Accounting Principles Second Canadian Edition Prepared by: Carole Bowman, Sheridan College Julia Banks, Cairine Wilson Weygandt · Kieso · Kimmel · Trenholm

FINANCIAL STATEMENT ANALYSIS CHAPTER 18

Analysing financial statements involves evaluating three characteristics of a company: 1. its liquidity - short-term creditor 2. its profitability – long-term creditor and investors and shareholders 3. its solvency - long-term creditors, investors, and shareholders BASICS OF FINANCIAL STATEMENT ANALYSIS

COMPARATIVE ANALYSIS Three types of comparisons: 1. Intracompany basis 2. Intercompany basis 3. Industry averages

1. Intracompany Basis Compares an item (i.e. cash) or relationship (i.e cash as a % of current assets) on a financial statement within the company in a given year with the same item or relationship in one or more prior years. Useful for detecting changes in financial relationships and significant trends within a company

2. Intercompany Basis Compares an item (i.e. cash) or relationship (i.e cash as a % of current assets) on a financial statement within the company in a given year with the same item or relationship in one or more competing companies. (i.e. comparing Sear’s total sales with The Bay’s total sales) Useful for understanding a company’s competitive position

3. Industry Averages Compares an item or financial relationship of a company with industry averages (or norms) Averages found in annual publications such as Dun & Bradstreet Canada’s Duns Financial Profile, The Financial Post’s Industry Reports, and Statistics Canada’s Financial Performance Indicators for Canadian Business. Provides info about a company’s relative performance within the industry.

COMPARATIVE ANALYSIS Three tools: 1.Horizontal analysis ( or Trend Analysis)  Evaluates a series of financial statement data over a period of time.  Used primarily in intracompany comparisons  See pg. 893 – Vertical analysis ( or Common Size Analysis)  Evaluates financial statement data by expressing each item in a financial statement as a percentage base amount for the same period of time  Used in both intracompany and intercompany comparisons.  See pg Ratio analysis  Expresses the relationship among selected items of financial statement data.  Used in intracompany, intercompany, and industry average comparisons.

HORIZONTAL ANALYSIS 127%121%119%112%100% ANY COMPANY INC. Assumed Net Sales For the Year Ended December 31 (in millions) $ 6,562.8$ 6,295.4$ 6,190.6$ 5,786.6$ 5,181.4 Change since base period  Determines an increase or decrease that has taken place.  May be expressed as either a $ amount or as a % percentage. For 2003 : ( ) / =.266 = 27% Or : / = = 127%

VERTICAL ANALYSIS VERTICAL ANALYSIS Expresses each item in a financial statement as a percent of a base amount (total assets or net sales) See pages ANY COMPANY, INC. Condensed Balance Sheets (Partial) December 31 (in millions) AssetsAmountPercent AmountPercent Current assets$1, $1, Capital assets 2, , Other assets Total assets$5, % $4, %

RATIO ANALYSIS Liquidity Ratios Measure short-term ability of the enterprise to pay its maturing obligations ( current liabilities) and to meet unexpected needs for cash. Profitability Ratios Measure the income or operating success of an enterprise for a given period of time. RevenuesExpenses - = Net Income Solvency Ratios Measure the ability of the enterprise to survive over a long period of time. XYZ Co. Since 1892

Ratio Analysis Can be expressed in 3 ways: Example: Current Assets are $33.4 million Current Liabilities are $13.8 million. 1.By Percentage: Current assets are 242% of current liabilities. 2.By Rate: Current assets are 2.42 times greater than current liabilities. 3.By Proportion: The relationship of current assets to liabilities is 2.42 : 1.

LIQUIDITY RATIOS LIQUIDITY RATIOS Interested parties include bankers and suppliers. Current ratio Acid test ratio Cash current debt coverage ratio Receivables turnover Collection period Inventory turnover Days sales in inventory

CURRENT RATIO Working Capital Ratio Measures short-term debt-paying ability Limitations: Portion of CA may be tied up in uncollectable A/R’s or slow moving inventory. Useful when comparing to industry averages (Discussed in Chapter 4) Current Ratio = Current Assets Current Liabilities

ACID TEST RATIO Measures immediate short-term debt-paying ability Does not include Inventory and Prepaids Compare it to the industry average. Generally a 1.0 : 1 is quite adequate. Limitations: Year end account balances may not represent position during most of the year. Acid test ratio = Cash + temporary investments + net receivables Current liabilities

CASH CURRENT DEBT COVERAGE RATIO Measures short-term debt-paying ability (cash basis) See page Average Current Liabilities is calculated by taking the balance of the current liabilities at the beginning of the fiscal period and at the end and dividing it by 2. Cash current debt coverage ratio = Cash provided by operating activities Average current liabilities (Discussed in Chapter 18)

RECEIVABLES TURNOVER Measures liquidity of receivables – the number of times, on average, receivables are collected during the fiscal period. The faster the turnover, the current and acid test ratios are considered to be more reliable. Net Credit Sales = Net Sales – Cash Sales Net Sales = Total Sales – Sales Returns and Allowances and Sales Discounts. Average Net Receivables = Beginning Net Receivables + Ending Net Receivables divided by 2 Receivables turnover = Net credit sales Average net receivables (Discussed in Chapter 9)

