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# Financial statement analysis

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### Financial statement analysis

1. 1. Financial Statement Analysis Chapter 15 PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
2. 2. 15-2 Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult. We use the LIFO method to value inventory. We use the average cost method to value inventory.
3. 3. 15-3 Limitations of Financial Statement Analysis Analysts should look beyond the ratios. Industry trends Technological changes Changes within the company Consumer tastes Economic factors
4. 4. 15-4 Learning Objective 1 Prepare and interpret financial statements in comparative and common-size form.
5. 5. 15-5 Statements in Comparative and Common-Size Form   Dollar and percentage changes on statements An item on a financial statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing comparisons.   Common-size statements   Ratios
6. 6. 15-6 Dollar and Percentage Changes on Statements Horizontal analysis (or trend analysis) shows the changes between years in the financial data in both dollar and percentage form.
7. 7. 15-7 Horizontal Analysis The following slides illustrate a horizontal analysis of Clover Corporation’s comparative balance sheets and comparative income statements for this year and last year.
8. 8. 15-8 Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31 This Year Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets Increase (Decrease) Last Year Amount % \$ \$ 12,000 60,000 80,000 3,000 155,000 40,000 120,000 160,000 \$ 315,000 23,500 40,000 100,000 1,200 164,700 40,000 85,000 125,000 \$ 289,700
9. 9. 15-9 Horizontal Analysis Calculating Change in Dollar Amounts Dollar Change = Current Year Figure – Base Year Figure The dollar amounts for last year become the “base” year figures.
10. 10. 15-10 Horizontal Analysis Calculating Change as a Percentage Percentage Change = Dollar Change Base Year Figure × 100%
11. 11. 15-11 Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31 This Year Increase (Decrease) Last Year Amount % Assets Current assets: Cash \$ 12,000 \$ 23,500 \$ (11,500) (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700 Property and equipment: \$12,000 – \$23,500 = \$(11,500) Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 (\$11,500 ÷ \$23,500) × 100% = (48.9%) Total property and equipment 160,000 125,000 Total assets \$ 315,000 \$ 289,700
12. 12. 15-12 Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31 This Year Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets Increase (Decrease) Last Year Amount % \$ \$ 12,000 60,000 80,000 3,000 155,000 40,000 120,000 160,000 \$ 315,000 23,500 40,000 100,000 1,200 164,700 40,000 85,000 125,000 \$ 289,700 \$ (11,500) 20,000 (20,000) 1,800 (9,700) (48.9) 50.0 (20.0) 150.0 (5.9) 35,000 35,000 \$ 25,300 0.0 41.2 28.0 8.7
13. 13. 15-13 Horizontal Analysis We could do this for the liabilities and stockholders’ equity, but now let’s look at the income statement accounts.
14. 14. 15-14 Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 This Year Last Year Sales \$ 520,000 \$ 480,000 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income \$ 17,500 \$ 22,400 Increase (Decrease) Amount %
15. 15. 15-15 Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 This Year Last Year Sales \$ 520,000 \$ 480,000 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income \$ 17,500 \$ 22,400 Increase (Decrease) Amount % \$ 40,000 8.3 45,000 14.3 (5,000) (3.0) 2,600 2.1 (7,600) (19.5) (600) (8.6) (7,000) (21.9) (2,100) (21.9) \$ (4,900) (21.9)
16. 16. 15-16 Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Increase (Decrease) This Year Last Year Amount % Sales \$ 520,000 \$ 480,000 \$ 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) OperatingSales increased by 8.3%, yet expenses 128,600 126,000 2,600 2.1 Net operating income decreased by 39,000 31,400 net income 21.9%. (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)
17. 17. 15-17 Horizontal Analysis CLOVER CORPORATION There were increases in both cost of goods Comparative Income Statements sold (14.3%) and the Years Ended December 31 operating expenses (2.1%). For These increased costs more than offset the Increase increase in sales, yielding an overall (Decrease) % decrease inThis Year Last Year Amount net income. Sales \$ 520,000 \$ 480,000 \$ 40,000 Cost of goods sold 360,000 315,000 45,000 Gross margin 160,000 165,000 (5,000) Operating expenses 128,600 126,000 2,600 Net operating income 31,400 39,000 (7,600) Interest expense 6,400 7,000 (600) Net income before taxes 25,000 32,000 (7,000) Less income taxes (30%) 7,500 9,600 (2,100) Net income \$ 17,500 \$ 22,400 \$ (4,900) 8.3 14.3 (3.0) 2.1 (19.5) (8.6) (21.9) (21.9) (21.9)
18. 18. 15-18 Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.
