2. Slide 14-2 CHAPTER 14 Analyzing Financial Statements: A Managerial Perspective

3. Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement. Slide 14-3 Why Managers Analyze Financial Statements  Managers analyze financial statements for a variety of reasons including: 1.To control operations 2.To assess the financial stability of vendors, customers, and other business partners 3.To assess how their companies appear to investors and creditors

4. Slide 14-4 Control of Operations  Managers analyze financial statements to gain insight into whether their goals have been achieved or plans implemented successfully  Managers expect that a successful implementation of their plans will be reflected in financial information  If financial information is inconsistent with a successful implementation an investigation will be launched Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

5. Slide 14-5 Assessment of Vendors, Customers, and Other Partners  Another important reason for analyzing financial statements is to review the financial stability of vendors, customers, and other strategic partners  Increasingly companies are establishing strong relationships with a small number of vendors willing to commit to high quality levels and short lead times Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

6. Slide 14-6 Assessment of Vendors, Customers, and Other Partners  Managers want to be confident that the vendor will be stable and continue in existence over the foreseeable future  Companies analyze customers to assess whether they will be able to pay the amounts they owe  Companies do not want to enter into partnerships with firms in financial difficulty Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

7. Slide 14-7 Assessment of Appearance to Investors and Creditors  Investors and creditors carefully analyze a company’s financial statements  Managers should anticipate how their financial information will appear to stakeholders  Managers can explain differences in the notes to the financial statements, or avoid transactions which cause differences Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

8. Slide 14-8 Why do managers analyze financial statements?  To control operations  To assess vendors, customers and other business partners  To assess appearance to investors and creditors  All of the above Answer: d All of the above Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

9. Slide 14-9 Horizontal and Vertical Analyses  Horizontal analysis  Analysis of the dollar value and percentage changes in financial statement amounts across time  The dollar value of the change is the new value minus the old value for each financial statement amount  The percentage change is the dollar value of the change divided by the old value for each financial statement amount Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

10. Slide 14-10 Horizontal and Vertical Analyses  Vertical analysis  Also called common size analysis  Analyze financial statement amounts in comparison to a base amount  Divide each financial statement amount by total assets for the balance sheet  Divide each financial statement amount by net sales for the income statement Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

11. Slide 14-11 Analysis of the Balance Sheet  The results of a horizontal analysis of the balance sheet are presented on the next slides  What can we conclude?  HGW is expanding (increases in land, buildings, furniture and fixtures, and equipment)  Funded by debt and internally generated funds (retained earnings) Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

12. Horizontal Analysis of the Balance Sheet Slide 14-12 Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

13. Horizontal Analysis of the Balance Sheet Slide 14-13 Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

14. Slide 14-14 Analysis of the Balance Sheet  A vertical analysis of the balance sheet is presented on the next two slides  The primary asset accounts are merchandise inventory, land, and buildings  All account balances are greater than 20 percent of total assets Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

15. Slide 14-15 Vertical Analysis of the Balance Sheet Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

16. Slide 14-16 Vertical Analysis of the Balance Sheet Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

17. Slide 14-17 Analyzing the Income Statement  A horizontal and vertical analysis of the balance sheet is presented on the next two slides  Both net sales and cost of goods sold have increased from 2013 to 2014  Gross profit has increased 43%  The vertical analysis shows that net income has declined from 6.5% of sales to 5.6% of sales Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

18. Slide 14-18 Horizontal Analysis Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

19. Slide 14-19 Vertical Analysis Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

20. Slide 14-20 Horizontal analysis evaluates:  Comparable companies  Changes in expenses as a percentage of sales  Changes in expenses as a percent of total assets  Changes in balances from one year to another Answer: d Changes in balances from one year to another Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

21. Slide 14-21 Vertical analysis evaluates:  Changes in net sales as a percentage of total assets  Changes in expenses as a percentage of sales  Financial statement amounts in comparison to a base amount  Changes in balances from one year to another Answer: c Financial statement amounts in comparison to a base amount Learning objective 1: Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement.

22. Learning objective 2: Discuss earnings management and the importance of comparing net income to cash flow from operations. Also, understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance. Slide 14-22 Earnings Management  Accounting earnings can be manipulated to make performance appear stronger than it actually is  Allegations of impropriety have been leveled against many companies, including:  Enron  Kroger  Lucent, and  Waste Management

23. Slide 14-23 Earnings Management  Why do managers manipulate earnings?  Managers often are evaluated and rewarded based on the level of firm earnings  If earnings are below the specified bonus level, managers have an inventive to manipulate earnings  Managers manipulate earnings to raise the stock price and profit from exercising stock options Learning objective 2: Discuss earnings management and the importance of comparing net income to cash flow from operations. Also, understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance.

