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  • 1. Chapter 23 Analysis and Interpretation of Financial Statements
  • 2. The Need for Financial Statement Analysis <ul><li>Owners, managers, and others use the information on a firm’s financial statements to make judgments and decisions. </li></ul><ul><li>However, the raw figures on the financial statements do not provide a complete picture. </li></ul><ul><li>To gain a good understanding of the information on the financial statements, it is necessary to make certain comparisons and analyses. </li></ul>
  • 3. Liquidity and Profitability <ul><li>For the users of financial statements, two major areas of interest are: </li></ul><ul><ul><li>Liquidity of a business </li></ul></ul><ul><ul><li>Profitability of a business </li></ul></ul>
  • 4. Liquidity <ul><li>Definition: Ability of a business to pay its debts when they become due. </li></ul>
  • 5. Profitability <ul><li>Definition: Ability of a business to earn a reasonable return on the investment of the owners. </li></ul>
  • 6. Comparative Financial Statements <ul><li>Present a side-by-side comparison of a firm’s statements for two or more accounting periods. </li></ul><ul><li>Used to observe trends. </li></ul><ul><li>Help to answer the following types of questions: Is net income increasing or decreasing? Is the firm’s cash position improving or getting worse? </li></ul>
  • 7. Approaches to Comparing Financial Statements <ul><li>Two basic approaches are used to compare financial statements. </li></ul><ul><ul><li>Horizontal Analysis </li></ul></ul><ul><ul><li>Vertical Analysis </li></ul></ul>
  • 8. Horizontal Analysis <ul><li>Definition: The comparison of each item in a company’s financial statements in the current period with the same item from a previous accounting period or periods. </li></ul><ul><li>The changes found in horizontal analysis can be expressed as dollar changes or percent changes. </li></ul>
  • 9. Horizontal Analysis Comparative Income Statement <ul><li>In 20X2, the Clay Corporation had sales of $345,000. In 20X1, the amount of sales was $300,000. </li></ul><ul><li>Thus, sales increased by $45,000 from 20X1 to 20X2. This is the dollar change. </li></ul>
  • 10. Horizontal Analysis Comparative Income Statement <ul><li>To find the percent change, it is necessary to divide the dollar change by the dollar amount for the earlier year. </li></ul><ul><li>$45,000  $300,000 = 15.0% increase </li></ul>
  • 11. Horizontal Analysis Comparative Income Statement <ul><li>In 20X2, the Clay Corporation had interest expense of $3,500. In 20X1, the amount of interest expense was $4,100. </li></ul><ul><li>Thus, interest expense decreased by $600. This is the dollar change. </li></ul>
  • 12. Horizontal Analysis Comparative Income Statement <ul><li>To find the percent change, it is necessary to divide the dollar change by the dollar amount for the earlier year. </li></ul><ul><li>$600  $4,100 = 14.6% decrease </li></ul>
  • 13. Interpreting Horizontal Analysis <ul><li>The horizontal income statement makes it possible to spot strengths and weaknesses in a firm’s operating results. </li></ul>
  • 14. Interpreting Horizontal Analysis <ul><li>Example: </li></ul><ul><li>If sales increase by 15% but total selling expenses increase by 28%, management should be concerned. </li></ul><ul><li>The rate of increase for total selling expenses is almost twice the rate of increase for sales. </li></ul>
  • 15. Horizontal Analysis Comparative Balance Sheet <ul><li>In 20X2, the Clay Corporation had cash totaling $34,000. In 20X1, the amount of cash was $25,000. </li></ul><ul><li>Thus, cash increased by $9,000 from 20X1 to 20X2. This is the dollar change. </li></ul>
  • 16. Horizontal Analysis Comparative Balance Sheet <ul><li>To find the percent change, it is necessary to divide the dollar change by the dollar amount for the earlier year. </li></ul><ul><li>$9,000  $25,000 = 36.0% </li></ul>
  • 17. Vertical Analysis <ul><li>Definition: The expression of each item on a financial statement as a percent of a base figure in order to see the relative importance of each item. </li></ul>
