Chapter 14

“How Well Am I Doing?”

Financial Statement Analysis

McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
14-2
Limitations of Financial Statement
Analysis

Differences in accounting methods

between companies sometimes
make comparisons difficult.

We use the LIFO method to We use the FIFO method to

value inventory. value inventory.
14-3
Limitations of Financial Statement
Analysis

Changes within
the company
Industry Consumer
trends tastes

Technological
changes
Economic
factors

Analysts should look beyond

the ratios.
14-4
Statements in Comparative and
Common-Size Form

 Dollar and percentage

changes on statements
Analytical
techniques used to  Common-size
examine statements
relationships among
financial statement
items  Ratios
14-5

Learning Objective 1

Prepare and interpret

financial statements in
comparative and
common-size form.
14-6

Horizontal Analysis

Horizontal analysis shows the

changes between years in the
financial data in both dollar and
percentage form.
14-7

Horizontal Analysis

Example

The following slides illustrate a

horizontal analysis of Clover
Corporation’s December 31, 2008
and 2007 comparative balance
sheets and comparative income
statements.
14-8

Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2008 2007 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
14-9

Horizontal Analysis

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

The
The dollar
dollar
amounts
amounts forfor
2007
2007 become
become
the
the “base”
“base” year
year
figures.
figures.
14-10

Horizontal Analysis

Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
14-11

Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2008 2007 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $12,000 –155,000
$23,500164,700
= $(11,500)
Property and equipment:
Land 40,000 40,000
($11,500
Buildings and equipment, net ÷ $23,500)
120,000 × 100% = 48.9%
85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
14-12

Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2008 2007 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
14-13

Horizontal Analysis

We could do this for the

liabilities & stockholders’
equity, but instead, let’s
look at the income
statement.
14-14

Horizontal Analysis

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2008 2007 Amount %
Net sales $ 520,000 $ 480,000
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
Net operating income 31,400 39,000
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
14-15

Horizontal Analysis

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2008 2007 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
14-16

Horizontal Analysis

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2008 2007 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin
Sales increased 160,000
by 8.3%,165,000
yet (5,000) (3.0)
Operating expenses 128,600
net income decreased by126,000
21.9%. 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
14-17

Horizontal Analysis

CLOVER CORPORATION
There were increases in both cost of goods
Comparative Income Statements
sold (14.3%) and operating expenses (2.1%).
For the Years Ended December 31
These increased costs more than offset theIncrease
increase in sales, yielding an overall (Decrease)
decrease in net income.
2008 2007 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
14-18

Trend Percentages

Trend percentages
state several years’
financial data in terms
of a base year, which
equals 100 percent.
14-19

Trend Percentages

Trend Current Year Amount 100%

Percentage
=
Base Year Amount
×
14-20

Trend Percentages

Example

Look at the information for Berry Products

for the years 2003 through 2007. We will
complete a trend analysis using these
amounts to see what we can learn about
the company.
14-21

Trend Percentages

Berry Products
Income Information
For the Years Ended December 31
Year
Item 2007 2006 2005 2004 2003
Sales $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of goods sold 285,000 250,000 225,000 198,000 190,000
Gross margin 115,000 105,000 95,000 92,000 85,000

The base
year is 2003, and its amounts
will equal 100%.
14-22

Trend Percentages

Berry Products
Income Information
For the Years Ended December 31
Year
Item 2007 2006 2005 2004 2003
Sales 105% 100%
Cost of goods sold 104% 100%
Gross margin 108% 100%

2004 Amount ÷ 2003 Amount × 100%

( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
14-23

Trend Percentages

Berry Products
Income Information
For the Years Ended December 31
Year
Item 2007 2006 2005 2004 2003
Sales 145% 129% 116% 105% 100%
Cost of goods sold 150% 132% 118% 104% 100%
Gross margin 135% 124% 112% 108% 100%

By analyzing the trends for Berry Products, we

can see that cost of goods sold is increasing
faster than sales, which is slowing the increase
in gross margin.
14-24

