Financial Statement Analysis

Chapter 3
Learning Objectives

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

2
Financial Statement Analysis
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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Financial Statement Analysis
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

4
 1
Perform a horizontal analysis of financial
statements

5
Horizontal Analysis
The study of percentage changes in comparative
statements
Increase (Decrease)
2024 2023 Amount Percentage
Revenues (same as Net sales) ………… $ 3,189 $ 1,466 $ 1,723 117.50%

2024 2023 Increase

Compute dollar changes $ 3,189 – $ 1,466 = $ 1,723

Compute percentage changes

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Example: Income Statement
Step 1
Increase (Decrease)
(Dollar amounts in millions) 2024 2023 Amount Percentage
Revenues $ 3,189 $ 1,466 $ 1,723 117.5%
Cost of revenues 1,458 626 832 132.9%
Gross profit $ 1,731 $ 840 $ 891 106.1%
Operating expenses:
Sales and marketing expense $ 246 $ 120 $ 126 105.0%
General and administrative expense 140 57 83 145.6%
Research and development expense 225 91 134 147.3%
Other expense 470 225 245 108.9%
Total operating expenses $ 1,081 $ 493 $ 588 119.3%
Income before income tax $ 650 $ 347 $ 303 87.3%
Income tax expense 251 241 10 4.1%
Net income $ 399 $ 106 $ 293 276.4%

Step 2
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Example: Balance Sheet (partial)
Increase
(Decrease)
(Dollar amounts in millions) 2024 2023 Amount Percentage
Assets
Current assets:
Cash and cash equivalents $ 427 $ 149 $ 278 186.6%
Other current assets 2,266 411 1,855 451.3%
Total current assets $ 2,693 $ 560 $ 2,133 380.9%
Property, plant, and equipment, net 379 188 191 101.3%
Intangible assets, net 194 106 88 83.0%
Other assets 47 17 30 176.5%
Total assets $ 3,313 $ 871 $ 2,442 280.4%
Liabilities
Current liabilities:
Accounts payable $ 33 $ 46 $ (13) (28.3)%
Other current liabilities 307 189 118 62.4%
Total current liabilities $ 304 $ 235 $ 105 44.7%
Long-term liabilities 44 47 (3) (6.4)%
Total liabilities $ 384 $ 282 $ 102 36.2%
Stockholders' Equity
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Trend Percentages
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 Trend % = Any year $  100
Base year $

(In millions) 2024 2023 2020 2019 2018

Net Sales ….................. $3,189 1,466 1,280 976 1,000
Trend persentages ….. 318.90% 146.60% 128.00% 97.60% 100%

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 E03-13: HORIZONTAL ANALYSIS—INCOME STATEMENT
Data for Mariner Designs, Inc., follow:
MARINER DESIGNS, INC.
Comparative Income Statement
Years Ended December 31, 2024 and 2023
2024 2023
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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 E03-13: HORIZONTAL ANALYSIS—INCOME STATEMENT

MARINER DESIGNS, INC.

Comparative Income Statement
Years Ended December 31, 2024 and 2023
Increase (Decrease)
2024 2023 Amount Percent
Net sales revenue
Expenses:
Cost of goods sold
Selling and general
expenses
Other expense
Total expenses
Net income
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 E03-13: HORIZONTAL ANALYSIS—INCOME STATEMENT

Data for Mariner Designs, Inc., follow:

2. Why did 2024 net income increase by a higher percentage

than net sales revenue?

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 2
Perform a vertical analysis of financial
statements

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Vertical Analysis
Shows relationship of each item to a base
amount on financial statements
Income statement–each item expressed as
percentage of net sales
Each income statement item
Vertical analysis % =  100
Revenues (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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Example: Income Statement
Base amount
2024
(Dollar amounts in millions) Amount Percent of Total
Revenues $ 3,189 100.0%
Cost of revenues 1,458 45.7%
Gross profit $ 1,731 54.3%
Operating expenses:
Sales and marketing expense $ 246 7.7%
General and administrative expense 140 4.4%
Research and development expense 225 7.1%
Other expense 470 14.7%
Total operating expenses $ 1,081 33.9%
Income before income tax $ 650 20.4%
Income tax expense 251 7.9%
Net income $ 399 12.5%

Percentage of the base amount

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Example: Balance Sheet
2024
(Dollar amounts in millions) Amount Percent of Total
Base amount Assets
Current assets:
Cash and cash equivalents $ 427 12.9%
Other current assets 2,266 68.4%
Total current assets $ 2,693 81.3%
Property, plant, and equipment, net 379 11.4%
Intangible assets, net 194 5.9%
Percentage Other assets 47 1.4%
of base Total assets
Liabilities
$ 3,313 100.0%

Current liabilities:
Accounts payable $ 33 1.0%
Other current liabilities 307 9.3%
Total current liabilities $ 304 10.3%
Long-term liabilities 44 1.3%
Total liabilities $ 384 11.6%
Stockholders' Equity
Common stock $1 0.0%
Retained earnings and other equity 2,928 88.4%
2,929 88.4%
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 S03-3 : VERTICAL ANALYSIS
Tri-State Optical Company reported the following amounts on its
balance sheet at December 31, 2024 and 2023:
2024 2023
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 2024 and 2023.

