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Financials ananlysis

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  • 1. 17-1 CHAPTER 17 ANALYSIS AND INTERPRETATION OFFINANCIAL STATEMENTS
  • 2. 17-2Financial Statement AnalysisNon-accounting majors, especially,should relate well to this chapter It looks at accounting information from users’ perspectiveRelates very closely to topics youwill study in your finance course Therefore, we will use a somewhat broader brush on this chapterWhat is financial statementanalysis? ”Tearing apart” the financial statements
  • 3. 17-3Financial Statement Analysis 625Who analyzes financial statements? Internal users (i.e., management) External users (emphasis of chapter) Examples? Investors, creditors, regulatory agencies & … stock market analysts and auditors
  • 4. 17-4Financial Statement Analysis 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 First sentence in chapter says...
  • 5. 17-5Financial Statement AnalysisInformation is available from 627 628 Published annual reports (1) Financial statements (2) Notes to financial statements (3) Letters to stockholders (4) Auditor’s report (Independent accountants) (5) Management’s discussion and analysis Reports filed with the government e.g., Form 10-K, Form 10-Q and Form 8-K
  • 6. 17-6Financial Statement AnalysisInformation is available from 627 628 Other sources (1) Newspapers (e.g., Wall Street Journal ) (2) Periodicals (e.g. Forbes, Fortune) (3) Financial information organizations such as: Moody’s, Standard & Poor’s, Dun & Bradstreet, Inc., and Robert Morris
  • 7. Methods of 17-7Financial Statement Analysis Horizontal Analysis Vertical Analysis Common-Size Statements Trend Percentages Ratio Analysis
  • 8. 17-8 Horizontal Analysis Using comparative financial Using comparative financialstatements to calculate dollarstatements to calculate dollar or percentage changes in a or percentage changes in afinancial statement item from financial statement item from one period to the next one period to the next
  • 9. 17-9Vertical AnalysisFor a single financial For a single financialstatement, each itemstatement, each item is expressed as a is expressed as a percentage of a percentage of a significant total, significant total, e.g., all income e.g., all income statement items are statement items are expressed as a expressed as a percentage of sales percentage of sales
  • 10. 17-10Common-Size Statements Financial statements that show Financial statements that show only percentages and no only percentages and no absolute dollar amounts absolute dollar amounts
  • 11. 17-11 Trend Percentages Show changes over time in Show changes over time ingiven financial statement itemsgiven financial statement items (can help evaluate financial (can help evaluate financial information of several years) information of several years)
  • 12. 17-12 Ratio AnalysisExpression of logical relationshipsExpression of logical relationships between items in a financial between items in a financial statement of a single period statement of a single period (e.g., percentage relationship (e.g., percentage relationshipbetween revenue and net income) between revenue and net income)
  • 13. 17-13Horizontal Analysis Example The management of Clover Company provides you with comparative balance sheets of the years ended December 31, 1999 and 1998. Management asks you to prepare a horizontal analysis on the information.
  • 14. 17-14
  • 15. 17-15Horizontal Analysis ExampleCalculating Change in Dollar Amounts Dollar Current Year Base Year = – Change Figure Figure
  • 16. 17-16Horizontal Analysis ExampleCalculating 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.
  • 17. 17-17Horizontal Analysis Example Calculating Change as a PercentagePercentage Dollar Change Change = Base Year Figure × 100%
  • 18. 17-18Horizontal Analysis Example $12,000 – $23,500 = $(11,500)
  • 19. 17-19Horizontal Analysis Example ($11,500 ÷ $23,500) × 100% = 48.9%
  • 20. 17-20Horizontal Analysis Example
  • 21. 17-21Horizontal Analysis Example Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet.
  • 22. 17-22 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
  • 23. 17-23Horizontal Analysis Example Now, let’s apply the procedures to the income statement.
  • 24. 17-24 CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 1999 and 1998 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)
  • 25. 17-25 CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 1999 and 1998 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) Sales increased by 8.3% while netNet income before taxes 25,000 32,000 (7,000) (21.9) income decreased by 21.9%.Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
  • 26. 17-26 There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the CLOVER CORPORATION increase inComparative Income Statements sales, yielding an overall For the Years Ended December 31, 1999 and 1998 decrease in net income. 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)
  • 27. 17-27 Vertical Analysis ExampleThe management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company.
  • 28. 17-28Vertical Analysis Example
  • 29. 17-29Vertical Analysis Example $82,000 ÷ $483,000 = 17% rounded $30,000 ÷ $387,000 = 8% rounded
  • 30. 17-30Vertical Analysis Example $76,000 ÷ $483,000 = 16% rounded
  • 31. 17-31Trend Percentages Example Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.