Trend Percentages

We can use the trend

160 percentages to construct a
graph so we can see the
150
trend over time.
140
Percentage

130

120 Sales
COGS
110 GM
100
2003 2004 2005 2006 2007
Year
14-25

Common-Size Statements

Common-size
statements use
percentages to express
the relationship of
individual components to
a total within a single
period. This is also
known as vertical
analysis.
analysis
14-26

Common-Size Statements

In income
statements, all
items are
expressed as a
percentage of
net sales.
14-27

Gross Margin Percentage

Gross Margin Gross Margin

=
Percentage Sales

This measure indicates how much

of each sales dollar is left after
deducting the cost of goods sold to
cover expenses and provide a profit.
14-28

Common-Size Statements

In balance
sheets, all items
are expressed
as a percentage
of total assets.
14-29

Common-Size Statements

Wendy's McDonald's
(dollars in millions) Dollars Percentage Dollars Percentage
2002 Net income $ 219 8.00% $ 894 5.80%

Common-size financial statements are

particularly useful when comparing
data from different companies.
14-30

Common-Size Statements

Example

Let’s take another look at the information

from the comparative income statements
of Clover Corporation for 2007 and 2008.
This time, let’s prepare common-size
statements.
14-31

Common-Size Statements

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2008 2007 2008 2007
Net sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000 Net sales is
Operating expenses 128,600 126,000 the base
Net operating income 31,400 39,000 and is
Interest expense 6,400 7,000 expressed
Net income before taxes 25,000 32,000
as 100%.
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
14-32

Common-Size Statements

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2008 2007 2008 2007
Net sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
2008 Cost
Net operating ÷ 2008 Sales
income 31,400× 100%
39,000
( $360,000
Interest expense ÷ $520,000 ) × 100%
6,400 = 69.2%
7,000
Net income before taxes 25,000 32,000
Less income 2007 Cost ÷ 2007
taxes (30%) 7,500 Sales × 100%
9,600
Net income ( $315,000 $÷17,500 $480,000 ) × 100% = 65.6%
$ 22,400
14-33

Common-Size Statements

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
What conclusions can we draw? Percentages
2008 2007 2008 2007
Net sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000 30.8 34.4
Operating expenses 128,600 126,000 24.8 26.2
Net operating income 31,400 39,000 6.0 8.2
Interest expense 6,400 7,000 1.2 1.5
Net income before taxes 25,000 32,000 4.8 6.7
Less income taxes (30%) 7,500 9,600 1.4 2.0
Net income $ 17,500 $ 22,400 3.4 4.7
14-34

Quick Check 

Which of the following statements describes

horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c. A comparison of the account balances on

the current year’s financial statements.

d. None of the above.
14-35

Quick Check 

Which of the following statements describes

horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c.Horizontal
A comparison of the
analysis account
shows the balances
changes on
between years in the financial data, in
theboth
current year’s
dollar and financial
percentagestatements.
form.
d. None of the above.
14-36

Ratios

Common
Stockholders

Short-term
Creditors

Long-term
Creditors
14-37
Now, let’s look at
Norton
Corporation’s
2006 and 2007
financial
statements.
14-38
NORTON CORPORATION
Balance Sheets
December 31

2007 2006
Assets
Current assets:
Cash $ 30,000 $ 20,000
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets $ 346,390 $ 300,000
14-39 NORTON CORPORATION
Balance Sheets
December 31

2007 2006
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 39,000 $ 40,000
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities:
Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Stockholders' equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000
Total liabilities and stockholders' equity $ 346,390 $ 300,000
14-40

NORTON CORPORATION
Income Statements
For the Years Ended December 31

2007 2006
Net sales $ 494,000 $ 450,000
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000
Net income before taxes 76,700 66,000
Less income taxes (30%) 23,010 19,800
Net income $ 53,690 $ 46,200
14-41

