lo1 analyze an income statement using vertical analysis. e · analyzing trends with vertical...

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LO1 Analyze an income statement using vertical analysis.


Vertical Analysis Ratios

● Vertical analysis ratios measure the relationship between one financial statement item and another item on the same financial statement.

● On the income statement, vertical analysis ratios focus on the ability of a business to earn a profit.

● A ratio that measures the ability of a business to generate income is called a profitability ratio.

SLIDE 2

Lesson 17-1

LO1

Continued on the next slide.


Vertical Analysis Ratios

● Vertical analysis ratios on an income statement are examples of profitability ratios.

● Managers use vertical analysis ratios to help make business decisions.

● For vertical analysis to be an effective tool, a business must set a target, or standard, for each ratio.

● A standard used to compare financial performance is called a benchmark.

SLIDE 3

Lesson 17-1

LO1


Factors Used to Determine Benchmark Ratios

● Actual ratios from prior fiscal periods

● Industry standards published by industry organizations

● Business plans

● Unexpected events

SLIDE 4

LO1

Lesson 17-1


Analyzing Trends with Vertical Analysis

● Financial statements that provide information for multiple fiscal periods are called comparative financial statements.

● An analysis of changes over time is called trend analysis.

● Net income after federal income tax as a percent of net sales is called profit margin.

SLIDE 5

LO1

Lesson 17-1


Analyzing Trends with Vertical Analysis

SLIDE 6

LO1

Lesson 17-1


Using Vertical Analysis to Analyze Gross Profit

● Gross profit as a percent of net sales is called gross margin.

● This ratio is also referred to as gross profit margin.

SLIDE 7

LO1

Lesson 17-1


Correcting an Unfavorable Gross Margin

● Increase unit sales prices

● Decrease the unit cost of merchandise

SLIDE 8

LO1

Lesson 17-1


Using Vertical Analysis to Analyze Operating Expenses

● Income from operations as a percent of net sales is called the operating margin.

● This ratio is also referred to as the rate of return on sales.

● Total operating expenses as a percent of net sales is called the operating expense ratio.

SLIDE 9

LO1

Lesson 17-1


Correcting an Unfavorable OperatingExpense Ratio

● Reduce operating expenses

● Modify the benchmark

● Increase net sales

SLIDE 10

LO1

Lesson 17-1


Lesson 17-1 Audit Your Understanding

1. Identify four factors that management can use to determine benchmark financial ratios.

SLIDE 11

ANSWER

1. Actual ratios from prior fiscal periods2. Industry standards published by industry

organizations3. Business plans4. Unexpected events

Lesson 17-1



2. Why should a business be cautious about increasing the markup on merchandise purchased for sale?

SLIDE 12

ANSWER

If the increase in markup is too large, a decrease in sales revenue could occur for two reasons: (1) the sales price may exceed what customers are willing to pay or (2) customers may elect to purchase from competing businesses having lower prices.

Lesson 17-1



3. What are two practices that can be used to reduce the cost of merchandise?

SLIDE 13

ANSWER

Purchase merchandise in larger quantities or from other vendors offering a lower cost

Lesson 17-1



4. Should managers interested in reducing operating expenses focus more on the operating expense ratio or the operating margin?

SLIDE 14

ANSWER

Operating expense ratio

Lesson 17-1



5. What are three possible actions to correct an unfavorable operating expense ratio?

SLIDE 15

ANSWER

• Reduce operating expenses• Modify the benchmark• Increase net sales

Lesson 17-1


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LO2 Perform vertical analysis of a balance sheet.

LO3 Analyze a balance sheet using vertical analysis.


Calculating Vertical Analysis Ratios on a Balance Sheet

SLIDE 17

LO2

Lesson 17-2

Liability and Stockholders’ Equity Amounts Divided by Total Assets

2

Asset Amounts Divided by Total Assets

1


Evaluating Vertical Analysis Asset Ratios

SLIDE 18

LO3

Lesson 17-2


Evaluating Vertical Analysis Liability Ratios

● A ratio that measures the ability of a business to pay its long-term liabilities is called a solvency ratio.

● Total liabilities divided by total assets is called the debt ratio.

SLIDE 19

LO3

Lesson 17-2


Evaluating Vertical Analysis Liability Ratios

SLIDE 20

LO3

Lesson 17-2



1. Why do many retailers perform vertical analysis on the Accounts Receivable and Merchandise Inventory accounts?

SLIDE 21

ANSWER

First, these are typically two of the largest asset accounts for a retail merchandising business.Second, industry standards are available for these accounts.

Lesson 17-2



2. What may cause a vertical analysis ratio for accounts receivable to be below the target range?

SLIDE 22

ANSWER

A ratio below the target range may indicate that a company is restricting customers’ ability to purchase on account. This action may have a negative effect on sales.

Lesson 17-2



3. What may cause a vertical analysis ratio for merchandise inventory to be below the target range?

SLIDE 23

ANSWER

The business may not be stocking an adequate supply or variety of merchandise.

Lesson 17-2



4. What should a company do if the vertical analysis ratio for merchandise inventory is above the target range?

SLIDE 24

ANSWER

The company should prepare a list of the inventory items having the largest cost. The company should assess whether the proper quantity of each item is available for sale. Future inventory purchases should ensure that the optimal quantity on hand is maintained.

