Financial
Statement
Analysis
Chapter 9
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
9-2
Learning Objective 1
Describe factors associated with
communicating useful information.
9-3
Factors in Communicating
Useful Information
The primary objective of accounting is to provide
information useful for decision making. To provide
information that supports this objective, accountants must
consider the following:
Users
Types of
Decisions
Methods
of
Analysis
9-4
Methods of Analysis
Horizontal
Analysis
Vertical
Analysis
Ratio
Analysis
9-5
Learning Objective 2
Differentiate between horizontal and
vertical analysis.
9-6
Milavec Company Financial Statements
9-7
Milavec Company Financial Statements
9-8
Horizontal Analysis
Horizontal analysis (or trend analysis)
refers to studying the behavior of
individual financial statement items
over several accounting periods.
Absolute
Amounts
Percentage
Analysis
9-9
Milavec Company Horizontal
Analysis
9-10
Milavec Company Trend
Analysis
Trend =
Percentage
Current Year Amount
Base Year Amount
× 100%
9-11
Vertical Analysis
Vertical analysis uses
percentages to compare
individual components of
financial statements to a
key statement figure. A
common-size financial
statement is a vertical
analysis in which each
financial statement item is
expressed as a
percentage.
9-12
Vertical Analysis of Income
Statement
In income
statements, all
items are
usually
expressed as a
percentage of
sales.
9-13
Milavec Company Vertical
Analysis
9-14
Vertical Analysis of Balance
Sheet
In balance
sheets, all items
are usually
expressed as a
percentage of
total assets.
9-15
Milavec Company Vertical Analysis
9-16
Learning Objective 3
Explain ratio analysis.
9-17
Ratio Analysis
Ratio analysis
involves studying
various
relationships
between different
items reported in a
set of financial
statements.
9-18
Learning Objective 4
Calculate ratios for assessing a
company’s liquidity.
9-19
Liquidity Ratios
Liquidity ratios indicate a
company’s ability to pay shortterm debts. They focus on
current assets and current
liabilities.
1. Working Capital
2. Current Ratio
3. Quick Ratio
4. Accounts Receivable Ratios
5. Inventory Ratios
9-20
Working Capital
• The excess of current assets over
current liabilities is known as
working capital.
9-21
Current Ratio
Current
Ratio
=
Current Assets
Current Liabilities
• The current ratio measures a
company’s short-term debt paying
ability.
A declining ratio may be a
sign of deteriorating
financial condition, or it
might result from eliminating
obsolete inventories.
9-22
Current Ratio
9-23
Quick (Acid-Test) Ratio
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
Quick assets include Cash,
Current Marketable Securities, and
Accounts Receivable.
This ratio measures a company’s ability
to meet obligations without having to
liquidate inventory.
9-24
Quick (Acid-Test) Ratio
9-25
Accounts Receivable Turnover
Accounts
Receivable
Turnover
=
Net Credit Sales
Average Accounts Receivable
This ratio measures how many times a company
converts its receivables into cash each year.
9-26
Average Days to Collect
Receivables
Average
365 Days
Collection = Accounts Receivable Turnover
Period
Average
Collection =
Period
365 Days
16.98 Times
This ratio measures, on average,
how many days it takes to collect
an account receivable.
= 21 days
9-27
Inventory Turnover
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
• This ratio measures how many times a company’s inventory
has been sold and replaced during the year.
9-28
Average Days to Sell Inventory
Average
Sale Period
Average
=
Sale Period
=
365 Days
Inventory Turnover
365 Days
10.80 Times
This ratio measures how many
days, on average, it takes to sell
the inventory.
= 34 days
9-29
Learning Objective 5
Calculate ratios for assessing a
company’s solvency.
9-30
Solvency Ratios
Solvency ratios are used to
analyze a company’s long-term
debt-paying ability and its
financing structure.
1. Debt to Assets Ratio
2. Debt to Equity Ratio
3. Number of Times Interest Earned
4. Plant Assets to Long-Term Liabilities
9-31
Debt to Equity Ratio
Debt to
Total Liabilities
Equity =
Stockholders’ Equity
Ratio
• This ratio compares creditor financing to
owner financing. Equity means
stockholders’ equity.
Stockholders like a lot of
debt if the company can
take advantage of
positive financial
leverage.
Creditors prefer less
debt and more equity
because equity
represents a buffer of
protection.
9-32
Debt to Assets Ratio
Debt to
Assets =
Ratio
Total Liabilities
Total Assets
• This ratio measures the percentage of a company’s assets
that are financed by debt.
9-33
Number of Times Interest Earned
Ratio
Times
Interest =
Earned
Earnings before Interest Expense
and Income Taxes
Interest Expense
This is the most common measure of a company’s
ability to provide protection for its long-term creditors.
9-34
Plant Assets to Long-Term
Liabilities
Plant Assets
to Long-Term =
Liabilities
Net Plant Assets
Long-Term Liabilities
This ratio suggests how well long-term debt is managed to
finance long-term assets.
9-35
Learning Objective 6
Calculate ratios for assessing company
management’s effectiveness.
9-36
Profitability Ratios
Profitability ratios measure a
company’s ability to generate
earnings.
1. Net Margin (or Return on Sales)
2. Asset Turnover Ratio
3. Return on Investment
4. Return on Equity
9-37
Net Margin
Net
=
Margin
Net Income
Net Sales
This measure describes the percent remaining
of each sales dollar after subtracting other
expenses as well as cost of goods sold.
9-38
Asset Turnover Ratio
Asset
Turnover
=
Net Sales
Average Total Assets
This ratio measures how many sales dollars were
generated for each dollar of assets invested.
9-39
Return on Investment (ROI)
Return on
Net Income
=
Investment
Average Total Assets
This is the ratio of wealth generated (net income) to
the amount invested (average total assets).
For Milavec, ROI was as follows:
9-40
Return on Equity
Return on =
Equity
Net Income
Average Total Stockholders’
Equity
This measure is often used to measure the profitability of
the stockholders’ investment.
9-41
Learning Objective 7
Calculate ratios for assessing a
company’s position in the stock
market.
9-42
Stock Market Ratios
Stock market ratios analyze the
earnings and dividends of a
company.
1. Earnings Per Share
2. Book Value
3. Price-Earnings (PE) Ratio
4. Dividend Yield
9-43
Earnings Per Share
Earnings
Net Earnings Available for Common Stock
=
per
Average Number of Outstanding Common
Share
Shares
This measure indicates how much
income was earned for each share of common stock
outstanding.
Milavec’s 2012 EPS is calculated as follows:
$25,000 (net income) - $3,000 (preferred dividend)
(15,000 + 12,500)/2 (average outstanding common shares)
= $1.60
per share
9-44
Book Value Per Share
Book Value
=
per Share
Stockholders’ Equity - Preferred Dividends
Outstanding Common Shares
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 and if all creditors were paid
off.
Book value per share for 2012
($362,000 - $50,000) ÷ 15,000 shares = $20.80 per share
9-45
Price-Earnings And Dividend
Yield
Price-Earnings
Ratio
=
Market Price Per Share
Earnings Per Share
This ratio compares the earnings of a company to the
market price for a share of the company’s stock.
Dividend
Yield
=
Dividends Per Share
Market Price Per Share
This ratio identifies the return, in terms of cash
dividends, on the current market price of the stock.
9-46
Presentation of Analytical Relationships
9-47
Learning Objective 8
Explain the limitations of financial
statement analysis.
9-48
Limitations of Financial
Statement Analysis
Changing
Economic
Environment
Different Industries
Accounting
Principles
9-49
End of Chapter Nine