Financial Statement Analysis: Warren Reeve Duchac

Example Exercise
CHAPTER
Financial Statement
17 Analysis
Accounting
26e
Warren
Reeve
Duchac
Learning Objectives
• LO1: Describe basic financial statement analytical

methods.
• LO2: Use financial statement analysis to assess the
solvency of a business.
• LO3: Use financial statement analysis to assess the
profitability of a business.
• LO4: Describe the contents of corporate annual
reports.
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Basic Analytical Methods
• Users analyze a company’s financial statements using

a variety of analytical methods. Three such methods
are:
o Horizontal analysis
o Vertical analysis
o Common-sized statements
Horizontal Analysis (slide 1 of 2)
• The analysis of increases and decreases in the amount

and percentage of comparative financial statement
items is called horizontal analysis.
o Each item on the most recent statement is compared with
the same item on one or more earlier statements in terms of
the following:
 Amount of increase or decrease
 Percent of increase or decrease
Horizontal Analysis (slide 2 of 2)
• When comparing statements, the earlier statement is

normally used as the base year for computing
increases and decreases.
Comparative Balance Sheet - Horizontal Analysis
Comparative Schedule of Current Assets -
Horizontal Analysis
Comparative Income Statement - Horizontal
Analysis
Comparative Retained Earnings Statement -
Horizontal Analysis
Example Exercise Horizontal Analysis
The comparative cash and accounts receivable balances

for a company follow:
Based on this information, what is the amount and

percentage of increase or decrease that would be
shown on a balance sheet with horizontal analysis?
©2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in
part.
Vertical Analysis (slide 1 of 3)
• The percentage analysis of the relationship of each

component in a financial statement to a total within
the statement is called vertical analysis.
• In a vertical analysis of the balance sheet, the

percentages are computed as follows:
o Each asset item is stated as a percent of the total assets.
o Each liability and stockholders’ equity item is stated as a
percent of the total liabilities and stockholders’ equity.
Comparative Balance Sheet - Vertical Analysis
• In a vertical analysis of the income statement, each

item is stated as a percent of sales.
Comparative Income Statement - Vertical
Analysis
Example Exercise Vertical Analysis
Income statement information for Lee Corporation

follows:
Prepare a vertical analysis of the income statement for

Lee Corporation.
part.
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
one company with another or comparing a company
with industry averages.
Common-Sized Income Statements
Liquidity and Solvency Analysis (slide 1 of 2)
• All users of financial statements are interested in the

ability of a company to do the following:
o Maintain liquidity and solvency
o Earn income, called profitability
• The ability of a company to convert assets into cash is

called liquidity, while the ability of a company to pay
its debts is called solvency.
• Liquidity, solvency, and profitability are interrelated.
• Liquidity and solvency are normally assessed using the following:

o Current position analysis
 Working capital
 Current ratio
 Quick ratio
o Accounts Receivable analysis
 Accounts receivable turnover
 Number of days’ sales in receivables
o Inventory analysis
 Inventory turnover
 Number of days’ sales in inventory
o The ratio of fixed assets to long-term liabilities
o The ratio of liabilities to stockholders’ equity
o The number of times interest charges are earned
Current Position Analysis
• A company’s ability to pay its current liabilities is

called current position analysis.
• Current position analysis is a solvency measure of
special interest to short-term creditors and includes
the computation and analysis of the following:
o Working Capital
o Current ratio
o Quick ratio
Current Position Analysis: Working Capital (slide
1 of 3)
• A company’s working capital is computed as

follows:
2 of 3)
• The working capital for Lincoln Company for 2016

and 2015 is computed as follows:
3 of 3)
• Working capital is used to evaluate a company’s

ability to pay current liabilities.
• A company’s working capital is often monitored
monthly, quarterly, or yearly by creditors and other
debtors.
Current Position Analysis: Current Ratio (slide 1 of
3)
• The current ratio is computed as follows:
3)
• The current ratio for Lincoln Company is computed

as follows:
3)
• The current ratio is a more reliable indicator of a

company’s ability to pay its current liabilities than is
working capital.
Current Position Analysis: Quick Ratio (slide 1 of 2)
• A ratio that measures the “instant” debt-paying ability

