Lecture Principles of financial accouting - Chapter 17: Analysis of financial statements

After completing this chapter you should be able to: Explain the purpose and identify the building blocks of analysis, describe standards for comparisons in analysis, summarize and report results of analysis, explain and apply methods of horizontal analysis, describe and apply methods of vertical analysis, define and apply ratio analysis.

PowerPoint Authors:

Susan Coomer Galbreath, Ph.D., CPA Charles W Caldwell, D.B.A., CMA Jon A Booker, Ph.D., CPA, CIA Cynthia J Rooney, Ph.D., CPA Winston Kwok, Ph.D., CPA

McGraw­Hill/Irwin         Copyright © 2011 by The McGraw­Hill Companies, Inc. All rights reserved.

ANALYSIS OF FINANCIAL

STATEMENTS

Involves transforming

Financial statement analysis helps users

make better decisions.

Financial statement analysis helps users

make better decisions.

Internal Users

ManagersOfficersInternal Auditors

External Users

ShareholdersLendersCustomers

BUILDING BLOCKS OF ANALYSIS

Liquidity and

Market prospects Profitability

INFORMATION FOR ANALYSIS

1 Income Statement (Statement of

Comprehensive Income)

2 Balance Sheet (Statement of

Financial Position)

3 Statement of Changes in Equity

4 Statement of Cash Flows

5 Notes to the Financial Statements

Intracompany Competitors Industry

Guidelines

STANDARDS FOR COMPARISON

When we interpret our analysis, it is essential to

compare the results we obtained to other

standards or benchmarks

Horizontal Analysis

Comparing a company’s financial condition and

performance across time.

TOOLS OF ANALYSIS

Vertical Analysis

Comparing a company’s financial condition and

performance to a base amount.

Ratio Analysis

Measurement of key relations between financial statement

items.

HORIZONTAL ANALYSIS

COMPARATIVE STATEMENTS

Calculate Change in Dollar Amount

Dollar Change

Dollar Change Analysis Period Amount

Analysis Period

Amount Base Period Amount

Base Period Amount

When measuring the amount of the change in dollar amounts, compare the analysis period balance to the base period balance The analysis period is usually the current year while the base

period is usually the prior year

When measuring the amount of the change in dollar amounts, compare the analysis period balance to the base period balance The analysis period is usually the current year while the base

period is usually the prior year

When calculating the change as a percentage, divide the amount of the dollar change by the base period amount, and then multiply by 100 to

convert to a percentage

When calculating the change as a percentage, divide the amount of the dollar change by the base period amount, and then multiply by 100 to

convert to a percentage

$1,550,861 – $835,546 = $715,315

($715,315 ÷ $835,546) × 100 = 85.6%

HORIZONTAL ANALYSIS

HORIZONTAL ANALYSIS

($3,888,038 ÷ $11,065,186) × 100 = 35.1%

$14,953,224 – $11,065,186 = $3,888,038

TREND ANALYSIS

Trend analysis is used to reveal patterns in data

covering successive periods.

Trend analysis is used to reveal patterns in data

covering successive periods.

Trend

Percent

Analysis Period Amount

Base Period Amount 100

TREND ANALYSIS

Research in MotionIncome Statement Information

Using 2006 as the base year we will get the following trend information :

Examples of 2006-2008 Calculations for Revenues:

2006 is base year Set to 100%

2007: $3,037,103 ÷ $2,065,845 × 100 = 147.0%

2008: $6,009,395 ÷ $2,065,845 × 100 = 290.9%

Examples of 2006-2008 Calculations for Revenues:

2006 is base year Set to 100%

2007: $3,037,103 ÷ $2,065,845 × 100 = 147.0%

2008: $6,009,395 ÷ $2,065,845 × 100 = 290.9%

TREND ANALYSIS

We can use the trend percentages to construct a

graph so we can see the trend over time.

We can use the trend percentages to construct a

graph so we can see the trend over time.

VERTICAL ANALYSISCommon-Size Statements

COMMON-SIZE INCOME STATEMENT

($8,368,958 ÷ $14,953,224) × 100 = 56.0%

COMMON-SIZE GRAPHICS

RATIO ANALYSIS

Liquidity and efficiency

Solvency

Market prospects Profitability

Acid-test Ratio

Accounts Receivable Turnover

Accounts Receivable Turnover

Inventory Turnover

Inventory Turnover

Days’ Sales Uncollected

Days’ Sales Uncollected

Total Asset Turnover

LIQUIDITY AND EFFICIENCY

Days’

Purchases in Accounts Payable

Days’

Purchases in Accounts Payable

= Working capital

More working capital suggests a strong liquidity

position and an ability to meet current obligations

More working capital suggests a strong liquidity

position and an ability to meet current obligations

This ratio measures the short-term paying ability of the company A higher current ratio suggests a strong liquidity

debt-position.

