Financial Statement Analysis

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 15

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.2

Perform a horizontal analysis of financial statements

Perform a vertical analysis of financial statements

Prepare and use common-size financial statements

Compute and evaluate the standard financial ratios


To make informed decisions about a companyHelpful in managing the companyComparison with competitionCharting a company’s progress, measure performanceEstablish financial healthUsed for investment decisions

Generally based on comparative financial dataFrom one year to the nextWith a competing companyWith the industry as a whole.

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Three main ways to analyze financial statementsHorizontal analysis

Year-to-year comparison

Vertical analysisCompare different companies

Using industry averagesCompare company’s performance against the industry averages

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Perform a horizontal analysis of financial statements

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The study of percentage changes in comparative statements

Compute dollar changes

Compute percentage changes

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Step 1

Step 27



Form of horizontal analysisIndicates business directionHow have things changed over the years?

Select a period of three to five yearsBase year, earliest year, is selected and set equal to 100%Subsequent years expressed as a percentage of the base period

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Data for Mariner Designs, Inc., follow:

1. Prepare a horizontal analysis of the comparative income statement of Mariner Designs, Inc. Round percentage changes to one decimal place.

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MARINER DESIGNS, INC.

Comparative Income Statement

Years Ended December 31, 2012 and 2011

2011 2012

Net sales revenue $ 431,000 $ 372,350

Expenses:

Cost of goods sold $ 200,000 $ 187,550

Selling and general expenses 99,000 91,050

Other expense 8,350 6,850

Total expenses $ 307,350 $ 285,450

Net income $ 123,650 $ 86,900


MARINER DESIGNS, INC.

Comparative Income Statement

Years Ended December 31, 2012 and 2011

Increase (Decrease)

2011 2012 Amount Percent

Net sales revenue $ 431,000 $ 372,350 $ 58,650 15.8 %

Expenses:

Cost of goods sold $ 200,000 $ 187,550 $ 12,450 6.6 %

Selling and general expenses

99,000 91,050 7,950 8.7 %

Other expense 8,350 6,850 1,500 21.9 %

Total expenses $ 307,350 $ 285,450 21,900 7.7 %

Net income $ 123,650 $ 86,900 $ 36,750 42.3 %


Data for Mariner Designs, Inc., follow:

2. Why did 2012 net income increase by a higher percentage than net sales revenue?

Revenues increase at a higher rate than total expenses.

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Perform a vertical analysis of financial statements

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Shows relationship of each item to a base amount on financial statements

Income statement–each item expressed as percentage of net sales

Balance sheet–each item expressed as percentage of total assets or total liabilities and equity.

Remember total assets = total liabilities and equity

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Base amount

Percentage of the base amount15


Base amount

Percentage of base

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Tri-State Optical Company reported the following amounts on its balance sheet at December 31, 2012 and 2011:

Prepare a vertical analysis of Tri-State assets for 2012 and 2011.

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2012 2011

Cash and receivables $ 54,530 $ 46,860

Inventory 42,435 32,670

Property, plant, and equipment, net 108,035 85,470

Total assets $ 205,000 $ 165,000

2012 % oftotal

2011 % oftotal

Cash and receivables $ 54,530 $ 46,860

Inventory 42,435 32,670

Property, plant, and equipment, net

108,035 85,470

Total assets $ 205,000 $ 165,000

26.620.752.7

100.0

28.419.851.8

100.0


Prepare and use common-size financial statements

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Common-size statements compare one company to another

Report only percentages (same as vertical analysis)Remove dollar value bias

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Comparing a company with another leading companyTwo main types:

Against a key competitorAgainst the industry average

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Data for Martinez, Inc., and Rosado, Corp., follow:

1. Prepare common-size income statements.

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Martinez Rosado

Net sales $ 10,600 $ 18,600

Cost of goods sold 6,455 13,522

Other expenses 3,541 4,185

Net income $ 604 $ 893

Martinez Rosado

Net sales 100 % 100 %

Cost of goods sold 60.9 % 72.7 %

Other expenses 33.4 % 22.5 %

Net income 5.7 % 4.8 %


(Continued)

2. Which company earns more net income?

3. Which company’s net income is a higher percentage of its net sales?

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Martinez Rosado

Net sales 100 % 100 %

Cost of goods sold 60.9 % 72.7 %

Other expenses 33.4 % 22.5 %

Net income 5.7 % 4.8 %

Rosado

Martinez


Compute and evaluate the standard financial ratios

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No single ratio tells the whole pictureDifferent ratios explain different aspects Types:

Evaluating ability to pay current liabilitiesEvaluating ability to sell inventory and collect receivablesEvaluating ability to pay long-term debtEvaluating profitabilityEvaluating stock as an investment

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Working capitalMeasures ability to meet short-term obligations

Working capital = Current assets – Current liabilitiesCurrent ratio

Proportion of current assets to current liabilities

Acceptable current ratio 1.50 25

Current assets Current liabilities

Current ratio =


Acid-test ratioTells if company could pay all its current liabilities immediately

Normal range 0.20 to 1.00 depending upon industry

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Cash + Short-term investments + Net current receivables Current liabilities

Acid-test Ratio =


Inventory turnover ratioMeasures number of times a company sells inventory during a yearHigh rate indicates ease in sellingLow rate indicates difficulty in selling

Formula

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Inventory turnover =Cost of goods soldAverage inventory


Days in inventory ratioMeasures the average number of days inventory is held by the company

Formula

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Days in inventory =365 days

Inventory turnover ratio


Gross profit percentageMeasures the profitability of each net sales dollar

Formula

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Gross profit percentage =Gross profit

Net sales


Accounts receivable turnover ratioMeasures ability to collect cash from credit customers

Formula

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Accounts receivable turnover =Net credit sales

Average net accounts receivable


Days’ sales in receivables ratioMeasures ability to collect receivables

Formula

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Days’ sales in average accounts = receivable

365 daysAccounts receivable

turnover ratio


Debt ratioShows portion of assets financed with debtThe higher the ratio, the higher the risk

Formula

Average debt ratio ranges from 57% to 67% 32

Debt ratio = Total liabilitiesTotal assets


Debt to equity ratio The proportion of total liabilities to the proportion of total equity that is financing the company’s assets

Formula

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Debt to equity =Total liabilities

Total equity


Times-interest-earned ratioMeasures number of times income can cover interest expenseHigh ratio indicates ease in paying interest

Formula

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Times-interest earned ratio

=Earnings Before Interest and Taxes

Interest expense


Return on net salesPercent of each sales dollar earned as net income

Formula

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Rate of returnon net sales

=Net income

Net sales


Return on total assetsMeasures success in using assets to earn a profit

Formula

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Rate of returnon total assets

= Net income + Interest expenseAverage total assets


Asset turnover ratioMeasures the amount of net sales generated for each average dollar of total assets invested

Formula

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Asset turnover ratio =Net sales

Average total assets


Return on common stockholders’ equityHow much income is earned for each dollar invested by common shareholders

Formula

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Rate of return on commonstockholders’ equity

= Net income – Preferred dividendsAverage common stockholders’ equity


Trading on the equityCompany borrows at a lower rate, then invests the money to earn a higher rateReturn on Equity > Return on Assets

Increases profits during goods timesCompounds losses during bad times

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Earnings per shareNet income earned for each share of outstanding common stockOutstanding stock = Issued stock – Treasury stock

Formula

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Earnings per shareof common stock

=Net income – Preferred Dividends

Number of shares of common stock outstanding


Price/earnings ratio (P/E)Market price compared to earnings per share

Formula

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P/E ratio = Market price per share of common stockEarnings per share


Dividend yieldPercentage of market value that is returned as dividends

Formula

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Dividend yield on common stock

=Annual dividends per share of common stock

Market price per share of common stock


Dividend PayoutThe ratio of annual dividends declared relative to the earnings per share of the company

Formula

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Dividend Payout =Annual dividends per share

Earnings per share


Book valueCommon equity per shareSome argue its relevance to investors

Formula

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Book value per share of common stock

= Total stockholders’ equity – Preferred equity



Win’s Companies, a home improvement store chain, reported the following summarized figures:

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(Continued)

1.Compute Win’s Companies’ current ratio at May 31, 2012 and 2011.

2. Did Win’s Companies’ current ratio improve, deteriorate, or hold steady during 2012?

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Current assets Current liabilities

Current ratio =

2012 - $ 54,300,000/$ 33,000,000 = 1.652011 - $ 25,200,000/$ 13,100,000 = 1.92

Win’s Companies current ratio deteriorated.