  • 18. Vertical Analysis <ul><li>In 20X2, the income statement of the Clay Corporation shows net sales of $332,000. </li></ul><ul><li>The base figure for the income statement is net sales (sales minus sales returns and allowances and sales discounts). </li></ul>
  • 19. Vertical Analysis Income Statement <ul><li>The income statement of the Clay Corporation for 20X2 shows a gross profit of $150,000. </li></ul><ul><li>The dollar amount of each item on the income statement is divided by the dollar amount of net sales (the base figure). </li></ul><ul><li>$150,000  $332,000 = 45.2% </li></ul>
  • 20. Interpreting Vertical Analysis <ul><li>The vertical income statement makes it possible to compare items from year to year in terms of the base figure. </li></ul><ul><li>Example: </li></ul><ul><li>In 20X2, the gross profit of the Clay Corporation was 45.2% of net sales. In 20X1, it was 46.1%. </li></ul>
  • 21. Interpreting Vertical Analysis <ul><li>Gross profit has decreased slightly. </li></ul><ul><li>Management should look at the gross profit percent for prior years to see whether a negative trend is developing. </li></ul>
  • 22. Vertical Analysis Balance Sheet <ul><li>The base figure for vertical analysis of the balance sheet is total assets. </li></ul><ul><li>In 20X2, the Clay Corporation had total assets of $270,000. The amount of cash was $34,000. </li></ul>
  • 23. Vertical Analysis Balance Sheet <ul><li>The dollar amount of each item on the balance sheet is divided by the dollar amount of total assets (the base figure). </li></ul><ul><li>$34,000  $270,000 = 12.6% </li></ul>
  • 24. Trend Percentages <ul><li>Used to compare financial data for a period of several years. </li></ul><ul><li>The base year is usually the earliest year. </li></ul><ul><li>Each item in the base year is assigned a value of 100%. </li></ul><ul><li>The dollar amount of an item for any year is expressed as a percent of the same item for the base year. </li></ul>
  • 25. Trend Percentages <ul><li>The Cox Corporation had the following net sales from 20X1 to 20X5. </li></ul><ul><li>20X1 $350,000 20X3 $330,000 20X5 $410,000 </li></ul><ul><li>20X2 $360,000 20X4 $380,000 </li></ul>
  • 26. Trend Percentages <ul><li>Using 20X1 as the base year, we calculate the percentages for 20X2 and 20X3 as shown below. </li></ul><ul><li>$360,000  $350,000 = 103% for 20X2 </li></ul><ul><li>$330,000  $350,000 = 94% for 20X3 </li></ul>
  • 27. Trend Percentages Example <ul><li>At the Cox Corporation, the trend percentages for net sales from 20X1 to 20X5 are as follows. </li></ul><ul><li>20X1 20X2 20X3 20X4 20X5 </li></ul><ul><li>100% 103% 94% 109% 117% </li></ul>
  • 28. Trend Percentages Example <ul><li>The figures show a positive trend except for 20X3. </li></ul><ul><li>However, the gain between 20X1 and 20X5 has been very small —only 17%. </li></ul>
  • 29. Short-term Liquidity Measures <ul><li>There are certain measures used to evaluate short-term liquidity —the ability to pay debts that will mature within one year. </li></ul><ul><li>These measures are often used by creditors and potential creditors such as banks and suppliers of goods. </li></ul>
  • 30. Working Capital <ul><li>Definition: The difference between current assets and current liabilities. </li></ul><ul><li>Working capital provides the funds needed for the day-to-day operations of a business. </li></ul>
  • 31. Working Capital <ul><li>In 20X1, the Drake Corporation had current assets of $135,000 and current liabilities of $40,000. Its working capital was $95,000. </li></ul><ul><li>$135,000  $40,000 = $95,000 </li></ul>
  • 32. Current Ratio <ul><li>A ratio is a fractional relationship of one number to another. </li></ul><ul><li>The current ratio is the ratio of current assets to current liabilities. </li></ul>
  • 33. Current Ratio <ul><li>At the end of 20X1, the Drake Corporation had a current ratio of 3.4 to 1. A current ratio of 2 to 1 is usually considered safe. </li></ul><ul><li>Current Assets  Current Liabilities = Current Ratio </li></ul><ul><li>$135,000  $40,000 = 3.4 to 1 </li></ul>
  • 34. Acid-test Ratio <ul><li>Certain current assets can be converted to cash more quickly than others. </li></ul><ul><li>Cash, accounts receivable, short-term notes receivable, and marketable securities are called quick assets. </li></ul><ul><li>They provide cash more quickly than merchandise inventory and supplies. </li></ul>
