MAS – Financial Statement Analysis

Purpose of Financial Statement Analysis

Horizontal Analysis
• Horizontal (trend) analyses are conducted to help financial statement users recognize important
financial changes that unfold over time.
• Horizontal analysis compares individual financial statement line items horizontally (from one period to
the next), with the general goal of identifying significant sustained changes (trends).
• These changes are typically described in terms of dollar amounts and year-over-year percentages.
• Computations:
o Horizontal analyses – Comparing across time, often expressing changes in account balances as
a percentage of prior year balances.
o Time-series analyses – Compare changes in account balances over a series of time periods.
o Year-to-Year Change (%) = (Change This Year divided by Prior Year’s Total) x100 or, in other
words, (Current Year’s Total – Prior Year’s Total) divided by Prior Year’s Total) x 100.

Vertical Analysis
• Vertical analyses focus on important relationships between items on the same financial statement.
• These items are compared vertically (one account balance versus another).
• These items are typically expressed as percentages to reveal the relative contributions made by each
financial statement items
• Computations:
o Vertical (common size) analyses – Expressing each financial statement amount as a
percentage of another amount on the same financial statement.
▪ When a company is growing or shrinking overall, it is difficult to tell from the dollar
amounts whether the proportions within each statement category are changing.
▪ Common size financial statements provide this information by expressing each financial
statement amount as a percentage of another amount on that statement.
o In a common size balance sheet, each asset appears as a percent of total assets, and each
liability or stockholders’ equity item appears as a percent of total liabilities and stockholders’
equity.
o The common size income statement reports each income statement item as a percentage of
sales.

Ratio Analysis
• Ratio analyses are conducted to understand relationships among various items reported in one or more
of the financial statements.
• Computations:
o Ratio analyses – Help financial statement users to understand relationships among various
items reported in the financial statements
o This type of analysis compares the amounts for one or more line items to the amounts for other
line items in the same year.
o Most analysts classify ratios into three categories of performance:
▪ Profitability – The extent to which a company generates income.
▪ Liquidity – The extent to which a company can pay its currently maturing obligations.
▪ Solvency – The ability to survive long enough to repay lenders when debt matures.
o Profitability Ratios include:
▪ Net profit margin = Net income divided by Net sales revenue
▪ Gross profit percentage = (Net sales revenue – Cost of goods sold) divided by Net sales
revenue
▪ Asset turnover = Net sales revenue divided by Average total assets
▪ Fixed asset turnover = Net sales revenue divided by Average net fixed assets
▪ Return on equity (ROE) = Net income divided by Average stockholders’ equity
▪ Earnings per share (EPS) = Net income divided by Average number of common shares
▪ Quality of income = Net cash from operations divided by Net income
 ▪ Price/ earnings (P/E) ratio = Stock price divided by EPS
o Liquidity Ratios include:
▪ Receivables turnover = Net sales revenue divided by Average net receivables
▪ Days to collect = 365 divided by Receivables turnover ratio
▪ Inventory turnover = Cost of sales divided by Average inventory
▪ Days to sell = 365 divided by Inventory turnover ratio
▪ Current ratio = Current assets divided by Current liabilities
▪ Quick ratio = (Cash + Short-term investments + Accounts receivable, net) divided by
Current liabilities
o Solvency Ratios include:
▪ Debt-to-assets = Total liabilities divided by Total assets
▪ Times interest earned = (Net income + Interest expense + Income tax expense) divided
by Interest expense
▪ Capital acquisitions ratio = Net cash from operations divided by Cash paid for PPE

• No analysis is complete unless it leads to an interpretation that helps financial statement users
understand and evaluate a company’s financial results.

Interpreting Horizontal and Vertical Analyses

• Financial statement analyses are not complete unless they lead to interpretations that help users
understand and evaluate a company’s financial results.
• Goals should be to understand what each analysis is telling you and then combine your findings into a
coherent “story” that explains the results of the company’s business activities.
• Trends Revealed in Horizontal Analyses
o Horizontal (trend) analysis of a company’s balance sheet reveals whether a company grew
during the year and indicates whether the company changed its reliance on debt vs. equity
financing.
o Horizontal analysis of a company’s income statement highlights key changes in its operations.
• Relationships Noted in Vertical Analyses
o Vertical (common size) analysis of a company’s balance sheet highlights key elements of the
company.
o Vertical (common size) analysis of a company’s income statement reveals the most important
determinants of the company’s profitability.

