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                     18 Financial Statement Analysis
Learning Objectives
1 Apply horizontal and vertical analysis to financial statements.
2 Analyze a company’s performance using ratio analysis.
3 Apply the concept of sustainable income.
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LEARNING Apply horizontal and vertical analysis to 
OBJECTIVE 1 financial statements.
Analyzing financial statements involves:
Comparison Tools of 
Characteristics
Bases Analysis
 Liquidity  Intracompany  Horizontal
 Profitability  Industry  Vertical
 Solvency averages  Ratio
 Intercompany 
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Horizontal Analysis
Horizontal analysis, also called trend analysis, is a 
technique for evaluating a series of financial statement data 
over a period of time. 
 Purpose is to determine the increase or decrease.
 Commonly applied to the 
► balance sheet, 
► income statement, and 
► statement of retained earnings.
18-3 LO 1
Horizontal Analysis
Illustration 18-5
Horizontal analysis of
balance sheets
Changes suggest that 
the company 
expanded its asset 
base during 2013 and 
financed this 
expansion primarily 
by retaining income 
rather than assuming 
additional long-term 
debt.
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Horizontal Analysis
Illustration 18-6
Horizontal analysis of
Income statements
Overall, gross profit 
and net income were 
up substantially. 
Gross profit increased
17.1%, and net 
income, 26.5%. 
Quality’s profit trend 
appears favorable.
18-5 LO 1
Horizontal Analysis
Illustration 18-7
Horizontal analysis of The ending retained earnings increased 38.6%. As 
retained earnings 
statements indicated earlier, the company retained a significant 
portion of net income to finance additional plant facilities.
18-6 LO 1
Vertical Analysis
Vertical analysis, also called common-size analysis, is a 
technique that expresses each financial statement item as 
a percent of a base amount. 
 On an income statement, we might say that selling 
expenses are 16% of net sales.
 Vertical analysis is commonly applied to the
► balance sheet and 
► income statement.
18-7 LO 1
Vertical Analysis
Illustration 18-8
Vertical analysis of
balance sheets
Quality is choosing to 
finance its growth 
through retention of 
earnings rather than 
through issuing 
additional debt.
18-8 LO 1
Vertical Analysis
Illustration 18-9
Vertical analysis of
Income statements
Quality appears
to be a profitable 
enterprise that is 
becoming even more 
successful.
18-9 LO 1
Vertical Analysis
Enables a comparison of companies of different sizes.
Illustration 18-10
Intercompany income statement comparison
18-10 LO 1
DO IT! 1 Horizontal Analysis
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LEARNING 2 Analyze a company’s performance using OBJECTIVE ratio analysis.
Ratio analysis expresses the relationship among selected 
items of financial statement data.
Financial Ratio Classifications
Liquidity Profitability Solvency
Measures short-term Measures the Measures the ability 
ability of the company income or operating of the company to 
to pay its maturing success of a survive over a long 
obligations and to company for a given period of time.
meet unexpected period of time.
needs for cash.
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Ratio Analysis
A single ratio by itself is not very meaningful.  
The discussion of ratios include the following types of 
comparisons.
1. Intracompany comparisons for two years for Quality 
Department Store.
2. Industry average comparisons based on median ratios 
for department stores.
3. Intercompany comparisons based on Macy’s, Inc. as 
Quality Department Store’s principal competitor.
18-13 LO 2
Ratio Analysis
Liquidity Ratios
Measure the short-term ability of the company to pay its 
maturing obligations and to meet unexpected needs for 
cash. 
 Short-term creditors such as bankers and suppliers are 
particularly interested in assessing liquidity. 
 Ratios include the current ratio, the acid-test ratio, 
accounts receivable turnover, and inventory 
turnover.
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Balance Sheet (partial)
For the Years Ended December 31
2013 2012 2013 2012
Illustration 18-12
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Ratio Analysis Liquidity Ratios
1. CURRENT RATIO
Illustration 18-12
2013 2012
1.52:1
Ratio of 2.96:1 means that for every dollar of current liabilities, Quality 
has $2.96 of current assets.
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Investor Insight
How to Manage the Current Ratio
The apparent simplicity of the current ratio can have real-world limitations 
because adding equal amounts to both the numerator and the denominator 
causes the ratio to decrease.  
