A Purpose of financial statement analysis for these users is to provide strategic information to
improve company efficiency and effectiveness in providing products and services. (Financial
statement analysis tools are also used for personal financial investment decisions.) (Financial
statement analysis is a topic on the CPA, CMA, CIA, and CFA exams.)
Our analysis emphasizes four areas of inquiry---with varying degrees of importance. These four
areas are described and illustrated in this chapter and are considered the building blocks of
financial statement analysis:
1. Liquidity and efficiency----ability to meet short-term obligations and to efficiently
generate revenues.
2. Solvency----ability to generate future revenues and meet long-term obligations.
3. Profitability----ability to provide financial rewards sufficient to attract and retain
financing.
4. Market prospects----ability to generate positive market expectations.
Most users must rely on general-purpose financial statements that in the (1) income statement,
(2) balance sheet, (3) statement of stockholders’ equity (or statement of retained earnings), (4)
statement of cash flows, and (5) notes to these statements.
Financial reporting refers to the communication of financial information useful for making
investment, credit, and other business decisions. Financial reporting includes not only general-
purpose financial statements but also information for SEC 10-K or other filings, press releases,
shareholders’ meetings, forecasts, management letters, auditors’ reports, and webcasts.
Management’s Discussion and Analysis (MD&A) is one example of useful information outside
traditional financial statements. Apple’s MD&A for example, begins with an overview, followed
by critical accounting policies and estimates. It then discusses operating results followed by
financial condition (liquidity, capital resources, and cash flows). The final few parts discuss legal
proceedings, market risk of financial instruments, and risks from interest rate and foreign
currency fluctuations. The MD&S is an excellent starting point in understanding a company’s
business activities.
When interpreting measures from financial statement analysis, we need to decide whether the
measures indicate good, bad, or average performance. To make such judgments, we need
standards (benchmarks) for comparisons that include the following:
1. Intracompany----The company under analysis can provide standards for comparisons
based on its own prior performance and relations between its financial items
2. Competitor----One or more direct competitors of the company being analyzed can
provide standards for comparisons.
3. Industry----Industry statistics can provide standards of comparisons.
4. Guidelines (rule of thumb)----General standards of comparisons can develop from
experience.
Three of the most common tools of financial statement analysis are
1. Horizontal analysis----comparison of a company’s financial condition and performance
across time.
2. Vertical analysis----comparison of a company’s financial condition and performance to a
base amount.
3. Ratio analysis----measurement of key relations between financial statement items.
Comparative financial statements facilitate this comparison by showing financial amounts in
side-by-side columns on a single statement, called a comparative format.
, Dollar change = Analysis period amount – Base period amount
Analysis period is the point or period of time for the financial statements under analysis, and
base period is the point or period of time for the financial statements used for comparison
purposes.
Analysis period amount – Base period amount
Base period amount
Percent change % = x 100
Trend analysis, also called trend percent analysis or index number trend analysis, is a form of
horizontal analysis that can reveal patterns in data across successive periods. It involves
computing trend percents for a series of financial numbers and is a variation on the use of
percent changes. The difference is that trend analysis does not subtract the base period amount
in the numerator. To compute trend percents, we do the following:
1. Select a base period and assign each item in the base period a weight of 100%.
2. Express financial numbers as a percent of their base period number.
Specifically, a trend percent, also called an index number, is computed as follows:
Analysis period amount
Base period amount
Trend percent % = x 100
Vertical analysis is a tool evaluate individual financial statement items or a group of items in
terms of a specific base amount. (The term vertical analysis arises from the up-down [or down-
up] movement of our eyes as we review common-size financial statements. Vertical analysis is
also called common-size analysis.)
Common-size financial statements to reveal changes in the relative importance of each financial
statement item. A common-size percent is measured by dividing each individual financial
statement amount under analysis by its base amount:
Analysis amount
Base amount
Common-size percent % = x 100
The purpose of financial statement is for internal users to provide strategic information to
improve company efficiency and effectiveness in providing products and services.
Most users must rely on general-purpose financial statements that in the (1) income statement,
(2) balance sheet, (3) statement of stockholders’ equity (or statement of retained earnings), (4)
statement of cash flows, and (5) notes to these statements.
Stella, Inc. needs to communicate financial information to outside users that is useful for making
investment, credit, and other business decisions. This is called financial reporting.
Management’s discussion and analysis begins with an overview, followed by critical accounting
policies, and a discussion of operating results and financial condition. It is an excellent starting
point in understanding a company’s business activities.
