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Financial Statement Analysis

Basics of Financial Statement Analysis

Horizontal and Vertical Analysis

Ratio Analysis

Earning Power and Irregular Items

Quality of Earnings

Need for comparative analysis

Tools of analysis

Balance sheet

Income statement

Retained earnings statement

Liquidity

Profitability

Solvency

Summary

Discontinued operations

Extraordinary items

Changes in accounting principle

Comprehensive income

Alternative accounting methods

Pro forma income

Improper recognition

Basics of Financial Statement Analysis

Analyzing financial statements involves:

Characteristics

Comparison

Bases

Tools of

Analysis

Liquidity

Profitability

Solvency

Intracompany

Industry averages

Intercompany

Horizontal

Vertical

Ratio

SO 1 Discuss the need for comparative analysis.

SO 2 Identify the tools of financial statement 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.

SO 3 Explain and apply 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.

SO 3 Explain and apply horizontal analysis.

Illustration 18-6

Horizontal analysis of

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.

SO 3 Explain and apply horizontal analysis.

Illustration 18-7

Horizontal analysis of

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.

SO 3 Explain and apply horizontal 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.

SO 4 Describe and apply 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.

SO 4 Describe and apply vertical analysis.

Illustration 18-9

Vertical analysis of

Income statements

Quality appears

to be a profitable enterprise that is becoming even more successful.

SO 4 Describe and apply 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%).

SO 4 Describe and apply vertical analysis.

Ratio analysisexpresses the relationship among selected items of financial statement data.

Financial Ratio Classifications

Liquidity

Profitability

Solvency

Measures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.

Measures the income or operating success of a company for a given period of time.

Measures the ability of the company to survive over a long period of time.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

A single ratio by itself is not very meaningful.

The discussion of ratios will include the following types of comparisons.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Compute the Acid-Test Ratiofor 2007.

Illustration 18-13

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Compute the Acid-Test Ratio for 2007.

Cash + Short-Term Investments + Receivables (Net)

Acid-Test Ratio

=

Current Liabilities

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

= 1.02 : 1

$344.500

The acid-test ratio measures immediate liquidity.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Compute the Receivables Turnoverratio 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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

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 periodin terms of days.

365 days / 10.2 times = every 35.78 days

This means that receivables are collected on average every 36 days.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Compute the Inventory Turnoverratio 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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Inventory Turnover

$1,281,000

= 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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Compute the Profit Marginratio 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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Compute the Asset Turnoverratio 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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Compute the Return on Assetsratio 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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Compute the Return on Common Stockholders’ Equity ratio for 2007.

Return on Common Stockholders’ Equity

Net Income – Preferred Dividends

=

Average Common Stockholders’ 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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

Compute the Price Earnings Ratio for 2007.

Price Earnings Ratio

Market Price per Share of Stock

=

Earnings Per Share

$12.00

= 12.4 times

$0.97

The price-earnings (PE) ratio reflects investors’ assessments of a company’s future earnings.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

Ratio Analysis

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.

SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

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