©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Financial Statement Analysis Chapter 18

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber The Annual Report Usually Contains... – financial statements. – notes to the financial statements. – a summary of accounting methods used. – management discussion and analysis of the financial statements. – an auditor’s report. – comparative financial data for 5 to 10 years.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Objective 1 Perform a horizontal analysis of financial statements.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Horizontal Analysis Increase/(Decrease) AmountPercent Sales$41,500$37,850$3, % Expenses 40,000 36,900 3, % Net income 1, %

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Difference Sales$41,500$37,850$3,650 $3,650 ÷ $37,850 =.0964, or 9.6% Horizontal Analysis

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Trend Percentages... – are computed by selecting a base year whose amounts are set equal to 100%. l The amounts of each following year are expressed as a percentage of the base amount. Trend % = Any year $ ÷ Base year $

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Year Revenues$27,611$24,215$21,718 Cost of sales 15,318 14,709 13,049 Gross profit$12,293$ 9,506$ 8, is the base year. What are the trend percentages? Trend Percentages

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Year Revenues127%111%100% Cost of sales117%113%100% Gross profit142%110%100% Trend Percentages These percentages were calculated by dividing each item by the base year.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Objective 2 Perform a vertical analysis of financial statements.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Vertical Analysis... – compares each item in a financial statement to a base number set to 100%. l Every item on the financial statement is then reported as a percentage of that base.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Vertical Analysis 1999 % Revenues$38, Cost of sales 19, Gross profit$18, Total operating expenses 13, Operating income$ 5, Other income 2, Income before taxes$ 7, Income taxes 2, Net income$ 4,

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Vertical Analysis Assets 1999 % Current assets: Cash$ 1, Receivables net 10, Inventories 6, Prepaid expenses 3, Total current assets$21, Plant and equipment, net 6, Other assets 9, Total assets$38,

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Objective 3 Prepare common-size financial statements.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Common-size Statements l On the income statement, each item is expressed as a percentage of net sales. l On the balance sheet, the common size is the total on each side of the accounting equation. l Common-size statements are used to compare one company to other companies, and to the industry average.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Benchmarking Percent of Net Sales MCILucent Technologies Cost of goods sold Operating expenses Income tax Net income

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Objective 4 Compute the standard financial ratios.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Ratio Classification 1 Measuring ability to pay current liabilities 2 Measuring ability to sell inventory and collect receivables 3 Measuring ability to pay short-term and long-term debt 4 Measuring profitability 5 Analyzing stock as an investment

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Palisades Furniture Example Net sales (Year 2002)$858,000 Cost of goods sold 513,000 Gross profit$345,000 Total operating expenses 244,000 Operating income$101,000 Interest revenue 4,000 Interest expense (24,000) Income before taxes$ 81,000 Income taxes 33,000 Net income$ 48,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Palisades Furniture Example Assets20x2 20x1 Current assets: Cash$ 29,000$ 32,000 Receivables net 114,000 85,000 Inventories 113, ,000 Prepaid expenses 6,000 8,000 Total current assets$262,000$236,000 Long-term investments 18,000 9,000 Plant and equipment, net 507, ,000 Total assets$787,000$644,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Palisades Furniture Example Liabilities20x2 20x1 Current liabilities: Notes payable$ 42,000$ 27,000 Accounts payable 73,000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities$142,000$126,000 Long-term debt 289, ,000 Total liabilities$431,000$324,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Stockholders’ Equity 20x2 20x1 Common stock, no par$186,000$186,000 Retained earnings 170, ,000 Total stockholders’ equity$356,000$320,000 Total liabilities and stockholders’ equity$787,000$644,000 Palisades Furniture Example

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Current ratio = Total current assets ÷ Total current liabilities Current ratio = Total current assets ÷ Total current liabilities The current ratio measures the company’s ability to pay current liabilities with current assets. The current ratio measures the company’s ability to pay current liabilities with current assets. Measuring Ability to Pay Current Liabilities

