1. Financial Statement Analysis
CHAPTER 13
Financial Statement Analysis
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

2. FINANCIAL STATEMENT ANALYSIS
The way to compare companies of different sizes is to use standard measures
Financial ratios are standard measures that enable analysts to compare companies of different sizes
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

3. FINANCIAL STATEMENT ANALYSIS
In addition to the financial statements, annual reports contain the following:
Notes to the financial statements, including a summary of the accounting methods used
Management’s discussion and analysis (MD&A) of the financial results
The auditor’s report
Comparative financial data for a series of years
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

4. FINANCIAL STATEMENT ANALYSIS
For example, the graphs in the next exhibit show Bristol-Myers Squibb’s three-year trend of net sales, market value of the company’s stock, and cumulative return to the company’s stockholders
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

5. Representative Financial Data of Bristol-Myers Squibb Company
Net Sales
$ Millions
Market Value
$ Millions
Cumulative Return to Shareholders
$20,000
15,000
10,000
5,000
$140,000
105,000
70,000
35,000
250%
200
150
100 50
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

6. FINANCIAL STATEMENT ANALYSIS
The objectives of financial statement analysis are to help investors
Predict their expected returns (see the previous graph)
Assess the risks associated with those returns
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

7. HORIZONTAL ANALYSIS
The study of percentage changes in comparative statements is called horizontal analysis
Computing a percentage change in comparative statements requires two steps:
Computing the dollar amount of the change from the base period to the later period
Dividing the dollar amount of change by the base-period amount
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

8. Horizontal analysis is illustrated for Bristol-Myers Squibb as follows (dollar amounts in millions):
Increase (Decrease)
Amount Percent
Sales $18,284 $16,701 $1, %
Net income 3, , (64) (2.0%)
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

9. Dollar amount of change
The percentage change in Bristol-Myers Squibb’s sales during 1998 is 9.5%, computed as follows:
Step 1. Compute the dollar amount of change in sales from 1997 to 1998:
1998
1997
Increase - =
$18,284
$16,701
$1,583
Step 2. Divide the dollar amount of change by the base-period amount to compute the percentage change during the later period:
Dollar amount of change
Percentage Change =
Base-year amount
$1,583 = =
9.5%
$16,701
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

10. HORIZONTAL ANALYSIS Trend percentages
Are a form of horizontal analysis that examine more than a two- or three-year period
Use a selected base year whose amounts are set equal to 100 percent
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

11. HORIZONTAL ANALYSIS
To compute trend percentages, each item for following years is divided by the corresponding amount during the base year
Any year $
Trend % =
Base year $
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

12. HORIZONTAL ANALYSIS
Bristol-Myers Squibb Company showed sales, cost of goods sold, and gross profit for the past six years as follows:
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

13. HORIZONTAL ANALYSIS The base year is 1993
Trend percentages for Net sales are computed by dividing each net sales amount by the 1993 amount of $11,413
Trend percentages for Cost of products sold is computed by dividing by each cost of products sold amount by $3,029
Trend percentages for Gross profit use the base gross profit of $8,383
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

14. HORIZONTAL ANALYSIS The resulting trend percentages follow:
Sales, cost of products sold, and gross profit have trended upward at almost identical rates throughout the five-year period
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

15. VERTICAL ANALYSIS
Vertical analysis of a financial statement reveals the relationship of each statement item to a specified base, which is the 100% figure
Every other item on the financial statement is then reported as a percentage of that base
When an income statement is analyzed vertically, net sales is usually the base
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

16. VERTICAL ANALYSIS
Vertical analysis of balance sheet amounts are shown as a percentage of total assets
The next exhibit shows the vertical analysis of Bristol-Myers Squibb’s income statement as a percentage of net sales
Each income statement item
Vertical analysis % =
Net Sales
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

17. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

18. COMMON-SIZE STATEMENTS
A common-size statement simplifies the comparison of different companies because their amounts are stated in percentages
On a common-size income statement, each item is expressed as a percentage of the net sales amount
In the balance sheet, the common size is total assets or the sum of total liabilities and stockholders’ equity
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

19. BRISTOL-MYERS SQUIBB COMPANY Analysis of Current Assets
December 31,1998 and 1997
Percent of Total Assets
1998
1997
Current Assets:
Cash and cash equivalents
Time deposits and marketable securities
Receivables, net
Inventories
Prepaid expenses
Total current assets
Long-Term Assets
Total Assets
13.8%
1.8
19.6
11.5
7.3
54.0
46.0
100.0%
9.7%
2.3
19.9
12.0
7.8
51.7
48.3
100.0%
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

