CHAPTER 11 FINANCIAL STATEMENT ANALYSIS McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 1.How can liquidity measures be influenced by the inventory cost-flow assumption used? 2.How do suppliers and creditors use a customer’s payment practices to judge liquidity? 3.What are the influences of alternative inventory cost-flow assumptions and depreciation methods on turnover ratios? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 4.How are the number of days’ sales in accounts receivable and inventory used to evaluate the effectiveness of the management of receivables and inventory? 5.What is the significance of the price/earnings ratio in the evaluation of the market price of a company’s stock? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 6.How are dividend yield and the dividend payout ratio used by investors to evaluate a company’s common stock? 7.What is financial leverage, and why is it significant to management, creditors, and owners? 8.What is book value per share of common stock, how is it calculated, and why is it not a very meaningful amount for most companies? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 9.How can common size financial statements be used to evaluate a firm’s financial position and results of operations over a number of years? 10.How can operating statistics using physical, or non-financial data, be used to help management evaluate the results of the firm’s activities? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 1 How can liquidity measures be influenced by the inventory cost-flow assumption used? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Financial Statement Analysis Ratios Used to facilitate the interpretation of an entity’ financial position and results of operations Can be classified into four groups: –Liquidity –Activity –Profitability –Debt, or financial leverage McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Liquidity Measures The balance sheet carrying values of inventory will depend on the cost-flow assumption used Cannot compare firms using different inventory cost-flow assumptions Firms often report the LIFO reserve – the difference between LIFO an FIFO inventory values McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Liquidity Ratios Working capital = Current assets – Current liabilities Current ratio = Current assets Current liabilities Acid-test ratio = Cash + Accounts receivable Current liabilities McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 2 How do suppliers and creditors use a customer’s payment practices to judge liquidity? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Customer’s Payment Practices Suppliers and creditors want to know if a firm is paying its bills promptly This information may be obtained from other suppliers, credit bureaus, and Dun & Bradstreet reports Credit bureaus and credit rating agencies provide a graded rating for firms McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 3 What are the influences of alternative inventory cost-flow assumptions and depreciation methods on turnover ratios? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Activity Measures Focus primarily on the relationship between assets and sales In computing activity measures, average assets is used Average asset amounts include inventory and fixed assets The values of inventory (based on cost-flow assumptions) and fixed assets (based on book cost less accumulated depreciation) depend on the cost-flow assumptions and depreciation methods used McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Activity Ratios Total asset turnover = Sales Average total assets Inventory turnover = Cost of goods sold Average inventories Number of days’ sales in accounts receivable = Accounts receivable Average days’ sales McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

More Activity Ratios Average days’ sales = Annual sales 365 Number of days’ sales in inventory = Inventory Average days’ cost of goods sold Average days’ cost of goods sold = Average cost of goods sold 365 McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 4 How are the number of days’ sales in accounts receivable and inventory used to evaluate the effectiveness of the management of receivables and inventory? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Number of Days’ Sales in Accounts Receivable Assesses the efficiency of managing accounts receivable The sooner accounts receivable are collected, the sooner cash is available for use in the business Generally, the higher the turnover and lower the number in days’ sales, the better An increase in the age of accounts receivable is a warning that profitability and liquidity may be weakening McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Number of Days’ Sales in Inventory Assesses the efficiency of managing inventory The lower that inventories can be maintained relative to sales,the less inventory that needs to be financed with debt and the greater the return on investment Trend in the efficiency of managing inventory is the important factor McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Profitability Measures Operating income is frequently used in ROI calculations because it is a more direct measure of management’s activities Average ROI based on net income for most American firms is between 7% and 10% Again, trends are important McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Profitability Ratios ROI = Return (Net income) Investment (Average total assets) DuPont model = Margin x Turnover Net income x Sales Sales Average total assets McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

More Profitability Ratios ROE = Net income Average total owners’ equity Dividend yield = Annual dividend per share Market price per share of stock Dividend payout ratio = Annual dividend per share Earnings per share McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 5 What is the significance of the price/earnings ratio in the evaluation of the market price of a company’s stock? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Price/Earning Ratio P/E ratio = Market price of a share of common stock Earnings per share of common stock Used extensively to evaluate the market price of a firm’s common stock relative to that of other firms and the market as a whole Also called earnings multiple McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Importance of P/E Ratio Investors can earn a return on stock two ways: –Through dividends –Through increases in the market value of the stock Market price reflects expectations of future dividends – which depend on earnings Typically, manufacturing firms’ P/E ratio ranges from 12 to 18 McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 6 How are dividend yield and the dividend payout ratio used by investors to evaluate a company’s common stock? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Dividend Yield Dividend yield = Annual dividend per share Market price per share of stock Should be compared to the yield available on other investments On common stock, historically this has ranged from 3% to 6% On preferred stock, the range is 5% to 8% McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Dividend Payout Ratio Dividend payout ratio = Annual dividend per share Earnings per share Reflects the dividend policy of the firm Most firms pay a relatively constant portion of earnings and avoid fluctuations Generally, ranges from 30% to 50% for manufacturing and merchandising firms McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Preferred Dividend Coverage Ratio Preferred dividend coverage ratio = Net income Preferred dividend requirement Indicates the margin of safety of the preferred stock dividend McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 7 What is financial leverage, and why is it significant to management, creditors, and owners? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Financial Leverage Measures Refers to the use of debt to finance the assets of the entity Adds risk to the operation of the firm Also magnifies the return to owners relative to the return on assets Firms want to borrow at a rate less than the rate of return on financed assets Interest is a deductible expense; dividends are not deductible McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Debt Ratio Indicates the extent to which a firm is using financial leverage Debt ratio = Total liabilities Total liabilities and owners’ equity Indicates the percentage of financing that is done with debt McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Debt/Equity Ratio Another indicator of the extent to which a firm is using financial leverage Debt/Equity ratio = Total liabilities Total owners’ equity Indicates the percentage of financing that is done with debt Since deferred taxes and current liabilities are not interest bearing, these items are often excluded from the computation McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Times Interest Earned Ratio A measure that shows the relationship of earnings before interest and taxes to interest expense The greater the ratio, the more confident the debt holders are about the firm continuing to earn enough to cover interest payments Times interest earned = Earnings before interest and taxes Interest expense McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 8 What is book value per share of common stock, how is it calculated, and why is it not a very meaningful amount for most companies? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Book Value per Share of Common Stock Easily misunderstood Cannot be compared to market value due to book value reflects the application of generally accepted accounting principles and the specific accounting policies that the firm has selected Book value per share of common stock = Common shareholders’ equity Number of shares of common stock outstanding McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 9 How can common size financial statements be used to evaluate a firm’s financial position and results of operations over a number of years? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Common Size Financial Statements Used when evaluating the operating results of a firm over a number of years Each asset, liability, and owners’ equity account is expressed as a percentage of total assets On the income statement, sales is set at 100%, and each item is expressed as a percentage of sales McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Use of Common Size Financial Statements Using percentages makes spotting trends easier Can compare firms of different sizes In horizontal analysis, several years’ financial data are stated in terms of a base year Each item in the base year is 100%; the items in subsequent years are a percentage of the item in the base year McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Learning Objective 10 How can operating statistics using physical, or non-financial data, be used to help management evaluate the results of the firm’s activities? McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002

Other Operating Statistics Physical measures also are useful Sales in units removes hidden price changes Total employees may be more useful than payroll costs Usually analysts combine financial and physical measures to show trends and to make comparisons McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002