©CourseCollege.com 1 26 Financial Statement Analysis Financial statement analysis should always...

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1

26 Financial Statement Analysis

Financial statement

analysis should always involve the statement of cash flows

from Chapter 17

Learning Objectives

1. Describe and apply methods of percentage analysis of financial statements

2. Describe and apply methods of ratio analysis of financial statements

ProfitDebit Credit or

Loss

Expenses

BALANCE SHEET INCOME STATEMENT

Assets Liabilities Revenue

Equity

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Vertical

HorizontalComparing statement components over time periodsComparing statement components over time periods

Comparing statement componentsto a total from the same statement

Comparing statement componentsto a total from the same statement

O26.1

Objective 26.1: Describe and apply methods of percentage

analysis of financial statements

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Horizontal –comparing across time

O26.1

Year 1Year 1

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

25,600

Year 2Year 2

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

31,200

Year 3Year 3

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

37,500

Year 4Year 4

Profitor

Loss

Expenses

INCOME STATEMENT

Revenue

38,400

What year had the greatest increase in sales?

OR

How much have sales grown over 4 years?

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Horizontal Analysis

O26.1

150%=

$ 38,400 (Year 4)

$ 25,600 (Year 1)

Year 4 Sales are 150% of Year 1 sales

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Horizontal analysis -trends

Calculating the

percentage of base year for each period helps spot

trends

Year 1 Year 2 Year 3 Year 4 Year 5Sales 330,500 347,025 343,720 353,635 363,550% of Yr 1 100% 105% 104% 107% 110%

Base Year

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Horizontal analysis -trends

343,720330,500 = 1.04 =

104%


Thedenominator

is Year 1 Sales.

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Vertical –comparing component with a total from the same statement

O26.1

Year 1Year 1

Profitor

Loss

Equity

BALANCE SHEET

Assets Liabilities

What part of total assets is total equity?

250,0001,000,000

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Vertical Analysis

O26.1

25%=

$ 250,000 equity

$ 1,000,000

assets

Equity is 25% of total

assets

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Vertical –comparing component with a total from the same statement

O26.1

Year 1Year 1

Profitor

Loss

Equity

BALANCE SHEET

Assets Liabilities

What part of total assets is Cash?

Cash

400,000Total assets

50,000

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Vertical Analysis

O26.1

12.5%=

$ 50,000 cash

$ 400,000 total

assets

Cash is 12.5% of

total assets

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Assets Liabilities% %

Cash 94,500 2% AP 167,000 4%AR 678,000 17% Taxes payable 21,000 1%Inventory 824,500 21% Current liab. 188,000 5%Current assets 1,597,000 41%

Long term debt 1,407,000 36%Prop., Plant, Equip. 2,345,000 59% Total liabilities 1,595,000 40%

EquityTotal equity 2,347,000 60%

Total assets 3,942,000 100% Total liab. & eq. 3,942,000 100%

2010 Year end Balance SheetHill Corporation







Using vertical analysis*

Hill’s cash position

has increased

* Comparing with the same firm in a

different fiscal period

* Comparing with the same firm in a

different fiscal period

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Cash 68,400 6% AP 45,600 4%AR 29,400 2% Taxes payable 31,500 3%Inventory 131,700 11% Current liab. 77,100 6%Current assets 229,500 19%

Long term debt 546,000 46%Prop., Plant, Equip. 956,700 81% Total liabilities 623,100 53%

EquityTotal equity 563,100 47%


2010 Year end Balance SheetHatch Corporation

Using vertical analysis*

Hatch has a stronger

cash position

* Compare to others. (Firms

compared should be in the same industry

with similar operations)

* Compare to others. (Firms

compared should be in the same industry

with similar operations)







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Combining horizontal and vertical

Horizontal

O26.1


Year 1 Year 2 Year 3 Year 4 Year 5COGS 214,825 235,977 240,604 275,835 298,111% of Yr 1 100% 110% 112% 128% 139%% COGS 65% 68% 70% 78% 82%Gross Profit 115,675 111,048 103,116 77,800 65,439% GP 35% 32% 30% 22% 18%Other exp. 99,150 96,126 89,367 61,532 49,079% Other exp. 30% 28% 26% 17% 14%Net Income 16,525 14,922 13,749 16,267 16,360% NI 5.0% 4.3% 4.0% 4.6% 4.5%NI as % Yr1 100% 90% 83% 98% 99%

Vertical

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O26.1



Has the firm been able to maintain

profitability over th

ese 5 years?

