Chapter 13

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Chapter 13Financial Statement Analysis

Using Financial Accounting Information: The Alternative to Debits and Credits, 6th

byGary A. Porter and Curtis L. Norton

Copyright © 2009 South-Western, a part of Cengage Learning.

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Stockholders

Financial Statement Analysis

Creditors

Management

Will I be paid?

How good is our investment? How are we

performing?

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LIFO FIFO

Limitations of Financial Statement Analysis

Use of different accounting methods Changes in accounting methods

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Limitations of Financial Statement Analysis

Failure to understand trends or use industry ratios

Difficulty of making industry comparisons (i.e., conglomerates)????

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Limitations of Financial Statement Analysis

Nonoperating items on income statement

Effects of inflation

=

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Horizontal Analysis

Net SalesGross ProfitNet Earnings

Increase (Decrease)

2002 2001 DollarsPercent

$2,746 $2,401 $345 14.4 %

1,596 1,404 192 13.7 402 363 39 10.7

Wm. Wrigley Jr. Company (in millions)

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Trend Analysis

Return onAvg. Equity

2002 2001 2000 19991998

28.7% 30.1% 29.0% 26.8%28.4%

Wm. Wrigley Jr. Company

Tracking items over a series of years

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Vertical Analysis

Common-size statements recast items as a percentage of a selected item

Allows comparisons of companies of different size

Compares percentages across years to identify trends

%

%

%

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Dollars Percent$24,000 100.0% 18,000 75.0$ 6,000 25.0% 3,000 12.5$ 3,000 12.5% 140 0.6$ 2,860 11.9% 1,140 4.8$ 1,720 7.1%

Common-Size Statements

Sales revenueCost of goods sold Gross profitSelling & admin. exp. Operating incomeInterest expense Income before taxIncome tax expense Net income

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Liquidity Analysis

Nearness to cash Ability to pay debts as they become due

CashRatios

TurnoverRatios

WorkingCapitalRatios

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Current Ratio

Measure of short-term financial health Consider composition of current assets

Rule of thumb2:1

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Acid-Test (Quick) Ratio

Stricter test of ability to pay debts Excludes inventories and prepaid assets

Quick AssetsCurrent Liabilities

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Accounts Receivable Turnover Ratio

Net Sales

Average Accounts Receivable

Indicates how quickly a company is collecting (i.e.,

turning over) its receivables

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Accounts Receivable Turnover Ratio

Too fast

Credit policies too stringent; may be losing sales

Too slow

Credit department not operating effectively; possible quality problems

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Number of Days’ Sales in Receivables

Represents the average # of days accounts are outstanding

365 Days . Accts. Receivable Turnover

*Some analysts use 360 days.

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Number of Days’ Sales in Receivables

If this company’s credit terms are net 30, what would this tell you about the efficiency

of the collection process?

365 Days4.8 Times = 76 days

Example:

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Inventory Turnover Ratio

Represents the number of times per period inventory is turned

over (i.e., sold).

Cost of Goods SoldAverage Inventory

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Inventory Turnover Ratio

Circuit City 5.8 times per yearSafeway 9.2 times per year

Can you compare the two ratios?

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# of Days’ Sales in Inventory

Represents the average # of days inventory is on hand before it’s sold

365 DaysInventory Turnover Ratio

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

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# of Days’ Sales in Inventory

Circuit City 62 days

Safeway 39 days

Do these averages seem reasonable?

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

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Solvency Analysis

Ability to stay in business over the long-term

Debt-to-EquityRatio

DebtService

Coverage

TimesInterestEarned

Cash Flowto Capital

Expenditures

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Debt-to-Equity Ratio

Total Liabilities Total Stockholders’ Equity

How much have creditors

contributed compared to

owners?

