Chapter 13Financial Statement Analysis

Using Financial Accounting Information:

The Alternative to Debits and Credits, 6th

by

Gary A. Porter and Curtis L. Norton

Copyright © 2009 South-Western, a part of Cengage Learning.

Stockholders

Financial Statement Analysis

Creditors

Management

Will I be paid?How

good is our investment?

How are weperforming?

LIFO FIFO

Limitations of Financial Statement Analysis

Use of different accounting methods

Changes in accounting methods

LO1

Limitations of FinancialStatement Analysis

Failure to recognize trends in ratios

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

????

Limitations of Financial Statement Analysis

Nonoperating items on income statement Effects of inflation

=Apples Oranges

Horizontal Analysis A comparison of financial statement items

over a period of time Read right to left to compare one year’s

results with the next as a dollar amount of change and as a percentage of change from year to year

LO2

%$

Horizontal Analysis

Cash $ 320 $1,350 $(1,030) (76)%

Accounts receivable 5,500 4,500 1,000 22

Inventory 4,750 2,750 2,000 73

Prepaid insurance 150 200 (50) (25)

Total current assets $10,720 $8,800 $ 1,920 22

December 31 Increase (Decrease)

2008 2007 Dollars Percent

Dollar change from year to year

Percentage changefrom one year to

the next year

Trend Analysis

Return on Average Equity

2006 2005 2004 2003

23% 23.5% 24.7% 26.7%

Wm. Wrigley Jr. Company

Tracking items over a series of years

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

%

%

%

LO3

Vertical Analysis

Cash $ 320 1.9% $ 1,350 9.8%

Accounts receivable 5,500 32.6 4,500 32.6

Inventory 4,750 28.1 2,750 19.9

Prepaid insurance 150 0.9 200 1.5

Total current assets $10,720 63.5% $8,800 63.8%

December 31, 2008 December 31, 2007

Dollars Percent Dollars Percent

Compare percentagesacross years to spotyear-to-year trends

Liquidity Analysis

Nearness to cash Ability to pay debts as they become due

LO4

Working Capital

Excess of current assets over current liabilities

Lacks meaningful comparisons for companies of different size

–

Current Ratio

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

Rule of thumb2:1

Acid-Test (Quick) Ratio

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

Quick AssetsCurrent Liabilities

Cash Flow from Operations to Current Liabilities

Focuses on cash only Can be used to indicate the flow of cash

during the year to cover the debts due

Net Cash Provided by Operating ActivitiesAverage Current Liabilities

Accounts Receivable Turnover Ratio

Net Credit SalesAverage Accounts Receivable

Indicates how quickly a company is collecting (i.e., turning over) its receivables

Number of Days’ Sales in Receivables

Represents the average number of days an account is outstanding

Number of Days in the PeriodAccounts Receivable Turnover

Number of 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?

360 days4.8 times

= 75 days

Example:

Inventory Turnover Ratio

Represents the number of times per period inventory is turned over (i.e., sold).

Cost of Goods SoldAverage Inventory

Number of Days’ Sales in Inventory

Represents the average number of days inventory is on hand before it’s sold

Number of Days in the PeriodInventory Turnover

Cash Operating Cycle Time between the purchase of merchandise

and the collection of the from the sale

Number of Days’ Sales in Inventory +

Number of Days’ Sales in Receivables

Purchase of Inventory

Collection of Accounts Receivable

Solvency Analysis

Ability to stay in business over the long-term

Debt-to-EquityRatio

DebtService

Coverage

TimesInterestEarned

Cash Flowfrom Operations

to CapitalExpenditures

LO5

Debt-to-Equity Ratio

Total Liabilities Total Stockholders’ Equity

How much have creditors

contributed compared to

owners?

Debt-to-Equity Ratio

Total LiabilitiesTotal Stockholders’ Equity = .89

For every dollar contributed by

owners, creditors have loaned $.89

Times Interest Earned

Measures ability to meet current interest payments

The greater the coverage the better

Net Income + Interest Expense + Income Tax ExpenseInterest Expense

Debt Service Coverage

Measures amount of cash from operating activities available to “service” the debt

Cash Flow from Operations Before Interest and Tax Payments

Interest and Principal Payments

Cash Flow from Operations to Capital Expenditures Ratio

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

Cash Flow from Operations – Total Dividends PaidCash Paid for Acquisitions

Profitability Analysis

Rate of Return on Assets Return on Common Stockholders’ Equity Earnings per Share Price/Earnings Ratio Dividend Ratios

LO6

Return on Assets Ratio

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

Net Income + Interest Expense, Net of TaxAverage Total Assets

Return on Common Stockholders’ Equity

Net Income – Preferred DividendsAverage Common Stockholders’ Equity

The owners earned 15%on their investment

in ABC Co... Not bad!

Earnings per Share

Presents profits on a per-share basis

Net Income – Preferred DividendsWeighted Average Number of Common Shares Outstanding

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 overpricedpossibly underpriced

Price/Earnings Ratio

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

ratios?

P/E Ratios

Co. A = 9 to 1Co. B = 8 to 1

Dividend Payout Ratio

Common Dividends per ShareEarnings per Share

We need to decide what

percentage of the firm’s income we

can return to owners

Dividend Yield Ratio

Investors willing to forgo dividends in lieu of price appreciation

Common Dividends per ShareMarket Price per Share

usually < 5%=

AppendixAccounting Tools: Reporting and

Analyzing Other Income Statement Items

Common Characteristics All such items are reported after income from

continuing operations Reported separately Shown net of tax effects Most analysts ignore these items, since they

are not likely to reoccur

LO7

Discontinued Operations Any gain or loss from disposal of a division

or segment of the business Any net income or loss from operating this

portion until the date of disposal

Extraordinary Items

Gain or loss due to an event that is Unusual in nature AND Infrequent in occurrence

End of Chapter 13