INTRODUCTION TO

ACCOUNTING
financial statements analysis
 Basics
Basics of
of Financial
Financial Statement
Statement Analysis
Analysis
Analyzing financial statements involves:
Comparison Tools of
Characteristics
Bases Analysis

Liquidity Intracompany Horizontal

Profitability Industry Vertical
Solvency averages Ratio
Intercompany

Page SO 1 Discuss the need for comparative analysis.

14-2 SO 2 Identify the tools of financial statement
 Horizontal
Horizontal Analysis
Analysis
Horizontal analysis, also called trend analysis, is a
technique for evaluating a series of financial
statement data over a period of time.

Its purpose is to determine the increase or decrease

that has taken place.

Horizontal analysis is commonly applied to the balance

sheet, income statement, and statement of retained
Page earnings.
14-3 SO 3 Explain and apply horizontal analysis.
 Horizontal
Horizontal Analysis
Analysis
Balance Sheet
These changes
suggest that the
company expanded its
asset base during
2007 and financed
this expansion
primarily by
retaining income
rather than assuming
additional long-term
Illustration 14-5
debt. Horizontal analysis of
balance sheets
Page
14-4 SO 3 Explain and apply horizontal analysis.
 Horizontal
Horizontal Analysis
Analysis
Income
Statement
Overall, gross profit
and net income were
up substantially.
Gross profit
increased
17.1%, and net
income, 26.5%.
Quality’s profit trend
appearsIllustration
favorable.14-6
Horizontal analysis of
Income statements
Page
14-5 SO 3 Explain and apply horizontal analysis.
 Horizontal
Horizontal Analysis
Analysis
Retained
Earnings
Statement

Illustration 14-7
Horizontal analysis of
retained earnings
statements

We saw in the horizontal analysis of the balance sheet that ending retained
earnings increased 38.6%. As indicated earlier, the company retained a
significant portion of net income to finance additional plant facilities.
Page
14-6 SO 3 Explain and apply horizontal analysis.
 Horizontal
Horizontal Analysis
Analysis
Summary financial information for Rosepatch
Company is as follows.

Compute the amount and percentage changes in 2011 using

horizontal analysis, assuming 2010 is the base year.

Page Solution on
14-7 notes page SO 3 Explain and apply horizontal analysis.
 Vertical
Vertical Analysis
Analysis
Vertical analysis, also called common-size analysis, is
a technique that expresses each financial statement
item as a percent of a base amount.

On an income statement, we might say that selling

expenses are 16% of net sales.

Vertical analysis is commonly applied to the balance

sheet and the income statement.
Page
14-8 SO 4 Describe and apply vertical analysis.
 Vertical
Vertical Analysis
Analysis
Balance Sheet
These results
reinforce the
earlier observations
that Quality is
choosing to finance
its growth through
retention of
earnings rather
than through
issuing Illustration
additional 14-8
debt. balance sheets
Vertical analysis of

Page
14-9 SO 4 Describe and apply vertical analysis.
 Vertical
Vertical Analysis
Analysis
Income
Statement
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.

Illustration 14-9
Vertical analysis of
Income statements
Page
14-10 SO 4 Describe and apply vertical analysis.
 Vertical
Vertical Analysis
Analysis
Enables a comparison of companies of different sizes.
Illustration 14-10
Intercompany income
statement comparison

J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C.
Penney’s net income as a percent of each sales dollar (5.6%) is only 44% of
Quality’s (12.6%).
Page
14-11 SO 4 Describe and apply vertical analysis.
Basic Financial Analysis
 Ratio analysis involves methods
of calculating and interpreting
financial ratios to assess a firm’s
financial condition and
performance.
 It is of interest to shareholders,
creditors, and the firm’s own
management
BASIC FINANCIAL ANALYSIS
 Ratio analysis involves methods of calculating and
interpreting financial ratios to assess a firm’s
financial condition and performance.
 It is of interest to shareholders, creditors, and the
firm’s own management
Using Financial Ratios:
Types of Ratio Comparisons
 Trend or time-series analysis
 Used to evaluate a firm’s performance
over time
 Cross-sectional analysis
 Used to compare different firms at the same point in
time
Using Financial Ratios:
Types of Ratio Comparisons (cont.)
 Cross-sectional analysis
 Industry comparative analysis
 One specific type of cross sectional analysis. Used to compare one
firm’s financial performance to the industry’s average performance
 Benchmarking
 A type of cross sectional analysis in which the firm’s ratio values
are compared to those of a key competitor or group of competitors
that it wishes to emulate
Using Financial Ratios:
Types of Ratio Comparisons (cont.)
 Trend or time-series analysis
 Cross-sectional analysis
 Combined Analysis
 Combined analysis simply uses a combination of both
time series analysis and cross-sectional analysis
Ratio Analysis
 Liquidity Ratios – measures capacity to meet short term
obligation
 Activity Ratios – measures effective use of resources
 Leverage (gearing) Ratios – measures indebtedness
 Profitability Ratios – measures overall profitability
 Market Ratios – measures based on market price of shares
- important to investors
 The Four Key Financial Statements
2-18

