2. Learning Objectives
After studying this chapter, you should be able to…
Describe basic financial statement analytical methods.
Use financial statement analysis to assess the solvency of a
business.
Use financial statement analysis to assess the profitability of a
business.
Describe the contents of corporate annual reports.
4. Horizontal Analysis
• The percentage analysis of increases and decreases in related
items in comparative financial statements
5. Vertical Analysis
• A percentage analysis used to show the relationship of each
component to the total within a single statement
6. Benefits of Analysis
• Horizontal and vertical analysis are useful in assessing
relationships and trends in financial conditions and operations
of a business
• Vertical analysis is useful for comparing one company with
another or with industry averages
• Both are made easier with common-size financial statements
8. Learning Objective 2
Apply financial statement analysis to
assess the solvency of a business
9. Solvency and Profitability
• Solvency – the ability to meet debt obligations as they
become due
• Profitability – the ability to earn income
Solvency and Profitability are interrelated!
10. Solvency Analysis
• Normally assessed by examining balance sheet relationships,
using the following major analyses:
– Current position analysis
– Accounts receivable analysis
– Inventory analysis
– Ratio of fixed assets to long-term liabilities
– Ratio of liabilities to stockholders’ equity
– Number of times interest charges are earned
11. Current Position Analysis
• Using measures to assess a business’s ability to pay its current
liabilities
– Working capital – current assets less current liabilities
– Current ratio – current assets divided by current liabilities
– Quick ratio – total “quick” assets divided by current
liabilities
13. Current Position Analysis – Quick Ratio
Quick Assets Quick Assets
$280,500 $160,000
Quick Ratio = Quick Assets / Current Liabilities
Lincoln Quick Ratio = $280,500 / $210,000 = 1.3
Jefferson Quick Ratio = $160,000 / $210,000 = .77
14. Accounts Receivable Analysis
• Measures efficiency of collection
• Reflects liquidity
Accounts receivable turnover = Net Sales
Avg. A/R
Days’ Sales in Receivables = Avg. A/R
Net Sales/365
15. Accounts Receivable Turnover
The company increased its accounts receivable turnover by 38% measured
in terms of the number of times receivables are collected within the year.
16. Days’ Sales in Receivables
The company improved its collections of accounts receivable by 10.9 days
in 2009 measured in days receivables have been outstanding.
18. Inventory Turnover
The company turned its inventory 1 time more in 2009, measured in
terms of the number of times inventory turns over within the year.
19. Days’ Sales in Inventory
The company reduced the time it held inventory by nearly 28% in
2009 measured in days the inventory was held in warehouses.
20. Ratio of Fixed Assets to Long-Term Liabilities
• Indicates the margin of safety for note-holders or bondholders
• Indicates the ability to borrow additional funds on a long-term
basis
Fixed Assets (net)
Long-term Liabilities
21. Ratio of Fixed Assets to Long-Term Liabilities
The company increased its margin of safety in financing fixed assets
mainly by lowering long-term debt.
22. Ratio of Liabilities to Stockholders’ Equity
• Indicates the margin of safety for creditors.
• Indicates the ability to withstand adverse business conditions.
Total Liabilities
Total Stockholders’ Equity
23. Ratio of Liabilities to Stockholders’ Equity
The ratio shows an increasing margin of safety for creditors.
24. Number of Times Interest Charges Earned
• Indicates the general financial strength of the business.
• Indicates the ability to withstand adverse business conditions.
Income before Taxes + Interest Expense
Interest Expense
25. Number of Times Interest Charges Earned
The number of times interest charges are earned improved from 12.2 to
28.1, a significant measure of safety for creditors.
26. Learning Objective 3
Apply financial statement analysis to
assess the profitability of a business
27. Profitability Analysis
• Normally assessed by examining the income statement and
balance sheet resources, using the following major analyses:
– Ratio of net sales to assets
– Rate earned on total assets
– Rate earned on stockholders’ equity
– Rate earned on common stockholders’ equity
– Earnings per share on common stock
– Price-earnings ratio
– Dividends per share
– Dividend yield
28. Ratio of Net Sales to Assets
• Shows how effectively a firm utilizes its assets
Net Sales
Avg. Total Assets (excluding LT Investments)
29. Rate Earned on Total Assets
• Measures the profitability of total assets without considering
how the assets are financed.
Interest Expense + Net Income
Avg. Total Assets
30. Rate Earned on Stockholders’ Equity
• Emphasizes the rate of income earned on the amount invested
by the stockholders.
