“How Well Am I Doing?”
Financial Statement
Analysis
Chapter Sixteen
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Limitations of Financial Statement Analysis
Differences in accounting methods between
companies sometimes make comparisons
difficult.
We use the LIFO method to
value inventory.
McGraw-Hill/Irwin
We use the average cost
method to value inventory.
Copyright © 2008, The McGraw-Hill Companies, Inc.
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Limitations of Financial Statement Analysis
Industry
trends
Technological
changes
Changes within
the company
Consumer
tastes
Economic
factors
Analysts should look beyond
the ratios.
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Learning Objective 1
Prepare and interpret
financial statements in
comparative and
common-size form.
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Statements in Comparative and CommonSize Form
 Dollar and percentage
changes on statements
An item on a financial
statement has little
meaning by itself. The
meaning of the numbers
can be enhanced by
drawing comparisons.
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 Common-size
statements
 Ratios
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Dollar and Percentage Changes on
Statements
16-6
Horizontal analysis (or trend analysis) shows
the changes between years in the financial
data in both dollar and percentage form.
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Horizontal Analysis
Example
The following slides illustrate a horizontal
analysis of Clover Corporation’s
December 31, 2007 and 2006, comparative
balance sheets and comparative
income statements.
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Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31
2007
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
McGraw-Hill/Irwin
$
12,000
60,000
80,000
3,000
155,000
40,000
120,000
160,000
$ 315,000
Increase (Decrease)
Amount
%
2006
$
23,500
40,000
100,000
1,200
164,700
40,000
85,000
125,000
$ 289,700
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Horizontal Analysis
Calculating Change in Dollar Amounts
Dollar
Change
=
Current Year
Figure
–
Base Year
Figure
The dollar
amounts for
2006 become
the “base” year
figures.
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Horizontal Analysis
Calculating Change as a Percentage
Percentage
Change
McGraw-Hill/Irwin
=
Dollar Change
Base Year Figure
×
100%
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16-11
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31
2007
2006
Increase (Decrease)
Amount
%
Assets
Current assets:
Cash
$ 12,000 $ 23,500 $ (11,500)
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
Total current assets
164,700
$12,000 155,000
– $23,500
= $(11,500)
Property and equipment:
Land
40,000
40,000
Buildings and equipment,($11,500
net
120,000
85,000
÷ $23,500)
× 100% =
Total property and equipment
160,000
125,000
Total assets
$ 315,000 $ 289,700
McGraw-Hill/Irwin
(48.9)
48.9%
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Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31
2007
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
McGraw-Hill/Irwin
$
12,000
60,000
80,000
3,000
155,000
40,000
120,000
160,000
$ 315,000
$
2006
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
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Horizontal Analysis
We could do this for the liabilities
& stockholders’ equity, but now
let’s look at the income statement
accounts.
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Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
2007
2006
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
McGraw-Hill/Irwin
Increase
(Decrease)
Amount
%
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Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
2007
2006
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
McGraw-Hill/Irwin
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)
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Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2007
2006
Amount
%
Sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Sales increased
by 8.3%,
yet
Operating expenses
128,600
126,000
2,600
2.1
net income decreased by 21.9%.
Net operating income
31,400
39,000
(7,600) (19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Net income before taxes
25,000
32,000
(7,000) (21.9)
Less income taxes (30%)
7,500
9,600
(2,100) (21.9)
Net income
$ 17,500 $ 22,400 $ (4,900) (21.9)
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Horizontal Analysis
CLOVER
CORPORATION
There were increases
in both
cost of goods
Comparative
Income
Statements
sold (14.3%) and
operating
expenses
(2.1%).
For the Years Ended December 31
These increased
costs more than offset the
Increase
increase in sales, yielding an overall (Decrease)
decrease in net
income.
2007
2006
Amount
%
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)
McGraw-Hill/Irwin
8.3
14.3
(3.0)
2.1
(19.5)
(8.6)
(21.9)
(21.9)
(21.9)
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Trend Percentages
Trend percentages
state several years’
financial data in terms
of a base year, which
equals 100 percent.
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Trend Analysis
Trend =
Percentage
McGraw-Hill/Irwin
Current Year Amount
Base Year Amount
× 100%
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16-20
Trend Analysis
Example
Look at the income information for Berry
Products for the years 2003 through 2007.
We will do a trend analysis on these
amounts to see what we can learn
about the company.
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Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
Item
Sales
Cost of goods sold
Gross margin
2007
$ 400,000
285,000
115,000
2006
$ 355,000
250,000
105,000
Year
2005
$ 320,000
225,000
95,000
2004
$ 290,000
198,000
92,000
2003
$ 275,000
190,000
85,000
The base
year is 2003, and its amounts
will equal 100%.
