Accounting and

Finance

FINANCIAL STATEMENT
ANALYSIS
 Learning Objectives

• Discuss the objectives of financial statement analysis for

different types of decision makers.
• Identify the key sources of information for financial
statement analysis.
• Prepare trend analyses of financial statement data.
• Prepare common-sized financial statements.
• Compute key financial ratios including liquidity, leverage,
activity, profitability, and market strength ratios.
• Assess earnings quality.
 Objectives of Financial
Statement Analysis

• Financial statement analysis comprises all the techniques

employed by users of financial statements to show
important relationships in the financial statements.
• Users of financial statements fall into two broad
categories: internal and external.
• The main focus in this chapter is on the external users of
financial statements and the analytical techniques they
employ.
 Users

• External Users
• Creditors make loans in the form of trade accounts, notes,
or bonds.
• Investors buy capital stock, from which they hope to receive
dividends and an increase in value.
• Both groups face risks and for both the goal is to achieve a
return that makes up for the risk.
 Uses of Financial
Statement Analysis
• It is in making individual investment or loan decisions that
financial statement analysis is most useful.
• Creditors and investors use financial statement analysis in
two general ways.
• 1. To judge past performance and current position.
• 2. To judge future potential and the risk connected with that
potential.
 Sources of Information
for Financial Statement
Analysis
• Annual reports
• Investment advisory services
• Business periodicals
• On-line financial services
• EDGAR . . . the SEC’s Web site
 Who Performs Financial Statement
Analysis

• Financial statement analysis is routinely performed by:

– 1) Creditors (short term and long term)

– 2) Equity investors (current and potential)
– 3) Company management

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 Objectives of Creditors

• Short-term creditors, both “trade” creditors and

“lending institutions,” are primarily concerned with
the firm’s ability to pay its bills in a timely fashion.
• Long-term creditors are concerned with the firm’s
long-term ability to repay any loan amounts
(including bonds) as well as the interest on that debt.

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 Objectives of Equity Investors

• Investors are concerned with many things, but

probably the most important consideration is the
company’s ability to generate income in the future.

• Profitable operations for the company usually

translate into dividends and stock price appreciation
for the investors.

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 Objectives of Management

• Members of management have the respon-

sibility of leading the firm through the day-to-
day activities. The results of these activities
are reflected in the financial statements.

• Thus, management has two main concerns

regarding financial statement analysis:
1) to present the information in the most
favorable light, and
2) to monitor the overall performance.
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 Gathering Background Information -
A First Step

• In order to properly analyze the financial statements of a

firm, it is necessary to understand the environment in
which the firm operates. In particular:
• the general economic conditions/expectations,
– the political events and political climate, and
– the industry outlook.

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 General Economic Conditions and
Expectations

• Another factor to consider in predicting the future financial

performance of a company would be the current condition
of the general economy and your expectations about the
future of the economy.
• Companies in certain industries would be affected more
than others when an economic downturn (or upswing)
occurs.

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 Political Events and Political Climate

• Additional external factors that will have an influence on a

company’s financial performance are the political events
and the general political climate.

• Congressional actions often affect the financial

performance through changes in the tax code,
environmental actions, or reductions in governmental
spending.

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 Industry Outlook

• A third external factor is the general outlook for the

industry in which the firm operates.

• For example, technology-based companies have

been “hot” in the late 1990s, while traditional
manufacturing companies have been more
“stagnant.”

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 Basic analytical procedures

Contrive
Contrive
Determine
Determine Collect
Collect Analyze
Analyze
analysis
analysis Conclude
Conclude
objective
objective data
data data
data
scheme
scheme
 Tools and Techniques of
Financial Analysis
• Few numbers are very significant when looked at
individually.
• It is the relationship between various numbers or
their change from year to year that is important.
• The tools of financial analysis are intended to show
relationships and changes.
 Three Common Approaches to
Financial Statement Analysis

• Trend analysis
• Common-sized financial
statements
• Ratio analysis
 Horizontal Analysis

• GAAP requires the presentation of comparative financial

statements that give financial information for the current
year and the previous year.
• Horizontal analysis begins with the computation of changes
from the previous year to the current year.
• Horizontal analysis uses both dollar amounts and
percentages.
 Horizontal Analysis

