Chapter 13 – Financial Statement Analysis

Precautions in Statement Analysis

Watch for Alternative Accounting Principles
• Every set of financial statements is based on various assumptions.
• Analysts or other users find this information in the financial statement notes.
• The selection of a particular inventory valuation method has a significant effect on certain key
ratios.
• Recognition of the acceptable alternatives is especially important in comparing two or more
companies.

Take Care When Making Comparisons

• No single ratio is capable of telling the user everything there is to know about a particular
company.
• The potential investor also must recognize the need to compare one company with others in the
same industry.
• Comparison with an industry standard, however, might indicate that the ratio is normal for
companies in that industry.
• Although industry comparisons are useful, caution is necessary in interpreting the results of such
analyses.
• Conglomerates, companies operating in more than one industry, present a special challenge to
the analyst.
• Many corporate income statements contain nonoperating items such as extraordinary items and
gains and losses from discontinued operations. When these items exist, the reader must exercise
extra caution in making comparisons.

Understand the Possible Effects of Inflation

• Inflation, or an increase in the level of prices, is another important consideration in analyzing
financial statements.
• The statements, to be used by outsiders, are based on historical costs and are not adjusted for the
effects of increasing prices.

Analysis of Comparative Statements: Horizontal Analysis

• Horizontal analysis: a comparison of financial statement items over a period of time.
• In horizontal analysis, read right to left to compare one year’s results with the next as a dollar
amount of change and as a percentage of change from year to year.
• Companies that experience sales growth often become lax about controlling expenses.
• Business owners must address these concerns if they want to get a reasonable return on their
investment.
• Horizontal analysis can be extended to include more than two years of results.
• Tracking items over a series of years, a practice called trend analysis, can be a very powerful tool
for the analyst.
Analysis of Common-Size Statements: Vertical Analysis
• Vertical analysis: a comparison of various financial statement items within a single period with the
use of common-size statements.
• Common-size statements recast all items on the statement as a percentage of a selected item on
the statement. This excludes size as a relevant variable in the analysis.
• Compare percentages across years to spot year-to-year trends.
• In vertical analysis, compare each line item as a percentage of total (100%) to highlight a
company's overall condition.
• All asset accounts are stated as a percentage of total assets. Similarly, all liability and stockholders’
equity accounts are stated as a percentage of total liabilities and stockholders’ equity.
• The base/benchmark, on which all other items in the income statement are compared is net sales.
• Gross profit as a percentage of sales is the gross profit ratio.
• The ratio of net income to net sales is the profit margin ratio (an overall indicator of management’s
ability to control expenses).

Liquidity Analysis and the Management of Working Capital

• The ratios are classified in three main categories according to their use in performing (1) liquidity
analysis, (2) solvency analysis, and (3) profitability analysis.
• Liquidity: the nearness to cash of the assets and liabilities.
• Nearness to cash deals with the length of time before cash is realized.
• The nearness to cash of the current assets is indicated by their placement on the balance sheet.
Current assets are listed on the balance sheet in descending order of their nearness to cash.

Working Capital
• Working capital is the excess of current assets over current liabilities at a point in time.
Working Capital = Current Assets – Current Liabilities
• The management of working capital is an extremely important task for any business.
• Working capital is limited in its informational value. It reveals nothing about the composition of
the current accounts.

Current Ratio
Current Assets
Current Ratio =
Current Liabilities
• Some analysts use a general rule of thumb of 2 to 1 for the current ratio as a sign of short-term
financial health.
• Interpreting the current ratio also involves the composition of the current assets.

