(Shail) analysis

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ANALYSIS ANDINTERPRETATION OF

FINANCIAL STATEMENTS

It looks at accounting information from users’ perspective

What is financial statement analysis?”Tearing apart” the financial statements and looking at the relationships

Financial Statement AnalysisFinancial Statement Analysis

Who need results of financial statement Analysis? Internal users (i.e., management) External users (emphasis of chapter)

Examples?

Investors, creditors, regulatory agencies & …

stock market analysts and

auditors

What do internal users use it for? Planning, evaluating and controlling

company operations What do external users use it for?

Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management

Information is available from Published annual reports

(1) Financial statements

(2) Notes to financial statements

(3) Letters to stockholders

(4) Auditor’s report (Independent accountants)

(5) Management’s discussion and analysis

Reports filed with the government

627 628

Information is available from Other sources

(1) Newspapers

(2) Periodicals

(3) Financial information organizations such as: AIFI

(4) Other business publications

627 628

Horizontal Analysis

Vertical Analysis

Common-Size Statements

Trend Percentages

Ratio Analysis

Methods ofMethods ofFinancial Statement AnalysisFinancial Statement Analysis

Horizontal AnalysisHorizontal Analysis

Using comparative financial statements to calculate rupee

or percentage changes in a financial statement item from

one period to the next

Using comparative financial statements to calculate rupee

or percentage changes in a financial statement item from

one period to the next

Vertical AnalysisVertical Analysis

For a single financial statement, each item

is expressed as a percentage of a

significant total, e.g., all income

statement items are expressed as a

percentage of sales

For a single financial statement, each item

is expressed as a percentage of a

significant total, e.g., all income

statement items are expressed as a

percentage of sales

Trend PercentagesTrend Percentages

Show changes over time in given financial statement items

(can help evaluate financial information of several years)

Show changes over time in given financial statement items

(can help evaluate financial information of several years)

Ratio AnalysisRatio Analysis

Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship

between revenue and net income)

Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship

between revenue and net income)

Horizontal Analysis ExampleHorizontal Analysis Example

The management of Clover Company provides you with comparative balance sheets of the years ended December 31, 1999 and 1998. Management asks you to

prepare a horizontal analysis horizontal analysis on the information.

Calculating Change as a Percentage

PercentageChange

Dollar Change Base Year Figure

100%= ×

Calculating Change in Dollar Amounts

DollarChange

Current YearFigure

Base YearFigure

$12,000 – $23,500 = $(11,500)

($11,500 ÷ $23,500) × 100% = 48.9%

Let’s apply the sameprocedures to the

liability and stockholders’equity sections of the

balance sheet.

CLOVER CORPORATIONComparative Balance SheetsDecember 31, 1999 and 1998

Increase (Decrease)1999 1998 Amount %

Liabilities and Stockholders' EquityCurrent liabilities: Accounts payable 67,000$ 44,000$ 23,000$ 52.3 Notes payable 3,000 6,000 (3,000) (50.0) Total current liabilities 70,000 50,000 20,000 40.0Long-term liabilities: Bonds payable, 8% 75,000 80,000 (5,000) (6.3) Total liabilities 145,000 130,000 15,000 11.5Stockholders' equity: Preferred stock 20,000 20,000 - 0.0 Common stock 60,000 60,000 - 0.0 Additional paid-in capital 10,000 10,000 - 0.0 Total paid-in capital 90,000 90,000 - 0.0Retained earnings 80,000 69,700 10,300 14.8 Total stockholders' equity 170,000 159,700 10,300 6.4Total liabilities and stockholders' equity 315,000$ 289,700$ 25,300$ 8.7

Now, let’s apply the procedures to theincome statement.

CLOVER CORPORATIONComparative Income Statements

For the Years Ended December 31, 1999 and 1998Increase (Decrease)

1999 1998 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)

Sales increased by 8.3% while net income decreased by 21.9%.

There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the

increase in sales, yielding an overall decrease in net income.

Vertical Analysis ExampleVertical Analysis Example

The management of Sample Company asks you to prepare a vertical analysis vertical analysis for the

comparative balance sheets of the company.

$82,000 ÷ $483,000 = 17% rounded$30,000 ÷ $387,000 = 8% rounded

$76,000 ÷ $483,000 = 16% rounded

Trend Percentages ExampleTrend Percentages Example

Wheeler, Inc. provides you with the following operating data and asks that

you prepare a trend analysis.

Wheeler, Inc. provides you with the following operating data and asks that

you prepare a trend analysis.

$1,991 - $1,820 = $171$1,991 - $1,820 = $171

Using 1995 as the base year, we develop the following percentage relationships.

