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CHAPTER 17

ANALYSISAND

INTERPRETATION OF

FINANCIAL STATEMENTS

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17-2

Non-accounting majors, especially,should relate well to this chapter

It looks at accounting information from

users perspective Relates very closely to topics you

will study in your finance courseTherefore, we will use a somewhat

broader brush on this chapter What is financial statement

analysis?Tearingapart the financial statementsand looking at the relationships

Financial Statement Analysis

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Who analyzes financial statements?

Internal users (i.e., management)

External users (emphasis of chapter)Examples?

Investors, creditors, regulatory agencies &

stock market analysts and

auditors

Financial Statement Analysis625
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17-4

What do internal users use it for?

Planning, evaluating and controllingcompany operations

What do external users use it for?

Assessing past performance and currentfinancial position and making predictions

about the future profitability and solvencyof the company as well as evaluating theeffectiveness of management

First sentence in chapter says...

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Information is available from

Published annual reports

(1) Financial statements

(2) Notes to financial statements

(3) Letters to stockholders

(4) Auditors report (Independent accountants)

(5) Managements discussion and analysis Reports filed with the government

e.g., Form 10-K, Form 10-Q and Form 8-K

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Information is available from

Other sources

(1) Newspapers (e.g., Wall Street Journal)

(2) Periodicals (e.g. Forbes, Fortune)

(3) Financial information organizations suchas: Moodys, Standard & Poors, Dun &

Bradstreet, Inc., and Robert MorrisAssociates

(4) Other business publications

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Horizontal Analysis

Vertical Analysis

Trend Percentages

Ratio Analysis

Methods ofFinancial Statement Analysis

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Horizontal Analysis

Using comparative financialstatements to calculate dollar

or percentage changes in afinancial statement item from

one period to the next

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Vertical Analysis

For a single financialstatement, each item

is expressed as apercentage of asignificant total,e.g., all income

statement items areexpressed as a

percentage of sales

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Common-Size Statements

Financial statements that showonly percentages and no

absolute dollar amounts

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Trend Percentages

Show changes over time ingiven financial statement items

(can help evaluate financialinformation of several years)

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Ratio Analysis

Expression of logical relationshipsbetween items in a financialstatement of a single period

(e.g., percentage relationshipbetween revenue and net income)

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Horizontal Analysis Example

The management of Clover Companyprovides you with comparative balancesheets of the years ended December 31,

1999 and 1998. Management asks you toprepare a horizontal analysis on the

information.

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17-14CLOVER CORPORATION

Comparative Balance Sheets

December 31, 1999 and 1998

1999 1998Assets

Current assets:

Cash 12,000$ 23,500$

Accounts receivable, net 60,000 40,000Inventory 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$

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Calculating Change in Dollar Amounts

Dollar

Change

Current Year

Figure

Base Year

Figure=


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Calculating Change in Dollar Amounts

Since we are measuring the amount ofthe change between 1998 and 1999, the

dollar amounts for 1998 become thebase year figures.

Dollar

Change

Current Year

Figure

Base Year

Figure=


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Calculating Change as a Percentage

Percentage

Change

Dollar Change

Base Year Figure 100%=


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CLOVER CORPORATIONComparative Balance Sheets


Increase (Decrease)

1999 1998 Amount %

Assets

Current assets:Cash 12,000$ 23,500$ (11,500)$

Accounts receivable, net 60,000 40,000

Inventory 80,000 100,000



Property and equipment:Land 40,000 40,000



Total assets 315,000$ 289,700$

$12,000 $23,500 = $(11,500)


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Increase (Decrease)

1999 1998 Amount %

Assets

Current assets:Cash 12,000$ 23,500$ (11,500)$ (48.9)


Inventory 80,000 100,000



Property and equipment:Land 40,000 40,000



Total assets 315,000$ 289,700$

($11,500 $23,500) 100% = 48.9%


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Increase (Decrease)

1999 1998 Amount %

Assets

Current 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 1,800 150.0

Total 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 41.2

Total property and equipment 160,000 125,000 35,000 28.0

Total assets 315,000$ 289,700$ 25,300$ 8.7


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Lets apply the sameprocedures to the

liability and stockholdersequity sections of the

balance sheet.


