Financial Statement Analysis

Chapter 17
 Learning Objectives
17.1 Explain how financial
statements are used to analyze a
business
17.2 Perform a horizontal analysis
of financial statements
17.3 Perform a vertical analysis of
financial statements
17.4 Compute and evaluate the
standard financial ratios
 Learning Objective 17.1
Explain how financial statements
are used to analyze a business
How Are Financial Statements Used to
Analyze a Business?
To determine the financial performance of a company, we
compare its performance in the following ways:
• From year to year
• With a competing company
• With the same industry as a whole
 Tools of Analysis
There are three main ways to analyze financial statements:
• Horizontal analysis provides a year-to-year comparison of a
company’s performance in different periods.
• Vertical analysis provides a way to compare different companies.
• Ratio analysis can be used to provide information about a
company’s performance.
 Corporate Financial Reports
An annual report provides information about a company’s
financial condition.
• Management’s discussion and analysis of financial conditions
and results of operations (MD&A)
• Report of the independent auditors
• Financial statements
• Notes to financial statements
 Learning Objective 17.2
Perform a horizontal analysis of
financial statements
 How Do We Use Horizontal Analysis to Analyze a
Business? (1 of 3)
• Many decisions hinge on whether the numbers are increasing or
decreasing.
• Sales may have increased, but considered in isolation, this fact is
not very helpful.
• Horizontal analysis is the study of percentage changes in line
items from comparative financial statements.
How Do We Use Horizontal Analysis to Analyze a
Business? (2 of 3)
Step 1: Compute the dollar amount of the change in a line item from
the earlier period to the later period.
Horizontal analysis illustrated for Smart Touch Learning as:

Step 1:

Dollar
= amount of change Later period amount − Earlier period amount
= $858,000 − $803,000
= $55,000
How Do We Use Horizontal Analysis to Analyze a
Business? (3 of 3)
Step 2: Divide the dollar amount of change by the earlier period amount
and multiply by 100.
Horizontal analysis illustrated for Smart Touch Learning as:

Step 2:

Horizontal analysis % (Dollar amount of change / Base period amount) × 100

= ($55,000 / $803,000) × 100
= 6.8% *
Exhibit F:17-1 Comparative Income Statement—
Horizontal Analysis
Exhibit F:17-2 Comparative Balance Sheet—
Horizontal Analysis
 Trend Analysis (1 of 2)
• Trend analysis is a form of horizontal analysis.
• Trend percentages indicate the direction a business is taking.
• The formula for trend analysis is as follows:

Trend % (Any period amount / Base period amount) × 100

 Trend Analysis (2 of 2)
Smart Touch Learning’s Net Sales Revenue was $750,000 in 2022
and rose to $858,000 in 2026.
Blank 2026 2025 2024 2023 2022
Net Sales $ 858,000 $ 803,000 $ 780,000 $ 748,000 $ 750,000
Revenue
Trend Percentages 114.4% 107.1% 104.0% 99.7% 100.0%
The trend percentage for 2023 is calculated as follows:

Trend % (Any period amount / Base period amount) × 100

= ($748,000 / $750,000 ) × 100
= 99.7%
 Learning Objective 17.3
Perform a vertical analysis of
financial statements
 How Do We Use Vertical Analysis to Analyze a
Business?
• Vertical analysis of a financial statement shows the
relationship of each item to its base amount, the 100% figure.
• Every other item on the statement is then reported as a
percentage of that base.

