CH 13 Notes

Ch.
13 Notes: Financial Statement Analysis
I. General
A. What is Financial Statement Analysis?
1. Financial Statements
a. Tell the health of a company
b. Consists of
i. Income Statement
ii. Balance Sheet
iii. Stmt of Owner’s Equity or Stmt of Shareholder’s Equity
iv. Stmt of Cash Flows
2. Analysis
- Definition: a careful examination of something
3. Put it together
a. Financial statement analysis is a careful examination of the Income Statement, Balance Sheet,
Statement of Owner’s Equity, and Statement of Cash Flows
b. The reason we do financial statement analysis is to better understand the health of company so we can
in turn make better business decisions
B. Who benefits from financial statement analysis

- Read p. 467 in your textbook
C. Comparative financial statements

1. Statements that allow for comparison of financial information.
2. Comparison can be against
a. Itself (aka intracompany basis)- comparison of a company’s performance against it’s past
b. A competitor (aka intercompany basis)
c. The industry it’s in
d. Guidelines (rules of thumb)
D. There are generally 3 types or tools of financial statement analysis

1. Horizontal Analysis
2. Vertical Analysis
3. Ratio Analysis
II. Horizontal Analysis

A. Basically, a comparison of a company’s performance over time. Study of percentage changes in
comparative statements
B. How this is done

1. Compute the absolute dollar amount of the change from the earlier base period to the later period (aka
analysis period)
2. Compute the percentage change by dividing the dollar amount of change by the base-period amount and then
multiplying by 100 to get a percentage
3. Record your calculations in 2 columns to the right hand side of your comparative financial statement
4. Do this for all the accounts on the financial statement
5. Things to note
a. Some people like to compute the absolute dollar amount of the change and the percentage change one
account at a time. Other people just compute the absolute dollar amount changes for every single account first
and then compute all the percentage changes at one time
b. If there is a negative amount in the base year and a positive amount in the year of analysis (or vice versa), we
cannot compute a meaningful percentage change. See example below.
c. If the base years amount is 0, you also can’t compute a meaningful percentage change. See example on
below.
d. If an account has an amount in the base year, but a 0 in the analysis year, the decrease is 100%. See example
below.
Analysis Year Based Year $ Amount Change Percent Change

1 $1,000 $(5,000) $6,000 --
2 $(1,000) $5,000 $(6,000) --
3 $1,000 -- $1,000 --
4 $0 $5,000 $(5,000) (100%)
C. Example of horizontal analysis of an income statement

1. Part 1- Compute the absolute dollar amount of the change from the earlier base period to the later period (aka
analysis period). Let’s do the first account “Revenues” first
2005 2004
27,433 – 24,548 = 2,885
2. Part 2- Compute the percentage change by dividing the dollar amount of change by the base-period amount
and then multiplying by 100 to get a percentage
Percentage change = _2,885_ X 100%

24,548
Percentage change = 11.8%
3. Part 3- Record your calculations in 2 columns to the right hand side of your comparative financial statement.
Obviously, you can see that is done.
D. Example
Given the following comparative income statement for Lincoln Company, perform horizontal analysis.
You would do all the percentage changes one by one like this…
E. Special form of horizontal analysis- Trend Analysis
1. General
a. Trends indicate the direction the company is taking and is widely used in forecasting (predicting the future)
b. You can perform trend analysis on any item you think is important
c. Usually deals with a period between 3 to 5 years.
2. How this is done- divide the current year amount you are using by the base year amount and then multiply
by 100 to get a percentage
3. Example
Supposed you are asked to perform trend analysis for 3 accounts--Revenue, COGS, and Selling, general &
administrative expenses
To performance trend analysis for 3 accounts (Revenue, COGS, and Selling and G&A Exp) divide every year’s
amount by the 2001 base year amount to get the percentage.
4. Practice Problem
a. How have sales changed over a 5 year period?
2028 2027 2026 2025 2024
Net Sales 1,498,000 1,200,000 1,011,000 911,279 902,256
b. Answer
Using the divide every your’s amount by the base year of 2024 to get the percentage.
2028 2027 2026 2025 2024
Net Sales 1,498,000 1,200,000 1,011,000 911,279 902,256

