Chapter 03 financial statement analysis and bank
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Transcript of Chapter 03 financial statement analysis and bank
Prepared by: C. Douglas Cloud Professor Emeritus of AccountingPepperdine University
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Student Version
Financial Statement Analysis in Bank
Chapter 03
These slides should be viewed using the presentation mode (click the icon to start presentation).
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Objective 1
1. Describe basic financial statement analytical methods.
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Horizontal Analysis
The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis.
LO 1LO 1
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Horizontal Analysis
Horizontal Analysis:
Difference $17,000Base year (2011) $533,000
= 3.2%
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Horizontal Analysis
Horizontal Analysis:
Difference $25,800Base year (2011) $64,700
= 39.9%
LO 1LO 1
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Horizontal AnalysisLO 1LO 1
Horizontal Analysis:
Difference $296,500Base year (2011) $1,234,000
= 24.0%
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Horizontal Analysis:
Difference $37,500Base year (2011) $ 100,000
= 37.5%
LO 1LO 1
Horizontal Analysis
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Vertical Analysis
A percentage analysis used to show the relationship of each component to the total within a single financial statement is called vertical analysis.
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In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets.
Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.
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Vertical Analysis
Vertical Analysis:
Current Assets $550,000 Total Assets $ 1,139,500
= 48.3%
LO 1LO 1
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Vertical AnalysisLO 1LO 1
Vertical Analysis:
Selling expenses $191,000Net sales $1,498,000
= 12.8%
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LO 1LO 1
Common-Sized Statements
In a common-sized statement, all items are expressed as percentages with no dollar amounts shown.
Common-sized statements are useful for comparing the current period with prior periods, individual businesses with one another, or one business with industry averages.
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Learning Objective 2
1. Describe basic financial statement analytical methods.
2. Use financial statement analysis to assess the solvency of a business.
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Solvency Analysis
All users of financial statements are interested in the ability of a company to do the following: Meet its financial obligations (debts),
called solvency. Earn income, called profitability.
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Solvency and Current Position Analysis
Solvency analysis focuses on the ability of a business to pay its current and noncurrent liabilities.
Solvency and profitability are interrelated. A company that cannot pay its debts will have difficulty obtaining credit, which can decrease its profitability.
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A company’s ability to pay its current liabilities is called current position analysis. It is of special interest to short-term creditors.
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Working Capital
The excess of current assets over current liabilities is called working capital. Working capital is often used to evaluate a company’s ability to pay current liabilities.
Working capital is computed as follows:
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Working Capital = Current Assets – Current Liabilities
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Current Ratio
The current ratio, sometimes called the working capital ratio or bankers’ ratio, also measures a company’s ability to pay its current liabilities.
The current ratio is computed as follows:
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Current Ratio = Current AssetsCurrent Liabilities
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Current RatioThe current ratio for Lincoln Company is computed below.
2012 2011Current assets $550,000 $533,000Current liabilities $210,000 $243,000
Current ratio 2.6 2.2
$550,000$210,000
$533,000$243,000
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Quick Ratio
A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio, or acid-test ratio. It is computed as follows:
Quick Ratio = Quick AssetsCurrent Liabilities
Quick assets are cash and other assets that
can be easily converted to cash.
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Quick Assets
The quick ratio for Lincoln Company is computed below.
2012 2011
Quick ratio 1.3 1.0
Quick assets:Cash $ 90,500 $ 64,700Temporary Investments 75,000 60,000Accounts receivable (net) 115,000 120,000 Total quick assets $280,500 $244,700
Current liabilities $210,000 $243,000
$280,500$210,000
$244,700$243,000
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Accounts Receivable Turnover
The relationship between sales and accounts receivable may be stated as accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a company’s solvency.
The accounts receivable turnover is computed as follows:
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Accounts Receivable Turnover =
Net SalesAverage Accounts
Receivable
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Accounts receivable turnover 12.7 9.2
Net sales $1,498,000 $1,200,000Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000End of year 115,000 120,000 Total $ 235,000 $ 260,000
Average (Total ÷ 2) $ 117,500 $ 130,000
2012 2011
The accounts receivable turnover for Lincoln Company is computed below.
