Learning Objective. LO1 Analyze an income statement using vertical analysis Cengage Learning. All Rights Reserved.

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1 Learning Objective LO1 Analyze an income statement using vertical analysis.

2 Lesson 17-1 Vertical Analysis Ratios LO1 Vertical analysis ratios measure the relationship between one financial statement item and another item on the same financial statement. On the income statement, vertical analysis ratios focus on the ability of a business to earn a profit. A ratio that measures the ability of a business to generate income is called a profitability ratio. Continued on the next slide. SLIDE 2

3 Lesson 17-1 Vertical Analysis Ratios Vertical analysis ratios on an income statement are examples of profitability ratios. Managers use vertical analysis ratios to help make business decisions. For vertical analysis to be an effective tool, a business must set a target, or standard, for each ratio. A standard used to compare financial performance is called a benchmark. LO1 SLIDE 3

4 Factors Used to Determine Benchmark Ratios Lesson 17-1 LO1 Actual ratios from prior fiscal periods Industry standards published by industry organizations Business plans Unexpected events SLIDE 4

5 Lesson 17-1 Analyzing Trends with Vertical Analysis LO1 Financial statements that provide information for multiple fiscal periods are called comparative financial statements. An analysis of changes over time is called trend analysis. Net income after federal income tax as a percent of net sales is called profit margin. SLIDE 5

6 Lesson 17-1 Analyzing Trends with Vertical Analysis LO1 SLIDE 6

7 Lesson 17-1 Using Vertical Analysis to Analyze Gross Profit LO1 Gross profit as a percent of net sales is called gross margin. This ratio is also referred to as gross profit margin. SLIDE 7

8 Lesson 17-1 Correcting an Unfavorable Gross Margin LO1 Increase unit sales prices Decrease the unit cost of merchandise SLIDE 8

Using Vertical Analysis to Analyze Operating Expenses Lesson 17-1 LO1 Income from operations as a percent of net sales is called the operating margin.

9 Using Vertical Analysis to Analyze Operating Expenses Lesson 17-1 LO1 Income from operations as a percent of net sales is called the operating margin. This ratio is also referred to as the rate of return on sales. Total operating expenses as a percent of net sales is called the operating expense ratio. SLIDE 9

10 Correcting an Unfavorable Operating Expense Ratio Lesson 17-1 LO1 Reduce operating expenses Modify the benchmark Increase net sales SLIDE 10

11 Lesson 17-1 Lesson 17-1 Audit Your Understanding 1. Identify four factors that management can use to determine benchmark financial ratios. ANSWER 1. Actual ratios from prior fiscal periods 2. Industry standards published by industry organizations 3. Business plans 4. Unexpected events SLIDE 11

12 Lesson 17-1 Lesson 17-1 Audit Your Understanding 2. Why should a business be cautious about increasing the markup on merchandise purchased for sale? ANSWER If the increase in markup is too large, a decrease in sales revenue could occur for two reasons: (1) the sales price may exceed what customers are willing to pay or (2) customers may elect to purchase from competing businesses having lower prices. SLIDE 12

13 Lesson 17-1 Lesson 17-1 Audit Your Understanding 3. What are two practices that can be used to reduce the cost of merchandise? ANSWER Purchase merchandise in larger quantities or from other vendors offering a lower cost SLIDE 13

14 Lesson 17-1 Lesson 17-1 Audit Your Understanding 4. Should managers interested in reducing operating expenses focus more on the operating expense ratio or the operating margin? ANSWER Operating expense ratio SLIDE 14

15 Lesson 17-1 Lesson 17-1 Audit Your Understanding 5. What are three possible actions to correct an unfavorable operating expense ratio? ANSWER Reduce operating expenses Modify the benchmark Increase net sales SLIDE 15

16 Learning Objectives LO2 Perform vertical analysis of a balance sheet. LO3 Analyze a balance sheet using vertical analysis.

17 Calculating Vertical Analysis Ratios on a Balance Sheet Lesson 17-2 LO2 1 Asset Amounts Divided by Total Assets 2 Liability and Stockholders Equity Amounts Divided by Total Assets SLIDE 17

18 Lesson 17-2 Evaluating Vertical Analysis Asset Ratios LO3 SLIDE 18

19 Lesson 17-2 Evaluating Vertical Analysis Liability Ratios LO3 A ratio that measures the ability of a business to pay its long-term liabilities is called a solvency ratio. Total liabilities divided by total assets is called the debt ratio. SLIDE 19

20 Lesson 17-2 Evaluating Vertical Analysis Liability Ratios LO3 SLIDE 20

21 Lesson 17-2 Lesson 17-2 Audit Your Understanding 1. Why do many retailers perform vertical analysis on the Accounts Receivable and Merchandise Inventory accounts? ANSWER First, these are typically two of the largest asset accounts for a retail merchandising business. Second, industry standards are available for these accounts. SLIDE 21

22 Lesson 17-2 Lesson 17-2 Audit Your Understanding 2. What may cause a vertical analysis ratio for accounts receivable to be below the target range? ANSWER A ratio below the target range may indicate that a company is restricting customers ability to purchase on account. This action may have a negative effect on sales. SLIDE 22

23 Lesson 17-2 Lesson 17-2 Audit Your Understanding 3. What may cause a vertical analysis ratio for merchandise inventory to be below the target range? ANSWER The business may not be stocking an adequate supply or variety of merchandise. SLIDE 23

24 Lesson 17-2 Lesson 17-2 Audit Your Understanding 4. What should a company do if the vertical analysis ratio for merchandise inventory is above the target range? ANSWER The company should prepare a list of the inventory items having the largest cost. The company should assess whether the proper quantity of each item is available for sale. Future inventory purchases should ensure that the optimal quantity on hand is maintained. SLIDE 24

25 Lesson 17-2 Lesson 17-2 Audit Your Understanding 5. Why is it risky for a business to have too many liabilities? ANSWER The business must be able to pay its liabilities on a timely basis. If sales decline during difficult financial times, a business may be unable to make its monthly payments. SLIDE 25

26 Learning Objectives LO4 Perform horizontal analysis on an income statement. LO5 Perform horizontal analysis on a balance sheet.

