Review of chapter of Horngren (Introduction to Financial Accounting) to be posted

Investors who purchased equity and debt securities of a company or who want to purchase securities of a company use financial statement analysis to predict expected returns and risk associated with those returns.

Normally the analysis (that is making judgments or developing estimates) uses financial statements of number of consecutive years up to the current year.

Many decisions hinge on whether the numbers - in sales, income, expenses and so on-are increasing or decreasing over time. Absolute changes as well as percentage changes are interesting and useful information.

The study of absolute amount of change and percentage change in comparative consecutive statements over a period of time is called horizontal analysis of financial statements.

The study of percentage changes in comparative statements is called horizontal

analysis. Horizontal analysis compares one year to the next. Computing a percentage

change in comparative statements requires two steps:

1. Compute the dollar amount of the change from the earlier period to the

later period.

2. Divide the dollar amount of change by the earlier period amount. We call the

earlier period the base period.

Calculation of trend percentages is also a form of horizontal analysis.

In this type of analytical statement, the amounts of a financial statement in a base year are stated as 100. The amounts in the corresponding line items in the subsequent years are expressed as percentage of this base amount. For example the sales in the base year is 100%, and in the next year it can be 110% and the subsequent year it can be 117%.

Trend precentages indicate the direction a business is taking. How have sales changed over a five-year period? What trend does net income show? These questions can be answered by trend analysis over a period, such as three to five years.

Trend analysis percentages are computed by selecting a base year (the earliest year). The base year amounts are set equal to 100%. The amounts for each subsequent year are expressed as a percentage of the base amount. To compute trend analysis percentages, we divide each item for the following years by the base year amount.

Vertical analysis of a financial statement reveals the relationship of each statement item to a specified base, which is the 100% figure. For an income statement, net sales is usually the base.

How Do We Compare One Company with Another?

Horizontal analysis and vertical analysis provide much useful data about a company.

Benchmarking

Benchmarking is the practice of comparing a company with other leading companies.

It often uses the common size percentages in a graphical manner to highlight differences.

There are two main types of benchmarks in financial statement analysis: benchmarking

against a key competitor and benchmarking against the industry average.

Using Ratios to Make Decisions

Different ratios explain different aspects of a company. The

ratios we cover further may be classified as follows:

1. Evaluating the ability to pay current liabilities

2. Evaluating the ability to sell inventory and collect receivables

3. Evaluating the ability to pay long-term debt

4. Evaluating profitability

5. Evaluating stock as an investment

Evaluating the Ability to Pay Current Liabilities

Working capital is defined as follows:

Working capital measures the ability to meet short-term obligations with current

assets.

Current Ratio

The most widely used ratio is the current ratio, which is current assets divided by current

liabilities. The current ratio measures a company’s ability to pay current liabilities

with its current assets.

What is an acceptable current ratio? The answer depends on the industry. The

norm for companies in most industries is around 1.50, as reported by the Risk

Management Association.

Acid-Test Ratio

The acid-test (or quick) ratio tells us whether the entity could pay all its current liabilities

if they came due immediately.

Acid-Test Ratio = [Cash + Short-term investments + Net current receivables]/Current liabilities

An acid-test ratio of 0.90 to 1.00 is acceptable in most industries

Evaluating the Ability to Sell Inventory

and Collect Receivables

Inventory Turnover

The inventory turnover ratio measures the number of times a company sells its average

level of inventory during a year.

To compute inventory turnover, we divide cost of goods sold by the average

inventory for the period. We use the cost of goods sold—not sales—because both

cost of goods sold and inventory are stated at cost.

Inventory turnover varies widely with the nature of the business. For example,

most manufacturers of farm machinery have an inventory turnover close to three

times a year. In contrast, companies that remove natural gas from the ground hold

their inventory for a very short period of time and have an average turnover of 30.

Days in Inventory

Another key measure is the number of days in inventory ratio.

Days in inventory = 365 days/Inventory turnover ratio

Gross Profit Percentage

Gross profit (gross margin) is net sales minus the cost of goods sold. Merchandisers

strive to increase the gross profit percentage (also called the gross margin

percentage). This measures the profitability of each net sales dollar.

Accounts Receivable Turnover

The accounts receivable turnover ratio measures the ability to collect cash from

credit customers. The higher the ratio, the faster the cash collections.

To compute accounts receivable turnover, divide net credit sales by average net accounts receivable.

Days’ Sales in Receivables

The days’ sales in receivables ratio also measures the ability to collect receivables.

Days’ sales in receivables tell us how many days’ sales remain in Accounts receivable.

To compute this ratio, divide 365 days by the

accounts receivable turnover ratio we previously calculated:

Reference

Horngren: Financial and Management Accounting

Introduction to Financial Accounting

Presentation

Financial Analysis

http://wps.prenhall.com/wps/media/objects/1838/1883037/powerpoints/ch_12.ppt

http://www.cob.sjsu.edu/mcwill_m/fa6ch13.ppt#476,1,Financial Statement Analysis

HBS Alumni Excel based tool

http://www.alumni.hbs.edu/new_alumni/toolkit/tools/ratioanalysis.xls

Financial Analysis - Southwest Airlines - Illustration

http://teknirvana.com/documents/Southwest.pdf

Updated 17 April 2016, 22 April 2015

First published: 8 December 2011

Investors who purchased equity and debt securities of a company or who want to purchase securities of a company use financial statement analysis to predict expected returns and risk associated with those returns.

