1. Financial Statement Analysis
Chapter 9

2. Learning Objectives
After studying this chapter, you should be able to:
Describe basic financial statement analytical methods
Use financial statement analysis to assess the liquidity and solvency of a business
Use financial statement analysis to assess the profitability of a business
Describe the contents of corporate annual reports

3. Learning Objective 1
Describe basic financial statement analytical methods

4. Horizontal Analysis
The percentage analysis of increases and decreases in related items in comparative financial statements
Each item on the most recent statement is compared with the related item on one or more earlier statements in terms of the following:
1. Amount of increase or decrease
2. Percent of increase or decrease
Horizontal analysis is one of the basic analytical methods for users to analyze the financial statements of a corporation. In horizontal analysis, each item on the most recent financial statement is compared with the related item on one or more earlier statements in terms of:
The amount of increase or decrease
The percentage of increase or decrease

5. Horizontal Analysis
As this exhibit illustrates, horizontal analysis occurs between the current assets at December 31, 20Y6 and the current assets at December 31, 20Y5. Overall, total current assets increased by $17,000 or 3.2% from 20Y5 to 20Y6. Further examination reveals that while cash and temporary assets increased from one year to the next, accounts receivable and inventories decreased over the same time period. Decreases in accounts receivable could be due to improved collection efforts which, in turn, would explain the increase in cash. Decreases to inventories could be caused by increased sales. Further examination would be needed to determine the exact causes.

6. Vertical Analysis
A percentage analysis used to show the relationship of each component to a total within a single statement
Another basic analytical method is the vertical analysis.
Vertical analysis computes a percentage analysis of each component of a financial statement to a total within that same financial statement. Although vertical analysis is applied to a single statement, it is more effective when the percentages are analyzed for changes over time.
In this exhibit, each asset category is stated as a percent of the total assets. Almost 50% of total assets are current assets as of December 31, 20Y6. To enhance the analysis, the user can see that current assets made up 43% of total assets as of December 31, 20Y5. This analysis could be expanded further to see the composition of each individual current asset stated as a percentage of total current assets. In addition, for the Liability and Stockholders’ Equity section of the Balance Sheet, each individual liability and equity item is stated as a percent of the total liabilities and stockholders’ equity.
In a vertical analysis of an Income Statement, each item is stated as a percentage of sales.

7. Benefits of Analysis
Horizontal and vertical analysis are useful in assessing relationships and trends in financial conditions and operations of a business
Vertical analysis is useful for comparing one company with another or with industry averages
Vertical analysis is made easier with common-sized financial statements
Utilizing both horizontal analysis and vertical analysis can give a user of financial statements a greater insight into the financial performance of an organization. Horizontal analysis is especially useful in identifying trends over time for a business. Trends from the past can be useful as predictors of the future. In addition to looking at vertical analysis over time for one organization, vertical analysis can also be useful in comparing one company to another or comparing the organization to industry averages.
When comparing two different companies, the size of the companies could distort the analysis. Vertical analysis is made easier through the use of common-sized statements.

8. Common-Sized Income Statement
All items are expressed as percentages with no dollar amounts shown:
In a common-sized statement, all items are expressed as percentages with no dollar amounts shown. Common-sized statements are useful in comparing:
The current period with prior periods
Individual businesses
One business with industry percentages
In the exhibit shown, while Mooney and Lowell’s gross profit is nearly the same, Mooney’s net income is nearly 3% less than Lowell’s net income. Further analysis shows Mooney’s operating expenses are 19.7% of total sales while Lowell’s operating expenses are 15.6% of total sales. Users of this analysis may want to investigate why Mooney has a higher operating expense ratio than Lowell. Or, it may be a conscious decision on the part of Mooney– perhaps a new advertising campaign to generate greater sales in the next year.

9. Learning Objective 2
Use financial statement analysis to assess the liquidity and solvency of a business

10. Liquidity and Solvency
Liquidity – the ability of a business to convert assets into cash
Solvency – the ability of a business to pay its debts
Profitability – earning income
All users of financial statements are interested in a company’s ability to maintain liquidity and solvency, and earn income. The ability to convert assets into cash is called liquidity, while the ability of a business to pay its debts is called solvency. Liquidity, solvency, and profitability are interrelated.
A company that cannot pay its bills cannot obtain additional credit. Without additional credit, it is more difficult to grow a business in order to generate future sales and profits.
Liquidity, solvency, and profitability
are interrelated!

