CHAPTER 13
Financial Analysis: The Big Picture
Discuss the Need for comparative analysis and identify the tools of financial
statement analysis
♦ Throughout the book we will rely on three types of comparisons to provide
decision usefulness of financial information:
1. Intracompany basis. Comparisons within a company are often useful to
detect changes in financial relationships and significant trends.
2. Intercompany basis. Comparisons with other companies provide insight into
a company’s competitive position
3. Industry averages. Comparisons with industry averages provide information
about a company’s relative position within the industry
♦ Three basic tools are used in financial statement analysis to highlight the
significance of financial statement data:
1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis
Study Objective 4 - Explain and Apply Horizontal Analysis
♦ Horizontal analysis, also known as __________________analysis, is a
technique for evaluating a series of financial statement data over a period of
time.
ƒ The purpose of horizontal analysis is to
determine___________________________________.
ƒ The increase or decrease can be expressed as either an amount or a percentage.
ƒ We can measure all percentage increases or decreases from this base-period
amount with the following formula:
Change Since =CURRENT YEAR AMOUNT – BASE YEAR AMOUNT
Base Period
BASE-YEAR AMOUNT
Study Objective 5 - Describe and Apply Vertical Analysis
♦ Vertical analysis, also called ______________________analysis, is a
technique for evaluating financial statement data that expresses each item in a
financial statement as a percent of a base amount.
♦ On a balance sheet we might say that current assets are 22% of total assets.
♦ ________________________is always the base amount in vertical analysis of
a balance sheet.
♦ On an income statement we say that selling expenses are 16% of net sales.
♦ _________________________is always the base amount in vertical analysis of
an income statement.
♦ Vertical analysis enables you to compare companies of __________________.
Study Objective 6 - Identify and Compute Ratios and Describe Their Purpose
and Use in Analyzing a Firm’s Liquidity, Solvency, and
Profitability
♦ For analysis of the primary financial statements, ratios can be classified into
three types:
1. Liquidity ratios: measures of the short-term ability of the enterprise to pay its
maturing obligations an to meet unexpected needs for cash
2. Solvency ratios: measures of the ability of the enterprise to survive over a
long period of time
3. Profitability ratios: measures of the income or operating success of an
enterprise for a given period of time
♦ Liquidity ratios—measure the short-term ability of the enterprise to pay its
maturing obligations and to meet unexpected needs for cash.
ƒ Short-term creditors such as ________________are particularly interested in
assessing liquidity.
ƒ The measures that can be used to determine the enterprise’s short-term debt
paying ability are the current ratio, the acid-test ratio, the current cash debt
coverage ratio, the receivables turnover ratio, the average collection period, the
inventory turnover, and the average days in inventory.
1. The current ratio expresses the relationship of current assets to current
liabilities, computed by dividing current assets by current liabilities.
The current ratio is widely used for evaluating a company’s ____________
The current ratio does not take into account the ________________________.
2. The acid-test ratio or quick ratio is a measure of a company’s
_________________________ liquidity.
• The acid-test ratio is computed by dividing the sum of
_______________________________ by current liabilities.
• The ratio does not include_________________________________.
• Cash, short-term investments, and receivables (net) are highly liquid compared
with inventory and prepaid expenses.
3. Current cash debt coverage ratio is the ratio of cash provided by
operating activities to average current liabilities.
• A disadvantage of the current ratio is that it uses year-end balances of
current asset and current liability accounts.
• Because it uses cash provided by operating activities rather than a
balance at one point in time, it may provide a better representation of
liquidity.
4. The receivables turnover ratio measures liquidity by determining how
quickly certain assets can be converted to cash.
• The receivables turnover ratio measures the number of times, on
average, receivables are collected during the period.
• The receivables turnover ratio is computed by dividing net credit sales
(net sales less cash sales) by average gross receivables during the year.
5. The average collection period is a popular variant of the receivables
turnover ratio.
• The average collection period converts the receivables turnover into an
average collection period expressed in days.
• The ratio is computed by dividing the receivables turnover ratio into 365
days.
• The general rule is that the collection period should not greatly exceed
the_____________________.
• Analysts frequently use the average collection period to assess the
effectiveness of a company’s________________________________.
6.
The inventory turnover ratio measures the number of times on average
the inventory is sold during the period.
• The purpose of this ratio is to measure the ______________of the
inventory.
