13 7/e PowerPoint Author: Catherine Lumbattis COPYRIGHT © 2011 South-Western/Cengage Learning Financial Statement Analysis Statements and the Annual Report

Stockholders Financial Statement Analysis Creditors Management Will I be paid? How good is our investment? How are we performing?

Limitations of Financial Statement Analysis  Nonoperating items on income statement  Effects of inflation = ApplesOranges

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, Inventory 4,750 2,750 2, Prepaid insurance (50) (25) Total current assets $10,720 $8,800 $ 1, December 31 Increase (Decrease) Dollars Percent Dollar change from year to year Percentage change from one year to the next year

Trend Analysis Inventory turnover GameStop Corp. 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 $ % $ 1, % Accounts receivable 5, , Inventory 4, , Prepaid insurance Total current assets $10, % $8, % December 31, 2010 December 31, 2009 Dollars Percent Dollars Percent Compare percentages across years to spot year-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 –

Acid-Test (Quick) Ratio  Stricter test of ability to pay debts  Excludes inventories and prepaid assets Quick Assets Current 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 Activities Average Current Liabilities

Accounts Receivable Turnover Ratio Net Credit Sales Average 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 Period Accounts Receivable Turnover

Inventory Turnover Ratio Represents the number of times per period inventory is turned over (i.e., sold). Cost of Goods Sold Average 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 Period Inventory 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- Equity Ratio Debt Service Coverage Times Interest Earned Cash Flow from Operations to Capital Expenditures LO5

Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed compared to owners?

Times Interest Earned  Measures ability to meet current interest payments  The greater the coverage the better Net Income + Interest Expense + Income Tax Expense Interest 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 Paid Cash 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 Tax Average Total Assets

Return on Common Stockholders’ Equity Net Income – Preferred Dividends Average 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 Dividends Weighted Average Number of Common Shares Outstanding

Price/Earnings Ratio  Relates earnings to the market price of the stock Current Market Price Earnings per Share very high P/E very low P/E possibly overpriced possibly underpriced

Dividend Payout Ratio Common Dividends per Share Earnings 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 Share Market Price per Share usually < 5% =

Appendix Accounting 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