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Chapter 17

Financial Statement
Analysis
Accounting, 21st Edition
Warren Reeve Fess

© Copyright 2004 South-Western, a division


PowerPoint Presentation by Douglas Cloud of Thomson Learning. All rights reserved.
Professor Emeritus of Accounting
Pepperdine University
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Some
Some of of the
the action
action hashas been
been automated,
automated,
so
so click
click the
themouse
mouse whenwhen you
you see
see this
this
lightning
lightning bolt
bolt in
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lower right-hand
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corner of of the
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screen.
Objectives
Objectives
1. List the basic financial statement analytical
procedures. After
After studying
studying this
this
2. Apply financialchapter, you
statement
chapter, should
youanalysis
shouldto assess the
solvency of a business.
be
be able
able to:
to:
3. Apply financial statement analysis to assess the
profitability of a business.
4. Summarize the uses and limitations of analytical
measures.
5. Describe the contents of corporate annual
reports.
Horizontal
Horizontal Analysis
Analysis

What
What isis horizontal
horizontal
analysis?
analysis?
Horizontal
Horizontal Analysis
Analysis
It’s
It’s an
an analysis
analysis of
of the
the percentage
percentage
increases
increases and
and decreases
decreases of
of
related
related items
items in
in comparative
comparative
financial
financial statements.
statements.
Lincoln Company
Comparative Balance Sheet Balance
Balance Sheet
Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500$ (91,000) (7.4%)
Liabilities
Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par$ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
Lincoln Company
Comparative Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 Analysis:
Horizontal 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets Difference
$1,139,500 $1,230,500$17,000
$ (91,000) (7.4%)
Liabilities = 3.2%
Current liabilities
Base year (2005) $533,000
$ 210,000 $ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par$ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
Lincoln Company
Comparative Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500$ (91,000) (7.4%)
Horizontal Analysis:
Liabilities
Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)
Difference $(82,500)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
= (46.5%)
Total liabilities Base year (2005)
$ 310,000 $177,500
$ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
Lincoln Company
Comparative Balance Sheet
Okay,
Okay, go
go to to the
the next
next slide
December 31, 2006 and 2005 slideIncrease (Decrease)
Assets and
and calculate
calculate
2006 the
the Amount Percent
2005
Current assets
percentage
percentage
Long-term investments
change
95,000change
for
$ 550,000 $ 533,000 $ 17,000 3.2%
for (82,500) (46.5%)
177,500
Fixed assets (net) fixed
fixed assets.
444,500assets.
470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities
Current liabilities Horizontal
$ 210,000 Analysis:
$ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ Difference
310,000 $ 443,000 ?$(133,000) (30.0%)
Stockholders’ Equity = ?
Base year (2005)
