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CHAPTER 16
Financial
Statement Analysis
© 2009 Cengage Learning
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Introduction
How can we determine:
The ability of an organization to pay loans?
Whether we are earning a fair return on our
investment?
The adequacy of cash flow to pay operating
expenses?
How to improve the overall performance of the
company?
Answer: Financial Statement Analysis
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Why Analyze Financial
Statements?
Key Concept
Ratio analysis provides
additional information
necessary to enhance the
decision-making ability of the
users of the information.
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Limitations of Financial Statement
Analysis
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When comparing companies and
interpreting financial statement
analysis, differences in
accounting methods and cost
flow assumptions need to be
considered.
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Limitations of Financial
Statement Analysis
Key Concept
Rather than focus on a single
ratio, decision makers need to
evaluate a company by
comparing ratios to those of
previous years, budgeted
amounts, and industry
standards.
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Limitations of Financial Statement
Analysis
Ratios of a company should be
compared with industry standards:
Dun & Bradstreet
http://www.dnb.com
Moody’s
http://www.moodys.com
Standard & Poor’s
http://www.standardpoor.com
Dow Jones Retrieval
http://www.dowjones.com
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The Impact of Inflation on Financial
Statement Analysis
Financial statements, and thus
financial ratios, are prepared
using historical costs and are
not adjusted for the effects of
increasing prices.
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Horizontal Analysis
Key Concept
Horizontal analysis is used to
analyze changes in accounts
occurring between years.
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Horizontal Analysis
Cash
Comparative Balance Sheets
2007
2006
$130,000 $110,000
$130,000 - $110,000 = $20,000
$20,000/$110,000 = 18.2% increase
Prepaid Insurance $25,000
$30,000
$25,000 - $30,000 = ($5,000)
($5,000)/$30,000 = (16.7%) decrease
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Horizontal Analysis
Changes in the income statement are
analyzed in the same way.
A few results:
Sales increased 7.7%
Cost of goods sold increased 9.9%
Total operating expenses increased 27.6%
Operating income decreased 26.2%
Net income decreased .05%
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Horizontal Analysis
Trend Analysis: horizontal analysis of financial
statements over several years
Can be used to:
Build prediction models to forecast financial
performance in the future.
Identify problem areas by looking for sudden
or abnormal changes in accounts.
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Vertical Analysis
Compares financial statements of different
companies and financial statements of the same
company across time after controlling for
differences in size.
Common-size financial statements are
statements in which all items have been restated as
a percentage of a selected item on the statements.
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Vertical Analysis
Key Concept
Vertical analysis uses common-size
financial statements to remove size
as a relevant variable in ratio
analysis.
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Vertical Analysis
Comparative Balance Sheet
Asset accounts are stated as a
percentage of total assets.
Liability and stockholders’
equity accounts are stated as a
percentage of total Liabilities &
Stockholders’ Equity.
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Vertical Analysis
Working Capital = Current Assets – Current Liabilities
Measure of an entity’s LIQUIDITY, or its ability to
meet its immediate financial obligations
More useful if we have information concerning the
makeup of Working Capital
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Vertical Analysis
Common-Size Comparative Income Statements
Percentages are based on NET sales
The gross profit percentage is usually closely
watched
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Comparison of Robyn’s and
Competitor
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Percentage of Assets
Robyn’s
Cash
14.0%
Inventory
24.0
Prepaids
2.7
P & E, net
33.3
L-T investment 11.8
Competitor
17.0%
20.0
3.4
39.5
10.5
Why are there differences?
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Comparison of Robyn’s and
Competitor
Accounts payable
Income tax
Long-term debt
Cost of goods sold
Operating expense
Net income after tax
Percentage of Total
Liabilities and Equity
Robyn’s Competitor
6.5%
8.5%
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2.0
10.8
13.5
71.4
65.0
19.0
23.5
13.6
10.5
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Ratio Analysis and Return
on Investment
Key Concept
Ratio analysis is useful in
assessing the impact of
transactions on ROI, residual
income, EVA, and other key
measures of performance.
