Chapter 3 Analysis of Financial Statements

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Perform a horizontal analysis of financial
statements
Perform a vertical analysis of financial
statements
Prepare and use common-size financial
statements
Compute and evaluate the standard
financial ratios
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To make informed decisions about a company
Helpful in managing the company
Comparison with competition
Charting a company’s progress, measure
performance
Establish financial health
Used for investment decisions
Generally based on comparative financial data
From one year to the next
With a competing company
With the industry as a whole.
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Three main ways to analyze financial statements
Horizontal analysis
Year-to-year comparison
Vertical analysis
Compare different companies
Using industry averages
Compare company’s performance against the
industry averages
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1
Perform a horizontal analysis of financial
statements
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The study of percentage changes in comparative
statements
Compute dollar changes
Compute percentage changes
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Step 1
Step 2
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Form of horizontal analysis
Indicates business direction
How have things changed over the years?
Select a period of three to five years
Base year, earliest year, is selected and set equal
to 100%
Subsequent years expressed as a percentage of
the base period
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Data for Mariner Designs, Inc., follow:
MARINER DESIGNS, INC.
Comparative Income Statement
Years Ended December 31, 2012 and 2011
2011 2012
Net sales revenue $ 431,000 $ 372,350
Expenses:
Cost of goods sold $ 200,000 $ 187,550
Selling and general expenses 99,000 91,050
Other expense 8,350 6,850
Total expenses $ 307,350 $ 285,450
Net income $ 123,650 $ 86,900
1. Prepare a horizontal analysis of the comparative income statement of Mariner

Designs, Inc. Round percentage changes to one decimal place.
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MARINER DESIGNS, INC.
Comparative Income Statement
Years Ended December 31, 2012 and 2011
Increase (Decrease)
2012 2011 Amount Percent
Net sales revenue $ 431,000 $ 372,350 $ 58,650 4.8 %
Expenses:
Cost of goods sold $ 200,000 $ 187,550 $ 12,450 6.6 %
Selling and general
99,000 91,050 7,950 8.7 %
expenses
Other expense 8,350 6,850 1,500 21.9 %
Total expenses $ 307,350 $ 285,450 21,900 7.7 %
Net income $ 123,650 $ 86,900 $ 36,750 42.3 %
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Data for Mariner Designs, Inc., follow:
2. Why did 2012 net income increase by a higher percentage

than net sales revenue?
Revenues increase at a higher rate than total expenses.
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2
Perform a vertical analysis of financial statements
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Shows relationship of each item to a base
amount on financial statements
Income statement–each item expressed as
percentage of net sales
Balance sheet–each item expressed as percentage of

total assets or total liabilities and equity.
Remember total assets = total liabilities and equity
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Base amount
Percentage of the base amount

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Base amount
Percentage
of base
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Tri-State Optical Company reported the following amounts on its
balance sheet at December 31, 2012 and 2011:
2012 2011
Cash and receivables $ 54,530 $ 46,860
Inventory 42,435 32,670
Property, plant, and equipment, net 108,035 85,470
Total assets $ 205,000 $ 165,000
Prepare a vertical analysis of Tri-State assets for 2012 and 2011.

2012 % of 2011 % of
total total
Cash and receivables $ 54,530 26.6 $ 46,860 28.4
Inventory 42,435 20.7 32,670 19.8
Property, plant, and equipment, 108,035 52.7 85,470 51.8
net 100.0 100.0
Total 17assets $ 205,000 $ 165,000
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Prepare and use common-size financial
statements
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Common-size statements compare one company
to another
Report only percentages (same as vertical analysis)
Remove dollar value bias
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Comparing a company with another leading
company
Two main types:
Against a key competitor
Against the industry average
20 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Data for Martinez, Inc., and Rosado, Corp., follow:
Martinez Rosado
Net sales $ 10,600 $ 18,600
Cost of goods sold 6,455 13,522
Other expenses 3,541 4,185
Net income $ 604 $ 893
1. Prepare common-size income statements.
Martinez Rosado
Net sales 100 % 100 %
Cost of goods sold 60.9 % 72.7 %
Other expenses 33.4 % 22.5 %
Net income 5.7 % 4.8 %
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(Continued)
Martinez Rosado
Net sales 100 % 100 %
Cost of goods sold 60.9 % 72.7 %
Other expenses 33.4 % 22.5 %
Net income 5.7 % 4.8 %
2. Which company earns more net income?
Rosado
3. Which company’s net income is a higher percentage of its net

sales?
Martinez
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4
Compute and evaluate the standard financial ratios
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No single ratio tells the whole picture
Different ratios explain different aspects
Types:
Evaluating ability to pay current liabilities
Evaluating ability to sell inventory and collect
receivables
Evaluating ability to pay long-term debt
Evaluating profitability
Evaluating stock as an investment
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Working capital
Measures ability to meet short-term obligations
Working capital = Current assets – Current liabilities
Current ratio
Proportion of current assets to current liabilities
Current assets
Current ratio = Current liabilities
Acceptable current ratio 1.50

