© 2002 Prentice Hall Publishing Company Introduction to Financial Accounting, 8th EditionHorngren,...

© 2002 Prentice Hall Publishing Company Introduction to Financial Accounting, 8th Edition Horngren, Sundem, and Elliott

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Chapter 13

Financial StatementAnalysis


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Learning ObjectivesAfter studying this chapter, you should be able to: Locate and use the many sources of information about

company performance. Analyze the components of a company using trend

analysis and other techniques. Use the basic financial ratios to guide your thinking. Evaluate corporate performance using ROA, ROE, and

EVA. Calculate EPS under complex circumstances. Adjust for nonrecurring items.


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Sources of InformationAbout Companies

Financial statement analysis - using financial statements to assess a company’s performance

Information about publicly traded companies comes in many forms and may be found in many places.• Annual reports• SEC filings and databases• Company press releases• Articles that appear in the financial press


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The annual report is important to investors because of its completeness and its reliability due to the audit performed by an independent auditor.• The annual report includes:

– Financial statements

– Footnotes to the financial statements

– A summary of accounting principles used

– Management’s discussion and analysis of the financial results

– The auditor’s report

– Comparative financial data for a series of years

– Narrative information about the company


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Publicly traded companies must also prepare reports for the Securities and Exchange Commission (SEC).• Form 10-K - presents financial statement data in

greater detail than the financial statements in annual reports

• Form 10-Q - includes quarterly financial statements that provide more timely but less complete information than annual reports


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Company press releases provide the basis for articles in the financial press such as The Wall Street Journal and Business Week.

Services such as Value Line, Moody’s Investors Services, Standard and Poor’s Industrial Surveys, and Dun & Bradstreet provide useful information to investors.


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The Internet is changing the way that people make investments.• Many investors now buy and sell securities without

the help of a broker.• Much of the market information

is available electronically, usually for free from various sources.


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Large investors often require pro forma statements which are carefully formulated expressions of predicted results.

Any investor should take the time to gather as much information about potential investments as possible.• There are many sources of information for investors

to use.


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Objectives of FinancialStatement Analysis

Although different investors demand different returns, they all use financial statement analysis for common reasons.• To predict their expected returns• To assess the risks associated with those returns

Financial statement analysis focuses on past performance to predict future performance.


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Creditors want to know about short-term liquidity and long-term solvency.• Short-term liquidity - an organization’s ability to meet

current payments as they become due• Long-term solvency - an organization’s ability to

generate enough cash to repay long-term debts as they mature


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Equity investors are more concerned with returns in the form of dividends and increased market price of the stock.• These investors are naturally more interested in

profitability.• Profits spur both dividends and

increased stock prices.


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Evaluating Trends and Components of the Business

Evaluating trends and components of a business are two ways of looking at financial information.• Trend analysis involves comparing financial trends

from one year to another.• Evaluating components of a business can be done in

more than one way.– Relationships among elements of the financial statements

may be examined.

– Components may also be thought of as separate business units or segments. These components may be examined.


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Trend Analysis Trends are predictable patterns that have been

observed in the past and are expected to continue into the future.• A pattern must be identified, and expectations of

whether the trend will continue must be formed.• Trends can be shown as changes in amounts from

year to year or as percentage changes from year to year.


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Trend Analysis The dollar amount of the change is simply the

current year minus the previous year.

The percentage change is computed as follows:

100amountyear Prior

change ofAmount Change %


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Trend AnalysisSTELLAR CORPORATION

Income Statementsfor the Years Ended December 31, 2002 and 2001

Increase % Increase 2002 2001 (Decrease) (Decrease)

Sales $98,600 $89,500 $9,100 10.2%Expenses: Wages expense 45,800 42,900 2,900 6.8 Rent expense 12,000 12,000 0 0.0 Utilities expense 6,500 6,450 50 0.8 Depreciation expense 5,000 5,900 (900) (15.3) Total expenses 69,300 67,250 2,050 3.0Net Income $29,300 $22,250 $7,050 31.7

============= ============= ===========


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Trend Analysis Changes in dollar amounts and percentage terms

help to expose patterns.• Understanding these patterns is most important.• The answers to why items changed tell a lot about

how a company is run, how it will perform in the future, and whether or not it would be a good investment.

Analysts generally look at several years’ worth of financial information to discover trends.


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Common-Size Statements Common-size statements - financial statements

expressed in component percentages• The income statement is expressed as a percentage of

sales.– This makes it easy to compare percentages to those of other

companies because percentages are a common index.

• The balance sheet is expressed as a percentage of total assets.

– This is often referred to as component percentages because they measure each component as a percentage of the total.


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Common-Size Statements For the income statement, sales is set at 100%

and each other element is expressed as a percentage of the sales figure.

For the balance sheet, the total assets amount is set at 100%, and each other element is expressed as a percentage of the total assets figure.


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Common-Size StatementsSTELLAR CORPORATION

Income Statementsfor the Years Ended December 31, 2002 and 2001

Sales 98,600$ 100% 89,500$ 100%Expenses Wages expense 45,800 46% 42,900 48% Rent expense 12,000 12% 12,000 13% Utilities expense 6,500 7% 6,450 7% Depreciation expense 5,000 5% 5,900 7% Total expenses 69,300 70% 67,250 75%Net income 29,300$ 30% 22,250$ 25%

2002 2001


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Management’s Discussionand Analysis

Management’s discussion and analysis - a required section of the annual report that concentrates on explaining the major changes in the income statement, liquidity, and capital resources• Management’s discussion often

includes a discussion of trends and analysis of components.


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Segment Reporting Many large companies are involved in more than

one type of business activity or market.• Each individual type of business activity or market

may be considered a segment.

The FASB requires information on a business segment to be reported based on the way it is reported to management.• The information is reported consistent with the way

the company manages the business.


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Segment Reporting When analyzing segment data, two things should

be considered.• Evaluating segment data forces us to ask important

questions that help us to truly understand the business.• Truly understanding the business means not only

understanding what is sold and how much is made but also interpreting how financial reports summarize dynamic changes in the business.


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Financial Ratios The cornerstone of financial statement analysis is

the use of ratios.

Financial ratios are sometimes grouped into four categories:• Short-term liquidity ratios• Long-term solvency ratios• Profitability ratios• Market price and dividends ratios


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Financial RatiosShort-term liquidity ratios

Name of Ratio Numerator Denominator

Current ratio Current assets Current liabilities

Quick ratio Cash + Marketable securities + Receivables

Current liabilities

Average collection period in days

Average accounts receivable x 365

Sales

Inventory turnover Cost of goods sold Average inventory at cost


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Financial RatiosLong-term solvency ratios


Total debt to total assets Total liabilities Total assets

Total debt to equity Total liabilities Stockholders' equity

Interest coverage Income before interest and taxes

Interest expense


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Financial RatiosProfitability ratios


Return on stockholders' equity

Net income Average stockholders' equity

Gross profit rate or percentage

Gross profit or gross margin Sales

Return on sales Net income Sales

Asset turnover Sales Average total assets available

Pretax return on operating assets

Operating income Average total assets available

Earnings per share Net income less dividends on preferred stock, if any

Average common shares outstanding


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Financial RatiosMarket price and dividend ratios


Price-earnings Market price of common stock

Earnings per share

Dividend yield Dividends per common share

Market price of common stock

Dividend-payout Dividends per common share

Earnings per share


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Evaluating Financial Ratios Financial ratios are evaluated using three types of

comparisons.• Time-series comparisons - comparisons of a

company’s financial ratios with its own historical ratios

• Benchmarks - general rules of thumb specifying appropriate levels for financial ratios

• Cross-sectional comparisons - comparisons of a company’s financial ratios with the ratios of other companies or with industry averages


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Ratios Financial analysis using ratios is useful to

investors because the ratios capture critical dimensions of the economic performance of the company.

