Analysis of Financial StatementsChapter 13

PowerPoint Editor:Beth Kane, MBA, CPA

Copyright © 2016 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of

McGraw-Hill Education.

Wild, Shaw, and ChiappettaFinancial & Managerial Accounting6th Edition

Wild, Shaw, and ChiappettaFinancial & Managerial Accounting6th Edition

13-C1: Purpose of Analysis

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Application of analytical

tools

Involves transforming

data

Reduces uncertainty

Basics of Analysis

Financial statement analysis helps users make better decisions.

Internal UsersManagersOfficers

Internal Auditors

External UsersShareholders

LendersCustomers

C 13

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Building Blocks of Analysis

C 1

Liquidity and efficiency

Solvency

Market prospects

Profitability

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Information for Analysis

C 1

1. Income Statement2. Balance Sheet 3. Statement of

Stockholders’ Equity4. Statement of Cash Flows5. Notes to the Financial

Statements

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13-C2: Standards for Comparisons

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Intracompany

Competitors

Industry

Guidelines

Standards for Comparison

C 2

When we interpret our analysis, it is essential to compare the results we obtained to other

standards or benchmarks.

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Horizontal Analysis

Comparing a company’s financial condition and performance across time.

Tools of Analysis

Vertical Analysis

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

Ratio Analysis

Measurement of key relations between financial statement items.C 2

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13-P1: Comparative Statements

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Horizontal Analysis

P 1

Horizontal analysis refers to examination of financial statement data across time.

Horizontal analysis refers to examination of financial

statement data across time.

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Comparative StatementsCalculate Change in Dollar Amount

Dollarchange

Analysis period amount

Base periodamount= –

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. P 1

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Comparative StatementsCalculate Change as a Percent

Percentchange

Dollar change Base period amount

100= ×

P 1

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

P 113

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Horizontal Analysis

P 114

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Trend Analysis

Trend analysis is used to reveal patterns in data covering successive periods.

Trendpercent

Analysis period amount Base period amount 100= ×

P 115

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Using 2009 as the base year we will get the following trend information:

P 1

Trend Analysis

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Trend Analysis

We can use the trend percentages to construct a graph so we can see the trend over time.

P 117

NEED-TO-KNOW

Compute trend percents for the following accounts, using 20X1 as the base year (round percents to wholenumbers). State whether the situation as revealed by the trends appears to be favorable or unfavorable foreach account.

($ in millions) 20X4 20X3 20X2 20X1Sales $500 $350 $250 $200Cost of goods sold 400 175 100 50

Sales trend percents 250% 175% 125% 100%$500/$200 $350/$200 $250/$200 $200/$200

Cost of goods sold trend percents 800% 350% 200% 100%$400/$50 $175/$50 $100/$50 $50/$50

P 118

13-P2: Common-Size Statements

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Vertical AnalysisCommon-Size Statements

Common-size percent

Analysis amountBase amount

100= ×

Financial Statement Base Amount

Balance Sheet Total Assets

Income Statement RevenuesP 2

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Common-Size Balance Sheet

P 221

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Common-Size Income Statement

P 222

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Common-Size Graphics

P 2

Common-Size Graphic ofAsset Components

Common-Size Graphic ofIncome Statement

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NEED-TO-KNOWExpress the following comparative income statements in common-size percents and assess whether or notthis company’s situation has improved in the most recent year (round percents to whole numbers).

($ in millions) 20X2 20X1Sales $800 $500Total expenses 560 400Net income $240 $100

Common-size percentsSales 100% 100%

($800/$800) ($500/$500)Total expenses 70% 80%

($560/$800) ($400/$500)Net income 30% 20%

($240/$800) ($100/$500)

Each item is expressed as a % of current year’s sales

P 224

13-P3: Ratio Analysis

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Ratio Analysis

P 3

Liquidity and

efficiencySolvency

Market prospects

Profitability

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Current Ratio

Acid-test Ratio

Accounts Receivable

Turnover

Inventory Turnover

Days’ Sales Uncollected

Days’ Sales in Inventory

Total Asset Turnover

Liquidity and Efficiency

P 327

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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.

P 328

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This ratio measures the short-term debt-paying ability of the company. A higher current

ratio suggests a strong liquidity position.

Current Ratio

Current ratio =Current assets

Current liabilities

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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.

Acid-Test Ratio

Acid-test ratio = Cash + Short-term investments + Current

receivables

Current liabilities

Referred to as Quick Assets

P 330

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This ratio measures how many times a company converts its receivables

into cash each year.