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Amount Amount

The dollar
amounts for
20X3 become
the “base” year
amount.
 Horizontal Analysis

Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Amount × 100%

%
 Horizontal Analysis

CLOVER CORPORATION
Comparative Balance Sheets
December 31, 20X4 and 20X3
Increase (Decrease)
20X4 20X3 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 155,000 164,700
Property and equipment:
Land $12,00040,000
– $23,500 = $(11,500)
40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets (-$11,500
$ 315,000÷ $$23,500)
289,700 × 100% = 48.9%
 Horizontal Analysis

CLOVER CORPORATION
Comparative Balance Sheets
December 31, 20X4 and 20X3
Increase (Decrease)
20X4 20X3 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 more of the

balance sheet, but let’s change
our attention and look at the
income statement accounts.
 Horizontal Analysis

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 20X4 and 20X3
Increase (Decrease)
20X4 20X3 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, 20X4 and 20X3
Increase (Decrease)
20X4 20X3 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)
Sales increased by 8.3% yet
Interest expense 6,400 7,000 (600) (8.6)
net income
Net income before taxes decreased
25,000 by32,000
21.9%. (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 CLOVER CORPORATION

in both cost of goods
sold (14.3%)Comparative Income Statements
and operating expenses
For the Years Ended December 31, 20X4 and 20X3
(2.1%). These increased costs more than Increase (Decrease)
offset the increase in sales,
20X4 yielding
20X3 an Amount %
overall decrease$in520,000
Net sales net income.
$ 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)
 Financial Statement Analysis

• Financial statement analysis is just what you would

think it is: analyzing the information presented in a
firm’s financial statements.

• Two major techniques are trend analysis and ratio

analysis.

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 Trend Analysis

• Trend analysis is a particular type of financial

statement analysis where key financial figures are
analyzed over time to see if there is a pattern of
change.

• Trend analysis can often be effectively illustrated

through the use of graphs or charts.

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 Trend Analysis

• Changes are calculated for several successive years

instead of for two years.
• Trend analysis is important because it may point to
basic changes in the nature of a business.
• Trend analysis uses an index number to show
changes in related items over a period of time.
 Trend Percentages

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

Current Year Amount

Trend % =
Base Year Amount
× 100%
 Trend Analysis

Berry Products
Income Information
For the Years Ended December 31,
Year
Item 2002 2001 2000 1999 1998
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

1998, and its amounts
will equal 100%.
 Trend Analysis

Berry Products
Income Information
For the Years Ended December
Year 31,
Item 2002 2001 2000 1999 1998
Sales 105% 100%
Cost of goods sold 104% 100%
Gross margin 108% 100%

1999 Amount ÷ 1998 Amount × 100%

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

Berry Products
Income Information
For the Years Ended December
Year 31,
Item 2002 2001 2000 1999 1998
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.
 Dollar and Percentage Changes on
Statements

Comparing
Comparing statements
statements underscores
underscores
movements
movements and
and trends
trends and
and may
may provide
provide
valuable
valuable clues
clues about
about what
what to
to expect
expect in
in the
the
future.
future.

Horizontal
Horizontal Trend
Trend
analysis
analysis analysis
analysis
 Vertical Analysis

• Percentages are used to show the relationship

of the different parts to a total in a single
statement.
• The accountant sets a total figure in the
statement equal to 100% and computes each
component’s percentage of that total.
• The statement of percentages is called a
common-size statement.
• Vertical analysis is useful for comparing the
importance of specific components in the
operation of a business.
 Vertical Analysis

Common-size
statements use
percentages to
express the
relationship of
individual components
to a total within a
single period.
 Vertical Analysis

