Ratios

1
Study Unit Thirteen
Financial Statement Analysis
13.1 Trend, Horizontal, and Common-Size Analysis ............................................................... 2

13.2 Liquidity Ratios ................................................................................................................. 6
13.3 Activity Ratios ................................................................................................................... 9
13.4 Solvency Ratios and Leverage ........................................................................................ 15
13.5 Returns and Profitability ................................................................................................... 19
13.6 Investor and Market Ratios .............................................................................................. 22
13.7 Risk and Return ............................................................................................................... 24
This study unit is the fourth of seven covering Domain IV: Financial Management from The IIA’s
CIA Exam Syllabus. This domain makes up 20% of Part 3 of the CIA exam and is tested primarily
at the basic cognitive level. This study unit on financial analysis is tested at the proficient cognitive
level. The seven study units are
● Study Unit 10: Concepts and Underlying Principles of Financial Accounting
● Study Unit 11: Financial Accounting Elements
● Study Unit 12: Advanced Financial Accounting Concepts
● Study Unit 13: Financial Statement Analysis
● Study Unit 14: Current Assets Management
● Study Unit 15: Capital Structure, Capital Budgeting, Basic Taxation, and Transfer Pricing
● Study Unit 16: Managerial Accounting
The learning objective of Study Unit 13 is

● Interpret financial analysis (horizontal and vertical analysis and ratios related to activity,
profitability, liquidity, and leverage)
Financial statement analysis is used by internal auditors in performing analytical procedures.

Analytical procedures are used to identify possible anomalies requiring further investigation or
provide support for an assessment of consistency with other evidence. Ratio analysis can provide
additional insight by expressing related financial data in percentages or rates. Trend analysis
compares changes in data over time. With these types of analysis, internal auditors can identify
patterns in company data from year to year. Internal auditors can also compare a company’s results
to competitors and industry benchmarks.
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2 SU 13: Financial Statement Analysis
The majority of financial management questions on the CIA exam test conceptual
understanding, not the ability to perform calculations. However, many of our financial
management questions require you to perform calculations. They are an effective
means of reinforcing your conceptual understanding.
13.1 Trend, Horizontal, and Common-Size Analysis
Overview
Financial statements on their own provide limited insights. To be useful to an internal auditor for the
purpose of analytical procedures, the numbers in the financial statements must be compared and
related to other numbers.
● Trend analysis compares the numbers of the current financial statement to the equivalent
numbers in previous financial statements.
● Ratio analysis calculates ratios and metrics based on the expected relationship between different
line items in the financial statements.
Financial analysts employ these techniques to help predict how a business is likely to perform in the
future, based on past performance. They provide a better understanding of risk and return and allow
analysts to determine whether to invest in or lend to a business.
Internal auditors use financial statement analysis techniques to identify fluctuations or relationships
that are inconsistent with expectations and therefore require further investigation.
● Internal auditors also typically have access to financial data that external analysts do not, such as
monthly management reports containing details not appearing in the external financial statements.
Effective financial analysis requires both accurate computations and valid interpretation of the
resulting information. Financial analysis will often prompt questions requiring further investigation.
Inflation, the decrease over time of the purchasing power of money, impairs the comparison of
monetary amounts spanning multiple periods. Because statement of financial position amounts are
expressed in terms of money, historical cost amounts for different periods are measured in units
representing different levels of purchasing power. Net income or loss is also distorted because of
inflation’s effect on depreciation expense and inventory costs.
● The use of financial analysis reduces the impact of inflation because financial data presented as
percentages and multiples are more readily comparable than monetary amounts.
Trend Analysis
Trend analysis is the comparison of data to the equivalent data in other periods.
This technique is widely used by management accounting professionals to identify and explain
movements between the current period and prior period(s) and often the budgeted or planned
amounts. Graphs may be used to enhance the presentation and analysis of the data.
SU 13: Financial Statement Analysis 3
Vertical Analysis
Vertical common-size analysis focuses on the relationships among the financial statement items of a
single accounting period. The changes are expressed in terms of a percentage relationship to a base
item (the base is 100%).
On a common-size income statement, sales is valued at 100%, and each line item is expressed as a
percentage of sales.
Example 13-1 Income Statement -- 2-Year Analysis
Income statement Income statement

External reporting format Common-size format
Current Prior Current Prior
Year Year Year Year
Net sales $1,800,000 $1,400,000 Net sales 100.0% 100.0%
Cost of goods sold (1,650,000) (1,330,000) Cost of goods sold (91.7%) (95.0%)
Gross profit 150,000 70,000 Gross profit 8.3% 5.0%
Selling expenses (50,000) (15,000) Selling expenses (2.8%) (1.1%)
General and General and
admin. expenses (15,000) (10,000) admin. expenses (0.8%) (0.7%)
Operating income 85,000 45,000 Operating income 4.7% 3.2%
Other revenues and gains 20,000 0 Other revenues and gains 1.1% 0.0%
Other expenses and losses (35,000) (10,000) Other expenses and losses (1.9%) (0.7%)
Income before taxes 70,000 35,000 Income before taxes 3.9% 2.5%
Income taxes (40%) (28,000) (14,000) Income taxes (40%) (1.6%) (1.0%)
Net income $ 42,000 $ 21,000 Net income 2.3% 1.5%
On a common-size balance sheet, total assets and total liabilities and stockholders’ equity are all
valued at 100%. Each line item can be interpreted in terms of its proportion of the base 100% amount.
Example 13-2 Balance Sheet -- 2-Year Analysis
Balance sheet Balance sheet

