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Intermediate Accounting

James D. Stice Earl K. Stice

© 2012 Cengage Learning

PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University

Analysis of Financial Statements

Chapter 23Chapter 23

18th Edition

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Framework for Financial Statement Analysis

• Financial statement analysis is the examination of both the relationships among financial statement numbers and the trends in those numbers over time.

• One purpose of financial statement analysis is to use the past performance of a company to predict its future profitability and cash flows.

(continued)

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• Another purpose of financial statement analysis is to evaluate the performance of a company with an eye toward identifying problem areas.

• Most pieces of information are meaningful only when they can be compared to some benchmark; such as past values or with values for other firms in the same industry.

(continued)

Framework for Financial Statement Analysis

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The Accounting Principles Board stated that comparisons between financial statements are most informative and useful under the following conditions:1. The presentations are in good form; that is,

the arrangement within the statement is identical.

2. The content of the statements is identical; that is, the same items from the underlying accounting records are classified under the same captions.

(continued)

Framework for Financial Statement Analysis

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3. Accounting principles are not changed, or, if they are changed, the financial effects of the changes are disclosed.

4. Changes in circumstances or in the nature of the underlying transactions are disclosed.

(continued)

Framework for Financial Statement Analysis

To the extent that the To the extent that the foregoing criteria are not met, foregoing criteria are not met,

comparisons may be comparisons may be misleading.misleading.

To the extent that the To the extent that the foregoing criteria are not met, foregoing criteria are not met,

comparisons may be comparisons may be misleading.misleading.

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Common-Size Financial Statements

• Financial statements are made comparable by dividing all financial statement numbers for a given year by sales for the year.

• The resulting financial statements are called common-size financial statements, with all amounts for a given year being shown as a percentage of sales for that year.

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DuPont Framework

• The DuPont framework was developed internally at DuPont around 1920.

• It provides a systematic approach to identifying general factors causing return on equity (ROE) to deviate from normal.

• Return on equity (net income/equity) is the single measure that summarizes the financial health of a company.

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DuPont Framework

Return on equity for Colesville Corporation for the years 2013 and 2012 is computed as follows:

2013 2012

Net income $180,000 $205,000Stockholders’ equity $1,468,000 $1,090,000Return on equity 12.3% 18.8%

(continued)

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Coleville’s ROE is 12.3% for 2013 and 18.8% for 2012.

DuPont Framework

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Accounts Receivable Turnover

Colesville CorporationColesville Corporation

$6,600,000

($333,500 + $375,000)/22012 =

$354,250

= 18.6 times

Sales

Average accounts receivable

(continued)

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$5,700,000

($375,000 + $420,000)/22013 =

$397,500 = 14.3 times

Sales

Average accounts receivable

The higher the turnover, the more rapid is a firm’s average collection period for receivables.

The higher the turnover, the more rapid is a firm’s average collection period for receivables.

Accounts Receivable Turnover

Colesville CorporationColesville Corporation

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($333,500 + $375,000)/2

$6,600,000/3652012 =

$18,082

$354,250

= 19.6 days

(continued)

Average Collection Period

Colesville CorporationColesville Corporation

Average accounts receivable

Average daily sales

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Average accounts receivable

Average daily sales

($375,000 + $420,000)/2

$5,700,000/3652013 =

$15,616

$397,500

= 25.5 days

What constitutes a reasonable average collection period varies with individual businesses.

What constitutes a reasonable average collection period varies with individual businesses.

Average Collection Period

Colesville CorporationColesville Corporation

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Inventory Turnover

$4,800,000

($125,000 + $330,000)/22012 =

$227,500

= 21.1 times

(continued)

Cost of goods soldAverage inventory

Colesville CorporationColesville Corporation

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Cost of goods soldAverage inventory

$4,000,000

($330,000 + $225,000)/22013 =

$277,500

= 14.4 times

Inventory turnover allows for evaluation of the firm’s inventory position and the appropriateness of the inventory size.

