Chapter 14

“How Well Am I Doing?”

Financial Statement Analysis

PowerPoint Authors:
Jon A. Booker, Ph.D., CPA, CIA
Charles W. Caldwell, D.B.A., CMA
Susan Coomer Galbreath, Ph.D., CPA
McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
14-2

Limitations of Financial Statement

Analysis
Differences in accounting methods
between companies sometimes make
comparisons difficult.

We use the LIFO method to We use the average cost

value inventory. method to value inventory.
14-3

Limitations of Financial Statement

Analysis
Analysts should look beyond the ratios.
Changes within
Industry the company Consumer
trends tastes

Technological Economic
changes factors
14-4

Learning Objective 1

Prepare and interpret

financial statements in
comparative and
common-size form.
14-5

Statements in Comparative and

Common-Size Form

 Dollar and percentage

changes on statements

An item on a financial
statement has little  Common-size
meaning by itself. The statements
meaning of the numbers
can be enhanced by
drawing comparisons.
 Ratios
14-6

Dollar and Percentage Changes on

Statements
Horizontal analysis (or trend analysis)
shows the changes between years in the
financial data in both dollar and
percentage form.
14-7

Horizontal Analysis

Example

The following slides illustrate a

horizontal analysis of Clover
Corporation’s December 31, 2009 and
2008, comparative balance sheets and
comparative income statements.
14-8

Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2009 2008 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
14-9

Horizontal Analysis

Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

The dollar
amounts for
2008 become
the “base” year
figures.
14-10

Horizontal Analysis

Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
14-11

Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2009 2008 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment: $12,000 – $23,500 = $(11,500)
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
($11,500 ÷160,000
Total property and equipment $23,500) × 100% = (48.9%)
125,000
Total assets $ 315,000 $ 289,700
14-12

Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2009 2008 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
14-13

Horizontal Analysis

We could do this
for the liabilities &
stockholders’
equity, but now
let’s look at the
income statement
accounts.
14-14

Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2009 2008 Amount %
Sales $ 520,000 $ 480,000
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
Net operating income 31,400 39,000
Interest expense 6,400 7,000
Net income before taxes 25,000 32,000
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
14-15

Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2009 2008 Amount %
Sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
14-16

Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2009 2008 Amount %
Sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
OperatingSales
expenses
increased128,600 126,000
by 8.3%, yet 2,600 2.1
Net operating income 31,400
net income decreased by 39,000
21.9%. (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
14-17

Horizontal Analysis
CLOVER CORPORATION
There were increases in both cost of goods
Comparative Income Statements
sold (14.3%) and
For operating expenses
the Years Ended (2.1%).
December 31
These increased costs more than offset theIncrease
increase in sales, yielding an overall (Decrease)
decrease in net income.
2008 2007 Amount %
Sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
14-18

Trend Percentages

Trend percentages
state several years’
financial data in terms
of a base year, which
equals 100 percent.
14-19

Trend Analysis

Trend = Current Year Amount

Percentage Base Year Amount
× 100%
14-20

Trend Analysis

Example

Look at the income information for Berry

Products for the years 2005 through 2009. We
will do a trend analysis on these amounts to
see what we can learn
about the company.
14-21

Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
Year
Item 2009 2008 2007 2006 2005
Sales $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000
Cost of goods sold 285,000 250,000 225,000 198,000 190,000
Gross margin 115,000 105,000 95,000 92,000 85,000

The base
year is 2005, and its amounts
will equal 100%.
14-22

Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
Year
Item 2009 2008 2007 2006 2005
Sales 105% 100%
Cost of goods sold 104% 100%
Gross margin 108% 100%

2006 Amount ÷ 2005 Amount × 100%

( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
14-23

Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
Year
Item 2009 2008 2007 2006 2005
Sales 145% 129% 116% 105% 100%
Cost of goods sold 150% 132% 118% 104% 100%
Gross margin 135% 124% 112% 108% 100%

By analyzing the trends for Berry Products, we

can see that cost of goods sold is increasing
faster than sales, which is slowing the increase
in gross margin.
14-24

Trend Analysis
160 We can use the trend
150 percentages to construct
a graph so we can see the
140 trend over time.
Percentage

130
Sales
120 COGS
GM
110

100
2005 2006 2007 2008 2009
Year
14-25

Common-Size Statements
Vertical analysis focuses
on the relationships
among financial
statement items at a
given point in time. A
common-size financial
statement is a vertical
analysis in which each
financial statement item
is expressed as a
percentage.
14-26

Common-Size Statements

In income
statements, all
items usually
are expressed
as a percentage
of sales.
14-27

Gross Margin Percentage

Gross Margin = Gross Margin
Percentage Sales

This measure indicates how much

of each sales dollar is left after
deducting the cost of goods sold to
cover expenses and provide a profit.
14-28

Common-Size Statements

In balance
sheets, all items
usually are
expressed as a
percentage of
total assets.
14-29

Common-Size Statements

Wendy's McDonald's
(dollars in millions) Dollars Percentage Dollars Percentage
2007 Net income $ 88 3.60% $ 2,396 10.50%

Common-size financial statements are

particularly useful when comparing
data from different companies.
14-30

Common-Size Statements

Example

Let’s take another look at the information from

the comparative income statements of Clover
Corporation for 2009 and 2008.

