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Chapter 17

ANALYSIS OF FINANCIAL
STATEMENTS

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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C1

BASICS OF ANALYSIS

Application
Application Involves
Involves
Reduces
Reduces of
of analytical
analytical transforming
transforming
uncertainty
uncertainty tools
tools data
data

Financial
Financial statement
statement analysis
analysis helps
helps users
users
make
make better
better decisions.
decisions.
Internal Users External Users
Managers Shareholders
Officers Lenders
Internal Auditors Customers
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C1

BUILDING BLOCKS OF ANALYSIS

Liquidity and
Solvency
efficiency

Market
Profitability
prospects
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C1

INFORMATION FOR ANALYSIS

1. Income Statement
2. Balance Sheet
3. Statement of Stockholders Equity
4. Statement of Cash Flows
5. Notes to the Financial Statements
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C1

STANDARDS FOR COMPARISON

When we interpret our analysis, it is essential to


compare the results we obtained to other
standards or benchmarks.

Intracompany
Competitors
Industry
Guidelines
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C2

TOOLS OF ANALYSIS
Horizontal Analysis
Comparing a companys financial condition and
performance across time.

Vertical Analysis
Comparing a companys financial condition and
performance to a base amount.

Ratio Analysis
Measurement of key relations between financial statement
items.
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P1

HORIZONTAL ANALYSIS
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P1

COMPARATIVE STATEMENTS
Calculate Change in Dollar Amount

Dollar Analysis Period Base Period


Change = Amount Amount

When measuring the amount of the


change in dollar amounts, compare the
analysis
analysis period balance
balance to the
the base
base
period balance. The analysis period is
usually the current
current year while the base
period is usually the prior year.
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P1

COMPARATIVE STATEMENTS
Calculate Change as a Percent

Percent Dollar Change


Change
=
Base Period Amount 100

When calculating
calculating the change
change as
as aa
percentage, divide the amount of of the
dollar change by the
the base period
period
amount, and then
then multiply
multiply by 100 to
convert to
to a percentage.
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P1

HORIZONTAL ANALYSIS

$1,550,861
$1,550,861 $835,546
$835,546 == $715,315
$715,315

($715,315 $835,546) 100 = 85.6%


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P1

HORIZONTAL ANALYSIS

$14,953,224
$14,953,224 $11,065,186
$11,065,186 == $3,888,038
$3,888,038

($3,888,038 $11,065,186) 100 = 35.1%


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P1

TREND ANALYSIS

Trend analysis is used to reveal patterns in data


covering successive periods.

Trend Analysis Period Amount


Percent
=
Base Period Amount 100
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P1

TREND ANALYSIS
Research in Motion
Income Statement Information

Using 2006 as the base year we will get the following trend information :

Examples
Examples of of 2006-2008
2006-2008 Calculations
Calculations for
for Revenues:
Revenues:
2006
2006 is
is base
base year.
year. Set
Set to
to 100%
100%
2007:
2007: $3,037,103
$3,037,103 $2,065,845
$2,065,845 100
100 == 147.0%
147.0%
2008:
2008: $6,009,395
$6,009,395 $2,065,845
$2,065,845 100
100 == 290.9%
290.9%
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P1

TREND ANALYSIS

We can use the trend percentages to construct a


graph so we can see the trend over time.
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P2

VERTICAL ANALYSIS
Common-Size Statements

Common-size Analysis Amount


Percent
= Base Amount 100

Financial Statement Base Amount


Balance Sheet Total Assets
Income Statement Revenues
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P2

COMMON-SIZE BALANCE SHEET

($1,550,861
($1,550,861 $10,204,409)
$10,204,409) 100
100 == 15.2%
15.2%

($835,546
($835,546 $8,101,372)
$8,101,372) 100
100 == 10.3%
10.3%
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P2

COMMON-SIZE INCOME STATEMENT

($8,368,958
($8,368,958 $14,953,224)
$14,953,224) 100
100 == 56.0%
56.0%
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P2

COMMON-SIZE GRAPHICS
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P3

RATIO ANALYSIS

Liquidity
and Solvency
efficiency

Market
Profitability
prospects
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P3

LIQUIDITY AND EFFICIENCY

Current
Current Inventory
Inventory
Ratio
Ratio Turnover
Turnover

Acid-test
Acid-test Days
Days Sales
Sales
Ratio
Ratio Uncollected
Uncollected

Accounts
Accounts Days
Days Sales
Sales
Receivable
Receivable in
in Inventory
Inventory
Turnover
Turnover

Total
Total Asset
Asset
Turnover
Turnover
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P3

WORKING CAPITAL
Working capital represents current assets
financed from long-term capital sources that
do not require near-term repayment.

