Analysis of Financial Statements

Chapter 17

Wild and Shaw

Fundamental Accounting Principles
24th Edition

Copyright ©2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 17 Learning Objectives
CONCEPTUAL
C1 Explain the purpose and identify the building blocks of analysis.
C2 Describe standards for comparisons in analysis.

ANALYTICAL
A1 Summarize and report results of analysis.
A2 Appendix 17A—Explain the form and assess the content of a complete income statement.

PROCEDURAL
P1 Explain and apply methods of horizontal analysis.
P2 Describe and apply methods of vertical analysis.
P3 Define and apply ratio analysis.

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 Learning Objective C1

Explain the purpose and

identify the building blocks of
analysis.

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Purpose of Analysis
Common goal of financial statement analysis for
both external and internal users is evaluate
company performance and financial condition
and to assist in evaluating:
1. Past and current performance
2. Current financial position
3. Future performance and risk
Internal Users External Users
Managers Shareholders
Officers Lenders
Internal Auditors Suppliers
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Learning Objective C1: Explain the purpose and identify the building blocks of analysis.
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Building Blocks of Analysis

Liquidity and
Solvency
efficiency

Market
Profitability prospects

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Learning Objective C1: Explain the purpose and identify the building blocks of analysis.
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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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Learning Objective C1: Explain the purpose and identify the building blocks of analysis.
Learning Objective C2

Describe standards for

comparisons in analysis.

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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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Learning Objective C2: Describe standards for comparisons in analysis.
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Tools of Analysis
Horizontal Analysis
Comparing the financial condition and
performance across time.

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

Ratio Analysis
Measurement of key relations between financial
statement items.
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Learning Objective C2: Describe standards for comparisons in analysis.
 Learning Objective P1

Explain and apply methods of

horizontal analysis.

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Horizontal Analysis
Horizontal analysis refers to examination of
financial statement data across time.
Horizontal analysis is the review
of financial statement data
across time.

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Learning Objective P1: Explain and apply methods of horizontal analysis.
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Comparative Statements:
Dollar Change
Dollar Analysis period Base period
change = amount – amount

• When measuring the amount of the change in

dollar amounts, compare the analysis period to the
base period.
• The analysis period refers to the financial
statements under analysis.
• The base period refers to the financial statements
used for comparison.

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Learning Objective P1: Explain and apply methods of horizontal analysis.
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Comparative Statements:
Percent Change
Analysis period amount – Base period amount
%
change
=
Base period amount
× 100

When calculating the change as a percentage,

divide the amount of the dollar change by the base
period amount, and then multiply by 100 to convert
to a percentage.

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Learning Objective P1: Explain and apply methods of horizontal analysis.
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Comparative Balance Sheets

Exhibit
17.1

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Learning Objective P1: Explain and apply methods of horizontal analysis.
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Comparative Income Statements

Exhibit
17.2

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Learning Objective P1: Explain and apply methods of horizontal analysis.
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Trend Analysis
Trend analysis is used to reveal patterns in data
across periods.

Trend
Analysis period amount
Percent =
Base period amount × 100
(%)

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Learning Objective P1: Explain and apply methods of horizontal analysis.
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Trend Analysis (continued)

Exhibit
17.3

Using the number reported 4 years ago as the

base year, we will get the following trend percents:

Exhibit
17.4

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Learning Objective P1: Explain and apply methods of horizontal analysis.
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Line Graph of Trend Percents

Exhibit
17.5

We can use the trend percentages to construct a

graph so we can see the trend over time.

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Learning Objective P1: Explain and apply methods of horizontal analysis.
 Learning Objective P2

Describe and apply methods of

vertical analysis.

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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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Learning Objective P2: Describe and apply methods of vertical analysis.
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Common-Size Balance Sheet

Exhibit
17.8

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Learning Objective P2: Describe and apply methods of vertical analysis.
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Common-Size Income Statement

Exhibit
17.9

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Learning Objective P2: Describe and apply methods of vertical analysis.
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Common-Size Graphics Exhibit

Common-Size Graphic of 17.12
Exhibit
Asset Components
17.10

Common-Size Graphic of
Income Statement

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Learning Objective P2: Describe and apply methods of vertical analysis.
 Learning Objective P3

Define and apply ratio analysis.

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Ratio Analysis

Liquidity
and Solvency
efficiency

Market
Profitability prospects

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Learning Objective P3: Define and apply ratio analysis.
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Liquidity and Efficiency

Current Inventory
Ratio Turnover

Acid-test Days’ Sales

Ratio Uncollected

Accounts Days’ Sales

Receivable in Inventory
Turnover

Total Asset
Turnover
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Learning Objective P3: Define and apply ratio analysis.
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Working Capital
Working capital is the amount of current
assets minus current liabilities.

  Current assets
– Current liabilities
= Working capital
   
More working capital suggests a strong liquidity
position and an ability to pay debts or continue
operating.

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Learning Objective P3: Define and apply ratio analysis.
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Current Ratio
Current assets
Current ratio =
Current liabilities

• This ratio measures the short-term debt-

paying ability of the company.
• A higher current ratio suggests a strong
ability to meet current obligations.

