CH 18

Chapter 18
Financial Statement
Analysis
Chapter
18-1 Accounting Principles, Ninth Edition
Study Objectives
1. Discuss the need for comparative analysis.

2. Identify the tools of financial statement analysis.
3. Explain and apply horizontal analysis.
4. Describe and apply vertical analysis.
5. Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
6. Understand the concept of earning power, and how
irregular items are presented.
7. Understand the concept of quality of earnings.
Chapter
18-2
Financial Statement Analysis
Basics of
Horizontal and Earning Power
Financial Quality of
Vertical Ratio Analysis and Irregular
Statement Earnings
Analysis Items
Analysis
Need for Balance Liquidity Discontinued Alternative

comparative sheet Profitability operations accounting
analysis Income Extraordinary methods
Solvency
Tools of statement items Pro forma
Summary
analysis Retained Changes in income
earnings accounting Improper
statement principle recognition
Comprehensive
income
Chapter
18-3
Basics of Financial Statement Analysis
Analyzing financial statements involves:
Comparison Tools of
Characteristics
Bases Analysis
Liquidity Intracompany Horizontal

Profitability Industry Vertical
Solvency averages Ratio
Intercompany
Chapter SO 1 Discuss the need for comparative analysis.

18-4 SO 2 Identify the tools of financial statement
Horizontal Analysis
Horizontal analysis, also called trend analysis, is a

technique for evaluating a series of financial
statement data over a period of time.
Its purpose is to determine the increase or decrease

that has taken place.
Horizontal analysis is commonly applied to the balance

sheet, income statement, and statement of retained
earnings.
Chapter
18-5 SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Illustration 18-5
Horizontal analysis of
balance sheets
These changes
suggest that the
company expanded
its asset base
during 2007 and
financed this
expansion primarily
by retaining income
rather than
assuming additional
long-term debt.
Chapter
Horizontal Analysis
Illustration 18-6
Income statements
Overall, gross
profit and net
income were up
substantially. Gross
profit increased
17.1%, and net
income, 26.5%.
Quality’s profit
trend appears
favorable.
Chapter
Horizontal Analysis
Illustration 18-7
retained earnings
statements
We saw in the horizontal analysis of the balance sheet that ending retained
earnings increased 38.6%. As indicated earlier, the company retained a
significant portion of net income to finance additional plant facilities.
Chapter
Vertical Analysis
Vertical analysis, also called common-size analysis, is

a technique that expresses each financial statement
item as a percent of a base amount.
On an income statement, we might say that selling

expenses are 16% of net sales.
Vertical analysis is commonly applied to the balance

sheet and the income statement.
Chapter
18-9 SO 4 Describe and apply vertical analysis.
Vertical Analysis
Illustration 18-8
Vertical analysis of
balance sheets
These results
reinforce the
earlier
observations that
Quality is
choosing to
finance its growth
through retention
of earnings rather
than through
issuing additional
debt.
Chapter
Vertical Analysis
Illustration 18-9
Vertical analysis of
Income statements
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.
Chapter
Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 18-10
Intercompany income
statement comparison
J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C.
Penney’s net income as a percent of each sales dollar (5.6%) is only 4% of
Quality’s (12.6%).
Chapter
Ratio Analysis
Ratio analysis expresses the relationship among

selected items of financial statement data.
Financial Ratio Classifications
Liquidity Profitability Solvency
Measures short- Measures the Measures the

term ability of income or ability of the
the company to operating success company to
pay its maturing of a company for survive over a
obligations and to a given period of long period of
meet unexpected time. time.
needs for cash.
Chapter SO 5 Identify and compute ratios used in analyzing
18-13
a firm’s liquidity, profitability, and solvency.
Ratio Analysis
A single ratio by itself is not very meaningful.
The discussion of ratios will

include the following types of
comparisons.

18-14
Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay

its maturing obligations and to meet unexpected needs
for cash.
 Short-term creditors such as bankers and
suppliers are particularly interested in assessing
liquidity.
 Ratios include the current ratio, the acid-test
ratio, receivables turnover, and inventory
turnover.
18-15
Ratio Analysis Liquidity Ratios
Compute the Current Ratio for 2007.

Current Assets
= Current Ratio
Current Liabilities
$1,020,000
= 2.96 : 1
$344,500
The ratio of 2.96:1 means that for every dollar of

current liabilities, Quality has $2.96 of current
assets.
18-16
Compute the Acid-Test Ratio for 2007.