  • 35. Acid-test Ratio <ul><li>The acid-test or quick ratio is the ratio of quick assets to current liabilities. </li></ul><ul><li>At the end of 20X1, the Drake Corporation had quick assets of $84,000 (cash of $21,000 and net receivables of $63,000). </li></ul>
  • 36. Acid-test Ratio <ul><li>Drake’s acid-test ratio is 2.1 to 1. An acid-test ratio of 1 to 1 is usually considered safe. </li></ul><ul><li>Quick Assets  Current Liabilities = Acid-test Ratio </li></ul><ul><li>$84,000  $40,000 = 2.1 to 1 </li></ul>
  • 37. Accounts Receivable Turnover <ul><li>Shows how quickly a firm is collecting its accounts receivable. </li></ul><ul><li>Specifically, this measure indicates how many times per year the average amount of accounts receivable is collected. </li></ul><ul><li>Found by dividing the net credit sales by the average net accounts receivable. </li></ul>
  • 38. Accounts Receivable Turnover <ul><li>In 20X1, the Drake Corporation had net credit sales of $250,000 (credit sales minus sales returns and allowances and sales discounts). </li></ul><ul><li>The average of the net accounts receivable for 20X1 is calculated as follows. (Net accounts receivable is accounts receivable minus estimated uncollectible accounts.) </li></ul>
  • 39. Accounts Receivable Turnover <ul><li>Net accounts receivable at beginning of year $35,000 </li></ul><ul><li>Net accounts receivable at end of year 63,000 </li></ul><ul><li>Total $98,000 </li></ul><ul><li>Average of net accounts receivable: $98,000  2 = $49,000 </li></ul>
  • 40. Accounts Receivable Turnover <ul><li>In 20X1, the Drake Corporation had an accounts receivable turnover of 5.1 times. </li></ul><ul><li>Net Credit Sales  Average Net Accts. Rec. = Accts. Rec. Turnover </li></ul><ul><li>$250,000  $49,000 = 5.1 times </li></ul><ul><li>Drake converted its accounts receivable to cash 5.1 times during 20X1. </li></ul>
  • 41. Average Collection Period for Accounts Receivable <ul><li>Definition: A rough measure of the length of time it takes the firm to collect its outstanding accounts receivable. </li></ul><ul><li>This measure is calculated by dividing 365 days by the accounts receivable turnover. </li></ul>
  • 42. Average Collection Period for Accounts Receivable <ul><li>At the Drake Corporation, the average collection period for 20X1 was 71.6 days. </li></ul><ul><li>365 days  Accts. Rec. Turnover = Average Collection Period </li></ul><ul><li>365 days  5.1 times = 71.6 days </li></ul>
  • 43. Average Collection Period for Accounts Receivable <ul><li>If Drake provides credit terms of n/30 to its customers, an average collection period of 71.6 days is very poor. </li></ul>
  • 44. Merchandise Inventory Turnover <ul><li>Definition: A measure of how many times a firm sells its average inventory during a year. </li></ul><ul><li>This measure is calculated by dividing the cost of goods sold by the average inventory. </li></ul>
  • 45. Merchandise Inventory Turnover <ul><li>In 20X1, the Drake Corporation had cost of goods sold of $168,000. </li></ul><ul><li>The average inventory is calculated as follows. </li></ul><ul><li>Merchandise inventory at beginning of year $40,000 </li></ul><ul><li>Merchandise inventory at end of year 44,000 </li></ul><ul><li>Total $84,000 </li></ul><ul><li>Average inventory: $84,000  2 = $42,000 </li></ul>
  • 46. Merchandise Inventory Turnover <ul><li>In 20X1, the Drake Corporation turned over (sold and replaced) its merchandise inventory 4.0 times. </li></ul><ul><li>Cost of Goods Sold  Average Inventory = Inventory </li></ul><ul><li> Turnover </li></ul><ul><li>$168,000  $42,000 = 4.0 times </li></ul>
  • 47. Merchandise Inventory Turnover <ul><li>To judge the meaning of this figure, it is necessary to know the firm’s inventory turnover in previous years and the inventory turnover of similar types of businesses. </li></ul>
  • 48. Number of Days in Merchandise Inventory <ul><li>This measure indicates the number of days it takes a firm to sell its merchandise inventory. </li></ul><ul><li>In 20X1, the Drake Corporation had 91.3 days in merchandise inventory. </li></ul><ul><li>365 days  Inventory Turnover = Number of Days in Inventory </li></ul><ul><li>365 days  4.0 times = 91.3 days </li></ul>
