McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Financial Statement Analysis Chapter 14

14-2 Financial Statements Are Designed for Analysis

14-3 Dollar & Percentage Changes Trend Percentages Component Percentages Ratios Tools of Analysis

14-4 Dollar and Percentage Changes Dollar Change: Analysis Period Amount Base Period Amount Dollar Change =– Percentage Change: Dollar Change Base Period Amount Percent Change = ÷

14-5 Dollar and Percentage Changes Sales and earnings should increase at more than the rate of inflation. In measuring quarterly changes, compare to the same quarter in the previous year. Percentages may be misleading when the base amount is small. Evaluating Percentage Changes in Sales and Earnings

14-6 $12,000 – $23,500 = $(11,500)

14-7 ($11,500 ÷ $23,500) × 100% = 48.94% Complete the analysis for the other assets.

14-8

14-9 Trend Percentages Trend analysis is used to reveal patterns in data covering successive periods. Trend Percentages Analysis Period Amount Base Period Amount 100%=×

is the base period so its amounts will equal 100%. Berry Products Income Information For the Years Ended 31 December Trend Percentages

14-11 Component Percentages Examine the relative size of each item in the financial statements by computing component (or common-sized) percentages. Component Percentage 100% Analysis Amount Base Amount = × Financial StatementBase Amount Balance SheetTotal Assets Income StatementRevenues Financial StatementBase Amount Balance SheetTotal Assets Income StatementRevenues

14-12 ($12,000 ÷ $315,000) × 100% = 3.8% ($23,500 ÷ $289,700) × 100% = 8.1%

14-13

14-14

14-15 Quality of Earnings Investors are interest in companies that demonstrate an ability to earn income at a growing rate each year. Stability of earnings growth helps investors predict future prospects for the company. Financial analyst often speak of the “quality of earnings” at one company being higher than another company in the same industry.

14-16 Quality of Assets and the Relative Amount of Debt While satisfactory earnings may be a good indicator of a company’s ability to pay its debts and dividends, we must also consider the composition of assets, their condition and liquidity, the timing of repayment of liabilities, and the total amount of debt outstanding

14-17 A Classified Balance Sheet

14-18 Ratios

14-19 Use this information to calculate the liquidity ratios for Babson Builders.

14-20 Working capital is the excess of current assets over current liabilities. Working Capital

14-21 Current Ratio Current Assets Current Liabilities = = 1.55 : 1 This ratio measures the short-term debt-paying ability of the company. Current Ratio Current Ratio $65,000 $42,000 =

14-22 Quick assets are cash, marketable securities, and receivables. This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash. This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash. Quick Assets Current Liabilities = Quick Ratio Quick Ratio

14-23 Quick Ratio $50,000 $42,000 =1.19 : 1= Quick Ratio Quick Assets Current Liabilities = Quick Ratio

14-24 Uses and Limitations of Financial Ratios

14-25 An income statement can be prepared in either a multiple-step or single-step format. The single-step format is simpler. The multiple-step format provides more detailed information. Measures of Profitability

14-26 Proper Heading Gross Margin Operating Expenses Non-operating Items Remember to compute EPS. Income Statement (Multiple-Step)

14-27 Proper Heading Expenses & Losses Revenues & Gains Income Statement (Single-Step) Remember to compute EPS.

14-28 Use this information to calculate the profitability ratios for Babson Builders Limited

14-29 Earning Per Share Profit for the year Average No. of Ordinary Shares Outstanding = EPS Look back at the information from Babson and get the values we need to calculate earning per share. $53,690 27,400 = $1.96 = $1.96

14-30 Price-Earnings Ratio Current Market Price of one Share Earnings Per Share = P/E $15.25 $1.96 = 7.78 = 7.78 The measure shows us the relationship between earning of the company and the market price of its share.

14-31 This ratio is a good measure of the efficiency of utilization of assets by the business. Return On Investment (ROI)

14-32 This ratio is generally considered the best overall measure of a company’s profitability. This ratio is generally considered the best overall measure of a company’s profitability. Return On Assets (ROA)

14-33 This measure indicates how well the company employed the owners’ investments to earn income. Return On Equity (ROE)

14-34 Dividend Yield Ratio $1.50 $15.25 = 9.84% = 9.84% Dividend Yield This ratio identifies the return, in terms of cash dividends, on the current market price of the share. Dividend Yield Ratio Dividends Per Share Market Price Per Share = Babson Builders pays an annual dividend of $1.50 per share. The market price of the company’s share was $15.25 at the end of 2009.

14-35 Analysis by Long-Term Creditors Use this information to calculate ratios to measure the well-being of the long-term creditors for Babson Builders. This is also referred to as net operating profit.

14-36 Interest Coverage Ratio This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor. Times Interest Earned Operating Profit before Interest and Income Taxes Annual Interest Expense = Times Interest Earned $84,000 7,300 == 11.5 times

14-37 A measure of creditor’s long-term risk. The smaller the percentage of assets that are financed by debt, the smaller the risk for creditors. A measure of creditor’s long-term risk. The smaller the percentage of assets that are financed by debt, the smaller the risk for creditors. Debt Ratio

14-38 Analysis by Short-Term Creditors Use this information to calculate ratios to measure the well-being of the short-term creditors for Babson Builders Limited

14-39 Accounts Receivable Turnover Rate This ratio measures how many times a company converts its receivables into cash each year. Net Sales Average Accounts Receivable Accounts Receivable Turnover = = times $500,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover =

14-40 Inventory Turnover Rate This ratio measures the number of times merchandise inventory is sold and replaced during the year. Cost of Goods Sold Average Inventory Inventory Turnover == times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover =

14-41 Operating Cycle Cash Inventory Accounts Receivable 1. Purchase of Merchandise 2. Sale of merchandise on account 3. Collection of accounts receivable

14-42 End of Chapter 14