Learning Objective 2

Compute and interpret

financial ratios that would be
useful to a common
stockholder.
14-42
Ratio Analysis – The Common
Stockholder
NORTON CORPORATION
2007
Use this Number of common shares
information to outstanding
Beginning of year 17,000
calculate ratios End of year 27,400
Net income $ 53,690
to measure the Stockholders' equity
well-being of Beginning of year 180,000

the common End of year 234,390

Dividends per share 2
stockholders of Dec. 31 market price per share 20

Norton Interest expense 7,300

Total assets
Corporation. Beginning of year 300,000
End of year 346,390
14-43

Earnings Per Share

Net Income – Preferred Dividends

Earnings per Share =
Average Number of Common
Shares Outstanding

Whenever a ratio divides an income statement

balance by a balance sheet balance, the average
for the year is used in the denominator.
14-44

Earnings Per Share

Net Income – Preferred Dividends

Earnings per Share =
Average Number of Common
Shares Outstanding
$53,690 – 0
Earnings per Share = = $2.42
(17,000 + 27,400)/2

This measure indicates how much

income was earned for each share of
common stock outstanding.
14-45

Price-Earnings Ratio

Price-Earnings Market Price Per Share

=
Ratio Earnings Per Share

Price-Earnings $20.00
= = 8.26 times
Ratio $2.42

This measure is often used by investors

as a general guideline in gauging stock
values. Generally, the higher the price-
earnings ratio, the more opportunity a
company has for growth.
14-46

Dividend Payout Ratio

Dividend Dividends Per Share

=
Payout Ratio Earnings Per Share

Dividend $2.00
= = 82.6%
Payout Ratio $2.42

This
This ratio
ratio gauges
gauges the
the portion
portion of
of current
current
earnings
earnings being
being paid
paid out
out in
in dividends.
dividends.
Investors
Investors seeking
seeking current
current income
income would
would
like
like this
this ratio
ratio to
to be
be large.
large.
14-47

Dividend Yield Ratio

Dividend Dividends Per Share

=
Yield Ratio Market Price Per Share

Dividend $2.00
= = 10.00%
Yield Ratio $20.00

This ratio identifies the return, in

terms of cash dividends, on the
current market price of the stock.
14-48

Return on Total Assets

Return on Net Income + [Interest Expense × (1 – Tax Rate)]

=
Total Assets Average Total Assets

Return on $53,690 +[7,300 × (1 – .30)]

= = 18.19%
Total Assets ($300,000 + $346,390) ÷ 2

This ratio measures how well

assets have been employed.
14-49
Return on Common Stockholders’
Equity

Return on Common = Net Income – Preferred Dividends

Stockholders’ Equity
Average Stockholders’ Equity

Return on Common = $53,690 – 0 = 25.91%

Stockholders’ Equity ($180,000 + $234,390) ÷ 2

This measure indicates how well the

company employed the owners’
investments to earn income.
14-50

Financial Leverage

Financial leverage involves

acquiring assets with funds at a
fixed rate of interest.
Fixed rate of
Return on return on Positive
investment in > borrowed = financial
assets funds leverage

Return on Fixed rate of Negative

investment in < return on = financial
assets borrowed leverage
funds
14-51

Quick Check 

Which of the following statements is true?

a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
14-52

Quick Check 

Which of the following statements is true?

a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
14-53

Book Value Per Share

Book Value Common Stockholders’ Equity

=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

This ratio measures the amount that would be

distributed to holders of each share of common
stock if all assets were sold at their balance sheet
carrying amounts and if all creditors were paid off.
14-54

Book Value Per Share

Book Value Common Stockholders’ Equity

=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

Notice that the book value per share of $8.55 does

not equal the market value per share of $20. This
is because the market price reflects expectations
about future earnings and dividends, whereas the
book value per share is based on historical cost.
14-55

Learning Objective 3

Compute and interpret

financial ratios that would be
useful to a short-term
creditor.
14-56
Ratio Analysis –
The Short–Term Creditor

NORTON CORPORATION
Use this 2007

information to Cash $ 30,000

Accounts receivable, net
calculate ratios Beginning of year 17,000
to measure the End of year 20,000

well-being of Inventory
Beginning of year 10,000
the short-term End of year 12,000
creditors for Total current assets 65,000

Norton Total current liabilities 42,000

Sales on account 500,000
Corporation. Cost of goods sold 140,000
14-57

Working Capital

The excess of current assets

over current liabilities is
known as working capital.

