CHAPTER 14
Financial Statement Analysis
1
OBJECTIVES
1.
Discuss the need for comparative analysis and identify
the tools of financial statement analysis.
2.
Explain and apply horizontal and vertical analysis.
3.
Identify and compute ratios used in analyzing a firm’s
liquidity, profitability, and solvency.
4.
Understand the concept of earning power, and how
irregular items are presented.
5.
Understand the concept of quality of earnings.
2
OBJECTIVES OF FS ANALYSIS
Forensic. . . Assessment of Past Performance
and Current position
 Future. . . Assessment of Future potential and
related Risk

3
SOURCES
Inside the company
 Outside the company
 Really outside the company

4
SOURCES
Inside the company – 10K, website, press releases
 Outside the company – external analysts, Standard

and Poors, Valueline, Hoovers, Dun & Bradstreet, Moody’s,
etc.
5
FINANCIAL STATEMENT ANALYSIS
Three basic tools are used in financial statement
analysis :
1. Horizontal (also called trend)analysis
2. Vertical analysis
3. Ratio analysis
6
HORIZONTAL ANALYSIS

Looking at the Trends over time….

In $$$$$$$$$$ or %%%%%%%%%%

From the base year
Shows growth or decline
 Used with Balance Sheet and Income Statement

7
HORIZONTAL ANALYSIS
OF A INCOME STATEMENT ITEMS
Kellogg ($ in millions)
Selected Income Statement Items - Horizontal Analysis
Period Ending
Total Revenue (Sales
Gross Profit
Total Operating Expenses
Net Income
2-Jan-10
$
12,575
3-Jan-09
$
12,822
29-Dec-07
$
11,776
106.78%
108.88%
100.00%
5,391
5,367
5,179
104.09%
103.63%
100.00%
3,390
3,414
3,311
102.39%
103.11%
100.00%
1,212
1,148
1,103
109.88%
104.08%
100.00%
Analysis:
Look at the Trends, all of them
What can you say about them?
8
HORIZONTAL ANALYSIS
OF A INCOME STATEMENT ITEMS
Kellogg ($ in millions)
Selected Income Statement Items - Horizontal Analysis
Period Ending
Total Revenue (Sales
Gross Profit
Total Operating Expenses
Net Income
2-Jan-10
$
12,575
3-Jan-09
$
12,822
29-Dec-07
$
11,776
106.78%
108.88%
100.00%
5,391
5,367
5,179
104.09%
103.63%
100.00%
3,390
3,414
3,311
102.39%
103.11%
100.00%
1,212
1,148
1,103
109.88%
104.08%
100.00%
Analysis:
Sales grew in 2009 compared to
2008, however dipped in 2010.
Net income grew each year;
reviewing costs, Kellogg’s
Operating Expenses grew at a
much slower pace, which
contributed to the Net Income
growth. Also Kellogg’s gross
profit improved in 2010, even
though its sales did not. This
suggests that Kellogg’s is
controlling costs.
Note: with more space, you
would quote actual numbers and
% for evidence.
9
Horizontal Analysis – Income Statement
CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT
BASE-YEAR AMOUNT
12,822.0 – 11,776= 108.88%
11,776.0
Net sales for Kellogg company increased 8.88% in
2011 compared to 2011.
10
HORIZONTAL ANALYSIS OF A BALANCE
SHEET ITEMS
Kellogg ($ in millions)
Selected Balance Sheet Items - Horizontal Analysis
Period Ending
Current assets
Total Assets
Current Liabliities
Long Term Liabilities
Retained Earnings
2-Jan-10
$
2,558
3-Jan-09
$
2,521
29-Dec-07
$
2,717
94.15%
92.79%
100.00%
11,200
10,946
11,397
98.27%
96.04%
100.00%
2,288
3,552
4,044
56.58%
87.83%
100.00%
8,928
9,498
8,871
100.64%
107.07%
100.00%
5,461
4,836
4,217
129.50%
114.68%
100.00%
Analysis:
Look at the Trends, all of them
What can you say about them?
11
HORIZONTAL ANALYSIS OF A BALANCE
SHEET ITEMS
Kellogg ($ in millions)
Selected Balance Sheet Items - Horizontal Analysis
Period Ending
Current assets
Total Assets
Current Liabliities
Long Term Liabilities
Retained Earnings
2-Jan-10
$
2,558
3-Jan-09
$
2,521
29-Dec-07
$
2,717
94.15%
92.79%
100.00%
11,200
10,946
11,397
98.27%
96.04%
100.00%
2,288
3,552
4,044
56.58%
87.83%
100.00%
8,928
9,498
8,871
100.64%
107.07%
100.00%
5,461
4,836
4,217
129.50%
114.68%
100.00%
Analysis: Total Assets are
decreasing; Current Assets are
decreasing at a faster rate,
suggesting more funds are being
dedicated to Long Term Assets.
However, Long Term Liabilities
are stable, suggesting that the
company is maintaining the
same debt levels. Retained
Earnings has grown by almost
30% over the base year,
indicating that the company has
been profitable.
12
WHAT DOES IT TELL YOU?

