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edmonds_survey6e_chap09_ppt_accessible.pptxChapter 9
Financial Statement Analysis
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Factors in Communicating Useful Information
The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the following:
Users of financial statement information include managers, creditors, stockholders, potential investors and regulatory agencies.
The information needs of users depend upon the decision at hand.
A variety of analysis techniques have been developed due to diversity of users, their differing levels of knowledge and varying information needs.
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L O 9-1:
Differentiate between horizontal and vertical analysis.
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Methods of Analysis
Horizontal analysis:
Absolute amounts.
Percentage analysis.
Vertical analysis.
Ratio analysis.
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Milavec Company Financial Statements 1
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Milavec Company Financial Statements 2
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Horizontal Analysis
Horizontal analysis, also called trend analysis, refers to studying the behavior of individual financial statement items over several accounting periods.
The analysis of a given item may focus on trends in the absolute dollar amount of the item or trends in percentages.
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Milavec Company Horizontal Analysis
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Percentage Analysis
When comparing more than two periods, analysts use either (1) choosing one base year from which to calculate all increases or decreases or (2) calculating each period’s percentage change from the preceding figure.
| Year 4 | Year 3 | Year 2 | Year 1 | |
| Sales | $900,000 | $800,000 | $750,000 | $600,000 |
| Increase over Year 1 sales | 50.0% | 33.3% | 25.0% | - |
| Increase over preceding year | 12.5% | 6.7% | 25.0% | - |
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Vertical Analysis
Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure.
Horizontal analysis compares items over many time periods; vertical analysis compares many items within the same time period.
A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.
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Vertical Analysis of Income Statement
Vertical analysis of an income statement (also called a common size income statement) involves converting each income statement component to a percentage of sales.
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Vertical Analysis of Balance Sheet 1
Vertical analysis of the balance sheet involves converting each balance sheet component to a percentage of total assets.
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Vertical Analysis of Balance Sheet 2
Vertical analysis of the balance sheet involves converting each balance sheet component to a percentage of total assets.
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Objectives of Ratio Analysis
Ratio analysis involves studying various relationships between different items reported in a set of financial statements.
Various users approach financial statement analysis with many different objectives.
Creditors are interested in whether a company can repay its debts on time.
Creditors and stockholders care how the company is financed.
Past earnings performance is analyzed.
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L O 9-2:
Calculate ratios for assessing a company’s liquidity.
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Liquidity Ratios
Liquidity ratios indicate a company’s ability to pay short-term debts. They focus on current assets and current liabilities.
Working Capital.
Current Ratio.
Quick Ratio.
Accounts Receivable Ratios.
Inventory Ratios.
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Working Capital
Working capital is current assets minus current liabilities. Working capital measures the funds a company will have available for operations.
| Year 4 | Year 3 | |
| Current assets | $168,000 | $145,000 |
| − Current liabilities | 46,000 | 43,000 |
| Working capital | $122,000 | $102,000 |
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Current Ratio
The current ratio, also called the working capital ratio, expresses the relationship between current assets and current liabilities as a ratio.
| Milavec | Laroque | |
| Current assets (a) | $168,000 | $500,000 |
| −Current liabilities (b) | 46,000 | 378,000 |
| Working capital | $122,000 | $122,000 |
| Current ratio (a ÷ b) | 3.65:1 | 1.32:1 |
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Quick Ratio
The quick ratio, also called the acid-test ratio, measures a company’s immediate debt-paying ability. Only cash, receivables and marketable securities are included in the numerator.
| Year 4 | Year 3 | |
| Current ratio | 168,000÷46,000 | 145,00÷43,000 |
| 3.65:1 | 3.37:1 | |
| Quick ratio | 94,000÷46,000 | 98,000÷43,000 |
| 2.04:1 | 2.28:1 |
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Accounts Receivable Ratios
Companies want to collect receivables as quickly as possible without losing customers. Two relationships are often examined to assess a company’s collection record.
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Accounts Receivable Turnover
| Year 4 | Year 3 | |
| Net sales (assume all on account) (a) | $900,000 | $ 800,000 |
| Beginning receivables (b) | $ 56,000 | $ 55,000* |
| Ending receivables (c) | 50,000 | 56,000 |
| Average receivables (d) = (b + c)÷2 | $ 53,000 | $ 55,500 |
| Accounts receivable turnover (a ÷ d) | 16.98 | 14.41 |
*The Year 3 beginning receivables balance was drawn from the Year 2 financial statements, which are not included in the illustration.
