17-1

ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
 17-2

Financial Statement Analysis

 What is financial statement
analysis?
”Tearing apart” the financial
statements

and looking at the

relationships
 17-3

Financial Statement Analysis

625
Who analyzes financial statements?
 Internal users (i.e., management)
 External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors
 17-4

Financial Statement Analysis

Information is available from 627 628
 Other sources
(1) Newspapers (e.g., Wall Street Journal )
(2) Periodicals (e.g. Forbes, Fortune)
(3) Other business publications
 Methods of
17-5

Financial Statement Analysis

 Horizontal Analysis
 Vertical Analysis
 Common-Size Statements
 Trend Percentages
 Ratio Analysis
 17-6

Horizontal 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
 17-7

Vertical Analysis
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 areare
expressed
expressed as as aa
percentage
percentage of of sales
sales
 17-8

Common-Size Statements
Financial
Financial statements
statements that
that show
show
only
only percentages
percentages and
and no
no
absolute
absolute dollar
dollar amounts
amounts
 17-9

Ratio Analysis
Expression
Expression of of logical
logical relationships
relationships
between
between items
items in in aa financial
financial
statement
statement ofof aa single
single period
period
(e.g.,
(e.g., percentage
percentage relationship
relationship
between
between revenue
revenue andand netnet income)
income)
 17-10

Horizontal Analysis Example

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.
17-11
 17-12

Horizontal Analysis Example

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure
 17-13

Horizontal Analysis Example

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

Since we are measuring the amount of

the change between 1998 and 1999, the
dollar amounts for 1998 become the
“base” year figures.
 17-14

Horizontal Analysis Example

Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
 17-15

Horizontal Analysis Example

₱ 12,000 – ₱ 23,500 = ₱
(11,500)
 17-16

Horizontal Analysis Example

(₱ 11,500 ÷ ₱ 23,500) × 100% = 48.9%

 17-18

Horizontal Analysis Example

Let’s apply the same
procedures to the
liability and stockholders’
equity sections of the
balance sheet.
 17-19

CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
 17-20

Horizontal Analysis Example

Now, let’s apply the
procedures to the
income statement.
 17-21

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)
 17-22

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)
Sales increased by 8.3% while net
Net income before taxes 25,000 32,000 (7,000) (21.9)
income decreased
Less income taxes (30%) 7,500
by 21.9%.
9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
 17-23

There were increases in both cost of goods

sold (14.3%) and operating expenses (2.1%).
These increased costs
CLOVERmore than offset the
CORPORATION
increase inComparative
sales, yielding anStatements
Income overall
Fordecrease
the Years Ended
in netDecember
income. 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)
 17-24

Vertical Analysis Example

The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.
 17-25

Vertical Analysis Example

 17-26

Vertical Analysis Example

₱ 82,000 ÷ ₱ 483,000 = 17% rounded

₱ 30,000 ÷ ₱ 387,000 = 8% rounded
 17-27

Vertical Analysis Example

₱ 76,000 ÷ ₱ 483,000 = 16% rounded

 17-28

Trend Percentages Example

Wheeler, Inc. provides you with the
following operating data and asks that you
prepare a trend analysis.
 17-29

Trend Percentages Example

 Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.

₱ 1,991 - ₱ 1,820 = ₱ 171

 17-30

Trend Percentages Example

Using 1995 as the base year, we develop
the following percentage relationships.

₱ 1,991 - ₱ 1,820 = ₱ 171

₱ 171 ÷ ₱ 1,820 = 9% rounded
 17-32

Ratios
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 be
hazardous to your health!”
lead to incorrect conclusions.”
 17-33

Categories of Ratios
 Liquidity Ratios
Indicate a company’s short-term
debt-paying ability
 Efficiency Ratios
How efficient the company is in terms of
collection period and producing sales
 Leverage (Long-Term Solvency) Ratios
Show relationship between debt and equity
financing in a company
 Profitability Tests
Relate income to other variables
 17-34

Ratios You Must Know

Liquidity Ratios
Current (working capital) ratio
Acid-test (quick) ratio

Efficiency Ratios
Accounts receivable turnover
Average collection period
Inventory turnover
Total assets turnover
Fixed asset turnover
 17-35

Ratios You Must Know

Leverage Ratios
Debt Ratio
Equity Ratio
Times interest earned ₱
Profitability Tests
Gross profit margin
Net profit margin
Operating Profit Margin
Operating income return on investment
 17-36

Now, let’s look at

Norton
Corporation’s 1999
and 1998 financial
statements.
17-37
17-38
17-39
 17-40

Now, let’s calculate

the ratios based on
Norton’s financial
statements.
 17-41
NORTON CORPORATION
1999
Cash $ 30,000
Accounts receivable, net
We will Beginning of year 17,000
use this End of year 20,000
information Inventory
to calculate Beginning of year 10,000
the liquidity
End of year 12,000
ratios for
Total current assets 65,000
Norton.
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000
 17-42

Working Capital*
The excess of current assets over
current liabilities.
12/31/99
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
* While this is not a ratio, it does give an
indication of a company’s liquidity.
 17-43

