Analysis and interpretation of ratios
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Analysis and interpretation of ratios

Analysis and interpretation of ratios

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Analysis and interpretation of ratios Analysis and interpretation of ratios Presentation Transcript

  • A NALYSIS A ND I NTERPRETATION O F F INANCIAL S TATEMENTS
    • 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 course
      • Therefore, 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 Analysis 625
    • 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...
    Financial Statement Analysis
    • 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
    Financial Statement Analysis 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
    Financial Statement Analysis 627 628
    • Horizontal Analysis
    • Vertical Analysis
    • Common-Size Statements
    • Trend Percentages
    • Ratio Analysis
    Methods of Financial 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
  • 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
  • Common-Size Statements 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)
  • 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)
  • Horizontal Analysis Example
    • The 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
    Horizontal Analysis Example Dollar Change Current Year Figure Base Year Figure = –
    • Calculating Change in Dollar Amounts
    Horizontal Analysis Example Since we are measuring the amount of the change between 1998 and 1999, the dollar amounts for 1998 become the “base” year figures. Dollar Change Current Year Figure Base Year Figure = –
    • Calculating Change as a Percentage
    Horizontal Analysis Example Percentage Change Dollar Change Base Year Figure 100% = ×
  • Horizontal Analysis Example $12,000 – $23,500 = $(11,500)
  • Horizontal Analysis Example ($11,500 ÷ $23,500) × 100% = 48.9%
  • Horizontal Analysis Example
  • Horizontal Analysis Example Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet.
  •  
  • Horizontal Analysis Example Now, let’s apply the procedures to the income statement.
  •  
  • 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 Example
    • The management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company.
  • Vertical Analysis Example
  • Vertical Analysis Example $82,000 ÷ $483,000 = 17% rounded $30,000 ÷ $387,000 = 8% rounded
  • Vertical Analysis Example $76,000 ÷ $483,000 = 16% rounded
  • Trend Percentages Example
    • Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.
  • Trend Percentages Example
    • Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.
    $1,991 - $1,820 = $171
  • Trend Percentages Example
    • Using 1995 as the base year, we develop the following percentage relationships.
    $1,991 - $1,820 = $171 $171 ÷ $1,820 = 9% rounded
  • Trend line for 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) Ratios
      • Show relationship between debt and equity financing in a company
    • Profitability Tests
      • Relate income to other variables
    • Market Tests
      • Help 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
    10 Ratios You Must Know 651
    • Equity (Long-Term Solvency) Ratios
      • Equity (stockholders’ equity) ratio
      • Equity to debt
    10 Ratios You Must Know
    • 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
    10 Ratios You Must Know $
    • 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
    10 Ratios You Must Know
  • 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.
    • We will
    • use this
    • information
    • to calculate the liquidity ratios for Norton.
  • Working Capital*
    • 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
    • #1
    Measures the ability of the company to pay current debts as they become due. Current Ratio $65,000 $42,000 = = 1.55 : 1 Current Ratio Current Assets Current Liabilities =
  • Acid-Test (Quick) Ratio
    • #2
    Quick assets are Cash, Marketable Securities, Accounts Receivable (net) and current Notes Receivable. Quick Assets Current Liabilities = Acid-Test Ratio
  • Acid-Test (Quick) Ratio
    • #2
    Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000. Quick Assets Current Liabilities = Acid-Test Ratio
  • Acid-Test (Quick) Ratio
    • #2
    Quick Assets Current Liabilities = Acid-Test Ratio $50,000 $42,000 = 1.19 : 1 = Acid-Test Ratio
  • Accounts Receivable Turnover
    • #3
    This ratio measures how many times a company converts its receivables into cash each year. Sales on Account Average Accounts Receivable Accounts Receivable Turnover = = 26.70 times $494,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover = Average, net accounts receivable Net, credit sales
  • Number of Days’ Sales in Accounts Receivable
    • #4
    Measures, on average, how many days it takes to collect an account receivable. Days’ Sales in Accounts Receivables = 365 Days Accounts Receivable Turnover = 13.67 days = 365 Days 26.70 Times Days’ Sales in Accounts Receivables
  • Number of Days’ Sales in Accounts Receivable
    • #4
    In practice, would 45 days be a desirable number of days in receivables? Days’ Sales in Accounts Receivables = 365 Days Accounts Receivable Turnover = 13.67 days = 365 Days 26.70 Times Days’ Sales in Accounts Receivables
  • Inventory Turnover
    • #5
    Measures the number of times inventory is sold and replaced during the year. Cost of Goods Sold Average Inventory Inventory Turnover = = 12.73 times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover =
  • Inventory Turnover
    • #5
    Would 5 be a desirable number of times for inventory to turnover? Cost of Goods Sold Average Inventory Inventory Turnover = = 12.73 times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover =
  • Equity, or Long–Term Solvency Ratios
    • This is part of the information to calculate the equity, or long-term solvency ratios of Norton Corporation.
  • Here is the rest of the information we will use.
  • Equity Ratio
    • #6
    Measures the proportion of total assets provided by stockholders. Equity Ratio = Stockholders’ Equity Total Assets Equity Ratio = $234,390 $346,390 67.7% =
  • Net Income to Net Sales A/K/A Return on Sales or Profit Margin
    • #7
    Net Income to Net Sales = Net Income Net Sales Measures the proportion of the sales dollar which is retained as profit. Net Income to Net Sales = $53,690 $494,000 = 10.9%
  • Net Income to Net Sales A/K/A Return on Sales or Profit Margin
    • #7
    Net Income to Net Sales = Net Income Net Sales Net Income to Net Sales = $53,690 $494,000 = 10.9% Would a 1% return on sales be good?
  • Return on Average Common Stockholders’ Equity (ROE)
    • #8
    Return on Stockholders’ Equity = Net Income Average Common Stockholders’ Equity Important measure of the income-producing ability of a company. = $53,690 ($180,000 + $234,390) ÷ 2 = 25.9% Return on Stockholders’ Equity
    • #9
    Earnings Per Share Earnings per Share Earnings Available to Common Stockholders Weighted-Average Number of Common Shares Outstanding = The financial press regularly publishes actual and forecasted EPS amounts. Earnings per Share $53,690 (17,000 + 27,400) ÷ 2 = = $2.42
    • What’s new from Chap. 15?
    • Weighted-average calculation
    Earnings Per Share
    • Three alternatives for calculating weighted-average number of shares
    EPS of common stock = _______________________ Earnings available to common stockholders Weighted-average number of common shares outstanding 644
  • Earnings Per Share
    • What’s new from Chap. 15?
    • Weighted-average calculation
    Alternate #1 EPS of common stock = _______________________ Earnings available to common stockholders Weighted-average number of common shares outstanding 645
  • Earnings Per Share Alternate #3 Alternate #2 645
    • ¶ EPS and Stock Dividends or Splits
      • Why restate all prior calculations of EPS?
      • Comparability - i.e., no additional capital was generated by the dividend or split
    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. 646
  • Price-Earnings Ratio A/K/A P/E Multiple
    • #10
    Price-Earnings Ratio Market Price Per Share EPS = Provides some measure of whether the stock is under or overpriced. Price-Earnings Ratio = $20.00 $ 2.42 = 8.3 : 1
  • 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 Question The current ratio is a measure of liquidity, but is computed by dividing current assets by current 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 Question
  • No more ratios, please!