Chapter 13
Financial Statement
Analysis
Financial Accounting, Alternate 4e by Porter and Norton
1
Financial Statement Analysis
Will I
be paid?
Creditors
How
good is our
investment?
How are we
performing?
Stockholders
Management2
Limitations of Financial
Statement Analysis
Use of different accounting methods
 Changes in accounting methods

LIFO
FIFO
3
Limitations of Financial
Statement Analysis
Failure to understand trends or
use industry ratios
 Difficulty of making industry
comparisons (i.e., conglomerates)

????
4
Limitations of Financial
Statement Analysis
Nonoperating items on income
statement
 Effects of inflation

=
5
Horizontal Analysis
Wm. Wrigley Jr. Company
(in millions)
2002
Net Sales
Gross Profit
Net Earnings
2001
$2,746 $2,401
1,596 1,404
402
363
Increase (Decrease)
Dollars
Percent
$345
192
39
14.4 %
13.7
10.7
6
Trend Analysis
Wm. Wrigley Jr. Company
2002
2001
2000
1999
1998
Return on
Avg. Equity 28.7% 30.1% 29.0% 26.8% 28.4%
Tracking items over a series of years
7
Vertical Analysis

Common-size statements recast
items as a percentage of a
selected item
%

Allows comparisons of
companies of different size
%

Compares percentages across
years to identify trends
%
8
Common-Size Statements
Sales revenue
Cost of goods sold
Gross profit
Selling & admin. exp.
Operating income
Interest expense
Income before tax
Income tax expense
Net income
Dollars
$24,000
18,000
$ 6,000
3,000
$ 3,000
140
$ 2,860
1,140
$ 1,720
Percent
100.0%
75.0
25.0%
12.5
12.5%
0.6
11.9%
4.8
7.1%
9
Liquidity Analysis
Nearness to cash
 Ability to pay debts as they become due

Working
Capital
Ratios
Turnover
Ratios
Cash
Ratios
10
Working Capital
Excess of current assets over current
liabilities
 Lacks meaningful comparisons for
companies of different size

11
Current Ratio
Measure of short-term financial health
 Consider composition of current assets

Rule of thumb
2:1
12
Acid-Test (Quick) Ratio
Stricter test of ability to pay debts
 Excludes inventories and prepaid assets

Quick Assets
Current Liabilities
13
Cash Flow from Operations to
Current Liabilities Ratio
Focuses on cash only
 Covers period of time

F
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DEBTS,
LEGAL
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TENDER
AND
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9
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1
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WASHINGTON, D.C.
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2
SERIES
1985
1
2
O
N
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O
L
L
A
R
O
N
ED
D
O
L
L
A
R
Net Cash Provided by Operating Activities
Average Current Liabilities
14
Accounts Receivable Turnover
Ratio
Net Credit Sales
Average Accounts Receivable
Indicates how quickly a
company is collecting (i.e.,
turning over) its receivables
15
Accounts Receivable Turnover
Ratio

Too fast
Credit policies too
stringent; may be
losing sales

Too slow
Credit department
not operating
effectively; possible
quality problems
16
Number of Days’ Sales in
Receivables
360 Days*
.
Accts. Receivable Turnover
Represents the average # of days
accounts are outstanding
*Some analysts use 365 days.
17
Number of Days’ Sales in
Receivables
Example:
360 Days
= 75 days
4.8 Times
If this company’s credit terms are net 30,
what would this tell you about the efficiency
of the collection process?
18
Inventory Turnover
Ratio
Cost of Goods Sold
Average Inventory
Represents the number of times
per period inventory is turned
over (i.e., sold).
19
Inventory Turnover Ratio
Circuit City
Safeway
5.8 times per year
9.2 times per year
Can you compare the two ratios?
20
# of Days’ Sales in Inventory
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
# of Days in Period
Inventory Turnover Ratio
Represents the average # of days
inventory is on hand before it’s sold
21
# of Days’ Sales in Inventory
Circuit City
62 days
Safeway
39 days
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
Do these averages seem reasonable?
22
Cash Operating Cycle

Time between purchase of merchandise
and collection from the sale
# of days sales in receivables
+
# of days sales in inventory
23
Solvency Analysis

Ability to stay in business over the
long-term
Times
Interest
Earned
Debt-toEquity
Ratio
Debt
Service
Coverage
Cash Flow
to Capital
Expenditures
24
Debt-to-Equity Ratio
Total Liabilities
Total Stockholders’ Equity
How much
have creditors
contributed
compared to
owners?
25
Debt-to-Equity Ratio
Total Liabilities
Total Stockholders’ Equity
= .60
For every dollar
contributed by
owners, creditors
have loaned $.60
26
Times Interest Earned Ratio
Measures ability to meet current
interest payments
 The greater the coverage the better

Net Income + Interest Expense + Income Tax Expense
Interest Expense
27
Debt Service Coverage Ratio

Measures amount of cash from
operations available to service the debt
Cash Flow from Operations before Interest & Taxes
Interest and Principal Payments
P+ i
28
Cash Flow from Operations to
Capital Expenditures Ratio

Measures company’s ability to use
operations (vs. creditors and owners) to
finance acquisitions of productive assets
Cash Flow from Operations – Dividends Paid
Cash Paid for Capital Acquisitions
29
Profitability Analysis
Rate of Return on Assets
 Return on Common S/E
 EPS
 P/E Ratio
 Dividend Ratios

30
Return on Assets Ratio

Measures return to all providers of
capital (creditors and owners)
Net Income + Interest Expense, Net of Tax
Average Total Assets
31
Return on Common
Stockholders’ Equity
Net Income - Preferred Dividends
Average Common Stockholders’ Equity
The owners
earned 15%
on their investment
in ABC Co...
Not bad!
32
Earnings per Share

Presents profits on a per-share basis
Net Income - Preferred Dividends
Weighted Avg. # of Common Shares Outstanding
Certificate of Stock
33
Price/Earnings Ratio

Relates earnings to the market price of
the stock
Current Market Price
Earnings per Share
very high P/E
very low P/E
possibly overvalued
possibly undervalued
34
Price/Earnings Ratio
P/E Ratios
Co. A
Co. B
= 10 to 1
= 7 to 1
Both companies
have earnings of $2
per share. So why
the different P/E
ratios?
35
Dividend Payout Ratio
Common Dividends per Share
Earnings per Share
We need to
decide what % of
the firm’s income
we can return to
owners.
36
Dividend Yield Ratio

Investors willing to forgo dividends in
lieu of price appreciation
Common Dividends per Share
Market Price per Share
=
usually
< 5%
37
Appendix
Accounting Tools:
Reporting and Analyzing
Other Income Statement Items
38
Common Characteristics
 All
such items are reported after
income from continuing operations
 Reported separately
 Shown net of tax effects
 Most analysts ignore these items,
since they are not likely to reoccur
39
Discontinued Operations
Any gain or loss from disposal of a
division or segment of the business
 Any net income or loss from operating
this portion until the date of disposal

40
Extraordinary Items
Gain or loss due to an event that is
 Unusual in nature AND
 Infrequent in occurrence
41
Cumulative Effect of a Change
in Accounting Principle
Reflects a change in a company’s
accounting principles, practices, or
methods
 Reports the difference in income in all
prior years between the old method and
the new method
 Sometimes such a change is dictated by
new accounting standards

42
End of Chapter 13
43