Analyzing and Interpreting Financial Statements

Analyzing and Interpreting Financial Statements
Chapter 13 Analyzing and Interpreting Financial Statements This chapter is important to all business majors. We will look in detail at ways to analyze a set of financial statements to gain new perspectives on the performance and financial position of a company. Let’s get started by looking at some cautions about the use or misuse of financial statement analysis.

Conceptual Learning Objectives
C1: Explain the purpose of analysis C2: Identify the building blocks of analysis C3: Describe standards for comparisons in analysis C4: Identify the tools of analysis

Analytical Learning Objectives
A1: Summarize and report results of analysis A2: Appendix 17A: Explain the form and assess the content of a complete income statement

Procedural Learning Objectives
P1: Explain and apply methods of horizontal analysis P2: Describe and apply methods of vertical analysis P3: Define and apply ratio analysis

Application of analytical tools Involves transforming data
Basics of Analysis C 1 Application of analytical tools Reduces uncertainty Involves transforming data We have many analytical tools we can use to analyze the financial statements of a company. These techniques help us to better understand the company and reduce any uncertainty associated with financial information.

Financial statement analysis helps users make better decisions.
Purpose of Analysis C 1 Financial statement analysis helps users make better decisions. Our financial analysis is used by many people within the organization. Managers find financial analysis helpful in planning and controlling operations. External users of financial statements are also interested in the results of comprehensive financial analysis. Shareholders, creditors, and customers all want to learn as much as possible about the financial health of a company. Internal Users External Users Managers Officers Internal Auditors Shareholders Lenders Customers

Building Blocks of Analysis
Ability to meet short-term obligations and to efficiently generate revenues Ability to generate future revenues and meet long-term obligations Liquidity and Efficiency Solvency As we complete this chapter by showing you how to calculate key business ratios, we will organize the ratios into four unique groups. Measures of liquidity and efficiency are most important to short-term creditors. Measures of solvency help people assess the ability of the company to generate revenues in the long-run. These measures are especially important to long-term creditors. Measures of profitability are important to managers and outsiders as well. Everyone with an interest in the company is concerned about the long-term profitability of its operations. Market prospects are most important to owners of the company’s common shares. Ability to provide financial rewards sufficient to attract and retain financing Ability to generate positive market expectations Market Prospects Profitability

Information for Analysis
C 2 Income Statement Notes Balance Sheet Statement of Stockholders’ Equity Statement of Cash Flows Basic information for our analysis comes from the financial statements and the notes to those statements. In some cases, we may need to develop supplemental information to complete our analysis.

Standards for Comparison
To help me interpret our financial statements, I use several standards of comparison. Intracompany Competitor Industry Guidelines When we complete our analysis, it is essential to compare the results we obtained to those of our competitors, other companies in our same industry, and general financial market guidelines.

Comparing a company’s financial condition and performance across time.
Tools of Analysis C 4 Horizontal Analysis Comparing a company’s financial condition and performance across time. Horizontal analysis can be extremely helpful in learning more about a company. It is the process of properly preparing financial data in dollar and percentage formats. This information is usually shown side-by-side. Time

Tools of Analysis V e r t i c a l
Comparing a company’s financial condition and performance to a base amount Vertical analysis is the process of comparing a company’s financial condition and results of operation in reference to a base amount.

Measurement of key relations between financial statement items
Tools of Analysis C 4 Measurement of key relations between financial statement items Ratio Analysis Over time, the business community has developed several key ratios that are considered important when evaluating the strengths and weaknesses of a company. We will cover many of these key ratios in this chapter.

Now, let’s look at some ways to use horizontal analysis.
C 4 Now, let’s look at some ways to use horizontal analysis. Let’s begin the process of analyzing the financial position and results of operations of a company by using horizontal analysis. Time

Horizontal Analysis CLOVER CORPORATION
Comparative (Partial) Balance Sheet December 31, 2007 2007 2006 Dollar Change Percent Assets Current assets: Cash and equivalents 12,000 $ 23,500 Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700 Property and equipment: Land Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000 Total assets 315,000 289,700 Here is the comparative balance sheet of Clover Corporation. Let’s begin our horizontal analysis by calculating the dollar change and the percentage change in account balances.