11. Solvency Analysis
Normally assessed by examining Balance Sheet relationships, using the following major analyses:
Current position analysis
Accounts receivable analysis
Inventory analysis
Ratio of fixed assets to long-term liabilities
Ratio of liabilities to stockholders’ equity
Number of times interest charges are earned
Solvency analysis focuses on the ability of a company to pay its liabilities. Some ratios measure this ability for the short-term. Other ratios measure an organization’s financial structure and its impact on long-term solvency.
Current position analysis, accounts receivable analysis and inventory analysis focus more on the short-term debt paying ability of an organization.
The ratio of fixed assets to long-term liabilities, the ratio of liabilities to stockholders’ equity, and the number of times interest charges are earned are longer term measures of solvency. The common understanding is that if a company is carrying a significant amount of debt, it may spell trouble in the future. For example, if a company had a bad year, they still must pay their debts even if the company is not profitable.

12. Current Position Analysis
Using measures to assess a business’s ability to pay its current liabilities
*Quick assets – cash and other current assets that can easily be converted to cash: (temporary investments, receivables)
Working Capital =
Current Assets - Current Liabilities
Current Assets
Current Liabilities
Current Ratio =
A company’s ability to pay its current liabilities is called current position analysis. This analysis is of special interest to short-term creditors and includes the computation and analysis of:
Working capital, which is current assets less current liabilities
Current ratio, calculated as current assets divided by current liabilities
Quick ratio, calculated as total “quick” assets divided by current liabilities
Quick Assets
Current Liabilities
Quick Ratio =

13. Current Assets - Current Liabilities
Working Capital
To illustrate, the working capital for Mooney Company for 20Y6 and 20Y5 is computed below:
Working Capital =
Current Assets - Current Liabilities
Current position analysis starts with a computation of an organization’s working capital. Working capital is computed by subtracting the current liabilities from the current assets of an organization. In the example presented, Mooney Company’s working capital is $340,000 for 20Y6 and $290,000 for 20Y5.
The greater the difference between current assets and current liabilities, the higher will be the working capital, and the ability to pay current liabilities as they come due. However, working capital is difficult to use when evaluating companies of different sizes.

14. Current Ratio
To illustrate, the working capital for Mooney Company for 20Y6 and 20Y5 is computed below:
Current Assets
Current Liabilities
Current Ratio =
The current ratio which is sometimes called the working capital ratio states working capital as a proportion and is a more effective measure of a company’s ability to pay current liabilities. The current ratio is computed by dividing current assets by current liabilities.
Mooney’s current ratio is 2.6 for 20Y6. This can be interpreted as, for every dollar of current liability owed by Mooney, there is $2.60 of current assets available to pay the current liability as it comes due.

15. Quick Ratio = Quick Assets Quick Ratio Current Liabilities
$280,500
$160,500
One limitation of working capital and the current ratio is they do not consider the overall makeup of current assets. Because of this, two companies that have the exact same working capital and current ratios may have significant differences in their ability to pay current liabilities as they come due.
In this illustration, both Mooney and Wendt have working capital of $340,000 and a current ratio of 2.6. However, Wendt is carrying much more of their current assets in inventories. These inventories must be sold, and then collected in cash before current liabilities could be paid. This takes time. In contrast, Mooney’s current assets contain more cash, temporary investments, and accounts receivable, which can easily be converted to cash more easily.
The quick ratio measures the “instant” debt-paying ability of a company. An organization’s “quick assets” are divided by current liabilities to determine the quick ratio. Sometimes called the acid-test ratio. Quick assets normally include cash, temporary assets, and accounts receivable. Mooney’s quick ratio is 1.3 and Wendt’s quick ratio is Analyzing the quick ratio of Mooney and Wendt reveals that Wendt is in a much more precarious situation for short-term solvency.
Quick Ratio:
Mooney
$280,500 ÷ $210,000 =
1.3
Wendt
$160,500 ÷ $210,000 =
0.76

