ANALYSIS AND

INTERPRETATION OF

FINANCIAL STATEMENTS
Prof. Asif Masood
Ahmad
Superior University
Lahore

Non-accounting majors, especially, should

relate well to this chapter

It looks at accounting information from

users perspective

Relates very closely to topics you will study

in your finance course

Therefore, we will use a somewhat broader

brush on this chapter

What is financial statement analysis?

Tearing apart the financial statements

relationships

and looking at the

Who analyzes financial statements?

Internal users (i.e., management)
External users (emphasis of chapter)

625

Examples?

Investors, creditors, regulatory agencies &

stock market analysts and
auditors

What do internal users use it for?

Planning, evaluating and controlling company

operations
What do external users use it for?

Assessing past performance and current

financial position and making predictions about
the future profitability and solvency of the
company as well as evaluating the
effectiveness of management
First sentence in chapter says...

Information is available from

627 628

Published annual reports

(1)
Financial statements
(2)
Notes to financial statements
(3)
Letters to stockholders
(4)
Auditors report (Independent accountants)
(5)
Managements discussion and analysis
Reports filed with the government
e.g., Tax reports with government agencies and
departments
Form 10-K, Form 10-Q and Form 8-K

Information is available from

627 628

Other sources
(1)
Newspapers (e.g., Wall Street Journal )
(2)
Periodicals (e.g. Forbes, Fortune)
(3)
Financial information organizations such as:
Moodys,
Standard & Poors, Dun & Bradstreet, Inc., and
Robert
Morris Associates
(4)
Other business publications

Horizontal Analysis
Vertical Analysis
Common-Size Statements
Trend Percentages
Ratio Analysis

Using
Using comparative
comparative financial
financial
statements
statements to
to calculate
calculate dollar
dollar
or
or percentage
percentage changes
changes in
in aa
financial
financial statement
statement item
item from
from
one
one period
period to
to the
the next
next

For
For aa single
single financial
financial
statement,
statement, each
each item
item
is
is expressed
expressed as
as aa
percentage
percentage of
of aa
significant
significant total,
total,
e.g.,
e.g., all
all income
income
statement
statement items
items are
are
expressed
expressed as
as aa
percentage
percentage of
of sales
sales

Financial
Financial statements
statements that
that show
show
only
only percentages
percentages and
and no
no
absolute
absolute dollar
dollar amounts
amounts

Show
Show changes
changes over
over time
time in
in
given
given financial
financial statement
statement items
items
(can
(can help
help evaluate
evaluate financial
financial
information
information of
of several
several years)
years)

Expression
Expression of
of logical
logical relationships
relationships
between
between items
items in
in aa financial
financial
statement
statement of
of aa single
single period
period
(e.g.,
(e.g., percentage
percentage relationship
relationship
between
between revenue
revenue and
and net
net income)
income)

The management of Clover Company

provides you with comparative balance
sheets of the years ended December 31,
1999 and 1998. Management asks you
to prepare a horizontal analysis on the
information.

Calculating Change in Dollar Amounts

Dollar
Change

Current Year
Figure

Base Year
Figure

Calculating Change in Dollar Amounts

Dollar
Change

Current Year
Figure

Base Year
Figure

Since we are measuring the amount of

the change between 1998 and 1999, the
dollar amounts for 1998 become the
base year figures.

Calculating Change as a Percentage

Percentage
Change

Dollar Change
Base Year Figure

100%

$12,000 $23,500 = $(11,500)

($11,500 $23,500) 100% = 48.9%

Lets apply the same

procedures to the
liability and stockholders
equity sections of the
balance sheet.

CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
1999
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities:
Bonds payable, 8%
Total liabilities
Stockholders' equity:
Preferred stock
Common stock
Additional paid-in capital
Total paid-in capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity

67,000 $
3,000
70,000

1998

Increase (Decrease)
Amount
%

44,000 $
6,000
50,000

23,000
(3,000)
20,000

52.3
(50.0)
40.0

75,000
145,000

80,000
130,000

(5,000)
15,000

(6.3)
11.5

20,000
60,000
10,000
90,000
80,000
170,000
315,000 $

20,000
60,000
10,000
90,000
69,700
159,700
289,700 $

10,300
10,300
25,300

0.0
0.0
0.0
0.0
14.8
6.4
8.7

Now, lets apply the

procedures to the
income statement.

