NETA POWERPOINT PRESENTATIONS TO ACCOMPANY VOLUME 2 Accounting Second Canadian Edition BY...

NETA POWERPOINT PRESENTATIONS TO ACCOMPANY

VOLUME 2

Accounting Second Canadian Edition

BY WARREN/REEVE/DUCHAC/ELWORTHY/KRISTJANSON/TOBER

Adapted by Sheila Elworthy and Tana Kristjanson

Copyright © 2014 by Nelson Education Ltd. 1

CHAPTER 17

Financial Statement Analysis


After studying this chapter, you should be able to:

1. Describe basic financial statement analytical methods.

2. Use ratio analysis to assess the liquidity of a business.

3. Use ratio analysis to assess the efficiency of a business.



After studying this chapter, you should be able to:

4. Use ratio analysis to assess the solvency of a business.

5. Use ratio analysis to assess the profitability of a business.

6. Describe the contents of corporate annual reports.



Describe basic financial statement analytical methods.

1


Basic Analytical Methods

Users analyze a company’s financial statements using a variety of analytical methods. Three such methods are as follows:1.Horizontal analysis2.Vertical analysis3.Common-sized statements4.Ratio analysis


Horizontal Analysis

The percentage analysis of increases and decreases in related items using comparative financial statements is called horizontal analysis.



Horizontal Analysis:

Difference $17,000Base year (2014) $533,000

= 3.2%


Difference $25,800Base year (2014) $64,700

= 39.9%



Difference $296,500Base year (2014) $1,234,000

= 24.0%


EXAMPLE EXERCISE 17-1

Horizontal Analysis

The cash and accounts receivable balances for a company are provided below.

Based on this information, what is the amount and percentage of increase or decrease that would be shown in a balance sheet with horizontal analysis?


FOLLOW MY EXAMPLE 17-1

Horizontal Analysis

Cash $12,500 increase ($62,500 – $50,000), 25%Accounts receivable $5,600 decrease ($74,400 – $80,000), 7%

For Practice: PE 17-1


Vertical Analysis

A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis.


Vertical Analysis of Balance Sheet

In a vertical analysis of the balance sheet, the percentages are computed as follows:•Each asset item is stated as a percent of the total assets. •Each liability and shareholders’ equity item is stated as a percent of the total liabilities and shareholders’ equity.



Vertical Analysis

Income statement information for Lee Corporation is provided below.

Prepare a vertical analysis of this income statement information for Lee Corporation.



Vertical Analysis




Difference $550,000Base year (2014) $1,139,000

= 48.3%

Vertical Analysis:

Vertical Analysis of the Income Statement

In a vertical analysis of the income statement, each item is stated as a percent of net sales.



Selling Expenses $191,000Net Sales $1,498,000

= 12.8%

Vertical Analysis:

Common-Size Statements

In a common-sized statement, a presentation form of vertical analysis, all items are expressed as a percentage. Common-sized statements are useful for comparing one company with another or for comparing a company with industry averages.


Ratio Analysis

Users of financial statements are interested in the ability of a company to do the following:•Meet its short-term financial obligations (debts), known as liquidity.•Use its assets to the best of its ability, known as efficiency.


Ratio Analysis

• Meet its long-term financial obligations (debts), or solvency.

• Earn income, known as profitability. Ratio analysis helps provide this

information.


The Langley Company financial statements presented earlier are used to illustrate the following ratio analyses.


Use ratio analysis to assess the liquidity of a business.

2


Liquidity Analysis

Evaluating a company’s ability to pay its current liabilities is called liquidity analysis.


Liquidity Analysis

Such analysis is of special interest to short-term creditors and includes the following:•Working capital•Current ratio•Quick ratio


Working Capital

Working Capital = Current Assets – Current Liabilities

The excess of current assets of a business over its current liabilities is called working capital.

The working capital is often used in evaluating a company’s ability to pay current liabilities.