Working capital is
not free. It must be
financed with
long-term debt and
equity.
14-58

Working Capital

December 31,
Norton Corporation
2007
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
14-59

Current Ratio

Current = Current Assets

Ratio Current Liabilities

The current ratio measures a

company’s short-term debt
paying ability.

A declining ratio may be a

sign of deteriorating
financial condition, or it
might result from
eliminating obsolete
inventories.
14-60

Current Ratio

Current Current Assets

=
Ratio Current Liabilities

Current = $65,000 = 1.55

Ratio $42,000

The current ratio measures a

company’s short-term debt
paying ability.
14-61

Acid-Test (Quick) Ratio

Acid-Test Quick Assets

=
Ratio Current Liabilities

Acid-Test $50,000
= = 1.19
Ratio $42,000
Norton
Norton
Quick assets include Cash, Corporation’s
Corporation’s
Marketable Securities, Accounts quick
quickassets
assets
Receivable and current Notes consist
consistof of cash
cash
Receivable. of
of $30,000
$30,000andand
The quick ratio measures a company’s accounts
accounts
ability to meet obligations without receivable
receivableof of
having to liquidate inventory. $20,000.
$20,000.
14-62

Accounts Receivable Turnover

Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover

Accounts
$500,000
Receivable = = 27.03 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
14-63

Average Collection Period

Average 365 Days

Collection = Accounts Receivable Turnover
Period

Average
365 Days
Collection = = 13.50 days
27.03 Times
Period

This
This ratio
ratio measures,
measures, on on average,
average,
how
how many
many days
days itit takes
takes to
to collect
collect
an
an account
account receivable.
receivable.
14-64

Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory

This ratio measures how many times

a company’s inventory has been
sold and replaced during the year.

If a company’s inventory
turnover Is less than its
industry average, it either
has excessive inventory or
the wrong sorts of inventory.
14-65

Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2

This ratio measures how many

times a company’s inventory
has been sold and replaced
during the year.
14-66

Average Sale Period

Average 365 Days

=
Sale Period Inventory Turnover

Average 365 Days

= = 28.67 days
Sale Period 12.73 Times

This
This ratio
ratio measures
measures howhow many
many
days,
days, on
on average,
average, itit takes
takes to
to
sell
sell the
the inventory.
inventory.
14-67

Learning Objective 4

Compute and interpret

financial ratios that would be
useful to a long-term creditor.
14-68
Ratio Analysis –
The Long–Term Creditor

Use this information to calculate ratios to

measure the well-being of the long-term
creditors for Norton Corporation.

NORTON CORPORATION
2007
Earnings before interest
expense and income taxes $ 84,000
Interest expense 7,300
EBIT is also
Total stockholders' equity 234,390
referred to as net
Total liabilities 112,000
operating income.
14-69

Times Interest Earned Ratio

Times Earnings before Interest Expense

Interest = plus Income Taxes
Earned Interest Expense

Times
$84,000
Interest = = 11.5 times
7,300
Earned
The
The times
times interest
interest earned
earned ratio
ratio is
is
the
the most
most common
common measure
measure of
of aa
company’s
company’s ability
ability to
to protect
protect its
its
long-term
long-term creditors.
creditors.
14-70

Debt-to-Equity Ratio
Debt to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio
This ratio indicates the relative
proportions of debt to equity on
a company’s balance sheet.

Stockholders like a lot of Creditors prefer less

debt if the company can debt and more equity
take advantage of because equity
positive financial represents a buffer of
leverage. protection.

In practice, debt-to-equity ratios from 0.0 to 3.0 are common.

14-71

Debt-to-Equity Ratio

Debt to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio

Debt to–
$112,000
Equity = = 0.48
$234,390
Ratio

This ratio indicates the relative

proportions of debt to equity on
a company’s balance sheet.
14-72
Published Sources That Provide
Comparative Ratio Data
14-73

End of Chapter 14