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Objective 5.04 Analyze financial indicators and ratios to
make business decisions.

Financial analysis shows the relationship and changes between items on the
financial statements.

Common techniques used to evaluate the information presented on financial
statements are horizontal analysis, vertical analysis, and ratio analysis.

Horizontal analysis – comparison of the same items on a company’s financial
statements for two or more periods.

Comparability – financial information that can be compared from one accounting
period to another or from one business to another.

Base year – year used for comparison.

Vertical analysis (component percentages) – requires each dollar amount reported
on a financial statement to be stated as a percentage of another amount (base
amount) appearing on the same statement. Percentages for the current year are
compared to percentages of previous years or other companies in the same
industry.

Ratio analysis – comparison of two amounts on a financial statement and the
evaluation of the relationship between these amounts.

Ratio analysis is used to evaluate a company’s profitability, liquidity, and financial
strength.

Companies must decide on acceptable levels of financial performance for each type
of analysis performed. Levels may vary due to different financial characteristics of
the businesses being compared.
CONTENT
I.
Horizontal Analysis
A. Compare same items on a financial statement for two or more periods.
B. Ex: 2009 Sales = $500,000; 2009 Sales = $400,000.
C. Analysis determines the cause of the change.
II.
Vertical Analysis (component percentages)
A. Show each amount as a percentage of another amount on the same financial
statements.
1. Income statement items are shown as a percentage of sales.
2. Asset items are shown as a percentage of total assets.
3. Liability and equity items are shown as a percentage of total liabilities and
stockholders’ equity.
B. Compare to percentages of previous years or companies in the same industry.
C. Analysis determines the cause of favorable or unfavorable changes.
III.
Ratio Analysis
A. Liquidity ratios – measure the ability of a business to pay its current debts and
provide cash for unexpected needs.
1. The higher the ratio, the more likely a company can meet its cash outflow
needs.
2. Changes in the ratios need to be investigated for signs of downward
trends.
3. Analysis determines the reasons behind increases and decreases to help
management with decision making.
B. Profitability ratios – evaluate the earnings performance of the business during
the accounting period.
1. Companies look for consistent or increasing ratios as a sign of stable or
increasing profitability.
2. Changes in the ratio need to be investigated for signs of downward trends.
C. Financial strength ratios – measure the ability of a business to pay its debts in
order to maintain credit standing and borrow funds in the future.
1. Creditors look for a high ratio.
2. Decreasing ratios need to be investigated for signs of downward trends.
3. Debt ratios measure the amount of debt in relation to total assets.
Therefore, favorable ratios would be lower. As the ratio increases, the less
favorable the ratio becomes.
5.04 Analyzing Financial Indicators and Ratios
Page 1:
Horizontal Analysis:
 Compare same items on a financial statement for two or more periods.
 Ex: 2009 Sales = $500,000; 2009 Sales = $400,000.
 Analysis determines the cause of the change.
Vertical Analysis (component percentages)
 Show each amount as a percentage of another amount on the same financial
statements.
o Income statement items are shown as a percentage of sales.
o Asset items are shown as a percentage of total assets.
o Liability and equity items are shown as a percentage of total liabilities
and stockholders’ equity.
o Compare to percentages of previous years or companies in the same
industry.
 Analysis determines the cause of favorable or unfavorable changes.
Page 2:
Ratio Analysis
 Liquidity Ratios – measures the ability of a business to pay its current debts and
provide cash for unexpected needs.
o The higher the ratio, the more likely a company can meet its cash
outflow needs.
o Changes in the ratios need to be investigated for signs of downward
trends.
o Analysis determines the reasons behind increases and decreases to help
management with decision making.
 Profitability Ratios – evaluate the earnings performance of the business during the
accounting period.
o Companies look for consistent or increasing ratios as a sign of stable or
increasing profitability.
o Changes in the ratio need to be investigated for signs of downward trends.
 Financial Strength Ratios – measures the ability of a business to pay its debts in
order to maintain credit standing and borrow funds in the future.
o Creditors look for a high ratio.
o Decreasing ratios need to be investigated for signs of downward trends.
 Debt ratios measure the amount of debt in relation to total assets.
o Therefore, favorable ratios would be lower.
o As the ratio increases, the less favorable the ratio becomes.
5.04 Financial Analysis Guided Practice A
You have been asked to analyze the income statement for Josh Walker Boots. In your
analysis, you discover the following information.
Josh Walker Boots
Income Statement
For the year ended December 31, 2010
Item
Net sales
Cost of merchandise sold
Gross profit on sales
Total operating expenses
Net Income
Increase from Prior Year
15%
22%
12%
10%
14%
1. What might be the reason for the large increase in the cost of merchandise sold?
2. List two ways to further increase net sales.
3. What strategies could Josh employ to improve net income?
5.04 Financial Analysis Guided Practice B
Home Depot
Current Ratio
Receivables Turnover
Return on Net Sales
Inventory Turnover
Year 1
2.5
8.1
6.2%
6.8
Year 2
2.7
8.8
6.4%
7.0
Year 3
2.9
9.2
6.3%
7.3
Based on the ratios given, explain the trends shown in the table
above.
Current Ratio:
Receivables Turnover:
Return on Net Sales:
Inventory Turnover:
5.04 Financial Analysis Independent Practice – Page 1
Wal-Mart
Current Ratio
Receivables Turnover
Return on Net Sales
Inventory Turnover
Year 1
1.9
8.2
4.6%
5.4
Year 2
2.3
7.8
4.8%
6.0
Year 3
2.5
6.5
4.9%
6.3
Target
Current Ratio
Receivables Turnover
Return on Net Sales
Inventory Turnover
Year 1
3.3
3.5
6.5%
9.2
Year 2
2.9
3.7
4.3%
8.7
Year 3
2.3
4.1
6.8%
6.4
K-Mart
Current Ratio
Receivables Turnover
Return on Net Sales
Inventory Turnover
Year 1
1.6
6.4
8.5%
12.2
Year 2
1.7
9.9
7.3%
12.1
Year 3
1.8
7.1
5.6%
12.2
Magic Mart
Current Ratio
Receivables Turnover
Return on Net Sales
Inventory Turnover
Year 1
1.8
9.4
5.5%
3.8
Year 2
1.3
4.7
5.3%
6.4
Year 3
0.4
9.2
5.4%
5.9
Figure 1
1. Based on the current ratio in Figure 1, explain the trends for each company
listed.
 Wal-Mart:

