1. Managerial Accounting Weygandt • Kieso • Kimmel Financial Statement Analysis: The Big Picture
Chapter 14
Prepared by
Alice Sineath
Forsyth Technical Community College
And
Ellen Sweat
Georgia Perimeter College

2. Chapter 14 Financial Statement Analysis: The Big Picture
PowerPoint Slides
Chapter 14 Financial Statement Analysis: The Big Picture
After studying Chapter 14, you should be able to:
Describe and apply horizontal analysis.
Describe and apply vertical analysis.
Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability.
Understand the concept of quality of earnings. 1

3. PowerPoint Slides
Comparative Analysis
Any item reported in a financial statement has significance if:
Its inclusion indicates that the item exists at a given time and in a certain quantity.
For example, when Kellogg Company reports $136.4 million on its balance sheet as cash, we know that Kellogg did have cash and that the quantity was $136.4 million. 28

4. PowerPoint Slides
Comparative Analysis
Whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's needs, cannot be determined from the amount alone.
The amount must be compared with other financial data to provide more information. 29

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Comparative Analysis
There are three types of comparisons to provide decision usefulness of financial information:
Intracompany basis
Intercompany basis
Industry averages 30

6. PowerPoint Slides
Intracompany Basis
Comparisons within a company are often useful to detect changes in financial relationships and significant trends.
A comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease.
A comparison of Kellogg's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash. 31

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Intercompany Basis
Comparisons with other companies provide insight into a company's competitive position.
Kellogg's total sales for the year can be compared with the total sales of its competitors such as Quaker Oats and General Mills. 32

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Industry Averages
Comparisons with industry averages provide information about a company's relative position within the industry.
Kellogg's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's. 33

9. Financial Statement Analysis
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Financial Statement Analysis
Three basic tools are used in financial statement analysis :
Horizontal analysis
Vertical analysis
Ratio analysis 34

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Horizontal Analysis
Is a technique for evaluating a series of financial statement data over a period of time.
Purpose is to determine whether an increase or decrease has taken place.
The increase or decrease can be expressed as either an amount or a percentage. 35

11. PowerPoint Slides
Horizontal Analysis 37

12. Percentage Change in Sales
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Percentage Change in Sales
The percentage change in sales for each of the 5 years, assuming 1997 as the base period is:
Kellogg Company
Net Sales (in millions) Base Period 1997
$8, $6, $6, $ $6,830.1
129.62% % % % % 38

13. Horizontal Analysis of a Balance Sheet
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KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Increase (Decrease)
during 2001
Amount Percent
Assets
Current Assets $ 1, $1, $
Plant assets , ,
Other assets 5, ,
Total assets $10, $4, $5, 39

14. Horizontal Analysis of a Balance Sheet
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Horizontal Analysis of a Balance Sheet
Increase (Decrease)
during 2001
Amount Percent
Liabilities and
Stockholders' Equity
Current liabilities $ 2, $2, $ (274.7) (11.1)
Long-term liabilities , , ,
Total liabilities , , ,
Stockholders' equity
Common stock (10.5) (5.1)
Retained earnings
and other 1, ,065.7 (52.4) (4.9)
Treasury stock (337.1) (374.0)
Total stockholders'
equity (26.0) (2.9)
Total liabilities and
stockholders' equity $10, $4, $5, 40

15. Condensed Income Statement For the Years Ended December 31
PowerPoint Slides
KELLOGG COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
Increase (Decrease)
during Amount Percent
Net sales $ 8, $6, $1,
Cost of goods sold , ,
Gross profit , , ,
Selling & Admin , ,
Nonrecurring charges (53.2) (61.5)
Income from operations 1,
Interest expense
Other income
(expense), net (12.3) (27.7) (179.9)
Income before taxes (63.6) (7.3)
Income tax expense
Net income $ $ $ (105.7) (18.0) 42

16. Let’s Review
In horizontal analysis, each item is expressed as a percentage of the:
a. net income amount.
b. stockholders’ equity amount.
c. total assets amount.
d. base-year amount.

