Financial Statement Analysis Chapter 15 Financial Statement Analysis

Financial Statement Analysis To make informed decisions about a company Helpful in managing the company Comparison with competition Charting a company’s progress, measure performance Establish financial health Used for investment decisions Generally based on comparative financial data From one year to the next With a competing company With the industry as a whole.

Financial Statement Analysis Three main ways to analyze financial statements Horizontal analysis Vertical analysis Using industry averages

Horizontal Analysis The study of percentage changes in comparative statements Compute dollar changes Compute percentage changes

Example: Income Statement Step 1 Step 2

Example: Balance Sheet (partial)

Trend Percentages Form of horizontal analysis Select a period of three to five years Base year, earliest year, is selected and set equal to 100% Subsequent years expressed as a percentage of the base period

E15-13: Horizontal analysis—income statement Data for Mariner Designs, Inc., follow: 1. Prepare a horizontal analysis of the comparative income statement of Mariner Designs, Inc. Round percentage changes to one decimal place. MARINER DESIGNS, INC. Comparative Income Statement Years Ended December 31, 2012 and 2011 2011 2012 Net sales revenue $ 431,000 $ 372,350 Expenses: Cost of goods sold $ 200,000 $ 187,550 Selling and general expenses 99,000 91,050 Other expense 8,350 6,850 Total expenses $ 307,350 $ 285,450 Net income $ 123,650 $ 86,900

E15-13: Horizontal Analysis—Income Statement MARINER DESIGNS, INC. Comparative Income Statement Years Ended December 31, 2012 and 2011 Increase (Decrease) 2011 2012 Amount Percent Net sales revenue $ 431,000 $ 372,350 $ 58,650 15.8 % Expenses: Cost of goods sold $ 200,000 $ 187,550 $ 12,450 6.6 % Selling and general expenses 99,000 91,050 7,950 8.7 % Other expense 8,350 6,850 1,500 21.9 % Total expenses $ 307,350 $ 285,450 21,900 7.7 % Net income $ 123,650 $ 86,900 $ 36,750 42.3 %

E15-13: Horizontal analysis—income statement Data for Mariner Designs, Inc., follow: 2. Why did 2012 net income increase by a higher percentage than net sales revenue? Revenues increase at a higher rate than total expenses.

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 or total liabilities and equity.

Example: Income Statement Base amount Percentage of the base amount

Example: Balance Sheet Base amount Percentage of base

Prepare a vertical analysis of Tri-State assets for 2012 and 2011. S15-3 : Vertical analysis Tri-State Optical Company reported the following amounts on its balance sheet at December 31, 2012 and 2011: Prepare a vertical analysis of Tri-State assets for 2012 and 2011. 2012 2011 Cash and receivables $ 54,530 $ 46,860 Inventory 42,435 32,670 Property, plant, and equipment, net 108,035 85,470 Total assets $ 205,000 $ 165,000 2012 % of total 2011 Cash and receivables $ 54,530 $ 46,860 Inventory 42,435 32,670 Property, plant, and equipment, net 108,035 85,470 Total assets $ 205,000 $ 165,000 26.6 20.7 52.7 100.0 28.4 19.8 51.8 100.0

Common-Size Statements Common-size statements compare one company to another

Benchmarking Comparing a company with another leading company Two main types: Against a key competitor Against the industry average

S15-4 :Common-size income statement Data for Martinez, Inc., and Rosado, Corp., follow: 1. Prepare common-size income statements. Martinez Rosado Net sales $ 10,600 $ 18,600 Cost of goods sold 6,455 13,522 Other expenses 3,541 4,185 Net income $ 604 $ 893 Martinez Rosado Net sales 100 % Cost of goods sold 60.9 % 72.7 % Other expenses 33.4 % 22.5 % Net income 5.7 % 4.8 %

S15-4 :Common-size income statement (Continued) 2. Which company earns more net income? 3. Which company’s net income is a higher percentage of its net sales? Martinez Rosado Net sales 100 % Cost of goods sold 60.9 % 72.7 % Other expenses 33.4 % 22.5 % Net income 5.7 % 4.8 % Rosado Martinez

Financial Ratios No single ratio tells the whole picture Different ratios explain different aspects

Ability to Pay Current Liabilities Working capital Working capital = Current assets – Current liabilities Current ratio Current assets Current liabilities Current ratio =

Ability to Pay Current Liabilities Acid-test ratio Cash + Short-term investments + Net current receivables Current liabilities Acid-test Ratio =

Ability to Sell Inventory and Collect Receivables Inventory turnover ratio Formula Inventory turnover = Cost of goods sold Average inventory

Ability to Sell Inventory and Collect Receivables Days in inventory ratio Formula Days in inventory = 365 days Inventory turnover ratio

Ability to Sell Inventory and Collect Receivables Gross profit percentage Formula Gross profit percentage = Gross profit Net sales

Ability to Sell Inventory and Collect Receivables Accounts receivable turnover ratio Formula Accounts receivable turnover = Net credit sales Average net accounts receivable

Ability to Sell Inventory and Collect Receivables Days’ sales in receivables ratio Formula Days’ sales in average accounts = receivable 365 days Accounts receivable turnover ratio

Ability to Pay Long-Term Debt Debt ratio Formula Average debt ratio ranges from 57% to 67% Debt ratio = Total liabilities Total assets

