• Purpose of Analysis; Financial statement analysis helps users make better decisions

• Financial Statements Are Designed for Analysis• Tools of Analysis– Dollar and Percentage Changes– Trend analysis is used to reveal patterns in data

covering successive periods– Component Percentages• Horizontal Analysis, Vertical Analysis

• Common Size Statements 1

Chapter

14FINANCIAL STATEMENT

ANALYSISRATIO ANALYSIS

2

Past perform ance topresent perform ance.

Other com panies toyour com pany.

Along w ith dollar and percentage changes,trend percentages, and com ponent percentages,

ratios can be used to com pare:

A ratio is a sim ple m athem atical expressionof the relationship betw een one item and another.

Ratios

3

NORTON CORPORATION2003

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 15,000 Total current assets 65,000 Total current liabilities 42,000 Total liabilities 103,917 Total assets Beginning of year 300,000 End of year 346,390 Revenues 494,000

NORTON CORPORATION2003

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 15,000 Total current assets 65,000 Total current liabilities 42,000 Total liabilities 103,917 Total assets Beginning of year 300,000 End of year 346,390 Revenues 494,000

Use this information to calculate the

liquidity ratios for Norton

Corporation.

4

Working capital Working capital is the excess of current assets over current liabilities.

Working capital Working capital is the excess of current assets over current liabilities.

Working Capital

5

CurrentRatio

Current Assets Current Liabilities

=

CurrentRatio

$65,000 $42,000

= = 1.55 : 1

This ratio measures the short-term debt-paying ability of the

company.

This ratio measures the short-term debt-paying ability of the

company.

Current Ratio

6

Quick assets are cash, marketable securities, and receivables.

Quick assets are cash, marketable securities, and receivables.

This ratio is like the currentratio but excludes current assets such as inventories that may be

difficult to quickly convert into cash.

This ratio is like the currentratio but excludes current assets such as inventories that may be

difficult to quickly convert into cash.

Quick Assets Current Liabilities

=QuickRatio

Quick Ratio

7

Quick Assets Current Liabilities

=QuickRatio

$50,000 $42,000

= 1.19 : 1=QuickRatio

This ratio is like the currentratio but excludes current assets such as inventories that may be

difficult to quickly convert into cash.

This ratio is like the currentratio but excludes current assets such as inventories that may be

difficult to quickly convert into cash.

Quick Ratio

8

A measure of creditor’s long-term risk. A measure of creditor’s long-term risk.

The smaller the percentage of assets that are financed by debt, the smaller the risk

for creditors.

A measure of creditor’s long-term risk. A measure of creditor’s long-term risk.

The smaller the percentage of assets that are financed by debt, the smaller the risk

for creditors.

Debt Ratio

9

Ratios help usersunderstand

financial relationships.

Ratios provide forquick com parison

of com panies.

U ses

M anagem ent m ay enterinto transactions m erely

to im prove the ratios.

Ratios do not help w ithanalysis of the com pany's

progress tow ardnonfinancial goals.

Lim ita tions

Uses and Limitations of Financial Ratios

10

An income statement can be prepared in either a multiple-step or single-step format.

An income statement can be prepared in either a multiple-step or single-step format.

The single-step format is simpler.The multiple-step format provides

more detailed information.

The single-step format is simpler.The multiple-step format provides

more detailed information.

Measures of Profitability

11

Proper Heading {Gross Margin {Operating Expenses {

{Non- operating Items

Income Statement (Multiple-Step) ExampleIncome Statement (Multiple-Step) Example

Remember to compute EPS.

Remember to compute EPS.

12

Proper Heading {Income Statement (Single-Step) ExampleIncome Statement (Single-Step) Example

Expenses & Losses {

Revenues & Gains {

Remember to compute EPS.

Remember to compute EPS.

13

Use this information to calculate the profitability

ratios for Norton Corporation.

NORTON CORPORATION

2003Number of common shares outstanding all of 2003 27,400 Net income 53,690$ Shareholders' equity Beginning of year 180,000 End of year 234,390 Revenues 494,000 Cost of sales 140,000 Total assets Beginning of year 300,000 End of year 346,390

NORTON CORPORATION

2003Number of common shares outstanding all of 2003 27,400 Net income 53,690$ Shareholders' equity Beginning of year 180,000 End of year 234,390 Revenues 494,000 Cost of sales 140,000 Total assets Beginning of year 300,000 End of year 346,390

14

This ratio is generally consideredthe best overall measure of a

company’s profitability.