2024 % of 2023 % of
total total
Cash and receivables
Inventory
Property, plant, and equipment, net
Total assets
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 3
Prepare and use common-size financial
statements

18
Common-Size Statements
Common-size statements compare one company
to another
Report only percentages (same as vertical analysis)
Remove dollar value bias

19
Benchmarking
Comparing a company with another leading
company
Two main types:
Against a key competitor
Against the industry average

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 S03-4 :COMMON-SIZE INCOME STATEMENT
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.

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 S03-4 :COMMON-SIZE INCOME STATEMENT
(Continued)

2. Which company earns more net income?

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

sales?

22
 4
Compute and evaluate the standard financial
ratios

23
Financial Ratios
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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Ability to Pay Current Liabilities
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
Greg's Tunes' Current Ratio Industry
2024 2023 Average
$262,000 236,000
= 1.85 = 1.87 0.60
$142,000 126,000

Acceptable current ratio 1.50

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Ability to Pay Current Liabilities
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
Greg's Tunes' Acid-Test Ratio Industry
2024 2023 Average
$29,000 + $0 $32,000 + $0
+ $114,000 + $85,000
= 1.01 = 0.93 0.46
$142,000 $126,000

Normal range 0.20 to 1.00 depending upon industry

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Ability to Sell Inventory and Collect
Receivables
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
Greg's Tunes' Industry
Inventory Turnover Average
$513,000
= 4.6 27.7
$112,000

27
Ability to Sell Inventory and Collect
Receivables
Days in inventory ratio
Measures the average number of days inventory is
held by the company
Formula
365 days
Days in inventory =
Inventory turnover ratio

Greg's Tunes' Industry

Inventory Turnover Average
365 days
= 79 days 13 days
4.6

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Ability to Sell Inventory and Collect
Receivables
Gross profit percentage
Measures the profitability of each net sales dollar
Formula
Gross profit
Gross profit percentage =
Net sales
Greg's Tunes' Industry
Gross Profit Percentage Average
$345,000
= 0.402 or 40.2% 43%
$858,000

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Ability to Sell Inventory and Collect
Receivables
Accounts receivable turnover ratio
Measures ability to collect cash from credit
customers
Formula
Net credit sales
Accounts receivable turnover =
Average net accounts receivable
Greg's Tunes' Industry
Accounts Receivable Turnover Average
$858,000
= 8.6 29.1
$99,500

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Ability to Sell Inventory and Collect
Receivables
Days’ sales in receivables ratio
Measures ability to collect receivables
Formula
Days’ sales in 365 days
average accounts = Accounts receivable
receivable turnover ratio
Greg's Tunes'
Industry
Days' Sales in
Average
Accounts Receivable
365
= 42 days 25 days
8.6

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Ability to Pay Long-Term Debt
Debt ratio
Shows portion of assets financed with debt
The higher the ratio, the higher the risk
Formula
Debt ratio = Total liabilities
Total assets
Greg's Tunes' Debt Ratio Industry
2024 2023 Average
$431,000 $324,000
= 0.548 (54.8%) = 0.503 (50.3%) 0.69 (69%)
$787,000 $644,000

Average debt ratio ranges from 57% to 67%

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Ability to Pay Long-Term Debt
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
Greg's Tunes' Debt Ratio Industry
2024 2023 Average
$431,000 $324,000
= 1.21 = 1.01 2.23
$356,000 $320,000

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Ability to Pay Long-Term Debt
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
Greg's Tunes' Acid-Test Ratio Industry
2024 2023 Average
$48,000 + $33,000 $26,000 + $17,000
+ $24000 + $14,000
= 4.38 = 4.07 7.80
$24,000 $14,000

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Measuring Profitability
Return on net sales
Percent of each sales dollar earned as net income
Formula
Rate of return Net income
=
on net sales Net sales
Greg's Tunes'
Industry
Rate of Return on Net Sales
Average
2024 2023
$48,000 $26,000
= 0.056 (5.6%) = 0.032 (3.2%) 0.017 (1.7%)
$858,000 $803,000

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Measuring Profitability
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

Greg's Tunes’ 2024 Industry

Rate of Return on Total Assets Average
$48,000 + $24,000
= 0.101 (10.1%) 0.060 (6.0%)
$715,500

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Measuring Profitability
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

Greg's Tunes' 2024 Industry

Asset Turnover Ratio Average
$858,000
= 1.20 times 3.52 times
$715,500

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Measuring Profitability
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

Greg's Tunes' 2024 Rate of Return Industry

on Common Stockholders' Equity Average
$48,000 - $0
= 0.142 (14.2%) 0.105 (10.5%)
$338,000

