Lesson 10 Understanding and Using Financial Statements Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Yat-sen University

Outline Demand and supply of financial analysis Basic analytical procedures Analysis methods Comprehensive analysis of financial ratios The limitations of financial analysis 2

3 What’s wrong with accounting information?

Demand and supply of financial analysis 4 Investors Managers Employees Customers auditors Government/regulatory agencies Investors Managers Employees Customers auditors Government/regulatory agencies Demand Internal analysts Intermediaries Financial analysts Bond rating agencies Internal analysts Intermediaries Financial analysts Bond rating agencies Supply

Basic analytical procedures 5 Conclude Contrive analysis scheme Contrive analysis scheme Analyze data Analyze data Determine objective Determine objective Collect data Collect data

Techniques of Financial Statement Analysis Horizontal analysis or Trend analysis Vertical analysis – Common-size financial statement Ratio analysis 6

Horizontal analysis Horizontal analysis, or trend analysis, is a technique for evaluating a series of financial statement data over a period of time. — Purpose is to determine the increase or decrease. — Commonly applied to the: balance sheet, income statement, and statement of retained earnings. 7

Horizontal analysis 8

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Vertical analysis Vertical analysis is used to show the relationship of the component parts to the total in a single statement – In the vertical analysis of the balance sheet, each asset or equity item is stated as a percent of total assets; – In the vertical analysis of the income statement, each item is stated as a percent of net sales; 10

A example of vertical analysis Year ended Net Sales Less: Cost of goods sold Gross profit on sales Selling expenses Administrative expenses Interest expenses Total expenses Income before taxes Income taxes Net income

Ratio analysis expresses the relationship among selected items of financial statement data. LiquidityProfitabilitySolvency Measures short- term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Financial Ratio Classifications Measures the income or operating success of a company for a given period of time. Measures the ability of the company to survive over a long period of time. Ratio Analysis 12

Illustration Ratio Analysis 13

Ratio Analysis 14

All sales were on account. The allowance for doubtful accounts was $3,200 on December 31, 2009, and $3,000 on December 31, Ratio Analysis 15

Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. Ratios include the current ratio, the acid-test ratio, receivables turnover, and inventory turnover. Ratio Analysis – Liquidity Ratios 16

Compute the Current Ratio for The ratio of 1.82:1 means that for every dollar of current liabilities, the company has $1.82 of current assets. Current Assets Current Liabilities = Current Ratio $369,900 $203,500 = 1.82 : 1 Ratio Analysis – Liquidity Ratios 17

Compute the Acid-Test Ratio for The acid-test ratio measures immediate liquidity. Cash + Short-Term Investments + Receivables (Net) Current Liabilities Acid-Test Ratio $60,100 + $69,000 + $107,800 $203,500 = 1.16 : 1 = 18 Ratio Analysis – Liquidity Ratios

Compute the Receivables Turnover ratio for It measures the number of times, on average, the company collects receivables during the period. $1,818,500 ($107,800 + $102,800) / 2 = 17.3 times Net Credit Sales Average Net Receivables Receivables Turnover = 19 Ratio Analysis – Liquidity Ratios

A variant of the receivables turnover ratio is to convert it to an average collection period in terms of days. This means that receivables are collected on average every 21 days. $1,818,500 ($107,800 + $102,800) / 2 = 17.3 times 365 days / 17.3 times = every 21.1 days Receivables Turnover 20 Ratio Analysis – Liquidity Ratios

Compute the Inventory Turnover ratio for Inventory turnover measures the number of times, on average, the inventory is sold during the period. $1,011,500 ($133,000 + $115,500) / 2 = 8.1 times Cost of Good Sold Average Inventory Inventory Turnover = 21 Ratio Analysis – Liquidity Ratios

A variant of inventory turnover is the days in inventory. Inventory turnover ratios vary considerably among industries. 365 days / 8.1 times = every 45.1 days $1,011,500 ($133,000 + $115,500) / 2 = 8.1 times Inventory Turnover 22 Ratio Analysis – Liquidity Ratios

Measure the income or operating success of a company for a given period of time. Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow. Ratios include the profit margin, asset turnover, return on assets, return on common stockholders’ equity, earnings per share, price-earnings, and payout ratio. Ratio Analysis – Profitability Ratios 23

Compute the Profit Margin ratio for Measures the percentage of each dollar of sales that results in net income. $199,000 $1,818,500 = 10.9% Net Income Net Sales Profit Margin = 24 Ratio Analysis – Profitability Ratios

