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Accounting: A Malaysian Perspective, 4
th
ed
(Adapted from Accounting 22
nd
ed)
Warren, Reeve and Duchac
Financial
Statement
Analysis
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1. List the users of financial statement.
2. Explain the importance of financial
statement analysis.
3. List basic financial statement analytical
procedures.
4. Apply financial statement analysis to
assess the solvency of a business.
5. Apply financial statement analysis to stress
the profitability of a business.
After studying this chapter, you
should be able to:
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Objective 1
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List the users of financial
statement.



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1. Internal stakeholders
a. Management team
b. Existing shareholders
c. Employees at all levels

2. External stakeholders
a. Creditors (suppliers and banks)
b. Inland revenue board (IRB)
c. Potential shareholders
d. Public at large

Two groups of financial statements users:
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Users have different expectation on financial statements:
User Example of use
Management team and
existing shareholders

Assess firms financial performance, growth, and future
planning
Employees Assess stability of the firm they are currently working
with
Creditors Evaluate credit worthiness and solvency of the firm
Inland revenue board Compute taxable income of the company and avoiding
tax evasion practice
Potential shareholders Facilitate investment decisions
Public at large Environmental awareness and corporate social
responsibilities
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Describe importance of financial statements
Objective 2
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1. Indicate financial positions of the company
for certain period
2. Provide comparative analysis of the firm
performance in relative to their competitors
3. Benchmark firm performance with an
overall industry performance
4. Assess firm financial performance and
operating efficiency by linking one type of
financial information to another (ratio
analysis)
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List basic financial statement analytical
procedures:
Horizontal Analysis
Vertical Analysis
Common-size statements
Objective 3
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The percentage analysis of increases
and decreases in related items in
comparative financial statements is
called horizontal analysis.
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Increase (Decrease)
Mercu Tanda Sdn Bhd
Comparative Balance Sheet
December 31, 2008 and 2007

Assets
Current assets $ 550,000 $ 533,000 $ 17,000 3.2%
Long-term investments 95,000 177,500 (82,500) (46.5%)
Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%)
Intangible assets 50,000 50,000
Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%)
Liabilities
Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%)
Long-term liabilities 100,000 200,000 100,000) (50.0%)
Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%)
Stockholders Equity
Preferred 6% stock, $100 par $ 150,000 $ 150,000
Common stock, $10 par 500,000 500,000
Retained earnings 179,500 137,500 $ 42,000 30.5%
Total stockholders equity $ 829,500 $ 787,500 $ 42,000 5.3%
Total liab. & stockholders eq. $1,139,500 $1,230,500 $ (91,000) (7.4%)


2008 2007 Amount Percent
Comparative Balance Sheets 6-3
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Comparative Schedule of Current Assets
Mercu Tanda Sdn Bhd
Comparative Schedule of Current Assets
December 31, 2008 and 2007
Increase (Decrease)
Cash $ 90,500 $ 64,700 $ 25,800 39.9%
Marketable securities 75,000 60,000 15,000 25.0%
Accounts receivable (net) 115,000 120,000 (5,000) (4.2%)
Inventories 264,000 283,000 (19,000) (6.7%)
Prepaid expenses 5,500 5,300 200 3.8%
Total current assets $550,000 $533,000 $17,000 3.2%
2008 2007 Amount Percent
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Mercu Tanda Sdn Bhd
Comparative Income Statement
For the Year Ended December 31, 2008 and 2007
Sales $1,530,500 $1,234,000 $296,500 24.0%
Sales returns and allowances 32,500 34,000 (1,500) (4.4%)
Net sales $1,498,000 $1,200,000 $298,000 24.8%
Cost of goods sold 1,043,000 820,000 223,000 27.2%
Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%
Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%
Administrative expenses 104,000 97,400 6,600 6.8%
Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7%
Income from operations $ 160,000 $ 135,600 $ 24,400 18.0%
Other income 8,500 11,000 (2,500) (22.7%)
$ 168,500 $ 146,600 $ 21,900 14.9%
Other expense (interest) 6,000 12,000 (6,000) (50.0%)
Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%
Income tax expense 71,500 58,100 13,400 23.1%
Net income $ 91,000 $ 76,500 $ 14,500 19.0%

