Financial statement analysis warren

Managerial Accounting
Fifteenth Edition
Chapter 16
Financial
Statement
Analysis
Copyright © 2019 Cengage. All Rights Reserved.

Learning Objectives (1 of 2)
• Obj. 1: Describe the techniques and tools used to
analyze financial statement information.
• Obj. 2: Describe and illustrate basic financial statement
analytical methods.
• Obj. 3: Describe and illustrate how to use financial
statement analysis to assess liquidity.
statement analysis to assess solvency.
statement analysis to assess profitability.
• Obj. 6: Describe the contents of corporate annual
reports.

Learning Objectives (2 of 2)
• Obj. App 1: Describe the reporting of unusual items on
the income statement.
• Obj. App 2: Describe the concepts of fair value and
comprehensive income.

The Value of Financial Statement
Information
• General-purpose financial statements are distributed to
a wide range of potential users, providing each group
with valuable information about a company’s economic
performance and financial condition.
• Users typically evaluate this information along three
dimensions:
1. Liquidity
2. Solvency
3. Profitability

Liquidity
• Short-term creditors such as banks and financial
institutions are primarily concerned with whether a
company will be able to repay short-term borrowings
such as loans and notes.
• As such, they are most interested in evaluating a
company’s ability to convert assets into cash, which is
called liquidity.

Solvency
• Long-term creditors, such as bondholders, loan money
for long periods of time.
• Thus, they are interested in evaluating a company’s
ability to make its periodic interest payments and repay
the face amount of debt at maturity, which is called
solvency.

Profitability
• Investors, such as stockholders, are interested in
evaluating the potential for the price of the company’s
stock to increase.
• As such, investors focus on evaluating a company’s
ability to generate earnings, which is called
profitability.

Techniques for Analyzing Financial
Statements (1 of 2)
• Financial statement users rely on the following
techniques to analyze and interpret a company’s
financial performance and condition:
– Analytical methods examine changes in the amount
and percentage of financial statement items within and
across periods.
– Ratios express a financial statement item or set of
financial statement items as a percentage of another
financial statement item, in order to measure an
important economic relationship as a single number.

Techniques for Analyzing Financial
Statements (2 of 2)
• Both analytical methods and ratios can be used to compare
a company’s financial performance over time or to another
company.
– Comparisons Over Time: The comparison of a financial
statement item or ratio with the same item or ratio from a prior
period often helps the user identify trends in a company’s
economic performance, financial condition, liquidity, solvency,
and profitability.
– Comparisons Among Companies: The comparison of a
financial statement item or ratio to another company in the
same industry can provide insight into a company’s economic
performance and financial condition relative to its
competitors.

Analytical Methods
• Users analyze a company’s financial statements using
a variety of analytical methods. Three such methods
are the following:
1. Horizontal analysis
2. Vertical analysis
3. Common-sized statements

Horizontal Analysis (1 of 2)
• The analysis of increases and decreases in the amount
and percentage of comparative financial statement
items is called horizontal analysis.
– Each item on the most recent statement is compared
with the same item on one or more earlier statements in
terms of the following:
 Amount of increase or decrease
 Percent of increase or decrease

Horizontal Analysis (2 of 2)
• When comparing statements, the earlier statement is
normally used as the base year for computing
increases and decreases.

Comparative Balance Sheet—Horizontal
Analysis

Comparative Schedule of Current Assets—
Horizontal Analysis

Comparative Income Statement—
Horizontal Analysis

Comparative Retained Earnings
Statement—Horizontal Analysis

Vertical Analysis (1 of 3)
• The percentage analysis of the relationship of each
component in a financial statement to a total within the
statement is called vertical analysis.

• In a vertical analysis of the balance sheet, the
percentages are computed as follows:
– Each asset item is stated as a percent of the total
assets.
– Each liability and stockholders’ equity item is stated as a
percent of the total liabilities and stockholders’ equity.

Comparative Balance Sheet—Vertical
Analysis

• In a vertical analysis of the income statement, each
item is stated as a percent of sales.

