Chapter 15

Chapter 15
Financial Statement
Analysis
 Financial Statement Analysis
 purpose & tools
 horizontal & vertical analysis
 ratio analysis
 measures of liquidity and credit risk
 measures of profitability
 limitation.
 Basic of Financial Statement Analysis
Analyzing financial statements involves:

Comparison Tools of
Characteristics
Bases Analysis

Liquidity Intracompany Horizontal

Profitability Industry Vertical
Solvency averages Ratio
Intercompany
 Horizontal Analysis
Horizontal analysis, or trend analysis, is a technique
for evaluating a series of financial statement data over
a period of time.

Purpose is to determine the increase or decrease.

Commonly applied to the:

 balance sheet,
 income statement, and
 statement of retained earnings.
 Horizontal Analysis
Exercise: The comparative condensed balance sheets of
Ramsey Corporation are presented below.

2009 2008
Current assets $ 76,000 $ 80,000
PP&E 99,000 90,000
Intangibles 25,000 40,000
Total assets $ 200,000 $ 210,000
Current liabilities $ 40,800 $ 48,000
Long-term liabilties 143,000 150,000
Stockholders' equity 16,200 12,000
Total liabilities & equity $ 200,000 $ 210,000

Instructions: Prepare a horizontal analysis of the balance

sheet data for Ramsey Corporation using 2008 as a base.
 Horizontal Analysis
Exercise: The comparative condensed balance sheets of
Ramsey Corporation are presented below.
Increase Percentage
2009 2008 (Decrease) Change
Current assets $ 76,000 $ 80,000 $ (4,000) -5.0%
PP&E 99,000 90,000 9,000 10.0%
Intangibles 25,000 40,000 (15,000) -37.5%
Total assets $ 200,000 $ 210,000 $ (10,000) -4.8%
Current liabilities $ 40,800 $ 48,000 $ (7,200) -15.0%
Long-term liabilties 143,000 150,000 (7,000) -4.7%
Stockholders' equity 16,200 12,000 4,200 35.0%
Total liabilities & equity $ 200,000 $ 210,000 $ (10,000) -4.8%

Instructions: Prepare a horizontal analysis of the balance

sheet data for Ramsey Corporation using 2008 as a base.
 Vertical Analysis
Vertical analysis, or 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.

Commonly applied to the:

 balance sheet and
 income statement.
 Vertical Analysis
Exercise: The comparative condensed income statements
of Hendi Corporation are shown below.

2009 2008
Amount Amount
Net sales $ 600,000 $ 500,000
Cost of goods sold 483,000 420,000
Gross profit 117,000 80,000
Operating expense 57,200 44,000
Net income $ 59,800 $ 36,000

Instructions: Prepare a vertical analysis of the income

statement data for Hendi Corporation in columnar form for
both years.
 Vertical Analysis
Exercise: The comparative condensed income statements
of Hendi Corporation are shown below.

2009 2008
Amount Percent Amount Percent
Net sales $ 600,000 100.0% $ 500,000 100.0%
Cost of goods sold 483,000 80.5% 420,000 84.0%
Gross profit 117,000 19.5% 80,000 16.0%
Operating expense 57,200 9.5% 44,000 8.8%
Net income $ 59,800 10.0% $ 36,000 7.2%

Instructions: Prepare a vertical analysis of the income

statement data for Hendi Corporation in columnar form for
both years.
 Ratio Analysis
Ratio analysis expresses the relationship among
selected items of financial statement data.
Financial Ratio Classifications

Liquidity Profitability Solvency

Measures short- Measures the Measures the

term ability of income or ability of the
the company to operating success company to
pay its maturing of a company for survive over a
obligations and to a given period of long period of
meet unexpected time. time.
needs for cash.
 Ratio Analysis

A single ratio by itself is not very meaningful.

The discussion of ratios will

include the following types of
comparisons.
 Ratio Analysis

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.
 Ratio Analysis
Taylor Tool Company
Income Statement
For the Year Ended December 31
2009 2008
Net sales $ 1,818,500 $ 1,750,500
Cost of goods sold 1,011,500 996,000
Gross profit 807,000 754,500
Selling and administrative expenses 506,000 479,000
Income from operations 301,000 275,500
Other expenses and losses:
Interest expense 18,000 14,000
Income before income taxes 283,000 261,500
Income tax expense 84,000 77,000
Net income $ 199,000 $ 184,500
 Ratio Analysis
Taylor Tool Company
Balance Sheets
December 31
Assets 2009 2008

Current assets
Cash $ 60,100 $ 64,200
Short-term investments 69,000 50,000
Accounts receivable (net) 107,800 102,800
Inventory 133,000 115,500
Total current assets 369,900 332,500
Plant assets (net) 600,300 520,300
Total assets $ 970,200 $ 852,800
 Ratio Analysis
Liabilities and Stockholders' Equity 2009 2008
Current liabilities
Accounts payable $ 160,000 $ 145,400
Income taxes payable 43,500 42,000
Total current liabilities 203,500 187,400
Bonds payable 200,000 200,000
Total liabilities 403,500 387,400
Stockholders' equity
Common stock ($5 par) 280,000 300,000
Retained earnings 286,700 165,400
Total stockholders' equity 566,700 465,400
Total liabilities and equity $ 970,200 $ 852,800

All sales were on account. The allowance for doubtful accounts was
$3,200 on December 31, 2009, and $3,000 on December 31, 2008.
 Ratio Analysis Liquidity Ratios

Compute the Current Ratio for 2009.

Current Assets
= Current Ratio
Current Liabilities

$369,900
= 1.82 : 1
$203,500

The ratio of 1.82:1 means that for every dollar of

current liabilities, the company has $1.82 of
current assets.
 Ratio Analysis Liquidity Ratios

Compute the Acid-Test Ratio for 2009.

Cash + Short-Term Investments + Receivables (Net)

= Acid-Test
Current Liabilities Ratio

$60,100 + $69,000 + $107,800

= 1.16 : 1
$203,500

The acid-test ratio measures immediate liquidity.

 Ratio Analysis Liquidity Ratios

Compute the Receivables Turnover ratio for 2009.

Net Credit Sales Receivables
=
Turnover
Average Net Receivables

$1,818,500
= 17.3 times
($107,800 + $102,800) / 2

It measures the number of times, on average, the

company collects receivables during the period.
 Ratio Analysis Liquidity Ratios

Receivables Turnover
$1,818,500
= 17.3 times
($107,800 + $102,800) / 2

A variant of the receivables turnover ratio is to convert

it to an average collection period in terms of days.

365 days / 17.3 times = every 21.1 days

This means that receivables are collected on average

every 21 days.
 Ratio Analysis Liquidity Ratios

Compute the Inventory Turnover ratio for 2009.

Cost of Good Sold Inventory
=
Turnover
Average Inventory

$1,011,500
= 8.1 times
($133,000 + $115,500) / 2

Inventory turnover measures the number of times,

on average, the inventory is sold during the period.
 Ratio Analysis Liquidity Ratios

$1,011,500 Inventory Turnover

= 8.1 times
($133,000 + $115,500) / 2

A variant of inventory turnover is the days in inventory.

365 days / 8.1 times = every 45.1 days

Inventory turnover ratios vary considerably among

industries.
 Ratio Analysis

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.
 Ratio Analysis Profitability Ratios

Compute the Profit Margin ratio for 2009.

Net Income Profit
=
Margin
Net Sales

$199,000
= 10.9%
$1,818,500

Measures the percentage of each dollar of sales

that results in net income.
 Ratio Analysis Profitability Ratios

Compute the Asset Turnover ratio for 2009.

Net Sales Asset
=
Turnover
Average Assets

$1,818,500
= 2.0 times
($970,200 + $852,800) / 2

Measures how efficiently a company uses its assets

to generate sales.
 Ratio Analysis Profitability Ratios

Compute the Return on Assets ratio for 2009.

Net Income Return
=
on Assets
Average Assets

$199,000
= 21.8%
($970,200 + $852,800) / 2

An overall measure of profitability.

