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ANALYSIS ANDINTERPRETATION OF
FINANCIAL STATEMENTS
Non-accounting majors, especially, should relate well to this chapter
It looks at accounting information from users’ perspective Relates very closely to topics you will study in your
finance courseTherefore, we will use a somewhat broader brush on this chapter
What is financial statement analysis?”Tearing apart” the financial statements and looking at the relationships
Financial Statement Analysis
Who analyzes financial statements? Internal users (i.e., management) External users (emphasis of chapter)
Examples? Investors, creditors, regulatory agencies & … stock market analysts and auditors
Financial Statement Analysis625
What do internal users use it for? Planning, evaluating and controlling company
operations
What do external users use it for? Assessing past performance and current financial
position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management
First sentence in chapter says...
Financial Statement Analysis
Information is available from Published annual reports
(1) Financial statements (2) Notes to financial statements (3) Letters to stockholders (4) Auditor’s report (Independent accountants) (5) Management’s discussion and analysis
Reports filed with the government e.g., Form 10-K, Form 10-Q and Form 8-K
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Financial Statement Analysis
Information is available from Other sources
(1) Newspapers (e.g., Wall Street Journal ) (2) Periodicals (e.g. Forbes, Fortune) (3) Financial information organizations such
as: Moody’s, Standard & Poor’s, Dun &
Bradstreet, Inc., and Robert Morris Associates (4) Other business publications
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Financial Statement Analysis
Horizontal Analysis
Vertical Analysis
Common-Size Statements
Trend Percentages
Ratio Analysis
Methods ofFinancial Statement Analysis
Horizontal Analysis
Using comparative financial statements to calculate dollar
or percentage changes in a financial statement item from
one period to the next
Using comparative financial statements to calculate dollar
or percentage changes in a financial statement item from
one period to the next
Vertical Analysis
For a single financial statement, each item
is expressed as a percentage of a
significant total, e.g., all income
statement items are expressed as a
percentage of sales
For a single financial statement, each item
is expressed as a percentage of a
significant total, e.g., all income
statement items are expressed as a
percentage of sales
Common-Size Statements
Financial statements that show only percentages and no absolute dollar amounts
Financial statements that show only percentages and no absolute dollar amounts
Trend Percentages
Show changes over time in given financial statement items
(can help evaluate financial information of several years)
Show changes over time in given financial statement items
(can help evaluate financial information of several years)
Ratio Analysis
Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship
between revenue and net income)
Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship
between revenue and net income)
Horizontal Analysis ExampleThe management of Clover Company provides you
with comparative balance sheets of the years ended December 31, 1999 and 1998.
Management asks you to prepare a horizontal analysis on the information.
Calculating Change in Dollar Amounts
DollarChange
Current YearFigure
Base YearFigure
= –
Horizontal Analysis Example
Calculating Change in Dollar Amounts
Since we are measuring the amount of the change between 1998 and 1999, the
dollar amounts for 1998 become the “base” year figures.
DollarChange
Current YearFigure
Base YearFigure
= –
Horizontal Analysis Example
Calculating Change as a Percentage
PercentageChange
Dollar Change Base Year Figure
100%= ×
Horizontal Analysis Example
$12,000 – $23,500 = $(11,500)
Horizontal Analysis Example
($11,500 ÷ $23,500) × 100% = 48.9%
Horizontal Analysis Example
Horizontal Analysis Example
Let’s apply the sameprocedures to the
liability and stockholders’equity sections of the
balance sheet.
Horizontal Analysis Example
CLOVER CORPORATIONComparative Balance SheetsDecember 31, 1999 and 1998
Increase (Decrease)1999 1998 Amount %
Liabilities and Stockholders' EquityCurrent liabilities: Accounts payable 67,000$ 44,000$ 23,000$ 52.3 Notes payable 3,000 6,000 (3,000) (50.0) Total current liabilities 70,000 50,000 20,000 40.0Long-term liabilities: Bonds payable, 8% 75,000 80,000 (5,000) (6.3) Total liabilities 145,000 130,000 15,000 11.5Stockholders' equity: Preferred stock 20,000 20,000 - 0.0 Common stock 60,000 60,000 - 0.0 Additional paid-in capital 10,000 10,000 - 0.0 Total paid-in capital 90,000 90,000 - 0.0Retained earnings 80,000 69,700 10,300 14.8 Total stockholders' equity 170,000 159,700 10,300 6.4Total liabilities and stockholders' equity 315,000$ 289,700$ 25,300$ 8.7
Now, let’s apply the procedures to theincome statement.
Horizontal Analysis Example
CLOVER CORPORATIONComparative Income Statements
For the Years Ended December 31, 1999 and 1998Increase (Decrease)
1999 1998 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)
CLOVER CORPORATIONComparative Income Statements
For the Years Ended December 31, 1999 and 1998Increase (Decrease)
1999 1998 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)
Sales increased by 8.3% while net income decreased by 21.9%.
