Financial Statement Analysis: Principles of Managerial Accounting

Financial Statement Analysis
11e
Principles of Managerial Accounting
Chapter 14
Prepared by: C. Douglas Cloud

Professor Emeritus of Accounting
Pepperdine University
Reeve Warren Duchac

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Objectives
1. Describe basic financial statement analytical
methods.
2. Use financial statement analysis to assess the
liquidity and solvency of a business.
3. Use financial statement analysis to assess the
profitability of a business.
4. Describe the contents of corporate annual
reports.
Learning Objective 1
Describe basic
financial statement
analytical
methods.
LO 1
Basic Analytical Methods

 Users analyze a company’s financial statements
using a variety of analytical methods. Three such
methods are:
 Horizontal analysis
 Vertical analysis
 Common-sized statements
LO 1
Horizontal Analysis
 The percentage analysis of increases and
decreases in related items in comparative
financial statements is called horizontal analysis.
LO 1
Horizontal Analysis
LO 1
Horizontal Analysis
Horizontal
Analysis:
Difference $17,000
= 3.2%
Base year (2011) $533,000
LO 1
Horizontal Analysis
LO 1
Horizontal Analysis
Horizontal
Analysis:
Difference $25,800
= 39.9%
Base year (2011) $64,700
LO 1
Horizontal Analysis
LO 1
Horizontal Analysis
Horizontal
Analysis:
Difference $296,500
= 24.0%
Base year (2011) $1,234,000
LO 1
Horizontal Analysis
LO 1
Horizontal Analysis
Horizontal
Analysis:
Difference $37,500
= 37.5%
Base year (2011) $ 100,000
EE 14-1
LO 1
Vertical Analysis
 A percentage analysis used to show the
relationship of each component to the total within
a single financial statement is called vertical
analysis.
LO 1
Vertical Analysis
 In a vertical analysis of the balance sheet, each
asset item is stated as a percent of the total assets.
 Each liability and stockholders’ equity item is
stated as a percent of the total liabilities and
stockholders’ equity.
LO 1
Vertical Analysis
LO 1
Vertical Analysis
Vertical
Analysis:
Current Assets $550,000

= 48.3%
Total Assets $ 1,139,500
LO 1
Vertical Analysis
 In a vertical analysis of the income statement,
each item is stated as a percent of net sales.
LO 1
Vertical Analysis
LO 1
Vertical Analysis
Vertical Analysis:
Selling expenses $191,000
= 12.8%
Net sales $1,498,000
EE 14-2
LO 1
Common-Sized Statements
 In a common-sized statement, all items are
expressed as percentages with no dollar amounts
shown.
 Common-sized statements are useful for
comparing the current period with prior periods,
individual businesses with one another, or one
business with industry averages.
LO 1
Common-Sized Statements
Use financial
statement analysis to
assess the liquidity
and solvency of a
business.
LO 2
Liquidity and Solvency Analysis

 All users of financial statements are interested in
the ability of a company to do the following:
 Maintain liquidity and solvency.
 Earn income, called profitability.
LO 2
Liquidity and Solvency Analysis

 The ability to convert assets into cash is called
liquidity.
 The ability of a business to pay debts is called
solvency.
 Liquidity, solvency, and profitability are
interrelated. A company that cannot pay its debts
will have difficulty obtaining credit, which can
decrease its profitability.
LO 2
Current Position Analysis

 A company’s ability to pay its current liabilities is
called current position analysis. It is of special
interest to short-term creditors and includes the
computation and analysis of the following:
 Working capital
 Current ratio
 Quick ratio
LO 2
Working Capital
 The excess of current assets over current
liabilities is called working capital. Working
capital is often used to evaluate a company’s
ability to pay current liabilities.
 Working capital is computed as follows:
Working Capital = Current Assets – Current Liabilities
LO 2
Current Ratio
 The current ratio, sometimes called the working
capital ratio or bankers’ ratio, also measures a
company’s ability to pay its current liabilities.
 The current ratio is computed as follows:
Current Assets
Current Ratio =
Current Liabilities
LO 2
Current Ratio
The current ratio for Lincoln Company is computed

below.
2012 2011
Current assets $550,000 $533,000
Current liabilities $210,000 $243,000
Current ratio 2.6 2.2
$550,000 $533,000
$210,000 $243,000
LO 2
Quick Ratio
 A ratio that measures the “instant” debt-paying
ability of a company is called the quick ratio, or
acid-test ratio. It is computed as follows:
Quick Assets
Quick Ratio =
Current Liabilities
Quick assets are cash

and other assets that
can be easily
converted to cash.
LO 2
Quick Assets
The quick ratio for Lincoln Company is computed

below.
Quick assets: 2012 2011
Cash $ 90,500 $ 64,700
Temporary Investments 75,000 60,000
Accounts receivable (net) 115,000 120,000
Total quick assets $280,500 $244,700
Current liabilities $210,000 $243,000
Quick ratio 1.3 1.0

