Lecture 2

Financial Statement
Analysis
 Learning Objectives
1. Analyze financial statements using two forms of common-size
analysis: horizontal analysis and vertical analysis
2. Explain why historical standards and industrial averages are
important for ratio analysis
3. Calculate and use liquidity ratios to assess the ability of a company
to meet its current obligations
4. Calculate and use leverage ratios to assess the ability of a company
to meet its long- and short-term obligations
5. Calculate and use profitability ratios to assess the extent to which a
company’s resources are being used efficiently
 Common-Size Analysis
• The simple first step in financial statement analysis is comparing
two financial statements
• For example, the income statement of this year and the previous year
• To make the analysis more meaningful, percentages can be used
• Common-size analysis expresses line items or accounts in the
financial statements as percentages
• The two major forms of common-size analysis are horizontal
analysis and vertical analysis
 Horizontal Analysis
• Also called trend analysis, horizontal analysis expresses a line item
as a percentage of some prior-period amount
• Allows the trend over time to be assessed
• In horizontal analysis, line items are expressed as a percentage of a
base period amount
• The base period can be the immediately preceding period, or it can
be a period further in the past
Horizontal Analysis
• By comparing a given financial statement line item, such as
sales or various expenses, as a percentage of some prior-period
amount, managers can better identify trends in performance
How to Prepare Common-Size Income Statements Using Base Period
Horizontal Analysis
How to Prepare Common-Size Income Statements Using Base Period
Horizontal Analysis
 Vertical Analysis
• While horizontal analysis involves relationships among items
over time, vertical analysis is concerned with relationships
among items within a particular time period
• Vertical analysis expresses the line item as a percentage of
some other line item for the same period
• With this approach, within-period relationships can be
assessed
 Vertical Analysis
• Line items on income statements often are expressed as
percentages of net sales. Items on the balance sheet often
are expressed as a percentage of total assets
• By comparing a given financial statement line item as a
percentage of some other line item (such as sales or total
assets) for the same time period, managers can better
understand the relative size and importance of each item
How to Prepare Income Statements Using Net Sales as the Base:
Vertical Analysis
How to Prepare Income Statements Using Net Sales as the Base:
Vertical Analysis
Percentages and Size Effects
• The use of common-size analysis makes comparisons
more meaningful because percentages eliminate the
effects of size
• For example, if Heisman Company earns P100,000 and
Casciani Company earns P1 million, which company is
more profitable?
• The answer depends to a large extent on the assets
employed to earn the profits
Percentages and Size Effects
• If Heisman used an investment of P1 million to earn the
P100,000, then the return expressed as a percentage of dollars
is 10% (P100,000/P1,000,000)
• If Casciani used an investment of P20 million to earn its P1
million, the percentage return is only 5%
(P1,000,000/P20,000,000)
• By using percentages, it is easy to see that the first firm is
relatively more profitable than the second
Ratio Analysis
• Ratio analysis is the second major technique for financial
statement analysis
• Ratios are fractions or percentages computed by dividing one
account or line-item amount by another
• For example, operating income divided by sales produces a ratio
that measures the profit margin on sales
 Standards for Comparison
• Ratios by themselves tell little about the financial well-being of a
company
• For meaningful analysis, the ratios should be compared with a
standard
• Only through comparison can someone using a financial statement
assess the financial health of a company
• Two standards commonly used are the past history of the company
and industrial averages
Ratio Analysis
Classification of Ratios
• Ratios generally are classified into one of three categories:
liquidity, borrowing capacity or leverage, and profitability
• Liquidity ratios measure the ability of a company to meet its
current obligations
• Leverage ratios measure the ability of a company to meet its
long- and short-term obligations. These ratios provide a
measure of the degree of protection provided to a
company’s creditors
Classification of Ratios
• Profitability ratios measure the earning ability of a company.
These ratios allow investors, creditors, and managers to
evaluate the extent to which invested funds are being used
efficiently
Liquidity Ratios
• Liquidity ratios are used to assess the short-term debt-paying
ability of a company
• If a company does not have the short-term financial strength to
meet its current obligations, it is likely to have difficulty meeting
its long-term obligations
Liquidity Ratios
• Although there are numerous liquidity ratios, only the most
common ones include:
• current ratio
• quick or acid-test ratio
• accounts receivable turnover ratio
• inventory turnover ratio
Current Ratio
• The current ratio is a measure of the ability of a company to pay
its short-term liabilities out of short-term assets
• The current ratio is computed as follows:

