Financial Statement Analysis

Describe basic financial statement analytical methods. Use financial statement analysis to assess the solvency of a business. Use financial statement analysis to assess the profitability of a business. Describe the contents of corporate annual reports.

Basic Analytical Methods

Users analyze a companys financial statements using a variety of analytical methods. Three such methods are as follows: 1. Horizontal analysis 2. Vertical analysis 3. Common-sized statements

Horizontal Analysis
The percentage analysis of increases and decreases in related items using comparative financial statements is called horizontal analysis.

Horizontal Analysis: Difference Base year (2009) $17,000 $533,000

3.2%

Comparative Schedule of Current Assets Horizontal Analysis

Comparative Income StatementHorizontal Analysis

Vertical Analysis
A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis.

Vertical Analysis of Balance Sheet

In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders equity item is stated as a percent of the total liabilities and stockholders equity.

Vertical Analysis: Current assets Total assets $550,000 = 48.3% $1,139,500

Vertical Analysis of the Income Statement In a vertical analysis of the income statement, each item is stated as a percent of net sales.

Vertical Analysis: Selling expenses $191,000 Net sales $1,498,000 = 12.8%

Solvency Analysis All users of financial statements are interested in the ability of a company to do the following: 1. Meet its financial obligations (debts), called solvency. 2. Earn income, called profitability.

Working Capital
The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a companys ability to pay current liabilities.
Working Capital = Current Assets Current Liabilities
2010 $550,000 210,000 $340,000 2009 $533,000 243,000 $290,000

Current assets Current liabilities Working capital

Current Ratio The current ratio, sometimes called the working capital ratio or bankers ratio measures a companys ability to pay its current liabilities.
Current Ratio = Current Assets Current Liabilities 2010 Current assets Current liabilities Currentratio Current ratio $550,000 $210,000 2.6 2.6 2009 $533,000 $243,000 2.2 2.2 $533,000 $243,000

$550,000 $210,000

Quick Ratio A ratio that measures the instant debt-paying ability of a company is called the quick ratio or acid-test ratio.
2010 Quick assets: Cash Temporary Investments Accounts receivable (net) a. Total quick assets b. Current liabilities Quick ratio (a b) $ 90,500 75,000 115,000 $280,500 $210,000 1.3 2009 $ 64,700 60,000 120,000 $244,700 $243,000 1.0

Accounts Receivable Turnover The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a companys solvency.
Accounts Receivable Turnover = Net Sales Average Accounts Receivable 2010 2009 $1,498,000 $ 120,000 115,500 $ 235,000 $ 117,500 $1,200,000 $ 140,000 120,000 $ 260,000 $ 130,000

a. Net sales Accounts receivable (net): Beginning of year End of year Total b. Average (Total 2) Accounts receivable turnover (a b)

12.7

9.2

Number of Days Sales in Receivables The number of days sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding.
Average Accounts Receivable Average Daily Sales

Number of Days Sales in = Receivables

Net Sales 365

2010 a. Average accounts receivable (Total accounts receivable 2)

2009

$ 117,500 $1,498,000 $ 4,104

$ 130,000 $1,200,000 $ 3,288

Net sales b. Average daily sales (Sales 365) Number of days sales in receivables (a b)

28.6

39.5

Inventory Turnover
The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory. Cost of Goods Sold
Inventory Turnover = Average Inventory 2010 a. Cost of goods sold Inventories: Beginning of year End of year Total b. Average (Total 2) Inventory turnover (a b) $1,043,000 $ 283,000 264,000 $ 547,000 $ 273,500 3.8 2009 $ 820,000 $ 311,000 283,000 $ 594,000 $ 297,000 2.8

Number of Days Sales in Inventory

The number of days sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory.
Average Inventory Number of Days = Sales in Inventory Average Daily Cost of Goods Sold Cost of Goods Sold 365 2010 $ 273,500 $1,043,000 $2,858 2009 $ 297,000 $ 820,000 $2,247

a. Average inventory (Total 2) Cost of goods sold b. Average daily cost of goods sold (COGS 365 days) Number of days sales in inventory (a b)

95.7

132.2

Ratio of Fixed Assets to Long-Term Liabilities The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis.
Ratio of Fixed Assets to Long= Term Liabilities Fixed Assets (net) Long-Term Liabilities 2010 a. Fixed assets (net) b. Long-term liabilities
Ratio of fixed assets to long-term liabilities (a b)

2009 $470,000 $200,000

$444,500 $100,000

4.4

2.4

Ratio of Fixed Assets to Long-Term Liabilities The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis.
Ratio of Fixed Assets to Long= Term Liabilities Fixed Assets (net) Long-Term Liabilities

2010 a. Fixed assets (net) b. Long-term liabilities Ratio of fixed assets to long-term liabilities (a b) $444,500 $100,000

2009 $470,000 $200,000

4.4

2.4