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Acid-test ratio
Tells if company could pay all its current liabilities
immediately
Acid-test Cash + Short-term investments + Net current receivables
Ratio = Current liabilities
Normal range 0.20 to 1.00 depending upon industry

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Inventory turnover ratio
Measures number of times a company sells
inventory during a year
High rate indicates ease in selling
Low rate indicates difficulty in selling
Formula Cost of goods sold
Inventory turnover =
Average inventory
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Days in inventory ratio
Measures the average number of days inventory is
held by the company
Formula
365 days
Days in inventory =
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Gross profit percentage
Measures the profitability of each net sales dollar
Formula
Gross profit
Gross profit percentage =
Net sales
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Accounts receivable turnover ratio
Measures ability to collect cash from credit
customers
Formula
Net credit sales
Accounts receivable turnover =
Average net accounts receivable
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Days’ sales in receivables ratio
Measures ability to collect receivables
Formula
Days’ sales in 365 days
average accounts = Accounts receivable
receivable turnover ratio
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Debt ratio
Shows portion of assets financed with debt
The higher the ratio, the higher the risk
Formula
Debt ratio = Total liabilities
Total assets
Average debt ratio ranges from 57% to 67%

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Debt to equity ratio
The proportion of total liabilities to the proportion
of total equity that is financing the company’s assets
Formula
Total liabilities
Debt to equity =
Total equity
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Times-interest-earned ratio
Measures number of times income can cover
interest expense
High ratio indicates ease in paying interest
Formula
Times-interest Earnings Before Interest and Taxes
=
earned ratio Interest expense
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Return on net sales
Percent of each sales dollar earned as net income
Formula
Rate of return Net income
=
on net sales Net sales
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Return on total assets
Measures success in using assets to earn a profit
Formula
Rate of return Net income + Interest expense
=
on total assets Average total assets
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Asset turnover ratio
Measures the amount of net sales generated for
each average dollar of total assets invested
Formula
Net sales
Asset turnover ratio =
Average total assets
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Return on common stockholders’ equity
How much income is earned for each dollar
invested by common shareholders
Formula
Rate of return on common Net income – Preferred dividends
=
stockholders’ equity Average common stockholders’
equity
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Trading on the equity
Company borrows at a lower rate, then invests the
money to earn a higher rate
Return on Equity > Return on Assets
Increases profits during goods times
Compounds losses during bad times
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Earnings per share
Net income earned for each share of outstanding
common stock
Outstanding stock = Issued stock – Treasury stock
Formula
Net income – Preferred Dividends
Earnings per share
= Number of shares of
of common stock
common stock outstanding
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Price/earnings ratio (P/E)
Market price compared to earnings per share
Formula
P/E ratio = Market price per share of common stock
Earnings per share
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Dividend yield
Percentage of market value that is returned as
dividends
Formula
Dividend yield on Annual dividends per share of common stock
=
common stock Market price per share of common stock
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Dividend Payout
The ratio of annual dividends declared relative to
the earnings per share of the company
Formula
Annual dividends per share
Dividend Payout =
Earnings per share
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Book value
Common equity per share
Some argue its relevance to investors
Formula
Book value per share Total stockholders’ equity – Preferred equity
=
of common stock Number of shares of common stock
outstanding
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Win’s Companies, a home improvement store chain, reported the
following summarized figures:
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(Continued)
1.Compute Win’s Companies’ current ratio at May 31, 2012 and

2011. Current assets
Current ratio = Current liabilities
2012 - $ 54,300,000/$ 33,000,000 = 1.65
2011 - $ 25,200,000/$ 13,100,000 = 1.92
2. Did Win’s Companies’ current ratio improve, deteriorate, or hold

steady during 2012?
Win’s Companies current ratio

deteriorated.
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Use the Win’s Companies data in Short Exercise 4-5 to
complete the following requirements.
1.Compute the rate of inventory turnover, days in inventory,
and gross profit percentage for 2012.
Cost of goods sold
Inventory turnover =
Average inventory
$ 28,400,000/($6,900,000 + $8,200,000)/2 = 3.76
365 days
Days in inventory =
365/3.76 = 97 days
Gross profit
Gross profit percentage =
Net sales
$21,800,000/$50,200,000 = 43.4 %
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(Continued)
2. Compute days’ sales in average receivables during 2012. Round

