Learning Objectives
Explain the purpose of analysis.
Identify the building blocks of analysis.
Describe standards for comparisons in analysis.
Identify the tools of analysis.
Explain and apply methods of horizontal analysis.
Describe and apply methods of horizontal analysis.
Define and apply ratio analysis.
Run an SAP demonstration.
Practise preparing Cash Flow statements in SAP.
SAP 2007 / SAP University Alliances Introductory Accounting

Purpose of Analysis
Financial statement analysis helps users make better decisions.
Internal Users
Managers
Officers
Internal Auditors
External Users
Shareholders
Lenders
Customers
SAP 2007 / SAP University Alliances Introductory Accounting

Building Blocks of Analysis
Ability to meet short-term obligations and to efficiently generate revenues
1.
Liquidity and
Efficiency
2.
Solvency
Ability to generate future revenues and meet long-term obligations
Ability to provide financial rewards sufficient to attract and retain financing
3.
Profitability
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4.
Market
Introductory Accounting
Ability to generate positive market expectations

Standards for Comparison
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 Intracompany
 Competitor
 Industry
 Guidelines
Introductory Accounting

Tools of Analysis
• Comparison of a company’s financial condition and performance across time.
SAP 2007 / SAP University Alliances Introductory Accounting

Tools of Analysis
Horizontal Analysis
Vertical Analysis
.
SAP 2007 / SAP University Alliances Introductory Accounting

Tools of Analysis
Horizontal Analysis
Vertical Analysis
Ratio Analysis
.
SAP 2007 / SAP University Alliances Introductory Accounting

Horizontal Analysis
Uses comparative financial statements.
Analysts focus on large dollar or percentage changes.
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Time
Introductory Accounting

Horizontal Analysis
Dollar
Change
=
Analysis Period
Amount
–
Base Period
Amount
Percent
Change
=
Dollar Change
Base Period Amount
×
100%
SAP 2007 / SAP University Alliances Introductory Accounting

Illustration: Dollar and Percentage Change
Assume a company’s year-end cash balances were $85,618 and $57,000 for 2005 and 2004 respectively.
Dollar change = $85,618 - $57,000
= $28,618
Percent change =
$85,618 - $57,000
$57,000 x 100
= 50.2%
SAP 2007 / SAP University Alliances Introductory Accounting

Trend Analysis
700%
600%
500%
400%
300%
200%
100%
2001
Sales
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2002 2003 2004 2005
Cost of goods sold Gross prof it
Introductory Accounting

Trend Analysis
Trend
Percent
=
Analysis Period Amount
Base Period Amount
100%
SAP 2007 / SAP University Alliances Introductory Accounting

Vertical or Common Size Analysis
Income statement items are expressed as a percentage of revenues.
Balance sheet items are expressed as a percentage of total assets.
Ralco Corporation
Partial Income Statement
For Year Ended November 30, 2005
Com m on-
Size
Pe r ce ntage
Sales
Cost of goods sold
Gross profit
$164,313 100.0%
$
35,940 21.9%
128,373 78.1%
SAP 2007 / SAP University Alliances Introductory Accounting

Common-Size Statements
Common-size
Percent
=
Analysis Amount
Base Amount
100%
Financial Statement
Balance Sheet
Income Statement
Base Amount
Total Assets
Revenues
SAP 2007 / SAP University Alliances Introductory Accounting

Ratio Analysis
Is widely used in financial analysis.
May identify areas requiring further investigation.
Ratios may be organized into the following building blocks:
• Liquidity and efficiency
• Solvency
• Profitability
• Market
SAP 2007 / SAP University Alliances Introductory Accounting

Liquidity and Efficiency
Liquidity
Refers to short-term debt paying ability.
Measures:
Working capital
Current ratio
Acid-test ratio
Days’ sales in inventory
A/R turnover
Days’ sales uncollected
Merchandise turnover
SAP 2007 / SAP University Alliances Introductory Accounting

Liquidity and Efficiency
Efficiency
Measures a company’s productivity in using its assets.
Measured by:
Total asset turnover ratio
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Liquidity
Working Capital
The difference between current assets and current liabilities.
Working
Capital
= Current Assets - Current Liabilities
SAP 2007 / SAP University Alliances Introductory Accounting

Liquidity
Current Ratio
Measures the short-term debt paying ability of the company.
Current
Ratio
=
Current Assets
Current Liabilities
SAP 2007 / SAP University Alliances Introductory Accounting

Liquidity
Acid-Test Ratio
This ratio is a more rigorous test of liquidity than the current ratio. It excludes assets such as inventories that may be difficult to quickly convert into cash.
Acid-Test
Ratio
=
Quick Assets*
Current Liabilities
* Cash, Short-Term Investments, Accounts Receivable, and Notes Receivable
SAP 2007 / SAP University Alliances Introductory Accounting

