Lecture 12

FINANCIAL STATEMENT ANALYSIS

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LEARNING OBJECTIVES
1. Understand the importance of financial
analysis.
2. Apply horizontal and vertical analyses.
3. Explain the purpose and identify the building
blocks of analysis.
4. Apply ratio analysis.
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BASICS OF ANALYSIS

Application Involves
Reduces
of analytical transforming
uncertainty
tools data

Financial statement analysis helps users

make better decisions.

Internal Users External Users

Managers Shareholders
Officers Lenders
Internal Auditors Customers
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BUILDING BLOCKS OF ANALYSIS

Liquidity and
Solvency
efficiency

Market
Profitability
prospects
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INFORMATION FOR ANALYSIS

1. Statement of Profit or Loss and

Other Comprehensive Income
(including the Income Statement)
2. Statement of Financial Position
3. Statement of Changes in Equity
4. Statement of Cash Flows
5. Notes to the Financial Statements
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STANDARDS FOR COMPARISON

When we interpret our analysis, it is essential to
compare the results we obtained to other
standards or benchmarks.

Intracompany
Competitors
Industry
Guidelines
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TOOLS OF ANALYSIS
Horizontal Analysis
Comparing a company’s financial condition and
performance across time.

Vertical Analysis
Comparing a company’s financial condition and
performance to a base amount.

Ratio Analysis
Measurement of key relations between financial statement
items.
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HORIZONTAL ANALYSIS
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COMPARATIVE STATEMENTS
Calculate Change in Dollar Amount

Dollar Analysis Period Base Period

Change = Amount – Amount

When measuring the amount of the

change in dollar amounts, compare the
analysis period balance to the base
period balance. The analysis period is
usually the current year while the base
period is usually the prior year.
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COMPARATIVE STATEMENTS
Calculate Change as a Percent

Percent Dollar Change

Change
=
Base Period Amount × 100

When calculating the change as a

percentage, divide the amount of the
dollar change by the base period
amount, and then multiply by 100 to
convert to a percentage.
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HORIZONTAL ANALYSIS

1,683 – 1,587 = 96

96 ÷ 1,587 × 100 = 6.0%

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HORIZONTAL ANALYSIS

14,534 – 14,203 = 331

331 ÷ 14,203 × 100 = 2.3%

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TREND ANALYSIS

Trend analysis is used to reveal patterns in data

covering successive periods.

Trend Analysis Period Amount

Percent
=
Base Period Amount ×100
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TREND ANALYSIS
Adidas
Income Statement Information

Examples of 2014 Calculations for Net Sales:

2010 is base year. Set to 100%
2014: 14,534 ÷ 11,990 × 100 = 121.2%
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TREND ANALYSIS

We can use the trend percentages to construct a

graph so we can see the trend over time.
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VERTICAL ANALYSIS
Common-Size Statements

Common-size Analysis Amount

Percent
= Base Amount × 100

Financial Statement Base Amount

Statement of Financial Position Total Assets
Income Statement Revenues
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COMMON-SIZE
STATEMENT OF FINANCIAL POSITION

(1,683 ÷ 12,417) × 100 = 13.6%

(1,587 ÷ 11,599) × 100 = 13.7%

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COMMON-SIZE INCOME STATEMENT

(7,610 ÷ 14,534) × 100 = 52.4%

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RATIO ANALYSIS

Liquidity
and Solvency
efficiency

Market
Profitability
prospects
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LIQUIDITY AND EFFICIENCY

Current Days’ Sales

Ratio Uncollected

Acid-test Days’ Sales

Ratio in Inventory

Accounts Accounts Days’

Receivable Payable Purchases in
Turnover Turnover Accounts
Payable
Inventory Total Asset
Turnover Turnover
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WORKING CAPITAL
Working capital represents current assets
financed from long-term capital sources that
do not require near-term repayment.

