Financial Statement Analysis Chapter 17 © 2009 The McGraw-Hill Companies, Inc.
Horizontal (Trend) Analysis Horizontal analysis compares a company’s financial conditionand performance over time. A year-over-year percentage change expresses the current year’s dollar change as a percentageof the prior year’s total using this formula. Percent Change Current Year’s Total ̶ Prior Year’s Total Prior Year’s Total × 100% =
Changes Revealed in Trend Analysis Lowe’s grew significantly in 2006. Total assets rose by 12.7 percent Net sales revenues rose by 8.5 percent. Gross profit rose by 9.5 percent Net income rose by 12.3 percent. The growth in net sales revenues more than offset the growth in expenses resulting in net income growth in 2006 that was greater than the net sales revenues growth.
Vertical (Common Size) Analysis Vertical analysis focuses on important relationships within financial statements by expressing each financial statement amount as a percentage of another amount on that statement. Common-size percentages for financialstatements are calculated using this formula. Common-size Percent Analysis Amount Base Amount × = 100% The base amount is total assets for the balance sheetand sales revenue for the income statement.
Interpreting Common Size Statements Lowe’s total assets grew in 2006 by more than $3,000,000,000. Most of the growth was in property and equipment which increased from 66.4 percent of total assets in 2005 to 68.3 of total assets in 2006. The growth in total assets was accompanied by increases in all major categories of liabilities and equities. However, only long-term liabilities increased as a percent of total assets, from 18.3 percent of total assets in 2005 to 19.8 percent of total assets in 2006.
Interpreting Common Size Statements Lowe’s was able to increase its net income as a percent of sales from 6.4 percent to 6.6 percent by reducing cost of goods sold as a percent of sales by 0.3 percent. The percentage decrease in cost of goods sold was partially offset by small increase in operating and other expenses.
Profitability Ratios Profitability ratios provide us with measuresof a company’s ability to generateincome in the current period. Net profit margin Gross profit percentage Fixed asset turnover Asset turnover Earnings per share (EPS) Return on equity (ROE) Return on assets (ROA) Price/earnings(P/E)
Liquidity Ratios Liquidity ratios focus on a company’s abilityto convert its assets into cash in order topay current liabilities as they come due. Inventory turnover Receivables turnover Current ratio Quick ratio
Solvency Ratios Solvency ratios focus on a company’s ability torepay debt, pay interest, and finance replacementand/or expansion of long-term assets. Times interest earned Debt-to- assets Free cashflow
Accounting Decisions and Ratio Analysis Differences in accounting methods between companies sometimes make comparisons difficult. We use the LIFO method to value inventory. We use the average cost method to value inventory.
Accounting Decisions and Ratio Analysis Ratios may be interpreted by comparison with ratios of other companies or with industry average ratios. Ratios may vary because of the company’s industry characteristics, nature of operations, size, andaccounting policies. Consider the following information from three home improvement retailers.
End of Chapter 17 © 2009 The McGraw-Hill Companies, Inc.