Financial Statement Analysis - Annual Report Analysis

INTRODUCTION TO
ACCOUNTING
financial statements analysis

2
Analyzing financial statements involves:
Basics of Financial Statement Analysis
Characteristics
Comparison
Bases
Tools of
Analysis
Liquidity
Profitability
Solvency
Intracompany
Industry
averages
Intercompany
Horizontal
Vertical
Ratio
SO 1 Discuss the need for comparative analysis.
SO 2 Identify the tools of financial statement

3 SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Horizontal analysis, also called trend analysis, is a
technique for evaluating a series of financial
statement data over a period of time.
Its purpose is to determine the increase or decrease
that has taken place.
Horizontal analysis is commonly applied to the balance
sheet, income statement, and statement of retained
earnings.

These changes
suggest that the
company expanded its
asset base during
2007 and financed
this expansion
primarily by
retaining income
rather than assuming
additional long-term
debt.
Horizontal Analysis
Balance Sheet
Illustration 14-5
Horizontal analysis of
balance sheets

Overall, gross profit
and net income were
up substantially.
Gross profit
increased
17.1%, and net
income, 26.5%.
Quality’s profit trend
appears favorable.
Horizontal Analysis
Income
Statement
Illustration 14-6
Income statements

We saw in the horizontal analysis of the balance sheet that ending retained
earnings increased 38.6%. As indicated earlier, the company retained a
significant portion of net income to finance additional plant facilities.
Horizontal Analysis
Illustration 14-7
retained earnings
statements
Retained
Earnings
Statement

7
Summary financial information for Rosepatch
Company is as follows.
Solution on
notes page SO 3 Explain and apply horizontal analysis.
Horizontal Analysis
Compute the amount and percentage changes in 2011 using
horizontal analysis, assuming 2010 is the base year.

8 SO 4 Describe and apply vertical analysis.
Vertical Analysis
Vertical analysis, also called common-size analysis, is
a technique that expresses each financial statement
item as a percent of a base amount.
On an income statement, we might say that selling
expenses are 16% of net sales.
Vertical analysis is commonly applied to the balance
sheet and the income statement.

9
These results
reinforce the
earlier observations
that Quality is
choosing to finance
its growth through
retention of
earnings rather
than through
issuing additional
debt.
Balance Sheet
Illustration 14-8
Vertical analysis of
balance sheets
SO 4 Describe and apply vertical analysis.
Vertical Analysis

10
Quality appears
to be a profitable
enterprise that is
becoming even
more successful.
Income
Statement
Illustration 14-9
Vertical analysis of
Income statements
Vertical Analysis

11
Enables a comparison of companies of different sizes.
Illustration 14-10
Intercompany income
statement comparison
Vertical Analysis
J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C.
Penney’s net income as a percent of each sales dollar (5.6%) is only 44% of
Quality’s (12.6%).

Basic Financial Analysis
 Ratio analysis involves methods of
calculating and interpreting
financial ratios to assess a firm’s
financial condition and
performance.
 It is of interest to shareholders,
creditors, and the firm’s own
management

BASIC FINANCIAL ANALYSIS
 Ratio analysis involves methods of calculating and
interpreting financial ratios to assess a firm’s
financial condition and performance.
 It is of interest to shareholders, creditors, and the
firm’s own management

Using Financial Ratios:
Types of Ratio Comparisons
 Trend or time-series analysis
 Used to evaluate a firm’s performance
over time
 Cross-sectional analysis
 Used to compare different firms at the same point in
time

Types of Ratio Comparisons (cont.)
 Industry comparative analysis
 One specific type of cross sectional analysis. Used to compare one
firm’s financial performance to the industry’s average performance
 Benchmarking
 A type of cross sectional analysis in which the firm’s ratio values are
compared to those of a key competitor or group of competitors that it
wishes to emulate

Types of Ratio Comparisons (cont.)
 Trend or time-series analysis
 Combined Analysis
 Combined analysis simply uses a combination of both
time series analysis and cross-sectional analysis

Ratio Analysis
 Liquidity Ratios – measures capacity to meet short term
obligation
 Activity Ratios – measures effective use of resources
 Leverage (gearing) Ratios – measures indebtedness
 Profitability Ratios – measures overall profitability
 Market Ratios – measures based on market price of shares -
important to investors