This ratio is generally consideredthe best overall measure of a

company’s profitability.

Return On Assets (ROA)

15

Use this information to calculate the profitability

ratios for Norton Corporation.

NORTON CORPORATION

2003Number of common shares outstanding all of 2003 27,400 Net income 53,690$ Shareholders' equity Beginning of year 180,000 End of year 234,390 Revenues 494,000 Cost of sales 140,000 Total assets Beginning of year 300,000 End of year 346,390

NORTON CORPORATION

2003Number of common shares outstanding all of 2003 27,400 Net income 53,690$ Shareholders' equity Beginning of year 180,000 End of year 234,390 Revenues 494,000 Cost of sales 140,000 Total assets Beginning of year 300,000 End of year 346,390

16

This measure indicates how well the company employed the owners’

investments to earn income.

This measure indicates how well the company employed the owners’

investments to earn income.

Return On Equity (ROE)

17

Can beaudited orunaudited.

Annual andquarterlyfinancialreports.

Reports filedw ith the SEC bypublicly ow ned

com panies.

Internet andother freesources.

Detailedanalyses by

financialanalysts.

Sources of Financial Information

18

More Examples of Ratios in Different Perspective

19

Solvency AnalysisSolvency AnalysisSolvency AnalysisSolvency Analysis Solvency is the ability of a business to

meet its financial obligations (debts) as they are due.

Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities.

This ability is normally assessed by examining balance sheet relationships.

20

Current Position AnalysisCurrent Position Analysis

Current assets $550,000 $533,000Current liabilities 210,000 243,000Working capital $340,000 $290,000

Current ratioCurrent ratio 2.6 2.6 2.2 2.2

Working Capital and Current RatioWorking Capital and Current RatioWorking Capital and Current RatioWorking Capital and Current Ratio

Use: To indicate the ability to meet currently maturing obligations.

Use: To indicate the ability to meet currently maturing obligations.

2006 2005

Divide current

assets by current

liabilities

Divide current

assets by current

liabilities21

Quick RatioQuick RatioQuick RatioQuick Ratio

Use: To indicate instant debt-paying ability.Use: To indicate instant debt-paying ability.

2006 2005Quick assets:

Cash $ 90,500 $ 64,700Marketable securities 75,000 60,000Accounts receivable (net) 115,000 120,000 Total $280,500 $244,700

Current liabilities $210,000 $243,000Quick ratioQuick ratio 1.3 1.3 1.0 1.0

Current Position AnalysisCurrent Position Analysis

22

Accounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable Turnover

Net sales on account $1,498,000 $1,200,000Accounts receivable (net):

Beginning of year $ 120,000 $ 140,000End of year 115,500 120,000Total $ 235,000 $ 260,000

Average (Total ÷ 2) $ 117,500 $ 130,000

2006 2005

Accounts Receivable AnalysisAccounts Receivable Analysis

Net sales on accountAverage accounts

receivable

Net sales on accountAverage accounts

receivable

23

Use: To assess the efficiency in collecting receivables and in the management of credit.

Use: To assess the efficiency in collecting receivables and in the management of credit.

Net sales on account $1,498,000 $1,200,000Accounts receivable (net):

Beginning of year $ 120,000 $ 140,000End of year 115,500 120,000Total $ 235,000 $ 260,000

Average $ 117,500 $ 130,000

Accounts receivable turnoverAccounts receivable turnover 12.7 12.7 9.2 9.2

2006 2005

Accounts Receivable AnalysisAccounts Receivable Analysis

Accounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable Turnover

24

Number of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in Receivables

Accounts receivable (net),end of year $ 115,000 $ 120,000

Net sales on account $1,498,000 $1,200,000Average daily sales on

account (sales ÷ 365) $ 4,104 $ 3,288

2006 2005

Accounts Receivable AnalysisAccounts Receivable Analysis

Accounts receivable, end of year

Average daily sales on account

Accounts receivable, end of year

Average daily sales on account

25

Number of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in Receivables

Use: To assess the efficiency in collecting receivables and in the management of credit.

Use: To assess the efficiency in collecting receivables and in the management of credit.

