CHAPTER © jsnyderdesign / iStockphoto 12 FINANCIAL STATEMENT ANALYSIS

12 HOW HEALTHY IS C&C? ► C&C’s cash balance has fallen dramatically, and George Douglas wonders why. ► Cedric Renn, a potential employee, wonders if C&C will be around for the long term. ► Meredith Lincoln wonders if she should increase C&C’s credit limit. ► Each can use C&C’s financial statements to help answer their question.

HORIZONTAL ANALYSIS OF FINANCIAL STATEMENTS Unit Unit 12.2Unit 12.3 © Tomwang112 / iStockphoto Unit 12.4

12 HORIZONTAL ANALYSIS ► Shows the percentage increase or decrease in a particular line item on the financial statements; may also be expressed in dollars ► Requires two years’ of information to calculate ► The earliest year is considered the “base year”

12 HORIZONTAL ANALYSIS Current Year Amount – Base Year Amount Base Year Amount

12 HORIZONTAL ANALYSIS: SALES REVENUE 12/31/1312/31/12$ Change% Change Sales revenue$5,237,000$4,654,000$583, % Cost of goods sold 3,876,432 3,464, , % Gross margin1,360,5681,178,560171, % Selling and administrative expenses 1,160,566 1,067,721 92,8458.7% Operating income200,002121,83978, % Interest expense 41,715 43,210 (1,492)(3.5%) Income before taxes158,28778,62979, % Income tax expense 47,486 23,589 23, % Net income$ 110,801$ 55,040$ 55, %

12 HORIZONTAL ANALYSIS: SALES REVENUE 12/31/1312/31/12$ Change% Change Sales revenue$5,237,000$4,654,000$583, % Cost of goods sold 3,876,432 3,464, , % Gross margin1,360,5681,178,560171, % Selling and administrative expenses 1,160,566 1,067,721 92,8458.7% Operating income200,002121,83978, % Interest expense 41,715 43,210 (1,492)(3.5%) Income before taxes158,28778,62979, % Income tax expense 47,486 23,589 23, % Net income$ 110,801$ 55,040$ 55, %

12 HORIZONTAL ANALYSIS ALLOWS US TO… ► Identify trends and changes in account balances over time ► Predict account balances based on the identified trend

12 TREND ANALYSIS ► Shows account balances as a percentage of the base year ► Can see how account balances are changing over time

12 TREND ANALYSIS CALCULATION FOR REVENUE 12/31/1312/31/012$ Change% Change Sales revenue$5,237,000$4,654,000$583, % Cost of goods sold 3,876,432 3,464, , % Gross margin1,360,5681,178,560171, % Selling and administrative expenses 1,160,566 1,067,721 92, % Operating income200,002121,83978, % Interest expense 41,715 43,210 (1,492)(13.5%) Income before taxes158,28778,62979, % Income tax expense 47,486 23,589 23, % Net income$ 110,801$ 55,040$ 55, %

COMMON SIZE FINANCIAL STATEMENTS Unit 12.1 Unit 12.2 Unit 12.3 © Tomwang112 / iStockphoto Unit

12 COMMON-SIZE STATEMENTS ► Every line item on the financial statement is presented as a percentage of a major statement component Total assets for the balance sheet Net sales for the income statement ► Also known as vertical analysis

12 COMMON-SIZE BALANCE SHEET Account Balance Total Assets

12 COMMON SIZE BALANCE SHEET 12/31/1312/31/12 $%$% Cash$ 7, %$ 22, % Accounts receivable, net623, %583, % Total inventory640, %547, % Prepaid expenses 24, % 8, % Total current assets1,296, %1,160, % Property, plant & equipment532, %600, % Other assets 41, % 35, % Total assets$1,870, %$1,797, %

12 12/31/13 Cash0.42% Accounts receivable, net33.34% Total inventory34.23% Prepaid expenses1.30% Total current assets69.29% Property, plant & equipment28.48% Other assets2.23% Total assets100.00% COMMON-SIZE BALANCE SHEET 12/31/13 Accounts payable23.60% Other accrued expenses4.64% Short-term debt6.68% Current maturities of LTD1.07% Total current liabilities35.99% Long-term debt14.97% Total liabilities50.96% Common stock11.23% Retained earnings37.81% Total stockholders’ equity49.04% Total liabilities & equity100.00% Notice that the Total Assets and Total Liabilities & Stockholders’ Equity lines must total to 100%