$280,500 $244,700
$210,000 $243,000
EE 14-3
LO 2
Accounts Receivable Turnover

 The relationship between sales and accounts
receivable may be stated as accounts receivable
turnover. Collecting accounts receivable as
quickly as possible improves a company’s
liquidity.
 The accounts receivable turnover is computed as
follows:
Net Sales
Accounts Receivable Turnover =
Average Accounts
Receivable
LO 2
Accounts Receivable Turnover

The accounts receivable turnover for Lincoln
Company is computed below.
2012 2011
Net sales $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year 115,000 120,000
Total $ 235,000 $ 260,000
Average (Total ÷ 2) $ 117,500 $ 130,000
Accounts receivable turnover 12.7 9.2

$1,498,000 $1,200,000
$117,500 $130,000
LO 2
Number of Days’ Sales in Receivables
 The number of days’ sales in receivables is an

estimate of the length of time (in days) the
accounts receivable have been outstanding. It is
computed as follows:
Average Accounts
Number of Days’ Sales = Receivable
in Receivables Average Daily Sales
Net Sales
365
LO 2
Number of Days’ Sales in Receivables

The number of days’ sales in receivables for
Lincoln Company is computed below.
2012 2011
Average accounts receivable
(Total accounts receivable ÷ 2) $ 117,500 $ 130,000
Net sales $1,498,000 $1,200,000
Average daily sales
(Net sales ÷ 365) $ 4,104 $ 3,288
Number of days’ sales in receivables 28.6 39.5

$117,500
$130,000
$4,104
$3,288
EE 14-4
LO 2
Inventory Turnover
 The relationship between the volume of goods
(merchandise) sold and inventory may be stated
as the inventory turnover. The purpose of this
ratio is to assess the efficiency of a firm in
managing its inventory.
 The inventory turnover is computed as follows:
Cost of Goods Sold

Inventory Turnover =
Average Inventory
LO 2
Inventory Turnover
Lincoln’s inventory balance at the beginning of
2011 is $311,000.
2012 2011
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

$1,043,000 $820,000
$273,500 $297,000
LO 2
Number of Days’ Sales in Inventory

 The number of days’ sales in inventory is a rough
measure of the length of time it takes to purchase,
sell, and replace the inventory.
 The number of days’ sales in inventory is
Number of Days’ Sales Average Inventory
=
in Inventory Average Daily Cost of
Goods Sold
Cost of Goods Sold
365
LO 2

The number of days’ sales in inventory for
2012 2011
Average Inventory $273,500 $297,000
$547,000 ÷ 2 $594,000 ÷ 2
LO 2

The number of days’ sales in inventory for
2012 2011
Average Inventory $273,500 $297,000

Average daily cost of goods sold $2,858 $2,247
Number of days’ sales in inventory $1,043,000

95.7 ÷ 132.2
$820,000 ÷ 365
365
$273,500 $297,000
$2,858 $2,247
EE 14-5
LO 2
Ratio of Fixed Assets to Long-Term Liabilities
 The ratio of fixed assets to long-term liabilities is

a solvency measure that indicates the margin of
safety of the note-holders or bondholders. It also
indicates the ability of the business to borrow
additional funds on a long-term basis.
 The ratio is computed as follows:
Ratio of Fixed Assets to Fixed Assets (net)

=
Long-Term Liabilities Long-Term Liabilities
LO 2
Ratio of Fixed Assets to Long-Term Liabilities
To illustrate, the ratio of fixed assets to long-

term liabilities for Lincoln Company is
computed below.
2012 2011
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
$444,500 $470,000
$100,000 $200,000
LO 2
Ratio of Liabilities to Stockholders’ Equity
 The relationship between the total claims of the

creditors and the owners, the ratio of liabilities to
stockholders’ equity, is a solvency measure that
indicates the margin of safety for creditors.
Ratio of Liabilities to Total Liabilities

