DESS Financial Analysis

17-1
CHAPTER 17
ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
Methods of
Financial Statement Analysis
Horizontal
Vertical
Analysis
Analysis
Common-Size
Trend
Ratio
Statements
Percentages
Analysis
17-2
17-3
Horizontal Analysis
Using comparative financial
statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
17-4
Vertical Analysis
For a single financial
statement, each item
is expressed as a
percentage of a
significant total,
e.g., all income
statement items are
expressed as a
percentage of sales
17-5
Common-Size Statements
Financial statements that show
only percentages and no
absolute dollar amounts
17-6
Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)
17-7
Ratio Analysis
Expression of logical relationships
between items in a financial
statement of a single period
(e.g., percentage relationship
between revenue and net income)
17-8
Horizontal Analysis Example

The management of Clover Company
provides you with comparative balance
sheets of the years ended December 31,
1999 and 1998. Management asks you to
prepare a horizontal analysis on the
information.
17-9
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
1999
1998
Assets
Current assets:
Cash
12,000
23,500
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
3,000
1,200
155,000
164,700
40,000
40,000
120,000
85,000
160,000
125,000
Prepaid expenses
Total current assets
Property and equipment:
Land
Buildings and equipment, net
Total property and equipment
Total assets
315,000
289,700
Incre
Amo
17-10

Calculating Change in Dollar Amounts
Dollar
Change
Current Year
Figure
Base Year
Figure
17-11

Calculating Change in Dollar Amounts
Dollar
Change
Current Year
Figure
Base Year
Figure
Since we are measuring the amount of

the change between 1998 and 1999, the
dollar amounts for 1998 become the
base year figures.
17-12

Calculating Change as a Percentage
Percentage
Change
Dollar Change
Base Year Figure
100%
17-13

CLOVER CORPORATION
1999
1998
Increase (Decrease)
Amount
%
Assets
Current assets:
Cash
$
12,000 $
23,500 $ (11,500)
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
155,000
164,700
$12,000
$23,500
= $(11,500)
Land
40,000
40,000
120,000
85,000
160,000
125,000
Total assets
$ 315,000 $ 289,700
17-14

CLOVER CORPORATION
1999
1998
Increase (Decrease)
Amount
%
Assets
Current assets:
Cash
$
12,000 $
23,500 $ (11,500)
(48.9)
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
155,000
164,700
($11,500
$23,500)
100% = 48.9%
Land
40,000
40,000
120,000
85,000
160,000
125,000
Total assets
$ 315,000 $ 289,700
17-15

CLOVER CORPORATION
Increase (Decrease)
Amount
%
1999
1998
12,000 $
60,000
80,000
3,000
155,000
23,500 $ (11,500)
40,000
20,000
100,000
(20,000)
1,200
1,800
164,700
(9,700)
40,000
120,000
160,000
315,000 $
40,000
85,000
125,000
289,700 $
Assets
Current assets:
Cash
Inventory
Prepaid expenses
Land
Total assets
35,000
35,000
25,300
(48.9)
50.0
(20.0)
150.0
(5.9)
0.0
41.2
28.0
8.7
17-16

Lets apply the same
procedures to the
liability and stockholders
equity sections of the
balance sheet.
17-17
CLOVER CORPORATION
1999
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities:
Bonds payable, 8%
Total liabilities
Stockholders' equity:
Preferred stock
Common stock
Additional paid-in capital
Total paid-in capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
67,000 $
3,000
70,000
1998
Increase (Decrease)
Amount
%
44,000 $
6,000
50,000
23,000
(3,000)
20,000
52.3
(50.0)
40.0
75,000
145,000
80,000
130,000
(5,000)
15,000
(6.3)
11.5
20,000
60,000
10,000
90,000
80,000
170,000
315,000 $
20,000
60,000
10,000
90,000
69,700
159,700
289,700 $
10,300
10,300
25,300
0.0
0.0
0.0
0.0
14.8
6.4
8.7
17-18