12 12/31/13 Cash0.42% Accounts receivable, net33.34% Total inventory34.23% Prepaid expenses1.30% Total current assets69.29% Property, plant & equipment28.48% Other assets2.23% Total assets100.00% 12/31/13 Accounts payable23.60% Other accrued expenses4.64% Short-term debt6.68% Current maturities of LTD1.07% Total current liabilities35.99% Long-term debt14.97% Total liabilities50.96% Common stock11.23% Retained earnings37.81% Total stockholders’ equity49.04% Total liabilities & equity100.00% WHAT DOES THIS MEAN? 33.34% of C&C’s assets are in the form of accounts receivable % of C&C’s capitalization is provided by short-term creditors.

12 COMMON SIZE INCOME STATEMENT Account Balance Net Sales

12 COMMON SIZE INCOME STATEMENT 12/31/1312/31/12 Sales revenue$5,237, %$4,654, % Cost of goods sold 3,876, % 3,464, % Gross margin1,360, %1,178, % Selling and administrative expenses 1,160, % 1,067, % Operating income200, %121, % Interest expense 41, % 43, % Income before taxes158, %78, % Income tax expense 47, % 23, % Net income$ 110, %$ 55, %

12 COMMON SIZE INCOME STATEMENT 12/31/1312/31/12 Sales revenue100.00% Cost of goods sold 74.02% 74.44% Gross margin25.98%25.56% Selling and administrative expenses 22.16% 22.94% Operating income3.82%2.62% Interest expense 0.80% 0.93% Income before taxes3.02%1.69% Income tax expense 0.91% 0.51% Net income 2.11% 1.18% Notice that we start with Net Sales at 100%. If there had been Gross Sales and then Sales Returns, Gross Sales would be greater than 100%.

12 WHAT DOES THIS MEAN? 12/31/1312/31/12 Sales revenue100.00% Cost of goods sold 74.02% 74.44% Gross margin25.98%25.56% Selling and administrative expenses 22.16% 22.94% Operating income3.82%2.62% Interest expense 0.80% 0.93% Income before taxes3.02%1.69% Income tax expense 0.91% 0.51% Net income 2.11% 1.18% This means that for every $1.00 collected in sales revenue in 2013, 74.02¢ goes to make C&C’s goods for sale.

12 COMMON SIZE STATEMENTS ALLOW US TO… ► Look at changes in the makeup of the base component Has COGS as a percentage of net sales increased this year? ► Compare companies of different absolute sizes Qualcomm vs. Ericsson ► Compare a firm to industry averages

RATIO ANALYSIS Unit 12.1Unit 12.2 Unit 12.3 © Tomwang112 / iStockphoto Unit

12 RATIO ANALYSIS ► A comparison of the relationship between two or more financial statement items ► Reveals symptoms of underlying strengths and weaknesses ► Four major categories Liquidity ratios Leverage ratios Profitability ratios Market measure ratios

12 RATIO ANALYSIS ALLOWS US TO… ► Compare a company with industry averages or norms (cross-sectional analysis) ► Examine changes in a company’s ratios over time (longitudinal analysis) ► Focus further investigations into a company’s performance (reveals symptoms, not answers)

12 LIQUIDITY RATIOS ► What is liquidity? Ability to convert assets into cash within a year or the length of the business cycle ► Why is it important? Need to pay bills on time Need to take advantage of opportunities

12 WORKING CAPITAL CALCULATION Total Current Assets – Total Current Liabilities Current Assets12/31/13 Cash$ 7,752 Accounts receivable, net623,713 Total inventory640,372 Prepaid expenses24,388 Total current assets$1,296,225 Current Liabilities12/31/13 Accounts payable$441,602 Other accrued expenses86,749 Short-term debt125,000 Current maturities of LTD20,000 Total current liabilities$673,351 $1,296,225 – $673,351 = $622,874

