Chapter 3

Financial Reporting Analysis

Essentials of Financial Reporting Analysis
• The analysis of financial data employs various techniques to
emphasize the comparative and relative importance of the data
presented and to evaluate the position of the firm
• These techniques include ratio analysis, common-size analysis,
study of differences in components of financial statements among
industries, review of descriptive material, and comparisons of
results with other types of data
• No one type of analysis supports overall findings or serves all
types of users
• Financial statement analysis is a judgmental process. The
judgment process can be improved by experience and by use of
analytical tools
• One of the primary objectives is identification of major changes
(turning points). Often, a turning point may signal an early
warning of a significant shift in the future success or failure of the
business
 Ratio Analysis

• Financial ratios are usually expressed as a percent or

as times per period.
• Liquidity
– Measures a firm’s ability to meet its current obligations
• Leverage (borrowing capacity)
– Measures the degree of protector for long-term creditors
• Profitability
– Measures the earning ability of a firm
• Cash flow
– Indicate liquidity, borrowing capacity, and profitability
 Ratio Analysis

• A ratio alone means nothing

• Must compare ratios to other ratios such as:
– Prior ratios
– Competitor ratios
– Industry ratios
– Predetermined standards
 Complexities and Context

• Use of average data from balance sheet

accounts
– Necessary when comparing against income
statement data
– Does not
• Eliminate cyclical or seasonal variations
• Capture changes that occur unevenly throughout the year
 Common-Size Analysis
• The use of percentages is usually preferable to the
use of absolute amounts
• For example, if cash is $40,000 and total assets is
$1 million, then cash represents 4% of total assets.
The use of percentages is usually preferable to the
use of absolute amounts.
• An illustration will make this clear. If Firm A earns
$10,000 and Firm B earns $1,000, which is more
profitable? Firm A is probably your response.
However, the total owners’ equity of A is $1 million,
and B’s is $10,000.
 Common-Size Analysis
• The use of common-size analysis makes
comparisons of firms of different sizes much more
meaningful
• Care must be exercised in the use of common-size
analysis with small absolute amounts because a
small change in amount can result in a very
substantial percentage change
• For example, if profits last year amounted to $100
and increased this year to $500, this would be an
increase of only $400 in profits, but it would
represent a substantial percentage increase
 Common-Size Analysis

• The use of percentages is usually preferable to

the use of absolute amounts
• Vertical analysis
– All amounts of a year expressed as a percentage of
a base amount (e.g., net sales revenue, total
assets)
• Horizontal analysis
– Amounts for comparative years are expressed as a
percentage of the base year amount
 Vertical Analysis
Income Statement
For the Years Ended December 31
A B C
Sales revenue $ 100,000 100.0% $ 95,000 100.0% $91,000 100.0%
Cost of goods sold 65,000 65.0% 60,800 64.0% 56,420 62.0%
Gross profit 35,000 35.0% 34,200 36.0% 34,580 38.0%
Operating expenses:
Selling expense 14,000 14.0% 11,400 12.0% 10,000 11.0%
General expense 16,000 16.0% 15,200 16.0% 13,650 15.0%
Total operating expense 30,000 30.0% 26,600 28.0% 23,650 26.0%
Operating Income before taxes 5,000 5.0% 7,600 8.0% 10,930 12.0%
Taxes related to operations 1,500 1.5% 2,280 2.4% 3,279 3.6%
Net Income $ 3,500 3.5% $ 5,320 5.6% $ 7,651 8.4%

Each financial statement element is presented as

a percentage of a designated base.
 Horizontal Analysis
Melcher Company
Income Statement
For the Years Ended December 31
2005 2004 2003 2005 2004 2003
Sales revenue $ 100,000 $ 95,000 $ 91,000 109.9% 104.4% 100.0%
Cost of goods sold 65,000 60,800 56,420 115.2% 107.8% 100.0%
Gross profit 35,000 34,200 34,580 101.2% 98.9% 100.0%
Operating expenses:
Selling expense 14,000 11,400 10,000 140.0% 114.0% 100.0%
General expense 16,000 15,200 13,650 117.2% 111.4% 100.0%
Total operating expense 30,000 26,600 23,650 126.8% 112.5% 100.0%
Operating Income before taxes 5,000 7,600 10,930 45.7% 69.5% 100.0%
Taxes related to operations 1,500 2,280 3,279 45.7% 69.5% 100.0%
Net Income $ 3,500 $ 5,320 $ 7,651 45.7% 69.5% 100.0%

Each financial statement element is presented as a

percentage of a base amount from a selected year.
 Year-to-Year Change Analysis

• Guidelines:
– When an item has value in the base year and none
in the next period, the decrease is 100%
– A meaningful percent change cannot be computed
when one number is positive and the other number
is negative
– A percent change is incomputable when there is no
figure for the base year.
 Year-to-Year Change Analysis

Item Year 1 Year2 Amount %

Advertising expense $20,000 — $(20,000) (100%)

Operating income 6,000 (3,000) (9,000) —

Net income (7,000) 8,000 15,000 —

Other — 4,000 4,000 —

 Industry Variations

• Financial components vary by type of industry

• Merchandising
– Inventory is a principal asset
– Sales may be primarily for cash or on credit
• Service
– Inventory is low or nonexistent
– investment in plant assets is low
• Manufacturing
– Large inventory holdings
– Substantial investment in plant assets
 Comparisons

• Common types
– Trend analysis
– SIC: Standard Industrial Classification
– NAICS: North American Industry Classification
System
– Industry averages; competitor comparisons
 Comparisons: Trend Analysis

• A study of the financial history of a firm

• Longitudinal ratio comparison
– Falling
– Rising
– Relatively constant
• Highlight
– Effective management
– Evidence of problems
Standard Industrial Classification (SIC)

• Classifies business by industry

• Defines industries in accordance with the
composition and structure of the economy
North American Industry Classification
System (NAICS)
• Joint creation of NAFTA partners: Canada,
U.S., and Mexico
• Industry is defined by similar production
processes
 Comparisons: Industry

