Financial Statement Analysis Insights

17-1
FAR740@MACC UiTM
ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
17-2
Financial Statement Analysis
Non-accounting majors, especially,

should relate well to this chapter
It looks at accounting information from
users perspective
Relates very closely to topics you will

study in your finance course
Therefore, we will use a somewhat broader
brush on this chapter
What is financial statement analysis?

Tearing apart the financial statements
and looking at the relationships
17-3

Who analyzes financial statements?
Internal users (i.e., management)
External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies &
stock market analysts and
auditors
625
17-4
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
First sentence in chapter says...
17-5

Information is available from
627 628
Published annual reports

(1)
Financial statements
(2)
Notes to financial statements
(3)
Letters to stockholders
(4)
Auditors report (Independent
accountants)
(5)
Managements discussion and analysis
Reports filed with the government

e.g., Form 10-K, Form 10-Q and Form 8-K
17-6

Information is available from
627 628
Other sources
(1)
Newspapers (e.g., Wall Street Journal )
(2)
Periodicals (e.g. Forbes, Fortune)
(3)
Financial information organizations
such
as:
Moodys, Standard & Poors, Dun &
Bradstreet, Inc., and Robert Morris
Associates
(4)
Other business publications
Methods of
Horizontal
Vertical
Analysis
Analysis
Common-Size
Trend
Ratio
Statements
Percentages
Analysis
17-7
17-8
Horizontal Analysis
Using
Using comparative
comparative financial
financial
statements
statements to
to calculate
calculate dollar
dollar
or
or percentage
percentage changes
changes in
in aa
financial
financial statement
statement item
item from
from
one
one period
period to
to the
the next
next
17-9
Vertical Analysis
For
For aa single
single financial
financial
statement,
statement, each
each item
item
is
is expressed
expressed as
as aa
percentage
percentage of
of aa
significant
significant total,
total,
e.g.,
e.g., all
all income
income
statement
statement items
items are
are
expressed
expressed as
as aa
percentage
percentage of
of sales
sales
17-10
Common-Size Statements
Financial
Financial statements
statements that
that show
show
only
only percentages
percentages and
and no
no
absolute
absolute dollar
dollar amounts
amounts
17-11
Trend Percentages
Show
Show changes
changes over
over time
time in
in
given
given financial
financial statement
statement items
items
(can
(can help
help evaluate
evaluate financial
financial
information
information of
of several
several years)
years)
17-12
Ratio Analysis
Expression
Expression of
of logical
logical relationships
relationships
between
between items
items in
in aa financial
financial
statement
statement of
of aa single
single period
period
(e.g.,
(e.g., percentage
percentage relationship
relationship
between
between revenue
revenue and
and net
net income)
income)
17-13
Horizontal Analysis Example

The management of Clover Company
provides you with comparative balance
sheets of the years ended December 31,
1999 and 1998. Management asks you to
prepare a horizontal analysis on the
information.
17-14
17-15

Calculating Change in Dollar Amounts
Dollar
Change
Current Year
Figure
Base Year
Figure
17-16

Calculating Change in Dollar Amounts
Dollar
Change
Current Year
Figure
Base Year
Figure
Since we are measuring the amount of

the change between 1998 and 1999, the
dollar amounts for 1998 become the
base year figures.
17-17

Calculating Change as a Percentage
Percentage
Change
Dollar Change
Base Year Figure
100%
17-18
$12,000 $23,500 = $(11,500)
17-19
($11,500 $23,500) 100% = 48.9%
17-20
17-21

Lets apply the same
procedures to the
liability and stockholders
equity sections of the
balance sheet.
17-22
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
1999
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities:
Bonds payable, 8%
Total liabilities
Stockholders' equity:
Preferred stock
Common stock
Additional paid-in capital
Total paid-in capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
67,000 $
3,000
70,000
1998
Increase (Decrease)
Amount
%
44,000 $
6,000
50,000
23,000
(3,000)
20,000
52.3
(50.0)
40.0
75,000
145,000
80,000
130,000
(5,000)
15,000
(6.3)
11.5
20,000
60,000
10,000
90,000
80,000
170,000
315,000 $
20,000
60,000
10,000
90,000
69,700
159,700
289,700 $
10,300
10,300
25,300
0.0
0.0
0.0
0.0
14.8
6.4
8.7
17-23

