Analyzing Financial Statements Module 12

SAP 2007 / SAP University Alliances Introductory Accounting Learning Objectives Explain the purpose of analysis.Identify the building blocks of analysis.Describe standards for comparisons in analysis.Identify the tools of analysis.Explain and apply methods of horizontal analysis.Describe and apply methods of horizontal analysis.Define and apply ratio analysis.Run an SAP demonstration.Practise preparing Cash Flow statements in SAP.

Internal UsersExternal Users Financial statement analysis helps users make better decisions. Managers Officers Internal Auditors Shareholders Lenders Customers Purpose of Analysis SAP 2007 / SAP University Alliances Introductory Accounting

1. Liquidity and Efficiency 2. Solvency 3. Profitability 4. Market Ability to meet short-term obligations and to efficiently generate revenues Ability to generate future revenues and meet long-term obligations Ability to generate positive market expectations Ability to provide financial rewards sufficient to attract and retain financing Building Blocks of Analysis SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting To help interpret financial statements, several standards of comparison are used.  Intracompany  Competitor  Industry  Guidelines Standards for Comparison

SAP 2007 / SAP University Alliances Introductory Accounting Tools of Analysis Horizontal Analysis Comparison of a company’s financial condition and performance across time.

SAP 2007 / SAP University Alliances Introductory Accounting Horizontal Analysis Vertical Analysis Comparison of a company’s financial condition and performance to a base amount. Tools of Analysis

SAP 2007 / SAP University Alliances Introductory Accounting Horizontal AnalysisVertical AnalysisRatio Analysis Determination of key relations among financial statement items. Tools of Analysis

Time Uses comparative financial statements.Analysts focus on large dollar or percentage changes. Horizontal Analysis SAP 2007 / SAP University Alliances Introductory Accounting

Dollar Change Analysis Period Amount Base Period Amount =– Percent Change Dollar Change Base Period Amount 100% × = Horizontal Analysis SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting Dollar change = $85,618 - $57,000 = $28,618 Illustration: Dollar and Percentage Change Assume a company’s year-end cash balances were $85,618 and $57,000 for 2005 and 2004 respectively. Percent change = $85,618 - $57,000 $57,000 x 100 = 50.2%

A tool used to reveal patterns in data covering successive periods. Trend Analysis SAP 2007 / SAP University Alliances Introductory Accounting

Trend Percent Analysis Period Amount Base Period Amount 100% = × Trend Analysis SAP 2007 / SAP University Alliances Introductory Accounting

Income statement items are expressed as a percentage of revenues. Balance sheet items are expressed as a percentage of total assets. Vertical or Common Size Analysis SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting Common-size Percent Analysis Amount Base Amount 100% = × Financial StatementBase Amount Balance SheetTotal Assets Income StatementRevenues Financial StatementBase Amount Balance SheetTotal Assets Income StatementRevenues Common-Size Statements

SAP 2007 / SAP University Alliances Introductory Accounting Is widely used in financial analysis.May identify areas requiring further investigation. Ratios may be organized into the following building blocks: Liquidity and efficiency Solvency Profitability Market Ratio Analysis

LiquidityRefers to short-term debt paying ability. Measures: Working capitalA/R turnover Current ratioDays’ sales uncollected Acid-test ratioMerchandise turnover Days’ sales in inventory Liquidity and Efficiency SAP 2007 / SAP University Alliances Introductory Accounting

SAP 2007 / SAP University Alliances Introductory Accounting EfficiencyMeasures a company’s productivity in using its assets. Measured by: Total asset turnover ratio Liquidity and Efficiency

SAP 2007 / SAP University Alliances Introductory Accounting Working CapitalThe difference between current assets and current liabilities. Current Assets - Current Liabilities= Working Capital Liquidity

SAP 2007 / SAP University Alliances Introductory Accounting Current RatioMeasures the short-term debt paying ability of the company. Current Assets Current Liabilities = Current Ratio Liquidity

SAP 2007 / SAP University Alliances Introductory Accounting Acid-Test Ratio This ratio is a more rigorous test of liquidity than the current ratio. It excludes assets such as inventories that may be difficult to quickly convert into cash. Quick Assets* Current Liabilities = Acid-Test Ratio * Cash, Short-Term Investments, Accounts Receivable, and Notes Receivable Liquidity

