1. 17-1
ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS

2. 17-2
Financial Statement Analysis
Financial Statement Analysis will help
business owners and other interested
people to analyse the data in financial
statements to provide them with better
information about such key factors for
decision making and ultimate business
survival.

3. 17-3
Financial Statement Analysis
Who analyzes financial statements?
Internal users (i.e., management)
External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors

4. 17-4
Financial Statement Analysis
What do internal users use it for?
Planning, evaluating and controlling
company operations
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

5. 17-5
Financial Statement Analysis
Information is available from
Published annual reports
(1) Financial statements
(2) Notes to financial statements
(3) Letters to shareholders
(4) Auditor’s report
(5) Management’s discussion and
analysis
Reports filed with the government
e.g., Form 10-K, Form 10-Q and Form 8-K

6. 17-6
Financial Statement Analysis
Information is available from
Other sources
(1) Newspapers (e.g., Journal
ledger )
(2) Periodicals (e.g. Forbes, Fortune)
(3) Financial information
organizations such
as:
Moody’s, Standard & Poor’s, Dun &
Bradstreet, Inc., and Robert Morris

7. Methods of
17-7
Financial Statement Analysis
Horizontal Analysis
Vertical Analysis
Common-Size Statements
Trend Percentages
Ratio Analysis

8. 17-8
Horizontal Analysis
Using comparative financial
Using comparative financial
statements to calculate amount
statements to calculate amount
or percentage changes in a
or percentage changes in a
financial statement item from
financial statement item from
one period to the next
one period to the next

9. 17-9
Vertical Analysis
For a single financial
For a single financial
statement, each item
statement, each item
is expressed as a
is expressed as a
percentage of a
percentage of a
significant total,
significant total,
e.g., all income
e.g., all income
statement items are
statement items are
expressed as a
expressed as a
percentage of sales
percentage of sales

10. 17-10
Common-Size Statements
Financial statements that show
Financial statements that show
only percentages and no
only percentages and no
absolute amounts
absolute amounts

11. 17-11
Trend Percentages
Show changes over time in
Show changes over time in
given financial statement items
given financial statement items
(can help evaluate financial
(can help evaluate financial
information of several years)
information of several years)

12. 17-12
Ratio Analysis
Expression of logical relationships
Expression of logical relationships
between items in a financial
between items in a financial
statement of a single period
statement of a single period
(e.g., percentage relationship
(e.g., percentage relationship
between revenue and net income)
between revenue and net income)

13. 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.

14. 17-14

15. 17-15
Horizontal Analysis Example
Calculating Change in Rupees Amounts
Rupees Current Year Base Year
= –
Change Figure Figure

16. 17-16
Horizontal Analysis Example
Calculating Change in Dollar Amounts
Dollar Current Year Base Year
= –
Change Figure Figure
Since we are measuring the amount of
the change between 1998 and 1999, the
Rupees amounts for 1998 become the
“base” year figures.

17. 17-17
Horizontal Analysis Example
Calculating Change as a Percentage
Percentage Rupees Change
Change
=
Base Year Figure × 100%

18. 17-18
Horizontal Analysis Example
$12,000 – $23,500 = $(11,500)

19. 17-19
Horizontal Analysis Example
($11,500 ÷ $23,500) × 100% = 48.9%

20. 17-20
Horizontal Analysis Example

21. 17-21
Horizontal Analysis Example
Let’s apply the same
procedures to the
liability and shareholders’
equity sections of the
balance sheet.

22. 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

23. 17-23
Horizontal Analysis Example
Now, let’s apply the
procedures to the
income statement.

24. 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)

25. 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%.

26. 17-26
There were increases in both cost of goods
sold (14.3%) and operating expenses (2.1%).
These increased costs more than offset the
CLOVER CORPORATION
increase in sales, yielding an overall
Comparative Income Statements
decrease in net income.
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)

27. 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.

28. 17-28
Vertical Analysis Example

29. 17-29
Vertical Analysis Example
$82,000 ÷ $483,000 = 17% rounded
$30,000 ÷ $387,000 = 8% rounded

30. 17-30
Vertical Analysis Example
$76,000 ÷ $483,000 = 16% rounded

31. 17-31
Trend Percentages Example
Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.

32. 17-32
Trend Percentages Example
Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
$1,991 - $1,820 = $171

33. 17-33
Trend Percentages Example
Using 1995 as the base year, we develop
the following percentage relationships.
$1,991 - $1,820 = $171
$171 ÷ $1,820 = 9% rounded

34. 17-34
Trend line
for Sales

35. 17-35
Ratios
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.”