• The analysis of an entity’s financial statements

is more meaningful if the results are compared
with industry averages and with results of
competitors.
• Industry comparison complicated by highly
diversified companies
 Comparisons: Caution
Ratios are subject to variance from:
• Differing data
• Inconsistent formula construction
• Optional (elective) accounting treatment
• Different fiscal year-ends
• Varying financial policies (capital intensive companies with
labor intensive, firms with large amount of debt with firms
don’t prefer risk)
• Inconsistent basis (before or after tax)
• Small samples that may not be representative of the
industry. An extreme statement, such as one containing a
large loss can also distort industry data.
 Users of Financial Statements

• Management
– Analyze information from the perspective of both
investors and creditors
– Management must be concerned about the current
position of the entity to meet its obligations, as well
as the future earning prospects of the firm.
– For example, liquidity and profitability are
competitive since the most highly liquid assets
(cash and marketable securities) are usually the
least profitable.
 Users of Financial Statements
• Investors
– Analysis of past and present information to project
the future prospects of the entity
• Creditors
– Short-term: focus is on current resources
– Long-term: consider the future prospects of the firm
– For example, if bonds are issued that are to be
repaid in 30 years, the current resources of the
entity will not be an indication of its ability to meet
this obligation. The repayment for this obligation will
come from future earnings.
Liquidity of Short-Term Assets; Related
Debt-Paying Ability
 Current Assets
• Current assets
– In the form of cash or will be realized in cash or
conserve the use of cash within the operating cycle,
or one year, whichever is longer
• Typical examples
– Cash – Marketable securities
– Receivables – Inventories
– Prepayments
 Operating Cycle

The time period between the acquisition of

goods and the final cash realization from sales
Retail and Wholesale Manufacturing

Purchase inventory Purchase material

Cash sale to customer Produce finished
product
Sell to customer on
credit
Collect amount due
from customer
 Cash Cycle

the length of time it takes to convert an investment of

cash in inventory back into cash, recognizing that
some purchases are made on credit. Thus, the cash
cycle is the time between the payment for the inventory
and the receipt of cash from the sale of the inventory.
The difference between the operating cycle and the
cash cycle is the number of days of sales in payables.
 Current Assets: Cash

• Unrestricted
– Available to pay creditors
– Report as current asset
• Restricted
– May report as current but disclose restrictions
– Eliminate cash and related current liability when
measuring short-term debt-paying ability
 Current Assets: Cash (cont’d)

• Compensating balance
– A portion of loan proceeds required to be retained
on deposit
– Increases effective interest rate
– Against current liability
• Part of current assets; disclosure
– Against noncurrent liability
• Reported as noncurrent asset
Current Assets: Marketable Securities
• Debt and equity securities
• Readily marketable
– Managerial intent to convert to cash within the year or
the operating cycle, whichever is longer
• Carried at fair value except for held to maturity (amortized cost)
• It is to management’s advantage to show investments
under marketable securities, instead of long-term
investments, because this classification improves the
liquidity appearance of the firm
• Analysis:
– Reclassify continuing investments as noncurrent
 Current Assets: Receivables

• Claims to future cash inflows

• Arise from sales to customers
– Trade (account) receivables
– Notes receivable
• Other current receivables (loans to employees,
tax refund)
Current Assets: Receivables (cont’d)

• Valuation
• The common characteristic of receivables is that the company
expects to receive cash sometime in the future. This causes two
valuation problems:
• The waiting a period until the receivable will be collected.
• Collection might not be made.
– Ignore cost of fund use for delayed collection
because of the short waiting period
– The waiting period problem is not ignored if the
receivable or note is long-term and classified as an
investment
Current Assets: Receivables (cont’d)
– Impairment
• Uncollectibility
• Allowed discounts
• Allowances given
• Returns
– the impairment of the asset must be recognized (or liability
recorded) under the following conditions:
1. Information available prior to the issuance of the financial
statements indicates that it is probable that an asset has
been impaired, or a liability has been incurred at the date of
the financial statements
2. The amount of the loss can be reasonably estimated
Current Assets: Receivables (cont’d)

• Impairment: Accrue (allowance method)

– Based on estimate of receivables’ realizable value
– Set up allowance
• Expense recognized on income statement
• Asset reduced by contra account “Allowance”
– Expense on income statement before deducted on
tax return
– Charge-off of a specific receivable
• Reduces accounts receivable and allowance for doubtful
accounts
• No impact on financial income or net assets
• Deductible event for income taxes
Current Assets: Receivables (cont’d)

• Impairment: Direct write-off

– Alternative to accrual method when
• Receivables are not material or
• Amount for accrual cannot be reasonably estimated
– Charge-off of a specific receivable
• Recognize expense
• Reduce asset
– Bad debt expense likely to be recognized in a year
subsequent to the sale
• Does not match expense with revenue
Current Assets: Receivables (cont’d)

• Trade receivables
– Typically collected within 30 days
• Installment receivables
– May be carried as a current asset yet collection
may be significantly longer than trade receivables
– Usually considered to be lower quality than trade
receivables
Current Assets: Receivables (cont’d)

• Customer concentration
– May impair the quality of receivables if a large
portion of receivables is from a few customers
• Liquidity
– Number of days’ sales in receivables
– Accounts receivable turnover
 Days’ Sales in Receivables
Gross Receivables
 Net Sales 
 
 365 
• For this computation, the accounts receivable amount should include trade
notes receivable. Other receivables not related to sales on account should
not be included in this computation.
• The increase in days’ sales in receivables indicates a negative trend in the
control of receivables.
• Should mirror the company’s credit terms
• An internal analyst compares days’ sales in receivables with the company’s
credit terms as an indication of how efficiently the company manages its
receivables. For example, if the credit term is 30 days, days’ sales in
receivables should not be materially over 30 days. If days’ sales in
receivables are materially more than the credit terms, the company has a
collection problem. An effort should be made to keep the days‘ sales in
receivables close to the credit terms.
 Days’ Sales in Receivables
• Reading reflects end-of-year status of receivables
– Use of the natural business year (lower sales at year-end) can
understate result
• Compare
– Firm data for several years
– Other industry firms and industry averages
• Liberal right of return privileges can be a negative factor in the
quality of receivables and on sales that have already been recorded.
Particular attention should be paid to any change in the right of
return privileges.
• Right of return privileges can readily be determined for internal
analysis, and this information should be available in a note if
considered to be material.
Days’ Sales in Receivables (cont’d)

