Chapter 14 © The McGraw-Hill Companies, Inc., 2007 McGraw-Hill /Irwin “How Well Am I Doing?”...

Chapter 14

© The McGraw-Hill Companies, Inc., 2007McGraw-Hill /Irwin

“How Well Am I Doing?” Financial Statement

Analysis

14-2

Limitations of Financial Statement Analysis

Differences in accounting methods Differences in accounting methods between companies sometimes make between companies sometimes make

comparisons difficult.comparisons difficult.

We use the LIFO method to value inventory.

We use the FIFO method to value inventory.

14-3

Limitations of Financial Statement Analysis

Analysts should look beyond the ratios.

Economic factors

Industry trends

Changes within the company

Technological changes

Consumer tastes

14-4

Statements in Comparative and Common-Size Form

Dollar and percentageDollar and percentage changes on statementschanges on statements

Common-sizeCommon-size statementsstatements

RatiosRatios

Analytical techniques used to

examine relationships among financial statement

items

14-5

Learning Objective

To prepare and interpret financial statements in

comparative and common-size form

LO1

14-6

Horizontal Analysis

Horizontal analysis shows the changes between years in the financial data in

both dollar and percentage form.

14-7

Horizontal Analysis

ExampleExample

The following slides illustrate a horizontal The following slides illustrate a horizontal analysis of Clover Corporation’s analysis of Clover Corporation’s

December 31, 2005 and 2004 December 31, 2005 and 2004 comparative balance sheets and comparative balance sheets and

comparative income statements. comparative income statements.

14-8

CLOVER CORPORATIONComparative Balance Sheets

December 31

Increase (Decrease)2005 2004 Amount %

AssetsCurrent assets: Cash 12,000$ 23,500$ Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700 Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000 Total assets 315,000$ 289,700$

Horizontal Analysis

14-9

Horizontal Analysis

Calculating Change in Dollar AmountsCalculating Change in Dollar Amounts

DollarDollarChangeChange

Current YearCurrent YearFigureFigure

Base YearBase YearFigureFigure= –

The dollar The dollar amounts for amounts for 2004 become 2004 become

the “base” year the “base” year figures.figures.

14-10

Horizontal Analysis

Calculating Change as a PercentageCalculating Change as a Percentage

PercentageChange

Dollar Change Base Year Figure 100%= ×

14-11

CLOVER CORPORATIONComparative Balance Sheets

December 31


AssetsCurrent assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700 Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000 Total assets 315,000$ 289,700$

Horizontal Analysis

($11,500 ÷ $23,500) × 100% = 48.9%

$12,000 – $23,500 = $(11,500)

14-12

Horizontal AnalysisCLOVER CORPORATION

Comparative Balance SheetsDecember 31


AssetsCurrent assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 20,000 50.0 Inventory 80,000 100,000 (20,000) (20.0) Prepaid expenses 3,000 1,200 1,800 150.0Total current assets 155,000 164,700 (9,700) (5.9)Property and equipment: Land 40,000 40,000 - 0.0 Buildings and equipment, net 120,000 85,000 35,000 41.2Total property and equipment 160,000 125,000 35,000 28.0Total assets 315,000$ 289,700$ 25,300$ 8.7

14-13

Horizontal Analysis

We could do this for the We could do this for the liabilities & stockholders’ liabilities & stockholders’

equity, but now, let’s look at equity, but now, let’s look at the income statement the income statement

accounts.accounts.

14-14

CLOVER CORPORATIONComparative Income Statements

For the Years Ended December 31Increase

(Decrease)2005 2004 Amount %

Net sales 520,000$ 480,000$ Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income 17,500$ 22,400$

Horizontal Analysis

14-15




Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net operating income 31,400 39,000 (7,600) (19.5)Interest expense 6,400 7,000 (600) (8.6)Net income before taxes 25,000 32,000 (7,000) (21.9)Less income taxes (30%) 7,500 9,600 (2,100) (21.9)Net income 17,500$ 22,400$ (4,900)$ (21.9)

Horizontal Analysis

14-16





Horizontal Analysis

Sales increased by 8.3%, yet net income decreased by 21.9%.

