This document discusses various techniques for analyzing financial statements, including horizontal analysis, vertical analysis, common-size statements, and financial ratios. It covers calculating ratios to measure a company's ability to pay debts, profitability, and stock valuation. The purpose is to identify trends, benchmark performance, and detect potential problems by analyzing changes in key financial metrics over time.

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3. Financial Statement Analysis
Chapter 13
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4. Perform a horizontal analysis of financial
statements
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5. Horizontal Analysis
• Study of percentage changes from year-to-
year
• Two steps:
1. Compute dollar amount of change
2. Divide dollar amount of change by base-period
amount
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6. Exercise 13-16A
Sensible Music Company
Comparative Income Statements
Years Ended December 31, 2010 and 2009
2010 2009 $ Change % Change
Total revenue $852,000 $912,000
Expenses:
Cost of goods sold $402,000 $408,000
Selling & gen’l expense 232,000 261,000
Interest expense 9,200 10,500
Income tax expense 83,000 84,000
Total expenses 726,200 763,500
Net income $125,800 $148,500
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7. Trend Percentages
• Form of horizontal analysis
• Base year selected and set equal to 100%
Any year
Trend %
Base year
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8. Perform a vertical analysis of financial
statements
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9. Vertical Analysis
• Shows relationship of a financial-statement item
to its base
Vertical Each income statement item
analysis %
Total revenue
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10. Prepare common-size financial statements
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11. Common-Size Statements
• Report only vertical analysis percents
• Help in the comparison of different
companies
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12. Benchmarking
• Compares company to a standard set by
others
• Facilitated by common-size statements
• Has goal of improvement
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13. Use the statement of cash flows for decisions
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14. Cash-Flow Signs of Healthy
Company
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15. Compute the standard financial ratios
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16. Ratio Categories
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17. Ability to Pay Current Liabilities
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18. Working Capital & Current Ratio
Working Current Current
capital assets liabilities
Current Current Current
ratio assets liabilities
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19. Acid-Test Ratio
?
?
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20. Ability to Sell Inventory and
Collect Receivables
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21. Inventory Turnover
Cost of goods sold
Average inventory
(Beginning inventory + Ending inventory)/2)
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22. Accounts Receivable Turnover
Net sales
Average net accounts receivable
(Beginning net receivables + Ending net receivables)/2)
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23. Days’-Sales-In-Receivables
Net sales
One day’s
sales
365 days
Average net accounts
Days’ sales in receivable
average accounts
receivable
One day’s sales
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24. Exercise 13-21A
Current Preceding
year year
Balance Sheet:
Cash
Short-term investments
Net receivables
Inventory
Prepaid expenses
Total current assets
Total current liabilities
Income Statement:
Net credit sales
Cost of goods sold
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25. Exercise 13-21A
Current Current Current
ratio assets liabilities
?
? ?
?
?
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26. Exercise 13-21A
Acid- test ratio = ?
Cash + Short-term investments + Net current receivables
Current liabilities
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27. Exercise13-21A
Inventory turnover =
Cost of goods sold ?
Average inventory ?
(Beginning inventory + Ending Inventory)/2)
?
(76,000 +94,000)/2)
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28. Exercise 13-21A
Accounts receivable
?
turnover =
Net sales ?
Average net
?
accounts receivable
(Beginning net receivables +
Ending net receivables)/2) ($73,000 + 50,000)/2
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29. Exercise 13-21A
Days’ Sales in Average Receivables
One day’s Net sales
1. sales
?
?
?
?
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30. Exercise 13-21A
Days’ Sales in Average Receivables
Average net accounts
Days’ sales in
receivable
2. average accounts
receivable
One day’s sales
?
46 days
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31. Measuring Ability to Pay Debts
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32. Debt ratio
Total liabilities
Total assets
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33. Times-Interest-Earned
Income from operations
Interest expense
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34. Measuring Profitability
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35. Rate of Return on Sales
Net income
Net sales
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36. Rate of Return on Total Assets
Net income + Interest expense
Average total assets
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37. Rate of Return on Common Equity
Net income – Preferred dividends
Average common stockholders’
equity
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38. Leverage
• Borrowing at a lower rate than invested
funds earn
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39. Earnings per Share
Net income –Preferred dividends
Average number of common shares
outstanding
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40. Use ratios in decision making
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41. Analyzing Stock Investments
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42. Price/Earnings Ratio
Market price per share of
common stock
Earnings per share
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43. Dividend Yield
Dividend per share of common
stock
Market price per share of
common stock
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44. Book Value
Total stockholders’
Preferred equity
equity
Number of common shares
outstanding
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45. Measure the economic value added by
operations
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46. Economic Value Added (EVA ®)
• Combines accounting and finance data
• Measures if operations have increased
stockholder wealth
▫ Positive EVA® suggests increase in wealth
Net Interest Capital
income expense charge
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47. Cost of Capital
Capital charge =
Current
Notes maturities of
payable long-term
debt Cost
of
capital
Long-term Stockholders’
debt equity
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48. Red Flags in Financial Statement
Analysis
• Earnings problems
• Decreased cash flow
• Too much debt
• Inability to collect receivables
• Buildup of inventories
• Trends of sales, inventory and receivables
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49. Efficient Markets
• Market prices fully reflect all information
▫ Managers cannot fool market with accounting
manipulations
▫ Market sets fair price for stock
• Appropriate investment strategy:
▫ Manage risk
▫ Diversify investments
▫ Minimize transaction costs
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