Chapter 14

 To make informed decisions about a company  Generally based on comparative financial data ◦ From one year to the next ◦ With a competing company ◦ With the industry 2Copyright (c) 2009 Prentice Hall. All rights reserved.

Perform a horizontal analysis of financial statements

 Compares two financial statements to determine dollar and percentage changes ◦ Compute dollar changes ◦ Compute percentage changes 4 Current year balancePrior year balance Dollar changeBase period Prior year balance Copyright (c) 2009 Prentice Hall. All rights reserved.

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 Form of horizontal analysis  Base year selected and set equal to 100% 6 Trend % Base year $ Any year $ Copyright (c) 2009 Prentice Hall. All rights reserved.

Perform a vertical analysis of financial statements

 Shows relationship of each item to a base amount on financial statements ◦ Income statement – each item expressed as percentage of net sales ◦ Balance sheet – each item expressed as percentage of total assets 8Copyright (c) 2009 Prentice Hall. All rights reserved.

Prepare and use common-size financial statements

 Reports only percentages  Removes dollar value bias ◦ Bias from comparing numbers in absolutes rather than relative terms 10Copyright (c) 2009 Prentice Hall. All rights reserved.

 Comparing a company with another leading company  Two main types: ◦ Against a key competitor ◦ Against the industry average 11Copyright (c) 2009 Prentice Hall. All rights reserved.

Compute the standard financial ratios

13 Ability to pay current liabilities Ability to sell inventory and collect receivables Ability to pay long-term debt Measure profitability Analyzing stock as an investment Copyright (c) 2009 Prentice Hall. All rights reserved.

14 Working capital Measures ability to meet short-term obligations Current ratio Most widely used Proportion of current assets to current liabilities Acid-test ratio Tells if company could pay all its current liabilities immediately Copyright (c) 2009 Prentice Hall. All rights reserved.

15 Working capital Current assets Current liabilities Current ratio Current assets Current liabilities Acid-test ratio Current liabilities Cash + short-term investments + net current receivables Results in a dollar amount Both result in a ratio Copyright (c) 2009 Prentice Hall. All rights reserved.

16 Inventory turnover Measures number of times a company sells inventory during a year Accounts receivable turnover Measures ability to collect cash from credit customers Days’-sales- in-receivables Also measures ability to collect receivables Copyright (c) 2009 Prentice Hall. All rights reserved.

17 Inventory turnover Cost of goods sold Average inventory Accounts receivable turnover Net credit sales Average accounts receivable The higher the turnover, the quicker it’s selling The higher the turnover, the quicker the collections Copyright (c) 2009 Prentice Hall. All rights reserved.

18 Days’ sales in receivables Net sales 365 Average day’s sales Average net accounts receivable Copyright (c) 2009 Prentice Hall. All rights reserved.

19 Current ratio Current assets Current liabilities $173,000$129, Copyright (c) 2009 Prentice Hall. All rights reserved.

20 Acid-test ratio Cash + short-term investments + net current receivables Current liabilities $18, , ,000 $129,000 $81, Copyright (c) 2009 Prentice Hall. All rights reserved.

21 Inventory turnover Cost of goods sold Average inventory $319,000 $75, ,000 2 $74,000 $319, Copyright (c) 2009 Prentice Hall. All rights reserved.

22 Days’ sales in receivables Net sales 365 Average day’s sales Average net accounts receivable $463, $1,268 $53, ,000 2 $64,000 $1, days Copyright (c) 2009 Prentice Hall. All rights reserved.

23 Debt ratio Shows portion of asset financed with debt The higher the ratio, the higher the risk Times-interest- earned ratio Measures number of times income can cover interest expense High ratio indicates ease in paying interest Copyright (c) 2009 Prentice Hall. All rights reserved.

24 Debt ratio Total liabilities Total assets Times interest earned Operating income Interest expense Copyright (c) 2009 Prentice Hall. All rights reserved.

25 Return on net sales Percent of each sales dollar earned as net income Return on total assets Measures success in using assets to earn a profit Return on common stockholders’ equity How much income is earned for dollar invested by common shareholders Earnings per share Net income earned for each share of common Copyright (c) 2009 Prentice Hall. All rights reserved.

26 Return on sales Net income Net sales Return on assets Net income + interest expense Average total assets Copyright (c) 2009 Prentice Hall. All rights reserved.

27 Return on equity Net income – preferred dividends Average common equity Earnings per share Net income – preferred dividends Number of common shares outstanding Copyright (c) 2009 Prentice Hall. All rights reserved.

 Trading on the equity ◦ Company borrows at a lower rate then invests the money to earn a higher rate  Increases profits during goods times ◦ Compounds losses during bad times 28 Return on equity Return on assets is greater than Copyright (c) 2009 Prentice Hall. All rights reserved.

29 Price/earnings ratio (P/E) Market price compared to EPS Dividend yield Percent of market value that is returned as dividends Book value Common equity per share Some argue its relevance to investors Copyright (c) 2009 Prentice Hall. All rights reserved.

30 P/E ratio Market price per share Earnings per share Dividend yield Dividends per share Book value Common shares outstanding Common equity Market price per share Copyright (c) 2009 Prentice Hall. All rights reserved.

 Suspect movement of sales, inventory, and receivables  Earnings problems  Decreased cash flow  Too much debt  Inability to collect receivables  Inventory buildup 31Copyright (c) 2009 Prentice Hall. All rights reserved.