ACG 2071
Module 3: Financial Statement Analysis
Basic Analytical Procedures
The basic financial statements provide much of the information users need
to make economic decisions about businesses.
In order to make decisions, we must analyze the financial statements.
Horizontal Analysis
o Percentage analysis of increases and decreases in related items in
comparative financial statements.
o Comparing of income statements for two years
o Comparing of balance sheets for two years
Example: Below is a excerpt from a comparative balance for Diaz Company.
2006
Assets
Current assets
Fixed assets
Total assets
Liabilities
Current liabilities
Long term liabilities
Total liabilities
Equity
Common stock
Retained earinings
Total equity
Total liab & equity
2005
Amount
Percent
$550,000
$445,000
$995,000
$533,000
$470,000
$1,003,000
$17,000
-$25,000
-$8,000
3.2%
-5.4%
-2.2%
$200,000
$100,000
$300,000
$150,000
$125,000
$275,000
$50,000
-$20,000
$30,000
25%
-20%
5%
$500,000
195,000
$695,000
$995,000
$428,000
$300,000
$728,000
$1,003,000
$72,000
$105,000
$33,000
- $8,000
17%
-35%
-18%
-2.2%
More information is needed to evaluate the decreases and increases above. But
we can see a significant change in liabilities but not in assets.
Same can be done for an income statement
Vertical Analysis
Created by: M. Mari
Fall 2007
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ACG 2071
Module 3: Financial Statement Analysis
o A percentage analysis may also be used to show the relationship of
each component to the total within a single statement.
o Balance sheet
 Each asset is shown as percentage of total assets
 Each liability as percentage of total liabilities
o Income statement
 Each item is shown as percentage of net sales.
o Common size statements
 Can be used to compare to companies in the same industry
Solvency Analysis
Solvency is the ability of a company to pay its debts.
Profitability is the ability of a business to earn income.
o They are interrelated.
Solvency analysis focuses on the ability of a business to pay or otherwise
satisfy its current and noncurrent liabilities.
o Assessed by examining balance sheet relationships
o Major analyses are:
 Current position analysis
 Accounts receivable analysis
 Inventory analysis
 The ratio of fixed assets to long-term liabilities
 The number of times interest charges are earned.
Example: Suppose the following balance sheet information is available for two
companies:
Company A
2006
Current Assets
Cash
Marketable Securities
Accounts receivable
Inventories
Prepaid Expenses
Total current assets
Current liabilities
$
$
$
$
$
$
$
78,000.00
52,000.00
106,000.00
218,000.00
6,000.00
460,000.00
320,000.00
Company B
2006
2005
$
$
$
$
$
$
$
82,500.00
60,000.00
152,000.00
260,000.00
4,200.00
558,700.00
480,000.00
$
$
$
$
$
$
$
160,000.00
85,000.00
208,000.00
350,000.00
10,000.00
813,000.00
705,000.00
2005
$
$
$
$
$
$
$
Current Position Analysis
o Measures to assess a business’s ability to pay its current liabilities
Created by: M. Mari
Fall 2007
Page 2 of 14
112,500.00
26,000.00
172,000.00
312,500.00
10,000.00
633,000.00
375,000.00
ACG 2071
Module 3: Financial Statement Analysis
o Special interest to short-term creditors
o Working Capital
 Current assets minus current liabilities
 Used in evaluating a company’s ability to meet currently
maturing debts.
o Current Ratio
 Working capital ratio or banker’s ratio
 Computed by dividing current assets by current liabilities.
Example: Using the example above compute the working capital and the current
ratio.
Company A
2006
Working Capital
Current assets current liabilities
Current ratio
current assets/current
liabilities
$
Company B
2006
2005
140,000.00
460000/320000
1.4
$
78,700.00
558700/480000
1.2
$
108,000.00
813000/705000
2005
$
258,000.00
633000/375000
1.2
The companies in the above example, both have positive working capital and
current ratios of over 1. Yet the ability of each company to pay its debts is
significantly different.
Monies tied up in inventory and receivables are harder to convert to cash than
cash or securities. Therefore, the time factor may make the companies less
solvent.
o Quick Ratio:
 A ratio that measures the instant debt paying ability of a
company
 Also called the acid test ratio
 Ratio of quick assets to total current liabilities
 Quick assets are cash and other current assets that can
be quickly converted to cash such as marketable
securities and accounts receivables.