Example
Let’s take another look at the
information from the comparative
income statements of Clover
Corporation for 2004 and 2003.
This time let’s prepare vertical
analysis income statements.
 Vertical Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 20X4 and 20X3
Common-Size
Percentages
20X4 20X3 20X4 20X3
Net sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Operating expenses 128,600 126,000Net sales is
Net operating income 31,400 39,000
Interest expense 6,400
usually the base
7,000
Net income before taxes 25,000 and is expressed
32,000
Less income taxes (30%) 7,500 9,600 as 100%.
Net income $ 17,500 $ 22,400
 Vertical Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 20X4 and 20X3
Common-Size
Percentages
20X4 20X3 20X4 20X3
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
Net operating income
2004 Cost ÷ 200431,400
Net Sales39,000
× 100%
Interest expense 6,400 7,000
( $360,000 ÷ $520,000
Net income before taxes 25,000
) × 32,000
100% = 69.2%
Less income taxes (30%) 7,500 9,600
Net income
2003 Cost ÷ 2003 Net Sales × 100%
$ 17,500 $ 22,400
( $315,000 ÷ $480,000 ) × 100% = 65.6%
 Vertical Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 20X4 and 20X3
Common-Size
Percentages
What conclusions can we draw?
20X4 20X3 20X4 20X3
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
 Ratio Analysis

• Ratio analysis is a particular type of financial statement

analysis where the relationship between two or more
items from the financial statements is analyzed.

• A particular ratio might include information from various

sources, including information not typically contained in
the financial statements, such as market price of a
stock.

42
 Objectives of Ratio Analysis

• Standardize financial information for comparisons

• Evaluate current operations
• Compare performance with past performance
• Compare performance against other firms or
industry standards
• Study the efficiency of operations
• Study the risk of operations
 Rationale Behind Ratio Analysis

• A firm has resources

• It converts resources into profits through
– production of goods and services
– sales of goods and services
• Ratios
– Measure relationships between resources and financial flows
– Show ways in which firm’s situation deviates from
• Its own past
• Other firms
• The industry
• All firms-
 Types of Ratios

• Financial Ratios:
– Liquidity Ratios
• Assess ability to cover current obligations
– Leverage Ratios
• Assess ability to cover long term debt obligations
• Operational Ratios:
– Activity (Turnover) Ratios
• Assess amount of activity relative to amount of resources used
– Profitability Ratios
• Assess profits relative to amount of resources used
• Valuation Ratios:
• Assess market price relative to assets or earnings
 Measuring Liquidity

• Liquidity (in this context) refers to the company’s ability to

generate cash as needed to pay its short-term obligations.
• Short-term creditors (current and potential) are particularly
concerned with a company’s liquidity measures.
• Liquidity measures focus on the “liquidity of the assets”
available to the company.

46
 Measuring Liquidity

• Commonly used measures include:

– Current ratio
– Quick ratio
– Net sales to working capital
– Receivables turnover
– Inventory turnover

47
 Liquidity Ratios

Current ratio = Current assets /

Current liabilities
Purpose: Measures a firm’s ability to pay its current liabilities
from its current assets.

Quick ratio = Quick assets / Current liabilities

Purpose: Measures a firm’s ability to pay its current
liabilities without relying on the sale of its inventory.
 Net Sales to
Working Capital Ratio

Sales
Current assets - Current
liabilities

• Working capital is the difference between current assets

and current liabilities. This ratio measures the generation of
sales in comparison to the working capital employed.

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 Receivables Turnover Ratio

Sales
Accounts receivable

• A measurement of how quickly a company collects their

accounts receivable. The higher the turnover, the more
quickly the receivables are being collected.

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 Inventory Turnover Ratio

Cost of sales
Inventory

• A measurement of how quickly a company collects their

accounts receivable. The higher the turnover, the more
quickly the receivables are being collected.

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 Leverage Ratios

Long-term debt = Long-term debt

to equity ratio Stockholders’ equity

Purpose: Measures a firm’s financial leverage.

Times interest Net income + interest expense +
= income taxes expense
earned ratio Interest expense

Purpose: Indicates the number of times that a firm’s

interest expense is covered by earnings.
 Measuring Solvency

• Solvency refers to the ability to meet long-

term obligations resulting from debt.
• These measurements are similar to the
liquidity measures, except the focus is on all
assets and liabilities rather than the current
assets and liabilities.
• These measures are of interest to long-term
creditors, stockholders, and management.

53
 Measuring Solvency

• Commonly used measures include:

– Debt ratio
– Total liabilities to net worth
– Coverage ratio

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 Debt Ratio

Total liabilities
Total assets

• Measures the percentage of a company’s assets

that is financed by debt, rather than equity. Debt %
+ Equity % = 100%

55
 Total Liabilities to
Net Worth Ratio

Total liabilities
Net worth
• Net worth is the same as owners’ equity, it is equal to
Assets - Liabilities. This ratio highlights the relationship
between creditors’ claims and owners’ claims to assets.

