Chapter 14
“How Well Am I Doing?”
Financial Statement
Analysis
McGraw-Hill /Irwin
© The McGraw-Hill Companies, Inc., 2007
Limitations of Financial Statement
Analysis
Differences in accounting methods
between companies sometimes make
comparisons difficult.
We use the LIFO method to
value inventory.
We use the FIFO method to
value inventory.
14-2
Limitations of Financial Statement
Analysis
Industry
trends
Technological
changes
Changes within
the company
Consumer
tastes
Economic
factors
Analysts should look beyond
the ratios.
14-3
Statements in Comparative and
Common-Size Form
 Dollar and percentage
changes on statements
Analytical
techniques used to
examine
relationships among
financial statement
items
 Common-size
statements
 Ratios
14-4
Learning Objective
LO1
To prepare and interpret
financial statements in
comparative and
common-size form
14-5
Horizontal Analysis
Horizontal analysis shows the changes
between years in the financial data in
both dollar and percentage form.
14-6
Horizontal Analysis
Example
The following slides illustrate a horizontal
analysis of Clover Corporation’s
December 31, 2005 and 2004
comparative balance sheets and
comparative income statements.
14-7
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31
2005
Assets
Current assets:
Cash
Accounts receivable, net
Inventory
Prepaid expenses
Total current assets
Property and equipment:
Land
Buildings and equipment, net
Total property and equipment
Total assets
$
12,000
60,000
80,000
3,000
155,000
40,000
120,000
160,000
$ 315,000
2004
$
Increase (Decrease)
Amount
%
23,500
40,000
100,000
1,200
164,700
40,000
85,000
125,000
$ 289,700
14-8
Horizontal Analysis
Calculating Change in Dollar Amounts
Dollar
Change
=
Current Year
Figure
–
Base Year
Figure
The dollar
amounts for
2004 become
the “base” year
figures.
14-9
Horizontal Analysis
Calculating Change as a Percentage
Percentage
Change
=
Dollar Change
Base Year Figure
×
100%
14-10
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31
2005
2004
Increase (Decrease)
Amount
%
Assets
Current assets:
Cash
$ 12,000 $ 23,500 $ (11,500)
(48.9)
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
$12,000 –155,000
$23,500164,700
= $(11,500)
Total current assets
Property and equipment:
Land
40,000
($11,500 ÷40,000
$23,500)
× 100% = 48.9%
Buildings and equipment, net
120,000
85,000
Total property and equipment
160,000
125,000
Total assets
$ 315,000 $ 289,700
14-11
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31
2005
Assets
Current assets:
Cash
Accounts receivable, net
Inventory
Prepaid expenses
Total current assets
Property and equipment:
Land
Buildings and equipment, net
Total property and equipment
Total assets
$
12,000
60,000
80,000
3,000
155,000
40,000
120,000
160,000
$ 315,000
$
2004
Increase (Decrease)
Amount
%
23,500
40,000
100,000
1,200
164,700
$ (11,500)
20,000
(20,000)
1,800
(9,700)
(48.9)
50.0
(20.0)
150.0
(5.9)
35,000
35,000
$ 25,300
0.0
41.2
28.0
8.7
40,000
85,000
125,000
$ 289,700
14-12
Horizontal Analysis
We could do this for the
liabilities & stockholders’
equity, but now, let’s look at
the income statement
accounts.
14-13
Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
2005
2004
Net sales
$ 520,000 $ 480,000
Cost of goods sold
360,000
315,000
Gross margin
160,000
165,000
Operating expenses
128,600
126,000
Net operating income
31,400
39,000
Interest expense
6,400
7,000
Net income before taxes
25,000
32,000
Less income taxes (30%)
7,500
9,600
Net income
$ 17,500 $ 22,400
Increase
(Decrease)
Amount
%
14-14
Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
2005
2004
Net sales
$ 520,000 $ 480,000
Cost of goods sold
360,000
315,000
Gross margin
160,000
165,000
Operating expenses
128,600
126,000
Net operating income
31,400
39,000
Interest expense
6,400
7,000
Net income before taxes
25,000
32,000
Less income taxes (30%)
7,500
9,600
Net income
$ 17,500 $ 22,400
Increase
(Decrease)
Amount
%
$ 40,000
8.3
45,000
14.3
(5,000)
(3.0)
2,600
2.1
(7,600) (19.5)
(600)
(8.6)
(7,000) (21.9)
(2,100) (21.9)
$ (4,900) (21.9)
14-15
Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
2005
2004
Net sales
$ 520,000 $ 480,000
Cost of goods sold
360,000
315,000
Gross margin
165,000
Sales increased160,000
by 8.3%,
yet
Operating
128,600by 126,000
net expenses
income decreased
21.9%.
