Financial Statement Analysis doc

Ratio Classification1 Measuring ability to pay current liabilities 2 Measuring ability to sell inventory and... Current ratio =Total current assets ÷ Total current liabilitiesThe current

Financial Statement

Analysis

Chapter

18

The Annual Report Usually Contains

…financial statements

– notes to the financial statements

– a summary of accounting methods used

– management discussion and analysis of the financial statements

– an auditor’s report

– comparative financial data for 5 to 10

years

Objective 1

Perform a Horizontal Analysis

of Financial Statements.

2005 2004 DifferenceSales $41,500 $37,850 $3,650

$3,650 ÷ $37,850 = 0964, or 9.6%

Horizontal Analysis

Year 2005 2004 2003Revenues $27,611 $24,215 $21,718Cost of sales 15,318 14,709 13,049Gross profit $12,293 $ 9,506 $ 8,669

2003 is the base year.

What are the trend percentages?

Trend Percentages

Year 2005 2004 2003

Cost of sales 117% 113% 100%Gross profit 142% 110% 100%

Trend Percentages

These percentages were calculated by

dividing each item by the base year

Objective 2

Perform a Vertical Analysis

of Financial Statements.

Vertical Analysis

…compares each item in a financial

statement to a base number set to 100%

• Every item on the financial statement is then reported as a percentage of that base

Plant and equipment, net 6,847 17.7

Objective 3

Understand Benchmarking

Common-size Statements

• On the income statement, each item is

expressed as a percentage of net sales

• On the balance sheet, the common size is the total on each side of the accounting

equation

• Common-size statements are used to

compare one company to other companies, and to the industry average

 Cost of goods sold  Operating expenses

 Income tax  Net income

Objective 4

Using Ratios

Ratio Classification

1 Measuring ability to pay current liabilities

2 Measuring ability to sell inventory and

Palisades Furniture Example

Palisades Furniture Example

Palisades Furniture Example

Stockholders’ Equity 20x5 20x4

Total stockholders’ equity $356,000 $320,000

Total liabilities and

Palisades Furniture Example

Current ratio =Total current assets ÷ Total current liabilities

The current ratio measuresthe company’s ability to paycurrent liabilities with current assets

Measuring Ability to Pay Current Liabilities

Measuring Ability to Pay Current Liabilities

• Palisades’ current ratio:

• 20x4: $236,000 ÷ $126,000 = 1.87

• 20x5: $262,000 ÷ $142,000 = 1.85

• The industry average is 1.50

• The current ratio decreased slightly during 20x5

Acid-test ratio =(Cash + Short-term investments

+ Net current receivables)

÷ Total current liabilities

Measuring Ability to Pay Current Liabilities

The acid-test ratio shows the company’s

ability to pay all current liabilities

if they come due immediately

Measuring Ability to Pay Current Liabilities

• Palisades’ acid-test ratio:

• 20x4: ($32,000 + $85,000) ÷ $126,000

= 93

• 20x5: ($29,000 + $114,000) ÷ $142,000 = 1.01

• The industry average is 40

• The company’s acid-test ratio improved considerably during 20x5

Inventory turnover = Cost of goods sold

÷ Average inventory

Inventory turnover is a measure

of the number of times the average level of inventory is sold during a year.

Measuring Ability to

Sell Inventory

Measuring Ability to

Sell Inventory

• Palisades’ inventory turnover:

• 20x5: $513,000 ÷ $112,000 = 4.58

• The industry average is 3.4

• A high number indicates an ability to quickly sell inventory

Accounts receivable turnover =Net credit sales ÷ Average accounts receivable

Accounts receivable turnover measures a company’s

ability to collect cash from credit customers

Measuring Ability to Collect Receivables

Measuring Ability to Collect Receivables

• Palisades’ accounts receivable turnover:

• 20x5: $858,000 ÷ $99,500 = 8.62 times

• The industry average is 51 times

• Palisades’ receivable turnover is much

lower than the industry average

• The company is a home-town store that sells to local people who tend to pay their bills over a lengthy period of time

One day’s sales = Net sales ÷ 365 days

Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales

Measuring Ability to Collect Receivables

Days’ sales in receivable ratio measures how

many day’s sales remain in Accounts Receivable

Measuring Ability to Collect Receivables

• Palisades’ days’ sales in Accounts Receivable for 20x5:

• One day’s sales:

Total liabilities ÷ Total assets

Measuring Ability to

Pay Debt

The debt ratio indicates the proportion

of assets financed with debt

• The industry average is 0.64.

• Palisades Furniture expanded operations during 20x5 by financing through

borrowing

• The industry average is 2.80.

• The company’s times-interest-earned ratio increased in 20x5

• This is a favorable sign

Rate of return on net sales =Net income ÷ Net sales

Measuring Profitability

Rate of return on net sales shows the percentage

of each sales dollar earned as net income

Measuring Profitability

• Palisades’ rate of return on sales:

• 20x4: $26,000 ÷ $803,000 = 0.032

• 20x5: $48,000 ÷ $858,000 = 0.056

• The industry average is 0.008

• The increase is significant in itself and also because it is much better than the industry average

Rate of return on total assets = (Net income + interest expense) ÷ Average total assets

Measuring Profitability

Rate of return on total assets measures

how profitably a company uses its assets

Measuring Profitability

• Palisades’ rate of return on total assets for 20x5:

• ($48,000 + $24,000) ÷ $715,500 = 0.101

• The industry average is 0.078

• How does Palisades compare to the

industry?

• Very favorably

Rate of return on common stockholders’ equity

= (Net income – preferred dividends)

÷ Average common stockholders’ equity

Measuring Profitability

Common equity includes additional

paid-in capital on commonstock and retained earnings

Measuring Profitability

• Palisades’ rate of return on common

stockholders’ equity for 20x5:

• ($48,000 – $0) ÷ $338,000 = 0.142

• The industry average is 0.121

• Why is this ratio larger than the return on total assets (.101)?

• Because Palisades uses leverage

Measuring Profitability

Earnings per share of common stock

= (Net income – Preferred dividends)

÷ Number of shares of common stock outstanding

Analyzing Stock as an

Investment

• Price/earning ratio is the ratio of market

price per share to earnings per share

• 20x4: $35 ÷ $2.60 = 13.5

• 20x5: $60 ÷ $4.80 = 12.5

• Given Palisades Furniture’s 20x5 P/E ratio

of 12.5, we would say that the company’s stock is selling at 12.5 times earnings

Dividend per share of common(or preferred) stock ÷ Market price per share

of common (or preferred) stock

Analyzing Stock as an

Investment

Dividend yield shows the percentage

of a stock’s market value returned as

dividends to stockholders each period

Analyzing Stock as an

Investment

Book value per share of common stock

= (Total stockholders’ equity – Preferred equity)

÷ Number of shares of common stock outstanding

Limitations of Financial

Analysis

• Business decisions are made in a world of uncertainty

• No single ratio or one-year figure should

be relied upon to provide an assessment of

a company’s performance

Objective 5

Other Evaluation Tools

Economic Value Added

(EVA®)

• Economic value added (EVA®) combines accounting income and corporate finance

to measure whether the company’s

operations have increased stockholder

wealth

• EVA® = Net income + Interest expense – Capital charge

End of Chapter

18