3 characteristics:

1. Liquidity
2. Profitability
3. Solvency

Short-term creditor = Liquidity

Long-term creditor, Stockholders= Profitability & Solvency (cz they indicate if

the company is able to survive over a long period of time.)

NEED

We need to compare with previous or other financial data to get a glimpse

over the financial situation of the company. Comparisons can be made on a
number of different bases.

1. Intracompany basis

Comparisons within a company. To detect changes in financial relationships

and trends.

2. Industry averages

Comparisons with industry averages provide information about a company’s

relative position within the industry. Compared by fin. rating org. like
Moody’s.

3. Intercompany basis

Insight into company’s competitive position.

Tools of analysis

1. Horizontal

Over a period of time. (used in Horizontal primarily)

2. Vertical

By expressing each item in statement as a percentage of a base amount.

Used in Vertical.

3. Ratio

Expresses relationship among selected items of financial statement

data.used in all three types.
HORIZONTAL ANALYSIS/ Trend analysis

technique for evaluating (increase or decrease) a series of financial

statement data over a period of time.

Balance sheet

In the assets section, plant assets (net) increased $167,500, or 26.5%. In the
liabilities section, current liabilities increased $41,500, or 13.7%. In the
stockholders’ equity section, retained earnings increased $202,600, or 38.6%.
These changes suggest that the company expanded its asset base during 2013 and
financed this expansion primarily by retaining income rather than assuming
additional long-term debt.

Income statement
Net sales increased $260,000, or 14.2%. Cost of goods sold increased $141,000, or
12.4%. Total operating expenses increased $37,000, or 11.6%. gross profit and net
income were up substantially. Gross profit increased 17.1%, and net income, 26.5%.
Quality’s profit trend appears favorable.

Retained earnings statement

Analyzed horizontally, net income increased $55,300, or 26.5%, whereas

dividends on the common stock increased only $1,200, or 2%. We saw in the
horizontal analysis of the balance sheet that ending retained earnings
increased 38.6%.

Can't compute if the previous year doesn't have value, also if a negative
number appears in one year and positive in another.
VERTICAL Analysis/ Common-size analysis

as a percentage of a base amount.

Balance sheet

The base for the asset items is total assets. The base for the liability and
stockholders’ equity items is total liabilities and stockholders’ equity.
we can see that current assets decreased from 59.2% of total assets in 2012 to 55.6% in
2013 (even though the absolute dollar amount increased $75,000 in that time). Plant assets
(net) have increased from 39.7% to 43.6% of total assets. Retained earnings have increased
from32.9% to 39.7% of total liabilities and stockholders’ equity. These results reinforce the
earlier observations that Quality Department Store is choosing to fi nance its growth through
retention of earnings rather than through issuing additional debt.

Income Statement
Cost of goods sold as a percentage of net sales declined 1% (62.1% vs.
61.1%), and total operating expenses declined 0.4% (17.4% vs. 17.0%). As a
result, it is not surprising to see net income as a percentage of net sales
increase from 11.4% to 12.6%. Quality Department Store appears to be a
profitable business that is becoming even more successful.

In this method, you can compare with other companies.

Though different in size, compared through percentage.

RATIO ANALYSIS

Percentage, rate (2,3 times), Proportion

In the discussion of ratios, these types of comparisons are used.

1. Intra-company comparison (data of two years)

2. Industry average comparisons (median ratios for same category
businesses)
3. Intercompany comparison (with competitor)

LIQUIDITY RATIOS

Liquidity ratios measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for cash.

Short-term creditors such as bankers and suppliers are particularly

interested in assessing liquidity.

the current ratio, the acid-test ratio, accounts receivable turnover, and
inventory turnover.

1. CURRENT RATIO
The current ratio is sometimes referred to as the working capital ratio.
Working capital is current assets minus current liabilities. The current
ratio is a more dependable indicator of liquidity than working capital.

The current ratio is only one measure of liquidity. It does not take into
account the composition of the current assets.

2. ACID-TEST (quick) RATIO

a measure of a company’s immediate short-term liquidity.

For example,
 3. ACCOUNTS RECEIVABLE TURNOVER

How quickly convert assets to cash.

The ratio is used to assessing the liquidity of the receivables is the accounts
receivable turnover. It measures the number of times, on average, the
company collects receivables during the period.

Net credit sales= Net sales – Cash sales.

If seasonal factors are signifcant (higher sale in one month, lower in other),
the average accounts receivable balance might be determined by using
monthly amounts.

AVERAGE COLLECTION PERIOD:

This means that accounts receivable are collected on average every 36 days.

4. INVENTORY TURNOVER

Inventory turnover measures the number of times, on average, the inventory

is sold during the period. Its purpose is to measure the liquidity of the
inventory.
The faster the inventory turnover, the less a company has tied up in
inventory.