External reporting format Common-size format
Assets: Year End Year End Assets: Year End Year End
Current assets $ 760,000 $ 635,000 Current assets 42.2% 39.7%
Noncurrent assets 1,040,000 965,000 Noncurrent assets 57.8% 60.3%
Total assets $1,800,000 $1,600,000 Total assets 100.0% 100.0%
Liabilities and stockholders’ equity: Liabilities and stockholders’ equity:

Current liabilities $ 390,000 $ 275,000 Current liabilities 21.7% 17.2%
Noncurrent liabilities 610,000 675,000 Noncurrent liabilities 33.9% 42.2%
Total liabilities $1,000,000 $ 950,000 Total liabilities 55.6% 59.4%
Stockholders’ equity 800,000 650,000 Stockholders’ equity 44.4% 40.6%
Total liabilities and Total liabilities and
stockholders’ equity $1,800,000 $1,600,000 stockholders’ equity 100.0% 100.0%
Preparing common-size statements makes it easier to analyze differences among companies of

various sizes or comparisons between a similar company and an industry average.
Horizontal Analysis
Horizontal common-size analysis focuses on changes in operating results and financial position
during two or more accounting periods. The changes are expressed in terms of percentages of
corresponding amounts in a base period.
Example 13-3 Horizontal Analysis
Income statement
External reporting format
nd
Current 2 Prior
Year Prior Year Year
Net sales $1,800,000 $1,400,000 $1,500,000
Cost of goods sold (1,650,000) (1,330,000) (1,390,000)
Gross profit $ 150,000 $ 70,000 $ 110,000
Income statement
Trend analysis
nd
Current 2 Prior
Year Prior Year Year
Net sales 120.0% 93.3% 100.0%
Cost of goods sold 118.7% 95.7% 100.0%
Gross profit 136.4% 63.6% 100.0%
Even though sales and cost of goods sold declined only slightly from the base year to the next year, gross
profit plunged (on a percentage basis). By the same token, when sales recovered in the current year, the
gain in gross profit was (proportionally) greater than the increases in its two components.
There is also a form of horizontal analysis that does not use common sizes. This method is used to
calculate the growth (or decline) of key financial line items.
● For example, if a company’s sales increased from $100,000 to $120,000, there would be a third
column showing the percentage increase, which was 20% in this case.
The financial statements below are used in calculations of ratios referred to in subsequent subunits.
Example 13-4 Balance Sheet
RESOURCES FINANCING
CURRENT ASSETS: Year End Year End CURRENT LIABILITIES: Year End Year End
Cash and equivalents $ 325,000 $ 275,000 Accounts payable $ 150,000 $ 75,000
Available-for-sale securities 165,000 145,000 Notes payable 50,000 50,000
Accounts receivable (net) 120,000 115,000 Accrued interest on note 5,000 5,000
Notes receivable 55,000 40,000 Current maturities of L.T. debt 100,000 100,000
Inventories 85,000 55,000 Accrued salaries and wages 15,000 10,000
Prepaid expenses 10,000 5,000 Income taxes payable 70,000 35,000
Total current assets $ 760,000 $ 635,000 Total current liabilities $ 390,000 $ 275,000
NONCURRENT ASSETS: NONCURRENT LIABILITIES:
Equity-method investments $ 120,000 $ 115,000 Bonds payable $ 500,000 $ 600,000
Property, plant, and equip. 1,000,000 900,000 Long-term notes payable 90,000 60,000
Less: Accum. depreciation (85,000) (55,000) Employee-related obligations 15,000 10,000
Goodwill 5,000 5,000 Deferred income taxes 5,000 5,000
Total noncurrent assets $1,040,000 $ 965,000 Total noncurrent liabilities $ 610,000 $ 675,000
Total liabilities $1,000,000 $ 950,000
STOCKHOLDERS’ EQUITY:
Preferred stock, $50 par $ 130,000 $ 0
Common stock, $1 par 500,000 500,000
Additional paid-in capital 100,000 100,000
Retained earnings 70,000 50,000
Total stockholders’ equity $ 800,000 $ 650,000
Total liabilities and
Total assets $1,800,000 $1,600,000 stockholders’ equity $1,800,000 $1,600,000
Example 13-5 Income Statement
Current Year Prior Year