Managers use ratios to guide, measure, and reward workers.• Often companies base employee bonuses on a specific

financial ratio or a combination of some other performance measure and a financial ratio.


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Ratios Ratios mean different things to different groups.

• A creditor might think that a high current ratio is good because it means that the company has the cash to pay the debt.

• However, a manager might think that a high current ratio is undesirable because it could mean that the company is carrying too much inventory or is allowing its receivables to get too high.


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Ratios Because financial ratios may be interpreted

differently by different users, the users of the financial ratios must understand the company and the business before drawing conclusions.


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Operating Performance andFinancial Performance

Measures of profitability are affected by both financing and operating decisions.• Financial management is concerned with where the

company gets cash and how it uses that cash.• Operating management is concerned with the day-to-

day activities that generate revenues and expenses.

Ratios that assess operating efficiency should not be affected by financial management performance.


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Operating Performance Rate of return on investment - evaluates the

overall success of an investment by comparing what the investment returns with the amount of investment initially made

capital Invested

IncomeRate of return

on investment


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Operating Performance Income may be defined differently for alternative

purposes.• Net earnings• Pretax income from operations• Earnings before interest and taxes (EBIT)

Invested capital may also be defined differently.• Stockholders’ equity• Total capital provided by both debt and equity sources


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Operating Performance Operating performance is best measured by

pretax operating rate of return on total assets, often referred to as return on total assets.

available assets totalAverage

income Operating

Pretax operatingrate of returnon total assets


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Operating Performance The right side of the previous equation is actually

composed of two more important ratios.

This equation may also be expressed as:

assets totalAvg.

Sales

Sales

income Operating

assets totalAvg.

income Operating

Operating incomepercentage on sales

Total assetturnover

Pretax operating rate of return on

total assets=


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Operating Performance The expanded expression of pretax operating rate

of return on total assets highlights that operating income percentage and asset turnover will each increase the rate of return on assets.• Using these two ratios allows manipulation of either

one to determine what happens to the rate of return under different scenarios.


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Operating Performance

Pretax Returnon Total Assets

Operating Income% on Sales

Total AssetTurnover

OperatingIncome

Sales

Sales

Average TotalAssets

x


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Operating Performance This decomposition of return on total assets can

also be applied to the return on equity.• This is often referred to as the DuPont analysis.

equity Average

assets totalAverage

assets totalAverage

Sales

Sales

incomeNet ROE

LeverageoverAsset turnsaleson Return ROE

or


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Financial Performance Debt and equity financing must be balanced in

order to achieve good financial performance.• Firms must choose how much debt is appropriate.• The firms must also choose how to split

their debt between short-term debt and long-term debt.

The prudent use of debt is a major part of intelligent financial management.


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Financial Performance Short-term debt must be repaid or refinanced in a

short period of time.• If a company has trouble repaying the debt, it will

also generally have trouble refinancing the debt.• Naturally, lenders like healthy borrowers, not troubled

borrowers.


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Financial Performance Long-term debt or equity are generally used to

finance long-term investments.• Debt financing is more attractive than equity

financing because:– Interest payments are deductible for income tax purposes,

but dividends are not deductible.

– The ownership rights to voting and profits are kept by the present shareholders.


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Trading on the Equity Capitalization (capital structure) - the total of a

company’s long-term financing• Owners’ equity plus long-term debt

Trading on the equity (financial leverage, leveraging) - using borrowed money at fixed interest rates with the objective of enhancing the rate of return on common equity


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Trading on the Equity There are costs and benefits to the shareholders

from leveraging.• Costs:

– Interest payments

– Increased risk

• Benefits:– Larger returns to the common shareholders, as long as

overall income is large enough to cover the increased interest payments


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Trading on the Equity General comments about leveraging:

• A debt-free, or unleveraged, company has identical return on assets (ROA) and return on equity (ROE).

