Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. To make informed decisions about a company Helpful in managing the company Comparison with competition Charting a company’s progress, measure performance Establish financial health Used for investment decisions Generally based on comparative financial data From one year to the next With a competing company With the industry as a whole. 1

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Three main ways to analyze financial statements Horizontal analysis Year-to-year comparison Vertical analysis Compare different companies Using industry averages Compare company’s performance against the industry averages 2

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Perform a horizontal analysis of financial statements 1 1 3

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The study of percentage changes in comparative statements Compute dollar changes Compute percentage changes 4

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Step 1 Step 2 5

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 6

Form of horizontal analysis Indicates business direction How have things changed over the years? Select a period of three to five years Base year, earliest year, is selected and set equal to 100% Subsequent years expressed as a percentage of the base period 7

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Data for Mariner Designs, Inc., follow: 1. Prepare a horizontal analysis of the comparative income statement of Mariner Designs, Inc. Round percentage changes to one decimal place. 8 MARINER DESIGNS, INC. Comparative Income Statement Years Ended December 31, 2012 and Net sales revenue$ 431,000$ 372,350 Expenses: Cost of goods sold $ 200,000 $ 187,550 Selling and general expenses 99,000 91,050 Other expense 8,350 6,850 Total expenses $ 307,350 $ 285,450 Net income $ 123,650 $ 86,900

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 9 MARINER DESIGNS, INC. Comparative Income Statement Years Ended December 31, 2012 and 2011 Increase (Decrease) AmountPercent Net sales revenue$ 431,000$ 372,350$ 58, % Expenses: Cost of goods sold$ 200,000$ 187,550$ 12, % Selling and general expenses 99,00091,0507, % Other expense8,3506,8501, % Total expenses$ 307,350$ 285,45021, % Net income$ 123,650$ 86,900$ 36, %

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Data for Mariner Designs, Inc., follow: 2. Why did 2012 net income increase by a higher percentage than net sales revenue? Revenues increase at a higher rate than total expenses. 10

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Perform a vertical analysis of financial statements

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Shows relationship of each item to a base amount on financial statements Income statement–each item expressed as percentage of net sales Balance sheet–each item expressed as percentage of total assets or total liabilities and equity. Remember total assets = total liabilities and equity 12

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Base amount Percentage of the base amount 13

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Base amount Percentage of base 14

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Tri-State Optical Company reported the following amounts on its balance sheet at December 31, 2012 and 2011: Prepare a vertical analysis of Tri-State assets for 2012 and Cash and receivables$ 54,530$ 46,860 Inventory42,43532,670 Property, plant, and equipment, net108,03585,470 Total assets$ 205,000$ 165, % of total 2011% of total Cash and receivables$ 54,530$ 46,860 Inventory42,43532,670 Property, plant, and equipment, net108,03585,470 Total assets$ 205,000$ 165,

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Prepare and use common-size financial statements

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Common-size statements compare one company to another Report only percentages (same as vertical analysis) Remove dollar value bias 17

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Comparing a company with another leading company Two main types: Against a key competitor Against the industry average 18

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Data for Martinez, Inc., and Rosado, Corp., follow: 1. Prepare common-size income statements. 19 MartinezRosado Net sales$ 10,600$ 18,600 Cost of goods sold6,45513,522 Other expenses3,5414,185 Net income$ 604$ 893 MartinezRosado Net sales 100 % Cost of goods sold60.9 %72.7 % Other expenses33.4 %22.5 % Net income5.7 %4.8 %

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. (Continued) 2. Which company earns more net income? 3. Which company’s net income is a higher percentage of its net sales? 20 MartinezRosado Net sales100 % Cost of goods sold60.9 %72.7 % Other expenses33.4 %22.5 % Net income5.7 %4.8 % Rosado Martinez

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Compute and evaluate the standard financial ratios

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. No single ratio tells the whole picture Different ratios explain different aspects Types: Evaluating ability to pay current liabilities Evaluating ability to sell inventory and collect receivables Evaluating ability to pay long-term debt Evaluating profitability Evaluating stock as an investment 22

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Working capital Measures ability to meet short-term obligations Working capital = Current assets – Current liabilities Current ratio Proportion of current assets to current liabilities Acceptable current ratio Current assets Current liabilities Current ratio =

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Acid-test ratio Tells if company could pay all its current liabilities immediately Normal range 0.20 to 1.00 depending upon industry 24 Cash + Short-term investments + Net current receivables Current liabilities Acid-test Ratio =

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Inventory turnover ratio Measures number of times a company sells inventory during a year High rate indicates ease in selling Low rate indicates difficulty in selling Formula 25 Inventory turnover = Cost of goods sold Average inventory

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Days in inventory ratio Measures the average number of days inventory is held by the company Formula 26 Days in inventory = 365 days Inventory turnover ratio

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Gross profit percentage Measures the profitability of each net sales dollar Formula 27 Gross profit percentage = Gross profit Net sales

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Accounts receivable turnover ratio Measures ability to collect cash from credit customers Formula 28 Accounts receivable turnover = Net credit sales Average net accounts receivable

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Days’ sales in receivables ratio Measures ability to collect receivables Formula 29 Days’ sales in average accounts = receivable 365 days Accounts receivable turnover ratio

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Debt ratio Shows portion of assets financed with debt The higher the ratio, the higher the risk Formula Average debt ratio ranges from 57% to 67% 30 Debt ratio = Total liabilities Total assets

