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Financial Statement Analysis
Management Accounting: The Cornerstone for
Business Decisions
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
Learning Objectives
1. Analyze financial statements using two forms of common-size analysis: horizontal analysis and vertical analysis.
2. Explain why historical standards and industrial averages are important for ratio analysis.
3. Calculate and use liquidity ratios to assess the ability of a company to meet its long- and short-term obligations.
Learning Objectives
4. Calculate and use leverage ratios to assess the ability of a company to meet its long- and short-term obligations.
5. Calculate and use profitability ratios to assess the extent to which a company’s resources are being used efficiently.
Match Definitions
Common-Size Analysis
Horizontal Analysis
Expresses a line item amount as a % of some prior-period amount
Expresses all the other items of a financial statement as a % of one item
Ratio Analysis
Vertical Analysis
Fractions or percentages computed by dividing one account or line-item by another
Comparing two financial statements by converting to percentages so size differences in companies is not an issue
Illustration of Common-Size Analysis
Comment on Common-Size Analysis
◙ First step in comparing two financial statements
◙ Uses both horizontal and vertical analysis
◙ Allows for two very different size companies to be compared
◙ Allows financial statements from multiple years to be compared to one another
How to prepare common-size income statements
using base period: horizontal analysis.
Simpson Company income statements for third and forth years of operation:
Year 3 Year 4Net sales $132,000 $144,000Less: COGS (81,000) (85,000)
Gross margin$51,000 $59,000Less:Operating exp.(29,000) (35,000)Income taxes (10,000) (11,000)
Net income $12,000 $13,000REQUIRED: Prepare common-size statement for year four using year three as the base.
16-1
How to prepare common-size income statements
using base period: horizontal analysis.
Calculation: Year 3 is the base year. Therefore, every dollar amount in year 3 is 100% of itself.
Year 3 Year 4Dollars % Dollars %
Net sales $132,000100%$144,000109.1%Less: COGS (81,000)100%(85,000)104.9%
Gross margin$51,000100%$59,000115.7%Less:
Operating exp. (29,000)100%(35,000)120.7%Income taxes (10,000)100%(11,000)110.0%
Net income $12,000100%$13,000108.3%
16-1
How to prepare common-size income statements
using net sales as the base: vertical analysis.
Simpson Company income statements for third and forth years of operation:
Year 3 Year 4Net sales $132,000 $144,000Less: COGS (81,000) (85,000)
Gross margin$51,000 $59,000Less:Operating exp.(29,000) (35,000)Income taxes (10,000) (11,000)
Net income $12,000 $13,000REQUIRED: Prepare common-size statement for year four using net sales as the base.
16-2
How to prepare common-size income statements
using net sales as the base: vertical analysis.Calculation: Since the analysis is based on net
sales, net sales in each year equals 100% of itself. Then, every line-item on the income statement is figured as a percent of that year’s net sales.
Year 3Year 4Dollars%Dollars %
Net sales $132,000100.0%$144,000100.0%Less: COGS (81,000)61.4%(85,000)59.0%
Gross margin$51,00038.6%$59,000 41.0%Less:
Operating exp.(29,000) 22.0%(35,000) 24.3%Income taxes (10,000)7.6%(11,000)7.6%
Net income $12,0009.1%$13,0009.0%
16-2
Discuss Ratio Analysis
◙ Ratios alone are meaningless, they need to be compared to some standard.
◙ One way to use them is to compare a ratio to a value over time.
◙ There are many industrial averages available through various publications.
◙ Ratios are classified into three categories: liquidity, leverage and profitability ratios.
Illustration of Ratio Analysis
Match Definitions
Liquidity Ratios
Leverage Ratios
Measures the earning ability of a company
The ability of a company to meet its current obligations
Profitability Ratios
The ability of a company to meet its long- and short-term obligations
How to calculate the current and the quick (or
acid-test) ratios.Bordner Company had current assets of $160,000,
$20,000 were cash, $15,000 were marketable securities, $35,000 were receivables and the rest were inventories. Current liabilities were $57,000.
REQUIRED:1.Calculate the current ratio.2.Calculate the quick ratio (acid-test).Calculation:1.Current ratio = Current assets / Current liabilities
= $160,000 / $57,000 = 2.812.Quick ratio = (Cash + Marketable securities
+ receivables) / Current liabilities
= ($20,000 +$15,000 + $35,000) / $57,000 = 1.23
16-3
How to calculate the average accounts receivable (A/R) the
A/R turnover ratio, the A/R turnover in days.
Last year Buttons, Inc., had net sales of $1,000,000 and cost of goods sold of $420,000. Buttons reported the following balances
January 1 December 31
A/R $150,000 $170,000
Inventories $75,000 $95,000
REQUIRED:
1. Calculate the average A/R.
2. Calculate the A/R turnover ratio.
3. Calculate the A/R in days.
16-4
Calculation:1. Average accounts receivable =
(Beginning receivables + Ending receivable) / 2= ($150,000 + $170,000) / 2 = $160,000
2. Accounts receivable turnover ratio = Net sales / Average accounts receivable = = $1,000,000 / $160,000 = 6.25
3. Accounts receivable in days = 365 / A/R turnover ratio = 365 / 6.25 = 58.4 days
How to calculate the average accounts receivable (A/R) the
A/R turnover ratio, the A/R turnover in days.
16-4
How to calculate the average inventory the inventory
turnover ratio, the inventory turnover in days.