Net sales $ 1,800,000 $ 1,400,000
Cost of goods sold (1,450,000) (1,170,000)
Gross profit $ 350,000 $ 230,000
SG&A expenses (200,000) (160,000)
Operating income $ 150,000 $ 70,000
Other income and expenses (65,000) (25,000)
Income before interest and taxes $ 85,000 $ 45,000
Interest expense (15,000) (10,000)
Income before taxes $ 70,000 $ 35,000
Income taxes (40%) (28,000) (14,000)
Net income $ 42,000 $ 21,000
13.2 Liquidity Ratios
Liquidity refers to an entity’s ability to pay its current obligations as they come due and remain in
business in the short run.
Figure 13-1
NOTE: Capital structure is covered in Study Unit 15.
Liquidity depends on the ease with which current assets can be converted to cash. Liquidity ratios
measure this ability by relating an entity’s current assets to its current liabilities.
● Current assets include cash and equivalents, marketable securities, receivables (net of allowance
for expected credit losses), inventories, and prepaid expenses.
● Current liabilities include accounts payable, notes payable, current maturities of long-term debt,
unearned revenues, taxes payable, wages payable, and accruals for purchases received but not
yet processed through the accounts payable system.
Working capital is the difference between current assets and current liabilities and is covered in Study
Unit 14, Subunit 1.
Example 13-6 Change in Working Capital
Current year: $760,000 – $390,000 = $370,000

Prior year: $635,000 – $275,000 = $360,000
Although the company’s current liabilities increased, its current assets increased by $10,000 more. The
company has more working capital. If current liabilities had increased by the same amount as current
assets, the working capital balance would not have changed.
Current Ratio
The current ratio expresses current assets as a ratio of current liabilities. The higher the ratio, the
more likely that the business will be able to pay its short-term obligations. However, an overly high
current ratio could suggest inefficient working capital management.
Example 13-7 Current Ratio
Current year: $760,000 ÷ $390,000 = 1.95

Prior year: $635,000 ÷ $275,000 = 2.31
Although working capital increased in absolute terms ($10,000), current assets now provide less
proportional coverage of current liabilities than in the prior year.
The quality of accounts receivable and merchandise inventory should be considered before
evaluating the current ratio. Obsolete or overvalued inventory or receivables can artificially inflate
the current ratio. Effective internal controls over financial reporting mitigate this risk through timely
recording of inventory and adequate allowances for expected credit losses.
The current ratio should be proportional to the operating cycle. Thus, a shorter cycle may justify a
lower ratio.
● For example, a grocery store has a short operating cycle and can operate with a lower current ratio
than a gold mining company, which has a much longer operating cycle.
Quick (Acid-Test) Ratio

Some current assets, such as inventories and prepaid expenses, are considered to be less readily
convertible to cash than other current assets. The quick (acid-test) ratio excludes these less
convertible assets from the numerator to provide a more conservative measure of liquidity.
Example 13-8 Quick (Acid-Test) Ratio
Current year: ($325,000 + $165,000 + $120,000 + $55,000) ÷ $390,000 = 1.71

Prior year: ($275,000 + $145,000 + $115,000 + $40,000) ÷ $275,000 = 2.09
Despite its increase in total working capital, the company’s position in its most liquid assets declined.
The quick ratio measures the firm’s ability to easily pay its short-term debts and avoids the problem of
inventory valuation.
Cash Ratio
The cash ratio reflects the significance of cash flow for settling obligations as they become due. It is
an even more conservative liquidity measure than the quick ratio, though less commonly used.
Example 13-9 Cash Flow Ratio
The company’s cash flows from operations for the two most recent years were $382,000 and $291,000,
respectively.
Current year: $382,000 ÷ $390,000 = 0.979

Prior year: $291,000 ÷ $275,000 = 1.058
Unlike the prior year, the cash flows generated by the company in the most recent year were not sufficient
to cover current liabilities.
Net Working Capital Ratio
The net working capital ratio is the most conservative of the working capital ratios.
Example 13-10 Net Working Capital Ratio
Current year: ($760,000 – $390,000) ÷ $1,800,000 = 0.206

Prior year: ($635,000 – $275,000) ÷ $1,600,000 = 0.225
Current liabilities are taking a bigger “bite” out of working capital than in the prior year.
13.3 Activity Ratios
Activity ratios (also known as asset utilization or efficiency ratios) can help provide insights into the
efficiency with which the business manages its assets or operations. Activity relates both to working
capital and long-term assets.
● Working capital efficiency has a direct impact on liquidity. Working capital is discussed in detail in
Study Unit 14, Subunit 1.
Turnover ratios express how many times assets were sold or turned over during a given year.
● The term “turnover” is also frequently used in some Commonwealth countries to describe sales or
revenue.
Many of the turnover ratio formulas use averages. The use of averages is more theoretically correct
when expressing an item that spans an accounting period. Some analysts may use year-end
balances as a simplification. When using balance sheet items, remember that these are amounts
existing at points in time that may not correspond to the typical level of the balances throughout the
year.
Businesses may engage in “window-dressing,” a practice of managing balances to desired levels at

year-ends. Payments may be delayed in order to boost bank balances, or inventory may be allowed
to fall below the usual balances. Even in the absence of attempts to manage balances reported at the
balance sheet dates, balances may be subject to seasonality inherent to the industry.
The higher the turnover ratios are, the more efficient the business is seen to be. The exception is
payables turnover, where a high multiple may indicate that the business is not taking full advantage of
credit facilities to which it has access and is therefore inefficient in its cash management.
Turnover ratios must be assessed against the context of the industry. A business can achieve an
acceptable return on equity despite a low asset turnover if it has a sufficiently high net income as a
● This relationship is reviewed in the coverage of the DuPont analysis in Subunit 13.5.
Receivables Ratios
The accounts receivable turnover ratio is the number of times in a year the total balance of
receivables is converted to cash.
Average accounts receivable equals beginning accounts receivable plus ending accounts receivable,
divided by two.
If a business is highly seasonal, a simple average of beginning and ending balances is inadequate.
The monthly balances should be averaged instead.
Interpreting the Results