Liquidity
Accounts Receivable Turnover Ratio
Measures how many times a company converts its receivables into cash each year.
A/R
Turnover
Ratio
=
Sales on Account
Average Accounts Receivable
SAP 2007 / SAP University Alliances Introductory Accounting

Liquidity
Days’ Sales Uncollected
Measures the liquidity of receivables.
Days’ Sales
Uncollected
=
Accounts Receivable x 365
Net Sales
SAP 2007 / SAP University Alliances Introductory Accounting

Liquidity
Merchandise Turnover Ratio
Measures the number of times merchandise is sold and replaced during the year.
Merchandise
Turnover
Ratio
=
Cost of Goods Sold
Average Inventory
SAP 2007 / SAP University Alliances Introductory Accounting

Liquidity
Days’ Sales In Inventory
Measures the liquidity of inventory.
Days’ Sales
Uncollected
=
Ending Inventory
Cost of Sales x 365
SAP 2007 / SAP University Alliances Introductory Accounting

Efficiency
Total Asset Turnover
Measures the ability of a company to use its assets to generate revenues.
Total Asset
Turnover
=
Net Sales (or Revenues)
Average Total Assets
SAP 2007 / SAP University Alliances Introductory Accounting

Solvency
Refers to a company’s long-run financial viability and its ability to cover long-term obligations.
Is affected by operating, investing, and financing activities.
Key solvency ratios include:
• Debt and equity ratios
• Pledged assets to secured liabilities
• Times interest earned
SAP 2007 / SAP University Alliances Introductory Accounting

Solvency
Debt Ratio
Measures the portion of assets contributed by a company’s creditors.
Debt Ratio =
Total Liabilities
Total Assets x 100
SAP 2007 / SAP University Alliances Introductory Accounting

Solvency
Equity Ratio
Measures the portion of assets contributed by a company’s owners.
Equity
Ratio
=
Total Shareholders’ Equity x 100
Total Assets
SAP 2007 / SAP University Alliances Introductory Accounting

Solvency
Pledged Assets to Secured Liabilities
Measures the protection of secured creditors.
Pledged assets to secured liabilities
=
Book value of pledged assets
Book value of secured liabilities
SAP 2007 / SAP University Alliances Introductory Accounting

Solvency
Times Interest Earned
Measures the ability of a firm’s operations to provide protection to its long-term creditors.
Times
Interest
Earned
=
Income before Interest and Taxes
Interest Expense
SAP 2007 / SAP University Alliances Introductory Accounting

Profitability
Refers to a company’s ability to generate an adequate return on invested capital.
Profitability is judged by assessing earnings relative to the level and sources of financing.
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Profitability
Profit Margin
Reflects a company’s ability to earn a net income from sales.
Profit
Margin
=
Net Income
Net Sales (or Revenues)
SAP 2007 / SAP University Alliances Introductory Accounting

Profitability
Gross Profit Ratio
Reflects the relation between sales and cost of goods sold.
Gross
Profit
Ratio
=
Gross Profit from Sales x 100
Net Sales
SAP 2007 / SAP University Alliances Introductory Accounting

Profitability
Return on Total Assets
Provides an overall measure of a company’s profitability. It combines the profit margin and total asset turnover ratios.
Profit
Margin
=
Net Income
Average Total Assets x 100
SAP 2007 / SAP University Alliances Introductory Accounting

Profitability
Return on Common Shareholders’ Equity (ROE)
Measures how well the company employed the owners’ investments to earn income.
ROE =
Net income – Preferred Dividends
Average common shareholders’ equity x 100
SAP 2007 / SAP University Alliances Introductory Accounting

Profitability
Book Value Per Share
Measures how much each share would be worth if the company was liquidated at the amounts reported on the balance sheet.
Book value
Shareholders’ equity applicable to common shares per common = share
Number of common shares outstanding
SAP 2007 / SAP University Alliances Introductory Accounting

Profitability
Basic Earnings Per Share
Measures net income per common share.
Basic
Earnings
Per Share
=
Net Income – Preferred Dividends
Weighted Average Common Shares
Outstanding
SAP 2007 / SAP University Alliances Introductory Accounting

Market
Used for corporations having publicly traded shares.
Share price is used in the calculations of the ratios.
Share price reflects the market’s expectations for the company.
SAP 2007 / SAP University Alliances Introductory Accounting

Market
Price –Earnings Ratio
Measures how investors judge the company’s future performance.
Price –
Earnings =
Ratio
Market Price per Share
Earnings per Share
SAP 2007 / SAP University Alliances Introductory Accounting

Market
Dividend Yield
Is used to compare the dividend-paying performance of different investment alternatives.
Dividend
Yield
=
Annual Dividends per Share
Market Price per Share
SAP 2007 / SAP University Alliances Introductory Accounting