This time, let’s prepare common-size

statements.
14-31

Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2009 2008 2009 2008
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000
Sales is
Operating expenses 128,600 126,000
usually the
Net operating income 31,400 39,000
Interest expense 6,400 7,000
base and is
Net income before taxes 25,000 32,000 expressed
Less income taxes (30%) 7,500 9,600 as 100%.
Net income $ 17,500 $ 22,400
14-32

Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2009 2008 2009 2008
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000
Operating expenses 128,600 126,000
2009 Cost
Net operating ÷ 2009 Sales
income 31,400 × 100%
39,000
( $360,000
Interest expense ÷ $520,000 6,400) × 100%
7,000 = 69.2%
Net income before taxes 25,000 32,000
2008(30%)
Less income taxes Cost ÷ 7,500
2008 Sales × 100%
9,600
Net income ( $315,000$ 17,500
÷ $480,000 ) × 100% = 65.6%
$ 22,400
14-33

Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
What conclusions can we draw? Percentages
2009 2008 2009 2008
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000 69.2 65.6
Gross margin 160,000 165,000 30.8 34.4
Operating expenses 128,600 126,000 24.8 26.2
Net operating income 31,400 39,000 6.0 8.2
Interest expense 6,400 7,000 1.2 1.5
Net income before taxes 25,000 32,000 4.8 6.7
Less income taxes (30%) 7,500 9,600 1.4 2.0
Net income $ 17,500 $ 22,400 3.4 4.7
14-34

Quick Check 
Which of the following statements describes
horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c. A comparison of the account balances on

the current year’s financial statements.

d. None of the above.
14-35

Quick Check 
Which of the following statements describes
horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c. A comparison of the account balances on
Horizontal analysis shows the changes
between years
the current in the
year’s financial
financial data in both
statements.
dollar and percentage form.
d. None of the above.
14-36

Now, let’s look at

Norton
Corporation’s 2009
and 2008 financial
statements.
14-37

NORTON CORPORATION
Balance Sheets
December 31

2009 2008
Assets
Current assets:
Cash $ 30,000 $ 20,000
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets $ 346,390 $ 300,000
14-38

NORTON CORPORATION
Balance Sheets
December 31

2009 2008
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 39,000 $ 40,000
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities:
Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Stockholders' equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000

Total liabilities and stockholders' equity $ 346,390 $ 300,000

14-39

NORTON CORPORATION
Income Statements
For the Years Ended December 31

2009 2008
Sales $ 494,000 $ 450,000
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000
Net income before taxes 76,700 66,000
Less income taxes (30%) 23,010 19,800
Net income $ 53,690 $ 46,200
14-40

Learning Objective 2

Compute and interpret

financial ratios that would be
useful to a common
stockholder.
14-41

Ratio Analysis – The Common

Stockholder NORTON CORPORATION
2009
The ratios that Number of common shares
outstanding
are of the most Beginning of year 17,000
interest to End of year 27,400

stockholders Net income $ 53,690

Stockholders' equity
include those
Beginning of year 180,000
ratios that focus End of year 234,390
on net income, Dividends per share 2
dividends, and Dec. 31 market price per share 20
stockholders’ Interest expense 7,300
equities. Total assets
Beginning of year 300,000
End of year 346,390
14-42

Earnings Per Share

Net Income – Preferred Dividends
Earnings per Share =
Average Number of Common
Shares Outstanding
Whenever a ratio divides an income statement
balance by a balance sheet balance, the average
for the year is used in the denominator.

Earnings form the basis for dividend payments

and future increases in the value of shares of
stock.
14-43

Earnings Per Share

Net Income – Preferred Dividends
Earnings per Share =
Average Number of Common
Shares Outstanding

Earnings per Share = $53,690 – $0 = $2.42

(17,000 + 27,400)/2

This measure indicates how much

income was earned for each share of
common stock outstanding.
14-44

Price-Earnings Ratio
Price-Earnings Market Price Per Share
=
Ratio Earnings Per Share

Price-Earnings $20.00
= = 8.26 times
Ratio $2.42

A higher price-earnings ratio means that

investors are willing to pay a premium
for a company’s stock because of
optimistic future growth prospects.
14-45

Dividend Payout Ratio

Dividend Dividends Per Share
=
Payout Ratio Earnings Per Share

Dividend $2.00
= = 82.6%
Payout Ratio $2.42

This ratio gauges the portion of current

earnings being paid out in dividends. Investors
seeking dividends (market price growth) would
like this ratio to be large (small).
14-46

Dividend Yield Ratio

Dividend Dividends Per Share
=
Yield Ratio Market Price Per Share

Dividend $2.00
= = 10.00%
Yield Ratio $20.00

This ratio identifies the return, in terms

of cash dividends, on the current
market price of the stock.
14-47

Return on Total Assets

Return on Net Income + [Interest Expense × (1 – Tax Rate)]
=
Total Assets Average Total Assets

Return on $53,690 + [$7,300 × (1 – .30)]

