Analysis and interpretation of financial statements Chapter 13 Analysis and interpretation of financial statements © Cambridge Business Publishers

Persistent earnings and discuss the content and format of the income statement. © Cambridge Business Publishers

Earnings Persistence An important role for accounting information is to predict future cash flows used in valuation studies. An important determinant of earning’s ability to predict future cash flows is the persistence of earnings. Persistent earnings are earnings that are expected to continue (recurring) into the future. (also called sustainable or permanent earnings) Transitory earnings are single-period events. © Cambridge Business Publishers

Multi-Step Income Statement The multi-step income statement is organized to present earnings information that separates items according to persistence, with more persistent items appearing higher in the statement. © Cambridge Business Publishers

Transitory Items Discontinued operations are reported separately when a company sells, abandons, or otherwise disposes of a segment of its operations. The income or loss from the segment’s operation for the portion of the year before its discontinuance. Any gain or loss from the disposal of the segment. © Cambridge Business Publishers

Changes in Accounting Principles Companies are allowed to change accounting principles from one generally accepted method to another generally accepted method as long as the change can be shown to better reflect financial results. In order to enhance analysis, companies that change are required to restate prior financial statements as if the new method had been in use. © Cambridge Business Publishers

Comprehensive Income Includes items that generate wealth for the company, but are not allowed by GAAP to appear on the income statement. Includes: Net income from the income statement Changes in market value of certain marketable securities (not sold yet) Unrealized gains and losses from translating foreign currencies when consolidating financial statements Comprehensive income can be reported by appending to the income statement, as a separate statement, or as part of the statement of stockholders’ equity. © Cambridge Business Publishers

Select the correct answer. Which of the following represents the correct order on a multi-step income statement? Revenue, gross profit, income from continuing operations, net operating income, net income. .Revenue, gross profit, net operating income, income from continuing operations, net income. Revenue, income from continuing operations, net operating income, gross profit, net income. Net income, Revenue, gross profit, income from continuing operations, net operating income. © Cambridge Business Publishers

Sources of financial information and techniques used by investment professionals © Cambridge Business Publishers

Analytical Techniques Simply knowing the dollar level of financial statement items is insufficient without more information. Techniques that can aid in analysis include: Horizontal (trend) analysis Vertical (common-size) analysis Ratio analysis © Cambridge Business Publishers

Coffee Roasters, Co. © Cambridge Business Publishers 2016 2015 Assets (in thousands) 2016 2015 Assets Current Assets Cash and cash equivalents $71,173 $40,512 Net receivables 448,327 364,810 Inventory 768,437 672,248 Other current assets 35,019 53,957 Total Current Assets 1,322,956 1,131,527 Property, plant and equipment 944,296 699,802 Goodwill 808,076 789,305 Intangible assets 498,352 529,494 Other long term assets 42,109 47,759 Total Assets $3,615,789 $3,197,887 Liabilities Current Liabilities Accounts payable $480,594 $410,751 Other current liabilities 39,393 60,623 Total Current Liabilities 519,987 471,374 Long-term liabilities 824,670 793,264 Total Liabilities 1,344,657 1,264,638 Stockholders’ Equity Common stock 1,499,932 1,521,522 Retained earnings 771,200 411,727 Total Stockholders' Equity 2,271,132 1,933,249 Total Liabilities & Stockholders' Equity (in thousands) 2016 2015 Net sales $3,859,198 $2,650,899 Cost of goods sold 2,589,799 1,746,274 Gross profit 1,269,399 904,625 Selling and operating expenses 481,493 348,696 General and administrative expenses 219,010 187,016 Operating income 568,896 368,913 Interest expense (22,983) (57,657) Other income (expense) 29,356 (10,056) Income before tax 575,269 301,200 Income tax expense 212,641 101,699 Net income $ 362,628 $ 199,501 (in thousands) 2016 2015 Operating Activities   Net income $ 362,628 $199,501 Adjustments To Net Income 115,157 (198,716) Net cash flow from operating activities 477,785 785 Investing Activities Capital expenditures (401,121) (283,444) Other cash flows from investing activities 135,476 (904,228) Net cash flow from investing activities (265,645) (1,187,672) Financing activities Sale/purchase of stock (64,378) 981,472 Net borrowings (116,544) 223,325 Other cash flows from financing activities (557) 17,846 Net cash flow from financing activities (181,479) 1,222,643 Change In cash and cash equivalents $ 30,661 $35,756 © Cambridge Business Publishers