17. Let’s Review
In horizontal analysis, each item is expressed as a percentage of the:
a. net income amount.
b. stockholders’ equity amount.
c. total assets amount.
d. base-year amount.

18. PowerPoint Slides
Vertical Analysis
Is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount.
Total assets is always the base amount in vertical analysis of a balance sheet.
Net sales is always the base amount in vertical analysis of an income statement. 45

19. Condensed Balance Sheets
PowerPoint Slides
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions) z
Assets Amount Percent Amount Percent
Current Assets $ 1, $1,
Property Assets , ,
Other assets 5,
Total assets $10, % $4, % 46

20. Condensed Balance Sheets
PowerPoint Slides
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Liabilities and Amount Percent* Amount Percent*
Stockholders' Equity
Current liabilities $ 2, $2,
Long-term liabilities , ,
Total liabilities , ,
Stockholders' equity
Common stock
Retained earnings
and other , ,
Treasury stock (337.1) (3.3) (374.0) (7.6)
Total stockholders'
equity
Total liabilities and
stockholders' equity $10, $4,
*Percentages may be rounded up or down 48

21. Condensed Income Statement For the Years Ended December 31
PowerPoint Slides
KELLOGG COMPANY, INC.
Condensed Income Statement
For the Years Ended December 31
(In millions)
Amount Percent* Amount Percent*
Net sales $8, $6,
Cost of goods sold 4, ,
Gross profit , ,
Selling & admin , ,
Nonrecurring chgs
Income operations 1,
Interest expense Other income
(expense),net (12.3) (0.1)
Income before
income taxes
Income tax ex
Net income $ $
*Percentages may be rounded up or down 51

22. Condensed Income Statements For the Year Ended December 31, 2001 (in millions)
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Kellogg Company, Inc. General Mills,Inc
Amount Percent* Amount Percent*
Net sales $8, $7,
Cost of goods sold , ,
Gross profit , ,
Selling and administrative
expenses , ,
Nonrecurring charges
Income from operations , ,
Other expenses and
revenues (including
income taxes)
Net income $ $
*Percentages may be rounded up or down 55

23. PowerPoint Slides
Ratio Analysis 57

24. PowerPoint Slides
Ratios
Three types:
Liquidity ratios
Solvency ratios
Profitability ratios
Can provide clues to underlying conditions that may not be apparent from an inspection of the individual components.
Single ratio by itself is not very meaningful. 57

25. Liquidity Ratios WHO CARES?
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Liquidity Ratios
Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.
WHO CARES?
Short-term creditors such as bankers and suppliers 60

26. Liquidity Ratios Working capital Current ratio
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Liquidity Ratios
Working capital
Current ratio
Current cash debt coverage ratio
Inventory turnover ratio
Days in inventory
Receivables turnover ratio
Average collection period 61

27. Working Capital Indicates immediate short-term debt-paying ability
Current Assets - Current Liabilities 32

28. Current Ratio Indicates short-term debt-paying ability Current Assets
Current Liabilities 32

29. Current Cash Debt Coverage Ratio
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Indicates short-term debt-paying ability (cash basis)
Cash provided by operations Average current liabilities 92

30. Inventory Turnover Ratio
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Inventory Turnover Ratio
Indicates liquidity of inventory
Cost of Goods Sold
Average Inventory 73

31. Inventory Turnover Ratio
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Days in Inventory
Indicates liquidity of inventory and inventory management
365 days
Inventory Turnover Ratio 35

32. Receivables Turnover Ratio
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Indicates liquidity of receivables
Net Credit Sales
Average Gross Receivables 28

33. Average Collection Period
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Indicates liquidity of receivables and collection success.
365 days
Receivables Turnover Ratio 28

34. Solvency Ratios WHO CARES?
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Solvency Ratios
Measure the ability of the enterprise to survive over a long period of time
WHO CARES?
Long-term creditors and stockholders 60