Current Ratio = Current Assets

Current Liabilities
Current Ratio
• Current liabilities must be paid within an operating cycle
(usually within a year) and current assets can be converted to
cash within an operating cycle
• The current ratio provides a direct measure of the ability of a
company to meet its short-term obligations
Current Ratio
• Many creditors use the rule of thumb that a 2.0 ratio is needed
to provide good debt-paying ability, but the rule has many
exceptions
• A declining current ratio is not necessarily bad, particularly if it
is falling from a high value
• A high current ratio may signal excessive investment in current
resources
Current Ratio
• A declining current ratio may signal a move toward more
efficient utilization of resources
• A declining current ratio coupled with a current ratio lower than
that of other firms in the industry supports the judgment that a
company is having liquidity problems
Quick or Acid-Test Ratio
• The quick or acid-test ratio is a measure of liquidity that
compares only the most liquid assets with current liabilities
• Excluded from the quick ratio are nonliquid current assets such
as inventories
• The numerator of the quick ratio includes only the most liquid
assets
(Cash + Marketable Securities + Accounts Receivable)
Quick Ratio =
Current Liabilities
Quick or Acid-Test Ratio
• The current ratio measures a company’s liquidity by showing
how many dollars of current assets it possesses relative to
current liabilities
• The quick ratio provides an even more direct assessment of
liquidity by including in the numerator only the three assets
that already are cash or typically are converted to cash most
quickly
How to Calculate the Current Ratio and the Quick (or
Acid-Test) Ratio
Accounts Receivable Turnover Ratio
• A company’s liquidity problem can be further investigated by
examining the liquidity of its receivables, or how long it takes
the company to turn its receivables into cash
• A low liquidity of receivables signals more difficulty since the
quick ratio would be overstated
Accounts Receivable Turnover Ratio
• The liquidity of receivables is measured by the accounts
receivable turnover ratio:

Net Sales
Accounts Receivable Turnover Ratio =
Average Accounts Receivable

• The Average Accounts Receivable is computed as follows:

Average Accounts Receivable = (Beginning Receivables + Ending Receivables)

2
Accounts Receivable Turnover in Days
• The accounts receivable turnover ratio can be taken further to
determine the number of days the average balance of accounts
receivable is outstanding before being converted into cash,
which is calculated as follows:
365
Turnover in Days =
Receivables Turnover Ratio
Accounts Receivable Turnover in Days
• Whether the result is good or bad depends to some extent on
what other companies in the industry are experiencing
• A low turnover ratio suggests a need to modify credit and
collection policies to speed up the conversion of receivables to
cash
• These three accounts receivable computations assesses the
speed at which a company converts its accounts receivables into
cash
How to Calculate the Average Accounts Receivable, the Accounts Receivable
Turnover Ratio, and the Accounts Receivable Turnover in Days
Inventory Turnover Ratio
• Inventory turnover is also an important liquidity measure
• The inventory turnover ratio is computed as follows:

Inventory Turnover Ratio = Cost of Goods Sold

Average Inventory

• The average inventory is computed as follows:

(Beginning Inventory + Ending Inventory)