The working capital for Langley Company is computed below:


2015 2014Current assets $550,000 $533,000Current liabilities –210,000 –243,000Working capital $340,000 $290,000

Working Capital = Current Assets – Current Liabilities

Current Ratio

The current ratio, sometimes called the working capital ratio, measures a company’s ability to pay its current liabilities.


Current Ratio = Current AssetsCurrent Liabilities


2015 2014Current assets $550,000 $533,000Current liabilities 210,000 243,000Current ratio 2.6 2.2

$550,000$210,000

$533,000$243,000

Quick Ratio

A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio or acid-test ratio.


Quick Ratio = Quick AssetsQuick Liabilities


2015 2014Quick assets:Cash $90,500 $64,700Temporary Investments 75,000 60,000Accounts Receivable (net) 115,000 120,000a. Total quick assets $280,500 $244,700 b. Current liabilities $210,000 $243,000Quick ratio (a/b) 1.31 1.02

Quick assets are cash and other current assets that can be quickly converted to cash.


Liquidity Analysis

The following items are reported on a company’s balance sheet:

Cash $300,000Temporary investments 100,000Accounts receivable (net) 200,000Inventories 200,000Accounts payable 400,000

Determine (a) the current ratio and (b) the quick ratio.



Liquidity Analysis


a. Current Ratio = Current Assets ÷ Current LiabilitiesCurrent Ratio = ($300,000 + $100,000 + $200,000 + $200,000) ÷ $400,000Current Ratio = 2.0

b. Quick Ratio = Quick Assets ÷ Current LiabilitiesQuick Ratio = ($300,000 + $100,000 + $200,000) ÷ $400,000Quick Ratio = 1.5


Use ratio analysis to assess the efficiency of a business.

3


Efficiency Analysis

Efficiency ratios focus on the ability of a business to use its assets efficiently. The following ratios are included in this analysis:


Efficiency Analysis

• Accounts receivable turnover• Days’ sales in receivables• Inventory turnover• Days’ sales in inventory• Total asset turnover


Accounts Receivable

Analysis

Inventory Analysis

Accounts Receivable Turnover

The relationship between sales and accounts receivable may be stated as the accounts receivable turnover.

Collecting accounts receivable as quickly as possible improves a company’s liquidity.


Accounts Receivable Turnover

Net Sales

Average Net Accounts Receivable

=


2015 2014a. Net Sales $1,498,000 $1,200,000Accounts Receivable (net):Beginning of year $ 120,000

$ 140,000End of year 115,000 120,000b. Average (Total/2) $ 235,000

$260,000 Accounts receivable turnover (a/b) 12.7 times 9.2 times

Langley Company:

Days’ Sales in Receivables

The days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding.



Average Net Accounts Receivable

Average Daily Sales=



Net Sales365


2015 2014a. Average accounts receivable (net)(Total accounts

receivable/2) $117,500 $

130,000Net sales $1,498,000 $1,200,000b. Average daily sales(Sales/365) $ 4,104 $

3,288Days’ sales in Receivables (a/b) 28.6 days 39.5 days


Days’ sales in receivables can also be calculated as follows:



365Accounts Receivable

Turnover

=


Accounts Receivable Analysis

A company reports the following:Net sales $960,000Average accounts receivable (net) 48,000

Determine (a) the accounts receivable turnover and (b) the days’ sales in receivables, using both methods for calculating the days’ sales in receivables ratio. Round to one decimal place.




a. Accounts Receivable Turnover = Sales ÷ Average Accounts Receivable

Accounts Receivable Turnover = $960,000 ÷ $48,000

Accounts Receivable Turnover = 20.0 times




b. Days’ Sales in Receivables = Average Accounts Receivable ÷ Average Daily Sales

Days’ Sales in Receivables = $48,000 ÷ ($960,000/365) = $48,000 ÷ $2,630

Days’ Sales in Receivables = 18.3 daysDays’ Sales in Receivables = 365 ÷ Accounts Receivable

TurnoverDays’ Sales in Receivables = 365 ÷ 20.0Days’ Sales in Receivables = 18.3 days



Inventory Analysis

The following help to evaluate a company’s ability to manage its inventory effectively:•Inventory turnover•Days’ sales in inventory


Inventory Analysis

While a company should keep enough inventory in stock so that it doesn’t lose sales, excess inventory decreases working capital, increases inventory related expenses, and increases the risk of losses due to price declines or obsolescence.