Table 2.1 Bartlett

Company Income
Statements ($000)

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 The Four Key Financial Statements
2-19

Table 2.2a Bartlett

Company Balance Sheets
($000)

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 The Four Key
Financial Statements (cont.)
2-20

Table 2.2b Bartlett

Company Balance
Sheets ($000)

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LIQUIDITY RATIOS
 Current Ratio – measures firm’s ability to meet its
short-term obligation
 The higher the ratio, the more liquid the firm is.
 A current ratio of 2.0 is occasionally acceptable
Current ratio = total current assets
total current liabilities

Current ratio = $1,233,000 = 1.97

$620,000
Liquidity Ratios – quick ratio
• Quick (acid-test) Ratio – similar to current ratio but excludes inventory and
prepaid expenses
 A quick ratio of 1.0 or greater is occasionally recommended – but
depends on the industry
Quick ratio = Total Current Assets - Inventory
total current liabilities
Quick ratio = $1,233,000 - $289,000 = 1.51
$620,000
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Liquidity Ratios

– Quick Ratio

Quick ratio = Total Current Assets - Inventory

total current liabilities
Quick ratio = $1,233,000 - $289,000 = 1.51
$620,000
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Activity ratio – inventory turnover
 Inventory Turnover – measures the
activity/liquidity of a firm’s inventory
 The higher the better but only meaningful if
compared with other firms in the same
industry (20 for grocery store, lower for an
art gallery)
Activity ratio – inventory turnover

Inventory Turnover = Cost of Goods Sold

Inventory (or average inventory*)

Inventory Turnover = $2,088,000 = 7.2

$289,000

• Inventory Turnover in days = 365/Inventory turnover

• To minimize seasonal factor.
• Average Inventory = (Beginning Inv + Ending Inv)/2
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Activity Ratio - Average Collection
Period (AR Turnover)
 Average Collection Period – average amount of time
needed to collect accounts receivable
 Meaningful only in relation to the firm’s credit terms
(credit-terms 30 days and average collection period
60days – poorly managed credit)

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Activity Ratio - Average Collection
Period

ACP = Accounts Receivable*

*or Average
Net Sales/365 AR

ACP = $503,000 = 59.7 days

$3,074,000/365

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Activity Ratio - Average Payment
Period (A/P Turnover)
• Average Payment Period – average amount of time
needed to pay accounts payable
Meaningful only in relation to the average credit
terms extended to the firm (credit terms 30 days,
average payment period 90 days – low credit rating)

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Activity Ratio - Average Payment Period

AP Turnover in days=
Average AP
COGS/365

APP = Accounts Payable

Annual Purchases/365
APP = $382,000 = 95.4 days
(.70 x $2,088,000)/365
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Activity ratio – Total Asset Turnover
• Total Asset Turnover – indicates the efficiency with which the firm uses its
assets to generate sales
 Generally, the higher the firm’s total asset turnover, the more efficiently its assets
have been used

Total Asset Turnover = Net Sales

* Or average TA
Total Assets *

Total Asset Turnover = $3,074,000 = .85

$3,597,000

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Cash Conversion Cycle (CCC)
• The length of time in days that it takes for a
company to convert resource inputs into cash
flow - It measures how fast a company can
convert cash on hand into even more cash on
hand (the shorter the better)
• CCC = Inventory turnover in days – A/P
turnover in days + A/R turnover in days
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Cash Conversion Cycle
Cash Conversion Cycle
Leverage Ratio - Debt Ratio
 Debt Ratio (Financial leverage ratio) – measures the
proportion of total assets financed by the firm’s creditors
 The higher this ratio, the greater the firms’ degree of

indebtedness, the more financial leverage it has

Debt Ratio = Total Liabilities/Total Assets
Debt Ratio = $1,643,000/$3,597,000 = 45.7%
Debt Ratio – Times Interest Earned Ratio
 Times Interest Earned Ratio (interest coverage) –
measures the firms’ ability to make contractual interest
payments
 The higher the better – a value of at least 3.0 and

preferably closer to 5.0 is often suggested

Times Interest Earned = EBIT (Operating Income)/Interest
Times Interest Earned = $418,000/$93,000 = 4.5
Debt ratio - Fixed-Payment Coverage
 Fixed-Payment Coverage Ratio – measures the firms’
ability to meet all fixed-payment obligations (loan
interest and principal, lease payments, preferred stock
dividend)
 The higher, the better. Also measures risk, the lower

the ratio, the greater the risk to both lenders and

owners
 Debt Ratio
2-37
 Fixed-Payment coverage Ratio (FPCR)