BALANCE SHEET:
 What
changed and in what direction?
 How was it financed?

INCOME STATEMENT:
 Are
sales increasing?
 Are costs following sales? (growth, decline)
13
WHAT DOES IT TELL YOU?
Tracks changes over time
 Tracks changes in one area (sales)
compared to other areas (net income)

14
VERTICAL ANALYSIS
Common
size analysis
What is your basis?
Balance
Sheet: Total Assets
Income Statement: Net Sales (net
revenues)
15
VERTICAL ANALYSIS – INCOME STATEMENT
Note that Net
Sales is always
the 100% base
figure for
Vertical Analysis
and all other
items are a
percentage of
this
Kellogg ($ in millions)
Selected Income Statement Items - Vertical Analysis
Period Ending
2-Jan-10
Amount
Total Revenue (Sales
12,575
Gross Profit
5,391
Total Operating Expenses
3,390
Net Income
1,212
3-Jan-09
Percent
100.00%
42.87%
26.96%
9.64%
Amount
12,822
5,367
3,414
1,148
29-Dec-07
Percent
Amount
100.00%
41.86%
26.63%
8.95%
11,776
Percent
100.00%
5,179
43.98%
3,311
28.12%
1,103
9.37%
Analysis:
Look at the Trends, all of them
What can you say about them?
16
VERTICAL ANALYSIS – INCOME STATEMENT
Note that Net
Sales is
always the
100% base
figure for
Vertical
Analysis and
all other
items are a
percentage
of this
Kellogg ($ in millions)
Selected Income Statement Items - Vertical Analysis
Period Ending
2-Jan-10
Amount
Total Revenue (Sales
3-Jan-09
Percent
12,575
100.00%
Cost of Goods Sold
Gross Profit
Amount
29-Dec-07
Percent
Amount
Percent
12,822
100.00%
11,776
100.00%
7,184
57.13%
7,455
58.14%
6,597
56.02%
5,391
42.87%
5,367
41.86%
5,179
43.98%
Total Operating Expenses
3,390
26.96%
3,414
26.63%
3,311
28.12%
Net Income
1,212
9.64%
1,148
8.95%
1,103
9.37%
Analysis: You can’t analyze
Sales much, as it is the 100%
number; so talk about the other
numbers: Net Income as a
percent of sales increased in
2009 compared to 2008. It
dipped slightly in 2010
compared to 2009, but is still
above 2008’s percentage level.
Analysis:
The improvements in Net Income were caused by
reduction in Operating Expenses which reduced almost
1.5%, as a percentage of net sales) and Gross Profit
(declined in 2008, but improved) in 2010
17
VERTICAL ANALYSIS – BALANCE SHEET
Note that Total
Assets are the
100% base figure
and all other items
are a percentage of
this
Kellogg ($ in millions)
Selected Balance Sheet Items - Vertical Analysis
Period Ending
2-Jan-10
Amount
Current assets
3-Jan-09
Percent
Amount
29-Dec-07
Percent
Amount
Percent
2,558
22.84%
2,521
23.03%
2,717
23.84%
11,200
100.00%
10,946
100.00%
11,397
100.00%
Current Liabliities
2,288
20.43%
3,552
32.45%
4,044
35.48%
Long Term Liabilities
8,928
79.71%
9,498
86.77%
8,871
77.84%
Retained Earnings
5,461
48.76%
4,836
44.18%
4,217
37.00%
Total Assets
18
LET’S GO BACK AND LOOK AT KELLOGG’S
HISTORY