• When a company has a ROA greater than the interest rate it is paying its lenders, ROE exceeds ROA.

– This is called favorable financial leverage.

• When a company is unable to earn at least the interest rate on the money borrowed, the return on equity will be lower than it would be for a debt-free company.

• The more stable the income, the less dangerous it is to trade on the equity.


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Economic Value Added The idea behind economic value added (EVA) is

that a company must earn more than it must pay for capital if it is to increase in value.• Capital is considered both debt and equity.• The cost of capital in EVA is a weighted average of

interest cost and the returns required by equity investors.

If a company has positive EVA, the company is adding value; if a company has negative EVA, the company is losing value and might be better off liquidating.


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Income Tax Effects If all things are equal, debt financing is less

costly to a corporation than equity financing because interest payments are deductible for income tax purposes.• Dividends paid on stock are not deductible.• Also, dividend rates on stock are generally higher

than interest rates on debt because of the increased risk associated with stock.


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Income Tax Effects General comments on debt financing versus

equity financing:• Because interest is deductible for income tax purposes,

net income attributable to common shareholders can be higher if debt is used because taxes are lower.

• Book net income is higher if equity financing is used because there are no interest payments to be deducted as expenses.

• Failure to pay interest is an act of bankruptcy, which gives creditors the right to control the company; failure to pay dividends has less severe consequences.


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Measuring Safety Investors in debt securities want assurance that

the company in which they have invested will be able to make the scheduled interest and principal payments.• These investors want to avoid the trouble of

recovering their investments through bankruptcy of the company.

• They would much rather a steady stream of income from a healthy company.


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Measuring Safety Interest coverage (times interest earned) - a ratio

that focuses on the interest-paying ability of a company

expenseInterest

taxesandinterest before Income coverageInterest


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Measuring Safety A rule of thumb for debt investors

is that the interest coverage should be at least five times even in the

poorest year in a span of 7 to 10 years.

The tax deductibility feature of interest is a major reason why debt financing is used more than equity financing using preferred stock.


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Prominence of Earnings Per Share Earnings per share is a basic reporting element in

the financial statements.

Some issues tend to complicate the calculation of earnings per share.• Use of a weighted-average number

of shares of common stock• Outstanding shares of nonconvertible

preferred stock• Changes in capitalization structure such as stock splits

and stock dividends


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Weighted-Average Shares and Preferred Stock

If all shares outstanding are common shares, the biggest complication is the use of a weighted-average number of shares of common stock.

The following formula is used in this case.

shares ofnumber average- Weighted

incomeNet Earning per share

of common stock


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Weighted-Average Sharesand Preferred Stock

Earnings per share is calculated as net income divided by weighted-average number of shares outstanding during the period.• The weighted-average number of shares is based on

the number of months that the shares were outstanding during the year.


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Online, Inc., has 750,000 shares of common stock outstanding at the beginning of the calendar year, and 200,000 additional shares were issued on October 1. What is the weighted-average number of shares outstanding during the year?


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The weighted-average number of shares is computed as follows:

750,000 x weighting of 12/12 = 750,000

200,000 x weighting of 3/12 = 50,000

800,000 =================

OR

750,000 x 9/12 = 562,500

950,000 x 3/12 = 237,500

800,000 =================


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Another complication arises if there are shares of nonconvertible preferred stock outstanding.• The dividends on preferred stock for the current

period, whether or not paid, should be deducted in calculating EPS because those dividends are not available to be paid to common shareholders.

shares ofnumber average- Weighted

dividends Preferred - incomeNet

Earning per shareof common stock


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Basic and Diluted EPS When a company has convertible securities, stock

options outstanding, or other financial instruments that can be converted to common shares, the calculation of EPS becomes even more complicated.• When convertible securities exist, EPS is calculated

using the assumption that any and all convertible shares are turned into common stock at the beginning of the period.


