Section 2.) Horizontal and Trend Analysis
As stated in the overview, horizontal and trend analysis both compare items within a particular statement across one or more years. Horizontal analysis deals only with a “one year to the next” analysis. Trend analysis expands that comparison across multiple years.
Assume you have the below selected data from the past four years’ balance sheets.
Horizontal analysis would involve taking one year’s balance minus the prior year’s balance and then dividing that difference by the current year. In the example cash from above, we could take the cash amount of $80,000 from 12/31/2020, minus the 12/31/2019 cash balance of $140,000 to get a $-60,000 change. We would then divide that by the 12/31/2019 balance of $140,000 to get a percentage change of -42.8571% (i.e., a decrease.) We could do the same thing for any of the account balances and any of the years (one year to the immediately preceding year.)
Trend analysis would allow us to see how something has changed between a base year and the later years. For example, we could compare the three latest years to the base year of 12/31/2017 to get an idea of how the balances have changed over time.
Keeping with the cash example, we could calculate the 12/31/2018 trend percentage by taking the 12/31/2018 cash balance divided by the 12/31/2017 cash balance. This would give us $135,000/$150,000 = 90%. Then, we could take the 12/31/2019 trend percentage by taking the 12/31/2019 cash balance divided by the 12/31/2017 cash balance. This would give us $140,000/$150,000 = 93.33%. Note that we are comparing everything to the base year of 12/31/2017, not just the immediately preceding year as in horizontal analysis. Then, we could take the 12/31/2020 trend percentage by taking the 12/31/2020 cash balance divided by the 12/31/2017 cash balance. This would give us $80,000/$150,000 = 53.33%.
The resulting trend analysis amounts are:
2017 = 100% (the first year divided by itself is always 100%.
2018 = 90%
2019 = 93.33%
2020 = 53.33%
Using this analysis, we can very quickly get an idea as to the direction and magnitude of changes compared against the base year.
If we graph the trend analysis for cash, inventory, and accounts receivables together, we will get something like this. This may help us to quickly see that the sudden decrease in cash in the final year may very well be due to sudden increases in accounts receivables and inventory. This may mean that we are having trouble collecting on our accounts, and also are stocking up on more inventory.
Section 3.) Vertical Analysis
Vertical analysis is the comparison of one item on a particular financial statement, compared to the base amount for that same financial statement. Essentially, we are looking for a percentage of total calculation.
For the income statement, everything is compared to the top number (sales or net sales.) This comparison is made by taking the individual numbers in question and dividing it by the sales figure.
For the balance sheet, everything (assets, liabilities, or equity) is compared to the total asset balance. Although it may seem unusual comparison a liability or equity amount to total assets, remember that the accounting equation states that Total Assets = Total Liabilities + Total Equity. As such, comparing account payable (a liability) to total assets is the same as comparing it to Total Liabilities and Equity.
Assume the following data from two years of income statements for the below company.
The vertical analysis for any of the items can be calculated by taking the balance divided by the sales figure for that same year. For example, I could calculate the net income analysis for 2019 by taking $65,700 divided by the $325,000 sales to get 20.22%. That seems like a reasonable profit margin, but for a true comparison I would want to compare that ratio to the same ratio calculated in a different year, or for a competitor, or against an industry standard (if one is known.)
The calculation of vertical analysis creates what are known as common size financial statements. This term comes from the fact that we can then compare one set of financial statements to another set that may be larger or smaller. This may be another company altogether or the same company before or after major expansions or shutdowns. See the examples below for the fully calculated common size financial statements. Looking at the ratios, we can easily see that cost of goods sold (as a percentage of sales) increased quite a bit. At the same time, selling, general and administrative expenses decreased. However, the net profit margin still decreased (largely due to the cost of goods sold.)
After calculations have been completed
Section 4.) Ratio Analysis
What is a Ratio?
The first thing to discuss is what exactly a ratio is. A ratio is simply a comparison of the relationship between two numbers. It is a division problem. Understanding the relationship between two numbers may help to better understand the company’s overall financial health, much better than one number can by itself. In addition, converting information to ratios allows for better comparison across time and across companies of a different size.
Once relationships are established, a company can compare the same ratios across time using what is known as trend analysis. If a ratio that is considered “good” increases over time, then the company can say that it is improving its operations and vice versa. On that note, ratios often do carry a connotation as good or bad. Often, there are also benchmarks that a company can use to get an estimate of where it should be at. That being said, what is good for one company in one situation is not necessarily the same for another company in a different situation. You have to understand the background of the company.
