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    1. 1. Analysis of Financial Statements
    2. 2. <ul><li>Organize a systematic financial ratio analysis using common-size financial statements and the DuPont framework. </li></ul><ul><li>Recognize the potential impact that differing accounting methods can have on the financial ratios of otherwise essentially identical companies. </li></ul><ul><li>Understand how foreign companies report their financial results to U.S. investors. </li></ul>Learning Objectives
    3. 3. <ul><li>Adjust reported financial statement numbers for the impact of inflation and for changes in the market values of specific assets. </li></ul>Learning Objectives EXPANDED MATERIAL <ul><li>Convert foreign currency financial statements into U.S. dollars using the translation method. </li></ul><ul><li>Incorporate material from the entire text into the preparation of a statement of cash flows. </li></ul>
    4. 4. Analytical Objectives <ul><li>Common-Size Financial Statements </li></ul><ul><li>Ratio Analysis </li></ul>Financial Statement Analysis is the examination of both the relationships among financial statement numbers and the trends of those numbers over time. Major Tools Include
    5. 5. Framework for Financial Statement Analysis <ul><li>Common-Size Financial Statements: Analysis of a company’s single-year financial statements. Financial statements are standardized by a measure of size, either sales or total assets. All amounts are stated in terms of a percentage of the size measure. </li></ul><ul><li>Ratio Analysis: Analysis of a company’s financial statements by computing ratios and comparing them against both trends and industry averages. </li></ul>
    6. 6. Comparisons Between Financial Statements Are Most Useful: <ul><li>When the presentations are in good form. </li></ul><ul><li>When the content of the statements is identical. </li></ul><ul><li>When accounting principles are not changed, or, if they are changed, the financial effects of the changes are disclosed. </li></ul><ul><li>When changes in circumstances or in the nature of the underlying transactions are disclosed. </li></ul>
    7. 7. Common-Size Income Statement <ul><li>For common-size income statements, the denominator, the entire pie, is equal to net sales. </li></ul>100% = Net Sales
    8. 8. <ul><li>Condensed Comparative Income Statement </li></ul><ul><li>2002 Percent 2001 Percent </li></ul><ul><li>Net sales $5,700 100.0 $6,600 100.0 </li></ul><ul><li>Cost of goods sold 4,000 70.2 4,800 72.7 </li></ul><ul><li>Gross profit on sales $ 1,700 29.8 $ 1,800 27.3 </li></ul><ul><li>Selling expense $1,120 19.6 $1,200 18.2 </li></ul><ul><li>General expense 400 7.0 440 6.7 </li></ul><ul><li>Total operating expenses $1,520 26.6 $ 1,640 24.9 </li></ul><ul><li>Operating income (loss) $ 180 3.2 $ 160 2.4 </li></ul><ul><li>Other revenue (expense) 80 1.4 130 2.0 </li></ul><ul><li>Income before taxes $ 260 4.6 $ 290 4.4 </li></ul><ul><li>Income tax 80 1.4 85 1.3 </li></ul><ul><li>Net income $ 180 3.2 $ 205 3.1 </li></ul>Common-Size Income Statement
    9. 9. Common-Size Balance Sheet <ul><li>For common-size balance sheets, the denominator, the entire pie, is equal to the total assets for the year. </li></ul>100% = Total Assets
    10. 10. <ul><li>Condensed Comparative Balance Sheet </li></ul><ul><li>2002 % 2001 % </li></ul><ul><li>Cash $ 200 3.5 $ 300 4.5 </li></ul><ul><li>Inventory 1,000 17.5 800 12.1 </li></ul><ul><li>Land & building (net) 3,000 52.6 3,200 48.5 </li></ul><ul><li>Total assets $4,200 73.6 $4,300 65.1 </li></ul><ul><li>Accounts payable $ 800 14.0 $1,000 15.1 </li></ul><ul><li>Long-term debt 3,000 52.6 1,500 22.7 </li></ul><ul><li>Total equity 400 7.0 1,800 27.3 </li></ul><ul><li>Total liab. & equity $4,200 73.6 $4,300 65.1 </li></ul>Common-Size Balance Sheet
    11. 11. Ratio Analysis <ul><li>DuPont Framework : Identifying factors that impact return on equity. </li></ul><ul><li>Efficiency Ratios : How efficiently is the firm utilizing its assets? </li></ul><ul><li>Leverage Ratios : To what degree is the company using other people’s money to purchase assets? </li></ul><ul><li>Other Financial Ratios : Other indications of liquidity, cash management, and profitability. </li></ul>
    12. 12. DuPont Framework The DuPont framework was named after a system of ratio analysis developed by DuPont around 1920.