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Inventory Ratios
A fine line exists between having too much and too little inventory in stock. To help analyze how efficiently a company manages inventory, we use two ratios similar to those used in analyzing accounts receivable.
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Inventory Turnover
| Year 4 | Year 3 | |
| Cost of goods sold (a) | $610,000 | $480,000 |
| Beginning inventory (b) | $ 43,000 | $ 40,000* |
| Ending inventory (c) | 70,000 | 43,000 |
| Average inventory (d) = (b + c)÷2 | $ 56,500 | $ 41,500 |
| Inventory turnover (a ÷ d) | 10.80 | 11.57 |
*The Year 3 beginning inventory balance was drawn from the company’s Year 2 financial statements, which are not included in the illustration.
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L O 9-3:
Calculate ratios for assessing a company’s solvency.
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Solvency Ratios
Solvency ratios are used to analyze a company’s long-term debt-paying ability and its financing structure.
Creditors are concerned with a company’s ability to satisfy outstanding obligations.
Stockholders are concerned about a company’s solvency.
If a company is unable to pay its debts, the owners could lose their investment.
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Debt Ratios
Debt-to-assets ratio measures the percentage of a company’s assets that are financed by debt.
Debt-to-equity ratio compares creditor financing to owner financing.
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Debt to Assets and Debt to Equity Ratios
| Year 4 | Year 3 | |
| Total liabilities (a) | $146,000 | $143,000 |
| Total stockholders’ equity (b) | 362,000 | 312,000 |
| Total equities (Liabilities + Stockholders’ equity) (c) | $508,000 | $455,000 |
| Debt to assets (a ÷ c) | 29% | 31% |
| Debt to equity ratio (a ÷ b) | 0.40:1 | 0.46:1 |
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Number of Times Interest is Earned
This ratio measures the burden a company’s interest payments represent. Users often consider the number of times interest is earned along with the debt ratios when evaluating financial risk.
| Year 4 | Year 3 | |
| Income before taxes | $42,000 | $40,000 |
| Interest expense (b) | 8,000 | 8,000* |
| Income before taxes and interest (a) | $50,000 | $48,000 |
| Times interest earned (a ÷ b) | 6.25 times | 6 times |
*Interest on bonds: $100,000 × 0.08 = $8,000.
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Plant Assets to Long-Term Liabilities
Companies often pledge plant assets as collateral for long-term liabilities. The plant assets to long-term liabilities ratio shows the amount of assets per each dollar of long-term debt.
| Year 4 | Year 3 | |
| Net plant assets (a) | $340,000 | $310,000 |
| Bonds payable (b) | 100,000 | 100,000 |
| Plant assets to long-term liabilities (a ÷ b) | 3.4:1 | 3.1:1 |
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L O 9-4:
Calculate ratios for assessing company management’s effectiveness.
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Measures of Profitability
Profitability refers to a company’s ability to generate earnings. Both management and external users employ profitability ratios to assess a company’s success in generating profits and how these profits are used to reward investors.
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Net Margin (or Return on Sales)
Net margin, sometimes called operating margin, profit margin, or the return-on-sales ratio, describes the percentage of each sales dollar remaining after subtracting other expenses, as well as cost of goods sold.
| Year 4 | Year 3 | |
| Net income (a) | $ 25,000 | $ 22,000 |
| Net sales (b) | 900,000 | 800,000 |
| Net margin (a ÷ b) | 2.78 | 2.75% |
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Asset Turnover Ratio
The asset turnover ratio (sometimes called turnover-of-assets ratio) measures how many sales dollars were generated for each dollar of assets invested.
| Year 4 | Year 3 | |
| Net sales (a) | $900,000 | $ 800,000 |
| Beginning assets (b) | $455,000 | $420,000* |
| Ending assets (c) | 508,000 | 455,000 |
| Average assets (d) = (b + c)÷2 | $481,500 | $ 437,500 |
| Asset turnover (a ÷ d) | 1.87 | 1.83 |
*The year 3 beginning asset balance was drawn from the year 2 financial statements, which are not included in the illustration.
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Return on Investment
Return on investment (R O I), also called return on assets or earning power, is the ratio of wealth generated (net income) to the amount invested (average total assets) to generate the wealth.
