Prepared by Debby Bloom-Hill CMA, CFM

CHAPTER 14 Analyzing Financial Statements: A Managerial Perspective

Why Managers Analyze Financial Statements Managers analyze financial statements for a variety of reasons including: To control operations To assess the financial stability of vendors, customers, and other business partners To assess how their companies appear to investors and creditors Learning objective 1: Explain why managers analyze financial statements

Control of Operations Managers analyze financial statements to gain insight into whether their goals have been achieved or plans implemented successfully Managers expect that a successful implementation of their plans will be reflected in financial information If financial information is inconsistent with a successful implementation an investigation will be launched Learning objective 1: Explain why managers analyze financial statements

Assessment of Vendors, Customers, and Other Partners Another important reason for analyzing financial statements is to review the financial stability of vendors, customers, and other strategic partners Increasingly companies are establishing strong relationships with a small number of vendors willing to commit to high quality levels and short lead times Learning objective 1: Explain why managers analyze financial statements

Assessment of Vendors, Customers, and Other Partners Managers want to be confident that the vendor will be stable and continue in existence over the foreseeable future Companies analyze customers to assess whether they will be able to pay the amounts they owe Companies do not want to enter into partnerships with firms in financial difficulty Learning objective 1: Explain why managers analyze financial statements

Assessment of Appearance to Investors and Creditors Investors and creditors carefully analyze a company’s financial statements Managers should anticipate how their financial information will appear to stakeholders Managers can explain differences in the notes to the financial statements, or avoid transactions which cause differences Learning objective 1: Explain why managers analyze financial statements

Test Your Knowledge 1 Why do managers analyze financial statements? To control operations To assess vendors, customers and other business partners To assess appearance to investors and creditors All of the above Answer: d Learning objective 1: Explain why managers analyze financial statements

Horizontal and Vertical Analyses Horizontal analysis Analysis of the dollar value and percentage changes in financial statement amounts across time The dollar value of the change is the new value minus the old value for each financial statement amount The percentage change is the dollar value of the change divided by the old value for each financial statement amount Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Horizontal and Vertical Analyses Vertical analysis Also called common size analysis Analyze financial statement amounts in comparison to a base amount Divide each financial statement amount by total assets for the balance sheet Divide each financial statement amount by net sales for the income statement Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Analysis of the Balance Sheet The results of a partial horizontal analysis of the balance sheet are presented on the next slide What can we conclude? HGW is expanding (increases in land, buildings, furniture and fixtures, and equipment) Funded by debt and internally generated funds (retained earnings) Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Horizontal Analysis of the Balance Sheet Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Analysis of the Balance Sheet A vertical analysis of the balance sheet is presented on the next slide The primary asset accounts are merchandise inventory, land, and buildings All account balances are greater than 20 percent of total assets Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Vertical Analysis of the Balance Sheet Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Analyzing the Income Statement A horizontal and vertical analysis of the balance sheet is presented on the next two slides Both net sales and cost of goods sold have increased from 2013 to 2014 Gross profit has increased 43% The vertical analysis shows that net income has declined from 6.5% of sales to 5.6% of sales Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Horizontal Analysis Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Vertical Analysis Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Test Your Knowledge 2 Horizontal analysis evaluates: Comparable companies Changes in expenses as a percentage of sales Changes in expenses as a percent of total assets Changes in balances from one year to another Answer: d Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Test Your Knowledge 3 Vertical analysis evaluates: Changes in net sales as a percentage of total assets Changes in expenses as a percentage of sales Financial statement amounts in comparison to a base amount Changes in balances from one year to another Answer: c Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Earnings Management Accounting earnings can be manipulated to make performance appear stronger than it actually is Allegations of impropriety have been leveled against many companies, including: Enron Kroger Lucent, and Waste Management Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

Earnings Management Why do managers manipulate earnings? Managers often are evaluated and rewarded based on the level of firm earnings If earnings are below the specified bonus level, managers have an inventive to manipulate earnings Managers manipulate earnings to raise the stock price and profit from exercising stock options Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

