Chapter 13: Financial Statement Analysis 1

Earnings Persistence:
 An important role for accounting information is to predict future cash flows used in
valuation studies
 An important determinant of earning’s ability to predict future cash flows is the
persistence of earnings
 Persistent earnings are earnings that are expected to continue into the future
 Transitory earnings are single-period events
Multi-Step Income Statement:
 The multi-step income statement is organized to present earnings information that
separates items according to persistence, with more persistent items appearing higher in
the statement
Transitionary Items:
 Discontinued operations are reported separately when a company sells, abandons, or
otherwise disposes of a segment of its operations
o The income or loss from the segment’s operation for the portion of the year before
its discontinuance
o Any gain or loss from the disposal of the segment
 Extraordinary items are transactions that are both unusual in nature and occur
infrequently
o Unusual means that it is highly abnormal and significantly different from a
company’s typical activities
Changes in Accounting Principles:
 Companies are allowed to change accounting principles from one generally accepted
method to another generally accepted method as long as the change can be shown to
better reflect financial results
 In order to enhance analysis, companies are required to restate prior financial statements
as if the new method had been in use
Comprehensive Income:
 Includes items that generate wealth for the company, but are not allowed by GAAP to
appear on the income statement.
 Includes:
o Net income from the income statement
o Changes in market value of certain marketable securities
o Unrealized gains and losses from translating foreign currencies when
consolidating financial statements
 Comprehensive income can be reported by appending to the income statement, as a
separate statement, or as part of the statement of stockholders’ equity.
Financial Statement Analysis:
 To determine the financial performance of a company, we compare its performance in the
following ways:
o From year to year
o With a competing company
o With the same industry as a whole
 Investors and creditors cannot evaluate a company by examining only one year’s data,
and that is why most financial statements cover at least two periods
 In fact, most financial analyses cover trends over three to five years
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 These tools can be used by small business owners to measure performance, by financial
analysts to analyze stock investments, by auditors to obtain an overall sense of a
company’s financial health, by creditors to determine credit risk, or by any other person
wanting to compare financial data in relevant terms
Corporate Financial Reports:
 An annual report provides information about a company’s financial condition.
o Management’s discussion and analysis of financial conditions and results of
operations (MD&A)
o Report of the independent auditors
o Financial statements
o Notes to financial statements
Comparative Financial Statements:
 Compare two or more years
 Often compare both dollar changes and percentage changes between years
 Care must be taken when comparing percentages
o Small numbers in the denominator
o Negative values
Analytical Techniques:
 Simply knowing the dollar level of financial statement items is insufficient without more
information.
 Techniques that can aid in analysis include:
o Horizontal (trend) analysis
o Vertical (common-size) analysis
o Ratio analysis
The three main ways to analyze financial statements are horizontal analysis, vertical analysis,
and ratio analysis
Horizontal Analysis:
 The study of percentages from year to year
 Two steps to compute:
o Compute dollar amount of change from one period to the next
o Divide the dollar amount of change by the base-period amount
How do we use Horizontal Analysis to analyze a business?
Many decisions hinge on whether the numbers are increasing or decreasing
 Sales may have increased, but considered in isolation, this fact is not very helpful
 Horizontal analysis is the study of percentage changes in line items from comparative
financial statements
Trend Analysis:
 Form of horizontal analysis
 Indicate the direction a business is taking
 Select a base year and set it equal to 100%
 Amount of each following year stated as a percentage of the base amount
 Trend % = (Any year $/Base year $) * 100
Vertical analysis:
 Shows the relationship of financial statement item to its base
 All items reported as a percentage of the base
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 Income statement usually use net revenue as base

 Vertical Analysis % = Each income statement item /Net Sales(Revenue)
 Balance sheet usually use total assets as base
Common-Size Financial Statements:
 The relative importance of various accounts for a single year can be highlighted by
showing them as a percentage of a key statement figure
 To compare one company to another company, we can use a common-size statement
 A common-size statement reports only percentages
 By reporting only percentages, it removes the dollar value bias we see when comparing
numbers in absolute terms (dollars)
 Assists in comparison of different companies using a common denominator
 Common-size statements also aid in the analysis of different firms, especially when they
differ in size
Benchmarking:
 Benchmarking is the practice of comparing a company with other leading companies
 There are two main types of benchmarking:
o Benchmarking against a key competitor
o Benchmarking against the industry average
 Compares a company to some standard set by others
 Goal is improvement
 Convert companies’ financials to common size for easy, more meaningful comparisons
Analyze the Statement of Cash Flows:
 Can also perform horizontal analysis on statement of cash flows
 Ability to generate cash from operations is sign of healthy company
 Increased spending on plant assets indicates a growing/healthy company
 Shortage of cash can throw a company into bankruptcy
In summary, cash flow signs of a healthy company include:
 Net cash flow provided by operating activities exceeds net income
 Operations are the major source of cash
 Investing activities include more purchases than sales of long-term assets
 Financing activities are not dominated by borrowing
How do we use Ratios to analyze a business?
 Different ratios explain different aspects of a company.
 Ratios are used for the following purposes:
o Evaluating the ability to pay current liabilities and long-term debt
o Evaluating the ability to sell merchandise inventory and collect receivables
o Evaluating profitability
o Evaluating stock as an investment
Ratio Classifications:
 Measuring the ability to pay current liabilities
 Measuring turnover and cash conversion cycle
 Measuring leverage: overall ability to pay debts
 Measuring profitability
 Analyzing stock as an investment
Chapter 13: Financial Statement Analysis 4

