WORKING WITH FINANCIAL
STATEMENTS
14-1
Financial Statement Analysis
14-2

Horizontal analysis (Comparative Analysis),
also called trend analysis

Vertical analysis (Common Size Analysis)

Ratio Analysis
3-2
Horizontal Analysis
Horizontal analysis, also called trend analysis, is a
technique for evaluating a series of financial statement data
over a period of time.
14-3

Purpose is to determine the increase or decrease.

Commonly applied to the
►
balance sheet,
►
income statement, and
►
statement of retained earnings.
LO 1
Horizontal Analysis
14-4
Horizontal Analysis
Illustration 14-5
Horizontal analysis of
balance sheets
Changes suggest that
the company
expanded its asset
base during 2013 and
financed this
expansion primarily
by retaining income
rather than assuming
additional long-term
debt.
14-5
LO 1
Horizontal Analysis
14-6
LO 1
Horizontal Analysis
Illustration 14-6
Horizontal analysis of
Income statements
Overall, gross profit
and net income were
up substantially.
Gross profit increased
17.1%, and net
income, 26.5%.
Quality’s profit trend
appears favorable.
14-7
LO 1
Horizontal Analysis
Illustration 14-7
Horizontal analysis of
retained earnings
statements
14-8
The ending retained earnings increased 38.6%. As
indicated earlier, the company retained a significant
portion of net income to finance additional plant facilities.
LO 1
Vertical Analysis
Vertical analysis, also called common-size analysis
When comparing the financial statements to those of other
similar companies, we may have a problem :
Differences in size  GM and Ford
Differences in Currency  GM and Toyota.
Therefore we do prepare
Common-Size Statements
14-9
Common-Size Balance Sheets
Common-Size Income Statements
Common-size
Balance Sheets
14-10

Common-size Balance Sheets restates the
balance sheets items as a percentage of total
assets
•
In other words, we compute all accounts as a percent of
total assets
Basket Wonders’ Common Size Balance
Sheets
Regular (thousands of $)
Assets
2002
2003
2001
2002
2003
Cash
AR
Inv
Other CA
148
283
322
10
100
410
616
14
90
394
696
15
12.10
23.14
26.33
0.82
4.89
20.06
30.14
0.68
4.15
18.17
32.09
0.69
Tot CA
Net FA
LT Inv
Other LT
763
349
0
111
1,140
631
50
223
1,195
701
50
223
62.39
28.54
0.00
9.08
55.77
30.87
2.45
10.91
55.09
32.32
2.31
10.28
1,223
2,044
2,169
100.0
100.0
100.0
Tot Assets
14-11
2001
Common-Size (%)
Basket Wonders’ Common Size Balance
Sheets
Regular (thousands of $)
Liab+Equity
14-12
2001
2002
2003
Common-Size (%)
2001
2002
2003
Note Pay
Acct Pay
Accr Tax
Other Accr
290
81
13
15
295
94
16
100
290
94
16
100
23.71
6.62
1.06
1.23
14.43
4.60
0.78
4.89
13.37
4.33
0.74
4.61
Tot CL
LT Debt
Equity
399
150
674
505
453
1,086
500
530
1,139
32.62
12.26
55.11
24.71
22.16
53.13
23.05
24.44
52.51
Tot L+E
1,223
2,044
2,169
100.0
100.0
100.0
Common-size
Income Statement

Common-size income statement restates the
income statement items as a percentage of
sales.
•
In other words, we compute all line items as a percent of
sales
14-13
Basket Wonders’ Common Size Income
Statements
Regular (thousands of $)
2001
Net Sales
COGS
14-14
2002
2003
Common-Size (%)
2001
2002
2003
1,235
849
2,106
1,501
2,211
1,599
100.0
68.7
100.0
71.3
100.0
72.3
Gross Profit
Adm.
386
180
605
383
612
402
31.3
14.6
28.7
18.2
27.7
18.2
EBIT
Int Exp
206
20
222
51
210
59
16.7
1.6
10.5
2.4
9.5
2.7
EBT
186
171
151
15.1
8.1
6.8
EAT
112
103
91
9.1
4.9
4.1
Cash Div
50
50
50
4.0
2.4
2.3
Vertical Analysis
Illustration 14-8
Vertical analysis of
balance sheets
Quality is choosing to
finance its growth
through retention of
earnings rather than
through issuing
additional debt.
14-15
LO 1
Vertical Analysis
Illustration 14-8
Vertical analysis of
balance sheets
These results
indicate the
company shifted
toward equity
financing by relying
less on debt and by
increasing the
amount
of retained
earnings.
14-16
LO 1
Vertical Analysis
Illustration 14-9
Vertical analysis of
Income statements
Quality appears
to be a profitable
enterprise that is
becoming even more
successful.
14-17
LO 1
Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 14-10
Intercompany income statement comparison
14-18
LO 1
Ratio Analysis
Ratio analysis expresses the relationship among selected
items of financial statement data.
Financial Ratio Classifications
14-19
Measuring Key Financial Relationships:
Six Key Questions
14-20
1.
How liquid is the firm?
2.
Is management generating adequate
operating profits on the firm’s assets?
3.
How is the firm financing its business?
4.
Is management providing a good return on
the capital provided by the shareholders?
(Management Effectiveness)
5.
Is the management team creating
shareholder value? (Valuations Ratios)
6.
Efficiency
Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for
cash.