=
Stockholders’ Equity Total Stockholders’
Equity
LO 2
Ratio of Liabilities to Stockholders’ Equity
The ratio of liabilities to stockholders’ equity for

2012 2011
Total liabilities $310,000 $443,000
Total stockholders’ equity $829,500 $787,500
Ratio of liabilities to
stockholders’ equity 0.4 0.6
$310,000 $443,000
$829,500 $787,500
EE 14-6
LO 2
Number of Times Interest Charges Earned
 Corporations in some industries normally have

high ratios of debt to stockholders’ equity.
 For such corporations, the relative risk of the
debt-holders is normally measured as the number
of times interest charges are earned (during the
year), sometimes called the fixed charge coverage
ratio.
LO 2
 It is computed as follows:
Income Before Income Tax +
Number of Times Interest Interest Expense
=
Charges Are Earned Interest Expense
LO 2

The number of times interest charges are earned
for Lincoln Company is computed below.
2012 2011
Income before income tax $162,500 $134,600
Add interest expense 6,000 12,000
Amount available to meet
interest charges $168,500 $146,600
Number of times interest

charges earned 28.1 12.2
$168,500 $146,600
$6,000 $12,000
LO 2
 The number of times interest charges are earned

can be adapted for use with dividends on
preferred stock.
 The number of times preferred dividends are
earned is computed as follows:
Number of Times Net Income
Preferred Dividends Are =
Earned Preferred Dividends
EE 14-7
Use financial
statement analysis
to assess the
profitability of a
business.
LO 3
Profitability Analysis
 Profitability analysis focuses primarily on the
relationship between operating results and the
resources available to a business.
LO 3
Ratio of Net Sales to Assets

 The ratio of net sales to assets is a profitability
measure that shows how effectively a company
utilizes its assets.
Net Sales
Ratio of Net Sales to Assets =
Average Total Assets
(excluding long-term
investments)
LO 3

The ratio of net sales to assets for Lincoln
2012 2011
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 long-term investments

(continued)
LO 3

The ratio of net sales to assets for Lincoln
2012 2011
Net sales $1,498,000 $1,200,000
Total assets:
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

$1,498,000 $1,200,000
$1,048,750 $1,031,500
EE 14-8
LO 3
Rate Earned on Total Assets

 The rate earned on total assets measures the
profitability of total assets, without considering
how the assets are financed.
Net Income + Interest
Expense
Rate Earned on Total Assets =
Average Total Assets
LO 3
Rate Earned on Total Assets

This ratio for Lincoln Company is computed below.
Total assets are $1,187,500 at the beginning of 2011.
2012 2011
Net income $ 91,000 $ 76,500
Plus interest expense 6,000 12,000
Total $ 97,000 $ 88,500
Total assets:
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%

$97,000 $88,500
$1,185,000 $1,209,000
EE 14-9
LO 3
Rate Earned on Stockholders’ Equity

 The rate earned on stockholders’ equity measures
the rate of income earned on the amount invested
by the stockholders.
Rate Earned on Net Income
=
Stockholders’ Equity Average Total Stockholders’
Equity
LO 3

The rate for Lincoln Company is computed below.
Total stockholders’ equity is $750,000 at the
beginning of 2011.
2012 2011
Net income $ 91,000 $ 76,500
Stockholders’ equity:
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%
$91,000 $76,500
$808,500 $768,750
LO 3

 The difference between the rate earned on
stockholders’ equity and the rate earned on total
assets is called leverage.
LO 3
For Lincoln Company, the effect of leverage is

2012 2011
Rate earned on stockholders’ equity 11.3% 10.0%
Less rate earned on total assets 8.2 7.3
Effect of leverage 3.1% 2.7%
LO 3
LO 3
Rate Earned on Common Stockholders’ Equity
 The rate earned on common stockholders’ equity

measures the rate of profits earned on the amount
invested by the common stockholders.
Net Income – Preferred