20. BENCHMARKING
Benchmarking is the practice of comparing a company to a standard set by other companies, with a view toward improvement
Benchmarking against the industry average
Managers, investors, and creditors need to know how one company compares with similar companies
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

21. BENCHMARKING
The next exhibit gives the common-size income statement of Bristol-Myers Squibb Company compared with the average for the pharmaceuticals industry
Its gross profit percentage is much higher than the industry average
Its percentage of net income is significantly higher that the industry average
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

22. BRISTOL-MYERS SQUIBB COMPANY
Common-Size Income Statement for Comparison with Industry Average
Year Ended December 31, 1998
Bristol-Myers Squibb
Industry Average
Net sales
Cost of products sold
Gross profit
Operating expenses
Earnings from continuing operation before income tax
Income tax expense
Earnings from continuing operations
Special items (discontinued operations, extraordinary gains and losses, and effect of accounting changes)
Net earnings
100.0%
26.6
73.4
50.1
23.3
6.1
17.2
17.2%
100.0%
54.7
45.3
36.5
8.8
2.3
6.5
1.4
5.1%
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

23. BENCHMARKING Benchmarking against a key competitor
Common-size statements are also used to compare the company to another specific company
The next exhibit presents the common-size income statements of Bristol-Myers Squibb and Procter & Gamble
Bristol-Myers Squibb has higher percentages of gross profit, earnings from continuing operations, and net earnings
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

24. BRISTOL-MYERS SQUIBB COMPANY
Common-Size Income Statement for Comparison with Key Competitor
Year Ended December 31, 1998
Bristol-Myers Squibb
Proctor & Gamble
Net sales
Cost of products sold
Gross profit
Operating expenses
Earnings from continuing operation before income tax
Income tax expense
Earnings from continuing operations
Special items (discontinued operations, extraordinary gains and losses, and effect of accounting changes)
Net earnings
100.0%
26.6
73.4
50.1
23.3
6.1
17.2
17.2%
100.0%
56.7
43.3
27.9
15.4
5.2
10.2
10.2%
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

25. STATEMENT OF CASH FLOWS IN DECISION MAKING
The cash-flow statement summarizes sources and uses of the entity’s cash flows
Internal and external decision makers want to see the majority of cash inflows coming from operating activities
WHY?
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

26. STATEMENT OF CASH FLOWS IN DECISION MAKING
A company cannot stay in business for long if it cannot generate enough cash from operations to cover operating expenses
While borrowing and investing activities provide cash for business use, long-term reliance on these activities for sources of cash is not advised
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

27. USING RATIOS TO MAKE BUSINESS DECISIONS
A ratio expresses the relationship of one number to another
The ratios used to make business decisions may be classified as follows:
Ratios that measure the company’s ability to pay current liabilities
Ratios that measure the company’s ability to sell inventory and collect receivables
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

28. USING RATIOS TO MAKE BUSINESS DECISIONS
Ratios that measure the company’s ability to pay long-term debt
Ratios that measure the company’s profitability
Ratios used to analyze the company’s stock as an investment
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

29. MEASURING A COMPANY’S ABILITY TO PAY CURRENT LIABILITIES
Working capital is defined as follows:
Working capital = Current assets - Current liabilities
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

30. MEASURING A COMPANY’S ABILITY TO PAY CURRENT LIABILITIES
Working capital is widely used to measure a business’s ability to meet its short-term obligations with its current assets
The larger the working capital, the better able is the business to pay its debts
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

31. CURRENT RATIO The current ratio
Is current assets divided by current liabilities
Measures the ability of the company to pay current liabilities with current assets
The following slides give the comparative income statement and balance sheet of Palisades Furniture, Inc.
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

32. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

33. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

34. The current ratio of Palisades Furniture, Inc
The current ratio of Palisades Furniture, Inc., at December 31, 20X3 and 20X2, follow, along with the average for the retail furniture industry:
Palisades’ Current Ratio
Formula
20X3
20X2
Current assets
$262,000
$236,000
Current ratio = =
1.85 =
1.87
Current liabilities
$142,000
$126,000
In most industries a
current ratio of 2.0 is
considered good
Industry Average = 1.70
In general, a higher current ratio indicates a stronger financial position
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

