Analysis of Financial Statements

Learning Objectives  Understand the purpose of financial statement analysis.  Perform a vertical analysis of a company’s financial statements by: Comparing those accounts on the income statement as a percentage of net sales and comparing those accounts on the balance sheet as a percentage of total assets for a period of two or more accounting cycles. Determining those areas within the company that require additional monitoring and control.

Learning Objectives (continued) Perform a horizontal analysis of a company’s financial statements by: ○ Comparing the percentage change of components on a company’s income statement and balance sheet for a period of two or more years. ○ Determining those areas within the company that require additional monitoring and control. Perform ratio analysis of a company and compare those ratios to other companies within the same industry using industry averages.

Learning Objectives (continued) Analyze the relationships that exist between the several categories of ratios in determining the health of a business. Distinguish between liquidity, activity, leverage, profitability, and market ratios. Know how to obtain financial statements and financial information from various sources.

Three Methods of Analyzing Financial Statements  Vertical analysis  Horizontal analysis  Ratio analysis

Vertical Analysis  Vertical analysis is the process of using a single variable on a financial statement as a constant and determining how all of the other variables relate as a percentage of the single variable.

Vertical Analysis of an Income Statement  The vertical analysis of the income statement is used to determine, specifically, how much of a company’s net sales consumed by each individual entry on the income statement.  Constant is net sales. The formula is:

Horizontal Analysis  Horizontal analysis is a determination of the percentage increase or decrease in an account from a base time period to successive time periods. The basic formula is:

Vertical Analysis of a Balance Sheet  Vertical analysis of the balance sheet is always carried out by using total assets as a constant, or 100 percent, and dividing every figure on the balance sheet by total assets. The formula is:

Ratio Analysis  Ratio analysis is used to determine the health of a business, especially as that business compares to other firms in the same industry or similar industries.  A ratio is nothing more than a relationship between two variables, expressed as a fraction.

Types of Business Ratios  Liquidity ratios determine how much of a firm’s current assets are available to meet short-term creditors’ claims.  Activity ratios indicate how efficiently a business is using its assets.  Leverage (debt) ratios indicate what percentage of the business assets is financed with creditors’ dollars.

Types of Business Ratios (continued)  Profitability ratios are used by potential investors and creditors to determine how much of an investment will be returned from either earnings on revenues or appreciation of assets.  Market ratios are used to compare firms within the same industry. They are primarily used by investors to determine if they should invest capital in the company in exchange for ownership.

Liquidity Ratios  Current Ratio: The current ratio is calculated by dividing total current assets by total current liabilities. The current ratio is given by the following:

Liquidity Ratios (continued)  Quick, or Acid Test, Ratio: This ratio does not count the sale of the company’s inventory or prepaids. It measures the ability of the firm to meet its short-term obligations without liquidating its inventory. The acid test ratio is given by the following:

Activity Ratios  Inventory turnover ratio (or, simply, inventory turnover) indicates how efficiently a firm is moving its inventory. It basically states how many times per year the firm moves it average inventory. Inventory turnover is given as follows: where

Activity Ratios (continued)  Accounts receivable turnover ratio allows us to determine how fast our company is turning its credit sales into cash. Accounts receivable turnover is given by the following:

Activity Ratios (continued)  Average collection period is the average number of days that it takes the firm to collect its accounts receivable. Average collection period is given by the following:

Activity Ratios (continued)  Fixed asset turnover ratio indicates how efficiently fixed assets are being used to generate revenue for a firm. Fixed asset turnover is given by the following:

Activity Ratios (continued)  Total asset turnover ratio indicates how efficiently our firm uses its total assets to generate revenue for the firm.  Total asset turnover is given by the following:

Leverage Ratios  Debt-to-equity ratio indicates what percentage of the owner’s equity is debt. Debt-to-equity is given by the following:

Leverage Ratios (continued)  Debt-to-total-assets ratio indicates what percentage of a business’s assets is owned by creditors.  Debt-to-total-assets is given by the following:

Leverage Ratios (continued)  Times-interest-earned ratio shows the relationship between operating income and the amount of interest in dollars the company has to pay to its creditors on an annual basis.  Times-interest-earned is given by the following:

Profitability Ratios  Gross profit margin ratio is used to determine how much gross profit is generated by each dollar in net sales.  Gross profit margin is given by the following:

Profitability Ratios (continued)  Operating profit margin ratio is used to determine how much each dollar of sales generates in operating income.  Operating profit margin is given by the following:

Profitability Ratios (continued)  Net profit margin ratio tells us how much a firm earned on each dollar in sales after paying all obligations including interest and taxes.  Net profit margin is given by the following:

Profitability Ratios (continued)  Operating return on assets ratio is also referred to as operating return on investment and allows us to determine how much we are actually earning on each dollar in assets prior to paying interest and taxes.  Operating return on assets is given by the following:

Profitability Ratios (continued)  Net return on assets (ROA) ratio is also referred to as net return on investment and tells us how much a firm earns on each dollar in assets after paying both interest and taxes.  Net return on assets is given by the following:

Profitability Ratios (continued)  Return on equity (ROE) ratio tells the stockholder, or individual owner, what each dollar of his or her investment is generating in net income.  Return on equity (ROE) is given by the following: or

Market Ratios  Earnings per share ratio is nothing more than the net profit or net income of the firm, less preferred dividends (if the company has preferred stock), divided by the number of shares of common stock outstanding (issued).  Earnings per share is given by the following:

Market Ratios (continued)  Price earnings ratio is a magnification of earnings per share in terms of market price of stock.  Price earnings ratio is given by the following:

Price Earnings to Growth ratio(PEG ratio)  The price earnings to growth ratio (PEG ratio) compares the company’s price earnings ratio to its expected earnings per share (EPS) growth rate over the next several years.  The PEG ratio is given by the following formula:

Market Ratios (continued)  Operating cash flow per-share ratio compares the operating cash flow on the statement of cash flows to the number of shares of common stock outstanding.  Operating cash flow is given by the following:

Free Cash Flow  Free cash flow gives businesses the opportunity to set aside moneys from operating activities and use them to generate growth.  The formula is: