Analysis and Interpretation of Financial Statements

 Site: Saylor Academy Course: BUS103: Introduction to Financial Accounting Book: Analysis and Interpretation of Financial Statements
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Description

Read this chapter, which discusses how to analyze financial statements and demonstrates the use of ratios and the horizontal and vertical analysis tools that everyone from creditors to investors, vendors, and top management use when they want to identify the strengths and weaknesses in an organization. Analysis tools can help you compare companies of different sizes, companies in different industries, and the same company over time.

Learning objectives

After studying this chapter, you should be able to:

• Describe and explain the objectives of financial statement analysis.
• Describe the sources of information for financial statement analysis.
• Calculate and explain changes in financial statements using horizontal analysis, vertical analysis, and trend analysis.
• Perform ratio analysis on financial statements using liquidity ratios, long-term solvency ratios, profitability tests, and market tests.
• Describe the considerations used in financial statement analysis.

Source: James Don Edwards and Roger H. Hermanson, https://s3.amazonaws.com/saylordotorg-resources/wwwresources/site/wp-content/uploads/2012/10/Accounting-Principles-Vol.-1.pdf

Accountants as investment analysts

More than ever, accounting students are being hired as securities analysts, portfolio managers, strategists, consultants, or other investment specialists. Duties in these fields involve understanding the operations of the company, assessing the value of the company, and predicting its future performance. These fields can be enormously exciting and may reap tremendous monetary rewards to those who are successful. For example, Apple's stock closed at USD 21.82 per share in January 2002, and at USD 218.95 in March 2010. So, if you had invested in Apple stock in 2002 your investment would have been worth ten times as much in 2010. Not bad!

Of course, failure to understand the relationship between financial accounting information and company value can result in negative consequences as well. For example, during the dot.com boom, the stock of Webvan, an online grocer, plummeted from a high of USD 40 to just six cents within a few months as investors realized that the company could not meet expected earnings projections and was therefore highly overvalued. (Later, however, framed Webvan stock certificates were selling on Ebay for over USD 100.00 as stark symbols of the dot.com bust).

In the area of investing, what accounting information can be used to separate the winners from the losers?

This is the goal of investment analysts - to understand the current value of a company and then use available information in predicting future performance. Investment analysts rely heavily on financial statements as a source of information in predicting stock price movements. Since financial statements are prepared by accountants, it is no surprise that accountants are being hired for purposes of interpreting financial information and making predictions. Given the complexity of business organizations and business transactions in today's global markets, accounting professionals no longer are solely responsible for preparing financial statements, but are being asked to interpret these statements as well.

The two primary objectives of every business are solvency and profitability. Solvency is the ability of a company to pay debts as they come due; it is reflected on the company's balance sheet. Profitability is the ability of a company to generate income; it is reflected on the company's income statement. Generally, all those interested in the affairs of a company are especially interested in solvency and profitability.

This chapter discusses several common methods of analyzing and relating the data in financial statements and, as a result, gaining a clear picture of the solvency and profitability of a company. Internally, management analyzes a company's financial statements as do external investors, creditors, and regulatory agencies. Although these users have different immediate goals, their overall objective in financial statement analysis is the same - to make predictions about an organization as an aid in decision making.

Objectives of financial statement analysis

Management's analysis of financial statements primarily relates to parts of the company. Using this approach, management can plan, evaluate, and control operations within the company. Management obtains any information it wants about the company's operations by requesting special-purpose reports. It uses this information to make difficult decisions, such as which employees to lay off and when to expand operations. Our primary focus in this chapter, however, is not on the special reports accountants prepare for management. Rather, it is on the information needs of persons outside the firm.

Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the company as a whole. Since they cannot request special-purpose reports, external users must rely on the general purpose financial statements that companies publish. These statements include a balance sheet, an income statement, a statement of stockholders' equity, a statement of cash flows, and the explanatory notes that accompany the financial statements.

Users of financial statements need to pay particular attention to the explanatory notes, or the financial review, provided by management in annual reports. This integral part of the annual report provides insight into the scope of the business, the results of operations, liquidity and capital resources, new accounting standards, and geographic area data. Moreover, this section provides an economic outlook that an analyst may find very helpful when considering the possible future profitability of the company.

Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information. This information reveals significant relationships between data and trends in those data that assess the company's past performance and current financial position. The information shows the results or consequences of prior management decisions. In addition, analysts use the information to make predictions that may have a direct effect on decisions made by users of financial statements.

Present and potential investors are interested in the future ability of a company to earn profits - its profitability. These investors wish to predict future dividends and changes in the market price of the company's common stock. Since both dividends and price changes are likely to be influenced by earnings, investors may predict earnings. The company's past earnings record is the logical starting point in predicting future earnings.

Some outside parties, such as creditors, are more interested in predicting a company's solvency than its profitability. The liquidity of the company affects its short-term solvency. The company's liquidity is its state of possessing liquid assets, such as cash and other assets easily converted to cash. Because companies must pay short-term debts soon, liquid assets must be available for their payment. For example, a bank asked to extend a 90-day loan to a company would want to know the company's projected short-term liquidity. Of course, the company's predicted ability to repay the 90-day loan is likely to be based at least partially on its past ability to pay off debts.

Long-term creditors are interested in a company's long-term solvency, which is usually determined by the relationship of a company's assets to its liabilities. Generally, we consider a company to be solvent when its assets exceed its liabilities so that the company has a positive stockholders' equity. The larger the assets are in relation to the liabilities, the greater the long-term solvency of the company. Thus, the company's assets could shrink significantly before its liabilities would exceed its assets and destroy the company's solvency.

Investors perform several types of analyses on a company's financial statements. All of these analyses rely on comparisons or relationships of data that enhance the utility or practical value of accounting information. For example, knowing that a company's net income last year was USD 100,000 may or may not, by itself, be useful information. Some usefulness is added when we know that the prior year's net income was USD 25,000. And even more useful information is gained if we know the amounts of sales and assets of the company. Such comparisons or relationships may be expressed as:

• Absolute increases and decreases for an item from one period to the next.
• Percentage increases and decreases for an item from one period to the next.
• Percentages of single items to an aggregate total.
• Trend percentages.
• Ratios.

Earlier chapters have discussed and illustrated many of these analysis techniques. However, in this chapter, we apply all of these techniques in analyzing Synotech, Inc.'s performance. This was the company introduced in Chapter 16.

Items 1 and 2 make use of comparative financial statements. Comparative financial statements present the same company's financial statements for one or two successive periods in side-by-side columns. The calculation of dollar changes or percentage changes in the statement items or totals is horizontal analysis. This analysis detects changes in a company's performance and highlights trends.

Analysts also use vertical analysis of a single financial statement, such as an income statement. Vertical analysis (item 3) consists of the study of a single financial statement in which each item is expressed as a percentage of a significant total. Vertical analysis is especially helpful in analyzing income statement data such as the percentage of cost of goods sold to sales.

Financial statements that show only percentages and no absolute dollar amounts are common-size statements. All percentage figures in a common-size balance sheet are percentages of total assets while all the items in a common-size income statement are percentages of net sales. The use of common-size statements facilitates vertical analysis of a company's financial statements.

Trend percentages (item 4) are similar to horizontal analysis except that comparisons are made to a selected base year or period. Trend percentages are useful for comparing financial statements over several years because they disclose changes and trends occurring through time.

Ratios (item 5) are expressions of logical relationships between items in the financial statements of a single period. Analysts can compute many ratios from the same set of financial statements. A ratio can show a relationship between two items on the same financial statement or between two items on different financial statements (e.g. balance sheet and income statement). The only limiting factor in choosing ratios is the requirement that the items used to construct a ratio have a logical relationship to one another.

Sources of information

Financial information about publicly owned corporations can come from different sources such as published reports, government reports, financial service information, business publications, newspapers, and periodicals.

Public corporations must publish annual financial reports. The Annual report appendix gives such data for The Limited, Inc. The major sections of an annual report are (not necessarily in this order):

•  Consolidated financial statements Consolidated financial statements include a balance sheet containing two years of comparative data; an income statement containing three years of comparative data; a statement of cash flows containing three years of comparative data; and a statement of shareholders' equity containing three years of comparative data. For examples of each statement, refer to the annual report booklet.

•  Notes to consolidated financial statements Notes to consolidated financial statements provide an in depth look into the numbers contained in the financial statements. The notes usually contain sections on significant accounting policies, long-term debt, leases, stock option plans, etc. These explanations allow stockholders to look beyond the numbers to the events that triggered the dollar amounts recorded in the financial statements.

•  Letters to stockholders Most annual reports are introduced with a letter to the stockholders. The letter often includes information about the company's past history, its mission, current year operating results, and the company's future goals.

•  Reports of independent accountants The Securities and Exchange Commission (SEC) requires the financial statements of certain companies to be audited. The report of independent accountants, found at the end of the financial statements, provides assurance that the financial statements prepared by the company have been audited and are free of material misstatements. The report also may include a paragraph highlighting the significant accounting policies that the company has changed recently.

•  Management discussion and analysis The management discussion and analysis section of the annual report provides management's view of the performance of the company. The analysis is based on the financial statements, the conditions of the industry, and ratios.

Publicly held companies must file detailed annual reports (Form 10-K), quarterly reports (Form 10-Q), and special events reports (Form 8-K) with the Securities and Exchange Commission. These reports are available to the public for a small charge and sometimes contain more detailed information than the published reports.

