1. Financial Statement Analysis
CHAPTER 13
Financial Statement Analysis
Chapter 13: Financial Statement Analysis
This chapter focuses upon 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.
PowerPoint Author:
LuAnn Bean, Ph.D., CPA, CIA, CFE
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

2. 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
Means of Analysis
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
The available means of analyzing the information.

3. Methods of Analysis Ratio Analysis Vertical Analysis
Horizontal Analysis
Percentage Analysis
Vertical Analysis
Ratio Analysis
This chapter discusses several categories of analysis methods: horizontal, percentage, vertical, and ratio.
Let’s look at the financial statements for Milavec for 2011 and We will refer to these financial statements in the examples of analysis techniques in this chapter.

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

5. Milavec Company Balance Sheets
Here are the comparative balance sheets for Milavec Company.

6. Horizontal and Percentage 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 I
Horizontal analysis (also known as trend analysis) involves analyzing financial data over several accounting periods.
Part II
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. The analysis of a given item may focus on trends in the absolute dollar amount of the item or trends in percentages. For example, a user may observe that revenue increased from one period to the next by $42 million (an absolute dollar amount) or that it increased by a percentage such as 15 percent.
Part III
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. Percentage analysis sidesteps the materiality problems of comparing different size companies by measuring changes in percentages rather than absolute amounts.

7. 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.

8. 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.

9. 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.

10. Milavec Company Vertical Analysis
This exhibit presents Milavec’s income statements, along with vertical percentages, for 2012 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.

11. 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.

12. This exhibit presents Milavec’s balance sheets, along with vertical percentages, for 2012 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 2011 to 2012, which may have unfavorable consequences. Careful analysis requires considering changes in both percentages and absolute amounts.

13. 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
Ratio analysis involves studying various relationships between different items reported in a set of financial statements. In this chapter we look at liquidity ratios, solvency ratios, profitability ratios, and ratios that relate to the stock market.
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.
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.
The current ratio is computed as current assets divided by current liabilities. 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.
The quick, or acid-test, ratio is computed as quick assets divided by current liabilities. 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 accounts receivable turnover is calculated as net credit sales divided by average accounts receivable. It measures how quickly credit sales are converted to cash. A related measure called the average days to collect receivables and is computed as by dividing the number of days in the year by the accounts receivable turnover. 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.
The inventory turnover ratio is computed as cost of goods sold divided by average inventory. It measures how many times a company’s inventory has been sold and replaced during the year. A related measure called the average days to sell inventory is computed as the number of days in the year divided by the inventory turnover ratio. It measures the number of days being taken, on average, to sell the entire inventory one time.

14. 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.
The debt to assets ratio is computed as total liabilities divided by total assets. This ratio measures the percentage of a company’s assets that are financed by debt.
The debt to equity ratio is computed as total liabilities divided by total stockholders’ equity. 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.
The number of times interest earned ratio is calculated as earnings before interest expense and income taxes divided by interest expense. 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.
Since companies often pledge plant assets as collateral for long-term liabilities, the plant assets to long-term liabilities ratio is often used for analysis. It is derived by dividing net plant assets by long-term liabilities. This ratio suggests how well long-term debt is managed to finance long-term assets.

15. 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.
Net margin is calculated as net income divided by net sales. This measure describes the percent remaining of each sales dollar after subtracting other expenses, as well as cost of goods sold.
The asset turnover ratio is calculated as net sales divided by average total assets. This ratio measures how many sales dollars were generated for each dollar of assets invested.
The return on investment is computed as net income divided by average total assets. This is the ratio of wealth generated (net income) to the amount invested (average total assets).
The return on common stockholders’ equity is computed as net income divided by average common stockholders’ equity. This measure is often used to measure the profitability of the stockholders’ investment.

16. 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.
Earnings per share indicates how much income was earned for each share of common stock outstanding. Earnings available for common shareholders is divided by the average number of outstanding common shares (which 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).
The book value per share is computed as (Stockholders’ Equity - Preferred Dividends) divided by 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 price-earnings ratio is computed as market price per share divided by earnings per share. 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.
The dividend yield ratio is computed as dividends per share divided by market price per share. 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.

17. Limitations of Financial Statement Analysis
Different Industries
Changing Economic Environment
Accounting Principles
Part I
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 II
When comparing firms, analysts must be alert to changes in general economic trends from year to year.
Part III
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 making comparing companies.

18. End of Chapter 13
End of Chapter 13.