Financial statement analysis and interpretation What is financial statement analysis? Examining the financial statements from a users’ perspective and looking at relationships in the accounting information

Financial statement analysis and interpretation Who analyzes financial statements? Internal users (i.e., management) External users (emphasis of chapter) Examples? Investors, creditors, regulatory agencies & … stock market analysts and auditors

Financial statement analysis and interpretation What do internal users use it for? Planning, evaluating and controlling company operations What do external users use it for? Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management

Financial statement analysis and interpretation Information is available from Published annual reports Financial statements Notes to financial statements Letters to stockholders Auditor’s report (Independent accountants) Management’s discussion and analysis Reports filed with governments

Financial statement analysis and interpretation Information is available from Other sources Newspapers Periodicals Financial information organizations Other business publications

Methods of financial statement analysis Horizontal analysis Vertical analysis Ratio analysis Common-size statements Trend percentages

Horizontal analysis Using comparative financial statements to calculate currency or percentage changes in a financial statement item from one period to the next

Vertical analysis For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

Ratio analysis Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

Common-size statements Financial statements that show only percentages and no absolute currency amounts

Trend percentages Show changes over time in given financial statement items (can help evaluate financial information of several years)

Horizontal analysis example The management of Example Company provides you with comparative balance sheets of the years ended December 31, 2012 and 2011. Management asks you to prepare a horizontal analysis on the information

Horizontal analysis example

Horizontal analysis example Calculating change in currency amounts Money amount change Current year figure Previous year figure = –

Horizontal analysis example Calculating change as a percentage Percentage change Money amount change Previous year figure × = 100%

Horizontal analysis example

Horizontal analysis example (11,500 ÷ 23,500) × 100% = 48.9%

Horizontal analysis example

Horizontal analysis example Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet

Sales increased by 8.3% while net income decreased by 21.9%.

There were increases in both cost of goods sold (14 There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

Vertical analysis example The management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company

Vertical analysis example

Vertical Analysis Example 82,000 ÷ 483,000 = 17% rounded 30,000 ÷ 387,000 = 8% rounded

Vertical analysis example

Vertical analysis example 76,000 ÷ 483,000 = 16% rounded

Ratios CAUTION! Ratios can be expressed in different ways: 1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of $2.25) CAUTION! Using ratios and percentages without considering the underlying causes may lead to incorrect conclusions

Categories of ratios Liquidity ratios Indicate a company’s short-term debt-paying ability Debt & Equity ratios (Long-term Solvency) Show relationship between debt and equity financing in a company Profitability ratios & tests Relate income to other variables Market ratios & tests Help assess relative merits of stocks in the marketplace

Liquidity ratios Current (working capital) ratio Quick ratio (‘acid test’) Liquid (cash) ratio Accounts receivable turnover Number of days sales in accounts receivable Inventory turnover Total assets turnover

Debt & Equity ratios (long-term Solvency) Debt to Equity ratio or Debt to TOTAL ‘long term’ funds (D+E) Equity ratio (stockholders’ equity)

Profitability ratios & tests Return on capital employed ROCE (ie. return on ‘operating assets’ Net income to net sales (return on sales or ‘net profit margin’) Gross profit percentage Return on equity ROE (ie. common stockholders equity)

Market ratios & tests Earnings per share Times interest earned Times preferred dividends earned Earnings yield on common stock Price-earnings ratio Payout ratio on common stock Dividend yield on common stock Dividend yield on preferred stock Cash flow per share of common stock

Ratios Now, let’s look at Aspect Corporation’s 2012 and 2011 financial statements

to calculate liquidity ratios for Aspect Co. This Information will be used to calculate liquidity ratios for Aspect Co.

