financial statement analysis
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Slide 14-1
Chapter 14
Financial Statement Financial Statement
AnalysisAnalysis
Financial Accounting, Seventh Edition
Slide 14-2
Balance Balance sheetsheet
Income Income statementstatement
Retained Retained earnings earnings statementstatement
Basics of Basics of Financial Financial Statement Statement AnalysisAnalysis
Basics of Basics of Financial Financial Statement Statement AnalysisAnalysis
Horizontal and Horizontal and Vertical Vertical AnalysisAnalysis
Horizontal and Horizontal and Vertical Vertical AnalysisAnalysis
Ratio AnalysisRatio AnalysisRatio AnalysisRatio AnalysisEarning Power Earning Power and Irregular and Irregular
ItemsItems
Earning Power Earning Power and Irregular and Irregular
ItemsItems
Quality of Quality of EarningsEarningsQuality of Quality of EarningsEarnings
Need for Need for comparative comparative analysisanalysis
Tools of Tools of analysisanalysis
LiquidityLiquidity
ProfitabilityProfitability
SolvencySolvency
SummarySummary
Discontinued Discontinued operationsoperations
Extraordinary Extraordinary itemsitems
Changes in Changes in accounting accounting principleprinciple
ComprehensiveComprehensive incomeincome
Alternative Alternative accounting accounting methodsmethods
Pro forma Pro forma incomeincome
Improper Improper recognitionrecognition
Financial Statement AnalysisFinancial Statement AnalysisFinancial Statement AnalysisFinancial Statement Analysis
Slide 14-3
Analyzing financial statements involves:
Basics of Financial Statement Basics of Financial Statement AnalysisAnalysisBasics of Financial Statement Basics of Financial Statement AnalysisAnalysis
CharacteristicsComparison
BasesTools 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.
Slide 14-4
SO 3 Explain and apply horizontal analysis.
Horizontal AnalysisHorizontal AnalysisHorizontal AnalysisHorizontal 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.
Slide 14-5
SO 3 Explain and apply horizontal analysis.
Horizontal AnalysisHorizontal AnalysisHorizontal AnalysisHorizontal Analysis
Illustration 14-5
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.
Balance Sheet
Slide 14-6
SO 3 Explain and apply horizontal analysis.
Horizontal AnalysisHorizontal AnalysisHorizontal AnalysisHorizontal Analysis
Illustration 14-5
Overall, gross profit and net income were up substantially. Gross profit increased17.1%, and net income, 26.5%. Quality’s profit trend appears favorable.
Income Statement
Illustration 14-6
Slide 14-7
SO 3 Explain and apply horizontal analysis.
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.
Horizontal AnalysisHorizontal AnalysisHorizontal AnalysisHorizontal Analysis
Retained Earnings Statement
Illustration 14-7
Slide 14-8
Illustration: Summary financial information for Rosepatch Company is as follows.
Compute the amount and percentage changes in 2011 using horizontal analysis, assuming 2010 is the base year.
Solution on notes page
Solution
SO 4 Describe and apply horizontal analysis.
Horizontal AnalysisHorizontal AnalysisHorizontal AnalysisHorizontal Analysis
2011
Slide 14-9
SO 4 Describe and apply vertical analysis.
Vertical AnalysisVertical AnalysisVertical AnalysisVertical 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.
Slide 14-10
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.
Vertical AnalysisVertical AnalysisVertical AnalysisVertical Analysis
Balance Sheet
Illustration 14-8
Slide 14-11
Quality appearsto be a profitable enterprise that is becoming even more successful.
SO 4 Describe and apply vertical analysis.
Vertical AnalysisVertical AnalysisVertical AnalysisVertical Analysis
Income Statement
Illustration 14-9
Slide 14-12
Enables a comparison of companies of different sizes.
Illustration 14-10Intercompany income statement comparison
SO 4 Describe and apply vertical analysis.
Vertical AnalysisVertical AnalysisVertical AnalysisVertical Analysis
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%).
Slide 14-13
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Ratio analysis expresses the relationship among selected items of financial statement data.
LiquidityLiquidity ProfitabilityProfitability SolvencySolvency
Measures short-term ability of
the company to pay its maturing obligations and
to meet unexpected
needs for cash.
Financial Ratio Classifications
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.
Slide 14-14
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
The discussion of ratios will include the following types of comparisons.
A single ratio by itself is not very meaningful.
Slide 14-15
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Liquidity RatiosLiquidity 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.
Slide 14-16
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio Analysis Ratio Analysis Ratio Analysis Ratio Analysis
Compute the Current Ratio for 2007.
The ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets.
Current Assets
Current Liabilities = Current Ratio
$1,020,000
$344,500 = 2.96 : 1
Liquidity RatiosLiquidity Ratios
Slide 14-17
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio Analysis Ratio Analysis Ratio Analysis Ratio Analysis
Compute the Acid-Test Ratio for 2007.