  • 49. Long-term Liquidity Measures <ul><li>There are certain measures used to evaluate a firm’s ability to pay its long-term liabilities. </li></ul><ul><li>Long-term liquidity measures are of particular interest to holders of mortgages and bonds. </li></ul>
  • 50. Ratio of Plant Assets to Long-term Liabilities <ul><li>Plant assets are sometimes pledged as security for long-term notes payable. </li></ul><ul><li>The ratio of plant assets to long-term liabilities indicates the margin of safety for the holders of notes backed by plant assets. </li></ul><ul><li>This ratio is calculated by dividing a firm’s plant assets by its long-term liabilities. </li></ul>
  • 51. Ratio of Plant Assets to Long-term Liabilities <ul><li>At the end of 20X1, the Drake Corporation had plant assets of $110,000 and long-term liabilities of $30,000. </li></ul><ul><li>Pl. Assets  Long-term Liab. = Ratio of Pl. Assets to Long-term Liab. </li></ul><ul><li>$110,000  $30,000 = 3.7 to 1 </li></ul>
  • 52. Ratio of Plant Assets to Long-term Liabilities <ul><li>A ratio of 2 to 1 for this measure is considered safe. Thus, Drake’s ratio of 3.7 to 1 is good. </li></ul>
  • 53. Ratio of Owner’s Equity to Total Liabilities <ul><li>Creditors and potential creditors will want to know how a firm’s liabilities and owner’s equity relate to each other. </li></ul><ul><li>This measure is known as the ratio of owner’s equity to total liabilities or the debt-equity ratio. </li></ul><ul><li>It is found by dividing owner’s equity by total liabilities. </li></ul>
  • 54. Ratio of Owner’s Equity to Total Liabilities <ul><li>At the end of 20X1, the Drake Corporation had owner’s equity of $175,000 and total liabilities of $70,000. </li></ul><ul><li>Owner’s Equity  Total Liab. = Ratio of OE to Total Liab. </li></ul><ul><li>$175,000  $70,000 = 2.5 to 1 </li></ul>
  • 55. Ratio of Owner’s Equity to Total Liabilities <ul><li>Drake has $2.50 of owner’s equity for each $1 of debt. </li></ul><ul><li>The higher this ratio is, the better the firm’s credit position will be. </li></ul>
  • 56. Times Interest Earned <ul><li>To evaluate a firm’s ability to meet its interest payments, analysts use a ratio called times interest earned. </li></ul><ul><li>This ratio shows the number of times a firm has earned its interest expense. </li></ul><ul><li>This ratio is calculated by adding net income, interest expense, and income taxes and dividing the result by interest expense. </li></ul>
  • 57. Times Interest Earned <ul><li>In 20X1, the Drake Corporation had net income of $56,000, interest expense of $11,000, and income taxes of $9,000. The total is $76,000. </li></ul><ul><li>To find the times interest earned ratio, it is necessary to divide the total of the net income, interest expense, and income taxes by the interest expense. </li></ul><ul><li>$76,000  $11,000 = 6.91 to 1 </li></ul>
  • 58. Times Interest Earned <ul><li>Most U.S. firms are in the range of 2.0 to 3.0 for this ratio. Thus, Drake has good coverage of its interest. </li></ul>
  • 59. Profitability Analysis <ul><li>Profitability measures are mostly of interest to owners, managers, potential investors, and financial analysts. </li></ul>
  • 60. Return on Assets <ul><li>Indicates the profitability of a firm’s assets. </li></ul><ul><li>This measure is calculated by adding net income and interest expense and dividing the result by the average of the total assets for the year. </li></ul><ul><li>In 20X1, the Drake Corporation had a net income of $56,000 and interest expense of $11,000. The total is $67,000. </li></ul>
  • 61. Return on Assets <ul><li>The next step in finding the return on assets is to calculate the average total assets for the year. </li></ul><ul><li>Beginning total assets for year $213,000 </li></ul><ul><li>Ending total assets for year 245,000 </li></ul><ul><li>Total $458,000 </li></ul><ul><li>Average total assets: $458,000  2 = $229,000 </li></ul>
  • 62. Return on Assets <ul><li>The final step in finding the return on assets is to divide the sum of the net income and the interest expense by the average total assets. </li></ul><ul><li>$67,000  $229,000 = 29.3% </li></ul>
  • 63. Asset Turnover <ul><li>Definition: A measure of how effectively the assets of a firm are being used to produce sales. </li></ul><ul><li>This measure is calculated by dividing the net sales for the year by the total assets (excluding investments) at the end of the year. </li></ul>
