Chapter 13

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Chapter 13

  1. 1. Chapter 13 Financial Statement Analysis <ul><li>Using Financial Accounting Information: </li></ul><ul><li>The Alternative to Debits and Credits, 6th </li></ul><ul><li>by </li></ul><ul><li>Gary A. Porter and Curtis L. Norton </li></ul>Copyright © 2009 South-Western, a part of Cengage Learning.
  2. 2. Financial Statement Analysis Stockholders Creditors Management Will I be paid? How good is our investment? How are we performing?
  3. 3. Limitations of Financial Statement Analysis <ul><li>Use of different accounting methods </li></ul><ul><li>Changes in accounting methods </li></ul>LIFO FIFO
  4. 4. Limitations of Financial Statement Analysis <ul><li>Failure to understand trends or use industry ratios </li></ul><ul><li>Difficulty of making industry comparisons (i.e., conglomerates) </li></ul>????
  5. 5. Limitations of Financial Statement Analysis <ul><li>Nonoperating items on income statement </li></ul><ul><li>Effects of inflation </li></ul>=
  6. 6. Horizontal Analysis <ul><li>Net Sales </li></ul><ul><li>Gross Profit </li></ul><ul><li>Net Earnings </li></ul><ul><li>Increase (Decrease) </li></ul><ul><li>2002 2001 Dollars Percent </li></ul><ul><li>$2,746 $2,401 $345 14.4 % </li></ul><ul><li>1,596 1,404 192 13.7 </li></ul><ul><li> 402 363 39 10.7 </li></ul>Wm. Wrigley Jr. Company (in millions)
  7. 7. Trend Analysis <ul><li>Return on </li></ul><ul><li>Avg. Equity </li></ul><ul><li>2002 2001 2000 1999 1998 </li></ul><ul><li>28.7% 30.1% 29.0% 26.8% 28.4% </li></ul>Wm. Wrigley Jr. Company Tracking items over a series of years
  8. 8. Vertical Analysis <ul><li>Common-size statements recast items as a percentage of a selected item </li></ul><ul><li>Allows comparisons of companies of different size </li></ul><ul><li>Compares percentages across years to identify trends </li></ul>% % %
  9. 9. Common-Size Statements <ul><li>Sales revenue </li></ul><ul><li>Cost of goods sold </li></ul><ul><li>Gross profit </li></ul><ul><li>Selling & admin. exp. </li></ul><ul><li>Operating income </li></ul><ul><li>Interest expense </li></ul><ul><li>Income before tax </li></ul><ul><li>Income tax expense </li></ul><ul><li>Net income </li></ul>Dollars Percent $24,000 100.0% 18,000 75.0 $ 6,000 25.0% 3,000 12.5 $ 3,000 12.5% 140 0.6 $ 2,860 11.9% 1,140 4.8 $ 1,720 7.1%
  10. 10. Liquidity Analysis <ul><li>Nearness to cash </li></ul><ul><li>Ability to pay debts as they become due </li></ul>Cash Ratios Turnover Ratios Working Capital Ratios
  11. 11. Current Ratio <ul><li>Measure of short-term financial health </li></ul><ul><li>Consider composition of current assets </li></ul>Rule of thumb 2:1
  12. 12. Acid-Test (Quick) Ratio <ul><li>Stricter test of ability to pay debts </li></ul><ul><li>Excludes inventories and prepaid assets </li></ul>Quick Assets Current Liabilities
  13. 13. Accounts Receivable Turnover Ratio <ul><li>Net Sales </li></ul><ul><li>Average Accounts Receivable </li></ul>Indicates how quickly a company is collecting (i.e., turning over) its receivables
  14. 14. Accounts Receivable Turnover Ratio <ul><li>Too fast </li></ul><ul><li>Credit policies too stringent; may be losing sales </li></ul><ul><li>Too slow </li></ul><ul><li>Credit department not operating effectively; possible quality problems </li></ul>
  15. 15. Number of Days’ Sales in Receivables Represents the average # of days accounts are outstanding 365 Days . Accts. Receivable Turnover *Some analysts use 360 days.
