Tools of Financial Statement Analysis

Vertical Analysis
Vertical Analysis, sometimes referred to as common size analysis, is a technique for evaluating
financial statement data that expresses each item within a financial statement in terms of a percent of a
base amount.
Balance Sheet Income Statement

Elements are a Elements are a

percent of total assets percent of total sales

Horizontal Analysis
Horizontal Analysis is a technique for evaluating two financial statements data. Its purpose is to deter-
mine the increase or decrease that has taken place, expressed as either an amount or a percentage.
We can measure all percentage increases or decreases from this base period amount as follows:
Current year amount – Base year amount
Base year amount

Trend Analysis
Current year amount
Base year amount (Fixed)

Ratio Analysis
Liquidity Ratios
1. Current Ratio (Current Assets/ Current Liabilities)
This ratio indicates the ability of the company to pay its current debts with its current assets, to determine the short- term debt
paying ability
2. Working Capital (Current Assets- Current Liabilities)
Indication of the short- run solvency of the business
3. Acid- Test Ratio ((Current assets- inventory- prepaid expenses- other current assets)/ Current liabilities)
Indicates the ability of the company to convert current assets to cash for the purpose of meeting current liabilities
4. Cash Ratio ((cash+ Marketable securities)/ current liabilities)
Indicator of the extent to which a company can pay its current liabilities without relying on the sale of inventory, and without
relying on the receipts of the accounts receivable

Turnover ( Activity- Efficiency) Ratios

5. Working capital Trun over (Sales/ working capital)
Indication of the turnover in working capital per year
6. Accounts receivable turnover (net sales/ accounts receivable)
Measures how quickly the firm collects its accounts receivable, and then re- establish the accounts receivable again through
sales
7. Days to Accounts receivables turnover (365/ Accounts receivable turnover)
Indicates the actual number of days needed to collect the Accounts receivables
8. Inventory turnover (cost of goods sold/ inventory)
Indicates how many times the company's inventory is sold and replaced again over a period
9. Days to inventory turnover (365/ inventory turnover)
Indicates the number of days it takes to sell inventory
10. Operating Cycle (Days to Accounts receivables turnover + Days to inventory turnover)
The period of time elapsing between the acquisition of goods and the final cash realization resulting from sales and subsequent
collections

Long- Term Debt Paying Ability

Ratios are used to measure the ability of the company its long- term liabilities and interest

1. Times Interest Earned (Earnings before interest and taxes/ interest expense)
It indicates a firm's long- term debt paying ability from income statement view.
2. Cash Basis Time Interest Earned ((Earnings before interest and taxes+ Depreciation expense)/ interest
expense)
This ratio is like the previous ratio, it gives an indicator about the ability of the company to cover its interest obligation with
excluding the non- cash items (depreciation expense).
3. Debt Ratio (total liabilities/ total assets)
This ratio indicates the extent to which the total assets of the firm have been financed using borrowed funds. It also indicates
how well creditors are protected in case of insolvency
4. Debt/ Equity Ratio
This ratio helps in determining the portion of the funds that are obtained by the company that came from debt versus equity.
It also helps in determining the long- term debt paying ability of the firm, by comparing the total debts of the firm with its
total shareholder's equity.
5. Debt to tangible net worth (total liabilities/ (total shareholder's equity- intangible assets))
It's a more conservative ratio than either debt ratio or debt to equity ratio, as it eliminates the intangible assets, as it doesn't
provide resources to pay the creditors, or the company's obligations.
6. Fixed Assets Equity Ratio (fixed assets/ shareholders equity)
This ratio indicates the extent to which stockholders have provided funds in relation to fixed assets.

Profitability Ratios
These ratios are used to measure the ability of the company to achieve profit.