Preferred 6% stock, $100 par$ 150,000 $ 150,000
? —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
Lincoln Company
Comparative Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500$ (91,000) (7.4%)
Liabilities
Current liabilities $ 210,000 $ 243,000 $ (33,000)
(5.4%)
(5.4%)
(13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par$ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
Lincoln Company
Comparative Income Statement Income
Income Statement
Statement
December 31, 2006 and 2005
Increase (Decrease)
2006 2005 Amount Percent
Sales $1,530,500$1,234,000$296,500 24.0%
Sales returns 32,50034,000(1,500) (4.4%)
Net sales $1,498,000$1,200,000$298,000 24.8%
Cost of goods sold 1,043,000820,000223,000 27.2%
Gross profit $ 455,000$ 380,000$ 75,000 19.7%
Selling expenses $ 191,000$ 147,000$ 44,000 29.9%
Administrative expenses 104,00097,4006,600 6.8%
Total operating expenses $ 295,000$ 244,400$ 50,600 20.7%
Operating income $ 160,000$ 135,600$ 24,400 18.0%
Other income 8,50011,000(2,500) (22.7%)
$ 168,500 $ 146,600$ 21,900 14.9%
Other expense 6,00012,000(6,000) (50.0%)
Income before income tax $ 162,500$ 134,600$ 27,900 20.7%
Income tax 71,50058,10013,400 23.1%
Net income $ 91,000$ 76,500$ 14,500 19.0%
Lincoln Company
Comparative Income Statement
December 31, 2006 and 2005
Increase (Decrease)
2006 2005 Amount Percent
Sales $1,530,500$1,234,000$296,500 24.0% 24.0%
Sales returns 32,50034,000(1,500) (4.4%)
Net sales $1,498,000$1,200,000$298,000 24.8%
Cost of goods sold 1,043,000820,000223,000 27.2%
Gross profit $ 455,000$ 380,000$ 75,000 19.7%
Selling expenses Horizontal
$ 191,000$Analysis:
147,000$ 44,000 29.9%
Administrative expenses 104,00097,4006,600 6.8% Total
operating expenses Increase
$ 295,000$amount
244,400$$296,500
50,600 20.7%
Operating income $ 160,000$ 135,600$ 24,400
= 18.0%
24.0%
Base year (2005) $1,234,000
Other income 8,50011,000(2,500) (22.7%)
$ 168,500 $ 146,600$ 21,900 14.9%
Other expense 6,00012,000(6,000) (50.0%)
Income before income tax $ 162,500$ 134,600$ 27,900 20.7%
Income tax 71,50058,10013,400 23.1%
Net income $ 91,000$ 76,500$ 14,500 19.0%
Lincoln Company
Comparative Income Statement
December 31, 2006 and 2005
Increase (Decrease)
2006 2005 Amount Percent
Sales $1,530,500$1,234,000$296,500 24.0%
Sales returns 32,50034,000(1,500) (4.4%)
Net sales $1,498,000$1,200,000$298,000 24.8% 24.8%
Cost of goods sold 1,043,000820,000223,000 27.2%
Gross profit $ 455,000$ 380,000$ 75,000 19.7%
Selling expenses $ 191,000$ 147,000$ 44,000 29.9%
Administrative expenses 104,00097,4006,600 6.8% Total
operating expenses $ 295,000$ 244,400$ 50,600 20.7%
Operating income Horizontal
$ 160,000$Analysis:
135,600$ 24,400 18.0%
Other income 8,50011,000(2,500) (22.7%)
$ 168,500
Increase amount $298,000
$ 146,600$ 21,900 14.9% = 24.8%
Other expense Base year (2005) $1,200,000 (50.0%)
6,00012,000(6,000)
Income before income tax $ 162,500$ 134,600$ 27,900 20.7%
Income tax 71,50058,10013,400 23.1%
Net income $ 91,000$ 76,500$ 14,500 19.0%
Vertical
Vertical Analysis
Analysis
A
A percentage
percentage analysis
analysis cancan bebe
used
used to
to show
show the
the relationship
relationship
of
of each
each component
component to to aa total
total
within
within aa single
single statement.
statement.
Vertical
Vertical Analysis
Analysis