Average Inventory =
2
Inventory Turnover Ratio
• This ratio tells an analyst how many times the average inventory
turns over, or is sold, during the year
• The number of days inventory is held before being sold can be
computed as:
365
Turnover in Days =
Inventory Turnover Ratio
Inventory Turnover Ratio
• A low turnover ratio may signal the presence of too much
inventory or sluggish sales
• These three inventory computations assess the speed at which
a company converts its inventory into cash
How to Calculate the Average Inventory, the Inventory Turnover
Ratio, and the Inventory Turnover in Days
Leverage Ratios
• When a company incurs debt, it has the obligation to repay the
principal and the interest
• Holding debt increases the riskiness of a company
• Leverage ratios can help an individual to evaluate a company’s
debt-carrying ability
• The most common leverage ratios are:
• Times-interest-earned-ratio
• Debt ratio
• Debt-to-equity ratio
Times-Interest-Earned Ratio
• The first leverage ratio uses the income statement to assess a
company’s ability to service its debt
• This ratio, called the times-interest-earned ratio, is computed
as follows:
(Income Before Taxes + Interest Expense)
Times-Interest-Earned Ratio =
Interest Expense
Times-Interest-Earned Ratio
• Income before taxes must be recurring income; thus, unusual or
infrequent items appearing on the income statement should be
excluded in order to compute the ratio
• Recurring income is used because it is the income that is
available each year to cover interest payments
• Times-interest-earned is a profitability ratio that compares a
company’s earnings to its interest expense to assess how well
the company can service its debt
Calculating the Times-Interest-Earned Ratio
Debt Ratio
• Investors and creditors are the two major sources of capital
• As the percentage of assets financed by creditors increases, the
riskiness of the company increases
• The debt ratio measures this percentage and is computed as
follows:
Total Liabilities
Debt Ratio =
Total Assets
Debt Ratio
• Since total liabilities are compared with total assets, the ratio
measures the degree of protection afforded creditors in case of
insolvency
• Creditors often impose restrictions on the percentage of
liabilities allowed
• If this percentage is exceeded, the company is in default, and
foreclosure can take place
Debt-to-Equity Ratio
• Another ratio useful in assessing the leverage used by a
company is the debt-to-equity ratio
• This ratio compares the amount of debt that is financed by
stockholders and is calculated as follows:
Total Liabilities
Debt-to-Equity Ratio =
Total Stockholders’ Equity
Debt-to-Equity Ratio
• Creditors would like this ratio to be relatively low, indicating
that stockholders have financed most of the assets of the firm
• Stockholders, on the other hand, may wish this ratio to be
higher because that indicates that the company is more highly
leveraged and stockholders can reap the return on the
creditors’ financing
• The debt ratio and debt-to-equity ratio provide insights into the
capital structure (i.e., debt or equity) used by a company to
finance its assets
How to Calculate the Debt Ratio and the Debt-to-Equity Ratio
Profitability Ratios
• Investors earn a return through the receipt of dividends and
appreciation of the market value of their stock
• Both dividends and market price of shares are related to the
profits generated by companies
• Since they are the source of debt-servicing payments, profits
also are of concern to creditors
Profitability Ratios
• Managers also have a vested interest in profits
• Bonuses, promotions, and salary increases often are tied to
reported profits
• Profitability ratios, therefore, are given particular attention by
both internal and external users of financial statements
Return on Sales
• Return on sales is the profit margin on sales
• It represents the percentage of each sales dollar that is left over as
net income after all expenses have been subtracted
• Return on sales is one measure of the efficiency of a firm and is
computed as follows:
Net Income
Return on Sales =
Sales

• Return on sales computes the cents from each sales dollar that
remain after subtracting all expenses
Information for Example Calculations
Information for Example Calculations
Return on Total Assets
• Return on assets measures how efficiently assets are used by
calculating the return on total assets used to generate profits
• Return on total assets is computed as follows:
{Net Income + [Interest Expense(1 – Tax Rate)]}
Return on Total Assets =
Average Total Assets

• Average total assets is computed as follows:

