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  • 1. Financial Statement Analysis Chapter 18
  • 2. Objectives
    • Perform horizontal analysis of comparative financial statements
    • Perform vertical analysis of financial statements
    • Prepare and use common size financial statements
    • Compute the standard financial ratios
    • Measure economic value added
  • 3. The Annual Report Usually Contains ...
    • President’s letter to the Stockholders
    • Management Discussion and Analysis of the financial statements
    • Financial Statements
    • Notes to the Financial Statements
      • a summary of accounting methods used
    • An Auditor’s Report
    • Comparative Financial Data for 5 to 10 years
  • 4. Horizontal Analysis
    • Interested in the percent change
      • Step 1: Figure the dollar amount change from the base period to the later period.
      • Step 2: Divide the dollar amount of change by the base amount to get a percent change.
  • 5. Horizontal Analysis 2005 2004 Difference Sales $41,500 $37,850 $3,650 $3,650 ÷ $37,850 = .0964, or 9.6% Increase/(Decrease) 2005 2004 Amount Percent Sales $41,500 $37,850 $3,650 9.6% Expenses 40,000 36,900 3,100 8.4% Net income 1,500 950 550 57.9%
  • 6. Trend Percentages...
    • …are computed by selecting a base year whose amounts are set equal to 100%.
    • The amounts of each following year are expressed as a percentage of the base amount.
    Trend % = Any year $ ÷ Base year $
  • 7.
    • Year 2005 2004 2003
    • Revenues $27,611 $24,215 $21,718
    • Cost of sales 15,318 14,709 13,049
    • Gross profit $12,293 $ 9,506 $ 8,669
    • 2003 is the base year.
    Trend Percentages What are the trend percentages?
  • 8.
    • Year 2005 2004 2003
    • Revenues % % %
    • Cost of sales % % %
    • Gross profit % % %
    Trend Percentages These percentages were calculated by dividing each item by the base year.
  • 9. Vertical Analysis...
    • …compares each item in a financial statement to a base number set to 100%.
    • Every item on the financial statement is then reported as a percentage of that base.
    % = each financial stmt item base number
  • 10. Vertical Analysis 2005 % Revenues $38,303 100.0 Cost of sales 19,688 51.4 Gross profit $18,615 48.6 Total operating expenses 13,209 34.5 Operating income $ 5,406 14.1 Other income 2,187 5.7 Income before taxes $ 7,593 19.8 Income taxes 2,827 7.4 Net income $ 4,766 12.4
  • 11. Vertical Analysis Assets 2005 % Current assets: Cash $ 1,816 4.7 Receivables net 10,438 26.9 Inventories 6,151 15.9 Prepaid expenses 3,526 9.1 Total current assets $21,931 56.6 Plant and equipment, net 6,847 17.7 Other assets 9,997 25.7 Total assets $38,775 100.0
  • 12. Vertical Analysis Liabilities 2005 % Current liabilities: Accounts Payable $ 2,055 5.3 Other current liab 13,455 34.7 Total current liab 15,510 40.0 Long term liab 10,624 27.4 Total liabilities 26,134 67.4 Owner’s Equity Capital 12,641 32.6 Total Liabilities & OE $38,775 100.0
  • 13. Common-size Statements
    • On the income statement, each item is expressed as a percentage of net sales.
    • On the balance sheet, the common size is the total on each side of the accounting equation.
    • Common-size statements are used to compare one company to other companies, and to the industry average.
  • 14. Benchmarking Percent of Net Sales MCI Lucent Technologies  Cost of goods sold  Operating expenses  Income tax  Net income
  • 15. Ratio Classification
    • Measuring ability to pay current liabilities
    • Measuring ability to sell inventory and collect receivables
    • Measuring ability to pay short-term and long-term debt
    • Measuring profitability
    • Analyzing stock as an investment
  • 16. Palisades Furniture Example Net sales ( Year 2005 ) $858,000 Cost of goods sold 513,000 Gross profit $345,000 Total operating expenses 244,000 Operating income $101,000 Interest revenue 4,000 Interest expense (24,000) Income before taxes $ 81,000 Income taxes 33,000 Net income $ 48,000
  • 17. Palisades Furniture Example Assets 20x5 20x4 Current assets: Cash $ 29,000 $ 32,000 Receivables net 114,000 85,000 Inventories 113,000 111,000 Prepaid expenses 6,000 8,000 Total current assets $262,000 $236,000 Long-term investments 18,000 9,000 Plant and equipment, net 507,000 399,000 Total assets $787,000 $644,000
  • 18. Palisades Furniture Example Liabilities 20x5 20x4 Current liabilities: Notes payable $ 42,000 $ 27,000 Accounts payable 73,000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities $142,000 $126,000 Long-term debt 289,000 198,000 Total liabilities $431,000 $324,000
  • 19. Palisades Furniture Example Stockholders’ Equity 20x5 20x4 Common stock, no par $186,000 $186,000 Retained earnings 170,000 134,000 Total stockholders’ equity $356,000 $320,000 Total liabilities and stockholders’ equity $787,000 $644,000
  • 20. Measuring Ability to Pay Current Liabilities Current ratio = Total current assets ÷ Total current liabilities The current ratio measures the company’s ability to pay current liabilities with current assets.
  • 21. Measuring Ability to Pay Current Liabilities
    • Palisades’ current ratio:
    • 20x4:
    • 20x5:
    • The industry average is 1.50.
    • The current ratio decreased slightly during 20x5.
  • 22. Measuring Ability to Pay Current Liabilities Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷ Total current liabilities The acid-test ratio shows the company’s ability to pay all current liabilities if they come due immediately.
  • 23. Measuring Ability to Pay Current Liabilities
    • Palisades’ acid-test ratio:
    • 20x4:
    • 20x5:
    • The industry average is .40.
