Learning Objective
LO1 Analyze an income statement using vertical
analysis.
© 2014 Cengage Learning. All Rights Reserved.
Lesson 17-1
Vertical Analysis Ratios
LO1
● Vertical analysis ratios measure the relationship
between one financial statement item and
another item on the same financial statement.
● On the income statement, vertical analysis ratios
focus on the ability of a business to earn a profit.
● A ratio that measures the ability of a business to
generate income is called a profitability ratio.
Continued on the next slide.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 2
Lesson 17-1
Vertical Analysis Ratios
LO1
● Vertical analysis ratios on an income
statement are examples of profitability ratios.
● Managers use vertical analysis ratios to help
make business decisions.
● For vertical analysis to be an effective tool, a
business must set a target, or standard, for
each ratio.
● A standard used to compare financial
performance is called a benchmark.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 3
Lesson 17-1
Factors Used to Determine
Benchmark Ratios
LO1
● Actual ratios from prior fiscal periods
● Industry standards published by industry
organizations
● Business plans
● Unexpected events
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 4
Lesson 17-1
Analyzing Trends with Vertical Analysis
LO1
● Financial statements that provide information
for multiple fiscal periods are called
comparative financial statements.
● An analysis of changes over time is called
trend analysis.
● Net income after federal income tax as a
percent of net sales is called profit margin.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 5
Lesson 17-1
Analyzing Trends with Vertical Analysis
© 2014 Cengage Learning. All Rights Reserved.
LO1
SLIDE 6
Lesson 17-1
Using Vertical Analysis to Analyze Gross Profit
LO1
● Gross profit as a percent of net sales is called
gross margin.
● This ratio is also referred to as gross profit margin.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 7
Lesson 17-1
Correcting an Unfavorable Gross Margin
LO1
● Increase unit sales prices
● Decrease the unit cost of merchandise
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 8
Lesson 17-1
Using Vertical Analysis to Analyze Operating
Expenses
LO1
● Income from operations as a percent of net sales is
called the operating margin.
● This ratio is also referred to as the rate of return on sales.
● Total operating expenses as a percent of net sales is
called the operating expense ratio.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 9
Lesson 17-1
Correcting an Unfavorable Operating
Expense Ratio
LO1
● Reduce operating expenses
● Modify the benchmark
● Increase net sales
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 10
Lesson 17-1
Lesson 17-1 Audit Your Understanding
1. Identify four factors that management can
use to determine benchmark financial ratios.
ANSWER
1. Actual ratios from prior fiscal periods
2. Industry standards published by industry
organizations
3. Business plans
4. Unexpected events
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 11
Lesson 17-1
Lesson 17-1 Audit Your Understanding
2. Why should a business be cautious about
increasing the markup on merchandise
purchased for sale?
ANSWER
If the increase in markup is too large, a decrease in sales
revenue could occur for two reasons: (1) the sales price
may exceed what customers are willing to pay or (2)
customers may elect to purchase from competing
businesses having lower prices.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 12
Lesson 17-1
Lesson 17-1 Audit Your Understanding
3. What are two practices that can be used to
reduce the cost of merchandise?
ANSWER
Purchase merchandise in larger quantities
or from other vendors offering a lower cost
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 13
Lesson 17-1
Lesson 17-1 Audit Your Understanding
4. Should managers interested in reducing
operating expenses focus more on the
operating expense ratio or the operating
margin?
ANSWER
Operating expense ratio
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 14
Lesson 17-1
Lesson 17-1 Audit Your Understanding
5. What are three possible actions to correct an
unfavorable operating expense ratio?
ANSWER
• Reduce operating expenses
• Modify the benchmark
• Increase net sales
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 15
Learning Objectives
LO2 Perform vertical analysis of a balance sheet.
LO3 Analyze a balance sheet using vertical
analysis.
© 2014 Cengage Learning. All Rights Reserved.
Lesson 17-2
Calculating Vertical Analysis Ratios on a
Balance Sheet
LO2
1
Asset Amounts Divided by
Total Assets
2
Liability and Stockholders’
Equity Amounts Divided by
Total Assets
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 17
Lesson 17-2
Evaluating Vertical Analysis Asset Ratios
© 2014 Cengage Learning. All Rights Reserved.
