Previous Lecture Purpose of Analysis; Financial statement analysis helps users make better decisions Financial Statements Are Designed for Analysis Tools of Analysis Dollar and Percentage Changes Trend analysis is used to reveal patterns in data covering successive periods Component Percentages Horizontal Analysis, Vertical Analysis Common Size Statements

FINANCIAL STATEMENT ANALYSISRATIO ANALYSIS Chapter 14 2

Ratios

Use this information to calculate the liquidity ratios for Norton Corporation.

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

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

Quick Ratio Quick Assets Quick = Current Liabilities Ratio 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 Quick Ratio Quick Assets Current Liabilities = Quick Ratio $50,000 $42,000 = 1.19 : 1 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.

A measure of creditor’s long-term risk. Debt Ratio 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.

Uses and Limitations of Financial Ratios

Measures of Profitability 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.

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

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

Use this information to calculate the profitability ratios for Norton Corporation.

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

Use this information to calculate the profitability ratios for Norton Corporation.

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

Sources of Financial Information

More Examples of Ratios in Different Perspective

Solvency Analysis Solvency is the ability of a business to meet its financial obligations (debts) as they are due. Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities. This ability is normally assessed by examining balance sheet relationships.

Current Position Analysis Working Capital and Current Ratio 2006 2005 Current assets $550,000 $533,000 Current liabilities 210,000 243,000 Working capital $340,000 $290,000 Current ratio 2.6 2.2 Divide current assets by current liabilities Use: To indicate the ability to meet currently maturing obligations.

Current Position Analysis Quick Ratio 2006 2005 Quick assets: Cash $ 90,500 $ 64,700 Marketable securities 75,000 60,000 Accounts receivable (net) 115,000 120,000 Total $280,500 $244,700 Current liabilities $210,000 $243,000 Quick ratio 1.3 1.0 Use: To indicate instant debt-paying ability.

Accounts Receivable Analysis Accounts Receivable Turnover 2006 2005 Net sales on account $1,498,000 $1,200,000 Accounts receivable (net): Beginning of year $ 120,000 $ 140,000 End of year 115,500 120,000 Total $ 235,000 $ 260,000 Average (Total ÷ 2) $ 117,500 $ 130,000 Net sales on account Average accounts receivable

Accounts Receivable Analysis Accounts Receivable Turnover 2006 2005 Net sales on account $1,498,000 $1,200,000 Accounts receivable (net): Beginning of year $ 120,000 $ 140,000 End of year 115,500 120,000 Total $ 235,000 $ 260,000 Average $ 117,500 $ 130,000 Accounts receivable turnover 12.7 9.2 Use: To assess the efficiency in collecting receivables and in the management of credit.

Accounts Receivable Analysis Number of Days’ Sales in Receivables 2006 2005 Accounts receivable (net), end of year $ 115,000 $ 120,000 Net sales on account $1,498,000 $1,200,000 Average daily sales on account (sales ÷ 365) $ 4,104 $ 3,288 Accounts receivable, end of year Average daily sales on account

Accounts Receivable Analysis Number of Days’ Sales in Receivables 2006 2005 Accounts receivable (net), end of year $ 115,000 $ 120,000 Net sales on account $1,498,000 $1,200,000 Average daily sales on account (sales ÷ 365) $ 4,104 $ 3,288 Number of days’ sales in receivables 28.0 36.5 Use: To assess the efficiency in collecting receivables and in the management of credit.

Inventory Analysis Inventory Turnover Cost of goods sold 2006 2005 Cost of goods sold $1,043,000 $ 820,000 Inventories: Beginning of year $ 283,000 $ 311,000 End of year 264,000 283,000 Total $ 547,000 $ 594,000 Average (Total ÷ 2) $ 273,500 $ 297,000 Cost of goods sold Average inventory Inventory turnover =

Inventory Analysis Inventory Turnover 2006 2005 Cost of goods sold $1,043,000 $ 820,000 Inventories: Beginning of year $ 283,000 $ 311,000 End of year 264,000 283,000 Total $ 547,000 $ 594,000 Average (Total ÷ 2) $ 273,500 $ 297,000 Inventory turnover 3.8 2.8 Use: To assess the efficiency in the management of inventory.

Inventory Analysis Number of Days’ Sales in Inventory 2006 2005 Inventories, end of year $ 264,000 $283,000 Cost of goods sold $1,043,000 $820,000 Average daily cost of goods sold (COGS ÷ 365) $ 2,858 $ 2,247 Inventories, end of year Average daily cost of goods sold Number of Days’ Sales in Inventory =

Inventory Analysis Number of Days’ Sales in Inventory 2006 2005 Inventories, end of year $ 264,000 $283,000 Cost of goods sold $1,043,000 $820,000 Average daily cost of goods sold (COGS ÷ 365) $ 2,858 $ 2,247 Number of days’ sales in inventory 92.4 125.9 Use: To assess the efficiency in the management of inventory.

Long-Term Creditors Ratio of Fixed Assets to Long-Term Liabilities 2006 2005 Fixed assets (net) $444,500 $470,000 Long-term liabilities $100,000 $200,000 Ratio of fixed assets to long-term liabilities 4.4 2.4 Use: To indicate the margin of safety to long-term creditors.

Long-Term Creditors Ratio of Liabilities to Stockholders’ Equity 2006 2005 Total liabilities $310,000 $443,000 Total stockholders’ equity $829,500 $787,500 Ratio of liabilities to stockholders’ equity 0.37 0.56 Use: To indicate the margin of safety to creditors.

Long-Term Creditors Number of Times Interest Charges Earned 2006 2005 Income before income tax $ 900,000 $ 800,000 Add interest expense 300,000 250,000 Amount available for interest $1,200,000 $1,050,000 Income before income tax + interest expense Interest expense Number of Times Interest Charges Earned =

Long-Term Creditors Number of Times Interest Charges Earned 2006 2005 Income before income tax $ 900,000 $ 800,000 Add interest expense 300,000 250,000 Amount available for interest $1,200,000 $1,050,000 Number of times earned 4.0 4.2 Use: To assess the risk to debtholders in terms of number of times interest charges were earned.

Profitability Analysis Profitability is the ability of an entity to earn profits. This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available. Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet.

The Common Stockholder Ratio of Net Sales to Assets 2006 2005 Net sales $1,498,000 $1,200,000 Total assets: Beginning of year $1,053,000 $1,010,000 End of year 1,044,500 1,053,000 Total $2,097,500 $2,063,000 Average (Total ÷ 2) $1,048,750 $1,031,500 Excludes long-term investments

The Common Stockholder Ratio of Net Sales to Assets 2006 2005 Net sales $1,498,000 $1,200,000 Total assets: Beginning of year $1,053,000 $1,010,000 End of year 1,044,500 1,053,000 Total $2,097,500 $2,063,000 Average (Total ÷ 2) $1,048,750 $1,031,500 Ratio of net sales to assets 1.4 1.2 Use: To assess the effectiveness of the use of assets.

The Common Stockholder Rate Earned on Total Assets 2006 2005 Net income $ 91,000 $ 76,500 Plus interest expense 6,000 12,000 Total $ 97,000 $ 88,500 Total assets: Beginning of year $1,230,500 $1,187,500 End of year 1,139,500 1,230,500 Total $2,370,000 $2,418,000 Average (Total ÷ 2) $1,185,000 $1,209,000 Rate earned on total assets 8.2% 7.3% Use: To assess the profitability of the assets.

The Common Stockholder Rate Earned on Stockholders’ Equity 2006 2005 Net income $ 91,000 $ 76,500 Stockholders’ equity: Beginning of year $ 787,500 $ 750,000 End of year 829,500 787,500 Total $1,617,000 $1,537,500 Average (Total ÷ 2) $ 808,500 $ 768,750 Rate earned on stockholders’ equity 11.3% 10.0% Use: To assess the profitability of the investment by stockholders.

Leverage 11.3% 10.0% Leverage 3.1% Leverage 2.7% 8.2% 7.3% 10% Leverage 2.7% 8.2% 7.3% 5% 0% 2006 2005 Rate earned on total assets Rate earned on stockholders’ equity

The Common Stockholder Rate Earned on Common Stockholders’ Equity 2006 2005 Net income $ 91,000 $ 76,500 Less preferred dividends 9,000 9,000 Remainder—common stock $ 82,000 $ 67,500 Common stockholders’ equity: Beginning of year $ 637,500 $ 600,000 End of year 679,500 637,500 Total $1,317,000 $1,237,500 Average (Total ÷ 2) $ 658,500 $ 618,750

The Common Stockholder Rate Earned on Common Stockholders’ Equity 2006 2005 Net income $ 91,000 $ 76,500 Less preferred dividends 9,000 9,000 Remainder—common stock $ 82,000 $ 67,500 Common stockholders’ equity: Beginning of year $ 637,500 $ 600,000 End of year 679,500 637,500 Total $1,317,000 $1,237,500 Average (Total ÷ 2) $ 658,500 $ 618,750 Rate earned on common stockholders’ equity 12.5% 10.9% Use: To assess the profitability of the investment by common stockholders.

The Common Stockholder Earnings Per Share on Common Stock 2006 2005 Net income $ 91,000 $ 76,500 Less preferred dividends 9,000 9,000 Remainder—common stock $ 82,000 $ 67,500 Shares of common stock 50,000 50,000 Earnings per share on common stock $1.64 $1.35 Use: To assess the profitability of the investment by common stockholders.

The Common Stockholder Price-Earnings Ratio 2006 2005 Market price per share of common $41.00 $27.00 Earnings per share on common ÷ 1.64 ÷ 1.35 Price-earnings ratio on common stock 25 20 Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings.

Dividends and Earnings Per Share $2.00 $1.64 $1.50 Per share $1.35 $1.00 $0.80 $0.60 $0.50 $0.00 2006 2005 Dividends Earnings

The Common Stockholder Dividend Yield on Common Stock 2006 2005 Dividends per share of common $ 0.80 $ 0.60 Market price per share of common ÷ 41.00 ÷ 27.00 Dividend yield on common stock 1.95% 2.22% Use: To indicate the rate of return to common stockholders in terms of dividends.

Corporate Annual Reports In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report. The MDA includes an analysis of the results of operations and discusses management’s opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition.

Corporate Annual Reports In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report. Before issuing annual statements, all publicly held corporations are required to have an independent audit of their financial statements. The CPAs who conduct the audit render an opinion as to the fairness of the statements.

End of Chapter 14 Allah Hafiz