Now, lets apply the
procedures to the
income statement.
17-24
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
Net operating income
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Net income before taxes
25,000
32,000
(7,000)
(21.9)
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)
17-25
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Sales increased by
8.3% while
net
25,000
32,000
(7,000)
(21.9)
income decreased
by 21.9%.
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)
17-26
There were increases in both cost of goods

sold (14.3%) and operating expenses (2.1%).
These increased costs
more
than offset the
CLOVER
CORPORATION
Income
increase inComparative
sales, yielding
anStatements
overall
Fordecrease
the Years Ended
in netDecember
income. 31, 1999 and 1998
Net sales
Cost of goods sold
Gross margin
Operating expenses
Interest expense
Net income
1999
$ 520,000
360,000
160,000
128,600
31,400
6,400
25,000
7,500
$ 17,500
1998
$ 480,000
315,000
165,000
126,000
39,000
7,000
32,000
9,600
$ 22,400
Increase (Decrease)
Amount
%
$ 40,000
8.3
45,000
14.3
(5,000)
(3.0)
2,600
2.1
(7,600)
(19.5)
(600)
(8.6)
(7,000)
(21.9)
(2,100)
(21.9)
$
(4,900)
(21.9)
17-27
Vertical Analysis Example

The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.
17-28
17-29
$82,000 $483,000 = 17% rounded

$30,000 $387,000 = 8% rounded
17-30
$76,000 $483,000 = 16% rounded
17-31
Trend Percentages Example

Wheeler, Inc. provides you with the following
operating data and asks that you prepare a
trend analysis.
17-32

Wheeler, Inc. provides you with the following
operating data and asks that you prepare a
trend analysis.
$1,991 - $1,820 = $171
17-33

Using 1995 as the base year, we develop the
following percentage relationships.
$1,991 $171 $1,820
$1,820 = $171
= 9% rounded
17-34
Trend line
for Sales
17-35
Ratios
Ratios can be expressed in three 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 be
hazardous to your health!
lead to incorrect conclusions.
17-36
Categories of Ratios
Liquidity Ratios
Indicate a companys short-term
debt-paying ability
Equity (Long-Term Solvency) Ratios

Show relationship between debt and equity
financing in a company
Profitability Tests
Relate income to other variables
Market Tests
Help assess relative merits of stocks in the
marketplace
17-37
10 Ratios You Must Know

Liquidity Ratios
Current (working capital) ratio
Acid-test (quick) ratio
Cash flow liquidity ratio
Accounts receivable turnover
Number of days sales in accounts
receivable
Inventory turnover
Total assets turnover
651
17-38

Equity (Long-Term Solvency) Ratios
Equity (stockholders equity) ratio
Equity to debt
17-39

Profitability Tests
Return on operating assets
Net income to net sales (return on
sales or profit margin)
margin
$
Return on average common
stockholders equity (ROE)
ROE
Cash flow margin
Earnings per share
Times interest earned
Times preferred dividends earned
17-40

Market Tests
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
17-41
Now, lets look at

Norton
Corporations 1999
and 1998 financial
statements.
17-42
17-43
17-44
17-45
Now, lets calculate

the 10 ratios based
on Nortons financial
statements.
NORTON CORPORATION
1999
Cash
$ 30,000
Accounts receivable, net
We will
use this
information
to calculate
the liquidity
ratios for
Norton.
Beginning of year
17,000
End of year
20,000
Inventory
Beginning of year
10,000
End of year
12,000
Total current assets
65,000
Total current liabilities
42,000
Sales on account
494,000
Cost of goods sold
140,000
17-46
17-47
Working Capital*
The excess of current assets over
current liabilities.
12/31/99
Current assets
Current liabilities
Working capital
65,000
(42,000)
23,000
* While this is not a ratio, it does give an

indication of a companys liquidity.
17-48
Current (Working Capital) Ratio

#1
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.
17-49
Acid-Test (Quick) Ratio

