Chapter 2 Financial Statements  and Analysis
Learning Goals <ul><li>Review the contents of the stockholders’ report and the procedures for consolidating international ...
Learning Goals (cont.) <ul><li>Use ratios to analyze a firm’s profitability and market value. </li></ul><ul><li>Use a summ...
The Stockholders’ Report <ul><li>The guidelines used to prepare and maintain financial records and reports are known as  g...
The Stockholders’ Report (cont.) <ul><li>The PCAOB is charged with protecting the interests of investors and furthering th...
The Four Key Financial Statements:  The Income Statement <ul><li>The income statement provides a financial summary of a co...
The Four Key Financial Statements Table 2.1  Bartlett Company Income Statements ($000)
The Four Key Financial Statements:  The Balance Sheet <ul><li>The balance sheet presents a summary of a firm’s financial p...
The Four Key Financial Statements Table 2.2a  Bartlett Company Balance Sheets ($000)
The Four Key  Financial Statements (cont.) Table 2.2b  Bartlett Company Balance Sheets ($000)
The Four Key Financial Statements: Statement of Retained Earnings <ul><li>The statement of retained earnings reconciles th...
The Four Key Financial Statements Table 2.3  Bartlett Company Statement of Retained Earnings ($000) for the Year Ended Dec...
The Four Key Financial Statements: Statement of Cash Flows <ul><li>The  statement of cash flows  provides a summary of the...
The Four Key Financial Statements Table 2.4  Bartlett Company Statement of Cash Flows ($000) for the Year Ended December 3...
Consolidating International  Financial Statements <ul><li>FASB 52 mandated that U.S. based companies translate their forei...
Consolidating International  Financial Statements (cont.) <ul><li>Equity accounts , on the other hand, are translated into...
Using Financial Ratios:  Interested Parties <ul><li>Ratio analysis involves methods of calculating and interpreting financ...
Using Financial Ratios:  Types of Ratio Comparisons <ul><li>Trend or time-series analysis </li></ul><ul><ul><li>Used to ev...
Using Financial Ratios:  Types of Ratio Comparisons (cont.) <ul><li>Trend or time-series analysis </li></ul><ul><li>Cross-...
Using Financial Ratios:  Types of Ratio Comparisons (cont.) <ul><li>Trend or time-series analysis </li></ul><ul><li>Cross-...
Using Financial Ratios:  Types of Ratio Comparisons (cont.) <ul><li>Trend or time-series analysis </li></ul><ul><li>Cross-...
Using Financial Ratios:  Types of Ratio Comparisons (cont.) <ul><li>Trend or time-series analysis </li></ul><ul><li>Cross-...
Using Financial Ratios:  Types of Ratio Comparisons (cont.) Table 2.5  Industry Average Ratios for Selected Lines of Busin...
Using Financial Ratios:  Types of Ratio Comparisons (cont.) Figure 2.1   Combined Analysis
Using Financial Ratios:  Cautions for Doing Ratio Analysis <ul><li>Ratios must be considered together; a single ratio by i...
Ratio Analysis Example <ul><li>We will illustrate the use of financial ratios for analyzing financial statements using the...
Ratio Analysis <ul><li>Liquidity Ratios </li></ul><ul><ul><li>Current Ratio </li></ul></ul>Current ratio  =  total current...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><ul><li>Current Ratio </li></ul></ul><ul><ul><li>Quick Ratio...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>Inventory Turnover...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>Average Age of Inv...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>Average Collection...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>Average Payment Pe...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>Total Asset Turnov...
Ratio Analysis (cont.) Table 2.6  Financial Statements Associated with Patty’s Alternatives
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Financial Leverage Rat...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) Table 2.7  Bartlett Company Common-Size Income Statements
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li><...
Summarizing All Ratios  Table 2.8  Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)
Summarizing All Ratios  (cont.) Table 2.8  Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)
DuPont System of Analysis <ul><li>The DuPont system  of analysis is used to dissect the firm’s financial statements and to...
