Financial Statement

Analysis
Chapter 13

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Limitations of Financial Statement
Analysis
Differences in accounting methods
between companies sometimes make
comparisons difficult.

We use the LIFO method to We use the average cost

value inventory. method to value inventory.
13-2
Limitations of Financial Statement
Analysis
Analysts should look beyond the ratios.
Changes within
Industry the company Consumer
trends tastes

Technological Economic
changes factors

13-3
Learning Objective 1

Prepare and interpret

financial statements in
comparative and
common-size form.

13-4
Statements in Comparative and
Common-Size Form

 Dollar and percentage

changes on statements

An item on a financial
statement has little  Common-size
meaning by itself. The statements
meaning of the numbers
can be enhanced by
drawing comparisons.
 Ratios

13-5
Dollar and Percentage Changes on
Statements
Horizontal analysis (or trend analysis) shows the
changes between years in the financial data in
both dollar and percentage form.

13-6
Horizontal Analysis

The following slides illustrate a horizontal

analysis of Clover Corporation’s
comparative balance sheets and
comparative income statements for this
year and last year.

13-7
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
This Year Last Year 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

13-8
Horizontal Analysis
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

The dollar
amounts for
last year
become the
“base” year
figures.
13-9
Horizontal Analysis
Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%

13-10
Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
This Year Last Year 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: $12,000 – $23,500 = $(11,500)
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
($11,500
Total property and equipment ÷ $23,500)
160,000 × 100% = (48.9%)
125,000
Total assets $ 315,000 $ 289,700

13-11
Horizontal Analysis

We could do this
for the liabilities
and stockholders’
equity, but now
let’s look at the
income statement
accounts.

13-12
Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
This Year Last Year Amount %
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
13-13
Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
This Year Last Year Amount %
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)
OperatingSales
expenses
increased128,600 126,000
by 8.3%, yet 2,600 2.1
Net operating income decreased
net income 31,400 by 39,000
21.9%. (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)
13-14
Horizontal Analysis
CLOVER CORPORATION
There were increases in both cost of goods
Comparative Income Statements
sold (14.3%) and operating expenses (2.1%).
For the Years Ended December 31
These increased costs more than offset theIncrease
increase in sales, yielding an overall (Decrease)
decrease inThis
net Year
income.
Last Year Amount %
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)
13-15
Trend Percentages

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

13-16
 Trend Analysis

Trend = Current Year Amount

Percentage Base Year Amount
×100%

13-17
Trend Analysis

Look at the income information for Berry

Products for the years 2007 through 2011. We
will do a trend analysis on these amounts to
see what we can learn about the company.

13-18
 Trend Analysis

Berry Products
Income Information
For the Years Ended December 31
Year
Item 2011 2010 2009 2008 2007
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 2007, and its amounts
will equal 100%.

13-19
 Trend Analysis

Berry Products
Income Information
For the Years Ended December 31
Year
Item 2011 2010 2009 2008 2007
Sales 105% 100%
Cost of goods sold 104% 100%
Gross margin 108% 100%

2008 Amount ÷ 2007 Amount × 100%

( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
13-20
 Trend Analysis

Berry Products
Income Information
For the Years Ended December 31
Year
Item 2011 2010 2009 2008 2007
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.
13-21
Trend Analysis
160

We can use the trend

percentages to construct
150

a graph so we can see the

140 trend over time.
Percentage

130
Sales

COGS
120
GM

110

100
2007 2008 2009 2010 2011
Year
13-22
Common-Size Statements
Vertical analysis focuses
on the relationships
among financial
statement items at a
given point in time. A
common-size financial
statement is a vertical
analysis in which each
financial statement item
is expressed as a
percentage.
13-23
Common-Size Statements

In income
statements, all
items usually
are expressed
as a percentage
of sales.

13-24
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.

13-25
Common-Size Statements

In balance
sheets, all items
usually are
expressed as a
percentage of
total assets.

13-26
 Common-Size Statements

Burger King McDonald's

(dollars in millions) Dollars Percentage Dollars Percentage
2008 Net income $ 190 7.70% $ 4,313 18.30%

Common-size financial statements are

particularly useful when comparing
data from different companies.

13-27
Common-Size Statements

Let’s take another look at the information

from the comparative income statements
of Clover Corporation for this year and
last year.

This time, let’s prepare common-size

statements.

13-28
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
This Year Last Year This Year Last Year
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000 Sales is
Operating expenses 128,600 126,000
usually the
Net operating income 31,400 39,000
base and is
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
expressed
Less income taxes (30%) 7,500 9,600 as 100%.
Net income $ 17,500 $ 22,400

13-29
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
This Year Last Year This Year Last Year
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
NetThis Year’s
operating Cost ÷ This
income 31,400Year’s Sales × 100%
39,000
Interest expense ÷ $520,000
( $360,000 ) × 100%
6,400 7,000 = 69.2%
Net income before taxes 25,000 32,000
Last Year’s
Less income taxes (30%)
Cost ÷ Last
7,500
Year’s
9,600
Sales × 100%
( $315,000 ÷ $$480,000
Net income
) × 100% = 65.6%
17,500 $ 22,400
13-30
Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
What conclusions can we draw? Percentages
This Year Last Year This Year Last Year
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
13-31
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.

