Financial Accounting

Module 15: Financial Statement Analysis

Module Learning Outcomes

Compare financial statements and analyze performance

15.1:
Describe how financial statements are used to analyze a business
15.2:
Calculate ratios that indicate a company's ability to pay short-term
debt

15.3: Calculate ratios that indicate a company's operating efficiency

15.4: Calculate ratios that analyze a company’s earnings performance

15.5:
Calculate ratios that analyze a company’s long-term debt-paying a
bility
15.6: Compare financial statements - intercompany and intracompany
Objectives of Financial Statement Analysis
Learning Outcomes: Objectives of Financial
Statement Analysis
15.1: Describe how financial statements are used to analyze a
business
15.1.1: Define financial statement analysis
15.1.2: Identify common sources of information for financial statement
analysis
Financial Statement Analysis Defined

• Ratio Analysis: examine the relationship among financial statement

data.
• Liquidity measures assess the short-term ability of the company to pay
obligations and to meet unexpected cash needs.
• Operating efficiency measures assess how efficiently a firm is paying its bills,
collecting cash from customers, and turning inventory into sales.
• Profitability measures assess the income or operating success of a company
for a given period of time.
• Solvency measures assess the ability of the company to survive over a long
period of time.
• Comparative Analysis: compare different ratios or measures
• Intracompany comparisons covering two years for the same company.
• Industry-average comparisons based on average ratios for particular
industries.
• Intercompany comparisons based on comparisons with a competitor in the
same industry.
Sources of Information

• For publicly traded companies, your most

reliable source of information for financial
statement analysis will be the Form 10-K
filed with the SEC.
• These can be found on each company’s
website.
• Additionally, there are some services, like
Morningstar, that have computed some of
the ratios and compiled additional
information, and may even allow you to
download financial information
Liquidity Measures
Learning Outcomes: Liquidity Measures

15.2: Calculate ratios that indicate a company's ability to pay

short-term debt
15.2.1: Calculate working capital
15.2.2: Calculate the current ratio
15.2.3: Calculate the common variations of the current ratio
15.2.4: Calculate the cash turnover ratio
Liquidity Measures

The most common measures of liquidity are:

• Working Capital
• Current Ratio
• Quick Ratio (also called Acid-Test Ratio)
• Cash Turnover Ratio
Working Capital and Current Ratio

Working Capital Current Ratio

a measure of a company’s a measure of the ability of a firm

liquidity, operational efficiency, to pay its current liabilities with
and its short-term financial its cash
health
current assets ÷ current
current assets − current liabilities
liabilities = working capital
Quick Ratio and Cash Turnover Ratio

Quick Ratio Cash Turnover Ratio

• Also called Acid-Test Ratio an efficiency ratio that shows the

• measures the firm’s ability to number of times cash is turned
pay its current liabilities with over in an accounting period.
its cash and other current
assets that can be converted
to cash revenue ÷ average cash and
cash equivalents

quick assets ÷ current

liabilities
Practice Question 1

What is the correct formula to calculate a company’s cash turnover ratio?

A. Cash Turnover Ratio = Revenue / Average Cash + Cash Equivalents

B. Cash Turnover Ratio = Cost of Goods Sold / Cash Equivalents + Avg
Cash
C. Cash Turnover Ratio = Revenue / Avg Cash Equivalents + Avg Cash
D. Cash Turnover Ratio = Total Assets / Revenue + Cash Equivalents
Operating Efficiency Measures
Learning Outcomes: Operating Efficiency
Measures
15.3: Calculate ratios that indicate a company's operating
efficiency
15.3.1: Calculate inventory turnover and number of days sales in inventory
15.3.2: Calculate accounts receivable turnover and number of days sales in
receivables
15.3.3: Calculate the asset turnover ratio
Operating Efficiency Measures

Indicators of efficiency include:

• Inventory turnover and number of

days’ sales in inventory that gauge
how effectively a company manages
its inventory.
• Accounts receivable turnover and
number of days’ sales in receivables
that look at the firm’s ability to
collect its accounts receivable.
• Asset turnover ratio that indicates
how efficient a company is at
generating revenue from its assets.
Inventory Turnover

shows how many times a company

has sold and replaced inventory
during a given period

cost of merchandise sold ÷

average inventory
Accounts Receivable Turnover and
Days' Sales in Accounts Receivable Ratio
Accounts Receivable Days' Sales in Accounts Receivable
Turnover Ratio

shows the number of times per • also known as the average collection
year a business collects its period
average accounts receivable • shows the number of days it took on
average to collect the company's
accounts receivable during the past
Net Annual Credit Sales ÷ year
(Beginning Accounts
Receivable + Ending
Accounts Receivable) / 2 the number of days in the year ÷ by
the accounts receivable turnover ratio
during a past year
Asset Turnover

shows how effectively a company

uses its assets to generate
revenue

net sales or revenue ÷ average

total assets
Measures of Profitability
Learning Outcomes: Measures of Profitability

15.4: Calculate ratios that analyze a company’s earnings

performance
15.4.1: Calculate the rate of return on total assets
15.4.2: Calculate the rate of return on shareholders' equity
15.4.3: Calculate gross and net profit margins
15.4.4: Calculate earnings per share and the price-earnings ratio
15.4.5: Calculate the dividend payout ratio
15.4.6: Calculate free cash flow
Profitability Measures