2008 2007 Amount Percent
Increase (Decrease)
Comparative Income Statement
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Comparative RE Statement
A percentage analysis that
shows the relationship of
each component to the
total within a single
statement is called vertical
analysis.
Mercu Tanda Sdn Bhd
Comparative Retained Earnings Statement
December 31, 2008 and 2007
Increase (Decrease)
Retained earnings, Jan. 1$137,500$100,000$37,500 37.5%
Net income for year 91,000 76,500 14,500 19.0%
Total $228,500 $176,500 $52,000 29.5%)
Dividends:
On preferred stock $ 9,000$ 9,000
On common stock 40,000 30,000 10,000 33.3%
Total $ 49,000 $ 39,000 $10,000 25.6%
Total current assets $179,500 $137,500 $42,000 30.5%
2008 2007 Amount Percent
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A percentage analysis used to show the
relationship of each component to the total
within a single statement is called vertical
analysis.
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In a vertical analysis of the balance sheet,
each asset item is stated as a percent of
the total assets. Each liability and
stockholders equity item is stated as a
percent of the total liabilities and
stockholders equity.
e.g. Current asset (2008):
=(Total current asset / Total asset) x 100
= $550,000/$1,139,500
= 48.3%
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Mercu Tanda Sdn Bhd
Comparative Balance Sheet
For the Years Ended December 31, 2008 and 2007
Assets
Current assets $ 550,000 48.3% $ 533,000 43.3%
Long-term investments 95,000 8.3 177,500 14.4
Property, plant, & equip. (net) 444,500 39.0 470,000 38.2
Intangible assets 50,000 4.4 50,000 4.1
Total assets $1,139,500 100.0% $1,230,500 100.0%
Liabilities
Current liabilities $ 210,000 18.4% $ 243,000 19.7%
Long-term liabilities 100,000 8.8 200,000 16.3
Total liabilities $ 310,000 27.2% $ 443,000 36.0%
Stockholders Equity
Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2%
2.2% Common stock, $10 par 500,000 43.9 500,000 40.6
Retained earnings 179,500 15.7 137,500 11.2
Total stockholders equity $ 829,500 72.8% $ 787,500 64.0%
Total liab. & Stockholders equity $1,139,500 100.0% $1,230,500 100.0%
Amount Percent Amount Percent
2008 2007
Total assets $1,139,500 100.0%$1,230,500100.0%
Total liab. & stockholders equity $1,139,500 100.0% $1,230,500100.0%
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In a vertical analysis of the income
statement, each item is stated as a percent
of net sales. As an example, lets see how
the percent of 12.8% was calculated for
2008 selling expenses.
e.g. Percentage of selling expense (2008):
=(Selling expense/Net sales) x 100
=($191,000 / $1,498,000) x 100
= 12.8%

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Sales $1,530,500 102.2% $1,234,000 102.8%
Sales returns and allow. 32,500 2.2 34,000 2.8
Net sales $1,498,000 100.0% $1,200,000 100.0%
Cost of goods sold 1,043,000 69.6 820,000 68.3
Gross profit $ 455,000 30.4% $ 380,000 31.7%
Selling expenses $ 191,000 12.8% $ 147,000 12.3%
Administrative expenses 104,000 6.9 97,400 8.1
Total operating expenses $ 295,000 19.7% $ 244,400 20.4%
Income from operations $ 160,000 10.7 $ 135,600 11.3%
Other income 8,500 0.6 11,000 0.9
$ 168,500 11.3% $ 146,600 12.2%
Other expense (interest) 6,000 0.4 12,000 1.0
Income before income tax $ 162,500 10.9% $ 134,600 11.2%
Income tax expense 71,500 4.8 58,100 4.8
Net income $ 91,000 6.1% $ 76,500 6.4%