12 CURRENT RATIO CALCULATION Total Current Assets Total Current Liabilities Total Current Assets Total Current Liabilities Current Assets12/31/13 Cash$ 7,752 Accounts receivable, net623,713 Total inventory640,372 Prepaid expenses24,388 Total current assets$1,296,225 Current Liabilities12/31/13 Accounts payable$441,602 Other accrued expenses86,749 Short-term debt125,000 Current maturities of LTD20,000 Total current liabilities$673,351 $1,296,225 $673,351 = 1.93

12 CURRENT RATIO – WHAT DOES IT MEAN? ► Literally, that C&C has 1.93 times more current assets than current liabilities ► Measures the buffer to cover shrinkage in asset value in the event of forced liquidation ► Measures ability to absorb random business shocks and uncertain cash flows ► Rule of thumb 2:1, but don’t let it get too high; very industry-sensitive

12 ACID-TEST RATIO CALCULATION Cash + Cash Equivalents + A/R Total Current Liabilities Current Assets12/31/13 Cash$ 7,752 Accounts receivable, net623,713 Total inventory640,372 Prepaid expenses24,388 Total current assets$1,296,225 Current Liabilities12/31/13 Accounts payable$441,602 Other accrued expenses86,749 Short-term debt125,000 Current maturities of LTD20,000 Total current liabilities$673,351 = 0.94 $7,752 + $623,713 $673,351

12 ACID-TEST RATIO – WHAT DOES IT MEAN? ► Literally, C&C has 0.94 times “highly liquid” current assets as current liabilities ► More stringent test than current ratio since it uses only the most liquid current assets ► Rule of thumb is 1:1

12 CURRENT AND ACID-TEST RATIO LIMITATIONS ► Static measures of liquidity ► Not useful for predictions of cash flows ► No insight into quality of the assets ► No insight into timing of cash conversion

12 ACTIVITY RATIOS ► What are they used for? Provides some insight into the quality of the assets underlying the liquidity ratios To measure how well a company is managing (using) its assets ► Two areas we’ll study Accounts Receivable Inventory

12 A/R TURNOVER CALCULATION Net Credit Sales Average A/R Current Assets12/31/1312/31/12 Cash$ 7,752$22,114 Accounts receivable, net623,713583,429 Total inventory640,372547,109 Prepaid expenses24,388 8,164 Total current assets$1,296,225$1,797,275 Income Statement12/31/13 Sales revenue$5,237,000 Cost of goods sold 3,876,432 Gross margin1,360,568 $5,237,000 ($623,713 + $583,429) / 2 = 8.68 times

12 WHAT DOES IT MEAN? ► A/R Turnover Measures how many times receivables are generated and collected within a year Higher turnover means faster collection of cash

12 AVERAGE COLLECTION PERIOD 365 Days A/R Turnover 365 days 8.68 times = 42 days

12 INVENTORY TURNOVER CALCULATION Cost of Goods Sold Average Inventory Current Assets12/31/1312/31/12 Cash$ 7,752$22,114 Accounts receivable, net623,713583,429 Total inventory640,372547,109 Prepaid expenses24,388 8,164 Total current assets$1,296,225$1,160,816 Income Statement12/31/13 Sales revenue$5,237,000 Cost of goods sold 3,876,432 Gross margin1,360,568 $3,876,432 ($640,372 + $547,109) / 2 = 6.53 times

12 WHAT DOES IT MEAN? ► Inventory Turnover Measures how many times inventory is sold within a year Higher turnover means faster sale of inventory and less likely to have obsolete items, but too high may indicate stock-out problems

12 AVERAGE DAYS TO SELL INVENTORY CALCULATION 365 Days Inventory Turnover 365 days 6.53 times = 55.9 days

12 LEVERAGE RATIOS ► Longer time-frame of concern than short-term creditors ► Interested in short-term position for payment of interest ► Interested in long-term position for repayment of loan balance

12 DEBT RATIO CALCULATION Total Liabilities Total Assets Assets12/31/13 Total current assets$1,296,225 Property, plant & equipment, net532,858 Other assets 41,704 Total assets$1,870,787 Liabilities12/31/13 Total current liabilities$673,351 Long-term debt 280,000 Total liabilities$953,351 $1,870,787 = 50.9%

