Page 704 - Accounting Principles (A Business Perspective)

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• 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.

Accounting Principles: A Business Perspective 705 A Global Text