16. Accounts Receivable Analysis
Measures efficiency of collection
Reflects liquidity
Net Sales
Average Accounts Receivable
Accounts Receivable Turnover =
Average Accounts Receivable
Net Sales/365
Number of Days’ Sales in Receivables =
A company’s ability to collect its accounts receivable has a direct impact on their ability to pay current liabilities as they are due. Accounts receivable analysis measures a company’s ability to turn their accounts receivable into cash in a timely manner. The analysis is made up of the accounts receivable turnover and the number of days’ sales in receivables.

17. Accounts Receivable Turnover
Accounts receivable turnover is measured by dividing net sales for a year by the average accounts receivable balance during the year. Average accounts receivable is calculated by adding the accounts receivable balance at the beginning and the end of the year and dividing it by two.
In the example given, the accounts receivable turnover is 12.7 times in 20Y6 and 9.2 times in 20Y5. The increase in Mooney’s accounts receivable turnover from 9.2 to 12.7 indicates that the collection of receivables has improved during 20Y6. This may be due to a change in how credit is granted, collection practices, or both.
The accounts receivable turnover indicates how many times receivables are “turned over” or collected each period, on average. This turnover is an indicator of the efficiency of a company with which the company collects the receivables and ultimately converts them back to cash. The higher the turnover, the better it is because it means less of the company’s assets are tied up in receivables. 

18. Number of Days’ Sales in Receivables
Average Accounts Receivable
Average Daily Sales
Number of Days’ Sales in Receivables =
The accounts receivable turnover ratio is often divided into the number of days in a business year to show the average collection period in days. This measure is called number of days’ sales in receivables and is computed by calculating average daily sales and taking that amount and dividing it into the average accounts receivable calculated in the accounts receivable turnover.
In this illustration, the number of days to collect a receivable has fallen from 39.5 days in 20Y5 to 28.6 days in 20Y6. This would be expected since the turnover ratio also improved. On average, this organization is collecting receivables in less than 30 days in 20Y6. The number of days’ sales in receivables is often compared to a company’s credit terms to evaluate collection practices and performance.
Average Daily Sales =
Net Sales / 365

19. Inventory Analysis Measures inventory efficiency Reflects liquidity
Avoid tying up funds in inventory
Avoid obsolescence
Reflects liquidity
Cost of Goods Sold
Average Inventory
Inventory Turnover =
A company’s ability to manage its inventory also has an impact on their ability to pay current liabilities as they are due. Inventory analysis measures a company’s ability to turn their inventory into sales and then, ultimately, cash in a timely manner. The analysis is made up of the inventory turnover and the number of days’ sales in inventory.
A company with a higher turnover is generally considered more efficient and minimizes the chance of being stuck with obsolete inventory. In addition, excess inventory increases insurance expenses, property taxes, storage costs, and other related expenses. These expenses also reduce funds that could be used elsewhere to improve or expand operations. However, too high a turnover may indicate lost sales as a result of insufficient inventory in stock.
Number of Days’ Sales in Inventory
Average Inventory
Cost of Goods Sold/365 =

20. Inventory Turnover Cost of Goods Sold Inventory Turnover =
Average Inventory
Inventory Turnover =
Inventory turnover is measured by dividing cost of goods sold for a year by the average inventory balance during the year. Average inventory is calculated by adding the inventory balance at the beginning of the year and at the end of the year, and dividing it by two. 
In the example given, the inventory turnover is 3.8 times in 20Y6 and 2.8 times in 20Y5. The inventory turnover indicates how many times the inventory is “turned over” or sold each period, on average. The higher the turnover, the better because it means less investment in inventories, the company is more effective in converting inventory into sales, and the total time to sell inventory and collect the cash on the sales is smaller. The improvement shown from 20Y5 to 20Y6 indicates that the management of inventory has improved in 20Y6.