• Causes for overstatement

– Sales volume expands materially late in the year
– Receivables are uncollectible and should have been written
off
– The company seasonally dates invoices
– A large portion of receivables are on the installment basis
• Causes for understatement
– Sales volume decreases materially late in the year
– A material amount of sales are on a cash basis
– The company has a factoring arrangement in which a
material amount of the receivables is sold to an outside party
 Accounts Receivable Turnover
Net Sales
Average Gross Receivables
• Indicates the liquidity of receivables
• Measured in times per year
• Misleading if the business has seasonal fluctuations or
uses natural business year.
• Determining average gross receivables
– End of year and beginning of year base points for
average mask seasonal fluctuations
– Internal analysis: use monthly or weekly amounts
– External analysis: use quarterly data
Accounts Receivable Turnover in Days
Average Gross Receivables
 Net Sales 
 
 365 

• Similar to Number of Days’ Sales in

Receivables except average receivables are
used
• Should reflect firm’s credit and collection
policies
 Credit Sales versus Cash Sales
• To have a realistic indication of the liquidity of receivables, only
the credit sales should be included in the computations. If cash
sales are included, the liquidity will be overstated.
• The internal analyst determines the credit sales figure and
eliminates the problem of credit sales versus cash sales. The
external analyst should be aware of this problem and should not
be misled by the liquidity figures.
• The distinction between cash sales and credit sales is not usually
a major problem for the external analyst because certain types of
businesses tend to sell only on cash terms, and others sell only
on credit terms. For example, a manufacturer usually sells only on
credit terms. Some businesses, such as a retail department store,
have a mixture of credit sales and cash sales.
 Current Assets: Inventories
• Held for sale in the normal course of business
• Inventory is often the most significant asset in determining the
short-term debt-paying ability of an entity. Often the inventory
account is more than half of the total current assets.
• Used in the production of goods
• Trading business
– Wholesale to retail
– Retail to end consumer
– Single inventory (merchandise) account
• Manufacturer has three distinct inventories
– Raw materials inventory
– Work in process inventory
– Finished goods inventory
 Inventory
• Perpetual
– A continuous record of
• Physical quantities is maintained
• Inventory and cost of goods sold, updated as sales and
purchases take place
– Records are verified through physical inventory
• Periodic
– Periodic physical inventories to determine quantity
– Attach costs to ending inventory based on selected
cost flow assumption(s)
– The cost of goods sold is calculated by subtracting the
ending inventory from the cost of goods available for
sale.
 Inventory Cost

• The most critical problem that most entities

face is determining which cost to use.
• Specific identification
– Tracking of specific cost normally impractical
– Exceptions: large and/or expensive items
• Cost flow assumptions
– FIFO (first-in, first-out)
– LIFO (last-in, first-out)
– Average
 FIFO Cost Flow Assumption

• First inventory acquired is the first sold

• Cost of goods sold is oldest costs (low)
– Current costs are not matched against revenue
– Inflates profit
• Ending inventory reflects latest costs
– Approximates replacement cost
– Slow turnover can distort the approximation of
replacement cost by ending inventory value
 LIFO Cost Flow Assumption
• Cost of most recently-acquired goods are matched against
sales revenue
– Profit is reflective of replacement cost
• Ending inventory contains oldest costs
– Inventory valuation can be based on costs that are years or decades old
– Because of inflation, the resulting inventory figure will not reflect current
replacement costs.
• During times of relatively high inflation, LIFO becomes more popular
because LIFO matches the latest costs against revenue.
• LIFO results in tax benefits because of the matching of recent higher costs
against revenue.
 Average Cost Flow Assumption

• Lump the costs to determine a midpoint.

• An average cost computation for inventories
results in an inventory amount and a cost of
goods sold amount somewhere between FIFO
and LIFO.
• During times of inflation, the resulting
inventory is more than LIFO and less than
FIFO. The resulting cost of goods sold is less
than LIFO and more than FIFO.
 Cost Flow Assumption Example
Cost
Number per Total
Date Description of Units Unit Cost
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 1,200 7.00 8,400 2,100 units
1-Jul Purchase 300 9.00 2,700 available for
1-Oct Purchase 400 11.00 4,400
2,100 $16,700
sale.
FIFO
1-Oct Purchase 400 $11.00 $ 4,400
1-Jul Purchase 300 9.00 2,700 800 units of
1-Mar Purchase 100 7.00 700 ending inventory
Ending inventory 800 $ 7,800 are valued at the
most recent
Cost of Goods Sold 8,900
LIFO
costs.
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 600 7.00 4,200 800 units of
Ending inventory 800 $ 5,400 ending inventory
Cost of goods sold $11,300 are valued at the
oldest costs.
 Cost Flow Assumption Example
Cost
Average Cost
Number per
Date Description of Units Unit Total Cost
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 1,200 7.00 8,400 2,100 units
1-Jul Purchase 300 9.00 2,700 available for
1-Oct Purchase 400 11.00 4,400 sale.
2,100 $ 16,700
800 units of
ending inventory
Total Cost $16,700
= = $7.95 are valued at
Total Units 2,100 average unit
cost.
Ending inventory (800 × $7.95) = $6,360
Cost of goods sold ($16,700 – $6,360) = $10,340

In general, the higher the inflation rate, the greater the differences
between the inventory methods.
 Analysis Problems and Inventory

• the analyst should be cautious when

comparing the liquidity of firms that have
different inventory cost flow assumptions.
• Short-term debt-paying ability is understated
– Understatement is reduced by reported operating
expenses that reduce gross profit to net income
– Replacement cost exceeds LIFO or FIFO cost of
goods sold
 Impact on Financial Statements

• Cash flow is higher when LIFO is used for tax

reporting
• LIFO profit generally lower than FIFO profit
• LIFO profit reflects current costs of sales
• LIFO reserve
– Measures the spread between LIFO and FIFO
inventory value
– Discloses the approximate FIFO inventory value
• FIFO inventory is closer to replacement value
of the asset
Inventory: Lower-of-Cost-or-Market