12 DEBT-TO-EQUITY RATIO CALCULATION Total Liabilities Total Stockholders’ Equity Liabilities12/31/13 Total current liabilities$673,351 Long-term debt 280,000 Total liabilities 953,351 Common stock210,000 Retained earnings 707,436 Total stockholders’ equity 917,436 Total liabilities & stockholders’ equity$1,807,787 $953,351 $917,436 = 1.04

12 WHAT DOES IT MEAN? ► Debt-to-Equity Ratio At C&C there is $1.04 in debt for every $1 of stockholder’s equity. Put another way, about 50% of the asset base is financed through debt, or borrowed money, while 50% is financed by stockholders’ capital The higher the ratio, the greater the risk assumed by the creditors

12 THE TIMES-INTEREST-EARNED CALCULATION Earnings before Interest and Taxes Interest Expense Income Statement12/31/13 Sales revenue$5,237,000 Cost of goods sold 3,876,432 Gross margin1,360,568 Selling and administrative expenses 1,160,566 Operating income200,002 Interest expense 41,715 Income before taxes158,287 Income tax expense 47,486 Net income$ 110,801 $200,002 $41,715 = 4.79 times

12 PROFITABILITY RATIOS ► Focuses on returns to the stockholder

12 GROSS MARGIN CALCULATION Gross Margin Net Sales $1,360,568 $5,237,000 = 25.98% Income Statement12/31/13 Sales revenue$5,237,000 Cost of goods sold 3,876,432 Gross margin1,360,568 Selling and administrative expenses 1,160,566 Operating income200,002 Interest expense 41,715 Income before taxes158,287 Income tax expense 47,486 Net income$ 110,801

12 RETURN ON ASSETS CALCULATION NI + [ Interest Expense × (1 – tax rate) ] Average Total Assets Income Statement12/31/13 Operating income200,002 Interest expense 41,715 Income before taxes158,287 Income tax expense 47,486 Net income$ 110,801 Balance Sheet12/31/1312/31/12 Total assets$1,870,787$1,797,275

12 RETURN ON COMMON STOCKHOLDER’S EQUITY CALCULATION NI – Preferred Dividends Average Common Stockholders’ Equity Income Statement12/31/13 Operating income200,002 Interest expense 41,715 Income before taxes158,287 Income tax expense 47,486 Net income$ 110,801 Balance Sheet12/31/1312/31/12 Common stock210,000 Retained earnings 707, ,635 Total common equity$917,436$806,635 $110,801 - $0 ($917,436 + $806,635) / 2 = 12.85%

12 MARKET MEASURE RATIOS ► Only calculated for publicly traded stocks

12 EARNINGS PER SHARE CALCULATION NI – Preferred Dividends Average Number of Shares Outstanding

12 PRICE/EARNINGS RATIO CALCULATION Market Price per Share Earnings per Share $61.66 $2.77 = times (Closing market price, 05/31/13)

12 DIVIDEND PAYOUT RATIO CALCULATION Dividends per Share Earnings per Share $0.81 $2.77 = 29%

12 SOME THINGS TO REMEMBER… ► Ratios are a snapshot ► The firm’s choice of accounting principles influences reported income ► Read the footnotes to find unusual items ► Contingent liabilities could influence future earnings ► Discontinued operations or extraordinary items may influence future performance

INDUSTRY ANALYSIS Unit 12.1Unit 12.2Unit 12.3 Unit 12.4 © Tomwang112 / iStockphoto124.

12 INDUSTRY CLASSIFICATION ► Standard Industrial Classification (SIC) code 2329 for C&C ► North American Industrial Classification System (NAICS) code for C&C

12 SOURCES OF INDUSTRY DATA ► Published Industry Analyses ► Government Statistics ► Industry trade groups

12 GOVERNMENT DATA EXAMPLE Value of U.S. Men’s and Boys’ Team Sports Uniform Shipments Sources: U.S. Census Bureau, Annual Survey of Manufactures Value of Product Shipments: 2001, 2004, 2006, 2008, 2010

12 TRADE ASSOCIATION DATA EXAMPLE Sources: SMGA, Sports Participation Topline Report: 2006 Edition; 2007 Sports and Fitness Participation Report; 2008 Sports and Fitness Participation Report; 2009 Sports and Fitness Participation Report U.S. Participants in Team Baseball, 6 Years of Age or Older, at Least Once per Year