Accounts Receivable Turnover

Accounts receivable = turnover

Net salesAverage accounts receivable,

net

Average accounts receivable = (Beginning acct. rec. + Ending acct. rec.)

2

P 331

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This ratio measures the number of times

merchandise is sold and replaced during the year.

Inventory Turnover

Inventory turnover = Cost of goods soldAverage inventory

Average inventory = (Beginning inventory + Ending inventory)2

P 332

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Provides insight into how frequently a company collects its accounts receivable.

Days’ Sales Uncollected

Day's sales = uncollected

Accounts receivable, net× 365

Net sales

P 333

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Days’ Sales in Inventory

Day's sales in = Inventory

Ending inventory× 365

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.

P 334

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Total Asset Turnover

Total asset turnover = Net sales

Average total assets

Average assets = (Beginning assets + Ending assets)

2

This ratio reflects a company’s ability to use its assets to generate

sales. It is an important indication of operating

efficiency.P 3

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DebtRatio

EquityRatio

Pledged Assets to Secured Liabilities

Times Interest Earned

Solvency

P 336

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Debt and Equity Ratios In Millions Amount RatioTotal liabilities $ 83,451 40.3% [Debt ratio]Total equity 123,549 59.7% [Equity ratio]Total liabilities and equity $ 207,000 100.0%

$83,451 ÷ $207,000 = 40.3%

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.

P 337

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Debt-to-Equity Ratio

Debt-to-equity ratio = Total liabilities 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.

P 338

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Times Interest Earned

Times interest earned =

Income before interest and taxes

Interest expense

This is the most common measure of the ability of a company’s operations to provide

protection to long-term creditors.

Net income+ Interest expense+ Income taxes= Income before interest and taxes

P 339

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Profit Margin

Return on Total Assets

Return on Common Stockholders’ Equity

Profitability

P 340

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Profit Margin

Profit margin = Net income Net sales

This ratio describes a company’s ability to earn net income from each sales dollar.

P 341

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Return on total asset =

Net income Average total

assets

Return on Total Assets

Return on total assets measures how well assets have been employed by the

company’s management.

P 342

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Return on Common Stockholders’ Equity

Return on common stockholders' equity =

Net income - Preferred dividends Average common stockholders'

equity

This measure indicates how well the company employed the stockholders’ equity to earn net

income.

P 343

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Price-Earnings Ratio

Dividend Yield

Market Prospects

P 344

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Price-Earnings Ratio

Price-earnings ratio = Market price per common share

Earnings per share

This measure is often used by investors as a general guideline in gauging stock values.

Generally, the higher the price-earnings ratio, the more opportunity a company has for growth.

P 345

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Dividend Yield

Dividend yield = Annual cash dividends per share

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 common stock.

P 346

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Summary of Ratios

P 347

NEED-TO-KNOW

For each ratio listed, identify whether the change in ratio value from 20X1 to 20X2 is regarded as favorable orunfavorable.

20X2 20X1 Change1. Profit margin ratio 6% 8% Unfavorable Lower % of net income in each sales dollar2. Debt ratio 50% 70% Favorable Fewer assets are claimed by creditors3. Gross margin ratio 40% 36% Favorable Higher % of gross margin in each sales dollar4. Accounts receivable turnover 8.8 9.4 Unfavorable Less efficiency in collection5. Basic earnings per share $2.10 $2.00 Favorable Higher net income per common share6. Inventory turnover 3.6 4.0 Unfavorable Less efficient inventory management

P 348

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Global View

Horizontal and Vertical AnalysisHorizontal and vertical analyses help eliminate many differences between U.S. GAAP

and IFRS when analyzing and interpreting financial statements. However, when fundamental differences in reporting regimes impact financial statements, the user

must exercise caution when drawing conclusions.

Ratio AnalysisRatio analysis of financial statements also helps eliminate differences between U.S.

GAAP and IFRS. Importantly, the use of ratio analysis is fine, with some possible changes in interpretation depending on what is and what is not included in certain

accounting measures across U.S. GAAP and IFRS. Care must be taken in drawing inferences from a comparison of ratios across reporting regimes.

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13-A1: Analysis Reporting

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Analysis Reporting

A1

1. Executive Summary2. Analysis Overview3. Evidential Matter4. Assumptions5. Key Factors6. Inferences

The purpose of financial statement analyses is to reduce uncertainty in business decisions through a

rigorous and sound evaluation. A financial statement analysis report directly addresses the building blocks of

analysis and documents the reasoning.

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13-A2: Sustainable Income

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Net Income

Appendix 13A: Sustainable Income

DiscontinuedSegments

ExtraordinaryItems

ContinuingOperations

A 253

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End of Chapter 13

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