# Financial Statement Analysis for

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```							     CHAPTER 13
Financial Statement Analysis
Financial Statement Analysis
   External users and
analysts rely on
publicly-available
information to
perform financial
analysis
   Such information is
contained in
corporate annual
report
Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS

FOOTNOTES TO THE FINANCIAL      1
STATEMENTS
2
SUMMARY OF ACCOUNTING METHODS
3
MANAGEMENT’S DISCUSSION AND       4
ANALYSIS OF FINANCIAL STATEMENTS
5
AUDITOR’S REPORT           6

COMPARATIVE FINANCIAL DATA FOR A
SERIES OF YEARS
Tools to Evaluate Financial
Information

Horizontal Analysis

1

2               Vertical Analysis
3

Ratio Analysis
Horizontal Analysis
 Examines percentage change in
each item on the financial
statements
 Compares current year’s dollar
amount with prior year’s dollar
amount
 Expresses the change in
 Dollars
 Percentage
 Look at Exhibit 13-3, Pg. 610
Horizontal - Trend Percentages
   Specialized form
of horizontal
analysis
   Shows trend of
financial
statement items
over longer time
periods such as 5
or 10 years
Vertical Analysis

2         Vertical Analysis
Vertical Analysis
 Compares each item on the financial
statement to a key, or base, item
 Base-item dollar amount always set to 100%
 Produces ―common-size‖ statements
 Income statement
   Net sales = 100%
   Balance sheet
 Total assets = 100%
 Look at exhibit 13-4, Pg 612 and 13-5, Pg 613
Benchmarking Against the
Industry Average

Benchmarking is a term used to
describe the process of comparing a
company’s activities to a standard of
excellence achieved by industry
Benchmarking Against Key
Competitors

 A company also can compare its
common-size financials to those of
 Determine where it differs
processes to bring financial results in
line with these benchmark entities
Decisions

3
Ratio Analysis
Decisions
 Ratios - the relationship between two
items on financial statements - permit
users to calculate a variety of financial
comparisons
 These ratios can be compared to:
 Prior years’ financial results
 Industry averages
 Benchmark entities’ ratios
Decisions

Ratios measure an entity’s ability to:
 Pay current liabilities
 Sell inventory and collect receivables
 Pay long-term debt
 Generate profits from operations
 Sustain shareholder wealth
Ratios in Chapter 13

Overview,
pp. 630
Decision
guidelines
lists all ratios
Ratio analysis
 The current ratio is a ratio of the current
assets to the current liabilities. Acceptable
current ratios vary from industry to
industry, but the norm for most companies
is between 1.6 and 1.9.
 There are five categories of current
assets that are listed in order of their
liquidity: Cash, Short-term Investments,
Receivables, Inventory, and Prepaid
Expenses.
Ratio analysis
 The acid-test (quick) ratio measures the
quick assets—cash, short-term
investments, and receivables—to current
liabilities. This ratio excludes inventory and
prepaid expenses because these current
assets are the least liquid current assets.
 Certain ratios measure the firm’s ability to
sell inventory and collect receivables, a
key factor in a firm’s success.
Ratio analysis
   Inventory turnover measures how many times
a year the company sells its average level of
inventory. A high turnover indicates relative ease
of selling inventory, while a low turnover
indicates relative difficulty of selling inventory.
   Accounts receivable turnover measures how
quickly the firm collects cash from credit
customers. The higher the ratio, the more
quickly a firm collects its receivables.
   Days’ sales in receivables is the number of
days’ sales that remain uncollected.
Ratio analysis
Suppose you were analyzing Company A and Company B
and the two companies reported the following:
Company A                    Company B
Current assets \$10,000       \$10,000,000
Current liabilities 5,000       9,995,000
Working capital \$ 5,000      \$       5,000

Both companies have identical working capital, but which
company has a better ability to pay its short-term debt?
Company A, because the ratio of the current assets to
current liabilities is higher for Company A. Working
capital is not a ratio; it does not calculate the relative
size of the current assets to current liabilities. The
current ratio provides a better understanding of the two
companies’ liquidity.
Current ratio of A is 2 (\$10,000  \$5,000) Current ratio of
B is 1.001 (\$10,000,000  \$9,995,000)
Ratio analysis
 Not all ratios apply to all companies. For
example, inventory turnover would not be
applicable to a service company
 Sharp changes in ratios indicate that
something significant has happened, but
the manager must analyze the change to
determine what has occurred and what
corrective action must be taken.
Analyzing the Company’s Stock
as an Investment
   Financial analysts
use several ratios
to assess value of
stock investments:
   Price/earnings
ratio
   Dividend yield
   Book value
(covered in
chapter 9)
Earnings Per Share

   Most widely quoted of all
financial statistics
   Computed by dividing net income
available to common stockholders by the
number of common shares outstanding
during the year
   = Net Income – Preferred Dividends
Number of common shares
outstanding
Price/Earnings Ratio

   Decision to buy, hold, or sell
stock
   Relationship between a stock’s market
price and its earnings per share
   Measures the number of times one
share of stock sells above the current
period’s reported earnings
   Widely published in The Wall Street
Journal
Price/Earnings Ratio
   Suppose the
market value of
Asian Art, Inc.,
Calculating the P/E ratio
common stock is
\$15.75 on the last
Market value of stock
day of its fiscal
Earnings per share
year
   The income
statement reports
EPS of \$.92
   What is Asian Art’s
price/earnings
ratio?
Price/Earnings Ratio Example
Market value of stock
Earnings per share

\$15.75
\$.92

= 17.12
Dividend Yield
 Ratio of dividends per share of stock to the
stock’s market value
 Indicates the percentage of a stock’s
market value ―returned‖ to the stockholder
in the form of dividends
 Assists investors who desire a steady flow
of dividend revenue in their decisions to
invest in a particular stock
Dividend Yield

Annual dividends per share
Stock’s market value per share

   Example: If Asian Art paid a total of \$1.25
in dividends per share, what would be its
dividend yield, assuming the same market
value for its stock (\$15.75)?
Dividend Yield
Annual dividends per share
Stock’s market value per share

\$1.25
\$15.75

= .079
Limitations of Financial Analysis
 No one ratio or year’s worth of financial
information should be relied upon to provide a
complete assessment of a corporation’s financial
condition
 Ratio analysis is most helpful when calculated
over a broad time frame and when used in
conjunction with other relevant information that
can affect a company, such as legislation,
competition, and scandals.
Analysts should:
 Examine trends over time
 Benchmark to industry and key competitors
End of
Lecture

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