Chapter 14

“How Well Am I Doing?”

Financial Statement
Analysis
 Limitations of Financial Statement
Analysis

Differences in accounting methods

between companies sometimes make
comparisons difficult.

We use the LIFO method to We use the FIFO method to

value inventory. value inventory.
Limitations of Financial Statement
Analysis

Changes within
the company
Industry Consumer
trends tastes

Technological
changes
Economic
factors

Analysts should look beyond

the ratios.
 Statements in Comparative and
Common-Size Form

 Dollar and percentage

changes on statements
Analytical
techniques used to  Common-size
examine statements
relationships among
financial statement
items  Ratios
 Learning Objective
LO1

To prepare and interpret

financial statements in
comparative and
common-size form
 Horizontal Analysis

Horizontal analysis shows the changes

between years in the financial data in
both dollar and percentage form.
 Horizontal Analysis
Example

The following slides illustrate a horizontal

analysis of Clover Corporation’s
December 31, 2005 and 2004
comparative balance sheets and
comparative income statements.
 Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
 Horizontal Analysis

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

The dollar
amounts for
2004 become
the “base” year
figures.
 Horizontal Analysis

Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
 Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $12,000 –155,000
$23,500164,700
= $(11,500)
Property and equipment:
Land 40,000 40,000
($11,500
Buildings and equipment, net
÷ $23,500)
120,000
× 100% = 48.9%
85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
 Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
Horizontal Analysis

We could do this for the

liabilities & stockholders’
equity, but now, let’s look at
the income statement
accounts.
 Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 Amount %
Net sales $ 520,000 $ 480,000
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
Net operating income 31,400 39,000
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
 Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 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)
 Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Sales increased160,000
Gross margin by 8.3%, yet
165,000 (5,000) (3.0)
Operating
net expenses 128,600by 126,000
income decreased 21.9%. 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)
 Horizontal Analysis
There were increases in both
CLOVER cost of goods
CORPORATION
sold (14.3%) andComparative
operatingIncome Statements
expenses (2.1%).
These increasedFor costs
the Years Ended
more December
than offset 31
the
Increase
increase in sales, yielding an overall
(Decrease)
decrease in net2005income.2004 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)
 Trend Percentages

Trend percentages
state several years’
financial data in terms
of a base year, which
equals 100 percent.
 Trend Percentages

Trend Current Year Amount

Percentage
=
Base Year Amount
× 100%
 Trend Percentages

Example
Look at the income information for
Berry Products for the years 2001
through 2005. We will do a trend
analysis on these amounts to see
what we can learn about the
company.
 Trend Percentages

Berry Products
Income Information
For the Years Ended December 31
Year
Item 2005 2004 2003 2002 2001
Sales $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of goods sold 285,000 250,000 225,000 198,000 190,000
Gross margin 115,000 105,000 95,000 92,000 85,000

The base year is 2001, and its amounts

will equal 100%.
 Trend Percentages

Berry Products
Income Information
For the Years Ended December 31
Year
Item 2005 2004 2003 2002 2001
Sales 105% 100%
Cost of goods sold 104% 100%
Gross margin 108% 100%

2002 Amount ÷ 2001 Amount × 100%

( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
 Trend Percentages

Berry Products
Income Information
For the Years Ended December 31
Year
Item 2005 2004 2003 2002 2001
Sales 145% 129% 116% 105% 100%
Cost of goods sold 150% 132% 118% 104% 100%
Gross margin 135% 124% 112% 108% 100%

By analyzing the trends for Berry Products, we can

see that cost of goods sold is increasing faster than
sales, which is slowing the increase in gross margin.
 Trend Percentages

We can use the trend

160 percentages to construct a
graph so we can see the
150
trend over time.
140
Percentage

130

120 Sales
COGS
110 GM
100
2001 2002 2003 2004 2005
Year
 Common-Size Statements

Common-size
statements use
percentages to express
the relationship of
individual components to
a total within a single
period. This is also
known as vertical
analysis.
Common-Size Statements

In income
statements, all
items are
expressed as a
percentage of
net sales.
Gross Margin Percentage

Gross Margin Gross Margin

=
Percentage Sales

This measure indicates how much

of each sales dollar is left after
deducting the cost of goods sold to
cover expenses and provide a profit.
Common-Size Statements

In balance
sheets, all items
are expressed
as a percentage
of total assets.
 Common-Size Statements

Wendy's McDonald's
(dollars in millions) Dollars Percentage Dollars Percentage
2002 Net income $ 219 8.00% $ 893 5.80%

Common-size financial statements are

particularly useful when comparing
data from different companies.
 Common-Size Statements

