Analyzing Financial Statements
Some Users of Financial Statements
Individuals
Government
regulatory
agencies
Businesses
Taxing
authorities
Investors and
creditors
Nonprofit
organizations
Understanding The Business
Individual
Company
Factors
Industry
Factors
No
Lend? Sell on credit?
Invest?
Economy-wide
Factors
Yes
Analyzing Financial Statements
Analytical techniques
used to examine
relationships among
financial statement
items
 Dollar and percentage
changes on statements
(Horizontal Analysis)/
Trend Analysis
 Common-size
statements
(Vertical Analysis)
 Ratios
Horizontal Analysis
Horizontal analysis shows the changes between
years in the financial data in both dollar and
percentage form.
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31
2013
2012
Increase (Decrease)
Amount
%
Assets
Current assets:
Cash
$ 12,000 $ 23,500 $ (11,500)
(48.9)
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
$12,000
– $23,500 164,700
= $(11,500)
Total current assets
155,000
Property and equipment:
Land
40,000
40,000
($11,50085,000
÷ $23,500) × 100% = 48.9%
Buildings and equipment, net
120,000
Total property and equipment
160,000
125,000
Total assets
$ 315,000 $ 289,700
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31
2013
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
$
12,000
60,000
80,000
3,000
155,000
40,000
120,000
160,000
$ 315,000
$
2012
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
Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
2013
Sales
$ 520,000
Cost of goods sold
360,000
Gross margin
160,000
Operating expenses
128,600
Net operating income
31,400
Interest expense
6,400
Net income before taxes
25,000
Less income taxes (30%)
7,500
Net income
$ 17,500
2012
$ 480,000
315,000
165,000
126,000
39,000
7,000
32,000
9,600
$ 22,400
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)
Trend Analysis
Trend Percentages
Trend percentages state
several years’ financial
data in terms of a base
year, which equals 100
percent.
Trend Analysis
Trend
Percentage
=
Current Year Amount
Base Year Amount
× 100%
Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
Item
Sales
Cost of goods sold
Gross margin
2013
145%
150%
135%
2012
129%
132%
124%
Year
2011
116%
118%
112%
2010
105%
104%
108%
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.
2007
100%
100%
100%
Vertical Analysis
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.
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2011
2010
2011
2010
Sales
$ 520,000 $ 480,000
100.0
100.0
Cost of goods sold
360,000
315,000
Sales is usually
the base and is
Gross margin
160,000
165,000
expressed as
Operating expenses
128,600
126,000
100%.
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
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2011
2010
2010
2009
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
Common-Size Statements
In balance sheets,
all items usually
are expressed as a
percentage of total
assets (or total
liabilities+equity).
Ratio Analysis
Interpreting Ratios
Ratios may be interpreted by comparison
with ratios of earlier periods, other companies, or
with industry average ratios.
Ratios may vary because of the
company’s industry characteristics,
nature of operations, size, and
accounting policies.
Limitations of Financial Statement
Analysis
Differences in accounting methods between
companies sometimes make comparisons
difficult.
We use the LIFO method to
value inventory.
We use the average cost
method to value inventory.
Limitations of Ratio Analysis
Analysts should look beyond the ratios.
Industry
trends
Technological
changes
Changes within the
company
Consumer
tastes
Economic
factors
Profitability Ratios
(The Common Stockholder)
Gross Margin Percentage
Gross Margin
Percentage
=
Gross Margin
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.
Earnings per (Common) Share (EPS)
EPS =
Net Income*
Average Number of Shares
Outstanding for the Period
*If there are preferred dividends, the amount is subtracted from net income.
EPS =
$5,761
(1,970 + 2124) ÷ 2
= $2.81
Average number of shares based on the number
of shares at the beginning and end of the year.
Earnings per share is probably the single most
widely watched financial ratio.
Price/Earnings (P/E) Ratio
Market tests relate the current market price of a share of stock
to an indicator of the return that might accrue to the investor.