24. Slide 14-24 Earnings Management  A red flag suggesting that accounting irregularities may be a problem is a difference between net income and operating cash flows  If a firm records fictitious sales income will increase but operating cash flows will not be affected  The company does not collect cash from fictitious sales Learning objective 2: Discuss earnings management and the importance of comparing net income to cash flow from operations. Also, understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance.

25. Slide 14-25 Cash Flow versus Earnings Learning objective 2: Discuss earnings management and the importance of comparing net income to cash flow from operations. Also, understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance.

26. Slide 14-26 Other Sources of Information on Financial Performance  A number of other information sources can be used to gain insight into a company’s financial performance  Management discussion and analysis  Contained in the annual report  Management provides users with explanations for financial results that are not obvious from reading the basic financial statements Learning objective 2: Discuss earnings management and the importance of comparing net income to cash flow from operations. Also, understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance.

27. Slide 14-27 Other Sources of Information on Financial Performance  A number of other information sources can be used to gain insight into a company’s financial performance  Credit reports  A number of firms sell credit reports that provide information on a company’s credit history  The ratings help managers evaluate the likelihood that a company they do business with will pay its bills on time Learning objective 2: Discuss earnings management and the importance of comparing net income to cash flow from operations. Also, understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance.

28. Slide 14-28 Other Sources of Information on Financial Performance  A number of other information sources can be used to gain insight into a company’s financial performance  News articles are another very valuable source of financial information  Lexis-Nexis is an example of a company that, for a fee, provides access to articles from major newspapers, magazines, and newswire services Learning objective 2: Discuss earnings management and the importance of comparing net income to cash flow from operations. Also, understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance.

29. Slide 14-29 Management Discussion & Analysis (MD&A) Example Learning objective 2: Discuss earnings management and the importance of comparing net income to cash flow from operations. Also, understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance.

30. Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios. Slide 14-30 Ratio Analysis  Managers frequently perform financial analyses using various ratios  To control operations  To assess the stability of vendors, customers, and other business partners  To assess how their companies appear to investors and creditors

31. Slide 14-31 Ratio Analysis  Ratios are grouped into 3 categories 1.Profitability ratios examine the firm’s ability to generate income 2.Turnover ratios reveal the efficiency with which a company uses its assets 3.Debt related ratios relate the amount of debt a company has and its ability to repay its obligations Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

32. Slide 14-32 Profitability Ratios  Earnings per share  Amount of earnings generated per share of common stock  The more earnings per share a company can generate, the higher its stock price  Price-earnings ratio  Indicates how much investors are willing to pay per dollar of earnings Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

33. Slide 14-33 Profitability Ratios  Gross margin percentage  Indicates how much a company earns per dollar of sales, taking into account the cost of the items it sells  Return on total assets  Indicates how profitable a company is in relation to its assets  Return on common stockholders’ equity  The return a company is able to earn on funds invested by shareholders Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

34. Slide 14-34 Profitability Ratio Formulas Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

35. Slide 14-35 Profitability Ratio Formulas Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

36. Slide 14-36 Profitability Ratios for HGWn Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

37. Slide 14-37 Turnover Ratios  Asset turnover  Shows how efficiently assets are used to generate sales  Accounts receivable turnover  The more times accounts receivable turn over, the sooner they are collected  Days’ sales in receivables  A measure of how long it will take to collect receivables Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

38. Slide 14-38 Turnover Ratios  Inventory turnover  Indicates how many times inventory turns over  Generally, the higher the ratio, the more efficient the management of inventory levels  Days’ sales in inventory  A measure of how long it will take to sell inventory Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

39. Slide 14-39 Turnover Ratio Formulas Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

40. Slide 14-40 Turnover Ratio Formulas Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

41. Slide 14-41 Turnover Ratios for HGW Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

42. Slide 14-42 The efficient use of assets is indicated by:  Turnover ratios  Debt-related ratios  The ratio of debt to equity  The ratio of current assets to current liabilities Answer: a Turnover ratios Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

43. Slide 14-43 Debt-Related Ratios  Current ratio  A measure of a company’s ability to pay short term obligations  Acid test ratio (quick ratio)  Compared to the current ratio, a more stringent test of a company’s ability to pay short term obligations Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

44. Slide 14-44 Debt-Related Ratios  Debt to equity ratio  A measure of the relative amount of debt versus equity in a firm’s capital structure.  Firms with relatively high values may have too much debt  Times interest earned  A measure of a company’s ability to make interest payments on its debt Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

45. Slide 14-45 Debt-Related Ratios Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

46. Slide 14-46 Debt-Related Ratios for HGW Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

47. Slide 14-47 Too Much Debt Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

48. Slide 14-48 The ratio times interest earned can be used to evaluate:  The amount of debt versus equity financing  The extent to which interest income exceeds interest expense  The extent to which interest expense exceeds interest income  The likelihood that a company will be able to make required interest payments Answer: d The likelihood that a company will be able to make required interest payments Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

49. Slide 14-49 Strategic Partners Learning objective 3: Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios.

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