Interpreting Ratio Analyses

• Benchmarks, which help when interpreting a company’s ratios, can include the company’s prior year
results, as well as the results of close competitors or the average for the industry.
• Industry averages are reported:
o In the Annual Statement Studies, published by the Risk Management Association, at
statementstudies.org.
o By reuters.com/finance or google.com/finance.
• Profitability Ratios – The analyses in this section focus on the level of profits the company generated
during the period.
• Liquidity Ratios – The analyses in this section focus on the company’s ability to survive in the short
term, by converting assets to cash that can be used to pay current liabilities as they come due.
• Solvency Ratios – The analyses in this section focus on the company’s ability to survive over the long
term—that is, its ability to repay debt when it matures, pay interest until that time, and finance the
replacement and/or expansion of long-term assets.

Questions:
1. Which of the following statements regarding trend analysis is true?
a. Time-series analysis is an example of trend analysis.
b. Trend data are always in dollars.
c. Trend analysis is also known as vertical analysis.
d. Common-size analysis is an example of trend analysis.
2. Which of the following statements regarding the effects of a business decision on a financial ratio is
true?
a. If a company is expanding its facilities, its fixed asset turnover ratio is likely to fall temporarily.
b. If a company extends its payment period for customers, its accounts receivable ratio is likely to
rise.
c. If a company eases its credit granting policies, its days to collect ratio is likely to fall.
d. If a company builds up inventories, its days to sell ratio is likely to fall.

3. Which of the following statements regarding liquidity and solvency ratios is true?
a. Unlike solvency ratios, liquidity ratios relate to the company's long-run survival.
b. Both liquidity ratios and solvency ratios measure a company's ability to meet its financial
obligations.
c. Liquidity ratios include the return on equity ratio and the times interest earned ratio.
d. Solvency ratios include the current ratio and the net profit margin ratio.

4. Which of the following analysis techniques does not pertain to changes over time?
a. Trend analysis.
b. Horizontal analysis.
c. Time-series analysis.
d. Vertical analysis.

5. If you wish to examine how one aspect of a business is doing relative to other aspects of the business
at the current time, you are most likely to use:
a. time-series analysis.
b. ratio analysis.
c. horizontal analysis.
d. cross-sectional analysis.

6. Which of the following is not a profitability ratio?

a. Return on equity (ROE).
b. Earnings per share.
c. Asset turnover.
d. Days to sell.

7. Solvency ratio data are primarily concerned with the ability of a company to:
a. produce profits.
b. handle its debt.
c. manage its cash flow.
d. provide income for stockholders.

8. Which of the following measures would assist in assessing the profitability of a company?
a. Debt-to-assets ratio.
b. Fixed asset turnover ratio.
c. Receivables turnover ratio.
d. Current ratio.

9. When evaluating its net profit margin for 2015, Coca Cola would most likely use all the following
benchmarks except:
a. Anheuser Busch's net profit margin for 2015.
b. Coca Cola's net profit margin for 2014.
c. Pepsi Co's net profit margin for 2015.
d. The average net profit margin for the soft drink manufacturing industry for 2015.

10. If net income is rising, but sales and the gross profit percentage remain the same, then:
a. operating expenses are falling.
 b. operating expenses are rising.
c. cost of goods sold is falling.
d. cost of goods sold is rising.

11. Which of the following could explain why a company has a lower net profit margin ratio but a higher
EPS than one of its competitors?
a. The company sells a higher percentage of goods on credit.
b. The company has fewer shares of outstanding common stock relative to its net income.
c. The company earns a higher percentage of net income from non-operating activities.
d. The company pays a higher dividend.

12. A current ratio of less than one is not so much of a concern when the company has a:
a. low fixed asset turnover ratio.
b. high days to collect number.
c. high inventory turnover ratio.
d. high debt-to-equity ratio.

13. Judging only from the ratios below, which of the following clothing wholesalers is least likely to be
having cash flow problems?
Company Receivable Turnover Inventory Turnover
A 5 2
B 2 5
C 10 10
D 1 1

14. The primary objective of external financial reporting is:

a. to enhance the ability of the company to acquire financial capital from external sources.
b. to accurately provide financial results for tax purposes.
c. to comply with external regulations and requirements of government and professional
associations.
d. to provide useful information to decision makers, especially investors and creditors.

