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Chapter 16
Financial Statement Analysis
Topics to be Discussed
Introduction
Why Analyze Financial Statements
Horizontal Analysis
Vertical Analysis
Comparison of Robyn’s to the GAAP
Introduction
How can we determine:
The ability of an organization to pay loans?
Whether we are earning a fair return on our investment?
The adequacy of cash flow to pay operating expenses?
How to improve the overall performance of the company?
Answer: Financial Statement Analysis
Why Analyze Financial Statements?
Key Concept
Ratio analysis provides additional information necessary to enhance the decision-making ability of the users of the information.
Limitations of Financial Statement Analysis
When comparing companies and interpreting financial statement analysis, differences in accounting methods and cost flow assumptions need to be considered.
Limitations of Financial Statement Analysis
Ratios of a company should be compared with industry standards:
Dun & Bradstreet www.dnb.com
Moody’s www.moodys.com
Standard & Poor’s www.standardpoor.com
Dow Jones Retrieval www.dowjones.com
Limitations of Financial Statement Analysis
Key Concept
Rather than focus on a single ratio, decision makers need to evaluate a company by comparing ratios to those of previous years, budgeted amounts, and industry standards.
The Impact of Inflation on Financial Statement Analysis
Financial statements, and thus financial ratios, are prepared using historical costs and are not adjusted for the effects of increasing prices.
Horizontal Analysis
Key Concept
Horizontal analysis is used to analyze changes in accounts occurring between years.
Horizontal Analysis
Examples from Robyn’s Boutique’s
Comparative Balance Sheets
2000 1999
Cash $130,000 $110,000
$130,000 - $110,000 = $20,000
$20,000/$110,000 = 18.2% increase
Prepaid Insurance $25,000 $30,000
$25,000 - $30,000 = ($5,000)
($5,000)/$30,000 = (16.7%) a decrease
Horizontal Analysis
Changes in the income statement are analyzed in the same way.
A few results:
Sales increased 7.7%
Cost of goods sold increased 9.9%
Total operating expenses increased 27.6%
Operating income decreased 26.2%
Net income decreased .05%
Horizontal Analysis
Pause and Reflect
Note that focusing on net income without looking at other changes in income statement items would definitely be a mistake in this case. Although net income was virtually unchanged from 1999 to 2000, operating income decreased over 26%.
Horizontal Analysis
Can be used to:Build prediction models to forecast financial performance in the future.Identify problem areas by looking for sudden or abnormal changes in accounts.
Trend Analysis: horizontal analysis of financial statements over several years.
Vertical Analysis
Compares financial statements of different companies and financial statements of the same company across time after controlling for differences in size.Common size financial statements are statements in which all items have been restated as a percentage of a selected item on the statement.
Vertical Analysis
Key Concept
Vertical analysis uses common size financial statements to remove size as a relevant variable in ratio analysis.
Vertical Analysis
Comparative Balance Sheet Asset accounts are stated as a % of total assets.Liability and stockholder’s equity are stated as a % of total L & SE.
On what numbers do I base the
percentages?
Vertical Analysis
Working Capital
Current Assets - Current Liabilities
Measure of an entity’s LIQUIDITY, or its ability to meet its immediate financial obligations
More useful if we have information concerning the makeup of WC
Vertical Analysis
Common Size Comparative Income Statements
Percentages are based on NET sales
The gross profit percentage is usually closely watched
Comparison of Robyn’s to the GAAP
% of Assets Robyn’s
GAAPCash 14.0%
27.0%Inventory 24.0
22.0Prepaids 2.7 5.5P & E, net 33.3
40.9LT invest. 11.8
0.0 What are the differences?
Comparison of Robyn’s to the GAAP
% of Total L + SE Robyn’s GAAP
Accounts payable 6.5% 12.5%Income tax 1.1 2.5Long-term debt 10.8 14.8
Cost of goods sold 71.4 61.8
Operating expense 19.0 25.1Net income after tax 13.6 8.2
Comparison of Robyn’s to the GAAP
Pause and Reflect
Spend some time looking at the preceding comparisons and speculate on what would cause the differences between two companies.
More Topics
Ratio Analysis
Ratio Analysis and Return on Investment
Key Concept
Ratio analysis is useful in assessing the impact of transactions on ROI, residual income, EVA, and other key measures of performance.
Current Ratio or Working Capital Ratio
Measures the entity’s liquidity.This ratio tells us the $$s of current assets for every $ of current liabilities.What is considered to be a good CR?