Short-term creditors such as bankers and suppliers are
particularly interested in assessing liquidity.

Ratios include the current ratio, the acid-test ratio,
accounts receivable turnover, inventory turnover, and
working capital.
14-21
LO 2
QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
2013
2012
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
2013
2012
Illustration 14-12
14-22
LO 2
Ratio Analysis
Liquidity Ratios
1. CURRENT RATIO
2013
Illustration 14-12
2012
1.52:1
Ratio of 2.96:1 means that for every dollar of current liabilities, Quality
has $2.96 of current assets.
14-23
LO 2
Ratio Analysis
Liquidity Ratios
2. ACID-TEST RATIO (Quick Ratio)
Illustration 14-13
2013
14-24
2012
LO 2
QUALITY DEPARTMENT STORE INC.
QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
Balance Sheet (partial)
2013
2012
2013
2012
Illustration 14-12
14-25
LO 2
Ratio Analysis
Liquidity Ratios
2. ACID-TEST RATIO (Quick Ratio)
Illustration 14-14
2013
2012
0.47:1
Acid-test ratio measures immediate liquidity.
14-26
LO 2
The Operating Cycle



14-27
Operating cycle = time between purchasing the
inventory and collecting the cash from sale of the
inventory
Inventory period = time required to purchase and
sell the inventory  the days in inventory
Accounts receivable period = time required to
collect on credit sales  average collection period
QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
2013
14-28
2012
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
2013
2012
LO 2
Ratio Analysis
Liquidity Ratios
3. ACCOUNTS RECEIVABLE TURNOVER
Illustration 14-15
2013
2012
69.1 times
Measures the number of times, on average, the company collects
receivables during the period.
14-29
LO 2
Ratio Analysis
Liquidity Ratios
3. ACCOUNTS RECEIVABLE TURNOVER
$2,097,000
= 10.2 times
($180,000 + $230,000) / 2
A variant of the accounts receivable turnover ratio is to convert it
to an average collection period in terms of days.
365 days / 10.2 times = every 35.78 days
Accounts receivable are collected on average every 36 days.
14-30
LO 2
QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)
2013
2012
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
2013
2012
Illustration 14-12
14-31
LO 2
Ratio Analysis
Liquidity Ratios
4. INVENTORY TURNOVER
Illustration 14-16
2013
2012
3.1 times
Measures the number of times, on average, the inventory is sold
during the period.
14-32
LO 2
Ratio Analysis
Liquidity Ratios
4. INVENTORY TURNOVER
$1,281,000
= 2.3 times
($500,000 + $620,000) / 2
A variant of inventory turnover is the days in inventory.
365 days / 2.3 times = every 159 days
Inventory turnover ratios vary considerably among industries.
14-33
LO 2
Ratio Analysis
5. WORKING CAPITAL
Illustration 2-14
Working capital is the difference between the amounts of
current assets and current liabilities.
Best Buy had working capital in 2011 of $1,810 million
($10,473 million - $8,663 million).
14-34
The Balance Sheet
14-35
2-35
Ratio Analysis




14-36
Larger the working capital, better the firm’s
ability to repay its debt
Working capital can be positive or zero or
negative. It is generally positive.
Usually positive in a healthy firm
An increase in working capital may not always
be good news. For example, if the level of
inventory goes up, current assets will increase
and thus Working capital will also increase.
However, increasing inventory level may well be
a sign of inability to sell.
Measuring Key Financial Relationships:
Six Key Questions
14-37
1.
How liquid is the firm?
2.
Is management generating adequate
operating profits on the firm’s assets?
3.
How is the firm financing its business?
4.
Is management providing a good return on
the capital provided by the shareholders?
(Management Effectiveness)
5.
Is the management team creating
shareholder value? (Valuations Ratios)
6.
Efficiency
Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for a
given period of time.

Income affects the company’s ability to obtain debt and
equity financing, their liquidity position, and their ability to
grow.