Target:

K-Mart:

Magic Mart:
5.04 Financial Analysis Independent Practice – Page 2
2. Based on the receivables turnover ratio in Figure 1, explain the trends for each
company listed.

Wal-Mart:

Target:

K-Mart:

Magic Mart:
3. Based on the return on net sales ratio in Figure 1, explain the trends for each
company listed.

Wal-Mart:

Target:

K-Mart:

Magic Mart:
5.04 Financial Analysis Independent Practice – Page 3
4. Based on the return on inventory turnover ratio in Figure 1, explain the trends
for each company listed.

Wal-Mart:

Target:

K-Mart:

Magic Mart:
5.04 Analyzing Financial Ratios – Page 1
Cooper Corporation
Balance Sheet
December 31, 2010
ASSETS
Ca s h
Ma rketa bl e Securi ties
Accounts Recei va bl e
Mercha ndi s e Inventory
Prepa i d Expens es
Property, Pl a nt & Equi pment (net)
TOTAL ASSETS
REVENUE
Sa l es (net)
TOTAL SALES
$
15,000.00
10,000.00
25,000.00
40,000.00
5,000.00
85,000.00
$
180,000.00
$
20,000.00
3,000.00
5,000.00
50,000.00
LIABILITIES & STOCKHOLDERS' EQUITY
LIABILITIES
Accounts Pa ya bl e
Sa l a ri es Pa ya bl e
Note Pa ya bl e - current
Note Pa ya bl e - l ong-term
TOTAL LIABILITIES
78,000.00
STOCKHOLDERS' EQUITY
PAID-IN CAPITAL
Common Stock ($1 pa r va l ue, 100,000 s ha res
Addi tiona l Pa i d-In Ca pi ta l
TOTAL PAID-IN CAPITAL
Reta i ned Ea rni ngs
10,000.00
5,000.00
15,000.00
87,000.00
TOTAL STOCKHOLDERS' EQUITY
TOTAL LIABILITIES & STOCKHOLDERS' EQUITY
Cooper Corporation
Income Statement
December 31, 2010
$
102,000.00
180,000.00
$
COST OF MERCHANDISE SOLD
Begi nni ng Inventory
Purcha s es
Les s Endi ng Inventory
TOTAL COST OF MERCHANDISE SOLD
GROSS PROFIT
OPERATING EXPENSES
Advertis i ng Expens e
Offi ce Expens e
Sa l a ry Expens e
Util i ties Expens e
Vehi cl e Expens e
TOTAL OPERATING EXPENSES
NET INCOME (LOSS)
Calculate the following.
Current Ratio
Merchandise Inventory Turnover
Accounts Receivables Turnover
Return on Stockholders’ Equity
Earnings per Share
Price-Earnings Ratio
Return on Net Sales
Debt Ratio
Equity Ratio
Equity per Share
155,000.00
155,000.00
35,000.00
70,000.00
40,000.00
65,000.00
90,000.00
2,000.00
4,000.00
35,000.00
7,000.00
6,000.00
54,000.00
$
36,000.00
5.04 Analyzing Financial Ratios – Page 2
1. Current Ratio
The Industry Standard for similar companies is 2.6:1. What can you determine based on the current ratio for
Cooper Corporation?
2. Merchandise Inventory Turnover
Cooper Corporation’s merchandise turnover rate for 2009 was 2.1. What can you determine, based on the 2010
ratio, about Cooper Corporation’s management of inventory?
3. Accounts Receivable Turnover
Cooper Corporation’s accounts receivable turnover for 2009 was 7.22. Beginning Accounts Receivable for 2010
was $20,000. Based on a 365 day year, what can you determine about Cooper Corporation’s cash flow for 2010?
4. Return on Stockholders’ Equity
Beginning Stockholders’ Equity for 2010 is $65,000. Return on Stockholders’ Equity for 2009 was 39%. What
does the 2010 ratio tell the stockholders of Cooper Corporation?
5.04 Analyzing Financial Ratios – Page 3
5. Earnings per Share
Earnings per share for the past two years was $3.50 per share for 2009 and $3.45 per share for 2008. Considering
the current year’s Earnings per Share, what can investors determine is happening with Cooper Corporation?
6. Price-Earnings Ratio
The current market price for Cooper Corporation stock is $5.75 per share. What can be determined by the priceearnings ratio?
7. Return on Net Sales
The return on net sales for 2009 and 2008 was 24% and 23%, respectively. What can be determined by reviewing
