Fundamental Cornerstones of
Managerial Accounting
Chapter Fourteen
Financial Statement Analysis
Heitger/Mowen/Hansen
Copyright © 2008 Cengage Learning South-Western.
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Common-Size Analysis
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Compares two financial statement periods or items
within one financial statement period
Line items expressed as percentages
◦ Eliminates the effects of size
Two major forms:
◦ Horizontal analysis
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Expresses a line item as a percentage of some priorperiod amount
Allows the trend over time to be assessed
Vertical analysis
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Concerned with relationships among items within a
particular time period
Line items on income statement are expressed as a
percentage of net sales
Line items on the balance sheet are expressed as a
percentage of total assets
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Ratio Analysis
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Fractions or percentages computed by dividing one
account or line-item amount by another
Help explain the financial well-being of a company
when used as a comparison
Common comparison standards:
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Company historical amounts
Industry averages
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Key Business Ratios
Standard and Poor’s Industry Survey
Annual Statement Studies
The Almanac of Business and Industrial Financial
Ratios
Dow Jones-Irwin Business and Investment Almanac
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Classification of Ratios
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Liquidity Ratios
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Measure the ability of a company to meet its current
obligations
Leverage Ratios
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Measure the ability of a company to meets its long- and
short-term obligations
Provide a measure of the degree of protection provided to a
company’s creditors
Profitability Ratios
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Measure the earning ability of a company
Allow investors, creditors, and managers to evaluate the
extent to which invested funds are being used efficiently
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Liquidity Ratios
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Current Ratio
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Current Assets ÷ Current Liabilities
Measure of the ability of a company to pay its
short-term liabilities using short-term assets
Rule of thumb
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2.0 ratio is needed to provide good debt-paying
ability
Quick or Acid-Test Ratios
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Compares only the most liquid assets with
current liabilities
Usual standard is ratio of 1.0
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Liquidity Ratios
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Accounts Receivable Turnover Ratio
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Measures how long it takes the company to
turn its receivables into cash
Net Sales ÷ Average Accounts Receivable
Inventory Turnover Ratio
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Cost of Goods Sold ÷ Average Inventory
Measures how many times the average
inventory turns over (sold) during the year
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Ratio Definition
Current ratio
= Current assets ÷ Current liabilities
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Ratio Definition
Quick ratio
= (Cash + Marketable Securities + Receivables)
÷ Current liabilities
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Ratio Definition
Average Accounts Receivable
= (Beginning Receivables + Ending Receivables) ÷ 2
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Ratio Definition
Accounts Receivable Turnover Ratio
= Net Sales ÷ Average Accounts Receivable
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Ratio Definition
Accounts Receivable in Days
= Days in a year ÷ Accounts Receivable Turnover Ratio
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Ratio Definition
Average Inventory
= (Beginning Inventory + Ending Inventory) ÷ 2
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Ratio Definition
Inventory Turnover Ratio
= Cost of Goods Sold ÷ Average Inventory
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Ratio Definition
Inventory Turnover in Days
= Days in a year ÷ Inventory Turnover Ratio
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Leverage Ratios
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Times-Interest-Earned Ratio
◦ (Income before taxes + Interest Expense) ÷ Interest
Expense
◦ Uses the income statement to assess a company’s
ability to service its debt
Debt Ratio
◦ Measures the degree of protection afforded creditors
in case of insolvency
◦ Reflects the percentage of assets financed by
creditors
◦ Total Liabilities ÷ Total Assets
Debt to Equity Ratio
◦ Total Liabilities ÷ Total Stockholders’ Equity
◦ Measures the amount of debt that is financed by
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stockholders
Ratio Definition
Times-Interest-Earned Ratio
= (Income Before Taxes + Interest Expense)
÷ Interest Expense
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Ratio Definition
Debt Ratio
= Total liabilities ÷ Total assets
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Ratio Definition
Debt to Equity Ratio
= Total liabilities ÷ Total stockholders’ equity
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Profitability Ratios
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Return on Sales
◦ Net Income ÷ Sales
◦ Measures the efficiency of a firm
◦ Tells what percentage of each sales dollar is earned as
net income
Return on Total Assets
◦ Operating Income After Taxes ÷ Average Total Assets
◦ Measures how efficiently total assets are used to
generate profits
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Profitability Ratios
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Return on Common Stockholders’ Equity
◦ (Net Income – Preferred Dividends) ÷ Average Common
Stockholders’ Equity
◦ Measures the return the company generated on the
common shareholders’ investment
Earnings Per Share
◦ (Net Income – Preferred Dividends) ÷ Average Common
Shares
◦ Measures the profit earned by the company for each
share of common stock outstanding
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Profitability Ratios
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Price-Earnings Ratio
◦ Market Price Per Share ÷ Earnings Per Share
◦ Measures the investors’ perceptions of a
company’s future growth prospects
Dividend Yield
◦ Dividends Per Common Share ÷ Market Price Per
Share
◦ Measures a reasonable approximation of the total
return accruing to an investor
Payout Ratio
◦ Common Dividends ÷ (Net Income – Preferred
Dividends)
◦ Tells an investor the proportion of earnings that a
company pays in dividends
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Ratio Definition
Return on Sales
= Net Income ÷ Sales
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Ratio Definition
Average Total Assets
= (Beginning Total Assets + Ending Total Assets) ÷ 2
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Ratio Definition
Return on Total Assets
= [Net Income + Interest Expense (1 – Tax Rate)]
÷ Average Total Assets
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Ratio Definition
Average Common Stockholders’ Equity
= (Beginning Common Stockholders’ Equity
+ Ending Common Stockholders’ Equity)
÷2
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Ratio Definition
Return on Stockholders’ Equity
= (Net Income – Preferred Dividends)
÷ Average Common Stockholders’ Equity
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Ratio Definition
Return on Stockholders’ Equity
= (Net Income – Preferred Dividends)
÷ Average Common Stockholders’ Equity
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Ratio Definition
Preferred Dividends
= Preferred Stock × Dividend Rate
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Ratio Definition
Number of Common Shares
= Common Stock ÷ Par Value per share
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Ratio Definition
Earnings Per Share
= (Net Income – Preferred Dividends)
÷ Number of Common Shares
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Ratio Definition
Price-Earnings Ratio
= Price per share ÷ Earnings Per Share
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Ratio Definition
Dividends Per Share
= Dividends to Common Shareholders
÷ Number of Common Shares
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Ratio Definition
Dividends Yield
= Dividends per share ÷ Market Price per share
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Ratio Definition
Dividend Payout Ratio
= Common Dividends ÷ (Net Income – Preferred Dividends)
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Just-in-Time Manufacturing Environment
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Goals:
◦ Reduce inventories
◦ Increase quality
If goals are being met:
◦ Inventory turnover ratio should increase
dramatically
◦ Current ratio will drop
◦ Quality costs as a percentage of sales should
decrease
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