Created by: M. Mari
Fall 2007
Page 3 of 14
1.7
ACG 2071
Module 3: Financial Statement Analysis
Company
Company
A
B
2006
2005
2006
2005
$
78,000.00
$
52,000.00
$
106,000.00
$
236,000.00
$
320,000.00
$
82,500.00
$
60,000.00
$
152,000.00
$
294,500.00
$
480,000.00
$
160,000.00
$
85,000.00
$
208,000.00
$
453,000.00
$
705,000.00
$
112,500.00
$
26,000.00
$
172,000.00
$
310,500.00
$
375,000.00
236000/320000
294500/480000
453000/705000
31500/375000
0.7
0.6
0.6
Current Assets
Cash
Marketable Securities
Accounts receivable
Total Quick Assets
Total current
liabilities
Quick ratio
quick assets/ current
liabilities
0.8
o Accounts receivable analysis
 The size and makeup of accounts receivable change constantly
during business operations
 Companies desire to collect receivables as promptly as possible
 Cash collected from receivables improve solvency
 Accounts receivable turnover
 Relationship between sales and accounts receivable
 Computed by net sales divided by average net accounts
receivable
 Average of accounts receivable
o Beginning balance plus ending balance divided by
2
 Higher the turnover the better.
Net sales
Accounts receivable
Beginning of year
End of Year
$
Company A
2006
1,500,000.00
$
$
152,000.00
76,000.00
Average Accounts Receivable
(152000+76000)/2
$
114,000.00
(152000+208000)/2
$
180,000.00
Accounts receivable turnover
1500000/114000
998000/180000
13.2
Created by: M. Mari
Fall 2007
Page 4 of 14
$
2005
998,000.00
$
$
208,000.00
152,000.00
5.5
ACG 2071
Module 3: Financial Statement Analysis
 Number of days sales in receivables
 Ratio is computed by dividing the average accounts
receivable by the average daily sales.
 Average daily sales is net sales divided by 365 days
 Lower the ratio the better
Net sales
Accounts receivable
Beginning of year
End of Year
Average Accounts
Receivable
$
Company A
2006
1,500,000.00
$
2005
998,000.00
$
$
152,000.00
76,000.00
$
$
208,000.00
152,000.00
(152000+76000)/2
$
114,000.00
1500000/365
$
4,109.59
Average daily sales
Number of days sales in
receivables
(152000+208000)/2
$
180,000.00
998000/365
$
2,734.25
114000/4109.59
180000/2734.25
27.7
65.8
o Inventory Analysis
 Inventory has to be managed carefully
 Too little inventory can cause customers to seek the
product from another supplier
 Too much inventory can increase storage costs,
insurance, and obsolescence.

Created by: M. Mari
Fall 2007
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Inventory Turnover
o Relationship between the volume of goods sold
and inventory
o Computed by cost of goods sold divided by
average inventory
o Average inventory is beginning inventory plus
ending inventory divided by 2
o Higher the ratio the better
ACG 2071
Module 3: Financial Statement Analysis
Cost of goods sold
Inventories
Beginning of year
End of year
Average inventory
Inventory Turnover
$
Company A
2006
765,000.00
$
$
312,000.00
$
189,000.00
(312000+189000)/2
$
250,500.00
765000/250500
2005
820,000.00
$
423,000.00
$
312,000.00
(312000+423000)/2
$
367,500.00
820000/367500
3.1

2.2
Number of days’ sales in inventory
 Relationship between cost of goods sold and inventory
 Computed by dividing the average inventory by the
average daily cost of goods sold ( COGS/365 days)
 Rough measure of the length of time it takes to acquire,
sell, and replace inventory
 Lower the ratio the better
Cost of goods sold
Inventories
Beginning of year
End of year
Average inventory
Average COGS
$
Company A
2006
765,000.00
$
$
312,000.00
$
189,000.00
(312000+189000)/2
$
250,500.00
765000/365
2,095.9
Number of days sales
in inventory
250500/2095.9
$
423,000.00
$
312,000.00
(312000+423000)/2
$
367,500.00
820000/365
2,246.6
367500/2246.6
119.5
Created by: M. Mari
Fall 2007
Page 6 of 14
2005
820,000.00
163.6
ACG 2071
Module 3: Financial Statement Analysis
o Ratio of fixed assets to long-term liabilities
 Indicates the margin of safety of the noteholders or bondholders
 Indicates the ability of the business to borrow additional funds
on a long-term basis.
