17-1

CHAPTER 17
ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
17-2
B Non-accounting majors, especially,
should relate well to this chapter
It looks at accounting information from
users perspective
B Relates very closely to topics you
will study in your finance course
Therefore, we will use a somewhat
broader brush on this chapter
B What is financial statement
analysis?
Tearing apart the financial statements
and looking at the relationships
Financial Statement Analysis
17-3
Who analyzes financial statements?
+ Internal users (i.e., management)
+ External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies &
stock market analysts and
auditors
Financial Statement Analysis
625
17-4
B What do internal users use it for?
Planning, evaluating and controlling
company operations
B What do external users use it for?
Assessing past performance and current
financial position and making predictions
about the future profitability and solvency
of the company as well as evaluating the
effectiveness of management
B First sentence in chapter says...
Financial Statement Analysis
17-5
Information is available from
+ Published annual reports
(1) Financial statements
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditors report (Independent accountants)
(5) Managements discussion and analysis
+ Reports filed with the government
e.g., Form 10-K, Form 10-Q and Form 8-K
627 628
Financial Statement Analysis
17-6
Information is available from
+ Other sources
(1) Newspapers (e.g., Wall Street J ournal )
(2) Periodicals (e.g. Forbes, Fortune)
(3) Financial information organizations such
as: Moodys, Standard & Poors, Dun &
Bradstreet, Inc., and Robert Morris
Associates
(4) Other business publications
627 628
Financial Statement Analysis
17-7
B Horizontal Analysis
B Vertical Analysis
B Common-Size Statements
B Trend Percentages
B Ratio Analysis
Methods of
Financial Statement Analysis
17-8

Horizontal Analysis
Using comparative financial
statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
17-9

Vertical Analysis
For a single financial
statement, each item
is expressed as a
percentage of a
significant total,
e.g., all income
statement items are
expressed as a
percentage of sales
17-10

Common-Size Statements
Financial statements that show
only percentages and no
absolute dollar amounts
17-11

Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)
17-12

Ratio Analysis
Expression of logical relationships
between items in a financial
statement of a single period
(e.g., percentage relationship
between revenue and net income)
17-13
Horizontal Analysis Example
The management of Clover Company
provides you with comparative balance
sheets of the years ended December 31,
1999 and 1998. Management asks you to
prepare a horizontal analysis on the
information.
17-14
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash 12,000 $ 23,500 $
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets 315,000 $ 289,700 $
17-15
Calculating Change in Dollar Amounts
Dollar
Change
Current Year
Figure
Base Year
Figure
=
Horizontal Analysis Example
17-16
Calculating Change in Dollar Amounts
Since we are measuring the amount of
the change between 1998 and 1999, the
dollar amounts for 1998 become the
base year figures.
Dollar
Change
Current Year
Figure
Base Year
Figure
=
Horizontal Analysis Example
17-17
Calculating Change as a Percentage
Percentage
Change
Dollar Change
Base Year Figure
100% =