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Current Ratio or Working
Capital Ratio
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Current Assets
Current Ratio =
Current Liabilities
Measures the entity’s liquidity.
This ratio tells us the amount of current
assets for every dollar of current liabilities.
What is considered to be a good Current
Ratio?
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Acid-Test Ratio or Quick Ratio
Quick Ratio =
Quick Assets
Current Liabilities
This ratio is a stricter test of a company’s
ability to pay its current debts with highly
liquid current assets.
This ratio removes inventories and prepaid
assets from the amount of current assets
used in the calculation.
A quick ratio of less than 1.0 should be of
concern.
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Cash Flow from Operations to Current
Liabilities Ratio
Net Cash Provided by Operating Activities
Average Current Liabilities
Cash flow from operations is sometimes
used as the numerator because all debt is
paid with cash.
The ratio is an indication of whether
enough cash is being generated from
operations to pay current obligations.
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Number of Days’ Sales in
Receivables
Number of Days in the Period
Accounts Receivable Turnover
This ratio is the average number of days to collect
a credit sale.
This ratio varies according to the credit policy of
the particular business and the industry standards.
This ratio has an impact on Return On
Investment.
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Inventory Turnover Ratio
Cost of Goods Sold
Average Inventory
Determines how many times during the period
the cost of the inventory was sold.
Determining what is good is dependent on the
industry and company standards.
For example, grocery stores would have a much
higher expected turnover than car dealerships.
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Number of Days Inventory Is Held
Before Sale
Number of Days in the Period
Inventory Turnover
Another way to look at inventory turnover is to
calculate the number of days inventory is held
before it is sold.
This may vary according to the particular
business and industry standards.
This ratio has an impact on Return On
Investment.
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Cash-to-Cash Operating Cycle Ratio
Number of Days in Inventory +
Number of Days in Receivables
Measures the length of time between
the purchase of inventory and the
collection of cash from sales.
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Debt-to-Equity Ratio
Total Liabilities
Total Stockholders’ Equity
A solvency ratio that measures the ability to stay
financially healthy over the long run.
Indicates the preference of the entity for debt or
equity financing.
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Times Interest Earned
Net Income + Interest Expense + Income Tax
Interest Expense
Measures a company’s ability to meet current
interest payments to creditors by specifically
measuring its ability to meet current-year interest
payments out of current-year earnings.
Especially important to bankers and other lenders.
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Debt Service Coverage Ratio
Cash Flow from Operations Before
Interest and Taxes
Interest and Principal Payments
Measures the amount of cash generated from operating
activities that is available to repay principal and interest in
the upcoming year.
The ratio indicates the amount of cash generated for every
$1 in interest and principal paid.
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Cash Flow from Operations to
Capital Expenditures Ratio
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Cash Flow from Operations - Total Dividends Paid
Cash Paid for Acquisitions
Measures a company’s ability to use cash flow from
operations to finance its acquisitions of property, plant, and
equipment.
The ability to use cash from operations diminishes the need
to acquire outside financing, such as debt.
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Return on Assets
Net Income + Interest Expense (net of tax)
Average Total Assets
Considers the return to investors on all
assets invested in the company.
Interpretation is based on the company’s
required return on assets, industry
standards, and trends.
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Return on Common
Stockholders’ Equity
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Net Income - Preferred Dividends
Average Common Stockholders’ Equity
Measures the return to common stockholders as
a percentage of stockholders’ equity.
Adequacy of return is dependent on a number of
factors, including the risk of the investment.
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Earnings per Share
Net Income - Preferred Dividends
Average Number of Common Shares
Outstanding
Used to measure performance.
Used to compare the performance of
companies of different sizes.
Used with caution to compare performance
across different industries.
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Price Earnings Ratio
Current Market Price
EPS
Important for investors because of the
relationship of earnings to dividends and the
market price of a company’s stock.
P/E ratio is very dependent on the industry.
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