= = 18.19%
Total Assets ($300,000 + $346,390) ÷ 2

Adding interest expense back to net income

enables the return on assets to be compared
for companies with different amounts of debt
or over time for a single company that has
changed its mix of debt and equity.
14-48

Return on Common Stockholders’

Equity
Return on Common = Net Income – Preferred Dividends
Stockholders’ Equity
Average Stockholders’ Equity
Return on Common $53,690 – $0
= = 25.91%
Stockholders’ Equity ($180,000 + $234,390) ÷ 2

This measure indicates how well the

company used the owners’
investments to earn income.
14-49

Financial Leverage
Financial leverage results from the difference between
the rate of return the company earns on investments in
its own assets and the rate of return that the company
must pay its creditors.
14-50

Quick Check 
Which of the following statements is true?
a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
14-51

Quick Check 
Which of the following statements is true?
a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
14-52

Book Value Per Share

Book Value Common Stockholders’ Equity
=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

This ratio measures the amount that would be

distributed to holders of each share of common
stock if all assets were sold at their balance sheet
carrying amounts after all creditors were paid off.
14-53

Book Value Per Share

Book Value Common Stockholders’ Equity
=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

Notice that the book value per share of $8.55 does

not equal the market value per share of $20. This
is because the market price reflects expectations
about future earnings and dividends, whereas the
book value per share is based on historical cost.
14-54

Learning Objective 3

Compute and interpret

financial ratios that would be
useful to a short-term
creditor.
14-55

Ratio Analysis – The Short–Term

Creditor
NORTON CORPORATION
Short-term 2009
creditors, such as Cash $ 30,000
suppliers, want to Accounts receivable, net

be paid on time. Beginning of year 17,000

End of year 20,000
Therefore, they
Inventory
focus on the Beginning of year 10,000
company’s cash End of year 12,000
flows and working Total current assets 65,000

capital. Total current liabilities 42,000

Sales on account 494,000
Cost of goods sold 140,000
14-56

Working Capital
The excess of current assets over
current liabilities is known as
working capital.

Working capital is not

free. It must be
financed with long-
term debt and equity.
14-57

Working Capital
December 31,
2009
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
14-58

Current Ratio
Current Current Assets
=
Ratio Current Liabilities

The current ratio measures a

company’s short-term debt paying
ability.

A declining ratio may be a

sign of deteriorating
financial condition, or it
might result from
eliminating obsolete
inventories.
14-59

Current Ratio
Current Current Assets
=
Ratio Current Liabilities

Current $65,000
= = 1.55
Ratio $42,000
14-60

Acid-Test (Quick) Ratio

Acid-Test Quick Assets
=
Ratio Current Liabilities

Acid-Test $50,000
= = 1.19
Ratio $42,000

Quick assets include Cash,

Marketable Securities, Accounts Receivable, and
current Notes Receivable.
This ratio measures a company’s ability to meet
obligations without having to liquidate inventory.
14-61

Accounts Receivable Turnover

Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover

Accounts
$494,000
Receivable = = 26.7 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
14-62

Average Collection Period

Average 365 Days
Collection = Accounts Receivable Turnover
Period

Average
365 Days
Collection = = 13.67 days
26.7 Times
Period

This ratio measures, on average,

how many days it takes to collect
an account receivable.
14-63

Inventory Turnover
Inventory Cost of Goods Sold
Turnover = Average Inventory
This ratio measures how many times a
company’s inventory has been sold and
replaced during the year.
If a company’s inventory
turnover Is less than its
industry average, it either
has excessive inventory or
the wrong types of
inventory.
14-64

Inventory Turnover
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2
14-65

Average Sale Period

Average 365 Days
=
Sale Period Inventory Turnover

Average 365 Days

= = 28.67 days
Sale Period 12.73 Times

This ratio measures how many

days, on average, it takes to sell
the entire inventory.
14-66

Learning Objective 4

Compute and interpret

financial ratios that would be
useful to a long-term creditor.
14-67

Ratio Analysis – The Long–Term

Creditor
Long-term creditors are concerned with a
company’s ability to repay its loans over the
long-run.
NORTON CORPORATION
2009
Earnings before interest
expense and income taxes $ 84,000
Interest expense 7,300
Total stockholders' equity 234,390
This is also referred
Total liabilities 112,000
to as net operating
income.
14-68

Times Interest Earned Ratio

Earnings before Interest Expense
Times and Income Taxes
Interest = Interest Expense
Earned

Times
$84,000
Interest = = 11.51 times
$7,300
Earned
This is the most common
measure of a company’s ability
to provide protection for its
long-term creditors. A ratio of
less than 1.0 is inadequate.
14-69

Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio

This ratio indicates the relative

proportions of debt to equity on a
company’s balance sheet.

Stockholders like a lot of Creditors prefer less debt

debt if the company can and more equity because
take advantage of positive equity represents a buffer
financial leverage. of protection.
14-70

Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio

Debt–to–
$112,000
Equity = = 0.48
$234,390
Ratio
14-71

Published Sources That Provide

Comparative Ratio Data
14-72

End of Chapter 14