Chapter 14

Financial
Statement
Analysis

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Using Accounting Information
The goal of accounting information is
to provide economic decision makers
with useful information.
The financial statements generated
through the accounting process are
designed to assist users in identifying
key relationships and trends.
The financial statements of most
publicly owned companies are
classified and are presented in
comparative form.
14-2
Classified and Comparative
Financial Statements
Classified Comparative
Financial Financial
Statements Statements
  The financial statement
Items with certain
characteristics are amounts for more than
placed together in a one accounting period
group, or classification, appear side by side in
to assist users of the vertical columns.
statements in their  This assists investors in
analyses. identifying and
 An example of a evaluating significant
classified financial changes and trends.
statement is a balance
sheet that separates
assets and liabilities
14-3
Consolidated Financial
Statements
 Consolidated financial
statements present the
financial position and
operating results of the
parent company and its
subsidiaries as if they
were a single business
organization.
 For example, PepsiCo,
which produces and
distributes Pepsi-Cola,
also owns and operates
the companies that
make Frito-Lay, Quaker © AP Photo/Steven Senne

Foods, Gatorade, and

Tropicana products.
14-4
Comparative Income
Statements
Comparative income statements present the
amounts for two or more years side by side in
adjacent columns.

14-5
Using Comparative Statements
 Comparative statements place important
financial information in a context that is
useful for gaining better understanding.
 For example, knowing that Benson
Corporation had sales of $600,000 in
2018 after years in which sales were
$500,000 (2017) and $400,000 (2016) is
helpful in understanding Benson’s sales
trend.
 Our impression of 2018 sales of $600,000
would have been quite different if sales
in 2017 and 2016 had been $700,000
and $800,000, respectively. 14-6
Techniques for Financial
Analysis
Analysis is largely a matter of
establishing significant relationships
and identifying changes and trends.
Four widely used analytical
techniques are:
1. Dollar and percentage changes
2. Trend percentages
3. Component percentages
4. Ratios

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Dollar and Percentage Changes
 The dollar amount of any change is the
difference between the amount for a
comparison year and the amount for a base
year.
 The percentage change is computed by dividing
the amount of the dollar change between years
by the amount for the previous year.

14-8
Evaluating Percentage Changes
Certain percentage changes provide
insight into a company’s rate of growth
such as:
o Sales
o Gross profit
o Net income
KEY POINT

Percentage changes may create a misleading

impression when the dollar amount used as a
base is unusually small.

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Trend Percentages
 The changes in financial statement items from a
base year to following years are sometimes
expressed as trend percentages to show the
extent and direction of change.
 Two steps are necessary to compute trend
percentages.
1. First, a base year is selected and each item
in the financial statements for the base year
is given a weight of 100 percent.
2. The second step is to express each item in
the financial statements for following years
as a percentage of its base-year amount.
This computation consists of dividing an item
such as sales in the years after the base year
by the amount of sales in the base year. 14-10
Trend Percentage Example
 Below we see a trend percentage analysis
covering sales and net income over a five
year period.
 Assume that 2013 serves as the base year;
each subsequent year is shown as a
percentage of the 2013 amount.

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Component Percentages:
Balance Sheet
 Component percentages indicate the relative
size of each item included in a total.
 For example, each item in a balance sheet
could be expressed as a percentage of total
assets.
◦ This shows the relative importance of each
type of asset as well as the relative
amount of financing obtained from current
creditors, long-term creditors, and
stockholders.
◦ By computing component percentages for
several successive balance sheets, we can
see which items are increasing in
importance and which are becoming less 14-12
Component Percentages: Income
Statement
 Another application of component percentages is
to express all items in an income statement as a
percentage of net sales.
 Such a statement is called a common size
income statement.

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Financial Ratios
A ratio is a mathematical expression of
the relationship of one item to another.
 Ratios are particularly important in
understanding financial statements
because they permit us to compare
information from one financial statement
with information from another financial
statement.
 For example, we might compare net
income (taken from the income
statement) with total assets (taken from
the balance sheet) to see how effectively
management is using available resources 14-14
Standards of Comparison
 In using dollar and percentage changes, trend
percentages, component percentages, and
ratios, financial analysts constantly search for
some standard of comparison against which to
judge whether the relationships they have
determined are favorable or unfavorable.
 Two commonly used standards are:

