Analysis and interpretation of ratios

ANALYSIS ANDINTERPRETATION OF

FINANCIAL STATEMENTS

Non-accounting majors, especially, should relate well to this chapter

It looks at accounting information from users’ perspective Relates very closely to topics you will study in your

finance courseTherefore, we will use a somewhat broader brush on this chapter

What is financial statement analysis?”Tearing apart” the financial statements and looking at the relationships

Financial Statement Analysis

Who analyzes financial statements? Internal users (i.e., management) External users (emphasis of chapter)

Examples? Investors, creditors, regulatory agencies & … stock market analysts and auditors

Financial Statement Analysis625

What do internal users use it for? Planning, evaluating and controlling company

operations

What do external users use it for? Assessing past performance and current financial

position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management

First sentence in chapter says...


Information is available from Published annual reports

(1) Financial statements (2) Notes to financial statements (3) Letters to stockholders (4) Auditor’s report (Independent accountants) (5) Management’s discussion and analysis

Reports filed with the government e.g., Form 10-K, Form 10-Q and Form 8-K

627 628


Information is available from Other sources

(1) Newspapers (e.g., Wall Street Journal ) (2) Periodicals (e.g. Forbes, Fortune) (3) Financial information organizations such

as: Moody’s, Standard & Poor’s, Dun &

Bradstreet, Inc., and Robert Morris Associates (4) Other business publications

627 628


Horizontal Analysis

Vertical Analysis

Common-Size Statements

Trend Percentages

Ratio Analysis

Methods ofFinancial Statement Analysis

Horizontal Analysis

Using comparative financial statements to calculate dollar

or percentage changes in a financial statement item from

one period to the next

Using comparative financial statements to calculate dollar

or percentage changes in a financial statement item from

one period to the next

Vertical Analysis

For a single financial statement, each item

is expressed as a percentage of a

significant total, e.g., all income

statement items are expressed as a

percentage of sales

For a single financial statement, each item

is expressed as a percentage of a

significant total, e.g., all income

statement items are expressed as a

percentage of sales

Common-Size Statements

Financial statements that show only percentages and no absolute dollar amounts

Financial statements that show only percentages and no absolute dollar amounts

Trend Percentages

Show changes over time in given financial statement items

(can help evaluate financial information of several years)

Show changes over time in given financial statement items

(can help evaluate financial information of several years)

Ratio Analysis

Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship

between revenue and net income)

Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship

between revenue and net income)

Horizontal Analysis ExampleThe management of Clover Company provides you

with comparative balance sheets of the years ended December 31, 1999 and 1998.

Management asks you to prepare a horizontal analysis on the information.

Calculating Change in Dollar Amounts

DollarChange

Current YearFigure

Base YearFigure

= –

Horizontal Analysis Example

Calculating Change in Dollar Amounts

Since we are measuring the amount of the change between 1998 and 1999, the

dollar amounts for 1998 become the “base” year figures.

DollarChange

Current YearFigure

Base YearFigure

= –


Calculating Change as a Percentage

PercentageChange

Dollar Change Base Year Figure

100%= ×


$12,000 – $23,500 = $(11,500)


($11,500 ÷ $23,500) × 100% = 48.9%



Let’s apply the sameprocedures to the

liability and stockholders’equity sections of the

balance sheet.


CLOVER CORPORATIONComparative Balance SheetsDecember 31, 1999 and 1998

Increase (Decrease)1999 1998 Amount %

Liabilities and Stockholders' EquityCurrent liabilities: Accounts payable 67,000$ 44,000$ 23,000$ 52.3 Notes payable 3,000 6,000 (3,000) (50.0) Total current liabilities 70,000 50,000 20,000 40.0Long-term liabilities: Bonds payable, 8% 75,000 80,000 (5,000) (6.3) Total liabilities 145,000 130,000 15,000 11.5Stockholders' equity: Preferred stock 20,000 20,000 - 0.0 Common stock 60,000 60,000 - 0.0 Additional paid-in capital 10,000 10,000 - 0.0 Total paid-in capital 90,000 90,000 - 0.0Retained earnings 80,000 69,700 10,300 14.8 Total stockholders' equity 170,000 159,700 10,300 6.4Total liabilities and stockholders' equity 315,000$ 289,700$ 25,300$ 8.7

Now, let’s apply the procedures to theincome statement.


CLOVER CORPORATIONComparative Income Statements

For the Years Ended December 31, 1999 and 1998Increase (Decrease)

1999 1998 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)




Sales increased by 8.3% while net income decreased by 21.9%.




There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the

increase in sales, yielding an overall decrease in net income.

