CHAPTER 3 AND 4

FINANCIAL STATEMENT ANALYSIS

1. Comparative Financial Statements

- Financial information reported side by side in vertical columns to see
relationship and trends between years. Can be presented in horizontal or
vertical analysis.

- Horizontal analysis shows dollar and percent changes from year to year.

2. Common Size Financial Statements

- Each component of the statement is represented in terms of percentages.

- Income statement
Each item is calculated as a percent of net sales

- Balance sheet
Each item is calculated as a percent of assets or total liabilities and
stockholder’s equity.

NOTE: This analysis will minimize the distortion, which may exist when trying
to compare companies with different financial strength and size.

3. All Financial Statement ratios should be compared to:

- Should analyze ratios based upon standards of comparison such as

i. Industry ratios and standards

ii. Similar businesses in the same industry

(competition)

iii. Past performance ratios.

iv. Prior years operating results

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Financial Statement Ratios

1. Current ratio and Working Capital

a. Measure of liquidity – short-term debt paying ability.

b. Current Assets (will be consumed within 12 months or less). Current

Liabilities (will be satisfied (paid) within 12 months or less).

c. Working Capital = current assets – current liabilities.

Amount of current assets that would remain after all debts have been paid
off.

d. Working capital is a measure of solvency

e. A negative working capital (if current assets < current liabilities) would
indicate that the company might not be able to pay off the maturing
liabilities of the next year.

2. Acid Test or Quick Test

a. Measure of short-term debt paying ability and liquidity.

b. Quick Assets  Current Liabilities

Quick Assets include those assets, which can be converted to cash very
quickly; usually include: The major exclusion is inventory, which is a current
asset but not a quick asset.

- Cash and cash equivalents (those with a stable market with maturity values of
90 days or less). Examples: short-term treasury bills, commercial paper,
certificates of deposits, etc.

- Accounts receivable (net of the allowance for doubtful accounts)

- Marketable securities (current assets valued at FMV with holding gains and
losses recognized as equity adjustments.)

Note: The quick or acid test ratio will always be lower than the current ratio due to
the exclusion of inventory.

3. Debt to Equity Ratio

a. Total Liabilities  Total Stockholder’s Equity

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 b. Measure of assets being provided by creditors for each dollar of assets
being provided by the stockholders.

4. Accounts Receivable Turnover & Days Sales

a. Indicates how quickly receivables are completely collected.

b. Increasing the turnover will generate more cash receipts on an annual

basis.

c. Credit sales  Average Accounts Receivables

((beginning + end)  2)

d. Days Sales in Accounts Receivable

Indicates a measure of the number of days it takes on average to collect
outstanding receivables.

Accounts Receivables  (Credit Sales  365)

or
Accounts Receivables  Average Daily Credit Sales

5. Inventory Turnover
a. Provides information relating to the potential salability of inventory and
obsolescence problems.

b. Indicates how quickly inventory is sold during the year.

c. COGS  Average Inventory

( beginning inventory + ending inventory)  2)

5A. Number of Day Sales in Inventory

- Relationship between COGS and Inventory

- Number of days sales in inventory = ending inventory  average daily COGS

(COGS  365)
- A rough measure of the length of time it takes to acquire, sell and replace the
inventory.

5B. Ratio of Plant Assets to Long Term Liabilities

- A solvency measure that indicates the margin of safety of the noteholders or
bondholders.

- Also indicates the ability of the business to borrow additional funds on a long-
term basis.

- (Net) Plant Assets  Long Term Liabilities

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 5C. Ratio of Liabilities to Stockholder’s Equity

- Assets = Claims

- Assets = Liabilities + Owner’s Equity

- The relationship between the total claims of the creditors and owners is a
solvency measure that indicates the margin of safety for creditors.

- It also indicates the ability of the business to withstand adverse business

conditions.

- Total Liabilities  Total Stockholder’s Equity

- The higher the ratio of liabilities to stockholder’s equity would indicate the
potential of high interest payments (assuming the existence of notes and/or
loans).

6. Times Interest Earned (number of times interest charges earned)

a. Indicates the relationship between interest expense to income.

b. If this number is high then it provides protection to creditors because it

indicates the ability of the company to generate income beyond the
amount of interest expense.

Earning Before Interest Taxes  Interest Expense = Times Interest Earned

c. Indicates the general financial strength of the business, which is of interest

to stockholders, employees and creditors.

7. Book Value Per Share

a. Indication of the net worth of the corporation.

b. Total Stockholder’s Equity  Common Stock O/S

c. Usually compared to the market price of the stock.

Profitability Analysis
- Profitability is the ability of an entity to earn profits.

- Evaluates the effectiveness and efficiency of operations as well as resources

available to the business.

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 - Relationship between the operating results as reported on the Income
Statement and resources available to the business as reported on the Balance
Sheet.

Ratio of Net Sales to Total Assets

- Net Sales  Total Assets

- Shows how effectively a firm utilizes its assets.

8. Earning Per Share

a. Represents the amount of earnings attributable to each share of stock of
the corporation.

b. Must be presented on the face of the income statement per GAAP.

c. (Net Income – Preferred Dividends)  Number of Common Stock O/S

d. Tends to have an effect on market price of stock.

9. Dividend Payout Ratio

a. Indicates how much earnings are paid out in dividends versus being
reinvested.

b. Dividends Per Share  EPS.

10. Dividend Yield Ratio

a. Shows the dividend return that each share of stock is generating in terms
of cash dividends.

b. Dividends Paid Per Share  Market Price Per Share

11. Price Earnings Ratio

a. Market Price Per Share  EPS

b. Value of stock in relation to its earnings

c. Indicator of future earnings potential

12. Return on Total Assets

a. Indicates how well the assets of the corporation are utilized to achieve a
profit without considering how the assets are financed.

Does not get affected by whether the assets are financed primarily by
creditors or stockholders

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 b. Deals with the operating responsibilities of the business.

c. Deals with earnings from continuing operations.

d. If we start at net income we must add back interest expense net of tax to
arrive at an amount that shows earnings before distribution made to
creditors or stockholders.

e. Earnings from Continuing Operations  Average Total Assets

Earnings from Continuing Operations = Net Income + (Interest Expense 

(1- Tax Rate).
(This computes interest expense on an after tax
basis).

13. Return on Common Stockholder’s Equity

a. This ratio removes the effect of funds that the corporation has borrowed.

b. (Net Income – Preferred Dividends)  Average Common Stockholder’s

Equity
(Average Total SE – Preferred
Stock)

13A. Rate Earnings on Stockholder’s Equity

- Net Income  Average Stockholder’s Equity

- Measures the rate of income earned on the amount invested by the

stockholders.

14. Financial Leverage

a. Involves the financing of assets in a company with funds that have been
acquired from creditors or from preferred stockholders at a fixed rate of
return (monies to be paid in the form of liabilities and dividends).

b. If the assets in which the funds are invested earn a greater return than the
fixed rate of return required to satisfy the suppliers of the funds a positive
financial leverage exists and the common stockholders benefit.

c. Sources of financial leverage:

-Long-term debt (bonds or notes payable)

-Current liabilities

-Preferred stock

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d. If the assets cannot generate a greater return that the fixed rate of return
then negative financial leverage exists and the common stockholders
suffer.