Financial Statement Analysis Chapter 13 Financial Statement Analysis

Limitations and Considerations in Financial Statement Analysis Watch for alternative accounting principles Selection of a inventory valuation method Changes in accounting method Take care when making comparisons Recognizing trends in ratios Extra caution for extraordinary items and gains and losses from discontinued operations LO 1

Limitations and Considerations in Financial Statement Analysis (continued) Understand the possible effects of inflation Financial statements are based on historical costs and are not adjusted for the effects of increasing prices

Analysis of Comparative Statements: Horizontal Analysis Comparison of financial statement items over a period of time LO 2

Example 13.1—Preparing and Reading Comparative Balance Sheets—Horizontal Analysis

Example 13.2—Preparing and Reading Comparative Statements of Income and Retained Earnings—Horizontal Analysis

Example 13.3—Preparing and Reading Comparative Statements of Cash Flows—Horizontal Analysis

Analysis of Common-Size Statements: Vertical Analysis Comparison of various financial statement items within a single period with the use of common-size statements Common-size statements recast items as a percentage of a selected item LO 3

Example 13.4—Preparing and Reading Common-Size Balance Sheets—Vertical Analysis

Example 13.5—Preparing and Reading Common-Size Income Statements—Vertical Analysis

Liquidity Analysis A relative measure of the nearness to cash of the assets and liabilities of a company LO 4

Working Capital The excess of current assets over current liabilities at a point in time

Current Ratio The ratio of current assets to current liabilities One of the most widely used financial statement ratios

Acid-Test Ratio A stricter test of liquidity than the current ratio Excludes inventory and prepayments from the numerator

Cash Flow from Operations to Current Liabilities A measure of the ability to pay current debts from operating cash flows

Accounts Receivable Analysis Accounts receivable turnover ratio: a measure of the number of times accounts receivable are collected in a period Number of days’ sales in receivables: a measure of the average age of accounts receivable

Inventory Analysis Inventory turnover ratio: a measure of the number of times inventory is sold during a period Number of days’ sales in inventory: a measure of how long it takes to sell inventory

Cash-to-Cash Operating Cycle The length of time from the purchase of inventory to the collection of any receivable from the sale

Solvency Analysis The ability of a company to remain in business over the long term The ability of the firm to stay financially healthy over the period of time that existing debt (short- and long-term) is outstanding LO 5

Debt-to-Equity Ratio The ratio of total liabilities to total stockholders’ equity The composition of debt and equity is an important determinant of the cost of capital to a company

Times Interest Earned Ratio Indicates the company’s ability to meet the current year’s interest payments out of the current year’s earnings

Debt Service Coverage Ratio Measure of the amount of cash that is generated from operating activities during the year and that is available to repay interest due and any maturing principal amounts

Cash Flow from Operations to Capital Expenditures Ratio A measure of the ability of a company to finance long-term asset acquisitions with cash from operations

Profitability Analysis How well management is using company resources to earn a return on the funds invested by various groups Two frequently used profitability measures: = Gross Profit Gross Profit Ratio = Net Sales Net Income Profit Margin Ratio = Net Sales LO 6

Rate of Return on Assets A measure of a company’s success in earning a return for all providers of capital

Components of Return on Assets Return on sales ratio: a variation of the profit margin ratio Measures earnings before payments to creditors Asset turnover ratio: the relationship between net sales and average total assets

Return on Common Stockholders’ Equity Ratio A measure of a company’s success in earning a return for the common stockholders

Leverage The use of borrowed funds and amounts contributed by preferred stockholders to earn an overall return higher than the cost of these funds

Earnings per Share A company’s bottom line stated on a per-share basis

Price/Earnings Ratio The relationship between a company’s performance according to the income statement and its performance in the stock market

Dividend Ratios Dividend payout ratio: the percentage of earnings paid out as dividends Dividend yield ratio: the relationship between dividend and the market price of a company’s stock

Reporting and Analyzing Other Income Statement Items Each of these items is shown net of their tax effects Discontinued operations Extraordinary items Reported near the end of the income statement, after income from continuing operations Reported separately to call the reader’s attention to their unique nature LO 7

Discontinued Operations Reflect any gains or losses from the disposal of a segment Also, reflect any net income or loss from operating that segment

Extraordinary Items Reflect any gains or losses that arise from an event that is both unusual in nature and infrequent in occurrence

End of Chapter 13