21. Number of Days’ Sales in Inventory
Average Inventory
Average Daily Cost of Goods Sold =
Average Daily Cost
of Goods Sold
Cost of Goods Sold
365 days =
The number of days sales in inventory divides the average inventory balance by the average daily cost of goods sold. The average daily cost of goods sold is computed by dividing total cost of goods sold for a year by the number of days in the year.
The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory. Care should be taken when looking at days’ sales in inventory as seasonal factors could distort the calculation.
The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory. Mooney’s number of days’ sales in inventory improved from days to 95.7 days during 20Y6. This is a major improvement in managing inventory.

22. Ratio of Fixed Assets to Long-Term Liabilities
Indicates the margin of safety for note-holders or bondholders
Indicates the ability to borrow additional funds on a long-term basis
Fixed Assets (net)
Long-Term Liabilities
Fixed Assets to Long-Term Liabilities =
The ratio of fixed assets to long-term liabilities is a long-term measure of solvency as it provides a measure of whether note holders or bondholders will be paid. The ratio is computed by simply dividing the net fixed assets by long-term liabilities. Since fixed assets are often pledged as security for long-term notes and bonds, the ratio indicates a margin of safety for creditors. Investors in long-term bonds and other creditors usually consider a company with a significant debt load relatively more unstable and a more risky investment.
In this illustration, the ratio of fixed assets to long-term liabilities improved from 2.4 in 20Y5 to 4.4 in 20Y6. This ratio means that, in 20Y6, for every dollar of long-term liability there is $4.40 of long-term assets. Improvement of this ratio means that creditors now have a greater margin of safety with regards to repayment. The decrease in liabilities has primarily triggered the improvement in the ratio. Paying off half of the long-term liabilities has improved this ratio.

23. Ratio of Liabilities to Stockholders’ Equity
Indicates the margin of safety for creditors
Indicates the ability to withstand adverse business conditions
Liabilities to Stockholders’ Equity
Total Liabilities
Total Stockholders’ Equity =
The ratio of total liabilities to stockholders’ equity is a measurement similar to the long-term assets to long-term liability ratio. This ratio is another measure of long-term solvency of a company as it measures the proportion of a company financed by debt and equity. The ratio is computed by dividing total liabilities by total stockholders’ equity. The higher the ratio, the more debt a company has in its capital structure.
Mooney’s ratio of liabilities to stockholders’ equity decreased from 0.6 to 0.4 during 20Y6. This is an improvement and indicates that Mooney’s creditors have an adequate margin of safety. High debt to equity ratios are dangerous to long-term solvency because of the interest expense due on the debt.

24. Number of Times Interest Charges Earned
Indicates the general financial strength of the business
Indicates the ability to withstand adverse business conditions
Times Interest
Charges Earned
Income before Taxes + Interest Expense
Interest Expense =
The number of times interest charges are earned, sometimes called the fixed charge coverage ratio , measures the risk that interest payments will not be made if earnings decrease. It is another indicator of long-term solvency and a measure of safety of creditors’ investment in the company. As a general rule, the higher the ratio the more likely interest payments will be paid even if earnings decrease. It is computed by dividing the income before taxes plus interest expense by the interest expense.
In this illustration, two factors made a significant impact on the calculation of times interest charges earned. First, income before tax improved from 20Y5 to 20Y6. The increased earnings will provide a greater measure of safety for creditors that their interest will be paid. The other factor is the decrease in interest expense. This is a result of decreasing liabilities.

25. Learning Objective 3
Use financial statement analysis to assess the profitability of a business

26. Profitability Analysis
Normally assessed by examining the income statement and balance sheet resources, using the following major analyses:
Ratio of net sales to assets
Rate earned on total assets
Rate earned on stockholders’ equity
Rate earned on common stockholders’ equity
Earnings per share on common stock
Price-earnings ratio
Dividends per share
Dividend yield
Profitability ratios serve as indicators of how effective a company has been in meeting the profit objectives of its owners. Profitability analysis focuses on the ability of a company to earn profits, especially relative to resources invested. The ability to earn profits is reflected in the company’s income statement. The resources invested to earn profits are reflected on a company’s balance sheet. Therefore, both the income statement and balance sheet are often used in evaluating profitability.
Common profitability analyses include the following:
1. Ratio of net sales to assets
2. Rate earned on total assets
3. Rate earned on stockholders’ equity
4. Rate earned on common stockholders’ equity
5. Earnings per share on common stock
6. Price-earnings ratio
7. Dividends per share
8. Dividend yield