1. The past performance of the company being

analyzed.
2. The performance of other companies in the
same industry.
KEY POINT
For internal management purposes, another important
comparison is with expected or budgeted numbers.
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Past Performance of the
Company
Comparing financial information for a
current period with similar information
for prior years affords some basis for
judging whether the condition of the
business is improving or worsening.
o Horizontal analysis demonstrates the
changes over a number of consecutive
periods.
o Vertical analysis covers a single
accounting period by computing each
amount as a component percentage of
a given base. 14-16
Industry Standards
The limitations of horizontal analysis
may be overcome to some extent by
finding appropriate external
benchmarks against which to measure
a particular company’s performance.
The benchmarks used by most
analysts are:
◦ The performance of comparable
companies.
◦ The average performance of several
companies in the same industry.
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Quality of Earnings
 In assessing the prospects of a company, we
are interested not only in the total amount of
earnings but also in the rate of earnings on:
◦ Sales
◦ Total assets
◦ Owners’ equity
 In addition, we must look at the stability and
source of earnings.
KEY POINT
An erratic earnings performance over a period of years,
for example, is less desirable than a steady level of
earnings. A history of increasing earnings is preferable
to a flat earnings record.
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Quality of Assets and Relative Amount
of Debt
While profitability is generally a good
indicator of a company’s long-term
ability to pay debts and dividends,
additional factors should be considered
such as:
• Composition of assets
• Condition and liquidity of assets
• Timing of repayment of liabilities
• Total amount of debt outstanding

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Measures of Liquidity and Credit
Risk
 Liquidity refers to a company’s ability to
meet its continuing obligations as they
come due.
◦ A company that has borrowed money
must make interest and principal
payments to the lender, usually a
financial institution.
◦ A company that has purchased its
inventory and other necessities on
credit may be required to pay the seller
within 30 days of the purchase date.
 Liquidity is very important in assessing
the amount, timing, and uncertainty of 14-20
Classified Balance Sheet
In a classified balance sheet, assets
are usually presented in three groups:
◦ Current assets
◦ Plant and equipment
◦ Other assets
Liabilities are classified into two
categories:
◦ Current liabilities
◦ Long-term (noncurrent) liabilities

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Classified Balance Sheet: Assets

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Classified Balance Sheet: Liabilities
& Equity

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Operating Cycle
Most companies have several
operating cycles within a year.
This means that they do the following
multiple times throughout the year:
◦ Use cash to purchase inventory.
◦ Sell the inventory.
◦ Collect the receivable in cash.
Some companies have relatively long
operating cycles such as ship or
airplane construction.

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Current Assets
 Current assets represent relatively liquid
resources.
 To qualify as a current asset, an asset must
already be cash or must be expected to be
converted into cash or used up within a
relatively short period of time, without
interfering with normal business operations.
 Common examples of current assets include:
◦ Cash
◦ Marketable securities
◦ Accounts receivables
◦ Inventories
◦ Prepaid expenses
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Current Liabilities
 Current liabilities are existing obligations
that are expected to be paid by using the
enterprise’s current assets.
 Common examples include:
◦ Accounts payable
◦ Notes payable (due within one year)
◦ Unearned revenue
◦ Accrued expenses such as:
 Income taxes payable
 Salaries payable
 Interest payable

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Relationship between Current
Assets and Current Liabilities
 The relationship between current assets
and current liabilities is as important as
the total dollar amount in either category.
 Current liabilities must be paid in the
near future, and the cash to pay these
liabilities is expected to come from
current assets.
 Decision makers evaluating the liquidity
of a business often compare the relative
amounts of current assets and current
liabilities, whereas an evaluation of long-
term credit risk requires a comparison of
total assets to total liabilities. 14-27
Working Capital
 Working capital is a measurement
sometimes used to express the relationship
between current assets and current
liabilities.
 Working capital is the excess of current
assets over current liabilities.
Computer City’s working capital at December
31, 2018, is $80,000, computed as follows.

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Current Ratio
A widely used measure of short-term debt-paying
ability is the current ratio.
 This ratio is computed by dividing total current
assets by total current liabilities.
In the illustrated balance sheet of Computer City,
current assets amount to $180,000 and current
liabilities total $100,000. Therefore, Computer
City’s current ratio is 1.8 to 1, computed as follows.

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Quick Ratio
 The quick ratio compares only the most
liquid current assets—called quick assets—
with current liabilities.
 Quick assets include cash, marketable
securities, and receivables—the current
assets that can be converted most quickly
into cash.
Computer City’s quick ratio is 1.06 to 1,
computed as follows.

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Debt Ratio
 If a business fails and must be liquidated,
the claims of creditors take priority over
those of the owners.
 A basic measure of the safety of creditors’
claims is the debt ratio, which states total
liabilities as a percentage of total assets.
A company’s debt ratio is computed by
dividing total liabilities by total assets, as
shown below for Computer City.

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Evaluating Financial Ratios
When evaluating financial ratios,
consider the following.
• Characteristics of the company.
• Industry in which the company
operates.
• Type of business (retailer,
wholesaler, manufacturer, service-
type, etc.).
• Size of the business.
• Trend in the ratio over a period of
years.
14-32
Annual Reports
 Publicly owned corporations issue annual
reports that provide a great deal of
information about the company.
 Such annual reports are filed with the SEC as
a 10-K.
 Reports may be accessed using the
company’s corporate website or the SEC
website.
 Annual reports include the following.
◦ Comparative audited financial statements.
◦ 5- to 10-year summaries of key financial
data.
◦ Management’s discussion and analysis
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Liquidity, Credit Risk, and the
Law
 The owners of unincorporated businesses (sole
proprietorships and partnerships) are personally
liable for any and all debts of the business
organization.
◦ Creditors of unincorporated businesses often
base their lending decisions on the financial
position of the owners, rather than the financial
strength of the business entity.
 If a business is organized as a corporation,
however, the owners (stockholders) are not
personally responsible for the liabilities of the
business.
◦ Creditors may look only to the business entity
in seeking payment of their claims.
◦ The liquidity of the business entity becomes
14-34
Measures of Profitability
 Measures of a company’s profitability are
of interest to equity investors and
management and are drawn primarily
from the income statement.
 Key measures of profitability include:
◦ Gross profit rates
◦ Operating income
◦ Net income as a percentage of sales
◦ Earnings per share
◦ Return on assets (ROA)
◦ Return on equity (ROE)
14-35
Income Statement: Multiple-
Step
A multiple-step income statement draws
its name from the series of steps in which
costs and expenses are deducted from
revenue and other nonoperating items are
incorporated into the income statement.
1. The cost of goods sold is deducted from
net sales to determine the subtotal
gross profit.
2. Operating expenses are deducted to
obtain a subtotal called operating
income (or income from operations).
3. Income tax expense and other
nonoperating items are taken into
14-36
Gross Profit: a Key Subtotal
 Ina multiple-step income statement, gross profit
appears as a subtotal.
 This assists users of the income statement in
computing the company’s gross profit rate (or
profit margin).
The gross profit rate is gross profit expressed as a
percentage of net sales. In 2018, Computer City
earned an average gross profit rate of 40 percent,
computed as follows.

14-37
Operating Income: Another Key
Subtotal
 Some of the revenue and expenses of a
business result from activities other than the
company’s basic business operations.
◦ Common examples include interest earned
on investments and income tax expense.
 Operating income (or income from
operations) shows the relationship between
revenue earned from customers and
expenses most directly related to producing
this revenue.
◦ In effect, operating income measures the
profitability of a company’s basic or core
business operations and leaves out other
types of revenue and expenses. 14-38
Net Income
 Many equity investors consider net income
(or net loss) to be the most important figure
in a company’s financial statements.
 Financial analysts often compute net income
as a percentage of net sales (net income
divided by net sales).
In 2018, Computer City’s net income amounts
to 8 percent of net sales.

14-39
Earnings per Share
 To assist individual stockholders in relating the
corporation’s net income to their ownership
shares, public companies compute earnings per
share and show these amounts at the bottom of
their income statements.
 In the simplest case, earnings per share is net
income, expressed on a per-share basis.
For example, the balance sheet in Exhibit 14–3
indicates that Computer City has 15,000 shares of
capital stock outstanding. Assuming these shares
had been outstanding all year, earnings per share
amounts to $4.80.

14-40
Price-Earnings Ratio
 Financial analysts express the relationship
between the market price of a company’s stock
and the underlying earnings per share as a price-
earnings (p/e) ratio.
 This ratio is computed by dividing the current
market price per share of the company’s stock
by annual earnings per share.
To illustrate, assume that, at the end of 2018,
Computer City’s capital stock is trading among
investors at a market price of $96 per share. The
p/e ratio of the company’s stock is computed as
follows.