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Sales have

grown

O26.1



%Net income

has droppe

d

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Objective 26.2: Describe and apply methods of ratio analysis of

financial statements

O26.2

Liquidity & Safety

measures

Leverage & Solvency measures

Efficiency measures

Profitability & Market measures

CATEGORIES

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Examples of each category

O26.2

Liquidity & Safety measures

Current ratioQuick ratioDoomsday ratioWorking capital ($)Pledged assets to secured liabilities


Debt to worth ratioDebt ratioEquity ratioTimes interest earned ratioDebt coverage ratio

Efficiency measures

AR turnoverDays sales in ARInventory turnoverDays sales in inventoryAP Payment periodWorking capital as a percentage of salesTotal asset turnover


Net profit ratioGross profit ratioOperating cash flow on assets ratioReturn on assetsReturn on equityBasic earnings per sharePrice earnings ratio

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Examples of

O26.2

Liquidity & Safety measures

Current ratioQuick ratioDoomsday ratioWorking capital ($)Pledged assets to secured liabilities

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Current Assets

Current Liabilities

Current Ratio

Working Capital

Current Assets

Current Liabilities

Current ratio and working capital

O26.2

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The current ratio answers the following question:

How many dollars of current assets are available to pay each dollar of current liabilities scheduled?

The higher the number, the more dollars of current assets are available and therefore the more liquid is the particular balance sheet being studied.

Current ratio

Current Assets

Current Liabilities

Current Ratio

O26.2

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Current Ratio Example

ASSETS LIABILITIESCash 25,600 Accounts Payable 165,700Accounts Receivable 56,700 Current liabilities 165,700Inventory 98,200 Notes Payable 36,750Supplies 2,100 Total 202,450

Current assets 182,600Equipment 121,000 EQUITY

Owner, Capital 283,750Total 486,200 Total 486,200

Current ratio Current assets/Current LiabilitiesCR = 1.10

BALANCE SHEETAs of 12/31/07

RAMOS Distributors

$1.10 of current assets are available to pay each dollar

of current liabilities

?1.10O26.2

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Working capital answers the following question:

How many dollars of current assets would remain if all current liabilities were paid using current assets?

The resulting answer is expressed in dollars. The higher the number, the more liquidity is displayed by the balance sheet.

Working capital

Working Capital

Current Assets

Current Liabilities

O26.2

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Working Capital Example




Working capital Current assets - Current LiabilitiesWorking capital = 16900.00


RAMOS Distributors

$16,900 of current assets would remain if

current assets were used to pay all current

liabilities

?$16,900O26.2

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Cash + cash equivalents

Current Liabilities

Doomsday ratio

Quick ratio

Doomsday ratio and the quick or acid test ratio

Cash + Short term

Investments + Accounts &

Notes Receivable Current

Liabilities

O26.2

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The doomsday ratio answers the following question:

If this business ceased to exist, what portion of current liabilities could be paid by just using existing cash available?

Doomsday ratio

Cash

Current Liabilities

Doomesday

Ratio

The doomsday ratio deals with a

worst case scenario.

O26.2

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Doomsday Ratio Example




Doomesday ratio Cash / Current liabilitiesDratio 0.15


RAMOS Distributors

15% of current liabilities could be

paid with cash available

?.15O26.2

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The quick ratio answers the following question:

How many dollars of cash, short term investments, accounts and notes receivable are available to pay current assets?

Quick ratio

Current Liabilities

Quick Ratio

Notice Inventory is not included

Cash + Short term

Investments + Accounts &

Notes Receivable

O26.2

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Quick Ratio Example




Quick ratio Cash + AR / Current LiabilitiesQuick ratio = 0.50


50% of current liabilities could be paid without relying on

Inventory or Supplies

?.50

O26.2

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Examples of

O26.2


Debt to worth ratioDebt ratioEquity ratioTimes interest earned ratioDebt coverage ratio

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Assets Liabilities

Balance Sheet

Equity

Leverage

Highly Leveraged (claims on assets are mostly from liabilities)

Assets Liabilities

Balance Sheet

Equity

Limited Leverage (claims on assets are mostly from equity)

O26.2

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Assets Liabilities

Balance Sheet

Equity

Leverage

Highly Leveraged (claims on assets are mostly from liabilities)

Assets Liabilities

Balance Sheet

Equity

Limited Leverage (claims on assets are mostly from equity)

O26.2

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The debt to worth ratio answers the following question:

For every $1 of Equity, how many dollars of Liabilities does the firm owe?

Debt to worth ratio

Total Liabilitie

s Debt to Worth

A leverage measure

Total Equity

O26.2

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Debt to Worth Example

ASSETS LIABILITIESCash 24,000 Accounts Payable 56,000Accounts Receivable 34,500 Salaries Payable 3,400Inventory 67,800 Notes Payable 1,200Supplies 1,500 Total 60,600Equipment 43,200

EQUITYOwner, Capital 110,400

Total 171,000 Total 231,600

Debt to Worth = Total Liab/Total EquityD/W = 0.55


CASE SUPPLY

Each dollar of Equity supports

55 cents of Liabilities

O26.2

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The debt ratio answers the following question:

What percentage of total assets is supported by debt?

