Financial Statement Analysis 17 Financial Statement Analysis Student Version

Describe basic financial statement analytical methods. 1 Describe basic financial statement analytical methods. 17-2

1 Horizontal Analysis The percentage analysis of increases and decreases in related items using comparative financial statements is called horizontal analysis.

1 Exhibit 1 Comparative Balance Sheet—Horizontal Analysis Difference $17,000 Base year (2009) $533,000 = 3.2%

1 Comparative Schedule of Current Assets—Horizontal Analysis Exhibit 2 Difference $25,800 Base year (2009) $64,700 = 39.9%

1 Comparative Income Statement—Horizontal Analysis Exhibit 3 Increase amount $296,500 Base year (2009) $1,234,000 = 24.0%

1 Comparative Retained Earnings Statement—Horizontal Analysis Exhibit 4 Horizontal Analysis: Increase amount $37,500 Base year (2009) $100,000 = 37.5%

X – whatever you are comparing X to* *also known as the “base”

Horizontal analysis shows trends over time. Cautions about horizontal analysis Many people will think of a simple linear regression when they see a trend, which is not always the case Many people will make predictions based on too few observations, and their predictions may seem reasonable given their limited frame of reference

1 Vertical Analysis A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis.

Vertical Analysis of Balance Sheet 1 Vertical Analysis of Balance Sheet In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.

1 Exhibit 5 Compar-ative Balance Sheet—Vertical Analysis Current assets $550,000 Total assets $1,139,500 = 48.3%

Vertical Analysis of the Income Statement 1 Vertical Analysis of the Income Statement In a vertical analysis of the income statement, each item is stated as a percent of net sales.

1 Comparative Income Statement—Vertical Analysis Exhibit 6 Selling expenses $191,000 Net sales $1,498,000 = 12.8%

Common-Size Statements 1 Common-Size Statements In a common-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with with industry percentages.

1 Exhibit 7 Common-Sized Income Statement

Use financial statement analysis to assess the solvency of a business. 2 Use financial statement analysis to assess the solvency of a business. 17-15

So, solvency is a very important topic! Measures of solvency are important to determine the ability of a business to pay its creditors. If a business can’t pay it’s creditors, it is technically BANKRUPT. So, solvency is a very important topic!

2 Working Capital The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company’s ability to pay current liabilities.

Working Capital = Current Assets – Current Liabilities 2 Working Capital = Current Assets – Current Liabilities 2010 2009 Current assets $550,000 $533,000 Current liabilities –210,000 –243,000 Working capital $340,000 $290,000 Indicates the ability to pay bills as they come due and pay for current operations. Does not tell you what current expenses are.

2 Current Ratio The current ratio, sometimes called the working capital ratio or bankers’ ratio measures a company’s ability to pay its current liabilities.

2 Current Assets Current Liabilities Current Ratio = Shows the number of times assets could cover liabilities. Indicates likelihood of payment of liabilities. 2010 2009 Current assets $550,000 $533,000 Current liabilities $210,000 $243,000 Current ratio 2.6 2.2 $550,000 $210,000 $533,000 $243,000 Again, however, it does not address expenses.

2 Quick Ratio A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio or acid-test ratio.

2 The quick ratio deducts inventory and uncollectible accounts allowances from assets to determine the cash available to repay debts. Quick assets are cash and other current assets that can be quickly converted to cash. 2010 2009 Quick assets: Cash $ 90,500 $ 64,700 Temporary Investments 75,000 60,000 Accounts receivable (net) 115,000 120,000 a. Total quick assets $280,500 $244,700 b. Current liabilities $210,000 $243,000 Quick ratio (a ÷ b) 1.3 1.0

Analysis Example Step 1: Descriptions Select the facts that give the reader a Comprehensive and fair view of the company’s operations. This section should be primarily descriptive. Write the narrative from an internal accountant’s perspective.

Lincoln Company had net sales of $1,480,000 in 2010, with operating expenses of $290,000. Lincoln currently has $340,000 in working capital, an increase of $50,000 over last year. Our current ratio has improved from 2.2 to 2.6, and our quick ratio has improved from 1.0 to 1.3.

Analysis Example Step 2: Comparisons Make comparisons to other companies and industry.

Lincoln’s primary competitors are Madison Company, Sugarland Inc Lincoln’s primary competitors are Madison Company, Sugarland Inc. and Bowland Ltd. The quick ratio for competitors and the industry overall are displayed in the table below. Lincoln Madison Sugarland Bowland Industry 2009 1.0 3.0 .99 1.8 2010 1.3 6.0 1.2

Analysis Example Step 3: Discussion Evaluate the result of your analysis and explain any differences (if you can) from media reports, competitor press releases, or general economic news.

Our current ratio of 1.3 is average compared to our competitors and industry standards. Madison Company has been selling off its real estate holdings resulting in large inflows of cash for the last two years, resulting in a higher than normal current ratio.

Lincoln Company had net sales of $1,480,000 in 2010, with operating expenses of $290,000. Lincoln currently has $340,000 in working capital, an increase of $50,000 over last year. Our current ratio has improved from 2.2 to 2.6, and our quick ratio has improved from 1.0 to 1.3.