Comparative Statements
Calculate Change in Dollar Amount Dollar Change Analysis Period Amount Base Period Amount = – Since we are measuring the amount of the change between 2006 and 2007, the dollar amounts for 2006 become the “base” period amounts. The first task that we face is establishing the base year and then calculating changes in reference to the base. In horizontal analysis, we use the oldest year shown as the base year and determine the dollar change between the base year and the current year. For Clover Corporation 2006 is the base year.

Comparative Statements
Calculate Change as a Percent Percent Change Dollar Change Base Period Amount × = 100 Once we establish the base year, we may calculate the percentage change by dividing the dollar change by the base year amount and multiplying by one hundred. With this background, let’s get started with our work on the Clover Corporation’s comparative balance sheet.

P 1 CLOVER CORPORATION Comparative (partial) Balance Sheet December 31, 2007 2007 2006 Dollar Change Percent Change* Assets Current assets: Cash and equivalents 12,000 $ 23,500 (11,500) (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 1,800 Total current assets 155,000 164,700 Property and equipment: Land - 0.0 Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000 Total assets 315,000 289,700 * Percent rounded to first decimal point. $12,000 – $23,500 = $(11,500) For the dollar change in cash, we subtract the base year amount of twenty-three thousand, five hundred dollars from the current year amount of twelve thousand dollars, and determine the change in cash was a negative eleven thousand, five hundred dollars. We know the percentage change will be negative. To determine the percentage change, we divide the dollar change of eleven thousand, five hundred dollars by the base year balance of twenty-three thousand, five hundred, and multiply by one hundred percent. The percentage change is a decrease in cash of forty eight point nine percent. Why don’t you take a few minutes and see if you can calculate the dollar and percentage changes for accounts receivable and inventory. When you are done, go to the next slide. ($11,500 ÷ $23,500) × 100 = 48.9%

Comparative (Partial) Balance Sheet December 31, 2007
CLOVER CORPORATION Comparative (Partial) Balance Sheet December 31, 2007 2007 2006 Dollar Change Percent Change* Assets Current assets: Cash and equivalents 12,000 $ 23,500 (11,500) (48.9) Accounts receivable, net 60,000 40,000 20,000 50.0 Inventory 80,000 100,000 (20,000) (20.0) Prepaid expenses 3,000 1,200 1,800 150.0 Total current assets 155,000 164,700 (9,700) (5.9) Property and equipment: Land - 0.0 Buildings and equipment, net 120,000 85,000 35,000 41.2 Total property and equipment 160,000 125,000 28.0 Total assets 315,000 289,700 25,300 8.7 * Percent rounded to first decimal point. How did you do? We can see that, overall, our assets increased by eight point seven percent, but our current assets decrease by five point nine percent. The decrease in current assets may impact some of the ratios that we calculate later in the presentation.

Let’s compare years using the income statement.

Now, let’s look at trend analysis!
P 1 Now, let’s look at trend analysis! Now let’s look at trend analysis. Trend analysis helps us analyze changes in financial information over a number of years. The change is usually stated in percentage terms.

Analysis Period Amount
Trend Analysis P 1 Trend analysis is used to reveal patterns in data covering successive periods. To calculate the trend percentage, we divide the current period amount by the base period amount and multiply by one hundred. All values will be expressed as a percentage increase or decrease from the base period. The base period is usually the oldest period shown. Trend Percent Analysis Period Amount Base Period Amount 100 = ×

Trend Analysis 2001 is the base period so its amounts will equal 100%.
Berry Products Income Information For the Years Ended December 31, Item 2005 2004 2003 2002 2001 Revenues 400,000 $ 355,000 320,000 290,000 275,000 Cost of sales 285,000 250,000 225,000 198,000 190,000 Gross profit 115,000 105,000 95,000 92,000 85,000 We have developed some income information for Berry Products for the years 2001 through Let’s analyze this information using trend analysis. 2001 is the base period so its amounts will equal 100%.

