17-1

ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
 17-2

Financial Statement Analysis

l Non-accounting majors, especially,
should relate well to this chapter
It looks at accounting information from
users’ perspective
l Relates very closely to topics you
will study in your finance course
Therefore, we will use a somewhat
broader brush on this chapter
l What is financial statement
analysis?
”Tearing apart” the financial statements
and looking at the relationships
 17-3

Financial Statement Analysis

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

Financial Statement Analysis

l What do internal users use it for?
Planning, evaluating and controlling
company operations
l 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
 17-5

Financial Statement Analysis

Information is available from 627 628

u Published annual reports

(1) Financial statements
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditor’s report (Independent accountants)
(5) Management’s discussion and analysis
u Reports filed with the government
e.g., Form 10-K, Form 10-Q and Form 8-K
 17-6

Financial Statement Analysis

Information is available from 627 628

u Other sources
(1) Newspapers (e.g., Wall Street Journal )
(2) Periodicals (e.g. Forbes, Fortune)
(3) Financial information organizations such
as: Moody’s, Standard & Poor’s, Dun &
Bradstreet, Inc., and Robert Morris
Associates
(4) Other business publications
 17-7

Methods of
Financial Statement Analysis
l Horizontal Analysis
l Vertical Analysis
l Common-Size Statements
l Trend Percentages
l Ratio Analysis
 17-8

Horizontal Analysis

Using comparative financial

statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
 17-9

Vertical Analysis
For a single financial
statement, each item
is expressed as a
percentage of a
significant total,
e.g., all income
statement items are
expressed as a
percentage of sales
 17-10

Common-Size Statements
Financial statements that show
only percentages and no
absolute dollar amounts
 17-11

Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)
 17-12

Ratio Analysis
Expression of logical relationships
between items in a financial
statement of a single period
(e.g., percentage relationship
between revenue and net 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
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Incre
1999 1998 Amo
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
 17-15

Horizontal Analysis Example

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure
 17-16

Horizontal Analysis Example

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure 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

Horizontal Analysis Example

Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
 17-18

Horizontal Analysis Example

CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
$12,000 – $23,500 = $(11,500)
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
 17-19

Horizontal Analysis Example

CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
($11,500 ÷ $23,500) × 100% = 48.9%
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
 17-20

Horizontal Analysis Example

CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
 17-21

Horizontal Analysis Example

Let’s 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
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
 17-23

Horizontal Analysis Example

Now, let’s 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
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense
Sales increased by 6,400 7,000net
8.3% while (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
income decreased by 21.9%.
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
 17-26

There were increases in both cost of goods

sold (14.3%) and operating expenses (2.1%).
These increased costs
CLOVERmore than offset the
CORPORATION
increase inComparative
sales, yielding anStatements
Income overall
Fordecrease
the Years Ended
in netDecember
income. 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)
 17-27

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

Vertical Analysis Example

Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
 17-29

Vertical Analysis Example

Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
$82,000 ÷ $483,000 = 17% rounded
Land 101,000 90,000 21% 23%
Equipment
$30,000110,000
÷ $387,000 100,000
= 8% rounded
23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
 17-30

Vertical Analysis Example

Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Acts. Payable $ 76,000 $ 60,000 16% 16%
Wages Payable 33,000 17,000 7% 4%
Notes Payable 50,000
$76,000 ÷ $483,000 = 50,000 10%
16% rounded 13%
Common Stock 170,000 160,000 35% 41%
Retained Earnings 154,000 100,000 32% 26%
Total $ 483,000 $ 387,000 100% 100%
 17-31

Trend Percentages Example

Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119
 17-32

Trend Percentages Example

Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119

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

 17-33

Trend Percentages Example

Using 1995 as the base year, we develop
the following percentage relationships.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%

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

$171 ÷ $1,820 = 9% rounded
 17-34

140
Trend line
130 for Sales
% of 100 Base

120

110

100

90
1995 1996 1997 1998 1999
Sales
Years
Expenses
 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
l Liquidity Ratios
Indicate a company’s short-term
debt-paying ability
l Equity (Long-Term Solvency) Ratios
Show relationship between debt and
equity financing in a company
l Profitability Tests
Relate income to other variables
l 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
u Cash flow liquidity ratio

Accounts receivable turnover

Number of days’ sales in accounts
receivable
Inventory turnover 651

u Total assets turnover

 17-38

10 Ratios You Must Know

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

10 Ratios You Must Know

Profitability Tests
u Return on operating assets
Net income to net sales (return on
sales or “profit margin”) $
Return on average common
stockholders’ equity (ROE)
u Cash flow margin

Earnings per share

u Times interest earned

u Times preferred dividends earned

 17-40

10 Ratios You Must Know

Market Tests
u Earnings yield on common stock
Price-earnings ratio
u Payout ratio on common stock

u Dividend yield on common stock

u Dividend yield on preferred stock

u Cash flow per share of common

stock
 17-41

Now, let’s look at

Norton
Corporation’s 1999
and 1998 financial
statements.
 17-42
NORTON CORPORATION
Balance Sheets
December 31, 1999 and 1998
1999 1998
Assets
Current assets:
Cash $ 30,000 $ 20,000
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets $ 346,390 $ 300,000
 17-43
NORTON CORPORATION
Balance Sheets
December 31, 1999 and 1998
1999 1998
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 39,000 $ 40,000
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities:
Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Stockholders' equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000
Total liabilities and stockholders' equity $ 346,390 $ 300,000
 17-44