Comparative Income Statement—Vertical
Analysis

Common-Sized Statements
• In a common-sized statement, all items are
expressed as percentages, with no dollar amounts
shown.
• Common-sized statements are often useful for
comparing one company with another or for comparing
a company with industry averages.

Common-Sized Income Statements

Check Up Corner: Horizontal and Vertical
Analyses (1 of 2)
Select income statement data for Bukasy Company for
two recent years ended December 31 are as follows:
20Y2 20Y1
Sales $ 2,200,000 $ 2,000,000
Costs of goods sold (1,337, 500) (1,250,000)
Gross profit $ 862,500 $ 750,000
Selling, general, and
administrative expenses (440,000) (400,000)
Operating income $ 422,500 $ 350,000
Prepare horizontal and vertical analyses of Bukasy’s
income statement. (Round percentages to one decimal
place.)

Check Up Corner: Horizontal and Vertical
Analyses (2 of 2)

Analyzing Liquidity
• Liquidity analysis evaluates the ability of a company to
convert current assets into cash.
• Liquidity ratios and measures focus upon a company’s
current position (current assets and liabilities),
accounts receivable, and inventory.

Liquidity Ratios and Measures
Current Position
Analysis
Accounts Receivable
Analysis
Inventory Analysis
Working Capital Accounts Receivable
Turnover
Inventory Turnover
Current Ratio Number of Days’ Sales in
Receivables
Number of Days’ Sales in
Inventory
Quick Ratio

Current Position Analysis
• Current position analysis evaluates a company’s
ability to pay its current liabilities.
• This information helps short-term creditors determine
how quickly they will be repaid.
• This analysis includes the following:
– Working capital
– Current ratio
– Quick ratio

Current Position Analysis: Working
Capital (1 of 3)
• A company’s working capital is computed as follows:
Working Capital = Current Assets – Current Liabilities

Current Position Analysis: Working Capital
(2 of 3)
• To illustrate, the working capital for Lincoln Company
for 20Y6 and 20Y5 is computed as follows:

Current Position Analysis: Working
Capital (3 of 3)
• The working capital is used to evaluate a company’s
ability to pay current liabilities.
• A company’s working capital is often monitored
monthly, quarterly, or yearly by creditors and other
debtors.
• However, it is difficult to use working capital to compare
companies of different sizes.

Current Position Analysis: Current Ratio
(1 of 3)
• The current ratio, sometimes called the working
capital ratio, is computed as follows:
s
Liabilitie
Current
Assets
Current
Ratio
Current 

(2 of 3)
• To illustrate, the current ratio for Lincoln Company is
computed as follows:

(3 of 3)
• The current ratio is a more reliable indicator of a
company’s ability to pay its current liabilities than is
working capital, and it is much easier to compare
across companies.

Current Position Analysis: Quick Ratio
(1 of 3)
• A ratio that measures the “instant” debt-paying ability of a
company is the quick ratio, sometimes called the acid-test
ratio.
• The quick ratio is computed as follows:
s
Liabilitie
Current
Assets
Quick
Ratio
Quick 
– Quick assets are cash and other current assets that can be
easily converted to cash.
 Quick assets normally include cash, temporary investments, and
receivables but exclude inventories and prepaid assets.

(2 of 3)
• To illustrate, the current assets and liabilities for Lincoln
Company and Jefferson Company are as follows:

(3 of 3)
• To illustrate, the quick ratio for Lincoln Company and
Jefferson Company are computed as follows:

Accounts Receivable Analysis (1 of 2)
• A company’s ability to collect its accounts receivable is
called accounts receivable analysis.
• Accounts receivable analysis includes the computation
and analysis of the following:
– Accounts receivable turnover
– Number of days’ sales in receivables

Accounts Receivable Analysis (2 of 2)
• Collecting accounts receivable as quickly as possible
does the following:
– Improves a company’s liquidity
– Provides cash to improve or expand operations
– Reduces the risk of uncollectible accounts

Accounts Receivable Analysis: Accounts
Receivable Turnover (1 of 2)
• The accounts receivable turnover is computed as
follows:
Receivable
Accounts
Average
Sales
Turnover
Receivable
Accounts 

Accounts Receivable Analysis: Accounts
Receivable Turnover (2 of 2)
• To illustrate, the accounts receivable turnover for
Lincoln Company for 20Y6 and 20Y5 is computed as
follows. Lincoln’s accounts receivable balance at the
beginning of 20Y5 is $140,000.

Accounts Receivable Analysis: Number of
Days’ Sales in Receivables (1 of 3)
• The number of days’ sales in receivables is
Days
365
Sales
Sales
Daily
Average
where
Sales
Daily
Average
Receivable
Accounts
Average
s
Receivable
in
Sales
Days'
of
Number



• To illustrate, the number of days’ sales in receivables
for Lincoln Company is computed as follows:

• The number of days’ sales in receivables is an estimate
of the time (in days) that the accounts receivable have
been outstanding.
• The number of days’ sales in receivables is often
compared with a company’s credit terms to evaluate
the efficiency of the collection of receivables.

Inventory Analysis (1 of 2)
• A company’s ability to manage its inventory effectively
is evaluated using inventory analysis.
• Inventory analysis includes the computation and
analysis of the following:
– Inventory turnover
– Number of days’ sales in inventory

Inventory Analysis (2 of 2)
• Excess inventory does the following:
– Decreases liquidity by tying up funds (cash) in inventory
– Increases insurance expense, property taxes, storage
costs, and other related expenses
– Increases the risk of losses because of price declines or
obsolescence of the inventory

Inventory Analysis: Inventory Turnover
(1 of 2)
• The inventory turnover is computed as follows:
Inventory
Average
sold
goods
of
Costs
Turnover
Inventory 

Inventory Analysis: Inventory Turnover
(2 of 2)
• To illustrate, the inventory turnover for Lincoln
Company for 20Y6 and 20Y5 is computed as follows:

Inventory Analysis: Number of Days’ Sales
in Inventory (1 of 3)
• The number of days’ sales in inventory is computed
as follows:
Days
365
Sold
Goods
of
Costs
Sold
Goods
of
Cost
Daily
Average
where
Sold
Goods
of
Cost
Daily
Average
Inventory
Average
Inventory
in
Sales
Days'
of
Number



• To illustrate, the number of days’ sales in inventory for
Lincoln Company is computed as follows:

• The number of days’ sales in inventory is a rough
estimate of the length of time it takes to purchase, sell,
and replace the inventory.

Check Up Corner: Liquidity Analysis (1 of 2)
Select financial statement data for OM&M Inc. for two recent years
follows:
Based on these data, calculate the following liquidity measures for 20Y2:
A. Current ratio
B. Quick ratio
C. Accounts receivable turnover
D. Inventory turnover

Check Up Corner: Liquidity Analysis (2 of 2)

Analyzing Solvency
• Solvency analysis evaluates a company’s ability to pay
its long-term debts.

Solvency Ratios

Ratio of Fixed Assets to Long-Term
Liabilities (1 of 2)
• The ratio of fixed assets to long-term liabilities
provides a measure of how much fixed assets a
company has to support its long-term debt.
• This measures a company’s ability to repay the face
amount of debt at maturity and is computed as follows:
s
Liabilitie
Term
Long
(net)
Assets
Fixed
s
Liabilitie
Term
Long
to
Assets
Fixed
of
Ratio




Ratio of Fixed Assets to Long-Term
Liabilities (2 of 2)
• To illustrate, the ratio of fixed assets to long-term
liabilities for Lincoln Company is computed as follows:

Ratio of Liabilities to Stockholders’ Equity
(1 of 2)
• The ratio of liabilities to stockholders’ equity
measures how much of the company is financed by
debt and equity. It indicates the margin of safety for
creditors.
• The ratio of liabilities to stockholders’ equity is
Equity
rs'
Stockholde
Total
s
Liabilitie
Total
Equity
rs'
Stockholde
to
s
Liabilitie
of
Ratio 

Ratio of Liabilities to Stockholders’ Equity
(2 of 2)
• To illustrate, the ratio of liabilities to stockholders’ equity

Times Interest Earned (1 of 2)
• The times interest earned, sometimes called the
coverage ratio, measures the risk that interest
payments will not be made if earnings decrease.
• The times interest earned is computed as follows:
Expense
Interest
Expense
Interest
Tax
Income
Before
Income
Earned
Interest
Times


• The higher the ratio, the more likely interest payments
will be paid if earnings decrease.

Times Interest Earned (2 of 2)
• To illustrate, the times interest earned for Lincoln
Company is computed as follows:

Check Up Corner: Solvency Analysis (1 of 2)
The following are select balance sheet and income statement data
for Wilton Strand Inc. for a recent year:
Based on these data, calculate the following solvency measures:
A. Ratio of fixed assets to long-term liabilities
B. Ratio of liabilities to stockholders’ equity
C. Times interest earned

Check Up Corner: Solvency Analysis (2 of 2)

Profitability Analysis
• Profitability analysis evaluates the ability of a company
to generate future earnings.
– This ability depends on the relationship between the
company’s operating results and the assets the
company has available for use in its operations.
 Thus, the relationship between income statement and
balance sheet items is used to evaluate profitability.

Profitability Ratios

Asset Turnover (1 of 2)
• The asset turnover measures how effectively a
company uses its assets.
• The asset turnover is computed as follows:
s)
investment
term
long
(excluding
Assets
Total
Average
Sales
Turnover
Asset


– Note that long-term investments are excluded in
computing asset turnover because long-term investments
are unrelated to normal operations and sales.

Asset Turnover (2 of 2)
• To illustrate, the asset turnover for Lincoln Company is

Return on Total Assets (1 of 3)
• The return on total assets measures the profitability of total
assets, without considering how the assets are financed.
– In other words, this rate is not affected by the portion of assets
financed by creditors or stockholders.
• The return on total assets is computed as follows:
assets
Total
Average
Expense
Interest
income
Net
Assets
Total
on
Return


– By adding interest expense to net income, the effect of whether the
assets are financed by creditors (debt) or stockholders (equity) is
eliminated.
– Because net income includes any income earned from long-term
investments, the average total assets includes long-term investments
and the net operating assets.

• To illustrate, the return on total assets by Lincoln

• The return on operating assets is sometimes computed
when there are large amounts of nonoperating income
and expense.
• The return on operating assets is computed as follows:
Assets
Operating
Average
Income
Operating
Assets
Operating
on
Return 

Return on Stockholders’ Equity (1 of 4)
• The return on stockholders’ equity measures the
rate of income earned on the amount invested by the
stockholders.
• The return on stockholders’ equity is computed as
follows:
Equity
rs'
Stockholde
Total
Average
Income
Net
Equity
rs'
Stockholde
on
Return 

• To illustrate, the return on stockholders’ equity for
Lincoln Company is computed as follows:

• The return on stockholders’ equity is normally higher
than the return on total assets.
– This is because of the effect of leverage.
 Leverage involves using debt to increase the return on an
investment.

• For Lincoln Company, the effect of leverage for 20Y6
and 20Y5 is computed as follows:

Effect of Leverage

Return on Common Stockholders’ Equity
(1 of 3)
• The return on common stockholders’ equity
measures the rate of profits earned on the amount
invested by the common stockholders.a
• The return on common stockholders’ equity is
Equity
rs'
Stockholde
Common
Average
Dividends
Preferred
Income
Net
Equity
rs'
Stockholde
Common
on
Return 


(2 of 3)
• To illustrate, the return on common stockholders’ equity

(3 of 3)
• Lincoln’s return on common stockholders’ equity differs
from the returns on total assets and stockholders’
equity because of leverage.

Earnings per Share on Common Stock
(1 of 3)
• Earnings per share (EPS) on common stock
measures the share of profits that are earned by a
share of common stock.
• EPS must be reported in the income statement.
• EPS on common stock is computed as follows:
 
g
Outstandin
Stock
Common
of
Shares
Dividends
Preferrred
Income
Net
Stock
Common
on
EPS
Share
per
Earnings 


(2 of 3)
• To illustrate, the earnings per share (EPS) of common
stock for Lincoln Company is computed as follows:

(3 of 3)
• Many corporations have complex capital structures with
various types of equity securities outstanding, such as
convertible preferred stock, stock options, and stock
warrants.
• In such cases, the possible effects of such securities
on the shares of common stock outstanding are
reported separately as earnings per common share
assuming dilution or diluted earnings per share.

Price-Earnings Ratio (1 of 2)
• The price-earnings (P/E) ratio on common stock
measures a company’s future earnings prospects.
• The price-earnings ratio is computed as follows:
Stock
Common
on
Share
per
Earnings
Stock
Common
of
Share
per
Price
Market
Ratio
(P/E)
Earnings
Price 


Price-Earnings Ratio (2 of 2)
• To illustrate, the price-earnings (P/E) ratio for Lincoln

Dividends per Share (1 of 3)
• Dividends per share measures the extent to which
earnings are being distributed to common
shareholders.
• Dividends per share is computed as follows:
g
Outstandin
Stock
Common
of
Shares
Stock
Common
on
Dividends
shares
per
Dividend 

• To illustrate, the dividends per share for Lincoln
Company are computed as follows:

• Comparing dividends per share and earnings per share
indicates the extent to which earnings are being
retained for use in operations.

Dividends and Earnings per Share of
Common Stock

Dividend Yield (1 of 2)
• The dividend yield on common stock measures the
rate of return to common stockholders from cash
dividends.
• It is of special interest to investors whose objective is to
earn revenue (dividends) from their investment.
• The dividend yield is computed as follows:
Stock
Common
of
Share
per
Price
Market
Stock
Common
of
Share
per
Dividends
Yield
Dividend 

Dividend Yield (2 of 2)
• To illustrate, the dividend yield for Lincoln Company is

Check Up Corner: Profitability Analysis (1 of 3)
The following data were taken from the financial
statements of French Broad Steel Works Inc. for a recent
year:

Based on these data, determine the following profitability
measures:
A. Asset turnover
B. Return on total assets
C. Return on stockholders’ equity
D. Earnings per share
E. Price-earnings ratio
F. Dividend yield

Summary of Analytical Measures (1 of 2)

Summary of Analytical Measures (2 of 2)

Corporate Annual Reports
• In addition to the financial statements and the
accompanying notes, corporate annual reports
normally include the following sections:
– Management discussion and analysis
– Report on internal control
– Report on fairness of the financial statements

Management Discussion and Analysis
(1 of 2)
• Management’s Discussion and Analysis (MD&A) is
required in annual reports filed with the Securities and
Exchange Commission.
• It includes management’s analysis of current operations
and its plans for the future.
• Typical items included in the MD&A are as follows:
– Management’s analysis and explanations of any
significant changes between the current and the prior
years’ financial statements.

Management Discussion and Analysis
(2 of 2)
– Important accounting principles or policies that could
affect interpretation of the financial statements, including
the effect of changes in accounting principles or the
adoption of new accounting principles.
– Management’s assessment of the company’s liquidity
and the availability of capital to the company.
– Significant risk exposures that might affect the company.
– Any “off-balance-sheet” arrangements such as leases
not included in the financial statements.

Report on Internal Control (1 of 2)
• The Sarbanes-Oxley Act of 2002 requires a report on
internal control by management.
– The report states management’s responsibility for
establishing and maintaining internal control.
– In addition, management’s assessment of the
effectiveness of internal controls over financial reporting
is included in the report.

Report on Internal Control (2 of 2)
• Sarbanes-Oxley also requires a public accounting firm
to verify management’s conclusions on internal control.
– Thus, two reports on internal control, one by
management and one by a public accounting firm, are
included in the annual report.

Report on Fairness of the Financial
Statements
• All publicly held corporations are required to have an
independent audit (examination) of their financial statements.
• The Certified Public Accounting (CPA) firm that conducts the
audit renders an opinion, called the Report of Independent
Registered Public Accounting Firm, on the fairness of the
statements.
– An opinion stating that the financial statements present fairly the
financial position, results of operations, and cash flows of the
company is said to be an unmodified opinion, sometimes called a
clean opinion.
– Any report other than an unmodified opinion raises a “red flag” for
financial statement users and requires further investigation as to its
cause.