Now, lets apply the
procedures to the
income statement.
17-19
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net 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)
17-20
CLOVER CORPORATION
Comparative Income Statements
Increase (Decrease)
1999
1998
Amount
%
Net 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
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Sales increased by
8.3% while
net
25,000
32,000
(7,000)
(21.9)
income
decreased
by
21.9%.
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)
17-21
There were increases in both cost of goods

sold (14.3%) and operating expenses (2.1%).
These increased costs
more
than offset the
CLOVER
CORPORATION
Income
increase inComparative
sales, yielding
anStatements
overall
Fordecrease
the Years Ended
in netDecember
income. 31, 1999 and 1998
Net sales
Cost of goods sold
Gross margin
Operating expenses
Interest expense
Net income
1999
$ 520,000
360,000
160,000
128,600
31,400
6,400
25,000
7,500
$ 17,500
1998
$ 480,000
315,000
165,000
126,000
39,000
7,000
32,000
9,600
$ 22,400
Increase (Decrease)
Amount
%
$ 40,000
8.3
45,000
14.3
(5,000)
(3.0)
2,600
2.1
(7,600)
(19.5)
(600)
(8.6)
(7,000)
(21.9)
(2,100)
(21.9)
$
(4,900)
(21.9)
17-22
Vertical Analysis Example

The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.
17-23

Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999
1998
1999
1998
Cash
$ 82,000
$ 30,000
17%
8%
Accts. Rec.
120,000
100,000
25%
26%
Inventory
87,000
82,000
18%
21%
Land
101,000
90,000
21%
23%
Equipment
110,000
100,000
23%
26%
Accum. Depr.
(17,000)
(15,000)
-4%
-4%
Total
$ 483,000
$ 387,000
100%
100%
17-24

Sample Company
Balance Sheet (Assets)
% of Total Assets
1999
1998
1999
1998
Cash
$ 82,000
$ 30,000
17%
8%
Accts. Rec.
120,000
100,000
25%
26%
Inventory
87,000
82,000
18%
21%
$82,000 $483,000 = 17% rounded
Land
101,000
90,000
21%
23%
$30,000110,000
$387,000 100,000
= 8% rounded
Equipment
23%
26%
Accum. Depr.
(17,000)
(15,000)
-4%
-4%
Total
$ 483,000
$ 387,000
100%
100%
17-25

Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
% of Total Assets
1999
1998
1999
1998
Acts. Payable
$ 76,000
$ 60,000
16%
16%
Wages Payable
33,000
17,000
7%
4%
Notes Payable
50,000
10%
13%
$76,000 $483,000
= 50,000
16% rounded
Common Stock
170,000
160,000
35%
41%
Retained Earnings
154,000
100,000
32%
26%
Total
$ 483,000
$ 387,000
100%
100%
17-26
Trend Percentages Example

Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
1999
Revenues $ 2,405
Expenses
2,033
Net income $
372
Wheeler, Inc.
Operating Data
1998
1997
$ 2,244
$ 2,112
1,966
1,870
$
278
$
242
1996
$ 1,991
1,803
$
188
1995
$ 1,820
1,701
$
119
17-27

Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
1999
Revenues $ 2,405
Expenses
2,033
Net income $
372
Wheeler, Inc.
Operating Data
1998
1997
$ 2,244
$ 2,112
1,966
1,870
$
278
$
242
1996
$ 1,991
1,803
$
188
1995
$ 1,820
1,701
$
119
$1,991 - $1,820 = $171
17-28

Using 1995 as the base year, we develop
the following percentage relationships.
Revenues
Expenses
Net income
1999
132%
120%
313%
Wheeler, Inc.
Operating Data
1998
1997
123%
116%
116%
110%
234%
203%
1996
109%
106%
158%
1995
100%
100%
100%
$1,991 - $1,820 = $171

$171 $1,820 = 9% rounded
17-29
140
Trend line
for Sales
% of 100 Base
130
120
110
100
90
Sales
Expenses
1995
1996
1997
Years
1998
1999
17-30
Ratios
Ratios can be expressed in three
different ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $
(e.g., EPS of $2.25)
CAUTION!
Using ratios and percentages without
considering the underlying causes may
be hazardous to your health!
lead to incorrect conclusions.
17-31
Categories of Ratios
Liquidity Ratios
Indicate a companys short-term
debt-paying ability
Equity (Long-Term Solvency) Ratios

Show relationship between debt and
equity financing in a company
Profitability Tests
Relate income to other variables
Market Tests
Help assess relative merits of stocks in
the marketplace
17-32
10 Ratios You Must Know