35. Solvency Ratios Debt to total assets ratio Cash debt coverage ratio
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Solvency Ratios
Debt to total assets ratio
Cash debt coverage ratio
Times interest earned ratio
Free cash flow 61

36. Debt to Total Assets Ratio
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Debt to Total Assets Ratio
Indicates % of total assets provided by creditors
Total Liabilities
Total Assets 79

37. Cash Debt Coverage Ratio
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Indicates long-term debt-paying ability (cash basis)
Cash provided by operations
Average total liabilities 92

38. Times Interest Earned Ratio
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Times Interest Earned Ratio
Indicates company’s ability to meet interest payments as they come due
Net Income Before Interest
Expense & Income Tax
Interest Expense 79

39. Free Cash Flow - Capital Expenditures - Dividends Paid Free Cash Flow
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Free Cash Flow
Indicates cash available for paying dividends or expanding operations
Cash Provided By Operations
Capital Expenditures
Dividends Paid
Free Cash Flow 81

40. PowerPoint Slides
Profitability Ratios
Measure the income or operating success of an enterprise for a given period of time
WHO CARES? Everybody
WHY? A company’s income affects:
its ability to obtain debt and equity financing
its liquidity position
its ability to grow 60

41. Profitability Ratios Earnings per share (EPS) Price-earnings ratio
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Profitability Ratios
Earnings per share (EPS)
Price-earnings ratio
Gross profit rate
Profit margin ratio
Return on assets ratio
Assets turnover ratio
Payout ratio
Return on common stockholders’ equity ratio 61

42. Earnings Per Share (EPS)
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Earnings Per Share (EPS)
Indicates net income earned on each share of common stock sales
Net Income - Preferred Stock
Average common shares outstanding
101

43. Price Earnings Ratio Stock Price Per Share Earnings Per Share
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Price Earnings Ratio
Indicates relationship between market price per share and earnings per share
Stock Price Per Share
Earnings Per Share
101

44. Gross Profit Rate Gross profit Net sales
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Gross Profit Rate
Indicates margin between selling price and cost of good sold
Gross profit
Net sales 45

45. Profit Margin Ratio Net income Net sales
Indicates net income generated by each dollar of sales
Net income
Net sales
Higher value suggests favorable return on each dollar of sales. 19

46. Return On Assets Ratio Net income Average total assets
Reveals the amount of net income generated by each dollar invested
Net income
Average total assets
Higher value suggests favorable efficiency. 18

47. Asset Turnover Ratio Net sales Average total assets
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Asset Turnover Ratio
Indicates how efficiently assets are used to generate sales
Net sales
Average total assets 45

48. Cash dividends decl. on common stock
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Payout Ratio
Indicates % of earnings distributed in the form of cash dividends
Cash dividends decl. on common stock
Net income
101

49. Return on Common Stockholders’ Equity Ratio
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Return on Common Stockholders’ Equity Ratio
Indicates profitability of common stockholders’ investment
Net income - preferred stock dividends
Average common stockholders’ equity 93

50. Limitations Of Financial Analysis
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Limitations Of Financial Analysis
Horizontal, vertical, and ratio analysis are frequently used in making significant business decisions.
One should be aware of the limitations of these tools and the financial statements.
107

51. Alternative Accounting Methods
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One company may use the FIFO method, while another company in the same industry may use LIFO.
If the inventory is significant for both companies, it is unlikely that their current ratios are comparable.
In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization.
110

52. PowerPoint Slides
Quality of Earnings
Indicates the level of full and transparent information that is provided to users of the financial statements.
111

53. PowerPoint Slides
Pro Forma Income
A measure of the net income generated that usually excludes items that the company thinks are unusual or nonrecurring.
112

54. Relationships among Profitability Measures

55. Let’s Review
In vertical analysis, the base amount for depreciation expense is generally:
a. net sales.
b. depreciation expense in a previous year.
c. gross profit.
d. fixed assets.

56. Let’s Review
In vertical analysis, the base amount for depreciation expense is generally:
a. net sales.
b. depreciation expense in a previous year.
c. gross profit.
d. fixed assets.

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