  16. 16. Number of Days’ Sales in Receivables <ul><li>If this company’s credit terms are net 30, what would this tell you about the efficiency of the collection process? </li></ul>365 Days 4.8 Times = 76 days Example:
  17. 17. Inventory Turnover Ratio Represents the number of times per period inventory is turned over (i.e., sold). Cost of Goods Sold Average Inventory
  18. 18. Inventory Turnover Ratio <ul><li>Circuit City 5.8 times per year </li></ul><ul><li>Safeway 9.2 times per year </li></ul><ul><li>Can you compare the two ratios? </li></ul>
  19. 19. # of Days’ Sales in Inventory Represents the average # of days inventory is on hand before it’s sold 365 Days Inventory Turnover Ratio 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27
  20. 20. # of Days’ Sales in Inventory <ul><li>Circuit City 62 days </li></ul><ul><li>Safeway 39 days </li></ul><ul><li>Do these averages seem reasonable? </li></ul>1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27
  21. 21. Solvency Analysis <ul><li>Ability to stay in business over the long-term </li></ul>Debt-to-Equity Ratio Debt Service Coverage Times Interest Earned Cash Flow to Capital Expenditures
  22. 22. Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed compared to owners?
  23. 23. Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity = .60 For every dollar contributed by owners, creditors have loaned $.60
  24. 24. Times Interest Earned Ratio <ul><li>Measures ability to meet current interest payments </li></ul><ul><li>The greater the coverage the better </li></ul>Net Income + Interest Exp. + Income Tax Exp. (EBIT) Interest Expense
  25. 25. Profitability Analysis <ul><li>Profit Margin % </li></ul><ul><li>Gross Margin % </li></ul><ul><li>Rate of Return on Assets </li></ul><ul><li>Return on Common S/E </li></ul><ul><li>EPS </li></ul><ul><li>P/E Ratio </li></ul><ul><li>Dividend Ratios </li></ul>
  26. 26. Profit Margin % <ul><li>Net Income/Net Sales </li></ul><ul><li>Shows how much profit is being earned per dollar of sales </li></ul>
  27. 27. Gross Margin % <ul><li>Gross Margin/Net Sales </li></ul><ul><li>(Gross Margin = Net Sales – COGS) </li></ul><ul><li>Shows the mark up % on goods sold </li></ul>
  28. 28. Return on Assets Ratio <ul><li>Measures return to all providers of capital (creditors and owners) </li></ul>Net Income Average Total Assets
  29. 29. Return on Common Stockholders’ Equity Net Income - Preferred Dividends Average Common Stockholders’ Equity The owners earned 15% on their investment in ABC Co... Not bad!
  30. 30. Earnings per Share <ul><li>Presents profits on a per-share basis </li></ul>Net Income - Preferred Dividends Weighted Avg. # of Common Shares Outstanding Certificate of Stock
  31. 31. Price/Earnings Ratio <ul><li>Relates earnings to the market price of the stock </li></ul>Current Market Price Earnings per Share very high P/E very low P/E possibly overvalued possibly undervalued
  32. 32. Dividend Payout Ratio Common Dividends per Share Earnings per Share We need to decide what % of the firm’s income we can return to owners.
