©CourseCollege.com 1 26 Financial Statement Analysis Financial statement analysis should always involve the statement of cash flows from Chapter 17 Learning Objectives 1.Describe and apply methods of percentage analysis of financial statements 2.Describe and apply methods of ratio analysis of financial statements

©CourseCollege.com 2 Vertical Horizontal Comparing statement components over time periods Comparing statement components over time periods Comparing statement components to a total from the same statement Comparing statement components to a total from the same statement O26.1 Objective 26.1: Describe and apply methods of percentage analysis of financial statements

©CourseCollege.com 3 Horizontal – comparing across time O26.1 Year 1 25,600 Year 2 31,200 Year 3 37,500 Year 4 38,400 What year had the greatest increase in sales? OR How much have sales grown over 4 years?

©CourseCollege.com 4 Horizontal Analysis O % = $ 38,400 (Year 4) $ 25,600 (Year 1) Year 4 Sales are 150% of Year 1 sales

©CourseCollege.com 5 Horizontal analysis -trends Calculating the percentage of base year for each period helps spot trends Base Year

©CourseCollege.com 6 Horizontal analysis -trends 343, ,500 = 1.04 = 104% The denominator is Year 1 Sales.

©CourseCollege.com 7 Vertical – comparing component with a total from the same statement O26.1 Year 1 What part of total assets is total equity? 250,000 1,000,000

©CourseCollege.com 8 Vertical Analysis O % = $ 250,000 equity $ 1,000,000 assets Equity is 25% of total assets

©CourseCollege.com 9 Vertical – comparing component with a total from the same statement O26.1 Year 1 What part of total assets is Cash? Cash 400,000 Total assets 50,000

©CourseCollege.com 10 Vertical Analysis O % = $ 50,000 cash $ 400,000 total assets Cash is 12.5% of total assets

©CourseCollege.com 11 Using vertical analysis* Hill’s cash position has increased * Comparing with the same firm in a different fiscal period

©CourseCollege.com 12 Using vertical analysis* Hatch has a stronger cash position * Compare to others. (Firms compared should be in the same industry with similar operations)

©CourseCollege.com 13 Combining horizontal and vertical Horizontal O26.1 Vertical

©CourseCollege.com 14 Combining horizontal and vertical O26.1 Has the firm been able to maintain profitability over these 5 years?

©CourseCollege.com 15 Combining horizontal and vertical Sales have grown O26.1 %Net income has dropped

©CourseCollege.com 16 Objective 26.2: Describe and apply methods of ratio analysis of financial statements O26.2 Liquidity & Safety measures Leverage & Solvency measures Efficiency measures Profitability & Market measures CATEGORIES

©CourseCollege.com 17 Examples of each category O26.2 Liquidity & Safety measures  Current ratio  Quick ratio  Doomsday ratio  Working capital ($)  Pledged assets to secured liabilities Leverage & Solvency measures  Debt to worth ratio  Debt ratio  Equity ratio  Times interest earned ratio  Debt coverage ratio Efficiency measures AA R turnover DD ays sales in AR II nventory turnover DD ays sales in inventory AA P Payment period WW orking capital as a percentage of sales TT otal asset turnover Profitability & Market measures  Net profit ratio  Gross profit ratio  Operating cash flow on assets ratio  Return on assets  Return on equity  Basic earnings per share  Price earnings ratio

©CourseCollege.com 18 Examples of O26.2 Liquidity & Safety measures  Current ratio  Quick ratio  Doomsday ratio  Working capital ($)  Pledged assets to secured liabilities

©CourseCollege.com 19 Current Assets Current Liabilities Current Ratio Working Capital Current Assets Current Liabilities Current ratio and working capital O26.2

©CourseCollege.com 20 The current ratio answers the following question: How many dollars of current assets are available to pay each dollar of current liabilities scheduled? The higher the number, the more dollars of current assets are available and therefore the more liquid is the particular balance sheet being studied. Current ratio Current Assets Current Liabilities Current Ratio O26.2

©CourseCollege.com 21 Current Ratio Example $1.10 of current assets are available to pay each dollar of current liabilities ?1.10 O26.2

©CourseCollege.com 22 Working capital answers the following question: How many dollars of current assets would remain if all current liabilities were paid using current assets? The resulting answer is expressed in dollars. The higher the number, the more liquidity is displayed by the balance sheet. Working capital Working Capital Current Assets Current Liabilities O26.2

©CourseCollege.com 23 Working Capital Example $16,900 of current assets would remain if current assets were used to pay all current liabilities ?$16,900 O26.2

©CourseCollege.com 24 Cash + cash equivalents Current Liabilities Doomsday ratio Quick ratio Doomsday ratio and the quick or acid test ratio Cash + Short term Investments + Accounts & Notes Receivable Current Liabilities O26.2

©CourseCollege.com 25 The doomsday ratio answers the following question: If this business ceased to exist, what portion of current liabilities could be paid by just using existing cash available? Doomsday ratio Cash Current Liabilities Doomesday Ratio The doomsday ratio deals with a worst case scenario. O26.2

©CourseCollege.com 26 Doomsday Ratio Example 15% of current liabilities could be paid with cash available ?.15 O26.2

©CourseCollege.com 27 The quick ratio answers the following question: How many dollars of cash, short term investments, accounts and notes receivable are available to pay current assets? Quick ratio Current Liabilities Quick Ratio Notice Inventory is not included Cash + Short term Investments + Accounts & Notes Receivable O26.2

