financial statement analysis chapter 19 horngren ♦ harrison ♦ bamber ♦ best ♦ fraser ♦...

Financial Statement Analysis

Chapter 19

HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

19 - 2Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia

Objectives

1. Perform a horizontal analysis of comparative financial statements

2. Perform vertical analysis of financial statements

3. Prepare common size financial statements

4. Calculate the standard financial ratios used for decision-makers

5. Use ratios in decision-making

6. Measure economic value added by a company’s operations


The Annual ReportUsually

Contains ...– financial statements.– footnotes to the financial statements.– a summary of accounting methods used.– management discussion and analysis of

the financial results.– an auditor’s report.– comparative financial data for series of

year.


Objective 1

Perform a horizontal analysis of comparative

financial statements.


Horizontal Analysis

Increase/(Decrease) 2004 2003 Amount Percent

Sales $41,500 $37,850 $3,650 9.6%Expenses 40,000 36,900 3,100 8.4%Net profit 1,500 950 550 57.9%


2004 2003 DifferenceSales $41,500 $37,850 $3,650

$3,650 ÷ $37,850 = .0964, or 9.6%

Horizontal Analysis


Trend Percentages...

– are calculated by selecting a base year whose amounts are set equal to 100%.

The amounts of each following year are expressed as a percentage of the base amount.

Trend % = Any year $ ÷ Base year $


Year 2004 2003 2002

Revenues $27,611 $24,215 $21,718 Cost of sales 15,318 14,709 13,049 Gross profit $12,293 $ 9,506 $

8,669

2002 is the base year.What are the trend percentages?

Trend Percentages


Year 2004 2003 2002

Revenues 127% 111% 100% Cost of sales 117% 113% 100% Gross profit 142% 110% 100%

Trend Percentages

These percentages were calculated bydividing each item by the base year.


Objective 2

Perform a vertical analysis

of financial statements.


Vertical Analysis...

– compares each item in a financial statement to a base number set to 100%.

Every item on the financial statement is then reported as a percentage of that base.


Vertical Analysis

2004 %

Revenues $38,303 100.0 Cost of sales 19,688 51.4 Gross profit $18,615 48.6 Total operating expenses 13,209 34.5 Operating profit $ 5,406 14.1 Other income 2,187 5.7 Income before taxes $ 7,593 19.8 Income taxes 2,827 7.4 Net profit $ 4,766 12.4


Vertical Analysis

Assets 2004 % Current assets: Cash $ 1,816 4.7 Receivables net 10,438 26.9 Inventories 6,151 15.9 Prepaid expenses 3,526 9.1 Total current assets $21,931 56.6 Plant and equipment, net 6,847 17.7 Other assets 9,997 25.7 Total assets $38,775 100.0


Objective 3

Prepare common-size

financial statements.


Common-size Statements

On the statement of financial performance, each item is expressed as a percentage of net sales.

On the statement of financial position, the common size is the total on each side of the accounting equation.

Common-size statements are used to compare one company to other companies, and to the industry average.


Benchmarking

43.0%

38.2%

8.0%

10.8%

51.4%

28.8%

7.4%

12.4%

Percent of Net Sales

Enterprise LimitedTechnology Limited

Cost of goods sold Operating expenses Income tax Net profit


Objective 4

Calculate the standardfinancial ratios usedby decision-makers.


Ratio Classification

1 Measuring ability to pay current liabilities

2 Measuring ability to sell inventory and collect receivables

3 Measuring ability to pay long-term debt4 Measuring profitability5 Analysing shares as an investment


The Data(Exhibit 19-1 Lucent Technology 20X7)

Net sales (Year 2004) $858,000 Cost of goods sold 513,000 Gross profit $345,000 Total operating expenses 244,000 Plus Interest revenue 4,000 Interest expense (24,000) Profits before taxes $ 81,000 Income tax 33,000 Net profits $ 48,000


The Data(Exhibit 19-2 Lucent Technology 20X7 and 20X6)

Assets 2004 2003 Current assets: Cash $ 29,000 $ 32,000 Receivables net 114,000 85,000 Inventories 113,000 111,000 Prepaid expenses 6,000 8,000 Total current assets $262,000 $236,000 Long-term investments 18,000 9,000 Plant and equipment, net 507,000 399,000 Total assets $787,000 $644,000



Liabilities 2004 2003 Current liabilities: Bills payable $ 42,000 $ 27,000 Accounts payable 73,000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities $142,000 $126,000 Long-term debt 289,000 198,000 Total liabilities $431,000 $324,000


Shareholders’ Equity 2004 2003

Ordinary shares (93,000) $186,000 $186,000 Retained earnings 170,000 134,000 Total shareholders’ equity $356,000 $320,000

Total liabilities andshareholders’ equity $787,000 $644,000



Current ratio =Total current assets ÷ Total current liabilities

Current ratio =Total current assets ÷ Total current liabilities

The current ratio measuresthe company’s ability to pay

current liabilities with current assets.