  33. 33. Appendix <ul><li>Accounting Tools: </li></ul><ul><li>Non-Operating Income Statement Items (DEC) </li></ul>
  34. 34. Common Characteristics <ul><li>All such items are reported after income from continuing operations </li></ul><ul><li>Shown net of tax effects </li></ul><ul><li>Most analysts ignore these items, since they are not likely to reoccur </li></ul>
  35. 35. Discontinued Operations <ul><li>Any gain or loss from disposal of a division or segment of the business </li></ul><ul><li>Any net income or loss from operating this portion until the date of disposal </li></ul>
  36. 36. Extraordinary Items <ul><li>Gain or loss due to an event that is </li></ul><ul><li>Unusual in nature AND </li></ul><ul><li>Infrequent in occurrence </li></ul>
  37. 37. Cumulative Effect of a Change in Accounting Principle <ul><li>Reflects a change in a company’s accounting principles, practices, or methods </li></ul><ul><li>Reports the difference in income in all prior years between the old method and the new method </li></ul><ul><li>Sometimes such a change is dictated by new accounting standards </li></ul>
  38. 38. Key Points Summary for Ch. 13 <ul><li>Why Analyze Financial Information? </li></ul><ul><ul><li>To make decisions – Ratios are tools of decision making </li></ul></ul><ul><li>Limitations of Financial Analysis: </li></ul><ul><ul><li>Different accounting methods </li></ul></ul><ul><ul><li>Difficulty of making comparisons (conglomerates) </li></ul></ul><ul><ul><li>Inflation/Non-operating income items </li></ul></ul>
  39. 39. Key Points Summary for Ch. 13 <ul><li>Horizontal/Trend Analysis: Year-to-year </li></ul><ul><li>Vertical Analysis: Within one year </li></ul><ul><li>Liquidity Analysis: Ability of company to operate in short-term </li></ul><ul><ul><li>Current Ratio = Current Assets/Current Liabilities </li></ul></ul><ul><ul><ul><li>Ability of Co. to pay short-term debt </li></ul></ul></ul><ul><ul><li>Quick Ratio = Quick Assets/Current Liabilities </li></ul></ul><ul><ul><ul><li>Ability of Co. to pay short-term debt (stricter) </li></ul></ul></ul><ul><ul><ul><li>(Quick Assets = Cash + A/R + ST investments) </li></ul></ul></ul>
  40. 40. Key Points Summary for Ch. 13 <ul><li>Liquidity Analysis (cont’d) </li></ul><ul><ul><li>A/R Turnover = Credit Sales/Avg. A/R </li></ul></ul><ul><ul><li># of times Co. collects A/R during year </li></ul></ul><ul><ul><li>Days’ Sales in Receivables = 365/ A/R Turnover </li></ul></ul><ul><ul><ul><li>Avg. collection period for receivables </li></ul></ul></ul><ul><ul><li>Inventory Turnover = COGS/Avg. Inventory </li></ul></ul><ul><ul><ul><li># of times Inventory is sold during year </li></ul></ul></ul><ul><ul><li>Days’ Sales in Inventory = 365/ Inv. Turnover </li></ul></ul><ul><ul><ul><li>Avg. days to sell inventory </li></ul></ul></ul>
  41. 41. Key Points Summary for Ch. 13 <ul><li>Solvency Analysis: Long-term ability of company to stay in business </li></ul><ul><ul><li>Debt-to-Equity Ratio = Total Liab./Total Equity </li></ul></ul><ul><ul><ul><li>Borrowing vs. Investments by owner </li></ul></ul></ul><ul><ul><li>Times Interest Earned = </li></ul></ul><ul><li>Net Income + Interest Exp. + Income Tax Exp. (EBIT) </li></ul><ul><li>Interest Expense </li></ul><ul><ul><ul><li>How many times over could Co. pay interest with current earnings </li></ul></ul></ul>
  42. 42. Key Points Summary for Ch. 13 <ul><li>Profitability Ratios: Ability of company to generate profits </li></ul><ul><ul><li>Profit margin % = Net Income/Net Sales </li></ul></ul><ul><ul><ul><li>How much profit per $1 of sales </li></ul></ul></ul><ul><ul><li>Gross margin % = Gross Margin/Net Sales </li></ul></ul><ul><ul><ul><li>Mark up on product sales </li></ul></ul></ul><ul><ul><li>Return on Assets = Net Income/Avg. Assets </li></ul></ul><ul><ul><ul><li>Effectivess of Company at using assets </li></ul></ul></ul>
  43. 43. Key Points Summary for Ch. 13 <ul><li>Profitability Ratios (cont’d): </li></ul><ul><ul><li>Return on Common Equity = Net Income – Preferred Dividends/Common Stockholders’ Equity </li></ul></ul><ul><ul><ul><li>Measures return on investment </li></ul></ul></ul><ul><ul><li>Earnings Per Share = Net Income/Avg Shares </li></ul></ul><ul><ul><ul><li>Earnings amount per share of stock </li></ul></ul></ul><ul><li>Non-operating Income Statement Items: DEC </li></ul>

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