Intermediate Accounting
Thomas H. Beechy
Schulich School of
Business,
York University
Joan E. D. Conrod
Faculty of Management
Dalhousie University
Powerpoint slides by:
Michael L. Hockenstein  Commerce Department • Vanier College
Copyright © 2003 McGraw-Hill Ryerson Limited, Canada
Financial Statement Analysis
Chapter 23
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Overview of Statement Analysis
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Clarify The Decision Focus
Objective
Examine the Auditor’s Report
Examine Accounting Policies
Financial
Recast the Financial Statements
Statements
Seek Comparative Information
Apply Analytical Techniques
Auditor’s Accounting
Report
Policies
Comparative
Information
Recast
FS
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Clarify the Decision Focus
 The starting point is to be clear about what
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decisions are to be made as a result of the
financial statement analysis
Possible decisions are:
 share investment decisions
 lending decisions
 contractual decisions
 regulatory decisions
Each type of decision will require a somewhat
different approach to the analysis and a different
set of priorities
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Clarify the Decision Focus (cont.)
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For example, a prospective investor in common
shares will be concerned with the long-run
profitability of the company (solvency and stability)
Trade creditors will be primarily interested in the
short-run liquidity (while still being interested in the
long-term survival possibilities of the company)
This difference in focus is illustrated by the fact that
many creditors will continue to extend credit to a
company with declining profitability that no objective
investor would buy shares in
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Examine the Auditor’s Report
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The auditor’s report should be reviewed with an eye
to qualifications and to comments regarding
accounting policies, if any
The auditor’s report serves as an assurance that
accounting policies are within the very broad
framework of GAAP or a disclosed basis of
accounting, that the statements are fairly stated (not
materially misstated), and that an audit was
performed using Generally Accepted Auditing
Standards
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Examine the Auditor’s Report (cont.)
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A public company must be audited and normally
will have an unqualified audit opinion, which is
often referred to as a “clean opinion”
When an auditor is in serious disagreement with a
company’s management about the suitability of its
accounting policies and believes that the
statements are misleading, the auditor will issue a
reservation of opinion or an adverse opinion
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Examine the Auditor’s Report (cont.)
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If a private company does not have an audit, an
auditor may nevertheless be retained for a review
engagement, in which a full audit is not performed
but the auditor does review the financial statements
for consistency with GAAP (or with disclosed basis
of accounting) and for reasonableness of
presentation
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Examine Accounting Policies
 The essential first step in statement analysis is to fully
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understand the financial statements
Meaningful analysis requires they be understood
within the framework of management’s reporting
objectives and accounting policies
Clues to the accounting policies being used by
management are found in the notes to the financial
statements
The policy note may give only sketchy information, but
the notes relating to individual financial statement
components may provide more useful information
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Recast the Financial Statements
 It is often necessary for users to recast the
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financial statements to suit their needs before
applying other analytical approaches
Situations that suggest a needed restatement
include the following:
 the income statement is revised to remove nonrecurring gains and losses
 the income statement and balance sheet are
revised to remove the effects of future income tax
liabilities and assets
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Recast the Financial Statements (cont.)
the income statement and balance sheet are
revised to reflect a different policy on
capitalization of certain costs:
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capitalized costs are shifted to the income
statement in the year they occurred, and
amortization is removed
expenditures charged directly to the income
statement are removed, capitalized, and
amortization is added.
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Recast the Financial Statements (cont.)
 necessary recurring reinvestments are
reclassified on the cash flow statement from
investing activities to operations
 interest expense and taxes are removed from
net income to yield a measure commonly
referred to as EBIT (earnings before interest
and taxes)
 loans to and from shareholders are reclassified
as owners’ equity
 retractable preferred shares are reclassified as
long-term debt
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Seek Comparative Information
 Data is useless unless there is some basis for
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comparison
Sometimes the comparison is with a mental
data base accumulated by the analyst over
years of experience in analyzing similar
companies
For less experienced analysts, empirical
comparisons are necessary
There are two bases for comparison:
 cross sectional
 longitudinal
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Seek Comparative Information (cont.)
 Cross sectional comparisons analyze a
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company in relation to other companies in the same
year
Comparisons of this type frequently appear in articles
in the business press that compare the recent
performance of one company with its competitors
 Longitudinal comparisons look at a company
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over time, comparing this year’s performance with
earlier years
A comparison is often made to other companies or to
general economic returns during the same time span
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Apply Analytical Techniques
 The basic tool of numerical analysis is ratios
 A ratio is one number divided by another
 Two commonly cited types of ratios are
 vertical analysis or common-size analysis
 horizontal analysis or trend analysis
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Apply Analytical Techniques (cont.)
 Vertical analysis (or common-size
analysis): involves calculating financial statement
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components as a percentage of a total, such as
balance sheet amounts as a percent of total assets
Vertical analysis is useful for removing the effects of
absolute changes in amounts; changes in the
relative composition of balance sheet and income
statement components become more readily
apparent
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Apply Analytical Techniques (cont.)
