CHAPTER

15 Financial Statement
Analysis

Financial and
Managerial
Accounting
13e

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Warren
Reeve
Duchac
Horizontal Analysis

• The analysis of increases and decreases in the amount

and percentage of comparative financial statement
items is called horizontal analysis.
o Each item on the most recent statement is compared with
the same item on one or more earlier statements in terms of
the amount of increase or decrease and the percent of
increase or decrease.
• When comparing statements, the earlier statement is
normally used as the base year for computing
increases and decreases.

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Vertical Analysis

• The percentage analysis of the relationship of each

component in a financial statement to a total within
the statement is called vertical analysis.
• In a vertical analysis of the balance sheet, the
percentages are computed as follows:
o Each asset item is stated as a percent of the total assets.
o Each liability and stockholders’ equity item is stated as a
percent of the total liabilities and stockholders’ equity.
• In a vertical analysis of the income statement, each
item is stated as a percent of sales.

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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
one company with another or comparing a company
with industry averages.

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Liquidity and Solvency Analysis
(slide 1 of 2)

• All users of financial statements are interested in the

ability of a company to do the following:
o Maintain liquidity and solvency
o Earn income, called profitability
• The ability of a company to convert assets into cash is
called liquidity, while the ability of a company to pay
its debts is called solvency.
• Liquidity, solvency, and profitability are interrelated.

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Liquidity and Solvency Analysis
(slide 2 of 2)

• Liquidity and solvency are normally assessed using the following:

o Current position analysis
 Working capital
 Current ratio
 Quick ratio
o Accounts Receivable analysis
 Accounts receivable turnover
 Number of days’ sales in receivables
o Inventory analysis
 Inventory turnover
 Number of days’ sales in inventory
o The ratio of fixed assets to long-term liabilities
o The ratio of liabilities to stockholders’ equity
o The number of times interest charges are earned

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Current Position Analysis

• A company’s ability to pay its current liabilities is

called current position analysis.
• Current position analysis is a solvency measure of
special interest to short-term creditors and includes
the computation and analysis of the following:
o Working Capital
o Current ratio
o Quick ratio

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Profitability Analysis

• Common profitability analyses include the following:

o Ratio of sales to assets
o Rate earned on total assets
o Rate earned on stockholders’ equity
o Rate earned on common stockholders’ equity
o Earnings per share on common stock
o Price-earnings ratio
o Dividends per share
o Dividend yield

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Summary of Analytical Measures
(slide 1 of 2)

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Summary of Analytical Measures
(slide 2 of 2)

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Corporate Annual Reports

• In addition to the financial statements and the

accompanying notes, corporate annual reports
normally include the following sections:
o Management discussion and analysis
o Report on internal control
o Report on fairness of the financial statements

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Management Discussion and Analysis

• Management’s Discussion and Analysis (MD&A) is required in annual

reports filed with the Securities and Exchange Commission.
• It includes management’s analysis of current operations and its plans for the
future.
• Typical items included in the MD&A are:
o Management’s analysis and explanations of any significant changes between
the current and prior years’ financial statements.
o Important accounting principles or policies that could affect interpretation of
the financial statements, including the effect of changes in accounting
principles or the adoption of new accounting principles.
o Management’s assessment of the company’s liquidity and the availability of
capital to the company.
o Significant risk exposures that might affect the company.
o Any “off-balance-sheet” arrangements such as leases not included directly in
the financial statements.

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Report on Internal Control

• The Sarbanes-Oxley Act of 2002 requires a report by

management.
o The report states management’s responsibility for
establishing and maintaining internal control.
o In addition, management’s assessment of the effectiveness
of internal controls over financial reporting is included in
the report.
• Sarbanes-Oxley also requires a public accounting
firm to verify management’s conclusions on internal
control.
o Thus, two reports on internal control, one by management
and one by a public accounting firm, are included in the
annual report.
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Report on Fairness of the Financial Statements

• All publicly held corporations are required to have an

independent audit (examination) of their financial statements.
• The Certified Public Accounting (CPA) firm that conducts the
audit renders an opinion, called the Report of Independent
Registered Public Accounting Firm, on the fairness of the
statements.

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Appendix: Unusual Items
on the Income Statement

• Generally accepted accounting principles require that

unusual items be reported separately on the income
statement.
o This is because such items do not occur frequently and are
typically unrelated to current operations.
• Unusual items on the income statement are classified
as one of the following:
o Affecting the current period income statement
o Affecting a prior period income statement

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Appendix: Unusual Items Affecting the Current
Period’s Income Statement—Discontinued Operations

• A company may discontinue a component of its

operations by selling or abandoning the component’s
operations.
o If the discontinued component is (1) the result of a strategic
shift and (2) has a major effect on the entity’s operations
and financial results, any gain or loss on discontinued
operations is reported on the income statement as a Gain
(or loss) from discontinued operations.
o A note to the financial statements should describe the
operations sold, including the date operations were
discontinued, and details about the assets, liabilities,
income, and expenses of the discontinued component.

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Appendix: Unusual Items Affecting the Current
Period’s Income Statement

• An extraordinary item is defined as an event or transaction

with both of the following characteristics:
o Unusual in nature
o Infrequent in occurrence
o Any gain or loss from extraordinary items is reported on the income
statement as Gain (or loss) from extraordinary item.
• Earnings per common share should be prepared separately in
the notes to the financial statements for discontinued
operations and extraordinary items.

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Appendix: Unusual Items Affecting the
Prior Period’s Income Statement

• An unusual item may occur that affects a prior

period’s income statement.
o Two such items are as follows:
 Errors in applying generally accepted accounting principles
 Changes from one generally accepted accounting principle to
another

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