AnalyzingFinancialStatements An overview of financial tools and techniques By Arpit amar
yzing Financial Statements Who analyzes financial statements? Internal users (i.e., management) External users Examples? Investors, creditors, regulatory agencies & … stock market analysts and auditors What do internal users use it for? Planning, evaluating and controlling company operations What do external users use it for? Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management
ds of Analyzing Financial Statement Horizontal Analysis Vertical Analysis Common-Size Statements Trend Percentages Ratio Analysis
ds of Analyzing Financial Statements Horizontal Analysis Using comparative financial statements to calculate dollar or percentage changes in a financial statement item from one period to the next Vertical Analysis For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales Common-Size Statements Financial statements that show only percentages and no absolute dollar amounts Trend Percentages Show changes over time in given financial statement items (can help evaluate financial information of several years) Ratio Analysis Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)
Horizontal AnalysisThe management of Clover Company provides you with comparativebalance sheets of the years ended December 31, 1999 and 1998.Management asks you to prepare a horizontal analysis on theinformation.
Horizontal AnalysisCalculating Change in Dollar Amounts Dollar Current Year Base Year Change Figure Figure Since we are measuring the amount of the change between 1998 and 1999, the dollar amounts for 1998 become the “base” year figures –Calculating Change as a Percentage Percentage Change = Dollar Change Base Year Figure × 100%
Horizontal Analysis Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet. CLOVER CORPORATION Comparative Balance Sheets December 31, 1999 and 1998 Increase (Decrease) 1999 1998 Amount % Liabilities and Stockholders EquityCurrent liabilities: Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3 Notes payable 3,000 6,000 (3,000) (50.0) Total current liabilities 70,000 50,000 20,000 40.0Long-term liabilities: Bonds payable, 8% 75,000 80,000 (5,000) (6.3) Total liabilities 145,000 130,000 15,000 11.5Stockholders equity: Preferred stock 20,000 20,000 - 0.0 Common stock 60,000 60,000 - 0.0 Additional paid-in capital 10,000 10,000 - 0.0 Total paid-in capital 90,000 90,000 - 0.0Retained earnings 80,000 69,700 10,300 14.8 Total stockholders equity 170,000 159,700 10,300 6.4Total liabilities and stockholders equity $ 315,000 $ 289,700 $ 25,300 8.7
Horizontal Analysis Now, let’s apply the procedures to the income statement. CLOVER CORPORATION Sales increased by 8.3% Comparative Income Statements while net income decreased For the Years Ended December 31, 1999 and 1998 by 21.9%. Increase (Decrease) 1999 1998 Amount %Net sales $ 520,000 $ 480,000 $ 40,000 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income $ 17,500 $ 22,400 $ (4,900) (21.9) There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.
Vertical analysisThe management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company. $82,000 ÷ $483,000 = 17% rounded $30,000 ÷ $387,000 = 8% rounded
Trend PercentageWheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis. $1,991 - $1,820 = $171Using 1995 as the base year, we develop the following percentage relationships. $171 ÷ $1,820 = 9% rounded
Trend Percentage Trend line for Sales
Ratio AnalysisRatios can be expressed in three different ways: 1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of $2.25)CAUTION! “Using ratios and percentages without considering the underlying causes may be hazardous to your health!” lead to incorrect conclusions.”
Major Ratio Analysis Tools Liquidity Ratios Indicate a company’s short-term debt-paying ability Equity (Long-Term Solvency) Ratios Show relationship between debt and equity financing in a company Profitability Tests Relate income to other variables Market Tests Help assess relative merits of stocks in the marketplace
1.Liquidity Ratios 4.Market TestsCurrent (working capital) ratio Earnings yield on common stockAcid-test (quick) ratio Price-earnings ratioCash flow liquidity ratio Payout ratio on common stockAccounts receivable turnover Dividend yield on common stockNumber of days’ sales in account receivableInventory turnover Dividend yield on preferred stockTotal assets turnover Cash flow per share of common stock2.Equity (Long-Term Solvency) RatiosEquity (stockholders’ equity) ratioEquity to debt3.Profitability TestsReturn on operating assetsNet income to net sales (return on sales or “profit margin”)Return on average common stockholders’ equity (ROE)Cash flow marginEarnings per shareTimes interest earnedTimes preferred dividends earned
Implementation of Ten main Ratio Analysis ToolsNow, let’s look at Norton Corporation’s 1999 and 1998 financial statements.