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Leverage
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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Measuring Profitability
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
Greg's Tunes' Earnings per Share Industry
2024 2023 Average
$48,000 - $0 $26,000 - $0
= $4.80 = $2.60 $9.76
10,000 10,000

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Analyzing Stock Investments
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

Greg's Tunes'
Industry
Price/Earnings Ratio
Average
2024 2023
$60.00 $35.00
= 12.50 = 13.46 17.79
$4.80 $2.60

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 Analyzing Stock Investments
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

Dividend Yield on Greg's

Industry
Tunes' Common Stock
Average
2024 2023
$1.20 $1.00
= 0.020 (2%) = 0.029 (2.9%) 0.036 (3.6%)
$60.00 $35.00

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Analyzing Stock Investments
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

Greg's Tunes' Dividend Payout

Industry
on Common Stock
Average
2024 2023
$1.20 $1.00
= 0.25 or 25% = 0.38 or 38% 0.63 or 63%
$4.80 $2.60

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 Analyzing Stock Investments
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
Greg's Tunes' Book Value per
Share of Common Stock
2024 2023
$356,000 - $0 $320,000 - $0
= $35.60 = $32.00
10,000 10,000

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 S03-5: EVALUATING CURRENT RATIO
Win’s Companies, a home improvement store chain, reported the
following summarized figures:
WIN'S COMPANIES
Income Statement
Years Ended May 31, 2024 and 2023
2024 2023
Net sales $ 50,200,200 $ 43,800,000
Cost of goods sold 28,400,000 29,300,000
Interest expense 500,000 140,000
All other expenses 5,800,000 8,400,000
Net income $ 15,500,00 $ 5,960,000
WIN'S COMPANIES
Balance Sheet
May 31, 2024 and 2023
Assets 2024 2023 Liabilities 2024 2023
Cash $ 2,000,000 $ 900,000Total current liabilities $ 33,000,000 $ 13,100,000
Short-term investment 28,000,000 9,000,000Long-term liabilities 12,300,000 10,600,000
Accounts receivable 7,400,000 5,300,000Total liabilities $ 45,300,000 $ 23,700,000
Inventory 6,900,000 8,200,000Stockholders' Equity
Other current assets 10,000,000 1,800,000Common stock $ 11,000,000 $ 11,000,000
Total current assets $ 54,300,000 $ 25,200,000Retained earnings 32,000,000 16,500,000
All other assets 34,000,000 26,000,000Total equity $ 43,000,000 $ 27,500,000
Total assets $ 88,300,000 $ 51,200,000Total liabilities and equity $ 88,300,000 $ 51,200,000
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 S03-5 : EVALUATING CURRENT RATIO

(Continued)

1. Compute Win’s Companies’ current ratio at May 31, 2024 and

2023. Current assets
Current ratio = Current liabilities

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

steady during 2024?

46
 S03-6: COMPUTING INVENTORY, GROSS PROFIT, AND
RECEIVABLES RATIOS
Use the Win’s Companies data in Short Exercise 03-5 to
complete the following requirements.
1.Compute the rate of inventory turnover, days in inventory,
and gross profit percentage for 2024.

Cost of goods sold

Inventory turnover =
Average inventory

365 days
Days in inventory =
Inventory turnover ratio

Gross profit
Gross profit percentage =
Net sales

47
 S03-6 : COMPUTING INVENTORY, GROSS PROFIT, AND
RECEIVABLES RATIOS

(Continued)

2. Compute days’ sales in average receivables during 2024. 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

48
 S03-7: MEASURING ABILITY TO PAY LIABILITIES

Use the financial statements of Win’s Companies in Short Exercise

03-5.

1. Compute the debt ratio and the debt to equity ratio at May 31,
2024.
Debt ratio = Total liabilities
Total assets

Total liabilities
Debt to equity =
Total equity

2. Is Win’s ability to pay its liabilities strong or weak? Explain

your reasoning.

49
 S03-8 : MEASURING PROFITABILITY
Use the financial statements of Win’s Companies in Short
Exercise 03-5 to complete the following profitability measures for
2024.
1. Compute the rate of return on net sales.
Rate of return = Net income
on net sales Net sales

2. Compute the rate of return on total assets.

Rate of return Net income + Interest expense
=
on total assets Average total assets

3. Compute the asset turnover ratio.

Net sales
Asset turnover ratio =
Average total assets
50
 S03-8 : MEASURING PROFITABILITY

(Continued)

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

Rate of return on
Net income – Preferred dividends
common =
Average common stockholders’ equity
stockholders’ equity

5. Are these rates of return strong or weak? Explain your reasoning.

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 S03-9 : COMPUTING EPS AND P/E RATIO
Use the financial statements of Win’s Companies in Short Exercise
03-5. Win’s has 500,000 common shares outstanding during 2024.
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

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

52
Red Flags
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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