Number of days’ sales inNumber of days’ sales in receivables 28.0 36.5receivables 28.0 36.5

Accounts receivable (net),end of year $ 115,000 $ 120,000

Net sales on account $1,498,000 $1,200,000Average daily sales on

account (sales ÷ 365) $ 4,104 $ 3,288

2006 2005

Accounts Receivable AnalysisAccounts Receivable Analysis

26

Inventory TurnoverInventory TurnoverInventory TurnoverInventory Turnover2006 2005

Cost of goods sold $1,043,000 $ 820,000Inventories:

Beginning of year $ 283,000 $ 311,000End of year 264,000 283,000Total $ 547,000 $ 594,000

Average (Total ÷ 2) $ 273,500 $ 297,000

Inventory AnalysisInventory Analysis

Cost of goods sold

Average inventory

Cost of goods sold

Average inventoryInventory turnover =

27

Inventory TurnoverInventory TurnoverInventory TurnoverInventory Turnover

Use: To assess the efficiency in the management of inventory.

Use: To assess the efficiency in the management of inventory.

2006 2005Cost of goods sold $1,043,000 $ 820,000Inventories:

Beginning of year $ 283,000 $ 311,000End of year 264,000 283,000Total $ 547,000 $ 594,000

Average (Total ÷ 2) $ 273,500 $ 297,000

Inventory turnoverInventory turnover 3.8 3.8 2.8 2.8

Inventory AnalysisInventory Analysis

28

Number of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in Inventory

2006 2005Inventories, end of year $ 264,000 $283,000Cost of goods sold $1,043,000 $820,000Average daily cost of

goods sold (COGS ÷ 365) $ 2,858 $ 2,247

Inventory AnalysisInventory Analysis

Inventories, end of year

Average daily cost of goods sold

Inventories, end of year

Average daily cost of goods sold

Number of Days’ Sales in Inventory

=

29

Number of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in Inventory

Use: To assess the efficiency in the management of inventory.

Use: To assess the efficiency in the management of inventory.

Inventories, end of year $ 264,000 $283,000Cost of goods sold $1,043,000 $820,000Average daily cost of

goods sold (COGS ÷ 365) $ 2,858 $ 2,247

Number of days’ sales Number of days’ sales

in inventoryin inventory 92.4 92.4 125.9 125.9

Inventory AnalysisInventory Analysis

2006 2005

30

Use: To indicate the margin of safety to long-term creditors.

Use: To indicate the margin of safety to long-term creditors.

2006 2005

Fixed assets (net) $444,500 $470,000Long-term liabilities $100,000 $200,000

Ratio of fixed assets toRatio of fixed assets to

long-term liabilitieslong-term liabilities 4.4 4.4 2.4 2.4

Ratio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term Liabilities

Long-Term CreditorsLong-Term Creditors

31

Ratio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ Equity

Use: To indicate the margin of safety to creditors.

Use: To indicate the margin of safety to creditors.

Total liabilities $310,000 $443,000Total stockholders’ equity $829,500 $787,500Ratio of liabilities toRatio of liabilities to

stockholders’ equitystockholders’ equity 0.37 0.37 0.56 0.56

Long-Term CreditorsLong-Term Creditors

2006 2005

32

Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned

2006 2005

Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000

Long-Term CreditorsLong-Term Creditors

Income beforeincome tax + interest expense

Interest expense

Income beforeincome tax + interest expense

Interest expense

Number of Times Interest

Charges Earned=

33

Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned

Use: To assess the risk to debtholders in terms of number of times interest charges were earned.

Use: To assess the risk to debtholders in terms of number of times interest charges were earned.

2006 2005

Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000

Number of times earnedNumber of times earned 4.0 4.0 4.2 4.2

Long-Term CreditorsLong-Term Creditors

34

Profitability AnalysisProfitability AnalysisProfitability AnalysisProfitability Analysis

Profitability is the ability of an entity to earn profits.

This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available.

Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet.

35

Ratio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to Assets2006 2005

Net sales $1,498,000 $1,200,000Total assets:

Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000

Average (Total ÷ 2) $1,048,750 $1,031,500

The Common StockholderThe Common Stockholder

Excludes long-term investmentsExcludes long-term investments

36

The Common StockholderThe Common Stockholder

Use: To assess the effectiveness of the use of assets.

Use: To assess the effectiveness of the use of assets.

Ratio of net sales to assets 1.4 1.2Ratio of net sales to assets 1.4 1.2

Ratio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to Assets2006 2005

Net sales $1,498,000 $1,200,000Total assets:

Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000

Average (Total ÷ 2) $1,048,750 $1,031,500

37

Rate Earned on Total AssetsRate Earned on Total AssetsRate Earned on Total AssetsRate Earned on Total Assets

Use: To assess the profitability of the assets.Use: To assess the profitability of the assets.