The current ratio measuresthe company’s ability to pay

current liabilities with current assets.

Measuring Ability toPay Current

Liabilities



Liabilities Lucent’s current ratio: 2003: $236,000 ÷ $126,000 = 1.87 2004: $262,000 ÷ $142,000 = 1.85 If the industry average is 1.80. What does this tell us? The current ratio decreased slightly

during 2004 but it is still slightly higher than the industry average.


Acid-test ratio =(Cash + Short-term investments

+ Net current receivables)÷ Total current liabilities

Acid-test ratio =(Cash + Short-term investments

+ Net current receivables)÷ Total current liabilities


LiabilitiesThe acid-test ratio shows the company’s

ability to pay all current liabilitiesif they come due immediately.

The acid-test ratio shows the company’sability to pay all current liabilities

if they come due immediately.



Liabilities Lucent’s acid-test ratio: 2003: ($32,000 + $85,000) ÷ $126,000 = .93 2004: ($29,000 + $114,000) ÷ $142,000 = 1.01 If the industry average is .60. The company’s acid-test ratio improved

considerably during 2004 and is well above the industry average.


Inventory turnover = Cost of goods sold÷ Average inventory

Inventory turnover = Cost of goods sold÷ Average inventory

Inventory turnover is a measureof the number of times the average

level of inventory is sold during a year.

Inventory turnover is a measureof the number of times the average

level of inventory is sold during a year.

Measuring Ability to

Sell Inventory



Sell Inventory Inventory turnover: 2004: $513,000 ÷ $112,000* = 4.58 If the industry average is 2.70. A high number indicates an ability to

quickly sell inventory, but it might indicate stock-outs!

* Average inventory ($113,000 + $111,000) ÷ 2


Accounts receivable turnover =Net credit sales ÷ Average accounts receivable

Accounts receivable turnover =Net credit sales ÷ Average accounts receivable

Accounts receivable turnover measures a company’sability to collect cash from credit customers.

Accounts receivable turnover measures a company’sability to collect cash from credit customers.


Collect Receivables



Collect Receivables Lucent’s accounts receivable turnover: 2004: $858,000 ÷ $99,500 = 8.62 times If the industry average is 22.2 times. Lucent’s receivable turnover is much

lower than the industry average. If the company is a rural store that sells to

local people who tend to pay their bills over a lengthy period of time – then?


One day’s sales = Net sales ÷ 365 daysOne day’s sales = Net sales ÷ 365 days

Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales

Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales


Collect Receivables

Days’ sales in receivable ratio measures howmany day’s sales remain in Accounts Receivable.

Days’ sales in receivable ratio measures howmany day’s sales remain in Accounts Receivable.



Collect Receivables Days’ sales in Accounts Receivable for

2004: One day’s sales: $858,000 ÷ 365 = $2,351 Days’ sales in Accounts Receivable: $99,500 ÷ $2,351 = 42 days What is the industry average - 365/22.2


Total liabilities ÷ Total assetsTotal liabilities ÷ Total assets


Pay Debt

The debt ratio indicates the proportionof assets financed with debt.

The debt ratio indicates the proportionof assets financed with debt.



Pay Debt Lucent’s debt ratio: 2003: $324,000 ÷ $644,000 = 0.50 2004: $431,000 ÷ $787,000 = 0.55 Industry average 0.61. Lucent expanded operations during

2004 by financing through borrowing – but it is still lower than the industry.


Times-interest-earned= Net Profits plus (interest expense and tax)

÷ Interest expense

Times-interest-earned= Net Profits plus (interest expense and tax)

÷ Interest expense


Pay Debt

Times-interest-earned ratio measures the number of times profits before both

interest and tax can cover interest expense.

Times-interest-earned ratio measures the number of times profits before both

interest and tax can cover interest expense.



Pay Debt Times-interest-earned ratio: 2004: ($81,000 + $24,000*) ÷ $24,000

= 4.37 The industry average is 2.00. This is a favorable sign.

* Profits before tax are $81,000 (or $48,000 + $33,000) and if we paid no interest of $24,000 profits would be $105,000.

