chapter 1 on design graphics

1. Assessing the Financial
Health of the Firm
Interpreting Financial Statements & Evaluating
Financial Performance

2. 14-2
Results
in standardized,
meaningful
subtotals.
Items with certain
characteristics are
grouped together.
Classified
Financial
Statements
Helps identify
significant
changes and
trends.
Amounts from
several years
appear side by side.
Comparative
Financial
Statements
Presented as if
the two companies
are a single
business unit.
Information for the
parent and subsidiary
are presented.
Consolidated
Financial
Statements
Financial Statements Are
Designed for Analysis

3. 14--3
Milton (Friedman) vs. Edward
(Freeman)
 Milton (Friedman)
◦ The only group that
has a moral claim on
the corporation is
the people who own
shares of the stock
(that is, the
shareholders).
 Edward (Freeman)
◦ Many groups have a
moral claim on the
corporation because
the corporation has
the potential to harm
or benefit them (call
these groups
stakeholders).

4. 14--4
How do Friedman and Freeman differ in
analyzing a case?
 (Milton) Friedman says to
maximize profit a) within
the law and b) without
violating social
standards.
◦ So, in looking at a business
decision (or analyzing a
case), identify relevant laws
and regulations – and also
identify current social
standards and opinions.
◦ Maximize profit without
breaking laws/regulations
AND without “disturbing”
society so much that it
decreases profits.
 (Edward) Freeman says
to a) identify stakeholder
groups and b) make a
decision that “takes them
into account.”
◦ So, in looking at a business
decision (or analyzing a
case), identify all
stakeholder groups.
◦ Identify available options
and determine the effect
they will have on the
stakeholders.
◦ Select and apply an ethical
theory to these options to
determine the best one.

5. 14-5
Dollar &
Percentage
Changes
Trend
Percentages
Component
Percentages
Ratios
Tools of Analysis

6. 13--6

7. 14-7
Dollar and Percentage
Changes
Dollar Change:
Analysis Period
Amount
Base Period
Amount
Dollar
Change = –
Percentage Change:
Dollar Change
Base Period
Amount
Percent
Change = ÷

8. 14-8
Dollar and Percentage
Changes
Sales and earnings
should increase at
more than the rate
of inflation.
In measuring quarterly
changes, compare to
the same quarter in
the previous year.
Percentages may be
misleading when the
base amount is small.
Evaluating Percentage Changes in
Sales and Earnings

9. 14-9
Clover, Inc.
Comparative Balance Sheets
December 31,
2011 2010 Dollar Change
Percent
Change*
Assets
Current assets:
Cash and equivalents 12,000
$ 23,500
$ (11,500)
$ ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000
$ 164,700
$
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000
$ 125,000
$
Total assets 315,000
$ 289,700
$
* Percent rounded to one decimal point.
$12,000 – $23,500 = $(11,500)

10. 14-10
Clover, Inc.
Comparative Balance Sheets
December 31,
2011 2010 Dollar Change
Percent
Change*
Assets
Current assets:
Cash and equivalents 12,000
$ 23,500
$ (11,500)
$ -48.9%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000
$ 164,700
$
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000
$ 125,000
$
Total assets 315,000
$ 289,700
$
* Percent rounded to one decimal point.
($11,500 ÷ $23,500) × 100% = 48.94%
Complete the
analysis for
the other
assets.

11. 14-11
Clover, Inc.
Comparative Balance Sheets
December 31,
2011 2010 Dollar Change
Percent
Change*
Assets
Current assets:
Cash and equivalents 12,000
$ 23,500
$ (11,500)
$ -48.9%
Accounts receivable, net 60,000 40,000 20,000 50.0%
Inventory 80,000 100,000 (20,000) -20.0%
Prepaid expenses 3,000 1,200 1,800 150.0%
Total current assets 155,000
$ 164,700
$ (9,700) -5.9%
Property and equipment:
Land 40,000 40,000 - 0.0%
Buildings and equipment, net 120,000 85,000 35,000 41.2%
Total property and equipment 160,000
$ 125,000
$ 35,000 28.0%
Total assets 315,000
$ 289,700
$ 25,300
$ 8.7%
* Percent rounded to one decimal point.