NORTON CORPORATION
Income Statements
For the Years Ended December 31, 1999 and 1998
1999 1998
Net sales $ 494,000 $ 450,000
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000
Net income before taxes 76,700 66,000
Less income taxes (30%) 23,010 19,800
Net income $ 53,690 $ 46,200
 17-45

Now, let’s calculate

the 10 ratios based
on Norton’s financial
statements.
 17-46
NORTON CORPORATION
1999
Cash $ 30,000
Accounts receivable, net
We will Beginning of year 17,000
use this End of year 20,000
information Inventory
to calculate Beginning of year 10,000
the liquidity
End of year 12,000
ratios for
Total current assets 65,000
Norton.
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000
 17-47

Working Capital*
The excess of current assets over
current liabilities.
12/31/99
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
* While this is not a ratio, it does give an
indication of a company’s liquidity.
 17-48

Current (Working Capital) Ratio

#1
Current Current Assets
=
Ratio Current Liabilities

Current $65,000
= = 1.55 : 1
Ratio $42,000

Measures the ability

of the company to pay current
debts as they become due.
 17-49

Acid-Test (Quick) Ratio

#2
Acid-Test Quick Assets
=
Ratio Current Liabilities

Quick assets are Cash,

Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
 17-50

Acid-Test (Quick) Ratio

#2
Acid-Test Quick Assets
=
Ratio Current Liabilities

Norton Corporation’s quick

assets consist of cash of
$30,000 and accounts
receivable of $20,000.
 17-51

Acid-Test (Quick) Ratio

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

Accounts Receivable Turnover

Net, credit sales #3 Average, net accounts
receivable
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover
Accounts
$494,000
Receivable = = 26.70 times
($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
17-53

in Accounts Receivable
#4
Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables

Measures, on average, how many

days it takes to collect an
account receivable.
 Number of Days’ Sales
17-54

in Accounts Receivable
#4
Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables

In practice, would 45 days be a

desirable number of days in
receivables?
 17-55

Inventory Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2

Measures the number of times

inventory is sold and
replaced during the year.
 17-56

Inventory Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2

Would 5 be a
desirable number of times
for inventory to turnover?
 17-57

Equity, or Long–Term
Solvency Ratios
This is part of the information to
calculate the equity, or long-term
solvency ratios of Norton Corporation.
NORTON CORPORATION
1999
Net operating income $ 84,000
Net sales 494,000
Interest expense 7,300
Total stockholders' equity 234,390
 17-58
NORTON CORPORATION
1999
Common shares outstanding
Beginning of year 17,000
End of year 27,400
Net income $ 53,690
Here is the Stockholders' equity
rest of the
Beginning of year 180,000
information
we will End of year 234,390
use. Dividends per share 2
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
 17-59

Equity Ratio
#6
Equity Stockholders’ Equity
=
Ratio Total Assets

Equity $234,390
= = 67.7%
Ratio $346,390

Measures the proportion

of total assets provided by
stockholders.
 17-60

Net Income to Net Sales

A/K/A Return on Sales or Profit Margin
#7
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales

Measures the proportion of the sales dollar

which is retained as profit.
 17-61

Net Income to Net Sales

A/K/A Return on Sales or Profit Margin
#7
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales

Would a 1% return on sales be good?

 17-62

Return on Average Common

Stockholders’ Equity (ROE)
#8

Return on Net Income

Stockholders’ = Average Common
Equity Stockholders’ Equity

Return on
$53,690
Stockholders’ = = 25.9%
($180,000 + $234,390) ÷ 2
Equity
Important measure of the
income-producing ability
of a company.
 17-63

Earnings Per Share

#9
Earnings Available to Common Stockholders
Earnings
= Weighted-Average Number of Common
per Share
Shares Outstanding

Earnings $53,690
= = $2.42
per Share (17,000 + 27,400) ÷ 2

The financial press regularly publishes

actual and forecasted EPS amounts.
 17-64

Earnings Per Share

l What’s new from Chap. 15? 644
Weighted-average calculation
Earnings available to
common stockholders
EPS of common stock = _______________________
Weighted-average number of
common shares outstanding
l Three alternatives for calculating
weighted-average number of shares
 17-65

Earnings Per Share

l What’s new from Chap. 15? 645
Weighted-average calculation
Earnings available to
common stockholders
EPS of common stock = _______________________
Weighted-average number of
Alternate #1 common shares outstanding
 17-66

Earnings Per Share

645
Alternate #2

Alternate #3
 17-67

Price-Earnings Ratio
P/E Multiple
#10

Price-Earnings Market Price Per Share

=
Ratio EPS
Price-Earnings $20.00
= = 8.3 : 1
Ratio $ 2.42

Provides some measure of whether the

stock is under or overpriced.
 17-68

Important Considerations
l Need for comparable data
u Data is provided by Dun &
Bradstreet, Standard & Poor’s etc.
u Must compare by industry

u Is EPS comparable?

l Influence of external factors

u General business conditions
u Seasonal nature of business operations

l Impact of inflation
 17-69

No more ratios, please!