17-1

CHAPTER 17
ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
 17-2

Financial Statement Analysis

 What is financial statement
analysis?
”Tearing apart” the financial statements

and looking
at the relationships
It is the process of extracting information
from financial statements to better
understand a company’s current and
future performance and financial
condition.
 17-3

Financial Statement Analysis

625
Who analyzes financial statements?
 Internal users (i.e., management)
 External users
Examples:
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors
 17-4

Financial Statement Analysis

 What do internal users use it for?
Planning, evaluating and controlling
company operations
 What do external users use it for?
Assessing past performance and current
financial position and making predictions
about the future profitability and solvency
of the company as well as evaluating the
effectiveness of management.
 Methods of
17-5

Financial Statement Analysis

 Horizontal Analysis
 Vertical Analysis
 Ratio Analysis
 17-6

Horizontal Analysis

Using
Using comparative
comparative financial
financial
statements
statements toto calculate
calculate peso
peso
or
or percentage
percentage changes
changes in in aa
financial
financial statement
statement item
item from
from
one
one period
period to
to the
the next
next
 17-7

Vertical Analysis
For
For aa single
single financial
financial
statement,
statement, each each item
item
is
is expressed
expressed as as aa
percentage
percentage of of aa
significant
significant total,
total,
e.g.,
e.g., all
all income
income
statement
statement items items areare
expressed
expressed as as aa
percentage
percentage of of sales
sales
 17-8

Ratio Analysis
Expression
Expression of of logical
logical relationships
relationships
between
between items
items in in aa financial
financial
statement
statement ofof aa single
single period
period
(e.g.,
(e.g., percentage
percentage relationship
relationship
between
between revenue
revenue andand netnet income)
income)
 17-9

Horizontal Analysis Example

The management of Clover Company
provides you with comparative balance
sheets of the years ended December 31,
1999 and 1998. Management asks you to
prepare a horizontal analysis on the
information.
17-10
 17-11

Horizontal Analysis Example

Calculating Change in Peso Amounts

Peso Current Year Base Year

= –
Change Figure Figure
 17-12

Horizontal Analysis Example

Calculating Change in Peso Amounts

Peso Current Year Base Year

= –
Change Figure Figure

Since we are measuring the amount of

the change between 1998 and 1999, the
dollar amounts for 1998 become the
“base” year figures.
 17-13

Horizontal Analysis Example

Calculating Change as a Percentage

Percentage Peso Change

Change
=
Base Year Figure × 100%
 17-14

Horizontal Analysis Example

$12,000 – $23,500 = $(11,500)

 17-15

Horizontal Analysis Example

($11,500 ÷ $23,500) × 100% = 48.9%

 17-16

Horizontal Analysis Example

 17-17

Horizontal Analysis Example

Let’s apply the same
procedures to the
liability and stockholders’
equity sections of the
balance sheet.
 17-18

CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
 17-19

Horizontal Analysis Example

Now, let’s apply the
procedures to the
income statement.
 17-20

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 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)
 17-21

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 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)
Sales increased by 8.3% while net
Net income before taxes 25,000 32,000 (7,000) (21.9)
income decreased
Less income taxes (30%) 7,500
by 21.9%.
9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
 17-22

There were increases in both cost of goods

sold (14.3%) and operating expenses (2.1%).
These increased costs
CLOVERmore than offset the
CORPORATION
increase inComparative
sales, yielding anStatements
Income overall
Fordecrease
the Years Ended
in netDecember
income. 31, 1999 and 1998
Increase (Decrease)
1999 1998 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)
 17-23

Vertical Analysis Example

The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.
 17-24

Vertical Analysis Example

 17-25

Vertical Analysis Example

$82,000 ÷ $483,000 = 17% rounded

$30,000 ÷ $387,000 = 8% rounded
 17-26

Vertical Analysis Example

$76,000 ÷ $483,000 = 16% rounded

 17-27

Ratios
Ratios can be expressed in three different
ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of $2.25)

CAUTION!
“Using ratios and percentages without
considering the underlying causes may be
hazardous to your health!”
lead to incorrect conclusions.”
 17-28

Categories of Financial Ratios

 Liquidity
It is the ability of the business to efficiently manage
working capital and ensure that there is adequate assets to
cover for its current obligations as they fall due.
 Profitability
It is the ability of the business to earn a satisfactory return
on owner’s capital.
 Solvency
It is the ability of the business to stand pressure and
operate indefinitely or for long period of time.
 17-29

Ratios You Must Know

Liquidity Ratios
1. Working Capital
2. Current Ratio
3. Quick Ratio or Acid-test ratio
4. Accounts receivable turnover
5. Number of days’ sales in accounts
receivable
6. Inventory turnover 651

7. Asset Turnover
 17-30

10 Ratios You Must Know

Profitability Ratio
1. Return on Sales/Net Profit Margin
2. Operating Ratio/Operating Profit
Margin $
3. Return on Total Assets
4. Return on Equity
 17-31

10 Ratios You Must Know

Solvency
1. Debt Ratio
2. Equity Ratio
3. Debt to Equity Ratio
 17-32

Liquidity Ratio
 Working Capital
 Current Ratio
 Acid-Test Ratio/Quick Ratio
 Turnover Rates
- Receivable Turnover
- Days Collection
- Inventory Turnover
- Holding Period
- Asset Turnover
 17-33

Working Capital*
It is the difference between the current
assets and current liabilities.
12/31/99
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
* While this is not a ratio, it does give an
indication of a company’s liquidity.
 17-34

Current Ratio
Primary test of solvency to meet current obligations from current assets
as a going concern; measure of adequacy of working capital.

