Corporate finance accounting 14e by warren reeve duchac chapter 14

o Comparisons Over Time: The comparison of a financial statement item or ratio with the same item or ratio from a prior period often helps the user identify trends in a company’s econom

The Value of Financial Statement Information

users, providing each group with valuable information about a company’s economic performance and financial condition

o Liquidity

o Solvency

o Profitability

with whether a company will be able to repay short-term borrowings such as loans and notes

assets into cash, which is called liquidity

interest payments and repay the face amount of debt at maturity, which is called

solvency

price of the company’s stock to increase

which is called profitability

Techniques for Analyzing Financial Statements

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company’s financial performance and condition:

o Analytical methods examine changes in the amount and percentage of financial statement items within and across periods.

o Ratios express a financial statement item or set of financial statement items as a percentage

of another financial statement item, in order to measure an important economic relationship

as a single number.

Techniques for Analyzing Financial Statements

(slide 2 of 2)

• Both analytical methods and ratios can be used to compare a company’s financial performance over time or to another company.

o Comparisons Over Time: The comparison of a financial statement item or ratio with the same item or ratio from

a prior period often helps the user identify trends in a company’s economic performance, financial condition, liquidity, solvency, and profitability.

o Comparisons Between Companies: The comparison of a financial statement item or ratio to another company

in the same industry can provide insight into a company’s economic performance and financial condition

relative to its competitors.

Analytical Methods

methods Three such methods are:

o Horizontal analysis

o Vertical analysis

o Common-sized statements

Horizontal Analysis

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o Each item on the most recent statement is compared with the same item on one or more earlier statements in terms of the following:

 Amount of increase or decrease

 Percent of increase or decrease

Horizontal Analysis

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year for computing increases and decreases

Vertical Analysis

(slide 1 of 3)

Vertical Analysis

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follows:

o Each asset item is stated as a percent of the total assets.

o Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.

Vertical Analysis

(slide 3 of 3)

sales

Common-Sized Statements

dollar amounts shown

another or for comparing a company with industry averages

Analyzing Liquidity

cash

assets and liabilities), accounts receivable, and inventory

Liquidity Ratios and Measures

Current Position Analysis

• Current position analysis evaluates a company’s ability to pay its current liabilities

Current Position Analysis: Working Capital

(slide 1 of 2)

Working Capital = Current Assets – Current Liabilities

Current Position Analysis: Working Capital

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creditors and other debtors

sizes

Current Position Analysis: Current Ratio

Current Position Analysis: Current Ratio

(slide 2 of 2)

liabilities than is working capital, and it is much easier to compare across

companies

Current Position Analysis: Quick Ratio

ratio, sometimes called the acid-test ratio.

Quick Assets

Quick Ratio =

Current Liabilities

o Quick assets are cash and other current assets that can be easily converted to cash.

 Quick assets normally include cash, temporary investments, and receivables but exclude inventories and prepaid assets.

Accounts Receivable Analysis

o Accounts receivable turnover

o Number of days’ sales in receivables

Accounts Receivable Analysis

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o Improves a company’s liquidity

o Provides cash to improve or expand operations

o Reduces the risk of uncollectible accounts

Accounts Receivable Analysis:

Accounts Receivable Turnover

• The accounts receivable turnover is computed as follows:

SalesAccounts Receivable Turnover =

Average Accounts Receivable

Accounts Receivable Analysis:

Number of Days’ Sales in Receivables

(slide 1 of 2)

• The number of days’ sales in receivables is computed as follows:

Average Daily Sales

where

Sales

Average Daily Sales =

365 Days

Accounts Receivable Analysis:

Number of Days’ Sales in Receivables

(slide 2 of 2)

the accounts receivable have been outstanding

terms to evaluate the efficiency of the collection of receivables

Inventory Analysis

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o Decreases liquidity by tying up funds (cash) in inventory

o Increases insurance expense, property taxes, storage costs, and other related expenses

o Increases the risk of losses because of price declines or obsolescence of the inventory

Inventory Analysis: Inventory Turnover

• The inventory turnover is computed as follows:

Average Inventory

Average Daily Cost of Goods Soldwhere

365 Days

Inventory Analysis:

Number of Days’ Sales in Inventory

(slide 2 of 2)

takes to purchase, sell, and replace the inventory

Analyzing Solvency

Solvency Ratios

Ratio of Fixed Assets to Long-Term Liabilities

• The ratio of fixed assets to long-term liabilities provides a measure of how much fixed assets a company has to support its long-term debt

is computed as follows:

Fixed Assets (net)Ratio of Fixed Assets to Long-Term Liabilities =

Long-Term Liabilities

Ratio of Liabilities to Stockholders’ Equity

• The ratio of liabilities to stockholders’ equity measures how much of the company is financed by debt and equity It indicates the margin of safety for creditors

Total LiabilitiesRatio of Liabilities to Stockholders’ Equity =

Total Stockholders’ Equity

Times Interest Earned

• The times interest earned, sometimes called the coverage ratio, measures the risk

that interest payments will not be made if earnings decrease

Interest Expense

decrease

Profitability Analysis

o This ability depends on the relationship between the company’s operating results and the assets the company has available for use in its operations.

 Thus, the relationship between income statement and balance sheet items are used to evaluate profitability.

Profitability Ratios

Asset Turnover

• The asset turnover measures how effectively a company uses its assets

SalesAsset Turnover =

Average Total Assets (excluding long-term investments)

o Note that term investments are excluded in computing asset turnover because term investments are unrelated to normal operations and sales.

long-Return on Total Assets

(slide 1 of 2)

financed

o In other words, this rate is not affected by the portion of assets financed by creditors or stockholders.

