Chapter Title

Transcript Chapter Title

Financial Statement Analysis

Chapter 15 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

Limitations of Financial Statement Analysis

Differences in accounting methods between companies sometimes make comparisons difficult.

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We use the LIFO method to value inventory.

We use the average cost method to value inventory.

Limitations of Financial Statement Analysis

Analysts should look beyond the ratios.

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Industry trends Changes within the company Consumer tastes Technological changes Economic factors

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Statements in Comparative and Common-Size Form

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Dollar and percentage changes on statements An item on a financial statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing comparisons.

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Common-size statements



Ratios

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Dollar and Percentage Changes on Statements

Horizontal analysis (or trend analysis) shows the changes between years in the financial data in both dollar and percentage form.

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Horizontal Analysis

The following slides illustrate a horizontal analysis of Clover Corporation’s comparative balance sheets and comparative income statements for this year and last year.

Horizontal Analysis

CLOVER CORPORATION Comparative Balance Sheets December 31 This Year Last Year Increase (Decrease) Amount % Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets $ 12,000 60,000 80,000 3,000 155,000 $ 23,500 40,000 100,000 1,200 164,700 40,000 120,000 160,000 $ 315,000 40,000 85,000 125,000 $ 289,700

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Horizontal Analysis

Calculating Change in Dollar Amounts Dollar Change = Current Year Figure – Base Year Figure The dollar amounts for last year become the “base” year figures.

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Horizontal Analysis

Calculating Change as a Percentage Percentage Change = Dollar Change Base Year Figure × 100%

Horizontal Analysis

CLOVER CORPORATION Comparative Balance Sheets December 31 This Year Last Year Increase (Decrease) Amount % Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: 155,000 164,700 $12,000 – $23,500 = $(11,500) Land 40,000 40,000 Buildings and equipment, net ($11,500 Total property and equipment ÷ $23,500) × 100% = (48.9%) 160,000 125,000 Total assets $ 12,000 60,000 80,000 3,000 $ 315,000 $ 23,500 40,000 100,000 1,200 $ 289,700 $ (11,500) (48.9)

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Horizontal Analysis

CLOVER CORPORATION Comparative Balance Sheets December 31 This Year Last Year Increase (Decrease) Amount % Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets $ 12,000 60,000 80,000 3,000 155,000 $ 23,500 40,000 100,000 1,200 164,700 $ (11,500) 20,000 (20,000) 1,800 (9,700) 40,000 120,000 160,000 $ 315,000 40,000 85,000 125,000 $ 289,700 35,000 35,000 $ 25,300 (48.9) 50.0

(20.0) 150.0

(5.9) 0.0

41.2

28.0

8.7

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Horizontal Analysis

We could do this for the liabilities and stockholders’ equity, but now let’s look at the income statement accounts.

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Horizontal Analysis

CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 This Year Last Year Increase (Decrease) Amount % Sales Cost of goods sold $ 520,000 360,000 $ 480,000 315,000 Gross margin Operating expenses 160,000 128,600 165,000 126,000 Net operating income Interest expense Net income before taxes Less income taxes (30%) 31,400 6,400 25,000 7,500 39,000 7,000 32,000 9,600 Net income $ 17,500 $ 22,400

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Horizontal Analysis

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Gross margin Operating expenses 160,000 128,600 165,000 126,000 (5,000) 2,600 (3.0) 2.1

Net operating income Interest expense Net income before taxes Less income taxes (30%) 31,400 6,400 25,000 7,500 39,000 7,000 32,000 9,600 (7,600) (600) (7,000) (2,100) (19.5) (8.6) (21.9) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

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Horizontal Analysis

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Gross margin 160,000 165,000 (5,000) 2,600 (3.0) 2.1

net income decreased by 21.9%.