FPCR = EBIT + Lease Payments________________

Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

FPCR = $418,000 + $35,000 = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}

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Debt-equity ratio
 Measures the relationship between the firm’s
resources provided through debt and those provided
through ownership (equity)
 The greater the D/E ratio is, the riskier the company
is as an investment
 Formula = Total Liabilities
Total stockholders’ equity
PROFITABILITY RATIOS
 Gross Profit Margin – measures the percentage of each sales
dollar remaining after the firm has paid for its goods
 The higher, the better

GPM = Gross Profit/Net Sales

GPM = $986,000/$3,074,000 = 32.1%
 Profitability Ratios
2-40  Operating Profit Margin (OPM)
 measures the percentage of each sales dollar remaining after
all costs and expenses other than interest, taxes, and preferred
stock dividends are deducted
 A higher operating profit margin is preferred

OPM = EBIT/Net Sales

OPM = $418,000/$3,074,000 = 13.6%
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 Profitability Ratios
2-41
 Net Profit Margin (NPM)- measures the percentage of each
sales dollar remaining after all costs and expenses including
interest, taxes, and preferred stock dividends are deducted
 The higher the firm’s net profit margin, the better

NPM = Earnings Available to Common Stockholders

Sales
NPM = $221,000/$3,074,000 = 7.2%
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 Profitability Ratios
2-42
 Earnings Per Share (EPS)- represents the dollar amount
earned on behalf of each outstanding share of common
stock
 The higher, the better

EPS = Earnings Available to Common Stockholders

Number of Shares Outstanding
EPS = $221,000/76,262 = $2.90
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 Profitability Ratios
2-43

 Return on Total Assets (ROA) - measures the overall

effectiveness of management in generating profits with its
available assets – return on investment
 The higher, the better

ROA = Earnings Available to Common Stockholders

Total Assets or Average TA
ROA = $221,000/$3,597,000 = 6.1%
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 Profitability Ratios
2-44

 Return on Equity (ROE) - measures the return earned on the

common stockholders’ investment in the firm
 The higher, the better

ROE = Earnings Available to Common Stockholders

Total Equity or Average Equity
ROE = $221,000/$1,754,000 = 12.6%
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 Market Ratios
2-45
 Price Earnings (P/E) Ratio - measures the amount that investors are
willing to pay for each dollar of a firm’s earnings
 Indicates the degree of confidence that investors have in the firm’s

future performance (the higher, the greater the confidence)

P/E = Market Price Per Share of Common Stock

Earnings Per Share
P/E = $32.25/$2.90 = 11.1
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 MARKET RATIOS
 Market/Book (M/B) Ratio – provides an assessment of
how investors view the firm’s performance
 Performing stocks – higher M/B ratios

M/B Ratio = Market Price/Share of Common Stock

Book Value/Share of Common Stock
M/B Ratio = $32.25/$23.00 = 1.40
 Summarizing All Ratios
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)
2-47
 Summarizing All Ratios (cont.)
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)

2-48
2-
Ratio Analysis (cont.)
49
Table 2.7
Bartlett Company
Common-Size
Income Statements

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2-
DuPont System of Analysis
50
 The DuPont system of analysis is used to dissect the firm’s financial
statements and to assess its financial condition.
 It merges the income statement and balance sheet into two summary
measures of profitability.
 The Modified DuPont Formula relates the firm’s ROA to its ROE using the
financial leverage multiplier (FLM), which is the ratio of total assets to
common stock equity:
 ROA and ROE as shown in the series of equations on the following slide and
in Figure 2.2 on the following slide.
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2-
DuPont System of Analysis
51

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 DuPont System of Analysis (cont.)
2-
52
Figure 2.2 DuPont
System of Analysis

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2-
Modified DuPont Formula (cont.)
53
 Use of the FLM to convert ROA into ROE reflects
the impact of financial leverage on the owner’s
return.
 Substituting the values for Bartlett Company’s ROA
of 6.1 percent calculated earlier, and Bartlett’s FLM
of 2.06 ($3,597,000 total assets ÷ $1,754,000
common stock equity) into the Modified DuPont
formula yields:
ROE = 6.1% X 2.06 = 12.6%
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