Vertical analysis % (Specific item / Base amount) × 100

=
Exhibit F:17-3 Comparative Income Statement—
Vertical Analysis
Exhibit F:17-4 Comparative Balance Sheet—
Vertical Analysis
 Common-Size Statements
• To compare one company to another company, we can use a
common-size statement.
• A common-size statement reports only percentages.
• By reporting only percentages, it removes the dollar value bias
we see when comparing numbers in absolute terms (dollars).
Exhibit F:17-5 Common-Size Income Statement—Smart Touch
Learning Versus Learning School
 Benchmarking
• Benchmarking is the practice of comparing a company with
other leading companies.
• There are two main types of benchmarking:
• Benchmarking against a key competitor
• Benchmarking against the industry average
 Benchmarking Against a Key Competitor
Exhibit F:17-6 Graphical Analysis of Common-Size Income Statement—
Smart Touch Learning Versus Learning School
 Benchmarking Against the Industry Average
• The industry average can also serve as a very useful
benchmark for evaluating a company.
• An industry comparison would show how Smart Touch
Learning is performing alongside the average for the e-learning
industry.
 Learning Objective 17.4
Compute and evaluate the
standard financial ratios
How Do We Use Ratios to Analyze a Business?
• Different ratios explain different aspects of a company.
• Ratios are used for the following purposes:
• Evaluating the ability to pay current liabilities
• Evaluating the ability to sell merchandise inventory and
collect receivables
• Evaluating the ability to pay long-term debt
• Evaluating profitability
• Evaluating stock as an investment
Exhibit F:17-7 Comparative Financial Statements
 Evaluating the Ability to Pay Current Liabilities
We discuss one equation and three ratios that measure a
company’s ability to pay current liabilities:
• Working capital
• Cash ratio
• Acid-test (or quick) ratio
• Current ratio
 Working Capital
Working capital measures the ability to meet short-term obligations
with current assets. Working capital is defined as follows:

Working
= capital Current assets − Current liabilities
Smart Touch Learning’s working capital at December 31, 2026 and
2025 is calculated as follows:

Working
= capital Current assets − Current liabilities
2026 : $262,000 − $142,000 $120,000
=
2025 : $236,000 − $126,000 $110,000
=
 Cash Ratio
The cash ratio helps determine a company’s ability to meet its
short-term obligations.
The cash ratios of Smart Touch Learning, at December 31, 2026
and 2025, along with the average for the industry, are as follows:

Cash + Cash equivalents

Cash ratio =
Total current liabilities
$29,000
2026 : = 0.20
$142,000
$32,000
2025 : = 0.25
$126,000
Industry average = 0.40
 Acid-Test (or Quick) Ratio
The acid-test ratio (sometimes called the quick ratio) tells whether a
company can pay all its current liabilities if they come due
immediately.
Smart Touch Learning’s acid-test ratios for 2026 and 2025 are:

Cash including cash equivalents + Short-term investments + Net current receivables

Acid-test ratio =
Total current liabilities
$29,000 + $0 + $114,000
2026 : = 1.01
$142,000
$32,000 + $0 + $85,000
2025 : = 0.93
$126,000
Industry average = 0.46
 Current Ratio
The current ratio, which is calculated as the total current assets divided by
total current liabilities, measures a company’s ability to pay its current
liabilities with its current assets.
The current ratios of Smart Touch Learning, at December 31, 2026 and 2025,
along with the average for the industry, are as follows:

Total current assets

Current ratio =
Total current liabilities
$262,000
2026 : = 1.85
$142,000
$236,000
2025 : = 1.87
$126,000
Industry average = 0.60
Evaluating the Ability to Sell Merchandise Inventory and Collect
Receivables
We look at five ratios that measure a company’s ability to sell
merchandise inventory and collect receivables:
• Inventory turnover
• Days’ sales in inventory
• Gross profit percentage
• Accounts receivable turnover ratio
• Days’ sales in receivables
 Inventory Turnover
The inventory turnover ratio measures the number of times a company
sells its average level of merchandise inventory during a year.
Smart Touch Learning’s inventory turnover for 2026 is as follows:

Cost of goods sold

Inventory turnover =
Average merchandise inventory
$513,000
2026 : = 4.58
[($111,000 + $113,000) / 2]
Industry average = 27.70
 Days’ Sales in Inventory
Days’ sales in inventory measures the average number of days
merchandise inventory is held by the company.
Smart Touch Learning’s days’ sales in inventory for 2026 is as
follows:

