Module 3: Financial Statement Analysis ACG 2071 Fall 2007 Created by M. Mari

Basic Analytical Procedures  The basic financial statements provide much of the information users need to make economic decisions about businesses.  In order to make decisions, we must analyze the financial statements.  Horizontal Analysis Percentage analysis of increases and decreases in related items in comparative financial statements. Comparing of income statements for two years Comparing of balance sheets for two years

Horizontal analysis AmountPercent Assets Current assets$550,000$533,000$17,0003.2% Fixed assets$445,000$470,000-$25, % Total assets$995,000$1,003,000-$8, % Liabilities Current liabilities$200,000$150,000$50,00025% Long term liabilities$100,000$125,000-$20,000-20% Total liabilities$300,000$275,000$30,0005% Equity Common stock$500,000$428,000$72,00017% Retained earinings 195,000$300,000$105,000-35% Total equity$695,000$728,000$33,000-18% Total liab & equity$995,000$1,003,000- $8, %

Vertical Analysis A percentage analysis may also be used to show the relationship of each component to the total within a single statement. Balance sheet  Each asset is shown as percentage of total assets  Each liability as percentage of total liabilities Income statement  Each item is shown as percentage of net sales. Common size statements  Can be used to compare to companies in the same industry

Solvency Analysis  Solvency is the ability of a company to pay its debts.  Profitability is the ability of a business to earn income. They are interrelated.  Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities. Assessed by examining balance sheet relationships Major analyses are:  Current position analysis  Accounts receivable analysis  Inventory analysis  The ratio of fixed assets to long-term liabilities  The number of times interest charges are earned.

Example Company A Company B Current Assets Cash $ 78, $ 82, $ 160, $ 112, Marketable Securities $ 52, $ 60, $ 85, $ 26, Accounts receivable $ 106, $ 152, $ 208, $ 172, Inventories $ 218, $ 260, $ 350, $ 312, Prepaid Expenses $ 6, $ 4, $ 10, Total current assets $ 460, $ 558, $ 813, $ 633, Current liabilities $ 320, $ 480, $ 705, $ 375,000.00

Solvency Analysis  Current Position Analysis Measures to assess a business’s ability to pay its current liabilities Special interest to short-term creditors Working Capital  Current assets minus current liabilities  Used in evaluating a company’s ability to meet currently maturing debts. Current Ratio  Working capital ratio or banker’s ratio  Computed by dividing current assets by current liabilities

Example Company A Company B Working Capital Current assets - current liabilities $ 140, $ 78, $ 108, $ 258, Current ratio / / / / current assets/current liabilities

Solvency Quick Ratio:  A ratio that measures the instant debt paying ability of a company  Also called the acid test ratio  Ratio of quick assets to total current liabilities  Quick assets are cash and other current assets that can be quickly converted to cash such as marketable securities and accounts receivables

Quick Ratio Example Company A Current Assets Cash $ 78, $ 82, Marketable Securities $ 52, $ 60, Accounts receivable $ 106, $ 152, Total Quick Assets $ 236, $ 294, Total current liabilities $ 320, $ 480, Quick ratio / / quick assets/ current liabilities0.70.6

Accounts receivable analysis  The size and makeup of accounts receivable change constantly during business operations  Companies desire to collect receivables as promptly as possible  Cash collected from receivables improve solvency  Accounts receivable turnover Relationship between sales and accounts receivable Computed by net sales divided by average net accounts receivable Average of accounts receivable  Beginning balance plus ending balance divided by 2 Higher the turnover the better.

Example Company A Net sales $ 1,500, $ 998, Accounts receivable Beginning of year $ 152, $ 208, End of Year $ 76, $ 152, Average Accounts Receivable ( )/2 ( )/2 $ 114, $ 180, Accounts receivable turnover / /

Number of days sales in receivables  Ratio is computed by dividing the average accounts receivable by the average daily sales. Average daily sales is net sales divided by 365 days  Lower the ratio the better

Example Company A Net sales $ 1,500, $ 998, Accounts receivable Beginning of year $ 152, $ 208, End of Year $ 76, $ 152, Average Accounts Receivable ( )/2 ( )/2 $ 114, $ 180, Average daily sales / /365 $ 4, $ 2, Number of days sales in receivables / /

Inventory Analysis  Inventory has to be managed carefully Too little inventory can cause customers to seek the product from another supplier Too much inventory can increase storage costs, insurance, and obsolescence.

Inventory Turnover  Relationship between the volume of goods sold and inventory  Computed by cost of goods sold divided by average inventory  Average inventory is beginning inventory plus ending inventory divided by 2  Higher the ratio the better

Example Company A Cost of goods sold $ 765, $ 820, Inventories Beginning of year $ 312, $ 423, End of year $ 189, $ 312, Average inventory ( )/2 ( )/2 $ 250, $ 367, Inventory Turnover / /

Number of days’ sales in inventory Relationship between cost of goods sold and inventory Computed by dividing the average inventory by the average daily cost of goods sold ( COGS/365 days) Rough measure of the length of time it takes to acquire, sell, and replace inventory Lower the ratio the better