©CourseCollege.com 28 Quick Ratio Example 50% of current liabilities could be paid without relying on Inventory or Supplies ?.50 O26.2

©CourseCollege.com 29 Examples of O26.2 Leverage & Solvency measures  Debt to worth ratio  Debt ratio  Equity ratio  Times interest earned ratio  Debt coverage ratio

©CourseCollege.com 30 AssetsLiabilities Balance Sheet Equity Leverage Highly Leveraged ( claims on assets are mostly from liabilities) AssetsLiabilities Balance Sheet Equity Limited Leverage ( claims on assets are mostly from equity) O26.2

©CourseCollege.com 31 AssetsLiabilities Balance Sheet Equity Leverage Highly Leveraged ( claims on assets are mostly from liabilities) AssetsLiabilities Balance Sheet Equity Limited Leverage ( claims on assets are mostly from equity) O26.2

©CourseCollege.com 32 The debt to worth ratio answers the following question: For every $1 of Equity, how many dollars of Liabilities does the firm owe? Debt to worth ratio Total Liabilities Debt to Worth A leverage measure Total Equity O26.2

©CourseCollege.com 33 Debt to Worth Example Each dollar of Equity supports 55 cents of Liabilities O26.2

©CourseCollege.com 34 The debt ratio answers the following question: What percentage of total assets is supported by debt? Debt ratio Total Liabilities Debt ratio A leverage measure Total Assets O26.2

©CourseCollege.com 35 Debt ratio Example Each dollar of Assets is supported by 35 cents of Liabilities O26.2

©CourseCollege.com 36 Times Interest Earned Ratio Adjusted accrual income = the sum of accrual net income + interest expense + income tax expense + non cash expenses such as depreciation, amortization and depletion. The higher the ratio, the more adequate earnings are to cover interest expense Times interest earned Interest expense Adjusted accrual income = O26.2

©CourseCollege.com 37 Debt Coverage Ratio Adjusted accrual income = the sum of accrual net income + interest expense + income tax expense + non cash expenses such as depreciation, amortization and depletion. The higher the ratio, the more adequate earnings are to cover debt service payments Debt Coverage Principal & Interest payments Adjusted accrual income = O26.2

©CourseCollege.com 38 Example -Times interest earned and Debt coverage ratios O26.2

©CourseCollege.com 39 Examples of O26.2 Efficiency measures AA R turnover DD ays sales in AR II nventory turnover DD ays sales in inventory AA P Payment period WW orking capital as a percentage of sales TT otal asset turnover

©CourseCollege.com 40 The AR turnover ratio answers the following question: How many times did the firm sell its’ average Accounts Receivable. AR Turnover Sales AR Turnover Average AR is often calculated as: (Beg AR +End AR)/2 Average Accounts Receivable O26.2

©CourseCollege.com 41 The days’ sales uncollected answers the following question: On average, how many days will it take to collect the current AR total? Days’ Sales Uncollected (in AR) AR Sales Days’ Sales Uncollected The AR balance is the end of year total. Sales is for the year. X 365 O26.2

©CourseCollege.com 42 Example O26.2

©CourseCollege.com 43 Inventory turnover answers the following question: How many times did the firm sell their average inventory during the year? Inventory Turnover COGS Average Inventory Inventory Turnover Remember to use the Average Inventory O26.2

©CourseCollege.com 44 Days Sales in Inventory answers the following question: How many days sales of inventory remain in the present balance of inventory? Days Sales in Inventory COGS Ending Inventory Days Sales in Inventory Remember to use the ending Inventory X 365 O26.2

©CourseCollege.com 45 Example –Inventory ratios O26.2

©CourseCollege.com 46 The AP payment period answers the following question: How many days is the firm expected to take to pay the present balance of Accounts Payable? AP payment period COGS AP AP payment period The AP balance is the end of year total. COGS is for the year. X 365 O26.2

©CourseCollege.com 47 Example –AP payment period 186,000 / 478,800 x 365 = 142 O26.2

©CourseCollege.com 48 Total Asset Turnover Ratio Total asset turnover ratio is: Net Sales / Average total assets Sales Average Assets The higher the turnover ratio, the more effective management is in utilizing assets to generate sales O26.2

©CourseCollege.com 49 Total asset turnover -Example O26.2

©CourseCollege.com 50 Examples of O26.2 Profitability & Market measures  Net profit ratio  Gross profit ratio  Operating cash flow on assets ratio  Return on assets  Return on equity  Basic earnings per share  Price earnings ratio

©CourseCollege.com ,600 / 894,580 = 15%. Or $.15 out of every sales dollar was remains as net profit. O26.2 Net Profit ratio

©CourseCollege.com ,080 / 894,580 = 51%. Or $.51 out of every sales dollar was left to cover remaining expenses and profit after the cost of sold merchandise was deducted. O26.2 Gross Profit ratio

©CourseCollege.com 53 Basic earnings per share Net income available to common stockholders divided by # of Common shares outstanding Net income less preferred dividends average # of common shares outstanding O26.2 Weighted average common shares during the earning period

©CourseCollege.com 54 Price earnings ratio Market price per share Basic earnings per share O26.2 How many times are investors paying for the annual earnings per share?

©CourseCollege.com 55 End Unit 26