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IQRA

UNIVERSITY

CITY CAMPUS

McGraw-Hi ll /Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

How Well Am I Doing?Financial Statement

Analysis

INTISAR M.USMANI FCMA

FIRST HABIB MODARABA


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2Limitations of Financial Statement

Analysis

Differences in accounting methodsbetween companies sometimes

make comparisons difficult.

We use the LIFO method tovalue inventory.

We use the FIFO method tovalue inventory.


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3Limitations of Financial Statement

Analysis

Analysts should look beyondthe ratios.

Economicfactors

Industrytrends

Changes withinthe company

Technologicalchanges

Consumertastes


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4Statements in Comparative and

Common-Size Form

Dollar and percentagechanges on statements

Common-sizestatements

Ratios

Analyticaltechniques used toexamine

relationships among

financial statementitems


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6

Horizontal Analysis

Horizontal analysis shows thechanges between years in the

financial data in both dollarand

percentage form.


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7

Horizontal Analysis

Example

The following slides illustrate ahorizontal analysis of Clover

Corporations December 31, 2008

and 2007 comparative balancesheets and comparative incomestatements.


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8

CLOVER CORPORATIONComparative Balance Sheets

December 31

Increase (Decrease)

2008 2007 Amount %

AssetsCurrent assets:

Cash 12,000$ 23,500$

Accounts receivable, net 60,000 40,000

Inventory 80,000 100,000

Prepaid expenses 3,000 1,200

Total current assets 155,000 164,700Property 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


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Horizontal Analysis

Calculating Change in Dollar Amounts

DollarChange

Current YearFigure

Base YearFigure=

The dollar

amounts for2007 become

the base year

figures.


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10

Horizontal Analysis

Calculating Change as a Percentage

Percentage

Change

Dollar Change

Base Year Figure100%

=


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11


December 31

Increase (Decrease)

2008 2007 Amount %


Cash 12,000$ 23,500$ (11,500)$ (48.9)

Accounts receivable, net 60,000 40,000

Inventory 80,000 100,000


Total current assets 155,000 164,700Property and equipment:

Land 40,000 40,000

Buildings and equipment, net 120,000 85,000


Total assets 315,000$ 289,700$

Horizontal Analysis

($11,500 $23,500) 100% = 48.9%

$12,000 $23,500 = $(11,500)


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Horizontal Analysis


December 31

Increase (Decrease)

2008 2007 Amount %


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


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13

Horizontal Analysis

We could do this for theliabilities & stockholders

equity, but instead, lets look

at the income statement.


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14

Horizontal Analysis

CLOVER CORPORATIONComparative Income Statements

For the Years Ended December 31

Increase

(Decrease)

2008 2007 Amount %Net sales 520,000$ 480,000$

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$


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Increase

(Decrease)

2008 2007 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3

Cost 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


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Increase

(Decrease)

2008 2007 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3


Gross margin 160,000 165,000 (5,000) (3.0)






Net income 17,500$ 22,400$ (4,900)$ (21.9)

Horizontal Analysis

Sales increased by 8.3%, yet

net income decreased by 21.9%.


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Increase

(Decrease)

2008 2007 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3


Gross margin 160,000 165,000 (5,000) (3.0)






Net income 17,500$ 22,400$ (4,900)$ (21.9)

Horizontal Analysis

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

increase in sales, yielding an overall

decrease in net income.


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Trend Percentages

Trend percentages

state several yearsfinancial data in termsof a base year, whichequals 100 percent.


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Trend Percentages

TrendPercentage

Current Year AmountBase Year Amount

100%=


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Trend Percentages

Example

Look at the information for Berry Productsfor the years 2003 through 2007. We will

complete a trend analysis using theseamounts to see what we can learn aboutthe company.


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Trend Percentages

Berry ProductsIncome Information


The baseyear is 2003, and its amounts

will equal 100%.

YearItem 2007 2006 2005 2004 2003

Sales 400,000$ 355,000$ 320,000$ 290,000$ 275,000$

Cost of goods sold 285,000 250,000 225,000 198,000 190,000

Gross margin 115,000 105,000 95,000 92,000 85,000

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Trend Percentages


For the Years Ended December 31Year

Item 2007 2006 2005 2004 2003

Sales 105% 100%

Cost of goods sold 104% 100%

Gross margin 108% 100%

2004 Amount 2003 Amount 100%( $290,000 $275,000 ) 100% = 105%( $198,000 $190,000 ) 100% = 104%( $ 92,000 $ 85,000 ) 100% = 108%

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Trend Percentages



By analyzing the trends for Berry Products, wecan see that cost of goods sold is increasing

faster than sales, which is slowing the increasein gross margin.

YearItem 2007 2006 2005 2004 2003

Sales 145% 129% 116% 105% 100%

Cost of goods sold 150% 132% 118% 104% 100%

Gross margin 135% 124% 112% 108% 100%

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Trend Percentages

We can use the trendpercentages to construct a

graph so we can see thetrend over time.

100

110

120

130

140

150

160

2003 2004 2005 2006 2007

Year

Percentage

Sales

COGS

GM

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25

Common-Size Statements

Common-size

statements use

percentages to express

the relationship ofindividual components to

a total within a single

period. This is alsoknown as vertical

analysis.

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In incomestatements, all

items areexpressed as apercentage of

net sales.

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Gross Margin Percentage

Gross MarginPercentage

Gross MarginSales

=

This measure indicates how muchof each sales dollar is left after

deducting the cost of goods sold to

cover expenses and provide a profit.

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In balancesheets, all itemsare expressed

as a percentageof total assets.

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Wendy's McDonald's

(do l l a rs i n m i l l i ons) Dollars Percentage Dollars Percentage

2002 Net income 219$ 8.00% 894$ 5.80%

Common-size financial statements are

particularly useful when comparingdata from different companies.

