CHAPTER 13 NOTES (Page 666-694)
Study Objectives 4-7
Horizontal Analysis
 In assessing the financial performance of a company, investors are interested in the core or
__________________ ___________________ of a company. Investors are also interested in
making comparisons from period to period.
 Three types of comparisons to improve the decision usefulness of financial information:
1. Intracompany basis. Comparisons within a company are often useful to detect ______________
in financial relationships and significant trends
2. Intercompany basis. Comparisons with other companies provide insight into a company's
________________________ position.
3. Industry averages. Comparisons with industry averages provide information about a company's
relative _________________ 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

Horizontal analysis, also known as __________ ________________, is a technique for evaluating
a series of financial statement data over a period of time.
 Its purpose is to determine the increase or decrease that has taken place.
 The increase or decrease can be expressed as either an ___________ or a
_________________________.
Horizontal analysis is just that--horizontal. One looks across the page. It takes one financial
statement element and draws a comparison between different accounting time periods.

Horizontal analysis requires the selection of a “base year” or a starting point on which to begin the
comparison. We can measure all percentage increases or decreases from this base-period amount
with the following formula:
Change Since Base Period = Current-Year Amount - Base-Year Amount
Base-Year Amount

Alternatively, we can express current-year sales as a percentage of the base period by dividing the
current-year amount by the base-year amount:
Current Results in
= Current-Year Amount
Relation to Base Period
Base-Year Amount
13-1

Current-period sales expressed as a percentage of the base-period for each of the five years,
assuming 1997 as the base period is:
2001
$8,853.3
129.62%

2000
$6,954.7
101.82%
1999
$6,984.2
102.26%
1998
$6,762.1
99%
1997
$6,830.1
100%
See Page 668 for Kellogg Company illustration
The percentages allow us to see the relevance of the increase or decrease.
See Page 668 & 669 for an example: A 2-year comparative balance sheet and income statement of
Kellogg Company for 2001 and 2000 are given in condensed format.
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 (total assets being the base
amount.)
 On an income statement we might say that selling expenses are 16% of net sales (net sales being the
base amount.)
 See Page 670 & 671 for a balance sheet and income statement that have been analyzed
vertically.
(BE 13-5)
Interpretation of Ratios Used in Analyzing a Company's Liquidity, Solvency, and
Profitability
Liquidity ratios
 The receivables turnover ratio measures liquidity by determining how quickly certain assets
can be converted to cash.
 The ________________ 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.
Ratio
Receivables
turnover ratio
Formula
Net credit sales
Average gross
receivables
Indicates:
Liquidity of
receivables
 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.
13-2

The general rule is that the collection period should not greatly exceed the credit term
period.
Ratio
Formula
Average
365 days
collection Receivable
period
turnover ratio


Indicates:
Liquidity of
receivables and
collection success
Analysts frequently use the average collection period to assess the effectiveness of a
company’s __________ and ______________ policies.
The difference could be due to less aggressive collection practices, but it is more likely due to
a difference in credit terms granted.
 The inventory turnover ratio measures the number of times on average the inventory is
________ during the period.
 The purpose of this ratio is to measure the liquidity of the inventory.
 The inventory turnover ratio is computed by dividing the _______ ___ __________
sold by the average inventory during the period.
Ratio
Inventory
turnover
ratio


Formula:
Cost of goods sold
Average inventory
Indicates:
Liquidity of
inventory
Generally, the faster 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.
 Days in inventory is a variant of the inventory turnover ratio.
 The days in inventory measures the average number of days it takes to ______ the
inventory.
 It is computed by dividing the inventory turnover ratio into 365 days.
Ratio
Days in
inventory
Formula
365 days
Inventory
turnover ratio
Indicates:
Liquidity of
inventory and
inventory
management
 Solvency ratios – measure the ability of the enterprise to survive over a long period of time.
 Long-term creditors and stockholders are interested in a company's long-run solvency, particularly
its ability to pay interest as it comes due and to repay the face value of debt at maturity.
 The debt to total assets ratio, the times interest earned ratio, and the cash debt coverage ratio
provide information abut debt-paying ability.
 In addition free cash flow provides information about the company’s solvency and its ability to pay
additional dividends or invest in new projects.
 The times interest earned ratio, also called _________________ _______________,
indicates the company's ability to meet interest payments as they come due.
13-3

Ratio
Times
Interest
earned ratio
The ratio is computed by dividing income before interest expense and income taxes by
interest expense.
Formula
Net
Interest
Tax
Income + Expense + Expense
Interest Expense
Indicates:
Ability to meet
interest payments
as they come due
 Profitability ratios – measure the income or operating success of an enterprise for a given period of
time.
 The gross profit rate indicates a company's ability to maintain an adequate __________
_________ above its cost of goods sold.
 The gross profit rate 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.
Ratio
Gross profit
rate
Formula
Gross profit
Net sales
Indicates:
Margin between
selling price and
Cost of goods sold
 The payout ratio measures the _______________ 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.
Ratio
Payout ratio
Formula
Cash dividends
declared on
common stock
Net income

Indicates:
Percentage of
earnings distributed
in the form of cash
dividends
Management has some control over the amount of dividends paid each year, and
companies are generally reluctant to reduce a dividend below the amount paid in a
previous year. Therefore, the payout ratio will actually increase if a company’s net income
declines but the company keeps its total dividend payment the same.
(E13-7)
Quality of Earnings
 A company that has a high quality of earnings provides full and _______________ 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 _________________ their income
and not enough time managing their business.
13-4
 Some of the factors affecting quality of earnings include the following:
 ______________________ accounting methods – Variations among companies in the
application of generally accepted accounting principles may hamper comparability and reduce
quality of earnings.
 For example, one company may use the FIFO method of inventory costing, while another
company in the same industry may use LIFO. If inventory is a significant asset to both
companies, it is unlikely that their current ratios are comparable.
 Differences also exist in reporting such items as depreciation, depletion, and amortization.
Although these differences in accounting methods might be detected from reading the notes to
the financial statements, adjusting the financial data to compensate for the different methods is
difficult, if not impossible, in some cases.
 _____ ____________ Income – Companies whose stock is publicly traded are required to
present their income statement following generally accepted accounting principles (GAAP).





Pro forma income is a measure that usually excludes items that the company thinks are
unusual or nonrecurring.
There are no rules as to how to prepare pro forma earnings. Companies have a free rein to
exclude any items they deem inappropriate for measuring their performance.
Many analysts are critical of the practice of using pro forma income because these numbers
often make companies look better then they really are.
Everyone seems to agree that pro forma numbers can be useful if they provide insights into
determining a company’s sustainable income. However, many companies have abused the
flexibility that pro forma numbers allow and have used the measure as a way to put their
companies in a good light.
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.
 The most common abuse is the improper recognition of _______________.
 One practice that companies are using is called channel stuffing. Offering deep discounts on
their products to customers, companies encourage their customers to buy early (stuff the
channel) rather than later.
 This lets the company report good earnings in the current period, but it often leads to a disaster
in subsequent periods because customers have no need for additional goods.
 Another practice is the improper capitalization of operating expenses. The classic case is
WorldCom, which capitalized over $7 billion of operating expenses to ensure that it would
report positive net income.
13-5