Use Ratios to Make Business Decisions:

 Compare ratios to:
o Industry averages
o Prior year ratios
o Competitors’ ratios
Measuring Ability to Pay Current Liabilities
 Working Capital
 Current Ratio
 Quick (Acid-test) Ratio
Working Capital:
 Measures ability to pay current liabilities with current assets
 In general, the larger the better ability to pay debts
 Working Capital = Current Assets – Current Liabilities
Current Ratio:
 Measures ability to pay current liabilities with current assets
 In general, a higher current ratio indicates a stronger financial position
 Current Ratio = Current Assets/Current Liabilities
Quick (Acid-Test) Ratio:
 Tells whether the entity could pay all current liabilities if they came due immediately
 Uses narrower base than current ratio
 Rate of .90 to 1.00 is acceptable in most industries
 Quick Ratio = (Cash and Cash Equivalents + Short-term Investments + Net Current
Receivables)/Current Liabilities
Measuring Turnover and the Cash Conversion Cycle:
 Inventory Turnover
 Accounts Receivable Turnover
 Days’ Sales Outstanding
 Accounts Payable Turnover
 Cash Conversion Cycle
Inventory Turnover:
 Measures number of times a company sells its average level of inventory during a year
 Varies widely by industry
 Compare to prior years and industry averages
 Inventory Turnover = Cost of Goods Sold/Average Inventory
Days’ Inventory Outstanding:
 Converts inventory turnover ratio into days
 Day’s Inventory Outstanding = (365or 360)/Inventory Turnover
Accounts Receivable Turnover:
 Measures ability to collect cash from credit customers
 In general, the higher the better
 Tells how many times during the year average receivables were turned into cash
 Accounts Receivable Turnover = Net Credit Sales/Average Net Account Receivable
Days’ Sales Outstanding:
 How many days’ sales remain in accounts receivable
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 Can be calculated two ways:

o Days’ sales outstanding = (365 or 360)/ Accounts Receivable Turnover
OR
o Average daily sales = Net Sales/(365 or 360)
o Convert Average Daily Sales = Average Net Accounts Receivable/Average Daily
Sales
Accounts Payable Turnover:
 Measures number of times per year the entity pays off its accounts payable
 Accounts Payable Turnover = Cost of goods sold/Average Accounts Payable
Days’ Payable Outstanding:
 How many days it takes a company to pay off accounts payable
 Days’ payable outstanding = (365 or 360) / Accounts Payable Turnover
Cash Conversion Cycle:
 Shows overall liquidity
 Computes total days it takes to convert inventory to receivables and back to cash, less the
days to pay off suppliers
 Cash Conversion Cycle = Days’ Inventory Outstanding + Day’s Sales Outstanding +
Day’s Payable Outstanding
Measuring Leverage: Overall Ability to Pay Debts
 Debt Ratio
 Times-Interest-Earned
Debt Ratio:
 Expresses the relationship between total liabilities and total assets
 Ratio of 1 indicates that debt financed all assets – higher ratio = greater pressure to pay
interest and principal
 Debt Ratio = Total Liabilities / Total Assets
Times-Interest-Earned Ratio:
 Measures number of times operating income can cover interest expense
 Higher ratio indicates ease in paying interest
 Low ratio indicates difficulty in paying interest
 Times-Interest-Earned Ratio = Income From Operations/Interest Expense
Measuring Profitability:
 Gross (Profit) Margin Percentage
 Operating Income (Profit) Percentage
 DuPont Analysis
 Rate of Return on Sales
 Asset Turnover
 Rate of Return on Total Assets (ROA)
 Leverage Ratio
 Rate of Return on Common Stockholders’ Equity
 Earnings per Share of Common Stock
Gross (Profit) Margin Percentage:
 Amount of profit entity makes from merely selling its products, before other operating
costs are subtracted
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 Gross Margin % = Gross Margin/Net Sales