$1,498,000 $117,500
$1,200,000 $130,000
Accounts Receivable TurnoverLO 2LO 2
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Number of Days’ Sales in Receivables
The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. It is computed as follows:
LO 2LO 2
Number of Days’ Sales in
Receivables
Average Accounts
ReceivableAverage Daily
Sales
=
Net Sales 365
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Number of Days’ Sales in Receivables
Number of days’ sales in receivables 28.6 39.5
Average accounts receivable(Total accounts receivable ÷ 2) $ 117,500
$ 130,000Net sales $1,498,000 $1,200,000Average daily sales (Net sales ÷ 365) $ 4,104 $ 3,288
2012 2011
The number of days’ sales in receivables for Lincoln Company is computed below.
$117,500 $4,104
$130,000 $3,288
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Inventory Turnover
The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of a firm in managing its inventory.
The inventory turnover is computed as follows:
LO 2LO 2
Inventory Turnover =
Cost of Goods Sold
Average Inventory
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Inventory Turnover
Inventory turnover 3.8 2.8
2012 2011Cost of goods sold $1,043,000 $820,000 Inventories:
Beginning of year $ 283,000 $311,000End of year 264,000 283,000Total $ 547,000 $594,000Average (Total ÷ 2) $ 273,500 $297,000
Lincoln’s inventory balance at the beginning of 2011 is $311,000.
$1,043,000 $273,500
$820,000 $297,000
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Number of Days’ Sales in Inventory
The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory.
The number of days’ sales in inventory is computed as follows:
Number of Days’ Sales in Inventory
Average Inventory
Average Daily Cost of Goods Sold
=
Cost of Goods Sold 365
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Average Inventory $273,500 $297,000Average daily cost of goods sold $2,858 $2,247
2012 2011
LO 2LO 2Number of Days’ Sales in InventoryThe number of days’ sales in inventory for Lincoln Company is computed below.
Number of days’ sales in inventory 95.7 132.2
$273,500 $2,858
$297,000 $2,247
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Ratio of Fixed Assets to Long-Term Liabilities
The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the note-holders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis.
The ratio is computed as follows:
LO 2LO 2
Ratio of Fixed Assets to Long-Term
Liabilities
Fixed Assets (net)
Long-Term Liabilities
=
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LO 2LO 2Ratio of Fixed Assets to Long-Term Liabilities
Ratio of fixed assets to long-term liabilities 4.4 2.4
2012 2011Fixed assets (net) $444,500 $470,000Long-term liabilities $100,000 $200,000
To illustrate, the ratio of fixed assets to long-term liabilities for Lincoln Company is computed below.
$444,500$100,000
$470,000$200,000
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Ratio of Liabilities to Stockholders’ Equity
The relationship between the total claims of the creditors and the owners—the ratio of liabilities to stockholders’ equity—is a solvency measure that indicates the margin of safety for creditors.
The ratio is computed as follows:
LO 2LO 2
Ratio of Liabilities to Stockholders’ Equity
Total LiabilitiesTotal
Stockholders’ Equity
=
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LO 2LO 2
Ratio of Liabilities to Stockholders’ Equity
Ratio of liabilities to stockholders’ equity 0.4 0.6
Total liabilities $310,000 $443,000Total stockholders’ equity $829,500 $787,500
2012 2011
The ratio of liabilities to stockholders’ equity for Lincoln Company is computed below.
$310,000$829,500
$443,000$787,500
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Number of Times Interest Charges Earned
Corporations in some industries normally have high ratios of debt to stockholders’ equity. For such corporations, the relative risk of the debt-holders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio.
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It is computed as follows:
Number of Times Interest Charges Earned
Number of Times Interest Charges Are
Earned
Income Before Income Tax + Interest Expense
Interest Expense=
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LO 2LO 2Number of Times Interest Charges EarnedThe number of times interest charges are earned for Lincoln Company is computed below.