Liquidity Ratios
Current (working capital) ratio
Acid-test (quick) ratio
Cash flow liquidity ratio
Accounts receivable turnover
Number of days sales in accounts
receivable
Inventory turnover
Total assets turnover
651
17-33

Equity (Long-Term Solvency) Ratios
Equity (stockholders equity) ratio
Equity to debt
17-34

Profitability Tests
Return on operating assets
Net income to net sales (return on
sales or profit margin)
$
Return on average common
stockholders equity (ROE)
Cash flow margin
Earnings per share
Times interest earned
Times preferred dividends earned
17-35

Market Tests
Earnings yield on common stock
Price-earnings ratio
Payout ratio on common stock
Dividend yield on common stock
Dividend yield on preferred stock
Cash flow per share of common
stock
17-36
Now, lets look at

Norton
Corporations 1999
and 1998 financial
statements.
17-37
NORTON CORPORATION
Balance Sheets
1999
1998
Assets
Current assets:
Cash
30,000
20,000
20,000
17,000
Inventory
12,000
10,000
3,000
2,000
65,000
49,000
Land
165,000
123,000
116,390
128,000
281,390
251,000
Prepaid expenses

Total assets
346,390
300,000
17-38
NORTON CORPORATION
Balance Sheets
1999
1998
Liabilities and Stockholders' Equity

Current liabilities:
Accounts payable
39,000
40,000
Notes payable, short-term
3,000
2,000
42,000
42,000
70,000
78,000
112,000
120,000
27,400
17,000
158,100
113,000
185,500
130,000
48,890
50,000
234,390
180,000
$ 346,390
$ 300,000
Long-term liabilities:
Notes payable, long-term
Total liabilities
Stockholders' equity:
Common stock, $1 par value
Additional paid-in capital
Total paid-in capital
Retained earnings
Total liabilities and stockholders' equity
17-39
NORTON CORPORATION
Income Statements
Net sales
Cost of goods sold
Gross margin
Operating expenses
Interest expense
Net income
1999
$ 494,000
140,000
354,000
270,000
84,000
7,300
76,700
23,010
$ 53,690
1998
$ 450,000
127,000
323,000
249,000
74,000
8,000
66,000
19,800
$ 46,200
17-40
Now, lets calculate

the 10 ratios based
on Nortons financial
statements.
17-41
NORTON CORPORATION
1999
Cash
$ 30,000
We will
use this
information
to calculate
the liquidity
ratios for
Norton.
Beginning of year
17,000
End of year
20,000
Inventory
Beginning of year
10,000
End of year
12,000
65,000
42,000
Sales on account
494,000
Cost of goods sold
140,000
17-42
Working Capital*
The excess of current assets over
current liabilities.
12/31/99
Current assets
Current liabilities
Working capital
65,000
(42,000)
23,000
* While this is not a ratio, it does give an

indication of a companys liquidity.
17-43
Current (Working Capital) Ratio

#1
Current
Ratio
Current Assets
Current Liabilities
Current
Ratio
$65,000
$42,000
1.55 : 1
Measures the ability

of the company to pay current
debts as they become due.
17-44
Acid-Test (Quick) Ratio

#2
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
17-45

#2
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
Norton Corporations quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.
17-46

#2
Acid-Test
=
Ratio
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
$50,000
$42,000
= 1.19 : 1
17-47
Accounts Receivable Turnover

Net, credit sales
Accounts
Receivable =
Turnover
#3
Average, net accounts

receivable
Sales on Account
Average Accounts Receivable
Accounts
$494,000
= 26.70 times
Receivable =
($17,000 + $20,000) 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.
Number of Days Sales

in Accounts Receivable
#4
Days Sales
in Accounts =
Receivables
Days Sales
in Accounts =
Receivables
365 Days
365 Days
26.70 Times
= 13.67 days
Measures, on average, how many

days it takes to collect an
account receivable.
17-48
Number of Days Sales

in Accounts Receivable
#4
Days Sales
in Accounts =
Receivables
Days Sales
in Accounts =
Receivables
365 Days
365 Days
26.70 Times
= 13.67 days
In practice, would 45 days be a

desirable number of days in
receivables?
17-49
17-50
Inventory Turnover
#5
Inventory
Turnover
Inventory
Turnover
Cost of Goods Sold