Current (Working Capital) Ratio

#1
Current Current Assets
=
Ratio Current Liabilities

Current = ₱ 65,000 = 1.55 : 1

Ratio ₱ 42,000

Measures the ability

of the company to pay current
debts as they become due.
 17-44

Acid-Test (Quick) Ratio

#2
Acid-Test Quick Assets
=
Ratio Current Liabilities

Quick assets are Cash,

Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
 17-45

Acid-Test (Quick) Ratio

#2
Acid-Test Quick Assets
=
Ratio Current Liabilities

Norton Corporation’s quick

assets consist of cash of ₱
30,000 and accounts
receivable of ₱ 20,000.
 17-46

Acid-Test (Quick) Ratio

#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Acid-Test ₱ 50,000
= = 1.19 : 1
Ratio ₱ 42,000

Indicated the ability to

pay current obligations
from the more liquid
current assets.
17-47
17-48
 17-49

Accounts Receivable Turnover

Net, credit sales #3 Average, net accounts
receivable
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover
Accounts
₱ 494,000
Receivable = = 24.70 times
(₱ 20,000)
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
 Number of Days’ Sales
17-50

in Accounts Receivable
#4
Days’ Sales
Accounts Receivable Turnover
in Accounts =
Sales / 365 Days
Receivables
Days’ Sales
₱ 20,000
in Accounts =
₱ 494,000 / 365 = 14.78 days
Receivables
Measures, on average, how many
days it takes to collect an
account receivable.

In practice, would 14.78 days be a

desirable number of days in receivables?
 17-51

Inventory Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory ₱ 140,000
= = 14 times
Turnover ₱ 10,000

Measures the number of times

inventory is sold and
replaced during the year.
 17-52

Fixed Asset Turnover

#6
Fixed Asset Sales
=
Turnover Total Fixed Asset

Fixed Asset ₱ 494,000

= = 1.76 times
Turnover ₱ 281,390

Fixed asset were used by the

company to produce sales
 17-53

Total Asset Turnover

#7
Total Asset Sales
=
Turnover Total Asset

Total Asset ₱ 494,000

= = 1.43 times
Turnover ₱ 346,390

Total resources of
the company were used
during the year to
produce sales
 17-54

Debt Ratio
#8
Debt Ratio Total Liabilities
=
Total Asset

Debt Ratio ₱ 112,000

= = 32 %
₱ 346,390
The company total liabilities
Accounted of its total assets

Indicates what portion

of total assets is provided
by the creditors
 17-55

Equity Ratio
#9
Equity Ratio = Total Equity
Total Asset
Equity ₱ 234,390
= = 68 %
Ratio ₱ 346,390

Indicates what portion

of total assets is provided
by the owners or stockholder
 17-56

This is part of the information to

calculate the equity, or long-term
solvency ratios of Norton Corporation.
NORTON CORPORATION
1999
Net operating income $ 84,000
Net sales 494,000
Interest expense 7,300
Total stockholders' equity 234,390
 17-57

Time Interest earned

#10
Time interest NOI or EBIT
=
earned Interest expense

Time interest ₱ 84,000

= = 11.5 times
earned ₱ 7,300

For 1 year the company

Was able to pay its interest
17-58
 17-59

Gross Profit Margin

#11 How well the firm’s
management control
Gross Gross profit its expenses
=
Profit Margin Sales
Gross ₱ 76,700
profit margin = ₱ 494,000
= 16 %

Gross profit of the

company’s realize sales
plus, cost of sales accounted To determine the adequacy of
to 100% gross margin to cover
operating expenses and
provide desired profit.
 17-60

Net Profit Margin

#12

Net Profit margin = Net Income after tax

Net Sales
Net profit margin = ₱ 53,690 = 10.87%
₱ 494,000

Measures the proportion of the sales

which is retained as profit.
 17-61

Operating Profit Margin

#13

Operating Profit Margin = EBIT or NOI

Net Sales

Operating Profit Margin = ₱ 84,000

₱ 494,000 = 17 %

How much profit generated from each

sales after accounting for both
COGS and operating expenses

Indicates what portion of sales is

absorbed by operating costs.
 Operating Income return on
17-62

Investment
#14
Operating
Income Net Operating Income
= Total Asset
return on
investment
Return on ₱ 84,000
Stockholders’ = = 24.25%
₱ 346,390
Equity
Investor’s return on his
business contribution from
his/her original contribution
 17-63

Important Considerations
 Need for comparable data
 Data is provided by Dun &
Bradstreet, Standard & Poor’s etc.
 Must compare by industry
 Is EPS comparable?
 Influence of external factors
 General business conditions
 Seasonal nature of business operations
 Impact of inflation
 17-64

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
b.
b. False
False
 17-65

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
b.
b. False
False The
The current
current ratio
ratio is
is aa measure
measure of
of
liquidity,
liquidity, but
but is
is computed
computed byby
dividing
dividing current
current assets
assets by
by
current
current liabilities
liabilities
 17-66

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
 17-67

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
 17-68

No more ratios, please!