* Copyright © 1999 by Harcourt Brace

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Copyright © 1999 by Harcourt Brace & Company. All rights reserved.

Chapter 13

Financial Statement Analysis

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Portions of this work were published in previous editions. Produced in the United States of America. 0-03-021353-3

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Stockholders

Financial Statement Analysis

Creditors

Management

Will I be paid?

How good is our investment? How are we

performing?

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Limitations of Financial Statement Analysis

Use of different accounting methods Changes in accounting methods

LIFO FIFO

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Failure to understand trends or use industry ratios

Difficulty of making industry comparisons (i.e. conglomerates)????

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Nonoperating items on income statement

Effects of inflation

=

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Horizontal Analysis

Net Sales

Earnings before factory closure

Net earnings

Increase (Decrease)

1996 1995 DollarsPercent

$1,836 $1,755 81 4.6%

243 224 19 8.5%

230 224 6 2.7%

Wm. Wrigley Jr. Company (in millions)

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Trend Analysis

Return onAvg. Equity

1996 1995 1994 19931992

27.2% 30.1% 36.5% 32.6%29.4%

Wm. Wrigley Jr. Company

Tracking items over a series of years

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Vertical Analysis

Common-size statements recast items as a percentage of a selected item

Allows comparisons of companies of different size

Compares percentages across years to identify trends

%

%

%

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Dollars %$60,000 100% 24,000 40 36,000 60 6,000 10 30,000 50 3,000 5 27,000 45 10,000 17$ 17,000 28%

Common-Size Statements

Sales revenueCost of goods sold Gross profitSelling & admin. exp. Operating incomeInterest expense Income before taxIncome tax expense Net income

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Analysis of Liquidity

Nearness to cash Ability to pay debts as they become due

Cash Ratios

TurnoverRatios

WorkingCapitalRatios

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Working Capital

Excess of current assets over current liabilities

Lacks meaningful comparisons for companies of different size

-

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Current Ratio

Measure of short-term financial health Consider composition of current assets

Rule of thumb2:1

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Acid-Test (Quick) Ratio

Stricter test of ability to pay debts Excludes inventories and prepaid assets

Quick AssetsCurrent Liabilities

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Cash Flow from Operations to Current Liabilities

Focuses on cash only Covers period of time

Net Cash Provided by Operating ActivitiesAverage Current Liabilities

A

FEDERAL RESERVE NOTE

THE UNITED STATES OF AMERICATHE UNITED STATES OF AMERICA

L70744629F

12

1212

12

L70744629F

ONE DOLLARONE DOLLAR

WASHINGTON, D.C.

THIS NOTE IS LEGAL TENDER

FOR ALL DEBTS, PUBLIC AND PRIVATE

SERIES

1985

H 293

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Accounts Receivable Turnover

Net Credit Sales

Average Accounts Receivable

Indicates how quickly a company is collecting (i.e.

turning over) its receivables

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Accounts Receivable Turnover

Too fast

credit policies too stringent; may be losing sales

Too slow

credit department not operating effectively; possible quality problems

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Days’ Sales in Receivables

Represents the average # of days accounts are outstanding

365 DaysAccts. Receivable Turnover

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

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Days’ Sales in Receivables

If this company’s credit terms are net 30, what would this tell you about the efficiency

of the collection process?

365 Days5.6 Times

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

= 65 days

Example:

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Inventory Turnover

Represents the number of times per period inventory is turned

over (i.e. sold).

Cost of Goods SoldAverage Inventory

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Inventory Turnover

Circuit City 4.3 times per yearSafeway 10.1 times per year

Can you compare the two ratios?

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# of Days’ Sales in Inventory

Represents the average # of days inventory is on hand before its sold

# of Days in PeriodInventory Turnover Ratio

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

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# of Days’ Sales in Inventory

Circuit City 84 days

Safeway 36 days

Do these averages seem reasonable?

1 2 3

4 5 6 7 8 9 10

11 12 13 14 15 16 17

18 19 20 21 22 23 24

25 26 28 29 30 3127

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Cash Operating Cycle

Time between purchase of merchandise and collection from the sale

# of days sales in receivables +

# of days sales in inventory

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Analysis of Solvency

Ability to stay in business over the long-term

Debt-to-EquityRatio

DebtService

Coverage

TimesInterestEarned

Cash Flowto Capital

Expenditures

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Debt-to-Equity Ratio

Total liabilitiesTotal Stockholders’ Equity

How much have creditors

contributed compared to

owners?

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Debt-to-Equity Ratio

Total liabilitiesTotal Stockholders’ Equity = .60

For every dollar contributed by

owners, creditors have loaned $.60

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Times Interest Earned Ratio

Measures ability to meet current interest payments

The greater the coverage the better

Net Income + Interest Expense + Income Tax ExpenseInterest Expense

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Debt Service Coverage Ratio

Measures amount of cash from operations available to service the debt

Cash Flow from Operations before Interest & TaxesInterest and Principal Payments

P + i

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Cash Flow from Operations to Capital Expenditures Ratio

Measures company’s ability to use operations (vs. creditors and owners) to finance acquisitions of productive assets

Cash Flow from Operations - DividendsCash Paid for Capital Acquisitions

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Analysis of Profitability

Rate of Return on Assets Return on Common S/E EPS P/E Ratio Dividend Ratios

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Rate of Return on Assets

Measures return to all providers of capital (creditors and owners)

Net Income + Interest Expense, net of taxAverage Total Assets

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Return on Common Stockholders’ Equity

Net Income - Preferred DividendsAverage Common Stockholders’ Equity

The owners earned 15%on their investment

in ABC Co... Not bad!

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Earnings per Share

Presents profits on a per-share basis

Net Income - Preferred DividendsWtd. # of Common Shares Outstanding

Certificate of Stock

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Price-Earnings Ratio

Relates earnings to the market price of the stock

Current Market PriceEarnings per Share

very high P/Every low P/E

possibly overvaluedpossibly undervalued

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Price-Earnings Ratio

Both companies have earnings of $2 per share. So why the different P-E

ratios?

P-E Ratios

Co. A = 6 to 1Co. B = 8 to 1

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Dividend Payout Ratio

Common Dividends per ShareEarnings per Share

We need to decide what % of the firm’s income we can return to

owners.

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Dividend Yield Ratio

Investors willing to forgo dividends in lieu of price appreciation

Common Dividends per ShareMarket Price per Share

usually < 5%=

Harcourt Brace & Company items and derived items:

* Copyright © 1999 by Harcourt Brace

Economy & Finance

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