19. 19. 15-19 Trend Analysis Trend = Percentage Current Year Amount Base Year Amount × 100%
20. 20. 15-20 Trend Analysis Look at the income information for Berry Products for the years 2007 through 2011. We will do a trend analysis on these amounts to see what we can learn about the company.
21. 21. 15-21 Trend Analysis Berry Products Income Information For the Years Ended December 31 Item Sales Cost of goods sold Gross margin 2011 \$ 400,000 285,000 115,000 2010 \$ 355,000 250,000 105,000 Year 2009 \$ 320,000 225,000 95,000 The base year is 2007, and its amounts will equal 100%. 2008 \$ 290,000 198,000 92,000 2007 \$ 275,000 190,000 85,000
22. 22. 15-22 Trend Analysis Berry Products Income Information For the Years Ended December 31 Item 2011 2010 Year 2009 Sales Cost of goods sold Gross margin 2008 Amount ÷ 2007 Amount × 100% ( \$290,000 ÷ \$275,000 ) × 100% = 105% ( \$198,000 ÷ \$190,000 ) × 100% = 104% ( \$ 92,000 ÷ \$ 85,000 ) × 100% = 108% 2008 105% 104% 108% 2007 100% 100% 100%
23. 23. 15-23 Trend Analysis Berry Products Income Information For the Years Ended December 31 Item Sales Cost of goods sold Gross margin 2011 145% 150% 135% 2010 129% 132% 124% Year 2009 116% 118% 112% 2008 105% 104% 108% By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin. 2007 100% 100% 100%
24. 24. 15-24 Trend Analysis 160 Percentage We can use the trend 150 percentages to construct a graph so we can see the 140 trend over time. 130 Sales COGS 120 GM 110 100 2007 2008 2009 Year 2010 2011
25. 25. 15-25 Common-Size Statements Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.
26. 26. 15-26 Common-Size Statements In income statements, all items usually are expressed as a percentage of sales.
27. 27. 15-27 Gross Margin Percentage Gross Margin = Percentage Gross Margin Sales This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.
28. 28. 15-28 Common-Size Statements In balance sheets, all items usually are expressed as a percentage of total assets.
29. 29. 15-29 Common-Size Statements Burger King McDonald's (dollars in millions) Dollars Percentage Dollars Percentage 2008 Net income \$ 190 7.70% \$ 4,313 18.30% Common-size financial statements are particularly useful when comparing data from different companies.
30. 30. 15-30 Common-Size Statements Let’s take another look at the information from the comparative income statements of Clover Corporation for this year and last year. This time, let’s prepare common-size statements.
31. 31. 15-31 Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size Percentages This Year Last Year This Year Last Year Sales \$ 520,000 \$ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Sales is Operating expenses 128,600 126,000 usually the Net operating income 31,400 39,000 base and is Interest expense 6,400 7,000 expressed Net income before taxes 25,000 32,000 as 100%. Less income taxes (30%) 7,500 9,600 Net income \$ 17,500 \$ 22,400
32. 32. 15-32 Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size Percentages This Year Last Year This Year Last Year Sales \$ 520,000 \$ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 This Year’s Net operating income Cost ÷ This Year’s Sales × 100% 31,400 39,000 ( \$360,000 ÷ \$520,000 ) ×7,000 = 69.2% 100% Interest expense 6,400 Net income before taxes 25,000 32,000 Last Year’s Cost ÷ Last Year’s Sales × 100% Less income taxes (30%) 7,500 9,600 ( \$315,000 ÷\$ \$480,000 ) × 100% = 65.6% Net income 17,500 \$ 22,400
33. 33. 15-33 Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size What conclusions can we draw? Percentages This Year Last Year This Year Last Year Sales \$ 520,000 \$ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0 Net income \$ 17,500 \$ 22,400 3.4 4.7
34. 34. 15-34 Quick Check ü Which of the following statements describes horizontal analysis? a. A statement that shows items appearing on it in percentage and dollar form. b. A side-by-side comparison of two or more years’ financial statements. c. A comparison of the account balances on the current year’s financial statements. d. None of the above.
35. 35. 15-35 Quick Check ü Which of the following statements describes horizontal analysis? a. A statement that shows items appearing on it in percentage and dollar form. b. A side-by-side comparison of two or more years’ financial statements. c. A comparison of the account balances on Horizontal year’s financial statements. the current analysis shows the changes between years in the financial data in both d. None of the above. dollar and percentage form.