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
Net operating income
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Net income before taxes
25,000
32,000
(7,000)
(21.9)
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
Net operating income
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Net income before taxes
25,000
32,000
(7,000)
(21.9)
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)

Sales increased by 8.3% while net

income decreased by 21.9%.

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.
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
Net operating income
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Net income before taxes
25,000
32,000
(7,000)
(21.9)
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)

The management of Sample Company

asks you to prepare a vertical analysis
for the comparative balance sheets of
the company.

$82,000 $483,000 = 17% rounded

$30,000 $387,000 = 8% rounded

$76,000 $483,000 = 16% rounded

Wheeler, Inc. provides you with the

following operating data and asks that
you prepare a trend analysis.

Wheeler, Inc. provides you with the

following operating data and asks that
you prepare a trend analysis.

$1,991 - $1,820 = $171

Using 1995 as the base year, we develop

the following percentage relationships.

$1,991 $171 $1,820

$1,820 = $171
= 9% rounded

Trend line
for Sales

Ratios can be expressed in three different ways:

1. Ratio (e.g., current ratio of 2:1)
2. %
(e.g., profit margin of 2%)
3. $
(e.g., EPS of $2.25)

CAUTION!
Using ratios and percentages without
considering the underlying causes may
lead to incorrect conclusions.

Liquidity Ratios

Indicate a companys short-term

debt-paying ability
Equity (Long-Term Solvency) Ratios

Show relationship between debt and equity

financing in a company
Profitability Tests

Relate income to other variables

Market Tests

Help assess relative merits of stocks in the

marketplace

Liquidity Ratios
Current (working capital) ratio
Acid-test (quick) ratio
Cash flow liquidity ratio
Accounts receivable turnover
Number of days sales in accounts
receivable
Inventory turnover
Total assets turnover
651

Equity (Long-Term Solvency)

Ratios
Equity (stockholders equity) ratio
Equity to debt

Profitability Tests
Return on operating assets

Net income to net sales (return on sales

or profit margin)
Return on average common
$
stockholders equity (ROE)
Cash flow margin
Earnings per share
Times interest earned
Times preferred dividends earned

Market Tests
Earnings yield on common stock

Price-earnings ratio
Payout ratio on common stock
Dividend yield on common stock
Dividend yield on preferred stock
Cash flow per share of common stock

Now, lets look at

Norton
Corporations 1999
and 1998 financial
statements.

Now, lets calculate

the 10 ratios based
on Nortons financial
statements.

NORTON CORPORATION
1999
Cash

$ 30,000

Accounts receivable, net

We will
use this
information
to calculate
the liquidity
ratios for
Norton.

Beginning of year

17,000

End of year

20,000

Inventory
Beginning of year

10,000

End of year

12,000

Total current assets

65,000

Total current liabilities

42,000

Sales on account

494,000

Cost of goods sold

140,000

The excess of current assets over current

liabilities.

12/31/99
Current assets

Current liabilities
Working capital

65,000
(42,000)

23,000

* While this is not a ratio, it does give an

indication of a companys liquidity.

#1
Current
Ratio

Current Assets
Current Liabilities

Current
Ratio

$65,000
$42,000

1.55 : 1

Measures the ability

of the company to pay current
debts as they become due.

#2
Acid-Test
=
Ratio

Quick Assets
Current Liabilities
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.

#2
Acid-Test
=
Ratio

Quick Assets
Current Liabilities
Norton Corporations quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.

#2
Acid-Test
=
Ratio
Acid-Test
=
Ratio

Quick Assets
Current Liabilities
$50,000
$42,000

= 1.19 : 1

#3
Accounts
Receivable =
Turnover

Sales on Account
Average Accounts Receivable

Accounts
$494,000
= 26.70 times
Receivable =
($17,000 + $20,000) 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.

#4
Days Sales
in Accounts =
Receivables
Days Sales
in Accounts =
Receivables

365 Days
Accounts Receivable Turnover
365 Days
26.70 Times

= 13.67 days

Measures, on average, how many

days it takes to collect an
account receivable.