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CLOVER CORPORATION

Comparative Balance Sheets


Increase (Decrease)1999 1998 Amount %

Liabilities and Stockholders' Equity

Current liabilities:

Accounts payable 67,000$ 44,000$ 23,000$ 52.3

Notes payable 3,000 6,000 (3,000) (50.0)

Total current liabilities 70,000 50,000 20,000 40.0

Long-term liabilities:

Bonds payable, 8% 75,000 80,000 (5,000) (6.3)

Total liabilities 145,000 130,000 15,000 11.5

Stockholders' equity:

Preferred stock 20,000 20,000 - 0.0

Common stock 60,000 60,000 - 0.0Additional paid-in capital 10,000 10,000 - 0.0

Total paid-in capital 90,000 90,000 - 0.0

Retained earnings 80,000 69,700 10,300 14.8

Total stockholders' equity 170,000 159,700 10,300 6.4

Total liabilities and stockholders' equity 315,000$ 289,700$ 25,300$ 8.7

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Now, lets apply the

procedures to theincome statement.


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CLOVER CORPORATION

Comparative Income StatementsFor the Years Ended December 31, 1999 and 1998

Increase (Decrease)

1999 1998 Amount %

Net sales 520,000$ 480,000$ 40,000$ 8.3

Cost of goods sold 360,000 315,000 45,000 14.3

Gross margin 160,000 165,000 (5,000) (3.0)

Operating expenses 128,600 126,000 2,600 2.1

Net 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)

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5

CLOVER CORPORATION


Increase (Decrease)

1999 1998 Amount %

Net sales 520,000$ 480,000$ 40,000$ 8.3


Gross margin 160,000 165,000 (5,000) (3.0)






Net income 17,500$ 22,400$ (4,900)$ (21.9)

Sales increased by 8.3% while net

income decreased by 21.9%.

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CLOVER CORPORATION


Increase (Decrease)

1999 1998 Amount %

Net sales 520,000$ 480,000$ 40,000$ 8.3


Gross margin 160,000 165,000 (5,000) (3.0)






Net income 17,500$ 22,400$ (4,900)$ (21.9)

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

increase in sales, yielding an overalldecrease in net income.

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Vertical Analysis Example

The management of Sample Company asksyou to prepare a vertical analysis for the

comparative balance sheets of the

company.

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Sample CompanyBalance Sheet (Assets)

At December 31, 1999 and 1998

% of Total Assets

1999 1998 1999 1998Cash 82,000$ 30,000$ 17% 8%

Accts. Rec. 120,000 100,000 25% 26%

Inventory 87,000 82,000 18% 21%

Land 101,000 90,000 21% 23%Equipment 110,000 100,000 23% 26%

Accum. Depr. (17,000) (15,000) -4% -4%

Total 483,000$ 387,000$ 100% 100%


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Sample CompanyBalance Sheet (Assets)


% of Total Assets

1999 1998 1999 1998Cash 82,000$ 30,000$ 17% 8%

Accts. Rec. 120,000 100,000 25% 26%

Inventory 87,000 82,000 18% 21%

Land 101,000 90,000 21% 23%Equipment 110,000 100,000 23% 26%

Accum. Depr. (17,000) (15,000) -4% -4%

Total 483,000$ 387,000$ 100% 100%

$82,000 $483,000 = 17% rounded

$30,000 $387,000 = 8% rounded

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Sample Company

Balance Sheet (Liabilities & Stockholders' Equity)


% of Total Assets

1999 1998 1999 1998Acts. Payable 76,000$ 60,000$ 16% 16%

Wages Payable 33,000 17,000 7% 4%

Notes Payable 50,000 50,000 10% 13%

Common Stock 170,000 160,000 35% 41%Retained Earnings 154,000 100,000 32% 26%

Total 483,000$ 387,000$ 100% 100%


$76,000 $483,000 = 16% rounded

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Trend Percentages Example

Wheeler, Inc. provides you with thefollowing operating data and asks that

you prepare a trend analysis.

Wheeler, Inc.

Operating Data

1999 1998 1997 1996 1995

Revenues 2,405$ 2,244$ 2,112$ 1,991$ 1,820$

Expenses 2,033 1,966 1,870 1,803 1,701Net income 372$ 278$ 242$ 188$ 119$

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Wheeler, Inc. provides you with thefollowing operating data and asks that

you prepare a trend analysis.

Wheeler, Inc.