For the Years Ended December 31,
Trend Analysis P 1 Berry Products Income Information For the Years Ended December 31, Item 2005 2004 2003 2002 2001 Revenues 400,000 $ 355,000 320,000 290,000 275,000 Cost of sales 285,000 250,000 225,000 198,000 190,000 Gross profit 115,000 105,000 95,000 92,000 85,000 Item 2005 2004 2003 2002 2001 Revenues 105% 100% Cost of sales 104% Gross profit 108% The base period will be the year Now we convert all the dollars shown to percentages using year 2001 amounts as one hundred percent. To determine the percentage increase in sales for 2002, we divide 2002 sales of two hundred ninety thousand dollars by 2001 sales of two hundred seventy five thousand dollars, and multiply by one hundred percent. Sales for 2002 are one hundred five percent of 2001 sales. We follow similar calculations for cost of goods sold and gross margin. Next, we complete the remaining years on our table. Before going to the next slide see if you can calculate the 2003 sales percent.

Trend Analysis How would this trend analysis look on a line graph?
Berry Products Income Information For the Years Ended December 31, Item 2005 2004 2003 2002 2001 Revenues 400,000 $ 355,000 320,000 290,000 275,000 Cost of sales 285,000 250,000 225,000 198,000 190,000 Gross profit 115,000 105,000 95,000 92,000 85,000 Item 2005 2004 2003 2002 2001 Revenues 145% 129% 116% 105% 100% Cost of sales 150% 132% 118% 104% Gross profit 135% 124% 112% 108% How did you do in your calculation? Now that the table is complete we can see that cost of goods sold is increasing faster than the increase in sales, so gross margin is increasing slowly. Better cost control would lead to a more rapid increase in gross margins. How would this trend analysis look on a line graph?

Trend Analysis P 1 We can use the trend percentages to construct a graph so we can see the trend over time. Some managers prefer to review trend information in chart form. Using Excel is an easy way to develop charts from our data. Here is the chart of the trend percentages for Berry Products. You can see the slow growth of gross margins clearly.

Common-Size Statements
V e r t i c a l A n y s Common-Size Statements P 2 Now, let’s look at some vertical analysis tools! Now, let’s move from horizontal analysis to vertical analysis.

Common-Size Statements
P 2 Calculate Common-size Percent Common-size Percent Analysis Amount Base Amount × = 100 Financial Statement Base Amount Balance Sheet Total Assets Income Statement Revenues Common size financial statements are prepared for a single period. We express all items on the statement in terms of a one component of that statement. For the income statement, we normally express all items as a percent of total revenues. For the balance sheet, we generally express all items as a percent of total assets.

CLOVER CORPORATION Comparative (Partial) Balance Sheet December 31, 2007 Common-size Percents* 2007 2006 Assets Current assets: Cash and equivalents 12,000 $ 23,500 3.8% 8.1% Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700 Property and equipment: Land 12.7% Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000 Total assets 315,000 289,700 * Percent rounded to first decimal point. P 2 ($12,000 ÷ $315,000) × 100 = 3.8% Here is the asset section of the comparative balance sheet of Clover Corporation. We want to express all line-items on the financial statement in terms of total assets, so we set total assets equal to one hundred percent. We calculate the percentage of total assets made up of cash and cash equivalents. We divide the total cash and cash equivalents for 2007 by the total assets for 2007, and multiply the result by one hundred percent. At the end of 2007, cash and cash equivalents made up three point eight percent of total assets. The same measure shows the percentage for 2006 to be eight point one percent. Why don’t you try and calculate the percent of total assets for accounts receivable and inventory before going to the next screen. The practice will be helpful to you. ($23,500 ÷ $289,700) × 100 = 8.1%