Inventory Turnover

The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory.


Inventory Turnover = Cost of Goods SoldAverage Inventory

a. Costs of goods sold $1,043,000 $ 820,000Inventories:Beginning of year $ 283,000

$ 311,000End of year 264,000

283,000Total $ 547,000

$ 594,000b. Average (Total/2) $ 273,500

$ 297,000Inventory turnover (a/b) 3.8 times

2.8 times


2015 2014

Days’ Sales in Inventory



Average InventoryAverage Daily Cost of Goods

Sold

=

Cost of Goods Sold365


The days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory.



a. Average inventory(Total/2) $ 273,500

$ 297,000Cost of goods sold $1,043,000 $ 820,000b. Average daily cost of goodssold (COGS/365 days) $ 2,858 $

2,247Days’ sales in inventory (a/b) 95.7 days 132.2 days

2015 2014


The days’ sales in inventory can also be calculated from the inventory turnover ratio as follows:



365Inventory Turnover

=


Inventory Analysis

A company reports the following:Cost of goods sold $560,000Average inventory 112,000

Determine (a) the inventory turnover and (b) the days’ sales in inventory, using both methods for calculating the days’ sales in inventory ratio. Round to one decimal place.



Inventory Analysis

a. Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

Inventory Turnover = $560,000 ÷ $112,000Inventory Turnover = 5.0 times



Inventory Analysis

b. Days’ Sales in Inventory = Average Inventory ÷ Average Daily Cost of Goods Sold

Days’ Sales in Inventory = $112,000 ÷ ($560,000/365) = $112,000 ÷ $1,534

Days’ Sales in Inventory = 73.0 daysDays’ Sales in Inventory = 365 ÷ Inventory TurnoverDays’ Sales in Inventory = 365 ÷ 5.0Days’ Sales in Inventory = 73.0 days

For Practice: PE17-5


Total Asset Turnover

The total asset turnover measures how effectively a company uses its assets.


Total Asset Turnover =

Net SalesAverage Total

Assets


a. Net sales $1,498,000 $1,200,000Total Assets:Beginning of year $1,230,500 $1,187,500End of year 1,139.500 1,230,500Total $2,370,000 $2,418,000b. Average (Total/2) $1,185,000 $2,418,000 Total asset turnover (a/b) 1.3 times 1.0 times

2015 2014

Use ratio analysis to assess the solvency of a business.

4


Solvency Analysis

Solvency analysis focuses on the ability of a company to pay its long-term liabilities. It is normally assessed using the following ratios:•Debt ratio•Times interest earned ratio


Debt Ratio

The debt ratio measures the percentage of assets that are financed with debt and is computed as follows:


Debt Ratio Total LiabilitiesTotal Assets

=


Total liabilities $ 310,000 $ 443,000Total assets $1,139,500 $1,230,500Debt Ratio 27.2% 36.0%

2015 2014Langley Company:


Debt Ratio

The following information was taken from Acme Company’s balance sheet:Total assets $1,960,000Long-term liabilities 400,000Total liabilities 560,000Total shareholders’ equity 1,400,000

Determine the company’s debt ratio.



Debt Ratio

Debt Ratio = Total Liabilities ÷ Total AssetsDebt Ratio = $560,000 ÷ $1,960,000Debt Ratio = 28.6%

For Practice: PE17-6


Times Interest Earned Ratio

The times interest earned ratio measures the risk that interest payments will not be made if earnings decrease. It is computed as follows:


Times Interest Earned

Income Before Income Taxes + Interest

ExpenseInterest Expense

=


Income before income taxes $ 162,500 $ 134,600a. Add interest expense 6,000 12,000Amount available to meet interest charges $ 168,500 $ 146,600Times interest earned (b/a) 28.1 times 12.2 times




A company reports the following:Income before income taxes $250,000Interest expense 100,000

Determine the times interest earned ratio.