2008 2007
Amount Percent Amount
Percent
Mercu Tanda Sdn Bhd
Comparative Income Statement
For the Years Ended December 31, 2008 and 2007
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In a common-sized statements, all items are
expressed as a percentage. Common-sized
statements are useful in comparing the
current period with prior periods, individual
businesses, or one business with industry
percentages.
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Mercu Tanda Sdn Bhd and Megah Sdn Bhd
Condensed Common-size Income Statement
For the year Ended December 31, 2008
Mercu Tanda Megah
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Apply financial statement analysis to
assess the solvency of a business:

Objective 4
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Using measures to assess a businesss
ability to pay its current liabilities is called
current position analysis. Such analysis is
of special interest to short-term creditors.
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Ratios used to assess current position analysis:
Working capital
Current ratio
Quick ratio
Accounts receivable turnover
Number of Days Sales in Receivables
Inventory turnover
Number of days sales in inventory
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The ability of a business to meet its
financial obligations (debts) is called
solvency.
The ability of a business to earn income
is called profitability.
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Ratios used in assessing business solvency:
Ratio of Fixed Assets to Long-Term Liabilities
Ratio of Liabilities to Stockholders Equity
Number of Times Interest Charges Earned
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Working Capital
The excess of current assets of a
business over its current liabilities is called
working capital. The working capital is
often used in evaluating a companys
ability to meet currently maturing debts.
Working capital:
Total current assets total current
liabilities
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Working capital (a b) $340,000
Current asset:
Cash $ 90,500
Marketable securities 75,000
Accounts receivable (net) 115,000
Inventories 264,000
Prepaid expenses 5,500
a. Total current assets $550,000
b. Current liabilities 210,000
Mercu Tanda Sdn Bhd
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Current Ratio
The current ratio, sometimes called the
working capital ratio or bankers ratio, is
computed by dividing the total current
assets by the total current liabilities.
Current ratio:
Total current assets
total current liabilities
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Current ratio (a/b) 2.6 2.2
a. Current assets $550,000 $533,000
b. Current liabilities 210,000 243,000
Working capital (a b) $340,000 $290,000
2008 2007
Mercu Tanda Sdn Bhd
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Quick Ratio
A ratio that measures the instant debt-
paying ability of a company is called the
quick ratio or acid-test ratio.
Quick ratio:
total quick assets
total current liabilities
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2008 2007
Quick ratio (a/b) 1.3 1.0
Quick assets:
Cash $ 90,500 $ 64,700
Marketable securities 75,000 60,000
Accounts receivable (net) 115,000 120,000
a. Total quick assets $280,500 $244,700
b. Current liabilities $210,000 $243,000
Mercu Tanda Sdn Bhd
Quick assets are cash
and other current assets
that can be quickly
converted to cash.
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Accounts Receivable Turnover
The relationship between sales and
accounts receivable may be stated as the
accounts receivable turnover. The ratio is
to assess the efficiency of the firm in
collecting receivables and in the managing
of credit.
A/R turnover:
Net sales
average Accounts receivable
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Accounts receivable turnover
(a/b) 12.7 9.2
a. Net sales $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year 115,500 120,000
Total $ 235,000 $ 260,000
b. Average (Total/2) $ 117,500 $ 130,000
2008 2007
Mercu Tanda Sdn Bhd
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Number of Days Sales in Receivables
The number of days sales in receivables is an
estimate of the length of time (in days) the
accounts receivable have been outstanding.
Comparing this measure with the credit terms
provides information on the efficiency in collecting
receivables.
Formula:
Average Accounts receivable
Average daily sales on account
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Number of days sales in
receivables (a/b) 28.6 39.5
a. Average (Total/2) $ 117,500 $ 130,000
Net sales $1,498,000 $1,200,000
b. Average daily sales on
account (Sales/365) $ 4,104 $ 3,288
2008 2007
Mercu Tanda Sdn Bhd
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Inventory Turnover
The relationship between the volume of
goods (merchandise) sold and inventory
may be stated as the inventory turnover.
The purpose of this ratio is to assess the
efficiency of the firm in managing its
inventory.
Formula:
Cost of goods sold
average inventories
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2008 2007
Inventory turnover (a/b) 3.8 2.8
a. Cost of goods sold $1,043,000 $ 820,000
Inventories:
Beginning of year $ 283,000 $ 311,000
End of year 264,000 283,000
Total $ 547,000 $ 594,000
b. Average (Total/2) $ 273,500 $ 297,000
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Formula:
Average inventories
average daily COGS
Number of Days Sales in Inventories
The number of days sales in inventories is
an estimate of the length of time (in days)
required to sell the inventories. This ratio
provides information on the efficiency in
converting inventories to sales.
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Number of days sales in
inventory (a/b) 95.7 132.2
a. Average (Total/2) $ 273,500 $ 297,000
Cost of goods sold $1,043,000 $ 820,000
b. Average daily cost of goods
sold (COGS/365 days) $2,858 $2,247
2008 2007
Number of Days Sales in Inventory
Mercu Tanda Sdn Bhd
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Ratio of Fixed Assets to Long-Term Liabilities
The ratio of fixed assets to long-term liabilities is
a solvency measure that indicates the margin of
safety of the note holders or bondholders. It also
indicates the ability of the business to borrow
additional funds on a long-term basis.
Formula:
Fixed assets (net)
long term liabilities
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2008 2007
Ratio of fixed assets to
long-term liabilities (a/b) 4.4 2.4
a. Fixed assets (net) $444,500 $470,000
b. Long-term liabilities $100,000 $200,000
Mercu Tanda Sdn Bhd
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Ratio of Liabilities to Stockholders Equity
The relationship between the total claims of
the creditors and ownersthe ratio of
liabilities to stockholders equityis a
solvency measure that indicates the margin
of safety for creditors.
Formula:
total liabilities
total stockholders equity
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Ratio of liabilities to
stockholders equity (a/b) 0.4 0.6
a. Total liabilities $310,000 $443,000
b. Total stockholders equity $829,500 $787,500