Operating Data

1999 1998 1997 1996 1995

Revenues 2,405$ 2,244$ 2,112$ 1,991$ 1,820$

Expenses 2,033 1,966 1,870 1,803 1,701Net income 372$ 278$ 242$ 188$ 119$

$1,991 - $1,820 = $171

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Using 1995 as the base year, we developthe following percentage relationships.

Wheeler, Inc.

Operating Data1999 1998 1997 1996 1995

Revenues 132% 123% 116% 109% 100%

Expenses 120% 116% 110% 106% 100%

Net income 313% 234% 203% 158% 100%

$1,991 - $1,820 = $171

$171 $1,820 = 9% rounded

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90

100

110

120

130

140

1995 1996 1997 1998 1999

Years

%

of100Base

Sales

Expenses

Trend line

for Sales

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Categories of Ratios

Liquidity RatiosIndicate a companys short-termdebt-paying ability

Equity (Long-Term Solvency) RatiosShow relationship between debt andequity financing in a company

Profitability TestsRelate income to other variables

Market TestsHelp assess relative merits of stocks in

the marketplace

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Liquidity RatiosCurrent (working capital) ratio

Acid-test (quick) ratio

Cash flow liquidity ratio

Accounts receivable turnover

Number of days sales in accounts

receivableInventory turnover

Total assets turnover

651

10 Ratios You Must Know

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Equity (Long-Term Solvency) RatiosEquity (stockholders equity) ratio

Equity to debt


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Profitability Tests Return on operating assets

Net income to net sales (return on

sales or profit margin)

Return on average commonstockholders equity (ROE)

Cash flow marginEarnings per share

Times interest earned

Times preferred dividends earned

$


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Market Tests Earnings yield on common stock

Price-earnings ratio

Payout ratio on common stock

Dividend yield on common stock

Dividend yield on preferred stock

Cash flow per share of commonstock


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Now, lets look at

NortonCorporations 1999

and 1998 financialstatements.

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NORTON CORPORATION

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NORTON CORPORATION

Balance Sheets


1999 1998

Assets

Current assets:

Cash 30,000$ 20,000$


Inventory 12,000 10,000



Property and equipment:

Land 165,000 123,000



Total assets 346,390$ 300,000$

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NORTON CORPORATION

Balance Sheets


1999 1998

Liabilities and Stockholders' EquityCurrent 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$

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NORTON CORPORATION

Income Statements

For the Years Ended December 31, 1999 and 1998

1999 1998

Net sales 494,000$ 450,000$

Cost of goods sold 140,000 127,000

Gross margin 354,000 323,000Operating 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$

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Now, lets calculate

the 10 ratios basedon Nortons financial

statements.

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NORTON CORPORATION

1999

Cash 30,000$

Accounts receivable, net

Beginning of year 17,000

End of year 20,000

Inventory


End of year 12,000

Total current assets 65,000Total current liabilities 42,000

Sales on account 494,000

Cost of goods sold 140,000

We willuse this

informationto calculatethe liquidity

ratios for

Norton.

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Working Capital*

12/31/99Current assets 65,000$

Current liabilities (42,000)

Working capital 23,000$

The excess of current assets overcurrent liabilities.

* While this is not a ratio, it does give an

indication of a companys liquidity.

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Current (Working Capital) Ratio

CurrentRatio

$65,000$42,000

= = 1.55 : 1

Measures the abilityof the company to pay current

debts as they become due.

CurrentRatio

Current AssetsCurrent Liabilities

=

#1

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Acid-Test (Quick) Ratio

Quick AssetsCurrent Liabilities

=Acid-Test

Ratio

Quick assets are Cash,Marketable Securities,

Accounts Receivable (net) and

current Notes Receivable.

#2

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=Acid-Test

Ratio

Norton Corporations quick

assets consist of cash of$30,000 and accounts

receivable of $20,000.


#2

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=Acid-Test

Ratio

$50,000$42,000

= 1.19 : 1=Acid-Test

Ratio


#2

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Sales on AccountAverage Accounts Receivable

AccountsReceivable

Turnover

=

Accounts Receivable Turnover

= 26.70 times$494,000

($17,000 + $20,000) 2

AccountsReceivableTurnover

=

This ratio measures how manytimes a company converts its

receivables into cash each year.

