18 - 1 ©2002 prentice hall, inc. business publishing
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18 - 1©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Financial Statement Analysis
Chapter 18
18 - 2©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
The Annual ReportUsually
Contains ...– financial statements.– notes to the financial statements.– a summary of accounting methods used.– management discussion and analysis of the
financial statements.– an auditor’s report.– comparative financial data for 5 to 10 years.
18 - 3©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Objective 1
Perform a horizontal analysis
of financial statements.
18 - 4©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Horizontal Analysis
Increase/(Decrease) 2002 2001 Amount Percent
Sales $41,500 $37,850 $3,650 9.6%Expenses 40,000 36,900 3,100 8.4%Net income 1,500 950 550 57.9%
18 - 5©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
2002 2001 DifferenceSales $41,500 $37,850 $3,650
$3,650 ÷ $37,850 = .0964, or 9.6%
Horizontal Analysis
18 - 6©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Trend Percentages...
– are computed by selecting a base year whose amounts are set equal to 100%.
The amounts of each following year are expressed as a percentage of the base amount.
Trend % = Any year $ ÷ Base year $
18 - 7©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Year 2000 1999 1998Revenues $27,611 $24,215 $21,718Cost of sales 15,318 14,709 13,049Gross profit $12,293 $ 9,506 $ 8,6691998 is the base year.
What are the trend percentages?
Trend Percentages
18 - 8©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Year 2000 1999 1998Revenues 127% 111% 100%Cost of sales 117% 113% 100%Gross profit 142% 110% 100%
Trend Percentages
These percentages were calculated bydividing each item by the base year.
18 - 9©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Objective 2
Perform a vertical analysis
of financial statements.
18 - 10©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Vertical Analysis...
– compares each item in a financial statement to a base number set to 100%.
Every item on the financial statement is then reported as a percentage of that base.
18 - 11©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Vertical Analysis
1999 %Revenues $38,303 100.0Cost of sales 19,688 51.4Gross profit $18,615 48.6Total operating expenses 13,209 34.5Operating income $ 5,406 14.1Other income 2,187 5.7Income before taxes $ 7,593 19.8Income taxes 2,827 7.4Net income $ 4,766 12.4
18 - 12©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Vertical Analysis
Assets 1999 %Current assets:Cash $ 1,816 4.7Receivables net 10,438 26.9Inventories 6,151 15.9Prepaid expenses 3,526 9.1Total current assets $21,931 56.6Plant and equipment, net 6,847 17.7Other assets 9,997 25.7Total assets $38,775 100.0
18 - 13©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Objective 3
Prepare common-size
financial statements.
18 - 14©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Common-size Statements
On the income statement, each item is expressed as a percentage of net sales.
On the balance sheet, the common size is the total on each side of the accounting equation.
Common-size statements are used to compare one company to other companies, and to the industry average.
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Benchmarking
43.0%
38.2%
8.0%
10.8%
51.4%
28.8%
7.4%
12.4%
Percent of Net Sales
MCILucent Technologies
Cost of goods sold Operating expenses Income tax Net income
18 - 16©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Objective 4
Compute the standard
financial ratios.
18 - 17©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Ratio Classification
1 Measuring ability to pay current liabilities2 Measuring ability to sell inventory and
collect receivables3 Measuring ability to pay short-term and
long-term debt4 Measuring profitability5 Analyzing stock as an investment
18 - 18©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Palisades Furniture Example
Net sales (Year 2002) $858,000Cost of goods sold 513,000Gross profit $345,000Total operating expenses 244,000Operating income $101,000Interest revenue 4,000Interest expense (24,000)Income before taxes $ 81,000Income taxes 33,000Net income $ 48,000
18 - 19©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Palisades Furniture Example
Assets 20x2 20x1Current assets:Cash $ 29,000 $ 32,000Receivables net 114,000 85,000Inventories 113,000 111,000Prepaid expenses 6,000 8,000Total current assets $262,000 $236,000Long-term investments 18,000 9,000Plant and equipment, net 507,000 399,000Total assets $787,000 $644,000
18 - 20©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Palisades Furniture Example
Liabilities 20x2 20x1Current liabilities:Notes payable $ 42,000 $ 27,000Accounts payable 73,000 68,000Accrued liabilities 27,000 31,000Total current liabilities $142,000 $126,000Long-term debt 289,000 198,000Total liabilities $431,000 $324,000
18 - 21©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Stockholders’ Equity 20x2 20x1Common stock, no par $186,000 $186,000Retained earnings 170,000 134,000Total stockholders’ equity $356,000 $320,000
Total liabilities andstockholders’ equity $787,000 $644,000
Palisades Furniture Example
18 - 22©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Current ratio =Total current assets ÷ Total current liabilities
Current ratio =Total current assets ÷ Total current liabilities
The current ratio measuresthe company’s ability to pay
current liabilities with current assets.
The current ratio measuresthe company’s ability to pay
current liabilities with current assets.
Measuring Ability toPay Current Liabilities
18 - 23©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Ability toPay Current Liabilities
Palisades’ current ratio: 20x1: $236,000 ÷ $126,000 = 1.87 20x2: $262,000 ÷ $142,000 = 1.85 The industry average is 1.80. The current ratio decreased slightly
during 20x2.
18 - 24©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Acid-test ratio =(Cash + Short-term investments
+ Net current receivables)÷ Total current liabilities
Acid-test ratio =(Cash + Short-term investments
+ Net current receivables)÷ Total current liabilities
Measuring Ability toPay Current Liabilities
The acid-test ratio shows the company’sability to pay all current liabilities
if they come due immediately.
The acid-test ratio shows the company’sability to pay all current liabilities
if they come due immediately.
18 - 25©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Ability toPay Current Liabilities
Palisades’ acid-test ratio: 20x1: ($32,000 + $85,000) ÷ $126,000 = .93 20x2: ($29,000 + $114,000) ÷ $142,000 = 1.01 The industry average is .60. The company’s acid-test ratio improved
considerably during 20x2.
18 - 26©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Inventory turnover = Cost of goods sold÷ Average inventory
Inventory turnover = Cost of goods sold÷ Average inventory
Inventory turnover is a measureof the number of times the average
level of inventory is sold during a year.
Inventory turnover is a measureof the number of times the average
level of inventory is sold during a year.
Measuring Ability to
Sell Inventory
18 - 27©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Ability to
Sell Inventory Palisades’ inventory turnover: 20x2: $513,000 ÷ $112,000 = 4.58 The industry average is 2.70. A high number indicates an ability to
quickly sell inventory.
18 - 28©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Accounts receivable turnover =Net credit sales ÷ Average accounts receivable
Accounts receivable turnover =Net credit sales ÷ Average accounts receivable
Accounts receivable turnover measures a company’sability to collect cash from credit customers.
Accounts receivable turnover measures a company’sability to collect cash from credit customers.
Measuring Ability to
Collect Receivables
18 - 29©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Ability to
Collect Receivables Palisades’ accounts receivable turnover: 20x2: $858,000 ÷ $99,500 = 8.62 times The industry average is 22.2 times. Palisades’ receivable turnover is much lower
than the industry average. The company is a home-town store that sells
to local people who tend to pay their bills over a lengthy period of time.
18 - 30©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
One day’s sales = Net sales ÷ 365 daysOne day’s sales = Net sales ÷ 365 days
Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales
Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales
Measuring Ability to
Collect Receivables
Days’ sales in receivable ratio measures howmany day’s sales remain in Accounts Receivable.
Days’ sales in receivable ratio measures howmany day’s sales remain in Accounts Receivable.
18 - 31©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Ability to
Collect Receivables Palisades’ days’ sales in Accounts
Receivable for 20x2: One day’s sales: $858,000 ÷ 365 = $2,351 Days’ sales in Accounts Receivable: $99,500 ÷ $2,351 = 42 days The industry average is 16 days.
18 - 32©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Total liabilities ÷ Total assetsTotal liabilities ÷ Total assets
Measuring Ability to
Pay Debt
The debt ratio indicates the proportionof assets financed with debt.
The debt ratio indicates the proportionof assets financed with debt.
18 - 33©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Ability to
Pay Debt Palisades’ debt ratio: 20x1: $324,000 ÷ $644,000 = 0.50 20x2: $431,000 ÷ $787,000 = 0.55 The industry average is 0.61. Palisades Furniture expanded operations
during 20x2 by financing through borrowing.
18 - 34©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Times-interest-earned= Income from operations
÷ Interest expense
Times-interest-earned= Income from operations
÷ Interest expense
Measuring Ability to
Pay Debt
Times-interest-earned ratiomeasures the number of times
operating income can cover interest expense.
Times-interest-earned ratiomeasures the number of times
operating income can cover interest expense.
18 - 35©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Ability to
Pay Debt Palisades’ times-interest-earned ratio: 20x1: $ 57,000 ÷ $14,000 = 4.07 20x2: $101,000 ÷ $24,000 = 4.21 The industry average is 2.00. The company’s times-interest-earned ratio
increased in 20x2. This is a favorable sign.