2008 2007
Mercu Tanda Sdn Bhd
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Number of Times Interest Charges Earned
Corporations in some industries normally have
high ratios of debt to stockholders equity. For
such corporations, the relative risk of the debt-
holders is normally measured as the number of
times interest charges are earned (during the
year), sometimes called the fixed charge coverage
ratio.
Formula:
(Income before tax + interest expense)
interest expense

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2008 2007
Income before income tax $162,500 $134,600
a. Add interest expense 6,000 12,000
b. Amount available to meet
interest charges $168,500 $146,600
Number of times interest
charges earned (b/a) 28.1 12.2
Mercu Tanda Sdn Bhd
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Apply financial statement analysis
to assess the profitability of a
business
Objective 5
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Profitability is the ability of an entity to
earn profits.
This ability to earn profits depends on
the effectiveness and efficiency of
operations as well as resources available
as reported in the balance sheet.
Profitability analysis focuses primarily on
the relationship between operating
results reported in the income statement
and resources reported in the balance
sheet.
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Ratios used to assess the profitability of a business include:
Ratio of Net Sales to Assets
Rate Earned on Total Assets
Rate Earned on Stockholders Equity
Leverage
Rate Earned on Common Stockholders Equity
Earnings per Share on Common Stock
Price earning ratio
Dividends per Share
Dividend yield
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Ratio of Net Sales to Assets
The ratio of net sales to assets is a
profitability measure that shows how
effectively a firm utilizes its assets.
Formula:
Net sales
average total asset *
(*exclude long term investment)

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2008 2007
a. Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
b. Average (Total/2) $1,048,750 $1,031,500

Excludes long-term investments
Mercu Tanda Sdn Bhd
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2008 2007
a. Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
b. Average (Total/2) $1,048,750 $1,031,500

Ratio of net sales to assets (a/b) 1.4 1.2
Mercu Tanda Sdn Bhd
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Rate Earned on Total Assets
The rate earned on total assets measures
the profitability of total assets, without
considering how the assets are financed.
Formula:
Net income + interest expense
Average total assets

