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Chapter 13
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  • 1. CHAPTER 13 Financial Statement Analysis
  • 2. Financial Statement Analysis
    • External users and analysts rely on publicly-available information to perform financial analysis
    • Such information is contained in corporate annual report
  • 4. Tools to Evaluate Financial Information
    • Horizontal Analysis
    • Vertical Analysis
    • Ratio Analysis
    3 2 1
  • 5. Horizontal Analysis
    • Examines percentage change in each item on the financial statements
    • Compares current year’s dollar amount with prior year’s dollar amount
    • Expresses the change in
      • Dollars
      • Percentage
      • Look at Exhibit 13-3, Pg. 610
  • 6. Horizontal - Trend Percentages
    • Specialized form of horizontal analysis
    • Shows trend of financial statement items over longer time periods such as 5 or 10 years
  • 7. Vertical Analysis
    • Vertical Analysis
  • 8. Vertical Analysis
    • Compares each item on the financial statement to a key, or base, item
    • Base-item dollar amount always set to 100%
    • Produces “common-size” statements
    • Income statement
      • Net sales = 100%
    • Balance sheet
      • Total assets = 100%
      • Look at exhibit 13-4, Pg 612 and 13-5, Pg 613
  • 9. Benchmarking Against the Industry Average
    • Benchmarking is a term used to describe the process of comparing a company’s activities to a standard of excellence achieved by industry leaders
  • 10.
    • A company also can compare its common-size financials to those of its industry’s leaders
    • Determine where it differs
    • Design and implement business processes to bring financial results in line with these benchmark entities
    Benchmarking Against Key Competitors
  • 11.
    • Ratio Analysis
    Using Ratios to Make Business Decisions 3
  • 12. Using Ratios to Make Business Decisions
    • Ratios - the relationship between two items on financial statements - permit users to calculate a variety of financial comparisons
    • These ratios can be compared to:
    • Prior years’ financial results
    • Industry averages
    • Benchmark entities’ ratios
  • 13.
    • Ratios measure an entity’s ability to:
    • Pay current liabilities
    • Sell inventory and collect receivables
    • Pay long-term debt
    • Generate profits from operations
    • Sustain shareholder wealth
    Using Ratios to Make Business Decisions
  • 14. Ratios in Chapter 13
    • Overview, pp. 630
    • Decision guidelines lists all ratios
  • 15. Ratio analysis
    • The current ratio is a ratio of the current assets to the current liabilities. Acceptable current ratios vary from industry to industry, but the norm for most companies is between 1.6 and 1.9.  
    • There are five categories of current assets that are listed in order of their liquidity: Cash, Short-term Investments, Receivables, Inventory, and Prepaid Expenses.
  • 16. Ratio analysis
    • The acid-test (quick) ratio measures the quick assets—cash, short-term investments, and receivables—to current liabilities. This ratio excludes inventory and prepaid expenses because these current assets are the least liquid current assets.
    • Certain ratios measure the firm’s ability to sell inventory and collect receivables , a key factor in a firm’s success.
  • 17. Ratio analysis
    • Inventory turnover measures how many times a year the company sells its average level of inventory. A high turnover indicates relative ease of selling inventory, while a low turnover indicates relative difficulty of selling inventory.
    • Accounts receivable turnover measures how quickly the firm collects cash from credit customers. The higher the ratio, the more quickly a firm collects its receivables.
    • Days’ sales in receivables is the number of days ’ sales that remain uncollected.
  • 18. Ratio analysis
    • Suppose you were analyzing Company A and Company B and the two companies reported the following:
    • Company A Company B
    • Current assets $10,000 $10,000,000
    • Current liabilities 5,000 9,995,000
    • Working capital $ 5,000 $ 5,000
    • Both companies have identical working capital, but which company has a better ability to pay its short-term debt?
    • Company A, because the ratio of the current assets to current liabilities is higher for Company A. Working capital is not a ratio; it does not calculate the relative size of the current assets to current liabilities. The current ratio provides a better understanding of the two companies’ liquidity.
    • Current ratio of A is 2 ($10,000  $5,000) Current ratio of B is 1.001 ($10,000,000  $9,995,000)
  • 19. Ratio analysis
    • Not all ratios apply to all companies. For example, inventory turnover would not be applicable to a service company
    • Sharp changes in ratios indicate that something significant has happened, but the manager must analyze the change to determine what has occurred and what corrective action must be taken.
  • 20.
    • Financial analysts use several ratios to assess value of stock investments:
    • Price/earnings ratio
    • Dividend yield
    • Book value (covered in chapter 9)
    Analyzing the Company’s Stock as an Investment
  • 21. Earnings Per Share
    • Most widely quoted of all financial statistics
    • Computed by dividing net income available to common stockholders by the number of common shares outstanding during the year
    • = Net Income – Preferred Dividends
    • Number of common shares outstanding
  • 22. Price/Earnings Ratio
    • Decision to buy, hold, or sell stock
    • Relationship between a stock’s market price and its earnings per share
    • Measures the number of times one share of stock sells above the current period’s reported earnings
    • Widely published in The Wall Street Journal
  • 23.
    • Suppose the market value of Asian Art, Inc., common stock is $15.75 on the last day of its fiscal year
    • The income statement reports EPS of $.92
    • What is Asian Art’s price/earnings ratio?
    Price/Earnings Ratio Calculating the P/E ratio Market value of stock Earnings per share
  • 24. Price/Earnings Ratio Example
    • Market value of stock
    • Earnings per share
    • $15.75
    • $.92
    • = 17.12
  • 25. Dividend Yield
    • Ratio of dividends per share of stock to the stock’s market value
    • Indicates the percentage of a stock’s market value “returned” to the stockholder in the form of dividends
    • Assists investors who desire a steady flow of dividend revenue in their decisions to invest in a particular stock
  • 26. Dividend Yield
    • Annual dividends per share
    • Stock’s market value per share
    • Example: If Asian Art paid a total of $1.25 in dividends per share, what would be its dividend yield, assuming the same market value for its stock ($15.75)?
  • 27. Dividend Yield
    • Annual dividends per share
    • Stock’s market value per share
    • $1.25
    • $15.75
    • = .079
  • 28. Limitations of Financial Analysis
    • No one ratio or year’s worth of financial information should be relied upon to provide a complete assessment of a corporation’s financial condition
    • Ratio analysis is most helpful when calculated over a broad time frame and when used in conjunction with other relevant information that can affect a company, such as legislation, competition, and scandals.
    • Analysts should:
    • Examine trends over time
    • Benchmark to industry and key competitors
    • Seek answers about why ratios are different
  • 29. End of Lecture