# Chapter 19: Financial Statement Analysis

## Learning Objectives

• Learn about horizontal financial statement analysis
• Learn about vertical financial statement analysis
• Learn about operating activity ratios
• Learn about risk coverage ratios

# Financial Statement Analysis

Financial statements are the primary method of presenting financial information to external users. All external users will need to be able to understand, analyze and interpret financial statements presented. Most companies present their financial statements based on a standardized set of rules and this allows external users to make comparisons between financial statements of different companies or the same company. This section will present the basic set of analytical procedures that are most commonly used by external users as well as various methods that are specific to each financial statement. The three basic methods used are: horizontal analysis, vertical analysis and financial ratios.

## Horizontal Analysis (Trend Analysis)

Horizontal analysis is used to determine trends in financial statement accounts over a period of time. For example, we might want to determine the percentage increase in cash compared to the previous cash account. By doing this, we can determine if the cash account is increasing or decreasing on a period-by-period basis. In horizontal analysis we may only use two periods with quarterly and annual periods being the most commonly used time periods. However, longer time periods could also be used. The first step to horizontal analysis is to determine the base period which will be compared. Generally, the earliest period is used as the base period. Once we have determined the base period, we can use a simple formula to calculate our percentage changes:

Dollar difference = Amount in Comparison year - Amount in the base year

Then calculate the percentage change as follows:

Percentage change = (dollar difference/amount in the base year) X 100

Horizontal analysis is most effective when used in a visual representation with all amounts on the financial statement showing the percentage change for each account. Horizontal analysis is most commonly used on the balance sheet, income statement, statement of retained earnings and current assets schedule. We will present examples of each to show the type of analysis that can be obtained.

## Horizontal Analysis: Balance Sheet Example

The example comparative balance sheet below shows us the balance sheets for December 31st, 2016 and 2017. Using the formulas presented above, we can calculate the amount change and the percentage change. The base year for our example is December 31st, 2016 since it is the earlier year. The cash account is calculated as follows:

Cash Dollar Difference = \$207,000 - \$187,000 = \$20,000

Cash Percentage Difference = \$20,000/\$187,000 = .106951 (move decimal place to the right by two digits and round the decimal to two digits) = 10.70%

All other accounts are calculated in the same manner, as seen below:

We can now analyze this comparative balance sheet by analyzing the percentage changes in each account which reveals new information in terms of how much magnitude each account is changing. Larger percentage changes show more significant changes in the account. We can also see that assets and stockholder's equity largely increased as a result of an increase in liabilities. Similar relationships exist as well throughout, for example, the cash increase was largely the result of inventory be sold for cash and accounts receivables being collected.

Additionally, if a company groups current assets into a single summarized account then a horizontal analysis can also be performed on that account. The current asset account is beneficial to analyze due to its ability to show how short-term liquidity is being handled by the company. Cash is the blood of a company and a company must have sufficient current assets to make sure the company can pay its bills as they come due. We can see an example of a current asset horizontal analysis below:

## Vertical Analysis

Vertical analysis is a method of analysis that compares different accounts relative to the entire financial statement or group of similar accounts. It is most commonly used to analyze the balance sheet or income statement.

For the balance sheet, vertical analysis is based on assets, liabilities and owner's equity/stockholder's equity. The balance sheet below shows a balance sheet being analyzed using vertical analysis:

For the income statement, vertical analysis often performed based on a percentage of sales. This form of analysis allows the user to determine how large the expense is compared to sales. The income statement below shows a vertical analysis of an income statement:

## Financial Ratios

Financial ratios are analytical tools that provident insights about the overall functioning of an entity. A financial ratio works by taking relevant data points found on financial statements and converts it into a numerical number. This numerical number can then be compared to other entities to provide comparisons. The ratio can also be applied to the same entity at different points in time to create a trend analysis.

The following are key benefits of financial ratios:

• Performance Analysis: The primary users of financial statements can analyze the perform of the entity.
• Valuation: The primary users of financial statements can use financial ratios to value an entity.
• Comparisons: Financial ratios enable primary users to easily compare ratios to other entities.

The following are limitations of financial ratios:

• Subject to Estimates: Since financial ratios derive their key data from accounting data the financial ratio would be subject to estimate bias. What this means is the financial ratio's quality is reliant on company managers making reliable estimates and not performing accounting fraud.
• Industry Differences: The financial ratios might not fully reflect differences in industries which have different operating characteristics.
• Lack of Seasonal Data: Financial ratios might be distorted by seasonal fluctuations.
• Loss of Contextual Data: In the process of creating a simple numerical figure, the financial ratio removes the context of where the data came from. For example a company's accounting policies are not reflected in the financial ratio.

