Chapter 13

Financial Statement Analysis

Limitations and Considerations inFinancial Statement Analysis

Watch for alternative accounting principles Selection of a inventory valuation method Changes in accounting method

Take care when making comparisons Recognizing trends in ratios Extra caution for extraordinary items and gains and

losses from discontinued operations

LO 1

Limitations and Considerations inFinancial Statement Analysis (continued)

Understand the possible effects of inflation Financial statements are based on historical costs

and are not adjusted for the effects of increasing prices

Analysis of Comparative Statements:Horizontal Analysis

Comparison of financial statement items over a period of time

LO 2

Example 13.1—Preparing and Reading Comparative Balance Sheets—Horizontal Analysis

Example 13.2—Preparing and Reading Comparative Statements of Income and Retained Earnings—Horizontal Analysis

Example 13.3—Preparing and Reading Comparative Statements of Cash Flows—Horizontal Analysis

Analysis of Common-Size Statements:Vertical Analysis

Comparison of various financial statement items within a single period with the use of common-size statements

Common-size statements recast items as a percentage of a selected item

LO 3

Example 13.4—Preparing and Reading Common-Size Balance Sheets—Vertical Analysis

Example 13.5—Preparing and Reading Common-Size Income Statements—Vertical Analysis

Liquidity Analysis

A relative measure of the nearness to cash of the assets and liabilities of a company

LO 4

Working Capital

The excess of current assets over current liabilities at a point in time

Current Ratio

The ratio of current assets to current liabilities One of the most widely used financial statement

ratios

Acid-Test Ratio

A stricter test of liquidity than the current ratio Excludes inventory and prepayments from the

numerator

Cash Flow from Operations to Current Liabilities

A measure of the ability to pay current debts from operating cash flows

Accounts Receivable Analysis Accounts receivable turnover ratio: a measure of the

number of times accounts receivable are collected in a period

Number of days’ sales in receivables: a measure of the average age of accounts receivable

Inventory Analysis

Inventory turnover ratio: a measure of the number of times inventory is sold during a period

Number of days’ sales in inventory: a measure of how long it takes to sell inventory

Cash-to-Cash Operating Cycle

The length of time from the purchase of inventory to the collection of any receivable from the sale

Solvency Analysis

The ability of a company to remain in business over the long term The ability of the firm to stay financially healthy over

the period of time that existing debt (short- and long-term) is outstanding

LO 5

Debt-to-Equity Ratio

The ratio of total liabilities to total stockholders’ equity

The composition of debt and equity is an important determinant of the cost of capital to a company

Times Interest Earned Ratio

Indicates the company’s ability to meet the current year’s interest payments out of the current year’s earnings

Debt Service Coverage Ratio

Measure of the amount of cash that is generated from operating activities during the year and that is available to repay interest due and any maturing principal amounts

Cash Flow from Operations to CapitalExpenditures Ratio

A measure of the ability of a company to finance long-term asset acquisitions with cash from operations

Profitability Analysis

How well management is using company resources to earn a return on the funds invested by various groups

Two frequently used profitability measures:

=

Gross Profit RatioGross Profit

=Net Sales

LO 6

Profit Margin RatioNet Income

=Net Sales

Rate of Return on Assets

A measure of a company’s success in earning a return for all providers of capital

Components of Return on Assets

Return on sales ratio: a variation of the profit margin ratio Measures earnings before payments to creditors

Asset turnover ratio: the relationship between net sales and average total assets

Return on Common Stockholders’ Equity Ratio

A measure of a company’s success in earning a return for the common stockholders

Leverage

The use of borrowed funds and amounts contributed by preferred stockholders to earn an overall return higher than the cost of these funds

Earnings per Share

A company’s bottom line stated on a per-share basis

Price/Earnings Ratio

The relationship between a company’s performance according to the income statement and its performance in the stock market

Dividend Ratios

Dividend payout ratio: the percentage of earnings paid out as dividends

Dividend yield ratio: the relationship between dividend and the market price of a company’s stock

Reporting and Analyzing Other Income Statement Items

Each of these items is shown net of their tax effects Discontinued operations Extraordinary items

Reported near the end of the income statement, after income from continuing operations

Reported separately to call the reader’s attention to their unique nature

LO 7

Discontinued Operations

Reflect any gains or losses from the disposal of a segment Also, reflect any net income or loss from operating

that segment

Extraordinary Items

Reflect any gains or losses that arise from an event that is both unusual in nature and infrequent in occurrence

End of Chapter 13