dollar amounts to three decimal places.
Days’ sales in 365 days
average accounts = Accounts receivable
receivable turnover ratio
Net credit sales
Accounts receivable turnover =
Average net accounts receivable
365/($ 50,200,000/($7,400,000 + $5,300,000)/2 ) = 46 days
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Use the financial statements of Win’s Companies in Short Exercise
4-5.
1.Compute the debt ratio and the debt to equity ratio at May 31,
2012.
Debt ratio = Total liabilities
Total assets
$ 45,300,000 / $ 88,300,000 = 51.3
Total liabilities
Debt to equity =
Total equity
$ 45,300,000 / $ 43,000,000 = 1.05
2. Is Win’s ability to pay its liabilities strong or weak? Explain your
reasoning.
The company’s ability to pay its liabilities
is strong since the debt ratio is low.
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4-5 to complete the following profitability measures for 2012.
1. Compute the rate of return on net sales.
Rate of return = Net income
on net sales Net sales
$ 4,500,000 / $ 50,200,000 = 30.9%
2. Compute the rate of return on total assets.
Rate of return Net income + Interest expense
=
on total assets Average total assets
$ 4,500,000 + 500,000 / ($ 88,300,000 + $ 51,200,000)/2 = 22.9%
3. Compute the asset turnover ratio.
Net sales
Asset turnover ratio =
Average total assets
$ 50,200,000 / ($ 88,300,000 + $ 51,200,000)/2 = 0.72
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(Continued)
4. Compute the rate of return on common stockholders’ equity.
Rate of return on common Net income – Preferred dividends

=
stockholders’ equity Average common stockholders’
equity
$ 4,500,000 – 0 / ($ 43,000,000 + $ 27,500,000) /2 = 44.0 %
5. Are these rates of return strong or weak? Explain your reasoning.
These rates of return are strong considering that average

companies present much lower rates of return.
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4-5. Win’s has 500,000 common shares outstanding during 2012.
1.Compute earnings per share (EPS) for Win’s. Round to the nearest
cent.
Earnings per share = Net income – Preferred Dividends
of common stock Number of shares of
common stock outstanding
$ 4,500,000 – 0/500,000 = $31.00
2. Compute Win’s Companies’ price/earnings ratio. The market
price per share of Win’s stock is $68.50.
P/E ratio = Market price per share of common stock

Earnings per share
$68.50/$31.00 = 2.2 times
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Analysts look for red flags that may signal
financial trouble
Recent accounting scandals highlight the
importance of:
Movement of sales, inventory, and receivables
Earnings problems
Decreased cash flow
Too much debt
Inability to collect receivables
Buildup of inventory
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Horizontal analysis allows a company to see the
percentage change from one year to the next.
Trend analysis can show the percentage change
from a base year forward to determine whether the
trend in net sales, for example, is positive or
negative.
Vertical analysis shows the relationship of each item
on the statement to a base amount. The base amount
is net sales on the income statement and total assets
on the balance sheet. All other items are reported as
a percentage of the 100% net sales line on the
income statement or the 100% total assets line on
the balance sheet.
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Vertical analysis can be used to prepare
common-size statements to compare companies
against each other. We can benchmark (measure)
a company against a key competitor or measure
a company against the industry average.
Ratio analysis is used to analyze financial
statement data. Ratios provide information about
a company’s performance and are best used to
measure a company against other firms in the
same industry and to denote trends within the
company.
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Ratios tell users about a company’s liquidity,
solvency, profitability, and asset management.
No one ratio can provide the whole picture a
decision maker needs.
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Chapter 3 Analysis of Financial Statements

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1

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Compute dollar changes

Compute percentage changes

1. Prepare a horizontal analysis of the comparative income statement of Mariner

2. Why did 2012 net income increase by a higher percentage

Revenues increase at a higher rate than total expenses.

Balance sheet–each item expressed as percentage of

Percentage of the base amount

Prepare a vertical analysis of Tri-State assets for 2012 and 2011.

20 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

3. Which company’s net income is a higher percentage of its net

Acceptable current ratio 1.50

Normal range 0.20 to 1.00 depending upon industry

Average debt ratio ranges from 57% to 67%

1.Compute Win’s Companies’ current ratio at May 31, 2012 and

2. Did Win’s Companies’ current ratio improve, deteriorate, or hold

Win’s Companies current ratio

2. Compute days’ sales in average receivables during 2012. Round

365/($ 50,200,000/($7,400,000 + $5,300,000)/2 ) = 46 days

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

4. Compute the rate of return on common stockholders’ equity.

Rate of return on common Net income – Preferred dividends

These rates of return are strong considering that average

P/E ratio = Market price per share of common stock

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