Horizontal Analysis Example
17-18
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash 12,000 $ 23,500 $ (11,500) $
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets 315,000 $ 289,700 $
$12,000 $23,500 = $(11,500)
Horizontal Analysis Example
17-19
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash 12,000 $ 23,500 $ (11,500) $ (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets 315,000 $ 289,700 $
($11,500 $23,500) 100% = 48.9%
Horizontal Analysis Example
17-20
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash 12,000 $ 23,500 $ (11,500) $ (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets 315,000 $ 289,700 $ 25,300 $ 8.7
Horizontal Analysis Example
17-21
Lets apply the same
procedures to the
liability and stockholders
equity sections of the
balance sheet.
Horizontal Analysis Example
17-22
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable 67,000 $ 44,000 $ 23,000 $ 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity 315,000 $ 289,700 $ 25,300 $ 8.7
17-23
Now, lets apply the
procedures to the
income statement.
Horizontal Analysis Example
17-24
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales 520,000 $ 480,000 $ 40,000 $ 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income 17,500 $ 22,400 $ (4,900) $ (21.9)
17-25
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales 520,000 $ 480,000 $ 40,000 $ 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income 17,500 $ 22,400 $ (4,900) $ (21.9)
Sales increased by 8.3% while net
income decreased by 21.9%.
17-26
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales 520,000 $ 480,000 $ 40,000 $ 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income 17,500 $ 22,400 $ (4,900) $ (21.9)
There were increases in both cost of goods
sold (14.3%) and operating expenses (2.1%).
These increased costs more than offset the
increase in sales, yielding an overall
decrease in net income.
17-27
Vertical Analysis Example
The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.
17-28
Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash 82,000 $ 30,000 $ 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total 483,000 $ 387,000 $ 100% 100%
Vertical Analysis Example
17-29
Vertical Analysis Example
Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash 82,000 $ 30,000 $ 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total 483,000 $ 387,000 $ 100% 100%
$82,000 $483,000 = 17% rounded
$30,000 $387,000 = 8% rounded
17-30
Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Acts. Payable 76,000 $ 60,000 $ 16% 16%
Wages Payable 33,000 17,000 7% 4%
Notes Payable 50,000 50,000 10% 13%
Common Stock 170,000 160,000 35% 41%
Retained Earnings 154,000 100,000 32% 26%
Total 483,000 $ 387,000 $ 100% 100%
Vertical Analysis Example
$76,000 $483,000 = 16% rounded
17-31
Trend Percentages Example
Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820 $
Expenses 2,033 1,966 1,870 1,803 1,701
Net income 372 $ 278 $ 242 $ 188 $ 119 $
17-32
Trend Percentages Example
Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820 $
Expenses 2,033 1,966 1,870 1,803 1,701
Net income 372 $ 278 $ 242 $ 188 $ 119 $
$1,991 - $1,820 = $171
17-33
Trend Percentages Example
Using 1995 as the base year, we develop
the following percentage relationships.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%
$1,991 - $1,820 = $171
$171 $1,820 = 9% rounded
17-34
90
100
110
120
130
140
1995 1996 1997 1998 1999
Years
%

o
f

1
0
0

B
a
s
e
Sales
Expenses
Trend line
for Sales
17-35
Ratios can be expressed in three
different ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of $2.25)
CAUTION!
Using ratios and percentages without
considering the underlying causes may
be hazardous to your health!
lead to incorrect conclusions.
Ratios
17-36
Categories of Ratios
B Liquidity Ratios
Indicate a companys short-term
debt-paying ability
B Equity (Long-Term Solvency) Ratios
Show relationship between debt and
equity financing in a company
B Profitability Tests
Relate income to other variables
B Market Tests
Help assess relative merits of stocks in
the marketplace
17-37
Liquidity Ratios
0Current (working capital) ratio
OAcid-test (quick) ratio
+ Cash flow liquidity ratio
OAccounts receivable turnover
ONumber of days sales in accounts
receivable
OInventory turnover
+ Total assets turnover
651
10 Ratios You Must Know
17-38
Equity (Long-Term Solvency) Ratios
OEquity (stockholders equity) ratio
+ Equity to debt
10 Ratios You Must Know
17-39
Profitability Tests
+ Return on operating assets
ONet income to net sales (return on
sales or profit margin)
OReturn on average common
stockholders equity (ROE)
+ Cash flow margin
OEarnings per share
+ Times interest earned
+ Times preferred dividends earned
$
10 Ratios You Must Know
17-40
Market Tests
+ Earnings yield on common stock
CPrice-earnings ratio
+ Payout ratio on common stock
+ Dividend yield on common stock
+ Dividend yield on preferred stock
+ Cash flow per share of common
stock
10 Ratios You Must Know
17-41
Now, lets look at
Norton
Corporations 1999
and 1998 financial
statements.
17-42
NORTON CORPORATION

Balance Sheets

December 31, 1999 and 1998

1999 1998
Assets
Current assets:
Cash 30,000 $ 20,000 $
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets 346,390 $ 300,000 $
17-43
NORTON CORPORATION