$1,991 - $1,820 = $171$1,991 - $1,820 = $171$171 ÷ $1,820 = 9% rounded$171 ÷ $1,820 = 9% rounded

Trend linefor Sales

Ratios can be expressed in three different ways:

1. Ratio (e.g., current ratio of 2:1)

2. % (e.g., profit margin of 2%)

3. Rs. (e.g., EPS of Rs.2.25)

CAUTION! “Using ratios and percentages without

considering the underlying causes may lead to incorrect conclusions.”

RatiosRatios

Categories of RatiosCategories of Ratios

Liquidity RatiosIndicate a company’s short-term debt-paying ability

Equity (Long-Term Solvency) RatiosShow relationship between debt and equity financing in a company

Profitability TestsRelate income to other variables

Market TestsHelp assess relative merits of stocks in the marketplace

Liquidity RatiosCurrent (working capital) ratioAcid-test (quick) ratio Cash flow liquidity ratioAccounts receivable turnoverNumber of days’ sales in accounts

receivableInventory turnover Total assets turnover

10 Ratios You Must Know10 Ratios You Must Know

Equity (Long-Term Solvency) RatiosEquity (stockholders’ equity) ratio Equity to debt

Profitability Tests Return on operating assetsNet income to net sales (return on

sales or “profit margin”“profit margin”)Return on average common

stockholders’ equity (ROEROE) Cash flow marginEarnings per share Times interest earned Times preferred dividends earned

Market Tests Earnings yield on common stockPrice-earnings ratio Payout ratio on common stock Dividend yield on common stock Dividend yield on preferred stock Cash flow per share of common

Now, let’s look at Norton

Corporation’s 1999 and 1998 financial

statements.

Now, let’s calculate the 10 ratios based

on Norton’s financial statements.

NORTON CORPORATION

Cash 30,000$

Accounts receivable, net

Beginning of year 17,000

End of year 20,000

Inventory

End of year 12,000

Total current assets 65,000

Total current liabilities 42,000

Sales on account 494,000

Cost of goods sold 140,000

We will use this

informationto calculatethe liquidity

ratios for Norton.

Working Capital*Working Capital*

12/31/99

Current assets 65,000$

Current liabilities (42,000)

Working capital 23,000$

The excess of current assets over current liabilities.

* While this is not a ratio, it does give an indication of a company’s liquidity.

Current (Working Capital) RatioCurrent (Working Capital) Ratio

CurrentRatio

$65,000 $42,000

= = 1.55 : 1

Measures the abilityof the company to pay current

debts as they become due.

CurrentRatio

Current Assets Current Liabilities

Acid-Test (Quick) RatioAcid-Test (Quick) Ratio

Quick Assets Current Liabilities

=Acid-Test

Quick assets are Cash,Marketable Securities,

Accounts Receivable (net) andcurrent Notes Receivable.

=Acid-Test

Norton Corporation’s quick assets consist of cash of

$30,000 and accounts receivable of $20,000.

=Acid-Test

$50,000 $42,000

= 1.19 : 1=Acid-Test

Sales on Account Average Accounts Receivable

Accounts ReceivableTurnover

Accounts Receivable TurnoverAccounts Receivable Turnover

= 26.70 times $494,000 ($17,000 + $20,000) ÷ 2

Accounts ReceivableTurnover

This ratio measures how many times a company converts its

receivables into cash each year.

#3#3 Average, net accounts receivable

Net, credit sales

Number of Days’ SalesNumber of Days’ Salesin Accounts Receivablein Accounts Receivable

Measures, on average, how many days it takes to collect an

account receivable.

Days’ Salesin AccountsReceivables

= 365 Days Accounts Receivable Turnover

= 13.67 days= 365 Days 26.70 Times

Number of Days’ SalesNumber of Days’ Salesin Accounts Receivablein Accounts Receivable

In practice, would 45 days be a desirable number of days in

receivables?

#4#4Days’ Salesin AccountsReceivables

= 365 Days Accounts Receivable Turnover

= 13.67 days= 365 Days 26.70 Times

Inventory TurnoverInventory Turnover

Cost of Goods Sold Average Inventory

InventoryTurnover

Measures the number of timesinventory is sold and

replaced during the year.

= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2

InventoryTurnover

Inventory TurnoverInventory Turnover

Cost of Goods Sold Average Inventory

InventoryTurnover

Would 5 be a desirable number of times for inventory to turnover?

= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2

InventoryTurnover

Equity, or Long–TermEquity, or Long–TermSolvency RatiosSolvency Ratios

This is part of the information to calculate the equity, or long-term

solvency ratios of Norton Corporation.