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Ability to Pay Current Liabilities l Palisades’ current ratio: l 20x1: $236,000 ÷ $126,000 = 1.87 l 20x2: $262,000 ÷ $142,000 = 1.85 l The industry average is l The current ratio decreased slightly during 20x2.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷ Total current liabilities Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷ Total current liabilities Measuring Ability to Pay Current Liabilities The acid-test ratio shows the company’s ability to pay all current liabilities if they come due immediately. The acid-test ratio shows the company’s ability to pay all current liabilities if they come due immediately.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Ability to Pay Current Liabilities l Palisades’ acid-test ratio: l 20x1: ($32,000 + $85,000) ÷ $126,000 =.93 l 20x2: ($29,000 + $114,000) ÷ $142,000 = 1.01 l The industry average is.60. l The company’s acid-test ratio improved considerably during 20x2.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Inventory turnover = Cost of goods sold ÷ Average inventory Inventory turnover = Cost of goods sold ÷ Average inventory Inventory turnover is a measure of the number of times the average level of inventory is sold during a year. Inventory turnover is a measure of the number of times the average level of inventory is sold during a year. Measuring Ability to Sell Inventory

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Ability to Sell Inventory l Palisades’ inventory turnover: l 20x2: $513,000 ÷ $112,000 = 4.58 l The industry average is l A high number indicates an ability to quickly sell inventory.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accounts receivable turnover = Net credit sales ÷ Average accounts receivable Accounts receivable turnover = Net credit sales ÷ Average accounts receivable Accounts receivable turnover measures a company’s ability to collect cash from credit customers. Accounts receivable turnover measures a company’s ability to collect cash from credit customers. Measuring Ability to Collect Receivables

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Ability to Collect Receivables l Palisades’ accounts receivable turnover: l 20x2: $858,000 ÷ $99,500 = 8.62 times l The industry average is 22.2 times. l Palisades’ receivable turnover is much lower than the industry average. l The company is a home-town store that sells to local people who tend to pay their bills over a lengthy period of time.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber One day’s sales = Net sales ÷ 365 days Days’ sales in Accounts Receivable = Average net Accounts Receivable ÷ One day’s sales Days’ sales in Accounts Receivable = Average net Accounts Receivable ÷ One day’s sales Measuring Ability to Collect Receivables Days’ sales in receivable ratio measures how many day’s sales remain in Accounts Receivable. Days’ sales in receivable ratio measures how many day’s sales remain in Accounts Receivable.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Ability to Collect Receivables l Palisades’ days’ sales in Accounts Receivable for 20x2: l One day’s sales: l $858,000 ÷ 365 = $2,351 l Days’ sales in Accounts Receivable: l $99,500 ÷ $2,351 = 42 days l The industry average is 16 days.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Total liabilities ÷ Total assets Measuring Ability to Pay Debt The debt ratio indicates the proportion of assets financed with debt. The debt ratio indicates the proportion of assets financed with debt.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Ability to Pay Debt l Palisades’ debt ratio: l 20x1: $324,000 ÷ $644,000 = 0.50 l 20x2: $431,000 ÷ $787,000 = 0.55 l The industry average is l Palisades Furniture expanded operations during 20x2 by financing through borrowing.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Times-interest-earned = Income from operations ÷ Interest expense Times-interest-earned = Income from operations ÷ Interest expense Measuring Ability to Pay Debt Times-interest-earned ratio measures the number of times operating income can cover interest expense. Times-interest-earned ratio measures the number of times operating income can cover interest expense.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Ability to Pay Debt l Palisades’ times-interest-earned ratio: l 20x1: $ 57,000 ÷ $14,000 = 4.07 l 20x2: $101,000 ÷ $24,000 = 4.21 l The industry average is l The company’s times-interest-earned ratio increased in 20x2. l This is a favorable sign.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Rate of return on net sales = Net income ÷ Net sales Rate of return on net sales = Net income ÷ Net sales Measuring Profitability Rate of return on net sales shows the percentage of each sales dollar earned as net income. Rate of return on net sales shows the percentage of each sales dollar earned as net income.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Profitability l Palisades’ rate of return on sales: l 20x1: $26,000 ÷ $803,000 = l 20x2: $48,000 ÷ $858,000 = l The industry average is l The increase is significant in itself and also because it is much better than the industry average.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Rate of return on total assets = (Net income + interest expense) ÷ Average total assets Rate of return on total assets = (Net income + interest expense) ÷ Average total assets Measuring Profitability Rate of return on total assets measures how profitably a company uses its assets. Rate of return on total assets measures how profitably a company uses its assets.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Profitability l Palisades’ rate of return on total assets for 20x2: l ($48,000 + $24,000) ÷ $715,500 = l The industry average is l How does Palisades compare to the industry? l Very favorably.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Rate of return on common stockholders’ equity = (Net income – preferred dividends) ÷ Average common stockholders’ equity Rate of return on common stockholders’ equity = (Net income – preferred dividends) ÷ Average common stockholders’ equity Measuring Profitability Common equity includes additional paid-in capital on common stock and retained earnings. Common equity includes additional paid-in capital on common stock and retained earnings.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Profitability l Palisades’ rate of return on common stockholders’ equity for 20x2: l ($48,000 – $0) ÷ $338,000 = l The industry average is l Why is this ratio larger than the return on total assets (.101)? l Because Palisades uses leverage.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Profitability Earnings per share of common stock = (Net income – Preferred dividends) ÷ Number of shares of common stock outstanding Earnings per share of common stock = (Net income – Preferred dividends) ÷ Number of shares of common stock outstanding

