Analyzing Financial Statements

Individuals

Some Users of Financial Statements

Businesses

Investors andcreditors

Governmentregulatoryagencies

Taxingauthorities

Nonprofitorganizations

Economy-wideFactors

IndustryFactors

IndividualCompany

Factors

Lend? Sell on credit?

Invest?

No Yes

Understanding The Business

Analyzing Financial Statements

Dollar and percentage changes on statements (Horizontal Analysis)/ Trend Analysis Common-size

statements(Vertical Analysis)

Ratios

Analytical techniques used to examine

relationships among financial statement

items

Horizontal Analysis

Horizontal analysis shows the changes between years in the financial data in both dollar and

percentage form.

CLOVER CORPORATIONComparative Balance Sheets

December 31

Increase (Decrease)2013 2012 Amount %

AssetsCurrent assets: Cash 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$

Horizontal Analysis

($11,500 ÷ $23,500) × 100% = 48.9%

$12,000 – $23,500 = $(11,500)

CLOVER CORPORATIONComparative Balance Sheets

December 31

Increase (Decrease)2013 2012 Amount %

AssetsCurrent assets: Cash 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

Horizontal Analysis

CLOVER CORPORATIONComparative Income Statements

For the Years Ended December 31Increase

(Decrease)2013 2012 Amount %

Sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3

Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1

Net 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)

Horizontal Analysis

Trend Analysis

Trend Percentages

Trend percentages state several years’ financial data in terms of a base year, which equals 100

percent.

Trend Analysis

TrendPercentage

Current Year Amount Base Year Amount

100%= ×

Trend Analysis

By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales,

which is slowing the increase in gross margin.

YearItem 2013 2012 2011 2010 2007

Sales 145% 129% 116% 105% 100%Cost of goods sold 150% 132% 118% 104% 100%Gross margin 135% 124% 112% 108% 100%

Berry ProductsIncome Information

For the Years Ended December 31

Vertical AnalysisVertical analysis focuses on

the relationships among financial statement items at

a given point in time. A common-size financial statement is a vertical analysis in which each

financial statement item is expressed as a percentage.

CLOVER CORPORATIONComparative Income Statements

For the Years Ended December 31Common-Size Percentages

2011 2010 2011 2010Sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000

Gross margin 160,000 165,000 Operating expenses 128,600 126,000

Net operating income 31,400 39,000 Interest expense 6,400 7,000

Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600

Net income 17,500$ 22,400$

Common-Size Statements

Sales is usually the base and is

expressed as 100%.

Common-Size StatementsCLOVER CORPORATION

Comparative Income StatementsFor the Years Ended December 31

Common-Size Percentages

2011 2010 2010 2009Sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6

Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2

Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5

Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0

Net income 17,500$ 22,400$ 3.4 4.7

Common-Size Statements

In balance sheets, all items usually

are expressed as a percentage of total

assets (or total liabilities+equity).

Ratio Analysis

Interpreting Ratios

Ratios may be interpreted by comparisonwith ratios of earlier periods, other companies, or

with industry average ratios.

Ratios may vary because of thecompany’s industry characteristics,

nature of operations, size, andaccounting policies.

Ratios may be interpreted by comparisonwith ratios of earlier periods, other companies, or

with industry average ratios.

Ratios may vary because of thecompany’s industry characteristics,

nature of operations, size, andaccounting policies.

Limitations of Financial Statement Analysis

We use the LIFO method to value inventory.

We use the average cost method to value inventory.

Differences in accounting methods between companies sometimes make comparisons

difficult.

Limitations of Ratio Analysis

Analysts should look beyond the ratios.

Economic factors

Industry trends

Changes within the company

Technological changes

Consumer tastes

Profitability Ratios(The Common Stockholder)

Gross Margin Percentage

Gross Margin Percentage

Gross Margin Sales

=

This measure indicates how muchof each sales dollar is left after deducting

the cost of goods sold to cover expenses and provide a profit.

Earnings per (Common) Share (EPS)

EPS $5,761

(1,970 + 2124) ÷ 2= = $2.81

Earnings per share is probably the single most widely watched financial ratio.

Earnings per share is probably the single most widely watched financial ratio.

Average number of shares based on the numberof shares at the beginning and end of the year.

Net Income* Average Number of Shares Outstanding for the Period

EPS =

*If there are preferred dividends, the amount is subtracted from net income.

Price/Earnings (P/E) Ratio

P/E Ratio =Current Market Price Per Share

Earnings Per Share

P/E Ratio =$45

$2.35= 19X

This ratio measures the relationship between the current market price of the stock and its earnings per share.

A recent price for

Home Depot

stock was $45 per share.

Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor.

Dividend Payout Ratio

DividendPayout Ratio

Dividends Per Share Earnings Per Share=

DividendPayout Ratio

$2.00 $2.42= = 82.6%

This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking dividends

(market price growth) would like this ratio to be large (small).

