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  1. 1. Managerial Accounting Weygandt • Kieso • Kimmel Financial Statement Analysis: The Big Picture Chapter 14 Prepared by Alice Sineath Forsyth Technical Community College And Ellen Sweat Georgia Perimeter College
  2. 2. Chapter 14 Financial Statement Analysis: The Big Picture <ul><li>After studying Chapter 14, you should be able to: </li></ul><ul><li>Describe and apply horizontal analysis. </li></ul><ul><li>Describe and apply vertical analysis. </li></ul><ul><li>Identify and compute ratios used in analyzing a company’s liquidity, solvency, and profitability. </li></ul><ul><li>Understand the concept of quality of earnings. </li></ul>
  3. 3. Comparative Analysis <ul><li>Any item reported in a financial statement has significance if: </li></ul><ul><ul><li>Its inclusion indicates that the item exists at a given time and in a certain quantity. </li></ul></ul><ul><li>For example, when Kellogg Company reports $136.4 million on its balance sheet as cash, we know that Kellogg did have cash and that the quantity was $136.4 million. </li></ul>
  4. 4. <ul><li>Whether the amount represents an increase over prior years, or whether it is adequate in relation to the company's needs, cannot be determined from the amount alone. </li></ul><ul><li>The amount must be compared with other financial data to provide more information. </li></ul>Comparative Analysis
  5. 5. <ul><li>There are three types of comparisons to provide decision usefulness of financial information: </li></ul><ul><li>Intracompany basis </li></ul><ul><li>Intercompany basis </li></ul><ul><li>Industry averages </li></ul>Comparative Analysis
  6. 6. Intracompany Basis <ul><li>Comparisons within a company are often useful to detect changes in financial relationships and significant trends. </li></ul><ul><li>A comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. </li></ul><ul><li>A comparison of Kellogg's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash. </li></ul>
  7. 7. Intercompany Basis <ul><li>Comparisons with other companies provide insight into a company's competitive position. </li></ul><ul><li>Kellogg's total sales for the year can be compared with the total sales of its competitors such as Quaker Oats and General Mills. </li></ul>
  8. 8. <ul><li>Comparisons with industry averages provide information about a company's relative position within the industry. </li></ul><ul><li>Kellogg's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's. </li></ul>Industry Averages
  9. 9. Financial Statement Analysis <ul><li>Three basic tools are used in financial statement analysis : </li></ul><ul><li>Horizontal analysis </li></ul><ul><li>Vertical analysis </li></ul><ul><li>Ratio analysis </li></ul>
  10. 10. Horizontal Analysis <ul><li>Is a technique for evaluating a series of financial statement data over a period of time. </li></ul><ul><li>Purpose is to determine whether an increase or decrease has taken place. </li></ul><ul><li>The increase or decrease can be expressed as either an amount or a percentage . </li></ul>
  11. 11. Horizontal Analysis
  12. 12. Percentage Change in Sales <ul><li>The percentage change in sales for each of the 5 years, assuming 1997 as the base period is: </li></ul><ul><li>Kellogg Company </li></ul><ul><li>Net Sales (in millions) Base Period 1997 </li></ul><ul><li> 2001 2000 1999 1998 1997 </li></ul><ul><li>$8,853.3 $6,954.7 $6,984.2 $6762.1 $6,830.1 </li></ul><ul><li> 129.62% 101.82 % 102.26% 99% 100.0% </li></ul>
  13. 13. Horizontal Analysis of a Balance Sheet <ul><li>KELLOGG COMPANY, INC. </li></ul><ul><li>Condensed Balance Sheets </li></ul><ul><li>December 31 </li></ul><ul><li>(In millions) </li></ul><ul><li> Increase (Decrease) </li></ul><ul><li>during 2001 </li></ul><ul><li> 2001 2000 Amount Percent </li></ul><ul><li>Assets </li></ul><ul><li>Current Assets $ 1,902.0 $1,617.1 $ 284.9 17.6 </li></ul><ul><li>Plant assets 2,952.8 2,526.9 425.9 16.9 </li></ul><ul><li>Other assets 5,513.8 742.0 4,771.8 643.1 </li></ul><ul><li>Total assets $10,368.6 $4,886.0 $5,482.6 112.2 </li></ul>