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Measuring Profitability l Palisades’ earnings per share: l 20x1: ($26,000 – $0) ÷ 10,000 = $2.60 l 20x2: ($48,000 – $0) ÷ 10,000 = $4.80 l This large increase in EPS is considered very unusual.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Analyzing Stock as an Investment l Price/earning ratio is the ratio of market price per share to earnings per share. l 20x1: $35 ÷ $2.60 = 13.5 l 20x2: $50 ÷ $4.80 = 10.4 l Given Palisades Furniture’s 20x2 P/E ratio of 10.4, we would say that the company’s stock is selling at 10.4 times earnings.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Dividend per share of common (or preferred) stock ÷ Market price per share of common (or preferred) stock Dividend per share of common (or preferred) stock ÷ Market price per share of common (or preferred) stock Analyzing Stock as an Investment Dividend yield shows the percentage of a stock’s market value returned as dividends to stockholders each period. Dividend yield shows the percentage of a stock’s market value returned as dividends to stockholders each period.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Analyzing Stock as an Investment l Dividend yield on Palisades’ common stock: l 20x1: $1.00 ÷ $35.00 =.029 (2.9%) l 20x2: $1.20 ÷ $50.00 =.024 (2.4%) l An investor who buys Palisades Furniture common stock for $50 can expect to receive 2.4% of the investment annually in the form of cash dividends.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Analyzing Stock as an Investment Book value per share of common stock = (Total stockholders’ equity – Preferred equity) ÷ Number of shares of common stock outstanding Book value per share of common stock = (Total stockholders’ equity – Preferred equity) ÷ Number of shares of common stock outstanding

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Analyzing Stock as an Investment l Book value per share of palisades’ common stock: l 20x1: ($320,000 – $0) ÷ 10,000 = $32.00 l 20x2: ($356,000 – $0) ÷ 10,000 = $35.60 l Book value bears no relationship to market value.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Objective 5 Use ratios in decision making.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Limitations of Financial Analysis l Business decisions are made in a world of uncertainty. l No single ratio or one-year figure should be relied upon to provide an assessment of a company’s performance.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Objective 6 Measure economic value added.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Economic Value Added (EVA®) l Economic value added (EVA®) combines accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth. l EVA® = Net income + Interest expense – Capital charge

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber End of Chapter 18