Comparative (Partial) Balance Sheet December 31, 2007 Common-size
CLOVER CORPORATION Comparative (Partial) Balance Sheet December 31, 2007 Common-size Percents* 2007 2006 Assets Current assets: Cash and equivalents 12,000 $ 23,500 3.8% 8.1% Accounts receivable, net 60,000 40,000 19.0% 13.8% Inventory 80,000 100,000 25.4% 34.5% Prepaid expenses 3,000 1,200 1.0% 0.4% Total current assets 155,000 164,700 49.2% 56.9% Property and equipment: Land 12.7% Buildings and equipment, net 120,000 85,000 38.1% 29.3% Total property and equipment 160,000 125,000 50.8% 43.1% Total assets 315,000 289,700 100.0% * Percent rounded to first decimal point. P 2 Here are the completed computations. How did you do? You can see that accounts receivable made up nineteen percent of total assets in 2007, and thirteen point eight percent in There has been a drop in total current assets, and an increase in property and equipment from 2006 to 2007.

Comparative (Partial) Balance Sheets December 31, 2007 Common-size
CLOVER CORPORATION Comparative (Partial) Balance Sheets December 31, 2007 Common-size Percents* 2007 2006 Liabilities and Shareholders' Equity Current liabilities: Accounts payable 67,000 $ 44,000 21.3% 15.2% Notes payable 3,000 6,000 1.0% 2.1% Total current liabilities 70,000 50,000 22.2% 17.3% Long-term liabilities: Bonds payable, 8% 75,000 80,000 23.8% 27.6% Total liabilities 145,000 130,000 46.0% 44.9% Shareholders' equity: Preferred stock 20,000 6.3% 6.9% Common stock 60,000 19.0% 20.7% Additional paid-in capital 10,000 3.2% 3.5% Total paid-in capital 90,000 28.6% 31.1% Retained earnings 69,700 25.4% 24.1% Total shareholders' equity 170,000 159,700 54.0% 55.1% Total liabilities and shareholders' equity 315,000 289,700 100.0% * Percent rounded to first decimal point. P 2 Here is our vertical analysis for the liabilities and equity side of the balance sheet. Check a few of the percentages to see if we agree.

Comparative Income Statements For the Years Ended December 31, 2007
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2007 Common-size Percents* 2007 2006 Revenues 520,000 $ 480,000 100.0% Costs and expenses: Cost of sales 360,000 315,000 69.2% 65.6% Selling and admin. 128,600 126,000 24.7% 26.3% Interest expense 6,400 7,000 1.2% 1.5% Income before taxes 25,000 32,000 4.8% 6.7% Income taxes (30%) 7,500 9,600 1.4% 2.0% Net income 17,500 22,400 3.4% 4.7% Net income per share 0.79 1.01 Avg. # common shares 22,200 * Rounded to first decimal point. P 2 Let’s go back and look at the comparative income statements of Clover Corporation and complete our common size calculations. We will express all line-items on the income statement as a percent of total sales. We begin by setting total sales equal to one hundred percent. We begin the calculation by determining the cost of goods sold percentages. For 2007, divide cost of goods sold of three hundred sixty thousand dollars by sales of five hundred twenty thousand dollars, and multiply by one hundred percent. For 2007, cost of goods sold was sixty nine point two percent of total sales. Before moving to the next slide, calculate the gross margin percent for each year as well as the percentages for the other line items. It will be good practice.

Common-Size Graphics P 2 This is a graphical analysis of Clover Corporation’s common-size income statement for 2007. This graph shows a common size income statement for All percentages are expressed in term of sales revenue. For example, cost of sales was sixty nine point two percent of total sales in Some business managers prefer to view charts rather than the raw numbers. We constructed this chart using Excel.

Liquidity and Efficiency
Ratio Analysis P 3 Liquidity and Efficiency Solvency Profitability Market Prospects Ratio Analysis On the next three slides we will present financial information from Norton Corporation’s 2006 and 2007 financial statements. We will use this information to prepare a ratio analysis for the company. You may want to print these three screens so you can refer to them as we compute the ratios. Let’s use the following financial statements for Norton Corporation for our ratio analysis.