27. Ratio of Net Sales to Assets
Shows how effectively a firm utilizes its assets
The ratio of net sales to assets measures how effectively a firm utilizes its assets to generate sales. It is computed by dividing net sales by average total assets excluding long-term investments. Long-term investments are excluded from the calculation because they are unrelated to normal operations and net sales. The average total assets is computed by adding total assets excluding the long-term investments at the beginning and at the end of the year, and dividing it by 2.
In this illustration, the ratio improved from 1.2 to 1.4 from 20Y5 to 20Y6. This is mainly due to the increase in net sales. This indicates that during the year 20Y6 Mooney generated $1.40 of sales for every dollar of asset.
Ratio of Net Sales to Assets
Net Sales
Avg. Total Assets
(excluding LT Investments) =

28. Rate Earned on Total Assets
Measures the profitability of total assets without considering how the assets are financed
The rate earned on total assets measures the profitability of total assets, with consideration as to how the assets are financed. The rate earned on total assets is computed by adding interest expense back to net income. By adding interest expense back to net income, the effect of how the assets are financed, by creditors or by stockholders, is eliminated. Average total assets include long-term investments because net income would include any income earned from these investments.
In this illustration, this ratio improved to 8.2% in 20Y6 from 7.3% in 20Y5. While this is an improvement, the ratio should also be measured against any earning targets set internally by the company. It would also be a good idea to compare this rate with industry averages.
Net Income + Interest Expense
Avg. Total Assets
Rate Earned on Total Assets =

29. Rate Earned on Stockholders’ Equity
Emphasizes the rate of income earned on the amount invested by the stockholders
Net income is divided by average stockholders’ equity to arrive at the rate earned on stockholders’ equity. This ratio measures net income relative to the amount invested by stockholders in a company, including retained earnings. Investors and financial analysts use the return on equity to compare performance of varying companies.
The rate improved to 11.3% in 20Y6 over 10.0% in 20Y5. The improvement could be the result of a company using leverage to improve performance.
Rate Earned on Stockholders’ Equity
Net Income
Avg. Stockholders’ Equity =

30. Leverage
The effect of leverage for 20Y6 is 3.1% which compares favorably with the 2.7% leverage for 20Y5
Leverage involves using debt to increase the return on stockholders’ equity. When the rate on stockholders’ equity exceeds the rate on total assets, a firm is said to have positive leverage. Financial leverage is defined as total assets divided by total stockholders’ equity. Leverage is also calculated as the difference between the return on stockholders’ equity and the return on assets.
In 20Y6, the rate earned on stockholders’ equity was 11.3% versus a rate earned on total assets of 8.2%. This creates positive leverage of 3.1%. For 20Y5, leverage was 2.7%. This indicates the company is using debt more effectively in 20Y6 to increase return on stockholders’ equity.

31. Rate Earned on Common Stockholders’ Equity
Measures the rate of profits earned on the amounts invested by the common stockholders
The rate earned on common stockholders’ equity measures the rate of profits earned on the amount invested only by common stockholders. This measure will be different from the rate earned on stockholders’ equity if the company has preferred stock. Because preferred stockholders’ rank ahead of common stockholders in their claim on earnings, preferred dividends are subtracted from net income in computing the rate earned on common stockholders’ equity.
Rate Earned on Common Stockholders’ Equity
Net Income – Preferred Dividends
Avg. Common Stockholders’ Equity =

32. Earnings Per Share on Common Stock
The income earned for each share of common stock
Earnings per Share
on Common Stock
Net Income – Preferred Dividends
Common Shares Outstanding
Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock. Generally accepted accounting principles require the reporting of EPS on the income statement. EPS figures are also reported in the financial press and followed closely by investors. In general, earnings per share is computed by dividing net income by the average number of shares of common stock outstanding during a fiscal period. When preferred and common stock are outstanding, preferred dividends are subtracted from net income to determine income related to common shares.
In this illustration, a share of common stock earned more in 20Y6 than it did in 20Y5. Since the common stock outstanding remained the same between the two years, the increase was due solely to improved earnings.
Trends in EPS are important because EPS is considered to be the best measure that summarizes the performance of a company, particularly for common shareholders. The amount of earnings per share, the change in earnings per share from the previous period, and the trend in earnings per share are all important indicators of the success or failure of a company. =