of a company is the quick ratio, sometimes called the
acid-test ratio.
• The quick ratio is computed as follows:
o Quick assets are cash and other current assets that can be
easily converted to cash.
 Quick assets include cash, temporary investments, and receivables
but exclude inventories and prepaid assets.
Current Position Analysis: Quick Ratio (slide 2 of 2)
• The quick ratio for Lincoln Company is computed as

follows:
Example Exercise Current Position Analysis, Part 2
The following items are reported on a company’s

balance sheet:
Determine (a) the current ratio and (b) the quick ratio.
part.
Accounts Receivable Analysis (slide 1 of 2)
• A company’s ability to collect its accounts receivable

is called accounts receivable analysis.
• Accounts receivable analysis includes:
o Accounts receivable turnover
o Number of days’ sales in receivables
Accounts Receivable Analysis (slide 2 of 2)
• Quick collection of accounts receivable does the

following:
o Improves a company’s liquidity
o Reduces the risk of uncollectible accounts
o Provides cash to improve or expand operations
Accounts Receivable Analysis: Accounts
Receivable Turnover (slide 1 of 2)
• The accounts receivable turnover is computed as
follows:
Accounts Receivable Analysis: Accounts
Receivable Turnover (slide 2 of 2)
• The accounts receivable turnover for Lincoln
Company for 2016 and 2015 is computed as follows:
Accounts Receivable Analysis: Number of
Days’ Sales in Receivables (slide 1 of 3)
• The number of days’ sales in receivables is

computed as follows:
where
• The number of days’ sales in receivables for Lincoln
Company is computed as follows:
• The number of days’ sales in receivables is an
estimate of the time (in days) that the accounts
receivable have been outstanding.
• The number of days’ sales in receivables is often
compared with a company’s credit terms to evaluate
the efficiency of the collection of receivables.
Example Exercise Accounts Receivable Analysis
A company reports the following:
Determine (a) the accounts receivable turnover and (b)

the number of days’ sales in receivables. Round to one
decimal place.
part.
Inventory Analysis (slide 1 of 2)
• A company’s ability to manage its inventory

effectively is evaluated using inventory analysis.
• Inventory analysis includes the computation and
analysis of the following:
o Inventory turnover
o Number of days’ sales in inventory
Inventory Analysis (slide 2 of 2)
• Excess inventory does the following:

o Decreases liquidity by tying up funds (cash) in inventory
o Increases insurance expense, property taxes, storage costs
and other related expenses
o Increases the risk of losses because of price declines or
obsolescence of the inventory
Inventory Analysis: Inventory Turnover (slide 1 of 2)
• The inventory turnover is computed as follows:
Inventory Analysis: Inventory Turnover (slide 2 of 2)
• The inventory turnover for Lincoln Company for

2016 and 2015 is computed as follows:
Inventory Analysis: Number of Days’ Sales in
Inventory (slide 1 of 3)
• The number of days’ sales in inventory is computed

as follows:
where
• The number of days’ sales in inventory for Lincoln
• The number of days’ sales in inventory is a rough
estimate of the length of time it takes to purchase,
sell, and replace the inventory.
Example Exercise Inventory Analysis
Determine (a) the inventory turnover and (b) the

number of days’ sales in inventory. Round to one
decimal place.
part.
Ratio of Fixed Assets to Long-Term Liabilities
(slide 1 of 2)
• The ratio of fixed assets to long-term liabilities

provides a measure of whether noteholders or
bondholders will be paid.
• Because fixed assets are often pledged as security for
long-term notes and bonds, it is computed as follows:
Ratio of Fixed Assets to Long-Term Liabilities
(slide 2 of 2)
• The ratio of fixed assets to long-term liabilities for Lincoln

Ratio of Liabilities to Stockholders’ Equity (slide 1
of 2)
• The ratio of liabilities to stockholders’ equity measures how

much of the company is financed by debt (creditors) and equity
(owners). It indicates the margin of safety for creditors.
• The ratio of liabilities to stockholders’ equity is computed as:
Ratio of Liabilities to Stockholders’ Equity (slide 2
of 2)
• The ratio of liabilities to stockholders’ equity for Lincoln

