Management Accounting Lecture 3 Financial Statement Analysis

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McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Management Accounting Lecture 3 (Chapter 14)

Financial Statement Analysis

Bangor University Transfer Abroad Programme


Today’s Agenda

n Financial Statement Analysis n  Dollar and Percentage Changes

n  “Horizontal Analysis” n  Common Sized Statements

n  “Vertical Analysis” n  Ratio Analysis


Cautions

n Be sure to recognize differences in accounting methods before coming to conclusions n  Are costs skewed towards COGS? n  Inventory valuation n  Depreciation policy

n Need to look beyond the numbers n  Economic conditions n  Industry trends, consumer tastes n  Technical changes, changes within the company


Limitations of Financial Statement Analysis

Differences in accounting methods between companies sometimes

make comparisons difficult.

We use the LIFO method to value inventory.

We use the FIFO method to value inventory.


Limitations of Financial Statement Analysis

Analysts should look beyond the ratios.

Economic factors

Industry trends

Changes within the company

Technological changes

Consumer tastes


Statements in Comparative and Common-Size Form

�  Dollar and percentage changes on statements

�  Common-size statements

�  Ratios

Analytical techniques used to

examine relationships among financial statement

items

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Horizontal Analysis

Horizontal analysis shows the changes between years in the

financial data in both dollar and percentage form.


Horizontal Analysis

Calculating Change in Dollar Amounts

Dollar Change

Current Year Figure

Base Year Figure = –

The dollar amounts for 2007 become

the “base” year figures.


Horizontal Analysis

Calculating Change as a Percentage

Percentage Change

Dollar Change Base Year Figure 100% = ×


CLOVER CORPORATIONComparative Balance Sheets

December 31

Increase (Decrease)2008 2007 Amount %

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)


Horizontal Analysis

We could do this for the liabilities & stockholders’

equity, but instead, let’s look at the income statement.


CLOVER CORPORATIONComparative Income Statements

For the Years Ended December 31Increase

(Decrease)2008 2007 Amount %

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

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

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For the Years Ended December 31Increase

(Decrease)2008 2007 Amount %

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

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.


Trend Percentages

Trend percentages state several years’

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


Trend Percentages

Trend Percentage

Current Year Amount Base Year Amount

100% = ×


Trend Percentages

Berry Products Income Information

For the Years Ended December 31

The base year is 2003, and its amounts

will equal 100%.

YearItem 2007 2006 2005 2004 2003

Sales 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


Trend Percentages


For the Years Ended December 31 Year

Item 2007 2006 2005 2004 2003Sales 105% 100%Cost of goods sold 104% 100%Gross margin 108% 100%

2004 Amount ÷ 2003 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108%


Trend Percentages


For the Years Ended December 31

By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing

faster than sales, which is slowing the increase in gross margin.

YearItem 2007 2006 2005 2004 2003

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

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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

2003 2004 2005 2006 2007

Year

Percentage

SalesCOGSGM


Common-Size Statements

Common-size statements use

percentages to express the relationship of

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

analysis.


Gross Margin Percentage

Gross Margin Percentage

Gross Margin Sales =

This measure indicates how much of each sales dollar is left after

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



In balance sheets, all items are expressed

as a percentage of total assets.



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

2002 Net income 219$ 8.00% 894$ 5.80%

Common-size financial statements are particularly useful when comparing

data from different companies.



For the Years Ended December 31Common-Size Percentages

2008 2007 2008 2007Net 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 is the base

and is expressed as 100%.

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2008 2007 2008 2007Net 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$


2007 Cost ÷ 2007 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6%

2008 Cost ÷ 2008 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2%





2008 2007 2008 2007Net 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?


Common Stockholders

Short-term Creditors

Long-term Creditors

Ratios


Earnings Per Share

Earnings per Share Net Income – Preferred Dividends Average Number of Common

Shares Outstanding

=

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

for the year is used in the denominator.


Earnings Per Share

Earnings per Share Net Income – Preferred Dividends Average Number of Common

Shares Outstanding

=

This measure indicates how much income was earned for each share of

common stock outstanding.

