Analysis of Financial Statements

Chapter 13

PowerPoint Editor: Beth Kane, MBA, CPA Wild, Shaw, and Chiappetta Financial & Managerial Accounting 6th Edition

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

13-C1: Purpose of Analysis

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Basics of Analysis

C 1 Reduces uncertainty Application of analytical tools Involves transforming data Financial statement analysis helps users make better decisions.

Internal Users Managers Officers Internal Auditors External Users Shareholders Lenders Customers 3 17 - 3

Building Blocks of Analysis

Liquidity and efficiency Solvency

17 - 4 C 1

Profitability Market prospects

4

C 1

Information for Analysis

1. Income Statement 2. Balance Sheet 3. Statement of Stockholders’ Equity 4. Statement of Cash Flows 5. Notes to the Financial Statements

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13-C2: Standards for Comparisons

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Standards for Comparison

When we interpret our analysis, it is essential to compare the results we obtained to other standards or benchmarks.

 Intracompany  Competitors  Industry  Guidelines C 2 7 17 - 7

C 2

Tools of Analysis

Horizontal Analysis Comparing a company’s financial condition and performance across time.

Vertical Analysis Comparing a company’s financial condition and performance to a base amount.

Ratio Analysis Measurement of key relations between financial statement items.

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13-P1: Comparative Statements

9

P 1

Horizontal Analysis

Horizontal analysis refers to examination of financial statement data

across time

.

Horizontal analysis refers to examination of financial statement data across time.

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P 1

Comparative Statements

Calculate Change in Dollar Amount

Dollar change = Analysis period amount – Base period amount When measuring the amount of the change in dollar amounts, compare the analysis period balance to the base period balance. The analysis period is usually the current year while the base period is usually the prior year.

11 17 - 11

P 1

Percent change

Comparative Statements

Calculate Change as a Percent

= Dollar change Base period amount

×

100

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When calculating the change as a percentage, divide the amount of the dollar change by the base period amount, and then multiply by 100 to convert to a percentage.

12

P 1

Horizontal Analysis

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P 1

Horizontal Analysis

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Trend Analysis

Trend analysis is used to reveal patterns in data covering successive periods.

Trend percent = Analysis period amount Base period amount × 100

17 - 15 P 1 15

Trend Analysis

P 1 Using 2009 as the base year we will get the following trend information : 16 17 - 16

Trend Analysis

17 - 17 P 1

We can use the trend percentages to construct a graph so we can see the trend over time.

17

P 1 NEED-TO-KNOW Compute trend percents for the following accounts, using 20X1 as the base year (round percents to whole numbers). State whether the situation as revealed by the trends appears to be favorable or unfavorable for each account.

($ in millions) Sales Cost of goods sold

Sales trend percents Cost of goods sold trend percents

20X4 $500 400 20X3 $350 175 20X2 $250 100 20X1 $200 50

250% 175% 125% 100%

$500/$200 $350/$200 $250/$200 $200/$200

800%

$400/$50

350%

$175/$50

200%

$100/$50

100%

$50/$50 18

13-P2: Common-Size Statements

19

Vertical Analysis

Common-Size Statements Common-size percent = Analysis amount Base amount

×

100

17 - 20 P 2 Financial Statement Balance Sheet Income Statement Base Amount Total Assets Revenues 20

P 2

Common-Size Balance Sheet

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P 2

Common-Size Income Statement

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P 2

Common-Size Graphics

Common-Size Graphic of Asset Components Common-Size Graphic of Income Statement

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P 2 NEED-TO-KNOW Express the following comparative income statements in common-size percents and assess whether or not this company’s situation has improved in the most recent year (round percents to whole numbers).

($ in millions) Sales Total expenses Net income 20X2 $800 560 $240 20X1 $500 400 $100

Common-size percents

Sales Total expenses Net income

Each item is expressed as a % of current year’s sales

100% ($800/$800) 70% ($560/$800) 30% ($240/$800) 100% ($500/$500) 80% ($400/$500) 20% ($100/$500) 24

13-P3: Ratio Analysis

25

Liquidity and efficiency

Ratio Analysis

Solvency

17 - 26 P 3

Profitability Market prospects

26

P 3

Liquidity and Efficiency

Current Ratio Acid-test Ratio Inventory Turnover Days’ Sales Uncollected Accounts Receivable Turnover Days’ Sales in Inventory Total Asset Turnover 27 17 - 27

Working Capital

Working capital represents current assets financed from long-term capital sources that do not require near-term repayment.

Current assets – Current liabilities = Working capital More working capital suggests a strong liquidity position and an ability to meet current obligations.

P 3 28 17 - 28

Current Ratio

Current ratio = Current assets Current liabilities 17 - 29 P 3 This ratio measures the short-term debt paying ability of the company. A higher current ratio suggests a strong liquidity position.

29

Acid-Test Ratio

Acid-test ratio = Cash + Short-term investments + Current receivables Current liabilities Referred to as Quick Assets This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash. P 3 30 17 - 30

Accounts Receivable Turnover

P 3 Accounts receivable = turnover Net sales Average accounts receivable, net Average accounts receivable = (Beginning acct. rec. + Ending acct. rec.) 2 This ratio measures how many times a company converts its receivables into cash each year.

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P 3

Inventory Turnover

Inventory turnover = Cost of goods sold Average inventory Average inventory = (Beginning inventory + Ending inventory) 2 This ratio measures the number of times merchandise is sold and replaced during the year.

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P 3

Days’ Sales Uncollected

Day's sales = Accounts receivable, net uncollected Net sales × 365 Provides insight into how frequently a company collects its accounts receivable.

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P 3

Days’ Sales in Inventory

Day's sales in = Inventory Ending inventory Cost of goods sold × 365 This ratio is a useful measure in evaluating inventory liquidity. If a product is demanded by customers, this formula estimates how long it takes to sell the inventory.

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P 3

Total Asset Turnover

Net sales Total asset turnover = Average total assets Average assets = (Beginning assets + Ending assets) 2 This ratio reflects a company’s ability to use its assets to generate sales. It is an important indication of operating efficiency.

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P 3 Debt Ratio

Solvency

Equity Ratio Pledged Assets to Secured Liabilities Times Interest Earned 36 17 - 36

Debt and Equity Ratios

In Millions Total liabilities Total equity Total liabilities and equity Amount $ 83,451 123,549 $ 207,000 Ratio 40.3% [Debt ratio] 59.7% [Equity ratio] 100.0% $83,451 ÷ $207,000 = 40.3% P 3 The

debt ratio

expresses total liabilities as a percent of total assets. The

equity ratio

provides complementary information by expressing total equity as a percent of total assets.

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P 3

Debt-to-Equity Ratio

Debt-to-equity ratio = Total liabilities Total equity This ratio measures what portion of a company’s assets are contributed by creditors. A larger debt-to equity ratio implies less opportunity to expand through use of debt financing.

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P 3

Times Interest Earned

Times interest earned = Income before interest and taxes Interest expense Net income + Interest expense + Income taxes = Income before interest and taxes This is the most common measure of the ability of a company’s operations to provide protection to long-term creditors.

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P 3 Profit Margin

Profitability

Return on Common Stockholders’ Equity Return on Total Assets 17 - 40 40

P 3

Profit Margin

Profit margin = Net income Net sales This ratio describes a company’s ability to earn net income from each sales dollar.

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P 3

Return on Total Assets

Return on total asset = Net income Average total assets Return on total assets measures how well assets have been employed by the company’s management.

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P 3 Return on Common Stockholders’ Equity Return on common stockholders' equity = Net income - Preferred dividends Average common stockholders' equity 17 - 43 This measure indicates how well the company employed the stockholders’ equity to earn net income.

43

P 3

Market Prospects

Price-Earnings Ratio Dividend Yield 17 - 44 44

P 3

Price-Earnings Ratio

Price-earnings ratio = Market price per common share Earnings per share This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth.

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Dividend Yield

Dividend yield = Annual cash dividends per share Market price per share This ratio identifies the return, in terms of cash dividends, on the current market price per share of the company’s common stock.

17 - 46 P 3 46

P 3

Summary of Ratios

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NEED-TO-KNOW For each ratio listed, identify whether the change in ratio value from 20X1 to 20X2 is regarded as favorable or unfavorable.

20X2 1. Profit margin ratio 2. Debt ratio 3. Gross margin ratio 4. Accounts receivable turnover 5. Basic earnings per share 40% 8.8

$2.10

6. Inventory turnover 6% 50% 3.6

20X1 8% 70% 36% 9.4

$2.00

4.0

Change Unfavorable Favorable Favorable Unfavorable Favorable Unfavorable Lower % of net income in each sales dollar Fewer assets are claimed by creditors Higher % of gross margin in each sales dollar Less efficiency in collection Higher net income per common share Less efficient inventory management P 3 48

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Global View

Horizontal and Vertical Analysis

Horizontal and vertical analyses help eliminate many differences between U.S. GAAP and IFRS when analyzing and interpreting financial statements. However, when fundamental differences in reporting regimes impact financial statements, the user must exercise caution when drawing conclusions.

Ratio Analysis

Ratio analysis of financial statements also helps eliminate differences between U.S. GAAP and IFRS. Importantly, the use of ratio analysis is fine, with some possible changes in interpretation depending on what is and what is not included in certain accounting measures across U.S. GAAP and IFRS. Care must be taken in drawing inferences from a comparison of ratios across reporting regimes.

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13-A1: Analysis Reporting

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A1

Analysis Reporting

The purpose of financial statement analyses is to reduce uncertainty in business decisions through a rigorous and sound evaluation. A financial statement analysis report directly addresses the building blocks of analysis and documents the reasoning.

1. Executive Summary 2. Analysis Overview 3. Evidential Matter 4. Assumptions 5. Key Factors 6. Inferences

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13-A2: Sustainable Income

52

Appendix 13A: Sustainable Income

Extraordinary Items Discontinued Segments 17 - 53 A 2 Continuing Operations

Net Income

53

End of Chapter 13

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