• Cost flow assumptions use historical data

• If “utility” (market) is below cost, inventory must
be written down to reflect the diminished value
• Definitions of market
– Replacement cost
– Net realizable value
 Liquidity of Inventory

• Number of days’ sales in inventory

• Inventory turnover in times per year
• Inventory turnover in days
 Days’ Sales in Inventory
Ending Inventory
 Cost of Goods Sold 
 
 365 
• Indicates the length of time needed to sell all
inventory on hand
• This can be misleading if sales are seasonal or
if the company uses a natural business year.
• Use of a natural business year
– Understates number of day’s sale in inventory
– Overstates liquidity of inventory
 Days’ Sales in Inventory
• If the company closes its year during peak activity, the
number of days’ sales in inventory would tend to be
overstated and the liquidity would be understated.
• A seasonal situation, with inventory unusually low or high at
the end of the year, would also result in an unrealistic days’
sales in inventory computation.
• the ending inventory figure may not be representative of the
quantity of inventory actually on hand, especially if using
LIFO.
• Implications of extremes
– High: excessive inventory for sales activity
– Low: inventory shortage and lost sales
 Inventory Turnover
Cost of Goods Sold
Average Inventory
• Indicates the liquidity of inventory
• Indicates the number of times per year it takes
to sell the inventory
• Determining average inventory
– End of year and beginning of year base points for
average mask seasonal fluctuations
– Internal analysis: use monthly or weekly amounts
– External analysis: use quarterly data
Inventory Turnover Comparison Issues

• Use caution when comparing a mix of natural

and calendar year companies
• Cost flow assumption issues
– LIFO yields lower inventory value and higher
inventory turnover
• Inter-industry comparisons may not be
reasonable
 Inventory Inventory Turnover
Turnover in Days per Year

Average Inventory 365

 Cost of Goods Sold  Inventory Turnover
 
 365  in Days

Indicates the number of days

it takes to sell the inventory
 Current Assets: Operating Cycle

• The time period between acquisition of goods

and the final cash realization from sales
Accounts Reciveable Inventory
Operating Cycle = Turnover + Turnover
in Days in Days
• Subject to potential understatement from
understatement of turnover measures
– Use of LIFO
– Use of a natural business year
– Averages are computed on beginning-of-year and
end-of-year data
 Current Assets: Prepayments

• Prepayments
– Unexpired costs for which payment has been made
– Have minor influence on short-term debt-paying
ability
– Valuation: use carrying cost
– Liquidity: not an issue since no cash is expected to
be received
 Current Assets: Other

• Will be realized in cash or conserve the use of

cash within the operating cycle of the business
or one year, whichever is longer
• If material, and nonrecurring, may distort
liquidity
• Examples
– Property held for sale
– Advances or deposits
 Current Liabilities

• Obligations whose liquidation is reasonably

expected to require the use of existing
resources properly classifiable as current
asset or the creation of other current liabilities
• Valuation: carried at face value
– Difference between present value and face value is
immaterial and disregarded
 Working Capital

Current Assets
– Current Liabilities
= Working Capital

• Subject to understatement if certain assets are

understated (i.e., LIFO inventory)
• Longitudinal comparison appropriate
• Inter-firm comparison is of no value (diff.
sizes)
 Acid-Test (Quick)
Current Ratio
Ratios
Current Assets Current Assets - Inventory
Current Liabilities Current Liabilities

 Cash Equivalents 
 + Marketable Securities 
 + Net Receivables 
 
Current Liabilities
 Current Ratio
• Determines short-term debt-paying ability
• Focus is on the relationship between current assets and current
liabilities
– Inter-firm comparison is possible and meaningful
• Traditional benchmark: 2.00
– Decreased current ratio indicates lower liquidity
– Industry averages provide contextual benchmark
• Considerations
– Quality of inventory and receivables ( if have liquidity
problems, the current ratio needs to be much higher)
– Inventory cost flow assumptions
• the shorter the operating cycle, the lower the current ratio. The
longer the operating cycle, the higher the current ratio.
 Acid-Test (Quick) Ratio

• Measures the immediate liquidity of the firm

• Relates the most liquid assets to current
liabilities
– Exclude inventory
– More conservative variation: Also exclude other
current assets that do not represent current cash
flow
• Traditional benchmark: 1.00
– Industry averages provide contextual benchmark
• Consideration
– Quality of receivables
 Cash Ratio
Cash Equivalents + Marketable Securities
Current Liabilities

• Extremely conservative
– Unrealistic for a firm to have sufficient cash and
securities to cover all its current liabilities
• Appropriate context
– Firms with naturally slow-moving inventory and
receivables
– Firms that are highly speculative
 Sales to Working Capital

Sales
Average Working Capital
• Measures the turnover of working capital per year
• Compare with
– Historical data
– Industry competitors
– Industry averages
• Assessment
– Low: potentially unprofitable use of working capital
– High: potential undercapitalization
 Cash Flow Ratio

• Operating cash flow is cash flows from operations

reported on the statement of cash flows. In the cash
flow ratio, the period-end balance for current liabilities
is used instead of the average balance for current
liabilities. An average balance incorporates past
balances. The cash flow ratio is an indicator of the
company’s ability to pay future obligations as they
come due.
• Future cash flow will be required to pay off current
liabilities that are outstanding as of the balance sheet
date, not the average of current liabilities over a past
period.
Accounts Payable Activity Ratios:
 Accounts Payable Activity Ratios:
• Limited information on credit purchases can be calculated from
published financial statements, but it is not complete. Assuming
that all purchases of inventory are made on credit, a rough
estimate of annual credit purchases of inventory can be
obtained for a merchandising company by adjusting cost of
goods sold by the amount of change in inventories during the
period, as follows:

• Purchases = Cost of sales + Ending inventory − Beginning

inventory
• Cash Cycle = Operating Cycle – Days’ Purchases in
Accounts Payable
 Other Liquidity Considerations
• Liquidity is better than indicated by financial
statements
– Unused bank credit lines
– Noncurrent assets that can be converted to cash quickly
– A firm may be in a very good long-term debt position and
therefore have the capability to issue debt or stock.
• Liquidity is weaker than indicated by financial
statements
– Co-signer on debt of another entity
– Subject to recourse obligation on discounted receivables
– Significant contingent (un accrued) liabilities
Long-Term Debt-Paying Ability
 Times Interest Earned

• Income Statement Consideration

• In the long run, a relationship exists between the
reported income resulting from the use of accrual
accounting and the ability of the firm to meet its long-
term obligations.

Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,
and Minority Earnings
Interest Expense, Including Capitalized Interest
 Times Interest Earned (cont’d)

• Indicates long-term debt-paying ability

• Consider only recurring income
– Exclude discontinued operations
– Exclude extraordinary items
• Exclude (add back) to income
– Interest expense
– Income tax expense
– Equity losses (earnings) of nonconsolidated
subsidiaries
– Minority loss (income)
• Include interest capitalized
 Times Interest Earned (cont’d)
• A relatively high, stable coverage of interest over the
years indicates a good record; a low, fluctuating
coverage from year to year indicates a poor record.
• Companies that maintain a good record can finance a
relatively high proportion of debt in relation to
shareholders’ equity and, at the same time, obtain
funds at favourable rates.
• A company issues debt obligations to obtain funds at
an interest rate less than the earnings from these
funds. This is called trading on the equity or leverage.
With a high interest rate, the added risk exists that the
company will not be able to earn more on the funds
than the interest cost on them.
 Times Interest Earned (cont’d)
• Comparisons
– 3 to 5 years of historical data
• Lowest value is the primary indicator of interest coverage
(because the co. needs to cover the interest in bad years)
– Industry competitors and averages
• Slightly different analysis
– Interest coverage on long-term debt
– Use only interest on long-term debt
• Not practical for external analysis
- In the long run, a firm must have the funds to meet all of its
expenses. In the short run, a firm can often meet its interest
obligations even when the times interest earned is less than 1.00.
 Times Interest Earned
Short-Run Variation
(Recurring Earnings + Noncash Expenses)
Excluding Interest Expense, Tax Expense,
Equity Earnings, and Minority Earnings
Interest Expense, Including Capitalized Interest
• Short-run coverage (cash basis times interest period)
– Add back noncash expenses to recurring income
(Depreciation/Gains/Losses)
– Less conservative
 Fixed Charge Coverage

Recurring Earnings, Excluding Interest

Expense, Tax Expense, Equity Earnings,
and Minority Earnings
+ Interest Portion of Rentals
Interest Expense, Including Capitalized Interest
+ Interest Portion of Rentals

• Ratio trend is usually similar to trend of times-

interest-earned ratio
 Fixed Charge Coverage (cont’d)

• Fixed charges include

– Interest portion of operating lease payments
• General approximation: 1/3 of payments
• SEC requires specific calculation using lease terms
– May also include
• Depreciation, depletion, and amortization
• Debt principal payments
• Pension payments
• Substantial preferred stock dividends
• The more items included as “fixed charges,”
the more conservative the ratio
 Debt Ratio (Balance sheet consideration)
Total Liabilities
Total Assets
• Indicates the percentage of assets financed by creditors
• Total liabilities include ( reserve, deferred tax liab., minority interest,
redeemable preferred stock)
• From the perspective of long-term debt-paying ability, the lower this
ratio, the better the company ’s position.
• This debt ratio is a conservative computation because all of the
liabilities and near liabilities have been included.
• At the same time, the assets are understated because no
adjustments have been made for assets that have a fair market
value greater than book value.
 Debt Ratio (Balance sheet consideration)
• Comparisons
– Industry competitors and averages
– Industries that have stable earnings can handle more debt
than industries that have cyclical earnings. This comparison
can be misleading if one firm has substantial hidden assets, or
liabilities that other firms do not (such as substantial land
carried at historical cost).
• Variations in application
– In practice, substantial disagreement occurs on the details of
the formula to compute the debt ratio.
– Exclude short-term liabilities if NOT part of long-term source of
funds
– Liabilities that do not necessarily represent a commitment to
pay out funds in the future
 Debt Ratio and Certain Liabilities

• Reserves
– Matches an expense but is not a liability per se
– Infrequently used in U.S. GAAP statements
– Include in ratio for conservative application
• Deferred Income Taxes
– Difference between income tax expense and income
taxes payable
– Commonplace in U.S. GAAP statements
– Recognized as a liability by GAAP; include in ratio
 Debt Ratio and Certain Liabilities
(cont’d)

• Minority Shareholders’ Interest

– Proportion of a consolidated entity that is not owned
by the controlling parent company
– Not a liability per se
– Include in ratio for conservative application
• Redeemable Preferred Stock
– Exclude from ratio; does not present a normal debt
relationship
– Include in ratio for conservative application
 Debt/Equity Ratio
Total Liabilities
Shareholders' Equity
• Helps determine how well creditors are protected in case of
insolvency (The debt ratio and the debt/equity ratio have the same
objectives)
• From the perspective of long-term debt-paying ability, the lower this
ratio is, the better the company’s debt position.
• the computation of the debt/equity ratio is conservative because all of
the liabilities and near liabilities are included, and the shareholders’
equity is understated to the extent that assets have a value greater
than book value.
• Comparisons (the lack of uniformity computation problem)
– Industry competitors and averages
 Debt to Tangible Net Worth Ratio
Total Liabilities
Shareholders' Equity - Intangible Assets
• Determines the entity’s long-term debt
payment ability
• Indicates how well creditors are protected in
case of the firm’s insolvency
• More conservative than debt ratio or
debt/equity ratio due to exclusion of intangibles
(because they do not provide resources to pay
creditors)
 Other Long-Term Debt-Paying Ability
Ratios
• Current debt/net worth ratio
– The relationship between current liabilities and funds
contributed by shareholders
– The higher the proportion of funds provided by current
liabilities, the greater the risk.
• The total capitalization ratio, compares long-term debt to
total capitalization. Total capitalization consists of long-term debt,
preferred stock, and common shareholders’ equity. The lower the
ratio, the lower the risk.
• Fixed asset/equity ratio
– The extent to which shareholders have provided funds in relation to fixed
assets (The higher the fixed assets in relation to equity, the greater the
risk)
 Long-Term Leasing
• Capital leases
– Asset and liability are reported on the balance sheet
• Operating leases
– Reported as expense on the income statement
– Supplemental analysis using future payments
• One-third can be estimated as interest
• Two-thirds can be added to the fixed assets and long-term liabilities
for debt ratio analyses
• If the total operating lease for the company is $755.2, some firms
estimate that one-third of operating lease as interest, two-third as
principal (liability). This amount $503.5 million ($755.2x 2/3). This
amount can be added to fixed asset and log-term liability.
 Joint Ventures
• An association of two or more businesses
established for a special purpose
• Consolidation
– Parent firm has control
• Carry as an investment
– Parent firm has significant influence
• Analysis
– Review footnote for commitments relating to the
joint venture
– Off-balance sheet commitments represent potential
liabilities
 Contingencies