Trend
percentages 166% 133% 112% 101% 100%
c. Interpretation
I typical interpretation would sound like this…
“Net sales started off slow through 2025. The rate of growth picked up in 2026 and increased rapidly in 2027
and 2028.”
III. Vertical Analysis

A. Comparison of a company’s performance to a base amount. Shows the percentage relationship of each
financial statement account to a designated base account amount
1. For the income statement, revenue or nets sales (Sales – Sales returns and allowances – Sales discounts) is
usually the base amount
2. For the balance sheet, totals assets is usually the base amount
B. How this is done

1. Compute the percentage by dividing the financial statement account amount by the base amount.
2. Do this for every single account on your financial statement
3. If you have a comparative financial statement, you would do this for both years. Then you can compare your
percentage with the previous year and the percentage (under normal conditions).
C. Example
Given the following income statement for Google, Inc. perform vertical analysis for 2004.
Answer:
To do vertical analysis for 2004, you would take every single 2004 account amount on the financial
statement and divide each one by the base account amount. Since the financial statement we are looking
at is the income statement, the base amount is revenue-- the amount being $3,189. In the end, you would
get something like this.
D. Common size statements
1. These are statements using vertical analysis where all items are expressed in percentages. This makes the
process of comparison a lot easier.
2. Common size statements allows for comparison with

a. Prior periods
b. 1 or more competitor businesses
c. Industry percentages
3. Example
Going back to the Google example above, if we were comparing Google to Yahoo (one of its competitors), then
the common size statement would look like this…
E. Benchmarking- termed used for comparing a company with other companies that area leaders in the industry
Ratio Analysis
I. General
A. These are formulas you will use to analyze businesses
B. Ratios express the mathematical relationship between different numbers.
C. Ratios can result answers that either a percentage, rate, or proportion
D. Note: I will just cover some ratios in class. You need to read your book and study the rest on your own.
E. Your book grouped the ratios under certain classifications—groupings usually varies between textbooks, but
the ratios are the same anyways
1. Liquidity and Efficiency
2. Solvency
3. Profitability
4. Market prospects
II. Liquidity and Efficiency

A. General
1. Liquidity
a. Used to assess a company’s ability to pay its current liabilities (debts that will mature soon) with current
assets
b. Short term creditors (i.e. bankers and suppliers) are interested in these ratios
2. Efficiency- how productive a company is in using its assets
B. Ratio/Formula
1. Working Capital
a. Formula: Working Capital = Current Assets – Current Liabilities
b. Used to assess a company’s ability to pay its current liabilities (debts that will mature soon) with current
assets
2. Current Ratio
a. Formula: Current Ratio = Current Assets
Current Liabilities
b Used to assess a company’s ability to pay its current liabilities (debts that will mature soon) with current
assets. However, it is a more reliable liquidity indicator. This is b/c it shows a proportional amount rather than
a working capital flat amount.
3. Quick Ratio (aka acid-test ratio)

a. Formula: Acid test = Cash + S/T Investments + Net Current Receivables
Current liabilities
b. Used to assess a company’s ability to pay its current liabilities (debts that will mature soon) with certain
current assets. However, it is more specifically measures a company’s ability to pay all current liabilities if they
were due immediately.
III. Closing Comments

A. I just covered 3 ratios that fall under liquidity and efficiency. Please read Ch. 13 in your book and study the
other ratios on your own.
B. What is an acceptable ratio? Are certain ratios being high or low good or bad?
- It depends—usually on the industry. However, in some cases such as a high current ratio usually shows a
strong financial position in that the business has sufficient liquid assets to maintain normal business operations.

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Ch.

13 Notes: Financial Statement Analysis

B. Who benefits from financial statement analysis

C. Comparative financial statements

D. There are generally 3 types or tools of financial statement analysis

II. Horizontal Analysis

B. How this is done

Analysis Year Based Year $ Amount Change Percent Change

C. Example of horizontal analysis of an income statement

Percentage change = _2,885_ X 100%

Percentage change = 11.8%

Net Sales 1,498,000 1,200,000 1,011,000 911,279 902,256

Net Sales 1,498,000 1,200,000 1,011,000 911,279 902,256

III. Vertical Analysis

B. How this is done

2. Common size statements allows for comparison with

II. Liquidity and Efficiency

3. Quick Ratio (aka acid-test ratio)

III. Closing Comments

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