Appendix 1: Unusual Items on the Income
Statement
• Generally accepted accounting principles require that
unusual items be reported separately on the income
statement.
– This is because such items do not occur frequently and
are typically unrelated to current operations.
• Unusual items on the income statement are classified
as one of the following:
– Affecting the current period income statement
– Affecting a prior period income statement

Appendix 1: Unusual Items Affecting the
Current Period’s Income Statement
• Discontinued operations are an unusual item that affect
the current period’s:
– income statement presentation.
– earnings per share presentation.
• Discontinued operations are reported separately on the
income statement for any period in which they occur.

Appendix 1: Unusual Items Affecting the Current Period’s
Income Statement—Income Statement Presentation
• A company may discontinue a component of its operations
by selling or abandoning the component’s operations.
– If the discontinued component is (1) the result of a strategic
shift and (2) has a major effect on the entity’s operations and
financial results, any gain or loss on discontinued operations
is reported on the income statement as a Gain (or loss) from
discontinued operations.
– A note to the financial statements should describe the
operations sold, including the date operations were
discontinued, and details about the assets, liabilities, income,
and expenses of the discontinued component.

Unusual Items in the Income Statement

Appendix 1: Unusual Items Affecting the Current
Period’s Income Statement—Earnings per Share
• Earnings per common share should be reported
separately for discontinued operations.

Income Statement with Earnings per Share

Appendix 1: Unusual Items Affecting the
Prior Period’s Income Statement
• An unusual item may occur that affects a prior period’s
income statement.
– Two such items are as follows:
1. Errors in applying generally accepted accounting
principles
2. Changes from one generally accepted accounting
principle to another

Appendix 2: Fair Value
• Fair value is the price that would be received for
selling an asset if it were sold today.
– This differs from historical cost, in that the amount
reported on the balance sheet changes each period to
reflect the asset’s fair (current) value at the balance
sheet date.
 The change in an asset’s fair value from one period to the
next is recorded in the financial statements as either:
o a gain or loss on the income statement, or
o an increase or decrease in stockholders’ equity reported as
other comprehensive income.

Appendix 2: Comprehensive Income (1 of 2)
• When a change in an asset’s fair value is not recorded as a gain
or a loss on the income statement, it is recorded as an element of
other comprehensive income.
– These include changes in the fair value of certain investment
securities, foreign currency exposures, and pension assets.
• The elements of other comprehensive income are included in the
computation of comprehensive income, which is defined as all
changes in stockholders’ equity during a period, except those
resulting from dividends and stockholders’ investments.
• Comprehensive income is determined as follows:

Appendix 2: Comprehensive Income (2 of 2)
• Companies must report comprehensive income in the
financial statements either:
– on the income statement, directly below net income, or
– in a separate statement of comprehensive income.

Appendix 2: Reporting Comprehensive
Income on the Income Statement (1 of 2)
• Bart Company purchased investment securities during
the year that had an increase of $2,600 in fair value.
Because of the accounting methods selected by Bart,
this increase in fair value is recorded as an element of
other comprehensive income and is called an
unrealized gain. If Bart elects to report other
comprehensive income on the income statement, the
elements of other comprehensive income are added to
or subtracted from net income at the bottom of the
income statement as follows:

Appendix 2: Reporting Comprehensive
Income on the Income Statement (2 of 2)

Appendix 2: Reporting Comprehensive Income in
the Statement of Comprehensive Income (1 of 2)
• As an alternative to reporting comprehensive income on the
income statement, companies may elect to report
comprehensive income on a separate statement of
comprehensive income.
– This statement should immediately follow the income
statement.

Appendix 2: Reporting Comprehensive Income in
the Statement of Comprehensive Income (2 of 2)

Appendix 2: Reporting Accumulated Other
Comprehensive Income on the Balance Sheet
• The cumulative effect of the elements of other
comprehensive income is reported on the balance sheet as
accumulated other comprehensive income.
– Bart Company’s unrealized gain of $2,600 would be reported
as accumulated other comprehensive income in the
Stockholders’ Equity section of the balance sheet, as follows:

Financial statement analysis warren

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