The years were 1998 and 1997
19
KELLOGG COMPANY, INC.
Condensed Income Statement – Vertical Analysis
For the Years Ended December 31
(In millions)
1998
Amount Percent
$6,762.1
100.0
Net sales
Cost of goods sold 3,282.6
Gross profit
3,479.5
Selling & Admin.
2,513.9
Nonrecurring Chgs
70.5
Income operations
895.1
Interest expense
119.5
Other income
(expense),net
6.9
Income before
income taxes
782.5
Income tax expense 279.9
Net income
$502.6
48.6
51.4
37.2
1.0
13.2
1.8
1997
Amount
Percent
$6,830.1
100.0
3,270.1
3,560.0
2,366.8
184.1
1,009.1
108.3
0.1
3.7
11.5
4.1
7.4
904.5
340.5
$564.0
47.9
52.1
34.6
2.7
14.8
1.6
0.1
13.3
5.0
8.3
20
WHAT IS WRONG WITH THIS PICTURE
Look at the changes in each
year?
 What is the trend in Sales?
 Does Cost of Goods Sold
follow the same trend?
 What about other costs?
You may not know the reason,
but what are your questions
as to WHY things do not look
right?

See end of slides for
solution
21
WHAT DOES IT TELL YOU?
Relative size of things on the statement. . .
.Over time
 Allows comparisons between companies

22
END OF PART 1
23
LIMITATIONS OF
FINANCIAL ANALYSIS
Estimates
 Cost
 Alternative Accounting
Methods
 Atypical Data
 Diversification

24
ESTIMATES

Financial statements are based on estimates.
 allowance
for uncollectible accounts
 depreciation
 costs of warranties
 contingent losses
To the extent that these estimates are inaccurate, the
financial ratios and percentages are also inaccurate.
25
COST
Traditional financial statements are based on
historical cost and are not adjusted for price
level changes.
 Comparisons of unadjusted financial data from
different periods may be rendered invalid by
significant inflation or deflation.

26
ALTERNATIVE ACCOUNTING
METHODS
One company may use the FIFO method, while
another company in the same
industry may
use LIFO.
 If the inventory is significant for both
companies, it is unlikely that their current ratios
are comparable.
 In addition to differences in inventory costing
methods, differences also exist in reporting
such items as depreciation, depletion, and
amortization.

27
ATYPICAL DATA
Fiscal year-end data may not be typical of
a company's financial condition during the
year.
28
DIVERSIFICATION
Diversification in American industry also
limits the usefulness of financial analysis.
 Many firms are so diverse they cannot be
classified by industry.

29
RATIO ANALYSIS
30
RATIOS

Types:
 Liquidity
ratios
 Profitability
 Solvency
ratios
ratios

Can provide clues to underlying conditions that may not be
apparent from an inspection of the individual components.

Single ratio by itself is not very meaningful
31
RATIO Analysis – Galore!
32
LIQUIDITY RATIOS
Measure the short-term ability of the
enterprise to pay its maturing
obligations and to meet unexpected
needs for cash.
WHO CARES?
Short-term creditors such as banks,
suppliers, employees
33
Liquidity Ratios
Current ratio
 Acid-test ratio
 Receivables turnover ratio
 Inventory turnover

34
CURRENT RATIO
Indicates short-term debt-paying ability
Current Assets
Current Liabilities
35
ACID-TEST RATIO
Indicates immediate short-term debtpaying ability
Cash + Short-term Investments
+ Net Receivables
Current Liabilities
36
RECEIVABLES TURNOVER RATIO
Indicates liquidity of receivables
Net Credit Sales
Average Net Receivables
37
AVERAGE COLLECTION PERIOD
Indicates liquidity of receivables and
collection success
365 days
Receivables Ratio Turnover
38
INVENTORY TURNOVER RATIO
Indicates liquidity of
inventory
Cost of Goods Sold
Average Inventory
39
AVERAGE DAYS IN INVENTORY
Indicates liquidity of inventory and
inventory management
365 days
Inventory Turnover Ratio
40
PROFITABILITY RATIOS
Measure the income or operating success of an
enterprise for a given period of time
WHO CARES? Everybody
WHY? A company’s income affects:
 its ability to obtain debt and equity financing
 its liquidity position
 its ability to grow