365 days
Days' sales in inventory =
Inventory turnover
365 days
2026 : = 79.7 days
4.58
Industry average = 13 days
 Gross Profit Percentage
The gross profit percentage measures the profitability of each
net sales dollar above the cost of goods sold.
Smart Touch Learning’s gross profit percentage for 2026 is as
follows:

Gross profit
Gross profit percentage =
Net sales revenue
$345,000
2026 : = 0.402 = 40.2%
$858,000
Industry average = 43%
 Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures the number of
times the company collects the average receivables balance in a
year.
Smart Touch Learning’s accounts receivable turnover ratio for
2026 is computed as follows:

Net credit sales

Accounts receivable turnover ratio =
Average net accounts receivable
$85,000
2026 : = 8.6
[($85,000 + $114,000) / 2]
Industry average = 29.1
 Days’ Sales in Receivables
Days’ sales in receivables indicates how many days it takes to collect
the average level of receivables.
To compute this ratio for Smart Touch Learning for 2026, we divide 365
days by the accounts receivable turnover ratio we previously
calculated:

365 days
Days' sales in receivables =
Accounts receivable turnover ratio
365 days
2026 : = 42.4 days
8.6
Industry average = 25 days
Evaluating the Ability to Pay Long-Term Debt
There are three key indicators of a business’s ability to pay long-
term liabilities:
• Debt ratio
• Debt to equity ratio
• Times-interest-earned ratio
 Debt Ratio
The debt ratio shows the proportion of assets financed with debt and
is calculated by dividing total liabilities by total assets.
The debt ratios for Smart Touch Learning at the end of 2026 and 2025
follow:

Total liabilities
Debt ratio =
Total assets
$431,000
2026 : = 0.548 = 54.8%
$787,000
$324,000
2025 : = 0.503 = 50.3%
$644,000
Industry average = 69%
 Debt to Equity Ratio
The debt to equity ratio shows the proportion of total liabilities
relative to total equity. This ratio measures financial leverage.
The debt to equity ratios for Smart Touch Learning at the end of 2026
and 2025 follow:

Total liabilities
Debt to equity ratio =
Total equity
$431,000
2026 : = 1.21
$356,000
$324,000
2025 : = 1.01
$320,000
Industry average = 2.23
 Times-Interest-Earned Ratio
The times-interest-earned ratio evaluates a business’s ability to pay
interest expense. This ratio is also called the interest-coverage ratio.
Calculation of Smart Touch Learning’s times-interest-earned ratio
follows:

Net income + Income tax expense + Interest expense

Times-interest-earned ratio =
Interest expense
$64,000 + $17,000 + $24,000
2026 : = 4.38
$24,000
$34,000 + $9,000 + $14,000
2025 : = 4.07
$14,000
Industry average = 7.80
 Evaluating Profitability
We now look at five ratios that are used to evaluate a company’s
profitability:
• Profit margin ratio
• Rate of return on total assets
• Asset turnover ratio
• Rate of return on common stockholders’ equity
• Earnings per share
 Profit Margin Ratio
The profit margin ratio shows how much net income a business earns
on every $1 of sales.
Smart Touch Learning’s profit margin ratio follows:

Net income
Profit margin ratio =
Net sales revenue
$64,000
2026 : = 0.075 = 7.5%
$858,000
$34,000
2025 : = 0.042 = 4.2%
$803,000
Industry average = 1.7%
 Rate of Return on Total Assets
The rate of return on total assets measures a company’s success
in using assets to earn a profit.
Computation of the rate of return on total assets ratio for Smart
Touch Learning follows:

Net income + Interest expense

Rate of return on total assets =
Average total assets
$64,000 + $24,000
2026 : = 0.123
= 12.3%
[($644,000 + $787,000) / 2]
Industry average = 6.0%
 Asset Turnover Ratio
The asset turnover ratio measures the amount of net sales
generated for each average dollar of total assets invested.
Smart Touch Learning’s 2026 asset turnover ratio is as follows:

