PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin Copyright © 2011 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 Users Managers Officers

Internal Auditors

External Users Shareholders

Lenders Customers

C 1

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BUILDING BLOCKS OF ANALYSIS C 1

Liquidity and efficiency Solvency

Market prospects Profitability

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INFORMATION FOR ANALYSIS C 1

1. Income Statement 2. Balance Sheet 3. Statement of Stockholders’ Equity 4. Statement of Cash Flows 5. Notes to the Financial Statements

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Intracompany

Competitors

Industry

Guidelines

STANDARDS FOR COMPARISON C 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 Analysis Comparing a company’s financial condition and

performance across time.

TOOLS OF ANALYSIS

Vertical Analysis Comparing a company’s financial condition and

performance to a base amount.

Ratio Analysis Measurement of key relations between financial statement

items.

C 2

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HORIZONTAL ANALYSIS P 1

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COMPARATIVE STATEMENTS

Calculate Change in Dollar Amount

Dollar Change

Analysis Period Amount

Base Period Amount = –

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

Percent Change

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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$1,550,861 – $835,546 = $715,315

P 1

($715,315 ÷ $835,546) × 100 = 85.6%

HORIZONTAL ANALYSIS

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HORIZONTAL ANALYSIS

($3,888,038 ÷ $11,065,186) × 100 = 35.1%

$14,953,224 – $11,065,186 = $3,888,038

P 1

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TREND ANALYSIS

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

Trend Percent

Analysis Period Amount Base Period Amount 100 = ×

P 1

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TREND ANALYSIS Research in Motion

Income Statement Information

Using 2006 as the base year we will get the following trend information:

Examples of 2006-2008 Calculations for Revenues: 2006 is base year. Set to 100% 2007: $3,037,103 ÷ $2,065,845 × 100 = 147.0% 2008: $6,009,395 ÷ $2,065,845 × 100 = 290.9%

P 1

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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 Amount Base Amount 100 = ×

Financial Statement Base Amount

Balance Sheet Total Assets

Income Statement Revenues

P 2

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($1,550,861 ÷ $10,204,409) × 100 = 15.2%

($835,546 ÷ $8,101,372) × 100 = 10.3%

COMMON-SIZE BALANCE SHEET P 2

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COMMON-SIZE INCOME STATEMENT P 2

($8,368,958 ÷ $14,953,224) × 100 = 56.0%

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COMMON-SIZE GRAPHICS P 2

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RATIO ANALYSIS P 3

Liquidity and

efficiency Solvency

Market prospects Profitability

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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 EFFICIENCY P 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

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 Assets Current 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

receivables Current 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 sales Average accounts receivable,

net

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

P 3

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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 sold Average inventory

Average inventory = (Beginning inventory + Ending inventory) 2

P 3

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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 sales Average 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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Debt Ratio

Equity Ratio

Pledged Assets to Secured Liabilities

Times Interest Earned

SOLVENCY P 3

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DEBT AND EQUITY RATIOS

Amount Ratio Total 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.

P 3

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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

PROFITABILITY P 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 PROSPECTS P 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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GLOBAL VIEW

Horizontal and Vertical Analysis Horizontal 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 Analysis Ratio analysis of financial statement 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 REPORTING A1

1. Executive Summary 2. Analysis Overview 3. Evidential Matter 4. Assumptions 5. Key Factors 6. 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 Income

APPENDIX 17A: SUSTAINABLE INCOME

Discontinued Segments

Extraordinary Items

Continuing Operations

A 2

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END OF CHAPTER 17