Vertical Analysis ExampleThe management of Sample Company asks you to

prepare a vertical analysis for the comparative balance sheets of the company.

Vertical Analysis Example


$82,000 ÷ $483,000 = 17% rounded$30,000 ÷ $387,000 = 8% rounded


$76,000 ÷ $483,000 = 16% rounded

Trend Percentages ExampleWheeler, Inc. provides you with the following operating data and asks that you prepare a trend

analysis.

Trend Percentages ExampleWheeler, Inc. provides you with the following operating data and asks that you prepare a trend

analysis.

$1,991 - $1,820 = $171

Trend Percentages ExampleUsing 1995 as the base year, we develop the

following percentage relationships.

$1,991 - $1,820 = $171$171 ÷ $1,820 = 9% rounded

Trend linefor Sales

Ratios can be expressed in three different ways: 1. Ratio (e.g., current ratio of 2:1)

2. % (e.g., profit margin of 2%)

3. $ (e.g., EPS of $2.25)

CAUTION! “Using ratios and percentages without considering

the underlying causes may be hazardous to your health!”

lead to incorrect conclusions.”

Ratios

Categories of Ratios Liquidity Ratios

Indicate a company’s short-term debt-paying ability

Equity (Long-Term Solvency) RatiosShow relationship between debt and equity financing in a company

Profitability TestsRelate income to other variables

Market TestsHelp assess relative merits of stocks in the marketplace

Liquidity Ratios Current (working capital) ratio Acid-test (quick) ratio Cash flow liquidity ratio Accounts receivable turnover Number of days’ sales in accounts receivable Inventory turnover Total assets turnover

651

10 Ratios You Must Know

Equity (Long-Term Solvency) Ratios Equity (stockholders’ equity) ratio Equity to debt


Profitability Tests Return on operating assets Net income to net sales (return on sales or “profit

margin”) Return on average common stockholders’ equity

(ROE) Cash flow margin Earnings per share Times interest earned Times preferred dividends earned

$


Market Tests Earnings yield on common stock Price-earnings ratio Payout ratio on common stock Dividend yield on common stock Dividend yield on preferred stock Cash flow per share of common stock


Now, let’s look at Norton

Corporation’s 1999 and 1998 financial

statements.

Now, let’s calculate the 10 ratios based

on Norton’s financial statements.

NORTON CORPORATION

1999

Cash 30,000$

Accounts receivable, net

Beginning of year 17,000

End of year 20,000

Inventory


End of year 12,000

Total current assets 65,000

Total current liabilities 42,000

Sales on account 494,000

Cost of goods sold 140,000

We will use this

informationto calculate

the liquidity ratios for Norton.

Working Capital*

12/31/99

Current assets 65,000$

Current liabilities (42,000)

Working capital 23,000$

The excess of current assets over current liabilities.

* While this is not a ratio, it does give an indication of a company’s liquidity.

Current (Working Capital) Ratio

CurrentRatio

$65,000 $42,000

= = 1.55 : 1

Measures the abilityof the company to pay current

debts as they become due.

CurrentRatio

Current Assets Current Liabilities

=

#1

Acid-Test (Quick) Ratio

Quick Assets Current Liabilities

=Acid-Test

Ratio

Quick assets are Cash,Marketable Securities,

Accounts Receivable (net) andcurrent Notes Receivable.

#2


=Acid-Test

Ratio

Norton Corporation’s quick assets consist of cash of

$30,000 and accounts receivable of $20,000.


#2


=Acid-Test

Ratio

$50,000 $42,000

= 1.19 : 1=Acid-Test

Ratio


#2

Sales on Account Average Accounts Receivable

Accounts ReceivableTurnover

=

Accounts Receivable Turnover

= 26.70 times $494,000 ($17,000 + $20,000) ÷ 2

Accounts ReceivableTurnover

=

This ratio measures how many times a company converts its

receivables into cash each year.

#3 Average, net accounts receivable

Net, credit sales

Number of Days’ Salesin Accounts Receivable

Measures, on average, how many days it takes to collect an

account receivable.

Days’ Salesin AccountsReceivables

= 365 Days Accounts Receivable Turnover

= 13.67 days= 365 Days 26.70 Times


#4

Number of Days’ Salesin Accounts Receivable

In practice, would 45 days be a desirable number of days in

receivables?

#4Days’ Salesin AccountsReceivables

= 365 Days Accounts Receivable Turnover

= 13.67 days= 365 Days 26.70 Times


Inventory Turnover

Cost of Goods Sold Average Inventory

InventoryTurnover

=

Measures the number of timesinventory is sold and

replaced during the year.

= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2

InventoryTurnover

=

#5

Inventory Turnover

Cost of Goods Sold Average Inventory

InventoryTurnover

=

Would 5 be a desirable number of times for inventory to turnover?

= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2

InventoryTurnover

=

#5

Equity, or Long–TermSolvency Ratios

This is part of the information to

calculate the equity, or long-term solvency

ratios of Norton Corporation.

NORTON CORPORATION

1999

Net operating income 84,000$ Net sales 494,000 Interest expense 7,300 Total stockholders' equity 234,390

NORTON CORPORATION

1999

Common shares outstanding Beginning of year 17,000 End of year 27,400

Net income 53,690$

Stockholders' equity


End of year 234,390

Dividends per share 2

Dec. 31 market price/share 20

Interest expense 7,300

Total assets


End of year 346,390

Here is therest of the

informationwe will

use.

Equity Ratio

EquityRatio

= Stockholders’ Equity Total Assets

EquityRatio

= $234,390 $346,390

67.7%=

Measures the proportionof total assets provided by

stockholders.

#6

Net Income to Net SalesA/K/A Return on Sales or Profit Margin

Net Incometo

Net Sales=

Net Income Net Sales

Net Incometo

Net Sales=

$53,690 $494,000

= 10.9%

Measures the proportion of the sales dollarwhich is retained as profit.

#7

Net Income to Net SalesA/K/A Return on Sales or Profit Margin

Net Incometo

Net Sales=

Net Income Net Sales

Net Incometo

Net Sales=

$53,690 $494,000

= 10.9%

Would a 1% return on sales be good?

#7

Return on Average Common Stockholders’ Equity (ROE)

Return onStockholders’

Equity=

Net Income Average Common

Stockholders’ Equity

= $53,690 ($180,000 + $234,390) ÷ 2

= 25.9%Return on

Stockholders’Equity

Important measure of theincome-producing ability

of a company.

#8

Earningsper Share

Earnings Available to Common StockholdersWeighted-Average Number of Common

Shares Outstanding=

Earningsper Share

$53,690 (17,000 + 27,400) ÷ 2

= = $2.42

The financial press regularly publishesactual and forecasted EPS amounts.

#9

Earnings Per Share

What’s new from Chap. 15? Weighted-average calculation

EPS of common stock = _______________________Earnings available tocommon stockholders

Weighted-average number ofcommon shares outstanding

644

Three alternatives for calculating weighted-average number of shares

Earnings Per Share

EPS of common stock = _______________________Earnings available tocommon stockholders

Weighted-average number ofcommon shares outstanding

645

Alternate #1

Earnings Per Share What’s new from Chap. 15? Weighted-average calculation

Alternate #3

Alternate #2

645

Earnings Per Share

¶ EPS and Stock Dividends or SplitsWhy restate all prior calculations of EPS?

Comparability - i.e., no additional capital was generated by the dividend or split

646

Earnings Per Share

¶ Primary EPS and Fully Diluted EPS

APB Opinion No. 15

I mentioned this 17-page pronouncement that required a 100-page explanation in the lecture for chapter 13.

Price-Earnings RatioA/K/A P/E Multiple

Price-EarningsRatio

Market Price Per Share EPS

=

Price-EarningsRatio

= $20.00

$ 2.42= 8.3 : 1

#10

Provides some measure of whether the stock is under or overpriced.

Important Considerations Need for comparable data

Data is provided by Dun & Bradstreet, Standard & Poor’s etc.

Must compare by industry Is EPS comparable?

Influence of external factors

General business conditions

Seasonal nature of business operations

Impact of inflation

Question

The current ratio is a measure of liquidity that is computed by dividing total assets by total

liabilities.

a. True

b. False

The current ratio is a measure of liquidity that is computed by dividing total assets by total

liabilities.

a. True

b. False

The current ratio is a measure of liquidity that is computed by dividing

total assets by total liabilities.

a. True

b. False

The current ratio is a measure of liquidity that is computed by dividing

total assets by total liabilities.

a. True

b. False

Question

The current ratio is a measure ofliquidity, but is computed by

dividing current assets bycurrent liabilities

The current ratio is a measure ofliquidity, but is computed by

dividing current assets bycurrent liabilities

Question

Quick assets are defined as Cash, Marketable Securities and net receivables.

a. True

b. False

Quick assets are defined as Cash, Marketable Securities and net receivables.

a. True

b. False

Quick assets are defined as Cash, Marketable Securities and net

receivables.

a. True

b. False

Quick assets are defined as Cash, Marketable Securities and net

receivables.

a. True

b. False

Question

No more ratios, please!

Business

Analysis and interpretation of ratios