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Apply horizontal analysis, trend analysis, and vertical analysis to financial statements.

Horizontal Analysis

It begins with the computation of changes from the previous year to the current year. The

base year is the first year considered.

Horizontal analysis uses both dollar amounts and percentages.

Percentage Change = 100 x(Amount of Change / Base Year Amount)

Trend Analysis

Changes are calculated for several successive years instead of for two years.

Trend analysis is important because it may point to basic changes in the nature of a business.

Trend analysis uses an index number to show changes in related items over a period of time.

Index = 100 x(Index Year Amount / Base Year Amount)

Vertical Analysis

Percentages are used to show the relationship of the different parts to a total in a single

statement.

The analyst sets a total figure in the statement equal to 100% and computes each

components percentage of that total.

The statement of percentages is called a common-size statement.

Vertical analysis is useful for comparing the importance of specific components in the

operation of a business and changes in the components from one year to the next.

Ratio Analysis

Ratios identify meaningful relationships between the components of the financial statements.

They are useful in:

Evaluating a companys financial position and operations.

Making comparisons with results in previous years or with other companies.

The primary purpose of ratios is to point out areas needing further investigation.

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Evaluating Liquidity

Liquidity is a company's ability to pay bills when they are due and to meet unexpected needs

for cash.

All ratios that relate to liquidity involve working capital or some part of it.

Current ratio: measures short-term debt-paying ability.

Current Ratio = Current Assets / Current Liabilities

Quick ratio: also measures short-term debt-paying ability.

Quick Ratio = (Cash + Marketable Securities + Receivables) / Current Liabilities

Receivable turnover: measures relative size of receivables and effectiveness of credit

policies.

Receivable Turnover = Net Sales / Average Accounts Receivable

Average days sales uncollected: measures average days taken to collect receivables.

Inventory turnover: measures relative size of inventory.

Inventory Turnover = Cost of Goods Sold / Average Inventory

Average days inventory on hand: measures average days taken to sell inventory.

Average Days Inventory on Hand = Days in Year / Inventory Turnover

Payables turnover: measures relative size of accounts payable.

Payables Turnover = (Cost of Goods Sold +/- Change in Inventory) / Average Accounts Payable

Average days payable: measures average days taken to pay accounts payables.

Average days payable = Days in Year / Payables Turnover

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Evaluating Profitability

Profitability reflects a company's ability to earn a satisfactory income.

A company's profitability is closely linked to its liquidity because earnings ultimately produce

cash flow.

Profitability ratios include:

Profit margin: measures net income produced by each sales dollar.

Profit Margin = Net Income / Net Sales

Asset turnover: measures how efficiently assets are used to produce sales.

Asset Turnover = Net Sales / Average Total Assets

Return on assets: measures overall earning power.

Return on Assets (ROA) = Net Income / Average Total Assets

Return on equity: measures profitability of stockholders investments.

Return on equity (ROE) = Net Income / Average Stockholders Equity

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Evaluating Long-Term Solvency

Long-term solvency has to do with a company's ability to survive for many years. The aim of

long-term solvency analysis is to detect early signs that a company is headed for financial

difficulty.

Early signs that a company is on the road to bankruptcy include:

Declining profitability and liquidity ratios.

Unfavorable debt to equity ratio.

Unfavorable interest coverage ratio.

Debt to Equity Ratio

Measures capital structure and leverage.

Failure to honor debt can result in bankruptcy, so debt is risky.

BUT debt provides flexible financing:

It can be temporary.

Interest is tax deductible.

It leverages stockholders investments if the company earns a return on assets

greater than the cost of interest.

Debt to Equity Ratio = Total Liabilities / Stockholders Equity

Interest Coverage Ratio

Measures creditors protection from default on interest payments.

Interest Coverage Ratio = (Income before Taxes + Interest Expense) / Interest Expense

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Evaluating Cash Flow Adequacy

Because cash flows are needed to pay debts when they are due, cash flow measures are

closely related to the objectives of liquidity and long-term solvency.

Cash flow adequacy ratios include:

Cash flow yield: measures overall ability to generate operating cash flows in relation to

net income.

Cash flow yield = Net Cash Flows from Operating Activities / Net Income

Cash flows to sales: measures ability of sales to generate operating cash flows.

Cash Flows to Sales = Net Cash Flows from Operating Activities / Net Sales

Cash flows to assets: measures ability of assets to generate operating cash flows.

Cash Flows to Assets = Net Cash Flows from Operating Activities / Average Total Assets

Free cash flow: measures cash generated or cash deficiency after providing for

commitments.

Free Cash Flow = NCF from OA Dividends Net Capital Expenditures

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Evaluating Market Strength

Market price is the price at which people are willing to buy or sell the stock.

Market price provides information about how investors view the potential return and risk

connected with owning the company's stock.

Market price by itself is not very informative.

Market price must be related to earnings by considering the price/earnings ratio and the

dividends yield.

Price/earnings ratio: Measures investor confidence in a company. It is useful for

comparing the value placed on a companys shares in relation to the overall market.

Price / Earnings Ratio = Market Price per Share / Earnings per Share

Dividends yield: Measures a stocks current return to an investor.

Dividends yield = Dividends per Share / Market Price per Share

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Ratio Analys is

Current Ratio

Quick Ratio

Days of Inventory (DI)

Days Sales Outstanding (DSO)

Fixed Assets Turnover

Total Assets TurnoverDebt/Assets

Profit Margin

ROA

ROE

Du Pont equation

ROE

ROA

K = ROE / ROA

Profit Margin

ROA:

TAT

FAT

DSO

DI