Lecture Accounting: What the numbers mean (5/e) - Chapter 11: Financial statement analysis

After reading this chapter, you should be able to answer the following questions: How can liquidity measures be influenced by the inventory cost-flow assumption used? How do suppliers and creditors use a customer’s payment practices to judge liquidity? What are the influences of alternative inventory cost-flow assumptions and depreciation methods on turnover ratios?...

CHAPTER 11

FINANCIAL STATEMENT

ANALYSIS

Learning Objectives

1 How can liquidity measures be

influenced by the inventory cost-flow

assumption used?

2 How do suppliers and creditors use a

customer’s payment practices to

judge liquidity?

3 What are the influences of alternative

inventory cost-flow assumptions and

depreciation methods on turnover

ratios?

Learning Objectives

4 How are the number of days’ sales in

accounts receivable and inventory

used to evaluate the effectiveness of

the management of receivables and

inventory?

5 What is the significance of the

price/earnings ratio in the evaluation

of the market price of a company’s

stock?

Learning Objectives

6 How are dividend yield and the

dividend payout ratio used by

investors to evaluate a company’s

common stock?

7 What is financial leverage, and why

is it significant to management,

creditors, and owners?

8 What is book value per share of

common stock, how is it calculated,

and why is it not a very meaningful

amount for most companies?

Learning Objectives

9 How can common size financial

statements be used to evaluate a

firm’s financial position and results

of operations over a number of

years?

10.How can operating statistics using

physical, or non-financial data, be

used to help management evaluate

the results of the firm’s activities?

Learning Objective 1

• How can liquidity measures be

influenced by the inventory

cost-flow assumption used?

Financial Statement Analysis

Ratios

• Used to facilitate the interpretation of

an entity’ financial position and results

Liquidity Measures

• The balance sheet carrying values of

inventory will depend on the cost-flow

assumption used

• Cannot compare firms using different

inventory cost-flow assumptions

• Firms often report the LIFO reserve –

the difference between LIFO an FIFO

inventory values

Liquidity Ratios

• Working capital =

Current assets – Current liabilities

• Current ratio = Current assets

Learning Objective 2

• How do suppliers and creditors

use a customer’s payment

practices to judge liquidity?

Customer’s Payment Practices

• Suppliers and creditors want to know

if a firm is paying its bills promptly

• This information may be obtained

from other suppliers, credit bureaus,

and Dun & Bradstreet reports

• Credit bureaus and credit rating

agencies provide a graded rating for

firms

Learning Objective 3

• What are the influences of

alternative inventory cost-flow

assumptions and depreciation

methods on turnover ratios?

Activity Measures

• Focus primarily on the relationship

between assets and sales

• In computing activity measures, average

assets is used

• Average asset amounts include inventory

and fixed assets

• The values of inventory (based on cost-flow

assumptions) and fixed assets (based on

book cost less accumulated depreciation)

depend on the cost-flow assumptions and

depreciation methods used

Activity Ratios

• Total asset turnover = Sales

Average total assets

• Inventory turnover = Cost of goods sold

Average inventories

• Number of days’ sales in accounts

receivable = Accounts receivable

Average days’ sales

More Activity Ratios

• Average days’ sales = Annual sales

365

• Number of days’ sales in inventory =

Inventory

Average days’ cost of goods sold

• Average days’ cost of goods sold =

Average cost of goods sold

365

Learning Objective 4

• How are the number of days’

sales in accounts receivable and

inventory used to evaluate the

effectiveness of the management

of receivables and inventory?

Number of Days’ Sales in

Accounts Receivable

• Assesses the efficiency of managing accounts receivable

• The sooner accounts receivable are collected,

the sooner cash is available for use in the

business

• Generally, the higher the turnover and lower

the number in days’ sales, the better

• An increase in the age of accounts receivable

is a warning that profitability and liquidity may

be weakening

Number of Days’ Sales

in Inventory

• Assesses the efficiency of managing

inventory

• The lower that inventories can be

maintained relative to sales,the less

inventory that needs to be financed

with debt and the greater the return on

investment

• Trend in the efficiency of managing

inventory is the important factor

Profitability Measures

• Operating income is frequently used in

ROI calculations because it is a more

direct measure of management’s

activities

• Average ROI based on net income for

most American firms is between 7%

and 10%

• Again, trends are important

Profitability Ratios

• ROI =

Return (Net income)