14-38
Ratios include

profit margin

asset turnover

return on assets
LO 2
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
2013
14-39
2012
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
2013
2012
LO 2
Ratio Analysis
Profitability Ratios
6. PROFIT MARGIN
Illustration 14-17
2013
2012
5.3%
Measures the percentage of each dollar of sales that results in net
income.
14-40
LO 2
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
2013
2012
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
2013
2012
Illustration 14-12
14-41
LO 2
Ratio Analysis
Profitability Ratios
7. ASSET TURNOVER
Illustration 14-18
2013
2012
1.3 times
Measures how efficiently a company uses its assets to generate
sales.
14-42
LO 2
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
2013
2012
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
2013
2012
Illustration 14-12
14-43
LO 2
Ratio Analysis
Profitability Ratios
8. RETURN ON ASSET
Illustration 14-19
2013
2012
7.0%
An overall measure of profitability.
14-44
LO 2
Measuring Key Financial Relationships:
Six Key Questions
14-45
1.
How liquid is the firm?
2.
Is management generating adequate
operating profits on the firm’s assets?
3.
How is the firm financing its business?
4.
Is management providing a good return on
the capital provided by the shareholders?
(Management Effectiveness)
5.
Is the management team creating
shareholder value? (Valuations Ratios)
6.
Efficiency
Ratio Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to survive
over a long period of time.

Debt to Assets

Debt to Equity
Is ratio that provide information about debt-paying ability.
14-46
LO 2
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
2013
2012
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
2013
2012
Illustration 14-12
14-47
LO 2
Ratio Analysis
Solvency Ratios
9. DEBT TO TOTAL ASSETS RATIO
Illustration 14-25
2013
2012
71.1%
Measures the percentage of the total assets that creditors provide.
14-48
LO 2
10. DEBT TO EQUITY RATIO
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
2013
2012
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
2013
2012
Illustration 14-12
$832,000
= 82,95%
1,003,000
14-49
LO 2
Measuring Key Financial Relationships:
Six Key Questions
14-50
1.
How liquid is the firm?
2.
Is management generating adequate
operating profits on the firm’s assets?
3.
How is the firm financing its business?
4.
Is management providing a good return on
the capital provided by the shareholders?
(Management Effectiveness)
5.
Is the management team creating
shareholder value? (Valuations Ratios)
6.
Efficiency
Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for a
given period of time.

Income affects the company’s ability to obtain debt and
equity financing, their liquidity position, and their ability to
grow.

Ratios include

14-51
return on common stockholders’ equity
LO 2
QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets
2013
2012
QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31
2013
2012
Illustration 14-12
14-52
LO 2
Ratio Analysis
Profitability Ratios
11. RETURN ON COMMON
STOCKHOLDERS’ EQUITY
2013
Illustration 14-20
2012
24.2%
Shows how many dollars of net income the company earned for each
dollar invested by the owners.
14-53
LO 2
Measuring Key Financial Relationships:
Six Key Questions
14-54
1.
How liquid is the firm?
2.
Is management generating adequate
operating profits on the firm’s assets?
3.
How is the firm financing its business?
4.
Is management providing a good return on
the capital provided by the shareholders?
(Management Effectiveness)
5.
Is the management team creating
shareholder value? (Valuations Ratios)
6.
Efficiency
Quality of Earnings
Price-Earnings Ratio
Reflects investors’ assessment of a company’s future
earnings.

P-E ratio will be higher if investors think that earnings will
increase substantially in the future.

P-E ratio will be lower when there is the belief that a company
has poor-quality earnings.
Illustration 13-19
14-55
LO 7 Understand the concept of quality of earnings.
Quality of Earnings
Price-Earnings Ratio
Illustration 13-19
Illustration 13-20
Earnings per share and P-E
ratios of various companies
14-56
LO 7 Understand the concept of quality of earnings.
Book value
balance sheet
assets
liabilities
equity
Assets
14-57
=
Liabilities + Equity
Book value
•
•
•
•
•
•
14-58
Book value is a relatively straightforward concept
Book value is literally the value of a company that can be
found on the accounting ledger
Book value per share = Shareholder’s equity
Number of share outstanding
If you then take share price and divide by the current book
values, you have the price-to-book ratio
The closer to book value you can buy something at, the
better it is
To value the financial companies like banks, multi finance,
leasing, brokerages and credit card companies, the book
value is extremely relevant.
58
Book value / price-to-book value
14-59
59
14-60
60
14-61
61
PT Astra International Tbk
14-62
62
Price-to-book value

Compares the market value of a share of
stock to the book value per share of the
reported equity on the balance sheet.

Formula:
= Price per share/Equity book value per share

14-63
A ratio greater than 1 indicates that the
shares are more valuable than what the
shareholders originally paid.
Measuring Key Financial Relationships:
Six Key Questions
14-64
1.
How liquid is the firm?
2.
Is management generating adequate
operating profits on the firm’s assets?
3.
How is the firm financing its business?
4.
Is management providing a good return on
the capital provided by the shareholders?
(Management Effectiveness)
5.
Is the management team creating
shareholder value? (Valuations Ratios)
6.
Efficiency
6. Efficiency


14-65
We can use five approaches to answer this
question:

Revenue / Employee

Net Income / Employee

Receivable Turnover

Inventory Turnover

Total Asset Turnover
These ratios indicate how efficient of
management’s past performance.