Operating Income (Profit) Percentage:
 Measures percentage of profit earned from sales dollar in a company’s core business
operations
 Operating Income % = Operating Income/Net Sales
Rate of Return (Net Profit Margin) on Sales
 Shows percentage of each sales dollar earned as net income
 Higher percentage, more profit being generated by sales dollars
 Rate of Return on sales (Net Profit Margin) =
(Net Income – Preferred Dividends)/Net Sales
Asset Turnover:
 Measures amount of net sales generated per dollar invested in assets
 Measures how efficiently management is operating the company
 Asset Turnover Ratio = Net Sales/Average Total Assets
Rate of Return on Total Assets (ROA):
 Measures how profitably the company uses its assets
 Return on Assets = Rate of return on Sales * Asset Turnover Ratio
Leverage (Equity Multiplier) Ratio:
 Measures impact of debt financing on profitability
 Shows proportion of each dollar of assets financed with stockholders’ equity
 Leverage Ratio = Average Total Assets / Average Common Stockholder’s equity
Rate of Return on Common Stockholders’ Equity:
 Shows relationship between net income and common stockholders’ investment in the
company – how much is earned for each $1 invested
 When a company has a higher rate of return on stockholders’ equity than its rate of return
on total assets, this is called trading on the equity
 Trading on the equity is earning more income on borrowed money than the related
interest expense, thereby increasing the earnings for the owners of the business
 Rate of return on common SE = (Net Income – Preferred Dividends)/Average Common
Stockholders’ Equity
Earnings per Share (EPS) of Common Stock:
 Amount of net income earned for each share of outstanding common stock
 Most widely used ratio
 Appears on the income statement
 Earnings Per Share of Common Stock (EPS) =
(Net Income – Preferred Dividends)/Average number of Common Stock
Outstanding
Evaluating Stock as an Investment:
 Investors purchase stock to earn a return on their investment.
 This return consists of two parts:
o Gains (or losses) from selling the stock at a price above (or below) purchase price
o Dividends
Analyzing Stock Investments:
 Price-Earnings Ratio (Multiple)
 Dividend Yield
Chapter 13: Financial Statement Analysis 7

 Book Value per Share of Common Stock

Price-Earnings Ratio (Multiple):
 Shows market price of $1 of earnings
 Appears in the Wall Street Journal stock listings
 Abbreviated P/E
 P/E ratio = Market price per share of common stock/Earnings Per Share
Dividend Yield:
 Measures percentage of a stock’s market value returned annually to stockholders as
dividends
 Dividend yield on common stock = Dividend per share of common stock/Market price
per share of common stock
Book Value per Share of Common Stock:
 Indicates recorded accounting amount for each share of common stock
 Book value per share of common stock = (Total stockholders’ equity – Preferred Equity)/
Number of shares of common stock outstanding
The Limitations of Ratio Analysis:
 Can indicate something is wrong, but not pinpoint what the problem is
 Legislation, international affairs, scandals, and other factors can turn profits into losses
 Should be analyzed over a period of years to consider all relevant factors
 Always involves uncertainty
Economic Value Added:
 Used to evaluate operating performance
 Measures if operations have increased stockholder wealth
o Positive EVA®  increase in wealth
 Capital charge: Amount that stockholders and lenders charge a company for the use of
their money
 EVA = Net income before taxes + Interest expense – Capital Charge
 Capital Charge = (Beginning Balances)(Notes Payable + Current Maturities of Long-
Term Debt + Stockholders’ Equity) * Cost of Capital
Red Flags in Financial Statement Analysis:
 Analysts look for red flags in financial statements that may signal financial trouble
 Examples:
o Movement of sales, merchandise inventory, and receivables
o Earnings problems
o Decreased cash flow
o Too much debt
o Inability to collect receivables
o Buildup of merchandise inventories
o Trends of sales, inventory, and receivables
Limitations of Financial Statement Analysis:
 Analysis must be interpreted with consideration of the general economic conditions and
industry conditions
 Comparability of financial statement data is hampered by the use of different accounting
methods
Chapter 13: Financial Statement Analysis 8

 Difficulty is often encountered when comparing companies of different sizes or modes of

operations
 Comparability is often difficult for conglomerates that operate in multiple industries
Financial Statements Disclosure:
 Parenthetical disclosures are placed next to account titles to provide additional detail
 Notes to financial statements may include:
o Significant accounting policies
o Explanations of complex or special transactions
o Details of reported amounts
o Commitments
o Contingencies
o Segments
o Quarterly data
o Subsequent events
 Supplemental information included with the financial statements also includes:
o Management discussion and analysis
o Comparative selected financial data
Sustainable Income:
 Sustainable income is the most likely level of income to be obtained by a company in the
future
 It differs from actual net income by the amount of unusual revenues, expenses, gains, and
losses included in the current year’s income
 Information on unusual items such as gains or losses on discontinued items and
components of other comprehensive income are disclosed
 These unusual items are reported net of income taxes
Efficient Markets:
 Efficient capital market: Market prices fully reflect all information available to the public
 Mangers cannot fool the market with accounting gimmicks
 Market as a whole sets “fair” prices for stock
 Appropriate strategy seeks to manage risks, diversify investments, and minimize
transaction costs