When interpreting measures from financial statement analysis, we need to decide whether the
measures indicate good, bad, or average performance. To make such judgments, we need
standards (or benchmarks) for comparisons.
A ratio expresses a mathematical relation between two quantities. It can be expressed as a
percent, rate, or proportion. It is a simple arithmetic operation, but its interpretation is not.
, An investor in Able Inc. would like to understand Able’s funding requirements, also known as the
availability of Able’s resources to meet its short-term cash requirements. This type of analysis is
known as a liquidity measure.
Efficiency refers to how productive a company is in using its assets. It is measured relative to
how much revenue is generated from a certain level of assets.
Working capital can be computed by taking current assets – current liabilities.
The current ratio, or current assets divided by current liabilities, is used to evaluate a company’s
ability to pay its short-term obligations.
Current assets
Current liabilities
Current ratio=
Vito Co. had current assets of $9,000 and current liabilities of $6,000 at the end of 2010. Net
income during the year was $21,000. The current ratio for the period is: 1.5
A good analysis report usually consists of six sections:
1. Executive summary---brief focus on important analysis results and conclusions.
2. Analysis overview---background on the company, its industry, and its economic setting.
3. Evidential matter---financial statements and information used in the analysis, including
ratios, trends, comparisons, statistics, and all analytical measures assembled; often
organized under the building blocks of analysis.
4. Assumptions---identification of important assumptions regarding a company’s industry
and economic environment, and other important assumptions for estimates.
5. Key factors---list of important favorable and unfavorable factors, both quantitative and
qualitative, for company performance; usually organized by areas of analysis.
6. Inferences---forecasts, estimates, interpretations, and conclusions drawing on all
sections of the report.
Earning per share---Reports information for each of the three subcategories of income.
Continuing Operations---Shows revenues, expenses, and income from ongoing operations.
Extraordinary Items---Reports gains and losses that are both unusual and infrequent.
Discontinued Segments---Reports income from operating the and selling or closing down a
segment.
The inventory turnover is calculated by dividing the cost of goods sold by the average inventory.
Cost of goods sold
Average inventory
Inventory turnover =
Total asset turnover—reflects a company’s ability to use its assets to generate sales and is an
important indication of operation efficiency. It is computer by taking net sales divided by average
total assets.
Income before interest expense and income taxes
Interest expense
Times interest earned=
The times interest earned ratio is computed by taking income before interest expense and
income taxes divided by interest expense.
The amount of income before deductions for interest expense and income taxes is the amount
available to pay interest. The times interest earned ratio takes this income divided by interest
expense to determine the risk for creditors.
, Income before interest expense and income taxes
Interest expense
Times interest earned=
A company reports Net Sales of $100,000 in 2010 and $90,000 in 2009. At the beginning of 2010,
Accounts Receivable was $6,000; at the end of the period Accounts Receivable was $10,000.
Accounts receivable turnover for 2010 is 12.5
Net sales
Average accounts receivable, net
Accounts receivable turnover=
Profit margin reflects a company’s ability to earn net income from sales. It is measured
by expressing net income as a percent of sales.
Dividend Yield is used to compare the dividend-paying performance of different
investment alternatives. It is computed by taking annual cash dividends per share
divided by market price per share.
Days’ Sales Uncollected is a measure of the liquidity of receivables. It is computed by
dividing the current balance of receivables by the annual credit (or net) sales and then
multiplying by 365
A company has Total Assets of $135,000 including $29,000 in Accounts Receivable, and Net Sales
of $380,000. Days’ sales uncollected is 27.9 29,000/380,000= 0.0763157894736842 x 365=
27.85526315789474
A company has 20,000 shares of $5 par-value common stock issued and outstanding. Earnings
per share were $4, annual cash dividends per share were $0.09, and market price per share is
$90. Dividend yield is 1% ( 0.01% must move 2 decimals to the right)
Annual cash dividends per share
Market price per share
Dividend yield=
Return on common stockholders’ equity is computed by taking (net income less preferred
dividends) divided by: average common stockholders’ equity
Profit margin is computed by taking net income divided by net sales
Net income
Net sales
Profit margin=
Solvency refers to a company’s long-run financial viability and its ability to cover long-term
obligations.
Days’ sales uncollected is computed by taking accounts receivable, net divided by net sales
multiplied by 365.
1.