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2008 2007
Rate earned on total
assets (a/b) 8.2% 7.3%
Net income $ 91,000 $ 76,500
Plus interest expense 6,000 12,000
a. Total $ 97,000 $ 88,500
Total assets:
Beginning of year $1,230,500 $1,187,500
End of year 1,139,500 1,230,500
Total $2,370,000 $2,418,000
b. Average (Total/2) $1,185,000 $1,209,000
Mercu Tanda Sdn Bhd
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Rate Earned on Stockholders Equity
The rate earned on stockholders equity
measure emphasizes the rate of income
earned on the amount invested by the
stockholders.
Formula:
Net income
Average stockholders equity

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Rate earned on stockholders
equity (a/b) 11.3% 10.0%
a. Net income $ 91,000 $ 76,500
Stockholders equity:
Beginning of year $ 787,500 $ 750,000
End of year 829,500 787,500
Total $1,617,000 $1,537,500
b. Average (Total/2) $ 808,500 $ 768,750
2008 2007
Mercu Tanda Sdn Bhd
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The difference in the rate earned on
stockholders equity and the rate earned
on total assets is called leverage.
Leverage
Formula:
Rate earned on stockholders equity rate
earned on total asset

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10
%
5%
0%
Rate earned on
total assets
Rate earned on
stockholders equity
8.2%
11.3%
Leverage
3.1%
2008
7.3%
10.0%
Leverage
2.7%
2007
Exhibit 8 Leverage 6-4
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The rate earned on common stockholders
equity focuses only on the rate of profits
earned on the amount invested by the
common stockholders.
Rate Earned on Common Stockholders Equity
Formula:
Net income preferred dividend
Average common stockholders equity

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2008 2007
Net income $ 91,000 $ 76,500
Less preferred dividends 9,000 9,000
a. Remaindercommon stock $ 82,000 $ 67,500
Common stockholders equity:
Beginning of year $ 637,500 $ 600,000
End of year 679,500 637,500
Total $1,317,000 $1,237,500
b. Average (Total/2) $ 658,500 $ 618,750
Rate earned on common
stockholders equity (a/b) 12.5% 10.9%
Mercu Tanda Sdn Bhd
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Earnings per Share on Common Stock
One of the profitability measures often quoted by
the financial press is earning per share (EPS) on
common stock. It is also normally reported in the
income statement in corporate annual reports.
Formula:
Net income preferred dividend
number of shares in common stock

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2008 2007
Earnings per share on common
stock (a/b) $1.64 $1.35
Net income $ 91,000 $ 76,500
Preferred dividends 9,000 9,000
a. Remainderidentified with
common stock $ 82,000 $ 67,500
b. Shares of common stock 50,000 50,000
Mercu Tanda Sdn Bhd
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Price-Earnings Ratio
Another profitability measure quoted by the
financial press is the price-earnings (P/E)
ratio on common stock. The price-earnings
ratio is an indicator of a firms future
earnings prospects.
Formula:
Share market price
earning/share of common stock

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2008
2007
Price-earnings ratio on
common stock 25 20
Market price per share of
common stock $41.00 $27.00
Earnings per share on common
stock 1.64 1.35
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Dividends per Share
Dividends per share can be reported with earnings
per share to indicate the relationship between
dividends and earnings. Comparing these two per
share amounts indicates the extent to which the
corporation is retaining its earnings for use in
operations.
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Dividends Earnings
$0.80
$1.64
2008
$0.60
$1.35
2007
Per
share
$2.00
$1.50
$1.00
$0.50
$0.0
0
Exhibit 9: Dividends and Earning per
Share of Common Stock
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The dividend yield on common stock is a
profitability measure that shows the rate of
return to common stockholders in terms of
cash dividends.
Dividend Yield
Formula:
Dividend per share
market price per share

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2008 2007
Dividend yield on
common stock 2.0% 2.2%
Dividends per share of
common stock $ 0.80 $ 0.60
Market price per share of
common stock 41.00 27.00
Mercu Tanda Sdn Bhd
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