Chapter 7 Financial Statements Analysis

Application of analytical tools Involves transforming data Reduces uncertainty Basics of Ratio Analysis C 1

Internal UsersExternal Users Financial statement analysis helps users make better decisions. Managers Officers Internal Auditors Shareholders Lenders Customers Purpose of Analysis C 1

Measurement of key relations between financial statement items Tools of Analysis C 4

5 There are three types of comparisons to provide decision usefulness of financial information: Intracompany basis Intercompany basis Industry averages Comparative Analysis

6 Intracompany Basis Comparisons within a company are often useful to detect changes in financial relationships and significant trends. A comparison of a company's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. A comparison of a company's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash.

7 Intercompany Basis Comparisons with other companies provide insight into a company's competitive position. A company's total sales for the year can be compared with the total sales of its competitors such as comparing Burger King to McDonald’s or Wendy’s or Marriott to Windham.

8 Comparisons with industry averages provide information about a company's relative position within the industry. Burger King's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's. Industry Averages

9 Financial Statement Analysis Three basic tools are used in financial statement analysis : 1.Horizontal analysis 2.Vertical analysis 3.Ratio analysis

10 Horizontal Analysis Is a technique for evaluating a series of financial statement data over a period of time. Purpose is to determine whether an increase or decrease has taken place. The increase or decrease can be expressed as either an amount or a percentage.

7-1 Horizontal Analysis Sales $150,000$125,000$100,00 Base Year 100%125%150% 50% increase 25% increase Percentage increase or decrease from base year formula: Current Year Amount – Base Year Amount Base Year Amount Example: Percent increase in sales in 2010 from 2008 $150,000 - $100,000 $100,000 = 50% HORIZONTAL ANALYSIS

Horizontal Analysis Time Comparing a company’s financial condition and performance across time. Tools of Analysis C 4

Time Now, let’s look at some ways to use horizontal analysis. Horizontal Analysis C 4

Horizontal Analysis C 4

Calculate Change in Dollar Amount Dollar Change Analysis Period Amount Base Period Amount =– Since we are measuring the amount of the change between 2006 and 2007, the dollar amounts for 2006 become the “base” period amounts. Comparative Statements P 1

Calculate Change as a Percent Percent Change Dollar Change Base Period Amount 100 = × Comparative Statements P 1

($11,500 ÷ $23,500) × 100 = 48.9% $12,000 – $23,500 = $(11,500) P 1

Trend Analysis Now, let’s look at trend analysis! P 1

Trend analysis is used to reveal patterns in data covering successive periods. Trend Percent Analysis Period Amount Base Period Amount 100 = × Trend Analysis P 1

Bangkok Thai Restaurant Income Information For the Years Ended December 31, Item Revenues400,000$ 355,000$ 320,000$ 290,000$ 275,000$ Cost of sales285, , , , ,000 Gross profit115, ,000 95,000 92,000 85, is the base period so its amounts will equal 100%. Trend Analysis P 1

Bangkok Thai Restaurant Income Information For the Years Ended December 31, Item Revenues105%100% Cost of sales104%100% Gross profit108%100% Trend Analysis P 1 Item Revenues400,000$ 355,000$ 320,000$ 290,000$ 275,000$ Cost of sales285, , , , ,000 Gross profit115, ,000 95,000 92,000 85,000

Trend Analysis We can use the trend percentages to construct a graph so we can see the trend over time. P 1

Comparing a company’s financial condition and performance to a base amount Tools of Analysis VerticalAnalysisVerticalAnalysis VerticalAnalysisVerticalAnalysis C 4

24 Vertical Analysis Is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount. Total assets is always the base amount in vertical analysis of a balance sheet. Net sales is always the base amount in vertical analysis of an income statement.

7-2 Vertical Analysis SMITH HOTEL COMPANY AmountPercentAmountPercent Sales $ 120, % $ 80, % Sales returns $ 6, % $ 5, % Net sales $ 113, % $ 75, % Cost of goods sold $ 65, % $ 40, % Gross profit $ 48, % $ 35, % Selling expenses $ 18, % $ 15, % Administrative expenses $ 10, % $ 8, % Total operating expenses $ 28, % $ 23, % Net income $ 20, % $ 12, % Reflects the size of each item relative to a base amount (net sales) VERTICALANALYSISVERTICALANALYSIS

7-2 Vertical Analysis (cont.) SMITH HOTEL COMPANY RODGERS HOTEL COMPANY 2009 AmountPercentAmountPercent Sales $ 120, % $ 80, % Sales returns $ 6, % $ 5, % Net sales $ 113, % $ 75, % Cost of goods sold $ 65, % $ 40, % Gross profit $ 48, % $ 35, % Selling expenses $ 18, % $ 15, % Administrative expenses $ 10, % $ 8, % Total operating expenses $ 28, % $ 23, % Net income $ 20, % $ 12, % Restating each item on a financial statement in terms of a percentage of a base amount, enables the comparison of companies of different sizes VERTICALANALYSISVERTICALANALYSIS COMMON SIZE ANALYSIS

Ratio Analysis

7-3 Liquidity Ratios RatioFormulaPurpose or Use Liquidity Ratios 1.Current ratioCurrent Assets / Current LiabilitiesMeasures short-term debt- paying ability. 2.Acid-test or Quick Ratio [Cash + Short-term Investments + receivables (net)] / Current Liabilities Measures immediate short- term liquidity. 3.Receivables Turnover Net Credit Sales / Average Net Receivables Measures liquidity of receivables. 4.Inventory Turnover Cost of Goods Sold / Average Inventory Measures liquidity of inventory.

