1 Click to edit Master title style 1 1 1 Financial Statement Analysis 15.

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Financial Financial Statement Statement AnalysisAnalysis

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1. List basic financial statement analytical procedures.

2. Apply financial statement analysis to assess the solvency of a business.

3. Apply financial statement analysis to stress the profitability of a business.

4. Describe the contents of corporate annual reports.

After studying this chapter, you should be able to:

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List basic financial statement analytical

procedures.

Objective 1Objective 1Objective 1Objective 1

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Horizontal Analysis

The percentage analysis of increases and decreases in

related items in comparative financial statements is called

horizontal analysis.

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Exhibit 1 Comparative Balance Sheets

AssetsCurrent assets $ 550,000 $ 533,000 $ 17,000 3.2%Long-term investments 95,000 177,500 (82,500) (46.5%)Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%)Intangible assets 50,000 50,000Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%) LiabilitiesCurrent liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)Long-term liabilities 100,000 200,000 100,000) (50.0%) Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%) Stockholders’ EquityPreferred 6% stock, $100 par $ 150,000 $ 150,000 — Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500 $ 42,000 30.5%Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3%Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%)

2008 2007 Amount Percent

Increase (Decrease)

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Lincoln CompanyComparative Balance SheetDecember 31, 2008 and 2007

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AssetsCurrent assets $ 550,000 $ 533,000 $ 17,000 3.2%Long-term investments 95,000 177,500 (82,500) (46.5%)Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%)Intangible assets 50,000 50,000Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%) LiabilitiesCurrent liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)Long-term liabilities 100,000 200,000 100,000) (50.0%) Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%) Stockholders’ EquityPreferred 6% stock, $100 par $ 150,000 $ 150,000 — Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500 $ 42,000 30.5%Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3%Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%)


Lincoln CompanyComparative Balance SheetDecember 31, 2008 and 2007

Increase (Decrease)

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Horizontal Analysis: Horizontal Analysis:

Difference $17,000

Base year (2007) $533,000= 3.2%

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Comparative Schedule of Current Assets

Lincoln CompanyComparative Schedule of Current Assets

December 31, 2008 and 2007

Increase (Decrease)

Cash $ 90,500 $ 64,700 $ 25,800 39.9%Marketable securities 75,000 60,000 15,000 25.0%Accounts receivable (net) 115,000 120,000 (5,000) (4.2%)Inventories 264,000 283,000 (19,000) (6.7%)Prepaid expenses 5,500 5,300 200 3.8%Total current assets $550,000 $533,000 $17,000 3.2%


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Lincoln CompanyComparative Income Statement

For the Year Ended December 31, 2008 and 2007

Sales $1,530,500 $1,234,000 $296,500 24.0%Sales returns and allowances 32,500 34,000 (1,500) (4.4%)Net sales $1,498,000 $1,200,000 $298,000 24.8%Cost of goods sold 1,043,000 820,000 223,000 27.2%Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%Administrative expenses 104,000 97,400 6,600 6.8%Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7%Income from operations $ 160,000 $ 135,600 $ 24,400 18.0%Other income 8,500 11,000 (2,500) (22.7%)

$ 168,500 $ 146,600 $ 21,900 14.9%Other expense (interest) 6,000 12,000 (6,000) (50.0%)Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%Income tax expense 71,500 58,100 13,400 23.1%Net income $ 91,000 $ 76,500 $ 14,500 19.0%


Increase (Decrease)

Comparative Income Statement 15-1

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Comparative Retained Earnings Statement

A percentage analysis that shows the relationship of each component to the total within

a single statement is called vertical analysis.