Example Exercise Long-Term Solvency Analysis
The following information was taken from Acme

Company’s balance sheet:
Determine the company’s (a) ratio of fixed assets to

long-term liabilities and (b) ratio of liabilities to total
stockholders’ equity.
part.
Number of Times Interest Charges Are Earned
(slide 1 of 3)
• The number of times interest charges are earned,

sometimes called the fixed charge coverage ratio,
measures the risk that interest payments will not be
made if earnings decrease.
• The number of times interest charges are earned is
• The higher the ratio the more likely interest payments

will be paid if earnings decrease.
(slide 2 of 3)
• The number of times interest charges are earned for

Lincoln Company is computed as follows:
(slide 3 of 3)
• 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:
• The higher the ratio, the more likely preferred

dividend payments will be paid if earnings decrease.
Example Exercise Times Interest Charges Are Earned
Determine the number of times interest charges are

earned.
part.
Profitability Analysis (slide 1 of 2)
• Profitability analysis focuses on the ability of a

company to earn profits.
o This ability is reflected in the company’s operating results,
as reported in its income statement.
o This ability also depends on the assets the company has
available for use in its operations, as reported in its balance
sheet.
Profitability Analysis (slide 2 of 2)
• Common profitability analyses include the following:

o Ratio of sales to assets
o Rate earned on total assets
o Rate earned on stockholders’ equity
o Rate earned on common stockholders’ equity
o Earnings per share on common stock
o Price-earnings ratio
o Dividends per share
o Dividend yield
Ratio of Sales to Assets (slide 1 of 2)
• The ratio of sales to assets measures how effectively

a company uses its assets.
• The ratio of sales to assets is computed as follows:
Ratio of Sales to Assets (slide 2 of 2)
• The ratio of sales to assets for Lincoln Company is

Example Exercise Sales to Assets
Determine the ratio of sales to assets.
part.
Rate Earned on Total Assets (slide 1 of 3)
• The rate earned on total assets measures the

profitability of total assets, without considering how
the assets are financed.
o In other words, this rate is not affected by the portion of
assets financed by creditors or stockholders.
• The rate earned on total assets is computed as
follows:
• The rate earned on total assets by Lincoln Company

• The rate earned on operating assets is sometimes

computed when there are large amounts of
nonoperating income and expense.
• The rate earned on operating assets is computed as
follows:
Example Exercise Rate Earned on Total Assets
A company reports the following income statement and

balance sheet information for the current year:
Determine the rate earned on total assets.
part.
Rate Earned on Stockholders’ Equity (slide 1 of 4)
• The rate earned on stockholders’ equity measures

the rate of income earned on the amount invested by
the stockholders.
• The rate earned on stockholders’ equity is computed
as follows:
• The rate earned on stockholders’ equity for Lincoln

• The rate earned on stockholders’ equity is normally

higher than the rate earned on total assets.
o This is because of the effect of leverage.
 Leverage involves using debt to increase the return on an
investment.
• For Lincoln Company, the effect of leverage for 2016

and 2015 is computed as follows:
Effect of Leverage
Rate Earned on Common Stockholders’ Equity
(slide 1 of 3)
• The rate earned on stockholders’ equity measures

the rate of profits earned on the amount invested by
the stockholders.
• The rate earned on stockholders’ equity is computed
as follows:
(slide 2 of 3)
• The rate earned on common stockholders’ equity for

Lincoln is computed as follows:
(slide 3 of 3)
• Lincoln’s rate earned on common stockholders’

equity differs from the rates earned on total assets and
stockholders’ equity because of leverage.
Example Exercise Common Stockholders’ Profitability
Analysis
Determine (a) the rate earned on stockholders’ equity

and (b) the rate earned on common stockholders’
equity.
part.
Earnings per Share on Common Stock (slide 1 of 3)
• Earnings per share (EPS) on common stock

measures the share of profits that are earned by a
share of common stock.
• Earnings per share must be reported in the income
statement.
• EPS on common stock is computed as follows:
• The earnings per share (EPS) of common stock for

