limitation of fs
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IQRA
UNIVERSITY
CITY CAMPUS
McGraw-Hi ll /Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
How Well Am I Doing?Financial Statement
Analysis
INTISAR M.USMANI FCMA
FIRST HABIB MODARABA
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2Limitations of Financial Statement
Analysis
Differences in accounting methodsbetween companies sometimes
make comparisons difficult.
We use the LIFO method tovalue inventory.
We use the FIFO method tovalue inventory.
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3Limitations of Financial Statement
Analysis
Analysts should look beyondthe ratios.
Economicfactors
Industrytrends
Changes withinthe company
Technologicalchanges
Consumertastes
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4Statements in Comparative and
Common-Size Form
Dollar and percentagechanges on statements
Common-sizestatements
Ratios
Analyticaltechniques used toexamine
relationships among
financial statementitems
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6
Horizontal Analysis
Horizontal analysis shows thechanges between years in the
financial data in both dollarand
percentage form.
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Horizontal Analysis
Example
The following slides illustrate ahorizontal analysis of Clover
Corporations December 31, 2008
and 2007 comparative balancesheets and comparative incomestatements.
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CLOVER CORPORATIONComparative Balance Sheets
December 31
Increase (Decrease)
2008 2007 Amount %
AssetsCurrent assets:
Cash 12,000$ 23,500$
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700Property 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
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Horizontal Analysis
Calculating Change in Dollar Amounts
DollarChange
Current YearFigure
Base YearFigure=
The dollar
amounts for2007 become
the base year
figures.
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Horizontal Analysis
Calculating Change as a Percentage
Percentage
Change
Dollar Change
Base Year Figure100%
=
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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 155,000 164,700Property 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 = $(11,500)
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Horizontal Analysis
CLOVER CORPORATIONComparative Balance Sheets
December 31
Increase (Decrease)
2008 2007 Amount %
AssetsCurrent assets:
Cash 12,000$ 23,500$ (11,500)$ (48.9)
Accounts receivable, net 60,000 40,000 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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Horizontal Analysis
We could do this for theliabilities & stockholders
equity, but instead, lets look
at the income statement.
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Horizontal Analysis
CLOVER CORPORATIONComparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2008 2007 Amount %Net sales 520,000$ 480,000$
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$
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CLOVER CORPORATIONComparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2008 2007 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)
Horizontal Analysis
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CLOVER CORPORATIONComparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2008 2007 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)
Horizontal Analysis
Sales increased by 8.3%, yet
net income decreased by 21.9%.
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CLOVER CORPORATIONComparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2008 2007 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)
Horizontal Analysis
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 overall
decrease in net income.
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Trend Percentages
Trend percentages
state several yearsfinancial data in termsof a base year, whichequals 100 percent.
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Trend Percentages
TrendPercentage
Current Year AmountBase Year Amount
100%=
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Trend Percentages
Example
Look at the information for Berry Productsfor the years 2003 through 2007. We will
complete a trend analysis using theseamounts to see what we can learn aboutthe company.
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Trend Percentages
Berry ProductsIncome Information
For the Years Ended December 31
The baseyear 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
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Trend Percentages
Berry ProductsIncome Information
For the Years Ended December 31Year
Item 2007 2006 2005 2004 2003
Sales 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%
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Trend Percentages
Berry ProductsIncome Information
For the Years Ended December 31
By analyzing the trends for Berry Products, wecan see that cost of goods sold is increasing
faster than sales, which is slowing the increasein 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 trendpercentages to construct a
graph so we can see thetrend over time.
100
110
120
130
140
150
160
2003 2004 2005 2006 2007
Year
Percentage
Sales
COGS
GM
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Common-Size Statements
Common-size
statements use
percentages to express
the relationship ofindividual components to
a total within a single
period. This is alsoknown as vertical
analysis.
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Common-Size Statements
In incomestatements, all
items areexpressed as apercentage of
net sales.
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Gross Margin Percentage
Gross MarginPercentage
Gross MarginSales
=
This measure indicates how muchof each sales dollar is left after
deducting the cost of goods sold to
cover expenses and provide a profit.
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Common-Size Statements
In balancesheets, all itemsare expressed
as a percentageof total assets.
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Common-Size Statements
Wendy's McDonald's
(do l l a rs i n m i l l i ons) Dollars Percentage Dollars Percentage
2002 Net income 219$ 8.00% 894$ 5.80%
Common-size financial statements are
particularly useful when comparingdata from different companies.
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Common-Size Statements
Example
Lets take another look at the information
from the comparative income statementsof Clover Corporation for 2007 and 2008.
This time, lets prepare common-sizestatements.