27 Lesson 17-3 Analyzing Trends with Horizontal Analysis A comparison of one item on a financial statement with the same item on a previous period s financial statement is called horizontal analysis. LO4 Current Period Prior Period = Increase (Decrease) $242, $221, = $21, Increase (Decrease) Prior Period = Horizontal Analysis Ratio $21, $221, = 9.5% SLIDE 27

28 Lesson 17-3 Horizontal Analysis of an Income Statement LO4 Current Year Less Prior Year 1 2 Difference Amount Divided by Prior Year SLIDE 28

29 Lesson 17-3 Horizontal Analysis of a Balance Sheet LO5 SLIDE 29

30 Lesson 17-3 Lesson 17-3 Audit Your Understanding 1. How could a 2.0% decrease in supplies expense be an unfavorable trend? ANSWER If management took actions that should have decreased supplies expense by significantly more than 2.0%, then only a 2% decrease would be unfavorable. SLIDE 30

31 Lesson 17-3 Lesson 17-3 Audit Your Understanding 2. How does a publicly held corporation use horizontal analysis when reporting to the Securities and Exchange Commission? ANSWER The document filed with the Securities and Exchange Commission contains a section titled Management s Discussion and Analysis of Financial Condition and Results of Operations and Results of Operations. Management often uses these ratios to explain the current year s results of operations compared to previous years. SLIDE 31

32 Learning Objectives LO6 Calculate earnings per share. LO7 Calculate and interpret market ratios. LO8 Calculate and interpret liquidity ratios.

33 Lesson 17-4 Earnings per Share LO6 Net income after federal income tax divided by the number of outstanding shares of stock is called earnings per share. Earnings per share is often abbreviated as EPS. Net Income after Federal Income Tax $ 79, $ 79, Number of Shares Outstanding 7,500 75,000 Earnings per Share $ $ 1.07 SLIDE 33

34 Lesson 17-4 Market Ratios A ratio that measures a corporation s financial performance in relation to the market value of its stock is called a market ratio. LO7 SLIDE 34

35 Lesson 17-4 Dividend Yield The relationship between dividends per share and market price per share is called the dividend yield. Dividends per Share Market Price per Share = Dividend Yield $2.00 $ = 0.87% LO7 SLIDE 35

36 Lesson 17-4 Price-Earnings Ratio LO7 The relationship between the market value per share and earnings per share of a stock is called the price-earnings ratio. It is often referred to as the P/E ratio. Market Price per Share Earnings per Share = Price-Earnings Ratio $ $10.65 = 21.5 SLIDE 36

37 Lesson 17-4 Liquidity Ratios A ratio that measures the ability of a business to pay its current financial obligations is called a liquidity ratio. LO8 SLIDE 37

38 Lesson 17-4 Working Capital The amount of current assets less current liabilities is called working capital. LO8 Current Assets Current Liabilities = Working Capital $185, $32, = $153, SLIDE 38

39 Lesson 17-4 Current Ratio A ratio that measures the relationship of current assets to current liabilities is called the current ratio. The current ratio measures a company s ability to pay its current liabilities when due. Current Assets Current Liabilities = Current Ratio $185, $32, = 5.75 SLIDE 39

40 Lesson 17-4 Quick Ratio Cash and other current assets that can be quickly converted into cash are called quick assets. Quick assets are also referred to as liquid assets. A ratio that measures the relationship of quick assets to current liabilities is called the quick ratio. SLIDE 40

41 Lesson 17-4 Quick Ratio Cash + Accounts Receivable = Quick Assets $54, $17, = $72, Quick Assets Current Liabilities = Quick Ratio $72, $32, = 2.24 SLIDE 41

42 Lesson 17-4 Lesson 17-4 Audit Your Understanding 1. Why can one corporation s earnings per share not be compared to the EPS of other corporations? ANSWER Each corporation s EPS is a unique number because corporations can issue any number of shares. As a result, the earnings of each corporation are divided by a different number of shares. SLIDE 42

43 Lesson 17-4 Lesson 17-4 Audit Your Understanding 2. What group is the primary user of market ratios? ANSWER Investors SLIDE 43

44 Lesson 17-4 Lesson 17-4 Audit Your Understanding 3. Do income stocks typically have low or high dividend yields? ANSWER High SLIDE 44

45 Lesson 17-4 Lesson 17-4 Audit Your Understanding 4. Do growth stocks typically have low or high price-earnings ratios? ANSWER High SLIDE 45

46 Lesson 17-4 Lesson 17-4 Audit Your Understanding 5. What is the primary source of data to calculate liquidity ratios? ANSWER Balance sheet SLIDE 46

47 Lesson 17-4 Lesson 17-4 Audit Your Understanding 6. What does working capital measure? ANSWER Working capital is a measure of the financial resources available for the daily operations of the business. SLIDE 47

48 Lesson 17-4 Lesson 17-4 Audit Your Understanding 7. Why is the current ratio a useful measure of financial strength? ANSWER The current ratio permits a business to compare itself to its industry or to provide a convenient relative measurement from year to year regarding the company s ability to pay current liabilities when due. SLIDE 48

LESSON Trend Analysis and Component Percentages. CENTURY 21 ACCOUNTING 2009 South-Western, Cengage Learning

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