LO3
SLIDE 18
Lesson 17-2
Evaluating Vertical Analysis Liability Ratios
LO3
● A ratio that measures the ability of a business
to pay its long-term liabilities is called a
solvency ratio.
● Total liabilities divided by total assets is called
the debt ratio.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 19
Lesson 17-2
Evaluating Vertical Analysis Liability Ratios
© 2014 Cengage Learning. All Rights Reserved.
LO3
SLIDE 20
Lesson 17-2
Lesson 17-2 Audit Your Understanding
1. Why do many retailers perform vertical
analysis on the Accounts Receivable and
Merchandise Inventory accounts?
ANSWER
First, these are typically two of the largest asset
accounts for a retail merchandising business.
Second, industry standards are available for
these accounts.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 21
Lesson 17-2
Lesson 17-2 Audit Your Understanding
2. What may cause a vertical analysis ratio for
accounts receivable to be below the target
range?
ANSWER
A ratio below the target range may indicate that
a company is restricting customers’ ability to
purchase on account. This action may have a
negative effect on sales.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 22
Lesson 17-2
Lesson 17-2 Audit Your Understanding
3. What may cause a vertical analysis ratio for
merchandise inventory to be below the target
range?
ANSWER
The business may not be stocking an
adequate supply or variety of
merchandise.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 23
Lesson 17-2
Lesson 17-2 Audit Your Understanding
4. What should a company do if the vertical analysis
ratio for merchandise inventory is above the target
range?
ANSWER
The company should prepare a list of the
inventory items having the largest cost. The
company should assess whether the proper
quantity of each item is available for sale. Future
inventory purchases should ensure that the
optimal quantity on hand is maintained.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 24
Lesson 17-2
Lesson 17-2 Audit Your Understanding
5. Why is it risky for a business to have too
many liabilities?
ANSWER
The business must be able to pay its
liabilities on a timely basis. If sales decline
during difficult financial times, a business
may be unable to make its monthly
payments.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 25
Learning Objectives
LO4 Perform horizontal analysis on an income
statement.
LO5 Perform horizontal analysis on a balance
sheet.
© 2014 Cengage Learning. All Rights Reserved.
Lesson 17-3
Analyzing Trends with Horizontal Analysis
LO4
● A comparison of one item on a financial
statement with the same item on a previous
period’s financial statement is called
horizontal analysis.
Current
Period
−
Prior
Period
=
Increase
(Decrease)
$242,584.00
−
$221,489.00
=
$21,095.00
Increase
(Decrease)
÷
Prior
Period
=
Horizontal
Analysis Ratio
$21,095.00
÷
$221,489.00
=
9.5%
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 27
Lesson 17-3
Horizontal Analysis of an Income Statement
Current Year 1
Less Prior Year
© 2014 Cengage Learning. All Rights Reserved.
LO4
2 Difference Amount
Divided by Prior Year
SLIDE 28
Lesson 17-3
Horizontal Analysis of a Balance Sheet
© 2014 Cengage Learning. All Rights Reserved.
LO5
SLIDE 29
Lesson 17-3
Lesson 17-3 Audit Your Understanding
1. How could a 2.0% decrease in supplies
expense be an unfavorable trend?
ANSWER
If management took actions that should
have decreased supplies expense by
significantly more than 2.0%, then only a
2% decrease would be unfavorable.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 30
Lesson 17-3
Lesson 17-3 Audit Your Understanding
2. How does a publicly held corporation use
horizontal analysis when reporting to the
Securities and Exchange Commission?
ANSWER
The document filed with the Securities and Exchange
Commission contains a section titled Management’s
Discussion and Analysis of Financial Condition and Results
of Operations and Results of Operations. Management
often uses these ratios to explain the current year’s
results of operations compared to previous years.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 31
Learning Objectives
LO6 Calculate earnings per share.
LO7 Calculate and interpret market ratios.
LO8 Calculate and interpret liquidity ratios.
© 2014 Cengage Learning. All Rights Reserved.