#2
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
17-50

#2
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
Norton Corporations quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.
17-51

#2
Acid-Test
=
Ratio
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
$50,000
$42,000
= 1.19 : 1
17-52
Accounts Receivable Turnover

Net, credit sales
Accounts
Receivable =
Turnover
#3
Average, net accounts

receivable
Sales on Account
Average Accounts Receivable
Accounts
$494,000
= 26.70 times
Receivable =
($17,000 + $20,000) 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.
Number of Days Sales

in Accounts Receivable
#4
Days Sales
in Accounts =
Receivables
Days Sales
in Accounts =
Receivables
365 Days
365 Days
26.70 Times
= 13.67 days
Measures, on average, how many

days it takes to collect an
account receivable.
17-53
Number of Days Sales

in Accounts Receivable
#4
Days Sales
in Accounts =
Receivables
Days Sales
in Accounts =
Receivables
365 Days
365 Days
26.70 Times
= 13.67 days
In practice, would 45 days be a

desirable number of days in
receivables?
17-54
17-55
Inventory Turnover
#5
Inventory
Turnover
Inventory
Turnover
Cost of Goods Sold

Average Inventory
$140,000
=
= 12.73 times
($10,000 + $12,000) 2
Measures the number of times

inventory is sold and
replaced during the year.
17-56
Inventory Turnover
#5
Inventory
Turnover
Inventory
Turnover
Cost of Goods Sold

Average Inventory
$140,000
=
= 12.73 times
($10,000 + $12,000) 2
Would 5 be a
desirable number of times
for inventory to turnover?
Equity, or LongTerm
Solvency Ratios
This is part of the information to
calculate the equity, or long-term
solvency ratios of Norton Corporation.
NORTON CORPORATION
1999
Net sales
Interest expense
Total stockholders' equity
$ 84,000
494,000
7,300
234,390
17-57
17-58
NORTON CORPORATION
1999
Common shares outstanding
Beginning of year
End of year
Net income
Here is the
rest of the
information
we will
use.
17,000
27,400
$ 53,690
Stockholders' equity
Beginning of year
180,000
End of year
234,390
Dividends per share

Dec. 31 market price/share
Interest expense
2
20
7,300
Total assets
Beginning of year
300,000
End of year
346,390
17-59
Equity Ratio
#6
Equity
=
Ratio
Equity
=
Ratio
Stockholders Equity
Total Assets
$234,390
$346,390
Measures the proportion

of total assets provided by
stockholders.
= 67.7%
Net Income to Net Sales
17-60
A/K/A Return on Sales or Profit Margin

#7
Net Income
to
=
Net Sales
Net Income
Net Sales
Net Income
to
=
Net Sales
$53,690
$494,000
= 10.9%
Measures the proportion of the sales dollar

which is retained as profit.
Net Income to Net Sales
17-61
A/K/A Return on Sales or Profit Margin

#7
Net Income
to
=
Net Sales
Net Income
Net Sales
Net Income
to
=
Net Sales
$53,690
$494,000
= 10.9%
Would a 1% return on sales be good?
Return on Average Common

Stockholders Equity (ROE)
17-62
#8
Return on
Stockholders =
Equity
Return on
Stockholders =
Equity
Net Income
Average Common
Stockholders Equity
$53,690
($180,000 + $234,390) 2
Important measure of the
income-producing ability
of a company.
= 25.9%
17-63
Earnings Per Share