For Milavec, R O I was as follows:
Year 4
$25,000 ÷ $481,500* = 5.19%
Year 3
$22,000 ÷ $437,500* = 5.03%
*The computation of average assets is shown previously.
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Return on Equity
Return on equity (R O E) is often used to measure the profitability of the stockholders’ investment.
| Year 4 | Year 3 | |
| Net income (a) | $ 25,000 | $ 22,000 |
| Preferred stock, 6%, $100 par, cumulative | 50,000 | 50,000 |
| Common stock, $10 par | 150,000 | 125,000 |
| Retained earnings | 162,000 | 137,000 |
| Ending stockholders’ equity (b) | $362,000 | $ 312,000 |
| Beginning stockholders’ equity (c) | $312,000 | $268,000* |
| Average stockholders’ equity (d) = (b + c) ÷ 2 | $337,000 | $ 290,000 |
| R O E (a ÷ d) | 7.4% | 7.6% |
*The Year 3 beginning stockholders’ equity balance was drawn from the Year 2 financial statements, which are not included in the illustration.
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L O 9-5:
Calculate ratios for assessing a company’s position in the stock market.
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Stock Market Ratios
Existing and potential investors in a company’s stock use many common ratios to analyze and compare the earnings and dividends of different-sized companies in different industries.
Purchasers of stock can profit in two ways: through receiving dividends and through increases in stock value.
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Earnings per Share
Perhaps the most frequently quoted measure of earnings performance is earnings per share (E P S).
Milavec’s Year 4 E P S is calculated as follows:
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Book Value
Book value per share is another frequently quoted measure of a share of stock.
Milavec’s book value per share for Year 3 is calculated as follows:
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Price-Earnings Ratio
The price-earnings (P/E) ratio compares the earnings per share of a company to the market price for a share of the company’s stock.
The P/E ratios for the three companies are as follows:
| Avalanche | Brushfire | Cyclone |
| 12.0 | 10.0 | 12.5 |
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Dividend Yield
Dividend yield measures dividends received as a percentage of a stock’s market price.
The information for calculating dividend yield follows:
| Dragonfly | Elk | |
| Dividends per share (a) | $ 1.80 | $ 3.00 |
| Market price per share (b) | 40.00 | 75.00 |
| Dividend yield (a ÷ b) | 4.5% | 4.0% |
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Summary of Key Relationships 1
EXHIBIT 9.6
Summary of Key Relationships
| Liquidity Ratios | 1. Working capital 2. Current ratio 3. Quick (acid-test) ratio 4. Accounts receivable turnover 5. Average days to collect receivables 6. Inventory turnover 7. Average days to sell inventory | Current assets − Current liabilities Current assets ÷ Current liabilities (Current assets − Inventory − Prepaids) ÷ Current liabilities Net credit sales ÷ Average receivables 365 ÷ Accounts receivable turnover Cost of goods sold ÷ Average inventory 365 ÷ Inventory turnover |
| Solvency Ratios | 8. Debt-to-assets ratio 9. Debt-to-equity ratio 10. Number of times interest is earned 11. Plant assets to long-term liabilities | Total liabilities ÷ Total assets Total liabilities ÷ Total stockholders’ equity Earnings before interest and taxes ÷ Interest expense Net plant assets ÷ Long-term liabilities |
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Summary of Key Relationships 2
EXHIBIT 9.6
Summary of Key Relationships
| Profitability Ratios | 12. Net margin 13. Asset turnover 14. Return on investment (also: return on assets) 15. Return on equity | Net income ÷ Net sales Net sales ÷ Average total assets Net income ÷ Average total assets Net income ÷ Average total stockholders’ equity |
| Stock Market Ratios | 16. Earnings per share 17. Book value per share 18. Price-earnings ratio 19. Dividend yield | Net earnings available for common stock ÷ Average outstanding common shares (Stockholders’ equity − Preferred rights) ÷ Outstanding common shares Market price per share ÷ Earnings per share Dividends per share ÷ Market price per share |
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Limitations of Financial Statement Analysis
External users can rely on financial statement analysis only as a general guide to the potential of a business.
Different industries may be affected by unique social policies, special accounting procedures, or other individual industry attributes.
When comparing firms, analysts must be alert to changes in general economic trends from year to year.