Net sales revenue

Asset turnover ratio =
Average total assets
$858,000
2026 : = 1.20 times
[($644,000 + $787,000) / 2]
Industry average = 3.52 times
Rate of Return on Common Stockholders’ Equity
(1 of 2)

The rate of return on common stockholders’ equity shows how much

income is earned for each $1 invested by the common shareholders.
The 2026 rate of return on common stockholders’ equity for Smart
Touch Learning follows:

Net income - Preferred dividends

Rate of return on common stockholders' equity =
Average common stockholders' equity
$64,000 − $0
2026 : = 0.189 = 18.9%
[($320,000 + $356,000) / 2]
Industry average = 10.5%
Rate of Return on Common Stockholders’ Equity
(2 of 2)

• When a company has a higher rate of return on

stockholders’ equity than its rate of return on total assets,
this is called trading on the equity.
• Trading on the equity is earning more income on borrowed
money than the related interest expense, thereby
increasing the earnings for the owners of the business.
 Earnings per Share (EPS)
Earnings per share (EPS) reports the amount of net income (loss) for
each share of the company’s outstanding common stock.
Smart Touch Learning’s EPS for 2026 and 2025 follow. (Note that Smart
Touch Learning had 10,000 shares of common stock outstanding
throughout both years.)

Net income − Preferred dividends

Earnings per share =
Weighted average number of common shares outstanding
$64,000 − $0
2026 : = $6.40 per share
10,000 shares
$34,000 − $0
2025 : = $3.40 per share
10,000 shares
Industry average = $9.76 per share
 Evaluating Stock as an Investment
• Investors purchase stock to earn a return on their investment.
• This return consists of two parts:
• Gains (or losses) from selling the stock at a price above (or
below) purchase price
• Dividends
 Price/Earnings Ratio
The price/earnings ratio is the ratio of the market price of a share of
common stock to the company’s earnings per share.
The market price for Smart Touch Learning’s common stock was $60 at
the end of 2026 and $35 at the end of 2025. Calculations for the P/E
ratios of Smart Touch Learning follow.

Market price per share of common stock

Price / earnings ratio =
Earnings per share
$60 per share
2026 : = 9.38
$6.40 per share
$35 per share
2025 : = 10.29
$3.40 per share
Industry average = 17.79
 Dividend Yield
The dividend yield measures the percentage of a stock’s market value
that is returned annually as dividends to shareholders.
Smart Touch Learning paid annual cash dividends of $1.20 per share of
common stock in 2026 and $1.00 in 2025. The firm’s dividend yields on
common stock follow:

Annual dividend per share

Dividend yield =
Market price per share
$1.20 per share
2026 : = 0.020 = 2.0%
$60 per share
$1.00 per share
2025 : = 0.029 = 2.9%
$35 per share
Industry average = 3.6%
 Dividend Payout
The dividend payout measures the percentage of earnings paid
annually to common shareholders as cash dividends.
Smart Touch Learning’s dividend payout yields are as follows:

Annual dividend per share

Dividend payout =
Earnings per share
$1.20 per share
2026 : = 0.19 = 19%
$6.40 per share
$1.00 per share
2025 : = 0.29 = 29%
$3.40 per share
Industry average = 63%
 Red Flags in Financial Statement Analyses
Analysts look for red flags in financial statements that may signal
financial trouble. Examples:
• Movement of sales, merchandise inventory, and receivables
• Earnings problems
• Decreased cash flow
• Too much debt
• Inability to collect receivables
• Buildup of merchandise inventories
Exhibit F:17-8 Using Ratios in Financial Statement
Analysis (1 of 5)
Evaluating the ability to pay current liabilities:

Ratio Computation Information Provided

A business’s ability to meet its short-term

Working capital Current assets − Current liabilities
obligations with its current assets.

Cashcash
start fraction + Cash equivalents
+ cash equivalents over total current The company’s ability to pay current liabilities
Cash ratio liabilities end fraction
Total current liabilities from cash and cash equivalents.