The most common measures of

profitability are:
• Return on assets (ROA)
• Return on equity (ROE)
• Gross profit
• Net profit
• Earnings per share
• Price-earnings ratio
• Dividend payout ratio
• Free cash flow
Return on Assets (ROA) and Return on Equity
(ROE)
Return on Assets (ROA) Return on Equity (ROE)

measures how effectively a • measures financial

company uses its assets to performance by dividing net
generate income income by shareholders'
equity
• ROE is considered the return
(interest expense + net on net assets (as opposed to
income) ÷ average total return on total assets)
assets

net income ÷ average total

stockholders' equity
Gross Profit Percentage and Net Profit
Percentage
Gross Profit Percentage Net Profit Percentage

measures how effectively a measures how effectively a

company generates gross profit company generates net profit
from sales or controls cost of from sales or controls cost of
merchandise sold merchandise sold

gross profit ÷ sales net profit ÷ sales

Earnings per Share

measures the dollar amount of net income associated with each share of
common stock outstanding

(net income − preferred stock dividends) ÷ common shares

Earning per share can also be expressed as a price/earnings ratio:

current price per share ÷ EPS

Dividend Payout Ratio

shows the total amount of dividends paid out to shareholders relative to the
net income of the company

common stock dividends ÷ net income

another useful analysis of dividends calculates dividends per share on

common stock

common stock dividends ÷ common stock shares outstanding

Free Cash Flow

represents the cash a company generates after accounting for cash outflows
to support operations and maintain its capital assets

operating cash flow − capital expenditures

Because FCF accounts for investments in property, plant, and equipment, it

can be lumpy and uneven over time

A variation of Free Cash Flow subtracts dividends from cash flows from
operating income as well as capital expenditures (can be used for
intracompany analysis over time)
Practice Question 2

The Quantum, Inc company reported sales at December 31, 20X3 of

$4,100,000 which included interest expense of $20,000 and Cost of Goods
Sold of $3,100,000. What was Quantum, Inc.’s gross profit percentage for
20X3?

A. 24.0%
B. 24.4%
C. 75.6%
D. 24.9%
Measures of Solvency
Learning Outcomes: Measures of Solvency

15.5: Calculate ratios that analyze a company’s long-term debt-

paying ability
15.5.1: Calculate the debt to equity ratio
15.5.2: Calculate the debt to assets ratio
15.5.3: Calculate the times-interest-earned ratio
Solvency Measures

Three of the common measures of

solvency are:
• Debt to Equity
• Debt to Assets (and Equity to
Assets)
• Times Interest Earned
Debt to Equity Ratio

• used to evaluate a company’s

financial leverage
• measure of the degree to
which a company is financing
its operations through debt
versus wholly-owned funds

company’s total liabilities ÷

shareholder equity
Debt to Total Assets Ratio and Equity to Assets

Variations on the debt to equity ratio include:

• Debt to total assets

• company’s total debt ÷ company’s total assets
• Equity to total assets
• company’s equity ÷ company’s total assets

These two as percentages should add up to 100%. If they don’t, check your
data and your calculations!
Times Interest Earned

shows how much a company earned, in comparison to the amount of

interest incurred

(net income before tax + interest expense) ÷ interest expense

a similar ratio could be applied in order to monitor the company’s ability to

pay those dividends

net income ÷ preferred dividends

Comparative Analysis of Financial
Statements
Learning Outcomes: Comparative Analysis of
Financial Statements
15.6: Compare financial statements: intercompany and
intracompany
15.6.1: Perform a horizontal analysis of a company's financial statements
15.6.2: Perform a vertical analysis of a company's financial statements
Horizontal Analysis

• Important information can

result from looking at changes
in the same financial statement
over time, both in terms of
dollar amounts and percentage
differences
• A horizontal analysis involves
noting the increases and
decreases both in the amount
and in the percentage of each
line item across different years.
Vertical Analysis

Vertical analysis can be used to compare and identify trends within a

company from year to year (intracompany) or between different companies
(intercompany).

Vertical analysis looks at percentages and how they compare, rather than
comparing dollar amounts.

Intracompany examples:
• comparative income statement
• comparative balance sheet
Intercompany examples:
• comparative income statement
Practice Question 3

Hesperia, Inc. reported at year end that it had $50,000 in long-term

investments, $200,000 in current assets, $650,000 in fixed assets minus
depreciation. Additionally the company had $100,000 in accounts payable
and $50,000 for a long-term note payable with the balance due in 5 years.
At the end of the next year, Hesperia, Inc. had $77,000 in long-term
investments and $250,000 in current assets, and $130,000 in accounts
payable. All other accounts were exactly the same as the previous year.
What account had the largest percentage change from the first to the
second year?

A. Fixed Assets
B. Accounts Payable
C. Current Assets
D. Long-Term Investments
Quick Review

• How is financial statement analysis defined?

• What are the common sources of information for financial statement
analysis?
• How is working capital calculated?
• How is the current ratio figured?
• How is the common variations of the current ratio calculated?
• When and how is the cash turnover ratio figured?
• How is inventory turnover and number of days sales in inventory
calculated?
• What is the process to calculate accounts receivable turnover and
number of days sales in receivables?
• What is the process of calculating the asset turnover ratio?
• How is the rate of return on total assets discovered?
More Quick Review

• How is the rate of return on shareholders' equity calculated?

• What is the formula for calculating gross and net profit margins?
• How are earnings per share and the price-earnings ratio figured out?
• How is the dividend payout ratio calculated?
• How does an accountant calculate free cash flow?
• What is the process to calculate the debt to equity ratio?
• How is the debt to assets ratio discovered?
• How is the times-interest-earned ratio calculated and understood?
• What is the process to create a horizontal analysis of a company's
financial statements?
• How is a vertical analysis of a company's financial statements
created?