© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 16: Financial Statement Analysis Cornerstones of Managerial Accounting, 4e

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Common-Size Analysis ► To make the analysis more meaningful, percentages can be used. ► Common-size analysis expresses line items or accounts in the financial statements as percentages. ► The two major forms of common-size analysis are horizontal analysis and vertical analysis. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Horizontal Analysis ► Also called trend analysis, horizontal analysis expresses a line item as a percentage of some prior- period amount. ► This approach allows the trend over time to be assessed. ► In horizontal analysis, line items are expressed as a percentage of a base period amount. ► The base period can be the immediately preceding period, or it can be a period further in the past. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Vertical Analysis ► While horizontal analysis involves relationships among items over time, vertical analysis is concerned with relationships among items within a particular time period. ► Vertical analysis expresses the line item as a percentage of some other line item for the same period. ► With this approach, within-period relationships can be assessed. ► Line items on income statements often are expressed as percentages of net sales. Items on the balance sheet often are expressed as a percentage of total assets. 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Ratio Analysis ► Ratio analysis is the second major technique for financial statement analysis. ► Ratios are fractions or percentages computed by dividing one account or line-item amount by another. ► For example, operating income divided by sales produces a ratio that measures the profit margin on sales. 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Standards for Comparison ► Ratios by themselves tell little about the financial well-being of a company. ► For meaningful analysis, the ratios should be compared with a standard. ► Only through comparison can someone using a financial statement assess the financial health of a company. ► Two standards commonly used are the past history of the company and industrial averages. 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Classification of Ratios ► Ratios generally are classified into one of three categories: liquidity, borrowing capacity or leverage, and profitability. ► Liquidity ratios measure the ability of a company to meet its current obligations. ► Leverage ratios measure the ability of a company to meet its long- and short-term obligations. These ratios provide a measure of the degree of protection provided to a company’s creditors. ► Profitability ratios measure the earning ability of a company. These ratios allow investors, creditors, and managers to evaluate the extent to which invested funds are being used efficiently. 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Current Ratio ► The current ratio is a measure of the ability of a company to pay its short-term liabilities out of short-term assets. ► The current ratio is computed as follows: ► Since current liabilities must be paid within an operating cycle (usually within a year) and current assets can be converted to cash within an operating cycle, the current ratio provides a direct measure of the ability of a company to meet its short- term obligations. 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Quick or Acid-Test Ratio ► The quick or acid-test ratio is a measure of liquidity that compares only the most liquid assets with current liabilities. ► Excluded from the quick ratio are non-liquid current assets such as inventories. ► The numerator of the quick ratio includes only the most liquid assets (cash, marketable securities, and accounts receivable). 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounts Receivable Turnover Ratio ► The extent of a company’s liquidity problem can be further investigated by examining the liquidity of its receivables, or how long it takes the company to turn its receivables into cash. ► A low liquidity of receivables signals more difficulty since the quick ratio would be overstated. ► The liquidity of receivables is measured by the accounts receivable turnover ratio, computed as follows: 3 Average accounts receivable is defined as follows:

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accounts Receivable Turnover in Days ► The accounts receivable turnover ratio can be taken further to determine the number of days the average balance of accounts receivable is outstanding before being converted into cash, which is calculated as follows: ► Whether the result is good or bad depends to some extent on what other companies in the industry are experiencing. ► A low turnover ratio may suggest a need to modify credit and collection policies to speed up the conversion of receivables to cash. 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Inventory Turnover Ratio 3 ► Inventory turnover is also an important liquidity measure. The inventory turnover ratio and average inventory is computed as follows: ► This ratio tells an analyst how many times the average inventory turns over, or is sold, during the year. ► A low turnover ratio may signal the presence of too much inventory or sluggish sales. ► The number of days inventory is held before being sold can be computed as: 365 ÷ Inventory Turnover Ratio = Turnover in Days