  • 32. 17-32Trend Percentages Example Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis. $1,991 - $1,820 = $171
  • 33. 17-33Trend Percentages ExampleUsing 1995 as the base year, we develop the following percentage relationships. $1,991 - $1,820 = $171 $171 ÷ $1,820 = 9% rounded
  • 34. 17-34Trend linefor Sales
  • 35. 17-35 RatiosRatios 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.”
  • 36. 17-36 Categories of RatiosLiquidity Ratios Indicate a company’s short-term debt-paying abilityEquity (Long-Term Solvency) Ratios Show relationship between debt and equity financing in a companyProfitability Tests Relate income to other variablesMarket Tests Help assess relative merits of stocks in the marketplace
  • 37. 17-3710 Ratios You Must Know Liquidity RatiosCurrent (working capital) ratioAcid-test (quick) ratioCash flow liquidity ratioAccounts receivable turnoverNumber of days’ sales in accounts receivableInventory turnover 651Total assets turnover
  • 38. 17-38 10 Ratios You Must KnowEquity (Long-Term Solvency) Ratios Equity (stockholders’ equity) ratio Equity to debt
  • 39. 17-3910 Ratios You Must Know Profitability TestsReturn on operating assetsNet income to net sales (return onsales or “profit margin”) margin” $Return on average common stockholders’ equity (ROE) ROECash flow marginEarnings per shareTimes interest earnedTimes preferred dividends earned
  • 40. 17-4010 Ratios You Must Know Market TestsEarnings yield on common stockPrice-earnings ratioPayout ratio on common stockDividend yield on common stockDividend yield on preferred stockCash flow per share of commonstock
  • 41. 17-41 Now, let’s look at NortonCorporation’s 1999and 1998 financial statements.
  • 42. 17-42
  • 43. 17-43
  • 44. 17-44
  • 45. 17-45 Now, let’s calculate the 10 ratios basedon Norton’s financial statements.
  • 46. 17-46 NORTON CORPORATION 1999 Cash $ 30,000 Accounts receivable, net We will Beginning of year 17,000 use this End of year 20,000information Inventoryto calculate Beginning of year 10,000 the liquidity End of year 12,000 ratios for Total current assets 65,000 Norton. Total current liabilities 42,000 Sales on account 494,000 Cost of goods sold 140,000
  • 47. 17-47 Working Capital* The excess of current assets over current liabilities. 12/31/99Current assets $ 65,000Current liabilities (42,000)Working capital $ 23,000 * While this is not a ratio, it does give an indication of a company’s liquidity.
  • 48. 17-48Current (Working Capital) Ratio #1 Current Current Assets = Ratio Current Liabilities Current $65,000 = = 1.55 : 1 Ratio $42,000 Measures the ability of the company to pay current debts as they become due.
  • 49. 17-49Acid-Test (Quick) Ratio #2Acid-Test Quick Assets = Ratio Current Liabilities Quick assets are Cash, Marketable Securities, Accounts Receivable (net) and current Notes Receivable.
  • 50. 17-50Acid-Test (Quick) Ratio #2Acid-Test Quick Assets = Ratio Current Liabilities Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000.
  • 51. 17-51Acid-Test (Quick) Ratio #2Acid-Test Quick Assets = Ratio Current LiabilitiesAcid-Test $50,000 = = 1.19 : 1 Ratio $42,000
  • 52. 17-52Accounts Receivable Turnover Net, credit sales #3 Average, net accounts receivable Accounts Sales on Account Receivable = Average Accounts Receivable Turnover Accounts $494,000 Receivable = = 26.70 times ($17,000 + $20,000) ÷ 2 Turnover This ratio measures how many times a company converts its receivables into cash each year.
  • 53. Number of Days’ Sales 17-53 in Accounts Receivable #4Days’ Sales 365 Daysin Accounts = Accounts Receivable TurnoverReceivablesDays’ Sales 365 Daysin Accounts = = 13.67 days 26.70 TimesReceivablesMeasures, on average, how many days it takes to collect an account receivable.
  • 54. Number of Days’ Sales 17-54 in Accounts Receivable #4Days’ Sales 365 Daysin Accounts = Accounts Receivable TurnoverReceivablesDays’ Sales 365 Daysin Accounts = = 13.67 days 26.70 TimesReceivables In practice, would 45 days be a desirable number of days in receivables?
  • 55. 17-55 Inventory Turnover #5 Inventory Cost of Goods Sold = Turnover Average Inventory Inventory $140,000 = = 12.73 times Turnover ($10,000 + $12,000) ÷ 2Measures the number of times inventory is sold and replaced during the year.
  • 56. 17-56 Inventory Turnover #5 Inventory Cost of Goods Sold = Turnover Average InventoryInventory $140,000 = = 12.73 timesTurnover ($10,000 + $12,000) ÷ 2 Would 5 be adesirable number of timesfor inventory to turnover?
