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1. 1. Financial Statement Analysis Chapter 18
2. 2. The Annual Report Usually Contains ... <ul><li>financial statements. </li></ul><ul><li>notes to the financial statements. </li></ul><ul><li>a summary of accounting methods used. </li></ul><ul><li>management discussion and analysis of the financial statements. </li></ul><ul><li>an auditor’s report. </li></ul><ul><li>comparative financial data for 5 to 10 years. </li></ul>
3. 3. Objective 1 <ul><li>Perform a horizontal analysis </li></ul><ul><li>of financial statements. </li></ul>
4. 4. Horizontal Analysis Increase/(Decrease) 2002 2001 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%
5. 5. Horizontal Analysis 2002 2001 Difference Sales \$41,500 \$37,850 \$3,650 \$3,650 ÷ \$37,850 = .0964, or 9.6%
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 2000 1999 1998 </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>1998 is the base year. </li></ul>Trend Percentages What are the trend percentages?
8. 8. <ul><li>Year 2000 1999 1998 </li></ul><ul><li>Revenues 127% 111% 100% </li></ul><ul><li>Cost of sales 117% 113% 100% </li></ul><ul><li>Gross profit 142% 110% 100% </li></ul>Trend Percentages These percentages were calculated by dividing each item by the base year.
9. 9. Objective 2 <ul><li>Perform a vertical analysis </li></ul><ul><li>of financial statements. </li></ul>
10. 10. 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>
11. 11. Vertical Analysis 1999 % 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
12. 12. Vertical Analysis Assets 1999 % 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
13. 13. Objective 3 <ul><li>Prepare common-size </li></ul><ul><li>financial statements. </li></ul>
14. 14. 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>
15. 15. Benchmarking Percent of Net Sales MCI Lucent Technologies  Cost of goods sold  Operating expenses  Income tax  Net income
16. 16. Objective 4 <ul><li>Compute the standard </li></ul><ul><li>financial ratios. </li></ul>
17. 17. 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>
18. 18. Palisades Furniture Example Net sales ( Year 2002 ) \$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
19. 19. Palisades Furniture Example Assets 20x2 20x1 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
20. 20. Palisades Furniture Example Liabilities 20x2 20x1 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
21. 21. Palisades Furniture Example Stockholders’ Equity 20x2 20x1 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
22. 22. 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.
23. 23. Measuring Ability to Pay Current Liabilities <ul><li>Palisades’ current ratio: </li></ul><ul><li>20x1: \$236,000 ÷ \$126,000 = 1.87 </li></ul><ul><li>20x2: \$262,000 ÷ \$142,000 = 1.85 </li></ul><ul><li>The industry average is 1.80. </li></ul><ul><li>The current ratio decreased slightly during 20x2. </li></ul>
24. 24. 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.
25. 25. Measuring Ability to Pay Current Liabilities <ul><li>Palisades’ acid-test ratio: </li></ul><ul><li>20x1: (\$32,000 + \$85,000) ÷ \$126,000 = .93 </li></ul><ul><li>20x2: (\$29,000 + \$114,000) ÷ \$142,000 = 1.01 </li></ul><ul><li>The industry average is .60. </li></ul><ul><li>The company’s acid-test ratio improved considerably during 20x2. </li></ul>
26. 26. 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.
27. 27. Measuring Ability to Sell Inventory <ul><li>Palisades’ inventory turnover: </li></ul><ul><li>20x2: \$513,000 ÷ \$112,000 = 4.58 </li></ul><ul><li>The industry average is 2.70. </li></ul><ul><li>A high number indicates an ability to quickly sell inventory. </li></ul>
28. 28. 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.
29. 29. Measuring Ability to Collect Receivables <ul><li>Palisades’ accounts receivable turnover: </li></ul><ul><li>20x2: \$858,000 ÷ \$99,500 = 8.62 times </li></ul><ul><li>The industry average is 22.2 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>
30. 30. 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.
31. 31. Measuring Ability to Collect Receivables <ul><li>Palisades’ days’ sales in Accounts Receivable for 20x2: </li></ul><ul><li>One day’s sales: </li></ul><ul><li>\$858,000 ÷ 365 = \$2,351 </li></ul><ul><li>Days’ sales in Accounts Receivable: </li></ul><ul><li>\$99,500 ÷ \$2,351 = 42 days </li></ul><ul><li>The industry average is 16 days. </li></ul>
32. 32. Measuring Ability to Pay Debt Total liabilities ÷ Total assets The debt ratio indicates the proportion of assets financed with debt.
