Financial Analysis

Instructor: Michael Booth

Cabrillo College

Factors in Communicating

Useful Information

Users

Types of

Decisions

Means of

Analysis

The primary objective of accounting is to provide

information useful for decision making. To provide

information that supports this objective, accountants must

consider the following:

THREE TYPES OF FINANCIAL

STATEMENT INFORMATION

PastPerformance

PresentCondition

FuturePerformance

Income, sales

volume, cash

flows, return-

on-investments,

EPS.

Assets, debt,

inventory,

various ratios.

Sales and earnings

trends are good

indicators of future

performance.

Financial Statement Analysis

Financial Statement Analysis

Examines a singlecompany to identify

trends over time.

Financial statement analysis

is based on comparisons.

Time series

analysis

Comparison with

similar companies

Google Finance

Learning Objective

To differentiate

between horizontal

and vertical

analysis

Methods of Analysis

Horizontal

Analysis

Vertical

Analysis

Ratio

Analysis

Phases of Statement Analysis

1. Computation Phase:

Vertical analysis

Horizontal analysis

Trend analysis

2. Interpretation Phase:

Vertical analysis is computing the

relationship between each item on a

financial statement to some base

amount on the statement.

ANSWER:

QUESTION:

What is vertical analysis?

Horizontal analysis is computing the

percentage change for individual

items in the financial statements

from year to year.

ANSWER:

QUESTION:

What is horizontal analysis?

A financial ratio is computing ratio

and percentage relationships of the

current year with those of the

immediately preceding year.

ANSWER:

QUESTION:

What is a financial ratio?

Trend analysis is a better technique

than just analyzing ratios. It

compares selected ratios and

percentages over a period of time.

ANSWER:

QUESTION:

What is trend analysis?

Comparative statements are

financial statements presented side

by side for two or more years.

ANSWER:

QUESTION:

What are comparative statements?

Common-size statements are

financial statements with items

expressed as percentages of a base

amount.

•Net Sales -> Income Statement

•Assets -> Balance Sheet

ANSWER:

QUESTION:

What are common-size statements?

California Products, Inc.

Comparative Income Statement

Year Ended December 31, 2008 and 2007

Amounts Percent of Net Sales

2008 2007 2008 2007

Revenue

Sales 3,105,650 2,850,625 104.6 104.6

Less Sales Returns and Allowances 135,450 125,625 4.6 4.6

Net Sales 2,970,200 2,725,000 100.0 100.0

Net Income After Income Taxes 56,578 41,250 1.9 1.5

Comparative Statement

California Products, Inc.

Comparative Income Statement

Year Ended December 31, 2008 and 2007

Amounts Percent of Net Sales

2008 2007 2008 2007

Revenue

Sales 3,105,650 2,850,625 104.6 104.6

Less Sales Returns and Allowances 135,450 125,625 4.6 4.6

Net Sales 2,970,200 2,725,000 100.0 100.0

Net Income After Income Taxes 56,578 41,250 1.9 1.5

Common-size Statement

California Products, Inc.

Comparative Income Statement

Year Ended December 31, 2008 and 2007

Amounts Percent of Net Sales

2008 2007 2008 2007

Revenue

Sales 3,105,650 2,850,625 104.6 104.6

Less Sales Returns and Allowances 135,450 125,625 4.6 4.6

Net Sales 2,970,200 2,725,000 100.0 100.0

Net Income After Income Taxes 56,578 41,250 1.9 1.5

Comparative Common-size Statement

Each item is expressed as a percentage of the

net sales figure (Common Denominator).

Vertical Analysis of the Income

Statement (Common Size)

Cost of goods sold

Net Sales=

$1,775,000

$2,970,200= 59.76%

Selling expenses

Net Sales=

$ 525,424

$ 2,970,200= 17.69%

=Net income(profit) after taxes

Net Sales

$ 56,578

$ 2,970,200= 1.9%

Each item is expressed as either a percentage of

total assets or of total liabilities plus stockholders’

equity.

Vertical Analysis of the Balance

Sheet

Cash

Total assets=

$108,886

$553,016= 19.7%

Accounts payabletotal liabilities plus stkhldrs’ equity or

(Total Assets)

=$ 72,090

$ 553,016= 13.0%

Total stockholders’ equitytotal liabilities plus stkhldrs’ equity

or (Total Assets)

= $311,921

$553,016= 56.4%

Horizontal Analysis

• Horizontal analysis techniques to analyze a

comparative income statement and balance

sheet.

• Trend analysis to evaluate financial

statements.

• Interpret the results of statement analyses by

comparison with industry averages.

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc. All rights reserved.

Evaluates financial statements for two or more

periods.

Compares items in each line to determine the

change in dollar amounts.

Uses the same method for both the income

statement and the balance sheet.

