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Chapter 15Financial
Statement Analysis
Learning Objectives
1. Explain how financial statements are used to analyze a business
2. Perform a horizontal analysis of financial statements
3. Perform a vertical analysis of financial statements
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Learning Objectives
4. Compute and evaluate the standard financial ratios
5. Complete a corporate income statement including earnings per share (Appendix 15A)
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Learning Objective 1
Explain how financial statements are used to analyze a business
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How Are Financial Statements Used to Analyze a Business?
• To determine the financial performance of a company, we compare its performance in the following ways:– From year to year– With a competing company– With the same industry as a whole
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Tools of Analysis
• There are three main ways to analyze financial statements:– Horizontal analysis provides a year-to-year
comparison of a company’s performance in different periods.
– Vertical analysis provides a way to compare different companies.
– Ratio analysis can be used to provide information about a company’s performance.
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Corporate Financial Reports
• Corporate financial reports include: – Annual reports– Management’s discussion and analysis of
financial conditions and results of operations (MD&A)
– Report of the independent auditors– Financial statements– Notes to financial statements
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Learning Objective 2
Perform a horizontal analysis of financial statements
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How Do We Use Horizontal Analysis to Analyze a Business?
• Many decisions hinge on whether the numbers are increasing or decreasing.
• Sales may have increased, but considered in isolation, this fact is not very helpful.
• Horizontal analysis is the study of percentage changes in comparative financial statements.
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How Do We Use Horizontal Analysis to Analyze a Business?
• Assume Smart Touch Learning has net sales of $858,000 in 2018 and $803,000 in 2017. Prepare the horizontal analysis:Step 1: Compute the dollar amount of change in sales from 2017-2018
Step 2: Divide the dollar amount of change by the base period amount and multiply by 100. This computes the percentage change for the period:
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Horizontal Analysis of the Income Statement
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Horizontal Analysis of the Balance Sheet
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Horizontal Analysis of the Balance Sheet
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Trend Analysis
• Trend analysis is a form of horizontal analysis.
• Trend percentages indicate the direction a business is taking.
• The formula for trend analysis is as follows:
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Trend Analysis
• Smart Touch Learning’s net sales were $750,000 for 2014 and rose to $858,000 in 2018. The base year is 2014, so that year’s percentage is set equal to 100.
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Learning Objective 3
Perform a vertical analysis of financial statements
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How Do We Use Vertical Analysis to Analyze a Business?
• Vertical analysis of a financial statement shows the relationship of each item to its base amount, the 100% figure.
• Every other item on the statement is then reported as a percentage of that base.
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Vertical Analysis of the Income Statement
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Vertical Analysis of the Balance Sheet
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Vertical Analysis of the Balance Sheet
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Common-Size Statements
• To compare one company to another company, we can use a common-size statement.
• A common-size statement reports only percentages.
• By reporting only percentages, it removes dollar value bias we see when comparing numbers in absolute terms (dollars).
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Common-Size Statements
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Benchmarking
• Benchmarking is the practice of comparing a company with other leading companies.
• There are two main types of benchmarking: – Benchmarking against a key competitor– Benchmarking against the industry average
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Benchmarking
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Learning Objective 4
Compute and evaluate the standard financial ratios
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How Do We Use Ratios to Analyze a Business?
• Different ratios explain different aspects of a company.
• Ratios are used for the following purposes:– Evaluating the ability to pay current
liabilities and long-term debit– Evaluating the ability to sell merchandise
inventory and collect receivables– Evaluating profitability– Evaluating stock as an investment
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How Do We Use Ratios
to Analyze a Business?
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How Do We Use Ratios
to Analyze a Business?
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Evaluating the Ability to Pay Current Liabilities
• Working capital measures the ability to meet short-term obligations with current assets. Working capital is defined as follows:
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Current Ratio
• The most widely used ratio is the current ratio. This ratio measures a company’s ability to pay its current liabilities with its current assets.
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Cash Ratio
• The cash ratio helps determine a company’s ability to meet its short-term obligations.
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Acid-Test (or Quick) Ratio
• The acid-test ratio (sometimes called the quick ratio) tells us whether a company can pay all its current liabilities if they come due immediately.
