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

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Learning Objective 1

1. Describe basic financial statement analytical methods.


Horizontal Analysis

The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis.

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Horizontal Analysis

Horizontal Analysis:

Difference $17,000Base year (2011) $533,000

= 3.2%


Horizontal Analysis


Difference $25,800Base year (2011) $64,700

= 39.9%

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Horizontal AnalysisLO 1LO 1


Difference $296,500Base year (2011) $1,234,000

= 24.0%



Difference $37,500Base year (2011) $ 100,000

= 37.5%

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Horizontal Analysis


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.


Vertical Analysis

Vertical Analysis:

Current Assets $550,000 Total Assets $ 1,139,500

= 48.3%

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Vertical AnalysisLO 1LO 1

Vertical Analysis:

Selling expenses $191,000Net sales $1,498,000

= 12.8%


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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.




2. Use financial statement analysis to assess the solvency of a business.


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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.


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.


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


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


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


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


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:

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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


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:

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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


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


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:

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Ratio of Fixed Assets to Long-Term

Liabilities

Fixed Assets (net)

Long-Term Liabilities

=


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


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.


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Total LiabilitiesTotal

Stockholders’ Equity

=


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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


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=


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


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=





3. Use financial statement analysis to assess the profitability of a business.


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.


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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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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


Rate Earned on Total Assets

The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed.


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Net Income + Interest Expense

Average Total Assets=


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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


Rate Earned on Stockholders’ Equity

The rate earned on stockholders’ equity measures the rate of income earned on the amount invested by the stockholders.


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Rate Earned on Stockholders’

Equity

Net Income Average Total

Stockholders’ Equity

=


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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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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.


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.


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Rate Earned on Common Stockholders’

Equity

Net Income – Preferred Dividends

Average 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


$82,000$658,500

$67,500$618,750


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.


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Earnings per Share (EPS) on Common

Stock

Net Income – Preferred DividendsShares of Common Stock Outstanding

=


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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


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.


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.

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(continued)


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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.


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:

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Dividend Yield Dividends per Share of

Common StockMarket Price per Share

of Common Stock=


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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





3. Use financial statement analysis to assess the profitability of a business.

4. Describe the contents of corporate annual reports.


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.

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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.

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Prepared by: C. Douglas Cloud Professor Emeritus of AccountingPepperdine University


Student Version

Financial Statement Analysis in Bank

The End

chapter 03 financial statement analysis and bank

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