Interest expense Net income before taxes Less income taxes (30%) 6,400 25,000 7,500 7,000 32,000 9,600 (7,600) (600) (7,000) (2,100) (19.5) (8.6) (21.9) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

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Horizontal Analysis

CLOVER CORPORATION There were increases in both cost of goods Comparative Income Statements sold (14.3%) and operating expenses (2.1%). For the Years Ended December 31 These increased costs more than offset the increase in sales, yielding an overall (Decrease) Amount % Sales Cost of goods sold $ 520,000 360,000 $ 480,000 315,000 $ 40,000 45,000 8.3

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Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) 160,000 128,600 31,400 6,400 25,000 7,500 165,000 126,000 39,000 7,000 32,000 9,600 (5,000) 2,600 (7,600) (600) (7,000) (2,100) (3.0) 2.1

(19.5) (8.6) (21.9) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

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Trend Percentages

Trend percentages state several years’ financial data in terms of a base year , which equals 100 percent.

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Trend Analysis

Trend Percentage = Current Year Amount Base Year Amount × 100%

Trend Analysis

Look at the income information for Berry Products for the years 2007 through 2011. We will do a trend analysis on these amounts to see what we can learn about the company.

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Trend Analysis

Item Sales Cost of goods sold Gross margin Berry Products Income Information For the Years Ended December 31 2011 $ 400,000 285,000 115,000 2010 $ 355,000 250,000 105,000 Year 2009 $ 320,000 225,000 95,000 2008 $ 290,000 198,000 92,000 2007 $ 275,000 190,000 85,000 The base year is 2007, and its amounts will equal 100%.

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Trend Analysis

Item Sales Cost of goods sold Gross margin Berry Products Income Information For the Years Ended December 31 2011 2010 Year 2009 2008 105% 104% 108% 2008 Amount ÷ 2007 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108% 2007 100% 100% 100%

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Trend Analysis

Item Sales Cost of goods sold Gross margin Berry Products Income Information For the Years Ended December 31 2011 145% 150% 135% 2010 129% 132% 124% Year 2009 116% 118% 112% 2008 105% 104% 108% By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.

2007 100% 100% 100%

Common-Size Statements

Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.

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Common-Size Statements

In income statements , all items usually are expressed as a percentage of sales .

Gross Margin Percentage

Gross Margin Percentage = Gross Margin Sales This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.

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Common-Size Statements

In balance sheets , all items usually are expressed as a percentage of total assets .

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Common-Size Statements

(dollars in millions)

2008 Net income Burger King Dollars Percentage $ 190 7.70% McDonald's Dollars Percentage $ 4,313 18.30%

Common-size financial statements are particularly useful when comparing data from different companies.

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Common-Size Statements

Let’s take another look at the information from the comparative income statements of Clover Corporation for this year and last year. This time, let’s prepare common-size statements.

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Common-Size Statements

Sales CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size Cost of goods sold Percentages This Year Last Year This Year Last Year $ 520,000 $ 480,000 100.0

100.0

360,000 315,000 Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) 160,000 128,600 31,400 6,400 25,000 7,500 165,000 126,000 39,000 32,000 7,000 9,600 Sales is usually the base and is expressed as 100%.

Net income $ 17,500 $ 22,400

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Common-Size Statements

Sales CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size Cost of goods sold Percentages This Year Last Year This Year Last Year $ 520,000 $ 480,000 100.0

100.0

360,000 315,000 69.2

65.6

Gross margin 160,000 165,000 Operating expenses 128,600 31,400 6,400 126,000 This Year’s Cost ÷ This Year’s Sales × 100% 7,000 25,000 32,000 Less income taxes (30%) Net income 7,500 9,600 ( $315,000 ÷ $480,000 ) × 100% = 65.6% $ 17,500 $ 22,400

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Common-Size Statements

CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size What conclusions can we draw?