Financial statement information is often more meaningful when users compare it with industry norms. Two firms that provide information on individual companies and industries are Moody's Investors Service and Standard & Poor's. Dun & Bradstreet Companies, Inc., publishes Key Business Ratios and Robert Morris Associates publishes Annual Statement Studies; both provide information for specific industries. Standard & Poor's Industry Surveys contains background descriptions and the economic outlook for different industries.

Business publications such as The Wall Street Journal, Barron's, Forbes, and Fortune also report industry financial news. Because financial statement users must be knowledgeable about current developments in business, the information in financial newspapers and periodicals is very valuable to them.

Horizontal analysis and vertical analysis: An illustration

The comparative financial statements of Synotech, Inc., will serve as a basis for an example of horizontal analysis and vertical analysis of a balance sheet and a statement of income and retained earnings. Recall that horizontal analysis calculates changes in comparative statement items or totals, whereas vertical analysis consists of a comparison of items on a single financial statement.

Imagine that you are a prospective investor interested in Synotech, Inc. You have acquired the 2010 Annual Report of the company and want to perform some horizontal and vertical analyses of the financial statements.

First, we begin with the balance sheets. Exhibit 133 shows the comparative balance sheets for 2010 and 2009 in Columns (1) and (2). Take a few minutes to study the balance sheets. Then review Columns (3) and (4), which show the horizontal analysis that would be performed on the comparative balance sheets.

Column (3) shows the change that occurred in each item between 2009 December 31, and 2010 December 31. If the change between the two dates is an increase from 2009 to 2010, the change is a positive figure. If the change is a decrease, the change is a negative figure and is shown in parentheses. Column (4) shows the percentage change in each item. You can calculate the percentage change by dividing the dollar change by the dollar balance of the earlier year (2009). While examining the horizontal analysis in Exhibit 133 note that:

• Total current assets have increased USD 14.3 million, consisting largely of increases in cash, marketable securities, and other current assets despite a USD 63.0 million decrease in net receivables, while total current liabilities have increased USD 181.4 million, largely as a result of increases in the current portion of long-term debt and other accruals.
• Total liabilities have decreased USD 114.1 million, while total assets increased by USD 311.0 million.

Next, study Column (4), which expresses as a percentage the dollar change in Column (3). Frequently, these percentage increases are more informative than absolute amounts, as illustrated by the current asset and current liability changes. Although the absolute amount of current liabilities has increased tremendously over the amount of current assets, the percentages reveal that current assets increased .5 per cent, while current liabilities increased 8.6 per cent. Thus, current liabilities are increasing at a faster rate than current assets. Current assets still exceed current liabilities. This fact indicates that the company will be able to pay its debts as they come due.

Studying the percentages in Column (4) could lead to several other observations. For instance, the 6.9 per cent decrease in long-term debt indicates that interest charges will be lower in the future, having a positive effect on future net income. The 14.2 per cent increase in retained earnings could be a sign of increased dividends in the future; in addition, the increase in cash of 19 per cent could support this conclusion.

Now examine Columns (5) and (6) to see the vertical analysis that would be performed. A vertical analysis of the company's balance sheet discloses each account's significance to total assets or total equities. This comparison aids in assessing the importance of the changes in each account. Columns (5) and (6) in Exhibit 133 express the dollar amount of each item in Columns (1) and (2) as a percentage of total assets or equities. For example, although other assets declined USD 6.3 million in 2010, the decrease of 1.4 per cent in the account represents only approximately 4.8 per cent of total assets and, therefore, probably does not have great significance. Vertical analysis also shows that total debt financing decreased from 78.0 per cent of total equities (liabilities and stockholders' equity) in 2009, to 74.3 per cent in 2010. At the same time, the percentage of stockholder financing to total assets of the company increased from 22.0 per cent to 25.7 per cent.

Synotech, Inc.

Comparative balance sheets

2010 December 31, and 2009

 December 31 Horizontal Analysis Increase or 2010 over (Decrease) 2009 Vertical Analysis Per cent of Total Assets (1) (2) (3) (4) (5) (6) Assets 2010 2009 Dollars* Per cent* 2010 2009 Current assets Cash and cash equivalents $298.0$ 250,5 $47.5 19.0% 3.1 % 2.7 % Marketable securities 71.3 57.5 13.8 24.0 0.8 0.6 Receivables, net 1,277.3 1,340.3 (63.0) (4.7) 13.5 14.6 Inventories 924.8 929.8 (5.0) (0.5) 9.8 10.1 Other current assets 275.3 254.3 21.0 8.3 2.9 2.8 Total current assets$2,846.7 $2,832.4$14.3 0.5 30.0 30.9 Property, plant and equipment, net 2,914.7 2,586.2 328.5 12.7 30.7 28.2 Goodwill and other intangibles, net 3,264.5 3,290.0 (25.5) (0.8) 34.4 35.9 Other assets 455.9 462.2 (6.3) (1.4) 4.8 5.0 Total assets Liabilities and shareholders' equity Current liabilities $9,481.8$9,170.8 $311.0 3.4 100.0 100.0 Notes and loans$ 206.8 payable $245.3$ (38.5) (15.7) 2.2 2.7 Current portion of long-term debt 132.5 44.4 88.1 198.4 1.4 0.5 Accounts payable 902.0 886.4 15.6 1.8 9.5 9.7 Accrued income taxes 111.7 92.1 19.6 21.3 1.2 1.0 Other accruals 932.2 835.6 96.6 11.6 9.8 9.1 Total current $2,285.2 liabilities$2,103.8 $181.4 8.6 24.1 22.9 Long-term debt 3,344.2 3,590.4 (246.2) (6.9) 35.3 39.2 Deferred income taxes 281.2 284.8 (3.6) (1.3) 3.0 3.1 Other liabilities 1,130.4 1,176.1 (45.7) (3.9) 11.9 12.8 Total liabilities$7,041.0 $7,155.1$(114.1) (1.6) 74.3 78.0 Shareholders' equity Preferred stock $471.2$ 484.2 $(13.0) (2.7) 5.0 5.3 Common stock, par value (500,000,000 shares authorized, 183,213,295 shares issued)$1.20 219.9 219.9 0.0 0.0 2.3 2.4 Additional paid-in capital 1,321.9 1,240.4 81.5 6.6 13.9 13.5 Retained earnings 3,277.1 2,870.6 406.5 14.2 34.6 31.3 Cumulative translation adjustments (641.6) (615.6) (26.0) 4.2 -6.8 -6.7 $4,648.5$4,199.5 $449.0 10.7 49.0 45.8 Unearned compensation (445.1) (453.6) 8.5 (1.9) -4.7 -4.9 Treasury stock, at cost (1,762.6) (1,30.2) (32.4) 1.9 -18.6 -18.9 Total shareholders' equity$2,440.8 $2,015.7$425.1 21.1 25.7 22.0 Total liabilities and stockholders equity $9,481.8$9,170.8 $311.0 3.4 100.0 100.0 *Dollars = (1) – (2); Per cent = (3)/(2) Exhibit 133: Comparative balance sheets Exhibit 134 provides the information needed to analyze Synotech's comparative statements of income and retained earnings. Such a statement merely combines the income statement and the statement of retained earnings. Columns (7) and (8) in Exhibit 134 show the dollar amounts for the years 2010 and 2009, respectively. Study these statements for a few minutes. Then examine Columns (9) and (10) which show the horizontal analysis that would be performed on the company's comparative statements of income and retained earnings. Columns (9) and (10) show the absolute and percentage increase or decrease in each item from 2009 to 2010. The absolute change is determined by deducting the 2009 amount from the 2010 amount. If the change between two dates is an increase from 2009 to 2010, the change is a positive figure. If the change is a decrease, the change is a negative figure and is shown in parentheses. You calculate the percentage change by dividing the dollar change by the dollar amount for 2009.  Horizontal analysis Vertical analysis Year ended (7) 2007 December 31 (8) 2006 Increase or 2010 over (9) Dollars* (decrease) 2009 (10) Per cent* Per cent sales (11) 2010 Net of (12) 2009 Net sales$10,498.8 $10,029.8$469.0 4.7% 100.0% 100.0% Cost of goods sold 5,341.3 5,233.7 117.6 2.3 50.9 52.1 Gross profit $5,157.5$4,806.1 $351.4 7.3 49.1 47.9 Selling, general and administrative expenses 3,662.5 3,455.5 207.0 6.0 34.9 34.5 Provision for restructured operations --- 552.6 (552.6) (100.0) 0.0 5.5 Other expense, net 112.6 115.3 (2.7) (2.3) 1.1 1.1 Interest expense, net of interest income of$41.2 and $36.7, respectively 236.9 246.5 (9.6) (3.9) 2.3 2.5 Income before income taxes$1,145.5 $436.2$709.3 162.6 10.9 4.3 Provision for income taxes 383.5 229.8 153.7 66.9 3.7 2.3 Net income $762.0$206.4 $555.6 269.2 7.3 2.1 Retained earnings, January 1 2,870.6 2,996.0 (125.4) (4.2) Total Dividends declared:$3,632.6 $3,202.4$430.2 13.4 Series B convertible preference stock, net of income taxes 25.1 25.3 (0.2) (0.8) Preferred stock 0.6 0.6 0.0 0.0 Common stock 329.8 305.9 23.9 7.8 Retained earnings, December 31 $3,277.1$2,870.6 $406.5 14.2 *Dollars = (7) – (8); Per cent = (9)/(8) Exhibit 134: Comparative statements of income and retained earnings Having completed the horizontal analysis and vertical analysis of Synotech's balance sheet and statement of income and retained earnings, you are ready to study trend percentages and ratio analysis. The last section in this chapter discusses some final considerations in financial statement analysis. Professional financial statement analysts use several tools and techniques to determine the solvency and profitability of companies. The horizontal analysis shows that sales increased a total of USD 469.0 million, an increase of 4.7 per cent. Since cost of goods sold increased by a much smaller amount (USD 117.6 million), gross profit increased by USD 351.4, or 7.3 per cent. The USD 552.6 million expense in 2009 was the result of a provision for restructured operations. Although this is not a recurring expense, it does not classify as an extraordinary expense and is treated as part of income from continuing operations. Now look at Columns (11) and (12) to see the vertical analysis that would be performed. Columns (11) and (12) express the dollar amount of each item in Columns (7) and (8) as a percentage of net sales. Even though cost of goods sold increased in 2010, it remained a fairly constant percentage of net sales. Therefore, gross profit as a percentage of net sales increased only slightly. The percentage of expenses to net sales decreased somewhat, thus yielding an increase in income before income taxes as a percentage of net sales. Trend percentages Trend percentages, also referred to as index numbers, help you to compare financial information over time to a base year or period. You can calculate trend percentages by: • Selecting a base year or period. • Assigning a weight of 100 per cent to the amounts appearing on the base-year financial statements. • Expressing the corresponding amounts on the other years' financial statements as a percentage of base-year or period amounts. Compute the percentages by dividing nonbase-year amounts by the corresponding baseyear amounts and then multiplying the result by 100. The following information for Synotech illustrates the calculation of trend percentages:  (USD millions) 2008 2009 2010 Net sales$9,105.5 $10,029.8$10,498.8 Cost of goods sold 4,696.0 5,223.7 5,341.3 Gross profit $4,409.5$4,806.1 $5,157.5 Operating expenses 3,353.6 4,369.9 4,012.0 Income before income taxes$1,055.9 $436.2$1,145.5