COLLECTION PERIOD Measures number of days receivables are outstanding. (The number of days it takes to collect the receivables.) Used to assess a company’s credit and collection policies. Collection period should not exceed the credit term period. Collection period = 365 days Receivables turnover (Discussed in Chapter 9)

INVENTORY TURNOVER INVENTORY TURNOVER Measures liquidity of inventory – the average number of times the inventory is sold during the period. Average Inventory = Beginning Inventory + Ending Inventory 2 Inventory turnover = Cost of goods sold Average inventory (Discussed in Chapter 5)

DAYS SALES IN INVENTORY Measures number of days inventory is on hand or average selling time. Days in inventory = 365 days Inventory turnover (Discussed in Chapter 5)

PROFITABILITY RATIOS Profit margin Gross profit margin Cash return on sales Asset turnover Return on assets Return on common shareholders’ equity Book value per share Cash flow per share Earnings per share (EPS) Price-earnings (PE) ratio Payout ratio Dividend yield  Measure income or operating success for a specific period of time  Profitability impacts company’s ability to obtain debt and equity financing.

PROFIT MARGIN Measures net income generated by each dollar of sales (Discussed in Chapter 5) Profit margin = Net income Net sales

GROSS PROFIT MARGIN Indicates a company’s ability to maintain its selling price above its cost of goods sold. (Discussed in Chapter 5) Gross profit margin = Gross profit Net sales

CASH RETURN ON SALES Measures net cash flow generated by each dollar of sales Measures profit margin based on cash basis of accounting. Does not include sales in A/R. (Discussed in Chapter 18) Cash return on sales = Net cash provided by operating activities Net sales

ASSET TURNOVER Measures how efficiently assets are used to generate sales  indicates the dollar of sales produced by each dollar of assets. (Discussed in Chapter 10) Asset turnover = Net sales Average total assets

RETURN ON ASSETS Measures overall profitability of assets Return on assets = Net income Average total assets (Discussed in Chapter 10)

RETURN ON COMMON SHAREHOLDERS’ EQUITY Measures profitability of common shareholders’ investment Common Shareholder’s Equity = Total Shareholder’s Equity – Preferred Shares Return on common shareholders’ equity = Net income Average common shareholders’ equity (Discussed in Chapter 14)

BOOK VALUE PER SHARE Measures the equity (net assets) per common share Book value per share = Common shareholders’ equity Number of common shares (Discussed in Chapter 14)

CASH FLOW PER SHARE Measures the net cash flow per common share Don’t need to know Cash flow per share = Net cash provided by all activities Number of common shares (Discussed in Chapter 18)

EARNINGS PER SHARE (EPS) Measures net income earned on each common share This is only meaningful when used as an intracompany comparison (Discussed in Chapter 15) Earnings per share = Net income Number of common shares issued

PRICE-EARNINGS (PE) RATIO Measures relationship between market price per share and earnings per share Reflects investors’ assessment of a company’s future earnings. Share sold for “ratio” times the amount that was earned on each share. (Discussed in Chapter 15) Price-earnings ratio = Share price Earnings per share

PAYOUT RATIO Measures % of earnings distributed in the form of cash dividends Companies with high growth rate usually have low payout ratios because they reinvest most of their net income in the business. Companies with stable earnings usually have high payout ratios. (Discussed in Chapter 15) Payout ratio = Cash dividends Net income

DIVIDEND YIELD Measures rate of return earned from dividends Cash Dividend Per Share = Cash Dividend / # of Common Shares (Discussed in Chapter 15) Dividend yield = Cash dividends per share Share price

SOLVENCY RATIOS SOLVENCY RATIOS  Measures a company’s ability to survive over a long period of time.  Ability to pay interest on long-term debt and repay principal when it comes due. Ratios include: Debt to total assets Interest coverage Cash interest coverage Cash total debt coverage

DEBT TO TOTAL ASSETS Measures % of total assets provided by creditors Debt to total assets = Total liabilities Total assets (Discussed in Chapter 16)

INTEREST COVERAGE Measures ability to meet interest payments as they come due based on accrual method. The higher the number the better Interest coverage = Income before interest expense and income tax expense (EBIT) Interest expense (Discussed in Chapter 16)

CASH INTEREST COVERAGE Measures cash available to meet interest payments as they come due (cash basis) Cash interest coverage = Income before interest expense, income tax expense, and amortization expense (EBITDA) Interest expense (Discussed in Chapter 16)

CASH TOTAL DEBT COVERAGE Measures long-term debt-paying ability (cash basis) without having to liquidate assets If CTDC was.2 times, then it would mean that it would take five years (1/.2) to generate enough cash to pay off all its liabilities. Cash total debt coverage ratio = Net cash provided by operating activities Average total liabilities (Discussed in Chapter 18)

Estimates – amortization, uncollectable accounts etc. Historical cost – does not account for inflation, recessionary effects etc. Alternative accounting methods – FIFO vs. LIFO, global differences Atypical data - year end balances may not reflect average activity that occurs throughout the year Company Diversification LIMITATIONS OF FINANCIAL ANALYSIS

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