Post on 11-Jan-2016
Module 3: Financial Statement Analysis
ACG 2071Fall 2007
Created by M. Mari
Basic Analytical Procedures
The basic financial statements provide much of the information users need to make economic decisions about businesses.
In order to make decisions, we must analyze the financial statements.
Horizontal Analysis Percentage analysis of increases and
decreases in related items in comparative financial statements.
Comparing of income statements for two years Comparing of balance sheets for two years
Horizontal analysis
2006 2005 Amount Percent
Assets
Current assets $550,000 $533,000 $17,000 3.2%
Fixed assets $445,000 $470,000 -$25,000 -5.4%
Total assets $995,000 $1,003,000 -$8,000 -2.2%
Liabilities
Current liabilities $200,000 $150,000 $50,000 25%
Long term liabilities $100,000 $125,000 -$20,000 -20%
Total liabilities $300,000 $275,000 $30,000 5%
Equity
Common stock $500,000 $428,000 $72,000 17%
Retained earinings 195,000 $300,000 $105,000 -35%
Total equity $695,000 $728,000 $33,000 -18%
Total liab & equity $995,000 $1,003,000 - $8,000 -2.2%
Vertical Analysis
A percentage analysis may also be used to show the relationship of each component to the total within a single statement.
Balance sheet Each asset is shown as percentage of total
assets Each liability as percentage of total liabilities
Income statement Each item is shown as percentage of net
sales. Common size statements
Can be used to compare to companies in the same industry
Solvency Analysis
Solvency is the ability of a company to pay its debts. Profitability is the ability of a business to earn income.
They are interrelated. Solvency analysis focuses on the ability of a business to
pay or otherwise satisfy its current and noncurrent liabilities.
Assessed by examining balance sheet relationships Major analyses are:
Current position analysis Accounts receivable analysis Inventory analysis The ratio of fixed assets to long-term liabilities The number of times interest charges are earned.
Example
Company A Company B
2006 2005 2006 2005
Current Assets
Cash $ 78,000.00 $ 82,500.00 $ 160,000.00 $ 112,500.00
Marketable Securities $ 52,000.00 $ 60,000.00 $ 85,000.00 $ 26,000.00
Accounts receivable $ 106,000.00 $ 152,000.00 $ 208,000.00 $ 172,000.00
Inventories $ 218,000.00 $ 260,000.00 $ 350,000.00 $ 312,500.00
Prepaid Expenses $ 6,000.00 $ 4,200.00 $ 10,000.00 $ 10,000.00
Total current assets $ 460,000.00 $ 558,700.00 $ 813,000.00 $ 633,000.00
Current liabilities $ 320,000.00 $ 480,000.00 $ 705,000.00 $ 375,000.00
Solvency Analysis
Current Position Analysis Measures to assess a business’s ability to pay
its current liabilities Special interest to short-term creditors Working Capital
Current assets minus current liabilities Used in evaluating a company’s ability to
meet currently maturing debts. Current Ratio
Working capital ratio or banker’s ratio Computed by dividing current assets by
current liabilities
Example
Company A Company B
2006 2005 2006 2005
Working Capital
Current assets - current liabilities $ 140,000.00
$ 78,700.00
$ 108,000.00
$ 258,000.00
Current ratio 460000/320000 558700/480000 813000/705000 633000/375000
current assets/current liabilities 1.4 1.2 1.2 1.7
Solvency
Quick Ratio: A ratio that measures the instant debt paying
ability of a company Also called the acid test ratio Ratio of quick assets to total current liabilities
Quick assets are cash and other current assets that can be quickly converted to cash such as marketable securities and accounts receivables
Quick Ratio Example
Company A
2006 2005
Current Assets
Cash $ 78,000.00 $ 82,500.00
Marketable Securities $ 52,000.00 $ 60,000.00
Accounts receivable $ 106,000.00 $ 152,000.00
Total Quick Assets $ 236,000.00 $ 294,500.00
Total current liabilities $ 320,000.00 $ 480,000.00
Quick ratio 236000/320000 294500/480000
quick assets/ current liabilities 0.7 0.6
Accounts receivable analysis
The size and makeup of accounts receivable change constantly during business operations
Companies desire to collect receivables as promptly as possible
Cash collected from receivables improve solvency
Accounts receivable turnover Relationship between sales and accounts
receivable Computed by net sales divided by average net
accounts receivable Average of accounts receivable
Beginning balance plus ending balance divided by 2
Higher the turnover the better.