Number of times interest charges earned 28.1 12.2
2012 2011Income before income tax $162,500 $134,600Add interest expense 6,000 12,000Amount available to meet interest charges $168,500 $146,600
$168,500 $6,000
$146,600 $12,000
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LO 2LO 2Number of Times Interest Charges EarnedThe number of times interest charges
are earned can be adapted for use with dividends on preferred stock.
The number of times preferred dividends are earned is computed as follows:Number of Times
Preferred Dividends Are
Earned
Net IncomePreferred Dividends=
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Learning Objective 3
1. Describe basic financial statement analytical methods.
2. Use financial statement analysis to assess the solvency of a business.
3. Use financial statement analysis to assess the profitability of a business.
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Ratio of Net Sales to Assets
The ratio of net sales to assets is a profitability measure that shows how effectively a company utilizes its assets.
The ratio is computed as follows:
LO 3LO 3
Ratio of Net Sales to Assets
Net SalesAverage Total
Assets(excluding long-
term investments)
=
Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business.
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LO 3LO 3
Ratio of Net Sales to Assets
2012 2011Net sales $1,498,000 $1,200,000Total assets:
Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000
Average (Total ÷ 2) $1,048,750 $1,031,500
The ratio of net sales to assets for Lincoln Company is computed below.
Ratio of net sales to assets 1.4 1.2$1,498,000$1,048,750
$1,200,000$1,031,500
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Rate Earned on Total Assets
The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed.
It is computed as follows:
LO 3LO 3
Rate Earned on Total Assets
Net Income + Interest Expense
Average Total Assets=
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LO 3LO 3
Rate Earned on Total Assets
Rate earned on total assets 8.2% 7.3%
2012 2011Net income $ 91,000 $ 76,500Plus interest expense 6,000 12,000 Total $ 97,000 $ 88,500Total assets: Beginning of year $1,230,500 $1,187,500
End of year 1,139,500 1,230,500Total $2,370,000 $2,418,000
Average (Total ÷ 2) $1,185,000 $1,209,000
This ratio for Lincoln Company is computed below. Total assets are $1,187,500 at the beginning of 2011.
$97,000$1,185,000
$88,500$1,209,000
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Rate Earned on Stockholders’ Equity
The rate earned on stockholders’ equity measures the rate of income earned on the amount invested by the stockholders.
It is computed as follows:
LO 3LO 3
Rate Earned on Stockholders’
Equity
Net Income Average Total
Stockholders’ Equity
=
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LO 3LO 3
Rate Earned on Stockholders’ Equity
Rate earned on stockholders’equity 11.3% 10.0%
Net income $ 91,000 $ 76,500Stockholders’ equity:
Beginning of year $ 787,500 $ 750,000End of year 829,500 787,500 Total $1,617,000 $1,537,500Average (Total ÷ 2) $ 808,500 $ 768,750
2012 2011
The rate for Lincoln Company is computed below. Total stockholders’ equity is $750,000 at the beginning of 2011.
$91,000$808,500
$76,500$768,750
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LO 3LO 3Rate Earned on Stockholders’ Equity
2012 2011Rate earned on stockholders’ equity 11.3% 10.0%Less rate earned on total assets 8.2 7.3Effect of leverage 3.1% 2.7%
For Lincoln Company, the effect of leverage is computed as follows:
The difference between the rate earned on stockholders’ equity and the rate earned on total assets is called leverage.
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Rate Earned on Common Stockholders’ Equity
The rate earned on common stockholders’ equity measures the rate of profits earned on the amount invested by the common stockholders.
