Corporate finance accounting 14e by warren reeve duchac chapter 14

Chapter

14

Financial Statement Analysis

Corporate Financial
Accounting
14e

Warren
Reeve
Duchac

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


The Value of Financial Statement Information

•

General-purpose financial statements are distributed to a wide range of potential
users, providing each group with valuable information about a company’s economic
performance and financial condition.

•

Users typically evaluate this information along three dimensions:

o

Liquidity

o

Solvency

o

Profitability

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Liquidity

•

Short-term creditors such as banks and financial institutions are primarily concerned
with whether a company will be able to repay short-term borrowings such as loans
and notes.

•

As such, they are most interested in evaluating a company’s ability to convert
assets into cash, which is called liquidity.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Solvency

•
•

Long-term creditors, such as bondholders, loan money for long periods of time.
Thus, they are interested in evaluating a company’s ability to make its periodic
interest payments and repay the face amount of debt at maturity, which is called
solvency.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Profitability

•

Investors, such as stockholders, are interested in evaluating the potential for the
price of the company’s stock to increase.

•

As such, investors focus on evaluating a company’s ability to generate earnings,
which is called profitability.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Techniques for Analyzing Financial Statements
(slide 1 of 2)

•

Financial statement users rely on the following techniques to analyze and interpret a
company’s financial performance and condition:

o

Analytical methods examine changes in the amount and percentage of financial statement
items within and across periods.

o

Ratios express a financial statement item or set of financial statement items as a percentage
of another financial statement item, in order to measure an important economic relationship
as a single number.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Techniques for Analyzing Financial Statements
(slide 2 of 2)

•

Both analytical methods and ratios can be used to compare a company’s financial performance
over time or to another company.

o

Comparisons Over Time: The comparison of a financial statement item or ratio with the same item or ratio from
a prior period often helps the user identify trends in a company’s economic performance, financial condition,
liquidity, solvency, and profitability.

o

Comparisons Between Companies: The comparison of a financial statement item or ratio to another company
in the same industry can provide insight into a company’s economic performance and financial condition
relative to its competitors.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Analytical Methods

•

Users analyze a company’s financial statements using a variety of analytical
methods. Three such methods are:

o

Horizontal analysis

o

Vertical analysis

o

Common-sized statements

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Horizontal Analysis
(slide 1 of 2)

•

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 following:



Amount of increase or decrease



Percent of increase or decrease

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Horizontal Analysis
(slide 2 of 2)

•

When comparing statements, the earlier statement is normally used as the base
year for computing increases and decreases.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Vertical Analysis
(slide 1 of 3)

•

The percentage analysis of the relationship of each component in a financial
statement to a total within the statement is called vertical analysis.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Vertical Analysis
(slide 2 of 3)

•

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.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Vertical Analysis
(slide 3 of 3)

•

In a vertical analysis of the income statement, each item is stated as a percent of
sales.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Common-Sized Statements

•

In a common-sized statement, all items are expressed as percentages, with no
dollar amounts shown.

•

Common-sized statements are often useful for comparing one company with
another or for comparing a company with industry averages.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Analyzing Liquidity

•

Liquidity analysis evaluates the ability of a company to convert current assets into
cash.

•

Liquidity ratios and measures focus upon a company’s current position (current

assets and liabilities), accounts receivable, and inventory.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Liquidity Ratios and Measures

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Current Position Analysis

•

Current position analysis evaluates a company’s ability to pay its current
liabilities.

•

This information helps short-term creditors determine how quickly they will be
repaid.

•

This analysis includes:

o

Working Capital

o

Current ratio

o

Quick ratio

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Current Position Analysis: Working Capital
(slide 1 of 2)

•

A company’s working capital is computed as follows:
Working Capital = Current Assets – Current Liabilities

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Current Position Analysis: Working Capital
(slide 2 of 2)

•

•

The working capital is used to evaluate a company’s ability to pay current liabilities.
A company’s working capital is often monitored monthly, quarterly, or yearly by
creditors and other debtors.

•

However, it is difficult to use working capital to compare companies of different
sizes.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Current Position Analysis: Current Ratio
(slide 1 of 2)

•

The current ratio, sometimes called the working capital ratio, is computed as
follows:
Current Assets
Current Ratio =

Current Liabilities

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Current Position Analysis: Current Ratio
(slide 2 of 2)

•

The current ratio is a more reliable indicator of a company’s ability to pay its current
liabilities than is working capital, and it is much easier to compare across
companies.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Current Position Analysis: Quick Ratio

•

A ratio that measures the “instant” debt-paying ability of a company is the quick
ratio, sometimes called the acid-test ratio.

•

The quick ratio is computed as follows:
Quick Assets
Quick Ratio =

o

Current Liabilities

Quick assets are cash and other current assets that can be easily converted to cash.



Quick assets normally include cash, temporary investments, and receivables but exclude inventories and
prepaid assets.

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Accounts Receivable Analysis
(slide 1 of 2)

•

A company’s ability to collect its accounts receivable is called accounts receivable
analysis.

•

Accounts receivable analysis includes the computation and analysis of the
following:

o

Accounts receivable turnover

o

Number of days’ sales in receivables

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Accounts Receivable Analysis
(slide 2 of 2)

•

Collecting accounts receivable as quickly as possible does the following:

o

Improves a company’s liquidity

o

Provides cash to improve or expand operations

o

Reduces the risk of uncollectible accounts

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© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Accounts Receivable Analysis:
Accounts Receivable Turnover

•

The accounts receivable turnover is computed as follows:
Sales
Accounts Receivable Turnover =

Average Accounts Receivable

®
© 2017 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.