36. 17-36
Categories of Ratios
Liquidity Ratios
Indicate a company’s short-term
debt-paying ability
Equity (Long-Term Solvency) Ratios
Show relationship between debt and
equity financing in a company
Profitability Tests
Relate income to other variables
Market Tests
Help assess relative merits of stocks in
the marketplace

37. 17-37
10 Ratios You Must Know
Liquidity Ratios
Current (working capital) ratio
Acid-test (quick) ratio
Cash flow liquidity ratio
Accounts receivable turnover
Number of days’ sales in accounts
receivable
Inventory turnover
Total assets turnover

38. 17-38
10 Ratios You Must Know
Equity (Long-Term Solvency) Ratios
Equity (stockholders’ equity) ratio
Equity to debt

39. 17-39
10 Ratios You Must Know
Profitability Tests
Return on operating assets
Net income to net sales (return on
sales or “profit margin”)
margin” $
Return on average common
stockholders’ equity (ROE)
ROE
Cash flow margin
Earnings per share
Times interest earned
Times preferred dividends earned

40. 17-40
10 Ratios You Must Know
Market Tests
Earnings yield on common stock
Price-earnings ratio
Payout ratio on common stock
Dividend yield on common stock
Dividend yield on preferred stock
Cash flow per share of common
stock

41. 17-41
Now, let’s look at
Norton
Corporation’s 1999
and 1998 financial
statements.

42. 17-42

43. 17-43

44. 17-44

45. 17-45
Now, let’s calculate
the 10 ratios based
on Norton’s financial
statements.

46. 17-46
NORTON CORPORATION
1999
Cash $ 30,000
Accounts receivable, net
We will Beginning of year 17,000
use this End of year 20,000
information Inventory
to calculate Beginning of year 10,000
the liquidity
End of year 12,000
ratios for
Total current assets 65,000
Norton.
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000

47. 17-47
Working Capital*
The excess of current assets over
current liabilities.
12/31/99
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
* While this is not a ratio, it does give an
indication of a company’s liquidity.

48. 17-48
Current (Working Capital) Ratio
#1
Current Current Assets
=
Ratio Current Liabilities
Current $65,000
= = 1.55 : 1
Ratio $42,000
Measures the ability
of the company to pay current
debts as they become due.

49. 17-49
Acid-Test (Quick) Ratio
#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.

50. 17-50
Acid-Test (Quick) Ratio
#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Norton Corporation’s quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.

51. 17-51
Acid-Test (Quick) Ratio
#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Acid-Test $50,000
= = 1.19 : 1
Ratio $42,000

52. 17-52
Accounts Receivable Turnover
Net, credit sales #3 Average, net accounts
receivable
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover
Accounts
$494,000
Receivable = = 26.70 times
($17,000 + $20,000) ÷ 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.

53. Number of Days’ Sales
17-53
in Accounts Receivable
#4
Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables
Measures, on average, how many
days it takes to collect an
account receivable.

54. 17-54
Inventory Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory
Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2
Measures the number of times
inventory is sold and
replaced during the year.

55. Equity, or Long–Term
17-55
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

56. 17-56
NORTON CORPORATION
1999
Common shares outstanding
Beginning of year 17,000
End of year 27,400
Net income $ 53,690
Here is the Stockholders' equity
rest of the Beginning of year 180,000
information
we will End of year 234,390
use. 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

57. 17-57
Equity Ratio
#6
Equity Stockholders’ Equity
=
Ratio Total Assets
Equity $234,390
= = 67.7%
Ratio $346,390
Measures the proportion
of total assets provided by
shareholders.

58. 17-58
Net Income to Net Sales
on Sales or Profit Margin
#7
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales
Measures the proportion of the sales
which is retained as profit.

59. Return on Average Common
17-59
Shareholders’ Equity (ROE)
#8
Return on Net Income
Stockholders’ = Average Common
Equity Stockholders’ Equity
Return on
$53,690
Stockholders’ = = 25.9%
($180,000 + $234,390) ÷ 2
Equity
Important measure of the
income-producing ability
of a company.

60. 17-60
Earnings Per Share
#9
Earnings Available to Common Shareholders
Earnings
= Weighted-Average Number of Common
per Share
Shares Outstanding
Earnings $53,690
= = $2.42
per Share (17,000 + 27,400) ÷ 2
The financial press regularly publishes
actual and forecasted EPS amounts.

61. 17-61
Price-Earnings Ratio
#10
Price-Earnings Market Price Per Share
=
Ratio EPS
Price-Earnings $20.00
= = 8.3 : 1
Ratio $ 2.42
Provides some measure of whether the
stock is under or overpriced.

62. 17-62
Important Considerations
Need for comparable data
Data is provided by Dun &
Bradstreet, Standard & Poor’s etc.
Must compare by industry
Is EPS comparable?
Influence of external factors
General business conditions
Seasonal nature of business operations
Impact of inflation

63. No more ratios, please! 17-63

64. 17-64
Question
The current ratio is a measure of
The current ratio is a measure of
liquidity that is computed by dividing
liquidity that is computed by dividing
total assets by total liabilities.
total assets by total liabilities.
a. True
a. True
b. False
b. False

65. 17-65
Question
The current ratio is a measure of
The current ratio is a measure of
liquidity that is computed by dividing
liquidity that is computed by dividing
total assets by total liabilities.
total assets by total liabilities.
a. True
a. True
b. False
b. False The current ratio is a measure of
The current ratio is a measure of
liquidity, but is computed by
liquidity, but is computed by
dividing current assets by
dividing current assets by
current liabilities
current liabilities

