Financial Statement Analysis Chapter 14

Purpose To make informed decisions about a company Generally based on comparative financial data From one year to the next With a competing company With the industry Copyright (c) 2009 Prentice Hall. All rights reserved.

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

Horizontal Analysis Compares two financial statements to determine dollar and percentage changes Compute dollar changes Compute percentage changes Current year balance Prior year balance Dollar change Base period Prior year balance Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 14-13 Copyright (c) 2009 Prentice Hall. All rights reserved.

Trend Percentages Any year $ Trend % Base year $ Form of horizontal analysis Base year selected and set equal to 100% Any year $ Trend % Base year $ Copyright (c) 2009 Prentice Hall. All rights reserved.

Perform a vertical analysis of financial statements Learning Objective 2 Perform a vertical analysis of financial statements

Vertical Analysis Shows relationship of each item to a base amount on financial statements Income statement – each item expressed as percentage of net sales Balance sheet – each item expressed as percentage of total assets Copyright (c) 2009 Prentice Hall. All rights reserved.

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

Common-Size Statements Reports only percentages Removes dollar value bias Bias from comparing numbers in absolutes rather than relative terms Copyright (c) 2009 Prentice Hall. All rights reserved.

Benchmarking Comparing a company with another leading company Two main types: Against a key competitor Against the industry average Copyright (c) 2009 Prentice Hall. All rights reserved.

Compute the standard financial ratios Learning Objective 4 Compute the standard financial ratios

Types of Ratios Copyright (c) 2009 Prentice Hall. All rights reserved. Ability to pay current liabilities Ability to sell inventory and collect receivables Ability to pay long-term debt Measure profitability Analyzing stock as an investment Copyright (c) 2009 Prentice Hall. All rights reserved.

Ability to Pay Current Liabilities Working capital Current ratio Acid-test ratio Copyright (c) 2009 Prentice Hall. All rights reserved.

Ability to Pay Current Liabilities Current assets Current liabilities Working capital Results in a dollar amount Current ratio Current assets Current liabilities Both result in a ratio Cash + short-term investments + net current receivables Acid-test ratio Current liabilities Copyright (c) 2009 Prentice Hall. All rights reserved.

Ability to Sell Inventory and Collect Receivables Inventory turnover Measures number of times a company sells inventory during a year Accounts receivable turnover Measures ability to collect cash from credit customers Days’-sales-in-receivables Also measures ability to collect receivables Copyright (c) 2009 Prentice Hall. All rights reserved.

Ability to Sell Inventory and Collect Receivables The higher the turnover, the quicker it’s selling Inventory turnover Average inventory Cost of goods sold The higher the turnover, the quicker the collections Accounts receivable turnover Net credit sales Average accounts receivable Copyright (c) 2009 Prentice Hall. All rights reserved.

Ability to Sell Inventory and Collect Receivables Days’ sales in receivables Net sales 365 Average day’s sales Average net accounts receivable Average day’s sales Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 14-17 1.34 Current ratio Current assets Current liabilities $173,000 $129,000 1.34 Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 14-17 (continued) Cash + short-term investments + net current receivables Acid-test ratio Current liabilities $18,000 +10,000 + 53,000 $129,000 $81,000 $129,000 0.63 Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 14-17 (continued) Inventory turnover Cost of goods sold Average inventory $75,000 + 73,000 2 $319,000 $319,000 $74,000 4.31 Copyright (c) 2009 Prentice Hall. All rights reserved.

Exercise 14-17 (continued) Copyright (c) 2009 Prentice Hall. All rights reserved. Exercise 14-17 (continued) Days’ sales in receivables 365 Average day’s sales Net sales $1,268 $463,000 365 Average net accounts receivable Average day’s sales $64,000 $1,268 $53,000 +75,000 2 50 days

Ability to Pay Long-Term Debt Debt ratio Shows portion of asset financed with debt The higher the ratio, the higher the risk Times-interest-earned ratio Measures number of times income can cover interest expense High ratio indicates ease in paying interest Copyright (c) 2009 Prentice Hall. All rights reserved.

Ability to Pay Long-Term Debt Debt ratio Total liabilities Total assets Times interest earned Interest expense Operating income Copyright (c) 2009 Prentice Hall. All rights reserved.

Measuring Profitability Return on net sales Return on total assets Return on common stockholders’ equity Earnings per share Copyright (c) 2009 Prentice Hall. All rights reserved.

Measuring Profitability Return on sales Net income Net sales Net income + interest expense Return on assets Average total assets Copyright (c) 2009 Prentice Hall. All rights reserved.

Measuring Profitability Net income – preferred dividends Return on equity Average common equity Net income – preferred dividends Earnings per share Number of common shares outstanding Copyright (c) 2009 Prentice Hall. All rights reserved.

Leverage Trading on the equity Increases profits during goods times Company borrows at a lower rate then invests the money to earn a higher rate Increases profits during goods times Compounds losses during bad times is greater than Return onequity Return on assets Copyright (c) 2009 Prentice Hall. All rights reserved.

Analyzing Stock Investments Price/earnings ratio (P/E) Market price compared to EPS Dividend yield Percent of market value that is returned as dividends Book value Common equity per share Some argue its relevance to investors Copyright (c) 2009 Prentice Hall. All rights reserved.

Analyzing Stock Investments Market price per share Earnings per share P/E ratio Market price per share Dividend yield Dividends per share Common shares outstanding Common equity Book value Copyright (c) 2009 Prentice Hall. All rights reserved.

Red Flags Suspect movement of sales, inventory, and receivables Earnings problems Decreased cash flow Too much debt Inability to collect receivables Inventory buildup Copyright (c) 2009 Prentice Hall. All rights reserved.

End of Chapter 14