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


Price-Earnings Ratio


Market Price Per Share Earnings Per Share =

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

company has for growth.


$20.00 $2.42 = = 8.26 times

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Dividend Payout Ratio

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

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


Dividends Per Share Earnings Per Share =


$2.00 $2.42 = = 82.6%


Dividend Yield Ratio

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

current market price of the stock.


Dividends Per Share Market Price Per Share =


$2.00 $20.00 = = 10.00%


Return on Total Assets

This ratio measures how well assets have been employed.


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

= = 18.19%


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


Return on Common Stockholders’ Equity


Net Income – Preferred Dividends Average Stockholders’ Equity =

This measure indicates how well the company employed the owners’

investments to earn income.


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


Financial Leverage

Financial leverage involves acquiring assets with funds at a

fixed rate of interest.

Return on investment in

assets >

Fixed rate of return on borrowed

funds

Positive financial leverage

=

Return on investment in

assets <

Fixed rate of return on borrowed

funds

Negative financial leverage

=


Book Value Per Share

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

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

Book Value per Share

Common Stockholders’ Equity Number of Common Shares Outstanding =

= $ 8.55 Book Value per Share

$234,390 27,400 =

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Book Value Per Share

Book Value per Share

Common Stockholders’ Equity Number of Common Shares Outstanding =

= $ 8.55 Book 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.


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.


Working Capital

December 31, 2007

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

Norton Corporation


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.

Current Ratio

Current Assets Current Liabilities =


Current Ratio

Current Ratio

$65,000 $42,000 = = 1.55

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

paying ability.

Current Ratio

Current Assets Current Liabilities =


Acid-Test (Quick) Ratio

Quick Assets Current Liabilities = Acid-Test

Ratio

Quick assets include Cash, Marketable Securities, Accounts

Receivable and current Notes Receivable.

The quick ratio measures a company’s ability to meet obligations without

having to liquidate inventory.

$50,000 $42,000 = 1.19 = Acid-Test

Ratio Norton

Corporation’s quick assets

consist of cash of $30,000 and

accounts receivable of

$20,000.

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Accounts Receivable Turnover

This ratio measures how many times a company converts its

receivables into cash each year.

Sales on Account Average Accounts Receivable


=

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


=


Average Collection Period

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

an account receivable.

Average Collection

Period =

365 Days Accounts Receivable Turnover

= 13.50 days Average

Collection Period

= 365 Days 27.03 Times


Inventory Turnover

Cost of Goods Sold Average Inventory

Inventory Turnover =

If a company’s inventory turnover Is less than its

industry average, it either has excessive inventory or

the wrong sorts of inventory.

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


Inventory Turnover

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


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

during the year.

Cost of Goods Sold Average Inventory



Average Sale Period

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

sell the inventory.

Average Sale Period = 365 Days

Inventory Turnover

= 28.67 days Average Sale Period = 365 Days

12.73 Times


Times Interest Earned Ratio

The times interest earned ratio is the most common measure of a company’s ability to protect its

long-term creditors.

Times Interest Earned

Earnings before Interest Expense plus Income Taxes Interest Expense

=

Times Interest Earned

$84,000 7,300 = = 11.5 times

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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.

In practice, debt-to-equity ratios from 0.0 to 3.0 are common. McGraw-Hill /Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Debt-to-Equity Ratio

$112,000 $234,390


= = 0.48

This ratio indicates the relative proportions of debt to equity on

a company’s balance sheet.

Total Liabilities Stockholders’ Equity


=


Review

n Financial Statement Analysis n  Dollar and Percentage Changes

n  “Horizontal Analysis” n  Common Sized Statements

n  “Vertical Analysis” n  Ratio Analysis


Tutorial

n  Review of today’s lecture n  Complete Review Problems

n  14-3 n  14-6

Management Accounting Lecture 3 Financial Statement Analysis

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Transcript of Management Accounting Lecture 3 Financial Statement Analysis