Inventory turnover allows for evaluation of the firm’s inventory position and the appropriateness of the inventory size.

Inventory Turnover

Colesville CorporationColesville Corporation

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Number of Days’ Sales in Inventory

365Inventory turnover

365

21.12012 =

= 17.3 days

(continued)

Colesville CorporationColesville Corporation

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365Inventory turnover

365

14.42013 =

= 25.3 days

Colesville is holding a 25-day supply of inventory in 2013 compared to a 17-day supply in 2012.

Colesville is holding a 25-day supply of inventory in 2013 compared to a 17-day supply in 2012.

Number of Days’ Sales in Inventory

Colesville CorporationColesville Corporation

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Fixed Asset Turnover

SalesAverage fixed assets

$6,600,000

($330,000 + $225,000)/22012 =

($925,000 + $1,075,000)/2 $1,000,000

= 6.60 times

(continued)

Colesville CorporationColesville Corporation

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$5,700,000

($330,000 + $225,000)/22013 =

($1,075,000 + $1,275,000)/2 $1,175,000

= 4.85 times

The fixed asset turnover measures a firm’s efficiency in using fixed assets to generate sales.

The fixed asset turnover measures a firm’s efficiency in using fixed assets to generate sales.

SalesAverage fixed assets

Fixed Asset Turnover

Colesville CorporationColesville Corporation

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Margin vs. Turnover

Profitability and efficiency combine to determine a company’s return on assets.

$205,000

($2,191,000 + $2,278,000)/22012 =

($1,760,000 + $2,191,000)/2 $1,975,500

= 10.4%

Colesville CorporationColesville Corporation

Net incomeAverage total assets ROA =

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Margin vs. Turnover

Profitability and efficiency combine to determine a company’s return on assets.

$180,000

($2,191,000 + $2,278,000)/22013 =

($2,191,000 + $2,278,000)/2 $2,234,500

= 8.1%

Net incomeAverage total assets ROA =

(continued)

Colesville CorporationColesville Corporation

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Margin vs. Turnover

• The profitability of each dollar in sales is sometimes called a company’s margin.

• The degree to which assets are used to generate sales is called turnover.

• Margin isn’t everything, nor is turnover everything.

• The important thing is how margin and turnover combine to generate return on assets.

(continued)

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Leverage Ratios

1. More borrowing means that more assets can be purchased without any additional equity investment by stockholders.

2. More assets means that more sales can be generated.

3. More sales means that net income should increase.

Higher leverage increases return on equity through the following chain of events:

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Debt Ratio

Colesville CorporationColesville Corporation

Total liabilitiesTotal assets

$1,101,000

$2,191,0002012 = = 50.3%

$810,000

$2,278,0002013 = = 35.6%

Debt ratio is a measure of the level of borrowing relative to funds used to finance the company.

Debt ratio is a measure of the level of borrowing relative to funds used to finance the company.

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Debt-to-Equity Ratio

Total liabilitiesStockholders’ equity

$1,101,000

$1,090,0002012 = = 1.01

$810,000

$1,468,0002013 = = 0.55

Another common way to measure the level of leverage is the debt-to-equity ratio.

Another common way to measure the level of leverage is the debt-to-equity ratio.

Colesville CorporationColesville Corporation

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Times Interest Earned

Colesville CorporationColesville Corporation

Income before interest or income taxesInterest expense

$290,000 + $60,000

$60,0002012 =

$350,000

= 5.8 times

(continued)

$600,000 x $600,000 x 0.100.10

$600,000 x $600,000 x 0.100.10

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Times Interest Earned

Income before interest or income taxesInterest expense

$260,000 + $40,000

$40,0002013 =

$300,000

= 7.5 times$400,000 x $400,000 x

0.100.10

$400,000 x $400,000 x 0.100.10This is a measure of the debt position of a

company in relation to its earnings ability.

This is a measure of the debt position of a company in relation to its earnings ability.