12. 14-12
Trend Percentages
Trend analysis is used to reveal patterns in
data covering successive periods.
Trend
Percentages
Analysis Period Amount
Base Period Amount
100%
= ×

13. 14-13
Berry Products
Income Information
For the Years Ended December 31,
Item 2011 2010 2009 2008 2007
Revenues 400,000
$ 355,000
$ 320,000
$ 290,000
$ 275,000
$
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000
Item 2011 2010 2009 2008 2007
Revenues 145% 129% 116% 105% 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit 135% 124% 112% 108% 100%
(290,000  275,000)  100% = 105%
(198,000  190,000)  100% = 104%
(92,000  85,000)  100% = 108%
Trend Percentages

14. 14-14
Component Percentages
Examine the relative size of each item in the
financial statements by computing component
(or common-sized) percentages.
Component
Percentage
100%
Analysis Amount
Base Amount
= ×
Financial Statement Base Amount
Balance Sheet Total Assets
Income Statement Revenues

15. 14-15
Clover, inc.
Comparative Balance Sheets
December 31,
Common-size
Percents*
2011 2010 2011 2010
Assets
Current assets:
Cash and equivalents 12,000
$ 23,500
$ 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000
$ 164,700
$
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000
$ 125,000
$
Total assets 315,000
$ 289,700
$ 100.0% 100.0%
* Percent rounded to first decimal point.
Complete the common-size analysis for the other
assets.
($12,000 ÷ $315,000) × 100% = 3.8%
($23,500 ÷ $289,700) × 100% = 8.1%

16. 14-16
Clover, Inc.
Comparative Balance Sheets
December 31,
Common-size
Percents*
2011 2010 2011 2010
Assets
Current assets:
Cash and equivalents 12,000
$ 23,500
$ 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.6%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets 155,000
$ 164,700
$ 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment 160,000
$ 125,000
$ 50.8% 43.1%
Total assets 315,000
$ 289,700
$ 100.0% 100.0%
* Percent rounded to first decimal point.

17. 14-17
Clover, Inc.
Comparative Income Statements
For the Years Ended December 31,
Common-size
Percents*
2011 2010 2011 2010
Revenues 520,000
$ 480,000
$ 100.0% 100.0%
Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes 25,000
$ 32,000
$ 4.8% 6.7%
Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income 17,500
$ 22,400
$ 3.4% 4.7%
Net income per share 0.79
$ 1.01
$
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.

18. 14-18
Quality of Earnings
Investors are interest in companies that
demonstrate an ability to earn income at a
growing rate each year. Stability of earnings
growth helps investors predict future prospects
for the company.
Financial analyst often speak of the “quality of
earnings” at one company being higher than
another company in the same industry.

19. 14-19
Quality of Assets and the
Relative Amount of Debt
While satisfactory earnings may be a
good indicator of a company’s ability to
pay its debts and dividends, we must also
consider the composition of assets, their
condition and liquidity, the timing of
repayment of liabilities, and the total
amount of debt outstanding

20. 14-20
A Classified Balance Sheet
Current assets:
Cash 30,000
$
Notes receivable 16,000
Accounts receivable 60,000
Inventory 70,000
Prepaid expenses 4,000
Total current assets 180,000
Plant and equipment:
Land 150,000
$
Building 121,000
$
Less: Accumulated depreciation (10,000) 111,000
Equipment and Fixtures 46,000
Less: Accumulated depreciation (27,000) 19,000
Total plant and equipment 280,000
Other assets:
Patents 170,000
Total assets 630,000
$
Matrix, Inc.
Asset Section: Classified Balance Sheet
December 31, 2011

21. 14-21
Past performance to
present performance.
Other companies to
your company.
Along with dollar and percentage changes,
trend percentages, and component percentages,
ratios can be used to compare:
A ratio is a simple mathematical expression
of the relationship between one item and another.
Ratios

22. 14-22
Use this information to calculate the liquidity
ratios for Babson Builders.
Babson Builders, Inc.
2011
Cash 30,000
$
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 15,000
Total current assets 65,000
Total current liabilities 42,000
Total liabilities 103,917
Total assets
Beginning of year 300,000
End of year 346,390
Revenues 494,000