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Learning Objective P3: Define and apply ratio analysis.
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Acid-Test Ratio
Cash + Short-term investments +
Acid-test ratio = Current receivables
Current liabilities
Referred to as Quick Assets

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

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Learning Objective P3: Define and apply ratio analysis.
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Accounts Receivable Turnover

Net sales
Accounts receivable =
turnover Average accounts receivable,
net
(Beg Accts. Rec. + End Accts. Rec.)
Average accounts receivable =
2

This ratio measures how

many times a company
converts its receivables
into cash.
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Learning Objective P3: Define and apply ratio analysis.
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Inventory Turnover
Cost of goods sold
Inventory turnover =
Average inventory

Average inventory = (Beginning inventory + Ending inventory)

2

This ratio measures the how

long a company holds
inventory before selling it.

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Learning Objective P3: Define and apply ratio analysis.
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Days’ Sales Uncollected

Accounts receivable, net
Day's sales =
× 365
uncollected
Net sales

This ratio measures how frequently a

company collects its accounts receivable.

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Learning Objective P3: Define and apply ratio analysis.
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Days’ Sales in Inventory

Day's sales in = Ending inventory

× 365
Inventory
Cost of goods sold
This ratio is a useful measure in evaluating
inventory liquidity.
Used to evaluate inventory liquidity.

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Learning Objective P3: Define and apply ratio analysis.
 17 - 34

Total Asset Turnover

Net sales
Total asset turnover =
Average total assets

(Beginning assets + Ending assets)

Average assets =
2

• This ratio measures a

company’s ability to use its
assets to generate sales.
• It is an important indication of
operating efficiency.

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Learning Objective P3: Define and apply ratio analysis.
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Solvency
Debt
Ratio

Equity
Ratio

Debt-to-Equity
Ratio

Times
Interest
Earned
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Learning Objective P3: Define and apply ratio analysis.
 17 - 36

Debt Ratio and Equity Ratio

$241,272 ÷ $375,319 = 64.3%

• The debt ratio shows total liabilities as a percent of total

assets.
• The equity ratio shows total equity as a percent of total
assets.

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Learning Objective P3: Define and apply ratio analysis.
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Debt-to-Equity Ratio
Total liabilities  
Debt-to-equity ratio =
Total equity  

This ratio measures what portion of a company’s

assets are contributed by creditors. A larger debt-to-
equity ratio implies less opportunity to expand
through use of debt financing.

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Learning Objective P3: Define and apply ratio analysis.
 17 - 38

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 is the most common measures a

company’s ability to pay interest.

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Learning Objective P3: Define and apply ratio analysis.
 17 - 39

Profitability
Profit Return on
Margin Total Assets

Return on Common
Stockholders’ Equity

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Learning Objective P3: Define and apply ratio analysis.
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Profit Margin

Net income  
Profit margin =
Net sales  

This ratio measures a company’s ability to

earn net income from each sales dollar.

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Learning Objective P3: Define and apply ratio analysis.
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Return on Total Assets

Net income  
Return on total asset =
Average total
assets  

Return on total assets measures how well

assets are utilized by the company.

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Learning Objective P3: Define and apply ratio analysis.
 17 - 42

Return on Common
Stockholders’ Equity

Return on common stockholders' Net income − Preferred dividends  

equity = Average common stockholders'
equity  

This measure indicates how the company’s

ability to earn income for common
stockholders.

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Learning Objective P3: Define and apply ratio analysis.
 17 - 43

Market Prospects
Price-Earnings Dividend
Ratio Yield

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Learning Objective P3: Define and apply ratio analysis.
 17 - 44

Price-Earnings Ratio
Market price per common share  
Price-earnings ratio =
Earnings per share  

This measure measures market expectations for

future growth.

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Learning Objective P3: Define and apply ratio analysis.
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Dividend Yield
Annual cash dividends per share  
Dividend yield =
Market price per share  

This ratio is used to compare the dividend-

paying performance of different companies.

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Learning Objective P3: Define and apply ratio analysis.
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Summary of Ratios Exhibit

17.16

46
Learning Objective P3: Define and apply ratio analysis. © McGraw-Hill Education 
 Learning Objective A1

Summarize and report results

of analysis.

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Analysis Reporting
1. Executive Summary
2. Analysis Overview
3. Evidential Matter
4. Assumptions
5. Key Factors
6. Inferences

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Learning Objective A1: Summarize and report results of analysis.
 Learning Objective A2

Appendix 17-A
Explain the form and assess
the content of a complete
income statement.

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 17 - 50

Sustainable Income
Changes in Earnings per
Accounting Principles share

Discontinued
Segments

Continuing
Operations Net Income
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Learning Objective A2: Explain the form and assess the content of a complete income statement.
 17 - 51

Income Statement All-inclusive

Exhibit
17A.1

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Learning Objective A2: Explain the form and assess the content of a complete income statement.
 17 - 52

End of Chapter 17

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