33. 33. Measuring Ability to Pay Debt <ul><li>Palisades’ debt ratio: </li></ul><ul><li>20x1: \$324,000 ÷ \$644,000 = 0.50 </li></ul><ul><li>20x2: \$431,000 ÷ \$787,000 = 0.55 </li></ul><ul><li>The industry average is 0.61. </li></ul><ul><li>Palisades Furniture expanded operations during 20x2 by financing through borrowing. </li></ul>
34. 34. 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.
35. 35. Measuring Ability to Pay Debt <ul><li>Palisades’ times-interest-earned ratio: </li></ul><ul><li>20x1: \$ 57,000 ÷ \$14,000 = 4.07 </li></ul><ul><li>20x2: \$101,000 ÷ \$24,000 = 4.21 </li></ul><ul><li>The industry average is 2.00. </li></ul><ul><li>The company’s times-interest-earned ratio increased in 20x2. </li></ul><ul><li>This is a favorable sign. </li></ul>
36. 36. 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.
37. 37. Measuring Profitability <ul><li>Palisades’ rate of return on sales: </li></ul><ul><li>20x1: \$26,000 ÷ \$803,000 = 0.032 </li></ul><ul><li>20x2: \$48,000 ÷ \$858,000 = 0.056 </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>
38. 38. 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.
39. 39. Measuring Profitability <ul><li>Palisades’ rate of return on total assets for 20x2: </li></ul><ul><li>(\$48,000 + \$24,000) ÷ \$715,500 = 0.101 </li></ul><ul><li>The industry average is 0.049. </li></ul><ul><li>How does Palisades compare to the industry? </li></ul><ul><li>Very favorably. </li></ul>
40. 40. 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.
41. 41. Measuring Profitability <ul><li>Palisades’ rate of return on common stockholders’ equity for 20x2: </li></ul><ul><li>(\$48,000 – \$0) ÷ \$338,000 = 0.142 </li></ul><ul><li>The industry average is 0.093. </li></ul><ul><li>Why is this ratio larger than the return on total assets (.101)? </li></ul><ul><li>Because Palisades uses leverage. </li></ul>
42. 42. Measuring Profitability Earnings per share of common stock = (Net income – Preferred dividends) ÷ Number of shares of common stock outstanding
43. 43. Measuring Profitability <ul><li>Palisades’ earnings per share: </li></ul><ul><li>20x1: (\$26,000 – \$0) ÷ 10,000 = \$2.60 </li></ul><ul><li>20x2: (\$48,000 – \$0) ÷ 10,000 = \$4.80 </li></ul><ul><li>This large increase in EPS is considered very unusual. </li></ul>
44. 44. 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>20x1: \$35 ÷ \$2.60 = 13.5 </li></ul><ul><li>20x2: \$50 ÷ \$4.80 = 10.4 </li></ul><ul><li>Given Palisades Furniture’s 20x2 P/E ratio of 10.4, we would say that the company’s stock is selling at 10.4 times earnings. </li></ul>
45. 45. 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.
46. 46. Analyzing Stock as an Investment <ul><li>Dividend yield on Palisades’ common stock: </li></ul><ul><li>20x1: \$1.00 ÷ \$35.00 = .029 (2.9%) </li></ul><ul><li>20x2: \$1.20 ÷ \$50.00 = .024 (2.4%) </li></ul><ul><li>An investor who buys Palisades Furniture common stock for \$50 can expect to receive 2.4% of the investment annually in the form of cash dividends. </li></ul>
47. 47. Analyzing Stock as an Investment Book value per share of common stock = (Total stockholders’ equity – Preferred equity) ÷ Number of shares of common stock outstanding
48. 48. Analyzing Stock as an Investment <ul><li>Book value per share of palisades’ common stock: </li></ul><ul><li>20x1: (\$320,000 – \$0) ÷ 10,000 = \$32.00 </li></ul><ul><li>20x2: (\$356,000 – \$0) ÷ 10,000 = \$35.60 </li></ul><ul><li>Book value bears no relationship to market value. </li></ul>
49. 49. Objective 5 <ul><li>Use ratios in decision making. </li></ul>
50. 50. 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>
51. 51. Objective 6 <ul><li>Measure economic value added. </li></ul>
52. 52. 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>
53. 53. End of Chapter 18