Financial Ch. 15 - Horngren's Accounting

Financial Statement Analysis Comparison Ways

From year to year, with a competing company, and with the same industry as a whole.

Three Main Tools of Financial Statement Analysis

Horizontal analysis, Vertical analysis, and Ratio analysis.

Horizontal Analysis

The study of percentage changes in line items from comparative financial statements. It provides a year-to-year comparison of a company’s performance in different periods.

Horizontal Analysis Dollar Change Calculation (Step 1)

Later period amount minus Earlier period amount.

Horizontal Analysis Percentage Calculation (Step 2)

(Dollar amount of change / Base period amount) multiplied by 100.

Vertical Analysis

Shows the relationship of each item on a financial statement to its base amount, the 100% figure, with every other item reported as a percentage of that base.

Vertical Analysis Percentage Calculation

(Specific item / Base amount) multiplied by 100.

Common-Size Statement

A report that uses only percentages, which removes the dollar value bias seen when comparing numbers in absolute terms (dollars), to compare one company to another.

Benchmarking

The practice of comparing a company with other leading companies.

Two Types of Benchmarking

Benchmarking against a key competitor and benchmarking against the industry average.

Corporate Annual Report Components

Management’s discussion and analysis (M D&A) of financial conditions and results of operations, Report of the independent auditors, Financial statements, and Notes to financial statements.

Working Capital Purpose

Measures the ability to meet short-term obligations with current assets.

Working Capital Formula

Current assets minus Current liabilities.

Cash Ratio Purpose

Helps determine a company’s ability to meet its short-term obligations and its ability to pay current liabilities from cash and cash equivalents.

Cash Ratio Formula

(Cash plus Cash equivalents) divided by Total current liabilities.

Acid-Test Ratio (Quick Ratio) Purpose

Tells whether a company can pay all its current liabilities if they come due immediately.

Acid-Test Ratio Formula

(Cash including cash equivalents + Short-term investments + Net current receivables) divided by Total current liabilities.

Current Ratio Purpose

Measures a company’s ability to pay its current liabilities with its current assets.

Current Ratio Formula

Total current assets divided by Total current liabilities.

Inventory Turnover Ratio Purpose

Measures the number of times a company sells its average level of merchandise inventory during a period.

Inventory Turnover Ratio Formula

Cost of goods sold divided by Average merchandise inventory.

Days’ Sales in Inventory Purpose

Measures the average number of days that inventory is held by a company.

Days’ Sales in Inventory Formula

365 days divided by Inventory turnover.

Gross Profit Percentage Purpose

Measures the profitability of each net sales dollar above the cost of goods sold.

Gross Profit Percentage Formula

Gross profit divided by Net sales revenue.

Accounts Receivable Turnover Ratio Purpose

Measures the number of times the company collects the average receivables balance in a year.

Accounts Receivable Turnover Ratio Formula

Net credit sales divided by Average net accounts receivable.

Days’ Sales in Receivables Purpose

Indicates how many days it takes to collect the average level of receivables.

Days’ Sales in Receivables Formula

365 days divided by Accounts receivable turnover ratio.

Debt Ratio Purpose

Shows the proportion of assets financed with debt.

Debt Ratio Formula

Total liabilities divided by Total assets.

Debt to Equity Ratio Purpose

Shows the proportion of total liabilities relative to total equity, measuring financial leverage.

Debt to Equity Ratio Formula

Total liabilities divided by Total equity.

Times-Interest-Earned Ratio Purpose

Measures a business’s ability to pay interest expense.

Times-Interest-Earned Ratio Formula

(Net income + Income tax expense + Interest expense) divided by Interest expense.

Profit Margin Ratio Purpose

Shows how much net income a business earns on every $1 of net sales.

Profit Margin Ratio Formula

Net income divided by Net sales revenue.

Asset Turnover Ratio Purpose

Measures the amount of net sales generated for each average dollar of total assets invested, showing how efficiently a business uses its average total assets to generate sales.

Asset Turnover Ratio Formula

Net sales revenue divided by Average total assets.

Rate of Return on Total Assets Purpose

Measures the success a company has in using its assets to earn income.

Rate of Return on Total Assets Formula

(Net income + Interest expense) divided by Average total assets.

Earnings Per Share (EPS) Purpose

The amount of a company's net income (or loss) for each share of its outstanding common stock.

Earnings Per Share (EPS) Formula

(Net income minus Preferred dividends) divided by Weighted average number of common shares outstanding.

Price/Earnings (P/E) Ratio Purpose

Measures the value the stock market places on $1 of a company's earnings.

Price/Earnings (P/E) Ratio Formula

Market price per share of common stock divided by Earnings per share.

Dividend Yield Purpose

Measures the percentage of a stock’s market value that is returned annually as dividends to stockholders.

Dividend Yield Formula

Annual dividend per share divided by Market price per share.

Dividend Payout Ratio Purpose

Ratio of dividends declared per common share relative to the earnings per share of the company.

Dividend Payout Ratio Formula

Annual dividend per share divided by Earnings per share.

Components of Return on Stock Investment

Gains (or losses) from selling the stock at a price above (or below) the purchase price, and Dividends.

Examples of Financial Red Flags (Financial Trouble)

Movement of sales, merchandise inventory, and receivables; earnings problems; decreased cash flow; too much debt; inability to collect receivables; and buildup of merchandise inventories.