Chapter 13

Financial Statement Analysis

Limitations and Considerations in

Financial Statement Analysis

Watch for alternative accounting principles

Selection of a inventory valuation method

Changes in accounting method

Take care when making comparisons

Recognizing trends in ratios

Extra caution for extraordinary items and gains and

losses from discontinued operations

LO 1

Limitations and Considerations in

Financial Statement Analysis (continued)

Understand the possible effects of inflation

Financial statements are based on historical costs

and are not adjusted for the effects of increasing

prices

Analysis of Comparative Statements:

Horizontal Analysis

Comparison of financial statement items over a period

of time

LO 2

Example 13.1—Preparing and Reading

Comparative Balance Sheets—Horizontal Analysis

Example 13.2—Preparing and Reading Comparative Statements of

Income and Retained Earnings—Horizontal Analysis

Example 13.3—Preparing and Reading Comparative

Statements of Cash Flows—Horizontal Analysis

Analysis of Common-Size Statements:

Vertical Analysis

Comparison of various financial statement

items within a single period with the use of

common-size statements

Common-size statements recast items as a

percentage of a selected item

LO 3

Example 13.4—Preparing and Reading

Common-Size Balance Sheets—Vertical Analysis

Example 13.5—Preparing and Reading

Common-Size Income Statements—Vertical Analysis

Liquidity Analysis

A relative measure of the nearness to cash of the

assets and liabilities of a company

LO 4

Working Capital

The excess of current assets over current liabilities at a

point in time

Current Ratio

The ratio of current assets to current liabilities

One of the most widely used financial statement

ratios

Acid-Test Ratio

A stricter test of liquidity than the current ratio

Excludes inventory and prepayments from the

numerator

Cash Flow from Operations to Current

Liabilities

A measure of the ability to pay current debts from

operating cash flows

Accounts Receivable Analysis

Accounts receivable turnover ratio: a measure of the

number of times accounts receivable are collected in a

period

Number of days’ sales in receivables: a measure of the

average age of accounts receivable

Inventory Analysis

Inventory turnover ratio: a measure of the number of

times inventory is sold during a period

Number of days’ sales in inventory: a measure of how

long it takes to sell inventory

Cash-to-Cash Operating Cycle

The length of time from the purchase of inventory to

the collection of any receivable from the sale

Solvency Analysis

The ability of a company to remain in business over

the long term

The ability of the firm to stay financially healthy over

the period of time that existing debt (short- and

long-term) is outstanding

LO 5

Debt-to-Equity Ratio

The ratio of total liabilities to total stockholders’

equity

The composition of debt and equity is an important

determinant of the cost of capital to a company

Times Interest Earned Ratio

Indicates the company’s ability to meet the current

year’s interest payments out of the current year’s

earnings

Debt Service Coverage Ratio

Measure of the amount of cash that is generated from

operating activities during the year and that is

available to repay interest due and any maturing

principal amounts

Cash Flow from Operations to Capital

Expenditures Ratio

A measure of the ability of a company to finance longterm asset acquisitions with cash from operations

Profitability Analysis

How well management is using company resources to

earn a return on the

= funds invested by various groups

Two frequently used profitability measures:

Gross Profit Ratio =

Profit Margin Ratio =

Gross Profit

Net Sales

Net Income

Net Sales

LO 6

Rate of Return on Assets

A measure of a company’s success in earning a return

for all providers of capital

Financial Statement Analysis

Limitations and Considerations in

Financial Statement Analysis

Watch for alternative accounting principles

Selection of a inventory valuation method

Changes in accounting method

Take care when making comparisons

Recognizing trends in ratios

Extra caution for extraordinary items and gains and

losses from discontinued operations

LO 1

Limitations and Considerations in

Financial Statement Analysis (continued)

Understand the possible effects of inflation

Financial statements are based on historical costs

and are not adjusted for the effects of increasing

prices

Analysis of Comparative Statements:

Horizontal Analysis

Comparison of financial statement items over a period

of time

LO 2

Example 13.1—Preparing and Reading

Comparative Balance Sheets—Horizontal Analysis

Example 13.2—Preparing and Reading Comparative Statements of

Income and Retained Earnings—Horizontal Analysis

Example 13.3—Preparing and Reading Comparative

Statements of Cash Flows—Horizontal Analysis

Analysis of Common-Size Statements:

Vertical Analysis

Comparison of various financial statement

items within a single period with the use of

common-size statements

Common-size statements recast items as a

percentage of a selected item

LO 3

Example 13.4—Preparing and Reading

Common-Size Balance Sheets—Vertical Analysis

Example 13.5—Preparing and Reading

Common-Size Income Statements—Vertical Analysis

Liquidity Analysis

A relative measure of the nearness to cash of the

assets and liabilities of a company

LO 4

Working Capital

The excess of current assets over current liabilities at a

point in time

Current Ratio

The ratio of current assets to current liabilities

One of the most widely used financial statement

ratios

Acid-Test Ratio

A stricter test of liquidity than the current ratio

Excludes inventory and prepayments from the

numerator

Cash Flow from Operations to Current

Liabilities

A measure of the ability to pay current debts from

operating cash flows

Accounts Receivable Analysis

Accounts receivable turnover ratio: a measure of the

number of times accounts receivable are collected in a

period

Number of days’ sales in receivables: a measure of the

average age of accounts receivable

Inventory Analysis

Inventory turnover ratio: a measure of the number of

times inventory is sold during a period

Number of days’ sales in inventory: a measure of how

long it takes to sell inventory

Cash-to-Cash Operating Cycle

The length of time from the purchase of inventory to

the collection of any receivable from the sale

Solvency Analysis

The ability of a company to remain in business over

the long term

The ability of the firm to stay financially healthy over

the period of time that existing debt (short- and

long-term) is outstanding

LO 5

Debt-to-Equity Ratio

The ratio of total liabilities to total stockholders’

equity

The composition of debt and equity is an important

determinant of the cost of capital to a company

Times Interest Earned Ratio

Indicates the company’s ability to meet the current

year’s interest payments out of the current year’s

earnings

Debt Service Coverage Ratio

Measure of the amount of cash that is generated from

operating activities during the year and that is

available to repay interest due and any maturing

principal amounts

Cash Flow from Operations to Capital

Expenditures Ratio

A measure of the ability of a company to finance longterm asset acquisitions with cash from operations

Profitability Analysis

How well management is using company resources to

earn a return on the

= funds invested by various groups

Two frequently used profitability measures:

Gross Profit Ratio =

Profit Margin Ratio =

Gross Profit

Net Sales

Net Income

Net Sales

LO 6

Rate of Return on Assets

A measure of a company’s success in earning a return

for all providers of capital

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