The
The total,
total, or
or 100%
100% item,
item,
on
on the
the balance
balance sheet
sheet isis
“total
“total assets.”
assets.”
Lincoln Company Balance
Comparative Balance Sheet Balance
December 31, 2006 Sheet
Sheet
December 31, 2005
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total assets $1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Vertical
Total Analysis:
liabilities $ 310,000 27.2% $ 443,000 36.0%
Stockholders’ Equity
Current assets $550,000
Preferred stock, 6%, $100 par $ 150,000 = 13.2%
48.3% $ 150,000 12.2%
Totalstock,
Common assets $10 par $1,139,500
500,000 43.9 500,000 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0%
Total liab. & SE $1,139,500 100.0% $1,230,500 100.0%
Lincoln Company
Comparative Balance Sheet
December 31, 2006 December 31, 2005
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total assets $1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Total liabilities Vertical Analysis:
$ 310,000 27.2% $ 443,000 36.0%
Stockholders’ Equity
Current assets $533,000
Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2%
= 43.3%
Common stock, $10 par Total assets500,000 $1,230,500500,000
43.9 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0%
Total liab. & SE $1,139,500 100.0% $1,230,500 100.0%
Lincoln Company
Comparative Balance Sheet
December 31, 2006 December 31, 2005
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total assets $1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Total liabilities $ 310,000 27.2% $ 443,000 36.0%
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2%
Common stock, $10 par 500,000 43.9 500,000 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0%
Total liab. & SE $1,139,500 100.0% $1,230,500 100.0%
Lincoln Company Income
Comparative Income Statement Income
For the Years Ended December 31, 2006 and 2005 Statement
Statement
2006 2005
Amount Percent Amount Percent
Sales $1,530,500102.2% $1,234,000102.8%
Sales returns 32,5002.234,000 2.8
Net sales $1,498,000100.0% $1,200,000100.0%
Cost of goods sold 1,043,00069.6820,000 68.3
Gross profit $ 455,00030.4%$ 380,000 31.7%
Selling expenses $ 191,00012.8%$ 147,000 12.3%
Administrative expenses
Net
104,0006.997,400
sales
Net sales 8.1
Total operating expenses isis 100.0%
$ 295,00019.7%$ 100.0%
244,400 20.4%
Income from operations $ 160,00010.7$ 135,600 11.3%
Other income 8,5000.611,000 0.9
$ 168,500 11.3%$ 146,600 12.2%
Other expense 6,0000.412,000 1.0
Income before income tax $ 162,50010.9%$ 134,600 11.2%
Income tax expense 71,5004.858,100 4.8
Net income $ 91,0006.1%$ 76,500 6.4%
Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500102.2% $1,234,000102.8%
Sales returns 32,5002.234,000 2.8
Net sales $1,498,000100.0% $1,200,000100.0%
Cost of goods sold 1,043,00069.6820,000 68.3
Gross profit $ 455,00030.4%$ 380,000 31.7%
Selling expenses $ 191,00012.8%$
191,000 147,000
12.8% 12.3%
Administrative expenses 104,0006.997,400 8.1
Total operating expenses $ 295,00019.7%$ 244,400 20.4%
Income from operations $ 160,00010.7$ 135,600 11.3%
Other income 8,5000.611,000 0.9
$ Vertical
168,500 Analysis: 11.3%$ 146,600 12.2%
Other expense 6,0000.412,000 1.0
Selling
Income beforeexpenses
income tax $191,000
$ 162,50010.9%$ 134,600 11.2%
Income tax expense = 12.8%
71,5004.858,100 4.8
Net sales $1,498,000
Net income $ 91,0006.1%$ 76,500 6.4%
Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500102.2% $1,234,000102.8%
Sales returns 32,5002.234,000 2.8
Net sales $1,498,000100.0% $1,200,000100.0%
Cost of goods sold 1,043,00069.6820,000 68.3
Gross profit $ 455,00030.4%$ 380,000 31.7%
Selling expenses $ 191,00012.8%$ 147,000 12.3%
Administrative expenses 104,0006.997,400 8.1
Total operating expenses $ 295,00019.7%$ 244,400 20.4%
Income from operations $ 160,00010.7$ 135,600 11.3%
Other income 8,5000.611,000 0.9
$ 168,500 11.3%$ 146,600 12.2%
Other expense 6,0000.412,000 1.0
Income before income tax $ 162,50010.9%$ 134,600 11.2%
Income tax expense 71,5004.858,100 4.8
Net income $ 91,0006.1%$ 76,500 6.4%
Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500102.2% $1,234,000102.8%
Sales returns 32,5002.234,000 2.8
Net sales $1,498,000100.0% $1,200,000100.0%
Cost of goods sold 1,043,00069.6820,000 68.3
Gross profit $ 455,00030.4%$ 380,000 31.7%
Selling expenses $ 191,00012.8%$ 147,000 12.3%
Administrative expenses 104,0006.997,400 8.1
Total operating expenses $ 295,00019.7%$ 244,400 20.4%
Income from operations $ 160,00010.7$ 135,600 11.3%
Other income 8,5000.611,000 0.9
$ 168,500 11.3%$ 146,600 12.2%
Other expense 6,0000.412,000 1.0
Income before income tax $ 162,50010.9%$ 134,600 11.2%
Income tax expense 71,5004.858,100 4.8
Net income $ 91,0006.1%$ 76,500 6.4%
Common
Common Size
Size Statements
Statements
Vertical
Vertical analysis
analysis with
with both
both dollar
dollar and
and
percentage
percentage amounts
amounts isis also
also useful
useful inin
comparing
comparing oneone company
company withwith another
another
or
or with
with industry
industry averages.
averages. Such
Such
comparisons
comparisons are are easier
easier to
to make
make with
with
the
the use
use of
of common-size
common-size statements
statements in in
which
which all
all items
items are
are expressed
expressed in in
percentages.
percentages.
Common-Size
Common-Size Income
Income Statement
Statement
Solvency
Solvency Analysis
Analysis
 Solvency is the ability of a business to
meet its financial obligations (debts) as
they are due.
 Solvency analysis focuses on the ability
of a business to pay or otherwise satisfy
its current and noncurrent liabilities.
 This ability is normally assessed by
examining balance sheet relationships.
Current Position Analysis
Working
Working Capital
Capital and
and Current
Current Ratio
Ratio
2006 2005
Current assets $550,000 $533,000
Current liabilities 210,000 243,000
Working capital $340,000 $290,000
Current ratio 2.6 2.2