Colesville CorporationColesville Corporation

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Current Ratio

Current assetsCurrent liabilities

$955,500

$501,0002012 = = 1.91

$855,000

$410,0002013 = = 2.09

The current ratio is a test of liquidity, or the firm’s ability to meet its current obligations.

The current ratio is a test of liquidity, or the firm’s ability to meet its current obligations.

Colesville CorporationColesville Corporation

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Cash Flow Adequacy Ratio

Cash from operating activitiesTotal primary cash requirements

(continued) 23-29

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Colesville CorporationColesville Corporation

$424,500

$375,0002012 = = 1.13

$249,000

$602,0002013 = = 0.41

Because the cash flow adequacy ratio in 2013 is less than 1.0, Colesville was not able to satisfy its primary cash requirements with cash generated by operations.

Because the cash flow adequacy ratio in 2013 is less than 1.0, Colesville was not able to satisfy its primary cash requirements with cash generated by operations.

Cash Flow Adequacy Ratio

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Earnings per Share

Net incomeWeighted shares outstanding

$205,000

$75,0002012 = = 2.73

$180,000

$90,0002013 = = 2.00

This well-known ratio shows the size of the dividend per share of common stock if all the net income is distributed.

This well-known ratio shows the size of the dividend per share of common stock if all the net income is distributed.

Colesville CorporationColesville Corporation

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Dividend Payout Ratio

Cash dividendsNet income

$145,000

$205,0002012 = = 70.7%

$102,000

$180,0002013 = = 56.7%

In general, high-growth stable firms have low dividend payout ratios.

In general, high-growth stable firms have low dividend payout ratios.

Colesville CorporationColesville Corporation

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Price-Earnings Ratio

Market value per shareEarnings per share

$60.00

$2.732012 = = 22.0

$29.00

$2.002013 = = 14.5

High P/E ratios are generally associated with firms for which strong future growth is predicted.

High P/E ratios are generally associated with firms for which strong future growth is predicted.

Colesville CorporationColesville Corporation

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Book-to-Market Ratio

Book value of stockholders’ equityTotal market value of equity

$1,090,000

$4,200,0002012 = = 0.26

$1,468,000

$2,900,0002013 = = 0.51

The book-to-market ratio reflects the difference between a company’s balance sheet value and the company’s actual market value.

The book-to-market ratio reflects the difference between a company’s balance sheet value and the company’s actual market value.

Colesville CorporationColesville Corporation

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Impact of Alternative Accounting Methods

• If companies are using different accounting practices, it will impact the comparability of ratios.

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Introduction to Equity Valuation

The following information for McDonald’s will be used for a simple valuation model:

Assume the required rate of return on equity capital for McDonald’s is 15%.

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Constant Future Dividends

The appropriate formula is as follows:

Price =Dividends

Required rate of return on equity capital

Price =$2.05

0.15= $13.67

Thus, the implied price per share for McDonald’s for 2009 was $13.67.

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Constant Dividend Growth

McDonald’s growth rate over the past 12 years has exceeded 20%. Assuming a slower future growth rate of 12%, the implied price per share is computed as follows:

Price = Dividends

Required rate of return on equity – Expected future dividend growth rate

Price = $2.05

0.150 – 0.12= $68.33

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Price-Earnings Multiple

An investor can value a company’s share by using the information in the P/E ratio as follows:

Price = Earnings × P/E ratio

P/E ratios for a selection of restaurant chains at the end of 2009 are as follows:

(continued)

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Price-Earnings Multiple

Using the average of these ratios (27.0), the implied price per share 2009 for McDonald’s is computed as follows:

Price = Earnings × P/E ratioPrice = $4.11 × 27.0 = $110.97

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Discounted Free Cash Flow

Free cash flow is defined as:

Cash from operating activities– Cash paid for capital expenditures= Free cash flow

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Comparison of the Valuation Models

The actual market price of a share of McDonald’s stock at the end of 2009 was $61.91.

The computed prices for McDonald’s shares at the end of 2009, using each of the four models are as follows:

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Chapter 23Chapter 23

The EndThe EndThe EndThe End

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