DuPont System of Analysis
DuPont System of Analysis (cont.) Figure 2.2  DuPont System of Analysis
Modified DuPont Formula (cont.) <ul><li>Use of the FLM to convert ROA into ROE reflects the impact of financial leverage o...
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Copyright © 2009 Pearson Prentice Hall. All rights reserved.

  1. 1. Chapter 2 Financial Statements and Analysis
  2. 2. Learning Goals <ul><li>Review the contents of the stockholders’ report and the procedures for consolidating international financial statements. </li></ul><ul><li>Understand who uses financial ratios, and how. </li></ul><ul><li>Use ratios to analyze a firm’s liquidity and activity. </li></ul><ul><li>Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt. </li></ul>
  3. 3. Learning Goals (cont.) <ul><li>Use ratios to analyze a firm’s profitability and market value. </li></ul><ul><li>Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis. </li></ul>
  4. 4. The Stockholders’ Report <ul><li>The guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP) . </li></ul><ul><li>GAAP is authorized by the Financial Accounting Standards Board (FASB) . </li></ul><ul><li>The Sarbanes-Oxley Act of 2002 , passed to eliminate the many disclosure and conflict of interest problems of corporations, established the Public Company Accounting Oversight Board (PCAOB), which is a not-for-profit corporation that overseas auditors. </li></ul>
  5. 5. The Stockholders’ Report (cont.) <ul><li>The PCAOB is charged with protecting the interests of investors and furthering the public interest in the preparation of informative, fair, and independent audit reports. </li></ul><ul><li>Public corporations with more than $5 million in assets and more than 500 stockholders are required by the SEC to provide their stockholders with an annual stockholders report . </li></ul>
  6. 6. The Four Key Financial Statements: The Income Statement <ul><li>The income statement provides a financial summary of a company’s operating results during a specified period. </li></ul><ul><li>Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes. </li></ul>
  7. 7. The Four Key Financial Statements Table 2.1 Bartlett Company Income Statements ($000)
  8. 8. The Four Key Financial Statements: The Balance Sheet <ul><li>The balance sheet presents a summary of a firm’s financial position at a given point in time. </li></ul><ul><li>Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed. </li></ul>
  9. 9. The Four Key Financial Statements Table 2.2a Bartlett Company Balance Sheets ($000)
  10. 10. The Four Key Financial Statements (cont.) Table 2.2b Bartlett Company Balance Sheets ($000)
  11. 11. The Four Key Financial Statements: Statement of Retained Earnings <ul><li>The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings. </li></ul>
  12. 12. The Four Key Financial Statements Table 2.3 Bartlett Company Statement of Retained Earnings ($000) for the Year Ended December 31, 2009
  13. 13. The Four Key Financial Statements: Statement of Cash Flows <ul><li>The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended. </li></ul><ul><li>This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets. </li></ul>
  14. 14. The Four Key Financial Statements Table 2.4 Bartlett Company Statement of Cash Flows ($000) for the Year Ended December 31, 2009
  15. 15. Consolidating International Financial Statements <ul><li>FASB 52 mandated that U.S. based companies translate their foreign-currency denominated assets and liabilities into dollars using the current rate (translation) method . </li></ul><ul><li>Under the translation method, companies translate all foreign-currency-denominated assets and liabilities into dollars at the exchange rate prevailing at the fiscal year ending date (the current rate). </li></ul><ul><li>Income statement items are usually treated similarly. </li></ul>
  16. 16. Consolidating International Financial Statements (cont.) <ul><li>Equity accounts , on the other hand, are translated into dollars by using the exchange rate that prevailed when the parent’s equity investment was made (the historical rate). </li></ul><ul><li>Retained earnings are adjusted to reflect each year’s operating profits (or losses). </li></ul>
