Chapter 16 Financial Statement Analysis

Topics to be Discussed Introduction Why Analyze Financial Statements Horizontal Analysis Vertical Analysis Comparison of Robyn’s to the GAAP

Introduction How can we determine: The ability of an organization to pay loans? Whether we are earning a fair return on our investment? The adequacy of cash flow to pay operating expenses? How to improve the overall performance of the company? Answer: Financial Statement Analysis

Why Analyze Financial Statements? Key Concept Ratio analysis provides additional information necessary to enhance the decision-making ability of the users of the information.

Limitations of Financial Statement Analysis When comparing companies and interpreting financial statement analysis, differences in accounting methods and cost flow assumptions need to be considered.

Limitations of Financial Statement Analysis Ratios of a company should be compared with industry standards: Dun & Bradstreetwww.dnb.com Moody’swww.moodys.com Standard & Poor’swww.standardpoor.com Dow Jones Retrievalwww.dowjones.com

Limitations of Financial Statement Analysis Key Concept Rather than focus on a single ratio, decision makers need to evaluate a company by comparing ratios to those of previous years, budgeted amounts, and industry standards.

The Impact of Inflation on Financial Statement Analysis Financial statements, and thus financial ratios, are prepared using historical costs and are not adjusted for the effects of increasing prices.

Horizontal Analysis Key Concept Horizontal analysis is used to analyze changes in accounts occurring between years.

Horizontal Analysis Examples from Robyn’s Boutique’s Comparative Balance Sheets Cash$130,000$110,000 $130,000 - $110,000 = $20,000 $20,000/$110,000 = 18.2% increase Prepaid Insurance $25,000 $30,000 $25,000 - $30,000 = ($5,000) ($5,000)/$30,000 = (16.7%) a decrease

Horizontal Analysis Changes in the income statement are analyzed in the same way. A few results: Sales increased 7.7% Cost of goods sold increased 9.9% Total operating expenses increased 27.6% Operating income decreased 26.2% Net income decreased.05%

Horizontal Analysis Pause and Reflect Note that focusing on net income without looking at other changes in income statement items would definitely be a mistake in this case. Although net income was virtually unchanged from 1999 to 2000, operating income decreased over 26%.

Horizontal Analysis Can be used to: Build prediction models to forecast financial performance in the future. Identify problem areas by looking for sudden or abnormal changes in accounts. Trend Analysis: horizontal analysis of financial statements over several years.

Vertical Analysis Compares financial statements of different companies and financial statements of the same company across time after controlling for differences in size. Common size financial statements are statements in which all items have been restated as a percentage of a selected item on the statement.

Vertical Analysis Key Concept Vertical analysis uses common size financial statements to remove size as a relevant variable in ratio analysis.

Vertical Analysis Comparative Balance Sheet Asset accounts are stated as a % of total assets. Liability and stockholder’s equity are stated as a % of total L & SE. On what numbers do I base the percentages?

Vertical Analysis Working Capital Current Assets - Current Liabilities Measure of an entity’s LIQUIDITY, or its ability to meet its immediate financial obligations More useful if we have information concerning the makeup of WC

Vertical Analysis Common Size Comparative Income Statements Percentages are based on NET sales The gross profit percentage is usually closely watched

Comparison of Robyn’s to the GAAP % of Assets Robyn’s GAAP Cash14.0%27.0% Inventory Prepaids P & E, net LT invest What are the differences?

Comparison of Robyn’s to the GAAP % of Total L + SE Robyn’sGAAP Accounts payable 6.5%12.5% Income tax Long-term debt Cost of goods sold Operating expense Net income after tax

Comparison of Robyn’s to the GAAP Pause and Reflect Spend some time looking at the preceding comparisons and speculate on what would cause the differences between two companies.

More Topics Ratio Analysis

Ratio Analysis and Return on Investment Key Concept Ratio analysis is useful in assessing the impact of transactions on ROI, residual income, EVA, and other key measures of performance.

Current Ratio or Working Capital Ratio Measures the entity’s liquidity. This ratio tells us the $$s of current assets for every $ of current liabilities. What is considered to be a good CR? Current Ratio = Current Assets Current Liabilities

Acid-Test Ratio or Quick Ratio This ratio is a stricter test of a company’s ability to pay its current debts with highly liquid current assets. This ratio removes inventories and prepaid assets from the CA amount used in the calculation. A quick ratio of less than 1.0 should be of concern. Quick Ratio = Quick Assets Current Liabilities

Cash Flow from Operations to Current Liabilities Ratio Cash flow from operations is sometimes used as the numerator because all debt is paid with cash. The ratio is an indication of whether enough cash is being generated from operations to pay current obligations. Net Cash Provided by Operating Activities Average Current Liabilities

Number of Days Sales Are in Receivables This number is the average number of days to collect a credit sale. This may vary according to the credit policy of the particular business and the industry standards. This ratio has an impact on ROI as part of the turnover of assets. Number of Days in the Period Accounts Receivable Turnover

Inventory Turnover Ratio Determines how many times during the time period that the value of the inventory was sold. Determining what is good is dependent on the industry and company standards. Grocery stores would have a much higher expected turnover than car dealerships. Cost of Goods Sold Average Inventory

Number of Days Inventory Is Held Before Sale Another way to look at inventory turnover is to calculate the number of days inventory is held before it is sold. This may vary according to the particular business and industry standards. This ratio has an impact on ROI as part of the turnover of assets. Number of Days in the Period Inventory Turnover

Cash-to-Cash Operating Cycle Ratio Number of Days in Inventory + Number of Days in Receivables Measures the length of time between the purchase of inventory and the collection of cash from sales.

Debt to Equity Ratio Total Liabilities Total Stockholders’ Equity A solvency ratio which measures the ability to stay financially healthy over the long-run. Indicates the preference of debt or equity financing of the entity.

Times Interest Earned Measures a company’s ability to meet current interest payments to creditors by specifically measuring its ability to meet current-year interest payments out of current-year earnings. Especially important to bankers and other lenders. Net Income + Interest Expense + Income Tax Interest Expense

Debt Service Coverage Ratio Measures the amount of cash generated from operating activities that is available to repay principal and interest in the upcoming year. The ratio indicates the $$s of cash generated for every $1 interest and principal paid. Cash Flow from Operations Before Interest and Taxes Interest and Principle Payments

Cash Flow from Operations to Capital Expenditures Ratio Measures a company’s ability to use cash flow from operations to finance its acquisitions of property, plant, and equipment. The ability to use cash from operations diminishes the need to acquire outside financing such as debt. Cash Flow from Operations - Total Dividends Paid Cash Paid for Acquisitions

Return on Assets Considers the return to investors on all assets invested in the company. Interpretation is based on the company’s required return on assets, industry standards, and trends. Net Income + Interest Expense (net of tax) Average Total Assets

Return on Common Stockholders’ Equity Measures the return to common stockholders as a percentage of stockholders’ equity. Adequacy of return is dependent on a number of factors including the risk of the investment. Net Income - Preferred Dividends Average Common Stockholders’ Equity

Earnings Per Share Used to measure performance. Used to compare the performance of companies across different industries. Net Income - Preferred Dividends Average Number of Common Shares Outstanding

Price Earnings Ratio Important for investors as it measures the relationship of earnings to dividends and the market price of a company’s stock. P/E are very dependent on the industry. Current Market Price EPS

Price Earnings Ratio Pause and Reflect In the past few years, Internet companies have often reflected high share prices with no historical earnings and minimal projected earnings.What do you think the prices of Internet stocks are based on? Reference values of companies such as Amazon.com, eBay.com, and Priceline.com

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