When

comparing two companies, one may have a higher net income simply because it is bigger, but not better. When comparing financial statements for one company over several accounting periods, sales may grow significantly during the period making comparison difficult. Solution: Comparative financial statement analysis

 Comparative

be either

financial statement analysis can

Vertical or Horizontal

Vertical

analysis (also called common-size financial statements) makes it possible to compare the performance of companies of different sizes during the same period of time. Horizontal (or trend analysis) enables comparison of data for a single company or single industry over a period of time.

 Vertical

analysis involves the conversion of items appearing in statement columns into terms of percentages of a base figure to show the relative significance of the items and to facilitate comparison. For example, individual items appearing on the income statement can be expressed as percentages of sales. On the balance sheet, individual assets can be expressed in terms of their relationship to total assets.

 Liabilities

and shareholders equity accounts can be expressed in terms of their relationship to total liabilities and shareholders equity. On the retained earnings statement, beginning retained earnings is 100 percent. Note: The percentages for the company in question can be compared with industry norms.

 Horizontal

(or trend analysis) enables comparison of data for a single company or single industry over a period of time. It indicates in which direction a company is headed. Trend percentages are computed by taking a base year and assigning its figures as a value of 100. Figures generated in subsequent years are expressed as percentages of base-year numbers.

With 20x1 taken as the base year, its numbers are divided into those from subsequent years to yield comparative percentages. For example, net sales in 20x1 ($775,000) is divided into 20x5s net-sales figure ($910,000).

 Net

sales shows an upward trend after a downturn in 20x2. Cost of goods sold shows a sharp increase between 20x4 and 20x5 after a small drop in costs between 20x1 and 20x2. There appears to be a substantial drop in gross profit between 20x4 and 20x5 which is attributable to the increased cost of goods sold.

Trend percentages show horizontally the degree of increase or decrease, but they do not indicate the reason for the changes. They do serve to indicate unfavorable developments that will require further investigation and analysis. A significant change may have been caused by a change in the application of an accounting principle or by controllable internal conditions, such as a decrease in operating efficiency.

 Liquidity

ratios measure the ability of the firms cash resources to meet its short-term cash obligations. Solvency ratios measure the ability of the company to pay its long-term obligations as they come due. Activity ratios relate information on a firms ability to manage its current assets (accounts receivable and inventory) and current liabilities (accounts payable) efficiently.

 Profitability

analysis measures the firms profit in relation to its total revenue, or the amount of net income from each dollar of sales and its return on invested assets. Market ratios and earnings per share analysis, or shareholder ratios describe the firms financial condition in terms of amounts per share of stock.

 Current

Ratio Quick Ratio or Acid Test Ratio Cash Ratio Cash Flow Ratio, and Net Working Capital Ratio

Current = Ratio

Current Assets Current Liabilities

The norm is 2:1. A lower ratio indicates a possible liquidity problem. However, the quality of the accounts receivable and merchandise inventory must be considered when assessing a companys current ratio. If the inventory and receivables can be quickly converted to cash, then a lower level of working capital, and thus a lower current ratio, can be maintained.

Quick Ratio
Quick

Quick Assets = Current Liabilities

assets are cash and cash equivalents, marketable securities, and receivables.

Inventory is not included in the numerator of this calculation, because if a company uses its inventory to pay its liabilities, then there will be no way for the company to generate future cash flows. Therefore, inventory should not be used to pay off short-term liabilities. Furthermore, inventory is not as liquid an asset as, for instance, accounts receivable. Note also that Prepaid Expenses are not included in the numerator of the ratio. Prepaid expenses are not current assets that can be liquidated to pay current liabilities, so they should not be included.

 Cash

Ratio is even more conservative than quick ratio. It measures simply the ratio between cash and current liabilities. However, in this measure of cash we include cash equivalents and short-term securities

 If

a company is not generating enough cash from operations to settle its obligations as they become due, it means the company is borrowing to settle current liabilities. Over the long term, this will lead to solvency problems, because there is a limit to how much financing can be obtained. Therefore, it is much better if the company is able to generate adequate cash flow from its operations to settle its current liabilities.

The Net Working Capital Ratio compares net liquid assets (net working capital) to total capitalization (total assets). It measures the firms ability to meet its obligations and expand by maintaining sufficient working capital. This ratio is particularly meaningful when compared with the same ratio in previous years, especially if it is decreasing. If net liquid assets are shrinking over time relative to total assets, this is a valuable indicator of possible future business failure. If working capital is negative (i.e., current liabilities are greater than current assets), this ratio will also be negative. A negative net working capital ratio is an indication of very serious problems.