 Ratio Analysis Profitability Ratios

Compute the Return on Common Stockholders’

Equity ratio for 2009.
Return on
Net Income – Preferred Dividends Common
=
Stockholders’
Average Common Stockholders’ Equity
Equity

$199,000 - $0
= 38.6%
($566,700 + $465,400) / 2

Shows how many dollars of net income the company

earned for each dollar invested by the owners.
 Ratio Analysis Profitability Ratios

Compute the Earnings Per Share for 2009.

Net Income Earnings
=
Per Share
Weighted Average Common
Shares Outstanding

$199,000
= $3.49 per share
57,000 (given)

A measure of the net income earned on each share

of common stock.
 Ratio Analysis Profitability Ratios

Compute the Price Earnings Ratio for 2009.

Market Price per Share of Stock Price
= Earnings
Earnings Per Share Ratio

$25 (given)
= 7.16 times
$3.49

The price-earnings (P-E) ratio reflects investors’

assessments of a company’s future earnings.
 Ratio Analysis Profitability Ratios

Compute the Payout Ratio for 2009.

Cash Dividends Payout
=
Ratio
Net Income

$77,700 *
= 39%
$199,000

Measures the percentage of earnings distributed in

the form of cash dividends.
* From analysis of retained earnings.
 Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company to

survive over a long period of time.
 Debt to total assets and times interest earned
are two ratios that provide information about
debt-paying ability.
 Ratio Analysis Solvency Ratios

Compute the Debt to Total Assets Ratio for 2009.

Total Debt Debt to
= Total Assets
Total Assets Ratio

$403,500
= 41.6%
$970,200

Measures the percentage of the total assets that

creditors provide.
 Ratio Analysis Solvency Ratios

Compute the Times Interest Earned ratio for 2009.

Income before Income Taxes and
Interest Expense Times
= Interest
Interest Expense Earned

$199,000 + $84,000 + $18,000

= 16.7 times
$18,000

Provides an indication of the company’s ability to

meet interest payments as they come due.
 Earning Power and Irregular Items

Earning power means the normal level of income to be

obtained in the future.

“Irregular” items are separately identified on the

income statement. Two types are:

1. Discontinued operations.
2. Extraordinary items.

These “irregular” items are reported net of income

taxes.
 Earning Power and Irregular Items

Discontinued Operations
(a) Refers to the disposal of a significant component
of a business.

(b) Report the income (loss) from discontinued

operations in two parts:

1. income (loss) from operations (net of tax)

and

2. gain (loss) on disposal (net of tax).

 Earning Power and Irregular Items
Exercise: McCarthy Corporation had after tax income from
continuing operations of $55,000,000 in 2007. During 2007,
it disposed of its restaurant division at a pretax loss of
$270,000. Prior to disposal, the division operated at a
pretax loss of $450,000 in 2007. Assume a tax rate of
30%. Prepare a partial income statement for McCarthy.

Income from continuing operations $55,000,000

Discontinued operations:
Loss from operations, net of $135,000 tax 315,000
Loss on disposal, net of $81,000 tax 189,000
Total loss on discontinued operations 504,000
Net income $54,496,000
 Earning Power and Irregular Items
Income Statement (in thousands)
Discontinued Operations Sales $ 285,000
are reported after Cost of goods sold 149,000
“Income from continuing
operations.” Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
“Net Income”. Discontinued operations:
Loss from operations, net of tax 315
Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Moved to
Net income $ 54,496
 Earning Power and Irregular Items

Extraordinary items are nonrecurring material

items that differ significantly from a company’s
typical business activities.

An extraordinary item must be both of an

Unusual Nature and
Occur Infrequently

Company must consider the environment in which it

operates.
Amounts reported “net of tax.”
 Earning Power and Irregular Items
Are these considered Extraordinary Items?
(a) A large portion of a tobacco manufacturer’s
crops are destroyed by a hail storm. Severe
YES
damage from hail storms in the locality where
the manufacturer grows tobacco is rare.
(b) A citrus grower's Florida crop is damaged by NO
frost.
(c) Loss from sale of temporary investments. NO
(d) Loss attributable to a labor strike. NO
 Earning Power and Irregular Items
Are these considered Extraordinary Items?
(d) Loss from flood damage. (The nearby Black
River floods every 2 to 3 years.) NO