• Loss contingencies that are not accrued are

footnoted if it is reasonably possible that an
asset has been impaired or a liability has been
incurred
– Review contingency note for possible liabilities not
disclosed on the balance sheet
• Gain contingencies are not accrued
– Examples: Viox lawsuits
 Midterm Exam
(1) Co. XYZ has prepared the following comparative balance sheets for 2020 and 2021:
December 31
2021 2020
Cash $ 64,000 $ 36,000
Accounts receivable, net 53,000 57,000
Inventory 171,000 123,000
Land 180,000 285,000
Building 300,000 300,000
Accumulated depreciation (75,000) (60,000)
Equipment 1,545,000 900,000
Accumulated depreciation (177,000) (141,000)
$2,061,000 $1,500,000
Accounts payable $ 172,000 $ 150,000
Bonds payable 480,000 -0-
Capital stock, $10 par 1,125,000 1,125,000
Retained earnings 284,000 225,000
$2,061,000 $1,500,000
Additional Data:
1. Net income for the year amounted to $104,000.
2. Cash dividends were paid amounting to 4% of par value.
3. Land was sold for $120,000.
4. The company sold equipment, which cost $225,000 and had accumulated depreciation of
$90,000, for $105,000.

From the information above, prepare a statement of cash flows (indirect method)
for XYZ, Inc. for the year ended December 31, 2021.
 Solution
XYZ Company
Statement of Cash Flows
For the Year Ended December 31, 2021
Cash flows from operating activities
Net income $104,000
Adjustments to reconcile net income to net cash provided
by operating activities:
Decrease in accounts receivable $ 4,000
Increase in inventory (48,000)
Increase in accounts payable 22,000
Gain on sale of land (15,000)
Loss on sale of equipment 30,000
Depreciation expense—building 15,000
Depreciation expense—equipment 126,000 134,000
Net cash provided by operating activities 238,000
Cash flows from investing activities
Sale of land 120,000
Sale of equipment 105,000
Purchase of equipment (870,000)
Net cash used by investing activities (645,000)
Cash flows from financing activities
Payment of cash dividends (45,000)
Issuance of bonds 480,000
Net cash provided by financing activities 435,000
Net increase in cash 28,000
Cash, January 1, 2021 36,000
Cash, December 31, 2021 $ 64,000
 Midterm Exam
(2) Presented below are net changes in working capital of XYZ, Inc.:
Debit Credit
Cash $12,000
Accounts receivable 15,000
Inventories $15,400
Salaries payable 8,000
Accounts payable 14,000
Income taxes payable 3,000
In addition, the following is the income statement
Sales revenue $280,000
Cost of goods sold 125,000
Gross profit $155,000
Operating expenses 90,000
Income before income taxes 65,000
Income taxes 25,000
Net income $ 40,000

Additional Information:
The depreciation expense for the year was $16,000 and the deferred tax liability account
decreased $2,600.
Required:
(a) prepare a schedule of net cash flow from operating activities using the direct method.
(b) prepare a schedule of net cash flow from operating activities using the indirect method.
 Solution

(a) (Indirect Method)

Cash flows from operating activities
Net income $40,000
Adjustments to reconcile net income to net
cash provided by operating activities:
Increase in trade accounts receivable $(15,000)
Decrease in inventories 15,400
Decrease in salaries payable (8,000)
Increase in trade accounts payable 14,000
Decrease in income taxes payable (3,000)
Depreciation expense 16,000
Decrease in deferred tax liability (2,600) 16,800
Net cash provided by operating activities $56,800
 Solution

(b) (Direct Method)

Cash flows from operating activities
Cash received from customers ($280,000 – $15,000) $265,000
Cash paid to suppliers ($125,000 – $15,400 – $14,000) $95,600
Operating expenses paid ($90,000 + $8,000 – $16,000) 82,000
Taxes paid ($25,000 + $3,000 + $2,600) 30,600 208,200
Net cash provided by operating activities $ 56,800
Profitability Analysis
 Profitability Measures

• The primary financial analysis of profit ratios

should include only the types of income arising
from the normal operations of the business.
Exclude items of income not arising from
normal operations
– Discontinued operations
– Extraordinary items
 Net Profit Margin

Net Income Before Minority Share of Earnings,

Equity Income, and Nonrecurring Items
Net Sales

• Also referred to as return on sales

• Reflects net income dollars generated by each
dollar of sales
• Potential distortion
– Net “other” income or loss but usually immaterial
(don’t relate to sales)
– Excluded only if required
 Gross Profit Margin

Gross Profit
Net Sales

Sales
Beginning Inventory
– Cost of Goods Sold + Purchases of Inventory
– Ending Inventory
= Gross Profit
 Gross Profit Margin
- This ratio should then be compared with industry data or analysed
by trend analysis.
- the gross profit margin could be declined to a number of factors:
1- The cost of buying inventory has increased more rapidly than
have selling prices.
2- Selling prices have declined due to competition.
3- The mix of goods has changed to include more products with
lower margins.
4- Theft is occurring. If sales are not recorded, the cost of goods
sold figure in relation to the sales figure is very high. If inventory is
being stolen, the ending inventory will be low and the cost of goods
sold will be high.
 Operating Income Margin