Liquidity RatiosLiquidity Ratios
Illustration 14-13
Slide 14-18
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Acid-Test Ratio for 2007.
The acid-test ratio measures immediate liquidity.
Cash + Short-Term Investments + Receivables (Net)
Current Liabilities
Acid-Test Ratio
$100,000 + $20,000 + $230,000
$344.500 = 1.02 : 1
=
Liquidity RatiosLiquidity Ratios
Slide 14-19
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Receivables Turnover ratio for 2007.
It measures the number of times, on average, the company collects receivables during the period.
$2,097,000
($180,000 + $230,000) / 2 = 10.2 times
Net Credit Sales
Average Net Receivables
Receivables Turnover=
Liquidity RatiosLiquidity Ratios
Slide 14-20
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
A variant of the receivables turnover ratio is to convert it to an average collection period in terms of days.
This means that receivables are collected on average every 36 days.
$2,097,000
($180,000 + $230,000) / 2= 10.2 times
Liquidity RatiosLiquidity Ratios
365 days / 10.2 times = every 35.78 days
Receivables Turnover
Slide 14-21
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Inventory Turnover ratio for 2007.
Inventory turnover measures the number of times, on average, the inventory is sold during the period.
$1,281,000
($500,000 + $620,000) / 2 = 2.31 times
Cost of Good Sold
Average Inventory
Inventory Turnover=
Liquidity RatiosLiquidity Ratios
Slide 14-22
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
A variant of inventory turnover is the days in inventory.
Inventory turnover ratios vary considerably among industries.
Liquidity RatiosLiquidity Ratios
365 days / 2.3 times = every 159 days
$1,281,000
($500,000 + $620,000) / 2 = 2.3 times
Inventory Turnover
Slide 14-23
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Profitability RatiosProfitability 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.
Slide 14-24
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Profit Margin ratio for 2007.
Measures the percentage of each dollar of sales that results in net income.
$263,800
$2,097,000 = 12.6%
Net Income
Net Sales
Profit Margin=
Profitability RatiosProfitability Ratios
Slide 14-25
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Asset Turnover ratio for 2007.
Measures how efficiently a company uses its assets to generate sales.
$2,097,000
($1,95,000 + $1,835,000) / 2 = 1.22 times
Net Sales
Average Assets
Asset Turnover=
Profitability RatiosProfitability Ratios
Slide 14-26
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Return on Assets ratio for 2007.
An overall measure of profitability.
$263,800
($1,595,000 + $1,835,000) / 2 = 15.4%
Net Income
Average Assets
Return on Assets=
Profitability RatiosProfitability Ratios
Slide 14-27
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Return on Common Stockholders’ Equity ratio for 2007.
Shows how many dollars of net income the company earned for each dollar invested by the owners.
$263,000 - $0
($795,000 + $1,003,000) / 2 = 29.3%
Net Income – Preferred Dividends
Average Common Stockholders’ Equity
Return on Common
Stockholders’ Equity
=
Profitability RatiosProfitability Ratios
Slide 14-28
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Earnings Per Share for 2007.
A measure of the net income earned on each share of common stock.
$263,800
270,000 + 275,400 / 2= $0.97 per share
Net Income
Weighted Average Common Shares Outstanding
Earnings Per Share=
Profitability RatiosProfitability Ratios
Slide 14-29
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Price Earnings Ratio for 2007.
The price-earnings (PE) ratio reflects investors’ assessments of a company’s future earnings.
$12.00
$0.97= 12.4 times
Market Price per Share of Stock
Earnings Per Share
Price Earnings
Ratio=
Profitability RatiosProfitability Ratios
Slide 14-30
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Payout Ratio for 2007.
Measures the percentage of earnings distributed in the form of cash dividends.
$61,200
$263,800= 23.2%
Cash Dividends
Net Income
Payout Ratio=
Profitability RatiosProfitability Ratios
*
* From analysis of retained earnings.
Slide 14-31
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Solvency RatiosSolvency Ratios
Solvency ratios measure the ability of a company to
survive over a long period of time.
Debt to total assets and times interest earned
are two ratios that provide information about debt-
paying ability.
Slide 14-32
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Debt to Total Assets Ratio for 2007.
Measures the percentage of the total assets that creditors provide.
$832,000
$1,835,000= 45.3%
Total Debt
Total Assets
Debt to Total
Assets Ratio
=
Solvency RatiosSolvency Ratios
Slide 14-33
SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.
Ratio AnalysisRatio AnalysisRatio AnalysisRatio Analysis
Compute the Times Interest Earned ratio for 2007.
Provides an indication of the company’s ability to meet interest payments as they come due.
$468,000
$36,000= 13 times
Income before Income Taxes and Interest Expense
Interest Expense
Times Interest Earned
=
Solvency RatiosSolvency Ratios
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