Common Classifications of Financial Ratios
Liquidity Ratios - These determine how easily a company can pay their current liabilities. The more liquid a company, the more flexibly they can pay these bills. Trouble that arises in the short term can very quickly cause trouble for a company. These need to be monitored regularly to determine what changes may need to be made.
Activity Ratios - One of a company’s most important activities is generating sales. These activity ratios determine how much of this sales activity is going on in a company compared with the assets that the company has at its disposal to generate more sales. This could include machines to produce more goods to sell, cash to buy more goods to sell, etc. These ratios show how efficiently the company has used its assets to generate sales revenue. Although selling is generally the activity that we are discussing, there are other alternatives that we will discuss. Keep in mind, however, that just because a company is generating activity (i.e., sales), it doesn’t necessarily mean they are operating profitably. Other later ratios
When we talk about activity ratios, we generally see them referred to as turnover ratios, however we may also talk about the number of days sales (activity) in the year-end balance sheet amounts.
Profitability and Market Ratios - These ratios determine how profitable a specific set of activities is for a company.
Debt or Financial Leverage (Solvency) - These ratios take a longer view of the company’s ability to continue into the future. Often these are comparing total assets to total debt, or perhaps even the two types of financing (debt vs equity.)
It is important to note that any individual ratio by itself only gives a snapshot of the big picture.
An analogy that can be used is to think of a pizza delivery driver. He is considering whether to buy a car to get a delivery job or whether to use what money he has to buy an older, less fuel-efficient car. Regardless of how he finances the car, the liquidity ratio could resemble whether the driver has enough cash on hand to buy gas for his car so he can go to work each day. This is short term. If he cannot buy gas, he cannot do his job and make money.
The activity ratio can resemble how many deliveries the driver is able to take. On a micro scale this is effectively the driver’s operating cycle. Taking a lot of deliveries doesn’t necessarily mean he is making a lot of money; it just means that he is performing high levels of activity.
The profitability ratio can resemble how much the driver gets in tips for the average delivery.
The debt or financial leverage tells us how the worker financed his car. If he got a loan to buy a newer car, not only could he get more fuel efficiency, but he could also (potentially) deduct the interest payments on his tax return.
Examples of Liquidity Ratios
These ratios tell us about the firm’s ability to meet their current debt loads so that the company can continue into the long run. These ratios help financial users to determine the short-term risks of the company.
Working Capital
Working capital is a dollar amount that tells us the excess of current assets over current liabilities. This is one measure that is not a true ratio, as it is simply a dollar amount.
Working Capital = Current Assets – Current Liabilities
Both of these figures would be taken from the ending balance on the balance sheet.
In other words, what amount of money do we have left after we pay our current bills? If this amount is negative, or very low, this is seen as a very serious risk, because the company will not be able to pay even their short-term debts without making some immediate changes.
On the other hand, this amount should not be too high, because then the question of whether the company is properly using its assets comes into play. The cash and other short-term investments that constitute current assets generally have lower rates of returns than more long-term investments. As such, if a company has too much in current assets, perhaps they should consider moving some into longer term, high return assets. If they don’t have any better use for the money, they may want to consider returning it to the investors in the form of a dividend.
Higher working capital is going to result in higher liquidity ratios as discussed below. The amount of working capital that a company should maintain will vary. There is no specific magic dollar amount for any company. Comparisons with other companies in the industry are the best measure here.
Current Ratio
This ratio specifically compares the current assets to the current liabilities. If these amounts were exactly the same, this would tell us that if we converted all of our current assets to cash then we could just barely pay our current liabilities. Generally, the higher the current assets in comparison to the current liabilities, the safer the company is.
Current Ratio = Current Assets
Current Liabilities
Both of these figures would be taken from the ending balance on the balance sheet.
Generally speaking, to be considered “safe” a company should have a current ratio of 2.0 or more. This is not an absolute and may depend on the company, and the industry. Again, too high of a ratio may indicate that the company has too much idle cash, etc.
Acid Test Ratio (aka Quick Ratio)
This ratio is identical to the current ratio except that it excludes inventory from the listing of current assets. This is done to provide a “near worst case” scenario for the company where their inventory has become obsolete or for some other reason, they cannot sell their inventory. Think of “acid” burning up the inventory so that it can no longer be sold.