Lincoln CompanyComparative Retained Earnings Statement

December 31, 2008 and 2007

Increase (Decrease)

Retained earnings, Jan. 1 $137,500 $100,000 $37,500 37.5%Net income for year 91,000 76,500 14,500 19.0%Total $228,500 $176,500 $52,000 29.5%)Dividends:

On preferred stock $ 9,000 $ 9,000 —On common stock 40,000 30,000 10,000 33.3%

Total $ 49,000 $ 39,000 $10,000 25.6%Total current assets $179,500 $137,500 $42,000 30.5%


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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 15-1

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Lincoln CompanyComparative Balance Sheet

For the Years Ended December 31, 2008 and 2007

AssetsCurrent assets $ 550,000 48.3% $ 533,000 43.3%Long-term investments 95,000 8.3 177,500 14.4Property, plant, & equip. (net) 444,500 39.0 470,000 38.2Intangible assets 50,000 4.4 50,000 4.1

Total assets $1,139,500 100.0% $1,230,500 100.0% LiabilitiesCurrent liabilities $ 210,000 18.4% $ 243,000 19.7%Long-term liabilities 100,000 8.8 200,000 16.3Total liabilities $ 310,000 27.2% $ 443,000 36.0% Stockholders’ EquityPreferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2%2.2% Common stock, $10 par 500,000 43.9 500,000 40.6Retained earnings 179,500 15.7 137,500 11.2Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0% Total liab. & Stockholders’ equity $1,139,500 100.0% $1,230,500 100.0%

Amount Percent Amount Percent 2008 2007

Total assets $1,139,500 100.0% $1,230,500 100.0%

Total liab. & stockholders’ equity $1,139,500 100.0% $1,230,500 100.0%

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Lincoln CompanyComparative Balance Sheet


AssetsCurrent assets $ 550,000 48.3% $ 533,000 43.3%Long-term investments 95,000 8.3 177,500 14.4Property, plant, & equip. (net) 444,500 39.0 470,000 38.2Intangible assets 50,000 4.4 50,000 4.1

Total assets $1,139,500 100.0% $1,230,500 100.0% LiabilitiesCurrent liabilities $ 210,000 18.4% $ 243,000 19.7%Long-term liabilities 100,000 8.8 200,000 16.3Total liabilities $ 310,000 27.2% $ 443,000 36.0% Stockholders’ EquityPreferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2% Common stock, $10 par 500,000 43.9 500,000 40.6Retained earnings 179,500 15.7 137,500 11.2Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0% Total liab. & Stockholders’ equity $1,139,500 100.0% $1,230,500 100.0%

Amount Percent Amount Percent 2008 2007

Total assets $1,139,500 100.0% $1,230,500100.0%

Total liab. & stockholders’ equity $1,139,500 100.0% $1,230,500100.0%

Vertical Analysis: Vertical Analysis:

Current assets $550,000

Total assets $1,139,500= 48.3%

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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 Income Statement 15-1

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Sales $1,530,500 102.2% $1,234,000 102.8%Sales returns and allow. 32,500 2.2 34,000 2.8Net sales $1,498,000 100.0% $1,200,000 100.0%Cost of goods sold 1,043,000 69.6 820,000 68.3Gross profit $ 455,000 30.4% $ 380,000 31.7%Selling expenses $ 191,000 12.8% $ 147,000 12.3%Administrative expenses 104,000 6.9 97,400 8.1Total operating expenses $ 295,000 19.7% $ 244,400 20.4%Income from operations $ 160,000 10.7 $ 135,600 11.3%Other income 8,500 0.6 11,000 0.9 $ 168,500 11.3% $ 146,600 12.2%Other expense (interest) 6,000 0.4 12,000 1.0Income before income tax $ 162,500 10.9% $ 134,600 11.2%Income tax expense 71,500 4.8 58,100 4.8Net income $ 91,000 6.1% $ 76,500 6.4%

2008 2007

Amount Percent Amount Percent

Lincoln CompanyComparative Income Statement


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Comparative Income Statement

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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-Size IncomeStatement

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Apply financial statement analysis to assess the solvency

of a business.


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Solvency Analysis

The ability of a business to meet its financial obligations (debts)

is called solvency.