It is computed as follows:
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Rate Earned on Common Stockholders’
Equity
Net Income – Preferred Dividends
Average Common Stockholders’ Equity
=
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Rate Earned on Common Stockholders’ Equity
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Lincoln Company had $150,000 of 6% preferred stock outstanding on December 31, 2012 and 2011. Thus, preferred dividends of $9,000 ($150,000 x 6%) are deducted from net income. Lincoln’s common stockholders’ equity is determined as follows:
(continued)
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Rate earned on common stockholders’ equity 12.5% 10.9%
2012 2011 Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000 Total $ 82,000 $ 67,500Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000End of year 679,500 637,500
Total $1,317,000 $1,237,500Average (Total ÷ 2) $ 658,500 $ 618,750
Rate Earned on Common Stockholders’ Equity
$82,000$658,500
$67,500$618,750
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Earnings per Share on Common Stock
Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock. GAAP requires the reporting of earnings per share in the income statement.
It is computed as follows:
LO 3LO 3
Earnings per Share (EPS) on Common
Stock
Net Income – Preferred DividendsShares of Common Stock Outstanding
=
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LO 3LO 3
Earnings per Share on Common Stock
Earnings per share on common stock $1.64 $1.35
2012 2011Net income $91,000 $76,500Less preferred dividends 9,000 9,000 Total $82,000 $67,500Shares of common stock 50,000 50,000
EPS for Lincoln Company is computed below.
$82,000 50,000
$67,500 50,000
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Price-Earnings Ratio
Another profitability measure quoted by the financial press is the price-earnings (P/E) ratio on common stock. The price-earnings ratio on common stock measures a company’s future earnings prospects.
The price-earnings ratio is computed as follows:
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Price-earnings (P/E) ratio
Market Price per Share of Common
StockEarnings per Share on
Common Stock
=
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Price-earnings ratio on common stock 25 20
2012 2010Market price per share of
common stock $41.00 $27.00Earnings per share on common
stock ÷ $1.64 ÷ $1.35
Price-Earnings Ratio
The P/E ratio for Lincoln Company is computed below.
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Dividends per Share
Dividends per share can be reported with earnings per share to indicate the relationship between dividends and earnings.
Comparing these two per-share amounts measures the extent to which earnings are being distributed to common shareholders. The calculations for dividends per share are at the top of the next slide.
LO 3LO 3
(continued)
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Dividends per ShareLO 3LO 3
Dividends per Share
DividendsShares of Common Stock Outstanding
=
Dividends per share of common stock $0.80 $0.60
2012 2011Dividends on common stock $40,000 $30,000Shares of common stock outstanding ÷ 50,000 ÷ 50,000
The dividends per share for Lincoln Company are computed below.
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Dividend Yield
The dividend yield on common stock measures the rate of return to common stockholders from cash dividends.
It is of special interest to investors whose objective is to earn dividends from their investment. It is computed as follows:
LO 3LO 3
Dividend Yield Dividends per Share of
Common StockMarket Price per Share
of Common Stock=
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LO 3LO 3
Dividend Yield
Dividend yield on common stock 2.0% 2.2%
2012 20119Dividends per share of
common stock $ 0.80$ 0.60
Market price per share of common stock $41.00$27.00
The dividend yield for Lincoln Company is computed below.
$0.80 $41
$0.60 $27
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Learning Objective 4
1. Describe basic financial statement analytical methods.
2. Use financial statement analysis to assess the solvency of a business.
3. Use financial statement analysis to assess the profitability of a business.
4. Describe the contents of corporate annual reports.
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Corporate Annual Reports
In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections: Management discussion and analysis Report on internal control Report on fairness of the financial
statements
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Report on Internal Control
The Sarbanes-Oxley Act of 2002 requires a report stating management’s responsibility for establishing and maintaining internal control. In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report.
It also requires a public accounting firm to verify management’s conclusions on internal control.
LO 4LO 4
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Report on Fairness of Financial StatementsAll publicly held corporations are
required by the Sarbanes-Oxley Act of 2002 to have an independent audit (examination) of their financial statements. The CPA firm that conducts the audit renders an opinion on the fairness of the statements.
LO 4LO 4
Prepared by: C. Douglas Cloud Professor Emeritus of AccountingPepperdine University
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Student Version
Financial Statement Analysis in Bank
The End