Chapter 23 Analysis and Interpretation of Financial Statements

o Prepare comparative financial statements using horizontal analysis

o Prepare comparative financial statements using vertical analysis

o Calculate trend percentages

o Compute ratios and measures in order to accurately interpret financial statements

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The Purpose of Financial Statement Analysis

• To provide information from which users of that information can make good judgments and decisions.

• Liquidity

– The ability of a business to pay its debts when they fall due.

– The ability of a business to convert its assets into cash, the most liquid asset.

• Profitability

– The ability of a business to earn a reasonable return on an owner’s investment.

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Horizontal Analysis

• Each item in a company’s financial statements in the current accounting period is compared with the same item from a previous accounting period.

• The changes can be expressed in

Dollar Changes

Percent Changes

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Horizontal Analysis (continued)

Vertical Analysis

• Each item in a company’s financial statements is stated as a percent of a base figure.

• The percent is calculated as a dollar value of an item divided by the dollar value of the base.

• On the income statement, the base is net sales.

• On the balance sheet, the base is total assets.

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Vertical Analysis (continued)

Trend Percentages

• A measure used to compare financial data over a period of years, in which one year is selected as the base year.

• Every other year’s amount is expressed as a percent of the base year’s amount.

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Liquidity Analysis

• Liquidity: The ability of a business to meet its financial obligations as they fall due.

• Certain relationships on the balance sheet can indicate the ability of a company to pay its debts.

• These relationships are usually expressed as a ratio.

• A Ratio: A fractional relationship of one number to another number.

Let’s look at some short-term liquidity measures:

o Working Capital = current assets – current liabilities

o Current Ratio = current assets ÷ current liabilities

o Acid-Test Ratio = quick assets ÷ current liabilities

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Working Capital Example

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Referring to Weeks Company’s comparative balance sheet, we can compute working capital for 20X2 and 20X1:

For 20X2 $318,700 - $86,400 = $232,300

For 20X1 $266,200 - $76,800 = $189,400

Current Ratio Example Company A Company B

Current assets $60,000 $90,000

Current liabilities $30,000 $60,000

The current ratio for each company: Company A = $60,000 ÷ $30,000 = 2 to 1 Company B = $90,000 ÷ $60,000 = 1.5 to 1

Analysis: Company A appears to be in a better position to receive additional credit. Company A has $2 of current assets for every $1 of current liabilities. Company B has $1.50 of current assets for every $1 of current liabilities.

Acid-Test Ratio • Quick assets include only the most liquid current assets: cash,

marketable securities, and net receivables.

• Companies with the same working capital:

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Company A Company B

Current assets $60,000 $90,000

Current liabilities $30,000 $60,000

• The acid-test ratio for each company, assuming Company A has quick assets of $18,000 and Company B has quick assets of $60,000:

Company A’s = $18,000 ÷ $30,000 = 0.6 to 1 Company B’s = $60,000 ÷ $60,000 = 1 to 1

Analysis: Company B is in a much better position to immediately pay any current debt that becomes due.

Accounts Receivable Turnover • A measure that indicates how quickly a company is collecting cash from

credit customers • Let’s refer back to Weeks Company’s comparative balance sheet to

compute the accounts receivable turnover for 20X2: • First we need to compute the average net accounts receivable for

20X2.

Assume net credit sales for Weeks Company for 20X2 amount to $586,300. The accounts receivable turnover = $586,300 ÷ $119,350 = 4.9 times. This figure means the Weeks Company turned average accounts receivable into cash 4.9 times during 20X2.

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Beg. A/R + End. A/R Net Accounts Receivable =

2

$109,800 + $128,900

2

$119,350

Average

Credit SalesAccounts Receivable Turnover =

Net Accounts Receivable

Net

Average

Average Collection Period for Accounts Receivable

• A rough measure of the length of time accounts receivable has been outstanding.

• The average collection period = 365 days ÷ accounts receivable turnover.

• We know the accounts receivable turnover for Weeks Company for 20X2 is 4.9 times.

• The average collection period for Weeks Company for 20X2

= 365 days ÷ accounts receivable turnover

= 365 days ÷ 4.9

= 75 days

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Merchandise Inventory Turnover • A measure of the number of times a firm’s average inventory is sold during

the year

• Let’s refer back to Weeks Company’s comparative income statement and balance sheet to compute the merchandise inventory turnover for 20X2. Compute the average merchandise inventory for 20X2:

• Merchandise inventory turnover

= cost of goods sold ÷ average inventory

= $375,000 ÷ $102,350

= 3.7 times

• This figure means the Weeks Company sold and replaced its merchandise inventory 3.7 times.

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of Goods SoldMerchandise Inventory Turnover =

Inventory

Cost

Average

Beg. Merch. Inv. + End. Merch. Inv. Merchandise Inventory =

2

$96,500 + $108,200

2

$102,350

Average

Number of Days in Merchandise Inventory

• A measure of the number of days that it takes a company to sell its inventory.

• Calculated as 365 days ÷ merchandise inventory turnover.

• We know the merchandise inventory turnover for Weeks Company for 20X2 is 3.7 times. The number of days in merchandise inventory for Weeks Company for 20X2

= 365 days ÷ 3.7

= 99 days

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Long-Term Liquidity Measures • The ratios we have reviewed so far would be of value to the

short-term creditor in determining the ability of a business to meet its current liabilities.