  17. 17. Using Financial Ratios: Interested Parties <ul><li>Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance. </li></ul><ul><li>It is of interest to shareholders, creditors, and the firm’s own management. </li></ul>
  18. 18. Using Financial Ratios: Types of Ratio Comparisons <ul><li>Trend or time-series analysis </li></ul><ul><ul><li>Used to evaluate a firm’s performance over time </li></ul></ul>
  19. 19. Using Financial Ratios: Types of Ratio Comparisons (cont.) <ul><li>Trend or time-series analysis </li></ul><ul><li>Cross-sectional analysis </li></ul><ul><ul><li>Used to compare different firms at the same point in time </li></ul></ul>
  20. 20. Using Financial Ratios: Types of Ratio Comparisons (cont.) <ul><li>Trend or time-series analysis </li></ul><ul><li>Cross-sectional analysis </li></ul><ul><ul><li>Industry comparative analysis </li></ul></ul><ul><ul><ul><li>One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance </li></ul></ul></ul>
  21. 21. Using Financial Ratios: Types of Ratio Comparisons (cont.) <ul><li>Trend or time-series analysis </li></ul><ul><li>Cross-sectional analysis </li></ul><ul><ul><li>Benchmarking </li></ul></ul><ul><ul><ul><li>A type of cross sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate </li></ul></ul></ul>
  22. 22. Using Financial Ratios: Types of Ratio Comparisons (cont.) <ul><li>Trend or time-series analysis </li></ul><ul><li>Cross-sectional analysis </li></ul><ul><li>Combined Analysis </li></ul><ul><ul><li>Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis </li></ul></ul>
  23. 23. Using Financial Ratios: Types of Ratio Comparisons (cont.) Table 2.5 Industry Average Ratios for Selected Lines of Business a
  24. 24. Using Financial Ratios: Types of Ratio Comparisons (cont.) Figure 2.1 Combined Analysis
  25. 25. Using Financial Ratios: Cautions for Doing Ratio Analysis <ul><li>Ratios must be considered together; a single ratio by itself means relatively little. </li></ul><ul><li>Financial statements that are being compared should be dated at the same point in time. </li></ul><ul><li>Use audited financial statements when possible. </li></ul><ul><li>The financial data being compared should have been developed in the same way. </li></ul><ul><li>Be wary of inflation distortions. </li></ul>
  26. 26. Ratio Analysis Example <ul><li>We will illustrate the use of financial ratios for analyzing financial statements using the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2. </li></ul>
  27. 27. Ratio Analysis <ul><li>Liquidity Ratios </li></ul><ul><ul><li>Current Ratio </li></ul></ul>Current ratio = total current assets total current liabilities Current ratio = $1,233,000 = 1.97 $620,000
  28. 28. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><ul><li>Current Ratio </li></ul></ul><ul><ul><li>Quick Ratio </li></ul></ul>Quick ratio = Total Current Assets - Inventory total current liabilities Quick ratio = $1,233,000 - $289,000 = 1.51 $620,000
  29. 29. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>Inventory Turnover </li></ul></ul>Inventory Turnover = Cost of Goods Sold Inventory Inventory Turnover = $2,088,000 = 7.2 $289,000
  30. 30. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>Average Age of Inventory </li></ul></ul>Average Age of Inventory = 365 Inventory Turnover Inventory Turnover = 365 = 50.7 days 7.2
  31. 31. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>Average Collection Period </li></ul></ul>ACP = Accounts Receivable Net Sales/365 ACP = $503,000 = 59.7 days $3,074,000/365
  32. 32. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>Average Payment Period </li></ul></ul>APP = Accounts Payable Annual Purchases/365 APP = $382,000 = 95.4 days (.70 x $2,088,000)/365
  33. 33. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><ul><li>Total Asset Turnover </li></ul></ul>Total Asset Turnover = Net Sales Total Assets Total Asset Turnover = $3,074,000 = .85 $3,597,000
  34. 34. Ratio Analysis (cont.) Table 2.6 Financial Statements Associated with Patty’s Alternatives
  35. 35. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Financial Leverage Ratios </li></ul><ul><ul><li>Debt Ratio </li></ul></ul>Debt Ratio = Total Liabilities/Total Assets Debt Ratio = $1,643,000/$3,597,000 = 45.7%
