23-1 Intermediate Accounting,17E Stice | Stice | Skousen © 2010 Cengage Learning PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University Analysis of Financial Statements

23-2 Framework for Financial Statement Analysis Financial statement analysis is the examination of both the relationships among financial statement numbers and the trends in those numbers over time. One purpose of financial statement analysis is to use the past performance of a company to predict its future profitability and cash flows. (continues)

23-3 Framework for Financial Statement Analysis Another purpose of financial statement analysis is to evaluate the performance of a company with an eye toward identifying problem areas. (continues)

23-4 Framework for Financial Statement Analysis The APB stated that comparisons between financial statements are most informative and useful under the following conditions: 1.The presentations are in good form; that is, the arrangement within the statement is identical. 2.The content of the statements is identical; that is, the same items from the underlying accounting records are classified under the same captions. (continues)

23-5 Framework for Financial Statement Analysis 3.Accounting principles are not changed, or, if they are changed, the financial effects of the changes are disclosed. 4.Changes in circumstances or in the nature of the underlying transactions are disclosed. (continues)

23-6 Framework for Financial Statement Analysis To analyze financial statements, analysts use common-size financial statements and ratio analysis.

23-7 Common-Size Financial Statements Financial statements are standardized by dividing all financial statement numbers for a given year by sales for the year. The resulting financial statements are called common-size financial statements, with all amounts for a given year being shown as a percentage of sales for that year.

23-8 Interpreting Ratios As you calculate the ratios in this chapter, you probably will wonder whether the ratio is good or bad. While there are a few “rules of thumb” that can be followed, the best way to interpret a ratio is to compare the value calculated to the same firm in previous years and/or to different companies in the same industry.

23-9 DuPont Framework The DuPont framework was developed internally at DuPont around It provides a systematic approach to identifying general factors causing ROE to deviate from normal. It establishes a framework for computing financial ratios to yield more in-depth analysis of a company’s areas of strength and weakness.

23-10 The number of pennies in profits generated from each dollar of sales The number of dollars in sales generated by each dollar of assets The number of dollars of assets a company is able to acquire using each dollar invested by stockholders

23-11 $180,000 $5,700,000

23-12 $5,700,000

23-13 $5,700,000 $2,278,000

23-14 $2,278,000

23-15 $2,278,000 $1,468,000

23-16 DuPont Framework Coleville’s ROE for 2011 is 12.3%. The ROE for 2010 would be calculated the same way.

23-17 Accounts Receivable Turnover Colesville Corporation $6,600,000 ($333,500 + $375,000)/ = $354,250 = 18.6 times Sales Average accounts receivable (continues)

23-18 Colesville Corporation $5,700,000 ($375,000 + $420,000)/ = $397,500 = 14.3 times Sales Average accounts receivable The higher the turnover, the more rapid is a firm’s average collection period for receivables. Accounts Receivable Turnover

23-19 Average Collection Period Colesville Corporation Average accounts receivable Average daily sales ($333,500 + $375,000)/2 $6,600,000/ = $18,082 $354,250 = 19.6 days (continues)

23-20 Average Collection Period Colesville Corporation Average accounts receivable Average daily sales ($375,000 + $420,000)/2 $5,700,000/ = $15,616 $397,500 = 25.5 days What constitutes a reasonable average collection period varies with individual businesses.

23-21 Inventory Turnover Colesville Corporation $4,800,000 ($125,000 + $330,000)/ = $227,500 = 21.1 times (continues) Cost of goods sold Average inventory

23-22 Inventory Turnover Colesville Corporation Cost of goods sold Average inventory $4,000,000 ($330,000 + $225,000)/ = $277,500 = 14.4 times Inventory turnover allows for evaluation of the firm’s inventory position and the appropriateness of the inventory size.

23-23 Number of Days’ Sales in Inventory Colesville Corporation 365 Inventory turnover = = 17.3 days (continues)

23-24 Number of Days’ Sales in Inventory Colesville Corporation 365 Inventory turnover = = 25.3 days Colesville is holding a 25-day supply of inventory in 2011 compared to a 17-day supply in 2010.

23-25 Fixed Asset Turnover Colesville Corporation Sales Average fixed assets $6,600,000 ($330,000 + $225,000)/ = ($925,000 + $1,075,000)/2 $1,000,000 = 6.60 times (continues)

23-26 Fixed Asset Turnover Colesville Corporation $5,700,000 ($330,000 + $225,000)/ = ($1,075,000 + $1,275,000)/2 $1,175,000 = 4.85 times Colesville was less efficient at using its fixed assets to generate sales in 2011 than it was in Sales Average fixed assets

23-27 Margin vs. Turnover The profitability of each dollar in sales is sometimes called a company’s margin. The degree to which assets are used to generate sales is called turnover. Margin isn’t everything, nor is turnover everything. The important thing is how margin and turnover combine to generate return on assets.