Percentages Sales Cost of goods sold This Year Last Year This Year Last Year $ 520,000 $ 480,000 100.0

100.0

360,000 315,000 69.2

65.6

Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income 160,000 128,600 31,400 6,400 25,000 7,500 $ 17,500 165,000 126,000 39,000 7,000 32,000 9,600 $ 22,400 30.8

24.8

6.0

1.2

4.8

1.4

3.4

34.4

26.2

8.2

1.5

6.7

2.0

4.7

Now, let’s look at Norton Corporation’s financial statements for this year and last year.

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NORTON CORPORATION Balance Sheets December 31 This Year Last Year Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets $ $ 30,000 20,000 12,000 3,000 65,000 165,000 116,390 281,390 346,390 $ 20,000 17,000 10,000 2,000 $ 49,000 123,000 128,000 251,000 300,000

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NORTON CORPORATION Balance Sheets December 31 This Year Last Year Liabilities and Stockholders' Equity Current liabilities: Accounts payable Notes payable, short-term Total current liabilities Long-term liabilities: Notes payable, long-term Total liabilities Stockholders' equity: Common stock, $1 par value Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equity $ 112,000 39,000 3,000 42,000 70,000 27,400 158,100 185,500 48,890 234,390 $ 120,000 40,000 2,000 42,000 78,000 17,000 113,000 130,000 50,000 180,000 Total liabilities and stockholders' equity $ 346,390 $ 300,000

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Sales Cost of goods sold Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income NORTON CORPORATION Income Statements For the Years Ended December 31 This Year $ 494,000 140,000 354,000 270,000 84,000 7,300 76,700 23,010 $ 53,690 Last Year $ 450,000 127,000 323,000 249,000 74,000 8,000 66,000 19,800 $ 46,200

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Ratio Analysis – The Common Stockholder

NORTON CORPORATION The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholders’ equities. This Year Number of common shares outstanding Beginning of year End of year Net income Stockholders' equity Beginning of year End of year Dividends per share Dec. 31 market price per share Interest expense Total assets Beginning of year End of year 17,000 27,400 $ 53,690 180,000 234,390 2 20 7,300 300,000 346,390

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Earnings Per Share

Earnings per Share = Net Income – Preferred Dividends Average Number of Common Shares Outstanding Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

Earnings form the basis for dividend payments and future increases in the value of shares of stock.

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Earnings Per Share

Earnings per Share = Net Income – Preferred Dividends Average Number of Common Shares Outstanding Earnings per Share = $53,690 – $0 = $2.42

($17,000 + $27,400)/2 This measure indicates how much income was earned for each share of common stock outstanding.

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Price-Earnings Ratio

Price-Earnings Ratio = Market Price Per Share Earnings Per Share Price-Earnings Ratio = $20.00 $2.42

= 8.26 times A higher price-earnings ratio means that investors are willing to pay a premium for a company’s stock because of optimistic future growth prospects.

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Dividend Payout Ratio

Dividend Payout Ratio = Dividends Per Share Earnings Per Share Dividend Payout Ratio = $2.00 $2.42

= 82.6% This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking dividends (market price growth) would like this ratio to be large (small).

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Dividend Yield Ratio

Dividend Yield Ratio = Dividends Per Share Market Price Per Share Dividend Yield Ratio = $2.00 $20.00

= 10.00% This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

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Return on Total Assets

Return on Total Assets = Net Income + [Interest Expense × (1 – Tax Rate)] Average Total Assets Return on Total Assets = $53,690 + [$7,300 × (1 – .30)] = 18.19% ($300,000 + $346,390) ÷ 2 Adding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity.

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Return on Common Stockholders’ Equity

Return on Common Stockholders’ Equity = Net Income – Preferred Dividends Average Stockholders’ Equity Return on Common Stockholders’ Equity = $53,690 – $0 ($180,000 + $234,390) ÷ 2 = 25.91% This measure indicates how well the company used the owners’ investments to earn income.

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Financial Leverage

Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors. Return on investment in assets > Fixed rate of return on borrowed funds = Positive financial leverage Return on investment in assets < Fixed rate of return on borrowed funds = Negative financial leverage

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Book Value Per Share

Book Value per Share = Common Stockholders’ Equity Number of Common Shares Outstanding Book Value per Share = $234,390 27,400 = $8.55

This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts after all creditors were paid off.