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Debt to equity ratio The proportion of total liabilities to the proportion of total equity that is financing the company’s assets Formula 31 Debt to equity = Total liabilities Total equity

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Times-interest-earned ratio Measures number of times income can cover interest expense High ratio indicates ease in paying interest Formula 32 Times-interest earned ratio = Earnings Before Interest and Taxes Interest expense

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Return on net sales Percent of each sales dollar earned as net income Formula 33 Rate of return on net sales = Net income Net sales

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Return on total assets Measures success in using assets to earn a profit Formula 34 Rate of return on total assets = Net income + Interest expense Average total assets

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Asset turnover ratio Measures the amount of net sales generated for each average dollar of total assets invested Formula 35 Asset turnover ratio = Net sales Average total assets

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Return on common stockholders’ equity How much income is earned for each dollar invested by common shareholders Formula 36 Rate of return on common stockholders’ equity = Net income – Preferred dividends Average common stockholders’ equity

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Trading on the equity Company borrows at a lower rate, then invests the money to earn a higher rate Return on Equity > Return on Assets Increases profits during goods times Compounds losses during bad times 37

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Earnings per share Net income earned for each share of outstanding common stock Outstanding stock = Issued stock – Treasury stock Formula 38 Earnings per share of common stock = Net income – Preferred Dividends Number of shares of common stock outstanding

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Price/earnings ratio (P/E) Market price compared to earnings per share Formula 39 P/E ratio = Market price per share of common stock Earnings per share

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Dividend yield Percentage of market value that is returned as dividends Formula 40 Dividend yield on common stock = Annual dividends per share of common stock Market price per share of common stock

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Dividend Payout The ratio of annual dividends declared relative to the earnings per share of the company Formula 41 Dividend Payout = Annual dividends per share Earnings per share

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Book value Common equity per share Some argue its relevance to investors Formula 42 Book value per share of common stock = Total stockholders’ equity – Preferred equity Number of shares of common stock outstanding

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Win’s Companies, a home improvement store chain, reported the following summarized figures: 43

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. (Continued) 1.Compute Win’s Companies’ current ratio at May 31, 2012 and Did Win’s Companies’ current ratio improve, deteriorate, or hold steady during 2012? 44 Current assets Current liabilities Current ratio = $ 54,300,000/$ 33,000,000 = $ 25,200,000/$ 13,100,000 = 1.92 Win’s Companies current ratio deteriorated.

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use the Win’s Companies data in Short Exercise 15-5 to complete the following requirements. 1.Compute the rate of inventory turnover, days in inventory, and gross profit percentage for Inventory turnover = Cost of goods sold Average inventory Days in inventory = 365 days Inventory turnover ratio Gross profit percentage = Gross profit Net sales $ 28,400,000/($6,900,000 + $8,200,000)/2 = /3.76 = 97 days $21,800,000/$50,200,000 = 43.4 %

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. (Continued) 2. Compute days’ sales in average receivables during Round dollar amounts to three decimal places /($ 50,200,000/($7,400,000 + $5,300,000)/2 ) = 46 days Days’ sales in average accounts = receivable 365 days Accounts receivable turnover ratio Accounts receivable turnover = Net credit sales Average net accounts receivable

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use the financial statements of Win’s Companies in Short Exercise Compute the debt ratio and the debt to equity ratio at May 31, Is Win’s ability to pay its liabilities strong or weak? Explain your reasoning. 47 Debt ratio = Total liabilities Total assets Debt to equity = Total liabilities Total equity $ 45,300,000 / $ 88,300,000 = 51.3 $ 45,300,000 / $ 43,000,000 = 1.05 The company’s ability to pay its liabilities is strong since the debt ratio is low.

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use the financial statements of Win’s Companies in Short Exercise 15-5 to complete the following profitability measures for Compute the rate of return on net sales. 2. Compute the rate of return on total assets. 3. Compute the asset turnover ratio. 48 Rate of return on net sales = Net income Net sales $ 15,500,000 / $ 50,200,000 = 30.9% Rate of return on total assets = Net income + Interest expense Average total assets $ 15,500, ,000 / ($ 88,300,000 + $ 51,200,000)/2 = 22.9% Asset turnover ratio = Net sales Average total assets $ 50,200,000 / ($ 88,300,000 + $ 51,200,000)/2 = 0.72

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. (Continued) 4. Compute the rate of return on common stockholders’ equity. 5. Are these rates of return strong or weak? Explain your reasoning. 49 Rate of return on common stockholders’ equity = Net income – Preferred dividends Average common stockholders’ equity $ 15,500,000 – 0 / ($ 43,000,000 + $ 27,500,000) /2 = 44.0 % These rates of return are strong considering that average companies present much lower rates of return.

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Use the financial statements of Win’s Companies in Short Exercise Win’s has 500,000 common shares outstanding during Compute earnings per share (EPS) for Win’s. Round to the nearest cent. 2. Compute Win’s Companies’ price/earnings ratio. The market price per share of Win’s stock is $ Earnings per share of common stock = Net income – Preferred Dividends Number of shares of common stock outstanding $ 15,500,000 – 0/500,000 = $31.00 P/E ratio = Market price per share of common stock Earnings per share $68.50/$31.00 = 2.2 times

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Analysts look for red flags that may signal financial trouble Recent accounting scandals highlight the importance of: Movement of sales, inventory, and receivables Earnings problems Decreased cash flow Too much debt Inability to collect receivables Buildup of inventory 51