Last year Buttons, Inc., had net sales of $1,000,000 and cost of goods sold of $420,000. Buttons reported the following balances
January 1 December 31A/R $150,000 $170,000Inventories $75,000 $95,000REQUIRED:1. Calculate the average inventory.2. Calculate the inventory turnover ratio.3. Calculate the inventory in days.
16-5
Calculation:1. Average inventory = (Beginning
inventory + Ending inventory) / 2= ($75,000 + $95,000) / 2 = $85,000
2. Inventory turnover ratio = Cost of goods sold / Average inventory = = $420,000 / $85,000 = 4.94
3. Inventory in days = 365 / Inventory turnover ratio = 365 / 4.94 = 73.9 days
16-5
How to calculate the average inventory the inventory
turnover ratio, the inventory turnover in days.
Match Ratio to Formula
Current
Quick or Acid-Test
365 / Inventory Turnover Ratio
Cost of Goods Sold / Ave. Inventory
A/R in days
A/R Turnover Current assets / Current liabilities
(Cash + Marketable Securities + Receivables) / Current Liabilities
Inventory Turnover in days
Inventory Turnover
365 / (A/R Turnover Ratio)
Net sales / Ave. accounts receivable
How to calculate the times-interest-earned
ratio.The Kuma Company provided the
following income statement for the prior year:
Sales $1,100,000Cost of goods sold 500,000
Gross margin $600,000Operating expenses 300,000
Operating income $300,000Interest expense 25,000
Net income before taxes $275,000Income taxes 110,000
Net Income $165,000
16-6
How to calculate the times-interest-earned
ratio.REQUIRED: Calculate
the times-interest-earned ratio.
Calculation:Times-interest-earned
= (Income before taxes + Interest expense) / Interest expense
= ($275,000 + $25,000) / $25,000 = 12
16-6
How to calculate the debt ratio and the debt
to equity ratio.The Jewell Company’s balance sheet showed total
liabilities of $600,000, total stockholders’ equity of $450,000, and total assets of $900,000.
REQUIRED:1. Calculate the debt ratio for the Jewell
Company.2. Calculate the debt to equity ratio for the Jewell
Company.Calculation:1. Debt ratio = Total liabilities / Total Assets
= $600,000 / $900,000 = 66.67%2. Debt to equity ratio = Total liabilities / Total
stockholders’ equity = $600,000 / $450,000 = 1.33
16-7
Match Ratio to Formula
Times-Interest-Earned
Debt Ratio
Total liabilities / Total stockholders’ equity
(Income before taxes + Interest expense) / Interest expense
Debt to Equity
Total liabilities / Total assets
Refer to Cornerstone 16-6 for the information.
REQUIRED: Calculation the return on sales.
Calculation: Return on sales = Net income / Sales
= $165,000 / $1,100,000 = .15
How to calculate the return on sales.16-8
How to calculate the average total assets and
the return on assets.Refer to Exhibits 16-3 and 16-4 in the book
for the Payne Company.REQUIRED:1. Calculate the average total assets.2. Calculate the return on total assets.Calculation:1. Average total assets = ($30,000,000 +
$32,000,000) / 2 = $31,000,0002. Return on total assets = [$2,300,000
+(0.5 x $400,000)] / $31,000,000 = ($2,300,000 + $200,000) / $31,000,000 = $2,500,000 / $31,000,000 = 0.0806 or 8.06%
16-9
How to calculate the average common
stockholders’ equity and return on stockholders’
equity.Refer to Exhibits 16-3 and 16-4 in the text for information on the Payne Company.
REQUIRED:1. Calculate the average common
stockholders’ equity.2. Calculate the return on stockholders’
equity.Calculation:1. Average common stockholders’ equity =
($11,724,000 + $12,800,000) / 2 = $12,262,000
2. Return on stockholders’ equity = ($2,300,000 - $224,000) / $12,262,000 = 0.1693 or 16.93%
16-10
How to compute earnings per share.
Refer to Exhibits 16-3 and 16-4 in the text for information on the Payne Company.
REQUIRED:1. Compute the dollar amount of preferred dividends.2. Compute the number of common shares.3. Compute the earning per share for Payne Company.Calculation: 1. Preferred dividends = $3,200,000 x .07 = $224,0002. Number of common shares = $1,600,000 / $2 =
800,000 shares3. Earnings per share = ($2,300,000 - $224,000) /
800,000 = $2,076,000 / 800,000 = $2.60
16-11
How to compute the price-earnings ratio.
Assume the price per share for Payne Company is $16.
REQUIRED: Compute the price-earnings ratio.
Calculation:Price-earnings ratio = $16 / $2.60
= = 6.1538 or 6.2
16-12
How to compute the dividend yield and dividend
payout ratio.Assume that the market price per common share
is $16. Refer to Exhibits 16-3 and 16-4 in the text.
REQUIRED:1. Compute the dividends per share.2. Compute the dividend yield.3. Compute the dividend payout ratio.Calculation:1. Dividends per share = $1,000,000 / 800,000 =
$1.252. Dividend yield = $1.25 / $16 = 0.7813 or 7.81%3. Dividend payout ratio = $1,000,000 /
($2,300,000 - $224,000) = $1,000,000 / $2,076,000 = 0.48
16-13
Match Ratio to Formula
Return on SalesReturn on Total Assets
Operating income after taxes / Average total assets
Earnings per Share
Price-Earnings Ratio
Net income / Sales
Dividends per common share / Market price per common share
Dividend Yield
Return on Stockholders’ Equity (Net income – Preferred
dividends) / Average stockholders’ equity
(Net income – Preferred dividends) / Average common shares
Market price per share / Earning per share