● A higher turnover implies that customers may be paying their accounts promptly.
● Because receivables are the denominator, encouraging customers to pay quickly via credit terms
(such as 2/10, net 30 discussed in Study Unit 14) will lower the balance of receivables. This results
in a higher turnover ratio.
● A lower turnover implies that customers are taking longer to pay.
Example 13-11 Accounts Receivable Turnover
All of the company’s sales are on credit. Net accounts receivables at the reporting date of the second prior
year were $105,000.
Current year: $1,800,000 ÷ [($120,000 + $115,000) ÷ 2] = 15.3 times

Prior year: $1,400,000 ÷ [($115,000 + $105,000) ÷ 2] = 12.7 times
The company turned over its accounts receivables balance 2.6 more times during the current year, even
as receivables were growing in absolute terms. Thus, the company’s effectiveness at collecting accounts
receivable has improved.
The average collection period, also called the days’ sales in receivables or days’ sales
outstanding, measures the average number of days between the time of sale and receipt of the
invoice amount.
Example 13-12 Days’ Sales in Receivables
Current year: 365 days ÷ 15.3 times = 23.9 days

Prior year: 365 days ÷ 12.7 times = 28.7 days
The denominator (calculated in Example 13-11) increased, and the numerator is a constant. Accordingly,
days’ sales in receivables must decrease. In addition to improving its collection practices, the company
also may have become better at assessing the creditworthiness of its customers.
Inventory Ratios
Inventory turnover measures the number of times in a year the total balance of inventory is
converted to cash or receivables.
Average inventory equals beginning inventory plus ending inventory, divided by two.

● A higher turnover implies strong sales or that the firm may be carrying low levels of inventory.
● A lower turnover implies that the firm may be carrying excess levels of inventory or inventory that
is obsolete.
■ Cost of goods sold is the numerator, so higher sales without an increase in inventory balances
results in a higher turnover ratio.
■ Inventory is the denominator, so reducing inventory levels results in a higher turnover ratio.
● The ideal level for inventory varies depending on the industry.
Example 13-13 Inventory Turnover
The balance in inventories at the balance sheet date of the second prior year was $45,000.

Prior year: $1,170,000 ÷ [($55,000 + $45,000) ÷ 2] = 23.4 times
The company did not turn over its inventory as often during the current year as in the prior year. A lower
turnover is expected during a period of growing sales (and increasing inventory). It is not necessarily a
sign of poor inventory management.
Days’ sales in inventory, also called the inventory conversion period, measures the average
number of days that pass between the acquisition of inventory and its sale.
Example 13-14 Days’ Sales in Inventory

Because the numerator is a constant, the decreased turnover means that days’ sales in inventory
increased. This is a common phenomenon during a period of increasing sales.
Other reasons could include (1) a change in production mix to items requiring materials with a longer
purchasing lead time or (2) a defensive move to ensure that sufficient inventory is on hand to reduce the
risk of supply chain issues.
Accounts Payable Ratios
The accounts payable turnover ratio is the number of times during a period that the firm pays its
accounts payable.
Average accounts payable equals beginning accounts payable plus ending accounts payable, divided
by two.

● A higher turnover implies that the firm is taking less time to pay off suppliers and may indicate that
the firm is taking advantage of discounts.
● A lower turnover implies that the firm is taking more time to pay off suppliers and is not taking
advantage of discounts.
Example 13-15 Accounts Payable Turnover
The company had current- and prior-year purchases of $1,480,000 and $1,180,000, respectively. Net
accounts payable at the beginning of the prior year was $65,000.

Prior year: $1,180,000 ÷ [($75,000 + $65,000) ÷ 2] = 16.9 times
The company now carries a much higher balance in payables, so it is not surprising that the balance turns
over less often. It also may be the case that the company was paying invoices too soon in the prior year.
The average payables period (also called payables turnover in days, or payables deferral period) is
the average time between the purchase of inventories and the payment of cash.
Example 13-16 Days’ Payables Outstanding

The increase in days’ payables outstanding may have been the result of deliberate action to negotiate
better credit terms with suppliers or take fuller advantage of the credit terms already available. It could
indicate that the business is having cash flow difficulties resulting in a need to delay payments. However,
an examination of the balance sheet suggests this is not the case.
The working capital management of payables, receivables, and inventory is often expressed in terms
of days rather than the multiples used in turnover metrics. The use of days allows the calculation of
the cash conversion (net operating) cycle.
● The cash conversion cycle compares the number of days that have elapsed from the time the
business invests in working capital in the form of inventory to the time it receives cash either as a
cash sale or as the collection of the receivables arising from a sale on credit.
Days sales in inventory