  • 64. Asset Turnover <ul><li>In 20X1, the Drake Corporation had net sales of $370,000. At the end of the year, its assets totaled $245,000. (There are no investments.) </li></ul><ul><li>Net Sales  Total Assets = Asset Turnover </li></ul><ul><li>$370,000  $245,000 = 1.5 times </li></ul>
  • 65. Asset Turnover <ul><li>Usually, the higher the asset turnover rate, the better the firm is using its assets to produce sales. </li></ul>
  • 66. Return on Stockholders’ Equity <ul><li>Stockholders and potential stockholders want to know what return a business is earning on its stockholders’ equity. </li></ul><ul><li>This measure is calculated by dividing the net income for a year by the average stockholders’ equity. </li></ul>
  • 67. Return on Stockholders’ Equity <ul><li>In 20X1, the Drake Corporation had net income of $56,000. </li></ul><ul><li>The average stockholders’ equity is found as follows. </li></ul>
  • 68. Return on Stockholders’ Equity <ul><li>Stockholders’ equity at beginning of year $143,000 </li></ul><ul><li>Stockholders’ equity at end of year 175,000 </li></ul><ul><li>Total $318,000 </li></ul><ul><li>Average stockholders’ equity: </li></ul><ul><li>$318,000  2 = $159,000 </li></ul>
  • 69. Return on Stockholders’ Equity <ul><li>In 20X1, the Drake Corporation had a return of 35.2% on stockholders’ equity. </li></ul><ul><li>Net income  Average Stockholders’ Equity = Return on S.E. </li></ul><ul><li>$56,000  $159,000 = 35.2% </li></ul><ul><li>Investors are attracted to a firm that has a high rate of return on stockholders’ equity. </li></ul>
  • 70. Earnings Per Share of Common Stock <ul><li>Definition: Amount of a corporation’s net income available for each share of common stock. </li></ul><ul><li>To calculate this amount: </li></ul><ul><li>Step 1. Subtract the dividends owed on the preferred stock from the net income. </li></ul><ul><li>Step 2. Divide the remaining net income by the average number of shares of common stock outstanding during the year. </li></ul>
  • 71. Earnings Per Share of Common Stock <ul><li>In 20X1, the Drake Corporation had net income of $56,000. There is no preferred stock. </li></ul><ul><li>The firm had 12,500 shares of common stock outstanding throughout the year. The common stock is not actively traded. </li></ul>
  • 72. Earnings Per Share of Common Stock <ul><li>The amount of earnings per share of common stock at Drake in 20X1 is $4.48. </li></ul><ul><li>Net Income  Shares Outstanding = Earnings per Share </li></ul><ul><li>$56,000  12,500 shares = $4.48 </li></ul>
  • 73. Price/earnings Ratio <ul><li>Definition: A measure of the relationship between the market price of common stock and the earnings per share. </li></ul><ul><ul><li>This measure is widely used by financial analysts as an indication of the future earnings prospects of a corporation. </li></ul></ul><ul><ul><li>The P/E ratio is calculated by dividing the market price of each share of common stock by the earnings per share. </li></ul></ul>
  • 74. Price/earnings Ratio <ul><li>Assume the common stock of the Drake Corporation has a market price of $32 on December 31, 20X1. </li></ul><ul><li>The amount of earnings per share of common stock for 20X1 is $4.48. </li></ul>
  • 75. Price/earnings Ratio <ul><li>The price/earnings ratio is 7.1. This means the common stock is selling for 7.1 times the amount of earnings per share. </li></ul><ul><li>Price per Share  Earnings per Share = P/E Ratio </li></ul><ul><li>$32.00  $4.48 = 7.1 </li></ul>
  • 76. Dividend Yield <ul><li>Shows the rate an investor has earned on the stock. </li></ul><ul><li>This measure is calculated by dividing the dividend per share by the market price per share. </li></ul>
  • 77. Dividend Yield <ul><li>During 20X1, the Drake Corporation paid a dividend of $1.50 per share of common stock. </li></ul><ul><li>The market price of each share of common stock is $32 on December 31, 20X1. </li></ul><ul><li>The dividend yield is 4.7%. </li></ul><ul><li>Dividend per Share  Price per Share = Dividend Yield </li></ul><ul><li>$1.50  $32.00 = 4.7% </li></ul>

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