• Now let’s look at three commonly used measures of particular interest to the long-term creditors.

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Ratio of Plant Assets to Long-Term Liabilities • Indicates the margin of safety for those who hold such notes.

• The higher the ratio, the more secure the creditors. Calculated as plant assets ÷ long-term liabilities.

• Referring to Weeks Company’s balance sheet for 20X2, we can calculate Weeks’ ratio of plant assets to long-term liabilities:

= $219,100 ÷ $40,200 = 5.5 to 1

• Weeks Company has a strong ratio of plant assets to long-term liabilities and is in a good position to secure additional long-term credit.

Ratio of Owner’s Equity to Total Liabilities

• States the amount of owner’s equity in relation to a company’s total liabilities. Also referred to as the debit-equity ratio

• Calculated as owner’s equity ÷ total liabilities

• Referring to Weeks Company’s balance sheet for 20X2, we can calculate Weeks’ ratio of owner’s equity to total liabilities:

= $411,200 ÷ $126,600 = 3.2 to 1.

• As of December 31, 20X2, Weeks Company had $3.20 in owner’s equity for each dollar in total liabilities.

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Times Interest Earned

• A ratio used to determine a firm’s ability to meets its interest payments. Shows the number of times that a firm has earned its interest expense. High ratio indicates ease in making interest payments. Low ratio indicates that a firm could have difficulty making interest payments.

• Assume Wagnor Corporation reports income before interest and taxes of $1,340,000 and interest expense of $320,000 on its income statement for the year ending Dec. 31, 20X2.

• Times interest earned ratio

= $1,340,000 ÷ $320,000 = 4.2

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Net Inc. + Interest Exp. + Inc. TaxesTimes Interest Earned =

Exp.Interest

Pro

fita

bili

ty A

nal

ysis

• The ability of a firm to earn a reasonable return on the

investment in the business.

• Of interest to the owners of the business rather than the creditors.

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Return on Total Assets

Measures the profitability of a firm’s assets; the amount of net income it earns in relation to the assets available for use during the year. • Calculated as (net income + interest expense) ÷ average

total assets. • Referring to Weeks Company’s income statement and

balance sheet for 20X2, we can calculate Weeks’ return on total assets:

Average total assets for 20X2 = (beginning 20X2 total assets + ending 20X2

total assets) ÷ 2 = ($483,800 + $537,800) ÷ 2 = $510,800

Return on total assets = ($90,642 + $6,800) ÷ $510,800 = 19.1%

Asset Turnover

• A measure of the amount of sales generated for each dollar of assets invested in the company.

• Calculated as net sales ÷ total assets (excluding investments).

• Referring to Weeks Company’s income statement and balance sheet for 20X2, we can calculate Weeks’ asset turnover:

$728,000 ÷ $537,800 = 1.4 times

• The higher the asset turnover rate, the better the firm is using its assets to generate sales.

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Return on Stockholders’ Equity

• A measure of the return on each dollar invested by stockholders.

• A company with a high rate of return on stockholders’ equity would appear more attractive to investors than one with a low rate.

• Calculated as net income ÷ average stockholders’ equity.

• Average stockholders’ equity for 20X2

= (beginning 20X2 stockholders’ equity + ending 20X2 stockholders’ equity) ÷ 2 = ($346,000 + $411,200) ÷ 2 = $378,600

• Return on stockholders’ equity = $90,642 ÷ $378,600 = 23.9%

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Earnings per Share on Common Stock

• Represents the amount of net income available to the owner of each share of common stock.

• GAAP requires corporations to report earnings per share on the income statement.

• The only ratio that must appear on the face of the income statement.

• Calculated as net income ÷ number of common shares outstanding.

• Assume Weeks Company had 86,400 shares of common stock outstanding during 20X2.

• Referring to Weeks Company’s income statement for the year ended December 31, 20X2, we know the net income was $90,642.

• EPS for 20X2

• = $90,642 ÷ 86,400 = $1.05 per share

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Price/Earnings Ratio

• A measure of investors’ confidence in the future earnings potential of a company.

• Calculated as market price per share of stock ÷ earnings per share of stock.

• Assume Weeks Company common stock is selling for $21 per share on December 31, 20X2.

• We know Weeks Company’s EPS for 20X2 is $1.05 per share.

• The P/E ratio on December 31, 20X2 = $21 ÷ $1.05 = 20 times

• A P/E ratio of 20 means Weeks’ stock was selling for 20 times the amount of EPS on December 31, 20X2.

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Dividend Yield • A profitability measure that tells the investor the rate earned

on an investment.

• Calculated as dividend per share of common stock ÷ market price per share of common stock.

• Assume that Weeks Company paid $1.02 in dividends to common stockholders in 20X2 and the market price per share on December 31, 20X2, is $21 per share.

• The dividend yield on December 31, 20X2 = $1.02 ÷ $21 = 4.9%

• An investor who buys Weeks’ stock for $21 can expect an annual cash dividend yield of 4.9%.

• If bank interest savings rates are lower than 4.9%, the investor will receive more cash dividends than interest and have the prospect of additional growth in the value of the stock.

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Equ

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Rev

iew

Sh

ort-Term

Liqu

idity M

easures

24 Long-Term Liquidity Measures

Equations Review (continued)

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Pro

fitability A

nalysis

An

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Inte

rpre

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of

Fin

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