Times Interest Earned = (Income Before Income Taxes + Interest Expense) ÷ Interest ExpenseTimes Interest Earned = ($250,000 + $100,000) ÷ $100,000Times Interest Earned = 3.5 times



Use ratio analysis to assess the profitability of a business.

5


Profitability Analysis

Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business. It includes the following:


Profitability Analysis

• Profit margin• Gross margin• Return on assets• Return on common shareholders’ equity• Earnings per share• Price-earnings ratio• Dividend yield


Profit Margin

The profit margin measures the overall profitability of a company as a percentage of its sales.


Profit Margin Net IncomeNet Sales

=


Net Income $ 91,000 $ 76,500Net Sales 1,498,000 1,200,000Profit Margin 6.1% 6.4%


Gross Margin

The gross margin, also referred to as the gross profit margin, assesses a company’s ability to earn a return on merchandise sold before other expenses are considered.


Gross Margin Gross ProfitNet Sales

=


Gross Profit $455,000 $380,000Net Sales 1,498,000 1,200,000Profit Margin 30.4% 31.7%

2015 2014


Profit Margin and Gross Margin

A company reports the following:Net Sales $1,450,000Gross profit 754,000Net income 101,500

Determine (a) the company’s profit margin and (b) the company’s gross margin.



Profit Margin and Gross Margin

a. Profit Margin = Net Income ÷ Net SalesProfit Margin = $101,500 ÷ $1,450,000Profit Margin = 7.0%

b. Gross Margin = Gross Profit ÷ Net SalesGross Margin = $754,000 ÷ $1,450,000Gross Margin = 52.0%



Return on Assets

The return on assets measures the profitability of total assets, without considering how the assets are financed.


Return on Assets

Net Income

Average Total Assets=


a. Net income $ 91,000 $ 76,500Total assets:Beginning of year $1,230,500 $1,187,500End of year 1,139,500 1,230,500Total $2,370,000 $2,418,000b. Average (Total/2) $1,185,000 $1,209,000Return on total assets (a/b) 7.7% 6.3%

2015 2014

Return on Operating Assets

The return on operating assets is sometimes computed when there are large amounts of nonoperating income and expenses.


Return on Operating Assets

Income from Operations

Average Operating Assets

=


Return on Assets

A company reports the following income statement and balance sheet information for the current year:Net income $ 125,000Total assets, beginning of year 1,770,000Total assets, end of year 2,000,000

Determine the return on assets.



Return on Assets

Return on Assets = Net Income ÷ Average Total AssetsReturn on Assets = $125,000 ÷ (($1,770,000 + $2,000,000) ÷ 2)Return on Assets = $125,000 ÷ $1,885,000Return on Assets = 6.6%



Return on Common Shareholders’ Equity

The return on common shareholders’ equity measures the rate of income earned on the amount invested by the common shareholders.



Net Income – Preferred Dividends

Average Common Shareholders’ Equity

=

Includes both contributed capital and

retained earnings


a. Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Total $ 82,000 $ 67,500Common shareholders’ equity:Beginning of year $ 637,500 $ 600,000End of year 679,500 637,500Total $1,317,000 $1,237,500b. Average (Total/2) $ 658,500 $ 618,750Return on common shareholders’ equity (a/b) 12.5% 10.9%

2015 2014

Leverage

The use of debt to finance operations is called leverage. Leverage magnifies both gains and losses. Common shareholders may receive a higher return if the company performs well, but the loss will be greater if the company does not perform well.




A company reports the following:

Net income $ 125,000Preferred dividends 5,000Average shareholders’ equity 1,000,000Average common shareholders’ equity 800,000

Determine the return on common shareholders’ equity.




Return on Common Shareholders’ Equity = (Net Income – Preferred Dividends) ÷ Average Common Shareholders’ Equity

Return on Common Shareholders’ Equity = ($125,000 – $5,000) ÷ $800,000

Return on Common Shareholders’ Equity = 15%



Earnings per Share

Earning per share (EPS) measures the share of profits that are earned by a common share. Companies preparing financial statements using IFRS must report earnings per share in the statement of comprehensive income.


