17-1

Chapter Three

Financial Statements
 17-2

Chapter objective

At the end of this chapter the students will

able to:
o Analyze the financial statements of a
company by using different methods
 17-3

Introduction
What is a Financial Statement?
 A financial statement is a quantitative way of showing how a
company is doing.
 Financial statements are summaries of the
operating, financing, and investment activities of a
business.
 Financial statements should provide information
useful to both investors and creditors in making
credit, investment, and other business decisions.
 17-4

Cont’
 Three different ways of representing the financial
statement of a company:
1. Cash Management (can the company meet its
obligations?)- Cash flow statement
2. Profitability (Is it making money?) - the income
statement
3. Assets versus Liabilities (what is the value of the
company? Who owns what?) - the balance sheet
 Each one of these questions is answered by our
Financial Statements.
 17-5

The big three financial statements

 Cash Flow Statements
 These answer the important managerial question
“do I have enough cash to run my business”
 Income Statements
 This is the financial sheet that tells you if your
company is profitable or not.
 Balance Sheets
 How much debt do I have? How large are my
assets? This sheet tells you the answer to these
questions.
 17-6

Characteristics
1.The Financial Statements should be relevant for the
purpose for which they are prepared. Unnecessary
and confusing disclosures should be avoided and all
those that are relevant and material should be
reported to the public.
2. They should convey full and accurate information
about the performance, position, progress and
prospects of an enterprise. It is also important that
those who prepare and present the financial
statements should not allow their personal prejudices
to distort the facts.
 17-7

Cont’
3.They should be easily comparable with
previous statements or with those of similar
concerns or industry. Comparability increases
the utility of financial statements.
4. They should be prepared in a classified form
so that a better and meaningful analysis could
be made.
 17-8

Cont…
5. The financial statements should be prepared
and presented at the right time. Undue delay
in their preparation would reduce the
significance and utility of these statements.
6. The financial statements must have general
acceptability and understanding. This can be
achieved only by applying certain “generally
accepted accounting principles” in their
preparation /IFRS/.
 17-9

Cont’
7. The financial statements should not be
affected by inconsistencies arising out of
personal judgment and procedural choices
exercised by the accountant.
8. Financial Statements should comply with
the legal requirements if any, as regards
form, contents, and disclosures and
methods.
 17-10

Limitations
1. Dependence on historical costs: Transactions are
initially recorded at their cost. This is a concern when
reviewing the balance sheet, where the values of assets
and liabilities may change over time. Some items, such as
marketable securities, are altered to match changes in
their market values, but other items, such as fixed assets,
do not change. Thus, the balance sheet could be
misleading if a large part of the amount presented is based
on historical costs.
2. Inflationary effects: If the inflation rate is relatively high,
the amounts associated with assets and liabilities in the
balance sheet will appear inordinately low, since they are
not being adjusted for inflation. This mostly applies to long-
term assets.
 Cont…
17-11

3. Intangible assets not recorded: Many intangible assets

are not recorded as assets. Instead, any expenditures made to
create an intangible asset are immediately charged to expense.
This policy can drastically underestimate the value of a
business, especially one that has spent a large amount to build
up a brand image or to develop new products. It is a particular
problem for start up companies that have created intellectual
property, but which have so far generated minimal sales.
4. Based on specific time period: A user of financial
statements can gain an incorrect view of the financial results
or cash flows of a business by only looking at one reporting
period. Any one period may vary from the normal operating
results of a business, perhaps due to a sudden spike in sales
or seasonality effects. It is better to view a large number of
consecutive financial statements to gain a better view of
ongoing results.
 17-12

Cont…
5. Not always comparable across companies: If a user
wants to compare the results of different companies,
their financial statements are not always comparable,
because the entities use different accounting practices.
These issues can be located by examining the
disclosures that accompany the financial statements.
6. Subject to fraud: The management team of a company
may deliberately skew the results presented. This
situation can arise when there is undue pressure to
report excellent results, such as when a bonus plan calls
for payouts only if the reported sales level increases.
One might suspect the presence of this issue when the
reported results spike to a level exceeding the industry
norm.
 Cont…
17-13

7. No discussion of non-financial issues: The financial

statements do not address non-financial issues, such as the
environmental attentiveness of a company's operations, or how
well it works with the local community. A business reporting
excellent financial results might be a failure in these other areas.
8. Not verified: If the financial statements have not been audited,
this means that no one has examined the accounting policies,
practices, and controls of the issuer to ensure that it has created
accurate financial statements. An audit opinion that accompanies
the financial statements is evidence of such a review.
9. No predictive value: The information in a set of financial
statements provides information about either historical results or
the financial status of a business as of a specific date. The
statements do not necessarily provide any value in predicting what
will happen in the future. For example, a business could report
excellent results in one month, and no sales at all in the next
month, because a contract on which it was relying has ended.
 17-14