2006 2005

Rate earned on total assets 8.2% 7.3%Rate earned on total assets 8.2% 7.3%

Net income $ 91,000 $ 76,500Plus interest expense 6,000 12,000

Total $ 97,000 $ 88,500Total assets:

Beginning of year $1,230,500 $1,187,500End of year 1,139,500 1,230,500Total $2,370,000 $2,418,000Average (Total ÷ 2) $1,185,000 $1,209,000

The Common StockholderThe Common Stockholder

38

Rate Earned on Stockholders’ EquityRate Earned on Stockholders’ EquityRate Earned on Stockholders’ EquityRate Earned on Stockholders’ Equity

Use: To assess the profitability of the investment by stockholders.

Use: To assess the profitability of the investment by stockholders.

Rate earned on stockholders’Rate earned on stockholders’equity 11.3% 10.0% equity 11.3% 10.0%

Net income $ 91,000 $ 76,500Stockholders’ equity:

Beginning of year $ 787,500 $ 750,000End of year 829,500 787,500Total $1,617,000 $1,537,500Average (Total ÷ 2) $ 808,500 $ 768,750

2006 2005

The Common StockholderThe Common Stockholder

39

Leverage10%

5%

0%

Rate earned on total assets

Rate earned on stockholders’ equity

8.2%

11.3%

Leverage 3.1%

2006

7.3%

10.0%Leverage

2.7%

2005

40

Rate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ Equity

2006 2005

The Common StockholderThe Common Stockholder

Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Remainder—common stock $ 82,000 $ 67,500Common stockholders’ equity:

Beginning of year $ 637,500 $ 600,000End of year 679,500 637,500Total $1,317,000 $1,237,500Average (Total ÷ 2) $ 658,500 $ 618,750

41

Use: To assess the profitability of the investment by common stockholders.

Use: To assess the profitability of the investment by common stockholders.

2006 2005

Rate earned on commonRate earned on common stockholders’ equity 12.5% 10.9%stockholders’ equity 12.5% 10.9%

Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Remainder—common stock $ 82,000$ 82,000 $ 67,500$ 67,500Common stockholders’ equity:

Beginning of year $ 637,500 $ 600,000End of year 679,500 637,500Total $1,317,000 $1,237,500Average (Total ÷ 2) $ 658,500$ 658,500 $ 618,750 $ 618,750

The Common StockholderThe Common StockholderRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ Equity

42

Earnings Per Share on Common StockEarnings Per Share on Common StockEarnings Per Share on Common StockEarnings Per Share on Common Stock

2006 2005

Earnings per share on common stock $1.64 $1.35Earnings per share on common stock $1.64 $1.35

Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Remainder—common stock $ 82,000 $ 67,500Shares of common stock 50,000 50,000

Use: To assess the profitability of the investment by common stockholders.

Use: To assess the profitability of the investment by common stockholders.

The Common StockholderThe Common Stockholder

43

Price-Earnings RatioPrice-Earnings RatioPrice-Earnings RatioPrice-Earnings Ratio

Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings.

Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings.

2006 2005

Price-earnings ratio on common stock 25 20Price-earnings ratio on common stock 25 20

Market price per share of common $41.00 $27.00Earnings per share on common ÷ 1.64 ÷ 1.35

The Common StockholderThe Common Stockholder

44

Dividends and Earnings Per Share

Dividends Earnings

$0.80

$1.64

2006

$0.60

$1.35

2005

Per share

$2.00$2.00

$1.50$1.50

$1.00$1.00

$0.50$0.50

$0.00

45

Dividend Yield on Common StockDividend Yield on Common StockDividend Yield on Common StockDividend Yield on Common Stock

Use: To indicate the rate of return to common stockholders in terms of dividends.

Use: To indicate the rate of return to common stockholders in terms of dividends.

2006 2005

Dividend yield on common stock 1.95% 2.22% Dividend yield on common stock 1.95% 2.22%

Dividends per share of common $ 0.80 $ 0.60Market price per share of common ÷ 41.00 ÷ 27.00

The Common StockholderThe Common Stockholder

46

Corporate Annual ReportsCorporate Annual ReportsCorporate Annual ReportsCorporate Annual Reports

In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report.

The MDA includes an analysis of the results of operations and discusses management’s

opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition.

47

Corporate Annual ReportsCorporate Annual ReportsCorporate Annual ReportsCorporate Annual Reports

In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report.

Before issuing annual statements, all publicly held corporations are required to have an independent audit of their financial statements. The CPAs who conduct the audit render an opinion as

to the fairness of the statements.48

49