If 2008 is the base year, to calculate trend percentages for each year divide net sales by USD 9,105.5 million; cost of goods sold by USD 4,696.0 million; gross profit by USD 4,409.5 million; operating expenses by USD 3,353.6 million; and income before income taxes by USD 1,055.9 million. After all divisions have been made, multiply each result by 100. The resulting percentages reflect trends as follows:

 2008 2009 2010 Net sales 100.0% 119.2% 115.3% Cost of goods sold 100.0 111.2 113.7 Gross profit 100.0 109.0 117.0 Operating expenses 100.0 130.3 119.6 Income before income taxes 100.0 41.3 108.5

These trend percentages indicate the changes taking place in the organization and highlight the direction of these changes. For instance, the percentage of sales is increasing each year compared to the base year. Cost of goods sold increased at a lower rate than net sales in 2008 and 2010, causing gross profit to increase at a higher rate than net sales. Operating expenses in 2009 increased due to the provision for restructured operations, causing a significant decrease in income before income taxes. Percentages provide clues to an analyst about which items need further investigation or analysis. In reviewing trend percentages, a financial statement user should pay close attention to the trends in related items, such as the cost of goods sold in relation to sales. Trend analysis that shows a constantly declining gross margin (profit) rate may be a signal that future net income will decrease.

As useful as trend percentages are, they have one drawback. Expressing changes as percentages is usually straightforward as long as the amount in the base year or period is positive - that is, not zero or negative. Analysts cannot express a USD 30,000 increase in notes receivable as a percentage if the increase is from zero last year to USD 30,000 this year. Nor can they express an increase from a loss last year of USD 10,000 to income this year of USD 20,000 in percentage terms.

Proper analysis does not stop with the calculation of increases and decreases in amounts or percentages over several years. Such changes generally indicate areas worthy of further investigation and are merely clues that may lead to significant findings. Accurate predictions depend on many factors, including economic and political conditions; management's plans regarding new products, plant expansion, and promotional outlays; and the expected activities of competitors. Considering these factors along with horizontal analysis, vertical analysis, and trend analysis should provide a reasonable basis for predicting future performance.

Ratio analysis

Logical relationships exist between certain accounts or items in a company's financial statements. These accounts may appear on the same statement or on two different statements. We set up the dollar amounts of the related accounts or items in fraction form called ratios. These ratios include: (1) liquidity ratios; (2) equity, or longterm solvency, ratios; (3) profitability tests; and (4) market tests.

Liquidity ratios indicate a company's short-term debt-paying ability. Thus, these ratios show interested parties the company's capacity to meet maturing current liabilities.

Current (or working capital) ratio Working capital is the excess of current assets over current liabilities. The ratio that relates current assets to current liabilities is the current (or working capital) ratio. The current ratio indicates the ability of a company to pay its current liabilities from current assets and, thus, shows the strength of the company's working capital position.

You can compute the current ratio by dividing current assets by current liabilities:

$\text { Current ratio }=\dfrac{\text { Current assets }}{\text { Current liabilities }}$

The ratio is usually stated as a number of dollars of current assets to one dollar of current liabilities (although the dollar signs usually are omitted). Thus, for Synotech in 2010, when current assets totaled USD 2,846.7 million and current liabilities totaled USD 2,285.2 million, the ratio is 1.25:1, meaning that the company has USD 1.25 of current assets for each USD 1.00 of current liabilities.

The current ratio provides a better index of a company's ability to pay current debts than does the absolute amount of working capital. To illustrate, assume that we are comparing Synotech to Company B. For this example, use the following totals for current assets and current liabilities:

 Synotech Company B Current assets (a) $2,846.7$120.0 Current liabilities (b) 2,285.2 53.2 Working capital (a – b) $561.5$ 66.8 Current ratio (a/b) 1.25:1 2.26:1

Synotech has eight times as much working capital as Company B. However, Company B has a superior debtpaying ability since it has USD 2.26 of current assets for each USD 1.00 of current liabilities.

Short-term creditors are particularly interested in the current ratio since the conversion of inventories and accounts receivable into cash is the primary source from which the company obtains the cash to pay short-term creditors. Long-term creditors are also interested in the current ratio because a company that is unable to pay short-term debts may be forced into bankruptcy. For this reason, many bond indentures, or contracts, contain a provision requiring that the borrower maintain at least a certain minimum current ratio. A company can increase its current ratio by issuing long-term debt or capital stock or by selling noncurrent assets.

A company must guard against a current ratio that is too high, especially if caused by idle cash, slow-paying customers, and/or slow-moving inventory. Decreased net income can result when too much capital that could be used profitably elsewhere is tied up in current assets.

Refer to Exhibit 133. The Synotech data in Column (4) indicate that current liabilities are increasing more rapidly than current assets. We could also make such an observation directly by looking at the change in the current ratio. Synotech's current ratios for 2010 and 2009 follow:

 December 31 (USD millions) 2010 2009 Amount of increase Net sales (a) $10,498.8$10,029.8 $469.0 Net accounts receivable: January 1$ 1,340.3 $1,259.5$80.8 December 31 1,277.30 1,340.30 (63) Total (b) $2,617.6$ 2,599.8 $17.8 Synotech's working capital decreased by USD 167.1 million, or 22.9 per cent (USD 167.1/USD 728.6), and its current ratio decreased from 1.35:1 to 1.25:1. Together, these figures reflect that its current liabilities increased faster than its current assets. Acid-test (quick) ratio The current ratio is not the only measure of a company's short-term debt-paying ability. Another measure, called the acid-test (quick) ratio, is the ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities. Analysts exclude inventories and prepaid expenses from current assets to compute quick assets because they might not be readily convertible into cash. The formula for the acid-test ratio is: $\text { Acid }-\text { test ratio }=\dfrac{\text { Quick assets }}{\text { Current liabilities }}$ Short-term creditors are particularly interested in this ratio, which relates the pool of cash and immediate cash inflows to immediate cash outflows. The acid-test ratios for 2010 and 2009 for Synotech are:  December 31 (USD millions) 2010 2009 Amount of increase or (decrease) Quick assets (a)$1,646.6 $1,648.3$(1.7) Current liabilities (b) 2,285.6 2,103.8 181.8 Net quick assets (a – b) $(639.0)$(455.5) $(183.5) Acid-test ratio (a/b) .72:1 .78:1 In deciding whether the acid-test ratio is satisfactory, investors consider the quality of the marketable securities and receivables. An accumulation of poor-quality marketable securities or receivables, or both, could cause an acidtest ratio to appear deceptively favorable. When referring to marketable securities, poor quality means securities likely to generate losses when sold. Poor-quality receivables may be uncollectible or not collectible until long past due. The quality of receivables depends primarily on their age, which can be assessed by preparing an aging schedule or by calculating the accounts receivable turnover. (Covered in Chapter 9.) Cash flow liquidity ratio Another approach to measuring short-term liquidity is the cash flow liquidity ratio. The numerator, as an approximation of cash resources, consists of (1) cash and marketable securities, or liquid current assets, and (2) net cash provided by operating activities, or the cash generated from the company's operations. This reflects the company's ability to sell inventory and collect accounts receivable. The formula for the cash flow liquidity ratio is: $\dfrac{\text { Cash also marketable securities + Net cash provided by operating activities }} {\text{Current liabilities}}$ For 2010, Synotech has USD 298.0 million in cash and cash equivalents, USD 71.3 million in marketable securities, USD 2,285.2 million in current liabilities, and USD 1,101.0 million in cash provided by operating activities (taken from the statement of cash flows in its annual report). Its cash flow liquidity ratio is: $\dfrac{\text { USD } 298.0+\text { USD } 71.3+\text { USD } 1,101.0}{\text { USD } 2,285: 2}=.64 \text { time }$ This indicates that the company is going to have to rely on some other sources of funding to pay its current liabilities. The company's liquid current assets will only cover about two-thirds of the current liabilities. Possibly net cash provided by operations will be substantially higher in 2011. Accounts receivable turnover Turnover is the relationship between the amount of an asset and some measure of its use. Accounts receivable turnover is the number of times per year that the average amount of receivables is collected. To calculate this ratio, divide net credit sales (or net sales) by average net accounts receivable; that is, accounts receivable after deducting the allowance for uncollectible accounts: $\text { Accounts receivable turnover }=\dfrac{\text { Net credit sales }(\text { net sales })}{\text { Average net accounts receivable }}$ When a ratio compares an income statement item (like net credit sales) with a balance sheet item (like net accounts receivable), the balance sheet item should be an average. Ideally, analysts calculate average net accounts receivable by averaging the end-of-month balances or end-of-week balances of net accounts receivable outstanding during the period. The greater the number of observations used, the more accurate the resulting average. Often, analysts average only the beginning-of-year and end-of-year balances because this information is easily obtainable from comparative financial statements. Sometimes a formula calls for the use of an average balance, but only the year-end amount is available. Then the analyst must use the year-end amount. In theory, the numerator of the accounts receivable turnover ratio consists of only net credit sales because those are the only sales that generate accounts receivable. However, if cash sales are relatively small or their proportion to total sales remains fairly constant, analysts can obtain reliable results by using total net sales. In most cases, the analyst may have to use total net sales because the separate amounts of cash sales and credit sales are not reported on the income statement.  December 31 (USD millions) 2010 2009 Amount of increase Net sales (a)$10,498.8 $10,029.8$469.0 Net accounts receivable: January 1 $1,340.3$1,259.5 $80.8 December 31 1,277.30 1,340.30 (63) Total (b)$2,617.6 $2,599.8$17.8 Average net receivables (c) (b/2 = c) $1,308.8$1,299.9 Turnover of accounts receivable (a/c) 8.02 7.72

