1. Accounting Principles, Ninth Edition
Chapter 18
Financial Statement
Analysis
Accounting Principles, Ninth Edition

2. Financial Statement Analysis
Basics of Financial Statement Analysis
Horizontal and Vertical Analysis
Ratio Analysis
Earning Power and Irregular Items
Quality of Earnings
Need for comparative analysis
Tools of analysis
Balance sheet
Income statement
Retained earnings statement
Liquidity
Profitability
Solvency
Summary
Discontinued operations
Extraordinary items
Changes in accounting principle
Comprehensive income
Alternative accounting methods
Pro forma income
Improper recognition
Service Cost - Actuaries compute service cost as the present value of the new benefits earned by employees during the year. Future salary levels considered in calculation.
Interest on Liability - Interest accrues each year on the PBO just as it does on any discounted debt.
Actual Return on Plan Assets - Increase in pension funds from interest, dividends, and realized and unrealized changes in the fair market value of the plan assets.
Amortization of Unrecognized Prior Service Cost - The cost of providing retroactive benefits is allocated to pension expense in the future, specifically to the remaining service-years of the affected employees.
Gain or Loss - Volatility in pension expense can be caused by sudden and large changes in the market value of plan assets and by changes in the projected benefit obligation. Two items comprise the gain or loss:
difference between the actual return and the expected return on plan assets and,
amortization of the unrecognized net gain or loss from previous periods

3. Basics of Financial Statement Analysis
Analyzing financial statements involves:
Characteristics
Comparison
Bases
Tools of
Analysis
Liquidity
Profitability
Solvency
Intracompany
Industry averages
Intercompany
Horizontal
Vertical
Ratio
SO 1 Discuss the need for comparative analysis.
SO 2 Identify the tools of financial statement analysis.

4. Horizontal Analysis
Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time.
Its purpose is to determine the increase or decrease that has taken place.
Horizontal analysis is commonly applied to the balance sheet, income statement, and statement of retained earnings.
SO 3 Explain and apply horizontal analysis.

5. Horizontal Analysis
Illustration 18-5
Horizontal analysis of
balance sheets
These changes suggest that the company expanded its asset base during 2007 and financed this expansion primarily by retaining income rather than assuming additional long-term debt.
SO 3 Explain and apply horizontal analysis.

6. Horizontal Analysis
Illustration 18-6
Horizontal analysis of
Income statements
Overall, gross profit and net income were up substantially. Gross profit increased
17.1%, and net income, 26.5%. Quality’s profit trend appears favorable.
SO 3 Explain and apply horizontal analysis.

7. Horizontal Analysis
Illustration 18-7
Horizontal analysis of
retained earnings statements
We saw in the horizontal analysis of the balance sheet that ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities.
SO 3 Explain and apply horizontal analysis.

8. Vertical Analysis
Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount.
On an income statement, we might say that selling expenses are 16% of net sales.
Vertical analysis is commonly applied to the balance sheet and the income statement.
SO 4 Describe and apply vertical analysis.

9. Vertical Analysis
Illustration 18-8
Vertical analysis of
balance sheets
These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt.
SO 4 Describe and apply vertical analysis.

10. Vertical Analysis Quality appears
Illustration 18-9
Vertical analysis of
Income statements
Quality appears
to be a profitable enterprise that is becoming even more successful.
SO 4 Describe and apply vertical analysis.

11. Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 18-10
Intercompany income statement comparison
J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C. Penney’s net income as a percent of each sales dollar (5.6%) is only 4% of Quality’s (12.6%).
SO 4 Describe and apply vertical analysis.

12. Financial Ratio Classifications
Ratio Analysis
Ratio analysis expresses the relationship among selected items of financial statement data.
Financial Ratio Classifications
Liquidity
Profitability
Solvency
Measures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Measures the income or operating success of a company for a given period of time.
Measures the ability of the company to survive over a long period of time.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

13. Ratio Analysis A single ratio by itself is not very meaningful.
The discussion of ratios will include the following types of comparisons.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

14. Ratio Analysis Liquidity Ratios
Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.
Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.
Ratios include the current ratio, the acid-test ratio, receivables turnover, and inventory turnover.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

15. Ratio Analysis Liquidity Ratios Compute the Current Ratio for 2007.
Current Assets
= Current Ratio
Current Liabilities
$1,020,000
= : 1
$344,500
The ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