Operating Income
Net Sales

• Use operating income in the numerator

• Operating income is also referred to as
earnings before interest and taxes (EBIT)
 Total Asset Turnover
Net Sales
Average Total Assets
• Measures the activity of the assets and the
ability of the firm to generate sales through the
use of the assets
• It is desirable for the total asset turnover ratio
to be close to the industry norm.
• Potential distortion (on the low side)
– Investments
– Construction in progress
– Other assets that do not relate to net sales
 Sales to Fixed Assets
Net Sales
Average Net Fixed Assets
• Measures the ability to make productive use of
property, plant, and equipment by generating
sales dollars
– Exclude construction in progress
• Possible distortions
– Old fixed assets
– Labor-intensive industry
– In these cases, the ratio is substantially higher
because of the low fixed asset base.
It is desirable to have a fixed asset turnover ratio close to
the industry norm.
 Operating Asset Turnover

Net Sales
Average Operating Assets

• Measures the ability of operating assets to

generate sales dollars

• Operating assets are assets that are essential

to the day-to-day operations of a business (such
as PPE, Cash, AR, Inventory, Patents and
licenses (if required for business operations),
Land (if used in the operations of the business).
 Return on Assets

Net Income Before Minority Share

of Earnings and Nonrecurring Items
Average Total Assets

• Measures the ability to utilize assets to create

profits
• Average total assets
– Internal analysis: month-end amounts
– External analysis: beginning and ending amounts
– If necessary, consistent use of end-of-year amounts
 DuPont Return on Asset
Adjusted NI Sales Adjusted NI Sales
 = 
AverageAsset Sales Sales AverageAsset

• ROA = Net Profit Margin Total Asset Turnover

• the company can increase ROA either by speeding up the
turnover or improving the profit margin ratio.
• If the company wants to improve the Asset Turnover (selling
more times), it will tend to cutting down the profit margin (mark
up).
• If the company wants to improve the profit margin, it will tend to
increase the prices or cutting the costs. But increases the
prices will reduce your times of sales (reduce the turnover) and
could drive the company out.
 Return on Operating Assets

Operating Income
Average Operating Assets

• Measures the ability of operating assets to

generate operating income
• Return on operating assets = operating
income margin operating asset turnover
 Return on Investment (ROI)
Net Income Before Minority Share of
Earnings and Nonrecurring Items
+ (Interest Expense )  (1-Tax Rate ) 
Average (Long-Term Liabilities + Equity )
• Measures the earnings on investment and
indicates how well the firm utilizes its asset
base
• Evaluates enterprise performance
• Measures ability to reward investors and to
attract providers of future funds
• Evaluates the earnings performance without
regard to financing sources
 Return on Total Equity

Net Income Before Nonrecurring Items

- Dividends on Redeemable Preferred Stock
Average Total Equity

• Measures the return to common and preferred

stockholders
• Adjustments for redeemable preferred stock
– Deduct dividends from net income (numerator)
– Deduct stock value from total equity (denominator)
 Return on Common Equity

Net Income Before Nonrecurring Items

- Preferred Dividends
Average Common Equity

• Measures the return to the common

stockholder
• Common equity:
Total stockholders’ equity
less preferred capital
less minority interest reported as equity
The Relationship Between Profitability
Ratios
Measures
Rate of return to
return on providers of Typical result
Assets All funds Lowest (includes all assets)
Investment Long-term funds Higher than ROA (relative small
amount of short-term funds)
Total equity Equity Higher than ROI (measures return only
to shareholders)
Common equity Common equity Highest
• Common shareholders absorb
greatest degree of risk
• Requires that return to preferred
shareholders exceed funds paid to
preferred shareholders
Leverage Analysis
 Financial Leverage
• Leverage in general refers to the potential to earn a high level
of return relative to the amount of cost expended.
• The use of debt is referred to as financial leverage
• The existence of fixed operating costs, called operating
leverage, also affects earnings. The higher the percentage of
fixed operating costs, the greater the variation in income as a
result of a variation in sales (revenue)
• The use of financing with a fixed charge (such as interest) is
termed financial leverage
• Financial leverage is successful if the firm earns more on the
borrowed funds than it pays to use them
• It is not successful if the firm earns less on the borrowed funds
than it pays to use them
 Financial Leverage
• The financial leverage ratio, also called the equity multiplier, is
calculated as follows:
• financial leverage = (Total Assets)/(Total Equity)
• A company with financial leverage is said to be “trading on the
equity.” “Trading on the equity” is simply a term that means the
company is using financial leverage (debt) in an effort to
achieve increased returns. Trading on the equity, or financial
leverage, may or may not be successful.
• If a leveraged company’s return on assets is greater than its
after-tax cost of debt, and therefore return on common equity is
higher, it is said to be successfully trading on the equity, and its
common shareholders will benefit.
• If a leveraged company’s return on assets is less than its after-
tax cost of debt, it is said to be unsuccessfully trading on the
equity, and its common shareholders will be hurt.
 Financial Leverage
• Using financial leverage results in a fixed financing
charge that can materially affect the earnings available
to the common shareholders
• Interest as related to debt financing
– A contractual obligation
– Must be paid regardless of entity’s current profits
• Contrast with dividends which are discretionary
– Interest is tax deductible
• Reduces taxable income
• Reduces income tax
 Degree of Financial Leverage
• The degree of financial leverage is the factor by which
net income can be expected to change in the future in
relation to a future change in earnings before interest
and taxes, since interest on debt is a fixed expense.
• The degree of financial leverage is meaningful at only
one level of income and interest expense. When those
levels change, the degree of financial leverage will
change as well.
• The degree of financial leverage is the multiplication
factor by which is the net income changes as
compared to the change in EBIT. One way of
computing it follows:
Computation of the Degree of Financial
Leverage
The degree of financial leverage is the
% Change Net Income multiplication factor by which the net income
% Change EBIT changes in respect to changes in EBIT ( 25% /
20% = 1.25)
Any change in EBIT will be accompanied by
1.25 times that change in net income. If net
income before interest and tax rises 4%,
earnings to the stockholder will rise 5%. If net
income before interest and tax falls 8%,
earnings to the stockholder will decline 10%.
Earnings Before
Interest and Tax A more simple formula for degree of
Earnings Before Tax financial leverage (1000000 / 800000=
1.25)
Computation of the Degree of Financial
Leverage (cont’d)
• Degree of financial leverage calculations
should exclude
– Minority share of earnings
– Equity income
– Nonrecurring items