CLOVER CORPORATIONComparative Income Statements
For the Years Ended December 31, 1999 and 1998Increase (Decrease)
1999 1998 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)
There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the
increase in sales, yielding an overall decrease in net income.
Vertical Analysis ExampleThe management of Sample Company asks you to
prepare a vertical analysis for the comparative balance sheets of the company.
Vertical Analysis Example
Vertical Analysis Example
$82,000 ÷ $483,000 = 17% rounded$30,000 ÷ $387,000 = 8% rounded
Vertical Analysis Example
$76,000 ÷ $483,000 = 16% rounded
Trend Percentages ExampleWheeler, Inc. provides you with the following operating data and asks that you prepare a trend
analysis.
Trend Percentages ExampleWheeler, Inc. provides you with the following operating data and asks that you prepare a trend
analysis.
$1,991 - $1,820 = $171
Trend Percentages ExampleUsing 1995 as the base year, we develop the
following percentage relationships.
$1,991 - $1,820 = $171$171 ÷ $1,820 = 9% rounded
Trend linefor Sales
Ratios can be expressed in three different ways: 1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of $2.25)
CAUTION! “Using ratios and percentages without considering
the underlying causes may be hazardous to your health!”
lead to incorrect conclusions.”
Ratios
Categories of Ratios Liquidity Ratios
Indicate a company’s short-term debt-paying ability
Equity (Long-Term Solvency) RatiosShow relationship between debt and equity financing in a company
Profitability TestsRelate income to other variables
Market TestsHelp assess relative merits of stocks in the marketplace
Liquidity Ratios Current (working capital) ratio Acid-test (quick) ratio Cash flow liquidity ratio Accounts receivable turnover Number of days’ sales in accounts receivable Inventory turnover Total assets turnover
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10 Ratios You Must Know
Equity (Long-Term Solvency) Ratios Equity (stockholders’ equity) ratio Equity to debt
10 Ratios You Must Know
Profitability Tests Return on operating assets Net income to net sales (return on sales or “profit
margin”) Return on average common stockholders’ equity
(ROE) Cash flow margin Earnings per share Times interest earned Times preferred dividends earned
$
10 Ratios You Must Know
Market Tests Earnings yield on common stock Price-earnings ratio Payout ratio on common stock Dividend yield on common stock Dividend yield on preferred stock Cash flow per share of common stock
10 Ratios You Must Know
Now, let’s look at Norton
Corporation’s 1999 and 1998 financial
statements.
Now, let’s calculate the 10 ratios based
on Norton’s financial statements.
NORTON CORPORATION
1999
Cash 30,000$
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 12,000
Total current assets 65,000
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000
We will use this
informationto calculate
the liquidity ratios for Norton.
Working Capital*
12/31/99
Current assets 65,000$
Current liabilities (42,000)
Working capital 23,000$
The excess of current assets over current liabilities.
* While this is not a ratio, it does give an indication of a company’s liquidity.
Current (Working Capital) Ratio
CurrentRatio
$65,000 $42,000
= = 1.55 : 1
Measures the abilityof the company to pay current
debts as they become due.
CurrentRatio
Current Assets Current Liabilities
=
#1
Acid-Test (Quick) Ratio
Quick Assets Current Liabilities
=Acid-Test
Ratio
Quick assets are Cash,Marketable Securities,
Accounts Receivable (net) andcurrent Notes Receivable.
#2
Quick Assets Current Liabilities
=Acid-Test
Ratio
Norton Corporation’s quick assets consist of cash of
$30,000 and accounts receivable of $20,000.
Acid-Test (Quick) Ratio
#2
Quick Assets Current Liabilities
=Acid-Test
Ratio
$50,000 $42,000
= 1.19 : 1=Acid-Test
Ratio
Acid-Test (Quick) Ratio
#2
Sales on Account Average Accounts Receivable
Accounts ReceivableTurnover
=
Accounts Receivable Turnover
= 26.70 times $494,000 ($17,000 + $20,000) ÷ 2
Accounts ReceivableTurnover
=
This ratio measures how many times a company converts its
receivables into cash each year.
#3 Average, net accounts receivable
Net, credit sales
Number of Days’ Salesin Accounts Receivable
Measures, on average, how many days it takes to collect an
account receivable.
Days’ Salesin AccountsReceivables
= 365 Days Accounts Receivable Turnover
= 13.67 days= 365 Days 26.70 Times
Days’ Salesin AccountsReceivables
#4
Number of Days’ Salesin Accounts Receivable
In practice, would 45 days be a desirable number of days in
receivables?
