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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Analysis of Financial Statements

Chapter 17

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Application of analytical

tools

Involves transforming

data

Reduces uncertainty

Basics of Analysis

Financial statement analysis helps users make better decisions.

Internal UsersManagersOfficers

Internal Auditors

External UsersShareholders

LendersCustomers

C 1

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Building Blocks of AnalysisC 1

Liquidity and efficiency Solvency

Market prospectsProfitability

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Information for AnalysisC 1

1. Income Statement2. Balance Sheet 3. Statement of

Stockholders’ Equity4. Statement of Cash Flows5. Notes to the Financial

Statements

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IntracompanyIntracompany

CompetitorsCompetitors

IndustryIndustry

GuidelinesGuidelines

Standards for ComparisonC 1

When we interpret our analysis, it is essential to compare the results we obtained to other

standards or benchmarks.

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Horizontal AnalysisComparing a company’s financial condition and

performance across time.

Tools of Analysis

Vertical AnalysisComparing a company’s financial condition and

performance to a base amount.

Ratio AnalysisMeasurement of key relations between financial

statement items.

C 2

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Horizontal AnalysisP 1

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Comparative Statements

Calculate Change in Dollar Amount

DollarChange

Analysis Period Amount

Base PeriodAmount= –

When measuring the amount of the change in dollar amounts, compare the

analysis period balance to the base period balance. The analysis period is usually the current year while the base

period is usually the prior year.

P 1

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Comparative Statements

Calculate Change as a Percent

PercentChange

Dollar Change Base Period Amount 100= ×

P 1

When calculating the change as a percentage, divide the amount of the

dollar change by the base period amount, and then multiply by 100 to

convert to a percentage.

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$325,336 – $393,927 = $(68,591)

($(68,591) ÷ $393,927) × 100 = (17.4)%

Horizontal AnalysisP 1

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Horizontal Analysis

($665,810 ÷ $1,991,139) × 100 = 33.4%

$2,656,949 – $1,991,139 = $665,810

P 1

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Trend Analysis

Trend analysis is used to reveal patterns in data covering successive periods.

TrendPercent

Analysis Period Amount Base Period Amount 100= ×

P 1

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Polaris Industries Inc.Income Statement Information

Using 2007 as the base year we will get the following trend information:

Examples of 2007-2011 Calculations for Revenues:2007 is base year. Set to 100%2008: $1,948,254 ÷ $1,780,009 × 100 = 109.5%2009: $1,565,887 ÷ $1,780,009 × 100 = 88.0%

P 1

Trend Analysis

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Trend Analysis

We can use the trend percentages to construct a graph so we can see the trend over time.

P 1

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Vertical Analysis

Common-Size Statements

Common-size Percent

Analysis AmountBase Amount 100= ×

Financial Statement Base Amount

Balance Sheet Total Assets

Income Statement Revenues

P 2

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($325,336 ÷ $1,228,024) × 100 = 26.5%

($393,927 ÷ $1,061,647) × 100 = 37.1%

Common-Size Balance SheetP 2

•Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

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Common-Size Income StatementP 2

($1,916,366 ÷ $2,656,949) × 100 = 72.1%

($1,460,926 ÷ $1,991,139) × 100 = 73.4%

•Percents are rounded to tenths and thus may not exactly sum to totals and subtotals.

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Common-Size GraphicsP 2

Common-Size Graphic ofAsset Components

Common-Size Graphic ofIncome Statement

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Ratio AnalysisP 3

Liquidity and efficiency Solvency

Market prospectsProfitability

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Current Ratio

Acid-test Ratio

Accounts Receivable

Turnover

Inventory Turnover

Days’ Sales Uncollected

Days’ Sales in Inventory

Total Asset Turnover

Liquidity and EfficiencyP 3

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Working Capital

Working capital represents current assets financed from long-term capital sources that

do not require near-term repayment.

  Current assets– Current liabilities= Working capital

More working capital suggests a strong liquidity More working capital suggests a strong liquidity

position and an ability to meet current obligations.position and an ability to meet current obligations.

P 3

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This ratio measures the short-term debt-paying ability of the company. A higher current ratio suggests a strong liquidity

position.

Current Ratio

Current Ratio = Current AssetsCurrent Liabilities

P 3

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This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be

difficult to quickly convert into cash.

Acid-Test Ratio

Acid-test ratio = Cash + Short-term investments + Current

receivablesCurrent Liabilities

Referred to as Quick Assets

P 3

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This ratio measures how many times a company converts its receivables

into cash each year.