Financial statement analysis is only as reliable as the data on which it is based.
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End of Chapter 9
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Accessibility Content: Text Alternatives for Images
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Milavec Company Financial Statements 1 – Text Alternative 1
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Year 4
Sales 900,000
Cost of goods sold:
Beginning inventory 43,000
Purchases 637,000
Goods available for sale 680,000
Ending inventory 70,000
Cost of goods sold 610,000
Gross margin 290,000
Operating expenses 248,000
Income before taxes 42,000
Income taxes 17,000
Net income 25,000
Plus: Retained earnings, beginning balance 137,000
Less: Dividends 0
Retained earnings, ending balance 162,000
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Milavec Company Financial Statements 1 – Text Alternative 2
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Year 3
Sales 800,000
Cost of goods sold:
Beginning inventory 40,000
Purchases 483,000
Goods available for sale 523,000
Ending inventory 43,000
Cost of goods sold 480,000
Gross margin 320,000
Operating expenses 280,000
Income before taxes 40,000
Income taxes 18,000
Net income 22,000
Plus: Retained earnings, beginning balance 130,000
Less: Dividends 15,000
Retained earnings, ending balance 137,000
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Milavec Company Financial Statements 2 – Text Alternative 1
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Year 4
Assets:
Cash 20,000
Marketable securities 20,000
Notes receivable 4,000
Accounts receivable 50,000
Merchandise inventory 70,000
Prepaid expenses 4,000
Property, plant, and equipment (net) 340,000
Total assets 508,000
Liabilities and Stockholders’ Equity:
Accounts payable 40,000
Salaries payable 2,000
Taxes payable 4,000
Bonds payable, 8% 100,000
Preferred stock, 6%, $100 par, cumulative 50,000
Common stock, $10 par 150,000
Retained earnings 162,000
Total liabilities and stockholders’ equity 508,000
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Milavec Company Financial Statements 2 – Text Alternative 2
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Year 3
Assets:
Cash 17,000
Marketable securities 22,000
Notes receivable 3,000
Accounts receivable 56,000
Merchandise inventory 43,000
Prepaid expenses 4,000
Property, plant, and equipment (net) 310,000
Total assets 455,000
Liabilities and Stockholders’ Equity:
Accounts payable 38,000
Salaries payable 3,000
Taxes payable 2,000
Bonds payable, 8% 100,000
Preferred stock, 6%, $100 par, cumulative 50,000
Common stock, $10 par 125,000
Retained earnings 137,000
Total liabilities and stockholders’ equity 455,000
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Milavec Company Horizontal Analysis – Text Alternative 1
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Year 4: Sales 900,000; Year 3: Sales 800,000; % difference +12.5*
Year 4: Cost of goods sold 610,000; Year 3: Cost of goods sold 480,000; % difference +27.1
Year 4: Gross margin 290,000; Year 3 Gross margin 320,000; % difference -9.4
Year 4: Operating expenses 248,000; Year 3: Operating expenses 280,000; % difference -11.4
Year 4: Income before taxes 42,000; Year 3: Income before taxes 40,000; % difference +5.0
Year 4: Income taxes 17,000; Year 3: Income taxes 18,000; % difference -5.6
Year 4: Net income 25,000; Year 3: Net income 22,000; % difference +13.6
*(900,000 − 800,000) ÷ 800,000; all changes expressed as percentages of previous totals.
