FinancialAccounting-OP_YioY6nY-205

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Figure A.2 Income Statements and Horizontal Analysis.
Depending on their expectations, Banyan Goods could make decisions to alter operations to produce expected
outcomes. For example, Banyan saw a 50% accounts receivable increase from the prior year to the current
year. If they were only expecting a 20% increase, they may need to explore this line item further to determine
what caused this difference and how to correct it going forward. It could possibly be that they are extending
credit more readily than anticipated or not collecting as rapidly on outstanding accounts receivable. The
company will need to further examine this difference before deciding on a course of action. Another method
of analysis Banyan might consider before making a decision is vertical analysis.
Vertical Analysis
Vertical analysis shows a comparison of a line item within a statement to another line item within that same
statement. For example, a company may compare cash to total assets in the current year. This allows a
company to see what percentage of cash (the comparison line item) makes up total assets (the other line item)
during the period. This is different from horizontal analysis, which compares across years. Vertical analysis
compares line items within a statement in the current year. This can help a business to know how much of one
item is contributing to overall operations. For example, a company may want to know how much inventory
contributes to total assets. They can then use this information to make business decisions such as preparing
the budget, cutting costs, increasing revenues, or capital investments.
The company will need to determine which line item they are comparing all items to within that statement and
then calculate the percentage makeup. These percentages are considered common-size because they make
businesses within industry comparable by taking out fluctuations for size. It is typical for an income statement
to use net sales (or sales) as the comparison line item. This means net sales will be set at 100% and all other
Appendix A 1011
line items within the income statement will represent a percentage of net sales.
On the balance sheet, a company will typically look at two areas: (1) total assets, and (2) total liabilities and
stockholders’ equity. Total assets will be set at 100% and all assets will represent a percentage of total assets.
Total liabilities and stockholders’ equity will also be set at 100% and all line items within liabilities and equity
will be represented as a percentage of total liabilities and stockholders’ equity. The line item set at 100% is
considered the base amount and the comparison line item is considered the comparison amount. The formula
to determine the common-size percentage is:
For example, if Banyan Goods set total assets as the base amount and wanted to see what percentage of total
assets were made up of cash in the current year, the following calculation would occur.
(A3)Common-size percentage = ⎛⎝$110,000
$250,000
⎞
⎠× 100 = 44%
Cash in the current year is $110,000 and total assets equal $250,000, giving a common-size percentage of 44%.
If the company had an expected cash balance of 40% of total assets, they would be exceeding expectations.
This may not be enough of a difference to make a change, but if they notice this deviates from industry
standards, they may need to make adjustments, such as reducing the amount of cash on hand to reinvest in
the business. Figure A.3 shows the common-size calculations on the comparative income statements and
comparative balance sheets for Banyan Goods.
Figure A.3 Income Statements and Vertical Analysis.
1012 Appendix A
This OpenStax book is available for free at http://cnx.org/content/col25448/1.4
Even though vertical analysis is a statement comparison within the same year, Banyan can use information
from the prior year’s vertical analysis to make sure the business is operating as expected. For example,
unearned revenues increased from the prior year to the current year and made up a larger portion of total
liabilities and stockholders’ equity. This could be due to many factors, and Banyan Goods will need to examine
this further to see why this change has occurred. Let’s turn to financial statement analysis using financial
ratios.
Overview of Financial Ratios
Financial ratios help both internal and external users of information make informed decisions about a
company. A stakeholder could be looking to invest, become a supplier, make a loan, or alter internal
operations, among other things, based in part on the outcomes of ratio analysis. The information resulting
from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set
budget expectations, and compare industry competitors. There are four main categories of ratios: liquidity,
solvency, efficiency, and profitability. Note that while there are more ideal outcomes for some ratios, the
industry in which the business operates can change the influence each of these outcomes has over
stakeholder decisions. (You will learn more about ratios, industry standards, and ratio interpretation in
advanced accounting courses.)
Liquidity Ratios
Liquidity ratios show the ability of the company to pay short-term obligations if they came due immediately
with assets that can be quickly converted to cash. This is done by comparing current assets to current
liabilities. Lenders, for example, may consider the outcomes of liquidity ratios when deciding whether to
extend a loan to a company. A company would like to be liquid enough to manage any currently due
obligations but not too liquid where they may not be effectively investing in growth opportunities. Three
common liquidity measurements are working capital, current ratio, and quick ratio.
Working Capital
Working capital measures the financial health of an organization in the short-term by finding the difference
between current assets and current liabilities. A company will need enough current assets to cover current
liabilities; otherwise, they may not be able to continue operations in the future. Before a lender extends credit,
they will review the working capital of the company to see if the company can meet their obligations. A larger
difference signals that a company can cover their short-term debts and a lender may be more willing to extend
the loan. On the other hand, too large of a difference may indicate that the company may not be correctly
using their assets to grow the business. The formula for working capital is:
Using Banyan Goods, working capital is computed as follows for the current year:
(A4)Working capital = $200,000 – $100,000 = $100,000
In this case, current assets were $200,000, and current liabilities were $100,000. Current assets were far greater
than current liabilities for Banyan Goods and they would easily be able to cover short-term debt.