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Book Value Per Share

Book Value per Share = Common Stockholders’ Equity Number of Common Shares Outstanding Book Value per Share = $234,390 27,400 = $8.55

Notice that the book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost.

Ratio Analysis – The Short–Term Creditor

NORTON CORPORATION Short-term creditors, such as suppliers, want to be paid on time. Therefore, they focus on the company’s cash flows and working capital.

Cash This Year Accounts receivable, net Beginning of year End of year Inventory Beginning of year End of year Total current assets Total current liabilities Sales on account $ 30,000 17,000 20,000 10,000 12,000 65,000 42,000 494,000 Cost of goods sold 140,000

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Working Capital

The excess of current assets over current liabilities is known as working capital.

Working capital is not free. It must be financed with long term debt and equity.

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Working Capital

Current assets Current liabilities Working capital December 31 This Year $ 65,000 (42,000) $ 23,000

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Current Ratio

Current Ratio = Current Assets Current Liabilities 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.

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Current Ratio

Current Ratio = Current Assets Current Liabilities Current Ratio = $65,000 $42,000 = 1.55

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Acid-Test (Quick) Ratio

Acid-Test Ratio = Quick Assets Current Liabilities Acid-Test Ratio = $50,000 $42,000 = 1.19

Quick assets include Cash, Marketable Securities, Accounts Receivable, and current Notes Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory.

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Accounts Receivable Turnover

Accounts Receivable Turnover = Sales on Account Average Accounts Receivable Accounts Receivable Turnover = $494,000 ($17,000 + $20,000) ÷ 2 = 26.7 times This ratio measures how many times a company converts its receivables into cash each year.

Average Collection Period

Average Collection Period = 365 Days Accounts Receivable Turnover Average Collection Period = 365 Days 26.7 Times = 13.67 days

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This ratio measures, on average, how many days it takes to collect an account receivable.

Inventory Turnover

Inventory Turnover = Cost of Goods Sold Average Inventory This ratio measures how many times a company’s inventory has been sold and replaced during the year.

If a company’s inventory turnover Is less than its industry average, it either has excessive inventory or the wrong types of inventory.

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Inventory Turnover

Inventory Turnover = Cost of Goods Sold Average Inventory Inventory Turnover = $140,000 ($10,000 + $12,000) ÷ 2 = 12.73 times

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Average Sale Period

Average Sale Period = 365 Days Inventory Turnover Average Sale Period = 365 Days 12.73 Times = 28.67 days

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This ratio measures how many days, on average, it takes to sell the entire inventory.

Ratio Analysis – The Long–Term Creditor

Long-term creditors are concerned with a company’s ability to repay its loans over the long-run.

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This is also referred to as net operating income.

NORTON CORPORATION This Year Earnings before interest expense and income taxes Interest expense Total stockholders' equity Total liabilities $ 84,000 7,300 234,390 112,000

Times Interest Earned Ratio

Times Interest Earned = Earnings +I nterest Expense + Income Taxes Interest Expense Times Interest Earned = $84,000 $7,300 = 11.51 times This is the most common measure of a company’s ability to provide protection for its long term creditors. A ratio of less than 1.0 is inadequate.

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Debt-to-Equity Ratio

Debt

–

Equity Ratio = Total Liabilities Stockholders’ Equity This ratio indicates the relative proportions of debt to equity on a company’s balance sheet.

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Stockholders like a lot of debt if the company can take advantage of positive financial leverage.

Creditors prefer less debt and more equity because equity represents a buffer of protection.

Debt-to-Equity Ratio

Debt

–

Equity Ratio = Total Liabilities Stockholders’ Equity Debt

–

Equity Ratio = $112,000 $234,390 = 0.48

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Published Sources That Provide Comparative Ratio Data 15-62