#4
Days Sales
in Accounts =
Receivables
Days Sales
in Accounts =
Receivables

365 Days
Accounts Receivable Turnover
365 Days
26.70 Times

= 13.67 days

In practice, would 45 days be a

desirable number of days in
receivables?

#5
Inventory
Turnover
Inventory
Turnover

Cost of Goods Sold

Average Inventory

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

Measures the number of times

inventory is sold and
replaced during the year.

#5
Inventory
Turnover
Inventory
Turnover

Cost of Goods Sold

Average Inventory

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

Would 5 be a
desirable number of times
for inventory to turnover?

This is part of the information to

calculate the equity, or long-term
solvency ratios of Norton
Corporation.
NORTON CORPORATION
1999
Net operating income
Net sales
Interest expense
Total stockholders' equity

$ 84,000
494,000
7,300
234,390

NORTON CORPORATION
1999
Common shares outstanding
Beginning of year
End of year
Net income

Here is the
rest of the
information
we will
use.

17,000
27,400
$ 53,690

Stockholders' equity
Beginning of year

180,000

End of year

234,390

Dividends per share

Dec. 31 market price/share
Interest expense

2
20
7,300

Total assets
Beginning of year

300,000

End of year

346,390

#6
Equity
=
Ratio
Equity
=
Ratio

Stockholders Equity
Total Assets
$234,390
$346,390

Measures the proportion

of total assets provided by
stockholders.

= 67.7%

#7
Net Income
to
=
Net Sales

Net Income
Net Sales

Net Income
to
=
Net Sales

$53,690
$494,000

= 10.9%

Measures the proportion of the sales dollar

which is retained as profit.

#7
Net Income
to
=
Net Sales

Net Income
Net Sales

Net Income
to
=
Net Sales

$53,690
$494,000

= 10.9%

Would a 1% return on sales be good?

#8
Return on
Stockholders =
Equity
Return on
Stockholders =
Equity

Net Income
Average Common
Stockholders Equity
$53,690
($180,000 + $234,390) 2
Important measure of the
income-producing ability
of a company.

= 25.9%

#9
Earnings Available to Common Stockholders
Earnings
=
Weighted-Average Number of Common
per Share
Shares Outstanding
Earnings
$53,690
=
per Share
(17,000 + 27,400) 2

= $2.42

The financial press regularly publishes

actual and forecasted EPS amounts.

Whats new ?

644

Weighted-average calculation
Earnings available to
EPS of common stock = _______________________
common stockholders
Weighted-average number of
common shares outstanding

Three alternatives for calculating

weighted-average number of shares

Whats new?

645

Weighted-average calculation
Earnings available to
EPS of common stock = _______________________
common stockholders
Weighted-average number of
common shares outstanding
Alternate #1

645
Alternate #2

Alternate #3

#10
Price-Earnings
=
Ratio

Market Price Per Share

EPS

Price-Earnings
=
Ratio

$20.00
$ 2.42

= 8.3 : 1

Provides some measure of whether the

stock is under or overpriced.

Need for comparable data

Data is provided by Dun &

Bradstreet, Standard & Poors etc.

Must compare by industry
Is EPS comparable?

Influence of external factors

General business conditions
Seasonal nature of business operations

Impact of inflation

The
The current
current ratio
ratio is
is aa measure
measure of
of liquidity
liquidity that
that
is
is
computed
computed by
by dividing
dividing total
total assets
assets by
by total
total
liabilities.
liabilities.
a.
a. True
True
b.
b. False
False

Question
The
The current
current ratio
ratio is
is aa measure
measure of
of
liquidity
liquidity that
that is
is computed
computed by
by dividing
dividing
total
total assets
assets by
by total
total liabilities.
liabilities.
a.
a. True
True
The
current
ratio
is
aa measure
of
The
current
ratio
is
measure
of
b.
False
b. False
liquidity, but is computed by
liquidity, but is computed by
dividing
dividing current
current assets
assets by
by
current
current liabilities
liabilities

Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash, Marketable
Marketable
Securities
Securities
and
and net
net receivables.
receivables.
a.
a. True
True
b.
b. False
False

Question
Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash,
Marketable
Marketable Securities
Securities and
and net
net
receivables.
receivables.
a.
a. True
True
b.
b. False
False