Lincoln Company is computed as follows:
• Many corporations have complex capital structures

with various types of equity securities outstanding,
such as convertible preferred stock, stock options,
and stock warrants.
• In such cases, the possible effects of such securities
on the shares of common stock outstanding are
reported separately as earnings per common share
assuming dilution or diluted earnings per share.
Price-Earnings Ratio (slide 1 of 2)
• The price-earnings (P/E) ratio on common stock

measures a company’s future earnings prospects.
• The price-earnings ratio is computed as follows:
Price-Earnings Ratio (slide 2 of 2)
• The price-earnings (P/E) ratio for Lincoln Company

Example Exercise Earnings per Share and Price-Earnings
Ratio
a. Determine the company’s earnings per share on common

stock.
b. Determine the company’s price-earnings ratio. Round to one
decimal place.
part.
Dividends per Share (slide 1 of 3)
• Dividends per share measures the extent to which

earnings are being distributed to common
shareholders.
• Dividends per share is computed as follows:
• The dividends per share for Lincoln Company are

• Comparing dividends per share and earnings per

share indicates the extent to which earnings are being
retained for use in operations.
Dividends and Earnings per Share of Common
Stock
Dividend Yield (slide 1 of 2)
• 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 revenue (dividends) from their investment.
• The dividend yield is computed as follows:
Dividend Yield (slide 2 of 2)
• The dividend yield for Lincoln Company is computed

as follows:
Summary of Analytical Measures (slide 1 of 2)
Summary of Analytical Measures (slide 2 of 2)
Corporate Annual Reports
• In addition to the financial statements and the

accompanying notes, corporate annual reports
normally include the following sections:
o Management discussion and analysis
o Report on internal control
o Report on fairness of the financial statements
Management Discussion and Analysis
• Management’s Discussion and Analysis (MD&A) is required in annual

reports filed with the Securities and Exchange Commission.
• It includes management’s analysis of current operations and its plans for the
future.
• Typical items included in the MD&A are:
o Management’s analysis and explanations of any significant changes between
the current and prior years’ financial statements.
o Important accounting principles or policies that could affect interpretation of
the financial statements, including the effect of changes in accounting
principles or the adoption of new accounting principles.
o Management’s assessment of the company’s liquidity and the availability of
capital to the company.
o Significant risk exposures that might affect the company.
o Any “off-balance-sheet” arrangements such as leases not included directly in
the financial statements.
Report on Internal Control (slide 1 of 2)
• The Sarbanes-Oxley Act of 2002 requires a report by

management.
o The report states management’s responsibility for
establishing and maintaining internal control.
o In addition, management’s assessment of the effectiveness
of internal controls over financial reporting is included in
the report.
Report on Internal Control (slide 2 of 2)
• Sarbanes-Oxley also requires a public accounting

firm to verify management’s conclusions on internal
control.
o Thus, two reports on internal control, one by management
and one by a public accounting firm, are included in the
annual report.
Report on Fairness of the Financial Statements
• All publicly held corporations are required to have an

independent audit (examination) of their financial statements.
• The Certified Public Accounting (CPA) firm that conducts the
audit renders an opinion, called the Report of Independent
Registered Public Accounting Firm, on the fairness of the
statements.
o An opinion stating that the financial statements present fairly the
financial position, results of operations, and cash flows of the company
is said to be an unqualified opinion, sometimes called a clean opinion.
o Any report other than an unqualified opinion raises a “red flag” for
financial statement users and requires further investigation as to its
cause.
Appendix: Unusual Items on the Income
Statement
• Generally accepted accounting principles require that

unusual items be reported separately on the income
statement.
o This is because such items do not occur frequently and are
typically unrelated to current operations.
• Unusual items on the income statement are classified
as one of the following:
o Affecting the current period income statement
o Affecting a prior period income statement
Appendix: Unusual Items Affecting the Current
Period’s Income Statement
• Unusual items affecting the current period’s income

