Prepared by

Coby Harmon
University of California, Santa Barbara
Westmont College

18-1
 18 Financial Statement
Analysis
Learning Objectives
After studying this chapter, you should be able to:
[1] Discuss the need for comparative analysis.
[2] Identify the tools of financial statement analysis.
[3] Explain and apply horizontal analysis.
[4] Describe and apply vertical analysis.
[5] Identify and compute ratios used in analyzing a firm’s liquidity,
profitability, and solvency.
[6] Understand the concept of earning power, and how irregular items are
presented.
[7] Understand the concept of quality of earnings.

18-2
 Preview of Chapter 18

Accounting Principles
Eleventh Edition
Weygandt Kimmel Kieso
18-3
 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 the income or ability of the
company to pay its operating success company to
maturing of a company for a survive over a long
obligations and to given period of period of time.
meet unexpected time.
needs for cash.

18-4
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 Ratio Analysis

A single ratio by itself is not very meaningful.

The discussion of ratios will include the following types of

comparisons.

1. Intracompany comparisons for two years for Quality

Department Store.

2. Industry average comparisons based on median ratios for

department stores.

3. Intercompany comparisons based on Macy’s, Inc. as Quality

Department Store’s principal competitor.

18-5
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 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,

accounts receivable turnover, and inventory turnover.

18-6
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-7 Advance slide in presentation mode to reveal solution. LO 5

 Ratio Analysis Liquidity Ratios

Current Ratio Illustration 18-12

Ratio of 2.96:1 means that for every dollar of current liabilities, Quality
has $2.96 of current assets.

18-8
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 Ratio Analysis Liquidity Ratios

Acid-Test Ratio
Illustration 18-13

18-9
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Balance Sheet (partial)
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-10 LO 5
 Ratio Analysis Liquidity Ratios

Acid-Test Ratio
Illustration 18-14

Acid-test ratio measures immediate liquidity.

18-11
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial) Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

18-12 LO 5
 Ratio Analysis Liquidity Ratios

Accounts Receivable Turnover

Illustration 18-15

Measures the number of times, on average, the company collects

receivables during the period.
18-13 LO 5
 Ratio Analysis Liquidity Ratios

Accounts Receivable Turnover

$2,097,000
= 10.2 times
($180,000 + $230,000) / 2

A variant of the accounts receivable turnover ratio is to convert it

to an average collection period in terms of days.

365 days / 10.2 times = every 35.78 days

Accounts receivable are collected on average every 36 days.

18-14
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial) Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-15 LO 5
 Ratio Analysis Liquidity Ratios

Inventory Turnover
Illustration 18-16

Measures the number of times, on average, the inventory is sold

during the period.
18-16 LO 5
 Ratio Analysis Liquidity Ratios

Inventory Turnover
$1,281,000
= 2.3 times
($500,000 + $620,000) / 2

A variant of inventory turnover is the days in inventory.

365 days / 2.3 times = every 159 days

Inventory turnover ratios vary considerably among industries.

18-17
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 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.

18-18
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

18-19 LO 5
 Ratio Analysis Profitability Ratios

Profit Margin
Illustration 18-17

Measures the percentage of each dollar of sales that results in

net income.

18-20
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-21 LO 5
 Ratio Analysis Profitability Ratios

Asset Turnover
Illustration 18-18

Measures how efficiently a company uses its assets to generate

sales.
18-22
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-23 LO 5
 Ratio Analysis Profitability Ratios

Return on Asset
Illustration 18-19

An overall measure of profitability.

18-24
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-25 LO 5
 Ratio Analysis Profitability Ratios

Return on Common Stockholders’ Equity

Illustration 18-20

Shows how many dollars of net income the company earned for each
dollar invested by the owners.
18-26 LO 5
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-27 LO 5
 Ratio Analysis Profitability Ratios

Earnings Per Share (EPS)

Illustration 18-22

A measure of the net income earned on each share of common stock.

18-28 LO 5
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-29 LO 5
 Ratio Analysis Profitability Ratios

Price-Earnings Ratio
Illustration 18-23

Measures the net income earned on each share of common stock.

18-30 LO 5
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-31 LO 5
 Ratio Analysis Profitability Ratios

Payout Ratio
Illustration 18-24

Measures the percentage of earnings distributed in the form of cash

dividends.

18-32 LO 5
 Ratio Analysis

Solvency Ratios

Solvency ratios measure the ability of a company to survive

over a long period of time.
 Debt to Assets and

 Times Interest Earned

are two ratios that provide information about debt-

paying ability.

18-33
LO 5 Identify and compute ratios used in analyzing a
firm’s liquidity, profitability, and solvency.
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-34 LO 5
 Ratio Analysis Solvency Ratios

Debt to Total Assets Ratio

Illustration 18-25

Measures the percentage of the total assets that creditors provide.

18-35 LO 5
 QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets Condensed Income Statements
For the Years Ended December 31 For the Years Ended December 31

Illustration 18-12

18-36 LO 5
 Ratio Analysis Solvency Ratios

Times Interest Earned

Illustration 18-25

Provides an indication of the company’s ability to meet interest

payments as they come due.

18-37 LO 5
 Ratio Analysis

Summary of Ratios
Illustration 18-27

18-38 LO 5
 Summary of Ratios
Illustration 18-27

18-39 LO 5