DAYS IN INVENTORY
PROFITABILITY RATIOS

Profitability ratios measure the income or operating success of a company

fora given period of time. Both creditors and investors are interested in
evaluating earning power—profitability.

5. PROFIT MARGIN

Profit margin is a measure of the percentage of each dollar of sales that

resultsin net income.

The higher, the better.

Example:

6. ASSET TURNOVER

Asset turnover measures how efficiently a company uses its assets to

generate sales.

The resulting number shows the dollars of sales produced by each dollar
invested in assets.
Asset turnover shows that in 2013 Quality generated sales of $1.20 for each
dollar it had invested in assets.

7. RETURN ON ASSETS

8. RETURN ON COMMON STOCKHOLDER’S EQUITY

It measures profitability from the common stockholders’ viewpoint. This ratio

shows how many dollars of net income the company earned for each dollar
invested by the owners.
PREFERRED STOCK

When a company has preferred stock, we must deduct preferred dividend

requirements from net income to compute income available to common
stockholders. Because preferred shareholders have priority over common
shareholders when it comes to dividends.

LEVARAGE

Leverage means using borrowed money (debt) to invest or operate the

business.

 If a company can borrow money at a low interest rate and then earn a
higher return on that money, it creates extra profit.
 That extra profit goes to the stockholders, not the lenders.
 This is also called trading on the equity.

If a company has no debt, then ROA and ROE will be similar (ROE= ROA),
because:

 Total Assets = Total Equity (no liabilities)

 No borrowed money means all assets are funded by shareholders

But if the company uses debt (borrows money), this changes:

 Total Assets = Equity + Liabilities (debt)

 If the company uses that borrowed money wisely (ROE> ROA), it can
generate more profits than the cost of borrowing (interest).

When ROE>ROA,

The company borrows money at a low interest rate (e.g., 5%). It invests that
money and earns a higher return on assets (e.g., 15%). That 10% difference
(15% – 5%) boosts net income. But the borrowed money does not increase
equity, only assets. So, net income increases, but equity stays the same,
making ROE increase

Let’s say two companies have:

 Net Income: $100,000

 Total Assets: $1,000,000

Company A has no debt:

 Equity = $1,000,000 → ROA = 10%, ROE = 10%

Company B borrows $500,000:

 Equity = $500,000 → ROA = 10%, but ROE = $100,000 ÷ $500,000 =

20%

So even though both earned the same on assets, Company B’s

shareholders earned double the return, thanks to leverage.

9. EARNINGS PER SHARE

Earnings per share (EPS) is a measure of the net income earned on each
share of common stock.

A measure of net income earned on a per share basis provides a useful

perspective for determining profitability.

Example:
Assuming that there is no change in the number of outstanding shares
during 2012 and that the 2013 increase occurred midyear,

The only meaningful EPS comparison is an intracompany trend comparison.

Here, Quality’s earnings per share increased 20 cents per share in 2013. This
represents a 26% increase over the 2012 earnings per share of 77 cents.

10. PRICE-EARINGS RATIO

the ratio of the market price of each share of common stock to the earnings
per share. The price-earnings (P-E) ratio reflects investors’ assessments of a
company’s future earnings. It shows how much investors are willing to pay
for $1 of the company’s earnings.

Example: Assuming that the market price of Quality Department Store stock
is $8 in 2012 and $12 in 2013,

11. PAYOUT RATIO

The payout ratio measures the percentage of earnings distributed in the

form of cash dividends.

Companies that have high growth rates generally have low payout ratios
because they reinvest most of their net income into the business.
SOLVENCY RATIOS

Solvency ratios measure the ability of a company to survive over a long

period of time.

Long-term creditors and stockholders are particularly interested in a

company’s ability to pay interest as it comes due and to repay the face value
of debt at maturity.

12. DEBT TO ASSET RATIO

measures the percentage of the total assets that creditors provide.

This ratio indicates the company’s degree of leverage. It also provides some
indication of the company’s ability to withstand losses without impairing the
interests of creditors. The higher the percentage of total liabilities to total
assets, the greater the risk that the company may be unable to meet its
maturing obligations.

The lower the ratio, the more equity “buffer” there is available to the
creditors. Thus, from the creditors’ point of view, a low ratio of debt to assets
is usually desirable. Because if things go south, creditors want to know if the
company can pay the liability.

A ratio of 45.3% means that creditors have provided 45.3% of Quality

Department Store’s total assets.
 13. TIMES INTEREST EARNED

Times interest earned provides an indication of the company’s ability to

meet interest payments as they come due.

Note that times interest earned uses net income before income tax expense
and interest expense. This represents the amount available to cover interest.

The less, the better.