Synotech's accounts receivable turnover ratios for 2010 and 2009 follow. Net accounts receivable on 2009 January 1, totaled USD 1,259.5 million.

The accounts receivable turnover ratio provides an indication of how quickly the company collects receivables. The accounts receivable turnover ratio for 2010 indicates that Synotech collected, or turned over, its accounts receivable slightly more than eight times. The ratio is better understood and more easily compared with a company's credit terms if we convert it into a number of days, as is illustrated in the next ratio.

Number of days' sales in accounts receivable The number of days' sales in accounts receivable ratio is also called the average collection period for accounts receivable. Calculate it as follows:

$\text { Number of days' sales per accounts receivable }=\dfrac{\text { Number of days per year }(365)}{\text { Accounts receivable turnover }}$

The turnover ratios for Synotech show that the number of days' sales in accounts receivable decreased from about 47 days (365/7.72) in 2009 to 46 days (365/8.02) in 2010. The change means that the average collection period for the company's accounts receivable decreased from 47 to 46 days.

The number of days' sales in accounts receivable ratio measures the average liquidity of accounts receivable and indicates their quality. Generally, the shorter the collection period, the higher the quality of receivables. However, the average collection period varies by industry; for example, collection periods are short in utility companies and much longer in some retailing companies. A comparison of the average collection period with the credit terms extended customers by the company provides further insight into the quality of the accounts receivable. For example, receivables with terms of 2/10, n/30 and an average collection period of 75 days need to be investigated further. It is important to determine why customers are paying their accounts much later than expected.

Inventory turnover A company's inventory turnover ratio shows the number of times its average inventory is sold during a period. You can calculate inventory turnover as follows:

$\text { Inventory turnover }=\dfrac{\text { Cost of goods sold }}{\text { Average inventory }}$

When comparing an income statement item and a balance sheet item, measure both in comparable dollars. Notice that we measure the numerator and denominator in cost rather than sales dollars. (Earlier, when calculating accounts receivable turnover, we measured both numerator and denominator in sales dollars.) Inventory turnover relates a measure of sales volume to the average amount of goods on hand to produce this sales volume.

Synotech's inventory on 2009 January 1, was USD 856.7 million. The following schedule shows that the inventory turnover decreased slightly from 5.85 times per year in 2009 to 5.76 times per year in 2010. To convert these turnover ratios to the number of days it takes the company to sell its entire stock of inventory, divide 365 by the inventory turnover. Synotech's average inventory sold in about 63 and 62 (365/5.76 and 365/5.85) in 2010 and 2009, respectively.

 December 31 (USD millions) 2010 2009 Amount of increase or (decrease) Cost of goods sold (a) Merchandise inventory: $5,341.3$5,223.7 $117.6 January 1$929.8 $856.7$ 73.1 December 31 924.8 929.8 (5.0) Total (b) $1,854.6$1,786.5 $68.1 Average inventory (c) (b/2 = c)$927.3 $893.3 Turnover of inventory (a/c) 5.76 5.85 Other things being equal, a manager who maintains the highest inventory turnover ratio is the most efficient. Yet, other things are not always equal. For example, a company that achieves a high inventory turnover ratio by keeping extremely small inventories on hand may incur larger ordering costs, lose quantity discounts, and lose sales due to lack of adequate inventory. In attempting to earn satisfactory income, management must balance the costs of inventory storage and obsolescence and the cost of tying up funds in inventory against possible losses of sales and other costs associated with keeping too little inventory on hand. An accounting perspective:Business insight Cabletron Systems develops, manufactures, installs, and supports a wide range of standards-based LAN and WAN connectivity hardware and software products. For the year ended 2009 December 31, both its number of day's sales in accounts receivable and its inventory turnover rate increased as compared to the prior year. In its 2009 annual report, the company explained these increases as follows: Accounts receivable, net of allowance for doubtful accounts, were USD 210.9 million, or 66 days of sales outstanding, at 2009 December 31 compared to USD 228.4 million at 2008 December 31, or 54 days sales outstanding. The increase in days of sales outstanding was a result of the timing of sales and related collections. Worldwide inventories were USD 98.1 million at 2009 December 31 or 63 days of inventory, compared to USD 85.0 million, or 37 days of inventory, at 2008 December 31. The increase of days in inventory was due to the increase in finished goods inventory purchased to protect against an anticipated shortage of supply components. Total assets turnover Total assets turnover shows the relationship between the dollar volume of sales and the average total assets used in the business. We calculate it as follows: $\text { Total assets turnover }=\dfrac{\text { Net sales }}{\text { Average total assets }}$ This ratio measures the efficiency with which a company uses its assets to generate sales. The larger the total assets turnover, the larger the income on each dollar invested in the assets of the business. For Synotech, the total asset turnover ratios for 2010 and 2009 follow. Total assets as of 2009 January 1, were USD 7,370.9 million.  (USD millions) 2010 2009 Amount of increase Net sales (a) Total assets:$10,498.8 $10,029.8$469.0 January 1 $9,170.8$7,370.9 $1,799.9 December 31 9,481.8 9,170.8 311.0 Total (b)$18,652.6 $16,541.7$2,110.9 Average total assets (c) (b/2 = c) $9,331.8$8,270.9 Turnover of total assets (a/c) 1.13:1 1.21:1

Each dollar of total assets produced USD 1.21 of sales in 2009 and USD 1.13 of sales in 2010. In other words, between 2009 and 2010, the company had a decrease of USD .08 of sales per dollar of investment in assets.

Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a company.

Equity (stockholders' equity) ratio The two basic sources of assets in a business are owners (stockholders) and creditors; the combined interests of the two groups are total equities. In ratio analysis, however, the term equity generally refers only to stockholders' equity. Thus, the equity (stockholders' equity) ratio indicates the proportion of total assets (or total equities) provided by stockholders (owners) on any given date. The formula for the equity ratio is:

$\text { Equity ratio }=\dfrac{\text { Stockholders' equity }}{\text { Total assets ( total equities })}$

Synotech's liabilities and stockholders' equity from Exhibit 133 follow. The company's equity ratio increased from 22.0 per cent in 2009 to 25.7 per cent in 2010. Exhibit 133 shows that stockholders increased their proportionate equity in the company's assets due largely to the retention of earnings (which increases retained earnings).

 2010 2009 December 31 December 31 (USD millions) Amount Per cent Amount Per cent Current liabilities $2,285.2 24.1%$2,103.8 22.9% Long-term liabilities 4,755.8 50.2 5,051.3 55.1 Total liabilities $7,041.0 74.3$7,155.1 78.0 Total stockholders' equity 2,440.8 25.7 2,015.7 22.0 Total equity (equal to total assets) $9,481.8 100%$9,170.8 100.0%

The equity ratio must be interpreted carefully. From a creditor's point of view, a high proportion of stockholders' equity is desirable. A high equity ratio indicates the existence of a large protective buffer for creditors in the event a company suffers a loss. However, from an owner's point of view, a high proportion of stockholders' equity may or may not be desirable. If the business can use borrowed funds to generate income in excess of the net after-tax cost of the interest on such funds, a lower percentage of stockholders' equity may be desirable.