23. 14-23
Working capital is the excess of current
assets over current liabilities.
Working Capital
12/31/11
Current assets 65,000
$
Current liabilities (42,000)
Working capital 23,000
$

24. 14-24
Current
Ratio
Current Assets
Current Liabilities
=
= 1.55 : 1
This ratio measures the
short-term debt-paying
ability of the company.
Current Ratio
Current
Ratio
$65,000
$42,000
=

25. 14-25
Quick assets are cash, marketable
securities, and receivables.
This ratio is like the current
ratio but excludes current assets
such as inventories that may be
difficult to quickly convert into cash.
Quick Assets
Current Liabilities
=
Quick
Ratio
Quick Ratio

26. 14-26
Quick Ratio
$50,000
$42,000
= 1.19 : 1
=
Quick
Ratio
Quick Assets
Current Liabilities
=
Quick
Ratio

27. 14-27
Ratios help users
understand
financial relationships.
Ratios provide for
quick comparison
of companies.
Uses
Management may enter
into transactions merely
to improve the ratios.
Ratios do not help with
analysis of the company's
progress toward
nonfinancial goals.
Limitations
Uses and Limitations of
Financial Ratios

28. 14-28
An income statement can be prepared in either a
multiple-step or single-step format.
The single-step format
is simpler. The multiple-step
format provides more detailed
information.
Measures of Profitability

29. 14-29
Babson Builders, Inc.
Income Statement
For the Year Ended 12/31/11
Sales, net 785,250
$
Cost of goods sold 351,800
Gross margin 433,450
$
Operating expenses:
Selling expenses 197,350
$
General & Admin. 78,500
Depreciation 17,500 293,350
Income from Operations 140,100
$
Other revenues & gains:
Interest income 62,187
$
Gain 24,600 86,787
Other expenses:
Interest 27,000
$
Loss 9,000 (36,000)
Income before taxes 190,887
$
Income taxes 62,500
Net income 128,387
$
Proper Heading
Gross Margin
Operating Expenses
Non-operating Items
Remember
to compute
EPS.
Income Statement (Multiple-
Step)

30. 14-30
Babson Builders, Inc.
Income Statement
For the Year Ended 12/31/11
Revenues and gains:
Sales, net 785,250
$
Interest income 62,187
Gain on sale of plant assets 24,600
Total revenues and gains 872,037
$
Expenses and losses:
Cost of goods sold 351,800
$
Selling Expenses 197,350
General and Admin. Exp. 78,500
Depreciation 17,500
Interest 27,000
Income taxes 62,500
Loss: sale of investment 9,000
Total expenses & losses 743,650
Operating income 128,387
$
Proper Heading
Expenses
& Losses
Revenues
& Gains
Income Statement (Single-
Step)
Remember
to compute
EPS.

31. 14-31
Use this information to calculate the
profitability ratios for Babson Builders,
Inc.
Babson Builders, Inc.
2011
Ending market price per share 15.25
$
Number of common shares
outstanding all of 2007 27,400
Net income 53,690
$
Total shareholders' equity
Beginning of year 180,000
End of year 234,390
Revenues 494,000
Cost of sales 140,000
Total assets
Beginning of year 300,000
End of year 346,390

32. 14-32
Earning Per Share
Net Income
Average Shares of Capital Stock Outstanding
= EPS
Look back at the information from Babson and get the
values we need to calculate earning per share.
$53,690
27,400
= $1.96

33. 14-33
Price-Earnings Ratio
Current Market Price of one Share of Stock
Earnings Per Share
= P/E
$15.25
$1.96
= 7.78
The measure shows us the relationship between earning
of the company and the market price of its stock.