1. Net Profit Margin (net income/ net sales)

This ratio gives a measure of net income dollars generated by each dollar of sales. It represents the return on sales, it also
measures the percentage of each sales dollar remaining after all expenses are paid.
2. Total Assets Turnover (net sales/ total assets)
This ratio measures the activity of the assets and the ability of the company to generate sales through the use of assets
3. Return on Assets (net income/ total assets)….. ROA
This ratio measures the company's ability to utilize its assets to create profit.
4. Operating Income Margin (operating income/ net sales)
This ratio is only interest in the operating income generated from the net sales
5. Return on Investment (net income+ interest + tax ) / (long term liabilities+ total equity)….ROI
It measures the income earned on the invested capital (long term debt+ total equity). It also measures the ability of the
company to reward those who provided long term funds and to attract providers of future funds
6. Return on Total Equity (net income/ total equity)….ROE
This ratio measures the return to the common stock holders, and the preferred stock holders.
 For the Investor
These ratios are used to help the investors take the decision whether to invest in the company or not.
1. Earnings per common Share ((net income- preferred dividends)/ number of common shares)….EPS
This ratio represents the amount of income earned on a share of common stock during an accounting period. This tells you if
and how profitable the company is.
2. Price/ Earnings Ratio (market price per share/ Earnings per share)
It expresses the relationship between the market price of a share of common stock and that stock's current earnings per share. It
also represents the payback period of the stock to the share holders.
3. Percentage of Accumulated Retained Earnings (Retained Earnings (accumulated)/ Net Income)
This percentage declares the policy of the company to keep retained earnings for internal growth.
4. Percentage of Retained Earnings (with calculated retained earnings) ((net income- all dividends)/ net
income)
This ratio is like the previous one, but the only difference is that the retained earnings are of each year on its own.
5. Dividends Payout (dividends per common share/ earnings per common share)
It declares the policy of the company to pay dividends. It also measures the portion of current earnings per common share
being paid out in dividends.
6. Dividends Yield (dividends per common share/ market price per share)
This ratio indicates the relationship between the dividends per common share and the market price per common share
7. Book Value per Common Share (common equity/ number of common shares)
This ratio indicates the amount of shareholder's equity that relates to each share of out standing common stock.

Z-Score Model
Z = 0.717T1 + 0.847T2 + 3.107T3 + 0.420T4 + 0.998T5
• T1: Working Capital/total assets (WC/TA)
• T2: Retained Earnings/total assets ( RE/TA)
• T3: Earnings before interest and taxes/Total assets (EBIT/TA)
• T4: Market Value of Equity/Book Value of total liabilities (MVE/TL)
• T5: Sales/Total Assets (S/TA)
Zones of Discrimination:
• Z > 2.9 -“Safe” Zone
• 1.23 < Z < 2.9 -“Grey” Zone
• Z < 1.23 -“Distress” Zone
Condensed balance sheet and income statement data for Los Colinas Corporation appears below:
LOS COLINAS CORPORATION
Balance Sheet
December 3 I
2012 2011 2010
Cash $ 40,000 $ 24,000 $ 20,000
Receivables (net) 70,000 45,000 48,000
Other current assets 80,000 75,000 62,000
Investments 90,000 70,000 50,000
Plant and equipment (net) 450,000 400,000 360,000
$730,000 $614,000 $540,000
Current liabilities $ 98,000 $ 75,000 $ 70,000
Long-term debt 97,000 75,000 65,000
Common stock, $10 par 400,000 340,000 300,000
Retained earnings 135,000 124,000 105,000
$730,000 $614,000 $540,000
LOS COLINAS CORPORATION
Income Statement
For the Years Ended
December 31
2012 2011
Sales $700,000 $750,000
Less: Sales returns and allowances 40,000 50,000
Net sales 660,000 700,000
Cost of goods sold 420,000 400,000
Gross profit 240,000 300,000
Operating expenses (including income 194,000 237,000
taxes)
Net income $ 46,000 $ 63,000
Additional information:
1. The market price of Los Colinas's common stock was $5.00, $4.50, and $2.30 for 2010, 2011, and
2012, respectively.
2. All dividends were paid in cash.
3. On July 1, 2011, 4,000 shares of common stock were issued and on July 1, 2012, 6,000 shares were
issued.
Condensed comparative financial statements for Woodstock Manufacturing Company appear below.
Balance Sheet
April 30
(in thousands of dollars)
2008 2007 2006
Assets:
Current assets $ 1,700 $1,120 $1,544
Plant and equipment (net) 8,110 7,830 5,404
Other assets 1,004 695 772
Total assets $10,814 $9,645 $7,720

Liabilities and Stockholders' Equity:

Current liabilities $ 950 $ 880 $ 772
Long-term liabilities 2,023 1,591 1,544
Capital stock ($10 par) 4,600 4,600 3,000
Paid-in capital in excess of par 770 770 386
Retained earnings 2,471 1,804 2,018
Total liabilities and stockholders' equity $10,814 $9,645 $7,720

Income Statement
For the Year Ended April 30
(in thousands of dollars)
2008 2007 2006
Net sales $38,610 $32,175 $25,740
Cost of sales 25,100 19,950 15,400
Gross profit $13,510 $12,225 $10,340
Selling expenses 7,700 6,565 5,148
Administrative expenses 4,270 4,175 3,861
Total operating expenses $11,970 $10,740 $9,009
Operating income $ 1,540 $ 1,485 $1,331
Interest expense 115 95 100
Net income before tax $ 1,425 $ 1,390 $1,231
Income taxes 655 645 541
Net income $ 770 $ 745 $ 690
Required:

o Perform Trend analysis of the asset items, using 2006 as the base year.
o Perform a vertical analysis for 2008 of the income statement.
o Perform a common size analysis for 2007 & 2008 of the income statement.
o Perform horizontal analysis of the Liabilities items.