41
Profitability Ratios
Return on common stockholders’ equity ratio
 Return on assets ratio
 Profit margin ratio
 Assets turnover ratio
 Gross profit rate
 Operating expenses to sales ratio
 Cash return on sales ratio
 Earnings per share (EPS)
 Price-earnings ratio
 Payout ratio

42
RETURN ON COMMON STOCKHOLDERS’
EQUITY RATIO
Indicates profitability of common stockholder
investment
Net income -preferred stock dividends
Average common stockholders’ equity
43
RETURN ON ASSETS RATIO
Reveals the amount of net income
generated by each dollar invested
Net income
Average total assets
Higher value suggests favorable
efficiency.
44
PROFIT MARGIN RATIO
Indicates net income generated by
each dollar of sales
Net income
Net sales
Higher value suggests favorable
return on each dollar of sales.
45
ASSET TURNOVER RATIO
Indicates how efficiently assets are
used to generate sales
Net sales
Average total assets
46
GROSS PROFIT RATE
Indicates margin between selling
price and cost of good sold
Gross profit
Net sales
47
OPERATING EXPENSES
TO SALES RATIO
Indicates the cost incurred to
support each dollar of sales
Operating expenses
Net sales
48
CASH RETURN ON SALES RATIO
Indicates net cash flow generated by
each dollar of sales
Cash provided by operations
Net sales
49
EARNINGS PER SHARE (EPS)
Indicates net income earned on each
share of common stock sales
Income available to common stockholders
Average number of outstanding common
shares
50
PRICE EARNINGS RATIO
Indicates relationship between market
price per share and earnings per share
Stock Price
Earnings Per Share
51
PAYOUT RATIO
Indicates % of earnings distributed in the
form of cash dividends
Cash Dividends
Net Income
52
SOLVENCY RATIOS
Measure the ability of the enterprise
to survive over a long period of time
WHO CARES?
Long-term creditors and stockholders
53
Solvency Ratios
 Debt
to total assets ratio
 Times interest earned ratio
54
DEBT TO TOTAL ASSETS RATIO
Indicates % of total assets provided by
creditors
Total Liabilities
Total Assets
55
TIMES INTEREST EARNED RATIO
Indicates company’s ability to meet
interest payments as they come due
Income before* Interest Expense & Income Tax
Interest Expense
* Also called Operating Income
56

Review and STOP HERE!
57
END OF PART 2
58
EARNING POWER
The value of a company is a function of
its future cash flows at normal income
levels.
59
AFFECTED BY. . . .

Accounting methods & estimates
 Industry
dependent
 Requires FULL DISCLOSURE & CONSISTENCY

Non operating items on the Income Statement
 Look
at the D-E-A
60
IRREGULAR ITEMS
Three types of irregular items are
reported -- (all net of taxes)
61
DISCONTINUED OPERATIONS...
Refers to the disposal of a significant
segment of a business...
the elimination of a major class of
customers or an entire activity.
62
EXAMPLES:
Pepsi spun off: Taco Bell, Pizza Hut, and KFC
 Quaker Oats spun off: Gatorade
 Western Wireless spun off: Voicestream
 PACCAR spun off: Paccar Automotive and Trico
(oil well digging manufacturer)

63
Discontinued Operations
 Assume
a company, Agroworld Inc. During
2001 the company discontinued and sold
its chemical division.
 The
income in 2001 from chemical operations
was $200,000, and
 The loss on disposal of the chemical division
$130,000.
 Apply a 30% tax rate
64
Discontinued Operations
Or, I could word this:
 During 2001 the company discontinued
and sold its chemical division.
 The
income in 2001 from chemical operations
(net of $60,000 taxes) was $140,000, and
 The loss on disposal of the chemical division
(net of $39,000 taxes) was $91,000.
65
Agroworld Inc.
Income Statement (Partial)
For the Year Ended December 31, 2001
Income before income taxes
Income tax expense (30% Tax Rate)
Income from continuing operations
Discontinued operations:
1) Income from operations of chemical division,
net of taxes, $60,000
2) Loss from disposal of chemical
division, net of $39,000 income
tax saving
Net income before extraordinary item
$800,000
240,000
560,000
$140,000
(91,000)
49,000
609,000
66
EXTRAORDINARY ITEMS...
Are events and
transactions that
meet two conditions:
Unusual in nature
Infrequent in
occurrence
67
Illustration 14-2
EXTRAORDINARY ITEMS
68
Illustration 14-2
ORDINARY ITEMS
69
Extraordinary Items
In 2001 a revolutionary foreign government
expropriated property held as an investment
by Agroworld Inc.
 The loss is $70,000 before applicable
income taxes of $21,000, the income
statement presentation will show a deduction
of $49,000.