Accounts Receivable Turnover

Accounts receivable = turnover

Net salesAverage accounts receivable,

net

Average accounts receivable = (Beginning acct. rec. + Ending acct. rec.)2

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This ratio measures the number of times

merchandise is sold and replaced during the year.

Inventory Turnover

Inventory turnover = Cost of goods soldAverage inventory

Average inventory = (Beginning inventory + Ending inventory)2

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Provides insight into how frequently a company collects its accounts receivable.

Days’ Sales Uncollected

Day's sales = uncollected

Accounts receivable, net× 365

Net sales

P 3

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Days’ Sales in Inventory

Day's sales in = Inventory

Ending inventory× 365

Cost of goods sold

This ratio is a useful measure in evaluating inventory liquidity. If a product is demanded by customers, this formula estimates how

long it takes to sell the inventory.

P3

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Total Asset Turnover

Total asset turnover = Net salesAverage total assets

Average assets = (Beginning assets + Ending assets)2

This ratio reflects a company’s ability to use its assets to generate

sales. It is an important indication of operating

efficiency.

P 3

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DebtRatio

EquityRatio

Pledged Assets to Secured Liabilities

Times Interest Earned

SolvencyP 3

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Debt and Equity Ratios

Amount RatioTotal liabilities $ 8,000,000 66.7% [Debt ratio]Total equity 4,000,000 33.3% [Equity ratio]Total liabilities and equity $ 12,000,000 100.0%

$8,000,000 ÷ $12,000,000 = 66.7%

The debt ratio expresses total liabilities as a percent of total assets. The equity ratio provides complementary

information by expressing total equity as a percent of total assets.

P 3

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Debt-to-Equity Ratio

Debt-to-equity ratio = Total liabilities Total equity

This ratio measures what portion of a company’s assets are contributed by creditors. A larger debt-to-

equity ratio implies less opportunity to expand through use of debt financing.

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Times Interest Earned

Times interest earned =

Income before interest and taxes

Interest expense

This is the most common measure of the ability of a company’s operations to provide

protection to long-term creditors.

Net income+ Interest expense+ Income taxes= Income before interest and taxes

P 3

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Profit Margin

Return on Total Assets

Return on Common Stockholders’ Equity

ProfitabilityP 3

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Profit Margin

Profit margin = Net income Net sales

This ratio describes a company’s ability to earn net income from each sales dollar.

P 3

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Return on total asset =

Net income Average total

assets

Return on Total Assets

Return on total assets measures how well assets have been employed by the

company’s management.

P 3

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Return on Common Stockholders’ Equity

Return on common stockholders' equity =

Net income - Preferred dividends Average common stockholders'

equity

This measure indicates how well the company employed the stockholders’ equity to earn net

income.

P 3

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Price-Earnings Ratio

Dividend Yield

Market ProspectsP 3

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Price-Earnings Ratio

Price-earnings ratio = Market price per common share Earnings per share

This measure is often used by investors as a general guideline in gauging stock values.

Generally, the higher the price-earnings ratio, the more opportunity a company has for growth.

P 3

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Dividend Yield

Dividend yield = Annual cash dividends per share Market price per share

This ratio identifies the return, in terms of cash dividends, on the current market price per share

of the company’s common stock.

P 3

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Summary of Ratios

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Global View

Horizontal and Vertical AnalysisHorizontal and vertical analyses help eliminate many differences between U.S. GAAP

and IFRS when analyzing and interpreting financial statements. However, when fundamental differences in reporting regimes impact financial statements, the user

must exercise caution when drawing conclusions.

Ratio AnalysisRatio analysis of financial statements also helps eliminate differences between U.S.

GAAP and IFRS. Importantly, the use of ratio analysis is fine, with some possible changes in interpretation depending on what is and what is not included in certain

accounting measures across U.S. GAAP and IFRS. Care must be taken in drawing inferences from a comparison of ratios across reporting regimes.

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Analysis ReportingA1

1. Executive Summary2. Analysis Overview3. Evidential Matter4. Assumptions5. Key Factors6. Inferences

The purpose of financial statement analyses is to reduce uncertainty in business decisions through a

rigorous and sound evaluation. A financial statement analysis report directly addresses the building blocks of

analysis and documents the reasoning.

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Net IncomeNet Income

Appendix 17A: Sustainable Income

DiscontinuedSegments

ExtraordinaryItems

ContinuingOperations

A 2

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End of Chapter 17