statement include the following:
o Discontinued operations
o Extraordinary items
Period’s Income Statement - Discontinued Operations
• A company may discontinue a component of its

operations by selling or abandoning the component’s
operations.
o If the discontinued component is (1) the result of a strategic
shift and (2) has a major effect on the entity’s operations
and financial results, any gain or loss on discontinued
operations is reported on the income statement as a Gain
(or loss) from discontinued operations.
o A note to the financial statements should describe the
operations sold, including the date operations were
discontinued, and details about the assets, liabilities,
income, and expenses of the discontinued component.
Period’s Income Statement - Extraordinary Items
• An extraordinary item is defined as an event or transaction

with both of the following characteristics:
o Unusual in nature
o Infrequent in occurrence
• Examples include the following:
o Gains and losses from natural disasters such as floods, earthquakes,
and fires provided that they occur infrequently
o Gains or losses from land or buildings taken (condemned) for public
use
• Any gain or loss from extraordinary items is reported on the
income statement as Gain (or loss) from extraordinary item.
Unusual Items in the Income Statement
Period’s Income Statement - Reporting Earnings per
Share
• Earnings per common share should be prepared
separately in the notes to the financial statements for
discontinued operations and extraordinary items.
Income Statement with Earnings per Share
Appendix: Unusual Items Affecting the Prior
Period’s Income Statement
• An unusual item may occur that affects a prior

period’s income statement.
o Two such items are as follows:
 Errors in applying generally accepted accounting principles
 Changes from one generally accepted accounting principle to
another

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Example Exercise

• LO1: Describe basic financial statement analytical

• Users analyze a company’s financial statements using

• The analysis of increases and decreases in the amount

• When comparing statements, the earlier statement is

The comparative cash and accounts receivable balances

Based on this information, what is the amount and

• The percentage analysis of the relationship of each

• In a vertical analysis of the balance sheet, the

• In a vertical analysis of the income statement, each

Income statement information for Lee Corporation

Prepare a vertical analysis of the income statement for

• In a common-sized statement, all items are

• All users of financial statements are interested in the

• The ability of a company to convert assets into cash is

• Liquidity and solvency are normally assessed using the following:

• A company’s ability to pay its current liabilities is

• A company’s working capital is computed as

• The working capital for Lincoln Company for 2016

• Working capital is used to evaluate a company’s

• The current ratio is computed as follows:

• The current ratio for Lincoln Company is computed

• The current ratio is a more reliable indicator of a

• A ratio that measures the “instant” debt-paying ability

• The quick ratio for Lincoln Company is computed as

The following items are reported on a company’s

• A company’s ability to collect its accounts receivable

• Quick collection of accounts receivable does the

• The number of days’ sales in receivables is

A company reports the following:

Determine (a) the accounts receivable turnover and (b)

• A company’s ability to manage its inventory

• Excess inventory does the following:

• The inventory turnover is computed as follows:

• The inventory turnover for Lincoln Company for

• The number of days’ sales in inventory is computed

A company reports the following:

Determine (a) the inventory turnover and (b) the

• The ratio of fixed assets to long-term liabilities

• The ratio of fixed assets to long-term liabilities for Lincoln

• The ratio of liabilities to stockholders’ equity measures how

• The ratio of liabilities to stockholders’ equity for Lincoln

The following information was taken from Acme

Determine the company’s (a) ratio of fixed assets to

• The number of times interest charges are earned,

• The higher the ratio the more likely interest payments

• The number of times interest charges are earned for

• The number of times interest charges are earned can

• The higher the ratio, the more likely preferred

A company reports the following:

Determine the number of times interest charges are

• Profitability analysis focuses on the ability of a

• Common profitability analyses include the following:

• The ratio of sales to assets measures how effectively

• The ratio of sales to assets for Lincoln Company is

A company reports the following:

Determine the ratio of sales to assets.

• The rate earned on total assets measures the

• The rate earned on total assets by Lincoln Company

• The rate earned on operating assets is sometimes

A company reports the following income statement and

Determine the rate earned on total assets.

• The rate earned on stockholders’ equity measures