• The inventory turnover ratio is computed by dividing the cost of goods
sold by the average inventory during the period.
• Generally, the ____________the inventory turnover the less cash is tied
up in inventory and the less the chance of inventory becoming obsolete.
• A downside of high inventory turnover is that the company can run out
of inventory when it is needed.
7. Days in inventory is a variant of the inventory turnover ratio.
• The days in inventory measures the average number of days it takes to
sell the inventory.
• It is computed by dividing the inventory turnover ratio into 365 days.
♦ Solvency ratios—measure the ability of the enterprise to survive over a long
period of time.
ƒ _______________________________________are interested in a company’s
long-run solvency, particularly its ability to pay interest as it comes due and to
repay the fact value of debt at maturity.
8. The debt to total asset ratio measures the percentage of total assets
provided by creditors.
• This ratio indicates the degree of financial leveraging and provides some
indication of the company’s ability to withstand losses without impairing the
interests of its creditors.
The higher the percentage of debt to total assets, the greater the ____________that
the company may be unable to meet its maturing obligations.
9. The times interest earned ratio, also called interest_______________,
indicates the company's ability to meet interest payments as they come due.
• The ratio is computed by dividing income before interest expense and
income taxes by interest expense.
10. The cash debt coverage ratio is the ratio of cash provided by operating
activities to average total liabilities.
• This ratio is a cash-basis measure of solvency.
• The cash debt coverage ratio indicates a company's ability to repay its
liabilities from cash generated from operating activities without having
to liquidate the assets used in its operations.
11. Free cash flow is an indication of a company's solvency and its ability
to______________________________________.
• Free cash flow is the amount of excess cash generated after investing to
maintain current productive capacity and pay dividends.
♦ Profitability ratios—measure the income or operating success of an enterprise
for a given period of time.
ƒ Profitability ratios are important because a company’s income or lack of it,
affects its ability to obtain debt and equity financing, its liquidity position, and
its ability to grow.
ƒ Profitability is frequently used as the ultimate test of ____________________
__________________________.
• 12.
The return on assets ratio measures the overall profitability of assets in
terms of the income earned on each dollar invested in assets.
• The return on assets ratio is computed by dividing net income by average total
assets.
13. The profit margin ratio, or rate of return on sales, is a measure of the
percentage of each dollar of sales that results in net income.
• The return on assets ratio is affected by two factors, the first of which is the
profit margin ratio.
The profit margin ratio is computed by dividing net income by net sales for the
period
14.
The gross profit rate indicates a company's ability to maintain an adequate
selling price above its cost of goods sold.
• The profit margin is one of two factors that strongly influence the profit
margin ratio.
• The gross profit rate is found by dividing gross profit (net sales less cost
of goods sold) by net sales.
15. Earnings per share (EPS) is a measure of the net income earned on each
share of common stock.
• Expressing net income earned on a per share basis provides a useful
perspective for determining profitability.
• Earnings per share is computed by dividing net income by the average
number of common shares outstanding during the year.
• When we use "net income per share" or "earnings per share," it refers to
the amount of net income applicable to each share of common stock.
16.
The price-earnings (P-E) ratio measures the ratio of the market price of
each share of common stock to the earnings per share.
• The price-earnings ratio is a reflection of investors' assessments of a
company's future earnings.
• The ratio is computed by dividing the market price per share of the
stock by earnings per share.
17.
The payout ratio measures the percentage of earnings distributed in the
form of cash dividends.
• Companies that have high growth rates are characterized by low payout
ratios because they reinvest most of their net income in the business.
• The payout ratio is computed by dividing cash dividends declared on
common stock by net income.
Study Objective 7 – Understand the Concept of Quality of Earnings
♦ A company that has a high ________________________provides full and transparent
information that will not confuse or mislead users of financial statements.
♦ The issue of quality of earnings has taken on increasing importance because recent
accounting scandals suggest that some companies are spending too much time
managing their income and not enough time managing their business.
♦ Some of the factors affecting quality of earnings include the following:
• Alternative accounting methods – Variations among companies in the
application of generally accepted accounting principles may hamper
comparability and reduce quality of earnings.
• Pro Forma Income – Companies whose stock is publicly traded are required
to present their income statement following generally accepted accounting
principles (GAAP).
• Improper recognition – Because some managers have felt the pressure to
continually increase earnings to meet Wall Street’s expectations, they have
manipulated the earnings numbers to meet these expectations.