14-41
Income Statements: Single-Step
 The single-step form of income
statement takes its name from the fact
that all costs and expenses are deducted
from total revenue in a single step.
 No subtotals are shown for gross profit or
for operating income, although the
statement provides investors with
enough information to compute these
subtotals on their
KEYown.
POINT

The amounts of net income and earnings per

share are the same in the multiple-step and
single-step income statements.
14-42
Return on Investment (ROI)
 In deciding where to invest their money,
equity investors want to know how efficiently
a company utilizes its resources.
 A common method of evaluating the
efficiency with which financial resources are
employed is to compute the rate of return
earned on these resources.
Formula:

14-43
Return on Assets (ROA)
 ROA is used in evaluating whether
management has earned a reasonable return
with the assets under its control.
◦ In this computation, return usually is
defined as operating income.
Formula:

14-44
Return on Assets: Example
Let us now determine the return on assets earned by
the management of Computer City in 2018. Operating
income, as shown in the income statement in Exhibit
14–4, amounts to $120,000. Assume that Computer
City’s assets at the beginning of the year totaled
$570,000. The illustrated balance sheet in Exhibit 14–3
shows total assets of $630,000 at year-end. Therefore,
the company’s average total assets during the year
amounted to $600,000 [($570,000 + $630,000) ÷ 2].
The return on assets in 2018 is 20 percent, determined
as follows.

14-45
Return on Equity (ROE)
 The return on assets that we calculated
previously measures the efficiency with
which management has utilized the assets
under its control, regardless of whether
these assets were financed with debt or
equity capital.
 The return on equity ratio, in contrast, looks
only at the return earned by management on
the stockholders’ investment—that is, on
owners’ equity.

14-46
Return on Equity: Example
To illustrate, let us again turn to the 2018 financial
statements of Computer City. The company earned
net income of $72,000. The year-end balance sheet
(Exhibit 14–3) shows total stockholders’ equity of
$420,000. To enable us to complete our
computation, we will assume that the stockholders’
equity at the beginning of the year amounted to
$380,000. Therefore, the average stockholders’
equity for the year amounts to $400,000
[($380,000 + $420,000) ÷ 2]. The return on
stockholders’ equity in 2018 is 18 percent,
computed as follows.

14-47
Comprehensive Illustration: Seacliff
Company
In the following slides, we will analyze
the results for Seacliff Company. Their
financial statements are presented in
the text as follows:
◦ Exhibit 14–6: Comparative Income
Statement
◦ Exhibit 14–7: Statement of Retained
Earnings
◦ Exhibit 14–8: Comparative Balance
Sheet
◦ Exhibit 14–9: Comparative
Statement of Cash Flows 14-48
Seacliff Company: Earnings per
Share
We can compute earnings per share for
Seacliff Company as follows.

14-49
Seacliff Company: Price-
Earnings Ratio
At the end of 2017, Seacliff’s p/e ratio was
approximately 8 to 1 ($160 ÷ $20.25 = 7.9),
suggesting that investors were expecting
earnings to decline in 2018. At December 31,
2018, the price-earnings ratio was 10 to 1
($132 ÷ $13.20 = 10.0). A p/e ratio in this
range suggests that investors expect future
earnings to stabilize around the current level.

14-50
Seacliff Company: Dividend
Yield
Dividends per share divided by market
price per share determine the yield rate of
a company’s stock. Dividend yield is
especially important to those investors
whose objective is to maximize the
dividend revenue from their investments.
For Seacliff, the dividend yield on its
common stock was 3.1 percent in 2017 ($5
÷ $160) and 3.6 percent in 2018 ($4.80 ÷
$132).

14-51
Seacliff Company: Summary of
Earnings and Dividend Data
The relationships of Seacliff’s per-share
earnings and dividends to its year-end
stock prices are summarized below.

14-52
Seacliff Company: Operating
Expense Ratio
Management generally has greater control
over operating expenses than over
revenue. The operating expense ratio is
often used as a measure of management’s
ability to control its operating expenses.
We show the unfavorable trend in this ratio
for Seacliff Company below.

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 Seacliff Company: Return on
Assets
An important test of management’s ability to
earn a return on funds supplied from all sources
is the rate of return on total assets.

14-54
 Seacliff Company: Return on
Common Stockholders’ Equity
The return to common stockholders is equal to net
income less any preferred dividends. The return on
common stockholders’ equity, assuming common
stockholders’ equity at the beginning of 2017 was
$355,000, is computed as follows.

14-55
Seacliff Company: Accounts
Receivable Turnover Rate
The accounts receivable turnover rate is determined by
dividing net sales by the average balance of accounts
receivable. The number of days required (on average)
to collect accounts receivable then may be determined
by dividing the number of days in a year (365) by the
turnover rate.

14-56
Seacliff Company: Inventory
Turnover Rate
The inventory turnover rate indicates how many times
during the year the company is able to sell a quantity of
goods equal to its average inventory. This rate is
determined by dividing the cost of goods sold for the
year by the average amount of inventory on hand
during the year. The number of days required to sell this
amount of inventory may be determined by dividing
365 days by the turnover rate.

