Financial Statement

Analysis
 Objectives
1. List the basic financial statement
analytical procedures.
2. Apply financial statement analysis to
assess the solvency of a business.
3. Apply financial statement analysis to
assess the profitability of a business.
4. Summarize the uses and limitations of
analytical measures.
5. Describe the contents of corporate
annual reports.
 Horizontal Analysis

What is horizontal
analysis?
Horizontal Analysis
It’s an analysis of the percentage
increases and decreases of related
items in comparative financial
statements.
 Lincoln Company
Comparative Balance Sheet Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities
Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 Analysis:
Horizontal 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets Difference
$1,139,500 $1,230,500$17,000
$ (91,000) (7.4%)
Liabilities = 3.2%
Base year (2005) $533,000
Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Horizontal Analysis:
Liabilities
Current liabilities $ 210,000
Difference $ 243,000 $ (33,000) (13.6%)
$(82,500)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
= (46.5%)
Total liabilities Base year (2005)
$ 310,000 $177,500
$ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Balance Sheet
Okay,
December 31, go
2006to
andthe
2005next
slideIncrease (Decrease)
Assets and calculate
2006 the
2005 Amount Percent
Current assets $ 550,000
percentage change$ 533,000
for $ 17,000
fixed 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) assets. 470,000 (25,500) (5.4%)
444,500
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities
Current liabilities Horizontal
$ 210,000 Analysis:
$ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $Difference
310,000 $ 443,000 ? $(133,000) (30.0%)
Stockholders’ Equity = ?
Base year (2005) ?
Preferred 6% stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities
Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 and 2005
Increase (Decrease)
Assets 2006 2005 Amount Percent
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Fixed assets (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000 —
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities
Current liabilities $ 210,000 $ 243,000 $ (33,000)
(5.4%)
(13.6%)
Long-term liabilities 100,000 200,000 (100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 $ 150,000 —
Common stock, $10 par 500,000 500,000 —
Retained earnings 179,500 137,500 $42,000 30.5%
Total stockholders’ equity $ 829,500 $ 787,500 $42,000 5.3%
Total liab. & SE $1,139,500 $1230,500 $(91,000) (7.4%)
 Lincoln Company
Comparative Income Statement Income Statement
December 31, 2006 and 2005
Increase (Decrease)
2006 2005 Amount Percent
Sales $1,530,500 $1,234,000 $296,500 24.0%
Sales returns 32,500 34,000 (1,500) (4.4%)
Net sales $1,498,000 $1,200,000 $298,000 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%
Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%
Administrative expenses 104,000 97,400 6,600 6.8%
Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7%
Operating income $ 160,000 $ 135,600 $ 24,400 18.0%
Other income 8,500 11,000 (2,500) (22.7%)
$ 168,500 $ 146,600 $ 21,900 14.9%
Other expense 6,000 12,000 (6,000) (50.0%)
Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%
Income tax 71,500 58,100 13,400 23.1%
Net income $ 91,000 $ 76,500 $ 14,500 19.0%
 Lincoln Company
Comparative Income Statement
December 31, 2006 and 2005
Increase (Decrease)
2006 2005 Amount Percent
Sales $1,530,500 $1,234,000 $296,500 24.0%
24.0%
Sales returns 32,500 34,000 (1,500) (4.4%)
Net sales $1,498,000 $1,200,000 $298,000 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%
Horizontal Analysis:
Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%
Administrative expenses 104,000
Increase amount 97,400
$296,500 6,600 6.8% Total
operating expenses $ 295,000 $ 244,400 $ 50,600
= 24.0%20.7%
Operating income Base year (2005)
$ 160,000 $1,234,000
$ 135,600 $ 24,400 18.0%
Other income 8,500 11,000 (2,500) (22.7%)
$ 168,500 $ 146,600 $ 21,900 14.9%
Other expense 6,000 12,000 (6,000) (50.0%)
Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%
Income tax 71,500 58,100 13,400 23.1%
Net income $ 91,000 $ 76,500 $ 14,500 19.0%
 Lincoln Company
Comparative Income Statement
December 31, 2006 and 2005
Increase (Decrease)
2006 2005 Amount Percent
Sales $1,530,500 $1,234,000 $296,500 24.0%
Sales returns 32,500 34,000 (1,500) (4.4%)
Net sales $1,498,000 $1,200,000 $298,000 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%
Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%
Administrative expenses 104,000 97,400 6,600 6.8% Total
operating expenses $ 295,000
Horizontal $ 244,400
Analysis: $ 50,600 20.7%
Operating income $ 160,000 $ 135,600 $ 24,400 18.0%
Other income Increase8,500
amount 11,000
$298,000 (2,500) (22.7%)
$ 168,500 $ 146,600 = 24.8%14.9%
$ 21,900
Other expense Base year (2005) $1,200,000
6,000 12,000 (6,000) (50.0%)
Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%
Income tax 71,500 58,100 13,400 23.1%
Net income $ 91,000 $ 76,500 $ 14,500 19.0%
Vertical Analysis
A percentage analysis can be
used to show the relationship of
each component to a total
within a single statement.
Vertical Analysis