* Profits before tax are $81,000 (or $48,000 + $33,000) and if we paid no interest of $24,000 profits would be $105,000.


Rate of return on net sales =Net profits ÷ Net sales

Rate of return on net sales =Net profits ÷ Net sales

Measuring Profitability

Rate of return on net sales shows the percentageof each sales dollar earned as net profits.

Rate of return on net sales shows the percentageof each sales dollar earned as net profits.



Lucent’s rate of return on sales: 2003: $26,000 ÷ $803,000 = 0.032 2004: $48,000 ÷ $858,000 = 0.056 The industry average is 0.008. The increase is significant in itself and also

because it is much better than the industry average.


Rate of return on total assets = (Net profits + income tax + interest expense)

÷ Average total assets

Rate of return on total assets = (Net profits + income tax + interest expense)

÷ Average total assets


Rate of return on total assets measureshow profitably a company uses its assets.

Rate of return on total assets measureshow profitably a company uses its assets.



Rate of return on total assets for 2004: $105,000 ÷ $715,500* = 0.147 What if the industry average is 0.049. How does Lucent compare to the

industry?

* ($644,000 + $787,000) ÷ 2 = $715,500


Rate of return on ordinary shareholders’ equity= (Net profits – preferred dividends)

÷ Average ordinary shareholders’ equity

Rate of return on ordinary shareholders’ equity= (Net profits – preferred dividends)

÷ Average ordinary shareholders’ equity


Shareholders equity includes any additionalissued ordinary shares and retained profits.Shareholders equity includes any additionalissued ordinary shares and retained profits.



Lucent’s rate of return on ordinary shareholders’ equity for 2004:

($48,000 – $0) ÷ $338,000* = 0.142 Why is this ratio larger than the return

on total assets (.101)? Because Lucent uses leverage or

gearing.

* ($356,000 + $320,000) ÷ 2 = $338,000


Gearing Example

I borrow $90 (at 5%) and I put in $10 Invest $100 and earn 10% on it

Revenue $10.00 ($100 x 10%)

Expenses $ 4.50 ($90 x 5%)

Profit $ 5.50 Not bad on the $10 I put in. But what if the assets only earned say 2% Loss of $2.50 Gearing is RISKY !



Earnings per share (EPS)= (Net profits – Preferred dividends)÷ Number of ordinary shares issued

Earnings per share (EPS)= (Net profits – Preferred dividends)÷ Number of ordinary shares issued



Lucent’s earnings per share: 2004: ($48,000 – $0) ÷ 93,000 = $0.52 EPS is important because it is becoming

common to express the profit in this form rather than large dollar amounts.

Only important in comparison to previous EPS not other companies EPS.

Why?


Analysing Shares as an Investment

Price/earning ratio is the ratio of market price per share ($5) to earnings per share.

2004: $5 ÷ $0.52 = 9.6 Given Lucent’s 2004 P/E ratio of 9.6, we

would say that the company’s shares are selling at 9.6 times earnings.

P/E ratios are commonly provided for listed companies.


Dividend per ordinary share ÷ market price per ordinary shares

Dividend per ordinary share ÷ market price per ordinary shares


Dividend yield shows the percentageof a share’s market value returned as

dividends to shareholders each period.

Dividend yield shows the percentageof a share’s market value returned as

dividends to shareholders each period.



Dividend yield on Lucent’s ordinary shares:

2004: $0.12 ÷ $5.00 = .024 (2.4%) An investor who buys Lucent’s ordinary

shares for $5 may expect to receive 2.4% of the investment annually in the form of cash dividends.



Book value per ordinary share = (Total ordinary shareholders’ equity)

÷ Number of ordinary shares issued

Book value per ordinary share = (Total ordinary shareholders’ equity)

÷ Number of ordinary shares issued



Book value per share of Lucent’s ordinary shares:

2003: ($320,000) ÷ 93,000 = $3.44 2004: ($356,000) ÷ 93,000 = $3.83 Book value bears no relationship to

market value.


Objective 5

Use ratios in decision making.


Limitations of Financial Analysis

Business decisions are made in a world of uncertainty.

No single ratio or one-year figure should be relied upon to provide an assessment of a company’s performance.


Objective 6

Measure economic value added.


Economic Value Added (EVA®)

Economic value added (EVA®) combines accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth.

EVA® = Net profits + Interest expense – Capital charge


End of Chapter 19

financial statement analysis chapter 19 horngren ♦ harrison ♦ bamber ♦ best ♦ fraser ♦...

Documents