23-28 Leverage Ratios 1.More borrowing means that more assets can be purchased without any additional equity investment by owners. 2.More assets means that more sales can be generated. 3.More sales means that net income should increase. Higher leverage increases ROE through the following chain of events:

23-29 Debt Ratio Colesville Corporation Total liabilities Total assets $1,101,000 $2,191, = = 50.3% $810,000 $2,278, = = 35.6% This is a measure of the level of borrowing relative to funds used to finance the company.

23-30 Debt-to-Equity Ratio Colesville Corporation Total liabilities Stockholders’ equity $1,101,000 $1,090, = = 1.01 $810,000 $1,468, = = 0.55 Measures the same thing as the debt ratio.

23-31 Times Interest Earned Colesville Corporation Income before interest or income taxes Interest expense $290,000 + $60,000 $60, = $350,000 = 5.8 times (continues)

23-32 Times Interest Earned Colesville Corporation Income before interest or income taxes Interest expense $260,000 + $40,000 $40, = $300,000 = 7.5 times This is a measure of the debt position of a company in relation to its earnings ability.

23-33 Current Ratio Colesville Corporation Current assets Current liabilities $955,500 $501, = = 1.91 $855,000 $410, = = 2.09 The current ratio is a test of liquidity, or the firm’s ability to meet its current obligations.

23-34 Cash Flow Adequacy Ratio Cash from operating activities Total primary cash requirements The formula: (continues)

23-35 Cash Flow Adequacy Ratio Colesville Corporation $424,500 $375, = = 1.13 $249,000 $602, = = 0.41 Because the cash flow adequacy ratio in 2011 is less than 1.0, Colesville was not able to satisfy its primary cash requirements with cash generated by operations.

23-36 Earnings per Share Colesville Corporation Net income Weighted shares outstanding $205,000 $75, = = 2.73 $180,000 $90, = = 2.00 This well-known ratio shows the size of the dividend per share of common stock if all the net income is distributed.

23-37 Dividend Payout Ratio Colesville Corporation Cash dividends Net income $145,000 $205, = = 70.7% $102,000 $180, = = 56.7% In general, high-growth firms have low dividend payout ratios. In general, low-growth stable firms have higher dividend payout ratios.

23-38 Price-Earnings Ratio Colesville Corporation Market value per share Earnings per share $60.00 $ = = 22.0 $29.00 $ = = 14.5 High P/E ratios are generally associated with firms for which strong future growth is predicted.

23-39 Book-to-Market Ratio Colesville Corporation Book value of stockholders’ equity Total market value of equity $1,090,000 $4,200, = = 0.26 $1,468,000 $2,900, = = 0.51 This ratio reflects the difference between a company’s balance sheet value and the company’s actual market value.

23-40 (continues)

23-41 (continues)

23-42

23-43 Impact of Alternative Accounting Methods If companies are using different accounting practices, it will impact the comparability of ratios. Financial statement users should make adjustments for accounting differences among the companies being analyzed.

23-44 Introduction to Equity Valuation The following information for McDonald’s will be used for a simple valuation model: Diluted EPS$1.98$2.83$2.04$1.79 Dividends per share Assume the required rate of return on equity capital is 15%.

23-45 Constant Future Dividends The appropriate formula is as follows: Price = Dividends Required rate of return on equity capital Price = $ = $10.00 Thus, the implied price per share for McDonald’s for 2007 was $10.00.

23-46 Constant Dividend Growth Using the Gordon growth model, the formula is modified to include a growth rate of 11.1 percent in dividends (excluding the large dividends given in 2006 and 2007). Price = Dividends Required rate of return on equity – Expected future dividend growth rate Price = $ – = $38.46 given

23-47 Price-Earnings Multiple An investor can value a company’s share by using the information in the P/E ratio as follows: Price = Earnings × P/E ratio P/E ratios of McDonald’s competitors average Using McDonald’s 2007 diluted EPS, the implied price per share for McDonald’s is calculated as follows: Price = $1.98 × 25.4 = $50.29

23-48 Discounted Free Cash Flow Free cash flow is defined as: Cash from operating activities – Cash paid for capital expenditures = Free cash flow Free cash flow for McDonald’s was computed as follows:

23-49 Comparison of the Valuation Models The actual market price of a share of McDonald’s stock at the end of 2007 was $58.91.