FINANCIAL STATEMENT ANALYSIS

         Financial statement analysis is the use of historical data to evaluate a
firm's per...
Ratio
                                 Computation
Working capital
                                 Current assets – curre...
Prepaid selling expenses                        15
Sales                                                                  ...
Example #2

Shown below are various business transactions, followed by a financial ratio. Indicate the effect each
transac...
other things, the bank stated that the company’s 2 to 1 current ratio was
     not adequate. Give reasons why a 2 to 1 cur...
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Ratio

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Ratio

  1. 1. FINANCIAL STATEMENT ANALYSIS Financial statement analysis is the use of historical data to evaluate a firm's performance. Financial statement analysis includes both intra-firm and inter-firm analysis. Most of the items in the statements are of limited significance when considered individually; however, their usefulness is enhanced when they are compared to other items: within a single year’s statements in a succession of financial statements with other companies’ statements. Financial statement analysis methods are used to judge present performance and predict future results. However, they are not definitive guides. Instead, they are a starting point in evaluating a firm's financial position, and must be used in conjunction with good judgment and decision - making experience. HORIZONTAL ANALYSIS (Trend Analysis) measures the dollar amount and percentage change in each financial statement item from a previous year trend analysis measures changes over period of several years used primarily in intra-company comparisons VERTICAL ANALYSIS (COMMON SIZE STATEMENTS) shows how each item in a financial statement compares to the statement total income statement - each item is shown as a percentage of sales balance sheet - each item is shown as a percentage of total assets RATIO ANALYSIS shows relationship between financial statement items used to evaluate short-term liquidity, long-term solvency, profitability, and market performance a firm’s ratios can be measured against its own past performance, industry standards, or a specific competitor
  2. 2. Ratio Computation Working capital Current assets – current Used for liabilities Measures ability to pay Current ratio current debts with current Current assets assets Current liabilities Acid-test (quick) ratio Measures ability to pay Cash + Mkt sec + A/R current debt Current liabilities Accounts receivable Measures very short term turnover Net credit sales debt paying ability Average accounts rec Measures efficiency in Avg days to collect collecting receivables and receivables 365 days managing credit A/R turnover Measures efficiency in Inventory turnover collecting receivables and Cost of goods sold managing credit Average inventory Measures efficiency in Solvency ratios management of inventory; the number of times a Debt-to-Equity ratio company sells its inventory Total debt Stockholders’ equity # Times interest earned Indicates percentage of Net Inc + int exp + inc tax assets financed with debt Interest expense Profitability measures Measures # of times income can cover interest Return on total assets expense Net income + interest exp Average total assets Return on common Measures how profitably a stockholders’ equity Net income – pfd div company uses its assets Avg common stk equity Shows how much income Earnings per share is earned with the money of common stock Net income – pfd div invested by stockholders Avg shares of com stock Outstanding Gives the amount of net Price-earnings ratio income for one share of Market price per share common stock Earnings per share Return on investment Indicates the market price Income of $1 of earnings Investment Residual income Income – (inv x min return %) Kellerman Company For the year ended December 31, 2000 Income Statement
  3. 3. Prepaid selling expenses 15 Sales 12 $ 1,450 Total current assets 328 Cost of goods sold 367 835 Gross profit Land 150 615 120 Selling and administrative exp $ 510 Equipment 125 Depreciation exp, bldg 15 150 Depreciation exp, equip 22 Accumulated depr, equip (85) Amortization exp, patent 3 (75) Interest expense 32 Buildings 280 582 200 Accumulated depr, bldgs (85) 33 (70) Gain on sale of equipment Patents 24 7 27 Income before income tax Total assets $ 737 40 719 Income tax expense 20 Liabilities Net income Accounts payable $ 88 $ 20 $ 120 Notes payable 160 90 Taxes payable 60 Kellerman Company 70 Statement of Retained Earnings Total current liabilities 308 For the year ended December 31, 2000 280 Bonds payable 100 Retained earnings, January 1 150 $ 59 Total liabilities 408 Net income 430 20 Dividends Stockholders' equity (10) Common stock, $10 par value 210 Retained earnings, December 31 180 $ 69 Additional paid in capital 50 50 Retained earnings 69 59 Total liabilities and stk equity $ 737 $ 719 Additional information: 1. On Jan 2, 2000, 3,000 shares of common stock were issued for land with a fair market value of $30,000. 2. Equipment with a cost of $25,000 and accumulated depreciation of $12,000 was sold at a gain of $7,000. 3. A building was purchased for cash. 4. Bonds were retired at no gain or loss. Kellerman Company Comparative Balance Sheets December 31, 2000 and 1999 2000 1999 Assets Cash $ 59 $ 87 Marketable securities 9 9 Accounts receivable 180 214 Inventory 65 45
  4. 4. Example #2 Shown below are various business transactions, followed by a financial ratio. Indicate the effect each transaction would have on the ratio (increase, decrease, or no effect). In each case, assume that the current assets exceed current liabilities both before and after the transaction. 1. Inventory was sold for cash at a profit Debt-to-equity _______________ 2. Land was purchased for cash Earnings per share _______________ 3. The company paid on accounts payable Working capital _______________ 4. The company sold inventory Acid test ratio _______________ 5. The company declared, but did not pay, a cash dividend Current ratio _______________ 6. A previously declared cash dividend was paid Current ratio _______________ 7. Obsolete inventory was written off at a loss Inventory turnover _______________ 8. The company’s income decreased, but long term debt remained unchanged Times interest earned _______________ 9. Inventory was purchased on credit Current ratio _______________ 10. The company’s common stock price increased, but earnings per share remained unchanged Price-earnings ratio _______________ Review 1. In financial statement analysis, why are ratios used rather than simply using raw data? What dangers are there in the use of ratios? 2. What is the basic objective in looking at trends? 3. A company seeking a line of credit at a bank was turned down. Among
  5. 5. other things, the bank stated that the company’s 2 to 1 current ratio was not adequate. Give reasons why a 2 to 1 current ratio might not be adequate. 4. How do accounting principles affect financial statement analysis? 5. What are some of the limitations of financial statement analysis?

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