Ability to Pay Long-Term Debt Debt to equity ratio Formula Debt to equity = Total liabilities Total equity

Ability to Pay Long-Term Debt Times-interest-earned ratio Formula Times-interest earned ratio = Earnings Before Interest and Taxes Interest expense

Measuring Profitability Return on net sales Formula Rate of return on net sales = Net income Net sales

Measuring Profitability Return on total assets Formula Rate of return on total assets = Net income + Interest expense Average total assets

Measuring Profitability Asset turnover ratio Formula Asset turnover ratio = Net sales Average total assets

Measuring Profitability Return on common stockholders’ equity Formula Rate of return on common stockholders’ equity = Net income – Preferred dividends Average common stockholders’ equity

Leverage Trading on the equity Increases profits during goods times Compounds losses during bad times

Measuring Profitability Earnings per share Formula Earnings per share of common stock = Net income – Preferred Dividends Number of shares of common stock outstanding

Analyzing Stock Investments Price/earnings ratio (P/E) Formula P/E ratio = Market price per share of common stock Earnings per share

Analyzing Stock Investments Dividend yield Formula Dividend yield on common stock = Annual dividends per share of common stock Market price per share of common stock

Analyzing Stock Investments Dividend Payout Formula Dividend Payout = Annual dividends per share Earnings per share

Analyzing Stock Investments Book value Formula Book value per share of common stock = Total stockholders’ equity – Preferred equity Number of shares of common stock outstanding

S15-5: Evaluating current ratio Win’s Companies, a home improvement store chain, reported the following summarized figures:

S15-5 : Evaluating current ratio (Continued) Compute Win’s Companies’ current ratio at May 31, 2012 and 2011. 2. Did Win’s Companies’ current ratio improve, deteriorate, or hold steady during 2012? Current assets Current liabilities Current ratio = - $ 54,300,000/$ 33,000,000 = 1.65 2011 - $ 25,200,000/$ 13,100,000 = 1.92 Win’s Companies current ratio deteriorated.

S15-6: Computing inventory, gross profit, and receivables ratios Use the Win’s Companies data in Short Exercise 15-5 to complete the following requirements. Compute the rate of inventory turnover, days in inventory, and gross profit percentage for 2012. Inventory turnover = Cost of goods sold Average inventory $ 28,400,000/($6,900,000 + $8,200,000)/2 = 3.76 Days in inventory = 365 days Inventory turnover ratio 365/3.76 = 97 days Gross profit percentage = Gross profit Net sales $21,800,000/$50,200,000 = 43.4 %

S15-6 : Computing inventory, gross profit, and receivables ratios (Continued) 2. Compute days’ sales in average receivables during 2012. Round dollar amounts to three decimal places. Days’ sales in average accounts = receivable 365 days Accounts receivable turnover ratio Accounts receivable turnover = Net credit sales Average net accounts receivable 365/($ 50,200,000/($7,400,000 + $5,300,000)/2 ) = 46 days

S15-7: Measuring ability to pay liabilities Use the financial statements of Win’s Companies in Short Exercise 15-5. Compute the debt ratio and the debt to equity ratio at May 31, 2012. 2. Is Win’s ability to pay its liabilities strong or weak? Explain your reasoning. Debt ratio = Total liabilities Total assets $ 45,300,000 / $ 88,300,000 = 51.3 Debt to equity = Total liabilities Total equity $ 45,300,000 / $ 43,000,000 = 1.05 The company’s ability to pay its liabilities is strong since the debt ratio is low.

S15-8 : Measuring profitability Use the financial statements of Win’s Companies in Short Exercise 15-5 to complete the following profitability measures for 2012. 1. Compute the rate of return on net sales. 2. Compute the rate of return on total assets. 3. Compute the asset turnover ratio. Rate of return on net sales = Net income Net sales $ 15,500,000 / $ 50,200,000 = 30.9% Rate of return on total assets = Net income + Interest expense Average total assets $ 15,500,000 + 500,000 / ($ 88,300,000 + $ 51,200,000)/2 = 22.9% Asset turnover ratio = Net sales Average total assets $ 50,200,000 / ($ 88,300,000 + $ 51,200,000)/2 = 0.72

S15-8 : Measuring profitability (Continued) 4. Compute the rate of return on common stockholders’ equity. 5. Are these rates of return strong or weak? Explain your reasoning. Rate of return on common stockholders’ equity = Net income – Preferred dividends Average common stockholders’ equity $ 15,500,000 – 0 / ($ 43,000,000 + $ 27,500,000) /2 = 44.0 % These rates of return are strong considering that average companies present much lower rates of return.

S15-9 : Computing EPS and P/E ratio Use the financial statements of Win’s Companies in Short Exercise 15-5. Win’s has 500,000 common shares outstanding during 2012. Compute earnings per share (EPS) for Win’s. Round to the nearest cent. 2. Compute Win’s Companies’ price/earnings ratio. The market price per share of Win’s stock is $68.50. Earnings per share of common stock = Net income – Preferred Dividends Number of shares of common stock outstanding $ 15,500,000 – 0/500,000 = $31.00 P/E ratio = Market price per share of common stock Earnings per share $68.50/$31.00 = 2.2 times