  14. 14. Increase (Decrease) during 2001 2001 2000 Amount Percent Liabilities and Stockholders' Equity Current liabilities $ 2,207.6 $2,482.3 $ (274.7) (11.1) Long-term liabilities 7,289.5 1,506.2 5,783.3 384.0 Total liabilities 9,497.1 3,988.5 5,508.6 138.1 Stockholders' equity Common stock 195.3 205.8 (10.5) (5.1) Retained earnings and other 1,013.3 1,065.7 (52.4) (4.9) Treasury stock (337.1 ) (374.0 ) 36.9 9.9 Total stockholders' equity 871.5 897.5 (26.0 ) (2.9) Total liabilities and stockholders' equity $10,368.6 $4,886.0 $5,482.6 112.2 Horizontal Analysis of a Balance Sheet
  15. 15. KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) Increase (Decrease) during 2001 2001 2000 Amount Percent Net sales $ 8,853.3 $6,954.7 $1,898.6 27.3 Cost of goods sold 4,128.5 3,327.0 801.5 24.1 Gross profit 4,724.8 3,627.7 1,097.1 30.2 Selling & Admin. 3,523.6 2,551.4 972.2 38.1 Nonrecurring charges 33.3 86.5 (53.2 ) (61.5) Income from operations 1,167.9 989.8 178.1 18.0 Interest expense 351.5 137.5 214.0 155.6 Other income (expense), net (12.3 ) 15.4 (27.7 ) (179.9) Income before taxes 804.1 867.7 (63.6) (7.3) Income tax expense 322.1 280.0 42.1 15.0 Net income $ 482.0 $ 587.7 $ (105.7) (18.0)
  16. 16. Let’s Review In horizontal analysis, each item is expressed as a percentage of the: a. net income amount. d. base-year amount. c. total assets amount. b. stockholders’ equity amount.
  17. 17. Let’s Review In horizontal analysis, each item is expressed as a percentage of the: a. net income amount. d. base-year amount. c. total assets amount. b. stockholders’ equity amount.
  18. 18. Vertical Analysis <ul><li>Is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount. </li></ul><ul><li>Total assets is always the base amount in vertical analysis of a balance sheet. </li></ul><ul><li>Net sales is always the base amount in vertical analysis of an income statement. </li></ul>
  19. 19. <ul><li>KELLOGG COMPANY, INC. </li></ul><ul><li>Condensed Balance Sheets </li></ul><ul><li>December 31 </li></ul><ul><li>(In millions) </li></ul><ul><li>2001 2000 z </li></ul><ul><li>Assets Amount Percent Amount Percent </li></ul><ul><li>Current Assets $ 1,902.0 18.3 $1,617.1 33.1 </li></ul><ul><li>Property Assets 2,952.8 28.5 2,526.9 51.7 </li></ul><ul><li>Other assets 5,513.8 53.2 742.0 15.2 </li></ul><ul><li>Total assets $10,368.6 100.0% $4,886.0 100.0% </li></ul>
  20. 20. <ul><li> 2001 2000 </li></ul><ul><li>Liabilities and Amount Percent* Amount Percent* </li></ul><ul><li>Stockholders' Equity </li></ul><ul><li>Current liabilities $ 2,207.6 21.3 $2,482.3 50.8 </li></ul><ul><li>Long-term liabilities 7,289.5 70.3 1,506.2 30.8 </li></ul><ul><li>Total liabilities 9,497.1 91.6 3,988.5 81.6 </li></ul><ul><li>Stockholders' equity </li></ul><ul><li>Common stock 195.3 1.9 205.8 4.2 </li></ul><ul><li>Retained earnings </li></ul><ul><li>and other 1,013.3 9.8 1,065.7 21.8 </li></ul><ul><li>Treasury stock (337.1 ) (3.3 ) (374.0 ) (7.6 ) </li></ul><ul><li>Total stockholders' </li></ul><ul><li>equity 871.5 8.4 897. 5 18.4 </li></ul><ul><li>Total liabilities and </li></ul><ul><li>stockholders' equity $10,368.6 100.0 $4,886.0 100.0 </li></ul><ul><li>*Percentages may be rounded up or down </li></ul>KELLOGG COMPANY, INC . Condensed Balance Sheets December 31 (In millions)
  21. 21. KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) 2001 2000 Amount Percent* Amount Percent* Net sales $8,853.3 100.0 $6,954.7 100.0 Cost of goods sold 4,128.5 46.6 3,327.0 47.8 Gross profit 4,724.8 53.4 3,627.7 52.2 Selling & admin. 3,523.6 39.8 2,551.4 36.7 Nonrecurring chgs. 33.3 0.4 86.5 1.3 Income operations 1,167.9 13.2 989.8 14.2 Interest expense 351.5 4.0 137.5 2.0 Other income (expense),net (12.3 ) (0.1 ) 15.4 0.2 Income before income taxes 804.1 9.1 867.7 12.4 Income tax ex. 322.1 3.6 280.0 4.0 Net income $ 482.0 5.5 $ 587.7 8.4 *Percentages may be rounded up or down
