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Chapter 15: Summary Handout for Students

1. Horizontal Analysis

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

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

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


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


Movement of Sales, Merchandise Inventory, and Receivables

Earnings Problems

Decreased Cash Flow

Too Much Debt

Inability to Collect Receivables

Buildup of Merchandise Inventories