36. 36. 15-36 Now, let’s look at Norton Corporation’s financial statements for this year and last year.
37. 37. 15-37 NORTON CORPORATION Balance Sheets December 31 This Year Last Year Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets \$ 30,000 20,000 12,000 3,000 65,000 165,000 116,390 281,390 \$ 346,390 \$ 20,000 17,000 10,000 2,000 49,000 123,000 128,000 251,000 \$ 300,000
38. 38. 15-38 NORTON CORPORATION Balance Sheets December 31 This Year Liabilities and Stockholders' Equity Current liabilities: Accounts payable Notes payable, short-term Total current liabilities Long-term liabilities: Notes payable, long-term Total liabilities Stockholders' equity: Common stock, \$1 par value Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equity Last Year \$ \$ 39,000 3,000 42,000 40,000 2,000 42,000 70,000 112,000 78,000 120,000 27,400 158,100 185,500 48,890 234,390 17,000 113,000 130,000 50,000 180,000 Total liabilities and stockholders' equity \$ 346,390 \$ 300,000
39. 39. 15-39 NORTON CORPORATION Income Statements For the Years Ended December 31 Sales Cost of goods sold Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income This Year \$ 494,000 140,000 354,000 270,000 84,000 7,300 76,700 23,010 \$ 53,690 Last Year \$ 450,000 127,000 323,000 249,000 74,000 8,000 66,000 19,800 \$ 46,200
40. 40. 15-40 Learning Objective 2 Compute and interpret financial ratios that would be useful to a common stockholder.
41. 41. 15-41 Ratio Analysis – The Common Stockholder NORTON CORPORATION The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholders’ equities. This Year Number of common shares outstanding Beginning of year End of year Net income 17,000 27,400 \$ 53,690 Stockholders' equity Beginning of year 180,000 End of year 234,390 Dividends per share Dec. 31 market price per share Interest expense 2 20 7,300 Total assets Beginning of year 300,000 End of year 346,390
42. 42. 15-42 Earnings Per Share Net Income – Preferred Dividends Earnings per Share = Average Number of Common Shares Outstanding Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. Earnings form the basis for dividend payments and future increases in the value of shares of stock.
43. 43. 15-43 Earnings Per Share Net Income – Preferred Dividends Earnings per Share = Average Number of Common Shares Outstanding Earnings per Share = \$53,690 – \$0 (\$17,000 + \$27,400)/2 = \$2.42 This measure indicates how much income was earned for each share of common stock outstanding.
44. 44. 15-44 Price-Earnings Ratio Price-Earnings Ratio Price-Earnings Ratio = = Market Price Per Share Earnings Per Share \$20.00 \$2.42 = 8.26 times A higher price-earnings ratio means that investors are willing to pay a premium for a company’s stock because of optimistic future growth prospects.
45. 45. 15-45 Dividend Payout Ratio Dividend Payout Ratio Dividend Payout Ratio = Dividends Per Share Earnings Per Share = \$2.00 \$2.42 = 82.6% This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking dividends (market price growth) would like this ratio to be large (small).
46. 46. 15-46 Dividend Yield Ratio Dividend Yield Ratio Dividend Yield Ratio = = Dividends Per Share Market Price Per Share \$2.00 \$20.00 = 10.00% This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
47. 47. 15-47 Return on Total Assets Return on = Total Assets Net Income + [Interest Expense × (1 – Tax Rate)] Average Total Assets Return on = Total Assets \$53,690 + [\$7,300 × (1 – .30)] = 18.19% (\$300,000 + \$346,390) ÷ 2 Adding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity.
48. 48. 15-48 Return on Common Stockholders’ Equity Return on Common = Net Income – Preferred Dividends Stockholders’ Equity Average Stockholders’ Equity Return on Common = \$53,690 – \$0 = 25.91% Stockholders’ Equity (\$180,000 + \$234,390) ÷ 2 This measure indicates how well the company used the owners’ investments to earn income.
49. 49. 15-49 Financial Leverage Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors. Return on investment in > assets Fixed rate of return on borrowed funds Positive = financial leverage Return on investment in < assets Fixed rate of return on borrowed funds Negative = financial leverage
50. 50. 15-50 Quick Check ü Which of the following statements is true? a. Negative financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets. c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year.
51. 51. 15-51 Quick Check ü Which of the following statements is true? a. Negative financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets. c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year.