Current assets
– Current liabilities
= Working capital

More working capital suggests a strong liquidity

position and an ability to meet current obligations.
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CURRENT RATIO
Current Assets
Current Ratio =
Current Liabilities

This ratio measures the short-term debt-

paying ability of the company. A higher current
ratio suggests a strong liquidity position.
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ACID-TEST RATIO

Cash + Short-term financial assets + Current

Acid-test ratio = receivables
Current Liabilities
Referred to as Quick Assets

This ratio is like the current ratio but excludes current assets
such as inventories and prepaid expenses that may be
difficult to quickly convert into cash.
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ACCOUNTS RECEIVABLE TURNOVER

Net sales
Accounts receivable =
Average accounts receivable,
turnover
net
(Beginning acct. rec. + Ending acct. rec.)
Average accounts receivable =
2

This ratio measures how

many times a company
converts its receivables
into cash each year.
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INVENTORY TURNOVER
Cost of goods sold
Inventory turnover =
Average inventory

Average inventory = (Beginning inventory + Ending inventory)

2

This ratio measures the

number of times
merchandise is sold and
replaced during the year.
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ACCOUNTS PAYABLE TURNOVER

Cost of goods sold
Accounts payable turnover =
Average accounts payable
(Beginning accounts payable +
Average accounts
Ending accounts payable)
payable =
2

A short-term liquidity
measure used to quantify
the rate at which a company
pays off its suppliers.
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DAYS’ SALES UNCOLLECTED

Day's sales = Accounts receivable, net

× 365
uncollected Net sales

Provides insight into how frequently a

company collects its accounts receivable.
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DAYS’ SALES IN INVENTORY

Day's sales in = Ending inventory

× 365
inventory Cost of goods sold

This ratio is a useful measure in evaluating

inventory liquidity. If a product is demanded
by customers, this formula estimates how
long it takes to sell the inventory.
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DAYS’ PURCHASES IN ACCOUNTS

PAYABLE

Days’ purchases in Accounts payable

× 365
accounts payable = Cost of goods sold

This ratio is a useful measure in evaluating

how long the business takes to pay its credit
suppliers.
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CASH CONVERSION CYCLE

The sum of the days’ sales uncollected and the

days’ sales in inventory subtracting the days’
purchases in accounts payable. It represents
the number of days a firm’s cash remains tied
up within the operations of the business.

The lower the cash conversion cycle, the more

healthy a company generally is.
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TOTAL ASSET TURNOVER

Net sales
Total asset turnover =
Average total assets

(Beginning assets + Ending assets)

Average assets =
2

This ratio reflects a

company’s ability to use
its assets to generate
sales. It is an important
indication of operating
efficiency.
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SOLVENCY
Debt
Ratio

Equity
Ratio

Debt-to-Equity
Ratio

Times
Interest
Earned
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DEBT AND EQUITY RATIOS

Amount Ratio
Total liabilities $ 8,000,000 66.7% [Debt ratio]
Total equity 4,000,000 33.3% [Equity ratio]
Total liabilities and equity $ 12,000,000 100.0%

$8,000,000 ÷ $12,000,000 = 66.7%

The debt ratio expresses total liabilities as a percent of

total assets. The equity ratio provides complementary
information by expressing total equity as a percent of total
assets.
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DEBT-TO-EQUITY RATIO

Total liabilities
Debt-to-equity ratio =
Total equity

This ratio measures what portion of a company’s

assets are contributed by creditors. A larger debt-to-
equity ratio implies less opportunity to expand
through use of debt financing.
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TIMES INTEREST EARNED

Profit before interest expense
Times interest earned = and income taxes
Interest expense

Net profit
+ Interest expense
+ Income taxes
= Profit before interest expense and taxes

This is the most common measure of the

ability of a company’s operations to provide
protection to long-term creditors.
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PROFITABILITY

Profit Return on
Margin Total Assets

Return on Ordinary Earnings

Shareholders’ Per Share
Equity
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PROFIT MARGIN