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Times-Interest-Earned Ratio ► The first leverage ratio uses the income statement to assess a company’s ability to service its debt. ► This ratio, called the times-interest-earned ratio, is computed as follows: ► Income before taxes must be recurring income; thus, unusual or infrequent items appearing on the income statement should be excluded in order to compute the ratio. ► Recurring income is used because it is the income that is available each year to cover interest payments. 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt Ratio ► Investors and creditors are the two major sources of capital. ► As percentage of assets financed by creditors increases, the riskiness of the company increases. ► The debt ratio measures this percentage and is computed as follows: ► Since total liabilities are compared with total assets, the ratio measures the degree of protection afforded to creditors in case of insolvency. ► Creditors often impose restrictions on the percentage of liabilities allowed. ► If this percentage is exceeded, the company is in default, and foreclosure can take place. 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt-to-Equity Ratio ► Another ratio useful in assessing the leverage used by a company is the debt-to-equity ratio. ► This ratio compares the amount of debt that is financed by stockholders and is calculated as follows: ► Creditors would like this ratio to be relatively low, indicating that stockholders have financed most of the assets of the firm. ► Stockholders, on the other hand, may wish this ratio to be higher because that indicates that the company is more highly leveraged and stockholders can reap the return of the creditors’ financing. 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Profitability Ratios ► Investors earn a return through the receipt of dividends and appreciation of the market value of their stock. ► Both dividends and market price of shares are related to the profits generated by companies. ► Since they are the source of debt-servicing payments, profits also are of concern to creditors. ► Managers also have a vested interest in profits. ► Bonuses, promotions, and salary increases often are tied to reported profits. ► Profitability ratios, therefore, are given particular attention by both internal and external users of financial statements. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Return on Sales ► Return on sales is the profit margin on sales. ► It represents the percentage of each sales dollar that is left over as net income after all expenses have been subtracted. ► Return on sales is one measure of the efficiency of a firm and is computed as follows: 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Return on Total Assets ► Return on assets measures how efficiently assets are used by calculating the return on total assets used to generate profits. ► Return on total assets and average total assets is computed as follows: ► By adding back the after-tax cost of interest, this measure reflects only how the assets were employed. ► It does not consider the manner in which they were financed (interest expense is a cost of obtaining the assets, not a cost of using them). 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Return on Common Stockholders’ Equity ► Return on total assets is measured without regard to the source of invested funds. ► For common stockholders, however, the return that they receive on their investment is of paramount importance. ► Of special interest to common stockholders is how they are being treated relative to other suppliers of capital funds. ► The return on stockholders’ equity provides a measure that can be used to compare against other return measures (e.g., preferred dividend rates and bond rates) and is computed as follows: 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Earnings Per Share ► Investors also pay considerable attention to a company’s profitability on a per-share basis. ► Earnings per share is computed as follows: ► Average common shares outstanding is computed by taking a weighted average of the common shares for the period under study. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Price-Earnings Ratio ► The price-earnings ratio is calculated as follows: ► Price-earnings ratios are viewed by many investors as important indicators of stock values. ► If investors believe that a company has good growth prospects, then the price-earnings ratio should be high. ► If investors believe that the current price-earnings ratio is low based on their view of future growth opportunities, the market price of the stock may be bid up. ► However, the price-earnings ratio should be interpreted with caution since it is comprised of stock price, which is a number that can be manipulated to meet certain targets involving analyst expectations, managerial bonuses, and other organizational goals. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Dividend Yield and Payout Ratios ► The profitability measure called dividend yield is computed as follows: ► By adding the dividend yield to the percentage change in stock price, a reasonable approximation of the total return accruing to an investor can be obtained. ► The dividend payout ratio is computed as follows: ► The payout ratio tells an investor the proportion of earnings that a company pays in dividends. ► Investors who prefer regular cash payments instead of returns through price appreciation will want to invest in companies with a high payout ratio; investors who prefer gains through appreciation will generally prefer a lower payout ratio. 5