14-57
Usefulness of Notes to Financial
Statements
A set of financial statements normally is
accompanied by several notes, disclosing
information useful in interpreting the
statements. Among the most useful are the
following.
 Accounting policies and methods.
 Unused lines of credit.
 Significant commitments and loss
contingencies.
 Current values of financial instruments (if
different from the carrying values shown in
the statements).
 Dividends in arrears.
14-58
Learning Objective Summary
LO14-1
LO14-1: Explain the uses of dollar and
percentage changes, trend percentages,
component percentages, and ratios. An important
aspect of financial statement analysis is determining
relevant relationships among specific items of
information. Companies typically present financial
information for more than one time period, which
permits users of the information to make comparisons
that help them understand changes over time. Dollar
and percentage changes and trend percentages are
tools for comparing information from successive time
periods. Component percentages and ratios, on the
other hand, are tools for establishing relationships and
making comparisons within an accounting period.
Both types of comparisons are important in
understanding an enterprise’s financial position,
results of operations, and cash flows. 14-59
Learning Objective Summary
LO14-2
LO14-2: Discuss the quality of a company’s
earnings, assets, and working capital. Assessing
the quality of information is an important aspect of
financial statement analysis. Enterprises have some
latitude in the selection of financial reporting methods
within generally accepted accounting principles.
Assessing the quality of a company’s earnings, assets,
and working capital is done by evaluating the
accounting methods selected for use in preparing
financial statements. Management’s choice of
accounting principles and methods that are in the best
long-term interests of the company, even though they
may currently result in lower net income, reported
total assets, or working capital, leads to a conclusion
of high quality in reported accounting information.

14-60
Learning Objective Summary
LO14-3
LO14-3: Explain the nature and purpose of
classifications in financial statements. In
classified financial statements, items with certain
common characteristics are placed together in a
group, or classification. The purpose of these
classifications is to develop subtotals that will assist
users in analyzing the financial statements.

14-61
Learning Objective Summary
LO14-4
LO14-4: Prepare a classified balance sheet and
compute widely used measures of liquidity and
credit risk. In a classified balance sheet, assets are
subdivided into the categories of current assets, plant
and equipment, and other assets. Liabilities are
classified either as current or long term.

14-62
Learning Objective Summary
LO14-5
LO14-5: Prepare a multiple-step and a single-
step income statement and compute widely
used measures of profitability. In a multiple-step
income statement, cost of goods sold is deducted from
net sales to provide the subtotal, gross profit.
Operating expenses then are deducted to arrive at
income from operations. As a final step, nonoperating
items are added together and subtracted from income
from operations to arrive at net income. In a single-
step income statement, all revenue items are listed
first, and then all expenses are combined and
deducted from total revenue.

14-63
Learning Objective Summary
LO14-6
LO14-6: Put a company’s net income into
perspective by relating it to sales, assets, and
stockholders’ equity. Financial accounting
information is most useful if viewed in comparison with
other relevant information. Net income is an important
measure of the financial success of an enterprise. To
make the amount of net income even more useful than
if it were viewed simply in isolation, it is often
compared with the sales from which net income
results, the assets used to generate the income, and
the amount of stockholders’ equity invested by owners
to earn the net income.

14-64
Learning Objective Summary
LO14-7
LO14-7: Compute the ratios widely used in
financial statement analysis and explain the
significance of each. Ratios are mathematical
calculations that compare one financial statement item
with another financial statement item. The two items
may come from the same financial statement, such as
the current ratio, which compares the amount of
current assets with the amount of current liabilities,
both of which appear in the statement of financial
position (balance sheet). On the other hand, the
elements of some ratios come from different financial
statements, such as the return on stockholders’
equity, which compares net income from the income
statement with the amount of stockholders’ equity
from the statement of financial position (balance
sheet). Accountants and financial analysts have
developed many ratios that place information from a
company’s financial statements in a context to permit 14-65
Learning Objective Summary
LO14-8
LO14-8: Analyze financial statements from the
viewpoints of common stockholders, creditors,
and others. Different groups of users of financial
statements are interested in different aspects of a
company’s financial activities. Short-term creditors are
interested primarily in the company’s ability to make
cash payments in the short term; they focus their
attention on operating cash flows and current assets
and liabilities. Long-term creditors, on the other hand,
are more interested in the company’s long-term ability
to pay interest and principal and would not limit their
analysis to the company’s ability to make cash
payments in the immediate future. The focus of
common stockholders can vary from one investor to
another, but generally stockholders are interested in
the company’s ability to pay dividends and increase
the market value of the stock of the company. Each
group may focus on different information in the 14-66
End of Chapter 14

14-67