    • The company’s acid-test ratio improved considerably during 20x5.
  • 24. Measuring Ability to Sell Inventory Inventory turnover = Cost of goods sold ÷ Average inventory Inventory turnover is a measure of the number of times the average level of inventory is sold during a year.
  • 25. Measuring Ability to Sell Inventory
    • Palisades’ inventory turnover:
    • 20x5:
    • The industry average is 3.4.
    • A high number indicates an ability to quickly sell inventory.
  • 26. Measuring Ability to Collect Receivables Accounts receivable turnover = Net credit sales ÷ Average accounts receivable Accounts receivable turnover measures a company’s ability to collect cash from credit customers.
  • 27. Measuring Ability to Collect Receivables
    • Palisades’ accounts receivable turnover:
    • 20x5:
    • The industry average is 51 times.
    • Palisades’ receivable turnover is much lower than the industry average.
    • The company is a home-town store that sells to local people who tend to pay their bills over a lengthy period of time.
  • 28. Measuring Ability to Collect Receivables One day’s sales = Net sales ÷ 365 days Days’ sales in Accounts Receivable = Average net Accounts Receivable ÷ One day’s sales Days’ sales in receivable ratio measures how many day’s sales remain in Accounts Receivable.
  • 29. Measuring Ability to Collect Receivables
    • Palisades’ days’ sales in Accounts Receivable for 20x5:
    • One day’s sales:
    • Days’ sales in Accounts Receivable:
    • The industry average is 7 days.
  • 30. Measuring Ability to Pay Debt Total liabilities ÷ Total assets The debt ratio indicates the proportion of assets financed with debt.
  • 31. Measuring Ability to Pay Debt
    • Palisades’ debt ratio:
    • 20x4:
    • 20x5:
    • The industry average is 0.64.
    • Palisades Furniture expanded operations during 20x5 by financing through borrowing.
  • 32. Measuring Ability to Pay Debt Times-interest-earned = Income from operations ÷ Interest expense Times-interest-earned ratio measures the number of times operating income can cover interest expense.
  • 33. Measuring Ability to Pay Debt
    • Palisades’ times-interest-earned ratio:
    • 20x4:
    • 20x5:
    • The industry average is 2.80.
    • The company’s times-interest-earned ratio increased in 20x5.
    • This is a favorable sign.
  • 34. Measuring Profitability Rate of return on net sales = Net income ÷ Net sales Rate of return on net sales shows the percentage of each sales dollar earned as net income.
  • 35. Measuring Profitability
    • Palisades’ rate of return on sales:
    • 20x4:
    • 20x5:
    • The industry average is 0.008.
    • The increase is significant in itself and also because it is much better than the industry average.
  • 36. Measuring Profitability Rate of return on total assets = (Net income + interest expense) ÷ Average total assets Rate of return on total assets measures how profitably a company uses its assets.
  • 37. Measuring Profitability
    • Palisades’ rate of return on total assets for 20x5:
    • The industry average is 0.078.
    • How does Palisades compare to the industry?
  • 38. Measuring Profitability Rate of return on common stockholders’ equity = (Net income – preferred dividends) ÷ Average common stockholders’ equity Common equity includes additional paid-in capital on common stock and retained earnings.
  • 39. Measuring Profitability
    • Palisades’ rate of return on common stockholders’ equity for 20x5:
    • The industry average is 0.121.
    • Why is this ratio larger than the return on total assets (.101)?
  • 40. Measuring Profitability Earnings per share of common stock = (Net income – Preferred dividends) ÷ Number of shares of common stock outstanding
  • 41. Measuring Profitability
    • Palisades’ earnings per share:
    • 20x4:
    • 20x5:
    • This large increase in EPS is considered very unusual.
  • 42. Analyzing Stock as an Investment
    • Price/earning ratio is the ratio of market price per share to earnings per share.
    • 20x4:
    • 20x5:
    • Given Palisades Furniture’s 20x5 P/E ratio of ____, we would say that the company’s stock is selling at ____ times earnings.
  • 43. Analyzing Stock as an Investment Dividend per share of common (or preferred) stock ÷ Market price per share of common (or preferred) stock Dividend yield shows the percentage of a stock’s market value returned as dividends to stockholders each period.
  • 44. Analyzing Stock as an Investment
    • Dividend yield on Palisades’ common stock:
    • 20x4:
    • 20x5:
    • An investor who buys Palisades Furniture common stock for $60 can expect to receive ___% of the investment annually in the form of cash dividends.
  • 45. Analyzing Stock as an Investment Book value per share of common stock = (Total stockholders’ equity – Preferred equity) ÷ Number of shares of common stock outstanding
  • 46. Analyzing Stock as an Investment
    • Book value per share of Palisades’ common stock:
    • 20x4:
    • 20x5:
    • Book value bears no relationship to market value.
  • 47. Limitations of Financial Analysis
    • Business decisions are made in a world of uncertainty.
    • No single ratio or one-year figure should be relied upon to provide an assessment of a company’s performance.
  • 48. Economic Value Added (EVA®)
    • Economic value added (EVA®) combines accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth.
    • EVA® = Net income + Interest expense – Capital charge
    • Capital charge = (notes pay. + bonds pay. + stockholders’ equity) x cost of capital
  • 49. Red Flags
    • Earnings Problems
    • Decreased Cash Flow
    • Too Much Debt
    • Inability to Collect Receivables
    • Buildup of Inventory
    • Strange Movements of Sales, Inventories, and Receivables
  • 50. Review
    • Horizontal Analysis
    • Trend Percentages
    • Vertical Analysis
    • Common Size Statement
    • Benchmarking
    • Ratio Analysis
    • Other Evaluation Tools