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• 1. Financial Statement Analysis Chapter 18
• 2. The Annual Report Usually Contains ...
• financial statements.
• notes to the financial statements.
• a summary of accounting methods used.
• management discussion and analysis of the financial statements.
• an auditor’s report.
• comparative financial data for 5 to 10 years.
• 3. Objective 1
• Perform a horizontal analysis
• of financial statements.
• 4. Horizontal Analysis Increase/(Decrease) 2002 2001 Amount Percent Sales \$41,500 \$37,850 \$3,650 9.6% Expenses 40,000 36,900 3,100 8.4% Net income 1,500 950 550 57.9%
• 5. Horizontal Analysis 2002 2001 Difference Sales \$41,500 \$37,850 \$3,650 \$3,650 ÷ \$37,850 = .0964, or 9.6%
• 6. Trend Percentages...
• are computed by selecting a base year whose amounts are set equal to 100%.
• The amounts of each following year are expressed as a percentage of the base amount.
Trend % = Any year \$ ÷ Base year \$
• 7.
• Year 2000 1999 1998
• Revenues \$27,611 \$24,215 \$21,718
• Cost of sales 15,318 14,709 13,049
• Gross profit \$12,293 \$ 9,506 \$ 8,669
• 1998 is the base year.
Trend Percentages What are the trend percentages?
• 8.
• Year 2000 1999 1998
• Revenues 127% 111% 100%
• Cost of sales 117% 113% 100%
• Gross profit 142% 110% 100%
Trend Percentages These percentages were calculated by dividing each item by the base year.
• 9. Objective 2
• Perform a vertical analysis
• of financial statements.
• 10. Vertical Analysis...
• compares each item in a financial statement to a base number set to 100%.
• Every item on the financial statement is then reported as a percentage of that base.
• 11. Vertical Analysis 1999 % Revenues \$38,303 100.0 Cost of sales 19,688 51.4 Gross profit \$18,615 48.6 Total operating expenses 13,209 34.5 Operating income \$ 5,406 14.1 Other income 2,187 5.7 Income before taxes \$ 7,593 19.8 Income taxes 2,827 7.4 Net income \$ 4,766 12.4
• 12. Vertical Analysis Assets 1999 % Current assets: Cash \$ 1,816 4.7 Receivables net 10,438 26.9 Inventories 6,151 15.9 Prepaid expenses 3,526 9.1 Total current assets \$21,931 56.6 Plant and equipment, net 6,847 17.7 Other assets 9,997 25.7 Total assets \$38,775 100.0
• 13. Objective 3
• Prepare common-size
• financial statements.
• 14. Common-size Statements
• On the income statement, each item is expressed as a percentage of net sales.
• On the balance sheet, the common size is the total on each side of the accounting equation.
• Common-size statements are used to compare one company to other companies, and to the industry average.
• 15. Benchmarking Percent of Net Sales MCI Lucent Technologies  Cost of goods sold  Operating expenses  Income tax  Net income
• 16. Objective 4
• Compute the standard
• financial ratios.
• 17. Ratio Classification
• Measuring ability to pay current liabilities
• Measuring ability to sell inventory and collect receivables
• Measuring ability to pay short-term and long-term debt
• Measuring profitability
• Analyzing stock as an investment
• 18. Palisades Furniture Example Net sales ( Year 2002 ) \$858,000 Cost of goods sold 513,000 Gross profit \$345,000 Total operating expenses 244,000 Operating income \$101,000 Interest revenue 4,000 Interest expense (24,000) Income before taxes \$ 81,000 Income taxes 33,000 Net income \$ 48,000
• 19. Palisades Furniture Example Assets 20x2 20x1 Current assets: Cash \$ 29,000 \$ 32,000 Receivables net 114,000 85,000 Inventories 113,000 111,000 Prepaid expenses 6,000 8,000 Total current assets \$262,000 \$236,000 Long-term investments 18,000 9,000 Plant and equipment, net 507,000 399,000 Total assets \$787,000 \$644,000
• 20. Palisades Furniture Example Liabilities 20x2 20x1 Current liabilities: Notes payable \$ 42,000 \$ 27,000 Accounts payable 73,000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities \$142,000 \$126,000 Long-term debt 289,000 198,000 Total liabilities \$431,000 \$324,000
• 21. Palisades Furniture Example Stockholders’ Equity 20x2 20x1 Common stock, no par \$186,000 \$186,000 Retained earnings 170,000 134,000 Total stockholders’ equity \$356,000 \$320,000 Total liabilities and stockholders’ equity \$787,000 \$644,000
• 22. Measuring Ability to Pay Current Liabilities Current ratio = Total current assets ÷ Total current liabilities The current ratio measures the company’s ability to pay current liabilities with current assets.
• 23. Measuring Ability to Pay Current Liabilities
• 20x1: \$236,000 ÷ \$126,000 = 1.87
• 20x2: \$262,000 ÷ \$142,000 = 1.85
• The industry average is 1.80.
• The current ratio decreased slightly during 20x2.
• 24. Measuring Ability to Pay Current Liabilities Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷ Total current liabilities The acid-test ratio shows the company’s ability to pay all current liabilities if they come due immediately.
• 25. Measuring Ability to Pay Current Liabilities
• 20x1: (\$32,000 + \$85,000) ÷ \$126,000 = .93
• 20x2: (\$29,000 + \$114,000) ÷ \$142,000 = 1.01
• The industry average is .60.
• The company’s acid-test ratio improved considerably during 20x2.
• 26. Measuring Ability to Sell Inventory Inventory turnover = Cost of goods sold ÷ Average inventory Inventory turnover is a measure of the number of times the average level of inventory is sold during a year.