(Beginning Total Assets + Ending Total Assets)
Average Total Assets =
2
Return on Total Assets
• By adding back the after-tax cost of interest, this measure
reflects only how the assets were employed
• It does not consider the manner in which they were financed
(interest expense is a cost of obtaining the assets, not a cost of
using them)
• Return on assets is a popular ratio that assesses the efficiency
with which assets generate earnings
How to Calculate the Average Total Assets and the Return on
Assets
Return on Common Stockholders’ Equity
• Return on total assets is measured without regard to the source
of invested funds
• For common stockholders, however, the return that they
receive on their investment is of paramount importance
• Of special interest to common stockholders is how they are
being treated relative to other suppliers of capital funds
Return on Common Stockholders’ Equity
• The return on stockholders’ equity provides a measure that can
be used to compare against other return measures (e.g.,
preferred dividend rates and bond rates) and is computed as
follows:
(Net Income – Preferred Dividends)
Return on Stockholders’ Equity =
Average Common Stockholders’ Equity
Earnings Per Share
• Investors also pay considerable attention to a company’s
profitability on a per-share basis
• Earnings per share is computed as follows:
(Net Income – Preferred Dividends)
Earnings per Share =
Average Common Shares

• Average common shares outstanding is computed by taking a

weighted average of the common shares for the period under
study
Earnings Per Share
• Earnings per share is the ratio most frequently cited by the
majority of investors because it calculates the earnings
generated per share of common stock
Price-Earnings Ratio
• The price-earnings ratio is calculated as follows:
Market Price per Share
Price-Earnings Ratio =
Earnings per Share

• Price-earnings ratios are viewed by many investors as important

indicators of stock values
• If investors believe that a company has good growth prospects,
then the price-earnings ratio should be high
Price-Earnings Ratio
• The price-earnings ratio should be interpreted with caution as it
is comprised of stock price “(a highly volatile measure) and
earnings, which is a number that can be manipulated to meet
certain targets involving analyst expectations, managerial
bonuses, and other organizational goals
• Price-earnings ratio varies widely across companies and
compares the market price per share of stock to the earnings
generated per share of common stock
Dividend Yield and Payout Ratios
▪ The profitability measure called dividend yield is computed as
follows:
Dividends per Common Share
Dividend Yield =
Market Price per Common Share

▪ By adding the dividend yield to the percentage change in stock

price, a reasonable approximation of the total return accruing
to an investor can be obtained
Dividend Yield and Payout Ratios
• The dividend payout ratio is computed as follows:

Common Dividends
Dividend Payout Ratio =
(Net Income – Preferred Dividends)

• The payout ratio tells an investor the proportion of earnings

that a company pays in dividends
• Investors who prefer regular cash payments instead of
returns through price appreciation will want to invest in
companies with a high payout ratio
Dividend Yield and Payout Ratios
• Investors who prefer gains through appreciation will generally
prefer a lower payout ratio
• The dividend yield and dividend payout ratios compare the
amount of dividends a company declares relative to other
popular measures of its profitability, such as the market price
per share of common stock or earnings
Impact of the Just-in-Time Manufacturing Environment
• In the just-in-time (JIT) manufacturing environment, reducing
inventories and increasing quality are critical activities
• Both activities are essential for many companies to retain their
competitive ability
• Users of financial statements should have a special interest in
ratios that measure a company’s progress in achieving the goals
of zero inventories and total quality
Impact of the Just-in-Time Manufacturing Environment
• As a company reduces its inventory, the inventory turnover ratio
should increase dramatically
• High turnover is interpreted as a signal of success—of achieving
the goal of zero inventories with all of the efficiency associated
with that state
Other Ratio Considerations for the JIT Manufacturing
Environment
• Since many lenders require a 2.0 current ratio to grant and
control a loan, some reevaluation of the use of this ratio is
needed for customers with a JIT system
• It may be necessary to rely more on the quick ratio or other
alternative ratios (such as cash flow divided by current
maturities of long-term debt)
• A ratio that says something about quality also is desirable for JIT
firms
Other Ratio Considerations for the JIT Manufacturing Environment
• The usual approach is to express quality costs as a percentage of
sales
• External users, however, may not have access to quality costs as
a separate category
Importance of Profitability Ratios to External Users
• Of course, for ratio analysis to be useful, it is critically important
that the underlying financial information be accurate
• The purpose of financial statements prepared for outside users
is to fairly represent the underlying economic position of the
firm
Importance of Profitability Ratios to External Users
• A look back at the recent past shows many instances in which
corporate heads, knowing the importance of various ratios, took
unethical steps to make the information fit the desired ratio
results rather than letting the ratios come from fairly generated
information