Chapter 15 Financial Statement Analysis

Introduction How can we determine:  The ability of an organization to pay loans?  Whether we are earning a fair return on our investment?  The adequacy of cash flow to pay operating expenses?  How to improve the overall performance of the company?

Limitations of Financial Statement Analysis When comparing companies and interpreting financial statement analysis, differences in accounting methods and cost flow assumptions need to be considered.

Horizontal Analysis Trend Analysis: horizontal analysis of financial statements over several years. Can be used to:  Build prediction models to forecast financial performance in the future.  Identify problem areas by looking for sudden or abnormal changes in accounts.

Vertical Analysis  Compares financial statements of different companies and financial statements of the same company across time after controlling for differences in size.  Common-size financial statements are statements in which all items have been restated as a percentage of a selected item on the statement.

Vertical Analysis Comparative Balance Sheet Asset accounts are stated as a percentage of total assets. Liability and stockholders’ equity accounts are stated as a percentage of total Liabilities & Stockholders’ Equity. On what numbers do I base the percentages?

Vertical Analysis Working Capital = Current Assets - Current Liabilities Measure of an entity’s LIQUIDITY, or its ability to meet its immediate financial obligations More useful if we have information concerning the make-up of Working Capital

Vertical Analysis Common-Size Comparative Income Statements  Percentages are based on NET sales  The gross profit percentage is usually closely watched

Current Ratio or Working Capital Ratio Measures the entity’s liquidity. This ratio tells us the amount of current assets for every dollar of current liabilities. Current Ratio = Current Assets Current Liabilities

Acid-Test Ratio or Quick Ratio This ratio is a stricter test of a company’s ability to pay its current debts with highly liquid current assets. This ratio removes inventories and prepaid assets from the amount of current assets used in the calculation. A quick ratio of less than 1.0 should be of concern. Quick Ratio = Quick Assets Current Liabilities

Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity A solvency ratio that measures the ability to stay financially healthy over the long run. Indicates the preference of debt or equity financing of the entity.

Return on Assets Considers the return to investors on all assets invested in the company. Interpretation is based on the company’s required return on assets, industry standards, and trends. Net Income + Interest Expense (net of tax) Average Total Assets

Earnings Per Share Used to measure performance. Used to compare the performance of companies across different industries. Net Income - Preferred Dividends Average Number of Common Shares Outstanding

End of Chapter 15