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Financial Statement
Analysis
Learning Objectives
After studying this chapter, you should be able to:
1. Discuss the need for comparative analysis.
2. Identify the tools of financial statement analysis.
3. Explain and apply horizontal analysis.
4. Describe and apply vertical analysis.
5. Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and
solvency.

14-0

Basics of Financial Statement Analysis

Analyzing financial statements involves:

Comparison Tools of
Characteristics
Bases Analysis

● Liquidity ● Intracompany ● Horizontal

● Profitability ● Industry ● Vertical
● Solvency averages ● Ratio
● Intercompany

LO 1 Discuss the need for comparative analysis.

14-0 LO 2 Identify the tools of financial statement analysis.

Horizontal Analysis

Horizontal analysis, also called trend analysis:

● Technique for evaluating a series of financial statement
data over a period of time.
● Purpose is to determine the increase or decrease that has
taken place.
● Loading...
Commonly applied to the balance sheet, income statement,
and statement of retained earnings.

14-0 LO 3 Explain and apply horizontal analysis.

Horizontal Analysis

Balance Sheet
These changes
suggest that the
company expanded its
asset base during
2009 and financed
this expansion
primarily by retaining
income rather than
assuming additional
long-term debt.

Illustration 14-5
Horizontal analysis of
balance sheets

14-0
LO 3

Horizontal Analysis

Income
Statement
Overall, gross profit
and net income were
up substantially. Gross
profit increased
17.1%, and net
income, 26.5%.
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Quality’s profit trend
appears favorable.

Illustration 14-6
Horizontal analysis of
Income statements

14-0 LO 3 Explain and apply horizontal analysis.

 Horizontal Analysis
Illustration 14-7
Retained Earnings Statement Horizontal analysis of
retained earnings statements

Ending retained earnings increased 38.6%. As indicated earlier, the company

retained a significant portion of net income to finance additional plant
facilities.

14-0
LO 3

Financial information for Rosepatch Company is as follows.

Compute the amount and percentage changes in 2014 using

horizontal analysis, assuming 2013 is the base year.
14-0
LO 3

Vertical Analysis

Vertical analysis, also called common-size analysis:

● Technique that expresses each financial statement item as
a percent of a base amount.
● On an income statement, we might say that selling
expenses are 16% of net sales.
● Commonly applied to the balance sheet and the income
statement.

14-0 LO 4 Describe and apply vertical analysis.

Vertical Analysis

Balance
Sheet
These results
reinforce the earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.

Illustration 14-8

14-0
LO 4

Vertical Analysis

Income
Statement
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.

Illustration 14-9

14-0
LO 4
 Vertical Analysis

Enables a comparison of companies of different sizes.

Illustration 14-10

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14-0
LO 4

Ratio Analysis

Ratio analysis expresses the relationship among selected

items of financial statement data.

Financial Ratio Classifications

Liquidity Profitability Solvency

Measures short- Measures the Measures the ability

term ability of the income or operating of the company to
company to pay its success of a survive over a long
maturing obligations company for a given period of time.
and to meet period of time.
unexpected needs
for cash.
 LO 5 Identify and compute ratios used in analyzing a
14-0
firm’s liquidity, profitability, and solvency.

Ratio Analysis

A single ratio by itself is not very meaningful.

Ratios will include the following types of comparisons.

1. Intracompany comparisons for two years for Quality
Department Store.
2. Industry average comparisons based on median ratios for
department stores.
3. Intercompany comparisons based on J.C. Penney
Company as Quality Department Store’s principal competitor.

LO 5 Identify and compute ratios used in analyzing a

14-0
firm’s liquidity, profitability, and solvency.

Ratio Analysis

Liquidity Ratios

Measure the short-term ability of the company to pay its

maturing obligations and to meet unexpected needs for cash.
● Short-term creditors such as bankers and suppliers are
particularly interested in assessing liquidity.
● Ratios include the current ratio, the acid-test ratio,
receivables turnover, and inventory turnover.

LO 5 Identify and compute ratios used in analyzing a

14-0
firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios

1. Current Ratio
Illustration 14-12

The ratio of 2.96:1 means that for every dollar of current liabilities,
Quality has $2.96 of current assets.