Horizontal (trend) financial statement analysis. © Cambridge Business Publishers

Comparative Financial Statements Compare two or more years Often compare both dollar changes and percentage changes between years Care must be taken when comparing percentages Small numbers in the denominator Negative values © Cambridge Business Publishers

Horizontal Analysis—Coffee Roasters, Co. COFFEE ROASTERS, CO. — BALANCE SHEET Assets 2016 2015 $ Change % Change Current Assets Cash and cash equivalents $71,173 $40,512 $30,661 75.7% Net receivables 448,327 364,810 83,517 22.9% Inventory 768,437 672,248 96,189 14.3% Other current assets 35,019 53,957 (18,938) -35.1% Total Current Assets 1,322,956 1,131,527 191,429 16.9% Property, plant and equipment 944,296 699,802 244,494 34.9% Goodwill 808,076 789,305 18,771 2.4% Intangible assets 498,352 529,494 (31,142) -5.9% Other long term assets 42,109 47,759 (5,650) -11.8% Total Assets $3,615,789 $3,197,887 $ 417,902 13.1% Liabilities Current liabilities Accounts payable $480,594 $410,751 $69,843 17.0% Other current liabilities 39,393 60,623 (21,230) -35.0% Total Current Liabilities 519,987 471,374 48,613 10.3% Long-term liabilities 824,670 793,264 31,406 4.0% Total Liabilities 1,344,657 1,264,638 80,019 6.3% Stockholders’ Equity Common stock 1,499,932 1,521,522 (21,590) -1.4% Retained earnings 771,200 411,727 359,473 87.3% Total Stockholders' Equity 2,271,132 1,933,249 337,883 17.5% Total Liabilities & Stockholders' Equity $417,902 © Cambridge Business Publishers

Horizontal Analysis—Coffee Roasters, Co. COFFEE ROASTERS, CO. — INCOME STATEMENT 2016 2015 $ Change % Change Net sales $3,859,198 $2,650,899 $ 1,208,299 45.6% Cost of goods sold 2,589,799 1,746,274 843,525 48.3% Gross profit 1,269,399 904,625 364,774 40.3% Selling and operating expenses 481,493 348,696 132,797 38.1% General and administrative expenses 219,010 187,016 31,994 17.1% Operating income 568,896 368,913 199,983 54.2% Interest expense -22,983 -57,657 34,674 -60.1% Other income (expense) 29,356 -10,056 39,412 -391.9% Income before tax 575,269 301,200 274,069 91.0% Income tax expense 212,641 101,699 110,942 109.1% Net income $362,628 $199,501 $ 163,127 81.8% © Cambridge Business Publishers

Trend Analysis—Coffee Roasters, Co. 2012 2013 2014 2015 2016 Thousands of Dollars % of Base Year Net sales $492,517 100% $786,135 160% $1,356,775 275% $2,650,899 538% $3,859,198 784% Net income $21,669 $54,439 251% $79,506 367% $199,501 921% $362,628 1,673% Most companies provide 5-year trend data for key items such as sales, net income, and total assets. Basing changes on the initial year allows one to see growth over the 5-year term in addition to year-to-year growth as seen in the previous table. © Cambridge Business Publishers

Vertical (common-size) financial statement analysis. © Cambridge Business Publishers

Common-Size Financial Statements The relative importance of various accounts for a single year can be highlighted by showing them as a percentage of a key statement figure. Total assets on the balance sheet Net sales on the income statement Common-size statements also aid in the analysis of different firms, especially when they differ in size. © Cambridge Business Publishers

Common-Size Balance Sheet Coffee Roasters, Co. © Cambridge Business Publishers

Common-Size Income Statement Coffee Roasters, Co. 2016 2015 Net sales $3,859,198 $2,650,899 100.0% Cost of goods sold 2,589,799 1,746,274 67.1% 65.9% Gross profit 1,269,399 904,625 32.9% 34.1% Selling and operating expenses 481,493 348,696 12.5% 13.2% General and administrative expenses 219,010 187,016 5.7% 7.1% Operating income 568,896 368,913 14.7% 13.9% Interest expense -22,983 -57,657 0.6% 2.2% Other income (expense) 29,356 -10,056 0.8% -0.4% Income before tax 575,269 301,200 14.9% 11.4% Income tax expense 212,641 101,699 5.5% 3.8% Net income $362,628 $199,501 9.4% 7.5% © Cambridge Business Publishers