Net operating income
31,400
39,000
Interest expense
6,400
7,000
Net income before taxes
25,000
32,000
Less income taxes (30%)
7,500
9,600
Net income
$ 17,500 $ 22,400
Increase
(Decrease)
Amount
%
$ 40,000
8.3
45,000
14.3
(5,000)
(3.0)
2,600
2.1
(7,600) (19.5)
(600)
(8.6)
(7,000) (21.9)
(2,100) (21.9)
$ (4,900) (21.9)
14-16
Horizontal Analysis
CLOVER
CORPORATION
There were increases
in both
cost of goods
Comparative
Statements
sold (14.3%) and
operatingIncome
expenses
(2.1%).
For costs
the Years
Ended
December
These increased
more
than
offset 31
the
Increase
increase in sales, yielding an overall
(Decrease)
decrease in net2005
income.2004
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
Cost of goods sold
360,000
315,000
45,000
Gross margin
160,000
165,000
(5,000)
Operating expenses
128,600
126,000
2,600
Net operating income
31,400
39,000
(7,600)
Interest expense
6,400
7,000
(600)
Net income before taxes
25,000
32,000
(7,000)
Less income taxes (30%)
7,500
9,600
(2,100)
Net income
$ 17,500 $ 22,400 $ (4,900)
8.3
14.3
(3.0)
2.1
(19.5)
(8.6)
(21.9)
(21.9)
(21.9)
14-17
Trend Percentages
Trend percentages
state several years’
financial data in terms
of a base year, which
equals 100 percent.
14-18
Trend Percentages
Trend
=
Percentage
Current Year Amount
Base Year Amount
×
100%
14-19
Trend Percentages
Example
Look at the income information for
Berry Products for the years 2001
through 2005. We will do a trend
analysis on these amounts to see
what we can learn about the
company.
14-20
Trend Percentages
Berry Products
Income Information
For the Years Ended December 31
Item
Sales
Cost of goods sold
Gross margin
2005
$ 400,000
285,000
115,000
2004
$ 355,000
250,000
105,000
Year
2003
$ 320,000
225,000
95,000
2002
$ 290,000
198,000
92,000
2001
$ 275,000
190,000
85,000
The base year is 2001, and its amounts
will equal 100%.
14-21
Trend Percentages
Berry Products
Income Information
For the Years Ended December 31
Item
2005
2004
Year
2003
Sales
Cost of goods sold
Gross margin
2002
105%
104%
108%
2001
100%
100%
100%
2002 Amount ÷ 2001 Amount × 100%
( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
14-22
Trend Percentages
Berry Products
Income Information
For the Years Ended December 31
Item
Sales
Cost of goods sold
Gross margin
2005
145%
150%
135%
2004
129%
132%
124%
Year
2003
116%
118%
112%
2002
105%
104%
108%
2001
100%
100%
100%
By analyzing the trends for Berry Products, we can
see that cost of goods sold is increasing faster than
sales, which is slowing the increase in gross margin.
14-23
Trend Percentages
160
Percentage
150
We can use the trend
percentages to construct a
graph so we can see the
trend over time.
140
130
Sales
COGS
GM
120
110
100
2001
2002
2003
2004
2005
Year
14-24
Common-Size Statements
Common-size
statements use
percentages to express
the relationship of
individual components to
a total within a single
period. This is also
known as vertical
analysis.
14-25
Common-Size Statements
In income
statements, all
items are
expressed as a
percentage of
net sales.
14-26
Gross Margin Percentage
Gross Margin
Percentage
=
Gross Margin
Sales
This measure indicates how much
of each sales dollar is left after
deducting the cost of goods sold to
cover expenses and provide a profit.
14-27
Common-Size Statements
In balance
sheets, all items
are expressed
as a percentage
of total assets.