15. Which of the following statements is true regarding the relationship of the debt-to-assets ratio and the
debt-to-equity ratio?
a. Debt to assets is usually greater than debt to equity.
b. Debt to assets is usually less than debt to equity
c. Debt to assets is usually equal to debt to equity.
d. There is no constant relationship between these two ratios.

16. Which of the following factors would not necessarily contribute to a going-concern problem?
a. Excessive reliance on debt financing.
b. Loss of key personnel without comparable replacement.
c. Inadequate maintenance of long-lived assets.
d. Declining profit margins.

17. Which of the following is generally the most useful in analyzing companies of different size?
a. Comparative financial statements.
b. Horizontal analysis.
c. Common size financial statements.
d. Trend analysis.

18. Which type of analysis could reveal that a company is relying heavily on debt financing?
a. Common size statements.
b. Horizontal analysis.
c. The asset turnover ratio.
d. Trend analysis.
 19. A company has a debt to assets ratio of 0.45. If the company then borrows cash from the bank to
finance a building acquisition, which of the following is a true statement?
a. The debt to assets ratio will be unchanged.
b. The debt to assets ratio will increase.
c. The debt to assets ratio will decrease.
d. The debt to assets ratio will increase as a result of the cash received and then decrease as a
result of the building acquisition.

20. E. Choudhury Company's price/earnings ratio is 15.3. Its closest competitor, Bhatt, Inc. has a P/E ratio
of 9.4. Which of the following would not be a valid conclusion to draw from a comparison of the two
companies' P/E ratios?
a. E. Choudhury Company's stock is overpriced.
b. Investors believe E. Choudhury Co. has a brighter future than Bhatt, Inc.
c. E. Choudhury Company has been more profitable than Bhatt, Inc.
d. The stock price of E. Choudhury Company has been bid up due to rumors of a merger.

Problems:
1. The financial information below presents selected information from the financial statements of Pelican
Company. Sales revenue in 2014 was $13,700,300. Cost of goods sold was $8,905,195.
2013 2014
Cash and cash equivalents $552,330 $599,780
Accounts receivable 4,550,000 3,800,000
Inventory 920,360 1,223,440
Accounts payable and accruals 7,200,300 7,476,000
Required: Calculate the following. Round to two decimal places.
a. Receivables turnover assuming all Pelican’s sales are made on account
b. Current ratios as of 2014 and 2013
c. Quick ratios as of 2014 and 2013
d. Inventory turnover ratio

2. Mercedes, Co. has the following quarterly financial information.

Q4 Q3 Q2 Q1
Sales $901,800 $911,300 $909,600 $917,400
Cost of goods sold 304,500 317,100 316,700 321,900
Operating 247,700 259,100 257,300 261,400
expenses
Interest expense 3,600 3,600 3,600 3,500
Income tax 84,300 87,200 87,200 89,700
expense

Average number 793,030 788,064 789,670 803,000

of common shares
outstanding
Stock price when $24.00
Q4 EPS released
Required: Use the financial information above to calculate the following. Round to two decimal places
(e.g., 0.1234 as 12.34%.)
a. Gross profit percentage for each quarter.
b. Net profit margin for each quarter.
c. Times-interest-earned ratio for each quarter
d. EPS for each quarter.
e. P/E ratio at the end of the year.
Self-assessment Questions:
Question Nos. 1 through 3 are based on the data taken from the balance sheet of Nomad Company at the end
of the current year:
Accounts payable P145,000
Accounts receivable 110,000
Accrued liabilities 4,000
Cash 80,000
Income tax payable 10,000
Inventory 140,000
Marketable securities 250,000
Notes payable, short-term 85,000
Prepaid expenses 15,000

1. The amount of net working capital for the company is:

a. P351,000
b. P361,000
c. P211,000
d. P336,000

2. The company’s current ratio as of the balance sheet date is:

a. 2.44:1
b. 2.67:1
c. 2.02:1
d. 1.95:1

3. The company’s acid-test ratio as of the balance sheet date is:

a. 2.40:1
b. 2.02:1
c. 1.76:1
d. 1.80:1

4. Pine Hardware Store had net credit sales of P6,500,000 and cost of goods sold of P5,000,000 for the
year. The Accounts Receivable balances at the beginning and end of the year were P600,000 and
P700,000, respectively. The receivables turnover was
a. 7.7 times
b. 10.8 times
c. 9.3 times
d. 10.0 times