Use:
Use: To
To indicate
indicate the
the ability to meet
abilityDivide
to meet
Divide
currently
currently maturing
maturing obligations.
obligations.
current
current
assets
assetsbyby
current
current
liabilities
liabilities
Current Position Analysis
Quick
Quick Ratio
Ratio
2006 2005
Quick assets:
Cash $ 90,500 $ 64,700
Marketable securities 75,000 60,000
Accounts receivable (net) 115,000 120,000
Total $280,500 $244,700
Current liabilities $210,000 $243,000
Quick ratio 1.3 1.0

Use:
Use: To
To indicate
indicate instant
instant debt-paying
debt-paying ability.
ability.
Accounts Receivable Analysis
Accounts
Accounts Receivable
Receivable Turnover
Turnover
2006 2005
Net sales on account $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year 115,500 120,000
Total $ 235,000 $ 260,000
Average (Total ÷ 2) $ 117,500 $ 130,000

Net
Net sales
sales on
on account
account
Average
Average accounts
accounts
receivable
receivable
Accounts Receivable Analysis
Accounts
Accounts Receivable
Receivable Turnover
Turnover
2006 2005
Net sales on account $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year 115,500 120,000
Total $ 235,000 $ 260,000
Average $ 117,500 $ 130,000
Accounts receivable turnover 12.7 9.2

Use:
Use: To
To assess
assess the
the efficiency
efficiency inin collecting
collecting
receivables
receivables and
and in
in the
the management
management of of credit.
credit.
Accounts Receivable Analysis
Number
Number of
of Days’
Days’ Sales
Sales in
in Receivables
Receivables
2006 2005
Accounts receivable (net),
end of year $ 115,000 $ 120,000
Net sales on account $1,498,000 $1,200,000
Average daily sales on
account (sales ÷ 365) $ 4,104 $ 3,288

Accounts
Accounts receivable,
receivable, end
end of
of year
year
Average
Average daily
daily sales
sales on
on account
account
Accounts Receivable Analysis
Number
Number of
of Days’
Days’ Sales
Sales in
in Receivables
Receivables
2006 2005
Accounts receivable (net),
end of year $ 115,000 $ 120,000
Net sales on account $1,498,000 $1,200,000
Average daily sales on
account (sales ÷ 365) $ 4,104 $ 3,288
Number of days’ sales in
receivables 28.0 36.5

Use:
Use: To
To assess
assess the
the efficiency
efficiency inin collecting
collecting
receivables
receivables and
and in
in the
the management
management of of credit.
credit.
Inventory Analysis
Inventory
Inventory Turnover
Turnover
2006 2005
Cost of goods sold $1,043,000 $ 820,000
Inventories:
Beginning of year $ 283,000 $ 311,000
End of year 264,000 283,000
Total $ 547,000 $ 594,000
Average (Total ÷ 2) $ 273,500 $ 297,000

Cost
Cost of
of goods
goods sold
sold
Inventory turnover =
Average
Average inventory
inventory
Inventory Analysis
Inventory
Inventory Turnover
Turnover
2006 2005
Cost of goods sold $1,043,000 $ 820,000
Inventories:
Beginning of year $ 283,000 $ 311,000
End of year 264,000 283,000
Total $ 547,000 $ 594,000
Average (Total ÷ 2) $ 273,500 $ 297,000
Inventory turnover 3.8 2.8