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 Coverage Ratio

Earnings before interest and income taxes

Interest expense
• Also called the “times interest earned ratio.” An indication
of the company’s ability to make interest payments.

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 Measuring Profitability

• Profitability refers to the company’s ability to generate

income. Profitability ratios are used to measure a firm’s
past performance and to aid in the prediction of future
profits.

• Most business people agree that long-term profits are

more important than short-term profits, yet most of the
commonly used ratios focus on short-term profitability.

58
 Measuring Profitability

• Commonly used measures include:

– Profit Margin
– Return on assets ratio
– Return on equity
– Total asset turnover
– Return before interest on equity

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Financial Statement for Ratio Analysis
Profitability Ratios
 Du Pont System of Analysis

• A satisfactory return on assets might be derived

through:
– A high profit margin
– A rapid turnover of assets (generating more sales
per dollar of its assets)
– Or both
Return of assets (investment) =
(Profit margin) X (Asset turnover)
 Du Pont System of Analysis
(cont’d)

• A satisfactory return on equity might be derived

through:
– A high return on total assets;
– A generous utilization of debt;
– Or a combination of both.

Return on equity = Return on assets

(investments)
[1 – (Debt/ Assets)]
Du Pont Analysis
Examples for Analysis using the
Du Pont System
 Asset Utilization Ratios

• These ratios relate the balance sheet to the income

statement.
Asset Utilization Ratios (cont’d)
Liquidity Ratios
 Debt Utilization Ratios

• Measures the prudence of the debt management

policies of the firm.
 Debt Utilization Ratios (cont’d)

• Fixed charge coverage measures the firm’s ability to

meet the fixed obligations.
• Interest payments alone are not considered.

Income before interest and taxes………………..$550,000

Lease payments…………………………………… $50,000
Income before fixed charges and taxes…………$600,000
Summary of Ratio Analysis
Trend Analysis
Trend Analysis in the Computer
Industry
 Stock Market Ratios

Earnings Net Income – Preferred Dividends

per Share =
Average Number of Common
Shares Outstanding

This
This ratio
ratio measure
measure indicates
indicates
how
how much
much income
income was
was earned
earned
for
for each
each share
share of
of common
common
stock
stock outstanding.
outstanding.
 Book Value

Book Value =Stockholders’ Equity – Preferred Rights

Average Outstanding Common Shares

This
This ratio
ratio measures
measures the the amount
amount that
that would
would be be
distributed
distributed to
to holders
holders ofof each
each share
share of
of common
common stockstock ifif
all
all assets
assets were
were sold
sold atat their
their balance
balance sheet
sheet carrying
carrying
amounts
amounts and
and ifif all
all creditors
creditors were
were paid
paid off.
off.
 Price-Earnings Ratio

Price-Earnings Market Price Per Share

=
Ratio Earnings Per Share

P/E
P/E ratio
ratio is
is often
often used
used by
by investors
investors
as
as aa general
general guideline
guideline in
in gauging
gauging
stock
stock values.
values.
 Dividend Yield

Dividend Dividends Per Share

=
Yield Market Price Per Share

This ratio identifies the return, in terms of

cash dividends, on the current market
price of the stock.
 Using the Ratios

• After calculating the ratios for a particular company, you

might want to do some or all of the following:
– Compare ratios to industry averages,
– Look for company trends,
– Consider the industry environment, and
– Draw conclusions

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 Limitations of Ratio Analysis

• As informative as ratio analysis can be, it also has some

inherent limitations:
• 1) Attempting to predict the future using past
results is problematic at best. Past results
are not always indicative of future
performance.
• 2) The financial statements used as the
basis of the ratios are based on the
accounting principle of historical cost.

79
 Limitations of Ratio Analysis

• 3) Figures from the balance sheet used in the

calculation of the ratios are year-end values,
which may or may not be representative.
• 4) Comparing the ratios of companies in
different industries is difficult because of
industry peculiarities.
• 5) There are no hard-and-fast rules telling the
analyst what numbers to use to calculate the
ratios.

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