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Chapter 15: Summary Handout for Students

1. Horizontal Analysis
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Percentage changes in comparative financial statements

Percentage change = (Dollar amount of change/Base period amount) * 100

The base period is the earlier of the two periods

Performed on the Income Statement and the Balance Sheet

Trend analysis is a form of horizontal analysis

Trend analysis = (Any period amount/Base period amount) * 100

Base period will equal 100%

Usually calculated over a period of years

2. Vertical Analysis
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Shows the relationship of each statement item to its base amount

Income statement:
Vertical Analysis Percentage = (Specific item/Base amount) * 100

Balance sheet:

The base amount for each asset is Total Assets

The base amount for each liability and equity item is Total Liabilities and Equity

3. Comparing Companies
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Common-size statements reports only percentages

Benchmarking comparing a company with other leading companies

Benchmarking against a key competitor

Benchmarking against the industry average

4. Use ratio analysis to aid in decision-making


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Evaluating the Ability to Pay Current Liabilities

Working Capital = Current assets Current liabilities

Current Ratio = Total current assets/Total current liabilities

Cash Ratio = (Cash + Cash equivalents)/Total current liabilities

Acid-Test (Quick) Ratio = (Cash + Short-term investments + Net current


receivables)/Total Current liabilities

Evaluating the Ability to Sell Merchandise Inventory and Collect Receivables

Inventory Turnover = Cost of goods sold/Average merchandise inventory

Days in Inventory= 365/Inventory Turnover

Gross Profit Percentage = Gross Profit/Net Sales Revenue

Accounts Receivable Turnover = Net credit sales/Average net accounts receivable

Days Sales in Receivables Ratio= 365 days/Accounts receivable turnover ratio

Evaluating Ability to Pay Long-Term Debt

Debt Ratio = Total liabilities/Total assets

Debt to Equity Ratio = Total liabilities/Total equity

Times-Interest-Earned Ratio = (Net income + Income tax expense + Interest


expense)/Interest expense

Evaluating Profitability

Profit Margin Ratio = Net income/Net sales

Rate of Return on Total Assets = (Net income + Interest expense)/Average total assets

Asset Turnover Ratio = Net sales/Average total assets

Rate of Return on Common Stockholders Equity = (Net income Preferred


dividends)/Average common stockholders equity

Earnings per Share = (Net income Preferred dividends)/Weighted average number


of common shares outstanding

Evaluating Stock as an Investment

Price/Earnings Ratio = Market price per share of common stock/Earnings per share

Dividend Yield = Annual Dividend per share/Market price per share

Dividend Payout = Annual dividends per share/Earnings per share

5. Red flags in financial statement analysis


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Movement of Sales, Merchandise Inventory, and Receivables

Earnings Problems

Decreased Cash Flow

Too Much Debt

Inability to Collect Receivables

Buildup of Merchandise Inventories