17-1 CHAPTER 17 A NALYSIS A ND I NTERPRETATION O F F INANCIAL S TATEMENTS

17-2 Who analyzes financial statements? u Internal users (i.e., management) u External users (emphasis of chapter) Examples? Investors, creditors, regulatory agencies & … stock market analysts and auditors Financial Statement Analysis 625

17-3 l What do internal users use it for? Planning, evaluating and controlling company operations l What do external users use it for? Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management l First sentence in chapter says... Financial Statement Analysis

17-4 Information is available from u Published annual reports (1)Financial statements (2)Notes to financial statements (3)Letters to stockholders (4)Auditor’s report (Independent accountants) (5)Management’s discussion and analysis u Reports filed with the government Financial Statement Analysis

17-5 Information is available from u Other sources (1)Newspapers (2) Periodicals 3 ) Financial information organizations such (4)Other business publications Financial Statement Analysis

17-6 l Horizontal Analysis l Vertical Analysis l Common-Size Statements l Ratio Analysis Methods of Financial Statement Analysis

17-7 Horizontal Analysis Using comparative financial statements to calculate dollar or percentage changes in a financial statement item from one period to the next

17-8 Vertical Analysis For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

17-9 Common-Size Statements Financial statements that show only percentages and no absolute dollar amounts

17-10 Trend Percentages Show changes over time in given financial statement items (can help evaluate financial information of several years)

17-11 Ratio Analysis Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

17-12 Horizontal Analysis Example horizontal analysis The management of Clover Company provides you with comparative balance sheets of the years ended December 31, 1999 and Management asks you to prepare a horizontal analysis on the information.

17-13

17-14 Calculating Change in Dollar Amounts Dollar Change Current Year Figure Base Year Figure =– Horizontal Analysis Example

17-15 Calculating Change in Dollar Amounts Since we are measuring the amount of the change between 1998 and 1999, the dollar amounts for 1998 become the “base” year figures. Dollar Change Current Year Figure Base Year Figure =– Horizontal Analysis Example

17-16 Calculating Change as a Percentage Percentage Change Dollar Change Base Year Figure 100% = × Horizontal Analysis Example

17-17 $12,000 – $23,500 = $(11,500) Horizontal Analysis Example

17-18 ($11,500 ÷ $23,500) × 100% = 48.9% Horizontal Analysis Example

17-19 Horizontal Analysis Example

17-20 Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet. Horizontal Analysis Example

17-21

17-22 Now, let’s apply the procedures to the income statement. Horizontal Analysis Example

17-23

17-24 Sales increased by 8.3% while net income decreased by 21.9%.

17-25 There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

17-26 Vertical Analysis Example vertical analysis The management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company.

17-27 Vertical Analysis Example

17-28 Vertical Analysis Example $82,000 ÷ $483,000 = 17% rounded $30,000 ÷ $387,000 = 8% rounded

17-29 Vertical Analysis Example $76,000 ÷ $483,000 = 16% rounded

17-30 Trend Percentages Example Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.

17-31 Trend Percentages Example Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis. $1,991 - $1,820 = $171

17-32 Trend Percentages Example Using 1995 as the base year, we develop the following percentage relationships. $1,991 - $1,820 = $171 $171 ÷ $1,820 = 9% rounded

17-33 Trend line for Sales

17-34 Ratios can be expressed in three different ways: 1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of $2.25) CAUTION! “Using ratios and percentages without considering the underlying causes may be hazardous to your health!” lead to incorrect conclusions.” Ratios

17-35 Categories of Ratios l Liquidity Ratios Indicate a company’s short-term debt-paying ability l Equity (Long-Term Solvency) Ratios Show relationship between debt and equity financing in a company l Profitability Tests Relate income to other variables l Market Tests Help assess relative merits of stocks in the marketplace