35. ACID TEST RATIO The acid-test (or quick) ratio
Indicates whether the entity could pay all its current liabilities if they came due immediately
Is computed by dividing cash, short-term investments, and net current receivables (accounts and notes receivable, net of allowances) by current liabilities
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

36. Palisades Furniture’s acid-test ratios for 20X3 and 20X2 are:
Palisades’ Acid-Test Ratio
Formula
20X3
20X2
Cash + short-term investments + net current receivables
Acid-Test ratio =
$29,000 + $0 + $114,000
$32,000 + $0 + $85,000 =
1.01 =
0.93
Current liabilities
$142,000
$126,000
An acid-test ratio of 0.90
to 1.00 is acceptable in
most industries
Industry Average = 0.40
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

37. MEASURING ABILITY TO SELL INVENTORY AND COLLECT RECEIVABLES
Three ratios are presented that measure the company’s ability to sell inventory and collect receivables
Inventory turnover
Accounts receivable turnover
Days’ sales in receivables
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

38. INVENTORY TURNOVER Inventory turnover is
A measure of the number of times a company sells its average level of inventory during a year
Computed by dividing the cost of goods sold by the average inventory for the period
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

39. INVENTORY TURNOVER
A high rate of turnover indicates relative ease in selling inventory; a low turnover indicates difficulty in selling
In general, companies prefer a high inventory turnover
Inventory turnover varies widely with the nature of the business
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

40. Palisades’ Inventory Turnover
Palisades Furniture’s inventory turnover for 20X3 is:
Palisades’ Inventory Turnover
Formula
Cost of goods sold
$513,000
Inventory turnover = =
4.58
Average inventory
$112,000
Industry Average = 3.00
Palisades Furniture’s turnover of 4.58 times a year is high for its industry, which has an average turnover of 3.00
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

41. ACCOUNTS RECEIVABLE TURNOVER
Measures a company’s ability to collect cash from credit customers
Is computed by dividing net sales by average net accounts receivable
The resulting ratio indicates how many times during the year the average level of receivables was turned into cash
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

42. ACCOUNTS RECEIVABLE TURNOVER
In general, the higher the ratio, the more successfully the business collects cash and the better off its operations
A receivable turnover that is too high may indicate that credit is too tight, causing the loss of sales to good customers
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

43. Palisades’ Accounts Receivable Turnover
Palisades’ Furniture’s accounts receivable turnover ratio for 20X3 is computed as follows:
Palisades’ Accounts Receivable Turnover
Formula
Accounts receivable = turnover
Net credit sales
$858,000 =
8.62
Average net accounts receivable
$99,000
Industry Average = 31.3
Palisades’ receivable turnover of 8.62 is much lower than the industry average, possibly because larger stores sell their receivables
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

44. DAYS’ SALES IN RECEIVABLES
The days’-sales-in-receivables ratio tells
How many days’ sales remain in Accounts Receivable
Is computed by a two-step process
First, divide net sales by 365 days to figure the average sales amount for one day
Second, divide this average day’s sales amount into the average net accounts receivable
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

45. Palisades’ Days’ Sales in Accounts Receivable
Formula
Net sales
$858,000
1. One day’s sales = =
$2,351
365 days
365 days
Average net accounts receivable
Days’ sales in average accounts = receivable 2.
$99,500 =
42 days
One days’ sales
$2,351
Industry Average = 2 days
The day’s sales in receivables for Palisades is higher (worse) than the industry average because the company collects its own receivables
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

46. MEASURING A COMPANY’S ABILITY TO PAY LONG-TERM DEBT
Two indicators of a business’s ability to pay long-term liabilities are the
Debt ratio
Times-interest-earned ratio
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

47. DEBT RATIO
The debt ratio tells the proportion of the company’s assets that it has financed with debt
The higher the debt ratio, the higher the strain of paying interest each year and the principal amount at maturity
The lower the ratio, the lower the business’s future obligations
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

48. Calculation of the debt ratios for Palisades Furniture at the end of 20X3 and 20X2 is as follows:
Palisades’ Debt Ratio
Formula
20X3
20X2
Total liabilities
$431,000
$324,000
Debt ratio = =
0.55 =
0.50
Total assets
$787,000
$644,000
The average debt ratio
for most companies
ranges from
Industry Average = 0.64
The company’s debt ratio indicates a fairly low-risk debt compared to the retail furniture industry average
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