 Horizontal analysis (or trend analysis):
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involves calculating individual financial statement
components over several years as an index
number, with a base year set at 100
Horizontal analysis is used to determine the
relative change in amounts between years
Obvious calculations include the trend of sales
over time and the trend of net income over time
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Ratio Analysis
 Ratio analysis: compares the proportional
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relationship between different items within a
single year’s financial statements
There are literally dozens of ratios that can be
computed from a single year’s financial
statements
The important task for an analyst is to focus on
the ratios that have primary meaning for the
decision at hand
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Ratio Analysis (cont.)
 There are many ways of grouping ratios
but we will group our ratios as follows:
 profitability ratios
 efficiency ratios
 solvency ratios
 liquidity ratios
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Profitability Ratios
 Profitability ratios: those that compare a
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measure of earnings (the numerator) to a measure of
investment (the denominator)
Some types of profitability ratios:
 capital employed or total capitalization
 return on long-term capital, before taxes
 return on long-term capital, after taxes
 return on total assets, before taxes
 return on total assets, after taxes
 return on gross assets, after tax
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Exhibit 23-5
Summary of Profitability Ratios
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Exhibit 23-5
Summary of Profitability Ratios
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Components of Profitability Ratios
 Ratios are based on accounting numbers that
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are the result of the company’s accounting
policies and that include the effects of many
estimates made by management
Despite the fact that ratios can be computed
to many decimals, they really are very
approximate measures that must be
interpreted with extreme caution
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Efficiency Ratios
 Efficiency ratios: ratios that attempt to measure
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selected aspects of the company’s operational
efficiency e.g., inventory turnover or the accounts
receivable collection period
Efficiency ratios must be used with great caution by
an external analyst because the balance sheet
amounts may not be typical of the balances
throughout the period
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Efficiency Ratios (cont.)
 Some types of efficiency ratios are:
asset turnover ratios
accounts receivable turnover
inventory turnover
the average collection period of accounts
receivable
accounts receivable aging schedule
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Exhibit 23-6
Summary of Eficiency Ratios
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Exhibit 23-6
Summary of Eficiency Ratios
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Solvency Ratios
 Solvency ratio: the basic objective is to
assess the ability of the company to make both
the interest and principal payments on its longterm debt
 Ratios can be further classified as:
 leveraged ratios
 debt service ratios
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Solvency Ratios (Cont.)
 Leveraged ratios: measure the relative amount
of the company’s financing that was obtained
through debt
 Leverage: the extent to which a company uses
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fixed term obligations to finance its assets
The most basic measure of leverage is debt-toequity ratio
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Solvency Ratios (cont.)
 Debt service ratios: test the ability of the
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company to generate sufficient cash flow from
operations to pay the debt interest or the debt interest
plus principal payments
A traditional ratio used in solvency analysis is the
times interest earned ratio
A broader debt service ratio is times debt service
earned that includes the amount of interest to be paid,
and the amount of principle payments to be made
23-30
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Exhibit 23-7
Summary of Solvency Ratios
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Exhibit 23-7
Summary of Solvency Ratios
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Liquidity Ratios
 Liquidity ratios: ratios that test the company’s
ability to cover its short-term obligations with its
existing monetary assets
 Some types of liquidity ratios are:
 current ratio
 quick ratio
 defensive-interval ratio
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Exhibit 23-8
Summary of Liquidity Ratios
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Consolidated Statements
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Many Canadian corporations, whether incorporated
federally or provincially, operate through a series of
subsidiaries
Canadian GAAP provides that the primary
statement for a company with subsidiaries is the
consolidated financial statements, wherein all of
the assets, liabilities, revenues, and expenses of all
of the companies in the group are combined
Investors in the parent want to see consolidated
statements
Creditors want to see separate company
statements
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Multi-Industry Corporations
 Many corporations engage in several lines of
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business
Because they have a broad spectrum of
activities, they cannot be classified as being in
a specific industry
Since industry comparisons are a common
aspect of financial statement analysis (and
particularly of ratio analysis), the inability to
slot many corporations into a specific industry
classification may appear to create a problem
for the analyst
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Multi-Industry Corporations (cont.)
 Risks often differ by industry
 Public companies are required to provide
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segment reporting as supplementary
information in their annual financial statements
The volume of activity is reported both by
industry and by geographic region
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Conclusion: Observations on Ratio Analysis
 Ratios are only as good as the underlying data
 Analyze the correct set of financial statements:
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consolidated or separate-legal-entity
Financial statements adjust to suit the analyst’s
needs before meaningful ratio analysis can be
performed
There is no assurance that the industry averages
(or quartiles) are “right” or are based on similar
accounting policies and measurements
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Conclusion: Observations on Ratio Analysis
(cont.)
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Assessments of profitability, solvency, and
liquidity are not really industry-dependent, but
they do depend to some extent on an analysis of
risk for each line of business
There is no point in computing masses of ratios; it
is more important to identify one or two key ratios
in each category that are relevant
Given the many estimates and approximations
underlying both the numerator and denominator
of all ratios, it is absurd to calculate them to more
than two significant digits
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