Lecture 10 - Financial Statement Analysis

Accounting Principles
Twelfth Edition
Weygandt ● Kimmel ● Kieso
Chapter 18
Financial Analysis: The Big Picture

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Chapter Outline
Learning Objectives
LO 1 Apply horizontal analysis and vertical analysis.
LO 2 Analyze a company’s performance using ratio
analysis.
2
Horizontal Analysis and Vertical Analysis
LEARNING OBJECTIVE 2
Apply horizontal analysis and vertical analysis.
Investors are interested in:

• Core or sustainable earnings of a company
• Making comparisons from period to period
o Three types of comparisons:
• Intracompany basis
• Intercompany basis
• Industry averages
LO 2 3
Horizontal Analysis and Vertical Analysis
Three basic tools in financial statement analysis:

1. Horizontal analysis
2. Vertical analysis
3. Ratio analysis
LO 2 4
Horizontal Analysis (1 of 5)
Also called trend analysis, is a technique for evaluating a
series of financial statement data over a period of time.
Purpose is to determine:
• Increase or decrease
• Expressed as either an amount or a percentage
LO 2 5
LO 2 6
LO 2 7
Vertical Analysis (1 of 7)
Also called common-size analysis, is a technique that expresses
each financial statement item as a percentage of a base amount.
• On a balance sheet, we might express current assets as 22% of
total assets (total assets being the base amount).
• On an income statement, we might say that selling expenses are
16% of net sales (net sales being the base amount).
LO 2 8
LO 2 9
LO 2 10
LO 2 11
Ratio Analysis (1 of 2)
Ratio analysis expresses the relationship among selected items of
financial statement data.
Financial Ratio Classifications

Liquidity Profitability Solvency
Measure short-term Measure the income or Measure the ability of
ability of the company operating success of a the company to survive
to pay its maturing company for a given over a long period of
obligations and to meet period of time time
unexpected needs for
cash
LO 2 12
Ratio Analysis
LEARNING OBJECTIVE 3
Analyze a company’s performance using ratio analysis.
Ratio analysis expresses the relationship among selected items of

financial statement data.
Financial Ratio Classifications
Liquidity Profitability Solvency
Measure short-term Measure the income or Measure the
ability of the company operating success of a ability of the
to pay its maturing company for a given company to
obligations and to period of time survive over a long
meet unexpected period of time
needs for cash
LO 3 13
Ratio Analysis
A single ratio by itself is not very meaningful.
We will use the following types of comparisons.
1. Intracompany comparisons for two years for Chicago Cereal.
2. Industry average comparisons based on median ratios for the
industry.
3. Intercompany comparisons based on Giant Mills as Chicago
Cereal’s principal competitor.
LO 3 14
Comprehensive Ratio Analysis (1 of 3)
LO 3 15
LO 3 16
LO 3 17
Liquidity Ratios (1 of 6)
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.
LO 3 18
Current Assets
1. Current Ratio 
Current Liabilities
Chicago Cereal
2020 2019
blank
$2,717 divided by $4,044
$2,717 = 0.67 0.60

$4 ,044
Industry Average Giant Mills 2020
1.06 .67
Chicago has $0.67 of current assets for every dollar of current liabilities.
LO 3 19
Net credit sales
2. Accounts Receivable Turnover 
Average net accounts receivable
Chicago Cereal
blank
2020 2019
$11,776 divided by a denominator consisting of the sum of $1,026 plus $945 divided by 2
$11,776 = 11.9 12.0

 $1,026 + $945 ÷ 2
11.2 12.2
Measures the number of times, on average, the company collects
receivables during the period.
20
365 days
3. Average Collection Period 
Average accounts turnover
Chicago Cereal
blank
2020 2019
365 divided by 11.9
365 = 30.7 30.4

11.9
32.6 29.9
Analysts frequently use average collection period to assess the

effectiveness of a company’s credit and collection policies.
21
Cost of goods sold
4. Inventory Turnover 
Average inventory
Chicago Cereal
blank
2020 2019
$6,597 divided by the denominator consisting of the sum of $924 plus $824 divided by 2
$6,597 = 7.5 7.9

 $924  $824   2
6.7 7.4
The faster the inventory turnover, the less cash is tied up in inventory and
less chance of inventory becoming obsolete.
22
365 days
5. Days in Inventory 
Inventory turnover
Chicago Cereal
blank
2020 2019
365 divided by 7.5
365 = 48.7 46.2

7.5
54.5 49.3
Measures the average number of days inventory is held.
LO 3 23
Solvency Ratios (1 of 4)
Measure the ability of a company to survive over a long
period of time.
• Debt to assets ratio and times interest earned provide
information about debt-paying ability.
• Free cash flow provides information about solvency and
ability to pay additional dividends or invest in new projects.
24
Total liabilities
6. Debt to assets ratio 
Total assets
Chicago Cereal
blank
2020 2019
$8,871 divided by $11,397
$8,871 = 78% 81%

