Chapter 17

Financial Statement Analysis

 The Value of Financial Statement Information

• General-purpose financial statements are distributed to a

wide range of potential users, providing each group with
valuable information about a company’s economic
performance and financial condition.
• Users typically evaluate this information along three
dimensions:
• Liquidity
• Solvency
• Profitability

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Current Position Analysis

• Current position analysis evaluates a company’s ability to pay its current

liabilities.
• This analysis includes:

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Example Exercise: Current Position Analysis

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Accounts Receivable Analysis
• A company’s ability to collect its accounts receivable is called accounts
receivable analysis.
• Accounts receivable analysis includes the computation and analysis of the
following:
• Accounts receivable turnover
• Number of days’ sales in receivables

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Accounts Receivable Analysis: Accounts Receivable Turnover

Accounts Receivable Analysis: Number of Days’ Sales in

Receivables

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Analyzing Solvency

• Solvency analysis evaluates a company’s ability to pay its

long-term debts.
• Bondholders and other long-term creditors use solvency
analysis to evaluate a company’s ability to:
1. Repay the face amount of debt at maturity
2. Make periodic interest payments

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Ratio of Fixed Assets to Long-Term Liabilities

•The ratio of fixed assets to long-term liabilities provides a measure of

how much fixed assets a company has to support its long-term debt.

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Ratio of Liabilities to Stockholder’s Equity

•The ratio of liabilities to stockholders’ equity measures how much of the

company is financed by debt and equity.

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Analyzing Profitability

• Profitability analysis evaluates the ability of a

company to generate future earnings.
• Investors, such as stockholders, are interested
in evaluating the potential for the price of the
company’s stock to increase.

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Asset Turnover
• The asset turnover measures how effectively a company uses its assets.
• The asset turnover is computed as follows:

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Return on Operating Assets

• The return on operating assets is sometimes computed when there

are large amounts of nonoperating income and expense.

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Return on Stockholders’ Equity

• The return on stockholders’ equity measures the rate of

income earned on the amount invested by the stockholders.
• The return on stockholders’ equity is computed as follows:

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Return on Stockholders’ Equity

• The return on stockholders’ equity is normally higher than the return on total
assets.
• This is because of the effect of leverage.
• Leverage involves using debt to increase the return on an investment.
• For Lincoln Company, the effect of leverage for 20Y6 and for 20Y5 is
computed as follows:

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Return on Common Stockholders’ Equity

• The return on common stockholders’ equity measures the rate

of profits earned on the amount invested by the common
stockholders.

• To illustrate, Lincoln Company had $150,000 par value of 6% preferred stock

outstanding on December 31, 20Y6 and 20Y5. Thus, preferred dividends of $9,000
($150,000 × 6%) are deducted from net income. Lincoln’s common stockholders’
equity is determined as follows:

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Return on Common Stockholders’ Equity

• To illustrate, the return on common stockholders’ equity for Lincoln

Company is computed as follows:

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Return on Common Stockholders’ Equity

• Lincoln’s return on common stockholders’ equity differs from

the returns on total assets and stockholders’ equity because of
leverage.

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1. Working Capital = Current Assets − Current Liabilities

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
2. 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑎𝑖𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠
3. 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑆𝑎𝑙𝑒𝑠
4. 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑖𝑒𝑣𝑎𝑏𝑙𝑒 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑖𝑒𝑣𝑎𝑏𝑙𝑒

′ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑖𝑒𝑣𝑎𝑏𝑙𝑒

5. 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑠 𝑎𝑙𝑒𝑠𝑖𝑛 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 = 𝐴𝑣𝑒𝑟𝑎 𝑔𝑒 𝐷𝑎𝑖𝑙𝑦 𝑆𝑎𝑙𝑒𝑠

𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 ሺ
𝑛𝑒𝑡 ሻ
6. 𝑅𝑎𝑡𝑖𝑜 𝑜𝑓 𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡𝑠 𝑡𝑜 𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑇𝑜𝑡𝑎𝑙 𝐿𝑎𝑖𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
7. 𝑅𝑎𝑡𝑖𝑜 𝑜𝑓 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑡𝑜 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝑇𝑜𝑡𝑎𝑙 𝑆𝑡𝑜𝑐 𝑘ℎ𝑜𝑙𝑑𝑒𝑟 𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦

𝑆𝑎𝑙𝑒𝑠
8. 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 +𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑠𝑛𝑒

9. 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
10. 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝑆𝑡𝑜𝑐 𝑘ℎ𝑜𝑙𝑑𝑒𝑟 𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 −𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

11. 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐 𝑘ℎ𝑜𝑙𝑑𝑒𝑟 𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦

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