14-28
Common-Size Statements
Wendy's
McDonald's
(dollars in millions)
Dollars Percentage Dollars Percentage
2002 Net income $
219
8.00% $
893
5.80%
Common-size financial statements are
particularly useful when comparing
data from different companies.
14-29
Common-Size Statements
Example
Let’s take another look at the information
from the comparative income statements
of Clover Corporation for 2005 and 2004.
This time let’s prepare common-size
statements.
14-30
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005
2004
2005
2004
Net sales
$ 520,000 $ 480,000
100.0
100.0
Cost of goods sold
360,000
315,000
Net sales is
Gross margin
160,000
165,000
the base
Operating expenses
128,600
126,000
Net operating income
31,400
39,000
and is
Interest expense
6,400
7,000
expressed
Net income before taxes
25,000
32,000
as 100%.
Less income taxes (30%)
7,500
9,600
Net income
$ 17,500 $ 22,400
14-31
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005
2004
2005
2004
Net sales
$ 520,000 $ 480,000
100.0
100.0
Cost of goods sold
360,000
315,000
69.2
65.6
Gross margin
160,000
165,000
Operating expenses
128,600
126,000
2005 Cost
÷ 2005 Sales
Net operating
income
31,400× 100%
39,000
( $360,000
) × 100%
= 69.2%
Interest
expense ÷ $520,000
6,400
7,000
Net income before taxes
25,000
32,000
Cost ÷ 2004
× 100%
Less income 2004
taxes (30%)
7,500 Sales
9,600
$480,000
) × 100% = 65.6%
Net income ( $315,000 $÷17,500
$ 22,400
14-32
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
What conclusions can we draw?
Percentages
2005
2004
2005
2004
Net sales
$ 520,000 $ 480,000
100.0
100.0
Cost of goods sold
360,000
315,000
69.2
65.6
Gross margin
160,000
165,000
30.8
34.4
Operating expenses
128,600
126,000
24.8
26.2
Net operating income
31,400
39,000
6.0
8.2
Interest expense
6,400
7,000
1.2
1.5
Net income before taxes
25,000
32,000
4.8
6.7
Less income taxes (30%)
7,500
9,600
1.4
2.0
Net income
$ 17,500 $ 22,400
3.4
4.7
14-33
Quick Check 
Which of the following statements describes
horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c. A comparison of the account balances on
the current year’s financial statements.
d. None of the above.
14-34
Quick Check 
Which of the following statements describes
horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c.Horizontal
A comparison
of theshows
account
analysis
thebalances
changes on
the
current
year’s
financial
statements.
between
years
in the
financial
data, in
d. None
ofdollar
the above.
both
and percentage form.
14-35
Ratios
Common
Stockholders
Short-term
Creditors
Long-term
Creditors
14-36
Now, let’s look at
Norton
Corporation’s
recent financial
statements.
14-37
NORTON CORPORATION
Balance Sheets
December 31
2005
Assets
Current assets:
Cash
Accounts receivable, net
Inventory
Prepaid expenses
Total current assets
Property and equipment:
Land
Buildings and equipment, net
Total property and equipment
Total assets
$
30,000
20,000
12,000
3,000
65,000
165,000
116,390
281,390
$ 346,390
2004
$
20,000
17,000
10,000
2,000
49,000
123,000
128,000
251,000
$ 300,000
14-38
NORTON CORPORATION
Balance Sheets
December 31
2005
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
$ 39,000 $
Notes payable, short-term
3,000
Total current liabilities
42,000
Long-term liabilities:
Notes payable, long-term
70,000
Total liabilities
112,000
Stockholders' equity:
Common stock, $1 par value
27,400
Additional paid-in capital
158,100
Total paid-in capital
185,500
Retained earnings
48,890
Total stockholders' equity
234,390
Total liabilities and stockholders' equity $ 346,390 $
2004
40,000
2,000
42,000
78,000
120,000
17,000
113,000
130,000
50,000
180,000
300,000
14-39
NORTON CORPORATION
Income Statements
For the Years Ended December 31
Net sales
Cost of goods sold
Gross margin
Operating expenses
Net operating income
Interest expense
Net income before taxes
Less income taxes (30%)
Net income
2005
$ 494,000
140,000
354,000
270,000
84,000
7,300
76,700
23,010
$ 53,690
2004
$ 450,000
127,000
323,000
249,000
74,000
8,000
66,000
19,800
$ 46,200
14-40
Learning Objective
LO2
To compute and
interpret financial ratios
that would be useful to
a common stockholder
14-41
Ratio Analysis – The Common
Stockholder
NORTON CORPORATION
2005
Use this
information to
calculate ratios
to measure the
well-being of
the common
stockholders of
Norton
Corporation.