Assume, for example, that a company has $2,000,000 of current assets 
and $1,000,000 of current liabilities. Thus, its current ratio is 2:1. If the 
company purchases $1,000,000 of inventory on account, it will have 
$3,000,000 of current assets and $2,000,000 of current liabilities. Its current 
ratio therefore decreases to 1.5:1. If, instead, the company pays off 
$500,000 of its current liabilities, it will have $1,500,000 of current assets 
and $500,000 of current liabilities. Its current ratio then increases to 3:1. 
Thus, any trend analysis should be done with care because the ratio is 
susceptible to quick changes and is easily influenced by management.
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Ratio Analysis Liquidity Ratios
2. ACID-TEST RATIO
Illustration 18-13
2013 2012
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial) Balance Sheet (partial)
2013 2012 2013 2012
Illustration 18-12
18-19 LO 2
Ratio Analysis Liquidity Ratios
2. ACID-TEST RATIO
Illustration 18-14
2013 2012
0.47:1
Acid-test ratio measures immediate liquidity. 
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Balance Sheet (partial)
For the Years Ended December 31
2013 2012 2013 2012
18-21 LO 2
Ratio Analysis Liquidity Ratios
3. ACCOUNTS RECEIVABLE TURNOVER
Illustration 18-15
2013 2012
69.1 times
Measures the number of times, on average, the company collects 
receivables during the period.
18-22 LO 2
Ratio Analysis Liquidity Ratios
3. ACCOUNTS RECEIVABLE TURNOVER
$2,097,000
=  10.2 times 
($180,000 + $230,000) / 2
A variant of the accounts receivable turnover ratio is to convert it 
to an average collection period in terms of days.
365 days / 10.2 times = every 35.78 days
Accounts receivable are collected on average every 36 days.
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Balance Sheet (partial)
For the Years Ended December 31
2013 2012 2013 2012
Illustration 18-12
18-24 LO 2
Ratio Analysis Liquidity Ratios
4. INVENTORY TURNOVER
Illustration 18-16
2013 2012
3.1 times
Measures the number of times, on average, the inventory is sold 
during the period.
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Ratio Analysis Liquidity Ratios
4. INVENTORY TURNOVER
$1,281,000
=  2.3 times 
($500,000 + $620,000) / 2  
A variant of inventory turnover is the days in inventory.
365 days / 2.3 times = every 159 days
Inventory turnover ratios vary considerably among industries.
18-26 LO 2
Ratio Analysis
Profitability Ratios
Measure the income or operating success of a company for a 
given period of time. 
 Income affects the company’s ability to obtain debt and 
equity financing, their liquidity position, and their ability to 
grow.
 Ratios include the profit margin, asset turnover, return 
on assets, return on common stockholders’ equity, 
earnings per share, price-earnings ratio, and payout 
ratio.
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed  Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012
18-28 LO 2
Ratio Analysis Profitability Ratios
5. PROFIT MARGIN
Illustration 18-17
2013 2012
5.3%
Measures the percentage of each dollar of sales that results in 
net income.
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed  Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012
Illustration 18-12
18-30 LO 2
Ratio Analysis Profitability Ratios
6. ASSET TURNOVER
Illustration 18-18
2013 2012
1.3 times
Measures how efficiently a company uses its assets to generate 
sales.
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed  Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012
Illustration 18-12
18-32 LO 2
Ratio Analysis Profitability Ratios
7. RETURN ON ASSETS
Illustration 18-19
2013 2012
7.0%
An overall measure of profitability.
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed  Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012
Illustration 18-12
18-34 LO 2
Ratio Analysis Profitability Ratios
8. RETURN ON COMMON STOCKHOLDERS’ 
EQUITY Illustration 18-20
2013 2012
24.2%
Shows how many dollars of net income the company earned for each 
dollar invested by the owners.
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Ratio Analysis Profitability Ratios
8. RETURN ON COMMON STOCKHOLDERS’ 
EQUITY
With Preferred Stock
 Deduct preferred dividend requirements from net income. 