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Basic and Diluted EPS The presence of convertible securities increases

the number of common shares to the highest possible number considering the convertible securities and stock options outstanding.• If the number or shares outstanding is increased,

earnings per share is decreased.• These convertible securities are said to dilute (reduce)

earnings per share.


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Disclosure of Nonrecurring Items Financial statement analysis focuses on normal

recurring items of the financial statements, not nonrecurring items.

Four major categories of nonrecurring items:• Special items• Extraordinary items• Discontinued operations• Accounting changes


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Special Items Special items - expenses that are large enough

and unusual enough to warrant separate disclosure• Companies generally have flexibility in deciding

when to treat something as a special item.• Special items appear as separate line items among

operating expenses on the income statement.• Any necessary discussion must be included in the

footnotes to the financial statements.


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Extraordinary Items Extraordinary items - items that are unusual in

nature and infrequent in occurrence that are shown separately, net of tax, in the income statement• Unusual in nature means that an item is different from

the typical or normal operating activities of a business.

• Infrequent in occurrence means that an event should not be expected to recur often.


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Extraordinary Items Examples of extraordinary items are the financial

effects of natural disasters such as earthquakes or hurricanes and government expropriations.• Whether an item is extraordinary sometimes depends

on where the event occurs.– For example, losses from damage resulting from a

hurricane on the coast of Louisiana would not be considered extraordinary, but losses from damage resulting from a hurricane in South Dakota would be extraordinary.


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Extraordinary Items Extraordinary items must be shown separately on

the income statement.

They must also be shown net of tax, which means that the amount on the income statement includes any tax effect the item might have.


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Discontinued Operations Discontinued operations - the termination

(closing or sale) of a business segment reported separately, net of tax, in the income statement• Any gain or loss from the actual disposal of the

segment must be disclosed along with the results of operations (income or loss) for that segment during the period before the disposal.


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Accounting Changes Accounting changes occur when the FASB

requires a new way of accounting for a particular item.• When the FASB changes its rules, it often requires a

major one-time recognition (revenue or expense).• Accounting changes are shown separately and are

shown net of tax.


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Accounting Changes The presentation of nonrecurring items on the

income statement is as follows:

Income from continuing operations before income taxes Deduct income taxesIncome from continuing operations Discontinued operations, net of taxIncome before extraordinary items Extraordinary items, net of taxIncome before cumulative effect of an accounting change Cumulative effect of an accounting change, net of taxNet income


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International Considerations Financial statement analysis may be complicated

by several factors when companies carry on operations in different countries.• Differences in accounting methods• Language in which the results

are reported• Currency in which results are reported• Different securities markets, tax

structures, and local customs


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Price-Earnings Ratios and Growth The P-E ratio is helpful for relating the price of a

stock to the earnings it is generating.• Value investors look for stocks with low P-E ratios

because they feel these stocks are undervalued.• Growth investors feel that stocks with high P-E ratios

are likely to be high growth stocks.– The price is high because investors see strong growth

ahead.


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Price-Earnings Ratios and Growth One way to relate P-E ratios to growth is the

price-earnings growth (PEG) ratio.• It is a tool to help focus attention on certain stocks

and to help moderate knee-jerk reactions to other ratios.

Price-earnings growth ratio

=P-E ratio

Earnings growth rate


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Relating Cash Flowand Net Income

Four possible combinations of net income and cash flows exists.

Relationship 1 2 3 4

Cash flow from operations + + – –

Net income + – + –


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Relating Cash Flowand Net Income

Four possible situations:• Situation 1 confirms the profitability of the company.• Situation 2 can occur where a company has large

noncash expenses such as depreciation.• Situation 3 is often an indication of trouble but may

also be an indication of a rapidly growing company.• Situation 4 confirms the lack of profitability of the

company.


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Introduction to Financial Accounting

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