Use the Win’s Companies data in Short Exercise 15-5 to complete the following requirements.

1.Compute the rate of inventory turnover, days in inventory, and gross profit percentage for 2012.

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Inventory turnover =Cost of goods soldAverage inventory

Days in inventory =365 days

Inventory turnover ratio

Gross profit percentage =Gross profit

Net sales

$ 28,400,000/($6,900,000 + $8,200,000)/2 = 3.76

365/3.76 = 97 days

$21,800,000/$50,200,000 = 43.4 %


(Continued)

2. Compute days’ sales in average receivables during 2012. Round dollar amounts to three decimal places.

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365/($ 50,200,000/($7,400,000 + $5,300,000)/2 ) = 46 days

Days’ sales in average accounts = receivable

365 daysAccounts receivable

turnover ratio

Accounts receivable turnover =Net credit sales

Average net accounts receivable


Use the financial statements of Win’s Companies in Short Exercise 15-5.

1.Compute the debt ratio and the debt to equity ratio at May 31, 2012.

2. Is Win’s ability to pay its liabilities strong or weak? Explain your reasoning.

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Debt ratio = Total liabilitiesTotal assets

Debt to equity =Total liabilities

Total equity

$ 45,300,000 / $ 88,300,000 = 51.3

$ 45,300,000 / $ 43,000,000 = 1.05

The company’s ability to pay its liabilities is strong since the debt ratio is low.


Use the financial statements of Win’s Companies in Short Exercise 15-5 to complete the following profitability measures for 2012.1. Compute the rate of return on net sales.

2. Compute the rate of return on total assets.

3. Compute the asset turnover ratio.

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Rate of returnon net sales

= Net incomeNet sales

$ 15,500,000 / $ 50,200,000 = 30.9%

Rate of returnon total assets

= Net income + Interest expenseAverage total assets

$ 15,500,000 + 500,000 / ($ 88,300,000 + $ 51,200,000)/2 = 22.9%

Asset turnover ratio =Net sales

Average total assets

$ 50,200,000 / ($ 88,300,000 + $ 51,200,000)/2 = 0.72


(Continued)

4. Compute the rate of return on common stockholders’ equity.

5. Are these rates of return strong or weak? Explain your reasoning.

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Rate of return on commonstockholders’ equity

= Net income – Preferred dividendsAverage common stockholders’ equity

$ 15,500,000 – 0 / ($ 43,000,000 + $ 27,500,000) /2 = 44.0 %

These rates of return are strong considering that average companies present much lower rates of return.


Use the financial statements of Win’s Companies in Short Exercise 15-5. Win’s has 500,000 common shares outstanding during 2012.1.Compute earnings per share (EPS) for Win’s. Round to the nearest cent.

2. Compute Win’s Companies’ price/earnings ratio. The market price per share of Win’s stock is $68.50.

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Earnings per shareof common stock

=Net income – Preferred Dividends


$ 15,500,000 – 0/500,000 = $31.00

P/E ratio = Market price per share of common stockEarnings per share

$68.50/$31.00 = 2.2 times


Analysts look for red flags that may signal financial troubleRecent accounting scandals highlight the importance of:

Movement of sales, inventory, and receivablesEarnings problemsDecreased cash flowToo much debtInability to collect receivablesBuildup of inventory

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Horizontal analysis allows a company to see the percentage change from one year to the next.Trend analysis can show the percentage change from a base year forward to determine whether the trend in net sales, for example, is positive or negative.Vertical analysis shows the relationship of each item on the statement to a base amount. The base amount is net sales on the income statement and total assets on the balance sheet. All other items are reported as a percentage of the 100% net sales line on the income statement or the 100% total assets line on the balance sheet.

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Vertical analysis can be used to prepare common-size statements to compare companies against each other. We can benchmark (measure) a company against a key competitor or measure a company against the industry average.Ratio analysis is used to analyze financial statement data. Ratios provide information about a company’s performance and are best used to measure a company against other firms in the same industry and to denote trends within the company.

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Ratios tell users about a company’s liquidity, solvency, profitability, and asset management. No one ratio can provide the whole picture a decision maker needs.

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Copyright

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Financial Statement Analysis

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