Current assets
Current liabilities
= Working capital

More
More working
working capital
capital suggests
suggests aa strong
strong liquidity
liquidity
position
position and
and an
an ability
ability to
to meet
meet current
current obligations.
obligations.
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P3

CURRENT RATIO
Current Assets
Current Ratio =
Current Liabilities

This
This ratio
ratio measures
measures thethe short-term
short-term debt-
debt-
paying
paying ability
ability of
of the
the company.
company. A A higher
higher current
current
ratio
ratio suggests
suggests aa strong
strong liquidity
liquidity position.
position.
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P3

ACID-TEST RATIO

Cash + Short-term investments + Current


Acid-test ratio = receivables
Current Liabilities
Referred
Referred to
to as
as Quick
Quick Assets
Assets

This
This ratio
ratio is
is like
like the
the current
current ratio
ratio but
but excludes
excludes current
current assets
assets
such
such as
as inventories
inventories andand prepaid
prepaid expenses
expenses that
that may
may be
be
difficult
difficult to
to quickly
quickly convert
convert into
into cash.
cash.
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P3

ACCOUNTS RECEIVABLE TURNOVER

Net sales
Accounts receivable =
turnover Average accounts receivable,
net
(Beginning acct. rec. + Ending acct. rec.)
Average accounts receivable =
2

This
This ratio
ratio measures
measures howhow
many
many times
times aa company
company
converts
converts its
its receivables
receivables
into
into cash
cash each
each year.
year.
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P3

INVENTORY TURNOVER
Cost of goods sold
Inventory turnover =
Average inventory

Average inventory = (Beginning inventory + Ending inventory)


2

This
This ratio
ratio measures
measures the the
number
number ofof times
times
merchandise
merchandise is is sold
sold and
and
replaced
replaced during
during the
the year.
year.
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P3

DAYS SALES UNCOLLECTED

Accounts receivable, net


Day's sales =
365
uncollected
Net sales
Provides
Provides insight
insight into
into how
how frequently
frequently aa
company
company collects
collects its
its accounts
accounts receivable.
receivable.
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P3

DAYS SALES IN INVENTORY

Ending inventory
Day's sales in =
365
Inventory
Cost of goods sold
This
This ratio
ratio is
is aa useful
useful measure
measure in in evaluating
evaluating
inventory
inventory liquidity.
liquidity. IfIf aa product
product isis demanded
demanded
by
by customers,
customers, this this formula
formula estimates
estimates how
how
long
long itit takes
takes to
to sell
sell the
the inventory.
inventory.
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P3

TOTAL ASSET TURNOVER


Net sales
Total asset turnover =
Average total assets

(Beginning assets + Ending assets)


Average assets =
2

This
This ratio
ratio reflects
reflects aa
companys
companys ability ability to
to use
use
its
its assets
assets to to generate
generate
sales.
sales. ItIt is
is an
an important
important
indication
indication of of operating
operating
efficiency.
efficiency.
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P3

SOLVENCY
Debt
Debt
Ratio
Ratio

Equity
Equity
Ratio
Ratio

Pledged
Pledged Assets
Assets
to
to Secured
Secured
Liabilities
Liabilities

Times
Times
Interest
Interest
Earned
Earned
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P3

DEBT AND EQUITY RATIOS


Amount Ratio
Total liabilities $ 8,000,000 66.7% [Debt ratio]
Total equity 4,000,000 33.3% [Equity ratio]
Total liabilities and equity $ 12,000,000 100.0%

$8,000,000
$8,000,000 $12,000,000
$12,000,000 == 66.7%
66.7%

The
The debt
debt ratio
ratio expresses
expresses total
total liabilities
liabilities as
as aa percent
percent of
of
total
total assets.
assets. The
The equity
equity ratio
ratio provides
provides complementary
complementary
information
information byby expressing
expressing total
total equity
equity as as aa percent
percent of
of total
total
assets.
assets.
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P3