To illustrate the effect of higher leveraging (i.e. a larger proportion of debt), assume that Synotech could have financed an increase in its productive capacity with USD 40 million of 6 per cent bonds instead of issuing 5 million additional shares of common stock. The effect on income for 2010 would be as follows, assuming a federal income tax rate of 40 per cent:

 Net income as presently stated (Exhibit 134) $762,000,000 Deduct additional interest on debt (0.06 x$40 million) 2,400,000 $759,600,000 Add reduced taxes due to interest deduction (.4 x 2,400,000) 960,000 Adjusted net income$760,560,000

As shown, increasing leverage by issuing bonds instead of common stock reduces net income. However, there are also fewer shares of common stock outstanding. Assume the company has 183 million shares of common stock outstanding. Earnings per share (EPS) with the additional debt would be USD 4.16 (or USD 760,560,000/183 million shares), and EPS with the additional stock would be USD 4.05 (or USD 762,000,000/188 million shares).

Since investors place heavy emphasis on EPS amounts, many companies in recent years have introduced large portions of debt into their capital structures to increase EPS, especially since interest rates have been relatively low in recent years.

We should point out, however, that too low a percentage of stockholders' equity (too much debt) has its dangers. Financial leverage magnifies losses per share as well as EPS since there are fewer shares of stock over which to spread the losses. A period of business recession may result in operating losses and shrinkage in the value of assets, such as receivables and inventory, which in turn may lead to an inability to meet fixed payments for interest and principal on the debt. As a result, the company may be forced into liquidation, and the stockholders could lose their entire investments.

Stockholders' equity to debt (debt to equity) ratio Analysts express the relative equities of owners and creditors in several ways. To say that creditors held a 74.3 per cent interest in the assets of Synotech on 2010 December 31, is equivalent to saying stockholders held a 25.7 per cent interest. Another way of expressing this relationship is the stockholders' equity to debt ratio:

$\text { Stockholders' equity for debt ratio }=\dfrac{\text { Stockholders 'equity }}{\text { Total debt }}$

Such a ratio for Synotech would be .28:1 (or USD 2,015.7 million/USD 7,155.1 million) on 2009 December 31, and .35:1 (or USD 2,440.8 million/USD 7,041.0 million) on 2010 December 31. This ratio is often inverted and called the debt to equity ratio. Some analysts use only long-term debt rather than total debt in calculating these ratios. These analysts do not consider short-term debt to be part of the capital structure since it is paid within one year.

Profitability is an important measure of a company's operating success. Generally, we are concerned with two areas when judging profitability: (1) relationships on the income statement that indicate a company's ability to recover costs and expenses, and (2) relationships of income to various balance sheet measures that indicate the company's relative ability to earn income on assets employed. Each of the following ratios utilizes one of these relationships.

Rate of return on operating assets The best measure of earnings performance without regard to the sources of assets is the relationship of net operating income to operating assets, the rate of return on operating assets. This ratio shows the earning power of the company as a bundle of assets. By disregarding both nonoperating assets and nonoperating income elements, the rate of return on operating assets measures the profitability of the company in carrying out its primary business functions. We can break the ratio down into two elements—the operating margin and the turnover of operating assets.

Operating margin reflects the percentage of each dollar of net sales that becomes net operating income. Net operating income excludes nonoperating income elements such as extraordinary items, cumulative effect on prior years of changes in accounting principle, losses or gains from discontinued operations, interest revenue, and interest expense. Another name for net operating income is "income before interest and taxes" (IBIT). The formula for operating margin is:

$\text { Operating margin }=\dfrac{\text { Net operatingincome }}{\text { Net sales }}$

Turnover of operating assets shows the amount of sales dollars generated for each dollar invested in operating assets. Operating assets are all assets actively used in producing operating revenues. Typically, we use year-end operating assets, even though in theory an average would be better. Nonoperating assets are owned by a company but not used in producing operating revenues, such as land held for future use, a factory building rented to another company, and long-term bond investments. Analysts do not use these nonoperating assets in evaluating earnings performance. Nor do they use total assets that include nonoperating assets not contributing to the generation of sales. The formula for the turnover of operating assets is:

$\text { Turnover of operating assets }=\dfrac{\text { Net sales }}{\text { Operating assets }}$

The rate of return on operating assets of a company is equal to its operating margin multiplied by turnover of operating assets. The more a company earns per dollar of sales and the more sales it makes per dollar invested in operating assets, the higher is the return per dollar invested. To find the rate of return on operating assets, use the following formulas:

$\text { Operating margin } \times \text { Turnover of operating assets }=\text { Rate of return on operating assets }$

or

$\text { Rate of return on operating assets }=\dfrac{\text { Net operating income }}{\text { Net sales }} \times \dfrac{\text { Net sales }}{\text { Operating assets }}$

Because net sales appears in both ratios (once as a numerator and once as a denominator), we can cancel it out, and the formula for rate of return on operating assets becomes:

$\text { Rate of return on operating assets }=\dfrac{\text { Net operating income }}{\text { Operating assets }}$

For analytical purposes, the formula should remain in the form that shows margin and turnover separately, since it provides more information.

The rates of return on operating assets for Synotech for 2010 and 2009 are:

 (USD millions) 2010 2009 Amount of increase or (decrease) Net operating income (a)* $1,382.4$682.7 $699.7 Net sales (b)$10,498.8 $10,029.8$469.0 Operating assets (c)  † $9,481.8$9,170.8 $311.0 Operating margin (a/b) 13.17% 6.81% Turnover of operating assets (b/c) 1.11 times 1.09 times Rate of return on operating assets (a/c) 14.58% 7.44% *Calculated as income before income taxes plus net interest expense. This method excludes nonoperating items. †When companies have no nonoperating assets, total assets are used in the calculation Net income to net sales (return on sales) ratio Another measure of a company's profitability is the net income to net sales ratio, calculated as follows: $\text { Net income by net sales }=\dfrac{\text { Net income }}{\text { Net sales }}$ This ratio measures the proportion of the sales dollar that remains after deducting all expenses. The computations for Synotech for 2010 and 2009 are: An accounting perspective:Business insight Companies that are to survive in the economy must attain some minimum rate of return on operating assets. However, they can attain this minimum rate of return in many different ways. To illustrate, consider a grocery store and a jewelry store, each with a rate of return of 8 per cent on operating assets. The grocery store normally would attain this rate of return with a low margin and a high turnover, while the jewelry store would have a high margin and a low turnover, as shown here:  Margin x Turnover = Rate of return on operating assets Grocery store 1% x 8.0 times = 8% Jewelry store 20 x 0.4 = 8  (USD millions) 2010 2009 Amount of increase or (decrease) Net income (a)$ 762.0 $206.4$555.6 Net sales (b) $10,498.$10,029. $469.0 8 8 Ratio of net income to net sales (a/b) 7.26% 2.06% Although the ratio of net income to net sales indicates that the net amount of profit increased on each sales dollar, exercise care in using and interpreting this ratio. The net income includes all nonoperating items that may occur only in a particular period; therefore, net income includes the effects of such things as extraordinary items, changes in accounting principle, effects of discontinued operations, and interest charges. Thus, a period that contains the effects of an extraordinary item is not comparable to a period that contains no extraordinary items. Also, since interest expense is deductible in the determination of net income while dividends are not, the methods used to finance a company's assets affect net income. Return on average common stockholders' equity From the stockholders' point of view, an important measure of the income-producing ability of a company is the relationship of return on average common stockholders' equity, also called rate of return on average common stockholders' equity, or simply the return on equity (ROE). Although stockholders are interested in the ratio of operating income to operating assets as a measure of management's efficient use of assets, they are even more interested in the return the company earns on each dollar of stockholders' equity. The formula for return on average common stockholders' equity if no preferred stock is outstanding is: $\text { Return on average common stockholders' equity }=\dfrac{\text { Net income }}{\text { Average common stockholders'equity }}$ When a company has preferred stock outstanding, the numerator of this ratio becomes net income minus the annual preferred dividends, and the denominator becomes the average book value of common stock. As described in Chapter 12, the book value of common stock is equal to total stockholders' equity minus (1) the liquidation value (usually equal to par value) of preferred stock and (2) any dividends in arrears on cumulative preferred stock. Thus, the formula becomes: $\text { Return on average common stockholders' equity }=\dfrac{\text { (Net income }-\text { Preferred stock dividends) }}{\text { Average book value of commonstock }}$ Synotech has preferred stock outstanding. The ratios for the company follow. Total common stockholders' equity on 2009 January 1, was USD 1,697.4 million. Preferred dividends were USD 25.7 million in 2010 and USD 25.9 million in 2009.  (USD millions) 2010 2009 Amount of increase or (decrease) Net income – Preferred stock dividends$ 736.3 $180.5$ 555.8 (a) Total common stockholders' equity (book value of common stock):* January 1 $1,531.5$1,697.4 $(165.9) December 31 1,969.6 1,531.5 438.1 Total (b)$3,501.1 $3,228.9$272.2 Average common stockholders' equity (c) (b/2 = c): $1,750.6$1,614.5 Return on common stockholders' equity (a/c) 42.06% 11.18% *Total stockholders' equity – par value of preferred stock

The stockholders would regard the increase in the ratio from 11.18 per cent to 42.06 per cent favorably. This ratio indicates that for each dollar of capital invested by a common stockholder, the company earned approximately 42 cents in 2010.

 Company 1 Company 2 Return on assets 12.0% 12.0% Return on stockholders' equity 6.4 8.0

Sometimes, two companies have the same return on assets but have different returns on stockholders' equity, as shown here:

The difference of 1.6 per cent in Company 2's favor is the result of Company 2's use of borrowed funds, particularly long-term debt, in its capital structure. Use of these funds (or preferred stock with a fixed return) is called trading on the equity. When a company is trading profitably on the equity, it is generating a higher rate of return on its borrowed funds than it is paying for the use of the funds. The excess, in this case 1.6 per cent, is accruing to the benefit of the common stockholders, because their earnings are being increased.