14-17





Horizontal Analysis

There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the

increase in sales, yielding an overall decrease in net income.

14-18

Trend Percentages

Trend percentages Trend percentages state several years’ state several years’

financial data in terms financial data in terms of a of a base yearbase year, which , which equals 100 percent. equals 100 percent.

14-19

Trend Percentages

TrendPercentage

Current Year Amount Base Year Amount

100%= ×

14-20

Trend Percentages

ExampleExampleLook at the income information for Look at the income information for

Berry Products for the years 2001 Berry Products for the years 2001 through 2005. We will do a trend through 2005. We will do a trend

analysis on these amounts to see analysis on these amounts to see what we can learn about the what we can learn about the

company.company.

14-21

Trend Percentages

The base year is 2001, and its amountsThe base year is 2001, and its amountswill equal 100%.will equal 100%.

Berry ProductsIncome Information

For the Years Ended December 31 Year

Item 2005 2004 2003 2002 2001Sales 400,000$ 355,000$ 320,000$ 290,000$ 275,000$ Cost of goods sold 285,000 250,000 225,000 198,000 190,000 Gross margin 115,000 105,000 95,000 92,000 85,000

14-22

Trend Percentages

YearItem 2005 2004 2003 2002 2001

Sales 105% 100%Cost of goods sold 104% 100%Gross margin 108% 100%

2002 Amount ÷ 2001 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105%( $198,000 ÷ $190,000 ) × 100% = 104%( $ 92,000 ÷ $ 85,000 ) × 100% = 108%


For the Years Ended December 31

14-23

Trend Percentages

By analyzing the trends for Berry Products, we can By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.sales, which is slowing the increase in gross margin.

YearItem 2005 2004 2003 2002 2001

Sales 145% 129% 116% 105% 100%Cost of goods sold 150% 132% 118% 104% 100%Gross margin 135% 124% 112% 108% 100%



14-24

Trend Percentages

We can use the trend percentages to construct a

graph so we can see the trend over time.

100

110

120

130

140

150

160

2001 2002 2003 2004 2005

Year

Perc

enta

ge

SalesCOGSGM

14-25

Common-Size Statements

Common-sizeCommon-size statements use

percentages to express the relationship of

individual components to a total within a singlesingle period. This is also known as vertical vertical

analysisanalysis.

14-26


In income statements, all

items are expressed as a percentage of

net sales.

14-27

Gross Margin Percentage

Gross Margin Percentage

Gross Margin Sales=

This measure indicates how muchof each sales dollar is left after

deducting the cost of goods sold to cover expenses and provide a profit.

14-28


In balance sheets, all items are expressed

as a percentage of total assets.

14-29


Wendy's McDonald's(dollars in millions) Dollars Percentage Dollars Percentage

2002 Net income 219$ 8.00% 893$ 5.80%

Common-size financial statements are particularly useful when comparing

data from different companies.

14-30


ExampleExample

Let’s take another look at the information Let’s take another look at the information from the comparative income statements from the comparative income statements of Clover Corporation for 2005 and 2004. of Clover Corporation for 2005 and 2004.

This time let’s prepare common-size This time let’s prepare common-size statements. statements.

14-31


For the Years Ended December 31Common-Size Percentages

2005 2004 2005 2004Net sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income 17,500$ 22,400$


Net sales Net sales is the base

and is expressed as 100%.

14-32



2005 2004 2005 2004Net sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income 17,500$ 22,400$


2004 Cost ÷ 2004 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6%

2005 Cost ÷ 2005 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2%

14-33




2005 2004 2005 2004Net sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0 Net income 17,500$ 22,400$ 3.4 4.7

What conclusions can we draw?

14-34

Quick Check

Which of the following statements describes horizontal analysis?a. A statement that shows items appearing

on it in percentage and dollar form.b. A side-by-side comparison of two or

more years’ financial statements.c. A comparison of the account balances on

the current year’s financial statements.d. None of the above.