Rate Earned on Common Dividends
Stockholders’ Equity =
Average Common
Stockholders’ Equity
LO 3
Lincoln Company had $150,000 of 6% preferred

stock outstanding on December 31, 2012 and
2011. Thus, preferred dividends of $9,000
($150,000 x 6%) are deducted from net income.
Lincoln’s common stockholders’ equity is
determined as follows:
LO 3
2012 2011
Net income $ 91,000 $ 76,500
Less preferred dividends 9,000 9,000
Total $ 82,000 $ 67,500
Common stockholders’ equity:
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%
$82,000 $67,500
$658,500 $618,750
EE 14-10
LO 3
Earnings per Share on Common Stock
 Earnings per share (EPS) on common stock

measures the share of profits that are earned by a
share of common stock. GAAP requires the
reporting of earnings per share in the income
statement.
Net Income – Preferred
Earnings per Share (EPS) on Dividends
Common Stock =
Shares of Common Stock
Outstanding
LO 3
Earnings per Share on Common Stock
Earnings per share for Lincoln Company is

computed below.
2012 2011
Net income $91,000 $76,500
Less preferred dividends 9,000 9,000
Total $82,000 $67,500
Shares of common stock 50,000 50,000
Earnings per share on common stock $1.64 $1.35
$82,000 $67,500
50,000 50,000
LO 3
Price-Earnings Ratio
 Another profitability measure quoted by the
financial press is the price-earnings (P/E) ratio on
common stock. The price-earnings ratio on
common stock measures a company’s future
earnings prospects.
 The price-earnings ratio is computed as follows:
Market Price per Share of

Common Stock
Price-earnings (P/E) ratio =
Earnings per Share on
Common Stock
LO 3
Price-Earnings Ratio
The price-earnings ratio for Lincoln Company is

computed below.
2012 2010
Market price per share of
common stock $41.00 $27.00
Earnings per share on common
stock ÷ $1.64 ÷ $1.35
Price-earnings ratio on
common stock 25 20
EE 14-11
LO 3
Dividends per Share

 Dividends per share can be reported with
earnings per share to indicate the relationship
between dividends and earnings.
 Comparing these two per-share amounts
measures the extent to which earnings are being
distributed to common shareholders. The ratio
for dividends per share is at the top of the next
slide.
LO 3
Dividends per Share
Dividends
Dividends per Share =
Shares of Common Stock
Outstanding
The dividends per share for Lincoln Company are
computed below.
2012 2011
Dividends on common stock $40,000 $30,000
Shares of common stock outstanding ÷ 50,000 ÷ 50,000
Dividends per share of common stock $0.80 $0.60
LO 3
Dividends and Earnings per Share
LO 3
Dividend Yield
 The dividend yield on common stock measures
the rate of return to common stockholders from
cash dividends.
 It is of special interest to investors whose
objective is to earn dividends from their
investment. It is computed as follows:
Dividends per Share of
Common Stock
Dividend Yield =
Market Price per Share of
Common Stock
LO 3
Dividend Yield
The dividend yield for Lincoln Company is

computed below.
2012 2011
Dividends per share of
common stock $ 0.80 $ 0.60
Market price per share of
common stock $41.00 $27.00
Dividend yield on common stock 2.0% 2.2%

$0.60
$0.80
$27
$41
LO 3
Summary of Analytical Measures
(continued)
LO 3
(continued)
LO 3
(concluded)
Describe the
contents of
corporate annual
reports.
LO 4
Corporate Annual Reports

 In addition to the financial statements and the
accompanying notes, corporate annual reports
usually include the following sections:
 Management discussion and analysis
 Report on internal control
 Report on fairness of the financial statements
LO 4
Management Discussion and Analysis
 Management’s Discussion and Analysis (MD&A) is

required in annual reports filed with the SEC.
 It contains management’s analysis of current
operations and its plans for the future.
 Typical items included in the MD&A are:
 Management’s analysis and explanations of any
significant changes between the current and prior year’s
financial statements.
(continued)
LO 4
Management Discussion and Analysis

 Important accounting principles or policies that could
affect interpretation of the financial statements.
 Management’s assessment of the company’s liquidity
and the availability of capital to the company.
 Significant risk exposures that might affect the
company.
 Any “off-balance-sheet” arrangements such as leases
not included directly in the financial statements.
LO 4
Report on Internal Control

 The Sarbanes-Oxley Act of 2002 requires a report
stating management’s responsibility for
establishing and maintaining internal control. In
addition, management’s assessment of the
effectiveness of internal controls over financial
reporting is included in the report.
 It also requires a public accounting firm to verify
management’s conclusions on internal control.
LO 4
Report on Fairness of Financial Statements
 All publicly held corporations are required by the