Companies that magnify the gains from this activity for the stockholders are using leverage. Using leverage is a risky process because losses also can be magnified, to the disadvantage of the common stockholders. We discussed trading on the equity and leverage in Chapter 15.

Cash flow margin The cash flow margin measures a company's overall efficiency and performance. The cash flow margin indicates the ability of a company to translate sales into cash. Measuring the amount of cash a company generates from every dollar of sales is important because a company needs cash to service debt, pay dividends, and invest in new capital assets. The formula for the cash flow margin is:

$\text { Cash flow margin }=\dfrac{\text { Net cash provided by operating activities }}{\text { Net sales }}$

Thus, we calculate Synotech's 2010 cash flow margin as follows:

$\dfrac{\text { USD 1,101.0 million net cash provided by operating activities }}{\text { USD } 10,498.8 \text { million net sales }}=10.49 \text { per cent }$

Earnings per share of common stock Probably the measure used most widely to appraise a company's operations is earnings per share (EPS) of common stock. EPS is equal to earnings available to common stockholders divided by the weighted average number of shares of common stock outstanding. The financial press regularly publishes actual and forecasted EPS amounts for publicly traded corporations, together with period-toperiod comparisons. The Accounting Principles Board noted the significance attached to EPS by requiring that such amounts be reported on the face of the income statement.52 (Chapter 13 illustrates how earnings per share should be presented on the income statement.)

The calculation of EPS may be fairly simple or highly complex depending on a corporation's capital structure. A company has a simple capital structure if it has no outstanding securities (e.g. convertible bonds, convertible preferred stocks, warrants, or options) that can be exchanged for common stock. If a company has such securities outstanding, it has a complex capital structure. Discussion of EPS for a corporation with a complex capital structure is beyond the scope of this text.

A company with a simple capital structure reports a single basic EPS amount, which is calculated as follows:

$\text { EPS of common stock }=\dfrac{\text { Earnings available for common stockholders }}{\text { Weighted }-\text { average number of common shares outstanding }}$

The amount of earnings available to common stockholders is equal to net income minus the current year's preferred dividends, whether such dividends have been declared or not.

Determining the weighted-average number of common shares The denominator in the EPS fraction is the weighted-average number of common shares outstanding for the period. If the number of common shares outstanding did not change during the period, the weighted-average number of common shares outstanding would, of course, be the number of common shares outstanding at the end of the period. The balance in the Common Stock account of Synotech (Exhibit 133) was USD 219.9 million on 2010 December 31. The common stock had a USD 1.20 par value. Assuming no common shares were issued or redeemed during 2010, the weighted-average number of common shares outstanding would be 183.2 million (or USD 219.9 million/USD 1.20 per share). (Normally, common treasury stock reacquired and reissued are also included in the calculation of the weighted-average number of common shares outstanding. We ignore treasury stock transactions to simplify the illustrations.)

If the number of common shares changed during the period, such a change increases or decreases the capital invested in the company and should affect earnings available to stockholders. To compute the weighted-average number of common shares outstanding, we weight the change in the number of common shares by the portion of the year that those shares were outstanding. Shares are outstanding only during those periods that the related capital investment is available to produce income.

To illustrate, assume that during 2009 Synotech's common stock balance increased by USD 14.0 million (11.7 million shares). Assume that the company issued 9.5 million of these shares on 2009 April 1, and the other 2.2 million shares on 2009 October 1. The computation of the weighted-average number of common shares outstanding would be:

 171.5 million shares x 1 year 171.500 million 9.5 million shares x ¾ year (April – December) 7.125 million 2.2 million shares x ¼ year (October – December) 0.55 Weighted-average number of common shares outstanding 179.125 million

An alternate method looks at the total number of common shares outstanding, weighted by the portion of the year that the number of shares was outstanding, as follows:

 171.5 million shares x ¼ year (January – March) 42.875 million 181.0 million shares x ½ year (April – September) 90.500 million 183.2 million shares x 1/3 year (October – December) 45.800 million Weighted-average number of shares outstanding 179.175 million

Another alternate method is:

 171.5 million shares x 3 months =   514.5 million share-months 181.0 million shares x 6 months =   1,086.0 million share-months 183.2 million shares x 3 months =   549.6 million share-months 12 months     2,150.1 million share-months 2,150.1 million share-months/12 months = 179.175 million

Note that all three methods yield the same result. In 2010, the balance in the common stock account did not change as it had during 2009. Therefore, the weighted-average number of common shares outstanding during 2010 is equal to the number of common shares issued, 183.2 million. The EPS of common stock for the Synotech are:

 (USD millions) 2010 2009 Amount of increase or (decrease) Net income-preferred dividends (a) USD 736.3 USD 180.50 USD 555.80 Average number of shares of common stock (b) 183.2 179.13 4.03 EPS of common stock (a,b) USD 4.02 USD 1.01

Synotech's stockholders would probably view the increase of approximately 298.0 per cent ([USD 4.02 - USD 1.01]/USD 1.01) in EPS from USD 1.01 to USD 4.02 favorably.

EPS and stock dividends or splits Increases in shares outstanding as a result of a stock dividend or stock split do not require weighting for fractional periods. Such shares do not increase the capital invested in the business and, therefore, do not affect income. All that is required is to restate all prior calculations of EPS using the increased number of shares. For example, assume a company reported EPS for 2010 as USD 1.20 (or USD 120,000/100,000 shares) and earned USD 180,000 in 2011. The only change in common stock over the two years was a two-for-one stock split on 2011 December 1, which doubled the shares outstanding to 200,000. The firm would restate EPS for 2010 as USD 0.60 (or USD 120,000/200,000 shares) and as USD 0.90 (USD 180,000/200,000 shares) for 2011.

Basic EPS and diluted EPS In the merger wave of the 1960s, corporations often issued securities to finance their acquisitions of other companies. Many of the securities issued were calls on common or possessed equity kickers. These terms mean that the securities were convertible to, or exchangeable for, shares of their issuers' common stock. As a result, many complex problems arose in computing EPS. Until 1997, APB Opinion No. 15 provided guidelines for solving these problems. In 1997, FASB Statement No. 128, "Earnings per Share" replaced APB Opinion No. 15. A company with a complex capital structure must present at least two EPS calculations, basic EPS and diluted EPS. Because of the complexities involved in the calculations, we reserve further discussion of these two EPS calculations for an intermediate accounting text.

Times interest earned ratio Creditors, especially long-term creditors, want to know whether a borrower can meet its required interest payments when these payments come due. The times interest earned ratio, or interest coverage ratio, is an indication of such an ability. It is computed as follows:

$\text { Time interest earned ratio }=\dfrac{\text { Income beforeinterest including taxes }(\text { IBIT })}{\text { Interest expense }}$

The ratio is a rough comparison of cash inflows from operations with cash outflows for interest expense. Income before interest and taxes (IBIT) is the numerator because there would be no income taxes if interest expense is equal to or greater than IBIT. (To find income before interest and taxes, take net income from continuing operations and add back the net interest expense and taxes.) Analysts disagree on whether the denominator should be (1) only interest expense on long-term debt, (2) total interest expense, or (3) net interest expense. We will use net interest expense in the Synotech illustration.

For Synotech, the net interest expense is USD 236.9 million. With an IBIT of USD 1,382.4 million, the times interest earned ratio is 5.84, calculated as:

$\dfrac{ USD 1,382.4}{ USD 236.9}=5.84 \text { time }$

The company earned enough during the period to pay its interest expense almost 6 times over.

Low or negative interest coverage ratios suggest that the borrower could default on required interest payments. A company is not likely to continue interest payments over many periods if it fails to earn enough income to cover them. On the other hand, interest coverage of 5 to 10 times or more suggests that the company is not likely to default on interest payments.

Times preferred dividends earned ratio Preferred stockholders, like bondholders, must usually be satisfied with a fixed-dollar return on their investments. They are interested in the company's ability to make preferred dividend payments each year. We can measure this ability by computing the times preferred dividends earned ratio as follows:

$\text { Time preferred dividends earned ratio }=\dfrac{\text { Net income }}{\text { Annual preferred dividends }}$

Synotech has a net income of USD 762.0 million and preferred dividends of USD 25.7 million. The number of times the annual preferred dividends are earned for 2010 is:

$\dfrac{\operatorname{USD} 762.0}{\operatorname{USD} 25.7}=29.65: 1 \quad, \text { or } 29.65 \text { times }$

The higher this rate, the higher is the probability that the preferred stockholders will receive their dividends each year.

Analysts compute certain ratios using information from the financial statements and information about the market price of the company's stock. These tests help investors and potential investors assess the relative merits of the various stocks in the marketplace.

The yield on a stock investment refers to either an earnings yield or a dividends yield.

Earnings yield on common stock You can calculate a company's earnings yield on common stock as follows:

$\text{Earnings yield on common stock} = \dfrac{\text{EPS}}{\text{Current market price per share of common stock}}$

Assume Synotech has common stock with an EPS of USD 5.03 and that the quoted market price of the stock on the New York Stock Exchange is USD 110.70. The earnings yield on common stock would be:

$\dfrac{ USD 5.03}{ USD 110.7}=4.54 \text { per cent }$

Price-earnings ratio When inverted, the earnings yield on common stock is the price-earnings ratio. To compute the price-earnings ratio:

$\text { Price }-\text { earnings ratio }=\dfrac{\text { Current market price per share of commonstock }}{\text { EPS }}$

$\dfrac{\text{USD} 110.7}{\text{USD 5.03}}=22.01: 1$

Investors would say that this stock is selling at 22 times earnings, or at a multiple of 22. These investors might have a specific multiple in mind that indicates whether the stock is underpriced or overpriced. Different investors have different estimates of the proper price-earnings ratio for a given stock and also different estimates of the future earnings prospects of the company. These different estimates may cause one investor to sell stock at a particular price and another investor to buy at that price.

Payout ratio on common stock Using dividend yield, investors can compute the payout ratio on common stock. Assume that Synotech's dividends per share were USD 1.80 and earnings per share were USD 5.03. To calculate payout ratio on common stock, divide the dividend per share of common stock by EPS. The payout ratio of stock in 2010 is:

$\text{Payout ratio on common stock} =\dfrac{\text { Dividend per share of common stock }}{\text { EPS }}$

$\dfrac{\operatorname{USD} 1.80}{\operatorname{USD} 5.03}=\text{35.8 per cent}$

A payout ratio of 35.8 per cent means that the company paid out 35.8 per cent of its earnings in the form of dividends. Some investors are attracted by the stock of companies that pay out a large percentage of their earnings. Other investors are attracted by the stock of companies that retain and reinvest a large percentage of their earnings. The tax status of the investor has a great deal to do with this preference. Investors in high tax brackets often prefer to have the company reinvest the earnings with the expectation that this reinvestment results in share price appreciation.

Dividend yield on common stock The dividend paid per share of common stock is also of much interest to common stockholders. When the current annual dividend per share of common stock is divided by the current market price per share of common stock, the result is called the dividend yield on common stock. Synotech's 2010 December 31, common stock price was USD 110.70 per share. Its dividends per share were USD 1.80. The company's dividend yield on common stock was:

$\text { Dividend yield on of common stock }=\dfrac{\text { Dividend per share of common stock }}{\text { Current market price per share of commonstock }}$

$\dfrac{\text{USD 1.80}}{\text{USD 110.7}}=1.63 \text { per cent }$

Dividend yield on preferred stock Preferred stockholders, as well as common stockholders, are interested in dividend yields. The computation of the dividend yield on preferred stock is similar to the common stock dividend yield computation. Assume that Synotech's dividend per share of preferred stock is USD 5.10 with a current market price of USD 84.00 per share. We compute the dividend yield on preferred stock as follows:

$\text { Dividend yield on preferred stock }=\dfrac{\text { Dividend per share of preferredstock }}{\text { Current market price per share of preferred stock }}$

$\dfrac{ \text{USD 5.10}}{\text{USD 84.00}}=6.07 \text { per cent }$

Through the use of dividend yield rates, we can compare different preferred stocks having different annual dividends and different market prices.

Cash flow per share of common stock Investors calculate the cash flow per share of common stock ratio as follows:

$\text { Cash flow per share of common stock }=\dfrac{\text { Net cash provided by operating activities }}{\text { Average number of shares of common stock outstanding }}$

Currently, FASB Statement No. 95 does not permit the use of this ratio for external reporting purposes. However, some mortgage and investment banking firms do use this ratio to judge the company's ability to pay dividends and pay liabilities. The cash flow per share of common stock ratio for Synotech is as follows:

 Fiscal Year 2010 2009 Cash provided by operating activities (a) $1,101.0$972.3 Average shares outstanding (b) (assumed) 146.6 145.2 Cash flow per share of common stock (a)/(b) $7.51$6.70

Final considerations in financial statement analysis

Standing alone, a single financial ratio may not be informative. Investors gain greater insight by computing and analyzing several related ratios for a company. Exhibit 135 summarizes the ratios presented in this chapter, and Exhibit 136 presents them graphically.

Financial analysis relies heavily on informed judgment. As guides to aid comparison, percentages and ratios are useful in uncovering potential strengths and weaknesses. However, the financial analyst should seek the basic causes behind changes and established trends.

An accounting perspective:Uses of technology

Most companies calculate some of the ratios we have discussed, if not all of them. To efficiently and effectively perform these calculations, accountants use computers. Some programs that gather information in the preparation of financial statements calculate the ratios at the end of a period. Accountants also create spreadsheets to perform this task. Remember, to interpret the numbers correctly, investors and management must compare these ratios with the industry in which the company operates.

 Liquidity ratios Formula Significance Current, or working capital, ratio Current assets + Current liabilities Test of debt-paying ability Acid-test (quick) ratio Quick assets (cash + marketable securities + net receivables) + Current liabilities Test of immediate debt-paying ability Cash flow liquidity ratio (Cash and marketable securities + Net cash provided by operating activities) + Current liabilities Test of short-term, debt-paying ability Accounts receivable turnover Net credit sales (or net sales) + Average net accounts receivable Test of quality of accounts receivable Number of days' sales in accounts accounts receivable) Number of days in year (365) + Accounts receivable (average collection period of receivable turnover Test of quality of accounts receivable Inventory turnover Cost of goods sold + Average inventory Test of whether or not a sufficient volume of business is being generated relative to inventory Total assets turnover Net sales + Average total assets Test of whether or not the volume of business generated is adequate relative to amount of capital invested in the business Equity, or Long-term Solvency, Ratios Equity (stockholders' equity) ratio Stockholders' equity + Total assets (or total equities) Index of long-run solvency and safety Stockholders' equity to debt (debt to equity) ratio Stockholders' equity + Total debt Measure of the relative proportion of stockholders' and of creditors' equities Profitability Tests Rate of return on operating assets Net operating income + Operating assets or Operating margin x Turnover operating assets Measure of managerial Net income to net sales (return on sales) Net income + Net sales Indicator of the amount of net profit on each dollar of sales Return on average common stockholders' equity Net income + Average common stockholders' equity Measure of what a given company earned for its stockholders from all sources as a percentage of common stockholders' investment Cash flow margin Net cash provided by operating activities + Net Measure of the ability of a firm to sales translate sales into cash EPS of common stock Earnings available to common stockholders' +  Weighted-average number of common shares outstanding Measure of the return to investors Times interest earned ratio Income before interest and taxes + Interest Test of the likelihood that expense creditors will continue to receive their interest payments Time preferred dividends earned ratio Net income + Annual preferred dividends Test of the likelihood that preferred stockholders will receive their dividend each year Market Tests Earnings yield on common stock EPS + Current market price per share of common stock Comparison with other common stocks Price-earnings ratio Current market price per share of common stock + EPS Index of whether a stock is relatively cheap or expensive based on the ratio Pay cut ratio on common stock Dividend per share of common stock + EPS Index of whether company pays out a large percentage of earnings as dividends or reinvests most of its earnings Dividend yield on common stock Dividend per share of common stock + Current market price per share of common stock Comparisons with other common stocks Dividend yield on preferred stock Dividend per share of preferred stock + Current market price per share of preferred stock Comparison with other preferred stocks Cash flow per share of common stock Net cash provided by operating activities +   Average number of share of common stock   outstanding Test of ability to pay dividends and liabilities

Exhibit 135: Summary of ratios

Analysts must be sure that their comparisons are valid - especially when the comparisons are of items for different periods or different companies. They must follow consistent accounting practices if valid interperiod comparisons are to be made. Comparable intercompany comparisons are more difficult to secure. Accountants cannot do much more than disclose the fact that one company is using FIFO and another is using LIFO for inventory and cost of goods sold computations. Such a disclosure alerts analysts that intercompany comparisons of inventory turnover ratios, for example, may not be comparable.

Also, when comparing a company's ratios to industry averages provided by an external source such as Dun &

Bradstreet, the analyst should calculate the company's ratios in the same manner as the reporting service. Thus, if Dun & Bradstreet uses net sales (rather than cost of goods sold) to compute inventory turnover, so should the analyst. Net sales is sometimes preferable because all companies do not compute and report cost of goods sold amounts in the same manner.

Facts and conditions not disclosed by the financial statements may, however, affect their interpretation. A single important event may have been largely responsible for a given relationship. For example, competitors may put a new product on the market, making it necessary for the company under study to reduce the selling price of a product suddenly rendered obsolete. Such an event would severely affect the percentage of gross margin to net sales. Yet there may be little chance that such an event will happen again.

Analysts must consider general business conditions within the industry of the company under study. A corporation's downward trend in earnings, for example, is less alarming if the industry trend or the general economic trend is also downward.

Investors also need to consider the seasonal nature of some businesses. If the balance sheet date represents the seasonal peak in the volume of business, for example, the ratio of current assets to current liabilities may be much lower than if the balance sheet date is in a season of low activity.

Potential investors should consider the market risk associated with the prospective investment. They can determine market risk by comparing the changes in the price of a stock in relation to the changes in the average price of all stocks.

Potential investors should realize that acquiring the ability to make informed judgments is a long process and does not occur overnight. Using ratios and percentages without considering the underlying causes may lead to incorrect conclusions.

Relationships between financial statement items also become more meaningful when standards are available for comparison. Comparisons with standards provide a starting point for the analyst's thinking and lead to further investigation and, ultimately, to conclusions and business decisions. Such standards consist of (1) those in the analyst's own mind as a result of experience and observations, (2) those provided by the records of past performance and financial position of the business under study, and (3) those provided about other enterprises. Examples of the third standard are data available through trade associations, universities, research organizations (such as Dun & Bradstreet and Robert Morris Associates), and governmental units (such as the Federal Trade Commission).

