Chapter 13, Slide #1 Using Financial Accounting Information: The Alternative to Debits and Credits Fifth Edition Gary A. Porter and Curtis L. Norton Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Chapter 13, Slide #2 Stockholders Financial Statement Analysis Creditors Management “Will I be paid?” “How good is our investment?” “How are we performing?”

Chapter 13, Slide #3 LIFOFIFO Limitations of Financial Statement Analysis  Use of different accounting methods  Changes in accounting methods LO1

Chapter 13, Slide #4 Limitations of Financial Statement Analysis  Failure to recognize trends in ratios  Difficulty of making industry comparisons (i.e., conglomerates )

Chapter 13, Slide #5 Limitations of Financial Statement Analysis  Nonoperating items on income statement  Effects of inflation

Chapter 13, Slide #6 Horizontal Analysis  A comparison of financial statement items over a period of time  Read right to left to compare one year’s results with the next as a dollar amount of change and as a percentage of change from year to year LO2

Chapter 13, Slide #7 Horizontal Analysis Cash $ 320 $1,350 $(1,030) (76)% Accounts receivable 5,500 4,500 1, Inventory 4,750 2,750 2, Prepaid insurance (50) (25) Total current assets $10,720 $8,800 $ 1, December 31 Increase (Decrease) Dollars Percent Dollar change from year to year Percentage change from one year to the next year

Chapter 13, Slide #8 Trend Analysis Return on Average Equity % 26.7% 28.7% 30.1% 29.0% Wm. Wrigley Jr. Company Tracking items over a series of years

Chapter 13, Slide #9 Vertical Analysis  Common-size statements recast items as a percentage of a selected item  Allows comparisons of companies of different size  Compares percentages across years to identify trends % % % LO3

Chapter 13, Slide #10 Vertical Analysis Cash $ % $ 1, % Accounts receivable 5, , Inventory 4, , Prepaid insurance (200) 1.5 Total current assets $10, % $8, % December 31, 2007 December 31, 2006 Dollars Percent Dollars Percent Compare percentages across years to spot year-to-year trends

Chapter 13, Slide #11 Liquidity Analysis  Nearness to cash  Ability to pay debts as they become due LO4

Chapter 13, Slide #12 Working Capital  Excess of current assets over current liabilities  Lacks meaningful comparisons for companies of different size CA – CL

Chapter 13, Slide #13 Current Ratio  Measure of short-term financial health  Consider composition of current assets Rule of thumb: 2:1 CA CL

Chapter 13, Slide #14 Acid-Test (Quick) Ratio  Stricter test of ability to pay debts  Excludes inventories and prepaid assets Quick Assets Current Liabilities

Chapter 13, Slide #15 Cash Flow from Operations to Current Liabilities  Focuses on cash only  Can be used to indicate the flow of cash during the year to cover the debts due Net Cash Provided by Operating Activities Average Current Liabilities

Chapter 13, Slide #16 Accounts Receivable Turnover Ratio Net Credit Sales Average Accounts Receivable Indicates how quickly a company is collecting (i.e., turning over) its receivables

Chapter 13, Slide #17 Number of Days’ Sales in Receivables Represents the average number of days an account is outstanding Number of Days in the Period Accounts Receivable Turnover

Chapter 13, Slide #18 Number of Days’ Sales in Receivables If this company’s credit terms are net 30, what would this tell you about the efficiency of the collection process? 360 days 4.8 times = 75 days Example:

Chapter 13, Slide #19 Inventory Turnover Ratio Represents the number of times per period inventory is turned over (i.e., sold). Cost of Goods Sold Average Inventory

Chapter 13, Slide #20 Number of Days’ Sales in Inventory Represents the average number of days inventory is on hand before it’s sold Number of Days in the Period Inventory Turnover

Chapter 13, Slide #21 Cash Operating Cycle  Time between the purchase of merchandise and the collection of the from the sale Number of Days’ Sales in Inventory + Number of Days’ Sales in Receivables

Chapter 13, Slide #22 Solvency Analysis  Ability to stay in business over the long-term Debt-to- Equity Ratio Debt Service Coverage Times Interest Earned Cash Flow from Operations to Capital Expenditures LO5

Chapter 13, Slide #23 Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed compared to owners?

Chapter 13, Slide #24 Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity =.60 “For every dollar contributed by owners, creditors have loaned $.60”

Chapter 13, Slide #25 Times Interest Earned  Measures ability to meet current interest payments  The greater the coverage the better Net Income + Interest Expense + Income Tax Expense Interest Expense

Chapter 13, Slide #26 Debt Service Coverage  Measures amount of cash from operating activities available to “service” the debt Cash Flow from Operations Before Interest and Tax Payments Interest and Principal Payments

Chapter 13, Slide #27 Cash Flow from Operations to Capital Expenditures Ratio  Measures company’s ability to use operations (vs. creditors and owners) to finance its acquisitions of productive assets Cash Flow from Operations – Total Dividends Paid Cash Paid for Acquisitions

Chapter 13, Slide #28 Profitability Analysis  Rate of Return on Assets  Return on Common Stockholders’ Equity  Earnings per Share  Price/Earnings Ratio  Dividend Ratios LO6

Chapter 13, Slide #29 Return on Assets Ratio  Measures return to all providers of capital (creditors and owners ) Net Income + Interest Expense, Net of Tax Average Total Assets

Chapter 13, Slide #30 Return on Common Stockholders’ Equity Net Income – Preferred Dividends Average Common Stockholders’ Equity “The owners earned 15% on their investment in ABC Co... Not bad!”

Chapter 13, Slide #31 Earnings per Share  Presents profits on a per-share basis Net Income – Preferred Dividends Weighted Average Number of Common Shares Outstanding

Chapter 13, Slide #32 Price/Earnings Ratio  Relates earnings to the market price of the stock Current Market Price Earnings per Share very high P/E very low P/E possibly overpriced possibly underpriced

Chapter 13, Slide #33 Price/Earnings Ratio Both companies have earnings of $2 per share. So why the different P/E ratios? P/E Ratios Co. A=10 to 1 Co. B= 7 to 1

Chapter 13, Slide #34 Dividend Payout Ratio Common Dividends per Share Earnings per Share “We need to decide what percentage of the firm’s income we can return to owners.”

Chapter 13, Slide #35 Dividend Yield Ratio  Investors willing to forgo dividends in lieu of price appreciation Common Dividends per Share Market Price per Share usually < 5% =

Chapter 13, Slide #36 Appendix Accounting Tools: Reporting and Analyzing Other Income Statement Items

Chapter 13, Slide #37 Common Characteristics  All such items are reported after income from continuing operations  Reported separately  Shown net of tax effects  Most analysts ignore these items, since they are not likely to reoccur LO7

Chapter 13, Slide #38 Discontinued Operations  Any gain or loss from disposal of a division or segment of the business  Any net income or loss from operating this portion until the date of disposal

Chapter 13, Slide #39 Extraordinary Items Gain or loss due to an event that is  Unusual in nature AND  Infrequent in occurrence

Chapter 13, Slide #40 Cumulative Effect of a Change in Accounting Principle  Reflects a change in a company’s accounting principles, practices, or methods  Reports the difference in income in all prior years between the old method and the new method  Sometimes such a change is dictated by a new accounting standard

Chapter 13, Slide #41 End of Chapter 13