Illustration 18-13

18-17
Compute the Acid-Test Ratio for 2007.
Cash + Short-Term Investments + Receivables (Net)

= Acid-Test
Current Liabilities Ratio
$100,000 + $20,000 + $230,000

= 1.02 : 1
$344.500
The acid-test ratio measures immediate liquidity.

18-18
Compute the Receivables Turnover ratio for 2007.

Net Credit Sales Receivables
=
Turnover
Average Net Receivables
$2,097,000
= 10.2 times
($180,000 + $230,000) / 2
It measures the number of times, on average, the

company collects receivables during the period.
18-19
Receivables Turnover
$2,097,000
= 10.2 times
($180,000 + $230,000) / 2
A variant of the receivables turnover ratio is to convert

it to an average collection period in terms of days.
365 days / 10.2 times = every 35.78 days
This means that receivables are collected on average

every 36 days.
18-20
Compute the Inventory Turnover ratio for 2007.

Cost of Good Sold Inventory
=
Turnover
Average Inventory
$1,281,000
= 2.31 times
($500,000 + $620,000) / 2
Inventory turnover measures the number of times,

on average, the inventory is sold during the period.
18-21
$1,281,000 Inventory Turnover

= 2.3 times
($500,000 + $620,000) / 2
A variant of inventory turnover is the days in inventory.
365 days / 2.3 times = every 159 days
Inventory turnover ratios vary considerably among

industries.

18-22
Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company

for a given period of time.
 Income, or the lack of it, affects the company’s
ability to obtain debt and equity financing,
liquidity position, and the ability to grow.
 Ratios include the profit margin, asset turnover,
return on assets, return on common stockholders’
equity, earnings per share, price-earnings, and
payout ratio.
18-23
Ratio Analysis Profitability Ratios
Compute the Profit Margin ratio for 2007.

Net Income Profit
=
Margin
Net Sales
$263,800
= 12.6%
$2,097,000
Measures the percentage of each dollar of sales

that results in net income.
18-24
Compute the Asset Turnover ratio for 2007.

Net Sales Asset
=
Turnover
Average Assets
$2,097,000
= 1.22 times
($1,95,000 + $1,835,000) / 2
Measures how efficiently a company uses its assets

to generate sales.
18-25
Compute the Return on Assets ratio for 2007.

Net Income Return
=
on Assets
Average Assets
$263,800
= 15.4%
($1,595,000 + $1,835,000) / 2
An overall measure of profitability.

18-26
Compute the Return on Common Stockholders’

Equity ratio for 2007.
Return on
Net Income – Preferred Dividends Common
=
Stockholders’
Average Common Stockholders’ Equity
Equity
$263,000 - $0
= 29.3%
($795,000 + $1,003,000) / 2
Shows how many dollars of net income the company

earned for each dollar invested by the owners.
18-27
Compute the Earnings Per Share for 2007.

Net Income Earnings
=
Per Share
Weighted Average Common
Shares Outstanding
$263,800
= $0.97 per share
270,000 + 275,400 / 2
A measure of the net income earned on each share

of common stock.
18-28
Compute the Price Earnings Ratio for 2007.

Market Price per Share of Stock Price
= Earnings
Earnings Per Share Ratio
$12.00
= 12.4 times
$0.97
The price-earnings (PE) ratio reflects investors’

assessments of a company’s future earnings.
18-29
Compute the Payout Ratio for 2007.

Cash Dividends Payout
=
Ratio
Net Income
$61,200 *
= 23.2%
$263,800
Measures the percentage of earnings distributed in

the form of cash dividends.
* From analysis of retained earnings.
18-30
Ratio Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to

survive over a long period of time.
 Debt to total assets and times interest earned
are two ratios that provide information about
debt-paying ability.

18-31
Ratio Analysis Solvency Ratios
Compute the Debt to Total Assets Ratio for 2007.

Total Debt Debt to
= Total Assets
Total Assets Ratio
$832,000
= 45.3%
$1,835,000
Measures the percentage of the total assets that

creditors provide.

18-32
Ratio Analysis Solvency Ratios
Compute the Times Interest Earned ratio for 2007.