18 - 36©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Rate of return on net sales =Net income ÷ Net sales
Rate of return on net sales =Net income ÷ Net sales
Measuring Profitability
Rate of return on net sales shows the percentageof each sales dollar earned as net income.
Rate of return on net sales shows the percentageof each sales dollar earned as net income.
18 - 37©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Profitability
Palisades’ rate of return on sales: 20x1: $26,000 ÷ $803,000 = 0.032 20x2: $48,000 ÷ $858,000 = 0.056 The industry average is 0.008. The increase is significant in itself and also
because it is much better than the industry average.
18 - 38©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Rate of return on total assets = (Net income + interest expense) ÷ Average total assets
Rate of return on total assets = (Net income + interest expense) ÷ Average total assets
Measuring Profitability
Rate of return on total assets measureshow profitably a company uses its assets.
Rate of return on total assets measureshow profitably a company uses its assets.
18 - 39©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Profitability
Palisades’ rate of return on total assets for 20x2:
($48,000 + $24,000) ÷ $715,500 = 0.101 The industry average is 0.049. How does Palisades compare to the
industry? Very favorably.
18 - 40©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Rate of return on common stockholders’ equity= (Net income – preferred dividends)
÷ Average common stockholders’ equity
Rate of return on common stockholders’ equity= (Net income – preferred dividends)
÷ Average common stockholders’ equity
Measuring Profitability
Common equity includes additionalpaid-in capital on commonstock and retained earnings.
Common equity includes additionalpaid-in capital on commonstock and retained earnings.
18 - 41©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Profitability
Palisades’ rate of return on common stockholders’ equity for 20x2:
($48,000 – $0) ÷ $338,000 = 0.142 The industry average is 0.093. Why is this ratio larger than the return on
total assets (.101)? Because Palisades uses leverage.
18 - 42©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Profitability
Earnings per share of common stock= (Net income – Preferred dividends)
÷ Number of shares of common stock outstanding
Earnings per share of common stock= (Net income – Preferred dividends)
÷ Number of shares of common stock outstanding
18 - 43©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Measuring Profitability
Palisades’ earnings per share: 20x1: ($26,000 – $0) ÷ 10,000 = $2.60 20x2: ($48,000 – $0) ÷ 10,000 = $4.80 This large increase in EPS is considered
very unusual.
18 - 44©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Analyzing Stock as an Investment
Price/earning ratio is the ratio of market price per share to earnings per share.
20x1: $35 ÷ $2.60 = 13.5 20x2: $50 ÷ $4.80 = 10.4 Given Palisades Furniture’s 20x2 P/E ratio
of 10.4, we would say that the company’s stock is selling at 10.4 times earnings.
18 - 45©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Dividend per share of common(or preferred) stock ÷ Market price per share
of common (or preferred) stock
Dividend per share of common(or preferred) stock ÷ Market price per share
of common (or preferred) stock
Analyzing Stock as an Investment
Dividend yield shows the percentageof a stock’s market value returned as
dividends to stockholders each period.
Dividend yield shows the percentageof a stock’s market value returned as
dividends to stockholders each period.
18 - 46©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Analyzing Stock as an Investment
Dividend yield on Palisades’ common stock: 20x1: $1.00 ÷ $35.00 = .029 (2.9%) 20x2: $1.20 ÷ $50.00 = .024 (2.4%) An investor who buys Palisades Furniture
common stock for $50 can expect to receive 2.4% of the investment annually in the form of cash dividends.
18 - 47©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Analyzing Stock as an Investment
Book value per share of common stock= (Total stockholders’ equity – Preferred equity)
÷ Number of shares of common stock outstanding
Book value per share of common stock= (Total stockholders’ equity – Preferred equity)
÷ Number of shares of common stock outstanding
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Analyzing Stock as an Investment
Book value per share of palisades’ common stock:
20x1: ($320,000 – $0) ÷ 10,000 = $32.00 20x2: ($356,000 – $0) ÷ 10,000 = $35.60 Book value bears no relationship to market
value.
18 - 49©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Objective 5
Use ratios in decision making.
18 - 50©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Limitations of Financial Analysis
Business decisions are made in a world of uncertainty.
No single ratio or one-year figure should be relied upon to provide an assessment of a company’s performance.
18 - 51©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Objective 6
Measure economic value added.
18 - 52©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
Economic Value Added (EVA®)
Economic value added (EVA®) combines accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth.
EVA® = Net income + Interest expense – Capital charge
18 - 53©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber
End of Chapter 18