Accounts receivable, net 17,000 Inventory 12,000 10,000
NORTON CORPORATION Balance Sheet December 31, 2007 2007 2006 Assets Current assets: Cash 30,000 $ 20,000 Accounts receivable, net 17,000 Inventory 12,000 10,000 Prepaid expenses 3,000 2,000 Total current assets 65,000 49,000 Property and equipment: Land 165,000 123,000 Buildings and equipment, net 116,390 128,000 Total property and equipment 281,390 251,000 Total assets 346,390 300,000 P 3 Here is the asset section of Norton’s comparative balance sheets.

Liabilities and Shareholders' Equity Current liabilities:
NORTON CORPORATION Balance Sheet December 31, 2007 2007 2006 Liabilities and Shareholders' Equity Current liabilities: Accounts payable 39,000 $ 40,000 Notes payable, short-term 3,000 2,000 Total current liabilities 42,000 Long-term liabilities: Notes payable, long-term 70,000 78,000 Total liabilities 112,000 120,000 Shareholders' equity: Common stock, $1 par value 27,400 17,000 Additional paid-in capital 158,100 113,000 Total paid-in capital 185,500 130,000 Retained earnings 48,890 50,000 Total shareholders' equity 234,390 180,000 Total liabilities and shareholders' equity 346,390 300,000 P 3 With this slide, we complete the presentation of the company’s balance sheet by providing the liabilities and stockholders’ equity sections.

Net income before taxes 76,700 66,000 Less income taxes (30%) 23,010
NORTON CORPORATION Income Statement For the Years Ended December 31 2007 2006 Revenues 494,000 $ 450,000 Cost of sales 140,000 127,000 Gross margin 354,000 323,000 Operating expenses 270,000 249,000 Net operating income 84,000 74,000 Interest expense 7,300 8,000 Net income before taxes 76,700 66,000 Less income taxes (30%) 23,010 19,800 Net income 53,690 46,200 P 3 Finally, we have Norton’s comparative income statements for 2006 and 2007.

P 3 Current Ratio Inventory Turnover Acid-test Ratio Days’ Sales Uncollected Accounts Receivable Turnover Now that we have the basic information we need, let’s calculate some of the company’s important ratios. On the next slide, we provide supplemental information that we will need. Days’ Sales in Inventory Total Asset Turnover

P 3 Use this information to calculate the liquidity and efficiency ratios for Norton Corporation. We will turn our attention to ratios that provide measures of the liquidity and efficiency for Norton Corporation. Some additional information is provided to help us complete this analysis.

Working Capital Dec. 31, 2007 Current assets 65,000 $
Working capital represents current assets financed from long-term capital sources that do not require near-term repayment. Dec. 31, 2007 Current assets 65,000 $ Current liabilities (42,000) Working capital 23,000 Working capital is defined as current assets minus current liabilities. It is a critical measure for all types of businesses. Positive working capital means the company will have enough assets converted into cash within the next year to pay its current obligations.

This ratio measures the short-term debt-paying ability of the company.
Current Ratio P 3 Current Ratio Current Assets Current Liabilities = Current Ratio $65,000 $42,000 = 1.55 : 1 Perhaps the most significant measure of a company’s ability to pay current obligations is the current ratio. It is merely current assets divided by current liabilities. At Norton, the current ratio is one point five five to one. This means that for every dollar of current liability that falls due we will have one dollar and fifty- five cents to pay that obligation. As a short-term creditor, you would be vitally interested in a company’s current ratio. If the ratio continues to lower over time, you may be less likely to be paid in full. This ratio measures the short-term debt-paying ability of the company.

Quick Assets Current Liabilities
Acid-Test Ratio P 3 Quick Assets Current Liabilities = Acid-Test Ratio Quick assets are Cash, Short-Term Investments, and Current Receivables. $50,000 $42,000 = 1.19 : 1 Acid-Test Ratio The acid-test ratio is a more stringent measure than the current ratio. We calculate the ratio by dividing quick assets by current liabilities. Quick assets include cash, marketable securities, current accounts and notes receivable. You can see that Norton’s only quick assets are cash and accounts receivable. The acid test ratio at Norton is one point one nine to one. The acid test ratio is generally lower than the current ratio because we have reduced the numerator. We have removed accounts from the numerator that generally require a period of time to convert into cash. For example, for some companies inventories may take a significant amount of time to be converted into cash. This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash.