Balance Sheets

December 31, 1999 and 1998

1999 1998
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable 39,000 $ 40,000 $
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities:
Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Stockholders' equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000
Total liabilities and stockholders' equity 346,390 $ 300,000 $
17-44
NORTON CORPORATION

Income Statements

For the Years Ended December 31, 1999 and 1998

1999 1998
Net sales 494,000 $ 450,000 $
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000
Net income before taxes 76,700 66,000
Less income taxes (30%) 23,010 19,800
Net income 53,690 $ 46,200 $
17-45
Now, lets calculate
the 10 ratios based
on Nortons financial
statements.
17-46
NORTON CORPORATION
1999
Cash 30,000 $
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 12,000
Total current assets 65,000
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000
We will
use this
information
to calculate
the liquidity
ratios for
Norton.
17-47
Working Capital*
12/31/99
Current assets 65,000 $
Current liabilities (42,000)
Working capital 23,000 $
The excess of current assets over
current liabilities.
* While this is not a ratio, it does give an
indication of a companys liquidity.
17-48
Current (Working Capital) Ratio
Current
Ratio
$65,000
$42,000
= = 1.55 : 1
Measures the ability
of the company to pay current
debts as they become due.
Current
Ratio
Current Assets
Current Liabilities
=
#1
17-49
Acid-Test (Quick) Ratio
Quick Assets
Current Liabilities
=
Acid-Test
Ratio
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
#2
17-50
Quick Assets
Current Liabilities
=
Acid-Test
Ratio
Norton Corporations quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.
Acid-Test (Quick) Ratio
#2
17-51
Quick Assets
Current Liabilities
=
Acid-Test
Ratio
$50,000
$42,000
= 1.19 : 1 =
Acid-Test
Ratio
Acid-Test (Quick) Ratio
#2
17-52
Sales on Account
Average Accounts Receivable
Accounts
Receivable
Turnover
=
Accounts Receivable Turnover
= 26.70 times
$494,000
($17,000 + $20,000) 2
Accounts
Receivable
Turnover
=
This ratio measures how many
times a company converts its
receivables into cash each year.
#3
Average, net accounts
receivable
Net, credit sales
17-53
Number of Days Sales
in Accounts Receivable
Measures, on average, how many
days it takes to collect an
account receivable.
Days Sales
in Accounts
Receivables
=
365 Days
Accounts Receivable Turnover
= 13.67 days
=
365 Days
26.70 Times
Days Sales
in Accounts
Receivables
#4
17-54
Number of Days Sales
in Accounts Receivable
In practice, would 45 days be a
desirable number of days in
receivables?
#4
Days Sales
in Accounts
Receivables
=
365 Days
Accounts Receivable Turnover
= 13.67 days
=
365 Days
26.70 Times
Days Sales
in Accounts
Receivables
17-55
Inventory Turnover
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
Measures the number of times
inventory is sold and
replaced during the year.
= 12.73 times
$140,000
($10,000 + $12,000) 2
Inventory
Turnover
=
#5
17-56
Inventory Turnover
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
Would 5 be a
desirable number of times
for inventory to turnover?
= 12.73 times
$140,000
($10,000 + $12,000) 2
Inventory
Turnover
=
#5
17-57
Equity, or LongTerm
Solvency Ratios
This is part of the information to
calculate the equity, or long-term
solvency ratios of Norton Corporation.
NORTON CORPORATION
1999
Net operating income 84,000 $
Net sales 494,000
Interest expense 7,300
Total stockholders' equity 234,390
17-58
NORTON CORPORATION
1999
Common shares outstanding
Beginning of year 17,000
End of year 27,400
Net income 53,690 $
Stockholders' equity
Beginning of year 180,000
End of year 234,390
Dividends per share 2
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
Here is the
rest of the
information
we will
use.
17-59
Equity Ratio
Equity
Ratio
=
Stockholders Equity
Total Assets
Equity
Ratio
=
$234,390
$346,390
67.7% =
Measures the proportion
of total assets provided by
stockholders.
#6
17-60
Net Income to Net Sales
A/K/A Return on Sales or Profit Margin
Net Income
to
Net Sales
=
Net Income
Net Sales
Net Income
to
Net Sales
=
$53,690
$494,000
= 10.9%
Measures the proportion of the sales dollar
which is retained as profit.
#7
17-61
Net Income to Net Sales
A/K/A Return on Sales or Profit Margin
Net Income
to
Net Sales
=
Net Income
Net Sales
Net Income
to
Net Sales
=
$53,690
$494,000
= 10.9%
Would a 1% return on sales be good?
#7
17-62
Return on Average Common
Stockholders Equity (ROE)
Return on
Stockholders
Equity
=
Net Income
Average Common
Stockholders Equity
=
$53,690
($180,000 + $234,390) 2
= 25.9%
Return on
Stockholders
Equity
Important measure of the
income-producing ability
of a company.
#8
17-63
Earnings
per Share
Earnings Available to Common Stockholders
Weighted-Average Number of Common
Shares Outstanding
=
Earnings
per Share
$53,690
(17,000 + 27,400) 2
= = $2.42
The financial press regularly publishes
actual and forecasted EPS amounts.
#9
Earnings Per Share
17-64
B Whats new from Chap. 15?
Weighted-average calculation
EPS of common stock = _______________________
Earnings available to
common stockholders
Weighted-average number of
common shares outstanding
644
B Three alternatives for calculating
weighted-average number of shares
Earnings Per Share
17-65
EPS of common stock = _______________________
Earnings available to
common stockholders
Weighted-average number of
common shares outstanding
645
Alternate #1
Earnings Per Share
B Whats new from Chap. 15?
Weighted-average calculation
17-66
Alternate #3
Alternate #2
645
Earnings Per Share
17-67
EPS and Stock Dividends or Splits
Why restate all prior calculations of EPS?
Comparability - i.e., no additional capital was
generated by the dividend or split
646
Earnings Per Share
Primary EPS and Fully Diluted EPS
APB Opinion No. 15
I mentioned this 17-page pronouncement that
required a 100-page explanation in the lecture
for chapter 13.
17-68
Price-Earnings Ratio
A/K/A P/E Multiple
Price-Earnings
Ratio
Market Price Per Share
EPS
=
Price-Earnings
Ratio
=
$20.00
$ 2.42
= 8.3 : 1
#10
Provides some measure of whether the
stock is under or overpriced.
17-69
Important Considerations
B Need for comparable data
+ Data is provided by Dun &
Bradstreet, Standard & Poors etc.
+ Must compare by industry
+ Is EPS comparable?
B Influence of external factors
+ General business conditions
+ Seasonal nature of business operations
B Impact of inflation
17-70
Question
The current ratio is a measure of
liquidity that is computed by dividing
total assets by total liabilities.
a. True
b. False
17-71
The current ratio is a measure of
liquidity that is computed by dividing
total assets by total liabilities.
a. True
b. False
Question
The current ratio is a measure of
liquidity, but is computed by
dividing current assets by
current liabilities
17-72
Question
Quick assets are defined as Cash,
Marketable Securities and net
receivables.
a. True
b. False
17-73
Quick assets are defined as Cash,
Marketable Securities and net
receivables.
a. True
b. False
Question
17-74
No more ratios, please!
17-75
About Test #1
B Will be challenging because the
material covered is challenging
B All questions are T/F or M/C
Questions are 5-pt., 3-pt. & 1-pt.
B No tricks such as patterns in answers
Order of answers is random
B Coverage is even over the 4 chapters
B Time allowed: 75 minutes
17-76
About Test #1
B Best way to study
+ Notes first
+ Study guide and/or Hermanson tutorials
B Calculators will be provided
B Must wait outside classroom
B Have your questions ready for next
actual class
B See course home page for office hours