  22. 22. Condensed Income Statements For the Year Ended December 31, 2001 (in millions) <ul><li>Kellogg Company, Inc. General Mills,Inc </li></ul><ul><li> Amount Percent* Amount Percent* </li></ul><ul><li>Net sales $8,853.3 100.0 $7,949.0 100.0 </li></ul><ul><li>Cost of goods sold 4,128.5 46.6 4,767.0 60.0 </li></ul><ul><li>Gross profit 4,724.8 53.4 3,182.0 40.0 </li></ul><ul><li>Selling and administrative </li></ul><ul><li>expenses 3,523.6 39.8 1,909.0 24.0 </li></ul><ul><li>Nonrecurring charges 33.3 0.4 190.0 2.4 </li></ul><ul><li>Income from operations 1,167.9 13.2 1,083.0 13.6 </li></ul><ul><li>Other expenses and </li></ul><ul><li>revenues (including </li></ul><ul><li>income taxes) 685.9 7.7 622.0 7.8 </li></ul><ul><li>Net income $ 482.0 5.5 $ 461.0 5.8 </li></ul><ul><li>*Percentages may be rounded up or down </li></ul>
  23. 23. Ratio Analysis
  24. 24. Ratios <ul><li>Three types: </li></ul><ul><ul><ul><li>Liquidity ratios </li></ul></ul></ul><ul><ul><ul><li>Solvency ratios </li></ul></ul></ul><ul><ul><ul><li>Profitability ratios </li></ul></ul></ul><ul><li>Can provide clues to underlying conditions that may not be apparent from an inspection of the individual components. </li></ul><ul><li>Single ratio by itself is not very meaningful. </li></ul>
  25. 25. Liquidity Ratios <ul><li>Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. </li></ul><ul><li>WHO CARES? </li></ul><ul><li>Short-term creditors such as bankers and suppliers </li></ul>
  26. 26. <ul><li>Working capital </li></ul><ul><li>Current ratio </li></ul><ul><li>Current cash debt coverage ratio </li></ul><ul><li>Inventory turnover ratio </li></ul><ul><li>Days in inventory </li></ul><ul><li>Receivables turnover ratio </li></ul><ul><li>Average collection period </li></ul>Liquidity Ratios
  27. 27. Working Capital <ul><li>Indicates immediate short-term debt-paying ability </li></ul>Current Assets - Current Liabilities
  28. 28. Current Ratio <ul><li>Indicates short-term debt-paying ability </li></ul>Current Assets Current Liabilities
  29. 29. Current Cash Debt Coverage Ratio <ul><li>Indicates short-term debt-paying ability (cash basis) </li></ul><ul><li>Cash provided by operations Average current liabilities </li></ul>
  30. 30. Inventory Turnover Ratio Indicates liquidity of inventory Cost of Goods Sold Average Inventory
  31. 31. <ul><ul><ul><li>Indicates liquidity of inventory and inventory management </li></ul></ul></ul><ul><ul><ul><li>365 days </li></ul></ul></ul><ul><ul><ul><li>Inventory Turnover Ratio </li></ul></ul></ul>Days in Inventory
  32. 32. Receivables Turnover Ratio <ul><li>Indicates liquidity of receivables </li></ul><ul><li>Net Credit Sales </li></ul><ul><li>Average Gross Receivables </li></ul>
  33. 33. Average Collection Period <ul><li>Indicates liquidity of receivables and collection success. </li></ul><ul><li>365 days </li></ul><ul><li>Receivables Turnover Ratio </li></ul>
  34. 34. Solvency Ratios <ul><li>Measure the ability of the enterprise to survive over a long period of time </li></ul><ul><li>WHO CARES? </li></ul><ul><li>Long-term creditors and stockholders </li></ul>
  35. 35. <ul><li>Debt to total assets ratio </li></ul><ul><li>Cash debt coverage ratio </li></ul><ul><li>Times interest earned ratio </li></ul><ul><li>Free cash flow </li></ul>Solvency Ratios
  36. 36. Debt to Total Assets Ratio <ul><li>Indicates % of total assets provided by creditors </li></ul>Total Liabilities Total Assets
  37. 37. Cash Debt Coverage Ratio <ul><li>Indicates long-term debt-paying ability (cash basis) </li></ul><ul><li>Cash provided by operations </li></ul><ul><li>Average total liabilities </li></ul>
  38. 38. Times Interest Earned Ratio <ul><li>Indicates company’s ability to meet interest payments as they come due </li></ul>Net Income Before Interest Expense & Income Tax Interest Expense
  39. 39. <ul><ul><li>Indicates cash available for paying dividends or expanding operations </li></ul></ul><ul><ul><li> Cash Provided By Operations </li></ul></ul><ul><ul><li> - Capital Expenditures </li></ul></ul><ul><ul><li> - Dividends Paid </li></ul></ul><ul><ul><li> Free Cash Flow </li></ul></ul>Free Cash Flow
