1. “How Well Am I Doing?” Financial Statement Analysis Chapter 17

2. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult. We use the LIFO method to value inventory. We use the FIFO method to value inventory.

3. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Limitations of Financial Statement Analysis Analysts should look beyond the ratios. Economic factors Industry trends Changes within the firm Technological changes Consumer tastes

4. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Statements in Comparative and Common-Size Form  Dollar and percentage changes on statements  Common-size statements  Ratios Analytical techniques used to examine relationships among financial statement items

5. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Dollar and Percentage Changes on Statements Comparing statements underscores movements and trends and may provide valuable clues about what to expect in the future. Horizontal analysis Trend analysis

6. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

7. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Example The following slides illustrate a horizontal analysis of Clover Corporation’s December 31, 2004 and 2003 comparative balance sheets and comparative income statements. Horizontal Analysis

8. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Horizontal Analysis

9. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Horizontal Analysis Calculating Change in Dollar Amounts Dollar Change Current Year Figure Base Year Figure =– The dollar amounts for 2003 become the “base” year figures.

10. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Calculating Change as a Percentage Percentage Change Dollar Change Base Year Figure 100% = × Horizontal Analysis

11. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Horizontal Analysis ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500)

12. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Horizontal Analysis

13. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Horizontal Analysis We could do this for the liabilities & stockholders’ equity, but now let’s look at the income statement accounts.

14. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Horizontal Analysis

15. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Horizontal Analysis Sales increased by 8.3% yet net income decreased by 21.9%.

16. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Horizontal Analysis There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

17. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.

18. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Trend Analysis Trend Percentage Current Year Amount Base Year Amount 100% = ×

19. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Trend Analysis Example Look at the income information for Berry Products for the years 2000 through 2004. We will do a trend analysis on these amounts to see what we can learn about the company.

20. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Trend Analysis The base year is 2000, and its amounts will equal 100%. Berry Products Income Information For the Years Ended December 31

21. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Trend Analysis Berry Products Income Information For the Years Ended December 31 2001 Amount ÷ 2000 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108%

22. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Trend Analysis By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin. Berry Products Income Information For the Years Ended December 31

23. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Trend Analysis We can use the trend percentages to construct a graph so we can see the trend over time.

24. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Common-Size Statements Common-size single vertical analysis Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis.

25. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Example Let’s take another look at the information from the comparative income statements of Clover Corporation for 2004 and 2003. This time let’s prepare common-size statements. Common-Size Statements

26. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Common-Size Statements Net sales Net sales is usually the base and is expressed as 100%.

27. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Common-Size Statements 2003 Cost ÷ 2003 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6% 2004 Cost ÷ 2004 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2%

28. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Gross Margin Percentage Gross Margin Percentage Gross Margin Sales = This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and a profit.

29. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Common-Size Statements What conclusions can we draw?

30. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Now, let’s look at Norton Corporation’s 2004 and 2003 financial statements.

31. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

32. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

33. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin

34. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Now, let’s calculate some ratios based on Norton Corporation’s financial statements.

35. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Ratio Analysis – The Common Stockholder Use this information to calculate ratios to measure the well-being of the common stockholders of Norton Corporation.

36. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Earnings Per Share Earnings per Share Net Income – Preferred Dividends Average Number of Common Shares Outstanding = Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

37. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Earnings Per Share Earnings per Share Net Income – Preferred Dividends Average Number of Common Shares Outstanding = Earnings per Share $53,690 – 0 (17,000 + 27,400)/2 == $2.42 This measure indicates how much income was earned for each share of common stock outstanding.

38. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share Earnings Per Share = Price-Earnings Ratio $20.00 $2.42 == 8.26 times This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price- earnings ratio, the more opportunity a company has for growth.

39. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Dividend Payout Ratio Dividend Payout Ratio Dividends Per Share Earnings Per Share = Dividend Payout Ratio $2.00 $2.42 == 82.6% This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking current income would like this ratio to be large.

40. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Dividend Yield Ratio Dividend Yield Ratio Dividends Per Share Market Price Per Share = Dividend Yield Ratio $2.00 $20.00 == 10.00% This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

41. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Return on Total Assets This ratio measures how well assets have been employed. Return on Total Assets $53,690 +[7,300 × (1 –.30)] ($300,000 + $346,390) ÷ 2 == 18.19% Return on Total Assets Net Income + [Interest Expense × (1 – Tax Rate)] Average Total Assets =

42. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Return on Common Stockholders’ Equity Return on Common Stockholders’ Equity Net Income – Preferred Dividends Average Stockholders’ Equity = Return on Common Stockholders’ Equity $53,690 – 0 ($180,000 + $234,390) ÷ 2 == 25.91% This measure indicates how well the company employed the owners’ investments to earn income.

43. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Financial Leverage Financial leverage Financial leverage involves acquiring assets with funds at a fixed rate of interest. Return on investment in assets > Fixed rate of return on borrowed funds Positive financial leverage = Return on investment in assets < Fixed rate of return on borrowed funds Negative financial leverage =

44. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Impact of Income Taxes Debt is more efficient in generating positive financial leverage than preferred stock.

45. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Book Value Per Share Book Value per Share Common Stockholders’ Equity Number of Common Shares Outstanding = This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off. = $ 8.55 Book Value per Share $234,390 27,400 =

46. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Ratio Analysis – The Short– Term Creditor Use this information to calculate ratios to measure the well-being of the short-term creditors for Norton Corporation.

47. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Working Capital

48. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $65,000 $42,000 ==1.55 : 1 This ratio measures the ability of the company to pay current debts as they become due.

49. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Acid-Test (Quick) Ratio Quick Assets Current Liabilities = Acid-Test Ratio Quick assets are Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000.

50. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Acid-Test (Quick) Ratio Quick Assets Current Liabilities = Acid-Test Ratio This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash. $50,000 $42,000 =1.19 : 1= Acid-Test Ratio

51. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Accounts Receivable Turnover Sales on Account Average Accounts Receivable Accounts Receivable Turnover = This ratio measures how many times a company converts its receivables into cash each year. = 27.03 times $500,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover =

52. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Average Collection Period = 365 Days Accounts Receivable Turnover This ratio measures, on average, how many days it takes to collect an account receivable. = 13.50 days Average Collection Period = 365 Days 27.03 Times

53. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = This ratio measures the number of times merchandise inventory is sold and replaced during the year. = 12.73 times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover =

54. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Average Sale Period = 365 Days Inventory Turnover This ratio measures how many days, on average, it takes to sell the inventory. = 28.67 days Average Sale Period = 365 Days 12.73 Times

55. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Ratio Analysis – The Long– Term Creditor Use this information to calculate ratios to measure the well-being of the long-term creditors for Norton Corporation. This is also referred to as net operating income.

56. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Times Interest Earned Ratio This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor. Times Interest Earned $84,000 7,300 == 11.5 times Times Interest Earned Earnings before Interest Expense and Income Taxes Interest Expense =

57. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity Debt–to– Equity Ratio = This ratio measures the amount of assets being provided by creditors for each dollar of assets being provided by the owners of the company. $112,000 $234,390 Debt–to– Equity Ratio == 0.48 to 1

58. © The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin End of Chapter 17