© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Financial & Managerial Accounting The Basis for Business Decisions FOURTEENTH EDITION Williams Haka Bettner Carcello

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin FINANCIAL STATEMENT ANALYSIS Chapter 14

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Internal UsersExternal Users Financial statement analysis helps users make better decisions. Managers Officers Internal Auditors Shareholders Lenders Customers Purpose of Analysis

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Purpose of Analysis

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Financial Statements Are Designed for Analysis

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO1 To explain the uses of dollar and percentage changes, trend percentages, component percentages and ratios.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Dollar & Percentage Changes Trend Percentages Component Percentages Ratios Tools of Analysis

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Dollar Change: Analysis Period Amount Base Period Amount Dollar Change =– Percentage Change: Dollar Change Base Period Amount Percent Change = ÷ % Dollar and Percentage Changes

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Let’s look at the asset section of Clover, Inc. comparative balance sheet and income statement for 2007 and Let’s look at the asset section of Clover, Inc. comparative balance sheet and income statement for 2007 and Compute the dollar change and the percentage change for cash. Let’s look at the asset section of Clover, Inc. comparative balance sheet and income statement for 2007 and Let’s look at the asset section of Clover, Inc. comparative balance sheet and income statement for 2007 and Compute the dollar change and the percentage change for cash. Dollar and Percentage Changes

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin $12,000 – $23,500 = $(11,500)

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin ($11,500 ÷ $23,500) × 100% = 48.94% Complete the analysis for the other assets.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Trend analysis is used to reveal patterns in data covering successive periods. Trend Percentages Analysis Period Amount Base Period Amount 100% = × Trend Percentages

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 2003 is the base period so its amounts will equal 100%. Berry Products Income Information For the Years Ended December 31, Trend Percentages

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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 Component Percentages

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin ($12,000 ÷ $315,000) × 100% = 3.8% ($23,500 ÷ $289,700) × 100% = 8.1%

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO2 To discuss the quality of a company’s earnings, assets, and working capital.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Quality of Earnings 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

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO3 To explain the nature and purpose of classifications in financial statements.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin A Classified Balance Sheet Asset Section of the Balance Sheet

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin A Classified Balance Sheet Liability and Stockholders’ Equity Section of the Balance Sheet

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO4 To prepare a classified balance sheet and compute widely used measures of liquidity and credit risk.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Ratios

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Use this information to calculate the liquidity ratios for Babson Builders, Inc. Use this information to calculate the liquidity ratios for Babson Builders, Inc.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Working capital is the excess of current assets over current liabilities. Working Capital

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Current Ratio Current Assets Current Liabilities = 1.55 : 1 = 1.55 : 1 This ratio measures the short-term debt-paying ability of the company. Current Ratio Current Ratio $65,000 $42,000 =

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Quick Ratio Quick Assets Current Liabilities = Quick Ratio 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. $50,000 $42,000 = 1.19 : 1 = Quick Ratio

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Uses and Limitations of Financial Ratios

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO5 To prepare a multiple- step and a single-step income statement and compute widely used measures of profitability.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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. The single-step format is simpler. The multiple-step format provides more detailed information. Measures of Profitability

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Proper Heading Gross Margin Operating Expenses Non-operating Items Remember to compute EPS. Income Statement (Multiple-Step)

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Proper Heading Expenses & Losses Revenues & Gains Remember to compute EPS. Income Statement (Single-Step)

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Use this information to calculate the profitability ratios for Babson Builders, Inc. Use this information to calculate the profitability ratios for Babson Builders, Inc.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO6 To put a company’s net income into perspective by relating it to sales, assets, and stockholders’ equity.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Earning Per Share Net Income Average Shares of Capital Stock 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

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Price-Earnings Ratio Current Market Price of one Share of Stock Earnings Per Share = P/E $15.25 $1.96 = 7.78 = 7.78

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO7 To compute the ratios widely used in financial statement analysis and explain the significance of each.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin This ratio is a good measure of the efficiency of utilization of assets by the business. Return On Investment (ROI)

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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)

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin This measure indicates how well the company employed the owners’ investments to earn income. Return On Equity (ROE)

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Learning Objective LO8 To analyze financial statements from the viewpoints of common stockholders, creditors, and others.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Dividend Yield This ratio identifies the return, in terms of cash dividends, on the current market price of the stock. Dividend Yield Ratio Dividends Per Share Market Price Per Share = Dividend Yield Ratio $1.50 $15.25 = 9.84% = 9.84% Babson Builders pays an annual dividend of $1.50 per share of capital stock. The market price of the company’s capital stock was $15.25 at the end of 2007.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Analysis by Long-Term Creditors Use this information to calculate ratios to measure the well-being of the long- term creditors for Babson Builders. 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 income.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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 income before Interest and Income Taxes Annual Interest Expense = Times Interest Earned $84,000 7,300 == 11.5 times

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Analysis by Short-Term Creditors Use this information to calculate ratios to measure the well-being of the short-term creditors for Babson Builders, Inc. Use this information to calculate ratios to measure the well-being of the short-term creditors for Babson Builders, Inc.

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin 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 = times $500,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover =

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Number of Days to Collect Receivables This ratio measures, on average, how many days it takes to collect an account receivable. Average Collection Period = 365 Days Accounts Receivable Turnover days = days Average Collection Period = 365 Days Times

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Inventory Turnover Rate This ratio measures the number of times merchandise inventory is sold and replaced during the year. 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 = times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover =

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Average Days Sales In Inventory This ratio measures how many days, on average, it takes to sell the inventory. Average Sale Period = 365 Days Inventory Turnover days = days Average Sale Period = 365 Days Times

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin Operating Cycle Cash Inventory Accounts Receivable 1. Purchase of Merchandise 2. Sale of merchandise on account 3. Collection of accounts receivable

© The McGraw-Hill Companies, Inc., 2008 McGraw-Hill/Irwin End of Chapter 14