Cash including cash equivalents

Start fraction cash including cash equivalents + short The company’s ability to pay all its current
Acid-test ratio + Short-term
term investments + net investments
current receivable over total
current liabilities
+ Net current receivables end fraction liabilities if they came due immediately.
Total current liabilities

Totaltotal
start fraction current assets
current assets over total current The company’s ability to pay current liabilities
Current ratio
Total current liabilities
liabilities end fraction from current assets.
Exhibit F:17-8 Using Ratios in Financial Statement
Analysis (2 of 5)
Evaluating the ability to sell merchandise inventory and collect receivables:

Ratio Computation Information Provided

Cost of goods sold The number of times a company sells its

start fraction cost of goods sold over average
Inventory turnover average level of merchandise inventory
Average merchandise
merchandise inventory
inventory end fraction
during a period.
365 days
start fraction 365 days over inventory turnover end The average number of days that inventory is
Days’ sales in inventory Inventory turnover
fraction held by a company.

Gross profit The profitability of each sales dollar above

start fraction gross profit over net sales revenue end
Gross profit percentage Net sales revenue
fraction the cost of goods sold.

Accounts receivable Net

start fraction net credit
credit sales
sales over average net accounts The number of times the company collects
turnover ratio Average net accounts receivable
receivable end fraction the average receivables balance in a year.

Days’ sales in 365 days

start fraction 365 days over accounts receivable turnover The number of days it takes to collect the
receivables Accounts receivable turnover ratio
ratio end fraction average level of receivables.
Exhibit F:17-8 Using Ratios in Financial Statement
Analysis (3 of 5)
Evaluating the ability to pay long-term debt:

Ratio Computation Information Provided

Total liabilities
Debt ratio start fraction total liabilities over total assets end fraction The proportion of assets financed with debt.
Total assets

Total liabilities The proportion of total liabilities relative to

Debt to equity ratio start fraction total liabilities over total equity end fraction
Total equity total equity.

Net income + Income tax expense

Times-interest-earned start fraction net income + income tax expense + interest
+ Interest expense A business’s ability to pay interest expense.
ratio expense over interest expense end fraction
Interest expense
Exhibit F:17-8 Using Ratios in Financial Statement
Analysis (4 of 5)
Evaluating profitability:

Ratio Computation Information Provided

start fraction netNet income

income over net sales revenue end How much net income is earned on every
Profit margin ratio fraction
Net sales revenue dollar of net sales revenue.

Rate of return on total startNet income

fraction net income++Interest expense
interest expense over average The success a company has in using its
assets total assets end fraction
Average total assets assets to earn income.

start fractionNet sales

net sales revenue
revenue over average total assets How efficiently a business uses its average
Asset turnover ratio end fraction
Average total assets total assets to generate sales.

The relationship between net income

Rate of return on Net income − Preferred dividends
start fraction net income minus preferred dividends over available to common stockholders and their
common stockholders’ Average common
average common stockholders'
stockholders equity average common equity invested in the
equity end fraction
equity
company.
Net income − Preferred dividends
start fraction net income minus preferred dividends over Amount of a company’s net income (loss) for
Earnings per share Weighted
weighted average
average number number
of common of
shares outstanding
end fraction each share of its outstanding common stock.
common shares outstanding
Exhibit F:17-8 Using Ratios in Financial Statement
Analysis (5 of 5)
Evaluating stock as an investment:

Ratio Computation Information Provided

Market price
start fraction per
market share
price ofofcommon
per share common stockstock
over The value the stock market places on
Price/earnings ratio earnings per share end fraction
Earnings per share $1 of a company’s earnings.

Annual dividend per The percentage of a stock’s market

start fraction annual dividend per share overshare
market price per share
Dividend yield end fraction value that is returned annually as
Market price per share dividends to stockholders.

Ratio of dividends declared per

start fractionAnnual dividend
annual dividend per shareper
over share
earnings per share end
Dividend payout fraction common share relative to the
Earnings per share earnings per share of the company.