#9
Earnings Available to Common Stockholders
Earnings
=
Weighted-Average Number of Common
per Share
Shares Outstanding
Earnings
$53,690
=
per Share
(17,000 + 27,400) 2
= $2.42
The financial press regularly publishes

actual and forecasted EPS amounts.
17-64
Earnings Per Share
Whats new from Chap. 15?
644
Weighted-average calculation
Earnings available to
EPS of common stock = _______________________
common stockholders
Weighted-average number of
common shares outstanding
Three alternatives for calculating

weighted-average number of shares
17-65
Earnings Per Share
Whats new from Chap. 15?
645
Weighted-average calculation
Earnings available to
EPS of common stock = _______________________
common stockholders
Weighted-average number of
common shares outstanding
Alternate #1
17-66
Earnings Per Share

645
Alternate #2
Alternate #3
17-67
Earnings Per Share

646
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
Primary EPS and Fully Diluted EPS

APB Opinion No. 15
I mentioned this 17-page pronouncement that
required a 100-page explanation in the lecture
for chapter 13.
Price-Earnings Ratio
A/K/A P/E Multiple
#10
Price-Earnings
=
Ratio
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.
17-68
17-69
Important Considerations
Need for comparable data

Data is provided by Dun &
Bradstreet, Standard & Poors etc.
Must compare by industry
Is EPS comparable?
Influence of external factors

General business conditions
Seasonal nature of business operations
Impact of inflation
17-70
Question
The
The current
current ratio
ratio is
is aa measure
measure of
of
liquidity
liquidity that
that is
is computed
computed by
by dividing
dividing
total
total assets
assets by
by total
total liabilities.
liabilities.
a.
a. True
True
b.
b. False
False
17-71
Question
The
The current
current ratio
ratio is
is aa measure
measure of
of
liquidity
liquidity that
that is
is computed
computed by
by dividing
dividing
total
total assets
assets by
by total
total liabilities.
liabilities.
a.
a. True
True
The
b.
The current
current ratio
ratio is
is aa measure
measure of
of
b. False
False
liquidity,
liquidity,but
but is
is computed
computed by
by
dividing
dividing current
current assets
assets by
by
current
current liabilities
liabilities
17-72
Question
a.
a.
b.
b.
Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash,
Marketable
Marketable Securities
Securities and
and net
net
receivables.
receivables.
True
True
False
False
17-73
Question
a.
a.
b.
b.
Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash,
Marketable
Marketable Securities
Securities and
and net
net
receivables.
receivables.
True
True
False
False
17-74
Thank You

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17-1

Financial Statement Analysis

Non-accounting majors, especially,

Relates very closely to topics you will

What is financial statement analysis?

Financial Statement Analysis

Financial Statement Analysis

What do internal users use it for?

What do external users use it for?

First sentence in chapter says...

Financial Statement Analysis

Published annual reports

Reports filed with the government

Financial Statement Analysis

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

Since we are measuring the amount of

Horizontal Analysis Example

Horizontal Analysis Example

$12,000 $23,500 = $(11,500)

Horizontal Analysis Example

($11,500 $23,500) 100% = 48.9%

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

There were increases in both cost of goods

Vertical Analysis Example

Vertical Analysis Example

Vertical Analysis Example

$82,000 $483,000 = 17% rounded

Vertical Analysis Example

$76,000 $483,000 = 16% rounded

Trend Percentages Example

Trend Percentages Example

$1,991 - $1,820 = $171

Trend Percentages Example

$1,991 $171 $1,820

Equity (Long-Term Solvency) Ratios

10 Ratios You Must Know

10 Ratios You Must Know

10 Ratios You Must Know

10 Ratios You Must Know

Now, lets look at

Now, lets calculate

Accounts receivable, net

Total current assets

Total current liabilities

Cost of goods sold

* While this is not a ratio, it does give an

Current (Working Capital) Ratio

Measures the ability

Acid-Test (Quick) Ratio

Acid-Test (Quick) Ratio

Acid-Test (Quick) Ratio

Accounts Receivable Turnover

Average, net accounts

Number of Days Sales

Measures, on average, how many

Number of Days Sales

In practice, would 45 days be a

Cost of Goods Sold