The total, or 100% item,

on the balance sheet is
“total assets.”
 Lincoln Company Balance
Comparative Balance Sheet
December 31, 2006 Sheet
December 31, 2005
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total assets $1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Vertical
Total Analysis:
liabilities $ 310,000 27.2% $ 443,000 36.0%
Stockholders’ Equity
Current assets $550,000
Preferred stock, 6%, $100 par $ 150,000 = 13.2%
48.3% $ 150,000 12.2%
Totalstock,
Common assets $10 par $1,139,500
500,000 43.9 500,000 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0%
Total liab. & SE $1,139,500 100.0% $1,230,500 100.0%
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 December 31, 2005
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total assets $1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Total liabilities Vertical Analysis:27.2%
$ 310,000 $ 443,000 36.0%
Stockholders’ Equity
Current assets $533,000
Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2%
= 43.3%
Common stock, $10 par Total assets 500,000 $1,230,500500,000
43.9 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0%
Total liab. & SE $1,139,500 100.0% $1,230,500 100.0%
 Lincoln Company
Comparative Balance Sheet
December 31, 2006 December 31, 2005
Amount Percent Amount Percent
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total assets $1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Total liabilities $ 310,000 27.2% $ 443,000 36.0%
Stockholders’ Equity
Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2%
Common stock, $10 par 500,000 43.9 500,000 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0%
Total liab. & SE $1,139,500 100.0% $1,230,500 100.0%
 Lincoln Company Income
Comparative Income Statement
Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 Net12.8%
sales $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 is 100.0%
19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
$ 168,500 11.3% $ 146,600 12.2%
Other expense 6,000 0.4 12,000 1.0
Income before income tax $ 162,500 10.9% $ 134,600 11.2%
Income tax expense 71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%
 Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 12.8% $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
Vertical Analysis: $ 168,500 11.3% $ 146,600 12.2%
Other expense
Selling expenses $191,0006,000 0.4 12,000 1.0
Income before income tax $ 162,500= 12.8%
10.9% $ 134,600 11.2%
Nettax
Income sales
expense $1,498,000
71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%
 Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 12.8% $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
$ 168,500 11.3% $ 146,600 12.2%
Other expense 6,000 0.4 12,000 1.0
Income before income tax $ 162,500 10.9% $ 134,600 11.2%
Income tax expense 71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%
 Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 12.8% $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
$ 168,500 11.3% $ 146,600 12.2%
Other expense 6,000 0.4 12,000 1.0
Income before income tax $ 162,500 10.9% $ 134,600 11.2%
Income tax expense 71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%
 Lincoln Company
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006 2005
Amount Percent Amount Percent
Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 12.8% $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
$ 168,500 11.3% $ 146,600 12.2%
Other expense 6,000 0.4 12,000 1.0
Income before income tax $ 162,500 10.9% $ 134,600 11.2%
Income tax expense 71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%
Common Size Statements
Vertical analysis with both dollar and
percentage amounts is also useful in
comparing one company with another or
with industry averages. Such
comparisons are easier to make with the
use of common-size statements in
which all items are expressed in
percentages.
Common-Size Income Statement
 Solvency Analysis
 Solvency is the ability of a business to meet
its financial obligations (debts) as they are
due.
 Solvency analysis focuses on the ability of
a business to pay or otherwise satisfy its
current and noncurrent liabilities.
 This ability is normally assessed by
examining balance sheet relationships.
 Current Position Analysis
Working Capital and Current Ratio
2006 2005
Current assets $550,000 $533,000
Current liabilities 210,000 243,000
Working capital $340,000 $290,000
Current ratio 2.6 2.2

Use: To indicate the ability to meet

Divide
currently maturing obligations.
current
assets by
current
liabilities
 Current Position Analysis
Quick Ratio
2006 2005
Quick assets:
Cash $ 90,500 $ 64,700
Marketable securities 75,000 60,000
Accounts receivable (net) 115,000 120,000
Total $280,500 $244,700
Current liabilities $210,000 $243,000
Quick ratio 1.3 1.0

Use: To indicate instant debt-paying ability.