DEBT-TO-EQUITY RATIO

Total liabilities
Debt-to-equity ratio =
Total equity

This
This ratio
ratio measures
measures what
what portion
portion of
of aa companys
companys
assets
assets are
are contributed
contributed by by creditors.
creditors. A
A larger
larger debt-to-
debt-to-
equity
equity ratio
ratio implies
implies less
less opportunity
opportunity to to expand
expand
through
through use
use ofof debt
debt financing.
financing.
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P3

TIMES INTEREST EARNED


Income before interest and
Times interest earned taxes
=
Interest expense
Net income
+ Interest expense
+ Income taxes
= Income before interest and taxes

This
This isis the
the most
most common
common measure
measure of of the
the
ability
ability of
of aa companys
companys operations
operations to
to provide
provide
protection
protection to
to long-term
long-term creditors.
creditors.
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P3

PROFITABILITY

Profit
Profit Return
Return on
on
Margin
Margin Total
Total Assets
Assets

Return
Return on
on Common
Common
Stockholders
Stockholders Equity
Equity
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P3

PROFIT MARGIN

Net income
Profit margin =
Net sales

This
This ratio
ratio describes
describes aa companys
companys ability
ability to
to
earn
earn net
net income
income from
from each
each sales
sales dollar.
dollar.
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P3

RETURN ON TOTAL ASSETS

Net income
Return on total asset =
Average total
assets

Return
Return on
on total
total assets
assets measures
measures how
how well
well
assets
assets have
have been
been employed
employed by
by the
the
companys
companys management.
management.
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P3
RETURN ON COMMON STOCKHOLDERS
EQUITY

Return on common stockholders' Net income - Preferred dividends


equity = Average common stockholders'
equity

This
This measure
measure indicates
indicates how
how well
well the
the
company
company employed
employed the
the stockholders
stockholders equity
equity
to
to earn
earn net
net income.
income.
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P3

MARKET PROSPECTS

Price-Earnings
Price-Earnings Dividend
Dividend
Ratio
Ratio Yield
Yield
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P3

PRICE-EARNINGS RATIO
Market price per common share
Price-earnings ratio =
Earnings per share

This
This measure
measure isis often
often used
used by
by investors
investors as
as aa
general
general guideline
guideline in
in gauging
gauging stock
stock values.
values.
Generally,
Generally, the
the higher
higher the
the price-earnings
price-earnings ratio,
ratio, the
the
more
more opportunity
opportunity aa company
company hashas for
for growth.
growth.
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P3

DIVIDEND YIELD
Annual cash dividends per share
Dividend yield =
Market price per share

This
This ratio
ratio identifies
identifies the
the return,
return, in
in terms
terms of
of cash
cash
dividends,
dividends, onon the
the current
current market
market price
price per
per share
share
of
of the
the companys
companys common
common stock.
stock.
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GLOBAL VIEW

Horizontal and Vertical Analysis


Horizontal and vertical analyses help eliminate many differences between
U.S. GAAP and IFRS when analyzing and interpreting financial
statements. However, when fundamental differences in reporting regimes
impact financial statements, the user must exercise caution when drawing
conclusions.

Ratio Analysis
Ratio analysis of financial statement also helps eliminate differences
between U.S. GAAP and IFRS. Importantly, the use of ratio analysis is fine,
with some possible changes in interpretation depending on what is and
what is not included in certain accounting measures across U.S. GAAP and
IFRS. Care must be taken in drawing inferences from a comparison of ratios
across reporting regimes.
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A1

ANALYSIS REPORTING
The purpose of financial statement analyses is to
reduce uncertainty in business decisions through a
rigorous and sound evaluation. A financial statement
analysis report directly addresses the building blocks of
analysis and documents the reasoning.

1. Executive Summary
2. Analysis Overview
3. Evidential Matter
4. Assumptions
5. Key Factors
6. Inferences
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A2 APPENDIX 17A: SUSTAINABLE


INCOME

Extraordinary
Extraordinary
Items
Items
Discontinued
Discontinued
Segments
Segments

Continuing
Continuing
Operations
Operations Net Income
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END OF CHAPTER 17