This ratio measures the short-term paying ability of the company A higher current ratio suggests a strong liquidity

debt-position.

CURRENT RATIO

Current Liabilities

This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be

difficult to quickly convert into cash

This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be

difficult to quickly convert into cash

ACID-TEST RATIO

Acid-test ratio =

Cash + Short-term investments + Current

receivablesCurrent Liabilities

Referred to as Quick Assets

This ratio measures how

many times a company

converts its receivables

into cash each year.

This ratio measures how

many times a company

converts its receivables

into cash each year.

ACCOUNTS RECEIVABLE TURNOVER

Accounts receivable =

turnover

Net salesAverage accounts receivable,

net

Average accounts receivable = (Beginning acct rec + Ending acct rec.)

2

This ratio measures the

number of times merchandise is sold and replaced during the year

This ratio measures the

number of times merchandise is sold and replaced during the year

Provides insight into how frequently a company collects its accounts receivable.

Provides insight into how frequently a company collects its accounts receivable

DAYS’ SALES UNCOLLECTED

Day's sales =

uncollected

Accounts receivable, net

× 365Net sales

DAYS’ SALES IN INVENTORY

Day's sales in =

Inventory

Ending inventory

× 365Cost of goods sold

This ratio is a useful measure in evaluating inventory liquidity If a product is demanded

by customers, this formula estimates how

long it takes to sell the inventory

This ratio is a useful measure in evaluating inventory liquidity If a product is demanded

by customers, this formula estimates how

long it takes to sell the inventory

This ratio is a useful measure in evaluating how long the business takes to pay its credit

suppliers

This ratio is a useful measure in evaluating how long the business takes to pay its credit

suppliers

CASH CONVERSION CYCLE

The sum of the days’ sales uncollected and the

days’ sales in inventory subtracting the days’

purchases in accounts payable It represents the number of days a firm’s cash remains tied

up within the operations of the business.

The lower the cash conversion cycle, the more

healthy a company generally is

The lower the cash conversion cycle, the more

healthy a company generally is

TOTAL ASSET TURNOVER

Average total assets

2

This ratio reflects a company’s ability to use its assets to generate sales It is an important indication of operating

efficiency

This ratio reflects a company’s ability to use its assets to generate sales It is an important indication of operating

efficiency

DebtRatio

EquityRatio

EquityRatio

Pledged Assets

to Secured Liabilities

Pledged Assets

to Secured Liabilities

Times Interest Earned

Times Interest Earned

SOLVENCY

DEBT AND EQUITY RATIOS

Total liabilities $ 8,000,000 66.7% [Debt ratio]

Total equity 4,000,000 33.3% [Equity ratio]

Total liabilities and equity $ 12,000,000 100.0%

$8,000,000 ÷ $12,000,000 = 66.7%

The debt ratio expresses total liabilities as a percent of

total assets The equity ratio provides complementary

information by expressing total equity as a percent of total

assets

total assets The equity ratio provides complementary

information by expressing total equity as a percent of total

assets

equity ratio implies less opportunity to expand

through use of debt financing

This ratio measures what portion of a company’s assets are contributed by creditors A larger debt-to-

equity ratio implies less opportunity to expand

through use of debt financing

TIMES INTEREST EARNED

Times interest earned

=

Income before interest and

taxesInterest expense

This is the most common measure of the ability of a company’s operations to provide

protection to long-term creditors

This is the most common measure of the ability of a company’s operations to provide

protection to long-term creditors

Profit Margin

Profit

Return on Total Assets

Return on Ordinary Shareholders’

Equity

Return on Ordinary Shareholders’

Equity

PROFITABILITY

Return on total asset = Net income

Average total

assets

RETURN ON TOTAL ASSETS

Return on total assets measures how well

assets have been employed by the

company’s management

Return on total assets measures how well

assets have been employed by the

company’s management

PRICE-EARNINGS RATIO

Price-earnings ratio = Market price per ordinary share

Earnings per share

This measure is often used by investors as a general guideline in gauging share values

Generally, the higher the price-earnings ratio, the more opportunity a company has for growth

This measure is often used by investors as a general guideline in gauging share values

Generally, the higher the price-earnings ratio, the more opportunity a company has for growth

DIVIDEND YIELD

Dividend yield = Annual cash dividends per share

Market price per share

This ratio identifies the return, in terms of cash dividends, on the current market price per share

of the company’s ordinary shares

This ratio identifies the return, in terms of cash dividends, on the current market price per share

of the company’s ordinary shares

analysis report directly addresses the building blocks of

analysis and documents the reasoning

The purpose of financial statement analyses is to reduce uncertainty in business decisions through a rigorous and sound evaluation A financial statement

analysis report directly addresses the building blocks of

analysis and documents the reasoning

END OF CHAPTER 17