 Debt

to equity ratio Long-term debt to equity ratio Total debt to total assets ratio Fixed assets to equity ratio Net tangible assets to long-term debt Total liabilities to net tangible assets Interest coverage (Times interest earned) ratio Fixed charge coverage (Earnings to fixed charges) ratio

This ratio is a comparison of how much of the financing of assets comes from creditors and how much comes from owners, in the form of equity. If this ratio is extremely low (for instance, 0.1:1), then there is no need to calculate other capital structure ratios because there is no real concern with this part of the companys financial situation. However, if the Debt to Equity ratio is in the neighborhood of 2:1 or higher, it would be important to do some extended analysis.

In this ratio, the debt figure used is Long-term Debt only instead of Total Debt. Current liabilities, including current maturities of long-term debt, are excluded. This ratio measures how much long-term debt a company has compared to its total equity. A ratio in excess of 1:1 indicates more reliance on long-term debt financing than on equity financing.

The Debt to Total Assets Ratio measures the proportion of the companys total assets that are financed by creditors and thus the firms long-term debt payment ability. Creditors would like this ratio to be as low as possible because it indicates a lower chance of default on the interest payments that the company will owe. Therefore, the higher this ratio is, the higher the companys cost of debt will be, because creditors will demand compensation for the increased risk they are bearing. This ratio includes all liabilities, including current liabilities such as accounts payable that probably do not require interest or principal payments. This makes it a more conservative ratio than ratios that include only long-term debt in the numerator.

The Interest Coverage ratio, also called the Times Interest Earned ratio, compares the funds available to pay interest (i.e., earnings before interest and taxes) with the amount of interest expense on the income statement. This ratio gives an indication of how much the company has available for the payment of its fixed interest expense. We use earnings before interest and taxes amount in the numerator because interest is a tax-deductible expense. Therefore, pre-tax earnings can be used to pay interest. A high ratio is desirable. An interest coverage ratio of greater than 3.0 is excellent. When the interest coverage ratio gets down to 1.5, a company has a heightened risk of default, which becomes higher the further the ratio declines below 1.5.

 Accounts

Receivable Turnover Ratio Days Sales in Receivables Inventory Turnover Ratio Days Sales in Inventory Accounts Payable Turnover Ratio Days Purchases in Accounts Payable Total Asset Turnover Ratio Fixed Asset Turnover Ratio

 By

comparing this ratio from year to year for one company, we can see how a companys collection rate can change over time. An increase in the accounts receivable turnover ratio indicates that receivables are being collected more rapidly. A decrease indicates slower collections.

The accounts receivable turnover rate and days sales in receivables, or average collection period, should be compared with industry averages, with previous periods amounts for the same company, and with the companys credit terms.

 The

number of days of sales in receivables should not be higher than the standard credit terms that the company offers. If it is, it may indicate poor collections efforts, customer dissatisfaction leading to refusal to pay, customers in financial distress or possibly the extreme delay of one or two large customers.

Inventory turnover ratios provide a measure of both the quality of the inventory and the liquidity of the inventory. The inventory turnover ratio calculates how many times during the year the company sells its average level of inventory. As with the accounts receivable activity ratios, the inventory activity ratios should be evaluated by comparing them with industry averages and with previous periods amounts for the same company.

This ratio should be low but not too low, because if it is too low, the company is risking lost sales because of not having enough inventory on hand. These ratios will be affected by the companys choice of inventory valuation methods (LIFO, FIFO, etc.) Thus, they may not be useful for comparing companies when the companies use different inventory valuation methods.

 The

Asset Turnover Ratio measures the amount of sales revenue the company is generating from the use of all of its assets. It provides a means to measure the overall efficiency of the companys use of all of its investments, as represented by both shortterm assets and long-term assets.

 The

Fixed Asset Turnover ratio measures the amount of sales revenue the company is generating from the use of only its fixed assets.

 Gross

Profit Margin Percentage Operating Profit Margin Percentage Net Profit Margin Percentage (Profit Margin on Sales) EBITDA Margin Percentage

 The

Operating Profit Margin Percentage measures how much of sales revenue the firm keeps as operating income.

 Return

on Assets Return on Equity Return on Common Equity

 This

ratio essentially measures how much return the company receives on the capital it has invested in assets. The higher this ratio, the better, or more effectively, the company is using its assets.

 Return

on Equity measures the return that is received from the business on the equity in the business. The above ratio includes preferred stock in average total equity. Companies with preferred stock would use another measure as well, Return on Common Equity, which focuses on the return to common shareholders only

 Book

Value per Share Market/Book Ratio Price/Earnings Ratio

Book Value per Share represents the per share amount for the common stockholders that would result if the company were to be liquidated at the amounts that are reported on the companys balance sheet. Book Value per Share is used, possibly with adjustments, to assess merger terms. It is also a very important ratio for analysis of companies with mainly liquid assets and liabilities, such as financial institutions. Book Value per Share is total assets minus all liabilities and claims of securities that are senior to the common stock (i.e., take priority over common stockholders claims), such as preferred stock, divided by the number of common shares outstanding.