1 Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Mowen/Hansen Financial Statement Analysis Chapter Sixteen Cornerstones of Managerial Accounting 2e

2 Common-Size Analysis Compares two financial statement periods or items within one financial statement period Line items expressed as percentages ◦Eliminates the effects of size Two major forms: ◦Horizontal analysis ∙Expresses a line item as a percentage of some prior- period amount ∙Allows the trend over time to be assessed ◦Vertical analysis ∙Concerned with relationships among items within a particular time period ∙Line items on income statement are expressed as a percentage of net sales ∙Line items on the balance sheet are expressed as a percentage of total assets

3 Ratio Analysis Fractions or percentages computed by dividing one account or line-item amount by another Help explain the financial well-being of a company when used as a comparison Common comparison standards: ◦Company historical amounts ◦Industry averages ∙Key Business Ratios ∙Standard and Poor’s Industry Survey ∙Annual Statement Studies ∙The Almanac of Business and Industrial Financial Ratios ∙Dow Jones-Irwin Business and Investment Almanac

4 Classification of Ratios Liquidity Ratios ◦Measure the ability of a company to meet its current obligations Leverage Ratios ◦Measure the ability of a company to meets its long- and short-term obligations ◦Provide a measure of the degree of protection provided to a company’s creditors Profitability Ratios ◦Measure the earning ability of a company ◦Allow investors, creditors, and managers to evaluate the extent to which invested funds are being used efficiently

5 Liquidity Ratios Current Ratio ◦Current Assets ÷ Current Liabilities ◦Measure of the ability of a company to pay its short-term liabilities using short-term assets ◦Rule of thumb ◦2.0 ratio is needed to provide good debt-paying ability Quick or Acid-Test Ratios ◦Compares only the most liquid assets with current liabilities ◦Usual standard is ratio of 1.0

6 Liquidity Ratios Accounts Receivable Turnover Ratio ◦Measures how long it takes the company to turn its receivables into cash ◦Net Sales ÷ Average Accounts Receivable Inventory Turnover Ratio ◦Cost of Goods Sold ÷ Average Inventory ◦Measures how many times the average inventory turns over (sold) during the year

7 Ratio Definition Current ratio = Current assets ÷ Current liabilities

8 Ratio Definition Quick ratio = (Cash + Marketable Securities + Receivables) ÷ Current liabilities

9 Average Accounts Receivable = (Beginning Receivables + Ending Receivables) ÷ 2 Ratio Definition

10 Accounts Receivable Turnover Ratio = Net Sales ÷ Average Accounts Receivable Ratio Definition

11 Accounts Receivable in Days = Days in a year ÷ Accounts Receivable Turnover Ratio Ratio Definition

12 Average Inventory = (Beginning Inventory + Ending Inventory) ÷ 2 Ratio Definition

13 Inventory Turnover Ratio = Cost of Goods Sold ÷ Average Inventory Ratio Definition

14 Inventory Turnover in Days = Days in a year ÷ Inventory Turnover Ratio Ratio Definition

15 Leverage Ratios Times-Interest-Earned Ratio ◦(Income before taxes + Interest Expense) ÷ Interest Expense ◦Uses the income statement to assess a company’s ability to service its debt Debt Ratio ◦Measures the degree of protection afforded creditors in case of insolvency ◦Reflects the percentage of assets financed by creditors ◦Total Liabilities ÷ Total Assets Debt to Equity Ratio ◦Total Liabilities ÷ Total Stockholders’ Equity ◦Measures the amount of debt that is financed by stockholders

16 Times-Interest-Earned Ratio = (Income Before Taxes + Interest Expense) ÷ Interest Expense Ratio Definition

17 Debt Ratio = Total liabilities ÷ Total assets Ratio Definition

18 Debt to Equity Ratio = Total liabilities ÷ Total stockholders’ equity Ratio Definition

19 Profitability Ratios Return on Sales ◦Net Income ÷ Sales ◦Measures the efficiency of a firm ◦Tells what percentage of each sales dollar is earned as net income Return on Total Assets ◦Operating Income After Taxes ÷ Average Total Assets ◦Measures how efficiently total assets are used to generate profits

20 Profitability Ratios Return on Common Stockholders’ Equity ◦(Net Income – Preferred Dividends) ÷ Average Common Stockholders’ Equity ◦Measures the return the company generated on the common shareholders’ investment Earnings Per Share ◦(Net Income – Preferred Dividends) ÷ Average Common Shares ◦Measures the profit earned by the company for each share of common stock outstanding

21 Profitability Ratios Price-Earnings Ratio ◦Market Price Per Share ÷ Earnings Per Share ◦Measures the investors’ perceptions of a company’s future growth prospects Dividend Yield ◦Dividends Per Common Share ÷ Market Price Per Share ◦Measures a reasonable approximation of the total return accruing to an investor Payout Ratio ◦Common Dividends ÷ (Net Income – Preferred Dividends) ◦Tells an investor the proportion of earnings that a company pays in dividends

22 Return on Sales = Net Income ÷ Sales Ratio Definition

23 Average Total Assets = (Beginning Total Assets + Ending Total Assets) ÷ 2 Ratio Definition

24 Return on Total Assets = [Net Income + Interest Expense (1 – Tax Rate)] ÷ Average Total Assets Ratio Definition

25 Average Common Stockholders’ Equity = (Beginning Common Stockholders’ Equity + Ending Common Stockholders’ Equity) ÷ 2 Ratio Definition

26 Return on Stockholders’ Equity = (Net Income – Preferred Dividends) ÷ Average Common Stockholders’ Equity Ratio Definition

27 Return on Stockholders’ Equity = (Net Income – Preferred Dividends) ÷ Average Common Stockholders’ Equity Ratio Definition

28 Preferred Dividends = Preferred Stock × Dividend Rate Ratio Definition

29 Number of Common Shares = Common Stock ÷ Par Value per share Ratio Definition

30 Earnings Per Share = (Net Income – Preferred Dividends) ÷ Number of Common Shares Ratio Definition

31 Price-Earnings Ratio = Price per share ÷ Earnings Per Share Ratio Definition

32 Dividends Per Share = Dividends to Common Shareholders ÷ Number of Common Shares Ratio Definition

33 Dividends Yield = Dividends per share ÷ Market Price per share Ratio Definition

34 Dividend Payout Ratio = Common Dividends ÷ (Net Income – Preferred Dividends) Ratio Definition

35 Just-in-Time Manufacturing Environment Goals: ◦Reduce inventories ◦Increase quality If goals are being met: ◦Inventory turnover ratio should increase dramatically ◦Current ratio will drop ◦Quality costs as a percentage of sales should decrease