    13. 13. Analysis of ROE Using the DuPont Framework Return on Equity : Profitability x Efficiency x Leverage Return on x Asset x Assets-to- Sales Turnover Equity Ratio Net Income x Sales x Assets Sales Assets Equity
    14. 14. Efficiency Ratios Continued Accounts receivable turnover: Sales Average accounts receivable Average collection period: Average accounts receivable Average daily sales Inventory turnover: Cost of goods sold Average inventory
    15. 15. Efficiency Ratios Number of days’ sales in inventory: Average inventory Average daily cost of goods sold Fixed asset turnover: Sales Average fixed assets
    16. 16. Leverage Ratios <ul><li>More borrowing means that more assets can be purchased without any additional equity investment by owners. </li></ul><ul><li>More assets means that more sales can be generated. </li></ul><ul><li>More sales means that net income should increase. </li></ul>Higher leverage increases return on equity through the following chain of events:
    17. 17. Leverage Ratios Debt ratio: Total liabilities Total assets Debt-to-equity ratio: Total liabilities Total equity Times interest earned: Earnings before interest and taxes Interest expense
    18. 18. Other Common Ratios Current ratio: Current assets Current liabilities Historically, the rule of thumb was to have a current ratio of at least 2.0.
    19. 19. Other Common Ratios Advances in information technology have allowed successful firms to reduce this ratio to below 1.0. Current ratio: Current assets Current liabilities
    20. 20. Cash flow adequacy ratio: Cash flow from operating activities Total primary cash requirements Other Common Ratios The sum of dividend payments, long-term asset purchases, and long-term debt repayments.
    21. 21. Other Common Ratios Book-to-market ratio: Stockholders’ equity Market value of shares outstanding Earnings per share: Net income Weighted-number of share outstanding Dividend payout ratio: Cash dividends Net income Price-earnings ratio: Market price per share Earnings per share
    22. 22. Alternative Reporting of the Effects of Changing Prices Nominal Dollar Measurement Constant Dollar Measurement Historical Cost Valuation Current Cost Valuation Historical Cost/ Nominal Dollar Historical Cost/ Constant Dollar Current Cost/ Nominal Dollar Current Cost/ Constant Dollar (GAAP)
    23. 23. Alternative Reporting of the Effects of Changing Prices Nominal Dollar Measurement Constant Dollar Measurement Historical Cost Valuation Current Cost Valuation Historical Cost/ Nominal Dollar Historical Cost/ Constant Dollar Current Cost/ Nominal Dollar Current Cost/ Constant Dollar (GAAP)
    24. 24. Impact of Changing Prices on the Financial Statements Assume: Index Converting To 125 Index Converting From 115 Nominal Dollar Amount $ 1,000 CDA = $1,000 x (125 ÷ 115) = $1,087 Constant Dollar Amount = Nominal Dollar Amount x Index Converting To Index Converting From
    25. 25. Purchasing Power Gains and Losses & Monetary Position <ul><li>Rising Prices Declining Prices </li></ul>Positive Net Monetary Position Loss Gain Gain Loss Negative Net Monetary Position
    26. 26. Alternative Reporting of the Effects of Changing Prices Nominal Dollar Measurement Constant Dollar Measurement Historical Cost Valuation Current Cost Valuation Historical Cost/ Nominal Dollar Historical Cost/ Constant Dollar Current Cost/ Nominal Dollar Current Cost/ Constant Dollar (GAAP) Current Cost/ Nominal Dollar
    27. 27. Current Cost/Nominal Dollar Example: Holding Gains <ul><li>Current cost of inventory $60,000 </li></ul><ul><li>Historical cost of inventory 50,000 </li></ul><ul><li>Total holding gain $10,000 </li></ul><ul><li>Realized holding gain </li></ul><ul><li>(50% of total holding gain) 5,000 </li></ul><ul><li>Unrealized holding gain $ 5,000 </li></ul>
    28. 28. Alternative Reporting of the Effects of Changing Prices Nominal Dollar Measurement Constant Dollar Measurement Historical Cost Valuation Current Cost Valuation Historical Cost/ Nominal Dollar Historical Cost/ Constant Dollar Current Cost/ Nominal Dollar Current Cost/ Constant Dollar (GAAP)
    29. 29. Current Cost/Constant Dollar Example: Basic Data <ul><li>Assume the following for Micro Computers, Corp. inventory account: </li></ul><ul><ul><li>Replacement cost $50,000 </li></ul></ul><ul><ul><li>Inflation adjusted value 40,000 </li></ul></ul><ul><ul><li>Historical cost 30,000 </li></ul></ul><ul><li>Compute: </li></ul><ul><ul><li>Total holding gain </li></ul></ul><ul><ul><li>Real component of holding gain </li></ul></ul><ul><ul><li>Inflationary component of holding gain </li></ul></ul>
    30. 30. Current Cost/Constant Dollar Example: Calculations <ul><li>Replacement cost $50,000 </li></ul><ul><li>HC/CD Cost $40,000 </li></ul><ul><li>HC/ND Cost $30,000 </li></ul>Total unrealized holding gain, $20,000 $10,000 Real Component $10,000 Inflationary Component
    31. 31. Foreign Currency Financial Statements <ul><li>Translation : Used when the foreign subsidiary is a relatively self-contained unit that is independent from the parent company’s operations. </li></ul><ul><li>Remeasurement : Is appropriate when the subsidiary does not operate independently of the parent company. </li></ul><ul><li>Functional currency : Currency of the primary economic environment of an entity. </li></ul>
    32. 32. The End
    33. 33. This electronic presentation was prepared by Douglas Cloud, Professor of Accounting, Pepperdine University

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