Financial ratios for analyzing a firm © Cambridge Business Publishers

Ratio Analysis Profitability analysis—how efficiently a firm has performed in its quest for profits Gross profit percentage Return on sales Asset turnover Return on assets Return on common stockholders’ equity © Cambridge Business Publishers

Ratio Analysis Short-term liquidity analysis—the ability to satisfy current obligations Working capital Current ratio Quick ratio Operating-cash-flow-to-current-liabilities ratio Accounts receivable turnover Average collection period Inventory turnover Days’ sales in inventory © Cambridge Business Publishers

Ratio Analysis Long-term solvency analysis—a firm’s long-term debt repayment capability Debt-to-equity ratio Time-interest earned ratio Operating-cash-flow-to-capital-expenditures ratio © Cambridge Business Publishers

Ratio Analysis Ratios for common stockholders analysis Earnings per share (EPS) Price-earnings (PE) ratio Dividend yield Dividend payout ratio © Cambridge Business Publishers

Profitability Analysis (Financial Statements) Gross Profit Percentage = Net sales – Cost of goods sold Net sales Indicates the percentage of income generated from sales after deducting the cost of goods sold. Coffee Roasters 2016 = $3,859,198 – $2,589,799 $3,859,198 = 32.9% Coffee Roasters 2015 = $2,650,899 – $1,746,274 $2,650,899 = 34.1% Coffee Roasters, Co. generated 32.9 cents of gross profits from each sales dollar in 2016, down from 34.1 cents in 2015. © Cambridge Business Publishers

Profitability Analysis (Financial Statements) Return on Sales = Net income Net sales Indicates the percentage of net income remaining from a dollar of sales after subtracting all expenses. Coffee Roasters 2016 = $362,628 $3,859,198 = 9.4% Coffee Roasters 2015 = $199,501 $2,650,899 = 7.5% Coffee Roasters, Co. generated over 9 cents of profit per dollar of sales in 2016, up nearly 2 cents from just 7.5 cents in 2015. © Cambridge Business Publishers

Profitability Analysis (Financial Statements) Asset Turnover = Net sales Average total assets Amount of sales generated from each dollar invested in assets. Coffee Roasters 2016 = $3,859,198 ($3,615,789 + $3,197,887) / 2 = $1.13 Coffee Roasters 2015 = $2,650,899 ($3,197,887 + $1,370,574) / 2 = $1.16 Every dollar invested in Coffee Roasters’ assets generated $1.13 of sales revenue during 2016, down 3 cents from $1.16 in 2015. © Cambridge Business Publishers

Profitability Analysis (Financial Statements) Return on Assets = Net income Average total assets Indicates the rate of return generated on a company’s investment in assets from all sources. Coffee Roasters 2016 = $362,628 ($3,615,789 + $3,197,887) / 2 = 10.6% Coffee Roasters 2015 = $199,501 ($3,197,887 + $1,370,574) / 2 = 8.7% Coffee Roasters, Co. generated 10.6 cents of profit for every dollar invested in assets in 2016, up from 8.7 cents in 2015. © Cambridge Business Publishers

Profitability Analysis (Financial Statements) Return on Common Stockholders’ Equity Net income – Preferred stock dividends Average common stockholders’ equity = Indicates the rate of return generated by a business for its common stockholders. Coffee Roasters 2016 = $362,628 – $0 ($2,271,132 + $1,933,249) / 2 = 17.3% Coffee Roasters 2015 = $199,501– $0 ($1,933,249 + $699,245) / 2 = 15.2% Coffee Roasters, Co. generated an increase in its return on equity, from 15.3% in 2015 to 17.2% in 2016, a favorable change. © Cambridge Business Publishers

Short-Term Liquidity Analysis (Financial Statements) Working Capital = Current assets – Current liabilities Provides an indication of a company’s ability to satisfy its current obligations from its current resources. Coffee Roasters 2016 = $1,322,956 – $519,987 = $802,969 Coffee Roasters 2015 = $1,131,527 – $471,374 = $660,153 Coffee Roasters’ working capital is a healthy $802,969 in 2016, increasing from $660,153 in 2015. © Cambridge Business Publishers

