Chapter 12:

Financial Statement
Analysis
Cornerstones of Financial & Managerial Accounting,
2e
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 The Use of Financial
1
Statements in Decisions

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 2 SEC Filings

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 Analyzing Financial
3 Statements with Cross
Sectional and Time Series
► Two general comparisonsAnalysis
we make when analyzing financial
statements are cross sectional analysis and time series (or
trend) analysis.
► Cross sectional analysis compares one corporation to another
corporation and to industry averages.
► Time series (or trend) analysis compares a single corporation
across time.
► Year-to-year comparisons of important accounts and account
groups help to identify the causes of changes in a company’s
income or financial position.
► Knowing the causes of these changes is helpful in forecasting a
company’s future profitability and financial position.
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 Analyzing The Financial
4 Statements with Horizontal
and Vertical Analysis
► The comparative financial statements included in the 10-K report
the results in dollar amounts.
► This makes it easy to detect large changes between years in
accounts or groups of accounts.
► These changes may indicate that the corporation is changing or that
the conditions under which the corporation operates are changing.
► However, while comparative financial statements show changes in
the amounts of financial statement items, analysts often prefer to
restate the financial statements in percentages using common size
statements.
► Common size statements express each financial statement line item
in percentage terms, which highlights differences.

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 4 Horizontal Analysis
►In horizontal analysis, each financial statement line
item is expressed as a percent of the base year
(typically the first year shown).
►Horizontal analysis is good for highlighting the
growth (or shrinkage) in financial statement line
items from year to year and is particularly useful for
trend analysis.

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 4 Vertical Analysis
► Vertical analysis, on the other hand, expresses each
financial statement line item as a percent of the largest
amount on the statement.
► On the income statement, this is net sales and on the
balance sheet it is total assets.
► Vertical analysis helps distinguish between changes in
account balances that result from growth and changes
that are likely to have arisen from other causes.
► Identifying non-growth changes and their causes can help
forecast a company’s future profitability or its future
financial position.

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 Analyzing the Financial
5 Statements with Ratio
Analysis
► Ratio analysis is an examination of financial statements conducted
by preparing and evaluating a series of ratios.
► Ratios (or financial ratios), like other financial analysis data,
normally provide meaningful information only when compared with
ratios from previous periods for the same firm (i.e., time series, or
trend analysis) or similar firms (i.e., cross-sectional analysis).
► Ratios help by removing most of the effects of size differences.
► When dollar amounts are used, size differences between firms may
make a meaningful comparison impossible.
► However, properly constructed financial ratios permit the
comparison of firms regardless of size.

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 Short-Term Liquidity
5
Ratios
► Short-term liquidity ratios are particularly helpful to short-
term creditors, but all investors and creditors have an interest
in these ratios.
► Analysts want to know the likelihood that a company will be
able to pay its current obligations as they come due.
► Failure to pay current liabilities can lead to suppliers refusing
to sell needed inventory and employees leaving.
► The cash necessary to pay current liabilities will come from
existing cash or from receivables and inventory, which should
turn into cash approximately at the same time the current
liabilities become due.
► The short-term liquidity ratios compare some combination of
current assets or operations to current liabilities.
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 Summary of Financial
5 Ratios: Short-term
Liquidity Ratios

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 Debt Management
5
Ratios
► Debt management ratios provide information on two aspects of debt.
► First, they provide information on the relative mix of debt and equity
financing (often referred to as its capital structure).
► The primary advantages of debt over equity are as follows:
► Interest payments are tax-deductible.
► Creditors do not share in profits.
► Second, debt management ratios also try to show the corporation’s
ability to meet, or cover its debt obligations through operations
because interest and principal payments must be made as scheduled.
► Debt is riskier than equity, because unless the interest and principal
payments are made when due, the firm may fall into bankruptcy.

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 Summary of Financial
5 Ratios:
Debt Management
Ratios

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 5 Asset Efficiency Ratios
► Asset efficiency ratios (or operating ratios) are measures of
how efficiently a company uses its assets.
► The principal asset efficiency ratios are measures of turnover,
that is, the average length of time required for assets to be
consumed or replaced.
► The faster an asset is turned over, the more efficiently it is
being used.
► These ratios provide managers and other users of a
corporation’s financial statements with easily interpreted
measures of the time required to turn receivables into cash,
inventory into cost of goods sold, or total assets into sales.

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 Summary of Financial
5 Ratios:
Asset Efficiency Ratios

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 5 Profitability Ratios
► Profitability ratios measure two aspects of a corporation’s
profits:
► elements of operations that contribute to profit
► the relationship of profit to total investment and investment by
stockholders
► The first group of profitability ratios, which includes gross
profit (or gross margin) percentage, operating margin
percentage, and net profit margin percentage, expresses
income statement elements as percentages of net sales.
► The second group of profitability ratios, which includes return
on assets and return on equity, divides measures of income by
measures of investment.
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 Summary of Financial
5 Ratios: Profitability
Ratios

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 5 Stockholder Ratios
► Stockholders are primarily interested in two things:
► the creation of value
► the distribution of value
► Stockholder ratios such as earnings per share and return on
common equity provide information about the creation of
value for stockholders.
► Value is distributed to stockholders in one of two ways.
► Either the corporation issues dividends or repurchases stock.
► The remainder of the stockholder ratios—dividend yield,
dividend payout, stock repurchase payout, and total payout—
address this distribution of value.

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 Summary of Financial
5 Ratios: Stockholder
Ratios

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5 Dupont Analysis
► Return on common equity (or return on equity, ROE) is the
most important measure of profitability for investors.
► It represents the amount of income generated per dollar of
book value of equity or common equity.
► In that way, it is conceptually similar to an interest rate.
ROE = Net income ÷ Average Equity
► Dupont analysis recognizes that ROE can be broken down into
Net Profit Margin x Asset Turnover x Total Leverage.

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 Data for Ratio
5
Comparisons
► Developing information from financial ratios requires that
comparisons be made among the ratios of the following:
► the same corporation over time
► similar corporations over time
► similar corporations at the present time
► Analysts rely on several sources to fulfill their need for a broad
range of data for individual corporations as well as for
industries and the economy.
► The best source of information about the corporation starts
with the investor relations section of their website.
► Links to the corporation’s 10-K (and other SEC filings), analyst
conference calls, and press releases are typically found there.
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