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Example

Lets take another look at the information

from the comparative income statementsof Clover Corporation for 2007 and 2008.

This time, lets prepare common-sizestatements.

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Common-Size

Percentages

2008 2007 2008 2007Net sales 520,000$ 480,000$ 100.0 100.0


Gross margin 160,000 165,000


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



Net income 17,500$ 22,400$


Net sales isthe base

and isexpressedas 100%.

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Common-Size

Percentages

2008 2007 2008 2007Net sales 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


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



Net income 17,500$ 22,400$


2007 Cost 2007 Sales 100%( $315,000 $480,000 ) 100% = 65.6%

2008 Cost 2008 Sales 100%( $360,000 $520,000 ) 100% = 69.2%

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Common-Size

Percentages

2008 2007 2008 2007Net sales 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 8.2Interest 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

What conclusions can we draw?

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Quick Check

Which of the following statements describeshorizontal analysis?

a. A statement that shows items appearing

on it in percentage and dollar form.b. A side-by-side comparison of two or

more years financial statements.

c. A comparison of the account balances onthe current years financial statements.

d. None of the above.

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Quick Check

Which of the following statements describeshorizontal analysis?

a. A statement that shows items appearing

on it in percentage and dollar form.b. A side-by-side comparison of two or

more years financial statements.

c. A comparison of the account balances onthe current years financial statements.

d. None of the above.

Horizontal analysis shows the changesbetween years in the financial data, in

both dollar and percentage form.

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CommonStockholders

Short-termCreditors

Long-termCreditors

Ratios

37


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37Now, lets look at

NortonCorporations

2006 and 2007financial

statements.

38NORTON CORPORATION


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38NORTON CORPORATION

Balance Sheets

December 31

2007 2006

Assets

Current assets:

Cash 30,000$ 20,000$

Accounts receivable, net 20,000 17,000Inventory 12,000 10,000


Total current assets 65,000 49,000

Property and equipment:

Land 165,000 123,000Buildings and equipment, net 116,390 128,000


Total assets 346,390$ 300,000$

39 NORTON CORPORATION


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NORTON CORPORATION

Balance Sheets

December 31

2007 2006

Liabilities and Stockholders' Equity

Current liabilities:

Accounts payable 39,000$ 40,000$

Notes payable, short-term 3,000 2,000

Total current liabilities 42,000 42,000

Long-term liabilities:

Notes payable, long-term 70,000 78,000

Total liabilities 112,000 120,000

Stockholders' equity:

Common stock, $1 par value 27,400 17,000Additional paid-in capital 158,100 113,000

Total paid-in capital 185,500 130,000

Retained earnings 48,890 50,000

Total stockholders' equity 234,390 180,000

Total liabilities and stockholders' equity 346,390$ 300,000$

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NORTON CORPORATION

Income Statements


2007 2006

Net sales 494,000$ 450,000$


Gross margin 354,000 323,000


Net operating income 84,000 74,000

Interest expense 7,300 8,000Net income before taxes 76,700 66,000


Net income 53,690$ 46,200$

41


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Learning Objective 2

Compute and interpret

financial ratios that would beuseful to a common

stockholder.

42Ratio Analysis The Common


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Ratio Analysis The Common

Stockholder

Use thisinformation to

calculate ratios

to measure thewell-being ofthe common

stockholders ofNorton

Corporation.

NORTON CORPORATION

2007Number of 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 per share 20

Interest expense 7,300

Total assets


End of year 346,390

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Earnings Per Share

Earnings per ShareNet Income Preferred Dividends

Average Number of CommonShares Outstanding

=

Whenever a ratio divides an income statementbalance by a balance sheet balance, the average

for the year is used in the denominator.

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Earnings Per Share

Earnings per ShareNet Income Preferred Dividends

Average Number of CommonShares Outstanding

=

This measure indicates how muchincome was earned for each share of

common stock outstanding.

Earnings per Share$53,690 0

(17,000 + 27,400)/2= = $2.42

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Price-Earnings Ratio

Price-EarningsRatio

Market Price Per ShareEarnings Per Share

=

This measure is often used by investorsas a general guideline in gauging stockvalues. Generally, the higher the price-earnings ratio, the more opportunity a

company has for growth.

Price-EarningsRatio

$20.00$2.42

= = 8.26 times

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Dividend Payout Ratio

This ratio gauges the portion of currentearnings being paid out in dividends.

Investors seeking current income wouldlike this ratio to be large.

DividendPayout Ratio

Dividends Per ShareEarnings Per Share

=

DividendPayout Ratio

$2.00$2.42

= = 82.6%

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Dividend Yield Ratio

This ratio identifies the return, interms of cash dividends, on the

current market price of the stock.

DividendYield Ratio

Dividends Per ShareMarket Price Per Share

=

DividendYield Ratio

$2.00$20.00

= = 10.00%

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Return on Total Assets

This ratio measures how wellassets have been employed.

Return on

Total Assets

$53,690 +[7,300 (1 .30)]

($300,000 + $346,390) 2= = 18.19%

Return on

Total Assets

Net Income + [Interest Expense (1 Tax Rate)]

Average Total Assets=

49Return on Common Stockholders


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Return on Common Stockholders

Equity

Return on CommonStockholders Equity

Net Income Preferred DividendsAverageStockholders Equity

=

This measure indicates how well thecompany employed the owners

investments to earn income.

Return on CommonStockholders Equity

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

= = 25.91%

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Financial Leverage

Financial leverageinvolvesacquiring assets with funds at a

fixed rate of interest.

Return oninvestment in

assets>

Fixed rate ofreturn onborrowed

funds

Positivefinancialleverage

=

Return oninvestment in

assets

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