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Financial Statement Analysis

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Basic Analytical Methods

Users analyze a company’s financial statements using a variety of analytical methods. Three such methods are as follows:1. Horizontal analysis

2. Vertical analysis

3. Common-sized statements

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Horizontal Analysis

The percentage analysis of increases and decreases in related items using comparative financial statements is called horizontal analysis.

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Comparative Balance Sheet—Horizontal Analysis

1

Exhibit 1

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1

Horizontal Analysis: Horizontal Analysis:

Difference $17,000

Base year (2009) $533,000= 3.2%

Exhibit 1

Comparative Balance Sheet—Horizontal Analysis

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Comparative Schedule of Current Assets—Horizontal Analysis

1

Exhibit 2

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Horizontal Analysis: Horizontal Analysis:

Difference $25,800

Base year (2009) $64,700= 39.9%

1Comparative Schedule of Current Assets—Horizontal AnalysisExhibit 2

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Comparative Income Statement—Horizontal Analysis

1Exhibit 3

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Horizontal Analysis:Horizontal Analysis:

Increase amount $296,500

Base year (2009) $1,234,000

= 24.0%

1Comparative Income Statement—Horizontal AnalysisExhibit 3

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Comparative Retained Earnings Statement—Horizontal Analysis

Horizontal Analysis:Horizontal Analysis:

Increase amount $37,500

Base year (2009) $100,000= 37.5%

1Exhibit 4

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Vertical Analysis

A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis.

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In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.

Vertical Analysis of Balance Sheet

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Compar-ative Balance Sheet—Vertical Analysis

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Exhibit 5

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Compar-ative Balance Sheet—Vertical Analysis

Vertical Analysis: Vertical Analysis:

Current assets $550,000

Total assets $1,139,500= 48.3%

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Exhibit 5

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In a vertical analysis of the income statement, each item is stated as a percent of net sales.

Vertical Analysis of the Income Statement

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Comparative Income Statement—Vertical Analysis

1Exhibit 6

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Vertical Analysis: Vertical Analysis:

Selling expenses $191,000

Net sales $1,498,000= 12.8%

1Comparative Income Statement—Vertical AnalysisExhibit 6

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Common-Size Statements

In a common-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with with industry percentages.

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Common-Sized Income Statement

1Exhibit 7

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Solvency Analysis

All users of financial statements are interested in the ability of a company to do the following:1. Meet its financial obligations (debts), called

solvency.2. Earn income, called profitability.

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Current Position Analysis

Using measures to assess a business’s ability to pay its current liabilities is called current position analysis. Such analysis is of special interest to short-term creditors.

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Working Capital

The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company’s ability to pay current liabilities.

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Working Capital = Current Assets – Current Liabilities

2010 2009

Current assets $550,000 $533,000Current liabilities –210,000 –243,000Working capital $340,000$290,000

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Current Ratio

The current ratio, sometimes called the working capital ratio or bankers’ ratio measures a company’s ability to pay its current liabilities.

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2010 2009Current assets $550,000 $533,000Current liabilities $210,000 $243,000Current ratio 2.6 2.2

$550,000

$210,000

$533,000

$243,000

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Current Ratio =Current Assets

Current Liabilities

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Quick Ratio

A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio or acid-test ratio.

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2010 2009

Quick ratio (a ÷ b) 1.3 1.0

Quick assets:Cash $ 90,500 $ 64,700Temporary Investments 75,000 60,000Accounts receivable (net) 115,000 120,000 a. Total quick assets $280,500 $244,700

b. Current liabilities $210,000 $243,000

Quick assets are cash and other current assets

that can be quickly converted to cash.

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Accounts Receivable Turnover

The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a company’s solvency.

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Accounts receivable turnover (a ÷ b) 12.7 9.2

a. Net sales $1,498,000$1,200,000

Accounts receivable (net):Beginning of year $ 120,000$ 140,000End of year 115,500 120,000

Total$ 235,000 $ 260,000

b. Average (Total ÷ 2) $ 117,500$ 130,000

2010 2009

Accounts Receivable Turnover =

Net Sales

Average Accounts Receivable

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Number of Days’ Sales in Receivables

The number of days’ sales in receivables is an estimate of the length

of time (in days) the accounts receivable have been outstanding.

Number of Days’ Sales in Receivables

Average Accounts Receivable

Average Daily Sales

=

Net Sales

365

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Number of days’ sales in receivables (a ÷ b) 28.6 39.5

a. Average accounts receivable(Total accounts receivable ÷ 2) $ 117,500

$ 130,000Net sales $1,498,000

$1,200,000b. Average daily sales

(Sales ÷ 365) $ 4,104$ 3,288

2010 2009

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Inventory Turnover

The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory.

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Inventory Turnover =

Cost of Goods Sold

Average Inventory

Inventory turnover (a ÷ b) 3.8 2.8

2010 2009

a. Cost of goods sold $1,043,000$ 820,000

Inventories:Beginning of year $ 283,000

$ 311,000End of year 264,000

283,000Total $ 547,000

$ 594,000

b. Average (Total ÷ 2) $ 273,500$ 297,000

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Number of Days’ Sales in Inventory

The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory.

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Number of Days’ Sales in Inventory

Average Inventory

Average Daily Cost of Goods Sold

=

Cost of Goods Sold

365

Number of days’ sales in inventory (a ÷ b) 95.7 132.2

a. Average inventory (Total ÷ 2) $ 273,500 $ 297,000Cost of goods sold $1,043,000 $ 820,000

b. Average daily cost of goodssold (COGS ÷ 365 days) $2,858 $2,247

2010 2009

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Profitability Analysis

Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business.

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Earnings per Share on Common Stock

Earning per share (EPS) on common stock measures the share of profits that are earned by share of common stock. GAAP require the reporting of earnings per share in the income statement.

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Earnings per Share (EPS) on Common Stock

Net Income – Preferred Dividends

Shares of Common Stock Outstanding

=

Earnings per share on common stock (a ÷ b) $1.64 $1.35

2010 2009

Net income $91,000$76,500

Preferred dividends 9,000 9,000

a. Remainder—identified with common stock $82,000$67,500

b. Shares of common stock 50,00050,000

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Price-Earnings Ratio

Another profitability measure quoted by the financial press is the price-earnings (P/E) ratio on common stock. The price-earnings ratio on common stock measures a company’s future earnings prospects.

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Price-earnings (P/E) ratio

Market Price per Share of Common Stock

Earnings per Share on Common Stock

=

Price-earnings ratio on common stock 25 20

2010 2009

Market price per share of common stock $41.00 $27.00

Earnings per share on commonstock ÷ 1.64 ÷ 1.35

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Corporate Annual Reports

In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections:• Management discussion and analysis

• Report on adequacy of internal control

• Report on fairness of financial statements

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The Management Discussion and Analysis (MD&A) includes an analysis of the results of operations and discusses management’s opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition.

Management Discussion and Analysis

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The Sarbanes-Oxley Act of 2002 requires a report stating management’s responsibility for establishing and maintaining internal control. In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report.

Report on Internal Control

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Questions

• Open Q&A Time

• What questions do you have?