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Debt-to-Equity Ratio

Total LiabilitiesTotal Stockholders’ Equity = .60

For every dollar contributed by

owners, creditors have loaned $.60

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Times Interest Earned Ratio

Measures ability to meet current interest payments

The greater the coverage the better

Net Income + Interest Exp. + Income Tax Exp. (EBIT)Interest Expense

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Profitability Analysis

Profit Margin % Gross Margin % Rate of Return on Assets Return on Common S/E EPS P/E Ratio Dividend Ratios

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Profit Margin %

Net Income/Net Sales

Shows how much profit is being earned per dollar of sales

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Gross Margin %

Gross Margin/Net Sales

(Gross Margin = Net Sales – COGS)

Shows the mark up % on goods sold

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Return on Assets Ratio

Measures return to all providers of capital (creditors and owners)

Net IncomeAverage Total Assets

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Return on Common Stockholders’ Equity

Net Income - Preferred DividendsAverage Common Stockholders’ Equity

The owners earned 15%on their investment

in ABC Co... Not bad!

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Earnings per Share

Presents profits on a per-share basis

Net Income - Preferred DividendsWeighted Avg. # of Common Shares Outstanding

Certificate of Stock

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Price/Earnings Ratio

Relates earnings to the market price of the stock

Current Market PriceEarnings per Share

very high P/Every low P/E

possibly overvaluedpossibly undervalued

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Dividend Payout Ratio

Common Dividends per ShareEarnings per Share

We need to decide what % of the firm’s income we can return to

owners.

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Appendix

Accounting Tools:

Non-Operating Income Statement Items (DEC)

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Common Characteristics

All such items are reported after income from continuing operations

Shown net of tax effects Most analysts ignore these items,

since they are not likely to reoccur

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Discontinued Operations

Any gain or loss from disposal of a division or segment of the business

Any net income or loss from operating this portion until the date of disposal

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Extraordinary Items

Gain or loss due to an event that is Unusual in nature AND Infrequent in occurrence

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Cumulative Effect of a Change in Accounting Principle

Reflects a change in a company’s accounting principles, practices, or methods

Reports the difference in income in all prior years between the old method and the new method

Sometimes such a change is dictated by new accounting standards

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Key Points Summary for Ch. 13• Why Analyze Financial Information?

•To make decisions – Ratios are tools of decision making

• Limitations of Financial Analysis:

• Different accounting methods

• Difficulty of making comparisons (conglomerates)

• Inflation/Non-operating income items

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Key Points Summary for Ch. 13• Horizontal/Trend Analysis: Year-to-year

• Vertical Analysis: Within one year

• Liquidity Analysis: Ability of company to operate in short-term

• Current Ratio = Current Assets/Current Liabilities

Ability of Co. to pay short-term debt

• Quick Ratio = Quick Assets/Current Liabilities

Ability of Co. to pay short-term debt (stricter)

(Quick Assets = Cash + A/R + ST investments)

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Key Points Summary for Ch. 13• Liquidity Analysis (cont’d)

• A/R Turnover = Credit Sales/Avg. A/R

# of times Co. collects A/R during year

• Days’ Sales in Receivables = 365/ A/R Turnover

Avg. collection period for receivables

• Inventory Turnover = COGS/Avg. Inventory

# of times Inventory is sold during year

•Days’ Sales in Inventory = 365/ Inv. Turnover

Avg. days to sell inventory

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Key Points Summary for Ch. 13• Solvency Analysis: Long-term ability of company to

stay in business

• Debt-to-Equity Ratio = Total Liab./Total Equity

Borrowing vs. Investments by owner

•Times Interest Earned = Net Income + Interest Exp. + Income Tax Exp. (EBIT)

Interest Expense

How many times over could Co. pay interest with current earnings

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Key Points Summary for Ch. 13

• Profitability Ratios: Ability of company to generate profits

• Profit margin % = Net Income/Net Sales

How much profit per $1 of sales

•Gross margin % = Gross Margin/Net Sales

Mark up on product sales

•Return on Assets = Net Income/Avg. Assets

Effectivess of Company at using assets

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Key Points Summary for Ch. 13

• Profitability Ratios (cont’d):

•Return on Common Equity = Net Income – Preferred Dividends/Common Stockholders’ Equity

Measures return on investment

•Earnings Per Share = Net Income/Avg Shares

Earnings amount per share of stock

• Non-operating Income Statement Items: DEC