 Accounts Receivable Analysis
Accounts Receivable Turnover
2006 2005
Net sales on account $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year 115,500 120,000
Total $ 235,000 $ 260,000
Average (Total ÷ 2) $ 117,500 $ 130,000

Net sales on account

Average accounts
receivable
 Accounts Receivable Analysis
Accounts Receivable Turnover
2006 2005
Net sales on account $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year 115,500 120,000
Total $ 235,000 $ 260,000
Average $ 117,500 $ 130,000
Accounts receivable turnover 12.7 9.2

Use: To assess the efficiency in collecting

receivables and in the management of credit.
 Accounts Receivable Analysis
Number of Days’ Sales in Receivables
2006 2005
Accounts receivable (net),
end of year $ 115,000 $ 120,000
Net sales on account $1,498,000 $1,200,000
Average daily sales on
account (sales ÷ 365) $ 4,104 $ 3,288

Accounts receivable, end of year

Average daily sales on account
 Accounts Receivable Analysis
Number of Days’ Sales in Receivables
2006 2005
Accounts receivable (net),
end of year $ 115,000 $ 120,000
Net sales on account $1,498,000 $1,200,000
Average daily sales on
account (sales ÷ 365) $ 4,104 $ 3,288
Number of days’ sales in
receivables 28.0 36.5

Use: To assess the efficiency in collecting

receivables and in the management of credit.
 Inventory Analysis
Inventory Turnover
2006 2005
Cost of goods sold $1,043,000 $ 820,000
Inventories:
Beginning of year $ 283,000 $ 311,000
End of year 264,000 283,000
Total $ 547,000 $ 594,000
Average (Total ÷ 2) $ 273,500 $ 297,000

Cost of goods sold

Inventory turnover =
Average inventory
 Inventory Analysis
Inventory Turnover
2006 2005
Cost of goods sold $1,043,000 $ 820,000
Inventories:
Beginning of year $ 283,000 $ 311,000
End of year 264,000 283,000
Total $ 547,000 $ 594,000
Average (Total ÷ 2) $ 273,500 $ 297,000
Inventory turnover 3.8 2.8

Use: To assess the efficiency in the

management of inventory.
 Inventory Analysis
Number of Days’ Sales in Inventory
2006 2005
Inventories, end of year $ 264,000 $283,000
Cost of goods sold $1,043,000 $820,000
Average daily cost of
goods sold
(COGS ÷ 365) $ 2,858 $ 2,247

Number of Inventories, end of year

Days’ Sales =
in Inventory Average daily cost of goods sold
 Inventory Analysis
Number of Days’ Sales in Inventory
2006 2005
Inventories, end of year $ 264,000 $283,000
Cost of goods sold $1,043,000 $820,000
Average daily cost of
goods sold
(COGS ÷ 365) $ 2,858 $ 2,247
Number of days’ sales
in inventory 92.4 125.9

Use: To assess the efficiency in the

management of inventory.
 Long-Term Creditors
Ratio of Fixed Assets to Long-Term Liabilities
2006 2005
Fixed assets (net) $444,500 $470,000
Long-term liabilities $100,000 $200,000
Ratio of fixed assets to
long-term liabilities 4.4 2.4

Use: To indicate the margin of safety

to long-term creditors.
 Long-Term Creditors
Ratio of Liabilities to Stockholders’ Equity
2006 2005
Total liabilities $310,000 $443,000
Total stockholders’ equity $829,500 $787,500
Ratio of liabilities to
stockholders’ equity 0.37 0.56

Use: To indicate the margin of safety to

creditors.
 Long-Term Creditors
Number of Times Interest Charges Earned
2006 2005
Income before income tax $ 900,000 $ 800,000
Add interest expense 300,000 250,000
Amount available for interest $1,200,000 $1,050,000

Number of Income before

Times Interest = income tax + interest expense
Charges Earned Interest expense
 Long-Term Creditors
Number of Times Interest Charges Earned
2006 2005
Income before income tax $ 900,000 $ 800,000
Add interest expense 300,000 250,000
Amount available for interest $1,200,000 $1,050,000
Number of times earned 4.0 4.2