2015 2014 2013 2012 2011
Sales $ 673,986 $ 443,412 $ 350,523 $ 252,175 $ 192,500
Cost of goods sold 326,113 214,488 171,751 122,994 92,400
Accounts receivable 32,756 26,028 23,976 14,677 13,205
improve company efficiency and effectiveness in providing products and services. (Financial
statement analysis tools are also used for personal financial investment decisions.) (Financial
statement analysis is a topic on the CPA, CMA, CIA, and CFA exams.)
Our analysis emphasizes four areas of inquiry---with varying degrees of importance. These four
areas are described and illustrated in this chapter and are considered the building blocks of
financial statement analysis:
1. Liquidity and efficiency----ability to meet short-term obligations and to efficiently
generate revenues.
2. Solvency----ability to generate future revenues and meet long-term obligations.
3. Profitability----ability to provide financial rewards sufficient to attract and retain
financing.
4. Market prospects----ability to generate positive market expectations.
Most users must rely on general-purpose financial statements that in the (1) income statement,
(2) balance sheet, (3) statement of stockholders’ equity (or statement of retained earnings), (4)
statement of cash flows, and (5) notes to these statements.
Financial reporting refers to the communication of financial information useful for making
investment, credit, and other business decisions. Financial reporting includes not only general-
purpose financial statements but also information for SEC 10-K or other filings, press releases,
shareholders’ meetings, forecasts, management letters, auditors’ reports, and webcasts.
Management’s Discussion and Analysis (MD&A) is one example of useful information outside
traditional financial statements. Apple’s MD&A for example, begins with an overview, followed
by critical accounting policies and estimates. It then discusses operating results followed by
financial condition (liquidity, capital resources, and cash flows). The final few parts discuss legal
proceedings, market risk of financial instruments, and risks from interest rate and foreign
currency fluctuations. The MD&S is an excellent starting point in understanding a company’s
business activities.
When interpreting measures from financial statement analysis, we need to decide whether the
measures indicate good, bad, or average performance. To make such judgments, we need
standards (benchmarks) for comparisons that include the following:
1. Intracompany----The company under analysis can provide standards for comparisons
based on its own prior performance and relations between its financial items
2. Competitor----One or more direct competitors of the company being analyzed can
provide standards for comparisons.
3. Industry----Industry statistics can provide standards of comparisons.
4. Guidelines (rule of thumb)----General standards of comparisons can develop from
experience.
Three of the most common tools of financial statement analysis are
1. Horizontal analysis----comparison of a company’s financial condition and performance
across time.
2. Vertical analysis----comparison of a company’s financial condition and performance to a
base amount.
3. Ratio analysis----measurement of key relations between financial statement items.
Comparative financial statements facilitate this comparison by showing financial amounts in
side-by-side columns on a single statement, called a comparative format.
, Dollar change = Analysis period amount – Base period amount
Analysis period is the point or period of time for the financial statements under analysis, and
base period is the point or period of time for the financial statements used for comparison
purposes.
Analysis period amount – Base period amount
Base period amount
Percent change % = x 100
Trend analysis, also called trend percent analysis or index number trend analysis, is a form of
horizontal analysis that can reveal patterns in data across successive periods. It involves
computing trend percents for a series of financial numbers and is a variation on the use of
percent changes. The difference is that trend analysis does not subtract the base period amount
in the numerator. To compute trend percents, we do the following:
1. Select a base period and assign each item in the base period a weight of 100%.
2. Express financial numbers as a percent of their base period number.
Specifically, a trend percent, also called an index number, is computed as follows:
Analysis period amount
Base period amount
Trend percent % = x 100
Vertical analysis is a tool evaluate individual financial statement items or a group of items in
terms of a specific base amount. (The term vertical analysis arises from the up-down [or down-
up] movement of our eyes as we review common-size financial statements. Vertical analysis is
also called common-size analysis.)
Common-size financial statements to reveal changes in the relative importance of each financial
statement item. A common-size percent is measured by dividing each individual financial
statement amount under analysis by its base amount:
Analysis amount
Base amount
Common-size percent % = x 100
The purpose of financial statement is for internal users to provide strategic information to
improve company efficiency and effectiveness in providing products and services.
Most users must rely on general-purpose financial statements that in the (1) income statement,
(2) balance sheet, (3) statement of stockholders’ equity (or statement of retained earnings), (4)
statement of cash flows, and (5) notes to these statements.
Stella, Inc. needs to communicate financial information to outside users that is useful for making
investment, credit, and other business decisions. This is called financial reporting.
Management’s discussion and analysis begins with an overview, followed by critical accounting
policies, and a discussion of operating results and financial condition. It is an excellent starting
point in understanding a company’s business activities.