Earnings Management A red flag suggesting that accounting irregularities may be a problem is a difference between net income and operating cash flows If a firm records fictitious sales income will increase but operating cash flows will not be affected The company does not collect cash from fictitious sales Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

Cash Flow versus Earnings Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

Other Sources of Information on Financial Performance A number of other information sources can be used to gain insight into a company’s financial performance Management discussion and analysis Contained in the annual report Management provides users with explanations for financial results that are not obvious from reading the basic financial statements Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

Other Sources of Information on Financial Performance A number of other information sources can be used to gain insight into a company’s financial performance Credit reports A number of firms sell credit reports that provide information on a company’s credit history The ratings help managers evaluate the likelihood that a company they do business with will pay its bills on time Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

Other Sources of Information on Financial Performance A number of other information sources can be used to gain insight into a company’s financial performance News articles are another very valuable source of financial information Lexis-Nexis is an example of a company that, for a fee, provides access to articles from major newspapers, magazines, and newswire services Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

Management Discussion & Analysis (MD&A) Example Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

Ratio Analysis Managers frequently perform financial analyses using various ratios To control operations To assess the stability of vendors, customers, and other business partners To assess how their companies appear to investors and creditors Learning objective 5: Calculate and interpret profitability ratios

Ratio Analysis Ratios are grouped into 3 categories Profitability ratios examine the firm’s ability to generate income Turnover ratios reveal the efficiency with which a company uses its assets Debt related ratios relate the amount of debt a company has and its ability to repay its obligations Learning objective 5: Calculate and interpret profitability ratios

Profitability Ratios Earnings per share Price-earnings ratio Amount of earnings generated per share of common stock The more earnings per share a company can generate, the higher its stock price Price-earnings ratio Indicates how much investors are willing to pay per dollar of earnings Learning objective 5: Calculate and interpret profitability ratios

Profitability Ratios Gross margin percentage Return on total assets Indicates how much a company earns per dollar of sales, taking into account the cost of the items it sells Return on total assets Indicates how profitable a company is in relation to its assets Return on common stockholders’ equity The return a company is able to earn on funds invested by shareholders Learning objective 5: Calculate and interpret profitability ratios

Profitability Ratio Formulas 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞= (𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞 −𝐩𝐫𝐞𝐟𝐞𝐫𝐫𝐞𝐝 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬) 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐜𝐨𝐦𝐦𝐨𝐧 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠 𝐏𝐫𝐢𝐜𝐞−𝐞𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐫𝐚𝐭𝐢𝐨= 𝐌𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞 𝐆𝐫𝐨𝐬𝐬 𝐦𝐚𝐫𝐠𝐢𝐧 𝐩𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞= 𝐆𝐫𝐨𝐬𝐬 𝐦𝐚𝐫𝐠𝐢𝐧 𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬 Learning objective 5: Calculate and interpret profitability ratios

Profitability Ratio Formulas 𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐭𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬= {𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞+[𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐄𝐱𝐩𝐞𝐧𝐬𝐞∗ 𝟏−𝐭𝐚𝐱 𝐫𝐚𝐭𝐞 ]} 𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬 𝐑𝐞𝐭𝐮𝐫𝐧 𝐨𝐧 𝐜𝐨𝐦𝐦𝐨𝐧 𝐬𝐭𝐨𝐜𝐤𝐡𝐨𝐥𝐝𝐞𝐫 𝐬 ′ 𝐞𝐪𝐮𝐢𝐭𝐲= (𝐍𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞 −𝐏𝐫𝐞𝐟𝐞𝐫𝐫𝐞𝐝 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬) 𝐂𝐨𝐦𝐦𝐨𝐧 𝐬𝐭𝐨𝐜𝐤𝐡𝐨𝐥𝐝𝐞𝐫 𝐬 ′ 𝐞𝐪𝐮𝐢𝐭𝐲 Learning objective 5: Calculate and interpret profitability ratios

Profitability Ratio Formulas Learning objective 5: Calculate and interpret profitability ratios

Profitability Ratio Formulas Learning objective 5: Calculate and interpret profitability ratios