49. TIMES-INTEREST-EARNED RATIO
The times-interest-earned ratio measures the number of times that operating income can cover interest expense
A high times-interest-earned ratio indicates ease in paying interest expense
A low value suggests difficulty
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

50. Palisades’ Times-Interest-Earned Ratio
Calculation of Palisades’ times-interest-earned ratio is as follows:
Palisades’ Times-Interest-Earned Ratio
Formula
20X3
20X2
Income from operations
Times-interest-earned ratio =
$101,000
$57,000 =
4.21 =
4.07
Interest expense
$24,000
$14,000
The norm for U.S.
business ranges from
for
most companies
Industry Average = 2.30
The company’s times-interest-earned ratio of around 4.00 is significantly better than the industry average for furniture retailers
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

51. MEASURING A COMPANY’S PROFITABILITY
There are four rate-of-return measurements that help evaluate a company’s profitability:
Rate of return on net sales
Rate of return on total assets
Rate of return on common stockholders’ equity
Earnings per share of common stock
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

52. RATE OF RETURN ON NET SALES
The rate of return on net sales shows the percentage of each sales dollar earned as net income
The higher the rate of return, the more net sales dollars are providing income to the business and the fewer net sales dollars are absorbed by expenses
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

53. Palisades’ Rate of Return on Sales
The rate-of-return-on-sales ratios for Palisades Furniture are calculated as follows:
Palisades’ Rate of Return on Sales
Formula
20X3
20X2
Rate of return on sales
Net income
$48,000
$26,000 = =
0.056 =
0.032
Net Sales
$858,000
$803,000
Industry Average = 0.008
The increase in Palisades Furniture’s return on sales identifies the company as more successful than the average furniture store
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

54. RATE OF RETURN ON TOTAL ASSETS
The rate of return on total assets (return on assets) measures a company’s success in using its assets to earn a profit
The sum of interest expense and net income in the numerator is the return to creditors and shareholders who have financed the company’s operations
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

55. Palisades’ 20X3 Rate of Return on Total Assets
Computation of the return-on-assets ratio for Palisades Furniture is as follows:
Palisades’ 20X3 Rate of Return on Total Assets
Formula
Net income
Interest Expense
Rate of return on assets +
$48,000 + $24,000 = =
0.101
Average total assets
$715,000
Industry Average = 0.042
The increase in Palisades Furniture’s return on assets is higher than the industry average
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

56. RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY
Rate of return on stockholders’ equity (return on equity)
Shows the relationship between net income and common stockholders’ investment in the company
Is calculated by dividing net income available to common stockholders by the average stockholders’ equity during the year
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

57. Palisades’ 20X3 Rate of Return on Common Stockholders’ Equity
The rate of return on common stockholders’ equity for Palisades Furniture is calculated as follows:
Palisades’ 20X3 Rate of Return on Common Stockholders’ Equity
Formula
Rate of return on common stockholders’ equity
Net income
Preferred Dividends -
$48,000 - $0
0.142 = =
Average common stockholders’ equity
$338,000
Industry Average = 0.121
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

58. RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY
Palisades’ return on equity (0.142) is higher than its return on assets (0.101).
This difference results from borrowing at one rate (8%) and investing the funds to earn a higher rate (14.2%)
This practice is called trading on the equity or using financial leverage
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

59. EARNINGS PER SHARE OF COMMON STOCK
Earnings per share (EPS) is
The amount of net income per share of the company’s outstanding common stock
Computed by dividing net income available to common stockholders by the number of common shares outstanding during the year
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

60. Palisades’ Earnings Per Share
Computation of the firm’s EPS for 20X3 and 20X2 follows, assuming the company had 10,000 share of common stock outstanding
Palisades’ Earnings Per Share
Formula
20X3
20X2
Net income
Preferred Dividends
Earnings per share of common stock -
$48,000 - $0
$26,000 - $0 = =
$4.80 =
$2.60
Number of shares of common stock outstanding
10,000
10,000
Most companies strive to
increase EPS by %
annually
Palisades Furniture’s EPS increased 85 percent
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