Net Income
Avg. Stockholders’ Equity
31. Leverage
The company’s leverage of 3.1% for 2009 compares favorably with the
2.7% leverage for 2008.
32. Rate Earned on Common Stockholders’ Equity
• Focuses on the rate of profits earned on the amounts
invested by the common stockholders.
Net Income – Preferred Dividends
Avg. Common Stockholders’ Equity
33. Earnings Per Share on Common Stock
• The income earned for each share of common stock.
Net Income – Preferred Dividends
Common Shares Outstanding
34. Price-Earnings Ratio
• Indicator of the firm’s future earnings prospects.
Market Price Per Share of Common Stock
Annual Earnings Per Share
35. Dividends per Share and Earnings per Share
Dividends per Share = Common Dividends
Common Shares
36. Dividends Per Share and Dividend Yield
• Dividend yield shows the rate of return to common
stockholders in terms of cash dividends.
Dividend Yield = Common Dividend/Share
Market Price/Share
38. Corporate Annual Reports
• Summarize operating activities for the past year and plans for
the future.
• Many variations in the order and form, but all include:
– Financial statements and notes
– Management discussion and analysis
– Independent auditors’ report
39. Management Discussion and Analysis (MDA)
• Provides critical information in interpreting the financial
statements and assessing the future of the company.
• Includes an analysis about past performance and financial
condition.
• Discusses management’s opinion about future performance.
• Discusses significant risk exposure.
40. Independent Auditors’ Report
• Publicly traded companies must get an independent opinion on
the fairness of the financial statements.
• This opinion must be included in the annual report along with
an opinion on the accuracy of management’s internal control
assertion.
Horizontal analysis is one of the basic analytical methods for users to analyze the financial statements of a corporation. In horizontal analysis, each item on the most recent financial statement is compared with the related item on one or more earlier statements in terms of: The amount of increase or decrease The percentage of increase or decrease As this exhibit illustrates, horizontal analysis occurs between the current assets at December 31, 2010 and the current assets at December 31, 2009. Overall, total current assets increased $17,000 or 3.2% from 2009 to 2010. Further examination reveals that while cash and temporary assets increased from one year to the next, accounts receivable and inventories decreased over the same time period. Decreases in accounts receivable could be due to improved collection efforts which, in turn, would explain the increase to cash. Decreases to inventories could be caused by increased sales. Further examination would be needed to determine the exact causes.
Another basic analytical method is vertical analysis. Vertical analysis computes a percentage analysis of each component of a financial statement to a total within that same financial statement. Although vertical analysis is applied to a single statement, it is more effective when the percentages are also analyzed for changes over time. In this exhibit, each asset category is stated as a percent of the total assets. Almost 50% of total assets are current assets as of December 31, 2010. To enhance the analysis, the user can see that current assets made up 43% of total assets as of December 31, 2009. This analysis could be expanded further to see the composition of each individual current asset stated as a percentage of total current assets. In addition, for the Liability and Stockholders’ Equity section of the Balance Sheet, each individual liability and equity item is stated as a percent of the total liabilities and stockholders’ equity. In a vertical analysis of an Income Statement, each item is stated as a percentage of sales.
Utilizing both horizontal analysis and vertical analysis can give a user of financial statements a greater insight into the financial performance of an organization. Horizontal analysis is especially useful in identifying trends over time for a business. Trends from the past can be useful as predictors of the future. In addition to looking at vertical analysis over time for one organization, vertical analysis can also be useful in comparing one company to another or comparing the organization to industry averages. When comparing two different companies, the size of the companies could distort the analysis. Both horizontal and vertical analysis can be made easier through the use of common-sized statements.
In a common-sized statement, all items are expressed as percentages with no dollar amounts shown. Common-sized statements are useful in comparing: The current period with prior periods Individual businesses One business with industry percentages In the exhibit shown, while Lincoln and Madison’s gross profit is nearly the same, Lincoln’s net income is nearly 3% less than Madison’s net income. Further analysis shows Lincoln’s operating expenses at 19.7% of total sales while Madison’s operating expenses are 15.6% of total sales. Users of this analysis may want to investigate why Lincoln has a higher operating expense ratio than Madison. Or, it may be a conscious decision on the part of Lincoln- perhaps a new advertising campaign to generate greater sales in the next year.
All users of financial statements are interested in a company’s ability to both pay their debts as they come due and earn income. Solvency measures an organization’s ability to meet obligations as they come due. Profitability measures an organization’s ability to earn income. Solvency and profitability are interrelated. A company that can not pay its bills can not obtain additional credit. Without additional credit, it is more difficult to grow a business in order to generate future sales and profits.
Solvency analysis focuses on the ability of a company to pay its liabilities. Some ratios measure this ability for the short-term. Other ratios measure an organization’s financial structure and its impact on long-term solvency. Current position analysis, accounts receivable analysis and inventory analysis focus more on the short-term debt paying ability of an organization. The ratio of fixed assets to long-term liabilities , the ratio of liabilities to stockholders’ equity, and the number of times interest charges are earned are longer term measures of solvency. The common understanding is that if a company is carrying a significant amount of debt, it may spell trouble in the future. For example, if a company has a bad year, they still must pay their debts even if the company is not profitable.
A company’s ability to pay its current liabilities is called current position analysis. This analysis is of special interest to creditors and include the computation and analysis of: Working capital Current ratio Quick ratio
Current position analysis starts with a computation of an organization’s working capital. Working capital is computed by subtracting the current liabilities of and organization from the current assets. In the example presented, Lincoln Company’s working capital is: 2010: $340,000 (working capital) = $550,000 (current assets) - $210,000 (current liabilities) 2009: $290,000 (working capital) = $533,000 (current assets) - $243,000 (current liabilities) The greater the difference between current assets and current liabilities, the higher the working capital and ability to pay current liabilities as they come due. However, working capital is difficult to use when evaluating companies of different sizes. The current ratio, sometimes called the working capital ratio, states working capital as a proportion and is a more effective measure of a company’s ability to pay current liabilities. The current ratio divides current assets by the current liabilities. In the example given, for 2010, what this means is that for every dollar of current liability owed by Lincoln, there is $2.60 of current assets available to pay the current liability as it comes due.
One limitation of working capital and the current ratio is they do not consider the overall makeup of current assets. Because of this, two companies that have the exact same working capital and current ratios may have significant differences in their ability to pay current liabilities as they come due. In this illustration, both Lincoln and Jefferson have working capital of $340,000 and a current ratio of 2.6:1. Upon further analysis, Jefferson is carrying much more of their current assets in inventories. These inventories must be sold, then collected in cash before current liabilities could be paid. This takes time. In contrast, Lincoln’s current assets contain more cash, temporary investments, and accounts receivable, which can normally be converted to cash more easily. The quick ratio measures the “instant” debt paying ability. An organizations “quick assets” are divided by current liabilities to determine the quick ratio. Quick assets normally include cash, temporary assets, and accounts receivable. Analyzing the quick ratio of Lincoln and Jefferson reveals the following: Lincoln Quick Ratio = $280,500 of quick assets / $210,000 current liabilities = 1.3 Jefferson Quick Ratio = $160,000 of quick assets / $210,000 current liabilities = .77 Jefferson is in a much more precarious situation for short-term solvency than Lincoln.
A company’s ability to collect its accounts receivable has a direct impact on their ability to pay current liabilities as they are due. Accounts receivable analysis measures a company’s ability to turn their accounts receivable into cash in a timely manner. The analysis is made up of the accounts receivable turnover and the days’ sales in receivables measures.
Accounts receivable turnover is measured by dividing net sales for a year by the average accounts receivable balance during the year. Average accounts receivable is calculated by taking the accounts receivable balance at the beginning of the year and the end of the year, adding them together and dividing by zero to arrive at an average. In the example given, the accounts receivable turnover is 12.7 times in 2010 and 9.2 times in 2009. The accounts receivable turnover indicates how many times receivables are “turned over” or collected each period, on average. This turnover is an indicator of the efficiency of a company with which the company collects the receivables and ultimately converts them back to cash. The higher the turnover, the better because it means less of the company’s assets are tied up in receivables. The improvement shown from 2009 to 2010 may be the result of how credit is granted, collection practices, or both.
The accounts receivable turnover ratio is often divided into the number of days in a business year to show the average collection period in days. This measure is called Days’ Sales in Receivables and is computed by calculating average daily sales and taking that amount and dividing it into the average accounts receivable calculated in the accounts receivable turnover. In this illustration, the average days to collect a receivable has fallen from 39.5 days in 2009 to 28.6 days in 2010. This would be expected since the turnover ratio also improved. On average, this organization is collecting receivables in less than 30 days in 2010. The number of days sales in receivables is often compared to a company’s credit terms to evaluate collection practices and performance.
A company’s ability to manage its inventory also has an impact on their ability to pay current liabilities as they are due. Inventory analysis measures a company’s ability to turn their inventory into sales and then, ultimately, cash in a timely manner. The analysis is made up of the inventory turnover and the number of days’ sales in inventory. A company with a higher turnover is generally considered more efficient and minimizes the chance of being stuck with obsolete inventory. In addition, excess inventory increases insurance expenses, property taxes, storage costs, and other related expenses. These expenses also reduce funds that could be used elsewhere to improve or expand operations. However, too high a turnover may indicate lost sales as a result of insufficient inventory in stock.
Inventory turnover is measured by dividing cost of goods sold for a year by the average inventory balance during the year. Average inventory is calculated by taking the inventory balance at the beginning of the year and the end of the year, adding them together and dividing by zero to arrive at an average. In the example given, the inventory turnover is 3.8 times in 2010 and 2.8 times in 2009. The inventory turnover indicates how many times the inventory is “turned over” or sold each period, on average. The higher the turnover, the better because it means less investment in inventories, the company is more effective in converting inventory into sales, and the total time to sell inventory and collect the cash on the sales is smaller. The improvement shown from 2009 to 2010 indicates that the management of inventory has improved in 2010.
The number of days sales in inventory divides the average inventory balance by the average daily cost of goods sold. The average daily cost of goods sold is computed by dividing total cost of goods sold for a year by the number of days in the year. The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory. Care should be taken when looking at days’ sales in inventory; seasonal factors could distort the calculation.
The ratio of fixed assets to long-term liabilities is a long-term measure of solvency as it provides a measure of whether noteholders or bondholders will be paid. The ratio is computed by simply dividing the net fixed assets by long-term liabilities. Since fixed assets are often pledged as security for long-term notes and bonds, the ratio indicates a margin of safety for creditors. Investors in long-term bonds and other creditors usually consider a company with a significant debt load relatively more unstable and a more risky investment.
In this illustration, the ratio of fixed assets to long-term liabilities improved from 2.4 in 2009 to 4.4 in 2010. This ratio means that, in 2010, there is $4.40 of long-term assets for every dollar of long-term liability. Improving from 2009 means creditors now have a greater margin of safety with regards to repayment. Since the fixed assets actually decreased from 2009 to 2010, the decrease in liabilities is what triggered the improvement in the ratio. Paying off half of the long-term liabilities improved this ratio.
The ratio of total liabilities to stockholders’ equity is a measurement similar to the long-term assets to long-term liability ratio. This ratio is a another measure of long-term solvency of a company as it measures the proportion of a company financed by debt and equity. The ratio is computed by dividing total liabilities by total stockholders’ equity. The higher the ratio, the more debt a company has in its capital structure.
The ratio of debt to equity decreased from .6 in 2009 to .4 in 2010. This is an improvement because it indicates less of the company’s capital structure is from debt. High debt to equity ratios are dangerous to long-term solvency because of the interest expense which is due on the debt.
The number of times interest charges are earned, sometimes called the fixed charge coverage ratio or interest coverage ratio, measures the risk that interest payments will not be made if earnings decrease. It is another indicator of long-term solvency and a measure of safety of creditors’ investment in the company. As a general rule, the higher the ratio the better able the company to meet its annual interest obligations. It is computed by dividing the income before taxes plus interest expense by the interest expense.
In this illustration, two factors made a significant impact on the calculation of times interest charges earned. First, income before tax improved from 2009 to 2010. Increased earnings provides a greater measure of safety for creditors that their interest will be paid. The other factor is the decrease in interest expense. This is result of decreasing liabilities.
Profitability ratios serve as indicators of how effective a company has been in meeting the profit objectives of its owners (stockholders). Profitability analysis focuses on the ability of a company to earn profits, especially relative to resources invested. The ability to earn profits is reflected in the company’s income statement. The resources invested to earn profits are reflected on a company’s balance sheet. Therefore, both the income statement and balance sheet are often used in evaluating profitability.
The ratio of net sales to assets measure how effectively a firm utilizes its assets to generate sales. It is computed by dividing net sales by average total assets (excluding long-term investments). Long-term investments are excluded from the calculation because they are unrelated to normal operations and net sales. Average total assets is computed by using total assets (excluding the long-term investments) at the beginning and end of the year, adding them together and dividing by 2. In this illustration, the ratio improved from 1.2 to 1.4 from 2009 to 2010. This is mainly due to the increase in net sales. The measure can be interpreted that for every dollar of asset, $1.40 of sales is generated.
