Financial Statement Analysis Chapter 18
Objectives <ul><li>Perform horizontal analysis of comparative financial statements </li></ul><ul><li>Perform vertical anal...
The Annual Report Usually Contains ... <ul><li>President’s letter to the Stockholders </li></ul><ul><li>Management Discuss...
Horizontal Analysis <ul><li>Interested in the percent change </li></ul><ul><ul><li>Step 1:  Figure the dollar amount chang...
Horizontal Analysis   2005   2004   Difference Sales $41,500 $37,850 $3,650 $3,650 ÷ $37,850 = .0964, or 9.6% Increase/(De...
Trend Percentages... <ul><li>…are computed by selecting a base year whose amounts are set equal to 100%. </li></ul><ul><li...
<ul><li>Year   2005  2004   2003 </li></ul><ul><li>Revenues $27,611 $24,215 $21,718 </li></ul><ul><li>Cost of sales   15,3...
<ul><li>Year 2005   2004     2003 </li></ul><ul><li>Revenues   %   %   % </li></ul><ul><li>Cost of sales   %   %   % </li>...
Vertical Analysis... <ul><li>…compares each item in a financial statement to a base number set to 100%. </li></ul><ul><li>...
Vertical Analysis   2005   % Revenues $38,303 100.0 Cost of sales   19,688   51.4 Gross profit $18,615   48.6 Total operat...
Vertical Analysis Assets   2005   % Current assets: Cash $  1,816   4.7 Receivables net   10,438   26.9 Inventories   6,15...
Vertical Analysis Liabilities   2005   % Current liabilities: Accounts Payable $  2,055   5.3 Other current liab   13,455 ...
Common-size Statements <ul><li>On the income statement, each item is expressed as a percentage of net sales. </li></ul><ul...
Benchmarking Percent of Net Sales MCI Lucent Technologies    Cost of goods sold    Operating expenses    Income tax   ...
Ratio Classification <ul><li>Measuring ability to pay current liabilities </li></ul><ul><li>Measuring ability to sell inve...
Palisades Furniture Example Net sales ( Year 2005 ) $858,000 Cost of goods sold   513,000 Gross profit $345,000 Total oper...
Palisades Furniture Example Assets 20x5   20x4 Current assets: Cash $  29,000 $  32,000 Receivables net   114,000   85,000...
Palisades Furniture Example   Liabilities 20x5     20x4 Current liabilities: Notes payable $  42,000 $  27,000 Accounts pa...
Palisades Furniture Example Stockholders’ Equity   20x5   20x4 Common stock, no par $186,000 $186,000 Retained earnings   ...
Measuring Ability to Pay Current Liabilities Current ratio = Total current assets ÷ Total current liabilities The current ...
Measuring Ability to Pay Current Liabilities <ul><li>Palisades’ current ratio: </li></ul><ul><li>20x4:  </li></ul><ul><li>...
Measuring Ability to Pay Current Liabilities Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷...
Measuring Ability to Pay Current Liabilities <ul><li>Palisades’ acid-test ratio: </li></ul><ul><li>20x4:  </li></ul><ul><l...
Measuring Ability to Sell Inventory Inventory turnover = Cost of goods sold ÷ Average inventory Inventory turnover is a me...
Measuring Ability to Sell Inventory <ul><li>Palisades’ inventory turnover: </li></ul><ul><li>20x5: </li></ul><ul><li>The i...
Measuring Ability to Collect Receivables Accounts receivable turnover = Net credit sales ÷ Average accounts receivable Acc...
Measuring Ability to Collect Receivables <ul><li>Palisades’ accounts receivable turnover: </li></ul><ul><li>20x5: </li></u...
Measuring Ability to Collect Receivables One day’s sales = Net sales ÷ 365 days Days’ sales in Accounts Receivable = Avera...
Measuring Ability to Collect Receivables <ul><li>Palisades’ days’ sales in Accounts Receivable for 20x5: </li></ul><ul><li...
Measuring Ability to Pay Debt Total liabilities ÷ Total assets The debt ratio indicates the proportion of assets financed ...
