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1. Financial Statement Analysis Chapter 17

2. Learning Objectives • Describe basic financial statement analytical methods. • Use financial statement analysis to assess the solvency of a business. • Use financial statement analysis to assess the profitability of a business. • Describe the contents of corporate annual reports.

3. Learning Objective 1 Describe basic financial statement analytical methods.

4. Basic Analytical Methods • Users analyze a company’s financial statements using a variety of analytical methods. Three such methods are as follows: • Horizontal analysis • Vertical analysis • Common-sized statements

5. Horizontal Analysis • The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis.

6. Horizontal Analysis

7. Horizontal Analysis: Difference\$17,000 Base year (2013)\$533,000 = 3.2% Horizontal Analysis

8. Horizontal Analysis

9. Horizontal Analysis: Difference\$25,800 Base year (2013)\$64,700 = 39.9% Horizontal Analysis

10. Horizontal Analysis

11. Horizontal Analysis Horizontal Analysis: Difference\$296,500 Base year (2013)\$1,234,000 = 24.0%

12. Horizontal Analysis

13. Horizontal Analysis Horizontal Analysis: Difference\$37,500 Base year (2013)\$ 100,000 = 37.5%

14. Vertical Analysis • A percentage analysis used to show the relationship of each component to the total within a single financial statement is called vertical analysis.

15. Vertical Analysis • In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. • Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.

16. Vertical Analysis

17. Vertical Analysis Vertical Analysis: Current Assets\$550,000 Total Assets\$ 1,139,500 = 48.3%

18. Vertical Analysis • In a vertical analysis of the incomestatement, each item is stated as a percent of net sales.

19. Vertical Analysis

20. Vertical Analysis Vertical Analysis: Selling expenses \$191,000 Net sales \$1,498,000 = 12.8%

21. Common-Sized Statements • In a common-sized statement, all items are expressed as percentages with no dollar amounts shown. • Common-sized statements are useful for comparing the current period with prior periods, individual businesses with one another, or one business with industry averages.

22. Common-Sized Statements

23. Learning Objective 2 Use financial statement analysis to assess the solvency of a business.

24. Solvency Analysis • All users of financial statements are interested in the ability of a company to do the following: • Meet its financial obligations (debts), calledsolvency. • Earn income, called profitability.

25. Solvency Analysis • Solvency analysis focuses on the ability of a business to pay its current and noncurrent liabilities. • Solvency and profitability are interrelated. A company that cannot pay its debts will have difficulty obtaining credit, which can decrease its profitability.

26. Current Position Analysis • A company’s ability to pay its current liabilities is called current position analysis. It is of special interest to short-term creditors.

27. Working Capital • The excess of current assets over current liabilities is called working capital. Working capital is often used to evaluate a company’s ability to pay current liabilities. • Working capital is computed as follows: Working Capital = Current Assets – Current Liabilities

28. Current Assets Current Liabilities Current Ratio = Current Ratio • The current ratio, sometimes called the working capital ratio,also measures a company’s ability to pay its current liabilities. • The current ratio is computed as follows:

29. \$550,000 \$210,000 \$533,000 \$243,000 Current Ratio • The current ratio for Lincoln Company is computed below. 2014 2013 Current assets \$550,000 \$533,000 Current liabilities \$210,000 \$243,000 Current ratio 2.6 2.2

30. Quick Assets Current Liabilities Quick Ratio = Quick Ratio • A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio, or acid-test ratio. It is computed as follows: Quick assets are cash and other assets that can be easily converted to cash.

31. \$280,500 \$210,000 \$244,700 \$243,000 Quick Assets • The quick ratio for Lincoln Company is computed below. 2014 2013 Quick assets: Cash \$ 90,500 \$ 64,700 Temporary Investments 75,000 60,000 Accounts receivable (net) 115,000 120,000 Total quick assets \$280,500 \$244,700 Current liabilities \$210,000 \$243,000 Quick ratio 1.3 1.0

32. Net Sales Average Accounts Receivable Accounts Receivable Turnover = Accounts Receivable Turnover • The relationship between sales and accounts receivable may be stated as accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a company’s solvency. • The accounts receivable turnover is computed as follows:

33. \$1,498,000 \$117,500 \$1,200,000 \$130,000 Accounts Receivable Turnover • The accounts receivable turnover for Lincoln Company is computed below. 2014 2013 Net sales \$1,498,000 \$1,200,000 Accounts receivable (net): Beginning of year \$ 120,000 \$ 140,000 End of year 115,000 120,000 Total \$ 235,000 \$ 260,000 Average (Total ÷ 2) \$ 117,500 \$ 130,000 Accounts receivable turnover 12.7 9.2