Use:
Use: To
To assess
assess the
the efficiency
efficiency in
in the
the
management
management of of inventory.
inventory.
Inventory Analysis
Number
Numberof
ofDays’
Days’Sales
Salesin
inInventory
Inventory
2006 2005
Inventories, end of year $ 264,000 $283,000
Cost of goods sold $1,043,000 $820,000
Average daily cost of
goods sold
(COGS ÷ 365) $ 2,858 $ 2,247

Number of Inventories,
Inventories, end
end of
of year
year
Days’ Sales =
in Inventory Average
Average daily
daily cost
cost of
of goods
goods sold
sold
Inventory Analysis
Number
Numberof
ofDays’
Days’Sales
Salesin
inInventory
Inventory
2006 2005
Inventories, end of year $ 264,000 $283,000
Cost of goods sold $1,043,000 $820,000
Average daily cost of
goods sold
(COGS ÷ 365) $ 2,858 $ 2,247
Number of days’ sales
in inventory 92.4 125.9

Use:
Use:To
To assess
assess the
the efficiency
efficiency in
in the
the
management
management of of inventory.
inventory.
Long-Term Creditors
Ratio
Ratioof
ofFixed
FixedAssets
Assetsto
toLong-Term
Long-TermLiabilities
Liabilities
2006 2005
Fixed assets (net) $444,500 $470,000
Long-term liabilities $100,000 $200,000
Ratio of fixed assets to
long-term liabilities 4.4 2.4

Use:
Use: To
To indicate
indicate the
the margin
margin of
of safety
safety
to
to long-term
long-term creditors.
creditors.
Long-Term Creditors
Ratio
Ratio of
of Liabilities
Liabilities to
to Stockholders’
Stockholders’ Equity
Equity
2006 2005
Total liabilities $310,000 $443,000
Total stockholders’ equity $829,500 $787,500
Ratio of liabilities to
stockholders’ equity 0.37 0.56

Use:
Use: To
To indicate
indicate the
the margin
margin of
of safety
safety to
to
creditors.
creditors.
Long-Term Creditors
Number
Number of
of Times
Times Interest
Interest Charges
Charges Earned
Earned
2006 2005
Income before income tax $ 900,000 $ 800,000
Add interest expense 300,000 250,000
Amount available for interest $1,200,000 $1,050,000

Number of Income
Income before
before
Times Interest = income
income tax
tax ++ interest
interest expense
expense
Charges Earned Interest
Interest expense
expense
Long-Term Creditors
Number
Number of
of Times
Times Interest
Interest Charges
Charges Earned
Earned
2006 2005
Income before income tax $ 900,000 $ 800,000
Add interest expense 300,000 250,000
Amount available for interest $1,200,000 $1,050,000
Number of times earned 4.0 4.2

Use:
Use: To
To assess
assess the
the risk
risk to
to debtholders
debtholders
in
in terms
terms of
of number
number of of times
times
interest
interest charges
charges werewere earned.
earned.
Profitability
Profitability Analysis
Analysis
 Profitability is the ability of an entity to earn profits.
 This ability to earn profits depends on the effectiveness
and efficiency of operations as well as resources
available.
 Profitability analysis focuses primarily on the
relationship between operating results reported in the
income statement and resources reported in the balance
sheet.
The Common Stockholder
Ratio
Ratio of
of Net
Net Sales
Sales to
to Assets
Assets
2006 2005
Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
Average (Total ÷ 2) $1,048,750 $1,031,500

Excludes
Excludes long-term
long-term investments
investments
The Common Stockholder
Ratio
Ratio of
of Net
Net Sales
Sales to
to Assets
Assets
2006 2005
Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
Average (Total ÷ 2) $1,048,750 $1,031,500
Ratio of net sales to assets 1.4 1.2

Use:
Use: To
To assess
assess the
the effectiveness
effectiveness of
of
the
the use
use of
of assets.
assets.
The Common Stockholder
Rate
RateEarned
Earned on
on Total
Total Assets
Assets
2006 2005
Net income $ 91,000 $ 76,500
Plus interest expense 6,000 12,000
Total $ 97,000 $ 88,500
Total assets:
Beginning of year $1,230,500 $1,187,500
End of year 1,139,500 1,230,500
Total $2,370,000 $2,418,000
Average (Total ÷ 2) $1,185,000 $1,209,000
Rate earned on total assets 8.2% 7.3%