Horizontal Analysis

A percentage change can be shown by using

the earlier figure as the base.

Sales for 2008 $3,105,650

Horizontal Analysis of the

Income Statement (know as

growth or % change)

Earlier year is the base year.

Increase in sales

Sales for base year=

$ 255,025

$2,850,6258.9%=

Sales for 2007 – 2,850,625

Increase $ 255,025

California Products, Inc.

Comparative Income Statement (Partial) (Horizontal Analysis)

Years Ended December 31, 2008 and 2007

Amounts Increase or (Decrease)

2008 2007 Amount Percent

Revenue

Sales 3,105,650 2,850,625 255,025 8.9

Less Sales Returns and Allowances 135,450 125,625 9,825 7.8

Net Sales 2,970,200 2,725,000 245,200 9.0

Horizontal Analysis of the

Balance Sheet

A decrease is expressed as a negative percentage.

Decrease in current liabilities

Current liabilities in base year=

$ (20,044)

$ 97,599– 20.53%=

Current liabilities 12/31/08 $ 77,595

Current liabilities 12/31/07 – 97,599

$(20,004)

Horizontal analysis is especially useful in

identifying items that need further investigation.

Interpretation is easier if some basis of

comparison is available.

Company budget

Industry averages

Interpretation of the

Percentages

Industry averages are the financial

ratios and percentages that reflect

averages for similar companies.

BiZminer Financial Ratio Sample

ANSWER:

QUESTION:

What are industry averages?

Use trend analysis to evaluate

financial statements.

Trend analysis compares selected

ratios and percentages over a period

of time.

ANSWER:

QUESTION:

What is trend analysis?

Often the time period is five years.

This decrease is significant and should be investigated.

Net Sales 2,050,650 2,223,240 2,587,500 2,725,000 2,970,200

Cost of goods sold 1,059,900 1,234,560 1,495,642 1,574,721 1,755,000

Gross profit on sales 990,750 988,680 1,091,858 1,150,279 1,215,200

2004 2005 2006 2007 2008

Percentage of

gross profit to net sales 48.3 44.5 42.2 42.2 40.9

Trend Analysis

Interpret the results of the

statement analyses by

comparison with industry

averages.

Using Industry Averages

Trade associations survey their members to

obtain financial information and other data.

Data is converted to a uniform presentation,

usually in common-size statements arranged

by company size.

Individual companies compare their results to

industry averages.

In comparing to industry averages, keep in

mind the following:

Different businesses keep different types of

accounts and do not classify items in the

same manner.

No two businesses are exactly alike.

The industry figures could include data from

corporations, partnerships, and sole

proprietorships.

SBA http://www.sba.gov

Learning Objective

To explain ratio

analysis

Ratio Analysis

Financial ratios have three classifications:

1. Profitability, operating results, and

efficiency

2. Financial strength

3. Liquidity

Ratio Analysis

Ratio analysis involves studying

various relationships between

different items reported in a set of

financial statements.

Liquidity RatiosLiquidity ratios indicate a

company’s ability to pay short-

term debts. They focus on

current assets and current

liabilities.

1. Working Capital

2. Cash Ratio

3. Current Ratio

4. Quick Ratio

5. Accounts Receivable Ratios

6. Inventory Ratios

Liquidity is a measure of the ability of a

business to pay its debts when due.

Conversion of assets to cash to meet

the operational cash requirements of

the business.

ANSWER:

QUESTION:

What is liquidity?

Cash Ratio

Cash

Ratio

Cash + Cash Equivalents

Current Liabilities=

= 0.296 to 1Cash

Ratio

$2,826

$9,554=

This ratio measures the

adequacy of available cash. This must be viewed in

conjunction with Cash Flow from operating activity, inventory

turns, and A/R turns.

Working Capital

Measures the ability of a company to meet its

current obligations.

Formula:

Example:

Current assets

– Current liabilities

Working capital

$168,000

– 46,000

$122,000

Working CapitalThe excess of current assets over

current liabilities is known as working capital.

Current Ratio

Measures the ability of a business to pay its

debts using current assets.

Formula:

Example:

Current assets ÷ Current liabilities = Current ratio

$418,056

$ 77,595= 5.39:1

In retail and manufacturing businesses, a popular

guideline is a current ratio of at least 2 to 1.

Note: This is shifted prior to 2007/2008 to accept levels

lower, based on cash flow, inventory turns, A/R turns

Current Ratio

The current ratio measures a

company’s short-term debt paying

ability.

A declining ratio may be a

sign of deteriorating

financial condition, or it

might result from eliminating

obsolete inventories.

Current

Ratio

Current Assets

Current Liabilities=

Current Ratio

Measures immediate liquidity.

Formula:

Acid-Test Ratio (Quick Ratio)

Quick assets are cash, receivables, and marketable securities.