13-32
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
Horizontal
the current analysis shows the
year’s financial changes
statements.
between years in the financial data in both
d. None of the above.
dollar and percentage form.

13-33
 Now, let’s look at
Norton
Corporation’s
financial statements
for this year and
last year.

13-34
 NORTON CORPORATION
Balance Sheets
December 31

This Year Last Year

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
13-35
 NORTON CORPORATION
Balance Sheets
December 31

This Year Last Year

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

13-36
 NORTON CORPORATION
Income Statements
For the Years Ended December 31

This Year Last Year

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

13-37
Learning Objective 2

Compute and interpret

financial ratios that
would be useful to a
common stockholder.

13-38
 Ratio Analysis – The Common
Stockholder NORTON CORPORATION
This Year
The ratios that Number of common shares
outstanding
are of the most Beginning of year 17,000
End of year 27,400
interest to
Net income $ 53,690
stockholders Stockholders' equity
include those Beginning of year 180,000

ratios that focus on End of year 234,390

Dividends per share 2
net income, Dec. 31 market price per share 20
dividends, and Interest expense 7,300
stockholders’ Total assets
Beginning of year 300,000
equities.
End of year 346,390

13-39
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 form the basis for dividend payments

and future increases in the value of shares of
stock.

13-40
Earnings Per Share
Net Income – Preferred Dividends
Earnings per Share =
Average Number of Common
Shares Outstanding

Earnings per Share = $53,690 – $0 = $2.42

(17,000 + 27,400)/2

This measure indicates how much

income was earned for each share of
common stock outstanding.

13-41
Price-Earnings Ratio
Price-Earnings Market Price per Share
=
Ratio Earnings per Share

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

A higher price-earnings ratio means that

investors are willing to pay a premium
for a company’s stock because of
optimistic future growth prospects.

13-42
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 dividends (market price growth) would
like this ratio to be large (small).

13-43
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.

13-44
 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

Adding interest expense back to net income

enables the return on assets to be compared
for companies with different amounts of debt
or over time for a single company that has
changed its mix of debt and equity.

13-45
 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 used the owners’
investments to earn income.

13-46
Financial Leverage
Financial leverage results from the difference between
the rate of return the company earns on investments
in its own assets and the rate of return that the
company must pay its creditors.

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
13-47
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.
13-48
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.
13-49
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 after all creditors were paid off.

13-50
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.
13-51
Learning Objective 3

Compute and interpret

financial ratios that
would be useful to a
short-term creditor.

13-52
Ratio Analysis – The Short–Term
Creditor
NORTON CORPORATION
Short-term This Year

creditors, such as Cash $ 30,000

Accounts receivable, net
suppliers, want to
Beginning of year 17,000
be paid on time. End of year 20,000
Therefore, they Inventory
focus on the Beginning of year 10,000

company’s cash End of year 12,000

Total current assets 65,000
flows and working
Total current liabilities 42,000
capital. Sales on account 494,000
Cost of goods sold 140,000

13-53
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.

13-54
Working Capital
December 31
This Year
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000

13-55
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.

13-56
Current Ratio
Current Current Assets
=
Ratio Current Liabilities

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

13-57
Acid-Test (Quick) Ratio
Acid-Test Quick Assets
=
Ratio Current Liabilities

Acid-Test $50,000
= = 1.19
Ratio $42,000

Quick assets include cash,

marketable securities, accounts receivable, and
current notes receivable.
This ratio measures a company’s ability to meet
obligations without having to liquidate inventory.

13-58
Accounts Receivable Turnover
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover

Accounts
$494,000
Receivable = = 26.7 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.

13-59
Average Collection Period
Average 365 Days
Collection = Accounts Receivable Turnover
Period

Average
365 Days
Collection = = 13.67 days
26.7 Times
Period

This ratio measures, on average,

how many days it takes to collect
an account receivable.

13-60
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.

13-61
Inventory Turnover
Inventory Cost of Goods Sold
=
Turnover Average Inventory

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

13-62
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 entire inventory.

13-63
Learning Objective 4

Compute and interpret

financial ratios that
would be useful to a
long-term creditor.

13-64
 Ratio Analysis – The Long–Term
Creditor
Long-term creditors are concerned with a
company’s ability to repay its loans over the
long-run.
NORTON CORPORATION
This Year
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.

13-65
Times Interest Earned Ratio
Earnings Before Interest Expense
Times and Income Taxes
Interest = Interest Expense
Earned

Times
$84,000
Interest = = 11.51 times
$7,300
Earned
This is the most common
measure of a company’s ability
to provide protection for its long-
term creditors. A ratio of less
than 1.0 is inadequate.

13-66
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

debt if the company can and more equity because
take advantage of positive equity represents a buffer
financial leverage. of protection.

13-67
Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio

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

13-68
Published Sources That Provide Comparative Ratio Data

13-69
End of Chapter 13

13-70