The ability of a business to earn income is 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 meet currently maturing debts.

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Working capital (a Working capital (a – b) $340,000 – b) $340,000

Current asset:Cash $ 90,500

Marketable securities 75,000

Accounts receivable (net) 115,000Inventories 264,000Prepaid expenses 5,500

a. Total current assets $550,000b. Current liabilities 210,000

Lincoln CompanyLincoln Company

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Current Ratio

The current ratio, sometimes called the working capital ratio or bankers’ ratio, is

computed by dividing the total current assets by the total

current liabilities.

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Current ratio (a/Current ratio (a/b) 2.6 2.2b) 2.6 2.2

a. Current assets $550,000 $533,000b. Current liabilities 210,000 243,000Working capital (a – b) $340,000 $290,000

2008 2007

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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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2008 2007

Quick ratio (a/Quick ratio (a/b) 1.3 1.0b) 1.3 1.0

Quick assets:Cash $ 90,500 $ 64,700Marketable securities 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.

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.

The ratio is to assess the efficiency of the firm in collecting receivables and

in the managing of credit.

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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

2008 2007


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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.

Comparing this measure with the credit terms provides information on the

efficiency in collecting receivables.

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

a. Average (Total/2) $ 117,500$ 130,000

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

b. Average daily sales onaccount (Sales/365) $ 4,104

$ 3,288

2008 2007Lincoln CompanyLincoln Company

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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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2008 2007

Inventory turnover (a/Inventory turnover (a/b) 3.8 2.8b) 3.8 2.8

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 inNumber of days’ sales in inventory (a/inventory (a/b) 95.7 132.2b) 95.7 132.2

a. Average (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

2008 2007

Number of Days’ Sales in Inventory


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Ratio of Fixed Assets to Long-Term Liabilities

The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It

also indicates the ability of the business to borrow additional funds

on a long-term basis.

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2008 2007

Ratio of fixed assets toRatio of fixed assets to long-term liabilities (a/long-term liabilities (a/b) 4.4 2.4b) 4.4 2.4

a. Fixed assets (net) $444,500 $470,000b. Long-term liabilities $100,000 $200,000


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Ratio of Liabilities to Stockholders’ Equity

The relationship between the total claims of the creditors and

owners—the ratio of liabilities to stockholders’ equity—is a

solvency measure that indicates the margin of safety for creditors.

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Ratio of liabilities toRatio of liabilities to stockholders’ equity (a/stockholders’ equity (a/b) 0.4 0.6b) 0.4 0.6

a. Total liabilities $310,000 $443,000b. Total stockholders’ equity $829,500 $787,500

2008 2007


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Number of Times Interest Charges Earned

Corporations in some industries normally have high ratios of debt to

stockholders’ equity. For such corporations, the relative risk of the

debtholders is normally measured as the number of times interest charges are earned (during the year), sometimes

called the fixed charge coverage ratio.

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2008 2007

Income before income tax $162,500$134,600

a. Add interest expense 6,000 12,000

b. Amount available to meetinterest charges $168,500

$146,600


Number of times interestNumber of times interest charges earned (b/charges earned (b/a) 28.1 12.2a) 28.1 12.2

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Apply financial statement analysis to

assess the profitability of a business.


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Profitability Analysis

Profitability is the ability of an entity to earn profits.

This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available as reported in the balance sheet.

Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet.

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Ratio of Net Sales to Assets

The ratio of net sales to assets is a profitability measure that shows how effectively a firm

utilizes its assets.

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2008 2007a. Net sales $1,498,000 $1,200,000

Total assets:Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000

b. Average (Total/2) $1,048,750 $1,031,500


Excludes long-term investmentsExcludes long-term investments

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2008 2007a. Net sales $1,498,000 $1,200,000

Total assets:Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000

b. Average (Total/2) $1,048,750 $1,031,500


Ratio of net sales to assets (a/Ratio of net sales to assets (a/b)b) 1.4 1.2 1.4 1.2

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Rate Earned on Total Assets

The rate earned on total assets measures the

profitability of total assets, without considering how the

assets are financed.

