Analysis of Financial Statements
Analytical procedures may be used to compare items on a current statement with related items on an earlier statement. Analytical procedures may also be used to examine relationships between items on the same financial statement. In this article, we’ll look at some of the ways to analyze statements.
Horizontal analysis is the percentage analysis of increases and decreases in related items in comparative financial statements. The amount of each item on the most recent statement is compared with the related item on one or more earlier statements. The earliest date or statement is used as the base.
As an example, the current assets for Driden Enterprises is being viewed through horizontal analysis comparing the 2006 and 2007 numbers. The 2007 financial statement states the current assets are $550,000. The 2006 current assets are $533,000. The difference between these two numbers is $17,000. Since the most recent number is the larger of the two, this is a positive $17,000, meaning that current assets have increased by $17,000. The percentage increase would be $17,000 divided by $533,000, or 3.2%. In horizontal analysis, the current assets for Driden Enterprises has increased 3.2%, or $17,000.
Horizontal analysis for one item on the statement doesn’t give you near enough information about what is happening with the company. Horizontal analysis needs to be performed on all items on the financial statement to get an idea of how the company is doing.
Vertical analysis is the percentage analysis to show the relationship of each component to the total within a single statement. In analysis of the balance sheet, for example, each asset item is stated as a percent of the total assets. Each liability and stockholder equity item is stated as a percent of the total liabilities and stockholders’ equity.
Vertical analysis of the income statement compares each item as a percent of net sales.
Vertical analysis with both dollar and percentage amounts is also useful in comparing one company to another, or to the industry average. These comparisons are listed in a statement form, and are called common-size statements. Common-size statements are expressed only in percentages.
The ability of a business to meet its financial obligations is (debts) is called solvency. The ability of a business to earn income is called profitability. The factors of solvency and profitability are interrelated.
Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities. Normally, it is assessed by examining the balance sheet relationships using the following major analysis:
1. Current position analysis
2. Accounts receivable analysis (AR turnover and number of days’ sales in receivables)
3. Inventory analysis (inventory turnover and number of days’ sales in inventory)
4. Ratios of fixed assets to long-term liabilities
5. Ratios of liabilities to stockholder equity
6. Number of times interest charges are earned
Current Position Analysis
Current position analysis is the process of using measures to assess a company’s ability ot pay its current liabilities.
Working Capital: The excess of the current assets of a business over its current liabilities is called working capital. This is used in evaluating a company’s ability to meet currently maturing debt.
Current Ratio: Another means of expressing the relationship between current assets and current liabilities is current ratio. This is sometimes referred to as working capital ratio or banker’s ratio. The total current assets is divided by the total current liabilities. Example: a company’s current assets are $550,000 and the current liabilities are $210,000. The working capital is ($550,000 minus $210,000) $340,000, and the current ratio is ($550,000 divided by $210,000) 2.6.
Quick Ratio: Working capital and current ratio do not consider what makes up the current assets. Some current assets are tied up in investments, or are part of inventories. The ratio that measures “instant” debt-paying ability of a company is called the quick ratio. Quick assets are cash and other current assets that can be quickly converted to cash. These normally include cash, marketable securities, and receivables.
Accounts Receivable Turnover: The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. This ratio is computed by taking the net sales and dividing it by the average net accounts receivable. Average net accounts receivable is determined by taking the beginning AR, adding the ending AR, and dividing by two.
Number of Days’ Sales in Receivables: This ratio is computed by dividing the average accounts receivable by the average daily sales. Average daily sales is determined by dividing net sales by 365 days. The number of days’ sales in receivables is an estimate of the length of time in days the accounts receivable have been outstanding.
Inventory Turnover and Number of Days’ Sales In Inventory: These two inventory analysis are very similar to the accounts receivables analysis. However, instead of using the net sales, the cost of goods sold is used. Inventory turnover is the cost of goods sold divided by the average inventory. Number of days’ sales in inventory is the average inventory divided by the average daily cost of goods sold.
Ratio of Fixed Assets to Long-Term Liabilities: This is a measure that indicates the margin of safety of the noteholders or bondholders. The net fixed assets is divided by the long-term liabilities.
Ratio of Liabilities to Stockholders’ Equity: This is the measure of the total claims of the creditors and owners that indicates the margin of safety for creditors. To determine this, the total liabilities is divided by the total stockholders’ equity. The lower the number, the larger the margin of safety for the stockholders.
Number of Times Interest Charges Earned: This is a measure of risk to the debtholders. The higher the ratio, the lower the risk that interest payments will not be made if earnings decrease. To compute this ratio, the income before taxes is taken, and added to it is the interest expense. This gives you the amount available to meet interest charges. The interest expense is then divided by the amount available to meet interest charges.
The ability of a business to earn profits is the profitability analysis. The major analyses used in assessing profitability include:
1. Ratio of net sales to assets
2. Rate earned on total assets
3. Rate earned on stockholders’ equity
4. Rate earned on common stockholders’ equity
5. Earnings per share on common stock
6. Price-earnings ratio
7. Dividends per share
8. Dividend yield
Ratio of Net Sales to Assets: This is a measure that shows how affective a company uses its assets. The ratio is determined by taking net sales and dividing by average of total assets (beginning assets, plus ending assets, divided by 2).
Rate Earned on Total Assets: This measures the profitability of total assets without the consideration of how the assets are financed. The rate is determined by taking the net income and adding the interest expense. This is then divided by the average assets, as determined in the ratio of net sales to assets.
Rate Earned on Stockholders’ Equity: This is computed by dividing net income by the average stockholders equity (beginning equity plus ending equity divided by two). The rate earned by a business on the equity of its stockholders is usually higher than the rate earned on total assets. The difference in the rate on stockholders’ equity and the rate on total assets is called leverage.
Rate Earned on Common Stockholders’ Equity: This is similar to the rate earned on stockholders’ equity. However, a company may have both preferred and common stock. When this is the case, the annual required preferred dividend is added into the net income.
Earnings Per Share on Common Stock: This is one of the most quoted profitability measures. EPS is normally reported in the income statement in annual reports. To determine EPS, preferred dividends (if there is preferred stock) is subtracted from the net income. This is then divided by the number of common shares outstanding.
Price-Earnings Ratio: P/E is an indicator of a company’s future earnings prospects. The market price per share of common stock at a specific date is divided by the annual earnings per share (EPS). This indicates, at the current rate of earnings, how many years of earnings would be needed to recover the amount spent on the stock.
Dividends Per Share and Dividend Yield: When a company declares a dividend, the amount of the dividend divided by the number of shares is the dividend per share. Dividend yield is the percentage from taking the dividend per share and dividing by the market price of the stock.