+ Days sales outstanding
– Days payables outstanding
Cash conversion cycle
● The reduction in the length of time that funds are tied up in working capital was driven by
improvements in all three elements as discussed above.
Example 13-17 Cash Conversion Cycle or Net Operating Cycle
Current year: 17.6 days + 23.9 days – 27.7 days = 13.8 days
Prior year: 15.6 days + 28.7 days – 21.6 days = 22.7 days
Other Turnover Ratios
The total assets turnover and fixed assets turnover are broader-based ratios that measure the
efficiency with which assets are used to generate revenue.
Both cash and credit sales are included in the numerator.
Average total net fixed assets equal beginning total net fixed assets plus ending total net fixed assets,
divided by two.
Example 13-18 Turnover Ratios for Total Assets and Fixed Assets
Current-year total assets turnover: $1,800,000 ÷ [($1,800,000 + $1,600,000) ÷ 2] = 1.06 times

Current-year fixed assets turnover: $1,800,000 ÷ [($915,000 + $845,000) ÷ 2] = 2.04 times
NOTE: The current- and prior-year net carrying amounts of fixed assets are $915,000 ($1,000,000 –
$85,000) and $845,000 ($900,000 – $55,000), respectively.
The working capital turnover ratio measures how effectively a company is using working capital to
generate sales.

● A higher turnover implies that the company is generating a lot of sales for the amount of money it
takes to generate those sales.
Example 13-19 Working Capital Turnover Ratio
Current Year: $1,800,000 ÷ ($760,000 – $390,000) = 4.86 times

Prior Year: $1,400,000 ÷ ($635,000 – $275,000) = 3.89 times
The company turned over its working capital balance .97 more times during the current year, even as
working capital was growing in absolute terms. Thus, the company’s effectiveness at producing sales with
working capital has improved.
13.4 Solvency Ratios and Leverage
Solvency refers to the ability of a business to meet its long-term obligations. This ability is related to
the extent to which the business uses debt versus equity financing. The key ingredients of solvency
are the entity’s capital structure (covered in Study Unit 15) and degree of leverage.
Figure 13-2
Businesses require finance from either debt or equity to fund their expenditures on capital assets and
operating activities.
● Debt can be a better choice than equity because interest payments are tax deductible and debt is
a cheaper source of finance than equity.
● Equity finance is last to receive a payout if the company is liquidated or dissolved. As a result,
shareholders expect a higher return to compensate for this higher risk.
Judicious use of debt financing or financial leverage benefits shareholders by providing them with
a higher return than would be achieved if the return was diluted through the issue of additional
equity. However, too much debt poses a risk to the long-term solvency of the company. Interest
payments and repayments of principal must be made when scheduled, or the company may be put
into liquidation.
Debt Ratios
The following are commonly used debt ratios:
The debt ratio indicates the percentage of assets that have been funded through liabilities.
Example 13-20 Debt Ratio
Current year: $1,000,000 ÷ $1,800,000 = 0.556

Prior year: $ 950,000 ÷ $1,600,000 = 0.594
The company became slightly less reliant on debt in its capital structure during the current year. The
company is thus less leveraged than before.
A debt-to-equity ratio greater than 1 indicates that the company funds more of its assets through
liabilities than it does through debt. A low ratio means lower relative debt and better debt repayment
ability.
Example 13-21 Debt-to-Equity Ratio
Current year: $1,000,000 ÷ $800,000 = 1.25

Prior year: $ 950,000 ÷ $650,000 = 1.46
The amount by which the company’s debts exceed its equity stake declined in the current year. This
reduction in the level of debt to equity was driven by an issue of preferred stock.
Earnings before interest, taxation, depreciation, and amortization (EBITDA) is an approximation of

cash flows before paying interest and taxes. The debt-to-EBITDA ratio expresses how long it would
take to repay the total liabilities from EBITDA. The smaller this time frame, the better the solvency
position of the company.
Earnings Coverage
Earnings coverage is a creditor’s best measure of an entity’s ongoing ability to generate the earnings
that will allow it to satisfy its debts and remain solvent.
The interest coverage ratio reflects the number of times that pretax earnings can cover the company’s
interest expense. The higher this number, the better the solvency position of the company.
Example 13-22 Times-Interest-Earned Ratio
Current year: $85,000 ÷ $15,000 = 5.67