• The return on total assets is computed as follows:

Average Total Assets

o By adding interest expense to net income, the effect of whether the assets are financed by creditors (debt) or stockholders

(equity) is eliminated.

o Because net income includes any income earned from long-term investments, the average total assets includes long-term

investments as well as the net operating assets.

Return on Total Assets

(slide 2 of 2)

amounts of nonoperating income and expense

Income from Operations

Return on Operating Assets =

Average Operating Assets

Return on Stockholders’ Equity

Average Total Stockholders’ Equity

Return on Stockholders’ Equity

(slide 2 of 2)

o This is because of the effect of leverage.

Return on Common Stockholders’ Equity

• The return on common stockholders’ equity measures the rate of profits earned

on the amount invested by the common stockholders

Earnings per Share on Common Stock

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• Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock

Earnings per Share on Common Stock

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securities outstanding, such as convertible preferred stock, stock options, and stock warrants

stock outstanding are reported separately as earnings per common share assuming

dilution or diluted earnings per share.

Price-Earnings Ratio

• The price-earnings (P/E) ratio on common stock measures a company’s future earnings prospects

Earnings per Share on Common Stock

Dividends per Share

(slide 1 of 2)

• Dividends per share measures the extent to which earnings are being distributed

to common shareholders

Dividends on Common StockDividend per Share =

Shares of Common Stock Outstanding

Dividends per Share

(slide 2 of 2)

which earnings are being retained for use in operations

Dividend Yield

• The dividend yield on common stock measures the rate of return to common stockholders from cash dividends

from their investment

Dividends per Share of Common StockDividend Yield =

Market Price per Share of Common Stock

Summary of Analytical Measures

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Summary of Analytical Measures

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Summary of Analytical Measures

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Corporate Annual Reports

annual reports normally include the following sections:

o Management discussion and analysis

o Report on internal control

o Report on fairness of the financial statements

Management Discussion and Analysis

• Management’s Discussion and Analysis (MD&A) is required in annual reports filed with the Securities and Exchange Commission.

• It includes management’s analysis of current operations and its plans for the future.

• Typical items included in the MD&A are as follows:

o Management’s analysis and explanations of any significant changes between the current and prior years’ financial statements.

o Important accounting principles or policies that could affect interpretation of the financial statements, including the effect of changes in

accounting principles or the adoption of new accounting principles.

o Management’s assessment of the company’s liquidity and the availability of capital to the company.

o Significant risk exposures that might affect the company.

o Any “off-balance-sheet” arrangements such as leases not included in the financial statements.

Report on Internal Control

Report on Internal Control

(slide 2 of 2)

conclusions on internal control

o Thus, two reports on internal control, one by management and one by a public accounting firm, are included in the annual report.

Report on Fairness of the Financial Statements

• All publicly held corporations are required to have an independent audit (examination) of their financial statements

• The Certified Public Accounting (CPA) firm that conducts the audit renders an opinion, called the

Report of Independent Registered Public Accounting Firm, on the fairness of the statements.

o An opinion stating that the financial statements present fairly the financial position, results of operations, and

cash flows of the company is said to be an unqualified opinion, sometimes called a clean opinion.

o Any report other than an unqualified opinion raises a “red flag” for financial statement users and requires

further investigation as to its cause.

Appendix 1: Unusual Items

on the Income Statement

separately on the income statement

o This is because such items do not occur frequently and are typically unrelated to current operations.

o Affecting the current period income statement

o Affecting a prior period income statement

Appendix 1: Unusual Items Affecting the

Current Period’s Income Statement

o Income statement presentation

o Earnings per share presentation

period in which they occur

Appendix 1: Unusual Items Affecting the Current Period’s

Income Statement—Income Statement Presentation

• A company may discontinue a component of its operations by selling or abandoning the

component’s operations.

o If the discontinued component is (1) the result of a strategic shift and (2) has a major effect on the entity’s

operations and financial results, any gain or loss on discontinued operations is reported on the income

statement as a Gain (or loss) from discontinued operations.

o A note to the financial statements should describe the operations sold, including the date operations were

discontinued, and details about the assets, liabilities, income, and expenses of the discontinued component.

Appendix 1: Unusual Items Affecting the Current Period’s Income Statement—Earnings per Share

financial statements for discontinued operations

Appendix 1: Unusual Items Affecting the

Prior Period’s Income Statement

o Two such items are as follows:

 Errors in applying generally accepted accounting principles

 Changes from one generally accepted accounting principle to another

Appendix 2: Fair Value

• Fair value is the price that would be received for selling an asset if it were sold today

o This differs from historical cost, in that the amount reported on the balance sheet changes each period to reflect the asset’s fair (current) value at the balance sheet date.

 The change in an asset’s fair value from one period to the next is recorded in the financial statements as either:

– a gain or loss on the income statement, or

– an increase or decrease in stockholders’ equity reported as other comprehensive income.

Appendix 2: Comprehensive Income

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• When a change in an asset’s fair value is not recorded as a gain or loss on the income statement, it is recorded as an element of other comprehensive income.

o These include changes in the fair value of certain investment securities, foreign currency exposures, and pension assets

• The elements of other comprehensive income are included in the computation of comprehensive income, which is defined as all changes in stockholders’ equity during a period, except those resulting from dividends and

stockholders’ investments.

• Comprehensive income is determined as follows:

Appendix 2: Comprehensive Income

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o on the income statement, directly below net income, or

o in a separate statement of comprehensive income.

Appendix 2: Accumulated Other

Comprehensive Income