34. Average Accounts Receivable Average Daily Sales Number of Days’ Sales in Receivables = Net Sales 365 Number of Days’ Sales in Receivables • The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. It is computed as follows:

35. 2014 2013 • Average accounts receivable • (Total accounts receivable ÷ 2) \$ 117,500 \$ 130,000 • Net sales \$1,498,000 \$1,200,000 • Average daily sales • (Net sales ÷ 365) \$ 4,104 \$ 3,288 \$117,500 \$4,104 \$130,000 \$3,288 Number of Days’ Sales in Receivables • The number of days’ sales in receivables for Lincoln Company is computed below. Number of days’ sales in receivables 28.6 39.5

36. Cost of Goods Sold Average Inventory Inventory Turnover = Inventory Turnover • The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of a firm in managing its inventory. • The inventory turnover is computed as follows:

37. \$1,043,000 \$273,500 \$820,000 \$297,000 Inventory Turnover • Lincoln’s inventory balance at the beginning of 2013 is \$311,000. 2014 2013 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

38. Cost of Goods Sold 365 Average Inventory Average Daily Cost of Goods Sold Number of Days’ Sales in Inventory = Number of Days’ Sales in Inventory • The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory. • The number of days’ sales in inventory is computed as follows:

39. Number of Days’ Sales in Inventory • The number of days’ sales in inventory for Lincoln Company is computed below. 2014 2013 • Average Inventory \$273,500 \$297,000 \$547,000 ÷ 2 \$594,000 ÷ 2 (continued)

40. \$273,500 \$2,858 \$297,000 \$2,247 Number of Days’ Sales in Inventory • The number of days’ sales in inventory for Lincoln Company is computed below. 2014 2013 • Average Inventory \$273,500 \$297,000 • Average daily cost of goods sold \$2,858 \$2,247 \$1,043,000 ÷ 365 \$820,000 ÷ 365 Number of days’ sales in inventory 95.7 132.2

41. Fixed Assets (net) Long-Term Liabilities Ratio of Fixed Assets to Long-Term Liabilities = Ratio of Fixed Assets to Long-Term Liabilities • The ratio of fixed assets to long-termliabilities is a solvency measure that indicates the margin of safety of the note-holders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis. • The ratio is computed as follows:

42. 2014 2013 Fixed assets (net) \$444,500 \$470,000 Long-term liabilities \$100,000 \$200,000 \$444,500 \$100,000 \$470,000 \$200,000 Ratio of Fixed Assets to Long-Term Liabilities • To illustrate, the ratio of fixed assets to long-term liabilities for Lincoln Company is computed below. Ratio of fixed assets to long-term liabilities 4.4 2.4

43. Total Liabilities Total Stockholders’ Equity Ratio of Liabilities to Stockholders’ Equity = Ratio of Liabilities to Stockholders’ Equity • The relationship between the total claims of the creditors and the owners—theratio ofliabilities to stockholders’equity—is a solvency measure that indicates the margin of safety for creditors. • The ratio is computed as follows:

44. 2014 2013 Total liabilities \$310,000 \$443,000 Total stockholders’ equity \$829,500 \$787,500 \$310,000 \$829,500 \$443,000 \$787,500 Ratio of Liabilities to Stockholders’ Equity • The ratio of liabilities to stockholders’ equity for Lincoln Company is computed below. Ratio of liabilities to stockholders’ equity 0.4 0.6

45. Number of Times Interest Charges Earned • Corporations in some industries normally have high ratios of debt to stockholders’ equity. For such corporations, the relative risk of the debt-holders is normally measured as the number of times interestcharges are earned (during the year), sometimes called the fixed chargecoverage ratio.

46. Income Before Income Tax + Interest Expense Interest Expense Number of Times Interest Charges Are Earned = Number of Times Interest Charges Earned • It is computed as follows:

47. \$168,500 \$6,000 \$146,600 \$12,000 Number of Times Interest Charges Earned • The number of times interest charges are earned for Lincoln Company is computed below. 2014 2013 Income before income tax \$162,500 \$134,600 Add interest expense 6,000 12,000 Amount available to meet interest charges \$168,500 \$146,600 Number of times interest charges earned 28.1 12.2

48. Number of Times Preferred Dividends Are Earned Net Income Preferred Dividends = Number of Times Interest Charges Earned • The number of times interest charges are earned can be adapted for use with dividends on preferred stock. • The number of times preferred dividends are earned is computed as follows:

49. Learning Objective 3 Use financial statement analysis to assess the profitability of a business.

50. Profitability Analysis • Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business.