7-4 Profitability Ratios RatioFormulaPurpose or Use Profitability Ratios 1.Profit MarginNet Income / Net SalesMeasures net income generated by each dollar of sales. 2.Asset TurnoverNet Sales / Average AssetsMeasures how efficiently assets are used to generate sales. 3.Return on AssetsNet Income / Average AssetsMeasures overall profitability of assets. 4.Return on Common Stockholders’ Equity Net Income / Average Common Stockholders’ Equity Measures profitability of owners’ investment.

7-5 Solvency Ratios RatioFormulaPurpose or Use Solvency Ratios 1.Debt to Total Assets Total Debt / Total AssetsMeasures the percentage of total assets provided by creditors. 2.Times Interest Earned Income Before Income Taxes and Interest Expense / Interest Expense Measures ability to meet interest payments as they come due.

Income StatementBalance Sheet Statement of Stockholders’ Equity Statement of Cash Flows Notes Information for Analysis C 2

To help me interpret our financial statements, I use several standards of comparison.  Intracompany  Competitor  Industry  Guidelines Standards for Comparison C 3

Calculate Common-size Percent Common-size Percent Analysis Amount Base Amount 100 = × Financial StatementBase Amount Balance SheetTotal Assets Income StatementRevenues Financial StatementBase Amount Balance SheetTotal Assets Income StatementRevenues Common-Size Statements P 2

This is a graphical analysis of Clover Corporation’s common-size income statement for Common-Size Graphics P 2

Let’s use the following financial statements for Bangkok Thai Restaurant for our ratio analysis. Ratio Analysis Liquidity and Efficiency Solvency Profitability Market Prospects P 3

Bangkok Thai Restaurant Balance Sheet December 31, Assets Current assets: Cash30,000$ 20,000$ Accounts receivable, net20,000 17,000 Inventory12,000 10,000 Prepaid expenses3,000 2,000 Total current assets65,000$ 49,000$ Property and equipment: Land165, ,000 Buildings and equipment, net116, ,000 Total property and equipment281,390$ 251,000$ Total assets346,390$ 300,000$ P 3

Bangkok Thai Restaurant Balance Sheet December 31, Liabilities and Shareholders' Equity Current liabilities: Accounts payable39,000$ 40,000$ Notes payable, short-term3,000 2,000 Total current liabilities42,000$ $ Long-term liabilities: Notes payable, long-term70,000 78,000 Total liabilities112,000$ 120,000$ Shareholders' equity: Common stock, $1 par value27,400 17,000 Additional paid-in capital158, ,000 Total paid-in capital185,500$ 130,000$ Retained earnings48,890 50,000 Total shareholders' equity234,390$ 180,000$ Total liabilities and shareholders' equity 346,390$ 300,000$ P 3

39 Liquidity Ratios Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. WHO CARES? Short-term creditors such as bankers and suppliers

Current Ratio Current Ratio Acid-test Ratio Acid-test Ratio Accounts Receivable Turnover Inventory Turnover Days’ Sales Uncollected Days’ Sales in Inventory Total Asset Turnover Liquidity and Efficiency P 3

Dec. 31, 2007 Current assets65,000$ Current liabilities(42,000) Working capital23,000$ Working capital Working capital represents current assets financed from long-term capital sources that do not require near-term repayment. Working Capital P 3

Current Ratio Current Assets Current Liabilities = This ratio measures the short-term debt-paying ability of the company. Current Ratio Current Ratio $65,000 $42,000 ==1.55 : 1 P 3

Quick assets are Cash, Short-Term Investments, and Current Receivables. This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash. Acid-Test Ratio Quick Assets Current Liabilities = Acid-Test Ratio $50,000 $42,000 =1.19 : 1= Acid-Test Ratio P 3

This ratio measures how many times a company converts its receivables into cash each year. Accounts Receivable Turnover Sales on Account Average Accounts Receivable Turnover = = 26.7 times $494,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover = P 3

This ratio measures the number of times merchandise is sold and and replaced during the year. Cost of Goods Sold Average Inventory Turnover == times $140,000 ($10,000 + $12,000) ÷ 2 = Inventory Turnover Inventory Turnover P 3

This ratio measures the liquidity of receivables. Days’ Sales Uncollected = Ending Accounts Receivable Net Sales  365 Days’ Sales Uncollected = $20,000 $494,000  365 = 14.8 days Days’ Sales Uncollected P 3

This ratio measures the liquidity of inventory. Days’ Sales in Inventory = Ending Inventory Cost of Goods Sold  365 Days’ Sales in Inventory = $12,000 $140,000  365 = days Days’ Sales in Inventory P3

