This chapter describes the objectives and sources of information for financial statement analysis, and explains how to measure change using horizontal analysis, vertical analysis, and trend analysis. It covers ratio analysis through liquidity ratios, long-term solvency ratios, profitability tests, and market tests, and the considerations that shape how analysts interpret the results.
Objectives and sources of financial statement analysis
Management analyzes financial statements to plan, evaluate, and control operations within the company, drawing on internally requested special-purpose reports. Investors, creditors, and regulatory agencies outside the firm instead rely on general-purpose statements, including the balance sheet, income statement, statement of stockholders’ equity, statement of cash flows, and the explanatory notes that accompany them. Although these users pursue different immediate goals, their shared objective is to use the information to predict a company’s future performance.
Horizontal, vertical, and trend analysis
Horizontal analysis compares financial statement items across two or more periods to measure the dollar and percentage change over time, while vertical analysis expresses each item as a percentage of a base figure, such as total assets or net sales, within a single period. Trend analysis extends horizontal analysis over a longer run of periods to reveal the direction a company’s results are moving, giving analysts a clearer picture of underlying performance than any single year’s figures alone.
Ratio analysis and its considerations
Ratio analysis relates one financial statement figure to another to assess a company from several angles: liquidity ratios test its ability to meet short-term obligations, long-term solvency ratios test its ability to meet long-term debt, profitability tests measure its capacity to generate income, and market tests relate its earnings and dividends to its share price. Because ratios are only as reliable as the statements behind them, analysts also weigh considerations such as comparability across periods and companies and the effects of estimates and accounting choices.
This chapter lists the characteristics of plant assets and the costs of acquiring them, the major factors affecting depreciation expense, and the methods used to calculate it. It distinguishes capital from revenue expenditures and describes the subsidiary records used to control plant assets, plus the rate of return on operating assets.
Acquiring property, plant, and equipment
Plant assets are long-lived resources used in operations rather than held for resale, and their recorded cost includes all reasonable and necessary expenditures needed to get the asset into working condition and location, not just its purchase price. The chapter identifies which costs are capitalized into the asset’s recorded cost and which are instead expensed immediately as incurred.
Depreciation methods
Depreciation expense depends on an asset’s cost, its estimated salvage value, its estimated useful life, and the pattern in which the asset is expected to be used over that life. The chapter works through the various methods available for calculating depreciation and shows how the choice of method affects both reported expense and the asset’s carrying value over time.
Capital versus revenue expenditures, and control records
A capital expenditure extends an asset’s useful life or increases its capacity and is added to the asset’s recorded cost, while a revenue expenditure merely maintains normal operating condition and is expensed immediately instead. The chapter also describes the subsidiary ledgers used to track individual plant assets, and the rate of return on operating assets used to evaluate how effectively property, plant, and equipment is being used.
This chapter covers accounting for uncollectible accounts receivable under the allowance method, recording credit card sales, and defining current and long-term liabilities. It explains clearly determinable, estimated, and contingent liabilities, and accounting for notes receivable and payable, including interest calculations and receivables turnover analysis for the business.
Uncollectible accounts and credit card sales
Under the allowance method, a business estimates in advance the portion of its accounts receivable it expects will never be collected, recording that expense in the same period as the related sales rather than waiting until a specific account is finally known to be uncollectible. The chapter also covers recording sales made through credit cards and the processing fees that come with them.
Types of liabilities among receivables and payables
Liabilities are classified as current or long-term based on when they fall due, and further as clearly determinable, estimated, or contingent depending on how certain their amount and existence actually are. A contingent liability, for example, depends on the outcome of some future event and is disclosed rather than formally recorded unless it becomes both probable and reasonably estimable.
Notes receivable and payable
Notes receivable and payable involve a formal written promise to pay a specific amount, often with interest, by a specific future date. The chapter shows how to calculate that interest and account for both interest-bearing and non-interest-bearing notes, and closes with turnover ratios used to analyze how efficiently a company is collecting on its receivables.
This chapter describes the necessity for and features of internal control, defines cash, and identifies procedures for controlling cash receipts and disbursements. It covers preparing a bank reconciliation, using a petty cash fund, and analyzing results with the quick ratio, a measure of short-term liquidity.
Internal control over cash
Because cash is the asset most easily misused, businesses rely on internal control procedures, such as separating the duties of handling cash from recording it, to safeguard both receipts and disbursements. The chapter describes what management seeks to achieve through effective control of cash, and the specific procedures used for both incoming customer payments and outgoing payments to suppliers and employees.
The bank reconciliation
A bank reconciliation compares a company’s own cash records to the bank statement and explains any differences, such as outstanding checks or deposits still in transit, arriving at one true, reconciled cash balance. The chapter works through preparing this reconciliation step by step and the journal entries needed for items it reveals, such as bank service fees the company had not yet recorded.
Petty cash and the quick ratio
A petty cash fund is a small, controlled amount of cash kept on hand for minor expenses that would be impractical to pay by check, and the chapter explains how it is established, used, and periodically replenished. It also introduces the quick ratio, which measures a company’s ability to meet short-term obligations using only its most liquid assets, cash chief among them.
This chapter explains how inventory errors affect financial statement items, which costs belong in inventory, and how to calculate the cost of ending inventory and cost of goods sold under the four major inventory costing methods, using both periodic and perpetual procedures, along with net realizable value and the lower-of-cost-or-market rule.
Inventory errors and inventoriable costs
An error in counting or valuing ending inventory flows directly into cost of goods sold and net income, and because ending inventory of one period becomes beginning inventory of the next, the error affects two periods’ statements before it finally corrects itself. The chapter also identifies which costs, beyond the purchase price alone, properly belong in the inventory figure reported on the balance sheet.
The four costing methods for measuring and reporting inventories
Specific identification, first-in first-out, last-in first-out, and weighted average each assign cost to units sold and units remaining in inventory differently, and can produce materially different reported income and inventory values from the exact same underlying purchases. The chapter works through calculating cost of ending inventory and cost of goods sold under each of these four methods in turn.
Net realizable value and lower-of-cost-or-market
Inventory is not always carried at its originally recorded cost. When net realizable value falls below cost, the lower-of-cost-or-market rule requires writing the inventory down, so the balance sheet does not overstate an asset whose value has genuinely declined since purchase. The chapter shows how this adjustment is calculated, applied, and recorded in the accounts.
