17-1

TOPIC
ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
 17-2

Financial Statement Analysis

 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

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

 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...
 17-5

Financial Statement Analysis

Information is available from 627 628
 Published annual reports
(1) Financial statements
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditor’s report (Independent
accountants)
(5) Management’s discussion and
analysis
 Reports filed with the government
e.g., Form 10-K, Form 10-Q and Form 8-K
 17-6

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) Financial information organizations
such

as: Moody’s,
Standard & Poor’s, Dun & Bradstreet, Inc.,
and Robert Morris Associates
(4) Other business publications
 Methods of
17-7

Financial Statement Analysis

 Horizontal Analysis
 Vertical Analysis
 Common-Size Statements
 Trend Percentages
 Ratio Analysis
 17-8

Horizontal Analysis

Using comparative financial

statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
 17-9

Vertical Analysis
For a single financial
statement, each item
is expressed as a
percentage of a
significant total,
e.g., all income
statement items are
expressed as a
percentage of sales
 17-10

Common-Size Statements
Financial statements that show
only percentages and no
absolute dollar amounts
 17-11

Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)
 17-12

Ratio Analysis
Expression of logical relationships
between items in a financial
statement of a single period
(e.g., percentage relationship
between revenue and net income)
 17-13

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.
17-14
 17-15

Horizontal Analysis Example

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure
 17-16

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.
 17-17

Horizontal Analysis Example

Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
 17-18

Horizontal Analysis Example

$12,000 – $23,500 = $(11,500)

 17-19

Horizontal Analysis Example

($11,500 ÷ $23,500) × 100% = 48.9%

 17-20

Horizontal Analysis Example

 17-21

Horizontal Analysis Example

Let’s apply the same
procedures to the
liability and stockholders’
equity sections of the
balance sheet.
 17-22

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
 17-23

Horizontal Analysis Example

Now, let’s apply the
procedures to the
income statement.
 17-24

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)
 17-25

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)
 17-26

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)
 17-27

Vertical Analysis Example

The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.
 17-28

Vertical Analysis Example

 17-29

Vertical Analysis Example

$82,000 ÷ $483,000 = 17% rounded

$30,000 ÷ $387,000 = 8% rounded
 17-30

Vertical Analysis Example

$76,000 ÷ $483,000 = 16% rounded

 17-31

Trend Percentages Example

Wheeler, Inc. provides you with the
following operating data and asks that you
prepare a trend analysis.
 17-32

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

 17-33

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
 17-34

Trend line
for Sales
 17-35

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.”
 17-36

Categories of Ratios
 Liquidity Ratios
Indicate a company’s 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
 17-37

10 Ratios You Must Know

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 651

 Total assets turnover

 17-38

10 Ratios You Must Know

Equity (Long-Term Solvency) Ratios
Equity (stockholders’ equity) ratio
 Equity to debt
 17-39

10 Ratios You Must Know

Profitability Tests
 Return on operating assets
Net income to net sales (return on
sales or “profit margin”)
margin” $
Return on average common
stockholders’ equity (ROE)
ROE
 Cash flow margin

Earnings per share

 Times interest earned

 Times preferred dividends earned

 17-40

10 Ratios You Must Know

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
 17-41

Now, let’s look at

Norton
Corporation’s 1999
and 1998 financial
statements.
17-42
17-43
17-44
 17-45

Now, let’s calculate

the 10 ratios based
on Norton’s financial
statements.
 17-46
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
 17-47

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.
 17-48

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.
 17-49

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.
 17-50

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.
 17-51

Acid-Test (Quick) Ratio

#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Acid-Test $50,000
= = 1.19 : 1
Ratio $42,000
 17-52

Accounts Receivable Turnover

Net, credit sales #3 Average, net accounts
receivable
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover
Accounts
$494,000
Receivable = = 26.70 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
 Number of Days’ Sales
17-53

in Accounts Receivable
#4
Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables

Measures, on average, how many

days it takes to collect an
account receivable.
 Number of Days’ Sales
17-54

in Accounts Receivable
#4
Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables

In practice, would 45 days be a

desirable number of days in
receivables?
 17-55

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

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

Measures the number of times

inventory is sold and
replaced during the year.
 17-56

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

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

Would 5 be a
desirable number of times
for inventory to turnover?
 Equity, or Long–Term
17-57

Solvency Ratios
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
 17-58
NORTON CORPORATION
1999
Common shares outstanding
Beginning of year 17,000
End of year 27,400
Net income $ 53,690
Here is the Stockholders' equity
rest of the Beginning of year 180,000
information
we will End of year 234,390
use. Dividends per share 2
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
 17-59

Equity Ratio
#6
Equity Stockholders’ Equity
=
Ratio Total Assets

Equity $234,390
= = 67.7%
Ratio $346,390

Measures the proportion

of total assets provided by
stockholders.
 17-60

Net Income to Net Sales

A/K/A Return on Sales or Profit Margin
#7
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales

Measures the proportion of the sales dollar

which is retained as profit.
 17-61

Net Income to Net Sales

A/K/A Return on Sales or Profit Margin
#7
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales

Would a 1% return on sales be good?

 Return on Average Common
17-62

Stockholders’ Equity (ROE)

#8

Return on Net Income

Stockholders’ = Average Common
Equity Stockholders’ Equity

Return on
$53,690
Stockholders’ = = 25.9%
($180,000 + $234,390) ÷ 2
Equity
Important measure of the
income-producing ability
of a company.
 17-63

Earnings Per Share

#9
Earnings Available to Common Stockholders
Earnings
= Weighted-Average Number of Common
per Share
Shares Outstanding

Earnings $53,690
= = $2.42
per Share (17,000 + 27,400) ÷ 2

The financial press regularly publishes

actual and forecasted EPS amounts.
 17-64

Earnings Per Share

 What’s new from Chap. 15? 644
Weighted-average calculation
Earnings available to
common stockholders
EPS of common stock = _______________________
Weighted-average number of
common shares outstanding
 Three alternatives for calculating
weighted-average number of shares
 17-65

Earnings Per Share

 What’s new from Chap. 15? 645
Weighted-average calculation
Earnings available to
common stockholders
EPS of common stock = _______________________
Weighted-average number of
Alternate #1 common shares outstanding
 17-66

Earnings Per Share

645
Alternate #2

Alternate #3
 17-67

Earnings Per Share

646

¶ EPS and Stock Dividends or Splits

Why restate all prior calculations of EPS?
Comparability - i.e., no additional capital
was
generated by the dividend or split
¶ Primary EPS and Fully Diluted EPS
APB Opinion No. 15
I mentioned this 17-page pronouncement that
required a 100-page explanation in the lecture
for chapter 13.
 17-68

Price-Earnings Ratio
A/K/A P/E Multiple
#10

Price-Earnings Market Price Per Share

=
Ratio EPS
Price-Earnings $20.00
= = 8.3 : 1
Ratio $ 2.42

Provides some measure of whether the

stock is under or overpriced.
 17-69

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
 17-70

Question
The current ratio is a measure of
liquidity that is computed by dividing
total assets by total liabilities.
a. True
b. False
 17-71

Question
The current ratio is a measure of
liquidity that is computed by dividing
total assets by total liabilities.
a. True
b. False The current ratio is a measure of
liquidity, but is computed by
dividing current assets by
current liabilities
 17-72

Question
Quick assets are defined as Cash,
Marketable Securities and net
receivables.
a. True
b. False
 17-73

Question
Quick assets are defined as Cash,
Marketable Securities and net
receivables.
a. True
b. False
 17-74

No more ratios, please!

 17-75

About Test #1
 Will be challenging because the
material covered is challenging
 All questions are T/F or M/C
Questions are 5-pt., 3-pt. & 1-pt.
 No tricks such as patterns in answers
Order of answers is random
 Coverage is even over the 4 chapters
 Time allowed: 75 minutes
 17-76

About Test #1
 Best way to study
 Notes first
 Study guide and/or Hermanson tutorials
 Calculators will be provided
 Must wait outside classroom
 Have your questions ready for next
actual class
 See course home page for office hours