CHAPTER 17 … Financial Statement Analysis
An Introduction to Financial Statement Analysis:
A.
In order to make informed decisions about financial statements, investors and lenders
must be able to analyze data.
B.
Financial statement analysis generally is based on comparative financial data for a
series of years; Exhibit 17-1 shows financial data for an actual company over a three-year
period.
C.
Horizontal analysis provides a direct year-to-year comparison of one company’s
performance while vertical analysis shows the relationship of each item on a financial
statement to a base amount on that financial statement for the same year.
Objective 1: Perform a horizontal analysis of financial statements
A.
Horizontal analysis is a study of percentage changes in comparative statements.
Exhibits 17-2 and 17-3 show horizontal analysis on the income statement and balance
sheet, respectively.
1.
2.
B.
Horizontal analysis uses two financial statements (for example, two year-end
statements) to determine percentage changes based on dollar changes.
a.
First the dollar change (increase or decrease) from the earlier (base)
period to the later period is calculated.
b.
Then the percentage change is calculated by dividing the dollar change
by the earlier (base) period amount.
This method reports both dollar and percentage changes on the statements.
Trend percentages are a form of horizontal analysis. They show the trend in a particular
financial statement item (such as net income) over a period of years.
17-1
1.
Select a number of years in order to gain a realistic view of where the company is
headed.
2.
Select a base year (the earliest year) and compare each year to the base year. The
base year percentage will always be 100%.
3.
Divide each year’s dollar amount by the base year dollar amount to calculate a
percentage.
4.
It is often useful to study several trend percentages together, such as net sales, cost
of goods sold, and gross margin.
5.
Trend analysis is widely used to predict future results.
Objective 2: Perform a vertical analysis of financial statements
A.
Vertical analysis shows the relationship of each item to a base amount on the financial
statement. Exhibits 17-4 and 17-5 illustrate vertical analysis on the income statement and
balance sheet, respectively.
B.
On the income statement, each item is expressed as a percentage of net sales (the base
amount) by dividing each number on the income statement by net sales. The net sales
percentage will always be 100%.
C.
On the balance sheet, each item is expressed as a percentage of total assets (the base
amount) by dividing each number on the balance sheet by total assets. The total asset
percentage will always be 100%.
D.
Vertical analysis shows the relative size of financial statement items and can help uncover
any deviations from normal.
17-2
Objective 3: Prepare and use common-size financial statements
A.
Common-size statements are a type of vertical analysis that reports only percentages.
B.
Common-size statements are also useful when benchmarking a company against
industry averages or key competitors.
1.
Such a comparison to other companies who are leaders in the industry often helps
a company improve its performance.
2.
Exhibit 17-6and 17-7 show the common-size income statement comparison with
both industry averages and a key competitor.
Objective 4: Compute the standard financial ratios
A.
On-line financial databases offer financial figures for many corporations, for many years.
This data is useful when computing and comparing various ratios for different companies.
B.
Managers, lenders, or financial analysts may use many different ratios for decisionmaking.
C.
Exhibit 17-8 shows a set of comparative financial statements whose amounts will be
used throughout this section of the chapter to illustrate the ratios.
D.
Certain ratios are used to measure the firm’s ability to pay current liabilities.
1.
Working capital is a measure of the amount of current assets remaining after all
current liabilities have been paid. The computation is:
Current assets – Current liabilities = Working capital
2.
The current ratio is a ratio of the current assets to the current liabilities.
a.
This ratio measures the company’s ability to pay current liabilities with
current assets.
17-3
b.
3.
E.
Acceptable current ratios vary from industry to industry, but generally, the
higher the current ratio, the greater the liquidity of the company. The
computation is:
Current assets
= Current ratio
Current liabilities
The acid-test (quick) ratio measures the ratio of the liquid, or quick, assets (cash,
short-term investments, and net current receivables) to current liabilities.
a.
The higher the quick ratio, the greater the liquidity of the company.
b.