Lesson 17-2



5. Why is it risky for a business to have too many liabilities?

SLIDE 25

ANSWER

The business must be able to pay its liabilities on a timely basis. If sales decline during difficult financial times, a business may be unable to make its monthly payments.

Lesson 17-2


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LO4 Perform horizontal analysis on an income statement.

LO5 Perform horizontal analysis on a balance sheet.


Analyzing Trends with Horizontal Analysis

● A comparison of one item on a financial statement with the same item on a previous period’s financial statement is called horizontal analysis.

SLIDE 27

LO4

Lesson 17-3

CurrentPeriod

−Prior

Period=

Increase(Decrease)

$242,584.00 − $221,489.00 = $21,095.00

Increase(Decrease)

÷Prior

Period=

HorizontalAnalysis Ratio

$21,095.00 ÷ $221,489.00 = 9.5%


Horizontal Analysis of an Income Statement

SLIDE 28

LO4

Lesson 17-3

Difference Amount Divided by Prior Year

2Current Year Less Prior Year

1


Horizontal Analysis of a Balance Sheet

SLIDE 29

LO5

Lesson 17-3



1. How could a 2.0% decrease in supplies expense be an unfavorable trend?

SLIDE 30

ANSWER

If management took actions that should have decreased supplies expense by significantly more than 2.0%, then only a 2% decrease would be unfavorable.

Lesson 17-3



2. How does a publicly held corporation use horizontal analysis when reporting to the Securities and Exchange Commission?

SLIDE 31

ANSWER

The document filed with the Securities and Exchange Commission contains a section titled Management’s Discussion and Analysis of Financial Condition and Results of Operations and Results of Operations. Management often uses these ratios to explain the current year’s results of operations compared to previous years.

Lesson 17-3


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LO6 Calculate earnings per share.

LO7 Calculate and interpret market ratios.

LO8 Calculate and interpret liquidity ratios.


Net Income after Federal Income Tax $ 79,896.57 $ 79,896.57

Number of Shares Outstanding ÷ 7,500 ÷ 75,000

Earnings per Share $ 10.65 $ 1.07

Earnings per Share

● Net income after federal income tax divided by the number of outstanding shares of stock is called earnings per share.

● Earnings per share is often abbreviated as EPS.

SLIDE 33

LO6

Lesson 17-4


Market Ratios

● A ratio that measures a corporation’s financial performance in relation to the market value of its stock is called a market ratio.

SLIDE 34

LO7

Lesson 17-4


Dividend Yield

● The relationship between dividends per share and market price per share is called the dividend yield.

SLIDE 35

LO7

Lesson 17-4

Dividendsper Share

÷Market Price

per Share =

DividendYield

$2.00 ÷ $228.75 = 0.87%


Price-Earnings Ratio

● The relationship between the market value per share and earnings per share of a stock is called the price-earnings ratio.

● It is often referred to as the P/E ratio.

SLIDE 36

LO7

Lesson 17-4

Market Priceper Share

÷Earnings

per Share =

Price-Earnings Ratio

$228.75 ÷ $10.65 = 21.5


Liquidity Ratios

● A ratio that measures the ability of a business to pay its current financial obligations is called a liquidity ratio.

SLIDE 37

LO8

Lesson 17-4


Working Capital

● The amount of current assets less current liabilities is called working capital.

SLIDE 38

LO8

Lesson 17-4

CurrentAssets

−Current

Liabilities =

Working Capital

$185,322.90 − $32,251.78 = $153,071.12


Current Ratio

● A ratio that measures the relationship of current assets to current liabilities is called the current ratio.

● The current ratio measures a company’s ability to pay its current liabilities when due.

SLIDE 39

Current Assets ÷ Current Liabilities = Current Ratio

$185,322.90 ÷ $32,251.78 = 5.75

Lesson 17-4


Quick Ratio

● Cash and other current assets that can be quickly converted into cash are called quick assets.

● Quick assets are also referred to as liquid assets.

● A ratio that measures the relationship of quick assets to current liabilities is called the quick ratio.

SLIDE 40

Lesson 17-4


Quick Ratio

SLIDE 41

Cash + Accounts Receivable = Quick Assets

Quick Assets ÷ Current Liabilities = Quick Ratio

$72,316.90 ÷ $32,251.78 = 2.24

$54,444.34 + $17,872.56 = $72,316.90

Lesson 17-4



1. Why can one corporation’s earnings per share not be compared to the EPS of other corporations?

SLIDE 42

ANSWER

Each corporation’s EPS is a unique number because corporations can issue any number of shares. As a result, the earnings of each corporation are divided by a different number of shares.

Lesson 17-4



2. What group is the primary user of market ratios?

SLIDE 43

ANSWER

Investors

Lesson 17-4



3. Do income stocks typically have low or high dividend yields?

SLIDE 44

ANSWER

High

Lesson 17-4



4. Do growth stocks typically have low or high price-earnings ratios?

SLIDE 45

ANSWER

High

Lesson 17-4



5. What is the primary source of data to calculate liquidity ratios?

SLIDE 46

ANSWER

Balance sheet

Lesson 17-4



6. What does working capital measure?

SLIDE 47

ANSWER

Working capital is a measure of the financial resources available for the daily operations of the business.

Lesson 17-4



7. Why is the current ratio a useful measure of financial strength?

SLIDE 48

ANSWER

The current ratio permits a business to compare itself to its industry or to provide a convenient relative measurement from year to year regarding the company’s ability to pay current liabilities when due.

Lesson 17-4

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