SAP 2007 / SAP University Alliances Introductory Accounting Accounts Receivable Turnover Ratio Measures how many times a company converts its receivables into cash each year. = A/R Turnover Ratio Sales on Account Average Accounts Receivable Liquidity

SAP 2007 / SAP University Alliances Introductory Accounting Days’ Sales Uncollected Days’ Sales UncollectedMeasures the liquidity of receivables. Accounts Receivable Net Sales = x 365 Liquidity

SAP 2007 / SAP University Alliances Introductory Accounting Merchandise Turnover Ratio Merchandise Turnover Ratio Measures the number of times merchandise is sold and replaced during the year. Cost of Goods Sold Average Inventory = Liquidity

SAP 2007 / SAP University Alliances Introductory Accounting Days’ Sales Uncollected Days’ Sales In InventoryMeasures the liquidity of inventory. Ending Inventory Cost of Sales = x 365 Liquidity

SAP 2007 / SAP University Alliances Introductory Accounting Total Asset Turnover Total Asset Turnover Measures the ability of a company to use its assets to generate revenues. Net Sales (or Revenues) Average Total Assets = Efficiency

SAP 2007 / SAP University Alliances Introductory Accounting Refers to a company’s long-run financial viability and its ability to cover long-term obligations. Is affected by operating, investing, and financing activities. Key solvency ratios include: Debt and equity ratios Pledged assets to secured liabilities Times interest earned Solvency

SAP 2007 / SAP University Alliances Introductory Accounting Debt Ratio Measures the portion of assets contributed by a company’s creditors. Total Liabilities Total Assets =x 100 Solvency

SAP 2007 / SAP University Alliances Introductory Accounting Equity Ratio Measures the portion of assets contributed by a company’s owners. Total Shareholders’ Equity Total Assets =x 100 Solvency

SAP 2007 / SAP University Alliances Introductory Accounting Pledged assets to secured liabilities Pledged Assets to Secured LiabilitiesMeasures the protection of secured creditors. Book value of pledged assets Book value of secured liabilities = Solvency

SAP 2007 / SAP University Alliances Introductory Accounting Times Interest Earned Measures the ability of a firm’s operations to provide protection to its long-term creditors. Income before Interest and Taxes Interest Expense = Solvency

SAP 2007 / SAP University Alliances Introductory Accounting Refers to a company’s ability to generate an adequate return on invested capital. Profitability is judged by assessing earnings relative to the level and sources of financing. Profitability

SAP 2007 / SAP University Alliances Introductory Accounting Profit Margin Reflects a company’s ability to earn a net income from sales. Net Income Net Sales (or Revenues) = Profitability

SAP 2007 / SAP University Alliances Introductory Accounting Gross Profit Ratio Gross Profit Ratio Reflects the relation between sales and cost of goods sold. Gross Profit from Sales Net Sales = x 100 Profitability

SAP 2007 / SAP University Alliances Introductory Accounting Profit Margin Return on Total Assets Provides an overall measure of a company’s profitability. It combines the profit margin and total asset turnover ratios. Net Income Average Total Assets = x 100 Profitability

SAP 2007 / SAP University Alliances Introductory Accounting ROE Return on Common Shareholders’ Equity (ROE) Measures how well the company employed the owners’ investments to earn income. Net income – Preferred Dividends Average common shareholders’ equity = x 100 Profitability

SAP 2007 / SAP University Alliances Introductory Accounting Book value per common share Book Value Per Share Measures how much each share would be worth if the company was liquidated at the amounts reported on the balance sheet. Shareholders’ equity applicable to common shares Number of common shares outstanding = Profitability

SAP 2007 / SAP University Alliances Introductory Accounting Basic Earnings Per Share Basic Earnings Per ShareMeasures net income per common share. Net Income – Preferred Dividends Weighted Average Common Shares Outstanding = Profitability

SAP 2007 / SAP University Alliances Introductory Accounting Used for corporations having publicly traded shares. Share price is used in the calculations of the ratios. Share price reflects the market’s expectations for the company. Market

SAP 2007 / SAP University Alliances Introductory Accounting Price– Earnings Ratio Measures how investors judge the company’s future performance. Market Price per Share Earnings per Share = Market

SAP 2007 / SAP University Alliances Introductory Accounting Dividend Yield Dividend Yield Is used to compare the dividend-paying performance of different investment alternatives. Annual Dividends per Share Market Price per Share = Market