14-0 LO 5

Ratio Analysis Liquidity Ratios

2. Acid-Test Ratio
 Illustration 14-13

14-0 LO 5

Ratio Analysis Liquidity Ratios

2. Acid-Test Ratio
Illustration 14-14

Measures immediate short-term liquidity.

LO 5 Identify and compute ratios used in analyzing a

14-0
firm’s liquidity, profitability, and solvency.
14-0

Ratio Analysis Liquidity Ratios

3. Receivables Turnover
Illustration 14-15
 Number of times, on average, the company collects receivables.

14-0 LO 5

Ratio Analysis Liquidity Ratios

Receivables Turnover
$2,097,000
= 10.2 times
($180,000 + $230,000) ÷ 2

A variant of the receivables turnover ratio is to convert it to an

average collection period in terms of days.

365 days ÷ 10.2 times = every 35.78 days

This means that receivables are collected on average every 36

days.

LO 5 Identify and compute ratios used in analyzing a

14-0
firm’s liquidity, profitability, and solvency.

Ratio Analysis Liquidity Ratios

4. Inventory Turnover
Illustration 14-16
 Number of times, on average, the inventory is sold.
14-0 LO 5

Ratio Analysis Liquidity Ratios

Inventory Turnover
$1,281,000
= 2.3 times
($500,000 + $620,000) ÷ 2

A variant of inventory turnover is the days in inventory.

365 days ÷ 2.3 times = every 159 days

Inventory turnover ratios vary considerably among industries.

LO 5 Identify and compute ratios used in analyzing a

14-0
firm’s liquidity, profitability, and solvency.

Ratio Analysis
 Profitability
Ratios
Measure the income or operating success of a company for a
given period of time.
● Income, or the lack of it, affects the company’s ability to obtain
debt and equity financing, liquidity position, and the ability to
grow.
● Ratios include the profit margin, asset turnover, return on
assets, return on common stockholders’ equity, earnings
per share, price-earnings, and payout ratio.

LO 5 Identify and compute ratios used in analyzing a

14-0
firm’s liquidity, profitability, and solvency.

Ratio Analysis Profitability

Ratios
5. Profit Margin
Illustration 14-17

Measures net income generated by each dollar of sales.

14-0 LO 5
 Ratio Analysis Profitability
Ratios
6. Asset Turnover
Illustration 14-18

Measures how efficiently assets are used to generate sales.

14-0 LO 5

Ratio Analysis Profitability

Ratios
7. Return on Assets
Illustration 14-19
 An overall measure of profitability.

14-0 LO 5

Ratio Analysis Profitability

Ratios
8. Return on Common Stockholders’ Equity
Illustration 14-20

Dollars of net income earned for each dollar invested by the owners.
14-0 LO 5

Ratio Analysis Profitability

Ratios
9. Earnings per Share (EPS)
Illustration 14-21
 Measures net income earned on each share of common stock.

14-0 LO 5

Ratio Analysis Profitability

Ratios
10. Price-Earnings Ratio
Illustration 14-22

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Reflects investors’ assessments of a company’s future earnings.

14-0 LO 5

Ratio Analysis Profitability

Ratios
11. Payout Ratio
 Illustration 14-23

Measures the percentage of earnings distributed in the form of cash

dividends.
14-0 * From analysis of retained earnings. LO 5

Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company to survive

over a long period of time.
● Debt to total assets and times interest earned are two
ratios that provide information about debt-paying ability.

LO 5 Identify and compute ratios used in analyzing a

14-0
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Solvency Ratios

12. Debt to Total Assets Ratio

Illustration 14-24

Measures the percentage of the total assets provided by creditors.

14-0 LO 5

Ratio Analysis Solvency Ratios

13. Times Interest Earned

Illustration 14-25
 Provides an indication of the company’s ability to meet interest
payments as they come due.
14-0 LO 5

Summary of Ratios

Illustration 14-26

14-0 LO 5

Summary of Ratios

Illustration 14-26
14-0 LO 5

Summary of Ratios

Illustration 14-26

14-0 LO 5