the return on net sales for the past three years?
8. Debt Ratio
The industry standard for companies similar to Cooper Corporation is 41%. What can be determined by reviewing
Cooper Corporation’s debt ratio?
5.04 Analyzing Financial Ratios – Page 4
9. Equity per Share
The equity per share for 2009 was $8.75 and for 2008 was $9.82. What can be determined by Cooper
Corporation’s equity per share for 2010?
10. Equity Ratio
The industry standard for companies similar to Cooper Corporation is 59%. What can be determined by reviewing
Cooper Corporation’s equity ratio?
5.04 Prototype Assessment Items – Page 1
These prototype assessment items illustrate the types of items used in the item bank for
this objective. All items have been written to match the cognitive process of the
analyze verb in the objective. These exact questions will not be used on the secure
postassessment, but questions in similar formats will be used.
1. RWM Textiles has equity per share of $145.00 for the current year. The equity per
share for the past two years was $115.00 and $126.00, respectively. Which of the
following would MOST LIKELY explain the change in equity per share over the past
three years?
A. RWM has consistently increased net income over the past three years.
B. RWM has issued a significant amount of notes receivable over the past three
years.
C. RWM has increased its operating expenses significantly over the past three
years.
D. RWM has had a significant decrease in sales over the past three years.
Combination 1
Combination 2
Combination 3
Combination 4
Current Ratio Debt Ratio
1.0
51%
2.6
34%
1.5
49%
2.9
59%
Return on Equity
11%
19%
16%
14%
Figure 5.04-A
2. As a short-term creditor concerned with a company’s ability to meet its financial
obligation to you, which one of the combinations of ratios shown in Figure 5.04 A,
would you most likely prefer?
A.
B.
C.
D.
Combination 1
Combination 2
Combination 3
Combination 4
5.04 Prototype Assessment Items – Page 2
3. Miller Manufacturing has a current ratio of 2.8:1. The industry standard for
companies similar to Miller is 2.3:1. This means that Miller:
A.
B.
C.
D.
Is in danger of filing bankruptcy due to lack of cash flow.
Has the ability to pay all of its current liabilities.
Does not have the ability to pay its current liabilities.
Has greater than average financial risk when compared to other firms in its
industry.
4. Parker Industries has a debt ratio of 49.2%. The industry average for companies
similar to Parker is 42.5%. This means that Parker:
A.
B.
C.
D.
Will not experience any difficulty with its creditors.
Has less liquidity than other firms in the industry.
Will be viewed as having high creditworthiness.
Has greater than average financial risk when compared to other firms in its
industry.
Company A
Price-earnings ratio
Equity per share
Inventory turnover
Year 1
8.9
$3.71
5.4
Year 2
10.5
$2.57
6.0
Year 3
11.2
$2.38
6.3
Company B
Price-earnings ratio
Equity per share
Inventory turnover
Year 1
6.1
$1.24
9.2
Year 2
7.1
$1.19
8.7
Year 3
7.9
$1.05
6.4
Company C
Price-earnings ratio
Equity per share
Inventory turnover
Year 1
3.5
$8.75
12.2
Year 2
3.4
$9.45
12.1
Year 3
3.3
$10.36
12.2
Company D
Price-earnings ratio
Equity per share
Inventory turnover
Year 1
14.6
$9.66
3.8
Year 2
9.3
$2.54
6.4
Year 3
6.5
$8.55
5.9
Figure 5.04-B
5. Based on the price-earnings ratio in Figure 5.04-B, which company has the least
favorable trend?
A. Company A
B. Company B
C. Company C
D. Company D