Earnings per Share


Earnings per Share (EPS)

Net Income – Preferred Dividends

Weighted Average Number of Common Shares

=


Net income $ 91,000 $ 76,500Preferred dividends 9,000 9,000a. Total $ 82,000 $ 67,500b. Number of common shares 50,000 50,000

outstandingEarnings per share (a/b) $1.64 $1.35

2015 2014

Weighted Average Number of Common Shares

If there is a change in the number of common shares outstanding during the year, it is necessary to calculate the weighted average number of common shares for the EPS ratio.


Norman Company started the year with 100,000 common shares, issued an additional 35,000 shares on July 1 and repurchased 12,000 shares on November 1. The company had net income of $1,246,200 and paid preferred dividends of $45,000.



EPS = $1,246,200 ‒ $45,000115,500 shares

= $10.40


Earnings per Share

A company reports the following:Net income $ 1,000,000Preferred dividends $ 50,000Number of common shares

outstanding at December 31 year-end 20,000

a.Determine the weighted average number of shares, given that 4,000 shares were issued on October 3.b.Determine the company’s earnings per share, rounding to two decimal places.



Earnings per Share

a. Weighted average number of shares = 16,000 × 9/12 + 20,000 × 3/12

Weighted average number of shares = 12,000 + 5,000

Weighted average number of shares = 17,000b. Earnings per Share = ($1,000,000 – $50,000) ÷

17,000Earnings per Share = $55.882, rounded to $55.88



Price-Earnings Ratio

Another profitability measure quoted by the financial press is the price-earnings (P/E) ratio on common shares. The price-earnings ratio on common shares measures a company’s future earnings prospects.


Price-Earnings (P/E) Ratio

Market Price per Common Share

Earnings per Share=


Market price per common share $41.00 $27.00Earnings per share ÷ $1.64 ÷$1.35Price-earnings ratio 25 20

2015 2014


Earnings per Share and Price-Earnings Ratio

A company reports the following:Net income $250,000Preferred dividends $ 15,000Number of common shares outstanding 20,000Market price per common share $ 35.00

a.Determine the company’s earnings per share.b.Determine the company’s price-earnings ratio. Round to one decimal place.




a. Earnings per Share = (Net Income – Preferred Dividends) ÷ Weighted Average Number of Common Shares Outstanding

Earnings per Share = ($250,000 – $15,000) ÷ 20,000

Earnings per Share = $11.75




b. Price-Earnings Ratio = Market Price per Share ÷ Earnings per Share

Price-Earnings Ratio = $35.00 ÷ $11.75Price-Earnings Ratio = 3.0



Dividend Yield

The dividend yield measures the rate of return to common shareholders from cash dividends.


Dividend Yield Annual Dividends per Share

Market Price per Share=


a. Dividends per share $ 0.80 $ 0.60b. Market price per share $41.00 $27.00Dividend yield 2.0% 2.2%

2015 2014

Exhibit 7 (cont.)


Financial Statement Analysis Ratios

Describe the contents of corporate annual reports.

6


Notes to the Financial Statements

Notes provide:•Additional detail. •Improved understandability of information contained in the statements. •Information on accounting policies choices.


Notes to the Financial Statements

• Information on items not shown on the statements.

• Better comparability between statements prepared by different companies.

(Understandability and comparability are two qualitative characteristics of the conceptual framework)


Corporate Annual Reports

In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections:•Management discussion and analysis•Management letter•Auditor’s report


Management Discussion and Analysis

The Management Discussion and Analysis (MD&A) 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.


Management Letter

The report by management, entitled Management Responsibility for Financial Reporting, states management’s responsibility for establishing and maintaining internal control. In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report.


Auditor’s Report

All publicly held corporations are required to have an independent audit (examination) of their financial statements. The professional accounting firm that conducts the audit renders an opinion on the fairness of the statements called the Auditor’s Report.


The End


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