Acid-Test Ratio
• The acid-test or quick ratio is a stricter test of a company’s ability to pay its current debts as they
are due (still not a perfect measure as compared to current ratio).
• It is intended to deal with the composition problem because it excludes inventories and prepaid
assets from the numerator of the fraction.
Quick Assets
Acid-Test or Quick Ratio =
Current Liabilities
Quick Assets = Cash + Marketable Securities + Current Receivables
• For many companies, an acid-test ratio below 1 is not desirable because it may signal the need to
liquidate marketable securities to pay bills, regardless of the current trading price of the securities.
Cash Flow from Operations to Current Liabilities
• Cash flow from operating activities, as reported on the statement of cash flows, can be used to
indicate the flow of cash during the year to cover the debts due.
• Cash flow from operations to current liabilities ratio: a measure of the ability to pay current debts
from operating cash flows.
Net Cash Provided by Operating Activities
Cash Flow from Operations to Current Liabilities Ratio =
Average Current Liabilities

Accounts Receivable Analysis

• A company must be willing to extend credit terms that are liberal enough to attract and maintain
customers, but at the same time, management must continually monitor the accounts to ensure
collection on a timely basis.
• One measure of the efficiency of the collection process is the accounts receivable turnover ratio
– a measure of the number of times accounts receivable are collected in a period:
Net Credit Sales
Accounts receivable turnover ratio =
Average Accounts Receivable
• Another way to measure efficiency in the collection process is to calculate the number of days’
sales in receivables – a measure of the average age of accounts receivable:
Number of Days in the Period
Number of days’ sales in receivables =
Accounts Receivable Turnover
Inventory Analysis
• A similar set of ratios can be calculated to analyze the efficiency in managing inventory.
• Inventory turnover ratio: a measure of the number of times inventory is sold during a period.
Cost of Goods Sold
Inventory Turnover Ratio =
Average Inventory
• The number of “turns” each year varies widely for different industries.
• The number of days’ sales in inventory is an alternative measure of the company’s efficiency in
managing inventory; it’s a measure of how long it takes to sell inventory:
Number of Days in the Period
Number of Days’ Sales in Inventory =
Inventory Turnover
• This measure can reveal a great deal about inventory management. An unusually low turnover
may signal a large amount of obsolete inventory or problems in the sales department, or it may
indicate that the company is pricing its products too high and the market is reacting by reducing
demand for the company’s products.

Cash Operating Cycle

• Cash-to-cash operating cycle: the length of time from the purchase of inventory to the collection
of any receivable from the sale.
Cash-to-Cash Operating Cycle = Number of Days’ Sales in Inventory + Number of Days’ Sales in
Receivables

Solvency Analysis
• Solvency: the ability of a company to remain in business over the long term.
• Solvency concerns the ability of the firm to stay financially healthy over the period of time that
existing debt (short- and long-term) is outstanding.
• Capital structure is the focal point in solvency analysis.
Debt-to-Equity Ratio
Total Liabilities
Debt-to-Equity Ratio =
Total Stockholder's Equity

• The objective of the measure is to determine the degree to which the company relies on outsiders
for funds.
• You should not assume that a lower debt-to-equity ratio is better – it depends on the company,
the industry, and many other factors.

Times Interest Earned

• Times interest earned ratio: an income statement measure of the ability of a company to meet its
interest payments.
Net Income + Interest Expense + Income Tax Expense
Times Interest Earned Ratio =
Interest Expense
• Both interest expense and income tax expense are added back to net income in the numerator
because interest is a deduction in arriving at the amount of income subject to tax.

Debt Service Coverage

• Debt service coverage ratio: a statement of cash flows measure of the ability of a company to meet
its interest and principal payments.
• It is a measure of the amount of cash that is generated from operating activities during the year
and that is available to repay interest due and any maturing principal amounts.
Cash Flow from Operations Before Interest and Tax Payments
Debt Service Coverage Ratio =
Interest and Principal Payments
• Some analysts use an alternative measure in the numerator of this ratio called EBITDA.

Cash Flow from Operations to Capital Expenditures Ratio

• Cash flow from operations to capital expenditures ratio: a measure of the ability of a company to
finance long-term asset acquisitions with cash from operations.
• Cash Flow from Operations to Capital Expenditures Ratio =
Cash Flow from Operations - Total Dividends Paid
Cash Paid for Acquisitions
• The numerator of the ratio measures the cash flow after all dividend payments are met.

