Fundamental Managerial Accounting Concepts Fifth Edition Fundamental Managerial Accounting Concepts Thomas P. Edmonds Bor-Yi Tsay Philip R. Olds Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Financial Statement Analysis CHAPTER 13 Financial Statement Analysis

Describe factors associated with communicating useful information. Learning Objective Describe factors associated with communicating useful information. LO1

Factors in Communicating Useful Information The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the following: Users Types of Decisions Means of Analysis

Differentiate between horizontal and vertical analysis. Learning Objective Differentiate between horizontal and vertical analysis. LO2

Methods of Analysis Horizontal Analysis Vertical Analysis Ratio Analysis

Milavec Company Financial Statements

Milavec Company Financial Statements

Horizontal Analysis Horizontal analysis (or trend analysis) refers to studying the behavior of individual financial statement items over several accounting periods. Absolute Amounts Percentage Analysis

Milavec Company Horizontal Analysis

Vertical Analysis Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.

Vertical Analysis of Income Statement In income statements, all items are usually expressed as a percentage of sales.

Milavec Company Vertical Analysis

Vertical Analysis of Balance Sheet In balance sheets, all items are usually expressed as a percentage of total assets.

Explain ratio analysis. Learning Objective Explain ratio analysis. LO3

Ratio Analysis Ratio analysis involves studying various relationships between different items reported in a set of financial statements.

Calculate ratios for assessing a company’s liquidity. Learning Objective Calculate ratios for assessing a company’s liquidity. LO4

Liquidity Ratios Liquidity ratios indicate a company’s ability to pay short-term debts. They focus on current assets and current liabilities. Working Capital Current Ratio Quick Ratio Accounts Receivable Ratios Inventory Ratios

Working Capital The excess of current assets over current liabilities is known as working capital.

The current ratio measures a company’s short-term debt paying ability. Current Assets Current Liabilities = The current ratio measures a company’s short-term debt paying ability. A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories.

Current Ratio

Quick (Acid-Test) Ratio Quick Assets Current Liabilities = Acid-Test Ratio Quick assets include Cash, Current Marketable Securities, and Accounts Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory.

Quick (Acid-Test) Ratio

Accounts Receivable Turnover Net Credit Sales Average Accounts Receivable Accounts Receivable Turnover = This ratio measures how many times a company converts its receivables into cash each year.

Accounts Receivable Turnover *The beginning receivables balance was drawn from the 2008 financial statements, which are not included in the illustration.

Average Days to Collect Receivables Average Collection Period = 365 Days Accounts Receivable Turnover = 21 days Average Collection Period = 365 Days 16.98 Times This ratio measures, on average, how many days it takes to collect an accounts receivable.

Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = This ratio measures how many times a company’s inventory has been sold and replaced during the year.

Inventory Turnover *The beginning inventory balance was drawn from the company’s 2008 financial statements, which are not included in the illustration.

Average Days to Sell Inventory Average Sale Period = 365 Days Inventory Turnover = 34 days Average Sale Period = 365 Days 10.80 Times This ratio measures how many days, on average, it takes to sell the inventory.

Calculate ratios for assessing a company’s solvency. Learning Objective Calculate ratios for assessing a company’s solvency. LO5

Solvency Ratios Solvency ratios are used to analyze a company’s long-term debt-paying ability and its financing structure. Debt to Assets Ratio Debt to Equity Ratio Number of Times Interest Earned Plant Assets to Long-Term Liabilities

Debt to Assets Ratio Total Liabilities Total Assets Debt to Assets Ratio = This ratio measures the percentage of a company’s assets that are financed by debt.

Debt to Equity Ratio Debt to Equity Ratio Total Liabilities = Stockholders’ Equity Debt to Equity Ratio = This ratio indicates the relative proportions of debt to equity on a company’s balance sheet. Stockholders like a lot of debt if the company can take advantage of positive financial leverage. Creditors prefer less debt and more equity because equity represents a buffer of protection.

Debt to Assets and Debt to Equity Ratios

Number of Times Interest is Earned Ratio Earnings before Interest Expense and Income Taxes Interest Expense Times Interest Earned = This is the most common measure of a company’s ability to provide protection for its long-term creditors.

Number of Times Interest Earned Ratio *Interest on bonds: $100,000 x .08 = $8,000

Plant Assets to Long-Term Liabilities Net Plant Assets Long-Term Liabilities = This ratio suggests how well long-term debt is managed to finance long-term assets.

Plant Assets to Long-Term Liabilities

Calculate ratios for assessing company management’s effectiveness. Learning Objective Calculate ratios for assessing company management’s effectiveness. LO6

Profitability ratios measure a company’s ability to generate earnings. Net Margin (or Return on Sales) Asset Turnover Ratio Return on Investment Return on Equity

Net Margin Net Margin Net Income Net Sales = This measure describes the percent remaining of each sales dollar after subtracting other expenses as well as cost of goods sold.

Net Margin

Asset Turnover Ratio Net Sales Average Total Assets Asset Turnover = This ratio measures how many sales dollars were generated for each dollar of assets invested.

Asset Turnover Ratio

Return on Investment (ROI) Net Income Average Total Assets = This is the ratio of wealth generated (net income) to the amount invested (average total assets).

Return on Investment (ROI) For Milavec, ROI was as follows. 2010 $25,000 ÷ $481,500* = %.19% 2009 $22,000 ÷ $437,500* = 5.03% * The computation of average assets is calculated as beginning assets plus ending assets divided by 2.

Average Total Stockholders’ Equity Return on Equity Return on Equity Net Income Average Total Stockholders’ Equity = This measure is often used to measure the profitability of the stockholders’ investment.

Return on Equity

Learning Objective Calculate ratios for assessing a company’s position in the stock market. LO7

Stock market ratios analyze the earnings and dividends of a company. Earnings Per Share Book Value Price-Earnings (PE) Ratio Dividend Yield

Average Number of Outstanding Common Shares Earnings Per Share Earnings per Share Net Earnings Available for Common Stock Average Number of Outstanding Common Shares = This measure indicates how much income was earned for each share of common stock outstanding.

Earnings Per Share

Stockholders’ Equity - Preferred Dividends Outstanding Common Shares Book Value Per Share Book Value per Share Stockholders’ Equity - Preferred Dividends Outstanding Common Shares = This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.

Book Value Per Share

Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share Earnings Per Share = This ratio compares the earnings of a company to the market price for a share of the company’s stock.

Dividend Yield Dividend Yield Dividends Per Share Market Price Per Share = This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

Explain the limitations of financial statement analysis. Learning Objective Explain the limitations of financial statement analysis. LO8

Limitations of Financial Statement Analysis Different Industries Changing Economic Environment Accounting Principles

End of Chapter 13