## Sample Financial Statements

In order to calculate the financial ratios, we need a set of financial statements to obtain our data points. The following financial statements will be used to calculate the financial ratios:

Additionally, the following select financial information is provided:

• Shares Outstanding: 5,000 for 2016 and 8,000 for 2017
• Operating Cash Flows: \$56,000 for 2016 and \$42,000 for 2017
• Earnings Per Share: \$4 per share for 2016 and \$3.30 for 2017
• Market Price Per Share: \$7 per share for 2016 and \$9 per share for 2017
• Dividends Per Share: \$0.25 for 2016 and \$0.15 for 2017
• All sales revenue is made on credit

## Liquidity Ratios

Liquidity ratios measure the amount of short-term ability to repay current liabilities as they come due. These ratios are commonly used to determine if the company has the ability to continue operating into the future without the risk of bankruptcy.

### Working Capital Ratio

Using our balance sheet and income statement, we can compute the working capital ratio for both years. In our balance sheet and income statement the current assets and current liabilities are given to us. If the current assets and current liabilities are not given in a summarized form then you will need to identify which assets and liabilities are current to calculate the current ratio.

• 2016 Working Capital Ratio: \$322,000 - \$485,000 = -\$163,000
• 2017 Working Capital Ratio: \$305,000 - \$388,000 = -\$83,000

As you can see, both of our working capital ratios are negative. What this means is that we do not have enough current assets to meet our current liability obligations. The more working capital we have, the better. However, very high working capital might mean the company is not using their assets efficiently because current assets generally do not have a high rate of return. The working capital might be better used by investing it in expanding the business operations.

### Current Ratio

The current ratio is used to convert the working capital numbers into a percentage figure. A high current ratio is considered more beneficial than a low current ratio number.

• 2016 Current Ratio:\$322,000/\$485,000 = 0.6639
• 2017 Current Ratio: \$305,000/\$388,000 = 0.7861

Our current ratio has increased compared to 2016 which means the company's is increasing the amount of current assets compared to the current liabilities. The increase in current ratio is seen as a positive.

### Quick Ratio (Acid-Test)

The quick ratio shows us the company's short-term liquidity. The numerator (top line) of the ratio takes all assets that can be converted quickly to cash and then compares it to current liabilities. It essentially shows us if the company would be able to quickly cover the current liabilities. Being able to quickly repay the current liabilities is significant because being forced to sell other assets might force the company sell assets which have higher transaction costs or might require the company to sell the asset at a less than desirable price.

• 2016 Quick Ratio: (\$187,000 + \$35,000 + \$50,000) / \$485,000 = 0.5608
• 2017 Quick Ratio: (\$150,000 + \$45,000 + \$45,000) / \$350,000 = 0.6857

Note that net receivables is calculated as accounts receivables less allowance for doubtful accounts. In our situation, no amount is given for an allowance for doubtful accounts so we assume that all of the accounts receivables will be collectible.

Our quick ratio is getting higher which is viewed as a positive because it means we are obtaining more quickly convertible to cash type assets to cover our current liabilities.

### Cash Ratio

The cash ratio shows us how much highly liquid current assets the firm has relative to our current liabilities. Marketable securities are included in the numerator due to securities being able to be sold on an active market (stock market) for the immediate exchange of cash.

• 2016 Quick Ratio: (\$187,000 + \$35,000) / \$485,000 = 0.4577
• 2017 Quick Ratio: (\$150,000 + \$45,000) / \$350,000 = 0.5571

The ratio increasing from 2016 to 2017 means we are obtaining additional highly liquid assets compared to our current liabilities. This is seen as a positive.

Note that there are no cash equivalents listed on our balance sheet.

## Operating Activity Ratios

Operating activity ratios determine how efficiently the company is using the resources (assets) of the company to increase value for the owners.

### Accounts Receivable Turnover

The accounts receivable turnover ratio shows how effective the company is at collecting money that is owed on account. The higher the ratio, the better since it shows that the company is effective at collecting the outstanding receivables. It also helps the company since the cash collected can be used for the business immediately. The beginning net receivable balance is not listed for the beginning of 2016. We will assume it is \$55,000 for our example calculation:

• 2016 Accounts Receivable Turnover: \$120,000 / (\$55,000 + \$50,000 / 2) = 2.2857
• 2017 Accounts Receivable Turnover: \$135,000 / (\$50,000 + \$45,000 / 2) = 2.8421

For the denominator we add the beginning net accounts receivable to the ending net receivable and divide it by two. This gives us the average net receivables for the period. As you can see, our accounts receivable turnover is increasing which shows the company is improving at collecting the outstanding receivables. This is a positive for the company.

## Profitability Ratios

Profitability ratios show how well a company is able to earn net income during a period of time.

## Risk Coverage Ratios

The risk coverage ratios show us how well the company is able to protect itself from creditors.