Accounts Receivable Turnover
P 3 Sales on Account Average Accounts Receivable Accounts Receivable Turnover = = times $494,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover = We calculate accounts receivable turnover by dividing our net credit sales, or sales on account, by average accounts receivable. This is yet another example of a ratio that contains an income measure in the numerator and a balance sheet measure in the denominator. Remember, in this type of ratio we always use an average amount in the denominator. At Norton, accounts receivable turnover is twenty-six point seven times. This means, that on average, accounts receivable turns over completely about twenty seven times per year. This ratio helps us get a feel for the number of times per year a company can convert its accounts receivable into cash. For any company, the higher the turnover, the faster the cash collection on accounts receivable. This ratio measures how many times a company converts its receivables into cash each year.

Inventory Turnover Cost of Goods Sold Average Inventory Inventory
P 3 Cost of Goods Sold Average Inventory Inventory Turnover = = times $140,000 ($10,000 + $12,000) ÷ 2 = Inventory Turnover Like receivables turnover, we can also calculate the inventory turnover. Inventory turnover is calculated by dividing cost of goods sold for the period by the average inventory. At Norton, inventory turnover is twelve point seven three times. So, inventory is turned over about thirteen times per year. The inventory turnover ratio measures the number of times inventory is sold and replaced during the year. Higher inventory turnover helps protect a company from obsolete inventory items. This ratio measures the number of times merchandise is sold and and replaced during the year.

Days’ Sales Uncollected
P 3 Days’ Sales Uncollected Ending Accounts Receivable Net Sales = ´ 365 Days’ Sales Uncollected $20,000 $494,000 = ´ = days Days sales uncollected is calculated by dividing ending accounts receivable by net sales, and multiplying this amount by three hundred sixty-five days. At Norton, the days sales uncollected is fourteen point eight days. If Norton offers a two-ten, net thirty cash discount, most customers would pay off the receivable balance close to the ten day discount period and reduce the days sales uncollected. This ratio measures the liquidity of receivables.

Days’ Sales in Inventory
P3 Days’ Sales in Inventory = Ending Inventory Cost of Goods Sold ´ 365 Days’ Sales in Inventory = $12,000 $140,000 ´ = days We can also calculate the days sales in inventory by dividing ending inventory by cost of goods sold, and multiplying this amount by three hundred sixty five days. At Norton, the days sales in inventory is thirty one point two nine days. Inventory is sold completely about once a month. This ratio measures the liquidity of inventory.

Total Asset Turnover Total Asset Turnover = Net Sales
P 3 Total Asset Turnover = Net Sales Average Total Assets = 1.53 times $494,000 ($300,000 + $346,390) ÷ 2 = Total Asset Turnover Total asset turnover is equal to net sales divided by average total assets. At Norton, asset turnover was one point five three times. Asset turnover is a measure of how efficiently management is using the available assets to generate sales. This ratio measures the efficiency of assets in producing sales.

Pledged Assets to Secured Liabilities
Solvency P 3 Debt Ratio Equity Ratio Pledged Assets to Secured Liabilities Let’s focus now on solvency ratios. Times Interest Earned

Solvency P 3 Use this information to calculate the solvency ratios for Norton Corporation. This screen contains some new supplemental information that will help us calculate the ratios that follow. One quick note; income before interest and taxes is often referred to as net operating income.

Debt Ratio Total Liabilities = Debt Ratio Total Assets $112,000
P 3 Total Liabilities = Total Assets Debt Ratio $112,000 = $346,390 Debt Ratio = 32.3% The debt ratio is determined by dividing total liabilities of the company by total assets. At Norton, the debt ratio is thirty two point three percent. This means that just over thirty cents of every dollar of assets was provided by creditors of the company. This ratio measures what portion of a company’s assets are contributed by creditors.