When interpreting measures from financial statement analysis, we need to decide whether the
measures indicate good, bad, or average performance. To make such judgments, we need
standards (or benchmarks) for comparisons.
A ratio expresses a mathematical relation between two quantities. It can be expressed as a
percent, rate, or proportion. It is a simple arithmetic operation, but its interpretation is not.
, An investor in Able Inc. would like to understand Able’s funding requirements, also known as the
availability of Able’s resources to meet its short-term cash requirements. This type of analysis is
known as a liquidity measure.
Efficiency refers to how productive a company is in using its assets. It is measured relative to
how much revenue is generated from a certain level of assets.
Working capital can be computed by taking current assets – current liabilities.
The current ratio, or current assets divided by current liabilities, is used to evaluate a company’s
ability to pay its short-term obligations.
Current assets
Current liabilities
Current ratio=
Vito Co. had current assets of $9,000 and current liabilities of $6,000 at the end of 2010. Net
income during the year was $21,000. The current ratio for the period is: 1.5
A good analysis report usually consists of six sections:
1. Executive summary---brief focus on important analysis results and conclusions.
2. Analysis overview---background on the company, its industry, and its economic setting.
3. Evidential matter---financial statements and information used in the analysis, including
ratios, trends, comparisons, statistics, and all analytical measures assembled; often
organized under the building blocks of analysis.
4. Assumptions---identification of important assumptions regarding a company’s industry
and economic environment, and other important assumptions for estimates.
5. Key factors---list of important favorable and unfavorable factors, both quantitative and
qualitative, for company performance; usually organized by areas of analysis.
6. Inferences---forecasts, estimates, interpretations, and conclusions drawing on all
sections of the report.
Earning per share---Reports information for each of the three subcategories of income.
Continuing Operations---Shows revenues, expenses, and income from ongoing operations.
Extraordinary Items---Reports gains and losses that are both unusual and infrequent.
Discontinued Segments---Reports income from operating the and selling or closing down a
segment.
The inventory turnover is calculated by dividing the cost of goods sold by the average inventory.
Cost of goods sold
Average inventory
Inventory turnover =
Total asset turnover—reflects a company’s ability to use its assets to generate sales and is an
important indication of operation efficiency. It is computer by taking net sales divided by average
total assets.
Income before interest expense and income taxes
Interest expense
Times interest earned=
The times interest earned ratio is computed by taking income before interest expense and
income taxes divided by interest expense.
The amount of income before deductions for interest expense and income taxes is the amount
available to pay interest. The times interest earned ratio takes this income divided by interest
expense to determine the risk for creditors.
, Income before interest expense and income taxes
Interest expense
Times interest earned=
A company reports Net Sales of $100,000 in 2010 and $90,000 in 2009. At the beginning of 2010,
Accounts Receivable was $6,000; at the end of the period Accounts Receivable was $10,000.
Accounts receivable turnover for 2010 is 12.5
Net sales
Average accounts receivable, net
Accounts receivable turnover=
Profit margin reflects a company’s ability to earn net income from sales. It is measured
by expressing net income as a percent of sales.
Dividend Yield is used to compare the dividend-paying performance of different
investment alternatives. It is computed by taking annual cash dividends per share
divided by market price per share.
Days’ Sales Uncollected is a measure of the liquidity of receivables. It is computed by
dividing the current balance of receivables by the annual credit (or net) sales and then
multiplying by 365
A company has Total Assets of $135,000 including $29,000 in Accounts Receivable, and Net Sales
of $380,000. Days’ sales uncollected is 27.9 29,000/380,000= 0.0763157894736842 x 365=
27.85526315789474
A company has 20,000 shares of $5 par-value common stock issued and outstanding. Earnings
per share were $4, annual cash dividends per share were $0.09, and market price per share is
$90. Dividend yield is 1% ( 0.01% must move 2 decimals to the right)
Annual cash dividends per share
Market price per share
Dividend yield=
Return on common stockholders’ equity is computed by taking (net income less preferred
dividends) divided by: average common stockholders’ equity
Profit margin is computed by taking net income divided by net sales
Net income
Net sales
Profit margin=
Solvency refers to a company’s long-run financial viability and its ability to cover long-term
obligations.
Days’ sales uncollected is computed by taking accounts receivable, net divided by net sales
multiplied by 365.
1.
2015 2014 2013 2012 2011
Sales $ 673,986 $ 443,412 $ 350,523 $ 252,175 $ 192,500
Cost of goods sold 326,113 214,488 171,751 122,994 92,400
Accounts receivable 32,756 26,028 23,976 14,677 13,205