The rate earned on total assets measures the profitability of total assets, with consideration as to how the assets are financed. The rate earned on total assets is computed by adding interest expense back to net income. By adding interest expense back to net income, the effect of how the assets are financed (by creditors or by stockholders) is eliminated. Average total assets includes long-term investments because net income would include any income earned from these investments. In this illustration, this ratio improved to 8.2% in 2010 from 7.3% in 2009. While this is an improvement, the ratio should also be measured against any earning targets set internally by the company. It would also be a good idea to compare this rate with industry averages.
Net income is divided by average stockholders’ equity to arrive at the rate earned (or return) on stockholders’ equity. This ratio measures net income relative to the amount invested by stockholders in a company, including retained earnings. Investors and financial analysts used the return on equity to compare performance of varying companies. The rate improved to 11.3% in 2010 over 10.0 in 2009. The improvement could be the result of a company using leverage to improve performance.
Leverage involves using debt to increase the return on stockholders’ equity. When the rate on stockholders’ equity exceeds the rate on total assets, a firm is said to have positive leverage. Financial leverage is defined as total assets divided by total stockholders’ equity. Leverage is also calculated as the difference between the return on stockholders’ equity and the return on assets. In 2010, the rate earned on stockholders’ equity was 11.3% versus a rate earned on total assets of 8.2%. This creates positive leverage of 3.1%. For 2009, leverage was 2.7%. This indicates the company is using debt more effectively in 2010 to increase return on stockholders’ equity.
The rate earned on common stockholders’ equity measures the rate of profits earned on the amount invested only by common stockholders. This measure will be different from the rate earned on stockholders’ equity if the company has preferred stock. Because preferred stockholders’ rank ahead of common stockholders in their claim on earnings, preferred dividends are subtracted from net income in computing the rate earned on common stockholders’ equity.
Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock. Generally accepted accounting principles require the reporting of EPS on the income statement. EPS figures are also reported in the financial press and followed closely by investors. In general, earnings per share is computed by dividing net income by the average number of shares of common stock outstanding during a fiscal period. When preferred and common stock are outstanding, preferred dividends are subtracted from net income to determine income related to common shares. In this illustration, a share of common stock earned more in 2010 than it did in 2009. Since the common stock outstanding remained the same between the two years, the increase was due solely to improved earnings. Trends in EPS are important because EPS is considered to be the best measure that summarizes the performance of a company, particularly for common shareholders. The amount of earnings per share, the change in earnings per share from the previous period, and the trend in earnings per share are all important indicators of the success or failure of a company.
The price to earnings ratio (P/E) measures a company’s future earnings prospects. It is another measure quoted and closely followed by the financial press and investors. The calculation of the P/E ratio is simply dividing the market price per share of common stock by the EPS on a common share. In this illustration, the P/E ratio has increased from 20 to 25. At the end of 2010, this means the stock was selling at 25 times the earnings per share. This is a good thing as it indicates the market expects favorable earnings in the future!
Dividends per share measure the extent to which earnings are being distributed to common shareholders. It is computed by dividing total common dividends paid by the number of common stock shares outstanding. Dividends per share are often compared to earnings per share. Comparing the two per-share amounts indicates the extent to which earnings are being retained in the operations for use in operations.
The dividend yield on common stock measure the rate of return to common stockholders from cash dividends. This measurement is of special interest to investors when the investors’ objective is to earn revenue (dividends) from their investment. Dividend yield is computed by dividing the dividend per share of common stock by the market price per share. The dividend yield in this illustration decreased because the stock price rose more than the dividend.
Public corporations issue annual reports summarizing their operating activities for the past year and plans for the future. Generally accepted accounting principles require companies to include information in addition to their financial statements in the annual report. This information includes management’s discussion and analysis for the company’s business activities and disclosures about methods used in determining accounting information.
Management’s Discussion and Analysis (MDA) 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. The MDA also explains important events and changes in performance during the years presented in the financial statements. Typical issues in the MDA include comparison of operating results, liquidity and cash flow measures, major business risks, financial risks and changes in accounting methods.
All publicly held corporations are required to have a independent audit of their financial 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 unqualified or clean opinion. Any report other than an unqualified report raises a “red flag” for financial statement users. However, in light of the many accounting scandals that have rocked the financial world over the past years, an unqualified opinion is not always a clean bill of health for an organization. A stakeholder must exercise due diligence in their evaluation of the organization.