Example:

A general guideline is that the acid-test ratio should be at least 1 : 1

CashReceivables 94,000Marketable securities

$94,000

$46,000= 2.04:1

Quick assets ÷ Current liabilities = Acid-test ratio

Quick (Acid-Test) Ratio

Accounts Receivable Turnover

Measures the speed with which sales on

account are collected.

Formula:

Procedure:

Step 1: Compute average accounts receivable.

Step 2: Divide net credit sales by average

accounts receivable.

Net credit sales ÷ Average receivables = Accounts receivable turnover

Accounts Receivable Turnover

Net Credit Sales

Average Accounts Receivable

Accounts

Receivable

Turnover

=

This ratio measures how many

times a company converts its

receivables into cash each year.

Accounts Receivable Turnover

Average Days to Collect

Receivables

Average

Collection

Period

=365 Days

Accounts Receivable Turnover

This ratio measures, on average, how many days it

takes to collect an accounts receivable.

= 21 days

Average

Collection

Period

=365 Days

16.98 Times

Inventory Turnover

Measures the number of times the inventory

is replaced during the period.

Formula:

Procedure:

Step 1: Compute the average inventory.

Step 2: Divide the cost of goods sold by the average

inventory.

Cost of goods sold ÷ Average inventory = Inventory turnover

Inventory Turnover

Cost of Goods Sold

Average Inventory

Inventory

Turnover=

This ratio measures how many times a

company’s inventory has been sold and

replaced during the year.

Inventory Turnover

INSERT Insert 20, p. 543,

Text Box here

Average Days to Sell Inventory

Average

Sale Period=

365 Days

Inventory Turnover

This ratio measures how many

days, on average, it takes to sell

the inventory.

= 34 daysAverage

Sale Period=

365 Days

10.80 Times

Learning Objective

To calculate ratios

for assessing a

company’s solvency

Solvency Ratios

Solvency ratios are used to analyze

a company’s long-term debt-

paying ability and its financing

structure.

1. Debt to Assets Ratio

2. Debt to Equity Ratio

3. Number of Times Interest Earned

4. Plant Assets to Long-Term Liabilities

Debt to Assets Ratio

This ratio measures the percentage of a company’s assets that are financed by

debt.

Total Liabilities

Total Assets

Debt to

Assets

Ratio

=

Debt to Equity Ratio

This ratio indicates the relative proportions of debt to equity on a

company’s balance sheet.

Stockholders like a lot of

debt if the company can

take advantage of

positive financial

leverage.

Total Liabilities

Stockholders’ Equity

Debt to

Equity

Ratio

=

Creditors prefer less

debt and more equity

because equity

represents a buffer of

protection.

Debt to Assets and Debt to

Equity Ratios

Note: Liabilities + SE = Total Assets

Number of Times

Interest is Earned Ratio (Bond or

Long term debt)

This is the most common

measure of a company’s ability

to provide protection for its long-

term creditors.

Times

Interest

Earned

Earnings before Interest Expense

and Income Taxes

Interest Expense=

Number of Times Bond Interest Earned

Measures the ability of net income to cover the required bond interest payments.

Formula:

Procedure:

Step 1: Compute the income before bond

interest and income taxes.

Step 2: Compute the cash required to pay bond

interest.

Step 3: Compute the ratio.

Income before bond interest and income taxes

Bond interest cash requirementTimes bond

interest earned=

Number of Times Interest

Earned Ratio

Note: this is the issue with the failing banks, GM, Ford, etc

• Call on Credit Default Swaps

Plant Assets to Long-Term

Liabilities

This ratio suggests how well

long-term debt is managed to

finance long-term assets.

Plant Assets

to Long-Term

Liabilities

Net Plant Assets

Long-Term Liabilities=

Plant Assets to Long-Term

Liabilities

Learning Objective

To calculate ratios

for assessing

company

management’s

effectiveness

Profitability Ratios

Profitability ratios measure a

company’s ability to generate

earnings.

1. Net Margin (or Return on Sales)

2. Asset Turnover Ratio

3. Return on Investment

4. Return on Equity

5. Quality of Income

Net Margin

This measure describes the percent

remaining of each sales dollar after

subtracting other expenses as well as

cost of goods sold.

Net

Margin

Net Income

Net Sales=

Net Margin

Asset Turnover Ratio

Net Sales

Average Total Assets

Asset

Turnover=

This ratio measures how many sales dollars were generated for each

dollar of assets invested.

Asset Turnover Ratio

Return on Investment or

Return on Assets (ROI)

This is the ratio of wealth generated

(net income) to the amount invested

(average total assets).

Return on

Investment

Net Income before interest & tax

Average Total Assets=

Rate of Return on Total Assets

Measures the rate of return on the assets used by the

company.