Describe options available to improve the ratios. Analysis Example Step 4: Options Describe options available to improve the ratios.

In order to improve our quick ratio, we could also sell off some of our fixed assets, as Madison is doing. We may also consider: ????? Brainstorming

Accounts Receivable Turnover 2 Accounts Receivable Turnover The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a company’s solvency.

Average Accounts Receivable 2 Accounts Receivable Turnover = Net Sales Average Accounts Receivable 2010 2009 a. Net sales $1,498,000 $1,200,000 Accounts receivable (net): Beginning of year $ 120,000 $ 140,000 End of year 115,500 120,000 Total $ 235,000 $ 260,000 Average (Total ÷ 2) $ 117,500 $ 130,000 Accounts receivable turnover (a ÷ b) 12.7 9.2

If available, it is better to use credit sales rather than net sales as the numerator. This gives a more accurate picture of accounts receivable turnover.

Average Collection Period 2 Average Collection Period The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. Number of Days’ Sales in Receivables Average Accounts Receivable Average Daily Sales = Net Sales 365

2 2010 2009 Average accounts receivable (Total accounts 2010 2009 Average accounts receivable (Total accounts receivable ÷ 2) $ 117,500 $ 130,000 Net sales $1,498,000 $1,200,000 Average daily sales (Sales ÷ 365) $ 4,104 $ 3,288 Number of days’ sales in receivables (a ÷ b) 28.6 39.5

The accounts receivables measures are helpful in determining how quickly the accounts receivables will generate cash. These measures are used to evaluate the effectiveness of the sales, credit, and collections policies and procedures of a company. To improve effectiveness in this area, changes to those areas may need attention.

Days Payables Outstanding The number of days’ payables outstanding is an estimate of the length of time (in days) the accounts payables have been outstanding.

2010 2009 Average accounts payable (Total accounts payable ÷ 2) $ 117,500 $ 130,000 Cost of goods $1,498,000 $1,200,000 Average cost of goods (cogs ÷ 365) $ 4,104 $ 3,288 Number of days’ cogs in Payables (a ÷ b) 28.6 39.5

To adjust the accounts payable cycle, what strategies might management consider?

2 Inventory Turnover The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory.

2 Cost of Goods Sold Average Inventory Inventory Turnover = 2010 2009 2010 2009 a. Cost of goods sold $1,043,000 $ 820,000 Inventories: Beginning of year $ 283,000 $ 311,000 End of year 264,000 283,000 Total $ 547,000 $ 594,000 Average (Total ÷ 2) $ 273,500 $ 297,000 Inventory turnover (a ÷ b) 3.8 2.8

Number of Days’ Sales in Inventory 2 Number of Days’ Sales in Inventory The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory.

Average Daily Cost of Goods Sold 2 Average Inventory Average Daily Cost of Goods Sold Number of Days’ Sales in Inventory = Cost of Goods Sold 365 a. Average inventory (Total ÷ 2) $ 273,500 $ 297,000 Cost of goods sold $1,043,000 $ 820,000 Average daily cost of goods sold (COGS ÷ 365 days) $2,858 $2,247 2010 2009 Number of days’ sales in inventory (a ÷ b) 95.7 132.2

In order to improve the inventory measures, management may implement changes in product mix or inventory management. Further information would be needed to determine the correct course of action. Possible actions include: Offering more frequent sales promotions Discounting obsolete inventory Implementing just-in-time inventory practices Adjusting re-order points . . . More???

The next three ratios measure the ability of the company to obtain long-term financing for fixed assets.

Ratio of Fixed Assets to Long-Term Liabilities 2 Ratio of Fixed Assets to Long-Term Liabilities The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis. . . . . “Collateral”

Long-Term Liabilities 2 Ratio of Fixed Assets to Long-Term Liabilities Fixed Assets (net) Long-Term Liabilities = 2010 2009 a. Fixed assets (net) $444,500 $470,000 b. Long-term liabilities $100,000 $200,000 Ratio of fixed assets to long-term liabilities (a ÷ b) 4.4 2.4

Debt-to-Capital Ratio 2 Debt-to-Capital Ratio The relationship between the total claims of the creditors and owners—the ratio of liabilities to stockholders’ equity—is a solvency measure that indicates the margin of safety for creditors.

Total Stockholders’ Equity 2 Total Liabilities Total Stockholders’ Equity Ratio of Liabilities to Stockholders’ Equity = 2010 2009 a. Total liabilities $310,000 $443,000 b. Total stockholders’ equity $829,500 $787,500 Ratio of liabilities to stockholders’ equity ( a÷ b) 0.4 0.6

Number of Times Interest Charges Earned 2 Number of Times Interest Charges Earned Corporations in some industries normally have high ratios of debt to stockholders’ equity. For such corporations, the relative risk of the debtholders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio.

2 Income Before Income Tax + Interest Expense Number of Times Interest Charges Earned = 2010 2009 Income before income tax $162,500 $134,600 a. Add interest expense 6,000 12,000 Amount available to meet interest charges $168,500 $146,600 Number of times interest charges earned (b ÷ a) 28.1 12.2

The three measures taken together tell creditors: Long-term loans can be secured by fixed assets Owners are “invested” in the assets Earnings will cover interest payments In order to improve the ability to secure long-term loans, managers may: Provide additional equity Increase earnings Offer additional fixed assets to secure the loan

Sometimes, creditors will accept preferred stock to secure their loans Sometimes, creditors will accept preferred stock to secure their loans. In that case they will use the following calculation:

Number of Times Preferred Dividends Are Earned 2 Number of Times Preferred Dividends Are Earned The number of times interest charges are earned can be adapted for use with dividends on preferred stock. Number of Times Preferred Dividends Are Earned Net Income Preferred Dividends =

3 Use financial statement analysis to assess the profitability of a business. 17-37

The purpose of a business is to earn a profit The purpose of a business is to earn a profit. If the investment in a business is not earning at least as much as the same amount of money invested in a certificate of deposit or other investment vehicle, why work so hard? The next set of measures help to determine whether the business is profitable, and how it could be made more profitable.

Profitability Analysis 3 Profitability Analysis Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business.

Before we get started, let’s look at: Net Sales: Sales after sales discounts and returns & Net Income: Generally, income after cost of goods and operating expenses and before interest, taxes, and depreciation and amortization (EBITDA, EBITD, EBIT, etc.)

Ratio of Net Sales to Assets 3 Net Sales Average Total Assets Ratio of Net Sales to Assets = 2010 2009 a. Net sales $1,498,000 $1,200,000 Total assets: Beginning of year $1,053,000 $1,010,000 End of year 1,044,500 1,053,000 Total $2,097,500 $2,063,000 b. Average (Total ÷ 2) $1,048,750 $1,031,500 Ratio of net sales to assets (a ÷ b) 1.4 1.2

This measure shows how well assets are being used to generate sales This measure shows how well assets are being used to generate sales. Specific industries use variations of this measure, such as: Sales per square foot Sales per room (hotel) Sales per employee

3 Net Income + Interest Expense Average Total Assets Rate Earned on Total Assets = 2010 2009 Net income $ 91,000 $ 76,500 Plus interest expense 6,000 12,000 a. Total $ 97,000 $ 88,500 Total assets: Beginning of year $1,230,500 $1,187,500 End of year 1,139,500 1,230,500 Total $2,370,000 $2,418,000 b. Average (Total ÷ 2) $1,185,000 $1,209,000 Rate earned on total assets (a ÷ b) 8.2% 7.3%

Market Measures of Profitability for Public Corporations

3 Net Income Rate Earned on Stockholders’ Equity Average Total Stockholders’ Equity Rate Earned on Stockholders’ Equity = a. Net income $ 91,000 $ 76,500 Stockholders’ equity: Beginning of year $ 787,500 $ 750,000 End of year 829,500 787,500 Total $1,617,000 $1,537,500 b. Average (Total ÷ 2) $ 808,500 $ 768,750 2010 2009 Rate earned on stockholders’ equity (a ÷ b) 11.3% 10.0%

3 Net Income – Preferred Dividends Average Common Stockholders’ Equity Rate Earned on Common Stockholders’ Equity = 2010 2009 Net income $ 91,000 $ 76,500 Less preferred dividends 9,000 9,000 a. Remainder—common stock $ 82,000 $ 67,500 Common stockholders’ equity: Beginning of year $ 637,500 $ 600,000 End of year 679,500 637,500 Total $1,317,000 $1,237,500 b. Average (Total ÷ 2) $ 658,500 $ 618,750 Rate earned on common stockholders’ equity (a ÷ b) 12.5% 10.9%

3 Net Income – Preferred Dividends Shares of Common Stock Outstanding Earnings per Share (EPS) on Common Stock = 2010 2009 Net income $91,000 $76,500 Preferred dividends 9,000 9,000 Remainder—identified with common stock $82,000 $67,500 b. Shares of common stock 50,000 50,000 Earnings per share on common stock (a ÷ b) $1.64 $1.35

3 Market Price per Share of Common Stock Earnings per Share on Common Stock Price-earnings (P/E) ratio = 2010 2009 Market price per share of common stock $41.00 $27.00 Earnings per share on common stock ÷ 1.64 ÷ 1.35 Price-earnings ratio on common stock 25 20

Shares of Common Stock Outstanding 3 Dividends Shares of Common Stock Outstanding Dividends per Share = 2010 2009 a. Dividends $40,000 $30,000 b. Shares of common stock outstanding 50,000 50,000 Dividends per share of common stock (a ÷ b) $0.80 $0.60

3 Dividend yield on Dividends per Share of Common Stock Market Price per Share of Common Stock Dividend Yield = 2010 2009 a. Dividends per share of common stock $ 0.80 $ 0.60 b. Market price per share of common stock 41.00 27.00 Dividend yield on common stock 2.0% 2.2%