$11,397
55% 55%
Provides some indication of company’s ability to withstand losses without

impairing the interests of its creditors.
25
Net Interest Income tax
+ +
Income expense expense
7. Times interest earned 
Interest expense
Chicago Cereal
blank
2020 2019
The sum of $1,103 + $321 + $444, divided by $321
$1,103  $321  $444 = 5.8 6.0

$321
5.5 9.9
Provides an indication of company’s ability to meet interest payments as
they come due.
26
Profitability Ratios (1 of 11)
Measure the income or operating success of a company for a
given period of time.
• Income affects ability to obtain debt and equity financing,
liquidity, and ability to grow.
• Creditors and investors are interested in evaluating
profitability.
• Analysts use profitability as ultimate test of management’s
operating effectiveness.
27
9. Return on Equity Net Income  Preferred dividends

Average common stockholders’ equity
Chicago Cereal
blank
2020 2019
$1,103 minus $0, divided by the sum of $2,526 plus $2,069 divided by 2
$1,103  $0 = 48% 46%

 $2, 526 + $2, 069  ÷ 2
19% 25%
Shows how many dollars of net income the company earned for each
dollar invested by the owners.
28
Neti ncome
10. Return on Assets 
Average total assets
Chicago Cereal
blank
2020 2019
$1,103 divided by the sum of $11,397 plus $10,714 divided by 2
$1,103 = 10.0% 9.4%

 $11,397 + $10, 714  ÷ 2
5.3% 6.2%
Measures the overall profitability of assets in terms of the income earned

on each dollar invested in assets.
29
Neti ncome
11. Profit Margin 
Net sales
Chicago Cereal
blank
2020 2019
$1,103 divided by $11,776
$1,103 = 9.4% 9.2%

$11,776
6.1% 8.2%
Measures of the percentage of each dollar of sales that results in net

income.
30
Net sales
12. Asset Turnover 
Average total assets
Chicago Cereal
blank
2020 2019
$11,776 divided by the sum of $11,397 plus $10,714 divided by 2
$11,776 = 1.07 1.02

 $11,397 + $10,714  ÷ 2
.87 .76
Measures how efficiently a company uses its assets to generate sales.
31
Gross profit
13. Gross Profit Rate 
Net sales
Chicago Cereal
blank
2020 2019
$5,179 divided by $11,776
$5,179 = 44% 44%

$11,776
30% 34%
Indicates a company’s ability to maintain an adequate selling price above

its cost of goods sold.
32
Neti ncome – Preferred dividends
14. Earnings Per Share 
Weighted-average common shares outstanding
Chicago Cereal
blank
2020 2019
$1,103 minus $0 divided by 418.7
$1,103  $0 = $2.63 $2.40

418.7
na $2.90
A measure of the net income earned on each share of common stock.
33
Market price per share
15. Price Earnings Ratio 
Earnings per share
Chicago Cereal
blank
2020 2019
$52.92 divided by $2.63
$52.92 = 20.1 20.9

$2.63
35.8 24.3
Reflects investors’ assessments of a company’s future earnings.
LO 3 Copyright ©2018 John Wiley & Sons, Inc. 34

Cash dividends declared on common stock
16. Payout ratio 
Net income
Chicago Cereal
blank
2020 2019
$475 divided by $1,103
$475 = 43% 45%

$1,103
37% 54%
Measures the percentage of earnings distributed in the form of cash

dividends.
LO 3 Copyright ©2018 John Wiley & Sons, Inc. 35

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Accounting Principles

Financial Analysis: The Big Picture

Investors are interested in:

Three basic tools in financial statement analysis:

Financial Ratio Classifications

Ratio analysis expresses the relationship among selected items of

$2,717 divided by $4,044

$2,717 = 0.67 0.60

$11,776 = 11.9 12.0

365 = 30.7 30.4

Analysts frequently use average collection period to assess the

$6,597 = 7.5 7.9

365 = 48.7 46.2

Measures the average number of days inventory is held.

$8,871 = 78% 81%

Provides some indication of company’s ability to withstand losses without

$1,103  $321  $444 = 5.8 6.0

$1,103  $0 = 48% 46%

$1,103 = 10.0% 9.4%

Measures the overall profitability of assets in terms of the income earned

$1,103 = 9.4% 9.2%

Measures of the percentage of each dollar of sales that results in net

$11,776 = 1.07 1.02

Measures how efficiently a company uses its assets to generate sales.

$5,179 = 44% 44%

Indicates a company’s ability to maintain an adequate selling price above

$1,103  $0 = $2.63 $2.40

A measure of the net income earned on each share of common stock.

$52.92 = 20.1 20.9

Reflects investors’ assessments of a company’s future earnings.

LO 3 Copyright ©2018 John Wiley & Sons, Inc. 34

$475 = 43% 45%

Measures the percentage of earnings distributed in the form of cash

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