Income before Income Taxes and
Interest Expense Times
= Interest
Interest Expense Earned
$468,000
= 13 times
$36,000
Provides an indication of the company’s ability to

meet interest payments as they come due.
18-33
Earning Power and Irregular Items
Earning power means the normal level of income to be

obtained in the future.
“Irregular” items are separately identified on the

income statement. Two types are:
1. Discontinued operations.
2. Extraordinary items.
These “irregular” items are reported net of income

taxes.
Chapter SO 6 Understand the concept of earning power,

18-34
and how irregular items are presented.
Discontinued Operations
(a) Refers to the disposal of a significant component
of a business.
(b) Report the income (loss) from discontinued

operations in two parts:
1. income (loss) from operations (net of tax)

and
2. gain (loss) on disposal (net of tax).

18-35
Illustration: During 2010 Acro Energy Inc. has income from
continuing operations of $560,000. During 2010 Acro
discontinued and sold its unprofitable chemical division. The
loss in 2010 from chemical operations (net of $60,000 taxes)
was $140,000. The loss on disposal of the chemical division (net
of $30,000 taxes) was $70,000. Assuming a 30% tax rate.
Income from continuing operations $560,000

Discontinued operations:
Loss from operations, net of $60,000 tax
Loss on disposal, net of $30,000 tax
140,000
Total loss on discontinued operations 210,000
70,000
Net income $350,000
18-36
Income Statement (in thousands)
Discontinued Operations Sales $ 285,000
are reported after Cost of goods sold 149,000
“Income from continuing
operations.” Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
“Net Income”. Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Moved to
Net income $ 54,496
Chapter
18-37 SO 6 Understand the concept of earning power,
Extraordinary items are nonrecurring material

items that differ significantly from a company’s
typical business activities.
An extraordinary item must be both of an

Unusual Nature and
Occur Infrequently
Company must consider the environment in which it

operates.
Amounts reported “net of tax.”
Chapter
18-38
SO 6 Understand the concept of earning power,
Are these considered Extraordinary Items?

(a) A large portion of a tobacco manufacturer’s
crops are destroyed by a hail storm. Severe
YES
damage from hail storms in the locality where
the manufacturer grows tobacco is rare.
(b) A citrus grower's Florida crop is damaged by NO
frost.
(c) Loss from sale of temporary investments. NO
(d) Loss attributable to a labor strike. NO
Chapter
18-39
Are these considered Extraordinary Items?

(d) Loss from flood damage. (The nearby Black
River floods every 2 to 3 years.) NO
(e) An earthquake destroys one of the oil

refineries owned by a large multi-national oil YES
company. Earthquakes are rare in this
geographical location.
(f) Write-down of obsolete inventory. NO
(g) Expropriation of a factory by a foreign YES
government.
Chapter
18-40
Illustration: In 2010 a foreign government expropriated

property held as an investment by Acro Energy Inc. If the
loss is $70,000 before applicable income taxes of $21,000,
the income statement will report a deduction of $49,000.
Illustration 18-30
Chapter
18-41
Extraordinary Items Sales $ 285,000
are reported after Cost of goods sold 149,000
“Income from continuing
operations.” Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Previously labeled as
“Net Income”. Extraordinary loss, net of tax 539
Net income $ 54,461
Moved to
Chapter
18-42
Reporting when both Sales $ 285,000
Discontinued Operations Cost of goods sold 149,000
and
Extraordinary Items Interest expense (21,000)
Total other (4,000)
are present. Income before taxes 79,000
Discontinued operations:
Discontinued Loss from operations, net of tax 315
Operations Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Income before extraordinary item 54,496
Extraordinary Item Extraordinary loss, net of tax 539
Net income $ 53,957
Chapter
18-43
Change in Accounting Principle

Occurs when the principle used in the current
year is different from the one used in the
preceding year.
Accounting rules permit a change if justified.
Changes are reported retroactively.
Example would include a change in inventory
costing method such as FIFO to average cost.
Chapter
18-44
Comprehensive Income All changes in stockholders’