 Higher the better
Fixed assets (net)
Long-term liabilities
Ratio of fixed assets
to long-term
liabilities
$
$
Company A
2006
350,000.00
175,000.00
2005
480,000.00
210,000.00
$
$
2.0
2.3
o Ratio of liabilities to stockholder’s equity
 Claims against the total assets of a business are divided into
two groups
 Claims of creditors
 Claims of owners
 the relationship between the total claims of the creditors and
owners
 solvency measure that indicates the margin of safety for
creditors
 indicates the ability of the business to withstand adverse
business conditions when the claims of creditors are large in
relation to the equity of the stockholders, there are usually
significant interest payments.
 If earnings decline to the point that company is unable to
meet interest payments, creditors may take over the
business.
 lower the better
Total liabilities
Total stockholder's Equity
Ratio of fixed assets to longterm liabilities
Created by: M. Mari
Fall 2007
Page 7 of 14
$
$
Company A
2006
425,000.00
680,000.00
$
$
0.6
2005
375,000.00
503,000.00
0.7
ACG 2071
Module 3: Financial Statement Analysis
o Number of times interest charges earned
 Called the fixed charge coverage ratio
 The relative risk of the debtholders is normally measured
 Higher the ratio, the lower the risk that interest payments will not
be made if earnings decrease.
 Indicates general financial strength of the business
Income before taxes
Add interest expense
Amount available to meet
interest charges
Number of times interest
charges earned
$
$
Company A
2006
150,000.00
4,500.00
$
$
2005
145,500.00
6,300.00
154,500.0
154500/4500
151,800.0
151800/6300
34.3
24.1
Profitability Analysis
o The ability of a business to earn profits depends of the effectiveness
and efficiency of its operations as well as the resources available to it.
o Focuses primarily on the relationship between operating results as
reported in the income statement and resources available to the
business as reported in the balance sheet
o Major analysis used
 Ratio of net sales to assets
 Rate earned on total assets
 Rate earned on stockholder’s equity
 Rate earned on common stockholder’s equity
 Earnings per share on common stock
 Price-earning ratio
 Dividends per share
 Dividend yield
o Ratio of net sales to assets
 Is a profitability measure that shows how effectively a firm
utilizes its assets
 Higher the ratio is better
 Computed by dividing net sales by average total assets
(beginning total assets + ending total assets)/2
Created by: M. Mari
Fall 2007
Page 8 of 14
ACG 2071
Module 3: Financial Statement Analysis
Company A
2006
765,000.00
2005
820,000.00
Net sales
Total assets
Beginning of year
End of year
Average Total Assets
$
$
$
980,000.00
$
1,020,000.00
(980000+1020000)/2
$
1,000,000.00
$
800,000.00
$
980,000.00
(980000+800000)/2
$
890,000.00
Ratio of net sales to total assets
765000/1000000
820000/890000
0.8
0.9
o Rate earned on total assets
 Measures the profitability of total assets without considering
how the assets are financed.
 Higher the ratio is better
 Computed by adding interest expense to net income and then
dividing by average total assets
Net income
Plus interest expense
TOTAL
Total assets
Beginning of year
End of year
Average Total Assets
Rate earned on total
assets
$
$
$
Company A
2006
165,000.00
6,000.00
171,000.00
$
$
$
$
980,000.00
$
1,020,000.00
(980000+1020000)/2
$
1,000,000.00
$
800,000.00
$
980,000.00
(980000+800000)/2
$
890,000.00
171000/1000000
269000/890000
0.2
Created by: M. Mari
Fall 2007
Page 9 of 14
2005
250,000.00
19,000.00
269,000.00
0.3
ACG 2071
Module 3: Financial Statement Analysis
o Rate earned on stockholder’s equity
 The measures emphasizes the rate of income earned on the
amount invested by the stockholders.
 Higher the ratio is better
 Computed by net income divided by average stockholder’s
equity
 The rate earned by a business on the equity of its stockholders
is usually higher than the rate earned on total assets.
 Occurs when the amount earned on assets acquired with
creditors’ funds is more than the interest paid to creditors
 The difference in the rate on stockholder’s equity and the
rate on total assets is called
o LEVERAGE
Net income
Stockholder's equity
Beginning of year
End of year
Average Total Assets
Rate earned on
stockholder’s equity
Rate earned on assets
LEVERAGE
$
Company A
2006
165,000.00
$
$
1,250,000.00
$
1,500,000.00
(1500000+1250000)/2
$
1,375,000.00
2005
250,000.00
$
800,000.00
$
1,250,000.00
(1250000+800000)/2
$
1,025,000.00
171000/1000000
269000/890000
12%
20%
8%
24%
30%
6%
o Rate earned on common stockholder’s equity
 Common stockholder’s have a residual claim on earnings
 This measure focuses only on the rate of profits earned on the
amount invested by the common stockholders
 Computed by subtracting the preferred dividends requirements
from the net income and dividing by the average common
stockholder’s equity. .