Note that in some cases there are other “current assets” that are included in the current ratio but would not be included in the acid test ratio; however, this is outside of the discussion of this text.
Acid Test Ratio = Cash + Short Term Cash Investments + Accounts Receivable
Current Liabilities
Both of these figures would be taken from the ending balance on the balance sheet.
Generally speaking, to be considered “safe” a company should have an acid test ratio of 1.0 or more. This is not an absolute and may depend on the company, and the industry.
Examples of Activity Ratios
Activity ratios tell us how efficiently management is using their assets to run the business. Depending on the type of ratio we are looking at, the “activity” may differ.
Total Asset Turnover Ratio
This ratio shows how efficiently management is using their total assets to generate sales. There are several other variations of these turnover ratios. For example, we could keep sales in the numerator but have some other grouping of assets (e.g., accounts receivable, plant and equipment, or total operating assets) in the denominator.
When thinking of turnover ratios, think of an asset being used up in the process of generating sales. As we discussed previously, this is the purpose of assets. Also remember that when we use up an asset it becomes an expense.
Although some of the turnover ratios show an entire asset actually being completely turned over (e.g., inventory sold and new inventory purchased), some of it represents just a portion of a long-term asset being used up. To help conceptualize this, think of a machine or vehicle with its engine running (i.e., turning over) while it is being used to create a product, deliver something, or otherwise generate sales.
Total Asset Turnover = Sales
Average Total Assets
- Sales would be taken from the income statement for the current period
- Average total assets would be calculated by taking the total asset balance at the beginning of the year (same as the balance at the end of last year) plus the ending asset balance and dividing that sum by two.
Inventory Turnover Ratio
This ratio is another type of turnover ratio and is similar to the asset turnover ratio discussed above, except that instead of sales it uses the cost of goods sold. This is because inventory is reported on the balance sheet at cost. The inventory turnover ratio represents the number of times the company has cycled through their operating cycle.
Inventory Turnover = Cost of Goods Sold
Average Inventories
- Cost of Goods Sold would be taken from the income statement for the current period
- Average inventories would be calculated by taking the total inventory balance at the beginning of the year (same as the balance at the end of last year) plus the ending inventory balance and dividing that sum by two.
Number of Days’ Sales in Accounts Receivable
This ratio is important to show the average age of accounts receivable for a company. This reflects a combination of the firm’s credit policy and their efficiency in the collection efforts. This ratio should closely align with the credit policy of the firm. If the ratio is more than the net payment due date, then this means too many customers are paying late.
Number of Days’ Sales in AR = Ending Accounts Receivable Balance
Average Day’s Sales
- Ending AR balance is taken from the balance sheet.
- Average day’s sales is calculated by taking the amount of sales divided by the number of days that the sales figure represents. Generally, this is one year or 365 days.
Number of Days’ Sales in Inventory
This ratio shows the number of day’s sales that could be made if we just sold the inventory, we have on hand without buying any new inventory.
The lower that the company can get this ratio WITHOUT stocking out (i.e., having to turn away customers due to not having the product they want) the better, because having too much inventory on hand has costs of its own. These include the cost of warehousing the merchandise, cost of insuring it, risk of obsolescence, etc.
Number of Days Sales in Inventory = Ending Inventory
Average Day’s Cost of Goods Sold
- Ending Inventory balance is self-explanatory
- Average day’s cost of goods sold is calculated by taking the amount of cost of goods sold divided by the number of days that the cost figure represents. Generally, this is one year or 365 days. Again, since we are dealing with inventory, we want the cost of goods sold rather than the sales figure, since inventory is reported at cost, not sales price.
Example of Profitability and Market Ratios
Return on Investment (ROI)
This is a very important ratio for a company. A company uses their assets to attempt to earn net income. The ROI is a rate of return on those assets, regardless of how the company financed those assets (i.e., whether they financed with debt financing or equity financing.) It essentially tells the company how much return (income) they are able to return over a period of time by using their investments (assets) that they had during that time.
The basic ratio is: ROI = Net Income
Average Total Assets
- Net income is taken from the income statement. Note that this is not the sales figure that we used in some of the other ratios. This is net income, because sales doesn’t necessarily mean income. We are only profitable if we can earn net income.