Use: To assess the risk to debtholders in

terms of number of times interest
charges were earned.
 Profitability Analysis
 Profitability is the ability of an entity to
earn profits.
 This ability to earn profits depends on the
effectiveness and efficiency of operations
as well as resources available.
 Profitability analysis focuses primarily on
the relationship between operating results
reported in the income statement and
resources reported in the balance sheet.
 The Common Stockholder
Ratio of Net Sales to Assets
2006 2005
Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
Average (Total ÷ 2) $1,048,750 $1,031,500

Excludes long-term investments

 The Common Stockholder
Ratio of Net Sales to Assets
2006 2005
Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
Average (Total ÷ 2) $1,048,750 $1,031,500
Ratio of net sales to assets 1.4 1.2

Use: To assess the effectiveness of

the use of assets.
 The Common Stockholder
Rate Earned on Total Assets
2006 2005
Net income $ 91,000 $ 76,500
Plus interest expense 6,000 12,000
Total $ 97,000 $ 88,500
Total assets:
Beginning of year $1,230,500 $1,187,500
End of year 1,139,500 1,230,500
Total $2,370,000 $2,418,000
Average (Total ÷ 2) $1,185,000 $1,209,000
Rate earned on total assets 8.2% 7.3%

Use: To assess the profitability of the assets.

 The Common Stockholder
Rate Earned on Stockholders’ Equity
2006 2005
Net income $ 91,000 $ 76,500
Stockholders’ equity:
Beginning of year $ 787,500 $ 750,000
End of year 829,500 787,500
Total $1,617,000 $1,537,500
Average (Total ÷ 2) $ 808,500 $ 768,750
Rate earned on stockholders’
equity 11.3% 10.0%

Use: To assess the profitability of the

investment by stockholders.
 Leverage
11.3%
10.0%
10% Leverage
Leverage
3.1%
8.2% 2.7%
7.3%
5%

0%
2006 2005

Rate earned Rate earned on

on total stockholders’
assets equity
 The Common Stockholder
Rate Earned on Common Stockholders’ Equity
2006 2005
Net income $ 91,000 $ 76,500
Less preferred dividends 9,000 9,000
Remainder—common stock $ 82,000 $ 67,500
Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000
End of year 679,500 637,500
Total $1,317,000 $1,237,500
Average (Total ÷ 2) $ 658,500 $ 618,750
 The Common Stockholder
Rate Earned on Common Stockholders’ Equity
2006 2005
Net income $ 91,000 $ 76,500
Less preferred dividends 9,000 9,000
Remainder—common stock $ 82,000 $ 67,500
Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000
End of year 679,500 637,500
Total $1,317,000 $1,237,500
Average (Total ÷ 2) $ 658,500 $ 618,750
Rate earned on common
stockholders’ equity 12.5% 10.9%
Use: To assess the profitability of the
investment by common stockholders.
 The Common Stockholder
Earnings Per Share on Common Stock
2006 2005
Net income $ 91,000 $ 76,500
Less preferred dividends 9,000 9,000
Remainder—common stock $ 82,000 $ 67,500
Shares of common stock 50,000 50,000
Earnings per share on common stock $1.64 $1.35

Use: To assess the profitability of the

investment by common stockholders.
 The Common Stockholder
Price-Earnings Ratio
2006 2005
Market price per share of common $41.00 $27.00
Earnings per share on common ÷ 1.64 ÷ 1.35
Price-earnings ratio on common stock 25 20

Use: To indicate future earnings

prospects, based on the relationship
between market value of common
stock and earnings.
Dividends and Earnings Per Share
$2.00
$1.64
Per $1.50 $1.35
share
$1.00 $0.80
$0.60
$0.50

$0.00
2006 2005

Dividends Earnings
 The Common Stockholder

Dividend Yield on Common Stock

2006 2005
Dividends per share of common $ 0.80 $ 0.60
Market price per share of common ÷ 41.00 ÷ 27.00
Dividend yield on common stock 1.95% 2.22%

Use: To indicate the rate of return to common

stockholders in terms of dividends.
 Corporate Annual Reports
In addition to financial statements, the annual
report includes a management discussion analysis
(MDA) and an independent auditors’ report.
The MDA includes an analysis of the results of
operations and discusses management’s
opinion about future performance. It
compares the prior year’s income statement
with the current year’s. It also contains an
analysis of the firm’s financial condition.
 Corporate Annual Reports
In addition to financial statements, the annual
report includes a management discussion analysis
(MDA) and an independent auditors’ report.
Before issuing annual statements, all
publicly held corporations are required
to have an independent audit of their
financial statements. The CPAs who
conduct the audit render an opinion as
to the fairness of the statements.
The End