Lesson 17-4
Earnings per Share
LO6
● Net income after federal income tax divided
by the number of outstanding shares of stock
is called earnings per share.
● Earnings per share is often abbreviated as EPS.
Net Income after Federal Income Tax $ 79,896.57 $ 79,896.57
Number of Shares Outstanding
÷ 7,500
÷ 75,000
Earnings per Share
$
10.65 $
1.07
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 33
Lesson 17-4
Market Ratios
LO7
● A ratio that measures a corporation’s financial
performance in relation to the market value of
its stock is called a market ratio.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 34
Lesson 17-4
Dividend Yield
LO7
● The relationship between dividends per share
and market price per share is called the
dividend yield.
Dividends
per Share
$2.00
Market Price
÷
=
per Share
÷
$228.75
=
© 2014 Cengage Learning. All Rights Reserved.
Dividend
Yield
0.87%
SLIDE 35
Lesson 17-4
Price-Earnings Ratio
LO7
● The relationship between the market value
per share and earnings per share of a stock is
called the price-earnings ratio.
● It is often referred to as the P/E ratio.
Market Price
÷
per Share
$228.75
÷
Earnings
per Share
$10.65
Price-Earnings
=
Ratio
=
© 2014 Cengage Learning. All Rights Reserved.
21.5
SLIDE 36
Lesson 17-4
Liquidity Ratios
LO8
● A ratio that measures the ability of a business
to pay its current financial obligations is called
a liquidity ratio.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 37
Lesson 17-4
Working Capital
LO8
● The amount of current assets less current
liabilities is called working capital.
Current
Assets
−
$185,322.90 −
Current
Liabilities
$32,251.78
=
Working
Capital
= $153,071.12
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 38
Lesson 17-4
Current Ratio
● A ratio that measures the relationship of
current assets to current liabilities is called the
current ratio.
● The current ratio measures a company’s ability
to pay its current liabilities when due.
Current Assets ÷ Current Liabilities =
$185,322.90 ÷
$32,251.78
=
© 2014 Cengage Learning. All Rights Reserved.
Current Ratio
5.75
SLIDE 39
Lesson 17-4
Quick Ratio
● Cash and other current assets that can be
quickly converted into cash are called quick
assets.
● Quick assets are also referred to as liquid assets.
● A ratio that measures the relationship of quick
assets to current liabilities is called the quick
ratio.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 40
Lesson 17-4
Quick Ratio
Cash
$54,444.34
+
+
Accounts Receivable
$17,872.56
=
=
Quick Assets
$72,316.90
Quick Assets
÷
Current Liabilities
=
Quick Ratio
$72,316.90
÷
$32,251.78
=
2.24
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 41
Lesson 17-4
Lesson 17-4 Audit Your Understanding
1. Why can one corporation’s earnings per share
not be compared to the EPS of other
corporations?
ANSWER
Each corporation’s EPS is a unique number
because corporations can issue any number of
shares. As a result, the earnings of each
corporation are divided by a different number of
shares.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 42
Lesson 17-4
Lesson 17-4 Audit Your Understanding
2. What group is the primary user of market
ratios?
ANSWER
Investors
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 43
Lesson 17-4
Lesson 17-4 Audit Your Understanding
3. Do income stocks typically have low or high
dividend yields?
ANSWER
High
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 44
Lesson 17-4
Lesson 17-4 Audit Your Understanding
4. Do growth stocks typically have low or high
price-earnings ratios?
ANSWER
High
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 45
Lesson 17-4
Lesson 17-4 Audit Your Understanding
5. What is the primary source of data to
calculate liquidity ratios?
ANSWER
Balance sheet
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 46
Lesson 17-4
Lesson 17-4 Audit Your Understanding
6. What does working capital measure?
ANSWER
Working capital is a measure of the
financial resources available for the daily
operations of the business.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 47
Lesson 17-4
Lesson 17-4 Audit Your Understanding
7. Why is the current ratio a useful measure of
financial strength?
ANSWER
The current ratio permits a business to compare
itself to its industry or to provide a convenient
relative measurement from year to year
regarding the company’s ability to pay current
liabilities when due.
© 2014 Cengage Learning. All Rights Reserved.
SLIDE 48