 Higher the ratio is better
Created by: M. Mari
Fall 2007
Page 10 of 14
ACG 2071
Module 3: Financial Statement Analysis
Net income
Preferred dividends
TOTAL
Common Stockholder's
equity
Beginning of year
End of year
Average Total Assets
Company A
2006
165,000.00
9,000.00
174,000.00
$
$
$
$
$
$
$
850,000.00
$
950,000.00
(850000+950000)/2
$
900,000.00
Rate earned on common
stockholder's equity
2005
250,000.00
9,000.00
259,000.00
$
600,000.00
$
850,000.00
(950000+600000)/2
$
725,000.00
174000/900000
259000/725000
19%
36%
o Earnings per share
 Normally reported in the income statement on corporate annual
reports
 Computed by dividing net income by the number of shares of
stock outstanding
 If preferred and common stock are outstanding, the net income
is reduced by the amount of preferred stock dividends.
Net income
Preferred dividends
TOTAL
Shares of common stock
EPS
$
$
$
Company A
2006
165,000.00
9,000.00
174,000.00
50000
174000/50000
$
3.48
2005
$
250,000.00
$
9,000.00
$
259,000.00
45000
259000/45000
$
5.76
o Price-Earnings Ratio
 Indicator of a firm’s future earnings prospects
 Computed by dividing the market price per share of common
stock at a specific date by the annual earnings per share.
Market price per share
Earnings per share
Price earnings ratio
Created by: M. Mari
Fall 2007
Page 11 of 14
$
$
Company A
2006
25.00
1.52
2005
$
$
16.45
17.50
1.36
12.87
ACG 2071
Module 3: Financial Statement Analysis
o Dividends per share and dividend yield
 Indicator of a firm’s future earnings prospects
 Computed by dividing the dividends per share by the market
price
Dividends per share
Market price per share
Dividend yield
Created by: M. Mari
Fall 2007
Page 12 of 14
$
$
Company A
2006
0.80
25.00
2005
$
$
0.03
1.20
17.50
0.07
ACG 2071
Module 3: Financial Statement Analysis
Formula
Solvency Measures:
Working Capital
Current Assets – Current Liabilities
Use
To indicate the ability to meet current
obligations
Current Ratio
Current Assets
Current Liabilities
Quick Ratio
Quick Assets
Current Liabilities
To indicate instant debt paying ability
Accounts receivable turnover
Net sales
Average accounts receivable
To assess the efficiency in collecting
receivables and in the management of
credit
Number of days’ sales in receivables
Average accounts receivable
Average daily sales
Inventory Turnover
Cost of Goods Sold
Average Inventory
Average inventory
Average Daily COGS
To assess the efficiency in the
management of inventory
Ratio of Fixed Assets to Long-term
Liabilities
Fixed Assets (net)
Long-term liabilities
To indicate the margin of safety to
creditors
Ratio of liabilities to Stockholders’
Equity
Total liabilities
Total stockholders’ Equity
To indicate the margin of safety to
creditors
Number of times interest charges
earned
Income before income tax + Interest Expense
Interest Expense
To assess the risk to debtholders in
terms of number of times interest
charges were earned
Net Sales
Average total assets
To assess the effectiveness in the use
of assets
Rate earned on total assets
Net income + Interest Expense
Average total assets
To assess the profitability of assets
Rate earned on Stockholders’ Equity
Net income
Average Total stockholders’ equity
To assess the profitability of the
investment by stockholders
Rate earned on Common
Stockholders’ Equity
Earnings per share on common
stock
Net income- Preferred dividends
Average Total common stockholders’ equity
Net income – Preferred dividends
Shares of common stock outstanding
To assess the profitability of investment
by common stockholders
Price Earnings Ratio
Market price per share of common stock
Earnings per share of common stock
Dividends per share of common
stock
Dividends
Shares of common stock outstanding
Dividend Yield
Dividends per share of common stock
Market price per share of common stock
To indicate the future earnings
prospects based on the relationship
between market value of common
stock and earnings
To indicate the extent to which
earnings are being distributed to
common stockholders
To indicate the rate of return to
common stockholders in terms of
dividends
Number of Days’ Sales in Inventory
Profitability Measures
Ratio of Net Sales to Assets
Created by: M. Mari
Fall 2007
Page 13 of 14
ACG 2071
Module 3: Financial Statement Analysis
Created by: M. Mari
Fall 2007
Page 14 of 14