70
Agroworld Inc.
Income Statement(Partial)
For the Year Ended December 31, 2001
Income before income taxes
Income tax expense
Income from continuing operations
Discontinued operations:
Income from operations of chemical
division, net of taxes, $60,000
Loss from disposal of chemical
division, net of $39,000 income
tax saving
Net income before extraordinary item
Extraordinary item
Expropriation of investment, net of
$21,000 income tax saving
Net income
$800,000
240,000
560,000
$140,000
(91,000)
49,000
609,000
49,000
$560,000
71
CHANGE IN
ACCOUNTING PRINCIPLE
 Is
permitted, when
New principle is PREFERABLE to the old
and
Effects are clearly DISCLOSED in the
income statement.
72
CHANGE IN
ACCOUNTING PRINCIPLE
 Examples:
a change in depreciation methods (such
as declining-balance to straight-line)
a change in inventory costing methods
(such as FIFO to average cost).

73
Change in
Accounting Principle

Use new principle in results of operations of the current
year.

The cumulative effect of the change on all prior-year
income statements should be disclosed net of applicable
taxes in a special section below Net Income.
74
Comprehensive Income

Most revenues, expenses, gains, and losses
recognized during the period are included in
net income.

Plus:
 Discontinued
Operations
 Extraordinary Items
 Accounting Changes.

Plus changes in unrealized investment gains and
losses
75
QUALITY OF EARNINGS
 The
substance of earnings
 And their sustainability into the future.
76
Quality of Earnings
A company that has a high quality of earnings provides full and
transparent information that will not confuse or mislead users of
the financial statements.
Companies have incentives to manage income to meet or beat Wall
Street expectations, so that
the market price of stock increases and
the value of stock options increase.
77
Quality of Earnings
Alternative Accounting Methods
Variations among companies in the application of GAAP
may hamper comparability and reduce quality of
earnings.
Pro Forma Income
Pro forma income usually excludes items that the
company thinks are unusual or nonrecurring.
Some companies have abused the flexibility that pro
forma numbers allow.
78
Quality of Earnings
Improper Recognition
Some managers have felt pressure to continually increase
earnings and have manipulated the earnings numbers to
meet these expectations.
Abuses include:
Improper recognition of revenue (channel stuffing).
Improper capitalization of operating expenses (WorldCom).
Failure to report all liabilities (Enron).
79
End of Chapter 14
Good Bye and Good Luck. – solutions follow
KELLOGG’S – DISCUSSION OF 1998 AND 1997
TREND ANALYSIS
81
KELLOGG’S 1998 AND 1997 RESULTS
COGS increased, but Sales went down – this is
reverse trend as Costs should directly proportional
to Sales (when sales go up, COGS should go up,
when sales go down, COGS should go down)…what
happened?
 Selling & Admin dramatically went up 2.6%, why?
 Most alarming, Net Income went down a full point
(0.9%)
 Why????????

82
KELLOGG’S IN 1998 AND 1997


Big, generic bags of cereal hit the supermarkets
in 1997 and 1998.
Kellogg’s made the management decision not to
participate in the big bags of cereal line





Argument: Our corn flake cereal is premium,
fresh, in a box. Customer will pay more for a
better product.
It didn’t work. Customers switched to the
cheaper cereal.
Kellogg’s spent more on advertising (reflected in
growth in Selling & Admin costs).
Kellogg’s finally reduced its prices (reflected in
lower sales but no corresponding reduction in
Cost of Goods Sold
The end result  Lower Net Income
83