Equity Ratio Total Equity Equity Ratio = Total Assets $234,390
P 3 Total Equity = Total Assets Equity Ratio $234,390 = $346,390 Equity Ratio = 67.7% The equity ratio is determined by dividing total equities of the company by total assets. At Norton, the equity ratio is sixty seven point seven percent. This means that about sixty eight cents of every dollar of assets was contributed by owners of Norton. This ratio measures what portion of a company’s assets are contributed by owners.

Debt-to-Equity-Ratio
P 3 Total Liabilities = Total Equity Debt-to-Equity-Ratio The Debt to Equity ratio is designed to measure the solvency of a company. A calculation above one indicates the company has more liabilities than equity. The lower the calculation, the more solvency the company has. This ratio measures the solvency of companies.

Net Income before Interest Expense
Times Interest Earned P 3 Times Interest Earned Net Income before Interest Expense and Income Taxes Interest Expense = Times Interest Earned $84,000 $7,300 = = Long-term creditors are particularly interested in the ability of a company to meet periodic interest payments. Times interest earned is a ratio that would be important to you. The ratio is calculated by dividing earnings before interest and taxes by interest expense for the period. At Norton, interest was earned eleven point five times during the year. This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor.

Profitability Profit Margin Basic Earnings per Share Gross Margin
Book Value per Common Share The next category of ratios deals with profitability measures. Return on Total Assets Return on Common Stockholders’ Equity

Profitability P 3 Use this information to calculate the profitability ratios for Norton Corporation. Here is some supplemental information about Norton that we will need to calculate our profitability ratios.

Profit Margin Profit Margin Net Income Net Sales = = 10.87% Profit
$53,690 $494,000 = Profit margin tells us how effective the company is at producing bottom line net income. The ratio is determined by dividing net income by net sales. At Norton, after all expenses and taxes have been paid, the company was able to produce a profit margin of ten point eighty seven percent. This ratio describes a company’s ability to earn a net income from sales.

Net Sales - Cost of Sales
Gross Margin P 3 Gross Margin Net Sales - Cost of Sales Net Sales = = 71.66% Gross Margin $494,000 - $140,000 $494,000 = Our gross margin percentage is an extremely important measure in business. The percentage indicates how much of each sales dollar is left to cover operating expenses, taxes and profit. Gross margin is equal to net sales less cost of goods sold divided by net sales for the period. At Norton, the gross margin is seventy one point sixty-six percent. This is a relatively high margin and indicates that, with effective cost control, the company will be able to produce net income. This ratio measures the amount remaining from $1 in sales that is left to cover operating expenses and a profit after considering cost of sales.

Return on Total Assets Return on Total Assets Net Income
P 3 Return on Total Assets Net Income Average Total Assets = = 16.61% $53,690 ($300,000 + $346,390) ÷ 2 = Return on Total Assets We can determine the return a company earns on its total assets. To calculate this ratio, we divide net income by the average total assets for the period. Norton is able to earn a return on its total assets of sixteen point sixty-one percent. Please spend a few minutes going over the calculation of this ratio. Return on total assets measures how well assets have been employed by the management of Norton. This ratio is generally considered the best overall measure of a company’s profitability.

Return on Common Stockholders’ Equity
P 3 Return on Common Stockholders’ Equity Net Income - Preferred Dividends Average Common Stockholders’ Equity = = 25.9% $53, ($180,000 + $234,390) ÷ 2 = Return on Common Stockholders’ Equity We may calculate the return on common stockholders’ equity. The numerator is net income available to common shareholders, that is net income less preferred dividends, divided by average common stockholders’ equity. The return on common stockholders’ equity at Norton is twenty five point nine percent. The return on equity is higher than the return on total assets. This measure indicates how well the company employed the owners’ investments to earn income.

Book Value per Common Share
Shareholders’ Equity Applicable to Common Shares Number of Common Shares Outstanding = Book value per share is calculated by dividing common stockholders’ equity by the number of common shares outstanding. Remember, we are including only common stockholders’ equity in the numerator. If your company has preferred shares outstanding, the total dollar amount will be removed to determine the stockholders’ equity relating to the common shareholders. This ratio measures liquidation at reported amounts.