The dollar value of the difference for working capital is limited given company size and scope. It is most useful
to convert this information to a ratio to determine the company’s current financial health. This ratio is the
current ratio.
Appendix A 1013
Current Ratio
Working capital expressed as a ratio is the current ratio. The current ratio considers the amount of current
assets available to cover current liabilities. The higher the current ratio, the more likely the company can cover
its short-term debt. The formula for current ratio is:
The current ratio in the current year for Banyan Goods is:
(A5)Current ratio = ⎛⎝$200,000
$100,000
⎞
⎠ = 2 or 2:1
A 2:1 ratio means the company has twice as many current assets as current liabilities; typically, this would be
plenty to cover obligations. This may be an acceptable ratio for Banyan Goods, but if it is too high, they may
want to consider using those assets in a different way to grow the company.
Quick Ratio
The quick ratio, also known as the acid-test ratio, is similar to the current ratio except current assets are more
narrowly defined as the mostliquid assets, which exclude inventory and prepaid expenses. The conversion of
inventory and prepaid expenses to cash can sometimes take more time than the liquidation of other current
assets. A company will want to know what they have on hand and can use quickly if an immediate obligation is
due. The formula for the quick ratio is:
The quick ratio for Banyan Goods in the current year is:
(A6)Quick ratio = ⎛⎝$110,000 + $20,000 + $30,000
$100,000
⎞
⎠ = 1.6 or 1.6:1
A 1.6:1 ratio means the company has enough quick assets to cover current liabilities.
Another category of financial measurement uses solvency ratios.
Solvency Ratios
Solvency implies that a company can meet its long-term obligations and will likely stay in business in the
future. To stay in business the company must generate more revenue than debt in the long-term. Meeting
long-term obligations includes the ability to pay any interest incurred on long-term debt. Two main solvency
ratios are the debt-to-equity ratio and the times interest earned ratio.
Debt to Equity Ratio
The debt-to-equity ratio shows the relationship between debt and equity as it relates to business financing. A
company can take out loans, issue stock, and retain earnings to be used in future periods to keep operations
running. It is less risky and less costly to use equity sources for financing as compared to debt resources. This
is mainly due to interest expense repayment that a loan carries as opposed to equity, which does not have this
requirement. Therefore, a company wants to know how much debt and equity contribute to its financing.
Ideally, a company would prefer more equity than debt financing. The formula for the debt to equity ratio is:
1014 Appendix A
This OpenStax book is available for free at http://cnx.org/content/col25448/1.4
The information needed to compute the debt-to-equity ratio for Banyan Goods in the current year can be
found on the balance sheet.
(A7)Debt-to-equity ratio = ⎛⎝$150,000
$100,000
⎞
⎠ = 1.5 or 1.5:1
This means that for every $1 of equity contributed toward financing, $1.50 is contributed from lenders. This
would be a concern for Banyan Goods. This could be a red flag for potential investors that the company could
be trending toward insolvency. Banyan Goods might want to get the ratio below 1:1 to improve their long-
term business viability.
Times Interest Earned Ratio
Time interest earned measures the company’s ability to pay interest expense on long-term debt incurred. This
ability to pay is determined by the available earnings before interest and taxes (EBIT) are deducted. These
earnings are considered the operating income. Lenders will pay attention to this ratio before extending credit.
The more times over a company can cover interest, the more likely a lender will extend long-term credit. The
formula for times interest earned is:
The information needed to compute times interest earned for Banyan Goods in the current year can be found
on the income statement.
(A8)Times interest earned = ⎛⎝$43,000
$2,000
⎞
⎠ = 21.5 times
The $43,000 is the operating income, representing earnings before interest and taxes. The 21.5 times outcome
suggests that Banyan Goods can easily repay interest on an outstanding loan and creditors would have little
risk that Banyan Goods would be unable to pay.
Another category of financial measurement uses efficiency ratios.
Efficiency Ratios
Efficiency shows how well a company uses and manages their assets. Areas of importance with efficiency are
management of sales, accounts receivable, and inventory. A company that is efficient typically will be able to
generate revenues quickly using the assets it acquires. Let’s examine four efficiency ratios: accounts receivable
turnover, total asset turnover, inventory turnover, and days’ sales in inventory.
Accounts Receivable Turnover
Accounts receivable turnover measures how many times in a period (usually a year) a company will collect
cash from accounts receivable. A higher number of times could mean cash is collected more quickly and that
credit customers are of high quality. A higher number is usually preferable because the cash collected can be
reinvested in the business at a quicker rate. A lower number of times could mean cash is collected slowly on
these accounts and customers may not be properly qualified to accept the debt. The formula for accounts
receivable turnover is:
Appendix A 1015
	Appendix A. Financial Statement Analysis*
	A.3. Vertical Analysis
	A.4. Overview of Financial Ratios