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Evaluating the Ability to Sell Merchandise Inventory and Collect Receivables
• Five ratios that measure a company’s ability to sell merchandise inventory and collect receivables are:– Inventory turnover– Days’ sales in inventory– Gross profit percentage– Accounts receivable turnover ratio– Days’ sales in receivables
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Inventory Turnover
• The inventory turnover ratio measures the number of times a company sells its average level of merchandise inventory during a year.
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Days’ Sales in Inventory
• Days’ sales in inventory measures the average number of days merchandise inventory is held by the company.
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Gross Profit Percentage
• The gross profit percentage measures the profitability of each net sales dollar above the cost of goods sold.
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Accounts Receivable Turnover Ratio
• The accounts receivable turnover ratio measures the number of times the company collects the average receivables balance in a year.
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Days’ Sales in Receivables
• Days’ sales in receivables indicates how many days it takes to collect the average level of receivables.
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Evaluating the Ability to Pay Long-Term Debt
• Most businesses have long-term debt. • Three key indicators of a business’s ability
to pay long-term liabilities are the: – Debt ratio– Debt to equity ratio– Times-interest-earned ratio
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Debt Ratio
• The debt ratio shows the proportion of assets financed with debt and is calculated by dividing total liabilities by total assets.
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Debt to Equity Ratio
• The debt to equity ratio shows the proportion of total liabilities relative to total equity.
• This ratio measures financial leverage.
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Times-Interest-Earned Ratio
• The times-interest-earned ratio evaluates a business’s ability to pay interest expense. This ratio is also called the interest coverage ratio.
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Evaluating Profitability
• Five ratios used to evaluate a company’s profitability are:– Profit margin ratio– Rate of return on total assets– Asset turnover ratio– Rate of return on common stockholders’ equity– Earnings per share
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Profit Margin Ratio
• The profit margin ratio shows how much net income a business earns on every $1 of sales.
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Rate of Return on Total Assets
• The rate of return on total assets measures a company’s success in using assets to earn a profit.
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Asset Turnover Ratio
• The asset turnover ratio measures the amount of net sales generated for each average dollar of total assets invested.
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Rate of Return on Common Stockholders’ Equity
• The rate of return on common stockholders’ equity shows how much income is earned for each $1 invested by the common shareholders.
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Rate of Return on Common Stockholders’ Equity
• When a company has a higher rate of return on stockholders’ equity than its rate of return on total assets, this is called trading on the equity.
• Trading on the equity is earning more income on borrowed money than the related interest expense, thereby increasing the earnings for the owners of the business.
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Earnings per Share (EPS)
• The earnings per share (EPS) reports the amount of net income (loss) for each share of the company’s outstanding common stock.
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Evaluating Stock as an Investment
• Investors purchase stock to earn a return on their investment.
• This return consists of two parts: – Gains (or losses) from selling the stock at a
price above (or below) purchase price– Dividends
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Price/Earnings Ratio
• The price/earnings ratio is the ratio of the market price of a share of common stock to the company’s earnings per share.
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Dividend Yield
• The dividend yield measures the percentage of a stock’s market value that is returned annually as dividends to shareholders.
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Dividend Payout
• The dividend payout measures the percentage of earnings paid annually to common shareholders as cash dividends.
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Red Flags in Financial Statement Analysis
• Analysts look for red flags in financial statements that may signal financial trouble. Examples: – Movement of sales, merchandise inventory,
and receivables– Earnings problems– Decreased cash flow– Too much debt– Inability to collect receivables – Buildup of merchandise inventories
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Summary of Ratios Used in Financial Statement Analysis
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Summary of Ratios Used in Financial Statement Analysis
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Summary of Ratios used in Financial Statement Analysis
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Summary of Ratios Used in Financial Statement Analysis
Learning Objective 5
Complete a corporate income statement including earnings per share (Appendix 15A)
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How Is the Complete Corporate Income Statement Prepared?
• A corporation’s income statement reports income from continuing operations to help investors make predications about future earnings.
• The income statement also includes unique items, such as:– Discontinued operations– Extraordinary items
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How Is the Complete Corporate
Income Statement Prepared?
Discontinued Operations
• Most corporations engage in several lines of business.
• A company may sell a segment of its business. This is reported as a discontinued operation.
• Discontinued operations are reported immediately after income from continuing operations.
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Extraordinary Items
• Extraordinary gains and losses, called extraordinary items, are both:– Unusual– Infrequent
• GAAP defines an event as infrequent if it is not expected to recur in the foreseeable future.
• These items are reported separately from continuing operations.
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