Debt ratio

Total Liabilitie

sDebt ratio

A leverage measure

Total Assets

O26.2

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Debt ratio Example

ASSETS LIABILITIESCash 24,000 Accounts Payable 56,000Accounts Receivable 34,500 Salaries Payable 3,400Inventory 67,800 Notes Payable 1,200Supplies 1,500 Total 60,600Equipment 43,200

EQUITYOwner, Capital 110,400

Total 171,000 Total 231,600

Debt ratio = Total Liab/Total AssetsDebt ratio = 0.35


DRUTCH SUPPLY

Each dollar of Assets is supported

by 35 cents of

Liabilities

O26.2

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Times Interest Earned Ratio

Adjusted accrual income = the sum of accrual net income + interest expense + income tax expense + non cash expenses such as depreciation, amortization and depletion.

The higher the ratio, the more adequate earnings

are to cover interest expense

Times interest earned

Interest expense

Adjusted accrual income=

O26.2

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Debt Coverage Ratio

Adjusted accrual income = the sum of accrual net income + interest expense + income tax expense + non cash expenses such as depreciation, amortization and depletion.

The higher the ratio, the more adequate earnings are to cover debt service

payments

Debt Coverage Principal & Interest

payments

Adjusted accrual income=

O26.2

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Example -Times interest earned and Debt coverage ratios

Assets LiabilitiesCash 123,000 Accounts Payable 536,700Accounts receivable 345,000 Current Portion Long Term Debt 138,600Inventory 410,500 Long Term Debt 823,400Property, Plant, Equipment 1,200,500 Total liabilities 1,498,700

Equity Total assets 2,079,000 Owner, Capital 580,300

Sales 2,347,000

Cost of Goods Sold 1,760,250 Adjusted accrual income 376,150Wages expense 210,600 (NP +Inc tax exp + Int exp + depr)Depreciation expense 60,025 Times Interest earned 4.3Interest expense 86,580 Adjusted accrual income / Interest expenseMisc expense 38,400 Debt Coverage 1.7

Net Profit 191,145

Balance Sheet -Ruiz RecyclingAs of 12/31 2009

Adjusted accrual income/ ( Principal + Interest exp)

Income StatementFor the year ended 12/31/09

X

X

O26.2

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Examples of

O26.2

Efficiency measures

AR turnoverDays sales in ARInventory turnoverDays sales in inventoryAP Payment periodWorking capital as a percentage of salesTotal asset turnover

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The AR turnover ratio answers the following question:

How many times did the firm sell its’ average Accounts Receivable.

AR Turnover

SalesAR

Turnover

Average AR is often calculated

as:(Beg AR +End

AR)/2

Average Accounts Receivable

O26.2

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The days’ sales uncollected answers the following question:On average, how many days will it take to collect the current AR total?

Days’ Sales Uncollected(in AR)

AR

Sales

Days’ Sales

Uncollected

The AR balance is the end of year

total. Sales is for the

year.

X 365

O26.2

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Assets 2007 2008 Liabilities 2007 2008 Cash 9,000 10,000 Accounts Payable 45,000 41,500 Accounts receivable 75,000 81,000 Inv. Loan 18,000 14,400 Alllowance for Uncol. Accounts (2,500) (2,600) Total liabilities 63,000 55,900

Inventory 151,000 164,000 Equity Total assets 232,500 252,400 Owner, Capital 169,500 196,500

Sales 654,000

Cost of Goods Sold 490,500 Average AR 75,450Wages expense 61,000 (net AR for years 2007 +2008) / 2Uncollectible account AR turnover 8.7 expense 2,000 (Sales / Avg. AR)Miscellaneous expense 73,500 Days' Sales Uncollected 43.8

Net Profit 27,000 (365 x AR / Sales)


days

X

Balance Sheet -April's GiftsAs of 12/31 2007 and 2008

Example

O26.2

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Inventory turnover answers the following question:How many times did the firm sell their average inventory during the year?

Inventory Turnover

COGS

Average Inventor

yInventory Turnover

Remember to use the Average

Inventory

O26.2

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Days Sales in Inventory answers the following question:How many days sales of inventory remain in the present balance of inventory?