equity except those
Sales $ 285,000
resulting from investments
Cost of goods sold 149,000 by stockholders and
Gross profit 136,000 distributions to
Operating expenses:
Advertising expense 10,000
stockholders.
Depreciation expense 43,000
Total operating expense 53,000 Reported in
Income from operations 83,000 Stockholders’ Equity
Other revenue:
Interest revenue 17,000 Unrealized gains and
Total other
Income before taxes
17,000
100,000
+ losses on available-
for-sale securities.
Net income $ 76,000 Plus other items
Chapter
18-45
Comprehensive Income
Why are gains and losses on available-for-sale
securities excluded from net income?
Because disclosing them separately
1. reduces the volatility of net income due to
fluctuations in fair value,
2. yet informs the financial statement user of the
gain or loss that would be incurred if the
securities were sold at fair value.
Chapter
18-46
Quality of Earnings
A company that has a high quality of earnings

provides full and transparent information that will
not confuse or mislead users of the financial
statements.
Companies have incentives to manage income to

meet or beat Wall Street expectations, so that
the market price of stock increases and
the value of stock options increase.
Chapter
18-47 SO 7 Understand the concept of quality of earnings.
Quality of Earnings
Alternative Accounting Methods

Variations among companies in the application of
GAAP may hamper comparability and reduce
quality of earnings.
Pro Forma Income

Pro forma income usually excludes items that the
company thinks are unusual or nonrecurring.
Some companies have abused the flexibility that
pro forma numbers allow.
Chapter
Quality of Earnings
Improper Recognition
Some managers have felt pressure to continually
increase earnings and have manipulated the earnings
numbers to meet these expectations.
Abuses include:
Improper recognition of revenue (channel stuffing).
Improper capitalization of operating expenses
(WorldCom).
Failure to report all liabilities (Enron).
Chapter
Copyright
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is unlawful. Request for further information should be
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information contained herein.”
Chapter
18-50

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CH 18

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Chapter 18

1. Discuss the need for comparative analysis.

Need for Balance Liquidity Discontinued Alternative

Analyzing financial statements involves:

Liquidity Intracompany Horizontal

Chapter SO 1 Discuss the need for comparative analysis.

Horizontal analysis, also called trend analysis, is a

Its purpose is to determine the increase or decrease

Horizontal analysis is commonly applied to the balance

Vertical analysis, also called common-size analysis, is

On an income statement, we might say that selling

Vertical analysis is commonly applied to the balance

Ratio analysis expresses the relationship among

Liquidity Profitability Solvency

Measures short- Measures the Measures the

A single ratio by itself is not very meaningful.

The discussion of ratios will

Chapter SO 5 Identify and compute ratios used in analyzing

Measure the short-term ability of the company to pay

Compute the Current Ratio for 2007.

The ratio of 2.96:1 means that for every dollar of

Compute the Acid-Test Ratio for 2007.

Chapter SO 5 Identify and compute ratios used in analyzing

Compute the Acid-Test Ratio for 2007.

Cash + Short-Term Investments + Receivables (Net)

$100,000 + $20,000 + $230,000

The acid-test ratio measures immediate liquidity.

Chapter SO 5 Identify and compute ratios used in analyzing

Compute the Receivables Turnover ratio for 2007.

It measures the number of times, on average, the

A variant of the receivables turnover ratio is to convert

365 days / 10.2 times = every 35.78 days

This means that receivables are collected on average

Compute the Inventory Turnover ratio for 2007.

Inventory turnover measures the number of times,

$1,281,000 Inventory Turnover

A variant of inventory turnover is the days in inventory.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among

Chapter SO 5 Identify and compute ratios used in analyzing

Measure the income or operating success of a company

Compute the Profit Margin ratio for 2007.

Measures the percentage of each dollar of sales

Compute the Asset Turnover ratio for 2007.

Measures how efficiently a company uses its assets

Compute the Return on Assets ratio for 2007.

An overall measure of profitability.

Chapter SO 5 Identify and compute ratios used in analyzing

Compute the Return on Common Stockholders’

Shows how many dollars of net income the company

Compute the Earnings Per Share for 2007.

A measure of the net income earned on each share

Compute the Price Earnings Ratio for 2007.

The price-earnings (PE) ratio reflects investors’

Compute the Payout Ratio for 2007.

Measures the percentage of earnings distributed in

Solvency ratios measure the ability of a company to

Chapter SO 5 Identify and compute ratios used in analyzing

Compute the Debt to Total Assets Ratio for 2007.

Measures the percentage of the total assets that

Chapter SO 5 Identify and compute ratios used in analyzing

Compute the Times Interest Earned ratio for 2007.

Provides an indication of the company’s ability to