66. 17-66
Question
Quick assets are defined as Cash,
Quick assets are defined as Cash,
Marketable Securities and net
Marketable Securities and net
receivables.
receivables.
a.
a. True
True
b.
b. False
False

67. 17-67
Question
Quick assets are defined as Cash,
Quick assets are defined as Cash,
Marketable Securities and net
Marketable Securities and net
receivables.
receivables.
a.
a. True
True
b.
b. False
False

68. 17-68
Question
Accounting Ratios are important tools
Accounting Ratios are important tools
used by.
used by.
a. Managers
a. Managers c. Investors,
c. Investors,
b. Researchers
b. Researchers d. All of the above
d. All of the above
Ans: d
Ans: d

69. 17-69
Question
Working Capital Turnover measures the
Working Capital Turnover measures the
relationship of Working Capital with.
relationship of Working Capital with.
a. Fixed Assets
a. Fixed Assets
b. Sales
b. Sales
c. Purchase
c. Purchase
d. Stock
d. Stock
Ans; a
Ans; a

70. 17-70
Question
In Current Ratio, Current Assets are
In Current Ratio, Current Assets are
compared with:.
compared with:.
a. Current Profit
a. Current Profit
b. Current Liabilities,
b. Current Liabilities,
c. Fixed Assets,
c. Fixed Assets,
d. Equity Share Capital.
d. Equity Share Capital.
Ans:b
Ans:b

71. 17-71
Question
Ratio of Net Income to Number of Equity
Ratio of Net Income to Number of Equity
Shares known as.
Shares known as.
a. Price Earnings Ratio,
a. Price Earnings Ratio,
b. Net Profit Ratio,
b. Net Profit Ratio,
c. Earnings per Share,
c. Earnings per Share,
d. Dividend per Share.
d. Dividend per Share.
Ans: c
Ans: c

72. 17-72
Question
Gross Profit Ratio for a firm remains
Gross Profit Ratio for a firm remains
same but the Net Profit Ratio is
same but the Net Profit Ratio is
decreasing. The reason for such
decreasing. The reason for such
behavior could be:
behavior could be:
(a)Increase in Costs of Goods Sold,
(a)Increase in Costs of Goods Sold,
(b)If Increase in Expense,
(b)If Increase in Expense,
(c)Increase in Dividend,
(c)Increase in Dividend,
(d)Decrease in Sales.
(d)Decrease in Sales.
Ans: b
Ans: b

73. 17-73
Which of the Question
Which of the following statements is
following statements is
correct?
correct?
(a)A Higher Receivable Turnover is not
(a)A Higher Receivable Turnover is not
desirable,
desirable,
(b)Interest Coverage Ratio depends upon
(b)Interest Coverage Ratio depends upon
Tax Rate,
Tax Rate,
(c) Increase in Net Profit Ratio means
(c) Increase in Net Profit Ratio means
increase in Sales,
increase in Sales,
(d) Lower Debt-Equity Ratio means
(d) Lower Debt-Equity Ratio means
lower Financial Risk.
lower Financial Risk.
Ans:d
Ans:d

74. 17-74
Question
Which of the following helps analysing
Which of the following helps analysing
return to equity Shareholders?
return to equity Shareholders?
(a) Return on Assets,
(a) Return on Assets,
(b) Earnings Per Share,
(b) Earnings Per Share,
(c) Net Profit Ratio,
(c) Net Profit Ratio,
(d)Return on Investment.
(d)Return on Investment.
Ans: b
Ans: b

75. 17-75
Question
Trend Analysis helps comparing
Trend Analysis helps comparing
performance of a firm
performance of a firm
(a)With other firms,
(a)With other firms,
(b)Over a period of firm,
(b)Over a period of firm,
(c)With other industries,
(c)With other industries,
(d) None of the above
(d) None of the above
Ans: b
Ans: b

76. 17-76
Question
Ratio Analysis can be used to study
Ratio Analysis can be used to study
liquidity, turnover, profitability, etc. of a
liquidity, turnover, profitability, etc. of a
firm. What does Debt-Equity Ratio help
firm. What does Debt-Equity Ratio help
to study?
to study?
(a)Solvency,
(a)Solvency,
(b)Liquidity,
(b)Liquidity,
(c)Profitability,
(c)Profitability,
(d) Turnover,
(d) Turnover,
Ans: a
Ans: a

77. 17-77
Question
In Inventory Turnover calculation, what
In Inventory Turnover calculation, what
is taken in the numerator?
is taken in the numerator?
(a) Sales,
(a) Sales,
(b)Cost of Goods Sold,
(b)Cost of Goods Sold,
(c)Opening Stock,
(c)Opening Stock,
(d) Closing Stock.
(d) Closing Stock.
Ans: b
Ans: b

78. 17-78
Thank you!!!
Ganesh.S.Uppin