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CLOVER CORPORATIONComparative Income Statements
For the Years Ended December 31
Common-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 39,000Interest 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$
Common-Size Statements
Net sales isthe base
and isexpressedas 100%.
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CLOVER CORPORATIONComparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
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 39,000Interest 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$
Common-Size Statements
2007 Cost 2007 Sales 100%( $315,000 $480,000 ) 100% = 65.6%
2008 Cost 2008 Sales 100%( $360,000 $520,000 ) 100% = 69.2%
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Common-Size Statements
CLOVER CORPORATIONComparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2008 2007 2008 2007Net sales 520,000$ 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 8.2Interest 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?
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Quick Check
Which of the following statements describeshorizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.b. A side-by-side comparison of two or
more years financial statements.
c. A comparison of the account balances onthe current years financial statements.
d. None of the above.
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Quick Check
Which of the following statements describeshorizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.b. A side-by-side comparison of two or
more years financial statements.
c. A comparison of the account balances onthe current years financial statements.
d. None of the above.
Horizontal analysis shows the changesbetween years in the financial data, in
both dollar and percentage form.
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CommonStockholders
Short-termCreditors
Long-termCreditors
Ratios
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37Now, lets look at
NortonCorporations
2006 and 2007financial
statements.
38NORTON CORPORATION
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38NORTON CORPORATION
Balance Sheets
December 31
2007 2006
Assets
Current assets:
Cash 30,000$ 20,000$
Accounts receivable, net 20,000 17,000Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets 346,390$ 300,000$
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NORTON CORPORATION
Balance Sheets
December 31
2007 2006
Liabilities and Stockholders' Equity
Current 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, $1 par value 27,400 17,000Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000
Total liabilities and stockholders' equity 346,390$ 300,000$
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NORTON CORPORATION
Income Statements
For the Years Ended December 31
2007 2006
Net sales 494,000$ 450,000$
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000Net 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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Learning Objective 2
Compute and interpret
financial ratios that would beuseful to a common
stockholder.
42Ratio Analysis The Common
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Ratio Analysis The Common
Stockholder
Use thisinformation to
calculate ratios
to measure thewell-being ofthe common
stockholders ofNorton
Corporation.
NORTON CORPORATION
2007Number of common shares
outstanding
Beginning of year 17,000
End of year 27,400
Net income 53,690$Stockholders' equity
Beginning of year 180,000
End of year 234,390
Dividends per share 2
Dec. 31 market price per share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
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Earnings Per Share
Earnings per ShareNet Income Preferred Dividends
Average Number of CommonShares Outstanding
=
Whenever a ratio divides an income statementbalance by a balance sheet balance, the average
for the year is used in the denominator.
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Earnings Per Share
Earnings per ShareNet Income Preferred Dividends
Average Number of CommonShares Outstanding
=
This measure indicates how muchincome was earned for each share of
common stock outstanding.
Earnings per Share$53,690 0
(17,000 + 27,400)/2= = $2.42
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Price-Earnings Ratio
Price-EarningsRatio
Market Price Per ShareEarnings Per Share
=
This measure is often used by investorsas a general guideline in gauging stockvalues. Generally, the higher the price-earnings ratio, the more opportunity a
company has for growth.
Price-EarningsRatio
$20.00$2.42
= = 8.26 times
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Dividend Payout Ratio
This ratio gauges the portion of currentearnings being paid out in dividends.
Investors seeking current income wouldlike this ratio to be large.
DividendPayout Ratio
Dividends Per ShareEarnings Per Share
=
DividendPayout Ratio
$2.00$2.42
= = 82.6%
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Dividend Yield Ratio
This ratio identifies the return, interms of cash dividends, on the
current market price of the stock.
DividendYield Ratio
Dividends Per ShareMarket Price Per Share
=
DividendYield Ratio
$2.00$20.00
= = 10.00%
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Return on Total Assets
This ratio measures how wellassets have been employed.
Return on
Total Assets
$53,690 +[7,300 (1 .30)]
($300,000 + $346,390) 2= = 18.19%
Return on
Total Assets
Net Income + [Interest Expense (1 Tax Rate)]
Average Total Assets=
49Return on Common Stockholders
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Return on Common Stockholders
Equity
Return on CommonStockholders Equity
Net Income Preferred DividendsAverageStockholders Equity
=
This measure indicates how well thecompany employed the owners
investments to earn income.
Return on CommonStockholders Equity
$53,690 0($180,000 + $234,390) 2
= = 25.91%
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Financial Leverage
Financial leverageinvolvesacquiring assets with funds at a
fixed rate of interest.
Return oninvestment in
assets>
Fixed rate ofreturn onborrowed
funds
Positivefinancialleverage
=
Return oninvestment in
assets