Sarbanes-Oxley Act of 2002 to have an
independent audit (examination) of their financial
statements. The CPA firm that conducts the audit
renders an opinion on the fairness of the
statements.
Appendix
Unusual
Items on the
Income
Statement
Appendix
Unusual Items on the Income Statement
 Unusual items affecting the current period’s

income statement include the following:
 Discontinued operations
 Extraordinary items
Appendix
Discontinued Operations
 A company may discontinue a segment of its
operations by selling or abandoning the
segment’s operations.
 A note accompanying the income statement
should describe the operations sold, including
such details as the date operations were
discontinued, the assets sold, and the effect (if
any) on current and future operations.
Appendix
Jones Corporation produces and sells electrical
products, hardware supplies, and lawn equipment.
Because of lack of profits, Jones discontinues its
electrical products operation and sells the remaining
inventory and other assets at a loss of $100,000.
Exhibit 11 (next slide) illustrates the reporting of the
loss on the discontinued operations.
Appendix
Appendix
Extraordinary Items
 An extraordinary item is defined as an event or
transaction with both of the following
characteristics:
 Unusual in nature
 Infrequent in occurrence
 A gain from condemnation of land is shown

as an extraordinary item for Jones
Corporation in Exhibit 11 (next slide).
Appendix
Extraordinary Items
Appendix
Reporting Earnings per Share
Financial Statement Analysis
The
The End
End
Prepared by: C. Douglas Cloud
Professor Emeritus of Accounting
Pepperdine University
© 2012 Cengage
permitted Learning. All distributed
in a license Rights Reserved.
with aMay notproduct
certain be copied,
or scanned,
service ororotherwise
duplicated,
on ainpassword-protected
whole or in part, except for for
website useclassroom
as use.

Financial Statement Analysis: Principles of Managerial Accounting

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Financial Statement Analysis: Principles of Managerial Accounting

Uploaded by

Copyright:

Available Formats

Financial Statement Analysis

Principles of Managerial Accounting

Prepared by: C. Douglas Cloud

Reeve Warren Duchac

Basic Analytical Methods

Current Assets $550,000

Liquidity and Solvency Analysis

Liquidity and Solvency Analysis

Current Position Analysis

Working Capital = Current Assets – Current Liabilities

The current ratio for Lincoln Company is computed

Quick assets are cash

The quick ratio for Lincoln Company is computed

Quick ratio 1.3 1.0

Accounts Receivable Turnover

Accounts Receivable Turnover

Accounts receivable turnover 12.7 9.2

Number of Days’ Sales in Receivables

 The number of days’ sales in receivables is an

Number of Days’ Sales in Receivables

Number of days’ sales in receivables 28.6 39.5

Cost of Goods Sold

Inventory turnover 3.8 2.8

Number of Days’ Sales in Inventory

Number of Days’ Sales in Inventory

Average Inventory $273,500 $297,000

Number of Days’ Sales in Inventory

Average Inventory $273,500 $297,000

Number of days’ sales in inventory $1,043,000

Ratio of Fixed Assets to Long-Term Liabilities

 The ratio of fixed assets to long-term liabilities is

Ratio of Fixed Assets to Fixed Assets (net)

Ratio of Fixed Assets to Long-Term Liabilities

To illustrate, the ratio of fixed assets to long-

Ratio of fixed assets to

Ratio of Liabilities to Stockholders’ Equity

 The relationship between the total claims of the

Ratio of Liabilities to Total Liabilities

Ratio of Liabilities to Stockholders’ Equity

The ratio of liabilities to stockholders’ equity for

Number of Times Interest Charges Earned

 Corporations in some industries normally have

Number of Times Interest Charges Earned

Number of Times Interest Charges Earned

Number of times interest

Number of Times Interest Charges Earned

 The number of times interest charges are earned

Ratio of Net Sales to Assets

Ratio of Net Sales to Assets

Excludes long-term investments

Ratio of Net Sales to Assets

Ratio of net sales to assets 1.4 1.2

Rate Earned on Total Assets

Rate Earned on Total Assets

Rate earned on total assets 8.2% 7.3%

Rate Earned on Stockholders’ Equity

Rate Earned on Stockholders’ Equity

Rate earned on stockholders’

Rate Earned on Stockholders’ Equity

Rate Earned on Stockholders’ Equity

For Lincoln Company, the effect of leverage is

Rate Earned on Stockholders’ Equity

Rate Earned on Common Stockholders’ Equity