5. During 2007, Tarlac Company purchased P960,000 of inventory. The cost of goods sold for 2007 was
P900,000, and the ending inventory at December 31, 2007 was P180,000. What was the inventory
turnover for 2007?
a. 6.0
b. 6.4
c. 5.3
d. 5.0

6. Net sales are P6,000,000, beginning total assets are P2,800,000, and the asset turnover is 3.0. What
is the ending total asset balance?
a. P2,000,000
b. P1,200,000
c. P2,800,000
d. P1,600,000

7. Brava Company reported the following on its income statement:

Income before taxes P400,000
 Income tax expense 100,000
Net income P300,000
An analysis of the income statement revealed that interest expense was P100,000. Brava Company’s
times interest earned (TIE) was
a. 3 times
b. 3.5 times
c. 5 times
d. 4 times

8. Jordan Manufacturing reports the following capital structure:

Current liabilities P100,000
Long-term debt 400,000
Deferred income taxes 10,000
Preferred stock 80,000
Common stock 100,000
Premium on common stock 180,000
Retained earnings 170,000
What is the debt ratio?
a. 0.48
b. 0.49
c. 0.93
d. 0.96

9. Selected information for Ivano Company as of December 31 is as follows:

2006 2007
Preferred stock, 8%, par P100, P250,000 P250,000
nonconvertible, noncumulative
Common stock 600,000 800,000
Retained earnings 150,000 370,000
Dividends paid on preferred stock for the 20,000 20,000
year
Net income for the year 120,000 240,000
Ivano’s return on common stockholders’ equity, rounded to the nearest percentage point, for 2007 is
a. 17%
b. 19%
c. 21%
d. 23%

10. A company has a profit margin of 10%, asset turnover of 6 times and a debt ratio of 20%. What is the
company’s return on equity?
a. 50%
b. 75%
c. 25%
d. None of the choices

11. What is the market price of a share of stock for a firm with 100,000 shares outstanding, a book value of
equity of P3,000,000, and a market/book ratio of 3.5?
a. P8.57
b. P30.00
c. P85.70
d. P105.00

12. On December 31, 2016 and 2017, Renegade Corporation had 100,000 shares of common stock and
50,000 shares of noncumulative and nonconvertible preferred stock issued and outstanding.
Additional information:
Stockholders’ equity at 12/31/17 P4,500,000
 Net income year ended 12/31/17 1,200,000
Dividends on preferred stock year ended 12/31/17 300,000
Market price per share of common stock at 12/31/17 144
The price-earnings ratio on common stock at December 31, 2017, was
a. 10 to 1
b. 12 to 1
c. 14 to 1
d. 16 to 1

13. Selected financial data of Alexander Corporation for the year ended December 31, 2007, is presented
below:
Operating income P900,000
Interest expense (100,000)
Income before income taxes 800,000
Income tax (320,000)
Net income 480,000
Preferred stock dividend (200,000)
Net income available to common stockholders 280,000
Common stock dividends were P120,000. The payout ratio is:
a. 25.0%
b. 42.9%
c. 66.7%
d. 71.4%

14. A summarized income statement for Leveraged Inc. is presented below.

Sales P1,000,000
Cost of Sales 600,000
Gross Profit P 400,000
Operating Expenses 250,000
Operating Income P 150,000
Interest Expense 30,000
Earnings Before Tax P 120,000
Income Tax 40,000
Net Income P 80,000
The degree of financial leverage is:
a. 5.0
b. 1.25
c. 2.50
d. 1.88

15. M Corporation’s stockholders’ equity at December 31, 2017 consists of the following:
6% cumulative preferred stock, P100 par, liquidating value
was P110 per share; issued and outstanding 50,000 shares P5,000,000
Common stock, par, P5 per share; issued and
outstanding, 400,000 shares 2,000,000
Retained earnings 1,000,000
Total P8,000,000
Dividends on preferred stock have been paid through 2016.
At December 31, 2017, M Corporation’s book value per share was
a. P6.25
b. P5.50
c. P7.50
d. P6.75

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