Current = Current Assets

Ratio Current Liabilities

Current $65,000
= = 1.55 : 1
Ratio $42,000

Measures the ability

of the company to pay current
debts as they become due.
 17-35

Acid-Test (Quick) Ratio

Acid-Test Quick Assets

=
Ratio Current Liabilities

Quick assets are Cash,

Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
 17-36

Acid-Test (Quick) Ratio

Acid-Test Quick Assets

=
Ratio Current Liabilities

A more severe test of immediate solvency; test

of ability to meet demands from current
assets.
 17-37

Acid-Test (Quick) Ratio

Acid-Test Quick Assets

=
Ratio Current Liabilities
Acid-Test $50,000
= = 1.19 : 1
Ratio $42,000
 17-38

Turnover Rates
 Receivable Turnover
- Days Collection
 Inventory Turnover
- Holding Period
 Asset Turnover
 17-39

Accounts Receivable Turnover

Net, credit sales Average, net accounts
receivable
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover
Accounts
$494,000
Receivable = = 26.70 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
 Number of Days’ Sales
17-40

in Accounts Receivable

Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables

Measures, on average, how many

days it takes to collect an
account receivable.
 Number of Days’ Sales
17-41

in Accounts Receivable

Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables

In practice, would 45 days be a

desirable number of days in
receivables?
 17-42

Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory

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

Measures the number of times

inventory is sold and
replaced during the year.
 17-43

Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory

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

Would 5 be a
desirable number of times
for inventory to turnover?
 17-44

Days Supply in Inventory/Holding

Period

Days 365 Days

=
Supply in Inventory
Inventory Turnover
Days 365 Days
= = 28.67 days
Supply in 12.73 Times
Inventory

 Measures average number of days to

sell or consume the average inventory.
 17-45

Asset Turnover

Asset Revenue
=
Turnover Average Total Asset

Asset $494,000
= = 7.6 times
Turnover $65,000
 17-46

PROFITABILITY
 Return on Sales/Net Profit Margin
 Operating Ratio/Operating Profit
Margin
 Return on Total Assets
 Return on Equity
 17-47

Return on Sales/Net Profit Margin

Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales

Measures profit generated after consideration

of all expenses and revenues
 17-48

Return on Sales/Net Profit Margin

Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales

Would a 1% return on sales be good?

 17-49

Operating ratio/Operating Profit

Margin

Operating Operating Income x100

=
Ratio Sales

Measures profit generated after

consideration of operating costs
 17-50

Return on Total Asset

Return on = Net Income

Total Asset Average Total Assets

Return on
$53,690
Stockholders’ = = 82.6%
$65,000
Equity
Measures overall efficiency of the firm in
managing assets and generating profits.
 Return on Average Common
17-51

Stockholders’ Equity (ROE)

Return on Net Income

Stockholders’ = Average Common
Equity Stockholders’ Equity

Return on
$53,690
Stockholders’ = = 25.9%
($180,000 + $234,390) ÷ 2
Equity
Measures rate of return on
resources provided by owners.
 17-52

SOLVENCY
 Debt Ratio
 Equity Ratio
 Debt To Equity Ratio
 17-53

Debt Ratio

Debt Total Liabilities

=
Ratio Total Assets

Shows proportion of all assets

That are financed with debt.
 17-54

Equity Ratio

Equity Stockholders’ Equity

=
Ratio Total Assets

Equity $234,390
= = 67.7%
Ratio $346,390

Measures the proportion

of total assets provided by
stockholders.
 17-55

Debt to Equity Ratio

Debt to Equity = Total Liabilities

Ratio Total Equity

Measures debt relative

To amounts of resources
Provided by owners.
 17-56

Question
The
The current
current ratio
ratio is
is aa measure
measure of of
liquidity
liquidity that
that is
is computed
computed by by dividing
dividing
total
total assets
assets by by total
total liabilities.
liabilities.
a.
a. True
True
b.
b. False
False
 17-57

Question
The
The current
current ratio
ratio is
is aa measure
measure of of
liquidity
liquidity that
that is
is computed
computed by by dividing
dividing
total
total assets
assets by by total
total liabilities.
liabilities.
a.
a. True
True
b.
b. False
False The
The current
current ratio
ratio is
is aa measure
measure of
of
liquidity,
liquidity, but
but is
is computed
computed byby
dividing
dividing current
current assets
assets by
by
current
current liabilities
liabilities
 17-58

Question
Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash,
Marketable
Marketable Securities
Securities and
and net
net
receivables.
receivables.
a.
a. True
True
b.
b. False
False
 17-59

Question
Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash,
Marketable
Marketable Securities
Securities and
and net
net
receivables.
receivables.
a.
a. True
True
b.
b. False
False
 17-60

No more ratios, please!