Average Inventory
$140,000
=
= 12.73 times
($10,000 + $12,000) 2
Measures the number of times

inventory is sold and
replaced during the year.
17-51
Inventory Turnover
#5
Inventory
Turnover
Inventory
Turnover
Cost of Goods Sold

Average Inventory
$140,000
=
= 12.73 times
($10,000 + $12,000) 2
Would 5 be a
desirable number of times
for inventory to turnover?
Equity, or LongTerm
Solvency Ratios
This is part of the information to
calculate the equity, or long-term
solvency ratios of Norton Corporation.
NORTON CORPORATION
1999
Net sales
Interest expense
$ 84,000
494,000
7,300
234,390
17-52
17-53
NORTON CORPORATION
1999
Common shares outstanding
Beginning of year
End of year
Net income
Here is the
rest of the
information
we will
use.
17,000
27,400
$ 53,690
Stockholders' equity
Beginning of year
180,000
End of year
234,390
Dividends per share

Dec. 31 market price/share
Interest expense
2
20
7,300
Total assets
Beginning of year
300,000
End of year
346,390
17-54
Equity Ratio
#6
Equity
=
Ratio
Equity
=
Ratio
Stockholders Equity
Total Assets
$234,390
$346,390
Measures the proportion

of total assets provided by
stockholders.
= 67.7%
17-55
Net Income to Net Sales

A/K/A Return on Sales or Profit Margin
#7
Net Income
=
to
Net Sales
Net Income
Net Sales
Net Income
=
to
Net Sales
$53,690
$494,000
= 10.9%
Measures the proportion of the sales dollar

which is retained as profit.
17-56
Net Income to Net Sales

A/K/A Return on Sales or Profit Margin
#7
Net Income
=
to
Net Sales
Net Income
Net Sales
Net Income
=
to
Net Sales
$53,690
$494,000
= 10.9%
Would a 1% return on sales be good?
Return on Average Common

Stockholders Equity (ROE)
17-57
#8
Return on
Stockholders =
Equity
Return on
Stockholders =
Equity
Net Income
Average Common
Stockholders Equity
$53,690
($180,000 + $234,390) 2
Important measure of the
income-producing ability
of a company.
= 25.9%
17-58
Earnings Per Share

#9
Earnings Available to Common Stockholders
Earnings
=
Weighted-Average Number of Common
per Share
Shares Outstanding
Earnings
$53,690
=
per Share
(17,000 + 27,400) 2
= $2.42
The financial press regularly publishes

actual and forecasted EPS amounts.
17-59
Price-Earnings Ratio
A/K/A P/E Multiple
#10
Price-Earnings
=
Ratio
Market Price Per Share

EPS
Price-Earnings
=
Ratio
$20.00
$ 2.42
= 8.3 : 1
Provides some measure of whether the

stock is under or overpriced.

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17-1

Horizontal Analysis Example

Accounts receivable, net

Horizontal Analysis Example

Horizontal Analysis Example

Since we are measuring the amount of

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

There were increases in both cost of goods

Vertical Analysis Example

Vertical Analysis Example

Vertical Analysis Example

Vertical Analysis Example

Trend Percentages Example

Trend Percentages Example

$1,991 - $1,820 = $171

Trend Percentages Example

$1,991 - $1,820 = $171

Equity (Long-Term Solvency) Ratios

10 Ratios You Must Know

10 Ratios You Must Know

10 Ratios You Must Know

10 Ratios You Must Know

Now, lets look at

Accounts receivable, net

Buildings and equipment, net

Total property and equipment

Liabilities and Stockholders' Equity

Notes payable, short-term

Total current liabilities

Now, lets calculate

Accounts receivable, net

Total current assets

Total current liabilities

Cost of goods sold

* While this is not a ratio, it does give an

Current (Working Capital) Ratio

Measures the ability

Acid-Test (Quick) Ratio

Acid-Test (Quick) Ratio

Acid-Test (Quick) Ratio

Accounts Receivable Turnover

Average, net accounts

Number of Days Sales

Measures, on average, how many

Number of Days Sales

In practice, would 45 days be a

Cost of Goods Sold

Measures the number of times

Cost of Goods Sold

Dividends per share

Measures the proportion

Net Income to Net Sales

Measures the proportion of the sales dollar

Net Income to Net Sales

Would a 1% return on sales be good?

Return on Average Common

Earnings Per Share

The financial press regularly publishes

Market Price Per Share