Copyright © 2009 Pearson Prentice Hall. All rights reserved.
2-18
The Four Key Financial Statements
Table 2.1 Bartlett
Company Income
Statements ($000)

2-19
The Four Key Financial Statements
Table 2.2a Bartlett
Company Balance Sheets
($000)

2-20
The Four Key
Financial Statements (cont.)
Table 2.2b Bartlett
Company Balance Sheets
($000)

LIQUIDITY RATIOS
 Current Ratio – measures firm’s ability to meet its
short-term obligation
 The higher the ratio, the more liquid the firm is.
 A current ratio of 2.0 is occasionally acceptable
Current ratio = total current assets
total current liabilities
Current ratio = $1,233,000 = 1.97
$620,000

Liquidity Ratios – quick ratio
• Quick (acid-test) Ratio – similar to current ratio but excludes inventory and
prepaid expenses
 A quick ratio of 1.0 or greater is occasionally recommended – but
depends on the industry
Quick ratio = Total Current Assets - Inventory
Quick ratio = $1,233,000 - $289,000 = 1.51
$620,000

Quick ratio = Total Current Assets - Inventory
Quick ratio = $1,233,000 - $289,000 = 1.51
$620,000
Liquidity Ratios
– Quick Ratio

Activity ratio – inventory turnover
 Inventory Turnover – measures the
activity/liquidity of a firm’s inventory
 The higher the better but only meaningful if
compared with other firms in the same
industry (20 for grocery store, lower for an
art gallery)

Activity ratio – inventory turnover
• Inventory Turnover in days = 365/Inventory turnover
• To minimize seasonal factor.
• Average Inventory = (Beginning Inv + Ending Inv)/2
Copyright © 2009 Pearson Prentice Hall. All rights reserve
Inventory Turnover = Cost of Goods Sold
Inventory (or average inventory*)
Inventory Turnover = $2,088,000 = 7.2
$289,000

Activity Ratio - Average Collection
Period (AR Turnover)
 Average Collection Period – average amount of time
needed to collect accounts receivable
 Meaningful only in relation to the firm’s credit terms
(credit-terms 30 days and average collection period
60days – poorly managed credit)
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-26

Activity Ratio - Average Collection
Period
ACP = Accounts Receivable*
Net Sales/365
ACP = $503,000 = 59.7 days
$3,074,000/365
*or Average
AR

Activity Ratio - Average Payment
Period (A/P Turnover)
• Average Payment Period – average amount of time
needed to pay accounts payable
Meaningful only in relation to the average credit
terms extended to the firm (credit terms 30 days,
average payment period 90 days – low credit rating)

APP = Accounts Payable
Annual Purchases/365
APP = $382,000 = 95.4 days
(.70 x $2,088,000)/365
Activity Ratio - Average Payment Period
AP Turnover in days=
Average AP
COGS/365

Activity ratio – Total Asset Turnover
• Total Asset Turnover – indicates the efficiency with which the firm uses its
assets to generate sales
 Generally, the higher the firm’s total asset turnover, the more efficiently its assets
have been used
Total Asset Turnover = Net Sales
Total Assets *
Total Asset Turnover = $3,074,000 = .85
$3,597,000
* Or average TA

Cash Conversion Cycle (CCC)
• The length of time in days that it takes for a
company to convert resource inputs into cash
flow - It measures how fast a company can
convert cash on hand into even more cash on
hand (the shorter the better)
• CCC = Inventory turnover in days – A/P
turnover in days + A/R turnover in days

Leverage Ratio - Debt Ratio
 Debt Ratio (Financial leverage ratio) – measures the
proportion of total assets financed by the firm’s creditors
 The higher this ratio, the greater the firms’ degree of
indebtedness, the more financial leverage it has
Debt Ratio = Total Liabilities/Total Assets
Debt Ratio = $1,643,000/$3,597,000 = 45.7%

Debt Ratio – Times Interest Earned Ratio
 Times Interest Earned Ratio (interest coverage) – measures
the firms’ ability to make contractual interest payments
 The higher the better – a value of at least 3.0 and
preferably closer to 5.0 is often suggested
Times Interest Earned = EBIT (Operating Income)/Interest
Times Interest Earned = $418,000/$93,000 = 4.5