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Vertical Analysis of Income Statement – Text Alternative 1
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Year 4: Sales 900,000; percent of sales 100.0; Year 3: Sales 800,000; percent of sales 100.0
Year 4: Cost of goods sold 610,000; percent of sales 67.8; Year 3: 480,000; percent of sales 60.0
Year 4: Gross margin 290,000; percent of sales 32.2; Year 3: Gross margin 320,000; percent of sales 40.0
Year 4: Operating expenses 248,000; percent of sales 27.6; Year 3: Operating expenses 280,000; percent of sales 35.0
Year 4: Income before taxes 42,000; percent of sales 4.7; Year 3: Income before taxes 40,000; percent of sales 5.0
Year 4: Income taxes 17,000; percent of sales 1.9; Year 3: Income taxes 18,000; percent of sales 2.3
Year 4: Net income 25,000; percent of sales 2.8; Year 3: Net income 22,000; percent of sales 2.8
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Vertical Analysis of Balance Sheet 1 – Text Alternative 1
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Assets:
Year 4: Cash 20,000; percent of total 3.9; Year 3: Cash 17,000 percent of total 3.7
Year 4: Marketable securities 20,000; percent of total 3.9; Year 3: Marketable securities 22,000; percent of total 4.8
Year 4: Notes receivable 4,000; percent of total 0.8; Year 3: Notes receivable 3,000; percent of total 0.7
Year 4: Accounts receivable 50,000; percent of total 9.8; Year 3: Accounts receivable 56,000; percent of total 12.3
Year 4: Merchandise inventory 70,000; percent of total 13.8; Year 3: Merchandise inventory 43,000; percent of total 9.5
Year 4: Prepaid expenses 4,000; percent of total 0.8; Year 3: Prepaid expenses 4,000; percent of total 0.9
Year 4: Total current assets 168,000; percent of total 33.1; Year 3: Total current assets 145,00; percent of total 31.9
Year 4: Property, plant, and equipment 340,000; percent of total 66.9; Year 3: Property, plant, and equipment 310,000; percent of total 68.1
Year 4: Total assets 508,000; percent of total 100.0; Year 3: Total assets 455,000; percent of total 100.0
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Vertical Analysis of Balance Sheet 2 – Text Alternative 1
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Liabilities and Stockholders’ Equity:
Year 4: Accounts payable 40,000; percent of total 7.9; Year 3: Accounts payable 38,000; percent of total 8.3
Year 4: Salaries payable 2,000; percent of total 0.4; Year 3: Salaries payable 3,000; percent of total 0.7
Year 4: Taxes payable 4,000; percent of total 0.8; Year 3: Taxes payable 2,000; percent of total 0.4
Year 4: Total current liabilities 46,000; percent of total 9.1; Year 3: Total current liabilities 43,000; percent of total 9.4
Year 4: Bonds payable, 8% 100,000; percent of total 19.7; Year 3: Bonds payable, 8% 100,000; percent of total 22.0
Year 4: Total liabilities 146,000; percent of total 28.8; Year 3 Total liabilities 143,000; percent of total 31.4
Year 4: Preferred stock, 6%, $100 par, 50,000; percent of total 9.8; Year 3: Preferred stock 6%, $100 par 50,000; percent of total 11.0
Year 4: Common stock, $10 par 150,000; percent of total 29.5; Year 3: Common stock, $10 par 125,000; percent of total 27.5
Year 4: Retained earnings 162,000; percent of total 31.9; Year 3: Retained earnings 137,000; percent of total 30.1
Year 4: Total stockholders’ equity 362,000; percent of total 71.2; Year 3: Total stockholder’s equity 312,000; percent of total 68.6
Year 4: Total liabilities and stockholders’ equity 508,000; percent of total 100.0; Year 3: Total liabilities and stockholders’ equity 455,000; percent of total 100.0
Footnote: Percentages may not add exactly due to rounding.
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Current assets
Current ratio
Current liabilities
=
Quick assets
Quickratio
Current liabilities
=
Net credits sales
Accounts receivable turnover
Average accounts receivable
=
365 days
Average days to collect receivables
Account receivable turnover
=
Cost of goods sold
Inventoryturnover
Averageinventory
=
365 days
Average days to sell inventory
Inventory turnover
=
Total liabilities
Debt toassets
Total assets
=
Total liabilities
Debt to equity
Totalstockholders' equity
=
Number of times
Earnings before interest and taxes expen
se
interest is earned
Interest expense
=
Net plant assets
Plant Assets to Long-term liabilities
Long-termliabilities
=
Net income
Net margin
Net sales
=
Net Sales
Asset turnover
Average total assets
=
Net income
ROI
Average total assets
=
Net income
ROE =
Average total stockholders' equity
Net earnings available for common stock
Earningsper share
Average number of outstanding
common shares
=
(
)
(
)
(
)
(
)
$25,000net income$3,000preferred dividen
d
$1.60per share
15,00012,5002average outstanding common
shares
-
=
+
Stockholders' equityPreferred stock
Book value per share
Outstanding common shares
-
=
$362,000$50,000
$20.80per share
15,000
-
=
Market price per share
Price-earnings ratio=
Earnings per share
Dividends per share
Dividend yield=
Market price per share