• 27. Measuring Ability to Sell Inventory
• 20x2: \$513,000 ÷ \$112,000 = 4.58
• The industry average is 2.70.
• A high number indicates an ability to quickly sell inventory.
• 28. Measuring Ability to Collect Receivables Accounts receivable turnover = Net credit sales ÷ Average accounts receivable Accounts receivable turnover measures a company’s ability to collect cash from credit customers.
• 29. Measuring Ability to Collect Receivables
• 20x2: \$858,000 ÷ \$99,500 = 8.62 times
• The industry average is 22.2 times.
• Palisades’ receivable turnover is much lower than the industry average.
• The company is a home-town store that sells to local people who tend to pay their bills over a lengthy period of time.
• 30. Measuring Ability to Collect Receivables One day’s sales = Net sales ÷ 365 days Days’ sales in Accounts Receivable = Average net Accounts Receivable ÷ One day’s sales Days’ sales in receivable ratio measures how many day’s sales remain in Accounts Receivable.
• 31. Measuring Ability to Collect Receivables
• Palisades’ days’ sales in Accounts Receivable for 20x2:
• One day’s sales:
• \$858,000 ÷ 365 = \$2,351
• Days’ sales in Accounts Receivable:
• \$99,500 ÷ \$2,351 = 42 days
• The industry average is 16 days.
• 32. Measuring Ability to Pay Debt Total liabilities ÷ Total assets The debt ratio indicates the proportion of assets financed with debt.
• 33. Measuring Ability to Pay Debt
• 20x1: \$324,000 ÷ \$644,000 = 0.50
• 20x2: \$431,000 ÷ \$787,000 = 0.55
• The industry average is 0.61.
• Palisades Furniture expanded operations during 20x2 by financing through borrowing.
• 34. Measuring Ability to Pay Debt Times-interest-earned = Income from operations ÷ Interest expense Times-interest-earned ratio measures the number of times operating income can cover interest expense.
• 35. Measuring Ability to Pay Debt
• 20x1: \$ 57,000 ÷ \$14,000 = 4.07
• 20x2: \$101,000 ÷ \$24,000 = 4.21
• The industry average is 2.00.
• The company’s times-interest-earned ratio increased in 20x2.
• This is a favorable sign.
• 36. Measuring Profitability Rate of return on net sales = Net income ÷ Net sales Rate of return on net sales shows the percentage of each sales dollar earned as net income.
• 37. Measuring Profitability
• Palisades’ rate of return on sales:
• 20x1: \$26,000 ÷ \$803,000 = 0.032
• 20x2: \$48,000 ÷ \$858,000 = 0.056
• The industry average is 0.008.
• The increase is significant in itself and also because it is much better than the industry average.
• 38. Measuring Profitability Rate of return on total assets = (Net income + interest expense) ÷ Average total assets Rate of return on total assets measures how profitably a company uses its assets.
• 39. Measuring Profitability
• Palisades’ rate of return on total assets for 20x2:
• (\$48,000 + \$24,000) ÷ \$715,500 = 0.101
• The industry average is 0.049.
• How does Palisades compare to the industry?
• Very favorably.
• 40. Measuring Profitability Rate of return on common stockholders’ equity = (Net income – preferred dividends) ÷ Average common stockholders’ equity Common equity includes additional paid-in capital on common stock and retained earnings.
• 41. Measuring Profitability
• Palisades’ rate of return on common stockholders’ equity for 20x2:
• (\$48,000 – \$0) ÷ \$338,000 = 0.142
• The industry average is 0.093.
• Why is this ratio larger than the return on total assets (.101)?
• 42. Measuring Profitability Earnings per share of common stock = (Net income – Preferred dividends) ÷ Number of shares of common stock outstanding
• 43. Measuring Profitability
• 20x1: (\$26,000 – \$0) ÷ 10,000 = \$2.60
• 20x2: (\$48,000 – \$0) ÷ 10,000 = \$4.80
• This large increase in EPS is considered very unusual.
• 44. Analyzing Stock as an Investment
• Price/earning ratio is the ratio of market price per share to earnings per share.
• 20x1: \$35 ÷ \$2.60 = 13.5
• 20x2: \$50 ÷ \$4.80 = 10.4
• Given Palisades Furniture’s 20x2 P/E ratio of 10.4, we would say that the company’s stock is selling at 10.4 times earnings.
• 45. Analyzing Stock as an Investment Dividend per share of common (or preferred) stock ÷ Market price per share of common (or preferred) stock Dividend yield shows the percentage of a stock’s market value returned as dividends to stockholders each period.
• 46. Analyzing Stock as an Investment
• Dividend yield on Palisades’ common stock:
• 20x1: \$1.00 ÷ \$35.00 = .029 (2.9%)
• 20x2: \$1.20 ÷ \$50.00 = .024 (2.4%)
• An investor who buys Palisades Furniture common stock for \$50 can expect to receive 2.4% of the investment annually in the form of cash dividends.
• 47. Analyzing Stock as an Investment Book value per share of common stock = (Total stockholders’ equity – Preferred equity) ÷ Number of shares of common stock outstanding
• 48. Analyzing Stock as an Investment
• Book value per share of palisades’ common stock:
• 20x1: (\$320,000 – \$0) ÷ 10,000 = \$32.00
• 20x2: (\$356,000 – \$0) ÷ 10,000 = \$35.60
• Book value bears no relationship to market value.
• 49. Objective 5
• Use ratios in decision making.
• 50. Limitations of Financial Analysis