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Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
Item
2007
2006
Year
2005
Sales
Cost of goods sold
Gross margin
2004
105%
104%
108%
2003
100%
100%
100%
2004 Amount ÷ 2003 Amount × 100%
( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
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Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
Item
Sales
Cost of goods sold
Gross margin
2007
145%
150%
135%
2006
129%
132%
124%
Year
2005
116%
118%
112%
2004
105%
104%
108%
2003
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.
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Trend Analysis
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
2003
2004
2005
2006
2007
Year
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Common-Size Statements
Vertical analysis focuses
on the relationships
among financial statement
items at a given point in
time. A common-size
financial statement is a
vertical analysis in which
each financial statement
item is expressed as a
percentage.
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Common-Size Statements
In income
statements, all
items usually
are expressed
as a percentage
of sales.
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Gross Margin Percentage
Gross Margin = Gross Margin
Percentage
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.
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Common-Size Statements
In balance
sheets, all items
usually are
expressed as a
percentage of
total assets.
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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.
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Common-Size Statements
Example
Let’s take another look at the information
from the comparative income statements
of Clover Corporation for 2007 and 2006.
This time, let’s prepare common-size
statements.
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Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2007
2006
2007
2006
Sales
$ 520,000 $ 480,000
100.0
100.0
Cost of goods sold
360,000
315,000
Sales is
Gross margin
160,000
165,000
usually the
Operating expenses
128,600
126,000
base and is
Net operating income
31,400
39,000
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
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Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2007
2006
2007
2006
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
2007 Cost ÷ 2007 Sales × 100%
Net operating income
31,400
39,000
( $360,000 ÷ $520,000
) × 100%
= 69.2%
Interest expense
6,400
7,000
Net income before taxes
32,000
2006 Cost ÷25,000
2006 Sales
× 100%
Less income taxes (30%)
7,500
9,600
( $315,000 ÷ $480,000 ) × 100% = 65.6%
Net income
$ 17,500 $ 22,400
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Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
What conclusions can we draw?
Percentages
2007
2006
2007
2006
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
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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.
McGraw-Hill/Irwin
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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
Horizontal
shows the
changes
the
current analysis
year’s financial
statements.
between years in the financial data in both
d. None of the above.
dollar and percentage form.
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Now, let’s look at
Norton
Corporation’s
2007 and 2006
financial
statements.
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NORTON CORPORATION
Balance Sheets
December 31
2007
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
McGraw-Hill/Irwin
$
2006
30,000
20,000
12,000
3,000
65,000
165,000
116,390
281,390
$ 346,390
$
20,000
17,000
10,000
2,000
49,000
123,000
128,000
251,000
$ 300,000
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16-38
NORTON CORPORATION
Balance Sheets
December 31
2007
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
Notes payable, short-term
Total current liabilities
Long-term liabilities:
Notes payable, long-term
Total liabilities
Stockholders' equity:
Common stock, $1 par value
Additional paid-in capital
Total paid-in capital
Retained earnings
Total stockholders' equity
$
39,000
3,000
42,000
2006
$
40,000
2,000
42,000
70,000
112,000
78,000
120,000
27,400
158,100
185,500
48,890
234,390
17,000
113,000
130,000
50,000
180,000
Total liabilities and stockholders' equity $ 346,390
$ 300,000
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NORTON CORPORATION
Income Statements
For the Years Ended December 31
Sales
Cost of goods sold
Gross margin
Operating expenses
Net operating income
Interest expense
Net income before taxes
Less income taxes (30%)
Net income
McGraw-Hill/Irwin
2007
2006
$ 494,000 $ 450,000
140,000
127,000
354,000
323,000
270,000
249,000
84,000
74,000
7,300
8,000
76,700
66,000
23,010
19,800
$ 53,690 $ 46,200
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16-40
Learning Objective 2
Compute and interpret
financial ratios that would
be useful to a common
stockholder.
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Ratio Analysis – The Common Stockholder
The ratios that
are of the most
interest to
stockholders
include those
ratios that focus
on net income,
dividends, and
stockholders’
equities.
McGraw-Hill/Irwin
NORTON CORPORATION
2007
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
2
Dec. 31 market price per share
Interest expense
20
7,300
Total assets
Beginning of year
300,000
End of year
346,390
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16-42
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.
Earnings form the basis for dividend payments
and future increases in the value of shares of
stock.
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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.