Net profit
Profit margin =
Net sales

This ratio describes a company’s ability

to earn net profit from each sales dollar.
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RETURN ON TOTAL ASSETS

Net profit
Return on total asset =
Average total assets

Return on total assets measures how well

assets have been employed by the
company’s management.
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RETURN ON ORDINARY SHAREHOLDERS'

EQUITY

Return on ordinary shareholders' Net profit - Preference dividends

equity = Average ordinary shareholders'
equity

This measure indicates how well the

company employed the shareholders’ equity
to earn net profit.
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EARNINGS PER SHARE (EPS)

 Earnings per Ordinary Share (EPS)

– Shows the amount of net income earned for each
outstanding ordinary share
– Most widely used ratio
– Net income available divided by the weighted-
average number of ordinary shares outstanding
during the year.
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MARKET PROSPECTS

Price-Earnings Dividend
Ratio Yield
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PRICE-EARNINGS RATIO
Market price per ordinary share
Price-earnings ratio =
Earnings per share

This measure is often used by investors as a

general guideline in gauging share values.
Generally, the higher the price-earnings ratio,
the more opportunity a company has for growth.
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DIVIDEND YIELD
Annual cash dividends per share
Dividend yield =
Market price per share

This ratio identifies the return, in terms of cash

dividends, on the current market price per share
of the company’s ordinary shares.
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FACTORS CONTRIBUTING TO GOING-CONCERN

PROBLEMS

Factors that commonly contribute to

going-concern problems are listed below.
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SUPPLEMENTARY EXAMPLES
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Example1: Preparing and Interpreting a Schedule for

Horizontal and Vertical Analyses
The average price of a gallon of gas in 2013 dropped $0.12 (3 percent) from $3.61
in 2012 (to $3.49 in 2013). Let’s see whether these changes are reflected in the
income statement of Chevron Corporation for the year ended December 31, 2013
(amounts in billions).

Required:
1. Conduct a horizontal analysis by calculating the year-over-year changes in each
line item, expressed in dollars and in percentages (rounded to one decimal place).
How did the change in gas prices compare to the changes in Chevron Corp.’s total
revenues and costs of crude oil and products?
2. Conduct a vertical analysis by expressing each line as a percentage of total
revenues (round to one decimal place). Excluding income tax and other operating
costs, did Chevron earn more profit per dollar of revenue in 2013 compared to
2012?
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Example 2: Analyzing the Impact of Selected Transactions

on the Current Ratio
The Sports Authority, Inc., is a private full-line sporting goods
retailer. Assume one of the Sports Authority stores reported
current assets of $88,000 and its current ratio was 1.75, and then
completed the following transactions:
1) paid $6,000 on accounts payable,
2) purchased a delivery truck for $10,000 cash,
3) wrote off a bad account receivable for $2,000, and
4) paid previously declared dividends in the amount of $25,000.

Required:
Compute the updated current ratio rounded to two decimal places,
after each transaction.
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Example 3: Inferring Financial Information from

Profitability and Liquidity Ratios
Dollar General Corporation operates approximately 9,400 general
merchandise stores that feature quality merchandise at low prices to
meet the needs of middle-, low-, and fixed-income families in southern,
eastern, and mid-western states. For the year ended January 31, 2014,
the company reported average inventories of $2,475 (in millions) and an
inventory turnover of 4.89. Average total fixed assets were $2,080
(million), and the fixed asset turnover ratio was 8.14.
Required:
1. Calculate Dollar General’s gross profit percentage (expressed as a
percentage with one decimal place). What does this imply about the
amount of gross profit made from each dollar of sales? TIP: Work
backward from the fixed asset turnover and inventory turnover ratios
to compute the amounts needed for the gross profit percentage.
2. Is this an improvement from the gross profit percentage of 31.7
percent earned during the previous year?