Turnover Ratios Asset turnover Accounts receivable turnover Shows how efficiently assets are used to generate sales Accounts receivable turnover The more times accounts receivable turn over, the sooner they are collected Days’ sales in receivables A measure of how long it will take to collect receivables Learning objective 6: Calculate and interpret turnover ratios

Turnover Ratios Inventory turnover Days’ sales in inventory Indicates how many times inventory turns over Generally, the higher the ratio, the more efficient the management of inventory levels Days’ sales in inventory A measure of how long it will take to sell inventory Learning objective 6: Calculate and interpret turnover ratios

Turnover Ratio Formulas 𝐀𝐬𝐬𝐞𝐭 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫= 𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬 𝐓𝐨𝐭𝐚𝐥 𝐚𝐬𝐬𝐞𝐭𝐬 𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫= 𝐍𝐞𝐭 𝐜𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬 𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝐃𝐚𝐲 𝐬 ′ 𝐬𝐚𝐥𝐞𝐬 𝐢𝐧 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬= 𝟑𝟔𝟓 𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 Learning objective 6: Calculate and interpret turnover ratios

Turnover Ratio Formulas 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫= 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐃𝐚𝐲 𝐬 ′ 𝐬𝐚𝐥𝐞𝐬 𝐢𝐧 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲= 𝟑𝟔𝟓 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫 Learning objective 6: Calculate and interpret turnover ratios

Turnover Ratio Formulas Learning objective 6: Calculate and interpret turnover ratios

Test Your Knowledge 4 The efficient use of assets is indicated by: Turnover ratios Debt-related ratios The ratio of debt to equity The ratio of current assets to current liabilities Answer: a Learning objective 6: Calculate and interpret turnover ratios

Debt-Related Ratios Current ratio Acid test ratio (quick ratio) A measure of a company’s ability to pay short term obligations Acid test ratio (quick ratio) Compared to the current ratio, a more stringent test of a company’s ability to pay short term obligations Learning objective 7: Calculate and interpret debt-related ratios

Debt-Related Ratios Debt to equity ratio Times interest earned A measure of the relative amount of debt versus equity in a firm’s capital structure. Firms with relatively high values may have too much debt Times interest earned A measure of a company’s ability to make interest payments on its debt Learning objective 7: Calculate and interpret debt-related ratios

Debt-Related Ratios 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐫𝐚𝐭𝐢𝐨= 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 𝐀𝐜𝐢𝐝 𝐭𝐞𝐬𝐭 𝐫𝐚𝐭𝐢𝐨 𝐪𝐮𝐢𝐜𝐤 𝐫𝐚𝐭𝐢𝐨 = (𝐂𝐚𝐬𝐡+𝐌𝐚𝐫𝐤𝐞𝐭𝐚𝐛𝐥𝐞 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐢𝐞𝐬+𝐒𝐡𝐨𝐫𝐭 𝐭𝐞𝐫𝐦 𝐫𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 𝐃𝐞𝐛𝐭 𝐭𝐨 𝐞𝐪𝐮𝐢𝐭𝐲 𝐫𝐚𝐭𝐢𝐨= 𝐓𝐨𝐭𝐚𝐥 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 𝐒𝐭𝐨𝐜𝐤𝐡𝐨𝐥𝐝𝐞𝐫 𝐬 ′ 𝐞𝐪𝐮𝐢𝐭𝐲 𝐓𝐢𝐦𝐞𝐬 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐞𝐚𝐫𝐧𝐞𝐝= 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐢𝐧𝐜𝐨𝐦𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐞𝐱𝐩𝐞𝐧𝐬𝐞 Learning objective 7: Calculate and interpret debt-related ratios

Debt-Related Ratios Learning objective 7: Calculate and interpret debt-related ratios

Too Much Debt Learning objective 7: Calculate and interpret debt-related ratios

Test Your Knowledge 5 The ratio times interest earned can be used to evaluate: The amount of debt versus equity financing The extent to which interest income exceeds interest expense The extent to which interest expense exceeds interest income The likelihood that a company will be able to make required interest payments Answer: d Learning objective 7: Calculate and interpret debt-related ratios

Strategic Partners Learning objective 7: Calculate and interpret debt-related ratios

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