CHAPTER
14
Financial Statement Analysis
Financial and
Managerial
Accounting
10e
Needles
Powers
Crosson
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Concepts Underlying Financial
Performance Measurement
 Financial statement analysis (or financial performance
measurement) is used to show how items in a company’s
financial statements relate to the company’s financial
performance objectives.
 When analyzing financial statements, decision makers must
judge whether the relationships they find in the statements
are favorable or unfavorable.
– Many financial analysts, investors, and lenders apply general
standards, or rule-of-thumb measures, to key financial ratios.
 Current ratio: The higher the ratio, the more likely the company will
be able to meet its liabilities. A ratio of 2 to 1 (2.0) or higher is
desirable.
 Current liabilities to net worth ratio (%): Normally a business starts to
have trouble when this relationship exceeds 80%.
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Past Performance and Industry Norms
 Comparing financial measures of the same company over time is an
improvement over using rule-of-thumb measures.
– Such a comparison gives the analyst some basis for judging
whether the measure or ratio is getting better or worse. However,
using a company’s past performance is not helpful in judging its
performance relative to that of other companies.
 Industry norms show how a company compares with other companies in
the same industry, which overcomes some of the limitations of
comparing a company’s measures over time.
– However, diversified companies (or conglomerates)—large
companies that have multiple segments and operate in more than
one industry—may not be comparable to any other company.
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Sources of Information
 The major sources of information about public corporations include:
– Reports published by a corporation
 Annual reports
 Interim financial statements—condensed financial statements
published each quarter and sometimes each month
– Reports filed with the Securities and Exchange Commission (SEC)
 Annual reports (Form 10-K)
 Quarterly reports (Form 10-Q)
 Current reports (Form 8-K)
– Business periodicals and credit and investment advisory services
 The Wall Street Journal
 Moody’s, Standard & Poor’s, and Dun and Bradstreet
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Horizontal Analysis
 To gain insight into year-to-year changes, analysts
use horizontal analysis, in which changes from
the previous year to the current year are
computed in both dollar amounts and
percentages.
– The percentage change is computed as follows:
100 × Comparative Year Amount − Base Year Amount
Base Year Amount
– The base year is the first year considered in any set of
data.
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Trend Analysis
 Trend analysis is a variation of horizontal
analysis that calculates percentage changes for
several successive years instead of for just two
years.
– It uses an index number to show changes in related
items over time.
 For an index number, the base year is set at 100 percent.
Other years are measured in relation to that number.
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Vertical Analysis
 Vertical analysis shows how the different components of a
financial statement relate to a total figure in the statement.
– The analyst sets the total figure at 100 percent and computes each
component’s percentage of that total.
– The resulting financial statement, which is expressed entirely in
percentages, is called a common-size statement.
 Vertical analysis and common-size statements are useful in
comparing the importance of specific components in the
operation of a business and in identifying important changes in
the components from one year to the next. They are often used
to make comparisons between companies.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Financial Ratio Analysis
 Financial ratio analysis identifies key relationships
between the components of the financial statements.
– Investors and creditors use profit margin to evaluate a company’s
ability to earn a satisfactory income (profitability). They use asset
turnover to determine whether the company uses assets in a way
that maximizes revenue (total asset management). Their combined
effect is overall earning power—that is, return on assets.
– Liquidity is a company’s ability to pay bills when they are due and
to meet unexpected needs for cash. To evaluate a company’s
liquidity, analysts compute: cash flow yield; cash flows to sales;
cash flows to assets; and free cash flow.
– Financial risk refers to a company’s ability to survive in good times
and bad. Ratios related to financial risk include debt to equity,
return on equity, and interest coverage.
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Profit Margin and Asset Turnover
 Profit margin measures the net income produced
by each dollar of sales.
 Asset turnover measures how efficiently assets
are used to produce sales.
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Return on Assets and Cash Flow Yield
 Return on assets measures a company’s overall
earning power, or profitability.
 Cash flow yield measures the ability to generate
operating cash flows in relation to net income.
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Cash Flows to Sales and Cash Flows to Assets
 Cash flows to sales refers to the ability of sales
to generate operating cash flows.
 Cash flows to assets measures the ability of
assets to generate operating cash flows.
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Free Cash Flow
 Free cash flow is a measure of the cash
remaining after providing for commitments.
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Debt to Equity Ratio and Return on Equity
 The debt to equity ratio shows the amount of
assets provided by creditors in relation to the
amount provided by stockholders.
 Return on equity measures the return to
stockholders.
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Interest Coverage
 The interest coverage ratio is a supplementary
ratio that measures the degree of protection
creditors have from default on interest payments.
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Evaluating Operating Asset Management
and Market Strength with Ratios
 The operating cycle spans the time it takes to purchase inventory, sell
it, and collect for it. The financing cycle—the period between the time
a supplier must be paid and the end of the operating cycle—defines
how much financing the company must have to support its operations.
– Because debt increases a company’s risk, it is important to keep
the financing period at a manageable level. Ratios that measure
operating asset management include inventory turnover, days’
inventory on hand, receivables turnover, days’ sales uncollected,
payables turnover, days’ payable, and current and quick ratio.
 Market price is the price at which stock is bought and sold.
– It must be related to earnings by considering the price/earnings
(P/E) ratio and the dividend yield.
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Inventory Turnover and
Days’ Inventory on Hand
 Inventory turnover measures the relative size of
inventories.
 Day’s inventory on hand measures the average
number of days that it takes to sell inventory.
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Receivables Turnover and
Days’ Sales Uncollected
 Receivables turnover measures the relative size
of accounts receivable and the effectiveness of
credit policies.
 Days’ sales uncollected measures the average
number of days it takes to collect receivables.
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Payables Turnover and Days’ Payable
 Payables turnover measures the relative size of
accounts payable and the credit terms extended
to a company.
 Days’ payable measures the average number of
days it takes to pay accounts payable.
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Financing Period
 The financing period is computed by deducting the
days’ payable from the operating cycle (days’
inventory on hand + days’ sales uncollected).
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Current Ratio and Quick Ratio
 The current ratio measures short-term debt-paying
ability by comparing current assets with current
liabilities.
 The quick ratio differs from the current ratio in
that the numerator of the quick ratio excludes
inventories and prepaid expenses.
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Price/Earnings (P/E) and Dividend Yield
 Price/earnings (P/E) is the ratio of the market
price per share to earnings per share.
 Dividend yield measures a stock’s current return
to an investor in the form of dividends.
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Evaluating Quality of Earnings
 The quality of earnings refers to the substance of earnings
and their sustainability into future periods.
– It is affected by accounting method, accounting estimates, and onetime items.
– Different accounting methods have different effects on net income.
– The latitude that companies have in their choice of accounting
method could cause problems in the interpretation of financial
statements were it not for the conventions of full disclosure and
consistency.
 Full disclosure requires management to explain, in a note to
the financial statements, the significant accounting policies
used.
 Consistency requires that the same accounting procedures be
used from year to year.
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Accounting Estimates and One-Time Items
 In allocating expenses among the periods that benefit from
them, accountants must make estimates and exercise
judgment, which will affect net income.
– Areas that require accounting estimates include: useful life of
assets; residual value of assets; uncollectible accounts receivable;
sales returns; total units of production; total recoverable units of
natural resources; amortization periods; warranty claims; and
environmental cleanup costs.
 If earnings increase because of one-time items, that portion
of earnings will not be sustained in the future.
– Examples of one-time items include: gains and losses; write-downs
and restructurings; and nonoperating items.
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Gains and Losses and
Write-Downs and Restructurings
 When a company sells or disposes of operating assets or
marketable securities, a gain or loss generally results.
– These gains or losses appear in the operating section of the income
statement, but they usually represent one-time events. From an
analyst’s standpoint, they should be ignored when considering
operating income.
 A write-down (or write-off) is a reduction in the value of an asset
below its carrying value on the balance sheet.
 A restructuring is the estimated cost of a change in a company’s
operations.
– Both write-downs and restructurings reduce current operating
income and boost future income by shifting future costs to the
current period.
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Nonoperating Items
 The nonoperating items that appear on the income
statement include discontinued operations—segments that
are no longer part of a company’s operations—and gains
or losses on the sale or disposal of these segments.
 These items can significantly affect net income.
 To make it easier to evaluate a company’s ongoing
operations, GAAP requires that gains and losses from
discontinued operations be reported separately on the
income statement.
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Management Compensation
 Under the Sarbanes-Oxley Act, a public corporation’s
board of directors must establish a compensation
committee made up of independent directors to determine
how the company’s top executives will be compensated.
– Typical components of the compensation of executive officers
include:
 Annual base salary
 Annual incentive bonuses—based on financial performance measures
that the compensation committee identifies as important to the
company’s long-term success
 Long-term incentive compensation (stock option awards)—usually
based on how well the company is achieving its long-term strategic
goals
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