17-36 Liquidity Ratios ¶Current (working capital) ratio ·Acid-test (quick) ratio u Cash flow liquidity ratio ¸Accounts receivable turnover ¹Number of days’ sales in accounts receivable ºInventory turnover u Total assets turnover Ratios You Must Know

17-37 Equity (Long-Term Solvency) Ratios »Equity (stockholders’ equity) ratio u Equity to debt 10 Ratios You Must Know

17-38 Profitability Tests u Return on operating assets “profit margin” ¼Net income to net sales (return on sales or “profit margin”) ROE ½Return on average common stockholders’ equity (ROE) u Cash flow margin ¾Earnings per share u Times interest earned u Times preferred dividends earned $ 10 Ratios You Must Know

17-39 Market Tests u Earnings yield on common stock ¿Price-earnings ratio u Payout ratio on common stock u Dividend yield on common stock u Dividend yield on preferred stock u Cash flow per share of common stock 10 Ratios You Must Know

17-40 Now, let’s look at Norton Corporation’s 1999 and 1998 financial statements.

17-41

17-42

17-43

17-44 Now, let’s calculate the 10 ratios based on Norton’s financial statements.

17-45 We will use this information to calculate the liquidity ratios for Norton.

17-46 Working Capital* The excess of current assets over current liabilities. * While this is not a ratio, it does give an indication of a company’s liquidity.

17-47 Current (Working Capital) Ratio Current Ratio $65,000 $42,000 ==1.55 : 1 Measures the ability of the company to pay current debts as they become due. Current Ratio Current Assets Current Liabilities = #1

17-48 Acid-Test (Quick) Ratio Quick Assets Current Liabilities = Acid-Test Ratio Quick assets are Cash, Marketable Securities, Accounts Receivable (net) and current Notes Receivable. #2

17-49 Quick Assets Current Liabilities = Acid-Test Ratio Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000. Acid-Test (Quick) Ratio #2

17-50 Quick Assets Current Liabilities = Acid-Test Ratio $50,000 $42,000 =1.19 : 1= Acid-Test Ratio Acid-Test (Quick) Ratio #2

17-51 Sales on Account Average Accounts Receivable Accounts Receivable Turnover = Accounts Receivable Turnover = times $494,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover = This ratio measures how many times a company converts its receivables into cash each year. #3 Average, net accounts receivable Net, credit sales

17-52 Number of Days’ Sales in Accounts Receivable Measures, on average, how many days it takes to collect an account receivable. Days’ Sales in Accounts Receivables = 365 Days Accounts Receivable Turnover = days = 365 Days Times Days’ Sales in Accounts Receivables#4

17-53 Number of Days’ Sales in Accounts Receivable In practice, would 45 days be a desirable number of days in receivables? #4 Days’ Sales in Accounts Receivables = 365 Days Accounts Receivable Turnover = days = 365 Days Times Days’ Sales in Accounts Receivables

17-54 Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = Measures the number of times inventory is sold and replaced during the year. = times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover = #5

17-55 Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = Would 5 be a desirable number of times for inventory to turnover? = times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover = #5

17-56 Equity, or Long–Term Solvency Ratios This is part of the information to calculate the equity, or long-term solvency ratios of Norton Corporation.

17-57 Here is the rest of the information we will use.

17-58 Equity Ratio Equity Ratio = Stockholders’ Equity Total Assets Equity Ratio = $234,390 $346, %= Measures the proportion of total assets provided by stockholders. #6

17-59 Net Income to Net Sales A/K/A Return on Sales or Profit Margin Net Income to Net Sales = Net Income Net Sales Net Income to Net Sales = $53,690 $494,000 = 10.9% Measures the proportion of the sales dollar which is retained as profit. #7

17-60 Net Income to Net Sales A/K/A Return on Sales or Profit Margin Net Income to Net Sales = Net Income Net Sales Net Income to Net Sales = $53,690 $494,000 = 10.9% Would a 1% return on sales be good? #7