34. 14-34
This ratio is a good measure of
the efficiency of utilization of
assets by the business.
Return On Investment (ROI)
Annual return (profit) from and investment
Average amount invested
ROI =

35. 14-35
ROA =
Operating
Income
÷ Average total assets
= 53,690
$ ÷ ($300,000 + $346,390) ÷ 2
= 16.61%
This ratio is generally considered
the best overall measure of a
company’s profitability.
Return On Assets (ROA)
ROA =
Operating
Income
÷ Average total assets
= 53,690
$ ÷ ($300,000 + $346,390) ÷ 2
= 16.61%

36. 14-36
ROA = Net income ÷ Average total equity
= 53,690
$ ÷ ($180,000 + $234,390) ÷ 2
= 25.91%
This measure indicates how well the
company employed the owners’
investments to earn income.
Return On Equity (ROE)

37. 14-37
Dividend Yield
This ratio identifies the return, in
terms of cash dividends, on the
current market price of the stock.
Dividend
Yield Ratio
Dividends Per Share
Market Price Per Share
=
Babson Builders pays an annual dividend of
$1.50 per share of capital stock. The market
price of the company’s capital stock was
$15.25 at the end of 2011.

38. 14-38
Dividend
Yield Ratio
$1.50
$15.25
= = 9.84%
Dividend Yield
This ratio identifies the return, in
terms of cash dividends, on the
current market price of the stock.
Dividend
Yield Ratio
Dividends Per Share
Market Price Per Share
=

39. 14-39
Analysis by Long-Term
Creditors
Use this information to calculate ratios to
measure the well-being of the long-term
creditors for Babson Builders.
Babson Builders, Inc.
2011
Earnings before interest
expense and income taxes 84,000
$
Interest expense 7,300
Total assets 346,390
Total stockholders' equity 234,390
Total liabilities 112,000
This is also
referred to as
net operating
income.

40. 14-40
Interest Coverage Ratio
This is the most common
measure of the ability of a firm’s
operations to provide protection
to the long-term creditor.
Times
Interest
Earned
Operating income before Interest
and Income Taxes
Annual Interest Expense
=
Times
Interest
Earned
$84,000
7,300
= = 11.5 times

41. 14-41
Debt
Ratio
=
Total
Liabilities
÷ Total Assets
= $112,000 ÷ $346,390
= 32.33%
A measure of creditor’s long-term risk.
The smaller the percentage of assets
that are financed by debt, the smaller
the risk for creditors.
Debt Ratio
Debt
Ratio
=
Total
Liabilities
÷ Total Assets
= $112,000 ÷ $346,390
= 32.33%

42. 14-42
Analysis by Short-Term
Creditors
Use this
information to
calculate ratios
to measure the
well-being of
the short-term
creditors for
Babson
Builders, Inc.
Babson Builders, Inc.
2011
Cash 30,000
$
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 12,000
Total current assets 65,000
Total current liabilities 42,000
Sales on account 500,000
Cost of goods sold 140,000

43. 14-43
Accounts Receivable Turnover
Rate
This ratio measures how many
times a company converts its
receivables into cash each year.
Net Sales
Average Accounts Receivable
Accounts
Receivable
Turnover
=
= 27.03 times
$500,000
($17,000 + $20,000) ÷ 2
Accounts
Receivable
Turnover
=

44. 14-44
Inventory Turnover Rate
This ratio measures the
number of times merchandise
inventory is sold and replaced
during the year.
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
= 12.73 times
$140,000
($10,000 + $12,000) ÷ 2
Inventory
Turnover
=

45. 14-45
Operating Cycle
Cash
Inventory
Accounts
Receivable
2. Sale of merchandise on account

46. 13--46
Summary of Analytical Measures
Solvency Measures (continued)

47. 13--47
4
Summary of Analytical Methods (continued)
Profitability Measures

48. 14--48
Limitations of Ratios
 FSs are based on historical data & do not necessarily reflect
the likely outcome of future performance. The balance sheet
is a snapshot in time. Its static nature, which does not take
into account inflation or changing market values, requires
users of FSs to be wary in their interpretation of the numbers
presented.
 The income statement of different companies reports a net
profit but there may be different ways of arriving at this net
profit.
 The analyst should attempt to understand the differences or
how exactly the net profit is arrived at before making
comparisons for analysis & interpretation.