Dividend Yield RatioDividend

Yield Dividends Per Share Market Price Per Share

=

DividendYield

$0.675$34

= = 2 %

This ratio is often used to compare the dividend-paying performance of different investment

alternatives.

This ratio is often used to compare the dividend-paying performance of different investment

alternatives.

Return on Total Assets

Return on Assets

Net Income + Interest Expense (net of tax)Average Total Assets

=

Return on Assets

$5,761 + ($392 × (1 - .34)) ($52,263 + $44,405) ÷ 2

= = 12.5%

This ratio is generally considered a measure of a company’s profitability.

This ratio is generally considered a measure of a company’s profitability.

Corporate tax rate is 34%.

Return on Common Stockholders’ Equity

Return on CommonStockholders’ Equity

Net Income – Preferred Dividends

Average Stockholders’ Equity

=

Return on CommonStockholders’ Equity

$53,690 – $0 ($180,000 + $234,390) ÷ 2

= = 25.91%

This measure indicates how well the company used the owners’ investments to

earn income.

Book Value Per Share

Book Value per Share

Common Stockholders’ Equity Number of Common Shares Outstanding=

This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were

sold at their balance sheet carrying amounts after all creditors were paid off.

= $8.55Book Value per Share

$234,390 27,400=

Financial Leverage

Financial leverage involves acquiring assets with borrowed funds.

Return on investment in

assets>

Interest rate on borrowed funds Positive

financial leverage

=

Return on investment in assets <

Interest rate on borrowed funds Negative

financial leverage

=

Financial Leverage Percentage

Financial Leverage

Return on Equity – Return on Assets=

9.7% = 22.2% – 12.5%

Financial leverage is the advantage or disadvantage that occurs as the result of earning a return on equity that is

different from the return on assets.

Financial leverage is the advantage or disadvantage that occurs as the result of earning a return on equity that is

different from the return on assets.

Liquidity Ratios(The Short-Term Creditor)

Working Capital

Working capital is not free. It must be financed with

long-term debt and equity.

The excess of current assets over current liabilities is known as

working capital.

Current Ratio

CurrentRatio

Current Assets Current Liabilities

=

CurrentRatio

$18,000

$12,931

= = 1.39 to 1

This ratio measures the abilityof the company to pay current

debts as they become due.

This ratio measures the abilityof the company to pay current

debts as they become due.

Quick Ratio (Acid Test) Quick Assets Current Liabilities

=QuickRatio

$3,837 $9,554

= 0.40 to 1=QuickRatio

This ratio is like the currentratio but measures the company’s

immediate ability to pay debts.

This ratio is like the currentratio but measures the company’s

immediate ability to pay debts.

Cash & Cash Equivalents 600$ Receivables, net 3,223 Short-term Investments 14 Quick Assets 3,837$

Receivable Turnover

Net Credit Sales Average Net Receivables

Receivable Turnover

=

Receivable Turnover

$90,837($3,223 + $2,396) ÷ 2

= 32.3 Times=

This ratio measures how quickly a company collects its accounts

receivable.

This ratio measures how quickly a company collects its accounts

receivable.

Average Collection Period

Days in Year Receivable Turnover

Average Collection Period

=

= 11.3 Days36532.3

Average Collection Period

=

This ratio measures the average number of days it takes to collect receivables.

This ratio measures the average number of days it takes to collect receivables.

Inventory Turnover

Cost of Goods Sold Average Inventory

Inventory Turnover

=

Inventory Turnover

$61,054($12,822 + $11,401) ÷ 2

= 5.0 Times=

This ratio measures how quickly the company sells its inventory.

This ratio measures how quickly the company sells its inventory.

Average Sale Period

Days in YearInventory Turnover

Average Sale Period =

= 73 Days3655.0

=Average Sale

Period

This ratio measures the average number of days it takes to sell the inventory.

This ratio measures the average number of days it takes to sell the inventory.

Solvency Ratios(The Long-Term Creditor)

This ratio indicates a margin of protection for creditors.

Times Interest Earned

Net Interest Income Tax Income Expense Expense Interest Expense

Times Interest Earned =

+ +

$5,761 + $392 + $3,547$392

Times Interest Earned = = 24.7 Times

Tests of solvency measure a company’sability to meet its long-term obligations.

Tests of solvency measure a company’sability to meet its long-term obligations.

Debt-to-Equity Ratio

This ratio measures the amount of liabilities that exists for each $1 invested by the

owners.

This ratio measures the amount of liabilities that exists for each $1 invested by the

owners.

$27,233$25,030

= 1.09=Debt-to-Equity

Ratio

Total LiabilitiesStockholders’ Equity

Debt-to-Equity Ratio

=

End of Chapter 15