Prior year: $45,000 ÷ $10,000 = 4.50
The entity has improved its ability to pay interest expense. In the prior year, EBIT was only four-and-a-half
times interest expense, but in the current year, it is more than five-and-a-half times.
Leverage
Leverage refers to the use of fixed charges in a company’s cost structure. These charges are either
interest payments (financial leverage) or fixed operating expenses (operating leverage). Either type
of leverage provides benefits during favorable business conditions and poses risks during adverse
business conditions.
Because the charges are fixed, shareholders retain more net income when sales increase.
Conversely, when sales decline, the fixed charges still need to be met and are not reduced in line
with the decline in sales.
The financial leverage ratio compares a company’s total assets against its total shareholders’ equity.
The higher this number, the lower a company’s use of equity financing and therefore the greater its
use of debt in funding the assets of the company.
Example 13-23 Financial Leverage
Current-year financial leverage ratio: $1,800,000 ÷ $800,000 = 2.25
Operating leverage is the extent to which a company’s costs of operating are fixed as opposed to
variable. The higher this number, the greater the company’s use of fixed costs within the operating
cost structure. Variable operating costs increase or decrease in line with increases or decreases in
production. (Behaviors of fixed and variable costs are covered in Study Unit 16.)
13.5 Returns and Profitability
Profitability Ratios
Two categories of profitability ratio can be used to assess the profit earned during a period. Returns
on sales express various levels of income (gross profit, operating profit, pre-tax profit, net profit) as a
● These returns are part of the vertical common-size income statement discussed in Subunit 13.1.
The higher these returns, the greater the amount of sales retained as a profit.
Ideally, a higher return on profit is desirable. However, businesses with a low net profit percentage
can still achieve an acceptable return on equity through a high asset turnover and the use of financial
leverage. This concept is explored in more detail in the discussion of the DuPont model later in this
subunit.
Gross profit margin (also referred to simply as gross margin) is the percentage of gross revenues
that remains with the firm after paying for merchandise. The key analysis with respect to the gross
profit margin is whether it remains stable with any increase or decrease in sales.
● For example, a 10% increase in sales should be accompanied by at least a 10% increase in gross
profit. Therefore, the gross profit margin as a percentage should remain relatively constant at
different sales levels.
● Gross profit is only applicable to certain businesses where there is a clear and substantial cost of
providing their products.
Operating profit margin is the percentage that remains after selling and general and administrative
expenses have been paid. Operating profit represents the profit a business makes from its core
business activities before the inclusion of non-core income and the deduction of interest expense and
taxes.
Example 13-24 Other Profitability Ratios
Current-year gross profit margin: $350,000 ÷ $1,800,000 = 19.4%