  36. 36. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><ul><li>Times Interest Earned Ratio </li></ul></ul>Times Interest Earned = EBIT/Interest Times Interest Earned = $418,000/$93,000 = 4.5
  37. 37. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><ul><li>Fixed-Payment coverage Ratio (FPCR) </li></ul></ul>FPCR = EBIT + Lease Payments________________ Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]} FPCR = $418,000 + $35,000 = 1.9 $93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}
  38. 38. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><li>Profitability Ratios </li></ul><ul><ul><li>Common-Size Income Statements </li></ul></ul>
  39. 39. Ratio Analysis (cont.) Table 2.7 Bartlett Company Common-Size Income Statements
  40. 40. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><li>Profitability Ratios </li></ul><ul><ul><li>Gross Profit Margin </li></ul></ul>GPM = Gross Profit/Net Sales GPM = $986,000/$3,074,000 = 32.1%
  41. 41. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><li>Profitability Ratios </li></ul><ul><ul><li>Operating Profit Margin (OPM) </li></ul></ul>OPM = EBIT/Net Sales OPM = $418,000/$3,074,000 = 13.6%
  42. 42. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><li>Profitability Ratios </li></ul><ul><ul><li>Net Profit Margin (NPM) </li></ul></ul>NPM = Earnings Available to Common Stockholders Sales NPM = $221,000/$3,074,000 = 7.2%
  43. 43. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><li>Profitability Ratios </li></ul><ul><ul><li>Earnings Per Share (EPS) </li></ul></ul>EPS = Earnings Available to Common Stockholders Number of Shares Outstanding EPS = $221,000/76,262 = $2.90
  44. 44. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><li>Profitability Ratios </li></ul><ul><ul><li>Return on Total Assets (ROA) </li></ul></ul>ROA = Earnings Available to Common Stockholders Total Assets ROA = $221,000/$3,597,000 = 6.1%
  45. 45. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><li>Profitability Ratios </li></ul><ul><ul><li>Return on Equity (ROE) </li></ul></ul>ROE = $221,000/$1,754,000 = 12.6% ROE = Earnings Available to Common Stockholders Total Equity
  46. 46. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><li>Profitability Ratios </li></ul><ul><li>Market Ratios </li></ul><ul><ul><li>Price Earnings (P/E) Ratio </li></ul></ul>P/E = Market Price Per Share of Common Stock Earnings Per Share P/E = $32.25/$2.90 = 11.1
  47. 47. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><li>Profitability Ratios </li></ul><ul><li>Market Ratios </li></ul><ul><ul><li>Market/Book (M/B) Ratio </li></ul></ul>BV/Share = Common Stock Equity Number of Shares of Common Stock BV/Share = $1,754,000/72,262 = $23.00
  48. 48. Ratio Analysis (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Activity Ratios </li></ul><ul><li>Leverage Ratios </li></ul><ul><li>Profitability Ratios </li></ul><ul><li>Market Ratios </li></ul><ul><ul><li>Market/Book (M/B) Ratio </li></ul></ul>M/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common Stock M/B Ratio = $32.25/$23.00 = 1.40
  49. 49. Summarizing All Ratios Table 2.8 Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)
  50. 50. Summarizing All Ratios (cont.) Table 2.8 Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)
  51. 51. DuPont System of Analysis <ul><li>The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition. </li></ul><ul><li>It merges the income statement and balance sheet into two summary measures of profitability. </li></ul><ul><li>The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity: </li></ul><ul><li>ROA and ROE as shown in the series of equations on the following slide and in Figure 2.2 on the following slide. </li></ul>
  52. 52. DuPont System of Analysis
  53. 53. DuPont System of Analysis (cont.) Figure 2.2 DuPont System of Analysis
  54. 54. Modified DuPont Formula (cont.) <ul><li>Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner’s return. </li></ul><ul><li>Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the Modified DuPont formula yields: </li></ul>ROE = 6.1% X 2.06 = 12.6%
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