52. 52. 15-52 Book Value Per Share Book Value per Share Book Value per Share = Common Stockholders’ Equity Number of Common Shares Outstanding = \$234,390 27,400 = \$8.55 This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts after all creditors were paid off.
53. 53. 15-53 Book Value Per Share Book Value per Share Book Value per Share = Common Stockholders’ Equity Number of Common Shares Outstanding = \$234,390 27,400 = \$8.55 Notice that the book value per share of \$8.55 does not equal the market value per share of \$20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost.
54. 54. 15-54 Learning Objective 3 Compute and interpret financial ratios that would be useful to a short-term creditor.
55. 55. 15-55 Ratio Analysis – The Short–Term Creditor NORTON CORPORATION Short-term creditors, such as suppliers, want to be paid on time. Therefore, they focus on the company’s cash flows and working capital. This Year 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
56. 56. 15-56 Working Capital The excess of current assets over current liabilities is known as working capital. Working capital is not free. It must be financed with longterm debt and equity.
57. 57. 15-57 Working Capital December 31 This Year Current assets \$ Current liabilities Working capital 65,000 (42,000) \$ 23,000
58. 58. 15-58 Current Ratio Current Ratio = Current Assets Current Liabilities The current ratio measures a company’s short-term debt paying ability. A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories.
59. 59. 15-59 Current Ratio Current Ratio = Current Assets Current Liabilities Current Ratio = \$65,000 \$42,000 = 1.55
60. 60. 15-60 Acid-Test (Quick) Ratio Acid-Test = Ratio Acid-Test = Ratio Quick Assets Current Liabilities \$50,000 \$42,000 = 1.19 Quick assets include Cash, Marketable Securities, Accounts Receivable, and current Notes Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory.
61. 61. 15-61 Accounts Receivable Turnover Accounts Receivable Turnover = Sales on Account Average Accounts Receivable Accounts \$494,000 Receivable = = 26.7 times (\$17,000 + \$20,000) ÷ 2 Turnover This ratio measures how many times a company converts its receivables into cash each year.
62. 62. 15-62 Average Collection Period Average Collection = Period Average Collection = Period 365 Days Accounts Receivable Turnover 365 Days 26.7 Times This ratio measures, on average, how many days it takes to collect an account receivable. = 13.67 days
63. 63. 15-63 Inventory Turnover Inventory Turnover = Cost of Goods Sold Average Inventory This ratio measures how many times a company’s inventory has been sold and replaced during the year. If a company’s inventory turnover Is less than its industry average, it either has excessive inventory or the wrong types of inventory.
64. 64. 15-64 Inventory Turnover Inventory Turnover = Inventory Turnover = Cost of Goods Sold Average Inventory \$140,000 = 12.73 times (\$10,000 + \$12,000) ÷ 2
65. 65. 15-65 Average Sale Period Average Sale Period = Average = Sale Period 365 Days Inventory Turnover 365 Days 12.73 Times This ratio measures how many days, on average, it takes to sell the entire inventory. = 28.67 days
66. 66. 15-66 Learning Objective 4 Compute and interpret financial ratios that would be useful to a long-term creditor.
67. 67. 15-67 Ratio Analysis – The Long–Term Creditor Long-term creditors are concerned with a company’s ability to repay its loans over the long-run. NORTON CORPORATION This Year Earnings before interest expense and income taxes Interest expense This is also referred to as net operating income. \$ 84,000 7,300 Total stockholders' equity 234,390 Total liabilities 112,000
68. 68. 15-68 Times Interest Earned Ratio Times Interest = Earned Times Interest = Earned Earnings Interest Expense and Income Taxes Interest Expense \$84,000 = 11.51 times \$7,300 This is the most common measure of a company’s ability to provide protection for its longterm creditors. A ratio of less than 1.0 is inadequate.
69. 69. 15-69 Debt-to-Equity Ratio Debt–to– Total Liabilities Equity = Stockholders’ Equity Ratio This ratio indicates the relative proportions of debt to equity on a company’s balance sheet. Stockholders like a lot of debt if the company can take advantage of positive financial leverage. Creditors prefer less debt and more equity because equity represents a buffer of protection.
70. 70. 15-70 Debt-to-Equity Ratio Debt–to– Total Liabilities Equity = Stockholders’ Equity Ratio Debt–to– Equity = Ratio \$112,000 = 0.48 \$234,390
71. 71. 15-71 Published Sources That Provide Comparative Ratio Data
72. 72. 15-72 End of Chapter 15