61. ANALYZING A COMPANY’S STOCK AS AN INVESTMENT
Investors purchase stock to earn a return on their investment, which consists of two parts:
Gains (or losses) from selling the stock at a price that differs from the investors’ purchase price
Dividends, the periodic distributions to stockholders
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

62. PRICE EARNINGS RATIO
The price earnings ratio is the ratio of the market price of a share of common stock to the company’s earnings
The higher a stock’s P/E ratio, the higher its downside risk--the risk that the stock’s market price will fall
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

63. Palisades’ Price/Earnings Ratio
Calculations for the P/E ratio of Palisades Furniture, Inc., follow. The market price of its common stock was $50 at the end of 20X3 and $35 at the end of 20X2:
Palisades’ Price/Earnings Ratio
Formula
20X3
20X2
Market price per share of common stock
$50.00
$35.00
P/E ratio = =
10.4 =
13.5
Earnings per share
$4.80
$2.60
P/E ratios vary from industry
to industry
Palisades Furniture’s 20X3 P/E ratio indicates that the company’s stock is selling at 10.4 times earnings
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

64. DIVIDEND YIELD
Dividend yield is the ratio of dividends per share of stock to the stock’s market price per share
This ratio measures the percentage of a stock’s market value that is returned annually as dividends
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

65. Dividend Yield on Palisades’ Common Stock
Palisades Furniture paid annual cash dividends of $1.20 per share of common stock in 20X3 and $1.00 in 20X2, and market prices of the company’s common stock were $50 in 20X3 and $35 in 20X2. Calculation of the firm’s dividend yields on common stock is as follows:
Dividend Yield on Palisades’ Common Stock
Formula
20X3
20X2
Dividend yield on common stock
Dividend per share of common stock
$1.20
$1.00 =
0.024
$0.029 = =
Market price per share of common stock
$50.00
$35.00
Dividend yields vary widely, from 5% to 8% for older, established companies, down to the range of 0% to 3% for young growth-oriented companies
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

66. BOOK VALUE PER SHARE OF COMMON STOCK
Book value per share of common stock is common stockholders’ equity divided by the number of shares of common stock outstanding
Some investors rank stock on the basis of the ratio of market price to book value
To these investors, the lower the ratio the more attractive the stock
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

67. Book Value per Share of Palisades’ Common Stock
Calculations of book-value-per-share-of-common-stock ratios follows:
Book Value per Share of Palisades’ Common Stock
Formula
20X3
20X2
Total stockholders’ equity
Book value per share of common stock
Preferred equity -
$356,000 - $0
$320,000 - $0 = =
$35.60 =
$32.00
Number of shares of common stock outstanding
10,000
10,000
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

68. LIMITATIONS OF FINANCIAL ANALYSIS
Ratios have their limitations
Financial analysis may indicate that something is wrong, but it may not identify the specific problem or show how to correct it
Managers must evaluate data on all ratios in the light of other information about the company
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

69. LIMITATIONS OF FINANCIAL ANALYSIS
Ratios should be analyzed over a period of years
Any one year, or even any two years, may not be representative of the company’s performance over the long term
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

70. ECONOMIC VALUE ADDED
Economic value added (EVA) combines the concepts of accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth
A positive EVA amount indicates
An increase in stockholder wealth
An attractive stock to investors
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

71. ECONOMIC VALUE ADDED
EVA = Net income + Interest expense - Capital charge
Where
Capital charge
Notes payable
Loans payable
Long-term debt
Stockholders’ equity
Cost of capital = + + + x
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

72. ECONOMIC VALUE ADDED
The capital charge is the amount that stockholders and lenders charge a company for the use of their money
The cost of capital is a weighted average of the returns demanded by the company’s stockholders and lenders
The cost of capital varies with the company’s risk
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

73. EFFICIENT MARKETS, MANAGEMENT ACTION, AND INVESTOR DECISIONS
An efficient capital market is one in which market prices fully reflect all information available to the public
Because stocks are priced in full recognition of all publicly accessible data, it can be argued that the stock market is efficient
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

74. EFFICIENT MARKETS, MANAGEMENT ACTION, AND INVESTOR DECISIONS
This means that managers cannot fool the market with accounting gimmicks
For investors, an appropriate strategy seeks to manage risk, diversity, and minimize transaction costs
The role of financial statement analysis consists mainly of identifying the risks of various stocks to manage the risk of the overall investment portfolio
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

75. END OF CHAPTER 13
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren