“How Well Am I Doing?

”
Financial Statement
Analysis

Lesson Nine

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Limitations of Financial Statement Analysis

Differences in accounting methods between

companies sometimes make comparisons
difficult.

We use the LIFO method to We use the average cost

value inventory. method to value inventory.

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Limitations of Financial Statement Analysis

Changes within
the company
Industry Consumer
trends tastes

Technological
changes
Economic
factors

Analysts should look beyond

the ratios.
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Learning Objective 1

Prepare and interpret

financial statements in
comparative and
common-size form.

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Statements in Comparative and
Common-Size Form

❶ Dollar and percentage

changes on statements

An item on a financial
statement has little ❷ Common-size
meaning by itself. The statements
meaning of the numbers
can be enhanced by
drawing comparisons.
❸ Ratios

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Dollar and Percentage Changes on
Statements

Horizontal analysis (or trend analysis) shows

the changes between years in the financial
data in both dollar and percentage form.

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Horizontal Analysis

Example

The following slides illustrate a horizontal

analysis of Clover Corporation’s
December 31, 2007 and 2006, comparative
balance sheets and comparative
income statements.

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Horizontal Analysis

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Horizontal Analysis

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

The dollar
amounts for
2006 become
the “base” year
figures.

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Horizontal Analysis

Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100

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Horizontal Analysis

$12,000 – $23,500 = $(11,500)

($11,500 ÷ $23,500) × 100 = 48.9%

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Horizontal Analysis

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Horizontal Analysis

We could do this for the liabilities

& stockholders’ equity, but now
let’s look at the income statement
accounts.

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Horizontal Analysis

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Horizontal Analysis

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Horizontal Analysis

Sales increased by 8.3%, yet

net income decreased by 21.9%.

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Horizontal Analysis

There were increases in both cost of goods

sold (14.3%) and operating expenses (2.1%).
These increased costs more than offset the
increase in sales, yielding an overall
decrease in net income.

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Trend Percentages

Trend percentages
state several years’
financial data in terms
of a base year, which
equals 100 percent.

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Trend Analysis

Trend = Current Year Amount

Percentage Base Year Amount
× 100%

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Trend Analysis

Example

Look at the income information for Berry

Products for the years 2003 through 2007.
We will do a trend analysis on these
amounts to see what we can learn
about the company.

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Trend Analysis

Berry Products
Income Information
For the Years Ended December 31

The base
year is 2003, and its amounts
will equal 100%.

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Trend Analysis

Berry Products
Income Information
For the Years Ended December 31

2004 Amount ÷ 2003 Amount × 100%

( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
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Trend Analysis

Berry Products
Income Information
For the Years Ended December 31

By analyzing the trends for Berry Products, we

can see that cost of goods sold is increasing
faster than sales, which is slowing the increase
in gross margin.

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Trend Analysis

We can use the trend

percentages to construct a
graph so we can see the
trend over time.

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Common-Size Statements

Vertical analysis focuses

on the relationships
among financial statement
items at a given point in
time. A common-size
financial statement is a
vertical analysis in which
each financial statement
item is expressed as a
percentage.
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Common-Size Statements

In income
statements, all
items usually are
expressed as a
percentage of
sales.

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Gross Margin Percentage

Gross Margin = Gross Margin

Percentage Sales

This measure indicates how much

of each sales dollar is left after
deducting the cost of goods sold to
cover expenses and provide a profit.

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Common-Size Statements

In balance
sheets, all items
usually are
expressed as a
percentage of
total assets.

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Common-Size Statements

Common-size financial statements are

particularly useful when comparing
data from different companies.

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Common-Size Statements

Example

Let’s take another look at the information

from the comparative income statements
of Clover Corporation for 2007 and 2006.
This time, let’s prepare common-size
statements.

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Common-Size Statements

Sales is
usually the
base and is
expressed
as 100%.

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Common-Size Statements

2007 Cost ÷ 2007 Sales × 100%

( $360,000 ÷ $520,000 ) × 100% = 69.2%

2006 Cost ÷ 2006 Sales × 100%

( $315,000 ÷ $480,000 ) × 100% = 65.6%

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Common-Size Statements

What conclusions can we draw?

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Quick Check ✔

Which of the following statements

describes horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c. A comparison of the account balances on
the current year’s financial statements.
d. None of the above.

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Quick Check ✔

Which of the following statements

describes horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c. A comparison of the account balances on
Horizontal
the current analysis shows the
year’s financial changes
statements.
d.between
None ofyears in the financial data in both
the above.
dollar and percentage form.

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Now, let’s look at

Norton
Corporation’s
2007 and 2006
financial
statements.

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Learning Objective 2

Compute and interpret

financial ratios that would
be useful to a common
stockholder.

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Ratio Analysis – The Common Stockholder

The ratios that

are of the most
interest to
stockholders
include those
ratios that focus
on net income,
dividends, and
stockholders’
equities.

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Earnings Per Share

Net Income – Preferred Dividends

Earnings per Share =
Average Number of Common
Shares Outstanding

Whenever a ratio divides an income statement

balance by a balance sheet balance, the average
for the year is used in the denominator.

Earnings form the basis for dividend payments

and future increases in the value of shares of
stock.

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Earnings Per Share

Net Income – Preferred Dividends

Earnings per Share =
Average Number of Common
Shares Outstanding

Earnings per Share = $53,690 – $0 = $2.42

(17,000 + 27,400)/2

This measure indicates how much

income was earned for each share of
common stock outstanding.