Current Ratio = Current AssetsCurrent Liabilities
Acid-Test Ratio or Quick Ratio
This ratio is a stricter test of a company’s ability to pay its current debts with highly liquid current assets.This ratio removes inventories and prepaid assets from the CA amount used in the calculation.A quick ratio of less than 1.0 should be of concern.
Quick Ratio = Quick Assets
Current Liabilities
Cash Flow from Operations to Current Liabilities Ratio
Cash flow from operations is sometimes used as the numerator because all debt is paid with cash.The ratio is an indication of whether enough cash is being generated from operations to pay current obligations.
Net Cash Provided by Operating ActivitiesAverage Current Liabilities
Number of Days Sales Are in Receivables
This number is the average number of days to collect a credit sale.
This may vary according to the credit policy of the particular business and the industry standards.
This ratio has an impact on ROI as part of the turnover of assets.
Number of Days in the Number of Days in the PeriodPeriodAccounts Receivable Accounts Receivable TurnoverTurnover
Inventory Turnover Ratio
Determines how many times during the time period that the value of the inventory was sold.Determining what is good is dependent on the industry and company standards.Grocery stores would have a much higher expected turnover than car dealerships.
Cost of Goods SoldCost of Goods SoldAverage InventoryAverage Inventory
Number of Days Inventory Is Held Before Sale
Another way to look at inventory turnover is to calculate the number of days inventory is held before it is sold.This may vary according to the particular business and industry standards.This ratio has an impact on ROI as part of the turnover of assets.
Number of Days in the PeriodInventory Turnover
Cash-to-Cash Operating Cycle Ratio
Number of Days in Inventory +Number of Days in Receivables
Measures the length of time between the purchase of inventory and the collection of cash from sales.
Debt to Equity Ratio
Total LiabilitiesTotal Stockholders’ Equity
A solvency ratio which measures the ability to stay financially healthy over the long-run.Indicates the preference of debt or equity financing of the entity.
Times Interest Earned
Measures a company’s ability to meet current interest payments to creditors by specifically measuring its ability to meet current-year interest payments out of current-year earnings.
Especially important to bankers and other lenders.
Net Income + Interest Expense + Net Income + Interest Expense + Income TaxIncome Tax
Interest ExpenseInterest Expense
Debt Service Coverage Ratio
Measures the amount of cash generated from operating activities that is available to repay principal and interest in the upcoming year.
The ratio indicates the $$s of cash generated for every $1 interest and principal paid.
Cash Flow from Operations Before Interest Cash Flow from Operations Before Interest and Taxesand Taxes
Interest and Principle PaymentsInterest and Principle Payments
Cash Flow from Operations to Capital Expenditures Ratio
Measures a company’s ability to use cash flow from operations to finance its acquisitions of property, plant, and equipment.The ability to use cash from operations diminishes the need to acquire outside financing such as debt.
Cash Flow from Operations - Total Cash Flow from Operations - Total Dividends PaidDividends Paid
Cash Paid for AcquisitionsCash Paid for Acquisitions
Return on Assets
Considers the return to investors on all assets invested in the company.
Interpretation is based on the company’s required return on assets, industry standards, and trends.
Net Income + Interest Expense Net Income + Interest Expense (net of tax)(net of tax)
Average Total AssetsAverage Total Assets
Return on Common Stockholders’ Equity
Measures the return to common stockholders as a percentage of stockholders’ equity.
Adequacy of return is dependent on a number of factors including the risk of the investment.
Net Income - Preferred DividendsNet Income - Preferred DividendsAverage Common Stockholders’ Average Common Stockholders’
EquityEquity
Earnings Per Share
Used to measure performance.
Used to compare the performance of companies across different industries.
Net Income - Preferred DividendsNet Income - Preferred DividendsAverage Number of Common Shares Average Number of Common Shares
OutstandingOutstanding
Price Earnings Ratio
Important for investors as it measures the relationship of earnings to dividends and the market price of a company’s stock.P/E are very dependent on the industry.
Current Market PriceCurrent Market PriceEPSEPS
Price Earnings Ratio
Pause and ReflectIn the past few years, Internet companies have often reflected high share prices with no historical earnings and minimal projected earnings.What do you think the prices of Internet stocks are based on? Reference values of companies such as Amazon.com, eBay.com, and Priceline.com
End of Chapter 16
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