Profitability Analysis
• Creditors are concerned with a company’s profitability because a profitable company is more likely
to be able to make principal and interest payments.
• Stockholders care about a company’s profitability because it affects the market price of the stock
and the ability of the company to pay dividends.
• Profitability: how well management is using company resources to earn a return on the funds
invested by various groups.

Rate of Return on Assets

• Every return ratio is a measure of the relationship between the income earned by the company
and the investment made in the company by various groups.
• Return on assets ratio: a measure of a company’s success in earning a return for all providers of
capital.
• The broadest rate of return ratio is the return on assets ratio because it considers the investment
made by all providers of capital, from short-term creditors to bondholders to stockholders.
• The denominator, or base, for the return on assets ratio is average total liabilities and
stockholders’ equity—which, of course, is the same as average total assets.
• The numerator of a return ratio will be some measure of the company’s income for the period.
• The income selected for the numerator must match the investment or base in the denominator.
• The income number used in the rate of return on assets is income after interest expense is added
back.
Net Income + Interest Expense (net of tax)
Return on Assets Ratio =
Average Total Assets

Components of Return on Assets

• Return on sales ratio: variation of the profit margin ratio; measures earnings before payments to
creditors.
Net Income + Interest Expense (net of tax)
Return on Sales Ratio =
Net Sales
• Asset turnover ratio: the relationship between net sales and average total assets.
Net Sales
Asset Turnover Ratio =
Average Total Assets
• Return on Assets = Return on Sales × Asset Turnover

Return on Common Stockholder’s Equity

• The appropriate income figure for the numerator is net income less preferred dividends because
we are interested in the return to the common stockholder after all claims have been settled.
• Income taxes and interest expense have already been deducted in arriving at net income, but
preferred dividends have not been because dividends are a distribution of profits, not an expense.
• Return on common stockholders’ equity ratio: a measure of a company’s success in earning a
return for the common stockholders.
Net Income - Preferred Dividends
Return on Common Stockholders’ Equity Ratio =
Average Common Stockholder's Equity

Return on Assets, Return on Equity, and Leverage

• Leverage: the use of borrowed funds and amounts contributed by preferred stockholders to earn
an overall return higher than the cost of these funds.
• It is necessary for comparative purposes to convert the average cost of borrowed funds to an
after-tax basis.
• If ROA and ROE are higher than the after-tax cost of borrowing money, then the company is doing
well with regards to leverage.

Earnings per Share

• Earnings per share (EPS): a company’s bottom line stated on a per-share basis.
Net Income - Preferred Dividends
Earnings per Share =
Weighted Average Number of Common Shares Outstanding
Price/Earnings Ratio
• Price/earnings (P/E) ratio: the relationship between a company’s performance according to the
income statement and its performance in the stock market.
Current Market Price
Price/Earnings Ratio =
Earnings per Share
• Because earnings are based on the most recent evaluation of the company for accounting
purposes, it seems logical to use current market price, which is based on the stock market’s current
assessment of the company.
• The P/E ratio compares the stock market’s assessment of a company’s performance with the
company’s success as reflected on the income statement.
• A relatively high P/E ratio may indicate that a stock is overpriced by the market; a P/E ratio that is
relatively low could indicate that a stock is underpriced.
• The P/E ratio is often thought to indicate the “quality” of a company’s earnings.

Dividend Ratios
• Dividend payout ratio: the percentage of earnings paid out as dividends.
Common Dividends per Share
Dividend Payout Ratio =
Earnings per Share
• Dividend yield ratio: the relationship between dividends and the market price of a company’s
stock.
Common Dividends per Share
Dividend Yield Ratio =
Market Price per Share
• The dividend yield is very important to investors who depend on dividend checks to pay their living
expenses.