Days Sales in Inventory

COGS

Ending Inventor

y

Days Sales in

Inventory

Remember to use the ending Inventory

X 365

O26.2

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Assets 2007 2008 Liabilities 2007 2008 Cash 9,000 10,000 Accounts Payable 45,000 41,500 Accounts receivable 75,000 81,000 Inv. Loan 18,000 14,400 Alllowance for Uncol. Accounts (2,500) (2,600) Total liabilities 63,000 55,900

Inventory 151,000 164,000 Equity Total assets 232,500 252,400 Owner, Capital 169,500 196,500

Sales 654,000

Cost of Goods Sold 490,500 Average Inventory 157,500Wages expense 61,000 (Inventory for years 2007 +2008) / 2Uncollectible account Inventory turnover 3.1 expense 2,000 (COGS / Avg. Inv.)Miscellaneous expense 73,500 Days' Sales In Inventory 122.0

Net Profit 27,000 (365 x Inv. / COGS)


days

X

Balance Sheet -April's GiftsAs of 12/31 2007 and 2008

Example –Inventory ratios

O26.2

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The AP payment period answers the following question:How many days is the firm expected to take to pay the present balance of Accounts Payable?

AP payment period

COGS

APAP

payment period

The AP balance is the end of year

total. COGS is for the

year.

X 365

O26.2

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Harianto ImportsIncome StatementFor the year ending 12/31/07

Assets Liabilities Sales 630,000Cash 56,000 AP 186,000 Less Sales R&A (7,560)AR 122,000 Credit Line 110,000 Net Sales 622,440

Inventory 311,000 Loan Payable 10,400 ExpensesSupplies 12,000 Total Liab. 306,400 COGS 478,800Equipment 45,000 Equity Wages 63,500

Owner, Capital 239,600 Supplies 1,120Total Assets 546,000 Total Liab. + Equity 546,000 Rent 18,500

Utilities 13,400Miscellaneous 1,200

Total Expenses 576,520

142 DAYS

Net Income 45,920(AP/COGS x 365)

Harianto ImportsBalance SheetAs of 12/31/07

AP Payment Period

Example –AP payment period

186,000 / 478,800 x 365 = 142

O26.2

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Total Asset Turnover Ratio

Total asset turnover ratio is:

Net Sales / Average total assets

Sales

AverageAssets

The higher the turnover

ratio, the more

effective management is in utilizing

assets to generate

sales

O26.2

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Total asset turnover -Example

Assets 2007 2008 Liabilities 2007 2008Cash 34,000 28,500 Accounts Payable 198,500 187,500Accounts receivable 265,000 301,400 Equipment loan 173,000 169,500Inventory 535,000 575,000Property Plant Equip 275,600 264,600 Total liabilities 371,500 357,000

Accumulated Depr. (175,500) (196,500) Equity Total assets 934,100 973,000 Owner, Capital 562,600 616,000

Sales 3,356,800

Cost of Goods Sold 2,517,600 Average Assets 953,550Wages expense 314,900 (TA for years 2010 +2011) / 2Depreciation expense 21,000Selling expense 296,700

Miscellaneous expense 153,200 Total asset turnover 3.5

Net Profit 53,400

X

Balance Sheet -Chen DistributorsAs of 12/31 2010 and 2011

( Sales/ Average assets)


O26.2

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Examples of

O26.2


Net profit ratioGross profit ratioOperating cash flow on assets ratioReturn on assetsReturn on equityBasic earnings per sharePrice earnings ratio

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%Net Sales 894,580

Cost of Goods Sold 435,500

Gross Profit 459,080 51%

Operating expenses 324,480

Net Profit 134,600 15%

All Fit Health SupplyIncome Statement

For the Year ending December 31, 2007

%Net Sales 894,580



Operating expenses 324,480


All Fit Health SupplyIncome Statement

For the Year ending December 31, 2007

134,600 / 894,580 = 15%.

Or $.15 out of every sales dollar was

remains as net profit.

O26.2

Net Profit ratio

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%Merchandise Sales 869,580Discount Card Sales 25,000 Net Sales 894,580



Total operating expenses 324,480


Income StatementFor the Year ending December 31, 2007

%Merchandise Sales 869,580Discount Card Sales 25,000 Net Sales 894,580



Total operating expenses 324,480


Income StatementFor the Year ending December 31, 2007

459,080 / 894,580 = 51%.

Or $.51 out of every sales

dollar was left to cover

remaining expenses and profit after the

cost of sold merchandise

was deducted.

O26.2

Gross Profit ratio

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Basic earnings per share

Net income available to common stockholdersdivided by

# of Common shares outstanding

Net income less preferred dividends

average # of common shares outstanding

O26.2

Weighted average common

shares during the earning

period

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Price earnings ratio

Market price per share

Basic earnings per share

O26.2

How many times are investors paying for the annual earnings

per share?

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