Investment (Average total assets)

• DuPont model =

Margin x Turnover

Net income x Sales

Sales Average total assets

More Profitability Ratios

• ROE = Net income

Average total owners’ equity

• Dividend yield = Annual dividend per share

Market price per share of stock

• Dividend payout ratio = Annual dividend per share

Earnings per share

Learning Objective 5

• What is the significance of

the price/earnings ratio in the evaluation of the market price

of a company’s stock?

Price/Earning Ratio

• P/E ratio =

Market price of a share of common stock

Earnings per share of common stock

• Used extensively to evaluate the market

price of a firm’s common stock relative to

that of other firms and the market as a whole

• Also called earnings multiple

Importance of P/E Ratio

• Investors can earn a return on stock two

Learning Objective 6

• How are dividend yield and

the dividend payout ratio used by investors to evaluate

a company’s common stock?

Dividend Yield

• Dividend yield =

Annual dividend per share

Market price per share of stock

• Should be compared to the yield available

on other investments

• On common stock, historically this has

ranged from 3% to 6%

Dividend Payout Ratio

• Dividend payout ratio =

Annual dividend per share

Earnings per share

• Reflects the dividend policy of the firm

• Most firms pay a relatively constant portion

of earnings and avoid fluctuations

• Generally, ranges from 30% to 50% for

manufacturing and merchandising firms

Preferred Dividend Coverage

Ratio

• Preferred dividend coverage ratio =

Net incomePreferred dividend requirement

• Indicates the margin of safety of the

preferred stock dividend

Financial Leverage Measures

• Refers to the use of debt to finance the

assets of the entity

• Adds risk to the operation of the firm

• Also magnifies the return to owners

relative to the return on assets

• Firms want to borrow at a rate less than

the rate of return on financed assets

• Interest is a deductible expense;

Debt Ratio

• Indicates the extent to which a firm is

using financial leverage

• Debt ratio =

Total liabilities

Total liabilities and owners’ equity

• Indicates the percentage of financing that

is done with debt

Debt/Equity Ratio

• Another indicator of the extent to which a firm

is using financial leverage

• Debt/Equity ratio = Total liabilities

Total owners’ equity

• Indicates the percentage of financing that is

done with debt

• Since deferred taxes and current liabilities are not interest bearing, these items are often

excluded from the computation

Times Interest Earned Ratio

• A measure that shows the relationship of

earnings before interest and taxes to interest

expense

• The greater the ratio, the more confident the

debt holders are about the firm continuing to

earn enough to cover interest payments

• Times interest earned =

Earnings before interest and taxes

Interest expense

Learning Objective 8

• What is book value per share of

common stock, how is it calculated, and why is it not a very meaningful

amount for most companies?

Book Value per Share

of Common Stock

• Easily misunderstood

• Cannot be compared to market value due to book value reflects the application of generally

accepted accounting principles and the specific

accounting policies that the firm has selected

•

• Book value per share of common stock =

Common shareholders’ equity

Number of shares of common stock

outstanding

Learning Objective 9

• How can common size financial

statements be used to evaluate a

firm’s financial position and

results of operations over a

number of years?

Common Size Financial Statements

• Used when evaluating the operating

results of a firm over a number of years

• Each asset, liability, and owners’ equity

account is expressed as a percentage of total assets

• On the income statement, sales is set at 100%, and each item is expressed as a

percentage of sales

Use of Common Size Financial Statements

• Using percentages makes spotting trends

easier

• Can compare firms of different sizes

• In horizontal analysis, several years’ financial data are stated in terms of a base year

• Each item in the base year is 100%; the items

in subsequent years are a percentage of the

item in the base year

Learning Objective 10

• How can operating statistics using

physical, or non-financial data, be

used to help management evaluate the results of the firm’s activities?

Other Operating Statistics

• Physical measures also are useful

• Sales in units removes hidden price

changes

• Total employees may be more useful

than payroll costs

• Usually analysts combine financial and

physical measures to show trends and

to make comparisons