REVIEW OF CHAPTER 19  

Characteristics

1.     Financial statement analysis enables the financial statement user to make informed decisions about a company.

2.      When analyzing financial statements, three major characteristics of a company are generally evaluated: (a) liquidity, (b) profitability, and (c) solvency.

3.      (S.O. 1)  Comparative analysis may be made on a number of different bases.

         a.     Intracompany basis Compares an item or financial relationship within a company in the current year with the same item or relationship in one or more prior years.

         b.     Industry averages Compares an item or financial relationship of a company with industry averages.

         c.     Intercompany basis Compares an item or financial relationship of one company with the same item or relationship in one or more competing companies.

Tools of Financial Analysis

4.      (S.O. 2)  There are thre basic tools of analysis: (a) horizontal, (b) vertical, and (c) ratio.

Horizontal Analysis

5.      (S.O. 3)  Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage.  In horizontal analysis, a base year is selected and changes are expressed as percentages of the base year amount.

Vertical Analysis

6.      (S.O. 4)  Vertical analysis, also called common size analysis, expresses each item within a financial statement as a percent of a base amount.  Generally, the base amount is total assets for the balance sheet, and net sales for the income statement.  For example, it may be determined that current assets are 22% of total assets, and selling expenses are 15% of net sales.

Ratio Analysis

7.     (S.O. 5)  A ratio expresses the mathematical relationship between one quantity and another as either a percentage, rate, or proportion.  Ratios can be classified as:

         a..... Liquidity ratios measures of the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.

         b..... Solvency ratios measures of the ability of the enterprise to survive over a long period of time.

         c..... Profitability ratios measures of the income or operating success of an enterprise for a given period of time.

 8.     There are five liquidity ratios:  the current ratio, the acid test ratio, current cash debt coverage ratio, receivables turnover, and inventory turnover.

 9.     The current ratio expresses the relationship of current assets to current liabilities.  It is a widely used measure for evaluating a company's liquidity and short-term debt paying ability.  The formula for this ratio is:

10.     The acid-test or quick ratio relates cash, short-term investments, and net receivables to current liabilities.  This ratio indicates a company's immediate liquidity.  It is an important complement to the current ratio.  The formula for the acid-test ratio is:

11.     The current cash debt coverage ratio also measures a company's liquidity but has the advantage of using the net cash provided by operating activities rather than a balance at a point in time.  The formula for the ratio is:

Current cash debt coverage ratio =

12.     The receivables turnover ratio is used to assess the liquidity of the receivables.  This ratio measures the number of times, on average, receivables are collected during the period.  The formula for the ratio is:

         Average net receivables can be computed from the beginning and ending balances of the net receivables.  A popular variant of the receivables turnover ratio is to convert it into an average collection period in terms of days.  This is done by dividing the turnover ratio into 365 days.

13.     Inventory turnover measures the number of times, on average, the inventory is sold during the period.  It indicates the liquidity of the inventory.  The formula for the ratio is:

         Average inventory can be computed from the beginning and ending inventory balances.  A variant of the inventory turnover ratio is to compute the average days to sell the inventory.  This is done by dividing the inventory turnover ratio into 365 days.

14.     The profitability ratios are explained in review points 15-22.

15.     The profit margin ratio is a measure of the percentage of each sales dollar that results in net income.  The formula is:

16.     The cash return on sales ratio is the cash basis counter-part to the accrual based profit margin ratio.  The formula for the ratio is:

Cash return on sales ratio =

17.     Asset turnover measures how efficiently a company uses its assets to generate sales.  The formula for this ratio is:

18.     Return on assets is an overall measure of profitability.  It measures the rate of return on each dollar invested in assets.  The formula is:

19.     Return on common stockholders' equity measures profitability from the common stockholders' viewpoint.  The ratio shows the dollars of income earned for each dollar invested by the owners.  The formula is:

         a..... When preferred stock is present, preferred dividend requirements are deducted from net income to compute income available to common stockholders.  Similarly, the par value of preferred stock (or call price, if applicable) must be deducted from total stockholders' equity to arrive at the amount of common stock equity used in this ratio.

         b..... Leveraging or trading on the equity at a gain means that the company has borrowed money through the issuance of bonds or notes at a lower rate of interest than it is able to earn by using the borrowed money.  A comparison of the rate of return on total assets with the rate of interest paid for borrowed money indicates the profitability of trading on the equity.

20.     Earnings per share measures the amount of net income earned on each share of common stock.  The formula is:

         Any preferred dividends declared for the period must be subtracted from net income.

21.     The price-earnings ratio measures the ratio of market price per share of common stock to earnings per share.  It is an oft-quoted statistic that reflects investors' assessments of a company's future earnings.  The formula for the ratio is:

22.     The payout ratio measures the percentage of earnings distributed in the form of cash dividends.  The formula is:

         Companies with high growth rates generally have low payout ratios because they reinvest most of their income into the business.

23.     There are three solvency ratios: debt to total assets, times interest earned, and cash debt coverage ratio.

24.     The debt to total assets ratio measures the percentage of total assets provided by creditors.  The formula for this ratio is:

         The adequacy of this ratio is often judged in the light of the company's earnings.  Companies with relatively stable earnings, such as public utilities, have higher debt to total assets ratios than cyclical companies with widely fluctuating earnings, such as many high-tech companies.

25.     The times interest earned ratio measures a company's ability to meet interest payments as they become due.  The formula is:

26.     The cash debt coverage ratio demonstrates a company's ability to repay its liabilities from cash generated from operating activities, without having to liquidate the assets employed in its operations.

Cash debt coverage ratio =

27.     (S.O. 6)  The limitations of financial statement analysis are:

         a..... Estimates.  The financial statements contain numerous estimates.  To the extent that these estimates are inaccurate, the financial ratios and percentages are inaccurate.

         b..... Cost.  Traditional financial statements are based on cost and are not adjusted for price-level changes.

         c..... Alternative accounting methods.  Variations among companies in the application of generally accepted accounting principles may hamper comparability.

         d..... Atypical data.  Companies frequently establish a fiscal year-end that coincides with the low point in operating activity or in inventory levels.  Therefore, year-end data may not be typical of the financial condition during the year.

         e..... Diversification of firms.  Many firms are so diversified that they cannot be classified by industry.