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Price-Earnings Ratio
Price-Earnings
Ratio
Price-Earnings
Ratio
=
=
Market Price Per Share
Earnings Per Share
$20.00
$2.42
= 8.26 times
A higher price-earnings ratio means that
investors are willing to pay a premium
for a company’s stock because of
optimistic future growth prospects.
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Dividend Payout Ratio
Dividend
Payout Ratio
Dividend
Payout Ratio
=
=
Dividends Per Share
Earnings Per Share
$2.00
$2.42
= 82.6%
This ratio gauges the portion of current
earnings being paid out in dividends. Investors
seeking dividends (market price growth) would
like this ratio to be large (small).
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Dividend Yield Ratio
Dividend
Yield Ratio
Dividend
Yield Ratio
=
=
Dividends Per Share
Market Price Per Share
$2.00
$20.00
= 10.00%
This ratio identifies the return, in terms
of cash dividends, on the current
market price of the stock.
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Return on Total Assets
Return on
=
Total Assets
Net Income + [Interest Expense × (1 – Tax Rate)]
Average Total Assets
Return on
=
Total Assets
$53,690 + [$7,300 × (1 – .30)]
= 18.19%
($300,000 + $346,390) ÷ 2
Adding interest expense back to net income
enables the return on assets to be compared
for companies with different amounts of debt
or over time for a single company that has
changed its mix of debt and equity.
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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 used the owners’
investments to earn income.
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Financial Leverage
Financial leverage results from the difference
between the rate of return the company earns on
investments in its own assets and the rate of return
that the company must pay its creditors.
McGraw-Hill/Irwin
Return on
investment in >
assets
Fixed rate of
return on
borrowed
funds
Positive
= financial
leverage
Return on
investment in <
assets
Fixed rate of
return on
borrowed
funds
Negative
= financial
leverage
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16-50
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.
McGraw-Hill/Irwin
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16-51
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.
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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 after all creditors were paid off.
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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.
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Learning Objective 3
Compute and interpret
financial ratios that would
be useful to a short-term
creditor.
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Ratio Analysis – The Short–Term Creditor
Short-term
creditors, such as
suppliers, want to
be paid on time.
Therefore, they
focus on the
company’s cash
flows and working
capital.
McGraw-Hill/Irwin
NORTON CORPORATION
2007
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
494,000
Cost of goods sold
140,000
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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 longterm debt and equity.
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Working Capital
December 31,
2007
Current assets
$
Current liabilities
Working capital
McGraw-Hill/Irwin
65,000
(42,000)
$
23,000
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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.
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Current Ratio
McGraw-Hill/Irwin
Current
Ratio
=
Current Assets
Current Liabilities
Current
Ratio
=
$65,000
$42,000
=
1.55
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Acid-Test (Quick) Ratio
Acid-Test
=
Ratio
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
$50,000
$42,000
= 1.19
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.
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Accounts Receivable Turnover
Accounts
Receivable
Turnover
=
Sales on Account
Average Accounts Receivable
Accounts
$494,000
= 26.7 times
Receivable =
($17,000 + $20,000) ÷ 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.
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Average Collection Period
Average
365 Days
Collection = Accounts Receivable Turnover
Period
Average
Collection =
Period
365 Days
26.7 Times
= 13.67 days
This ratio measures, on average,
how many days it takes to collect
an account receivable.
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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.
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Inventory Turnover
Inventory
Turnover
=
Inventory
Turnover
=
McGraw-Hill/Irwin
Cost of Goods Sold
Average Inventory
$140,000
= 12.73 times
($10,000 + $12,000) ÷ 2
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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.
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Learning Objective 4
Compute and interpret
financial ratios that would
be useful to a long-term
creditor.
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Ratio Analysis – The Long–Term Creditor
Long-term creditors are concerned with
a company’s ability to repay its loans
over the long-run.
NORTON CORPORATION
2007
Earnings before interest
expense and income taxes
Interest expense
This is also referred
to as net operating
income.
McGraw-Hill/Irwin
$
84,000
7,300
Total stockholders' equity
234,390
Total liabilities
112,000
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Times Interest Earned Ratio
Times
Interest =
Earned
Times
Interest =
Earned
Earnings before Interest Expense
and Income Taxes
Interest Expense
$84,000
= 11.51 times
$7,300
This is the most common
measure of a company’s ability
to provide protection for its longterm creditors. A ratio of less
than 1.0 is inadequate.
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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.
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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
McGraw-Hill/Irwin
$112,000
$234,390
= 0.48
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Published Sources That Provide
Comparative Ratio Data
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End of Chapter 16
McGraw-Hill/Irwin
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