02 financial statements and analysis

Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt... 2-18 Using Financial Ratios: Types of Ratio Comparisons – Used to evaluate

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Chapter 2

Financial

Statements and Analysis

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2-2

Learning Goals

1 Review the contents of the stockholders’ report

and the procedures for consolidating

international financial statements.

2 Understand who uses financial ratios,

and how.

3 Use ratios to analyze a firm’s liquidity

and activity.

4 Discuss the relationship between debt and

financial leverage and the ratios used to

analyze a firm’s debt.

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Learning Goals (cont.)

5 Use ratios to analyze a firm’s profitability

and market value.

6 Use a summary of financial ratios and

the DuPont system of analysis to

perform a complete ratio analysis.

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2-4

The Stockholders’ Report

• The guidelines used to prepare and maintain financial

records and reports are known as generally accepted

accounting principles (GAAP).

• GAAP is authorized by the Financial Accounting

Standards Board (FASB).

• The Sarbanes-Oxley Act of 2002, passed to eliminate

the many disclosure and conflict of interest problems of corporations, established the Public Company

Accounting Oversight Board (PCAOB), which is a for-profit corporation that overseas auditors

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not-The Stockholders’ Report (cont.)

• The PCAOB is charged with protecting the

interests of investors and furthering the public interest in the preparation of informative, fair,

and independent audit reports.

• Public corporations with more than

$5 million in assets and more than 500

stockholders are required by the SEC to

provide their stockholders with an annual

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2-6

The Four Key Financial Statements:

The Income Statement

summary of a company’s operating results during a specified period.

reporting purposes, they are generally

computed monthly by management and

quarterly for tax purposes.

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The Four Key

Financial

Statements

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The Balance Sheet

a firm’s financial position at a given point

in time.

equity represents the owners’ investment, and liabilities indicate what the firm

has borrowed.

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The Four Key Financial Statements

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The Four Key

Financial Statements (cont.)

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Statement of Retained Earnings

reconciles the net income earned and

dividends paid during the year, with the

change in retained earnings.

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Statement of Cash Flows

summary of the cash flows over the period

of concern, typically the year just ended.

into a company’s investment, financing

and operating activities, but also ties

together the income statement and

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• Income statement items are usually treated similarly.

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Consolidating International

Financial Statements (cont.)

• Equity accounts, on the other hand, are

translated into dollars by using the

exchange rate that prevailed when the

parent’s equity investment was made (the historical rate).

• Retained earnings are adjusted to reflect

each year’s operating profits (or losses).

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Using Financial Ratios:

Interested Parties

calculating and interpreting financial ratios

to assess a firm’s financial condition

and performance.

and the firm’s own management.

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Types of Ratio Comparisons

– Used to evaluate a firm’s performance

over time

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Types of Ratio Comparisons (cont.)

– Used to compare different firms at the same point in time

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– Industry comparative analysis

• One specific type of cross sectional analysis

Used to compare one firm’s financial performance

to the industry’s average performance

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– Benchmarking

• A type of cross sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes

to emulate

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– Combined analysis simply uses a

combination of both time series analysis and cross-sectional analysis

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Cautions for Doing Ratio Analysis

• Ratios must be considered together; a single

ratio by itself means relatively little.

• Financial statements that are being compared should be dated at the same point in time.

• Use audited financial statements when possible.

• The financial data being compared should have been developed in the same way.

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Ratio Analysis Example

for analyzing financial statements using

the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2.

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Current ratio = total current assets

total current liabilities Current ratio = $1,233,000 = 1.97

Ratio Analysis

– Current Ratio

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Quick ratio = Total Current Assets - Inventory

total current liabilities Quick ratio = $1,233,000 - $289,000 = 1.51

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Inventory Turnover = Cost of Goods Sold

Inventory Inventory Turnover = $2,088,000 = 7.2

Ratio Analysis (cont.)

– Inventory Turnover

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Average Age of Inventory = 365

Inventory Turnover Inventory Turnover = 365 = 50.7 days

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ACP = Accounts Receivable

Net Sales/365 ACP = $503,000 = 59.7 days

– Average Collection Period

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Total Asset Turnover = Net Sales

Total Assets Total Asset Turnover = $3,074,000 = 85

– Total Asset Turnover

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2-34Insert Table 2.6 here

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Debt Ratio = Total Liabilities/Total Assets

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FPCR = EBIT + Lease Payments

Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

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OPM = EBIT/Net Sales

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NPM = Earnings Available to Common Stockholders

Sales NPM = $221,000/$3,074,000 = 7.2%

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EPS = Earnings Available to Common Stockholders Number of Shares Outstanding

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Addison-2-44

ROA = Earnings Available to Common Stockholders

Total Assets ROA = $221,000/$3,597,000 = 6.1%

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ROE = Earnings Available to Common Stockholders

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Addison-2-46

P/E = Market Price Per Share of Common Stock

Earnings Per Share P/E = $32.25/$2.90 = 11.1

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BV/Share = Common Stock Equity

Number of Shares of Common Stock

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Addison-2-48

M/B Ratio = Market Price/Share of Common Stock

Book Value/Share of Common Stock

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Summarizing All Ratios

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Summarizing All Ratios (cont.)

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DuPont System of Analysis

• The DuPont system of analysis is used to dissect

the firm’s financial statements and to assess its

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Addison-2-54

DuPont System

of Analysis (cont.)

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Modified DuPont Formula

• The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage

multiplier (FLM), which is the ratio of total assets

to common stock equity:

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ROE = 6.1% X 2.06 = 12.6%

Modified DuPont Formula (cont.)

• Use of the FLM to convert ROA into ROE

reflects the impact of financial leverage on the owner’s return.

• Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and

Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷

$1,754,000 common stock equity) into the

Modified DuPont formula yields:

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