Financial Statement Analysis Chapter 13

Learning Objective 1 Perform a horizontal analysis of comparative financial statements.

Horizontal Analysis Study of percentage changes in comparative statements 1. Compute the dollar amount of the change from the base period to the later period. 2. Divide the dollar amount of change by the base-period amount.

Trend % = Any year $ ÷ Base year $ Trend Percentages Computed by selecting a base year whose amounts are set equal to 100%. Trend % = Any year $ ÷ Base year $

Learning Objective 2 Perform a vertical analysis of financial statements.

Vertical Analysis Reveals the relationship of each statement item to a specified base, which is the 100% figure. Every other item on the financial statement is then reported as a percentage of that base.

Learning Objective 3 Prepare and use common-size financial statements.

Common-Size Statements On a common-size income statement, each item is expressed as a percentage of net sales. In the balance sheet, the common size is total assets. A common-size statement eases the comparison of different companies.

Benchmarking Practice of comparing a company to other companies Common-size statements are also used to compare the company to a specific company

Learning Objective 4 Use the statement of cash flows for decisions.

Statement of Cash Flows Cash-flow signs of a healthy company: Operations are a major source of cash. Investing activities include more purchases than sales of long-term assets. Financing activities are not dominated by borrowing.

Learning Objective 5 Compute the standard financial ratios.

Ratio Classification 1. Measure ability to pay current liabilities 2. Measure ability to sell inventory and collect receivables 3. Measure ability to pay long-term debt 4. Measure profitability 5. Analyze stock as an investment

Working Capital Measures ability to pay current liabilities with current assets Current assets – Current liabilities

Current assets ÷ Current liabilities Current Ratio Measures company’s ability to pay current liabilities with current assets Current assets ÷ Current liabilities

Acid-Test Ratio Shows the company’s ability to pay all current liabilities if they come due immediately. (Cash + Short-term investments + Net current receivables) ÷ Current liabilities

Measuring Ability to Sell Inventory Inventory turnover – measure of the number of times the average level of inventory is sold during a year Cost of goods sold ÷ Average inventory

Measuring Ability to Collect Receivables Accounts receivable turnover measures a company’s ability to collect cash from credit customers. Net credit sales ÷ Average accounts receivable

Measuring Ability to Collect Receivables Days’ sales in receivables ratio measures how many day’s sales remain in Accounts Receivable. One day’s sales = Net sales ÷ 365 days Days’ sales in receivable = Avg net accounts receivable ÷ One day’s sales

Measuring Ability to Pay Debt The debt ratio indicates the proportion of assets financed with debt. Total liabilities ÷ Total assets

Measuring Ability to Pay Debt Times-interest-earned ratio measures the number of times operating income can cover interest expense. Income from operations ÷ Interest expense

Measuring Profitability Rate of return on net sales shows the percentage of each sales dollar earned as net income. Net income ÷ Net sales

Measuring Profitability Rate of return on total assets measures how profitably a company uses its assets. (Net income + Interest expense) ÷ Average total assets

Measuring Profitability Rate of Return on Common Stockholders’ Equity: Net income – Preferred dividends ÷ Average common stockholders’ equity

Measuring Profitability Earnings per share of common stock (Net income – Preferred dividends) ÷ Number of shares of common stock outstanding

Objective 6 Use ratios in decision making

Analyzing Stock Investments Price/earning ratio - ratio of market price per share to earnings per share Dividend yield - percentage of stock’s market value returned as dividends to stockholders each period Dividend per share of common stock ÷ Market price per share of common stock

Analyzing Stock Investments Book value per share of common stock (Total stockholders’ equity – Preferred equity) ÷ Number of shares of common stock outstanding ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Learning Objective 7 Measure the economic value added by operations.

Net income + Interest expense – Capital charge Economic Value Added Combines concepts of accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth. EVA® = Net income + Interest expense – Capital charge

Economic Value Added Capital charge Notes payable Loans Long-term debt Stockholders’ equity + = × Cost of capital ©2006 Prentice Hall Business Publishing Financial Accounting, 6/e Harrison/Horngren

Economic Value Added Capital charge - amount that stockholders, lenders charge a company for use of their money Cost of capital – weighted average of the returns demanded by company’s stockholders and lenders. A positive EVA® amount indicates an increase in stockholder wealth