This ratio measures the efficiency of assets in producing sales. Total Asset Turnover = Net Sales Average Total Assets = 1.53 times $494,000 ($300,000 + $346,390) ÷ 2 = Total Asset Turnover Total Asset Turnover P 3

49 Solvency Ratios Measure the ability of the enterprise to survive over a long period of time WHO CARES? Long-term creditors and stockholders

Debt Ratio Debt Ratio Equity Ratio Equity Ratio Pledged Assets to Secured Liabilities Times Interest Earned Solvency P 3

Total Liabilities = Total Assets Debt Ratio This ratio measures what portion of a company’s assets are contributed by creditors. $112,000 = $346,390 Debt Ratio = 32.3% Debt Ratio P 3

This ratio measures what portion of a company’s assets are contributed by owners. Total Equity = Total Assets Equity Ratio $234,390 = $346,390 Equity Ratio = 67.7% Equity Ratio P 3

This ratio measures the solvency of companies. Total Liabilities = Total Equity Debt-to- Equity- Ratio Debt-to-Equity Ratio P 3

This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor. Times Interest Earned Net Income before Interest Expense and Income Taxes Interest Expense = Times Interest Earned $84,000 $7,300 == Times Interest Earned P 3

55 Profitabilty Ratios Measure the ability of the enterprise to generate income over time WHO CARES? Long-term creditors and stockholders

Profit Margin Profit Margin Gross Margin Return on Total Assets Basic Earnings per Share Book Value per Common Share Return on Common Stockholders’ Equity Profitability P 3

This ratio describes a company’s ability to earn a net income from sales. Profit Margin Net Income Net Sales = = 10.87% Profit Margin $53,690 $494,000 = Profit Margin P 3

This ratio measures the amount remaining from $1 in sales that is left to cover operating expenses and a profit after considering cost of sales. Gross Margin Net Sales - Cost of Sales Net Sales = = 71.66% Gross Margin $494,000 - $140,000 $494,000 = Gross Margin P 3

This ratio is generally considered the best overall measure of a company’s profitability. = 16.61% $53,690 ($300,000 + $346,390) ÷ 2 = Return on Total Assets Return on Total Assets Net Income Average Total Assets = Return on Total Assets P 3

Return on Common Stockholders’ Equity Net Income - Preferred Dividends Average Common Stockholders’ Equity = = 25.9% $53, ($180,000 + $234,390) ÷ 2 = Return on Common Stockholders’ Equity This measure indicates how well the company employed the owners’ investments to earn income. Return on Common Stockholders’ Equity P 3

Book Value per Common Share Shareholders’ Equity Applicable to Common Shares Number of Common Shares Outstanding = This ratio measures liquidation at reported amounts. Book Value per Common Share P 3

This measure indicates how much income was earned for each share of common stock outstanding. Basic Earnings per Share Net Income - Preferred Dividends Weighted-Average Common Shares Outstanding = Basic Earnings per Share $53, ,400 == $1.96 per share Basic Earnings per Share P 3

Price- Earnings Ratio Dividend Yield Market Prospects P 3

Use this information to calculate the market ratios for Bangkok Thai Restaurant. Market Prospects P 3

This ratio measures what portion of a company’s assets are contributed by owners. Total Equity = Total Assets Equity Ratio $234,390 = $346,390 Equity Ratio = 67.7% Equity Ratio P 3

This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth. Price-Earnings Ratio Market Price Per Share Earnings Per Share = Price-Earnings Ratio $15.00 $1.96 == 7.65 times Price-Earnings Ratio P 3

This ratio identifies the return, in terms of cash dividends, on the current market price of the stock. Dividend Yield Annual Dividends Per Share Market Price Per Share = Dividend Yield $2.00 $15.00 == 13.3% Dividend Yield P 3

68 Limitations Of Financial Analysis Horizontal, vertical, and ratio analysis are frequently used in making significant business decisions. One should be aware of the limitations of these tools and the financial statements.

69 Estimates Financial statements are based on estimates. –allowance for uncollectible accounts –depreciation –costs of warranties –contingent losses To the extent that these estimates are inaccurate, the financial ratios and percentages are also inaccurate.

Net Income Reporting Income and Equity Discontinued Segments Changes in Accounting Principles Extraordinary Items Continuing Operations A 2

Income Statement A 2

Revenues, expenses and income generated by the company’s continuing operations. Revenues, expenses and income generated by the company’s continuing operations. Continuing Operations Continuing Operations Net Income A 2

Income from operating the discontinued segment prior to its disposal and gain or loss on the sale of the net assets of the segment. Discontinued Segments Discontinued Segments Net Income A 2

A gain or loss that is unusual in nature and infrequent in occurrence. A gain or loss that is unusual in nature and infrequent in occurrence. Extraordinary Items Extraordinary Items Net Income A 2

The increase or decrease in income when changing from one generally accepted accounting principle to another. The increase or decrease in income when changing from one generally accepted accounting principle to another. Changes in Accounting Principles Changes in Accounting Principles Net Income A 2