Example

Let’s take another look at the information

from the comparative income statements
of Clover Corporation for 2005 and 2004.
This time let’s prepare common-size
statements.
 Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005 2004 2005 2004
Net sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000 Net sales is
Operating expenses 128,600 126,000 the base
Net operating income 31,400 39,000 and is
Interest expense 6,400 7,000 expressed
Net income before taxes 25,000 32,000
as 100%.
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
 Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005 2004 2005 2004
Net sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
2005 Cost
Net operating ÷ 2005 Sales
income 31,400× 100%
39,000
( $360,000
Interest expense ÷ $520,000 ) × 100%
6,400 = 69.2%
7,000
Net income before taxes 25,000 32,000
Less income 2004 Cost ÷ 2004
taxes (30%) 7,500 Sales × 100%
9,600
Net income ( $315,000 $÷17,500 $480,000 ) × 100% = 65.6%
$ 22,400
 Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
What conclusions can we draw?
Percentages
2005 2004 2005 2004
Net sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000 30.8 34.4
Operating expenses 128,600 126,000 24.8 26.2
Net operating income 31,400 39,000 6.0 8.2
Interest expense 6,400 7,000 1.2 1.5
Net income before taxes 25,000 32,000 4.8 6.7
Less income taxes (30%) 7,500 9,600 1.4 2.0
Net income $ 17,500 $ 22,400 3.4 4.7
 Quick Check 

Which of the following statements describes

horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c. A comparison of the account balances on
the current year’s financial statements.
d. None of the above.
 Quick Check 

Which of the following statements describes

horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c.Horizontal
A comparison of theshows
analysis account
thebalances
changes on
the current
between year’s
years financial
in the statements.
financial data, in
d. None
bothofdollar
the above.
and percentage form.
 Ratios
Common
Stockholders

Short-term
Creditors

Long-term
Creditors
Now, let’s look at
Norton
Corporation’s
recent financial
statements.
 NORTON CORPORATION
Balance Sheets
December 31

2005 2004
Assets
Current assets:
Cash $ 30,000 $ 20,000
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets $ 346,390 $ 300,000
 NORTON CORPORATION
Balance Sheets
December 31

2005 2004
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 39,000 $ 40,000
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities:
Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Stockholders' equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000
Total liabilities and stockholders' equity $ 346,390 $ 300,000
 NORTON CORPORATION
Income Statements
For the Years Ended December 31

2005 2004
Net sales $ 494,000 $ 450,000
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000
Net income before taxes 76,700 66,000
Less income taxes (30%) 23,010 19,800
Net income $ 53,690 $ 46,200
 Learning Objective
LO2

To compute and
interpret financial ratios
that would be useful to
a common stockholder
 Ratio Analysis – The Common
Stockholder
NORTON CORPORATION
2005
Use this Number of common shares
outstanding
information to Beginning of year 17,000
End of year 27,400
calculate ratios Net income $ 53,690
to measure the Stockholders' equity
well-being of Beginning of year 180,000

the common End of year 234,390

Dividends per share 2
stockholders of
Dec. 31 market price per share 20
Norton Interest expense 7,300
Corporation. Total assets
Beginning of year 300,000
End of year 346,390
 Earnings Per Share

Net Income – Preferred Dividends

Earnings per Share =
Average Number of Common
Shares Outstanding

Whenever a ratio divides an income statement

balance by a balance sheet balance, the average
for the year is used in the denominator.
 Earnings Per Share

Net Income – Preferred Dividends

Earnings per Share =
Average Number of Common
Shares Outstanding

$53,690 – 0
Earnings per Share = = $2.42
(17,000 + 27,400)/2

This measure indicates how much

income was earned for each share of
common stock outstanding.
 Price-Earnings Ratio

Price-Earnings Market Price Per Share

=
Ratio Earnings Per Share

Price-Earnings $20.00
Ratio = = 8.26 times
$2.42

This measure is often used by investors

as a general guideline in gauging stock
values. Generally, the higher the price-
earnings ratio, the more opportunity a
company has for growth.
 Dividend Payout Ratio

Dividend Dividends Per Share

=
Payout Ratio Earnings Per Share

Dividend $2.00
= = 82.6%
Payout Ratio $2.42

This ratio gauges the portion of current

earnings being paid out in dividends.
Investors seeking current income would
like this ratio to be large.
 Dividend Yield Ratio

Dividend Dividends Per Share

=
Yield Ratio Market Price Per Share

Dividend $2.00
= = 10.00%
Yield Ratio $20.00

This ratio identifies the return, in

terms of cash dividends, on the
current market price of the stock.
 Return on Total Assets

Return on Net Income + [Interest Expense × (1 – Tax Rate)]

=
Total Assets Average Total Assets

Return on $53,690 +[7,300 × (1 – .30)]

