Analysis of Financial Statements Notes

Chapter 17: Analysis of Financial Statements

Learning Objectives

• C1: Define the building blocks of analysis and the standards for comparisons.
• A1: Summarize and report results of analysis.
• A2: Explain the form and assess the content of a complete income statement (Appendix 17A).
• P1: Explain and apply methods of horizontal analysis.
• P2: Describe and apply methods of vertical analysis.
• P3: Define and apply ratio analysis.

Purpose of Analysis

The common goal of financial statement analysis is to evaluate company performance and financial condition for both external and internal users. This analysis assists in evaluating:

1. Past and current performance
2. Current financial position
3. Future performance and risk

• Internal Users: Managers, officers, internal auditors.
• External Users: Shareholders, lenders, suppliers.

Building Blocks of Analysis

• Liquidity and efficiency
• Solvency
• Profitability
• Market prospects

Information for Analysis

General-purpose financial statements include:

1. Income Statement
2. Balance Sheet
3. Statement of Stockholders’ Equity
4. Statement of Cash Flows
5. Notes to the Financial Statements

Standards for Comparison

When interpreting analysis results, it is essential to compare them to other standards or benchmarks:

• Intracompany: Comparing a company's current performance to its past performance.
• Competitor: Comparing a company's performance to its competitors.
• Industry: Comparing a company's performance to industry averages.
• Guidelines: Using general rules of thumb or benchmarks.

Tools of Analysis

• Horizontal Analysis: Comparing financial condition and performance across time.
• Vertical Analysis: Comparing financial condition and performance to a base amount.
• Ratio Analysis: Measurement of key relations between financial statement items.

Horizontal Analysis

Horizontal analysis involves examining financial statement data across time.

• Comparative Statements: Compare the analysis period amount to the base period amount.
  • Dollar Change:
    $Dollar : change = Analysis : period : amount - Base : period : amount$
  • The analysis period refers to the financial statements under analysis.
  • The base period refers to the financial statements used for comparison.
  • Percent Change:
    $Percent : change = \frac{Analysis : period : amount - Base : period : amount}{Base : period : amount} \times 100$

Comparative Balance Sheets and Income Statements are used as examples.

Trend Analysis

Trend analysis reveals patterns in data across periods.

• Trend Percent Equation:

$Trend : Percent : ($

Using the number reported 4 years ago as the base period, trend percents are calculated for each year by dividing that year’s amount by the base period amount.

Trend percentages can be graphed to visualize trends over time.

Vertical Analysis

• Common-Size Statements:

$Common-size : percent : ($

Examples of Common-Size Balance Sheet and Income Statement, and Data Visualizations are given.

Ratio Analysis

Ratio analysis involves the calculation of key relations between financial statement items. The categories are:

• Liquidity and efficiency
• Solvency
• Profitability
• Market prospects

Liquidity and Efficiency

Includes ratios such as Working Capital, Current Ratio, Acid-test Ratio, Accounts Receivable Turnover, Inventory Turnover, Days’ Sales Uncollected, Days’ Sales in Inventory, and Total Asset Turnover.

• Working Capital:

  • Working capital is the amount of current assets minus current liabilities.

  $Current : assets – Current : liabilities = Working : capital$

  • More working capital suggests a strong liquidity position.

• Current Ratio:

  • Measures the short-term debt-paying ability of the company.

  $Current : ratio = \frac{Current : assets}{Current : liabilities}$

  • A higher current ratio suggests a strong ability to meet current obligations.

• Acid-Test Ratio:

  • Excludes current assets that may be difficult to quickly convert into cash (inventories, prepaid expenses).
  • Also referred to as Quick Assets

  $Acid-test : ratio = \frac{Cash + Short-term : investments + Current : receivables}{Current : liabilities}$

• Accounts Receivable Turnover:

  • Measures how many times a company converts its receivables into cash.

  $Accounts : receivable : turnover = \frac{Net : sales}{Average : accounts : receivable, : net}$

  $Average : accounts : receivable = \frac{(Beginning : Accts. : Rec. + End : Accts. : Rec.)}{2}$

• Inventory Turnover:

  • Measures how many times a company sells its inventory during a period.

  $Inventory : turnover = \frac{Cost : of : goods : sold}{Average : inventory}$

  $Average : inventory = \frac{(Beginning : inventory + Ending : inventory)}{2}$

• Days’ Sales Uncollected:

  • Measures how frequently a company collects its accounts receivable.

  $Day's : sales : uncollected = \frac{Accounts : receivable, : net}{Net : sales} \times 365$

• Days’ Sales in Inventory:

  $Day's : sales : in : Inventory = \frac{Ending : inventory}{Cost : of : goods : sold} \times 365$

  • Useful measure in evaluating inventory liquidity.

• Total Asset Turnover:

  • Measures a company’s ability to use its assets to generate sales.

  $Total : asset : turnover = \frac{Net : sales}{Average : total : assets}$

  $Average : assets = \frac{(Beginning : assets + Ending : assets)}{2}$

• Indication of operating efficiency.

Solvency

Includes ratios such as Debt Ratio, Equity Ratio, Debt-to-Equity Ratio, and Times Interest Earned.

• Debt Ratio and Equity Ratio:

  • The debt ratio shows total liabilities as a percent of total assets.
  • The equity ratio shows total equity as a percent of total assets.

• Debt-to-Equity Ratio:

  $Debt-to-equity : ratio = \frac{Total : liabilities}{Total : equity}$

  • Measures the proportion of assets contributed by creditors.
  • A larger ratio suggests less opportunity to expand through debt financing.

• Times Interest Earned:

  • Measures a company’s ability to pay interest expense.

  $Times : interest : earned = \frac{Income : before : interest : expense : and : income : taxes}{Interest : expense}$

  $Net : income + Interest : expense + Income : taxes = Income : before : interest : and : taxes$

Profitability

Includes ratios such as Gross Margin Ratio, Profit Margin, Return on Total Assets, and Return on Equity.

• Gross Margin Ratio:

  $Gross : margin : ratio = \frac{Net : sales – Cost : of : goods : sold}{Net : sales}$

  • Measures a company’s percentage of gross margin in each dollar of net sales.

• Profit Margin:

  $Profit : margin = \frac{Net : income}{Net : sales}$

  • Measures a company’s ability to earn net income from each sales dollar.

• Return on Total Assets:

  $Return : on : total : assets = \frac{Net : income}{Average : total : assets}$

  • Measures how well assets are utilized by the company.

• Return on Equity:

  $Return : on : equity = \frac{Net : income}{Average : total : equity}$

  • Indicates the company’s ability to earn income for common stockholders.

Market Prospects

Includes ratios such as Price-Earnings Ratio and Dividend Yield.

• Price-Earnings Ratio:

  $Price-earnings : ratio = \frac{Market : price : per : common : share}{Earnings : per : share}$

  • Measures market expectations for future growth.

• Dividend Yield:

  $Dividend : yield = \frac{Annual : cash : dividends : per : share}{Market : price : per : share}$

  • Used to compare the dividend-paying performance of different companies.

Analysis Reporting

The following elements are included in analysis reporting:

1. Executive Summary
2. Analysis Overview
3. Evidential Matter
4. Assumptions
5. Key Factors
6. Inferences

Appendix 17A: Complete Income Statement

A complete income statement includes elements such as:

• Net Income
• Sustainable Income
• Discontinued Segments
• Changes in Accounting Principles: Retrospective application on prior financial statements.
• Continuing Operations
• Earnings per share
• All-inclusive Income Statement is provided as an example.