  40. 40. Profitability Ratios <ul><li>Measure the income or operating success of an enterprise for a given period of time </li></ul><ul><li>WHO CARES? Everybody </li></ul><ul><li>WHY? A company’s income affects: </li></ul><ul><li>its ability to obtain debt and equity financing </li></ul><ul><li>its liquidity position </li></ul><ul><li>its ability to grow </li></ul><ul><li> </li></ul>
  41. 41. <ul><li>Earnings per share (EPS) </li></ul><ul><li>Price-earnings ratio </li></ul><ul><li>Gross profit rate </li></ul><ul><li>Profit margin ratio </li></ul><ul><li>Return on assets ratio </li></ul><ul><li>Assets turnover ratio </li></ul><ul><li>Payout ratio </li></ul><ul><li>Return on common stockholders’ equity ratio </li></ul>Profitability Ratios
  42. 42. Earnings Per Share (EPS) <ul><li>Indicates net income earned on each share of common stock sales </li></ul>Net Income - Preferred Stock Average common shares outstanding
  43. 43. Price Earnings Ratio <ul><li>Indicates relationship between market price per share and earnings per share </li></ul>Stock Price Per Share Earnings Per Share
  44. 44. Gross Profit Rate <ul><li>Indicates margin between selling price and cost of good sold </li></ul><ul><li>Gross profit </li></ul><ul><li>Net sales </li></ul>
  45. 45. Profit Margin Ratio <ul><li>Indicates net income generated by each dollar of sales </li></ul>Higher value suggests favorable return on each dollar of sales. Net income Net sales
  46. 46. Return On Assets Ratio <ul><li>Reveals the amount of net income generated by each dollar invested </li></ul>Net income Average total assets Higher value suggests favorable efficiency.
  47. 47. Asset Turnover Ratio <ul><li>Indicates how efficiently assets are used to generate sales </li></ul><ul><li>Net sales </li></ul><ul><li>Average total assets </li></ul>
  48. 48. Payout Ratio <ul><li>Indicates % of earnings distributed in the form of cash dividends </li></ul><ul><li>Cash dividends decl. on common stock </li></ul><ul><li>Net income </li></ul>
  49. 49. Return on Common Stockholders’ Equity Ratio <ul><ul><li>Indicates profitability of common stockholders’ investment </li></ul></ul><ul><ul><li>Net income - preferred stock dividends </li></ul></ul><ul><ul><li>Average common stockholders’ equity </li></ul></ul>
  50. 50. Limitations Of Financial Analysis <ul><li>Horizontal, vertical, and ratio analysis are frequently used in making significant business decisions. </li></ul><ul><li>One should be aware of the limitations of these tools and the financial statements. </li></ul>
  51. 51. Alternative Accounting Methods <ul><li>One company may use the FIFO method, while another company in the same industry may use LIFO. </li></ul><ul><li>If the inventory is significant for both companies, it is unlikely that their current ratios are comparable. </li></ul><ul><li>In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization. </li></ul>
  52. 52. Quality of Earnings <ul><li>Indicates the level of full and transparent information that is provided to users of the financial statements . </li></ul>
  53. 53. Pro Forma Income <ul><li>A measure of the net income generated that usually excludes items that the company thinks are unusual or nonrecurring. </li></ul>
  54. 54. Relationships among Profitability Measures
  55. 55. Let’s Review In vertical analysis, the base amount for depreciation expense is generally: a. net sales. d. fixed assets. c. gross profit. b. depreciation expense in a previous year.
  56. 56. Let’s Review In vertical analysis, the base amount for depreciation expense is generally: a. net sales. d. fixed assets. c. gross profit. b. depreciation expense in a previous year.
  57. 57. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that named in Section 117 of the United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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