Working Capital* The excess of current assets over (ie. minus) current liabilities While this is not a ratio, it does give an indication of a company’s liquidity

of the company to pay current debts as they become due Current ratio Current Ratio Current Assets Current Liabilities = Current Ratio 65,000 42,000 = 1.55 : 1 Measures the ability of the company to pay current debts as they become due

Current Assets - Inventory Quick ratio Current Assets - Inventory Current Liabilities = Quick Ratio 65,000 - 12000 42,000 = 1.26 : 1 Quick Ratio 53,000 42,000 = 1.26 : 1 Quick Ratio This ratio is often and confusingly also referred to as the “acid-test”

Liquid (‘acid-test’) ratio Liquid Assets Current Liabilities = Acid-test ratio 30,000 42,000 = .71 : 1 Liquid Ratio Liquid assets are cash, and current marketable securities

Accounts receivable turnover Net, credit sales Average, net accounts receivable Sales on Account Average accounts receivable Accounts receivable turnover = = 26.70 times 494,000 (17,000 + 20,000) ÷ 2 Accounts receivable turnover = This ratio measures how many times a company converts its receivables into cash each year

Number of days in accounts receivable days sales in accounts receivables 365 Days Accounts receivable turnover = = 13.67 days = 365 days 26.70 times days sales in accounts receivables Measures, on average, how many days it takes to collect an account receivable What would be a desirable number of days for collection of accounts receivable ?

Measures the number of times replaced during the year Inventory turnover Cost of Goods sold Average inventory Inventory turnover = = 12.73 times 140,000 (10,000 + 12,000) ÷ 2 Inventory turnover = Measures the number of times inventory is sold and replaced during the year What would be a desirable number of times for inventory to turnover ?

Debt to Equity, or long–term Solvency ratios This is part of the information to calculate the equity, or long-term solvency ratios of Aspect Corporation

Here is the rest of the information we will use

Debt to Equity ratio Debt to Equity = Long term Debt Total Assets 70,000 234,390 0.30 Measures the ‘risk’

Equity ratio Equity ratio = Total assets Equity ratio = 234,390 346,390 67.7% Measures the proportion of total assets provided by stockholders

Return On Capital Employed ROCE = Earning Before Interest and Tax Equity + Debt (average) ROCE = PBIT Equity + Debt (average) ROCE = 76,700 346,390 22.1%

Net Income to Net Sales (Return on Sales or Profit Margin) = Net Income to Net Sales = 53,690 494,000 = 10.9% Measures the proportion of the sales dollar which is retained as profit

Return on Equity ROE (return on common stockholders funds) net income Common equity (average) Return on equity funds = = 53,690 (180,000 + 234,390) ÷ 2 = 25.9% Return on equity Important measure of the income-producing ability of a company

Weighted Average Number of Common Shares Outstanding Earnings Per Share Earnings Available to Common Stockholders Weighted Average Number of Common Shares Outstanding Earnings per Share = Earnings per Share 53,690 (17,000 + 27,400) ÷ 2 = = $2.42 The financial press regularly publishes actual and forecasted EPS amounts

Weighted average calculation Earnings Per Share Weighted average calculation EPS of common stock = _______________________ Earnings available to common stockholders Weighted average number of common shares outstanding

EPS and Stock Dividends or Splits Earnings Per Share EPS and Stock Dividends or Splits Why restate all prior calculations of EPS? Comparability - i.e., no additional capital was generated by the dividend or split Basic EPS and Diluted EPS IAS 33

Price-Earnings Ratio ( P/E Multiple ) Market Price Per Share EPS = Price-Earnings Ratio = $20.00 $ 2.42 = 8.3 : 1 Provides some measure of whether the stock is under or overpriced

Trend Percentages Example Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis

Trend Percentages Example Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis 1,991 - 1,820 = 171

Trend Percentages Example Using 2008 as the base year, we develop the following percentage relationships 1,991 - 1,820 = 171 171 ÷ 1,820 = 9% rounded

Trend line for Sales

Important Considerations Need for comparable data Data is provided by the media etc. Must compare by industry Is EPS comparable? Influence of external factors General business conditions Seasonal nature of business operations