16. Ratio Analysis Liquidity Ratios Compute the Acid-Test Ratio for 2007.
Illustration 18-13
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

17. Ratio Analysis Liquidity Ratios Compute the Acid-Test Ratio for 2007.
Cash + Short-Term Investments + Receivables (Net)
Acid-Test Ratio =
Current Liabilities
$100,000 + $20,000 + $230,000
= : 1 $
The acid-test ratio measures immediate liquidity.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

18. Average Net Receivables
Liquidity Ratios
Ratio Analysis
Compute the Receivables Turnover ratio for 2007.
Net Credit Sales
Receivables Turnover =
Average Net Receivables
$2,097,000
= times
($180,000 + $230,000) / 2
It measures the number of times, on average, the company collects receivables during the period.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

19. 365 days / 10.2 times = every 35.78 days
Liquidity Ratios
Ratio Analysis
Receivables Turnover
$2,097,000
= times
($180,000 + $230,000) / 2
A variant of the receivables turnover ratio is to convert it to an average collection period in terms of days.
365 days / 10.2 times = every days
This means that receivables are collected on average every 36 days.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

20. Ratio Analysis Liquidity Ratios
Compute the Inventory Turnover ratio for 2007.
Cost of Good Sold
Inventory Turnover =
Average Inventory
$1,281,000
= times
($500,000 + $620,000) / 2
Inventory turnover measures the number of times, on average, the inventory is sold during the period.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

21. 365 days / 2.3 times = every 159 days
Liquidity Ratios
Ratio Analysis
Inventory Turnover
$1,281,000
= 2.3 times
($500,000 + $620,000) / 2
A variant of inventory turnover is the days in inventory.
365 days / 2.3 times = every 159 days
Inventory turnover ratios vary considerably among industries.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

22. Ratio Analysis Profitability Ratios
Measure the income or operating success of a company for a given period of time.
Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow.
Ratios include the profit margin, asset turnover, return on assets, return on common stockholders’ equity, earnings per share, price-earnings, and payout ratio.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

23. Ratio Analysis Profitability Ratios
Compute the Profit Margin ratio for 2007.
Net Income
Profit Margin =
Net Sales
$263,800
= 12.6%
$2,097,000
Measures the percentage of each dollar of sales that results in net income.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

24. Ratio Analysis Profitability Ratios
Compute the Asset Turnover ratio for 2007.
Net Sales
Asset Turnover =
Average Assets
$2,097,000
= times
($1,95,000 + $1,835,000) / 2
Measures how efficiently a company uses its assets to generate sales.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

25. Ratio Analysis Profitability Ratios
Compute the Return on Assets ratio for 2007.
Net Income
Return on Assets =
Average Assets
$263,800
= 15.4%
($1,595,000 + $1,835,000) / 2
An overall measure of profitability.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

26. Return on Common Stockholders’ Equity
Profitability Ratios
Ratio Analysis
Compute the Return on Common Stockholders’ Equity ratio for 2007.
Return on Common Stockholders’ Equity
Net Income – Preferred Dividends =
Average Common Stockholders’ Equity
$263,000 - $0
= 29.3%
($795,000 + $1,003,000) / 2
Shows how many dollars of net income the company earned for each dollar invested by the owners.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

27. Weighted Average Common Shares Outstanding
Profitability Ratios
Ratio Analysis
Compute the Earnings Per Share for 2007.
Net Income
Earnings Per Share =
Weighted Average Common Shares Outstanding
$263,800
= $0.97 per share
270, ,400 / 2
A measure of the net income earned on each share of common stock.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

28. Market Price per Share of Stock
Profitability Ratios
Ratio Analysis
Compute the Price Earnings Ratio for 2007.
Price Earnings Ratio
Market Price per Share of Stock =
Earnings Per Share
$12.00
= times
$0.97
The price-earnings (PE) ratio reflects investors’ assessments of a company’s future earnings.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

29. Ratio Analysis Profitability Ratios Compute the Payout Ratio for 2007.
Cash Dividends
Payout Ratio =
Net Income *
$61,200
= 23.2%
$263,800
Measures the percentage of earnings distributed in the form of cash dividends.
* From analysis of retained earnings.
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.