14-35

Quick Check

Which of the following statements describes horizontal analysis?a. A statement that shows items appearing

on it in percentage and dollar form.b. A side-by-side comparison of two or

more years’ financial statements.c. A comparison of the account balances on

the current year’s financial statements.d. None of the above.

Horizontal analysis shows the changes between years in the financial data, in

both dollar and percentage form.

14-36

Common Stockholders

Short-term Creditors

Long-term Creditors

Ratios

14-37

Now, let’s look at Norton

Corporation’s recent financial

statements.

14-38

NORTON CORPORATION Balance Sheets

December 31

2005 2004Assets

Current assets: Cash 30,000$ 20,000$ Accounts receivable, net 20,000 17,000 Inventory 12,000 10,000 Prepaid expenses 3,000 2,000 Total current assets 65,000 49,000 Property and equipment: Land 165,000 123,000 Buildings and equipment, net 116,390 128,000 Total property and equipment 281,390 251,000 Total assets 346,390$ 300,000$

14-39

NORTON CORPORATION Balance Sheets

December 31

2005 2004Liabilities and Stockholders' Equity

Current liabilities: Accounts payable 39,000$ 40,000$ Notes payable, short-term 3,000 2,000 Total current liabilities 42,000 42,000 Long-term liabilities: Notes payable, long-term 70,000 78,000 Total liabilities 112,000 120,000 Stockholders' equity: Common stock, $1 par value 27,400 17,000 Additional paid-in capital 158,100 113,000 Total paid-in capital 185,500 130,000 Retained earnings 48,890 50,000 Total stockholders' equity 234,390 180,000 Total liabilities and stockholders' equity 346,390$ 300,000$

14-40

NORTON CORPORATION Income Statements


2005 2004Net sales 494,000$ 450,000$ Cost of goods sold 140,000 127,000 Gross margin 354,000 323,000 Operating expenses 270,000 249,000 Net operating income 84,000 74,000 Interest expense 7,300 8,000 Net income before taxes 76,700 66,000 Less income taxes (30%) 23,010 19,800 Net income 53,690$ 46,200$

14-41

Learning Objective

To compute and interpret financial ratios that would be useful to a common stockholder

LO2

14-42

Ratio Analysis – The Common Stockholder

Use this Use this information to information to

calculate ratios calculate ratios to measure the to measure the well-being of well-being of the common the common

stockholders of stockholders of Norton Norton

Corporation.Corporation.

NORTON CORPORATION2005

Number of common shares outstanding Beginning of year 17,000 End of year 27,400 Net income 53,690$ Stockholders' equity Beginning of year 180,000 End of year 234,390 Dividends per share 2 Dec. 31 market price per share 20 Interest expense 7,300 Total assets Beginning of year 300,000 End of year 346,390

14-43

Earnings Per Share

Earnings per Share Net Income – Preferred Dividends

Average Number of Common Shares Outstanding

=

Whenever a ratio divides an income statement Whenever a ratio divides an income statement balance by a balance sheet balance, the average balance by a balance sheet balance, the average

for the year is used in the denominator.for the year is used in the denominator.

14-44

Earnings Per Share

Earnings per Share Net Income – Preferred Dividends

Average Number of Common Shares Outstanding

=

This measure indicates how muchThis measure indicates how muchincome was earned for each share of income was earned for each share of

common stock outstanding.common stock outstanding.

Earnings per Share $53,690 – 0 (17,000 + 27,400)/2= = $2.42$2.42

14-45

Price-Earnings Ratio

Price-EarningsRatio

Market Price Per Share Earnings Per Share=

This measure is often used by investors This measure is often used by investors as a general guideline in gauging stock as a general guideline in gauging stock values. Generally, the higher the price-values. Generally, the higher the price-earnings ratio, the more opportunity a earnings ratio, the more opportunity a

company has for growth.company has for growth.

Price-EarningsRatio

$20.00 $2.42= = 8.26 times8.26 times

14-46

Dividend Payout Ratio

This ratio gauges the portion of current This ratio gauges the portion of current earnings being paid out in dividends. earnings being paid out in dividends.

