Financial Statement Analysis
is used to assess the financial health of a company. It includes
examining trends in key financial data, comparing financial data
across companies, and analyzing financial ratios.
By: Van Callanta
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
FINANCIAL STATEMENT ANALYSIS
Involves careful selection of
data from financial statements
in order to assess and evaluate
the firm’s past performance, its
present condition, and future
business potentials.
OBJECTIVES OF FINANCIAL
STATEMENTS ANALYSIS
The primary purpose of FS analysis is to
evaluate and forecast the company’s financial
health.
Profitability of the business firm;
Firm’s ability to meet its obligations;
Safety of the investment in the business; and
Effectiveness of management in running the
firm.
GENERAL APPROACH TO FINANCIAL
STATEMENTS
Evaluation of the environment (industry
and economy as a whole) where the
company conducts business.
Analysis of the firm’s short term solvency
Analysis of the company’s capital structure
and long-term solvency
Evaluation of the management’s efficiency
in running the business
Analysis of the firm’s profitability
Limitations of Financial Statement Analysis
Analysts should look beyond the ratios.
Changes within
Industry the company Consumer
trends tastes
Technological Economic
changes factors
16-5
Ratios should not be viewed as an end, but
rather as a starting point. They raise many
questions and point to opportunities for further
analysis, but they rarely answer questions by
themselves.
In addition to ratios, other sources of data
should also be considered, such as industry
trends, technological changes, changes in
consumer tastes, changes in broad economic
factors, and changes within the company itself.
Statements in Comparative and
Common-Size Form
❶ Dollar and percentage
changes on statements
An item on a financial
statement has little ❷ Common-size
meaning by itself. The statements
meaning of the numbers
can be enhanced by
drawing comparisons.
❸ Ratios
16-7
An item on a balance sheet or income statement has little
meaning by itself. The meaning of the number can be
enhanced by drawing comparisons. This chapter
discusses three such means of enabling comparisons:
1. Dollar and percentage changes on statements (also
known as horizontal analysis),
2. Common-size statements (also known as vertical
analysis), and
3. Ratios.
Horizontal Analysis
Calculating Change in Dollar Amounts
Dollar Current Year Base Year
= –
Change Figure Figure
The dollar
amounts for
2007 become
the “base” year
figures.
16-9
Horizontal Analysis
Calculating Change as a Percentage
Percentage Dollar Change
Change
=
Base Year Figure × 100%
16-1
Trend Percentages
Trend percentages
state several years’
financial data in terms
of a base year, which
equals 100 percent.
16-1
Horizontal analysis can be even more
useful when data from a number of
years are used to compute trend
percentages.
Trend Analysis
Trend = Current Year Amount
Percentage Base Year Amount
× 100%
16-1
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.
16-1
Common-Size Statements
In income
statements, all
items usually are
expressed as a
percentage of
sales.
16-1
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.
16-1
Managers often pay close attention to the gross
margin percentage, which is computed as gross
margin divided by sales. The gross margin
percentage tends to be more stable for retailing
companies because cost of goods sold excludes
fixed costs.
Common-Size Statements
In balance
sheets, all items
usually are
expressed as a
percentage of
total assets.
16-1
Common-Size Statements
Common-size financial statements are
particularly useful when comparing
data from different companies.
16-1
Ratio Analysis – The Short–Term Creditor
Short-term
creditors, such as
suppliers, want to
be paid on time.
Therefore, they
focus on the
company’s cash
flows and working
capital.
16-2
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.
16-2
Therefore, managers often seek to minimize
working capital.
A large and growing working capital balance
may not be a good sign. For example, it could
be the result of unwarranted growth in
inventories.
Working Capital
16-2
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.
16-2
Current Ratio
Current Current Assets
=
Ratio Current Liabilities
Current $65,000
= = 1.55
Ratio $42,000
16-2
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.
16-2
It is a more rigorous measure of short-term debt
paying ability because it only includes cash,
marketable securities, accounts receivable, and
current notes receivable.
It measures a company’s ability to meet its
obligations without having to liquidate its
inventory.
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.
16-2
It measures how quickly credit sales are
converted to cash.
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.
16-3
It should be interpreted relative to the credit
terms offered to customers.
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.
16-3
It should increase for companies that adopt just-in-time
methods.
It should be interpreted relative to a company’s industry.
For example, grocery stores turn their inventory over
quickly, whereas jewelry stores tend to turn their inventory
over slowly.
If a company’s inventory turnover is less than its industry
average, it either has excessive inventory or the wrong
types of inventory.
Inventory Turnover
Inventory Cost of Goods Sold
=
Turnover Average Inventory
Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2
16-3
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.
16-3
It measures the number of days being taken,
on average, to sell the entire inventory one
time.
Ratio Analysis – The Long–Term Creditor
Long-term creditors are concerned with a
company’s ability to repay its loans over the
long-run.
This is also referred
to as net operating
income.
16-3
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.
16-3
It is based on earnings before interest and
income taxes because that is the amount of
earnings that is available for making interest
payments.
A ratio of less than one is inadequate.
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.
16-4
Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio
Debt–to–
$112,000
Equity = = 0.48
$234,390
Ratio
16-4
Other Formulas:
Return on Sales: Net Income / Sales
Return on Equity: Net Income / Equity
Return on Asset: Net Income / Asset