(e) An earthquake destroys one of the oil

refineries owned by a large multi-national oil YES
company. Earthquakes are rare in this
geographical location.
(f) Write-down of obsolete inventory. NO
(g) Expropriation of a factory by a foreign YES
government.
 Earning Power and Irregular Items
Exercise: McCarthy Corporation had after tax income from
continuing operations of $55,000,000 in 2007. In addition,
it suffered an unusual and infrequent pretax loss of
$770,000 from a volcano eruption. The corporation’s tax
rate is 30%. Prepare a partial income statement for
McCarthy Corporation beginning with income from continuing
operations.

Income from continuing operations $55,000,000

Extraordinary loss, net of $231,000 tax 539,000
Net income $54,461,000

($770,000 x 30% = $231,000 tax)

 Earning Power and Irregular Items
Income Statement (in thousands)
Extraordinary Items Sales $ 285,000
are reported after Cost of goods sold 149,000
“Income from continuing
operations.” Other revenue (expense):
Interest revenue 17,000
Interest expense (21,000)
Total other (4,000)
Income before taxes 79,000
Income tax expense 24,000
Previously labeled as
Income from continuing operations 55,000
“Net Income”. Extraordinary loss, net of tax 539
Net income $ 54,461
Moved to
 Earning Power and Irregular Items
Income Statement (in thousands)
Reporting when both Sales $ 285,000
Discontinued Operations Cost of goods sold 149,000
and
Extraordinary Items Interest expense (21,000)
Total other (4,000)
are present. Income before taxes 79,000
Income tax expense 24,000
Income from continuing operations 55,000
Discontinued operations:
Discontinued Loss from operations, net of tax 315
Operations Loss on disposal, net of tax 189
Total loss on discontinued operations 504
Income before extraordinary item 54,496
Extraordinary Item Extraordinary loss, net of tax 539
Net income $ 53,957
 Earning Power and Irregular Items

Change in Accounting Principle

Occurs when the principle used in the current
year is different from the one used in the
preceding year.
Accounting rules permit a change if justified.
Changes are reported retroactively.
Example would include a change in inventory
costing method such as FIFO to average cost.
 Earning Power and Irregular Items

Comprehensive Income All changes in stockholders’

equity except those
Income Statement (in thousands)
Sales $ 285,000
resulting from investments
Cost of goods sold 149,000 by stockholders and
Gross profit 136,000 distributions to
Operating expenses:
Advertising expense 10,000
stockholders.
Depreciation expense 43,000
Total operating expense 53,000 Reported in
Income from operations 83,000 Stockholders’ Equity
Other revenue:
Interest revenue 17,000 Unrealized gains and
Total other
Income before taxes
17,000
100,000
+ losses on available-
Income tax expense 24,000
for-sale securities.
Net income $ 76,000 Plus others
 Earning Power and Irregular Items

Comprehensive Income
Why are gains and losses on available-for-sale
securities excluded from net income?
Because disclosing them separately
1. reduces the volatility of net income due to
fluctuations in fair value,
2. informs the financial statement user of the gain
or loss that would be incurred if the securities
were sold at fair value.
 Quality of Earnings
A company that has a high quality of earnings
provides full and transparent information that will
not confuse or mislead users of the financial
statements.

Companies have incentives to manage income to

meet or beat Wall Street expectations, so that
the market price of stock increases and
the value of stock options increase.
 Quality of Earnings
Alternative Accounting Methods
Variations among companies in the application of
GAAP may hamper comparability and reduce
quality of earnings.

Pro Forma Income

Pro forma income usually excludes items that the
company thinks are unusual or nonrecurring.
Some companies have abused the flexibility that
pro forma numbers allow.
 Quality of Earnings
Improper Recognition
Some managers have felt pressure to continually
increase earnings and have manipulated the earnings
numbers to meet these expectations.
Abuses include:
Improper recognition of revenue (channel stuffing).
Improper capitalization of operating expenses
(WorldCom).
Failure to report all liabilities (Enron).