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- 1. Analysis of Financial Statements
- 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. <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. 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. 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. 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. 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. <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. 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. <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. 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. DuPont Framework The DuPont framework was named after a system of ratio analysis developed by DuPont around 1920.
- 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. 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. Efficiency Ratios Number of days’ sales in inventory: Average inventory Average daily cost of goods sold Fixed asset turnover: Sales Average fixed assets
- 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. The End
- 33. This electronic presentation was prepared by Douglas Cloud, Professor of Accounting, Pepperdine University

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