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2008 2007

Rate earned on total Rate earned on total assets (a/b) 8.2% 7.3%assets (a/b) 8.2% 7.3%

Net income $ 91,000 $ 76,500Plus interest expense 6,000 12,000a. Total $ 97,000 $ 88,500Total assets:

Beginning of year $1,230,500 $1,187,500End of year 1,139,500 1,230,500Total $2,370,000 $2,418,000

b. Average (Total/2) $1,185,000 $1,209,000


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Rate Earned on Stockholders’ Equity

The rate earned on stockholders’ equity measure emphasizes the rate of income earned on the amount invested

by the stockholders.

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Rate earned on stockholders’Rate earned on stockholders’equity (a/equity (a/b)b) 11.3% 10.0% 11.3% 10.0%

a. Net income $ 91,000 $ 76,500Stockholders’ equity:

Beginning of year $ 787,500 $ 750,000End of year 829,500 787,500Total $1,617,000 $1,537,500

b. Average (Total/2) $ 808,500 $ 768,750

2008 2007Lincoln CompanyLincoln Company

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The difference in the rate earned on stockholders’ equity

and the rate earned on total assets is called leverage.

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10%

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Rate earned on total assets

Rate earned on stockholders’ equity

8.2%

11.3%

Leverage 3.1%

2008

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10.0%Leverage

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2007

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The rate earned on common stockholders’ equity focuses

only on the rate of profits earned on the amount invested by the common stockholders.

Rate Earned on Common Stockholders’ Equity

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2008 2007Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000

a. Remainder—common stock $ 82,000 $ 67,500Common stockholders’ equity:

Beginning of year $ 637,500 $ 600,000End of year 679,500 637,500Total $1,317,000 $1,237,500

b. Average (Total/2) $ 658,500 $ 618,750 Rate earned on commonRate earned on common stockholders’ equity (a/stockholders’ equity (a/b)b) 12.5% 10.9% 12.5% 10.9%


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Earnings per Share on Common Stock

One of the profitability measures often quoted by the financial press is earning per

share (EPS) on common stock. It is also normally reported in

the income statement in corporate annual reports.

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2008 2007

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

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 is an

indicator of a firm’s future earnings prospects.

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2008 2007

Price-earnings ratio onPrice-earnings ratio on common stock 25 20common stock 25 20

Market price per share of common stock $41.00 $27.00

Earnings per share on commonstock / 1.64 / 1.35


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Dividends per Share

Dividends per share can be reported with earnings per share to indicate the

relationship between dividends and earnings. Comparing these two per

share amounts indicates the extent to which the corporation is retaining its

earnings for use in operations.

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86Dividends Earnings

$0.80

$1.64

2008

$0.60

$1.35

2007

Per share

$2.00$2.00

$1.50$1.50

$1.00$1.00

$0.50$0.50

$0.00


Dividends and Earning per Share of Common Stock

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The dividend yield on common stock is a profitability measure that shows the rate of return to common stockholders in terms

of cash dividends.

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2008 2007

Dividend yield onDividend yield on common stock 2.0% 2.2% common stock 2.0% 2.2%

Dividends per share ofcommon stock $ 0.80$ 0.60

Market price per share of common stock /41.00/27.00


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Describe the contents of corporate

annual reports.


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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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Management is required by the Sarbanes-Oxley Act of 2002 to provide a report stating

their responsibility for establishing and maintaining internal control. In addition, the report must state management’s conclusion

concerning the effectiveness of internal controls over financial reporting.

Report on Adequacy of Internal Control

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All publicly held corporations are required to have an independent audit

(examination) of their financial statements. The CPAs who conduct the audit render an opinion on the fairness

of the statements.

Report on Fairness of Financial Statements

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