Earnings Before Interest, Tax,

Minority Share of Earnings, The all-inclusive
Equity Income, and Nonrecurring Items formula for degree of
Earnings Before Tax, financial leverage
Minority Share of Earnings,
Equity Income, and Nonrecurring Items
Definition of Financial Leverage and
Magnification Effects
DOWELL COMPANY (Exhibit 9-1)
Financial Leverage
Partial Income Statement to Illustrate Magnification Effects

20% Decrease 10% Increase

in Earnings in Earnings
Base Year Before Interest Before Interest
Figures and Tax and Tax

Earnings before interest and tax $1,000,000 $ 800,000 $1,100,000

Interest (200,000) (200,000) (200,000)
Earnings before tax 800,000 600,000 900,000
Income tax (40%) (320,000) (240,000) (360,000)
Net income $ 480,000 $ 360,000 $ 540,000

Percentage change in net income [A] 25.0% 12.5%

Percentage change in earnings before
Interest and tax [B] 20.0% 10.0%
Degree of financial leverage [A ÷ B] 1.25 1.25

Net income increase [A] is greater than change in EBIT [B] due
to the fixed nature of interest expense
Market Analysis
 Earnings per Share

• The amount of income earned on a share of

common stock during an accounting period.
• Required disclosure for corporate income
statements
• Pertains only to common stock
• Per-share amounts are disclosed for
– Income from recurring items
– Discontinued operations
– Extraordinary items
– Net income
 Basic Earnings per Share
Net Income - Preferred Dividends
Weighted Average Number of
Common Shares Outstanding

• Earnings pertain to an entire fiscal period

• Average common shares outstanding is used
Calculation of Weighted Average Common
Outstanding
To illustrate, assume that a corporation had 10,000 shares of
common stock outstanding at the beginning of the year. On July 1, it
issued 2,000 shares, and on October 1, it issued another 3,000
shares. The weighted average number of shares outstanding would
be computed as follows:

Months Shares Shares Fraction of Year Weighted

Are Outstanding Outstanding × Outstanding = Average

January–June 10,000 × 6/12 = 5,000

July–September 12,000 × 3/12 = 3,000
October–December 15,000 × 3/12 = 3,750
11,750
Calculation of Weighted Average Common
Outstanding
• Must take into account all stock dividends and stock splits
• In the weighted average common shares illustration, if we
assume that a 2-for-1 stock split took place on December
31, the denominator of the earnings per share computation
becomes 23,500 (11,750 × 2). The denominator of prior
years’ earnings per share computations would also be
doubled
• If we assume that net income is $100,000 and preferred
dividends total $10,000 in this illustration, then the earnings
per common share would be $3.83 [($100,000 −
$10,000)/23,500].
 Diluted Earnings Per Share

• Complex capital structure contains potentially dilutive

securities:
– Options, rights, warrants
– Convertible debt
– Convertible preferred equity
– Contingent shares

Net Income - Preferred Dividends

Weighted Average # of Shares Outstanding
+ All Above potential # of Shares
 Price/Earnings Ratio
Market Price per Share
Diluted Earnings per Share
Before Nonrecurring Items

• Measures the relationship between the market

price of a share of common stock and that
stock’s current earnings per share
– Use of diluted earnings per share gives more
conservative price/earnings ratio
 Price/Earnings Ratio (cont’d)
• Compare with
– Industry competitors
– Industry average
– Exchange (e.g., NYSE) average
• Interpretation
– High-growth-potential firms have higher P/E ratios
– P/E ratio can be a function of the market
• - P/E ratios do not have any meaning when a firm has
abnormally low profits in relation to the asset base or when a
firm has losses. The P/E ratio in these cases would be
abnormally high or negative.
 Percentage of Earnings Retained
Net Income Before Nonrecurring
Items - All Dividends
Net Income Before
Nonrecurring Items
• Reflects the proportion of current earnings retained for internal growth
• Trend analysis is improved by exclusion of nonrecurring items
• A problem occurs because the percentage of earnings retained implies that
earnings represent a cash pool for paying dividends. Under accrual
accounting, earnings do not represent a cash pool. Operating cash flow
compared with cash dividends gives a better indication of the cash from
operations and the dividends paid
• Higher percentage typically found in
– New firms
– Growing firms and firms perceived as growth firms
 Dividend Payout

Dividends per Common Share

Diluted EPS Before Nonrecurring Items

• Measures the portion of current earnings per

common share being paid out in dividends
• A stable dividend policy is developed by
consideration of recurring earnings
• Lower payout typically found in
– New firms
– Growing firms and firms perceived as growth firms
 Dividend Yield
Dividends per Common Share
Market Price per Common Share

• Indicates the relationship between the dividends

per common share and the market price per
common share
• The yield is a function of
– The firm’s dividend policy
– Market price
 Dividend Yield

• If the firm successfully invests the money not distributed as

dividends, the price should rise
• If the firm holds the dividends at low amounts to allow for
reinvestment of profits, the dividend yield is likely to be low
• A low dividend yield satisfies many investors if the company
has a record of above-average return on common equity.
Investors that want current income prefer a high dividend
yield
 Book Value per Share
Total Stockholders' Equity
- Preferred Stock Equity
Number of Common Shares Outstanding

• The market price of the securities usually does not

approximate the book value
• When market value is below book value, investors view the
company as lacking potential
• A market value above book value indicates that investors view
the company as having enough potential to be worth more than
the book numbers
• When investors are pessimistic about the prospects for stocks,
the stocks sell below book value. On the other hand, when
investors are optimistic about stock prospects, the stocks sell
above book value.
 Market-to-Book Ratio

• The market-to-book ratio will generally be greater than 1.0 if the

market expects abnormally high earnings in the future;
however, it will be lower than 1.0 if the market expects
abnormally low earnings in the future.

• Furthermore, the market-to-book ratio should be greater than

1.0 because of the way fixed assets are accounted for under
GAAP. Whereas the market price of a share of stock is a good
approximation of its fair value, the book value of a share
represents only its share of the issuing entity’s accounting
assets minus its accounting liabilities.