Compute the Asset Turnover ratio for Measures how efficiently a company uses its assets to generate sales. $1,818,500 ($970,200 + $852,800) / 2 = 2.0 times Net Sales Average Assets Asset Turnover = 25 Ratio Analysis – Profitability Ratios

Compute the Return on Assets ratio for An overall measure of profitability. $199,000 ($970,200 + $852,800) / 2 = 21.8% Net Income Average Assets Return on Assets = 26 Ratio Analysis – Profitability Ratios

Compute the Return on Common Stockholders’ Equity ratio for Shows how many dollars of net income the company earned for each dollar invested by the owners. $199,000 - $0 ($566,700 + $465,400) / 2 = 38.6% Net Income – Preferred Dividends Average Common Stockholders’ Equity Return on Common Stockholders’ Equity = 27 Ratio Analysis – Profitability Ratios

Compute the Earnings Per Share for A measure of the net income earned on each share of common stock. $199,000 57,000 (given) = $3.49 per share Net Income Weighted Average Common Shares Outstanding Earnings Per Share = 28 Ratio Analysis – Profitability Ratios

Compute the Price Earnings Ratio for The price-earnings (P-E) ratio reflects investors’ assessments of a company’s future earnings. $25 (given) $3.49 = 7.16 times Market Price per Share of Stock Earnings Per Share Price Earnings Ratio = 29 Ratio Analysis – Profitability Ratios

Compute the Payout Ratio for Measures the percentage of earnings distributed in the form of cash dividends. $77,700 $199,000 = 39% Cash Dividends Net Income Payout Ratio = * * From analysis of retained earnings. 30 Ratio Analysis – Profitability Ratios

Solvency ratios measure the ability of a company to survive over a long period of time.  Debt to total assets and times interest earned are two ratios that provide information about debt-paying ability. Ratio Analysis – Solvency Ratios 31

Compute the Debt to Total Assets Ratio for Measures the percentage of the total assets that creditors provide. $403,500 $970,200 = 41.6% Total Debt Total Assets Debt to Total Assets Ratio = 32 Ratio Analysis – Solvency Ratios

Compute the Times Interest Earned ratio for Provides an indication of the company’s ability to meet interest payments as they come due. $199,000 + $84,000 + $18,000 $18,000 = 16.7 times Income before Income Taxes and Interest Expense Interest Expense Times Interest Earned = 33 Ratio Analysis – Solvency Ratios

Dupond Analysis 34 Net income Net Sales Net income Net Sales ROE=Net Margin X Asset Turnover X Leverage Factor Net income owner’s equity Net income owner’s equity Sales Assets Sales Assets Owner’s equity Assets Owner’s equity

Dupond analysis for five firms FirmNetMarginAssetTurnoverROALeverageFactorROE A8.36% % % B22.83% % % C3.87% % % D1.42% % % E4.24% % % 35

Why ratio analysis is useful? They facilitate inter-company comparison; They downplay the impact of size and allow evaluation over time or across entities without undue concern for the effects of size difference; They serve as benchmarks for targets such as financing ratios and debt burden; They help provide an informed basis for making investment- related decisions by comparing an entity’s financial performance to another; …… 36

How is ratio analysis limited? 37 It is restricted to information reported in the financial statements; It is based on past performance. Comparability is hampered when accounting policies are not uniform across an industry; The past may not predict the future.

How is ratio analysis limited? (cont) 38 Trends and relationships must be carefully evaluated with reference to industry norms, budgets, and strategic decisions; Because of some potential problems in standard, comparison must be careful.

Standards of comparison for financial statement analysis 39 Prior years’ results Industry averages Internal projections or budget May include inefficiencies or reflect different operating policies than in effect in the current year. May not be representative or desirable for this firm. May not be available; may be based on different or budgets operating policies than in effect in the current year. Standard of comparison Potential problem

What should an analyst keep in mind about financial analysis? An overview of all ratios can provide important information concerning the strategic decisions of a company and the nature of its business; However, accounting information can only provide so much data. An analyst must proceed with caution. 40

Summary Users of financial statements often gain a clearer picture of the economic condition of an entity by the analysis of accounting information; The analytical measures obtained from financial statements are usually expressed as ratios or percentages; 41

Summary Financial analysis techniques work best when they are used to confirm or refute other information. When using analytical tools to evaluate a company, the analyst should keep in mind the limitations of analysis 42

Discussion questions What is the advantage of using comparative statements for financial analysis rather than statements for a single date or period? What does an increase in the number of days’ sales in receivables ordinarily indicate about the credit and collection policy of the firm? Why would the dividend yield differ significantly from the rate earned on common stockholders’ equity? 43

The End of Lesson 10