Prof.

Asif Masood Ahmad

Superior University
Lahore
ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
Non-accounting majors, especially, should relate
well to this chapter
It looks at accounting information from users
perspective
Relates very closely to topics you will study in your
finance course
Therefore, we will use a somewhat broader brush on
this chapter
What is financial statement analysis?

Tearing apart the financial statements
and looking at the relationships
Who analyzes financial statements?
Internal users (i.e., management)
External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies &
stock market analysts and
auditors
625
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
First sentence in chapter says...
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., Tax reports with government agencies and departments
Form 10-K, Form 10-Q and Form 8-K
627 628
Information is available from
Other sources
(1) Newspapers (e.g., Wall Street Journal )
(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
Horizontal Analysis
Vertical Analysis
Common-Size Statements
Trend Percentages
Ratio Analysis
Using comparative financial
statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
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
Financial statements that show
only percentages and no
absolute dollar amounts
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)
Expression of logical relationships
between items in a financial
statement of a single period
(e.g., percentage relationship
between revenue and net income)
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.
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 $
Calculating Change in Dollar Amounts
Dollar
Change
Current Year
Figure
Base Year
Figure
=
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
=
Calculating Change as a Percentage
Percentage
Change
Dollar Change
Base Year Figure
100% =

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)
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%
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
Lets apply the same
procedures to the
liability and stockholders
equity sections of the
balance sheet.
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
Now, lets apply the
procedures to the
income statement.
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)
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%.
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.
The management of Sample Company asks you
to prepare a vertical analysis for the
comparative balance sheets of the company.
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%
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
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%
$76,000 $483,000 = 16% rounded
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 $
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
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
90
100
110
120
130
140
1995 1996 1997 1998 1999
%

o
f

1
0
0

B
a
s
e
Years
Sales
Expenses
Trend line
for Sales
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
lead to incorrect conclusions.
Liquidity Ratios
Indicate a companys 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
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
Equity (Long-Term Solvency) Ratios
OEquity (stockholders equity) ratio
Equity to debt
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
$
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
Now, lets look at
Norton
Corporations 1999
and 1998 financial
statements.
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 $
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 $
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 $
Now, lets calculate
the 10 ratios based
on Nortons financial
statements.
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.
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 companys liquidity.
#1
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
=
#2
Quick Assets
Current Liabilities
=
Acid-Test
Ratio
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
Quick Assets
Current Liabilities
=
Acid-Test
Ratio
Norton Corporations quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.
#2
Quick Assets
Current Liabilities
=
Acid-Test
Ratio
$50,000
$42,000
= 1.19 : 1 =
Acid-Test
Ratio
#2
Sales on Account
Average Accounts Receivable
Accounts
Receivable
Turnover
=
#3
= 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.
Average, net accounts
receivable
Net, credit sales
#4
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
In practice, would 45 days be a
desirable number of days in
receivables?
Days Sales
in Accounts
Receivables
=
365 Days
Accounts Receivable Turnover
= 13.67 days
=
365 Days
26.70 Times
Days Sales
in Accounts
Receivables
#5
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
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
=
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
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.
#6
Equity
Ratio
=
Stockholders Equity
Total Assets
Equity
Ratio
=
$234,390
$346,390
67.7% =
Measures the proportion
of total assets provided by
stockholders.
#7
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
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?
#8
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.
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
Whats new ?
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
EPS of common stock = _______________________
Earnings available to
common stockholders
Weighted-average number of
common shares outstanding
645
Alternate #1
Whats new?
Weighted-average calculation
Alternate #3
Alternate #2
645
#10
Price-Earnings
Ratio
Market Price Per Share
EPS
=
Price-Earnings
Ratio
=
$20.00
$ 2.42
= 8.3 : 1
Provides some measure of whether the
stock is under or overpriced.
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
The current ratio is a measure of liquidity that is
computed by dividing total assets by total liabilities.
a. True
b. False
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
Quick assets are defined as Cash, Marketable Securities
and net receivables.
a. True
b. False
Quick assets are defined as Cash,
Marketable Securities and net
receivables.
a. True
b. False
Question