Financial Statement Analysis

 What is financial statement analysis?
“Analyzing financial statements is a process of
evaluating the relationship between the component
parts of the financial statements to obtain a better
understanding of a firm’s position and
performance”.
 The type of relationship to be investigated depends
upon the objective and purpose of evaluation.
 The purpose of evaluation of financial statements
differs among various groups: creditors,
shareholders, potential investors, management and
so on. For example, short-term creditors are
primarily interested in judging the firm’s ability to
pay its currently-maturing obligations.
 17-15

Financial Statement Analysis

Who analyzes financial statements?
 Internal users (i.e., management)
 External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors
 17-16

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.
 17-17

Financial Statement Analysis

Information is available from
 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
 17-18

Financial Statement Analysis

Information is available from
 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
 17-19

Methods of Financial Statement

Analysis

 Horizontal Analysis
 Vertical Analysis
 Common-Size Statements
 Trend Percentages
 Ratio Analysis
 17-20

1. Horizontal Analysis

Using comparative financial

statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
 17-21

2. 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
 17-22

3. Common-Size Statements
Financial statements that show only
percentages and no absolute dollar
amounts
 17-23

Cont’
 A common size financial statement displays
entries as a percentage of a common base figure
rather than as absolute numerical figures.
 Common size statements let analysts compare
companies of different sizes, in different
industries, or across time in an apples-to-apples
way.
 Common size financial statements commonly
include the income statement, balance sheet, and
cash flow statement.
 17-24

4. Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial information of
several years)
 17-25

5. 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)
 17-26

1. 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.
17-27
 17-28

Horizontal Analysis Example

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure
 17-29

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.
 17-30

Horizontal Analysis Example

Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
 17-31

Horizontal Analysis Example

$12,000 – $23,500 = $(11,500)

 17-32

Horizontal Analysis Example

($11,500 ÷ $23,500) × 100% = 48.9%

 17-33

Horizontal Analysis Example

 17-34

Horizontal Analysis Example

Let’s apply the same
procedures to the
liability and stockholders’
equity sections of the
balance sheet.
 17-35

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
 17-36

Horizontal Analysis Example

Now, let’s apply the
procedures to the
income statement.
 17-37

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)
 17-38

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 operatingSales
incomeincreased 31,400
by 8.3% while
39,000net (7,600) (19.5)
Interest expenseincome decreased 6,400 by 21.9%.
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)
 17-39

There were increases in both cost of goods sold

(14.3%) and operating expenses (2.1%). These
increased costs more than offset the increase in
sales, yielding an overall decrease in net income.
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)
 17-40

2. Vertical Analysis Example

The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the company.
 17-41

Vertical Analysis Example

 17-42

Vertical Analysis Example

$82,000 ÷ $483,000 = 17% rounded

$30,000 ÷ $387,000 = 8% rounded
 17-43

Vertical Analysis Example

$76,000 ÷ $483,000 = 16% rounded

 17-44

3. Trend Percentages Example

Wheeler, Inc. provides you with the following
operating data and asks that you prepare a
trend analysis.
 17-45

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

 17-46

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
 17-47

Trend line
for Sales
 17-48

4. 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.”
 17-49

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 Ratio
Relate income to other variables
 Market Ratio
Help to assess relative merits of stocks in the
market place
 17-50

10 Ratios You Must Know

A. 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
 Total assets turnover
 17-51

10 Ratios You Must Know

B. Equity (Long-Term Solvency) Ratios
Equity (stockholders’ equity) ratio
 Equity to debt
 17-52

10 Ratios You Must Know

C. Profitability Ratio
 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

 17-53

10 Ratios You Must Know

D. Market Ratio
 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

 17-54

Now, let’s look at

Norton Corporation’s
1999 and 1998
financial statements.
17-55
17-56
17-57
 17-58

Now, let’s calculate

the 10 ratios based
on Norton’s financial
statements.
 17-59
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
 17-60

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.
 17-61

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.
Industry average = 4.2 times, so its liquidity
position is relatively weak.
 17-62

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.
 17-63

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.
 17-64

Acid-Test (Quick) Ratio

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

Industry average 2.1 times, so Co’s

1.19 ratio is low in comparison
with other firms in its industry.
 17-65

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.
 17-66

Number of Days’ Sales

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
17-67

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?
 17-68

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.
 17-69

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?
 17-70

Equity, or Long–Term
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
 17-71
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
 17-72

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.
 Net Income to Net Sales 17-73

also known as 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.
 17-74

Net Income to Net Sales

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
17-75

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.
 17-76

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.
 17-77

Price-Earnings Ratio
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.
 17-78

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
 17-79

END OF CHAPTER THREE