49. 14--49
Financial trends may or may not
indicate the future
 Acquisition & divestments
◦ The analyst needs to make sure that the figures comprising
the ratios indicating the trend in the first place are
comparable.
◦ Even so assured, the trend in place may not indicate the
future or cannot be a basis for projecting future returns for
the simple reason that there is an impending acquisition or
divestment by the company, which would effect net profits
significantly. The trick is obvious to be well informed of
company developments & to keep track of any changes over
time.
◦ In some industries where there is rapid technological change
or fashion obsolescence, the figure tend to be volatile. Wide
fluctuations from period to period render the ratios generated
less useful or meaningful.

50. 14--50
Timing and window dressing
 Trends observed may provide false indications
due to the timing & window dressing activities.
 Related to the timing issue is window dressing.
For example, the current ratio of a company can
be made to look healthier by full recognition of
progress billings just before book closing, thus
increasing trade receivables.

51. 14--51
Requirement of monetary
expression
 The only information captured by the acctg. system & reported
in FSs is economic information that can be expressed in
monetary terms. This eliminates the inclusion of other
information that might be of interest to investors.
 For example, where the FSs do you find information about
mgmt. expertise or talented technical staff? What about
information concerning innovative new products or processes
being developed as a result of R&D. This type of qualitative
information does not fall within the scope of traditional FSs but
may have significant impact on the value of a company.

52. 14--52
Capitalisation of expenses
 Companies do capitalise certain expenses. These expenses are
added to the asset value & written off over the life of the asset
through amortisation or depreciation instead of being expensed in
the current period.
◦ For example, if a company performed a major overhaul on machinery
to increase capacity, the cost of the overhaul may be added to asset
value rather than expensed off in the income statement. By capitalizing
expenses, both the reported profit for the period & the asset valuation
are higher.
 MFRS 138 deals with R&D costs. The primary issue discussed is
whether the cost of development activities should be recognised
as an asset or as an expense. This depends on the mgmt.
judgement or whether the criteria for asset recognition are met.
The acctg. Standard also specifies that development cost
capitalised should be amortised when the product or process is
available for sale or use & appropriate disclosure be made in the
notes to the accounts.

53. 14--53
Profit reporting
 FS users may need to make decisions about what is
classified as normal profit.
 In analysing financial performance, abnormal of unusual
items, non-recurring items of item arising from activities not in
the ordinary course of a company’s operations, are eliminated
from reported profit so that normal profit is used as the basis
of the analysis.
 The results of a discontinued operation are generally included
in the profit or loss from ordinary activities.
 Other non-recurring items an analyst should consider when
arriving at normal profit are:
◦ One-off tax concession;
◦ Disposal of fixed assets particularly land & buildings;
◦ Change in depreciation policy
◦ Compensation from profit guarantee;
◦ Retrenchment expenses; and
◦ Gain on disposal of investment

54. Profit Margin and Asset
Turnover
 Profit margin and asset turnover are
interdependent
◦ Profit margin is a function of sales and operating
expenses
 (selling price x units sold)
◦ Turnover is also a function of sales
 (sales/assets)
$5,000,000 $10,000,000 $10,000,000
$500,000 $500,000 $100,000
$5,000,000 $5,000,000 $1,000,000
10% 5% 1%
1 2 10
10% 10% 10%
NOPAT
Sales
Analysis of Return on Net Operating Assets
Return on net operating assets
NOA turnover
NOPAT margin
NOA

55. Capital Structure Composition and
Solvency
 Composition analysis
◦ Performed by constructing a common-size
statement of the liabilities and equity section
of the balance sheet.
◦ Reveals relative magnitude of financing
sources.
Tennessee Teletech’s Capital Structure
Common-Size Analysis
Current liabilities $ 428,000 19 %
Long-term debt 500,000 22.2
Equity capital
Preferred stock 400,000 17.8
Common stock 800,000 35.6
Paid-in capital 20,000 0.9
Retained earnings 102,000 4.5
Total equity capital 1,322,000 58.8
Total liabilities and equity $2,250,000 100 %
Common-Size Statements in Solvency Analysis

56. Capital Structure Composition and Solvency
 Asset composition in solvency analysis
◦ Important tool in assessing capital structure
risk exposure.
◦ Typically evaluated using common-size
statements of asset balances.
Asset-Based Measures of Solvency

57. 14-57
End of Chapter