Investors seeking current income would Investors seeking current income would like this ratio to be large.like this ratio to be large.

DividendPayout Ratio

Dividends Per Share Earnings Per Share=

DividendPayout Ratio

$2.00 $2.42= = 82.6%82.6%

14-47

Dividend Yield Ratio

This ratio identifies the return, in This ratio identifies the return, in terms of cash dividends, on the terms of cash dividends, on the

current market price of the stock.current market price of the stock.

DividendYield Ratio

Dividends Per Share Market Price Per Share=

DividendYield Ratio

$2.00 $20.00= = 10.00%10.00%

14-48

Return on Total Assets

This ratio measures how well This ratio measures how well assets have been employed.assets have been employed.

Return onTotal Assets

$53,690 +[7,300 × (1 – .30)] ($300,000 + $346,390) ÷ 2

= = 18.19%18.19%

Return onTotal Assets

Net Income + [Interest Expense × (1 – Tax Rate)]Average Total Assets=

14-49

Return on Common Stockholders’ Equity

Return on CommonStockholders’ Equity

Net Income – Preferred Dividends

Average Stockholders’ Equity

=

This measure indicates how well the This measure indicates how well the company employed the owners’ company employed the owners’

investments to earn income.investments to earn income.

Return on CommonStockholders’ Equity

$53,690 – 0 ($180,000 + $234,390) ÷ 2= = 25.91%25.91%

14-50

Financial Leverage

Financial leverageFinancial leverage involves acquiring assets with funds at a fixed rate of

interest.

Return on Return on investment in investment in

assetsassets>>

Fixed rate of Fixed rate of return on return on borrowed borrowed

fundsfunds

Positive Positive financial financial leverageleverage

==

Return on Return on investment in investment in

assetsassets<<

Fixed rate of Fixed rate of return on return on borrowed borrowed

fundsfunds

Negative Negative financial financial leverageleverage

==

14-51

Quick Check

Which of the following statements is true?a. Negative financial leverage is when the

fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets.

b. Positive financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets.

c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year.

14-52

Which of the following statements is true?a. Negative financial leverage is when the

fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets.

b. Positive financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets.

c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year.

Quick Check

14-53

Book Value Per Share

This ratio measures the amount that would be This ratio measures the amount that would be distributed to holders of each share of common distributed to holders of each share of common

stock if all assets were sold at their balance sheet stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.carrying amounts and if all creditors were paid off.

Book Value per Share

Common Stockholders’ Equity Number of Common Shares Outstanding=

= $ 8.55$ 8.55Book Value per Share

$234,390 27,400=

14-54

Book Value Per Share

Book Value per Share

Common Stockholders’ Equity Number of Common Shares Outstanding=

= $ 8.55Book Value per Share

$234,390 27,400=

Notice that the book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost.

14-55

Learning Objective

To compute and interpret financial ratios that would be useful to a short-term creditor

LO3

14-56

Ratio Analysis – The Short–Term Creditor


Cash 30,000$ Accounts receivable, net Beginning of year 17,000 End of year 20,000 Inventory Beginning of year 10,000 End of year 12,000 Total current assets 65,000

Total current liabilities 42,000 Sales on account 500,000 Cost of goods sold 140,000

Use this Use this information to information to

calculate ratios calculate ratios to measure the to measure the well-being of the well-being of the

short-term short-term creditorscreditors for for

Norton Norton Corporation.Corporation.

14-57

Working Capital

The excess of current assets over current liabilities is known as

working capital.

Working capital is not free. It must be

financed with long-term debt and equity.

14-58

Working Capital

December 31, 2005

Current assets 65,000$ Current liabilities (42,000) Working capital 23,000$

14-59

Current Ratio

The current ratio measures a company’s short-term debt

paying ability.

A declining ratio may be a sign of deteriorating

financial condition, or it might result from eliminating

obsolete inventories.