#4Days’ Salesin AccountsReceivables
= 365 Days Accounts Receivable Turnover
= 13.67 days= 365 Days 26.70 Times
Days’ Salesin AccountsReceivables
Inventory Turnover
Cost of Goods Sold Average Inventory
InventoryTurnover
=
Measures the number of timesinventory is sold and
replaced during the year.
= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2
InventoryTurnover
=
#5
Inventory Turnover
Cost of Goods Sold Average Inventory
InventoryTurnover
=
Would 5 be a desirable number of times for inventory to turnover?
= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2
InventoryTurnover
=
#5
Equity, or Long–TermSolvency Ratios
This is part of the information to
calculate the equity, or long-term solvency
ratios of Norton Corporation.
NORTON CORPORATION
1999
Net operating income 84,000$ Net sales 494,000 Interest expense 7,300 Total stockholders' equity 234,390
NORTON CORPORATION
1999
Common shares outstanding Beginning of year 17,000 End of year 27,400
Net income 53,690$
Stockholders' equity
Beginning of year 180,000
End of year 234,390
Dividends per share 2
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
Here is therest of the
informationwe will
use.
Equity Ratio
EquityRatio
= Stockholders’ Equity Total Assets
EquityRatio
= $234,390 $346,390
67.7%=
Measures the proportionof total assets provided by
stockholders.
#6
Net Income to Net SalesA/K/A Return on Sales or Profit Margin
Net Incometo
Net Sales=
Net Income Net Sales
Net Incometo
Net Sales=
$53,690 $494,000
= 10.9%
Measures the proportion of the sales dollarwhich is retained as profit.
#7
Net Income to Net SalesA/K/A Return on Sales or Profit Margin
Net Incometo
Net Sales=
Net Income Net Sales
Net Incometo
Net Sales=
$53,690 $494,000
= 10.9%
Would a 1% return on sales be good?
#7
Return on Average Common Stockholders’ Equity (ROE)
Return onStockholders’
Equity=
Net Income Average Common
Stockholders’ Equity
= $53,690 ($180,000 + $234,390) ÷ 2
= 25.9%Return on
Stockholders’Equity
Important measure of theincome-producing ability
of a company.
#8
Earningsper Share
Earnings Available to Common StockholdersWeighted-Average Number of Common
Shares Outstanding=
Earningsper Share
$53,690 (17,000 + 27,400) ÷ 2
= = $2.42
The financial press regularly publishesactual and forecasted EPS amounts.
#9
Earnings Per Share
What’s new from Chap. 15? Weighted-average calculation
EPS of common stock = _______________________Earnings available tocommon stockholders
Weighted-average number ofcommon shares outstanding
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Three alternatives for calculating weighted-average number of shares
Earnings Per Share
EPS of common stock = _______________________Earnings available tocommon stockholders
Weighted-average number ofcommon shares outstanding
645
Alternate #1
Earnings Per Share What’s new from Chap. 15? Weighted-average calculation
Alternate #3
Alternate #2
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Earnings Per Share
¶ EPS and Stock Dividends or SplitsWhy restate all prior calculations of EPS?
Comparability - i.e., no additional capital was generated by the dividend or split
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Earnings Per Share
¶ Primary EPS and Fully Diluted EPS
APB Opinion No. 15
I mentioned this 17-page pronouncement that required a 100-page explanation in the lecture for chapter 13.
Price-Earnings RatioA/K/A P/E Multiple
Price-EarningsRatio
Market Price Per Share EPS
=
Price-EarningsRatio
= $20.00
$ 2.42= 8.3 : 1
#10
Provides some measure of whether the stock is under or overpriced.
Important Considerations Need for comparable data
Data is provided by Dun & Bradstreet, Standard & Poor’s etc.
Must compare by industry Is EPS comparable?
Influence of external factors
General business conditions
Seasonal nature of business operations
Impact of inflation
Question
The current ratio is a measure of liquidity that is computed by dividing total assets by total
liabilities.
a. True
b. False
The current ratio is a measure of liquidity that is computed by dividing total assets by total
liabilities.
a. True
b. False
The current ratio is a measure of liquidity that is computed by dividing
total assets by total liabilities.
a. True
b. False
The current ratio is a measure of liquidity that is computed by dividing
total assets by total liabilities.
a. True
b. False
Question
The current ratio is a measure ofliquidity, but is computed by
dividing current assets bycurrent liabilities
The current ratio is a measure ofliquidity, but is computed by
dividing current assets bycurrent liabilities
Question
Quick assets are defined as Cash, Marketable Securities and net receivables.
a. True
b. False
Quick assets are defined as Cash, Marketable Securities and net receivables.
a. True
b. False
Quick assets are defined as Cash, Marketable Securities and net
receivables.
a. True
b. False
Quick assets are defined as Cash, Marketable Securities and net
receivables.
a. True
b. False
Question
No more ratios, please!