#3 Average, net accountsreceivable

Net, credit sales

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Number of Days Sales
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Number of Days Salesin Accounts Receivable

Measures, on average, how manydays it takes to collect an

account receivable.

Days Salesin Accounts

Receivables

=365 Days


= 13.67 days=365 Days

26.70 Times

Days Salesin AccountsReceivables

#4

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Number of Days Sales

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Number of Days Salesin Accounts Receivable

In practice, would 45 days be adesirable number of days in

receivables?

#4Days Salesin Accounts

Receivables

=365 Days


= 13.67 days=365 Days

26.70 Times

Days Salesin AccountsReceivables

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Inventory Turnover

Cost of Goods SoldAverage Inventory

InventoryTurnover

=

Measures the number of timesinventory is sold and

replaced during the year.

= 12.73 times$140,000

($10,000 + $12,000) 2InventoryTurnover

=

#5

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Inventory Turnover

Cost of Goods SoldAverage Inventory

InventoryTurnover

=

= 12.73 times$140,000

($10,000 + $12,000) 2InventoryTurnover

=

#5

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Fixed Assets Turnover Turnover

Cost of Goods SoldNet Fixed Assets

FixedAssets

Turnover

=

Fixed assets turnover ratio is also known as sales to fixed assets ratio. This ratio measures

the efficiency and profit earning capacity of the concern. Higher the ratio, greater is the

intensive utilization of fixed assets. Lower ratio means under-utilization of fixed assets.

= times$000000000000

FixedAssets

Turnover

=

#5

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Equity, or Long TermSolvency Ratios

This is part of the information tocalculate the equity, or long-term

solvency ratios of Norton Corporation.

NORTON CORPORATION

1999

Net operating income 84,000$

Net sales 494,000

Interest expense 7,300

Total stockholders' equity 234,390

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1999

Common shares outstanding


End of year 27,400

Net income 53,690$

Stockholders' equity


End of year 234,390

Dividends per share 2

Dec. 31 market price/share 20

Interest expense 7,300

Total assets


End of year 346,390

Here is therest of the

informationwe will

use.

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Equity Ratio

EquityRatio

=Stockholders Equity

Total Assets

EquityRatio

=$234,390$346,390

67.7%=

Measures the proportionof total assets provided by

stockholders.

#6

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Net Income to Net Sales

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Net Income to Net SalesA/K/A Return on Sales or Profit Margin

Net Incometo

Net Sales

=Net IncomeNet Sales

Net Incometo

Net Sales=

$53,690$494,000

= 10.9%

Measures the proportion of the sales dollarwhich is retained as profit.

#7

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Net Income to Net Sales

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Net Income to Net SalesA/K/A Return on Sales or Profit Margin

Net Incometo

Net Sales

=Net IncomeNet Sales

Net Incometo

Net Sales=

$53,690$494,000

= 10.9%

#7

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Return on Average Common

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Return on Average CommonStockholders Equity (ROE)

Return on

StockholdersEquity

=

Net Income

Average CommonStockholders Equity

=

$53,690

($180,000 + $234,390) 2 = 25.9%

Return on

StockholdersEquity

Important measure of theincome-producing ability

of a company.

#8

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Earnings

per Share

Earnings Available to Common StockholdersWeighted-Average Number of Common

Shares Outstanding

=

Earningsper Share

$53,690(17,000 + 27,400) 2

= = $2.42

The financial press regularly publishesactual and forecasted EPS amounts.

#9

Earnings Per Share

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Price-Earnings Ratio

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Price-Earnings RatioA/K/A P/E Multiple

Price-Earnings

Ratio

Market Price Per Share

EPS

=

Price-EarningsRatio

=$20.00$ 2.42

= 8.3 : 1

#10

Provides some measure of whether thestock is under or overpriced.

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Question

The current ratio is a measure ofliquidity that is computed by dividing

total assets by total liabilities.

a. True

b. False

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The current ratio is a measure ofliquidity that is computed by dividing

total assets by total liabilities.

a. True

b. False

Question

The current ratio is a measure ofliquidity, but is computed by

dividing current assets bycurrent liabilities

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Question

Quick assets are defined as Cash,Marketable Securities and net

receivables.

a. True

b. False

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Quick assets are defined as Cash,Marketable Securities and net

receivables.

a. True

b. False

Question

chapter no. 20

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