  • 57. Equity, or Long–Term 17-57 Solvency Ratios This is part of the information to calculate the equity, or long-termsolvency ratios of Norton Corporation. NORTON CORPORATION 1999Net operating income $ 84,000Net sales 494,000Interest expense 7,300Total stockholders equity 234,390
  • 58. 17-58 NORTON CORPORATION 1999 Common shares outstanding Beginning of year 17,000 End of year 27,400 Net income $ 53,690 Here is the Stockholders equity rest of the Beginning of year 180,000information we will End of year 234,390 use. 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
  • 59. 17-59 Equity Ratio #6 Equity Stockholders’ Equity = Ratio Total Assets Equity $234,390 = = 67.7% Ratio $346,390 Measures the proportionof total assets provided by stockholders.
  • 60. 17-60 Net Income to Net SalesA/K/A Return on Sales or Profit Margin #7 Net Income Net Income to = Net Sales Net Sales Net Income $53,690 to = = 10.9% $494,000 Net Sales Measures the proportion of the sales dollar which is retained as profit.
  • 61. 17-61 Net Income to Net SalesA/K/A Return on Sales or Profit Margin #7 Net Income Net Income to = Net Sales Net Sales Net Income $53,690 to = = 10.9% $494,000 Net Sales Would a 1% return on sales be good?
  • 62. Return on Average Common 17-62 Stockholders’ Equity (ROE) #8 Return on Net IncomeStockholders’ = Average Common Equity Stockholders’ Equity Return on $53,690Stockholders’ = = 25.9% ($180,000 + $234,390) ÷ 2 Equity Important measure of the income-producing ability of a company.
  • 63. 17-63 Earnings Per Share #9 Earnings Available to Common StockholdersEarnings = Weighted-Average Number of Commonper Share Shares OutstandingEarnings $53,690 = = $2.42per Share (17,000 + 27,400) ÷ 2 The financial press regularly publishes actual and forecasted EPS amounts.
  • 64. 17-64 Earnings Per Share What’s new from Chap. 15? 644 Weighted-average calculation Earnings available to common stockholdersEPS of common stock = _______________________ Weighted-average number of common shares outstanding Three alternatives for calculating weighted-average number of shares
  • 65. 17-65 Earnings Per Share What’s new from Chap. 15? 645 Weighted-average calculation Earnings available to common stockholdersEPS of common stock = _______________________ Weighted-average number ofAlternate #1 common shares outstanding
  • 66. 17-66 Earnings Per Share 645Alternate #2Alternate #3
  • 67. 17-67 Earnings Per Share 646¶ EPS and Stock Dividends or Splits Why restate all prior calculations of EPS? Comparability - i.e., no additional capital was generated by the dividend or split¶ Primary EPS and Fully Diluted EPS APB Opinion No. 15 I mentioned this 17-page pronouncement that required a 100-page explanation in the lecture for chapter 13.
  • 68. 17-68 Price-Earnings Ratio A/K/A P/E Multiple #10Price-Earnings Market Price Per Share = Ratio EPSPrice-Earnings $20.00 = = 8.3 : 1 Ratio $ 2.42 Provides some measure of whether the stock is under or overpriced.
  • 69. 17-69 Important ConsiderationsNeed 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 operationsImpact of inflation
  • 70. 17-70 Question The current ratio is a measure of The current ratio is a measure of liquidity that is computed by dividing liquidity that is computed by dividing total assets by total liabilities. total assets by total liabilities.a. Truea. Trueb. Falseb. False
  • 71. 17-71 Question The current ratio is a measure of The current ratio is a measure of liquidity that is computed by dividing liquidity that is computed by dividing total assets by total liabilities. total assets by total liabilities.a. Truea. Trueb. Falseb. False The current ratio is a measure of The current ratio is a measure of liquidity, but is computed by liquidity, but is computed by dividing current assets by dividing current assets by current liabilities current liabilities
  • 72. 17-72 Question Quick assets are defined as Cash, Quick assets are defined as Cash, Marketable Securities and net Marketable Securities and net receivables. receivables.a.a. True Trueb.b. False False
  • 73. 17-73 Question Quick assets are defined as Cash, Quick assets are defined as Cash, Marketable Securities and net Marketable Securities and net receivables. receivables.a.a. True Trueb.b. False False
  • 74. 17-74No more ratios, please!
  • 75. 17-75 About Test #1Will be challenging because thematerial covered is challengingAll questions are T/F or M/CQuestions are 5-pt., 3-pt. & 1-pt.No tricks such as patterns in answersOrder of answers is randomCoverage is even over the 4 chaptersTime allowed: 75 minutes
  • 76. 17-76 About Test #1Best way to study Notes first Study guide and/or Hermanson tutorialsCalculators will be providedMust wait outside classroomHave your questions ready for nextactual classSee course home page for office hours