Number of common shares
outstanding
Beginning of year
End of year
Net income
17,000
27,400
$
53,690
Stockholders' equity
Beginning of year
180,000
End of year
234,390
Dividends per share
Dec. 31 market price per share
Interest expense
2
20
7,300
Total assets
Beginning of year
300,000
End of year
346,390
14-42
Earnings Per Share
Earnings per Share =
Net Income – Preferred Dividends
Average Number of Common
Shares Outstanding
Whenever a ratio divides an income statement
balance by a balance sheet balance, the average
for the year is used in the denominator.
14-43
Earnings Per Share
Earnings per Share =
Earnings per Share =
Net Income – Preferred Dividends
Average Number of Common
Shares Outstanding
$53,690 – 0
(17,000 + 27,400)/2
= $2.42
This measure indicates how much
income was earned for each share of
common stock outstanding.
14-44
Price-Earnings Ratio
Price-Earnings
Ratio
Price-Earnings
Ratio
=
Market Price Per Share
Earnings Per Share
=
$20.00
= 8.26 times
$2.42
This measure is often used by investors
as a general guideline in gauging stock
values. Generally, the higher the priceearnings ratio, the more opportunity a
company has for growth.
14-45
Dividend Payout Ratio
Dividend
Payout Ratio
=
Dividend
Payout Ratio
=
Dividends Per Share
Earnings Per Share
$2.00
= 82.6%
$2.42
This ratio gauges the portion of current
earnings being paid out in dividends.
Investors seeking current income would
like this ratio to be large.
14-46
Dividend Yield Ratio
Dividend
Yield Ratio
Dividend
Yield Ratio
=
Dividends Per Share
Market Price Per Share
=
$2.00
= 10.00%
$20.00
This ratio identifies the return, in
terms of cash dividends, on the
current market price of the stock.
14-47
Return on Total Assets
Return on
=
Total Assets
Return on
=
Total Assets
Net Income + [Interest Expense × (1 – Tax Rate)]
Average Total Assets
$53,690 +[7,300 × (1 – .30)]
= 18.19%
($300,000 + $346,390) ÷ 2
This ratio measures how well
assets have been employed.
14-48
Return on Common Stockholders’ Equity
Return on Common = Net Income – Preferred Dividends
Stockholders’ Equity
Average Stockholders’ Equity
Return on Common
$53,690 – 0
=
= 25.91%
Stockholders’ Equity
($180,000 + $234,390) ÷ 2
This measure indicates how well the
company employed the owners’
investments to earn income.
14-49
Financial Leverage
Financial leverage involves acquiring
assets with funds at a fixed rate of
interest.
Fixed rate of
Return on
return on
investment in > borrowed
assets
funds
Positive
= financial
leverage
Fixed rate of
return on
borrowed
funds
Negative
= financial
leverage
Return on
investment in <
assets
14-50
Quick Check 
Which of the following statements is true?
a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
14-51
Quick Check 
Which of the following statements is true?
a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
14-52
Book Value Per Share
Book Value
per Share
=
Book Value
per Share
Common Stockholders’ Equity
Number of Common Shares Outstanding
=
$234,390
27,400
= $ 8.55
This ratio measures the amount that would be
distributed to holders of each share of common
stock if all assets were sold at their balance sheet
carrying amounts and if all creditors were paid off.
14-53
Book Value Per Share
Book Value
per Share
=
Book Value
per Share
Common Stockholders’ Equity
Number of Common Shares Outstanding
=
$234,390
27,400
= $ 8.55
Notice that the book value per share of $8.55 does
not equal the market value per share of $20. This
is because the market price reflects expectations
about future earnings and dividends, whereas the
book value per share is based on historical cost.