Current-year operating income margin: $150,000 ÷ $1,800,000 = 8.3%
Current-year net income margin: $ 42,000 ÷ $1,800,000 = 2.3%
Return on Investment
Return on investment, or ROI (also called return on invested capital), is a broad concept for measures
that reflect how efficiently an entity is using the resources contributed by its shareholders to generate
a profit.
Return on Assets
Return on assets (ROA) is the most basic form of the ROI ratio and is an important element of the
DuPont model discussed later in this subunit. However, an issue with this ratio is that, though it
expresses the return to the shareholders, total assets are funded by both equity and debt funding.
Example 13-25 Return on Assets
Current year: $42,000 ÷ [($1,800,000 + $1,600,000) ÷ 2] = 0.025
During the current year, the company generated $0.025 in net income for each $1 invested in the
company’s assets.
Return on Equity
The return on equity (ROE) ratio measures the return to the providers of equity capital, including
holders of preferred stock.
● This is a key ratio given that the ultimate purpose of a business is to provide adequate returns to
its investors.
Example 13-26 Return on Equity
Current-year ROE: $42,000 net income ÷ [($800,000 + $650,000) ÷ 2] = 0.058
● ROE can be adapted to measure the return accruing to the providers of common stock and/or
ordinary shares.
DuPont Model
The original DuPont model treats ROA as the product of a two-component ratio.
ROA Profit Margin Total Assets Turnover
= ×
The advantage of this analysis is that it examines both the results of operations and the efficiency of
asset usage in generating sales.
Example 13-27 DuPont Model -- ROA
Current-year profit margin: $42,000 net income ÷ $1,800,000 total sales = 0.0233
● Profit margin of 0.0233 means the company generates $0.0233 of net income from each $1 of sales.
● The total assets turnover is 1.06 (as calculated in Example 13-18 on page 14).
● The ROA is 0.025 (0.0233 × 1.06).
Two retailers can have a similar ROA despite having vastly different business models.
● A grocery chain can have very low profit margins while having very high asset turnover.
Conversely, a retailer of luxury items such as jewelry can have high profit margins and low asset
turnover.
13.6 Investor and Market Ratios
Price-Earnings Ratio
Valuation ratios are used as part of the investment decision process. The most prominent is the price-
earnings (P/E) ratio.
The P/E ratio measures the amount that investors are willing to pay for $1 of the company’s earnings.
The P/E ratio is routinely published in the financial press and is used as an indicator of the
affordability of a share of stock.
● A high P/E ratio may suggest that a security is overpriced and that investors may wish to sell.
● Conversely, a low P/E ratio may indicate a value stock that is underpriced and that investors would
want to acquire.
● In either case, the investor would want to perform further analysis before making a decision.
The P/E ratio is based on net income, which may be subject to nonrecurring items that are not
indicative of long-term profitability. The P/E ratio also uses historic earnings that may not be reflective
of future earnings’ prospects.
● A high P/E ratio may not be an indication of an overpriced stock but rather an updated assessment
of the company’s situation. To address this flaw, a projected P/E may be calculated based on the
profits expected for the next year.
Earnings per Share
Earnings per share (EPS) is an essential element of the P/E calculation. The accounting standard
setters prescribe the method that must be used to calculate EPS. Two forms of EPS are required.
● Basic EPS is a ratio of particular interest to the corporation’s common shareholders. It is a
profitability ratio that measures the amount of current-period earnings that can be associated with
a single share of a corporation’s common stock.
● Diluted EPS presents the EPS that would have occurred if potential shares, such as those related
to convertible bonds or convertible preferred stock, had been issued.
Dividend Ratios
Dividend Payout Ratio
Increasing shareholder wealth is the fundamental goal of any business. The dividend payout ratio
measures the portion of available earnings the entity actually distributed to shareholders.
Growing entities tend to have a low payout. They prefer to use earnings for expansion.
Dividend Yield Ratio
The dividend yield ratio measures the percentage of a share’s market price that was returned as
dividends. This ratio can be applied to both common and preferred stock.
Book Value per Common Share
Book value per common share equals the amount of net assets available to shareholders divided by
the number of shares outstanding.
Book value per common share is the amount per share of net assets at the book value (carrying
amounts) that will be received by the common shareholders upon the liquidation of the company.
The limitation of book value per share is that it is a valuation based solely on the amounts recorded in
the books.
Unlike market value, book value does not consider future earnings potential in determining a
company’s valuation.
The recorded values of assets on the books are subject to accounting estimates (e.g., choice of
depreciation method) that may vary across companies within the same industry. Consequently, net
assets may be overstated if estimates are inaccurate.
● Those same assets may be pledged as loan collateral. However, a pledge of collateral is not
recorded as a liability. Thus, book value will not account for this potential liability.
A well-managed firm’s stock should sell at high multiples of its book value.
13.7 Risk and Return
There is a positive relationship between expected risk and return. Pursuing higher returns entails
increased exposure to risk, and making high risk investments presupposes the expectation of greater
returns as compensation. However, returns will not exceed the amount justified by the expected risk.
Risk and return are of concern to individual and institutional investors as well as the businesses they
invest in.
Capital Asset Pricing Model and Beta Coefficient
The return expected by investors on an equity security is important to the management of the
corporation in which the investment is held. Management must consider this expectation when
appraising their own performance of managing existing assets and determining in which capital
projects to invest. Expected return must be inferred or estimated.
The most prominent technique to estimate expected return is the capital asset pricing model
(CAPM).
● CAPM surveys the volatility of the past returns of both the individual security and the market as a
whole.
● These past returns are used to determine a stock’s beta coefficient, a measure of the sensitivity of
the return on the security to the return on the market as a whole.
■ A beta of 1 means that the security will move up or down at the same rate as the market.
■ A beta of more than 1 means that the security moves up or down at a greater rate than the
market.
■ Conversely, a beta of less than 1 means that security has less pronounced movements, up or
down, than the market.
■ A negative beta, which is possible, though unlikely, means that the security will move in the
opposite direction of the market.
● Beta is used along with the risk-free rate and the expected return for the market to estimate the
expected return for the security. The market risk premium is the expected return on the market
less the risk-free rate. The risk-free rate is typically the rate on a government security.
Expected return on security = Risk-free rate + β(Expected return on market – Risk-free rate)
Example 13-28 Required Rate of Return -- CAPM
An investor is considering the purchase of a stock with a beta of 1.2. Treasury bills currently return 8.6%,
and the average return on the market is 10.1%. (U.S. Treasuries are as close to a risk-free investment as
possible.) The return that the investor requires is calculated as follows:
Required rate of return = RF + β(RM – RF)
= 8.6% + 1.2(10.1% – 8.6%)
= 8.6% + 1.8%
= 10.4%
This expected return is the estimate of the cost of equity and is used together with the cost of debt
to determine the weighted average cost of capital (WACC). The WACC can be used in capital
budgeting and the performance measurement metric, residual income.
Two Basic Types of Investment Risk

Systematic risk, or market risk, is unavoidable. Changes in the economy as a whole, such as
inflation or the business cycle, affect all market participants.
● Systematic risk is sometimes called undiversifiable risk. All investments are affected, and this
risk cannot be reduced by diversification.
Unsystematic risk, or firm-specific risk, is the risk inherent in a specific investment. This type of
risk is determined by the firm’s industry, products, customer loyalty, degree of leverage, management
competence, etc.
● Unsystematic risk is diversifiable risk. Because individual investments are affected by the
strengths and weaknesses of the firm, this risk can be reduced by diversification.
Residual Income
Residual income (RI) is a performance management metric intended to align the interests of
managers with those of the organization. In contrast to ROI, which is a percentage return, RI is a
monetary metric that incentivizes profit maximization. ROI is covered in Subunit 13.5.
Residual income = Operating income – Target return on invested capital
The target return equals average invested capital times an imputed interest rate. The rate ordinarily is
the weighted-average cost of capital (defined in Study Unit 15, Subunit 4), but it may be a hurdle rate
reflecting the specific risks of a project.
Generally, projects with a positive residual income should be accepted. Projects with a negative
residual income should be rejected.
If managers are evaluated and compensated on the basis of ROI, they may not pursue investment
opportunities that are beneficial to the organization as a whole.
● RI is therefore often considered superior to ROI because it eliminates the incentive for managers
to decline projects that would lower the existing ROI of their responsibility center but exceed the
required rate of return for the organization.
Types of Investment Risk

