sold
Average inventory
Inventory
turnover =
= times
140,000
(10, ,000) ÷ 2
Inventory
turnover =
Measures the number of times
inventory is sold and
replaced during the year
What would be a desirable number of times for inventory to turnover ?

48. Debt to Equity, or long–term Solvency ratios
This is part of the information to calculate the equity, or long-term solvency ratios of Aspect Corporation

49. Here is the
rest of the
information
we will
use

50. Debt to Equity ratio Debt to Equity = Long term Debt Total Assets
70,000
234,390
0.30
Measures the ‘risk’

51. Equity ratio Equity ratio = Total assets Equity ratio = 234,390
346,390
67.7%
Measures the proportion
of total assets provided by
stockholders

52. Return On Capital Employed ROCE=
Earning Before Interest and Tax
Equity + Debt (average)
ROCE =
PBIT
Equity + Debt (average)
ROCE =
76,700
346,390
22.1%

53. Net Income to Net Sales (Return on Sales or Profit Margin)=
Net Income to
Net Sales =
53,690
494,000
= 10.9%
Measures the proportion of the sales dollar which is retained as profit

54. Return on Equity ROE (return on common stockholders funds)
net income
Common equity (average)
Return on
equity funds = =
53,690
(180, ,390) ÷ 2
= 25.9%
Return on
equity
Important measure of the
income-producing ability of a company

55. Weighted Average Number of Common Shares Outstanding
Earnings Per Share
Earnings Available to Common Stockholders
Weighted Average Number of Common Shares Outstanding
Earnings
per Share =
Earnings
per Share
53,690
(17, ,400) ÷ 2 =
= $2.42
The financial press regularly publishes
actual and forecasted EPS amounts

56. Weighted average calculation
Earnings Per Share
Weighted average calculation
EPS of common stock = _______________________
Earnings available to
common stockholders
Weighted average number of
common shares outstanding

57. EPS and Stock Dividends or Splits
Earnings Per Share
EPS and Stock Dividends or Splits
Why restate all prior calculations of EPS?
Comparability - i.e., no additional capital was generated by the dividend or split
Basic EPS and Diluted EPS IAS 33

58. Price-Earnings Ratio ( P/E Multiple )
Market Price Per Share
EPS =
Price-Earnings
Ratio =
$20.00
$ 2.42
= 8.3 : 1
Provides some measure of whether the stock is under or overpriced

59. Trend Percentages Example
Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis

60. Trend Percentages Example
Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis
1, ,820 = 171

61. Trend Percentages Example
Using 2008 as the base year, we develop the following percentage relationships
1, ,820 = 171
171 ÷ 1,820 = 9% rounded

62. Trend line
for Sales

63. Important Considerations
Need for comparable data
Data is provided by the media etc.
Must compare by industry
Is EPS comparable?
Influence of external factors
General business conditions
Seasonal nature of business operations