33. Price-Earnings Ratio
Price-earnings (P/E) ratio on common stock measures a firm’s future earnings prospects
The price-earnings ratio measures a company’s future earnings prospects. It is another measure quoted and closely followed by the financial press and investors. The calculation of the price-earnings ratio is computed by dividing the market price per share of common stock by the EPS on a common share.
In this illustration, the price-earnings ratio has increased from 20 to 25. This means that the stock was selling at 25 times the earnings per share. This is a good thing as it indicates the market expects favorable earnings in the future.
Market Price per Share of Common Stock
Earnings per Share on Common Stock
P/E Ratio =

34. Shares of Common Stock Outstanding
Dividends per Share
Dividends
Shares of Common Stock Outstanding
Dividends per Share =
Dividends per share measures the extent to which earnings are being distributed to common shareholders. It is computed by dividing dividends paid by the shares of common stock outstanding. Dividends per share are often compared to earnings per share. Comparing the two per-share amounts indicates the extent to which earnings are being retained in the operations for use in operations.

35. Dividend Yield
Dividend yield shows the rate of return to common stockholders in terms of cash dividends
Dividends per Share of Common Stock Market Price per Share of Common Stock
Dividend Yield =
The dividend yield on common stock measure the rate of return to common stockholders from cash dividends. This measurement is of special interest to investors when the investors’ objective is to earn revenue in the form of dividends from their investment. Dividend yield is computed by dividing the dividend per share of common stock by the market price per share.
The dividend yield in this illustration decreased because the stock price rose more than the dividend.

36. Learning Objective 4
Describe the contents of corporate annual reports

37. Corporate Annual Reports
Summarize operating activities for the past year and plans for the future
Many variations in the order and form, but all include:
Management’s discussion and analysis
Report on internal control
Report on fairness of the financial statements
Public corporations issue annual reports summarizing their operating activities for the past year and plans for the future. The annual report is accompanied by notes having disclosures about methods used in determining accounting information. Companies also include management’s discussion and analysis, report on internal control and report on fairness of the financial statements in their annual report.

38. Management Discussion and Analysis (MD&A)
Provides critical information in interpreting the financial statements and assessing the future of the company
Includes an analysis about past performance and financial condition
Discusses management’s opinion about future performance
Discusses significant risk exposure
Management’s assessment of the company’s liquidity and the availability of capital to the company
Any “off-balance-sheet” arrangements such as leases not included directly in the financial statements
Management’s Discussion and Analysis is required in annual reports filed with the Securities and Exchange commission. It includes management’s analysis of current operations and its plans for the future. This report also explains important events and changes in performance during the years presented in the financial statements. Typical issues in the report include comparison of operating results, liquidity and cash flow measures, major business risks, financial risks and changes in accounting methods. Also any “off-balance-sheet” arrangements such as leases not included directly in the financial statements.

39. Independent Auditors’ Report
Publicly traded companies must get an independent opinion on the fairness of the financial statements
The Certified Public Accounting (CPA) firm that conducts the audit renders an opinion, called the Report of Independent Registered Public Accounting Firm, on the fairness of the statements
This opinion must be included in the annual report along with an opinion on the accuracy of management’s internal control assertion
All publicly held corporations are required to have an independent audit of their financial statements. An opinion stating that the financial statements present fairly the financial position, results of operations, and cash flows of the company is said to be an unqualified or clean opinion. The Certified Public Accounting (CPA) firm that conducts the audit renders an opinion, called the Report of Independent Registered Public Accounting Firm, on the fairness of the statements. Any report other than an unqualified opinion raises a “red flag” for financial statement users. However, in light of the many accounting scandals that have rocked the financial world over the past years, an unqualified opinion is not always a clean bill of health for an organization.