The computation is:
Quick assets
=
Current liabilities
Acid-test (Quick) ratio
Certain ratios are used to measure the firm’s ability to sell inventory and collect
receivables.
1.
Inventory turnover measures how many times a year the company sells its
average level of inventory.
a.
Generally, a high rate of inventory turnover indicates that the inventory is
selling well. However, inventory turnover varies widely among industries.
b.
The computation is:
Cost of goods sold =
*Average inventory
Inventory turnover
*Average inventory = Beginning inventory + Ending inventory
2
2.
Accounts receivable turnover measures how quickly the company collects cash
from credit customers.
a.
Generally, a higher turnover is better.
b.
The computation is:
Net credit sales
=
*Average net accounts receivable
17-4
Accounts receivable turnover
*Average accounts receivable = Beginning receivables + Ending
receivables
2
3.
Days’ sales in receivables tells how many days’ sales remain uncollected in
accounts receivable.
a.
This ratio also measures the ability to collect receivables.
b.
The computation is:
Average net accounts receivable = Days’ sales in accounts receivable
One days’ sales*
*One days’ sales = Net sales/365
F.
Certain ratios are used to measure the ability of a company to pay long-term debt.
1.
2.
The debt ratio shows the proportion of the company’s assets financed with debt.
a.
The greater the proportion of debt, the more fixed debt and interest
payments the company must make; therefore, higher debt leads to greater
risk.
b.
The computation is:
Total liabilities
=
Total assets
Debt ratio
Times-interest-earned ratio (interest-coverage) tells how many times operating
income can cover interest expense.
a.
Generally, the higher the number of times interest is earned, the better.
b.
The computation is:
Income from operations*
Interest expense
17-5
=
Times-interest-earned ratio
* Income from operations = Income before income tax + interest
expense
G.
Certain ratios are used to measure profitability. Profitability is the fundamental goal for
a business.
1.
2.
Rate of return on net sales, or return on sales, shows income as a percentage of
net sales.
a.
This ratio shows the percentage of each sales dollar that is earned as net
income.
b.
The computation is:
Net income = Rate of return on net sales
Net sales
Rate of return on total assets, or return on assets, measures how successful the
business is in using assets to earn a profit.
a.
Generally, a higher return is better.
b.
The computation is:
Net income + Interest expense
*Average total assets
=
Rate of return on total assets
*Average total assets = Beginning assets + Ending assets
2
3.
Rate of return on common stockholders’ equity, or return on equity, expresses
the relationship between the common stockholders’ investment and net income.
a.
Generally, a higher return is better. If a company is favorably leveraged,
then the return on assets will be greater than the rate of return on common
stockholders’ equity. This practice is called trading on the equity.
b.
Leverage means that the company borrows at a lower rate then invests the
money to earn a higher rate.
c.
The computation is:
17-6
__Net income - Preferred dividends__ = Rate of return on common
*Average common stockholders’ equity stockholders’ equity
*Average common Beginning + Ending common stkhlders’ equity
stockholders’ equity =
2
4.
H.
Earnings per share of common stock (EPS) measures the income generated by
one share of stock.
a.
EPS is the most widely quoted of all financial ratios.
b.
This is the only ratio that appears on the face of the income statement.
The computation is:
Net income - Preferred dividends = Earnings per share of
Number of shares of
common stock
common stock outstanding
Certain ratios are used to analyze stock as an investment. These ratios help analysts
evaluate stock in terms of market prices and dividend payments.
1.
The price/earnings ratio (P/E) is important to an investor-owner when
evaluating whether to hold, buy, or sell stocks.
a.
It tells the market price of $1 of earnings.
b.
The computation is:
Market price per share
EPS
=
P/E ratio
2.
Dividend yield measures the percentage of a stock’s market value that is returned
annually as dividends. The computation is:
Dividend per share
= Dividend yield
Market price per share
3.
Book value per share of common stock expresses the net assets per share of
common stock. Book value bears no relationship to the stock’s market value.
The computation is:
(Total stckhldrs’ equity - Preferred equity) = Book value per share
Outstanding shares of common stock
17-7