Measuring Ability to Pay Debt <ul><li>Palisades’ debt ratio: </li></ul><ul><li>20x4:  </li></ul><ul><li>20x5:  </li></ul><...
Measuring Ability to Pay Debt Times-interest-earned = Income from operations ÷ Interest expense Times-interest-earned rati...
Measuring Ability to Pay Debt <ul><li>Palisades’ times-interest-earned ratio: </li></ul><ul><li>20x4:  </li></ul><ul><li>2...
Measuring Profitability Rate of return on net sales = Net income ÷ Net sales Rate of return on net sales shows the percent...
Measuring Profitability <ul><li>Palisades’ rate of return on sales: </li></ul><ul><li>20x4: </li></ul><ul><li>20x5: </li><...
Measuring Profitability Rate of return on total assets = (Net income  + interest expense) ÷ Average total assets Rate of r...
Measuring Profitability <ul><li>Palisades’ rate of return on total assets  for 20x5: </li></ul><ul><li>The industry averag...
Measuring Profitability Rate of return on common stockholders’ equity = (Net income – preferred dividends) ÷ Average commo...
Measuring Profitability <ul><li>Palisades’ rate of return on common stockholders’ equity for 20x5: </li></ul><ul><li>The i...
Measuring Profitability Earnings per share of common stock = (Net income – Preferred dividends) ÷ Number of shares of comm...
Measuring Profitability <ul><li>Palisades’ earnings per share: </li></ul><ul><li>20x4:  </li></ul><ul><li>20x5:  </li></ul...
Analyzing Stock as an Investment <ul><li>Price/earning ratio is the ratio of market price per share to earnings per share....
Analyzing Stock as an Investment Dividend per share of common (or preferred) stock ÷ Market price per share of common (or ...
Analyzing Stock as an Investment <ul><li>Dividend yield on Palisades’ common stock: </li></ul><ul><li>20x4: </li></ul><ul>...
Analyzing Stock as an Investment Book value per share of common stock = (Total stockholders’ equity – Preferred equity) ÷ ...
Analyzing Stock as an Investment <ul><li>Book value per share of Palisades’ common stock: </li></ul><ul><li>20x4: </li></u...
Limitations of Financial Analysis <ul><li>Business decisions are made in a world of uncertainty. </li></ul><ul><li>No sing...
Economic Value Added  (EVA®)   <ul><li>Economic value added  (EVA®)  combines accounting income and corporate finance to m...
Red Flags <ul><li>Earnings Problems </li></ul><ul><li>Decreased Cash Flow </li></ul><ul><li>Too Much Debt </li></ul><ul><l...
Review <ul><li>Horizontal Analysis </li></ul><ul><li>Trend Percentages </li></ul><ul><li>Vertical Analysis </li></ul><ul><...
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  1. 1. Financial Statement Analysis Chapter 18
  2. 2. Objectives <ul><li>Perform horizontal analysis of comparative financial statements </li></ul><ul><li>Perform vertical analysis of financial statements </li></ul><ul><li>Prepare and use common size financial statements </li></ul><ul><li>Compute the standard financial ratios </li></ul><ul><li>Measure economic value added </li></ul>
  3. 3. The Annual Report Usually Contains ... <ul><li>President’s letter to the Stockholders </li></ul><ul><li>Management Discussion and Analysis of the financial statements </li></ul><ul><li>Financial Statements </li></ul><ul><li>Notes to the Financial Statements </li></ul><ul><ul><li>a summary of accounting methods used </li></ul></ul><ul><li>An Auditor’s Report </li></ul><ul><li>Comparative Financial Data for 5 to 10 years </li></ul>
  4. 4. Horizontal Analysis <ul><li>Interested in the percent change </li></ul><ul><ul><li>Step 1: Figure the dollar amount change from the base period to the later period. </li></ul></ul><ul><ul><li>Step 2: Divide the dollar amount of change by the base amount to get a percent change. </li></ul></ul>
  5. 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. 6. Trend Percentages... <ul><li>…are computed by selecting a base year whose amounts are set equal to 100%. </li></ul><ul><li>The amounts of each following year are expressed as a percentage of the base amount. </li></ul>Trend % = Any year $ ÷ Base year $
  7. 7. <ul><li>Year 2005 2004 2003 </li></ul><ul><li>Revenues $27,611 $24,215 $21,718 </li></ul><ul><li>Cost of sales 15,318 14,709 13,049 </li></ul><ul><li>Gross profit $12,293 $ 9,506 $ 8,669 </li></ul><ul><li>2003 is the base year. </li></ul>Trend Percentages What are the trend percentages?