Example
Company A
2006 2005
Net sales $ 1,500,000.00 $ 998,000.00
Accounts receivable
Beginning of year $ 152,000.00 $ 208,000.00
End of Year $ 76,000.00 $ 152,000.00
Average Accounts Receivable (152000+76000)/2 (152000+208000)/2
$ 114,000.00 $ 180,000.00
Accounts receivable turnover 1500000/114000 998000/180000
13.2 5.5
Number of days sales in receivables
Ratio is computed by dividing the average accounts receivable by the average daily sales.
Average daily sales is net sales divided by 365 days
Lower the ratio the better
Example
Company A
2006 2005
Net sales $ 1,500,000.00 $ 998,000.00
Accounts receivable
Beginning of year $ 152,000.00 $ 208,000.00
End of Year $ 76,000.00 $ 152,000.00
Average Accounts Receivable (152000+76000)/2 (152000+208000)/2
$ 114,000.00 $ 180,000.00
Average daily sales 1500000/365 998000/365
$ 4,109.59 $ 2,734.25
Number of days sales in receivables 114000/4109.59 180000/2734.25
27.7 65.8
Inventory Analysis
Inventory has to be managed carefully
Too little inventory can cause customers to seek the product from another supplier
Too much inventory can increase storage costs, insurance, and obsolescence.
Inventory Turnover
Relationship between the volume of goods sold and inventory
Computed by cost of goods sold divided by average inventory
Average inventory is beginning inventory plus ending inventory divided by 2
Higher the ratio the better
Example
Company A
2006 2005
Cost of goods sold $ 765,000.00 $ 820,000.00
Inventories
Beginning of year $ 312,000.00 $ 423,000.00
End of year $ 189,000.00 $ 312,000.00
Average inventory (312000+189000)/2 (312000+423000)/2
$ 250,500.00 $ 367,500.00
Inventory Turnover 765000/250500 820000/367500
3.1 2.2
Number of days’ sales in inventory
Relationship between cost of goods sold and inventory
Computed by dividing the average inventory by the average daily cost of goods sold ( COGS/365 days)
Rough measure of the length of time it takes to acquire, sell, and replace inventory
Lower the ratio the better
Example
Company A
2006 2005
Cost of goods sold $ 765,000.00 $ 820,000.00
Inventories
Beginning of year $ 312,000.00 $ 423,000.00
End of year $ 189,000.00 $ 312,000.00
Average inventory (312000+189000)/2 (312000+423000)/2
$ 250,500.00 $ 367,500.00
Average COGS 765000/365 820000/365
2,095.9 2,246.6
Number of days sales in inventory 250500/2095.9 367500/2246.6
119.5 163.6
Ratio of fixed assets to long-term liabilities
Indicates the margin of safety of the noteholders or bondholders
Indicates the ability of the business to borrow additional funds on a long-term basis.
Higher the betterHigher the better
Company A
2006 2005
Fixed assets (net)
$ 350,000.00
$ 480,000.00
Long-term liabilities
$ 175,000.00
$ 210,000.00
Ratio of fixed assets to long-term liabilities 2.0 2.3
Ratio of liabilities to stockholder’s equity
Claims against the total assets of a business are divided into two groups
Claims of creditors Claims of owners
the relationship between the total claims of the creditors and owners
solvency measure that indicates the margin of safety for creditors
indicates the ability of the business to withstand adverse business conditions when the claims of creditors are large in relation to the equity of the stockholders, there are usually significant interest payments.
If earnings decline to the point that company is unable to meet interest payments, creditors may take over the business.
lower the better
Example
Company A
2006 2005
Total liabilities $
425,000.00 $
375,000.00
Total stockholder's Equity
$ 680,000.00
$ 503,000.00
Ratio of fixed assets to long-term liabilities 0.6 0.7
Number of times interest charges earned
Called the fixed charge coverage ratio The relative risk of the debtholders is
normally measured Higher the ratio, the lower the risk that
interest payments will not be made if earnings decrease.
Indicates general financial strength of the business
Example
Company A
2006 2005
Income before taxes $ 150,000.00 $ 145,500.00
Add interest expense $ 4,500.00 $ 6,300.00
Amount available to meet interest charges 154,500.0 151,800.0
Number of times interest charges earned 154500/4500 151800/6300
34.3 24.1
Profitability Analysis
The ability of a business to earn profits depends of the effectiveness and efficiency of its operations as well as the resources available to it.