Calculating the liquidity ratios for Norton. NORTON CORPORATION 1999 Cash $ 30,000 Accounts receivable, net Beginning of year 17,000 End of year 20,000 Inventory Beginning of year 10,000 End of year 12,000 Total current assets 65,000 Total current liabilities 42,000 Sales on account 494,000 Cost of goods sold 140,000
1.Working CapitalThe excess of current assets over current liabilities. 12/31/99 Current assets $ 65,000 Current liabilities (42,000) Working capital $ 23,000* While this is not a ratio, it does give an indication of a company’s liquidity.Working capital ratio Current Current Assets Ratio = Current Liabilities Current $65,000 Ratio = = 1.55 : 1 $42,000Measures the ability of the company to pay current debts as they become due.
2.Acid –Test (Quick) RatioAcid-Test Quick Assets Ratio = Current LiabilitiesQuick assets are Cash, Marketable Securities, AccountsReceivable (net) and current Notes Receivable. Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000. Acid-Test $50,000 = 1.19 : 1 Ratio = $42,0003.Account Receivable Turnover Accounts Sales on Account Receivable = Average Accounts Receivable Turnover Accounts $494,000 = 26.70 times Receivable = ($17,000 + $20,000) ÷ 2 Turnover This ratio measures how many times a company converts its receivables into cash each year.
4.Number of Day’s sales in account receivable Days’ Sales 365 Days in Accounts = Accounts Receivable Turnover Receivables Days’ Sales 365 Days in Accounts = = 13.67 days 26.70 Times Receivables Measures, on average, how many days it takes to collect an account receivable.5.Inventory Turnover Inventory Cost of Goods Sold Turnover = Average Inventory Inventory $140,000 Turnover = ($10,000 + $12,000) ÷ 2 = 12.73 times Measures the number of times inventory is sold and replaced during the year.
Equity or Long Term Solvency ratiosCalculating the equity, or long-term solvency ratios of Norton Corporation. NORTON CORPORATION NORTON CORPORATION 1999 1999 Common shares outstanding Net operating income $ 84,000 Beginning of year 17,000 Net sales 494,000 End of year 27,400 Interest expense 7,300 Net income $ 53,690 Total stockholders equity 234,390 Stockholders equity Beginning of year 180,000 End of year 234,390 Dividends per share 2 Dec. 31 market price/share 20 Interest expense 7,300 Total assets Beginning of year 300,000 End of year 346,390
6.Equity Ratio Equity Stockholders’ Equity Ratio = Total Assets Equity $234,390 = 67.7% Ratio = $346,390 Measures the proportion of total assets provided by stockholders.7.Net income to Sales Ratio Net Income Net Income to = Net Sales Net Sales Net Income to $53,690 = = 10.9% Net Sales $494,000 Measures the proportion of the sales dollar which is retained as profit.
8.Return on Equity (ROE) Return on Net IncomeStockholders’ = Average Common Equity Stockholders’ Equity Return on $53,690Stockholders’ = ($180,000 + $234,390) ÷ 2 = 25.9% EquityImportant measure of the income-producing ability of a company.9.Earning per share(EPS) Earnings Earnings Available to Common Stockholders per Share = Weighted-Average Number of Shares Outstanding Earnings $53,690 per Share = (17,000 + 27,400) ÷ 2 = $2.42The financial press regularly publishes actual and forecasted EPS amounts.
10.Price-Earning ratio Price-Earnings = Market Price Per Share Ratio EPS Price-Earnings $20.00 Ratio = $ 2.42 = 8.3 : 1 Provides some measure of whether the stock is under or overpriced.
Important ConsiderationNeed for comparable data Data is provided by Dun & Bradstreet, Standard & Poor’s etc. Must compare by industry Is EPS comparable?Influence of external factors General business conditions Seasonal nature of business operations Impact of inflationThanks for reading