Debt ratio - Fixed-Payment Coverage
 Fixed-Payment Coverage Ratio – measures the firms’
ability to meet all fixed-payment obligations (loan
interest and principal, lease payments, preferred stock
dividend)
 The higher, the better. Also measures risk, the lower the
ratio, the greater the risk to both lenders and owners

2-37
FPCR = EBIT + Lease Payments________________
Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}
FPCR = $418,000 + $35,000 = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}
Debt Ratio
 Fixed-Payment coverage Ratio (FPCR)

Debt-equity ratio
 Measures the relationship between the firm’s resources
provided through debt and those provided through
ownership (equity)
 The greater the D/E ratio is, the riskier the company is
as an investment
 Formula = Total Liabilities
Total stockholders’ equity

PROFITABILITY RATIOS
 Gross Profit Margin – measures the percentage of each sales
dollar remaining after the firm has paid for its goods
 The higher, the better
GPM = Gross Profit/Net Sales
GPM = $986,000/$3,074,000 = 32.1%

2-40
OPM = EBIT/Net Sales
OPM = $418,000/$3,074,000 = 13.6%
Profitability Ratios
 Operating Profit Margin (OPM)
 measures the percentage of each sales dollar remaining after
all costs and expenses other than interest, taxes, and
preferred stock dividends are deducted
 A higher operating profit margin is preferred

2-41
NPM = Earnings Available to Common Stockholders
Sales
NPM = $221,000/$3,074,000 = 7.2%
 Net Profit Margin (NPM)- measures the percentage of each
sales dollar remaining after all costs and expenses including
interest, taxes, and preferred stock dividends are deducted
 The higher the firm’s net profit margin, the better

2-42
EPS = Earnings Available to Common Stockholders
Number of Shares Outstanding
EPS = $221,000/76,262 = $2.90
 Earnings Per Share (EPS)- represents the dollar amount
earned on behalf of each outstanding share of common
stock

2-43
ROA = Earnings Available to Common Stockholders
Total Assets or Average TA
ROA = $221,000/$3,597,000 = 6.1%
 Return on Total Assets (ROA) - measures the overall
effectiveness of management in generating profits with its
available assets – return on investment

2-44
ROE = $221,000/$1,754,000 = 12.6%
ROE = Earnings Available to Common Stockholders
Total Equity or Average Equity
 Return on Equity (ROE) - measures the return earned on the
common stockholders’ investment in the firm

2-45
P/E = Market Price Per Share of Common Stock
Earnings Per Share
P/E = $32.25/$2.90 = 11.1
Market Ratios
 Price Earnings (P/E) Ratio - measures the amount that investors are willing
to pay for each dollar of a firm’s earnings
 Indicates the degree of confidence that investors have in the firm’s
future performance (the higher, the greater the confidence)

MARKET RATIOS
 Market/Book (M/B) Ratio – provides an assessment of
how investors view the firm’s performance
 Performing stocks – higher M/B ratios
M/B Ratio = Market Price/Share of Common Stock
Book Value/Share of Common Stock
M/B Ratio = $32.25/$23.00 = 1.40

Summarizing All Ratios
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)
2-47

Summarizing All Ratios (cont.)
Table 2.8 Summary of Bartlett Company Ratios
(2007–2009, Including 2009 Industry Averages)
2-48

2-
49
Ratio Analysis (cont.)
Table 2.7
Bartlett Company
Common-Size
Income Statements

2-
50
DuPont System of Analysis
 The DuPont system of analysis is used to dissect the firm’s financial statements
and to assess its financial condition.
 It merges the income statement and balance sheet into two summary measures of
profitability.
 The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial
leverage multiplier (FLM), which is the ratio of total assets to common stock equity:
 ROA and ROE as shown in the series of equations on the following slide and in
Figure 2.2 on the following slide.

2-
51
DuPont System of Analysis

2-
52
DuPont System of Analysis (cont.)
Figure 2.2 DuPont
System of Analysis

2-
53
ROE = 6.1% X 2.06 = 12.6%
Modified DuPont Formula (cont.)
 Use of the FLM to convert ROA into ROE reflects the
impact of financial leverage on the owner’s return.
 Substituting the values for Bartlett Company’s ROA of
6.1 percent calculated earlier, and Bartlett’s FLM of
2.06 ($3,597,000 total assets ÷ $1,754,000 common
stock equity) into the Modified DuPont formula yields:

Financial Statement Analysis - Annual Report Analysis

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