14-54
Learning Objective
LO3
To compute and
interpret financial ratios
that would be useful to
a short-term creditor
14-55
Ratio Analysis –
The Short–Term Creditor
NORTON CORPORATION
Use this
information to
calculate ratios
to measure the
well-being of the
short-term
creditors for
Norton
Corporation.
2005
Cash
$
30,000
Accounts receivable, net
Beginning of year
17,000
End of year
20,000
Inventory
Beginning of year
10,000
End of year
12,000
Total current assets
65,000
Total current liabilities
42,000
Sales on account
500,000
Cost of goods sold
140,000
14-56
Working Capital
The excess of current assets over
current liabilities is known as
working capital.
Working capital is not
free. It must be
financed with long-term
debt and equity.
14-57
Working Capital
December 31,
2005
Current assets
$
Current liabilities
Working capital
65,000
(42,000)
$
23,000
14-58
Current Ratio
Current
Ratio
=
Current Assets
Current Liabilities
The current ratio measures a
company’s short-term debt
paying ability.
A declining ratio may be a
sign of deteriorating
financial condition, or it
might result from eliminating
obsolete inventories.
14-59
Current Ratio
Current
Ratio
=
Current Assets
Current Liabilities
Current
Ratio
=
$65,000
$42,000
=
1.55 : 1
The current ratio measures a
company’s short-term debt
paying ability.
14-60
Acid-Test (Quick) Ratio
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
Acid-Test
=
Ratio
$50,000
$42,000
= 1.19 : 1
Quick assets include Cash,
Marketable Securities, Accounts
Receivable and current Notes
Receivable.
This ratio measures a company’s ability
to meet obligations without having to
liquidate inventory.
Norton
Corporation’s
quick assets
consist of cash
of $30,000 and
accounts
receivable of
$20,000. 14-61
Accounts Receivable Turnover
Accounts
Receivable
Turnover
=
Sales on Account
Average Accounts Receivable
Accounts
$500,000
= 27.03 times
Receivable =
($17,000 + $20,000) ÷ 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.
14-62
Average Collection Period
Average
365 Days
Collection = Accounts Receivable Turnover
Period
Average
Collection =
Period
365 Days
27.03 Times
= 13.50 days
This ratio measures, on average,
how many days it takes to collect
an account receivable.
14-63
Inventory Turnover
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
This ratio measures how many
times a company’s inventory
has been sold and replaced
during the year.
If a company’s inventory
turnover Is less than its
industry average, it either
has excessive inventory or
the wrong types of inventory.
14-64
Inventory Turnover
Inventory
Turnover
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
$140,000
=
= 12.73 times
($10,000 + $12,000) ÷ 2
This ratio measures how many
times a company’s inventory
has been sold and replaced
during the year.
14-65
Average Sale Period
Average
Sale Period
Average
=
Sale Period
=
365 Days
Inventory Turnover
365 Days
12.73 Times
= 28.67 days
This ratio measures how many
days, on average, it takes to
sell the inventory.
14-66
Learning Objective
LO4
To compute and
interpret financial ratios
that would be useful to
a long-term creditor
14-67
Ratio Analysis –
The Long–Term Creditor
Use this information to calculate ratios
to measure the well-being of the longterm creditors for Norton Corporation.
NORTON CORPORATION
2005
Earnings before interest
expense and income taxes
This is also referred
to as net operating
income.
Interest expense
$
84,000
7,300
Total stockholders' equity
234,390
Total liabilities
112,000
14-68
Times Interest Earned Ratio
Times
Interest =
Earned
Times
Interest =
Earned
Earnings before Interest Expense
plus Income Taxes
Interest Expense
$84,000
= 11.5 times
7,300
This is the most common
measure of the ability of a firm’s
operations to provide protection
to the long-term creditor.
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Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio
This ratio indicates the relative
proportions of debt to equity on
a company’s balance sheet.
Stockholders like a lot of
debt if the company can
take advantage of
positive financial
leverage.
Creditors prefer less
debt and more equity
because equity
represents a buffer of
protection.
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Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio
Debt–to–
Equity =
Ratio
$112,000
$234,390
= 0.48
This ratio indicates the relative
proportions of debt to equity on
a company’s balance sheet.
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Published Sources That Provide
Comparative Ratio Data
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End of Chapter 14
14-73