Short-Term Liquidity Analysis (Financial Statements) Current Ratio = Current assets Current liabilities Amount of current assets available to service current liabilities. Coffee Roasters 2016 = $1,322,956 $519,987 = 2.5 Coffee Roasters 2015 = $1,131,527 $471,374 = 2.4 Coffee Roasters’ current assets are 2.5 times as large as its current obligations at the end of 2016, up from 2.4 at the end of 2015, indicating adequate liquidity. © Cambridge Business Publishers

Short-Term Liquidity Analysis (Financial Statements) Quick Ratio = Cash + Short-term investments + Accounts receivable Current liabilities Amount of liquid assets available to pay short-term liabilities. Coffee Roasters 2016 = $71,173 + $0 + $448,327 $519,987 = 1.00 Coffee Roasters 2015 = $40,512 + $0 + $364,810 $471,374 = 0.86 Coffee Roasters’ liquid assets are approximately equal to its current obligations at the end of 2016, up from 0.86 at the end of 2015, indicating an increase in liquidity. © Cambridge Business Publishers

Short-Term Liquidity Analysis (Financial Statements) = Cash flow from operating activities Average current liabilities Operating-Cash-Flow- to-Current-Liabilities Ratio Indicates the company’s ability to pay current liabilities from operating cash flows. Coffee Roasters 2016 = $477,785 ($519,987 + $471,374) / 2 = 0.96 Coffee Roasters 2015 = $785 ($471,374 + $238,055) / 2 = 0.00 Coffee Roasters’ operating cash flows are nearly equal to the company’s current obligations in 2016, up considerably from 2015. © Cambridge Business Publishers

Short-Term Liquidity Analysis (Financial Statements) Accounts Receivable Turnover = Net sales Average accounts receivable Indicates the number of sales/collection cycles experienced by a firm. Coffee Roasters 2016 = $3,859,198 ($448,327 + $364,810) / 2 = 9.49 times Coffee Roasters 2015 = $2,650,899 ($364,810 + $294,825) / 2 = 8.04 times Coffee Roasters’ sales/collections cycles numbered 9.49 in 2016, which is up from 8.04 in 2015. © Cambridge Business Publishers

Short-Term Liquidity Analysis (Financial Statements) Average Collection Period = 365 Accounts receivable turnover Indicates the number of days required, on average, to collect an outstanding account receivable. Coffee Roasters 2016 = 365 9.49 = 38.5 days Coffee Roasters 2015 = 365 8.04 = 45.4 days Coffee Roasters required 38.5 days on average to collect an outstanding receivable in 2016, which is 6.9 days quicker than in 2015. © Cambridge Business Publishers

Short-Term Liquidity Analysis (Financial Statements) Inventory Turnover = Cost of goods sold Average inventory Indicates the number of production/sales cycles experienced by a firm. Coffee Roasters 2016 = $2,589,799 ($768,437 + $672,248) / 2 = 3.6 times Coffee Roasters 2015 = $1,746,274 ($672,248 + $262,478) / 2 = 3.7 times Coffee Roasters’ production/sales cycles numbered 3.6 in 2016, down slightly from 3.7 times in 2015. © Cambridge Business Publishers

Short-Term Liquidity Analysis (Financial Statements) Days’ Sales in Inventory = 365 Inventory turnover Indicates the number of days required, on average, to sell the inventory currently on hand. Coffee Roasters 2016 = 365 3.6 = 101.4 days Coffee Roasters 2015 = 365 3.7 = 98.6 days Coffee Roasters required 101.4 days, on average, to sell its inventory in 2016, a slight increase from 98.6 days in 2015. © Cambridge Business Publishers

Long-Term Solvency Analysis (Financial Statements) Debt-to-Equity Ratio = Total liabilities Total stockholders’ equity Relative investment of creditors versus shareholders in a business. Coffee Roasters 2016 = $1,344,657 $2,271,132 = 0.59 Coffee Roasters 2015 = $1,264,638 $1,933,249 = 0.65 Coffee Roasters’ debt-to-equity ratio is 0.59 in 2016, down somewhat from 0.65 in 2015. © Cambridge Business Publishers