CurrentRatio

Current Assets Current Liabilities=

14-60

Current Ratio

CurrentRatio

Current Assets Current Liabilities=

CurrentRatio

$65,000 $42,000= = 1.55 : 11.55 : 1

The current ratio measures a company’s short-term debt

paying ability.

14-61

Acid-Test (Quick) Ratio

Quick Assets Current Liabilities=Acid-Test

Ratio

Quick assets include Cash,Marketable Securities, Accounts

Receivable and current Notes Receivable.

This ratio measures a company’s ability to meet obligations without having to

liquidate inventory.

$50,000 $42,000 = 1.19 : 11.19 : 1=Acid-Test

RatioNorton Norton

Corporation’s Corporation’s quick assets quick assets

consist of cash consist of cash of $30,000 and of $30,000 and

accounts accounts receivable of receivable of

$20,000.$20,000.

14-62

Accounts Receivable Turnover

This ratio measures how many This ratio measures how many times a company converts its times a company converts its

receivables into cash each year.receivables into cash each year.

Sales on Account Average Accounts Receivable

Accounts ReceivableTurnover

=

= 27.03 times27.03 times $500,000 ($17,000 + $20,000) ÷ 2

Accounts ReceivableTurnover

=

14-63

Average Collection Period

This ratio measures, on average, This ratio measures, on average, how many days it takes to collect how many days it takes to collect

an account receivable. an account receivable.

Average Collection

Period=

365 Days Accounts Receivable Turnover

= 13.50 days13.50 daysAverage

Collection Period

= 365 Days 27.03 Times

14-64

Inventory Turnover

Cost of Goods Sold Average Inventory

InventoryTurnover =

If a company’s inventory turnover Is less than its

industry average, it either has excessive inventory or

the wrong types of inventory.

This ratio measures how many times a company’s inventory has been sold and replaced

during the year.

14-65

Inventory Turnover

Cost of Goods Sold Average Inventory

InventoryTurnover =

= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2

InventoryTurnover =

This ratio measures how many times a company’s inventory has been sold and replaced

during the year.

14-66

Average Sale Period

This ratio measures how many This ratio measures how many days, on average, it takes to days, on average, it takes to

sell the inventory.sell the inventory.

Average Sale Period = 365 Days

Inventory Turnover

= 28.67 days28.67 daysAverage Sale Period = 365 Days

12.73 Times

14-67

Learning Objective

To compute and interpret financial ratios that would be useful to

a long-term creditor

LO4

14-68

Ratio Analysis – The Long–Term Creditor

Use this information to calculate ratios Use this information to calculate ratios to measure the well-being of the long-to measure the well-being of the long-term creditors for Norton Corporation.term creditors for Norton Corporation.


Earnings before interest expense and income taxes 84,000$ Interest expense 7,300 Total stockholders' equity 234,390 Total liabilities 112,000

This is also referred This is also referred to as net operating to as net operating

income.income.

14-69

Times Interest Earned Ratio

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

to the long-term creditor.to the long-term creditor.

Times Interest Earned

Earnings before Interest Expense plus Income TaxesInterest Expense

=

Times Interest Earned

$84,0007,300= = 11.5 times11.5 times

14-70

Debt-to-Equity Ratio

This ratio indicates the relative proportions of debt to equity on

a company’s balance sheet.

Stockholders like a lot of debt if the company can

take advantage of positive financial

leverage.

Total Liabilities Stockholders’ Equity

Debt–to–Equity Ratio

=

Creditors prefer less debt and more equity

because equity represents a buffer of

protection.

14-71

Debt-to-Equity Ratio

Total Liabilities Stockholders’ Equity


=

$112,000 $234,390


= = 0.48

This ratio indicates the relative proportions of debt to equity on

a company’s balance sheet.

14-72

Published Sources That Provide Comparative Ratio Data

14-73

End of Chapter 14

Chapter 14 © The McGraw-Hill Companies, Inc., 2007 McGraw-Hill /Irwin “How Well Am I Doing?”...

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Transcript of Chapter 14 © The McGraw-Hill Companies, Inc., 2007 McGraw-Hill /Irwin “How Well Am I Doing?”...