Illustration 18-21
Return on common stockholders’
equity with preferred stock
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed  Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012
Illustration 18-12
18-37 LO 2
Ratio Analysis Profitability Ratios
9. EARNINGS PER SHARE (EPS)
Illustration 18-22
2013 2012
A measure of the net income earned on each share of common stock.
18-38 LO 2
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed  Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012
Illustration 18-12
18-39 LO 2
Ratio Analysis Profitability Ratios
10. PRICE-EARNINGS RATIO
Illustration 18-23
2013 2012
13.5 times
Reflects investors’ assessments of a company’s future earnings.
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed  Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012
Illustration 18-12
18-41 LO 2
Ratio Analysis Profitability Ratios
11. PAYOUT RATIO
Illustration 18-24
2013 2012
24.2%
Measures the percentage of earnings distributed in the form of cash 
dividends.
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Ratio Analysis
Solvency Ratios
Solvency ratios measure the ability of a company to survive 
over a long period of time.
 Debt to Assets and 
 Times Interest Earned 
are two ratios that provide information about debt-paying 
ability.
18-43 LO 2
QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed  Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012
Illustration 18-12
18-44 LO 2
Ratio Analysis Solvency Ratios
12. DEBT TO TOTAL ASSETS RATIO
Illustration 18-25
2013 2012
71.1%
Measures the percentage of the total assets that creditors provide.
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QUALITY DEPARTMENT STORE INC. QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
Condensed  Balance Sheets
For the Years Ended December 31
2013 2012 2013 2012
Illustration 18-12
18-46 LO 2
Ratio Analysis Solvency Ratios
13. TIMES INTEREST EARNED
Illustration 18-26
Provides an indication of the company’s 
ability to meet interest payments as they 
come due.
18-47 LO 2
Ratio Analysis
Summary of Ratios
Illustration 18-27
18-48 LO 2
Summary of Ratios
Illustration 18-27
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LEARNING Apply the concept of sustainable 
OBJECTIVE 3 income.
Sustainable income is the most likely level of income to be 
obtained by a company in the future. It differs from actual net 
income by the amount of unusual revenues, expenses, 
gains, and losses included in the current year’s income.
Information on unusual items such as gains or losses on 
discontinued items and components of other comprehensive 
income are disclosed.
These unusual items are reported net of income taxes.
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Discontinued Operations
(a) Disposal of a significant component of a business.
(b) Report the income (loss) from discontinued operations 
in two parts: 
1. income (loss) from operations (net of tax) and 
2. gain (loss) on disposal (net of tax).
18-51 LO 3
Discontinued Operations
Illustration:  During 2017 AE Inc. has income before income 
taxes of $79,000,000. During 2017, AE Inc. discontinued and 
sold its unprofitable chemical division. The loss in 2017 from 
chemical operations (net of $135,000 taxes) was $315,000. 
The loss on disposal of the chemical division (net of $81,000 
taxes) was $189,000. Assuming a 30% tax rate on income. 
Show how this discontinued operation would be presented on 
the income statement.
18-52 LO 3
Discontinued Operations
Income Statement (in thousands)
Discontinued Sales $ 285,000
Operations are reported Cost of goods sold    149,000
after “Income from 
continuing operations.” Other revenue (expense):
Interest revenue      17,000
Interest expense     (21,000)
Total other       (4,000)
Income before taxes      79,000
Previiouslly  llabelled  as  Income tax expense      24,000
Income from continuing operations      55,000
“Nett  IIncome”..  Discontinued operations:
Loss from operations, net of tax            315
Loss on disposal, net of tax            189
Total loss on discontinued operations            504
Moved to
Net income $   54,496
18-53 LO 3
Other Comprehensive Income
Income Statement (in thousands) All changes in stockholders’ 
Sales $ 285,000 equity except those resulting 
Cost of goods sold    1 49,000 from investments by 
Gross profit    1 36,000 stockholders and distributions 
Operating expenses:
Advertising expense      1 0,000 to stockholders.
Depreciation expense      4 3,000
Total operating expense      5 3,000 Reported in 
Income from operations       83,000 Stockholders’ Equity
Other revenue:
Interest revenue      1 7,000 Unrealized gains and 
Total other      1 7,000 + losses on available-for-
Income before taxes     100,000 sale securities.