Long-Term Solvency Analysis (Financial Statements) Times-Interest- Earned Ratio Income before interest expense and income taxes Interest expense = Indicates the ability to pay current interest charges from operating income. Coffee Roasters 2016 = $362,628 + $22,983 + $212,641 $22,983 = 26.0 Coffee Roasters 2015 = $199,501 + $57,657 + $101,699 $57,657 = 6.2 Coffee Roasters’ interest coverage increased from 6.2 times in 2015 to 26.0 times in 2016, indicating a high level of solvency. © Cambridge Business Publishers

Long-Term Solvency Analysis (Financial Statements) Operating-Cash-Flow- to-Capital-Expenditure Ratio Cash flow from operating activities Annual net capital expenditures = The ability of a company’s operations to provide sufficient cash to replace and expand plant assets. Coffee Roasters 2016 = $477,785 $401,121 = 1.19 Coffee Roasters 2015 = $785 $283,444 = 0.00 Coffee Roasters was unable to fund capital expenditures from operating cash flows in 2015, however they were able to fully fund them in 2016. © Cambridge Business Publishers

Ratios for Common Stockholders (Financial Statements) Earnings per Share Net income – Preferred stock dividends Weighted-average # of common shares outstanding = The earnings of the company for common shareholders stated on a per share basis. Coffee Roasters 2016 = $362,628 – $0 154,934 = $2.34 Coffee Roasters 2015 = $199,501 – $0 146,215 = $1.36 Coffee Roasters’ earnings per share increased from $1.36 in 2015 to $2.34 in 2016. © Cambridge Business Publishers

Ratios for Common Stockholders (Financial Statements) Price-Earnings Ratio Market price per share Earnings per share = An indication of the fair value of a company’s stock. Coffee Roasters 2016 = $23.74 $2.34 = 10.1 times Coffee Roasters 2015 = $104.26 $1.36 = 76.7 times Coffee Roasters’ stock sold at a multiple of 10.1 times its earnings in 2016, down drastically from 76.7 times in 2015. © Cambridge Business Publishers

Ratios for Common Stockholders (Financial Statements) Dividend Yield Annual dividend per share Market price per share = How much a company pays out in dividends relative to the company’s share price. Coffee Roasters 2016 = Coffee Roasters does not pay a dividend Coffee Roasters 2015 = Coffee Roasters does not pay a dividend © Cambridge Business Publishers

Ratios for Common Stockholders (Financial Statements) Dividend Payout Ratio Annual dividend per share Earnings per share = The percentage of earnings paid out as dividends. Coffee Roasters 2016 = Coffee Roasters does not pay a dividend Coffee Roasters 2015 = Coffee Roasters does not pay a dividend © Cambridge Business Publishers

Select the correct answer. Which of the following ratios are most useful for accessing a company’s profitability? Debt-to-equity ratio, times-interest-earned ratio, operating-cash-flow-to-capital-expenditure ratio. Price-earnings ratio, dividend yield, dividend payout ratio. Current ratio, quick ratio, inventory turnover. .Gross profit percentage, return on sales, return on assets. © Cambridge Business Publishers

Limitations of financial statement analysis. © Cambridge Business Publishers

Limitations of Financial Statement Analysis Analysis must be interpreted with consideration of the general economic conditions and industry conditions. Comparability of financial statement data is hampered by the use of different accounting methods. Difficulty is often encountered when comparing companies of different sizes or modes of operations. Comparability is often difficult for conglomerates that operate in multiple industries. © Cambridge Business Publishers

Appendix 13A Learning Objective 6 Describe financial statement disclosures. © Cambridge Business Publishers

Financial Statement Disclosures Parenthetical disclosures are placed next to account titles to provide additional detail. Notes to financial statements may include: Significant accounting policies Explanations of complex or special transactions Details of reported amounts Commitments Contingencies Segments Quarterly data Subsequent events © Cambridge Business Publishers

Financial Statement Disclosures Supplemental information included with the financial statements also includes: Management discussion and analysis Comparative selected financial data © Cambridge Business Publishers

Corporate Social Responsibility Leading firms have found many ways to show their social responsibility. Social responsibility often takes the form of charitable giving, sometimes through contributions tied to product purchases. Another form of social responsibility practiced by some companies is providing time off for their employees to do volunteer work with recognized not-for-profits. © Cambridge Business Publishers

© Cambridge Business Publishers