P/E Ratio =
P/E Ratio =
Current Market Price Per Share
Earnings Per Share
$45
$2.35
= 19X
This ratio measures the relationship between the current market
price of the stock and its earnings per share.
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).
Dividend Yield Ratio
Dividend
Yield
Dividend
Yield
=
=
Dividends Per Share
Market Price Per Share
$0.675
$34
=
2%
This ratio is often used to compare the dividendpaying performance of different investment
alternatives.
Return on Total Assets
Return on
Assets
Return on
Assets
=
=
Net Income + Interest Expense (net of tax)
Average Total Assets
$5,761 + ($392 × (1 - .34))
($52,263 + $44,405) ÷ 2
= 12.5%
Corporate tax rate
is 34%.
This ratio is generally considered a measure of a
company’s profitability.
Return on Common Stockholders’
Equity
Return on Common
Stockholders’ Equity
=
Return on Common
Stockholders’ Equity
=
Net Income – Preferred Dividends
Average Stockholders’ Equity
$53,690 – $0
($180,000 + $234,390) ÷ 2
= 25.91%
This measure indicates how well the
company used the owners’ investments to
earn income.
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.
Financial Leverage
Financial leverage involves acquiring assets with
borrowed funds.
Return on
investment in >
assets
Return on investment
in assets
<
Interest rate on
borrowed funds
Interest rate on
borrowed funds
=
Positive
financial
leverage
=
Negative
financial
leverage
Financial Leverage
Percentage
Financial
Leverage
9.7%
=
=
Return on Equity – Return on Assets
22.2% – 12.5%
Financial leverage is the advantage or disadvantage that
occurs as the result of earning a return on equity that is
different from the return on assets.
Liquidity Ratios
(The Short-Term Creditor)
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
long-term debt and equity.
Current Ratio
Current
Ratio
Current
Ratio
=
=
Current Assets
Current Liabilities
$18,000
$12,931
=
1.39 to 1
This ratio measures the ability
of the company to pay current
debts as they become due.
Quick Ratio (Acid Test)
Quick
Ratio
=
Quick Assets
Current Liabilities
Quick
Ratio
=
$3,837
$9,554
Cash & Cash Equivalents
Receivables, net
Short-term Investments
Quick Assets
=
0.40 to 1
$
600
3,223
14
$ 3,837
This ratio is like the current
ratio but measures the company’s
immediate ability to pay debts.
Receivable Turnover
Receivable
Turnover
Receivable
Turnover
=
=
Net Credit Sales
Average Net Receivables
$90,837
($3,223 + $2,396) ÷ 2
This ratio measures how quickly a
company collects its accounts
receivable.
= 32.3 Times
Average Collection Period
Average
Collection Period
Average
Collection Period
=
Days in Year
Receivable Turnover
=
365
32.3
= 11.3 Days
This ratio measures the average number of days
it takes to collect receivables.
Inventory Turnover
Inventory
Turnover
Cost of Goods Sold
=
Average Inventory
Inventory
Turnover
$61,054
=
($12,822 + $11,401) ÷ 2
= 5.0 Times
This ratio measures how quickly the
company sells its inventory.
Average Sale Period
Average Sale
Period
Average Sale
Period
=
Days in Year
Inventory Turnover
=
365
5.0
= 73 Days
This ratio measures the average number of days
it takes to sell the inventory.
Solvency Ratios
(The Long-Term Creditor)
Times Interest Earned
Tests of solvency measure a company’s
ability to meet its long-term obligations.
Times Interest
Earned
=
Times Interest
Earned
=
Net
Interest
Income Tax
+
+
Income
Expense
Expense
Interest Expense
$5,761 + $392 + $3,547
$392
= 24.7 Times
This ratio indicates a margin of protection for creditors.
Debt-to-Equity Ratio
Debt-to-Equity
Ratio
Debt-to-Equity
Ratio
=
Total Liabilities
Stockholders’ Equity
=
$27,233
$25,030
=
1.09
This ratio measures the amount of liabilities
that exists for each $1 invested by the
owners.
End of Chapter 15