NORTON CORPORATION

Net operating income 84,000$ Net sales 494,000 Interest expense 7,300 Total stockholders' equity 234,390

17-56NORTON CORPORATION

Common shares outstanding Beginning of year 17,000 End of year 27,400

Net income 53,690$

Stockholders' equity

End of year 234,390

Dividends per share 2

Dec. 31 market price/share 20

Interest expense 7,300

Total assets

End of year 346,390

Here is therest of the

informationwe will

Equity RatioEquity Ratio

EquityRatio

= Stockholders’ Equity Total Assets

EquityRatio

= $234,390 $346,390

67.7%=

Measures the proportionof total assets provided by

stockholders.

Net Income to Net SalesNet Income to Net SalesA/K/A Return on Sales or Profit MarginA/K/A Return on Sales or Profit Margin

Net Incometo

Net Sales=

Net Income Net Sales

Net Incometo

Net Sales=

$53,690 $494,000

= 10.9%

Measures the proportion of the sales dollarwhich is retained as profit.

Net Income to Net SalesNet Income to Net SalesA/K/A Return on Sales or Profit MarginA/K/A Return on Sales or Profit Margin

Net Incometo

Net Sales=

Net Income Net Sales

Net Incometo

Net Sales=

$53,690 $494,000

= 10.9%

Would a 1% return on sales be good?

Return on Average Common Return on Average Common Stockholders’ Equity (ROE)Stockholders’ Equity (ROE)

Return onStockholders’

Equity=

Net Income Average Common

Stockholders’ Equity

= $53,690 ($180,000 + $234,390) ÷ 2

= 25.9%Return on

Stockholders’Equity

Important measure of theincome-producing ability

of a company.

Earningsper Share

Earnings Available to Common StockholdersWeighted-Average Number of Common

Shares Outstanding=

Earningsper Share

$53,690 (17,000 + 27,400) ÷ 2

= = $2.42

The financial press regularly publishesactual and forecasted EPS amounts.

Earnings Per ShareEarnings Per Share

What’s new from Chap. 15? Weighted-average calculation

EPS of common stock = _______________________Earnings available tocommon stockholders

Weighted-average number ofcommon shares outstanding

Three alternatives for calculating weighted-average number of shares

EPS of common stock = _______________________Earnings available tocommon stockholders

Weighted-average number ofcommon shares outstanding

Alternate #1

What’s new from Chap. 15? Weighted-average calculation

Alternate #3

Alternate #2

¶ EPS and Stock Dividends or SplitsWhy restate all prior calculations of EPS?

Comparability - i.e., no additional capital was generated by the dividend or split

¶ Primary EPS and Fully Diluted EPSAPB Opinion No. 15

I mentioned this 17-page pronouncement that required a 100-page explanation in the lecture for chapter 13.

Price-Earnings RatioPrice-Earnings RatioA/K/A P/E MultipleA/K/A P/E Multiple

Price-EarningsRatio

Market Price Per Share EPS

Price-EarningsRatio

= $20.00

$ 2.42= 8.3 : 1

#10#10

Provides some measure of whether the stock is under or overpriced.

Important ConsiderationsImportant Considerations

Need for comparable data Data is provided by Dun &

Bradstreet, Standard & Poor’s etc. Must compare by industry Is EPS comparable?

Influence of external factors General business conditions Seasonal nature of business operations

Impact of inflation

QuestionQuestion

The current ratio is a measure of liquidity that is computed by dividing

total assets by total liabilities.

a. True

b. False

a. True

b. False

a. True

b. False

a. True

b. False

QuestionQuestion

The current ratio is a measure ofliquidity, but is computed by

dividing currentcurrent assets bycurrentcurrent liabilities

The current ratio is a measure ofliquidity, but is computed by

dividing currentcurrent assets bycurrentcurrent liabilities

QuestionQuestion

Quick assets are defined as Cash, Marketable Securities and net

receivables.

a. True

b. False

receivables.

a. True

b. False

receivables.

a. True

b. False

receivables.

a. True

b. False

QuestionQuestion

No more ratios, please!

About Test #1About Test #1

Will be challenging because the material covered is challenging

All questions are T/F or M/CQuestions are 5-pt., 3-pt. & 1-pt.

No tricks such as patterns in answersOrder of answers is random

Coverage is even over the 4 chapters Time allowed: 75 minutes

About Test #1About Test #1

Best way to study Notes first Study guide and/or Hermanson tutorials

Calculators will be provided Must wait outside classroom Have your questions ready for next

actual class See course home page for office hours

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