Use:
Use: To
To assess
assess the
the profitability
profitability of
of the
the assets.
assets.
The Common Stockholder
Rate
Rate Earned
Earned on
on Stockholders’
Stockholders’ Equity
Equity
2006 2005
Net income $ 91,000 $ 76,500
Stockholders’ equity:
Beginning of year $ 787,500 $ 750,000
End of year 829,500 787,500
Total $1,617,000 $1,537,500
Average (Total ÷ 2) $ 808,500 $ 768,750
Rate earned on stockholders’
equity 11.3% 10.0%

Use:
Use: To
To assess
assess the
the profitability
profitability of
of
the
the investment
investment byby stockholders.
stockholders.
The Common Stockholder
Rate
Rate Earned
Earned on
on Common
Common Stockholders’
Stockholders’ Equity
Equity
2006 2005
Net income $ 91,000 $ 76,500
Less preferred dividends 9,000 9,000
Remainder—common stock $ 82,000 $ 67,500
Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000
End of year 679,500 637,500
Total $1,317,000 $1,237,500
Average (Total ÷ 2) $ 658,500 $ 618,750
The Common Stockholder
Rate
Rate Earned
Earned on
on Common
Common Stockholders’
Stockholders’ Equity
Equity
2006 2005
Net income $ 91,000 $ 76,500
Less preferred dividends 9,000 9,000
Remainder—common stock $ 82,000 $ 67,500
Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000
End of year 679,500 637,500
Total $1,317,000 $1,237,500
Average (Total ÷ 2) $ 658,500 $ 618,750
Rate earned on common
stockholders’ equity 12.5% 10.9%
Use:
Use: To
To assess
assess the
the profitability
profitability of
of the
the
investment
investment byby common
common stockholders.
stockholders.
The Common Stockholder
Earnings
Earnings Per
Per Share
Share on
on Common
Common Stock
Stock
2006 2005
Net income $ 91,000 $ 76,500
Less preferred dividends 9,000 9,000
Remainder—common stock $ 82,000 $ 67,500
Shares of common stock 50,000 50,000
Earnings per share on common stock $1.64 $1.35

Use:
Use: To
To assess
assess the
the profitability
profitability of
of the
the
investment
investment byby common
common stockholders.
stockholders.
The Common Stockholder
Price-Earnings
Price-Earnings Ratio
Ratio
2006 2005
Market price per share of common $41.00 $27.00
Earnings per share on common ÷ 1.64 ÷ 1.35
Price-earnings ratio on common stock 25 20

Use:
Use: To
To indicate
indicate future
future earnings
earnings
prospects,
prospects, based
based onon the
the relationship
relationship
between
between market
market value
value of
of common
common
stock
stock and
and earnings.
earnings.
The Common Stockholder

Dividend
Dividend Yield
Yield on
on Common
Common Stock
Stock
2006 2005
Dividends per share of common $ 0.80 $ 0.60
Market price per share of common ÷ 41.00 ÷ 27.00
Dividend yield on common stock 1.95% 2.22%

Use:
Use: To
To indicate
indicate the
the rate
rate of
of return
return to
to common
common
stockholders
stockholders in in terms
terms of
of dividends.
dividends.
Corporate
Corporate Annual
Annual Reports
Reports
In addition to financial statements, the annual
report includes a management discussion analysis
(MDA) and an independent auditors’ report.
The MDA includes an analysis of the results
of operations and discusses management’s
opinion about future performance. It
compares the prior year’s income statement
with the current year’s. It also contains an
analysis of the firm’s financial condition.
Corporate
Corporate Annual
Annual Reports
Reports
In addition to financial statements, the annual
report includes a management discussion analysis
(MDA) and an independent auditors’ report.
Before issuing annual statements, all
publicly held corporations are required
to have an independent audit of their
financial statements. The CPAs who
conduct the audit render an opinion as
to the fairness of the statements.
Chapter 17

The
The End
End