= = 18.19%
Total Assets ($300,000 + $346,390) ÷ 2

This ratio measures how well

assets have been employed.
Return on Common Stockholders’ Equity

Return on Common = Net Income – Preferred Dividends

Stockholders’ Equity Average Stockholders’ Equity

Return on Common $53,690 – 0

= = 25.91%
Stockholders’ Equity ($180,000 + $234,390) ÷ 2

This measure indicates how well the

company employed the owners’
investments to earn income.
 Financial Leverage
Financial leverage involves acquiring
assets with funds at a fixed rate of
interest.
Fixed rate of
Return on return on Positive
investment in > borrowed = financial
assets funds leverage

Return on Fixed rate of Negative

investment in < return on = financial
assets borrowed leverage
funds
 Quick Check 
Which of the following statements is true?
a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
 Quick Check 
Which of the following statements is true?
a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
 Book Value Per Share

Book Value Common Stockholders’ Equity

=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

This ratio measures the amount that would be

distributed to holders of each share of common
stock if all assets were sold at their balance sheet
carrying amounts and if all creditors were paid off.
 Book Value Per Share

Book Value Common Stockholders’ Equity

=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

Notice that the book value per share of $8.55 does

not equal the market value per share of $20. This
is because the market price reflects expectations
about future earnings and dividends, whereas the
book value per share is based on historical cost.
 Learning Objective
LO3

To compute and
interpret financial ratios
that would be useful to
a short-term creditor
 Ratio Analysis –
The Short–Term Creditor

NORTON CORPORATION
Use this 2005
information to Cash $ 30,000
calculate ratios Accounts receivable, net

to measure the Beginning of year 17,000

End of year 20,000
well-being of the
Inventory
short-term Beginning of year 10,000
creditors for End of year 12,000
Norton Total current assets 65,000
Corporation. Total current liabilities 42,000
Sales on account 500,000
Cost of goods sold 140,000
 Working Capital

The excess of current assets over

current liabilities is known as
working capital.

Working capital is not

free. It must be
financed with long-term
debt and equity.
 Working Capital

December 31,
2005
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
 Current Ratio

Current Current Assets

=
Ratio Current Liabilities

The current ratio measures a

company’s short-term debt
paying ability.

A declining ratio may be a

sign of deteriorating
financial condition, or it
might result from eliminating
obsolete inventories.
 Current Ratio

Current Current Assets

=
Ratio Current Liabilities

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

The current ratio measures a

company’s short-term debt
paying ability.
 Acid-Test (Quick) Ratio

Acid-Test Quick Assets

=
Ratio Current Liabilities

Acid-Test $50,000
= = 1.19 : 1
Ratio $42,000
Norton
Quick assets include Cash, Corporation’s
Marketable Securities, Accounts quick assets
Receivable and current Notes consist of cash
Receivable. of $30,000 and
This ratio measures a company’s ability accounts
to meet obligations without having to receivable of
liquidate inventory. $20,000.
 Accounts Receivable Turnover
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover

Accounts
$500,000
Receivable = = 27.03 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
 Average Collection Period

Average 365 Days

Collection = Accounts Receivable Turnover
Period

Average
365 Days
Collection = = 13.50 days
27.03 Times
Period

This ratio measures, on average,

how many days it takes to collect
an account receivable.
 Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory
This ratio measures how many
times a company’s inventory
has been sold and replaced
during the year.

If a company’s inventory
turnover Is less than its
industry average, it either
has excessive inventory or
the wrong types of inventory.
 Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory

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

This ratio measures how many

times a company’s inventory
has been sold and replaced
during the year.
 Average Sale Period
Average 365 Days
=
Sale Period Inventory Turnover

Average 365 Days

= = 28.67 days
Sale Period 12.73 Times

This ratio measures how many

days, on average, it takes to
sell the inventory.
 Learning Objective
LO4

To compute and
interpret financial ratios
that would be useful to
a long-term creditor
 Ratio Analysis –
The Long–Term Creditor

Use this information to calculate ratios

to measure the well-being of the long-
term creditors for Norton Corporation.
NORTON CORPORATION
2005
Earnings before interest
expense and income taxes $ 84,000
Interest expense 7,300
This is also referred
Total stockholders' equity 234,390
to as net operating
Total liabilities 112,000
income.
Times Interest Earned Ratio

Times Earnings before Interest Expense

Interest = plus Income Taxes
Earned Interest Expense

Times
$84,000
Interest = = 11.5 times
7,300
Earned

This is the most common

measure of the ability of a firm’s
operations to provide protection
to the long-term creditor.
 Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio

This ratio indicates the relative

proportions of debt to equity on
a company’s balance sheet.

Stockholders like a lot of Creditors prefer less

debt if the company can debt and more equity
take advantage of because equity
positive financial represents a buffer of
leverage. protection.
 Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio

Debt–to–
$112,000
Equity = = 0.48
$234,390
Ratio

This ratio indicates the relative

proportions of debt to equity on
a company’s balance sheet.
Published Sources That Provide
Comparative Ratio Data
End of Chapter 14