Formula:

Income before income taxes $ 80,826

Rate of return

on total assets

Income before interest expense and income taxes

Total assets=

Example:

Income before interest and taxes $ 92,326

Avg assets $557,016

16.6%$92,326

$557,016=

Add back interest expense 11,500

Return on Equity

This measure is often used to measure

the profitability of the stockholders’

investment.

Return on

Equity

Net Income

Average Total Stockholders’

Equity

=

Return on Equity

Quality of Income(see page 712 in text)

Quality

of Income

Cash Flow from Operating Activities

Net Income=

Cash Flow from Operating Activities

Net Income 4,304$

Add: Depreciation and Amortization 1,076

Decrease in Receivables, net 25

Increase in Accounts Payable 790

Increase in Deferred Revenue 279

Increase in Deferred Income Taxes 605

Other 186

Deduct: Increase in Merchandise Inventories (693)

Decrease in Income Taxes Payable (27)

Cash Flow from Operating Activities 6,545$

Quality of Income

Quality

of Income

$6,545

$4,304= = 1.52

A ratio higher than 1 indicates

high-quality earnings.

Quality

of Income

Cash Flow from Operating Activities

Net Income=

Learning Objective

To calculate ratios

for assessing a

company’s position

in the stock market

Stock Market Ratios

Stock market ratios analyze the

earnings and dividends of a

company.

1. Earnings Per Share

2. Book Value

3. Price-Earnings (PE) Ratio

4. Dividend Yield

Measures the profit accruing to each share of

common stock owned.

Formula:

Earnings per Share of Common

Stock

Analysts, stockholders, and creditors watch the

earnings per share measurement very closely.

Earnings

per share=

Income available to common stockholders

Average number of shares of common

stock outstanding during year

Earnings Per Share

Price-Earnings Ratio

Compares the current market value of common stock

with the earnings per share of that stock.

Formula:

PE ratio = 12 to 1

The price-earnings ratio is an indicator of the

attractiveness of a stock as an investment.

Example:

Price-earnings ratioMarket price per share

Earnings per share=

12$144

$ 12=

Book Value per Share of Stock

Measures the financial strength underlying each

share of stock.

Formula:

Procedure:

Step 1: Compute the claims of preferred shareholders.

Step 2: Compute the claims of common stockholders.

Step 3: Divide the total claims of common

stockholders by the number of shares

outstanding.

Common stockholders’ equity

Number of common sharesBook value per share

of stock=

Step 1: Compute the claims of

preferred stockholders.

For California Products, Inc. the book value of

preferred stock is the same as the par value,

$100 per share.

$ 100

x 500 shares outstanding

$50,000

Book Value per Share of Stock

Step 2: Compute the claims of common

stockholders.

Stockholders’ equity $315,921

Less preferred stock equity 50,000

Claims of common stockholders $265,921

Step 1: Claims of preferred

stockholders = $50,000

Book Value per Share of Stock

Step 1: Subtract the Claims of Preferred

Stockholders = $50,000

Step 2: Claims of common stockholders = $265,921

Step 3: Divide the total claims of common

stockholders by the number of shares

outstanding.

$265,921

6,000 shares= $44.32

Book Value per Share of Stock

Note this is for

common stock

shares Outstanding

Book value and fair market value often are quite

different.

Book value per share does not indicate how much

the stockholder would receive if the assets were

sold and the corporation liquidated.

Book Value per Share

Fair Market Value

Definition

The price that an interested but not desperate buyer

would be willing to pay and an interested but not

desperate seller would be willing to accept on the open

market assuming a reasonable period of time for an

agreement to arise.

Book Value

Definition:1. It is the total value of the company's net assets that

shareholders would theoretically receive if a company

were liquidated, less total liabilities.

2. By being compared to the company's market value,

the book value can indicate whether a stock

is under- or overpriced.

Dividend Yield

Dividend

Yield

Dividends Per Share

Market Price Per Share=

This ratio identifies the return, in terms

of cash dividends, on the current

market price of the stock.

Yield on Common Stock

Relationship between the dividends received by the

stockholders and the market value of each share.

Formula:

Yield on Common StockDividend per share

Market price per share=

Example:

10%$ 6

$ 60=

The limitations of

financial statement

analysis

Financial statements use book values.

Book value depends on accounting policies and

procedures.

Businesses have choices about certain things,

such as depreciation methods and useful lives.

Financial statements assume that the dollar is a stable

monetary unit.

No two companies are exactly the same:

Different legal entities

Different product mixes

Different financing methods

Precautionary Notes on Statement Analysis

Financial statement analysis is useful only if these

limitations are understood.

Limitations of Financial

Statement Analysis

Different

Industries

Changing

Economic

Environment

Accounting

Principles

Assignments:

See web: http//www.cabrillo.edu/~mbooth

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