- Average total assets would be calculated by taking the total asset balance at the beginning of the year (same as the balance at the end of last year) plus the ending asset balance and dividing that sum by two.
Depending on how the company chooses, they may elect to use slight deviations from this basic equation. For example, they may decide to use operating income instead of net income. This would basically exclude interested income and income tax expense. Likewise, the company may also elect to use operating assets rather than total assets.
Although this model gives an important view of the company’s health, there is another model that comes up to the same result but gives a better understanding of why.
This is known as the Dupont Model. It is simply an expansion of the ROI, but it gives you the exact same result.
ROI (DuPont Model) is: ROI = Profit Margin * Total Asset Turnover
This means:
ROI (DuPont Model) is: ROI = Net Income * Sales
Sales Average Total Assets
Algebraically, the two sales amounts cancel themselves out and you are left with the basic ROI equation. However, the two components by themselves (profit margin) and (asset turnover) tell us that to earn a profit, the company must do two things. They must turn their assets into sales, and then earn a profit on each dollar of sale.
Although it goes without saying that higher return on investment amounts is always better, once a company in an industry starts to have extremely high profitability ratios, expect that other companies will begin to enter the industry to try to earn some of these high returns as well. These will generally have an equalizing effect, causing returns to drop a bit.
ROI Averages in the U.S. have historically ranged from 7-10 percent.
Return on Equity (ROE)
Although ROI is a return on all assets (regardless of how they are financed), ROE is a return only on the portion of assets financed by equity, not debt.
ROE = Net Income
Average Owner’s Equity
ROE averages around 12-20%, depending on the company’s financial structure and their industry.
As discussed in previous chapters, a company’s proper use of leverage (debt financing) can result in a magnification effect to return on equity. If they borrow at an interest rate that is less than the company’s return on investment (ROI) then the return on the debt financed funds is magnified and it is a good decision. If they borrow at a rate that is more than the return on investment then extra expense is magnified, and it is not a good decision.
The magnification effect that debt financing has on ROE is due to the following. The two ratios have the same numerator (net income), but the ROI has a larger denominator (total assets, which can also be thought of as liabilities plus owner’s equity.) Therefore, when net income increases due to debt financing and earning a higher rate of return as compared with the rate of interest, this is going to have a larger effect on ROE than it does on ROI.
Price to Earnings Ratio (P/E Ratio or Earnings Multiplier)
This ratio shows how much investors are currently willing to pay for a share of common stock as compared with its earnings. A higher number indicates confidence in the company’s future, as the investor believes that this stock has growth potential that will allow them to recoup the extra money, they spent to purchase the stock.
Price to Earnings Ratio = Market Price Per Share
Earnings Per Share
- Market price can be found via several different online websites, financial newspapers, etc.
- Earnings per share is a computation that we learned how to calculate in an earlier chapter. Generally, companies will use diluted earnings per share when they calculate this ratio.
Dividend Yield
Investors in a company (stockholders) make two types of returns on their investments. One is the actual growth in the value of the stock and the other is the dividends that are paid out. Dividend yield measures the return generated by the dividend. This is an important measure for investors that are looking at how the company earns them a return.
Dividend Yield = Annual Dividend Per Share
Market Price Per Share of Stock
- Annual dividend per share is found by taking the annual dividend per share declared by the board.
- Market price can be found via several different online websites, financial newspapers, etc.
Dividend Payout Ratio
This ratio tells us what percentage of earnings of the company are actually paid out as opposed to being “retained” by the company for future use. This is important to investors because if they do not see the company using their investments wisely to earn a proper return, they would rather have the money returned to them in the form of dividends.
Dividend Payout Ratio = Annual Dividend Per Share
Earnings Per Share
- Annual dividend per share is found by taking the annual dividend per share declared by the board.
- Earnings per share is a computation that we learned how to calculate in an earlier chapter. Generally, companies will use diluted earnings per share when they calculate this ratio.
Preferred Dividend Coverage Ratio
This ratio is important to common stockholders because it allows them to determine what the likelihood of them receiving dividends is. Keep in mind that preferred stockholders receive their dividends before common stockholders. If there is not enough for both, common stockholders will not get any that year.
Preferred Dividend Coverage Ratio = Net Income
Preferred Dividend Requirement
- Net income comes from the most recent income statement
- Preferred dividend requirement can be found by looking at the preferred dividend policy. This should generally be found in the footnotes.