Focuses primarily on the relationship between operating results as reported in the income statement and resources available to the business as reported in the balance sheet
Major analysis used Ratio of net sales to
assets Rate earned on total
assets Rate earned on
stockholder’s equity Rate earned on
common stockholder’s equity
Earnings per share on common stock
Price-earning ratio Dividends per share Dividend yield
Ratio of net sales to assets
Is a profitability measure that shows how effectively a firm utilizes its assets
Higher the ratio is better Computed by dividing net sales by
average total assets (beginning total assets + ending total assets)/2
Example
Company A
2006 2005
Net sales $ 765,000.00 $ 820,000.00
Total assets
Beginning of year $ 980,000.00 $ 800,000.00
End of year $ 1,020,000.00 $ 980,000.00
Average Total Assets (980000+1020000)/2 (980000+800000)/2
$ 1,000,000.00 $ 890,000.00
Ratio of net sales to total assets 765000/1000000 820000/890000
0.8 0.9
Rate earned on total assets
Measures the profitability of total assets without considering how the assets are financed.
Higher the ratio is better Computed by adding interest expense to
net income and then dividing by average total assets
Example Company A
2006 2005
Net income $ 165,000.00 $ 250,000.00
Plus interest expense $ 6,000.00 $ 19,000.00
TOTAL $ 171,000.00 $ 269,000.00
Total assets
Beginning of year $ 980,000.00 $ 800,000.00
End of year $ 1,020,000.00 $ 980,000.00
Average Total Assets (980000+1020000)/2 (980000+800000)/2
$ 1,000,000.00 $ 890,000.00
Rate earned on total assets 171000/1000000 269000/890000
0.2 0.3
Rate earned on stockholder’s equity
The measures emphasizes the rate of income earned on the amount invested by the stockholders.
Higher the ratio is better Computed by net income divided by average
stockholder’s equity The rate earned by a business on the equity of
its stockholders is usually higher than the rate earned on total assets.
Occurs when the amount earned on assets acquired with creditors’ funds is more than the interest paid to creditors
The difference in the rate on stockholder’s equity and the rate on total assets is called
LEVERAGE
Example
Company A
2006 2005
Net income $ 165,000.00 $ 250,000.00
Stockholder's equity
Beginning of year $ 1,250,000.00 $ 800,000.00
End of year $ 1,500,000.00 $ 1,250,000.00
Average Total Assets (1500000+1250000)/2 (1250000+800000)/2
$ 1,375,000.00 $ 1,025,000.00
Rate earned on stockholder’s equity 171000/1000000 269000/890000
Rate earned on assets 12% 24%
20% 30%
LEVERAGE 8% 6%
Rate earned on common stockholder’s equity
Common stockholder’s have a residual claim on earnings
This measure focuses only on the rate of profits earned on the amount invested by the common stockholders
Computed by subtracting the preferred dividends requirements from the net income and dividing by the average common stockholder’s equity. .
Higher the ratio is better
Example
Company A
2006 2005
Net income $ 165,000.00 $ 250,000.00
Preferred dividends $ 9,000.00 $ 9,000.00
TOTAL $ 174,000.00 $ 259,000.00
Common Stockholder's equity
Beginning of year $ 850,000.00 $ 600,000.00
End of year $ 950,000.00 $ 850,000.00
Average Total Assets (850000+950000)/2 (950000+600000)/2
$ 900,000.00 $ 725,000.00
Rate earned on common stockholder's equity 174000/900000 259000/725000
19% 36%
Earnings per share (EPS)
Normally reported in the income statement on corporate annual reports
Computed by dividing net income by the number of shares of stock outstanding
If preferred and common stock are outstanding, the net income is reduced by the amount of preferred stock dividends.
Example
Company A
2006 2005
Net income $ 165,000.00 $ 250,000.00
Preferred dividends $ 9,000.00 $ 9,000.00
TOTAL $ 174,000.00 $ 259,000.00
Shares of common stock 50000 45000
EPS 174000/50000 259000/45000
$ 3.48 $ 5.76
Price-Earnings Ratio
Indicator of a firm’s future earnings prospects
Computed by dividing the market price per share of common stock at a specific date by the annual earnings per share.
Company A
2006 2005
Market price per share
$ 25.00
$ 17.50
Earnings per share
$ 1.52
$ 1.36
Price earnings ratio 16.45 12.87
Dividends per share and dividend yield
Indicator of a firm’s future earnings prospects
Computed by dividing the dividends per share by the market price
Company A
2006 2005
Dividends per share
$ 0.80
$ 1.20
Market price per share
$ 25.00
$ 17.50
Dividend yield 0.03 0.07