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Price-Earnings Ratio

Price-Earnings Market Price Per Share

=
Ratio Earnings Per Share

Price-Earnings $20.00
= = 8.26 times
Ratio $2.42

A higher price-earnings ratio means that

investors are willing to pay a premium
for a company’s stock because of
optimistic future growth prospects.

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Dividend Payout Ratio

Dividend Dividends Per Share

=
Payout Ratio Earnings Per Share

Dividend $2.00
= = 82.6%
Payout Ratio $2.42

This ratio gauges the portion of current

earnings being paid out in dividends. Investors
seeking dividends (market price growth) would
like this ratio to be large (small).

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Dividend Yield Ratio

Dividend Dividends Per Share

=
Yield Ratio Market Price Per Share

Dividend $2.00
= = 10.00%
Yield Ratio $20.00

This ratio identifies the return, in terms

of cash dividends, on the current
market price of the stock.

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Return on Total Assets

Return on Net Income + [Interest Expense × (1 – Tax Rate)]

=
Total Assets Average Total Assets

Return on $53,690 + [$7,300 × (1 – .30)]

= = 18.19%
Total Assets ($300,000 + $346,390) ÷ 2

Adding interest expense back to net income

enables the return on assets to be compared
for companies with different amounts of debt
or over time for a single company that has
changed its mix of debt and equity.

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Return on Common Stockholders’ Equity

Return on Common = Net Income – Preferred Dividends

Stockholders’ Equity Average Stockholders’ Equity

Return on Common = $53,690 – $0 = 25.91%

Stockholders’ Equity ($180,000 + $234,390) ÷ 2

This measure indicates how well the

company used the owners’
investments to earn income.

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Financial Leverage

Financial leverage results from the difference

between the rate of return the company earns on
investments in its own assets and the rate of return
that the company must pay its creditors.
Fixed rate of
Return on return on Positive
investment in > borrowed = financial
assets funds leverage

Return on Fixed rate of Negative

investment in < return on = financial
assets borrowed leverage
funds
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Quick Check ✔

Which of the following statements is true?

a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
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Quick Check ✔

Which of the following statements is true?

a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
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Book Value Per Share

Book Value Common Stockholders’ Equity

=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

This ratio measures the amount that would be

distributed to holders of each share of common
stock if all assets were sold at their balance sheet
carrying amounts after all creditors were paid off.

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Book Value Per Share

Book Value Common Stockholders’ Equity

=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

Notice that the book value per share of $8.55 does

not equal the market value per share of $20. This
is because the market price reflects expectations
about future earnings and dividends, whereas the
book value per share is based on historical cost.

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Learning Objective 3

Compute and interpret

financial ratios that would
be useful to a short-term
creditor.

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Ratio Analysis – The Short–Term Creditor

Short-term
creditors, such as
suppliers, want to
be paid on time.
Therefore, they
focus on the
company’s cash
flows and working
capital.

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Working Capital

The excess of current assets over

current liabilities is known as
working capital.

Working capital is not

free. It must be
financed with long-term
debt and equity.

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Working Capital

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Current Ratio

Current Current Assets

=
Ratio Current Liabilities

The current ratio measures a

company’s short-term debt paying
ability.

A declining ratio may be a

sign of deteriorating
financial condition, or it
might result from eliminating
obsolete inventories.

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Current Ratio

Current Current Assets

=
Ratio Current Liabilities

Current $65,000
= = 1.55
Ratio $42,000

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Acid-Test (Quick) Ratio

Acid-Test Quick Assets

=
Ratio Current Liabilities

Acid-Test $50,000
= = 1.19
Ratio $42,000

Quick assets include Cash,

Marketable Securities, Accounts Receivable and
current Notes Receivable.
This ratio measures a company’s ability to meet
obligations without having to liquidate inventory.

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Accounts Receivable Turnover

Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover

Accounts
$494,000
Receivable = = 26.7 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.

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Average Collection Period

Average 365 Days

Collection = Accounts Receivable Turnover
Period

Average
365 Days
Collection = = 13.67 days
26.7 Times
Period

This ratio measures, on average,

how many days it takes to collect
an account receivable.

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Inventory Turnover

Inventory Cost of Goods Sold

Turnover = Average Inventory

This ratio measures how many times a

company’s inventory has been sold and
replaced during the year.

If a company’s inventory
turnover Is less than its
industry average, it either
has excessive inventory or
the wrong types of inventory.

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Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2

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Average Sale Period

Average 365 Days

=
Sale Period Inventory Turnover

Average 365 Days

= = 28.67 days
Sale Period 12.73 Times

This ratio measures how many

days, on average, it takes to sell
the inventory.

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Learning Objective 4

Compute and interpret

financial ratios that would
be useful to a long-term
creditor.

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Ratio Analysis – The Long–Term Creditor

Long-term creditors are concerned with

a company’s ability to repay its loans
over the long-run.

This is also referred

to as net operating
income.

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Times Interest Earned Ratio

Earnings before Interest Expense

Times and Income Taxes
Interest = Interest Expense
Earned

Times
$84,000
Interest = = 11.51 times
$7,300
Earned
This is the most common
measure of a company’s ability
to provide protection for its
long-term creditors. A ratio of
less than 1.0 is inadequate.

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Debt-to-Equity Ratio

Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio

This ratio indicates the relative proportions

of debt to equity on a company’s balance
sheet.

Stockholders like a lot of Creditors prefer less debt

debt if the company can and more equity because
take advantage of positive equity represents a buffer
financial leverage. of protection.

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Debt-to-Equity Ratio

Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio

Debt–to–
$112,000
Equity = = 0.48
$234,390
Ratio

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Published Sources That Provide
Comparative Ratio Data

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End of Chapter 16

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