● Credit default risk, or counterparty risk, is the risk that the borrower will default and will not be
able to repay principal or interest. This risk is estimated by credit-rating agencies.
● Liquidity risk is the risk that a security cannot be sold on short notice for its market value.
■ This is distinct from the liquidity concerns addressed by liquidity ratios (the potential inability of
the business to pay its short-term obligations as they come due).
● Maturity risk, or interest rate risk, is the risk that an investment security will fluctuate in value
between the time it was issued and its maturity date. The longer the time until maturity, the greater
the maturity risk.
● Inflation risk is the risk that the purchasing power of the currency will decline.
● Political risk is the possibility of loss from actions of governments, such as from changes in tax
laws or environmental regulations or from expropriation of assets.
● Exchange rate risk, or currency risk, is the risk of loss because of fluctuation in the relative
value of foreign currency.
● Business risk is the risk of fluctuations in operating earnings. Business risk is the combination of
the following:
■ Sales risk results from uncertainty with regard to sales prices and sales volumes.
■ Operating risk results from operating cost structure, particularly the use of fixed costs
(operating leverage).
Efficient Markets Hypothesis
The efficient markets hypothesis states that current stock prices immediately and fully reflect all
relevant information. Thus, the market is continuously adjusting to new information and acting to
correct pricing errors. The efficient markets hypothesis has three forms.
Strong Form All public and private information is instantaneously reflected in securities’ prices.
All publicly available data are reflected in security prices, but private or insider data
Semistrong Form
are not immediately reflected.
Weak Form Current securities prices reflect all recent price movement data.

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1

Study Unit Thirteen

Financial Statement Analysis

13.1 Trend, Horizontal, and Common-Size Analysis ............................................................... 2

The learning objective of Study Unit 13 is

Financial statement analysis is used by internal auditors in performing analytical procedures.

13.1 Trend, Horizontal, and Common-Size Analysis

Example 13-1 Income Statement -- 2-Year Analysis

Income statement Income statement

Example 13-2 Balance Sheet -- 2-Year Analysis

Balance sheet Balance sheet

Liabilities and stockholders’ equity: Liabilities and stockholders’ equity:

Preparing common-size statements makes it easier to analyze differences among companies of

Example 13-3 Horizontal Analysis

Example 13-4 Balance Sheet

Example 13-5 Income Statement

Current Year Prior Year

13.2 Liquidity Ratios

NOTE: Capital structure is covered in Study Unit 15.

Example 13-6 Change in Working Capital

Current year: $760,000 – $390,000 = $370,000

Example 13-7 Current Ratio

Current year: $760,000 ÷ $390,000 = 1.95

Quick (Acid-Test) Ratio

Example 13-8 Quick (Acid-Test) Ratio

Current year: ($325,000 + $165,000 + $120,000 + $55,000) ÷ $390,000 = 1.71

Example 13-9 Cash Flow Ratio

Current year: $382,000 ÷ $390,000 = 0.979

Net Working Capital Ratio

Example 13-10 Net Working Capital Ratio

Current year: ($760,000 – $390,000) ÷ $1,800,000 = 0.206

13.3 Activity Ratios

Businesses may engage in “window-dressing,” a practice of managing balances to desired levels at

Interpreting the Results

● A lower turnover implies that customers are taking longer to pay.

Example 13-11 Accounts Receivable Turnover

Current year: $1,800,000 ÷ [($120,000 + $115,000) ÷ 2] = 15.3 times

Example 13-12 Days’ Sales in Receivables

Current year: 365 days ÷ 15.3 times = 23.9 days

Interpreting the Results

● The ideal level for inventory varies depending on the industry.

Example 13-13 Inventory Turnover

Current year: $1,450,000 ÷ [($85,000 + $55,000) ÷ 2] = 20.7 times

Example 13-14 Days’ Sales in Inventory

Current year: 365 days ÷ 20.7 times = 17.6 days

Accounts Payable Ratios

Interpreting the Results

Example 13-15 Accounts Payable Turnover

Current year: $1,480,000 ÷ [($150,000 + $75,000) ÷ 2] = 13.2 times

Example 13-16 Days’ Payables Outstanding

Current year: 365 days ÷ 13.2 times = 27.7 days

Days sales in inventory

Example 13-17 Cash Conversion Cycle or Net Operating Cycle

Other Turnover Ratios

Both cash and credit sales are included in the numerator.

Current-year total assets turnover: $1,800,000 ÷ [($1,800,000 + $1,600,000) ÷ 2] = 1.06 times

Interpreting the Results

Example 13-19 Working Capital Turnover Ratio

Current Year: $1,800,000 ÷ ($760,000 – $390,000) = 4.86 times

13.4 Solvency Ratios and Leverage