Basic Earnings per Share
Net Income - Preferred Dividends Weighted-Average Common Shares Outstanding = Basic Earnings per Share $53, 27,400 = = $1.96 per share Earnings per share is equal to net income less preferred stock dividends divided by the average number of common shares outstanding. The numerator of the equation is sometimes referred to as income available to common shareholders. Earnings per share is one dollar and ninety six cents per common share. Notice that we had no preferred dividends to impact our numerator. Earnings per share is one of the most widely quoted financial ratios calculated. It is a measure of the company’s ability to produce income for each common share outstanding. As an investor, we will want to track this ratio carefully. This measure indicates how much income was earned for each share of common stock outstanding.

Market Prospects Price-Earnings Ratio Dividend Yield P 3
As a shareholder, we often need information about the market prospects of our investment.

Market Prospects P 3 Use this information to calculate the market ratios for Norton Corporation. Here is some supplemental information we will need to calculate the market prospect ratios. The supplemental information includes information about the closing market price of the common stock and the annual cash dividend.

Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share
Earnings Per Share = Price-Earnings Ratio $15.00 $1.96 = = 7.65 times Once we know the earnings per share, we can calculate the price-earnings ratio, or P E ratio. We will divide the closing market price of the Norton’s common stock by earnings per share. For Norton the P E ratio is seven point sixty-five times. This means that the stock is selling for seven point sixty-five times its current earnings per share. 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.

Annual Dividends Per Share
Dividend Yield P 3 Dividend Yield Annual Dividends Per Share Market Price Per Share = $2.00 $15.00 = 13.3% If you are an investor who required current income; you will want to look for companies with high dividend payout ratios. If you believe that a company can invest its funds and earn a higher return than you would be able to earn, you might look for a company with high growth and a low payout ratio. To determine the dividend yield ratio, we divide the annual dividend per share by the closing market price per share of the company’s common stock. At Norton, the dividend yield is thirteen point three percent. If we purchase the stock today for fifteen dollars per share and receive an annual dividend of two dollars, we will earn a return of thirteen point three percent on our investment. This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

Reporting Income and Equity
Extraordinary Items Discontinued Segments Changes in Accounting Principles When a company’s income-related activities include events not part of its normal, continuing operations, it must disclose this information. Reporting this information separately provides users with more information about what to expect in the future. Let’s look at continuing operations, discontinued operations, extraordinary items, and changes in accounting principles. Net Income Continuing Operations

Continuing Operations
Revenues, expenses and income generated by the company’s continuing operations. Continuing operations shows revenues, expenses, and income generated by the company’s continuing operations. This information helps users predict future operations. Earlier chapters explained items comprising income from operations. Net Income Continuing Operations

Discontinued Segments
A 2 Income from operating the discontinued segment prior to its disposal and gain or loss on the sale of the net assets of the segment. Discontinued Segments Discontinued operations reports income or loss from operating a segment that has been discontinued and the gain or loss on the sale of the net assets of the segment. A business segment is a part of a company’s operations that serves a particular line of business or class of customers. A segment has assets, liabilities and financial results of operations that can be distinguished from those of other parts of the company. Net Income

Net Income Extraordinary Items A gain or loss that
is unusual in nature and infrequent in occurrence. Extraordinary items are gains and losses that are both unusual and infrequent in occurrence. Some examples include losses from natural disasters and expropriation of property by a foreign government. Net Income

Changes in Accounting Principles
The increase or decrease in income when changing from one generally accepted accounting principle to another. Changes in Accounting Principles The consistency principle directs a company to apply the same accounting principles across periods, yet a company can change from one acceptable accounting principle to another as long as the change improves the usefulness of information in the financial statements. Any increase or decrease in income resulting from a change in accounting principle is reported separately on the income statement. Net Income

Income Statement A 2 Gains and losses from discontinued operations and extraordinary items are reported net of tax effects just below Income from Continuing Operations.

End of Chapter 13 We think the material in this chapter will help you when you enter into a management position or begin to invest in stocks and bonds of companies.

Analyzing and Interpreting Financial Statements

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Analyzing and Interpreting Financial Statements

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