Normally the analysis (that is making judgments or developing estimates) uses financial statements of number of consecutive years up to the current year.

## Horizontal Analysis

Many decisions hinge on whether the numbers - in sales, income, expenses and so on-are increasing or decreasing over time. Absolute changes as well as percentage changes are interesting and useful information.

The study of absolute amount of change and percentage change in comparative consecutive statements over a period of time is called horizontal analysis of financial statements.

The study of percentage changes in comparative statements is called horizontal

analysis. Horizontal analysis compares one year to the next. Computing a percentage

change in comparative statements requires two steps:

1. Compute the dollar amount of the change from the earlier period to the

later period.

2. Divide the dollar amount of change by the earlier period amount. We call the

earlier period the base period.

### Trend Percentages

Calculation of trend percentages is also a form of horizontal analysis.

In this type of analytical statement, the amounts of a financial statement in a base year are stated as 100. The amounts in the corresponding line items in the subsequent years are expressed as percentage of this base amount. For example the sales in the base year is 100%, and in the next year it can be 110% and the subsequent year it can be 117%.

Trend precentages indicate the direction a business is taking. How have sales changed over a five-year period? What trend does net income show? These questions can be answered by trend analysis over a period, such as three to five years.

Trend analysis percentages are computed by selecting a base year (the earliest year). The base year amounts are set equal to 100%. The amounts for each subsequent year are expressed as a percentage of the base amount. To compute trend analysis percentages, we divide each item for the following years by the base year amount.

## Vertical Analysis

Vertical analysis of a financial statement reveals the relationship of each statement item to a specified base, which is the 100% figure. For an income statement, net sales is usually the base.

How Do We Compare One Company with Another?

Horizontal analysis and vertical analysis provide much useful data about a company.

Benchmarking

Benchmarking is the practice of comparing a company with other leading companies.

It often uses the common size percentages in a graphical manner to highlight differences.

There are two main types of benchmarks in financial statement analysis: benchmarking

against a key competitor and benchmarking against the industry average.

Using Ratios to Make Decisions

Different ratios explain different aspects of a company. The

ratios we cover further may be classified as follows:

1. Evaluating the ability to pay current liabilities

2. Evaluating the ability to sell inventory and collect receivables

3. Evaluating the ability to pay long-term debt

4. Evaluating profitability

5. Evaluating stock as an investment

Evaluating the Ability to Pay Current Liabilities

Working capital is defined as follows:

Working capital measures the ability to meet short-term obligations with current

assets.

Current Ratio

The most widely used ratio is the current ratio, which is current assets divided by current

liabilities. The current ratio measures a company’s ability to pay current liabilities

with its current assets.

What is an acceptable current ratio? The answer depends on the industry. The

norm for companies in most industries is around 1.50, as reported by the Risk

Management Association.

Acid-Test Ratio

The acid-test (or quick) ratio tells us whether the entity could pay all its current liabilities

if they came due immediately.

Acid-Test Ratio = [Cash + Short-term investments + Net current receivables]/Current liabilities

An acid-test ratio of 0.90 to 1.00 is acceptable in most industries

Evaluating the Ability to Sell Inventory

and Collect Receivables

Inventory Turnover

The inventory turnover ratio measures the number of times a company sells its average

level of inventory during a year.

To compute inventory turnover, we divide cost of goods sold by the average

inventory for the period. We use the cost of goods sold—not sales—because both

cost of goods sold and inventory are stated at cost.

Inventory turnover varies widely with the nature of the business. For example,

most manufacturers of farm machinery have an inventory turnover close to three

times a year. In contrast, companies that remove natural gas from the ground hold

their inventory for a very short period of time and have an average turnover of 30.

Days in Inventory

Another key measure is the number of days in inventory ratio.

Days in inventory = 365 days/Inventory turnover ratio

Gross Profit Percentage

Gross profit (gross margin) is net sales minus the cost of goods sold. Merchandisers

strive to increase the gross profit percentage (also called the gross margin

percentage). This measures the profitability of each net sales dollar.

Accounts Receivable Turnover

The accounts receivable turnover ratio measures the ability to collect cash from

credit customers. The higher the ratio, the faster the cash collections.

To compute accounts receivable turnover, divide net credit sales by average net accounts receivable.

Days’ Sales in Receivables

The days’ sales in receivables ratio also measures the ability to collect receivables.

Days’ sales in receivables tell us how many days’ sales remain in Accounts receivable.

To compute this ratio, divide 365 days by the

accounts receivable turnover ratio we previously calculated:

Reference

Horngren: Financial and Management Accounting

Introduction to Financial Accounting

Presentation

Financial Analysis

http://wps.prenhall.com/wps/media/objects/1838/1883037/powerpoints/ch_12.ppt

http://www.cob.sjsu.edu/mcwill_m/fa6ch13.ppt#476,1,Financial Statement Analysis

HBS Alumni Excel based tool

http://www.alumni.hbs.edu/new_alumni/toolkit/tools/ratioanalysis.xls

Financial Analysis - Southwest Airlines - Illustration

http://teknirvana.com/documents/Southwest.pdf

Updated 17 April 2016, 22 April 2015

First published: 8 December 2011

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