  8. 8. <ul><li>Year 2005 2004 2003 </li></ul><ul><li>Revenues % % % </li></ul><ul><li>Cost of sales % % % </li></ul><ul><li>Gross profit % % % </li></ul>Trend Percentages These percentages were calculated by dividing each item by the base year.
  9. 9. Vertical Analysis... <ul><li>…compares each item in a financial statement to a base number set to 100%. </li></ul><ul><li>Every item on the financial statement is then reported as a percentage of that base. </li></ul>% = each financial stmt item base number
  10. 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. 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. 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. 13. Common-size Statements <ul><li>On the income statement, each item is expressed as a percentage of net sales. </li></ul><ul><li>On the balance sheet, the common size is the total on each side of the accounting equation. </li></ul><ul><li>Common-size statements are used to compare one company to other companies, and to the industry average. </li></ul>
  14. 14. Benchmarking Percent of Net Sales MCI Lucent Technologies  Cost of goods sold  Operating expenses  Income tax  Net income
  15. 15. Ratio Classification <ul><li>Measuring ability to pay current liabilities </li></ul><ul><li>Measuring ability to sell inventory and collect receivables </li></ul><ul><li>Measuring ability to pay short-term and long-term debt </li></ul><ul><li>Measuring profitability </li></ul><ul><li>Analyzing stock as an investment </li></ul>
  16. 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. 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. 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. 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. 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. 21. Measuring Ability to Pay Current Liabilities <ul><li>Palisades’ current ratio: </li></ul><ul><li>20x4: </li></ul><ul><li>20x5: </li></ul><ul><li>The industry average is 1.50. </li></ul><ul><li>The current ratio decreased slightly during 20x5. </li></ul>
  22. 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. 23. Measuring Ability to Pay Current Liabilities <ul><li>Palisades’ acid-test ratio: </li></ul><ul><li>20x4: </li></ul><ul><li>20x5: </li></ul><ul><li>The industry average is .40. </li></ul><ul><li>The company’s acid-test ratio improved considerably during 20x5. </li></ul>
  24. 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. 25. Measuring Ability to Sell Inventory <ul><li>Palisades’ inventory turnover: </li></ul><ul><li>20x5: </li></ul><ul><li>The industry average is 3.4. </li></ul><ul><li>A high number indicates an ability to quickly sell inventory. </li></ul>
  26. 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. 27. Measuring Ability to Collect Receivables <ul><li>Palisades’ accounts receivable turnover: </li></ul><ul><li>20x5: </li></ul><ul><li>The industry average is 51 times. </li></ul><ul><li>Palisades’ receivable turnover is much lower than the industry average. </li></ul><ul><li>The company is a home-town store that sells to local people who tend to pay their bills over a lengthy period of time. </li></ul>
  28. 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. 29. Measuring Ability to Collect Receivables <ul><li>Palisades’ days’ sales in Accounts Receivable for 20x5: </li></ul><ul><li>One day’s sales: </li></ul><ul><li>Days’ sales in Accounts Receivable: </li></ul><ul><li>The industry average is 7 days. </li></ul>
  30. 30. Measuring Ability to Pay Debt Total liabilities ÷ Total assets The debt ratio indicates the proportion of assets financed with debt.