Examples of Leverage Ratios - Use of Debt to Finance the Assets of Entity
Debt Ratio
Note that since total liabilities + owner’s equity equals total assets (remember the basic accounting equation), this ratio can also be thought of as total liabilities/total assets. In other words, what percent of our assets are financed by debt? What percent of our total financing is debt, rather than equity financing? Since negative assets create a very unusual (and very dire) situation we should almost always see this ratio as less than 1.0.
Debt Ratio = Total Liabilities
Total Liabilities + Owner’s Equity
- All of these amounts are found on the balance sheet
Debt to Equity Ratio
This ratio is different than the debt ratio because it compares our two types of financing directly. If the numerator (Liabilities) exceeds the denominator (Owner’s Equity, then this ratio is going to be greater than 1 and vice versa.
Debt to Equity Ratio = Total Liabilities
Total Owner’s Equity
- All of these amounts are found on the balance sheet
Times Interest Earned
Another way to think of this ratio is by asking how many times over we have earned the amount of money needed to pay our interest expense. In other words, if we end up with a ratio of 3.0, this means we have earned 3 times as much as we need to pay our interest expense. The reason we have to back interest expense out of the numerator is that that amount of earnings is indeed available for paying interest expense 1 time, thus we would be understating our ratio if we used net income after subtracting interest expense. The reason we subtract out income tax expense is because this expense is not subject to much control by management, thus we shouldn’t measure them based on it.
Times Interest Earned = Earnings Before Interest and Income Tax Expense
Interest Expense
- All of these amounts are found on the income statement.
This below video goes through the various types of financial analysis discussed in the text.
Wrap-Up
Financial analysis serves as part of the wrap-up for the first two thirds of the course. First, we learned all of the accounts and financial statements. Then, we learned how to analyze that data. Next week is essentially a review week to fully wrap the financial section up before we move onto managerial accounting for the remainder of the course.
Section 1.) Overview of Financial Statement Analysis
Up to this point, we have been discussing the various accounts that go to financial statements, as well as the format of the statements themselves. In this chapter we discuss how an investor or others would analyze the company’s financial statements to determine the health of the company.
One of the first things to note is that anyone can find the financial statements for a publicly traded company by simply going to the Securities Exchange Commission website at www.SEC.gov.
From that website, you can either use the search bar to identify the name of a company. Or you can go to the “company filings” link to browse to more advanced searching.
Once you have found the company, look for the 10-K section. The 10-K form is the annual report that a company must file. The 10-Q is the same, only on a quarterly basis.
Once you are in the form 10-K, find the link for the financial statements. Once there, you can see all of the various financial statement data for your analysis. Note that in many cases, more than one year is presented at a time for this very comparison. The form 10-K can be quite large. Using CTRL-F keyword searches for phrases such as “financial statements”, “income statement”, “statement of operations”, “balance sheet” or “statement of position” will help you to find what you are looking for.
The analysis that we are performing will be comparing various pieces of those statements, between the same company across time, and between similar companies.
There are a few different types of analysis that are common within companies:
1.) Horizontal Analysis is comparing the same information across time. For example, looking at the dollar and percentage change of cash or accounts receivable or net income from one year to the next.
2.) Trend Analysis is horizontal analysis across multiple years. For example, horizontal analysis would tell us how net income changed from 2019 to 2020. Trend analysis would tell us how the balance of net income has changed from 2010 through the current year. It is one thing to see that net income decreased from last year to the current year, but it is quite another to see that it has been steadily decreasing for the past ten years.
3.) Vertical analysis is the comparison of an individual amount on an income statement or balance sheet to some amount that has been determined to be a base amount. For income statement items, the total sales number is determined to be the base amount. For balance sheet items, the total asset number is the base amount. For example, we could say that cash is 10% of total assets. We could also say that salaries are 15% of total sales. These would both be examples of vertical analysis.
4.) Ratio analysis is the comparison of specified items on the financial statements to other specified items (on the same or different financial statement.) These specific items, although seemingly different, are known to have meaningful relationships. For example, we may want to compare current assets to current liabilities (current ratio) to see whether we will be able to pay our debt that is nearing the due date without taking on additional long-term debt. We may also compare the net income to the number of shares we have outstanding to determine the earnings per share. There are several ratios that can be used, and this topic represents the most expansive portion of this particular chapter.
Each of these items will be discussed in the sections below.
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