In financial statement analysis, remember that standards for comparison vary by industry, and financial analysis must be carried out with knowledge of specific industry characteristics. For example, a wholesale grocery company would have large inventories available to be shipped to retailers and a relatively small investment in property, plant, and equipment, while an electric utility company would have no merchandise inventory (except for repair parts) and a large investment in property, plant, and equipment.

Even within an industry, variations may exist. Acceptable current ratios, gross margin percentages, debt to equity ratios, and other relationships vary widely depending on unique conditions within an industry. Therefore, it is important to know the industry to make comparisons that have real meaning.

Exhibit 136: Graphic depiction of financial statement analysis utilizing financial rations

The bankruptcies of companies like General Motors and Lehman Brothers, with the resulting significant losses to employees, stockholders, and other members of the general public, have caused important changes in corporate governance, standards of accounting, and auditing procedures and standards. These changes have come about as a result of self-regulation, oversight by the Public Company Accounting Oversight Board, regulation by the Securities and Exchange Commission, regulation by the stock exchanges, and legislation passed by Congress, and by some combination of these actions. Further changes are likely.

Financial statements are likely to become more "transparent". This means they will reveal more clearly the results of operations and the financial condition of the company. There is likely to be an increased focus on the balance sheet and on the quality and measurement of assets and the extent and nature of liabilities as well as on a proper identification of other risks. The quality of earnings will continue to be of paramount importance. There have been too many situations where companies have had to restate their earnings for prior years because they did not properly disclose material facts or properly implement the revenue recognition and/or expense recognition principles that were covered in Chapter 5.

The Enron situation was the focus of a massive investigation that led to significant changes in corporate governance, accounting rules, and auditing procedures. Enron was formed in 1985 and became a major player in the energy industry. Its stock reached a high of about USD 90 per share in August 2000. Top executives began selling stock shortly thereafter, while at least for a short period during the ensuing fall in the stock's price, employees were prevented from doing so. In October of 2001, the disclosure of off-balance sheet partnerships, with attendant liabilities for Enron, resulted in a USD 1.2 billion write-off in stockholder's equity. In November of 2001, Enron revealed that it had overstated earnings by USD 586 million since 1997. In December 2001, Enron filed for bankruptcy. Enron stock became almost worthless, selling for under USD 1. Employees of Enron not only lost their jobs, but many also lost their retirement savings because they consisted largely of Enron stock. Individual and pension fund investors as a group lost billions of dollars. The state of Florida's pension fund lost about USD 340 million. Enron's external auditor, Arthur Andersen & Co., was accused of shredding documents pertaining to Enron after the US Justice Department confirmed its investigation and was indicated in March of 2002 for that action.

External auditors, internal auditors, audit committee members, and members of Boards of Directors are likely to ask much tougher questions of management. They are also more likely to investigate questionable transactions.

Audit committees may be required to publicly disclose their activities that were performed to carry out their duties.

Management's letter to the stockholders contained in the annual report, and usually signed by the CEO, contains the views of management regarding current operations, operating results, and plans for the future. This letter is likely to become even more important in the future than it is now. There could be financial penalties if this letter is purposely misleading in that its contents are not supported by the financial statements or they misrepresent significant facts. To the extent these letters are more conservative rather than being unrealistic, individuals analyzing financial statements will be able to rely on their content to a greater extent in the future. The SarbanesOxley Act of 2002 in the US sets more stringent standards for financial reporting for public companies and their managers. Boards, and independent auditors, along with strict penalties for non-compliance.

Financial statement analysis is going to have increasing importance. There will be more focus on the cash flow statement, covered in Chapter 16, and its "cash flow from operating activities", since this amount is considered by some to be "cash earnings". Some consider this amount to be less susceptible to manipulation than is net income.

Management may disclose in an accounting policy statement, its policies regarding their business practices and those accounting policies that were followed in preparing the financial statements. Conflicts of interest will be identified and discouraged.

Professional financial analysts, such as those working for stock brokerage firms and those employed to help evaluate possible merger and acquisition candidates, typically go "beyond the numbers" in analyzing a company. They usually visit the company, interview management, and assess the physical facilities and plans for the future. They are interested in evaluating such factors as the competence and integrity of management. Professional financial analysts form an overall impression of the company by giving all of the data and other information the "smell test". In other words, does everything seem legitimate or are there possible significant hidden factors that have not yet been identified which makes one think that something is not right.

The future looks bright.  Needed changes will be made to maintain public confidence in financial reporting.

Protecting the public interest should be paramount in the future.

This chapter concludes our coverage of financial accounting. It is likely you will continue on with studies in managerial accounting. It is important to realize that it is impossible to completely separate financial and managerial accounting information into neat packages. Managers use both the published financial statements and managerial accounting information in making decisions. Also, some of the concepts covered in managerial accounting (e.g. job costing and process costing) have a direct impact on the formal financial statements. Many accountants are attracted to managerial accounting because it is not constrained by having to conform to generally accepted accounting principles. Instead, management accountants can provide to management whatever information in whatever form management requests.

An accounting perspective:Uses of technology

The Journal of Accountancy periodically publishes articles on Internet resources to encourage greater use of technology by accountants. One of the best in this category is called “Smart Stops on the Web”, a series authored by Megan Pinkston. (For example, see this one from 2007): http://www.journalofaccountancy.com/Issues/2007/Jun/SmartStopsOnTheWebArticle.

You may want to investigate this article and some of the others in the series and then visit some of the websites they list. There is no doubt that the Internet will only grow in importance in the future. The more you know about it, the more marketable you will be upon graduation.

Understanding the learning objectives

•  A company's financial statements are analyzed internally by management and externally by investors, creditors, and regulatory agencies.

•  Management's analysis of financial statements primarily relates to parts of the company. Management is able to obtain specific, special-purpose reports to aid in decision making.

•  External users focus their analysis of financial statements on the company as a whole. They must rely on the general-purpose financial statements that companies publish.

•  Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information.

•  This information is the significant relationships between data and trends in those data assessing the company's past performance and current financial position.

•  The information is useful for making predictions that may have a direct effect on decisions made by many users of financial statements.

•  Present and potential company investors use this information to assess the profitability of the firm.

•  Outside parties and long-term creditors sometimes are interested in a company's solvency, and thus use the information in predicting the company's solvency.

•  Published reports are one source of financial information. Published reports include financial statements, explanatory notes, letters to stockholders, reports of independent accountants, and management's discussion and analysis (MDA).

•  Government reports are another source of financial information and include Form 10-K, Form 10-Q, and Form 8-K. These reports are available to the public for a small charge.

•  Financial service information, business publications, newspapers, and periodicals offer meaningful financial information to external users. Moody's Investors Services; Standard & Poor's; Dun & Bradstreet, Inc.; and Robert Morris Associates all provide useful industry information. Business publications, such as The Wall Street Journal and Forbes, also report industry financial news.

•  Horizontal analysis is the calculation of dollar changes or percentage changes in comparative statement items or totals. Use of this analysis helps detect changes in a company's performance and highlights trends.

•  Vertical analysis consists of a study of a single financial statement in which each item is expressed as a percentage of a significant total. Use of this analysis is especially helpful in analyzing income statement data such as the percentage of cost of goods sold to sales or the percentage of gross margin to sales.

•  Trend analysis compares financial information over time to a base year. The analysis is calculated by:

(a) Selecting a base year or period.

(b) Assigning a weight of 100 per cent to the amounts appearing on the base-year financial statements.

(c) Expressing the corresponding amounts shown on the other years' financial statements as a percentage of base-year or period amounts. The percentages are computed by dividing nonbase-year amounts by the corresponding base-year amounts and then multiplying the results by 100.

Trend analysis indicates changes that are taking place in an organization and highlights the direction of these changes.

•  Liquidity ratios indicate a company's short-term debt-paying ability. These ratios include (1) current, or working capital, ratio; (2) acid-test (quick) ratio; (3) cash flow liquidity ratio; (4) accounts receivable turnover; (5) number of days' sales in accounts receivable; (6) inventory turnover; and (7) total assets turnover.

•  Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a company. These ratios include (1) equity (stockholders' equity) ratio and (2) stockholders' equity to debt ratio.

•  Profitability tests are an important measure of a company's operating success. These tests include (1) rate of return on operating assets, (2) net income to net sales, (3) net income to average common stockholders' equity, (4) cash flow margin, (5) earnings per share of common stock, (6) times interest earned ratio, and (7) times preferred dividends earned ratio.

•  Market tests help investors and potential investors assess the relative merits of the various stocks in the marketplace. These tests include (1) earnings yield on common stock, (2) price-earnings ratio, (3) dividend yield on common stock, (4) payout ratio on common stock, (5) dividend yield on preferred stock, and (6) cash flow per share of common stock.

•  For a complete summary and a graphic depiction of all liquidity, long-term solvency, profitability, and market test ratios, see Exhibit 135 and Exhibit 136.

•  Need for comparative data: Analysts must be sure that their comparisons are valid - especially when the comparisons are of items for different periods or different companies.

•  Influence of external factors: A single important event, such as the unexpected placing of a product on the market by a competitor, may affect the interpretation of the financial statements. Also, the general business conditions and the possible seasonal nature of the business must be taken into consideration, since these factors could have an impact on the financial statements.

•  Impact of inflation: Since financial statements fail to reveal the impact of inflation on the reporting entity, one must make sure that the items being compared are all comparable; that is, the impact of inflation has been taken into consideration.

•  Need for comparative standards: In financial statement analysis, remember that standards for comparison vary by industry, and financial analysis must be carried out with knowledge of specific industry characteristics.