Income tax expense      2 4,000 Plus other items
Net income $   7 6,000
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Other Comprehensive Income
Illustration: During 2017 Stassi Company purchased IBM stock for 
$10,000 as an investment. At the end of 2017, Stassi was still holding 
the investment, but the stock’s market price was now $8,000. In this 
case, Stassi is required to reduce the recorded value of its IBM 
investment by $2,000. The $2,000 difference is an unrealized loss.
Should Stassi include this $2,000 unrealized loss in net income? It 
depends on whether Stassi classifies the IBM stock as a trading 
security or an available-for-sale security. 
Trading securities: Unrealized gains and losses are reported in the 
“Other expenses and losses” section of the income statement.
Available-for-sale securities: Unrealized gains and losses are 
reported as a direct adjustment to stockholders’ equity.
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Other Comprehensive Income
Assume Stassi Company classifies their investment in IBM stock as 
available-for-sale.
Illustration 18-30
Lower portion of statement of
comprehensive income
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Other Comprehensive Income
Assume Stassi Corporation has common stock of $3,000,000, 
retained earnings of $1,500,000, and an unrealized loss on available-
for-sale securities of $2,000. Illustration 18-31 shows the balance 
sheet presentation of the unrealized loss.
Illustration 18-31
Unrealized loss in stockholders’ equity section
18-57 LO 3
Illustration 18-32
Complete statement of
comprehensive income
18-58 LO 3
DO IT! 3 Unusual Items
In its proposed 2017 income statement, AIR Corporation 
reports income before income taxes $400,000, unrealized gain 
on available-for-sale securities $100,000, income taxes 
$120,000 (not including unusual items), loss from operation of 
discontinued flower division $50,000, and loss on disposal of 
discontinued flower division $90,000. The income tax rate is 
30%. 
Prepare a correct statement of comprehensive income, 
beginning with “Income before income taxes.”
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DO IT! 3 Unusual Items
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A Look at IFRS
LEARNING
OBJECTIVE 4
Compare financial statement analysis and income 
statement presentation under GAAP and IFRS.
Relevant Facts
 The tools of financial statement analysis covered in this chapter are 
universal and therefore no significant differences exist in the analysis 
methods used.
 The basic objectives of the income statement are the same under 
both GAAP and IFRS. A very important objective is to ensure that 
users of the income statement can evaluate the sustainable income 
of the company.
18-61 LO 4
A Look at IFRS
Relevant Facts
 The basic accounting for discontinued operations is the same 
under IFRS and GAAP.
 The accounting for changes in accounting principles and changes 
in accounting estimates are the same for both GAAP and IFRS.
 Both GAAP and IFRS follow the same approach in reporting 
comprehensive income.
18-62 LO 4
A Look at IFRS
Looking to the Future
The FASB and the IASB are working on a project that would rework the 
structure of financial statements. Recently, the IASB decided to require a 
statement of comprehensive income, similar to what was required under 
GAAP.
18-63 LO 4
A Look at IFRS
IFRS Self-Test Questions
The basic tools of financial analysis are the same under both GAAP and 
IFRS except that:
a) horizontal analysis cannot be done because the format of the 
statements is sometimes different.
b) analysis is different because vertical analysis cannot be done 
under IFRS.
c) the current ratio cannot be computed because current liabilities 
are often reported before current assets in IFRS statements of 
position.
d) None of the above.
18-64 LO 4
A Look at IFRS
IFRS Self-Test Questions
Presentation of comprehensive income must be reported 
under IFRS in:
a) the statement of stockholders’ equity.
b) the income statement ending with net income.
c) the notes to the financial statements.
d) a statement of comprehensive income.
18-65 LO 4
A Look at IFRS
IFRS Self-Test Questions
In preparing its income statement for 2017, Parmalane assembles the following 
information.
Sales revenue $500,000
Cost of goods sold 300,000
Operating expenses 40,000
Loss on discontinued operations 20,000
Ignoring income taxes, what is Parmalane’s income from continuing 
operations for 2017 under IFRS?
(a) $260,000.
(b) $250,000.
(c) $240,000.
(d) $160,000.
18-66 LO 4
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