Example Company A Cost of goods sold $ 765, $ 820, Inventories Beginning of year $ 312, $ 423, End of year $ 189, $ 312, Average inventory ( )/2 ( )/2 $ 250, $ 367, Average COGS / /365 2,095.92,246.6 Number of days sales in inventory / /

Ratio of fixed assets to long-term liabilities  Indicates the margin of safety of the noteholders or bondholders  Indicates the ability of the business to borrow additional funds on a long- term basis.  Higher the better Company A Fixed assets (net) $ 350, $ 480, Long-term liabilities $ 175, $ 210, Ratio of fixed assets to long-term liabilities2.02.3

Ratio of liabilities to stockholder’s equity  Claims against the total assets of a business are divided into two groups Claims of creditors Claims of owners  the relationship between the total claims of the creditors and owners  solvency measure that indicates the margin of safety for creditors  indicates the ability of the business to withstand adverse business conditions when the claims of creditors are large in relation to the equity of the stockholders, there are usually significant interest payments. If earnings decline to the point that company is unable to meet interest payments, creditors may take over the business.  lower the better

Example Company A Total liabilities $ 425, $ 375, Total stockholder's Equity $ 680, $ 503, Ratio of fixed assets to long-term liabilities0.60.7

Number of times interest charges earned  Called the fixed charge coverage ratio  The relative risk of the debtholders is normally measured  Higher the ratio, the lower the risk that interest payments will not be made if earnings decrease.  Indicates general financial strength of the business

Example Company A Income before taxes $ 150, $ 145, Add interest expense $ 4, $ 6, Amount available to meet interest charges154, ,800.0 Number of times interest charges earned154500/ /

Profitability Analysis The ability of a business to earn profits depends of the effectiveness and efficiency of its operations as well as the resources available to it. Focuses primarily on the relationship between operating results as reported in the income statement and resources available to the business as reported in the balance sheet Major analysis used  Ratio of net sales to assets  Rate earned on total assets  Rate earned on stockholder’s equity  Rate earned on common stockholder’s equity  Earnings per share on common stock  Price-earning ratio  Dividends per share  Dividend yield

Ratio of net sales to assets  Is a profitability measure that shows how effectively a firm utilizes its assets  Higher the ratio is better  Computed by dividing net sales by average total assets (beginning total assets + ending total assets)/2

Example Company A Net sales $ 765, $ 820, Total assets Beginning of year $ 980, $ 800, End of year $ 1,020, $ 980, Average Total Assets ( )/2 ( )/2 $ 1,000, $ 890, Ratio of net sales to total assets / /

Rate earned on total assets  Measures the profitability of total assets without considering how the assets are financed.  Higher the ratio is better  Computed by adding interest expense to net income and then dividing by average total assets

Example Company A Net income $ 165, $ 250, Plus interest expense $ 6, $ 19, TOTAL $ 171, $ 269, Total assets Beginning of year $ 980, $ 800, End of year $ 1,020, $ 980, Average Total Assets ( )/2 ( )/2 $ 1,000, $ 890, Rate earned on total assets / /

Rate earned on stockholder’s equity  The measures emphasizes the rate of income earned on the amount invested by the stockholders.  Higher the ratio is better  Computed by net income divided by average stockholder’s equity  The rate earned by a business on the equity of its stockholders is usually higher than the rate earned on total assets. Occurs when the amount earned on assets acquired with creditors’ funds is more than the interest paid to creditors The difference in the rate on stockholder’s equity and the rate on total assets is called  LEVERAGE

Example Company A Net income $ 165, $ 250, Stockholder's equity Beginning of year $ 1,250, $ 800, End of year $ 1,500, $ 1,250, Average Total Assets ( )/2 ( )/2 $ 1,375, $ 1,025, Rate earned on stockholder’s equity / / Rate earned on assets12%24% 20%30% LEVERAGE8%6%

Rate earned on common stockholder’s equity  Common stockholder’s have a residual claim on earnings  This measure focuses only on the rate of profits earned on the amount invested by the common stockholders  Computed by subtracting the preferred dividends requirements from the net income and dividing by the average common stockholder’s equity..  Higher the ratio is better

Example Company A Net income $ 165, $ 250, Preferred dividends $ 9, TOTAL $ 174, $ 259, Common Stockholder's equity Beginning of year $ 850, $ 600, End of year $ 950, $ 850, Average Total Assets ( )/2 ( )/2 $ 900, $ 725, Rate earned on common stockholder's equity / / %36%

Earnings per share (EPS)  Normally reported in the income statement on corporate annual reports  Computed by dividing net income by the number of shares of stock outstanding  If preferred and common stock are outstanding, the net income is reduced by the amount of preferred stock dividends.

Example Company A Net income $ 165, $ 250, Preferred dividends $ 9, TOTAL $ 174, $ 259, Shares of common stock EPS / /45000 $ 3.48 $ 5.76

Price-Earnings Ratio  Indicator of a firm’s future earnings prospects  Computed by dividing the market price per share of common stock at a specific date by the annual earnings per share. Company A Market price per share $ $ Earnings per share $ 1.52 $ 1.36 Price earnings ratio

Dividends per share and dividend yield  Indicator of a firm’s future earnings prospects  Computed by dividing the dividends per share by the market price Compa ny A Dividends per share $ 0.80 $ 1.20 Market price per share $ $ Dividend yield