17-61 Return on Average Common Stockholders’ Equity (ROE) Return on Stockholders’ Equity = Net Income Average Common Stockholders’ Equity = $53,690 ($180,000 + $234,390) ÷ 2 = 25.9% Return on Stockholders’ Equity Important measure of the income-producing ability of a company. #8

17-62 Earnings per Share Earnings Available to Common Stockholders Weighted-Average Number of Common Shares Outstanding = Earnings per Share $53,690 (17, ,400) ÷ 2 == $2.42 The financial press regularly publishes actual and forecasted EPS amounts. #9 Earnings Per Share

17-63 l What’s new from Chap. 15? Weighted-average calculation EPS of common stock = _______________________ Earnings available to common stockholders Weighted-average number of common shares outstanding 644 l Three alternatives for calculating weighted-average number of shares Earnings Per Share

17-64 EPS of common stock = _______________________ Earnings available to common stockholders Weighted-average number of common shares outstanding 645 Alternate #1 Earnings Per Share l What’s new from Chap. 15? Weighted-average calculation

17-65 Alternate #3 Alternate #2 645 Earnings Per Share

17-66 ¶ EPS and Stock Dividends or Splits Why restate all prior calculations of EPS? Comparability - i.e., no additional capital was generated by the dividend or split 646 Earnings Per Share ¶ Primary EPS and Fully Diluted EPS APB Opinion No. 15 I mentioned this 17-page pronouncement that required a 100-page explanation in the lecture for chapter 13.

17-67 Price-Earnings Ratio A/K/A P/E Multiple Price-Earnings Ratio Market Price Per Share EPS = Price-Earnings Ratio = $20.00 $ 2.42 = 8.3 : 1 #10 Provides some measure of whether the stock is under or overpriced.

17-68 Important Considerations l Need for comparable data u Data is provided by Dun & Bradstreet, Standard & Poor’s etc. u Must compare by industry u Is EPS comparable? l Influence of external factors u General business conditions u Seasonal nature of business operations l Impact of inflation

17-69Question The current ratio is a measure of liquidity that is computed by dividing total assets by total liabilities. a.True b.False The current ratio is a measure of liquidity that is computed by dividing total assets by total liabilities. a.True b.False

17-70 The current ratio is a measure of liquidity that is computed by dividing total assets by total liabilities. a.True b.False The current ratio is a measure of liquidity that is computed by dividing total assets by total liabilities. a.True b.False Question The current ratio is a measure of liquidity, but is computed by current dividing current assets by current current liabilities The current ratio is a measure of liquidity, but is computed by current dividing current assets by current current liabilities

17-71Question Quick assets are defined as Cash, Marketable Securities and net receivables. a.True b.False Quick assets are defined as Cash, Marketable Securities and net receivables. a.True b.False

17-72 Prepare B/S CR 1.75 LR 1.25 STR 9 GPR 25% DCP 1.5 month Reserves and surplus to capital 0.2 Turnover to Fixed assets 1.2 Capital Gearing ratio 0.6 Fixed Assets to net worth 1.25 Sales for the Year 1200k Prepare B/S CR 1.75 LR 1.25 STR 9 GPR 25% DCP 1.5 month Reserves and surplus to capital 0.2 Turnover to Fixed assets 1.2 Capital Gearing ratio 0.6 Fixed Assets to net worth 1.25 Sales for the Year 1200k

17-73 l Capital on April 1 Rs l Drawings Rs l Working Capital Rs l Dep. Of fixed assets during the year based on a rate of 10% per year on cost 3000 l Ratio of annual sales to year end values of fixed assets plus working capital 2:1 l Ratio of CA to CL 2:1 l Ratio of liquid assets(cash + debtors) to CL 5:4 l Debtors at the year end as percent of annual sales 12 l General expenses (excluding dep.) as percent of net sales 20 l Stock are turned over four times during the year l CL consists only of creditors