  31. 31. Measuring Ability to Pay Debt <ul><li>Palisades’ debt ratio: </li></ul><ul><li>20x4: </li></ul><ul><li>20x5: </li></ul><ul><li>The industry average is 0.64. </li></ul><ul><li>Palisades Furniture expanded operations during 20x5 by financing through borrowing. </li></ul>
  32. 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. 33. Measuring Ability to Pay Debt <ul><li>Palisades’ times-interest-earned ratio: </li></ul><ul><li>20x4: </li></ul><ul><li>20x5: </li></ul><ul><li>The industry average is 2.80. </li></ul><ul><li>The company’s times-interest-earned ratio increased in 20x5. </li></ul><ul><li>This is a favorable sign. </li></ul>
  34. 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. 35. Measuring Profitability <ul><li>Palisades’ rate of return on sales: </li></ul><ul><li>20x4: </li></ul><ul><li>20x5: </li></ul><ul><li>The industry average is 0.008. </li></ul><ul><li>The increase is significant in itself and also because it is much better than the industry average. </li></ul>
  36. 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. 37. Measuring Profitability <ul><li>Palisades’ rate of return on total assets for 20x5: </li></ul><ul><li>The industry average is 0.078. </li></ul><ul><li>How does Palisades compare to the industry? </li></ul>
  38. 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. 39. Measuring Profitability <ul><li>Palisades’ rate of return on common stockholders’ equity for 20x5: </li></ul><ul><li>The industry average is 0.121. </li></ul><ul><li>Why is this ratio larger than the return on total assets (.101)? </li></ul>
  40. 40. Measuring Profitability Earnings per share of common stock = (Net income – Preferred dividends) ÷ Number of shares of common stock outstanding
  41. 41. Measuring Profitability <ul><li>Palisades’ earnings per share: </li></ul><ul><li>20x4: </li></ul><ul><li>20x5: </li></ul><ul><li>This large increase in EPS is considered very unusual. </li></ul>
  42. 42. Analyzing Stock as an Investment <ul><li>Price/earning ratio is the ratio of market price per share to earnings per share. </li></ul><ul><li>20x4: </li></ul><ul><li>20x5: </li></ul><ul><li>Given Palisades Furniture’s 20x5 P/E ratio of ____, we would say that the company’s stock is selling at ____ times earnings. </li></ul>
  43. 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. 44. Analyzing Stock as an Investment <ul><li>Dividend yield on Palisades’ common stock: </li></ul><ul><li>20x4: </li></ul><ul><li>20x5: </li></ul><ul><li>An investor who buys Palisades Furniture common stock for $60 can expect to receive ___% of the investment annually in the form of cash dividends. </li></ul>
  45. 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. 46. Analyzing Stock as an Investment <ul><li>Book value per share of Palisades’ common stock: </li></ul><ul><li>20x4: </li></ul><ul><li>20x5: </li></ul><ul><li>Book value bears no relationship to market value. </li></ul>
  47. 47. Limitations of Financial Analysis <ul><li>Business decisions are made in a world of uncertainty. </li></ul><ul><li>No single ratio or one-year figure should be relied upon to provide an assessment of a company’s performance. </li></ul>
  48. 48. Economic Value Added (EVA®) <ul><li>Economic value added (EVA®) combines accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth. </li></ul><ul><li>EVA® = Net income + Interest expense – Capital charge </li></ul><ul><li>Capital charge = (notes pay. + bonds pay. + stockholders’ equity) x cost of capital </li></ul>
  49. 49. Red Flags <ul><li>Earnings Problems </li></ul><ul><li>Decreased Cash Flow </li></ul><ul><li>Too Much Debt </li></ul><ul><li>Inability to Collect Receivables </li></ul><ul><li>Buildup of Inventory </li></ul><ul><li>Strange Movements of Sales, Inventories, and Receivables </li></ul>
  50. 50. Review <ul><li>Horizontal Analysis </li></ul><ul><li>Trend Percentages </li></ul><ul><li>Vertical Analysis </li></ul><ul><li>Common Size Statement </li></ul><ul><li>Benchmarking </li></ul><ul><li>Ratio Analysis </li></ul><ul><li>Other Evaluation Tools </li></ul>
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