1. COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Analysis of Financial Statements Chapter 22 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

2. Learning Objectives 1.Organize a systematic financial ratio analysis using common-size financial statements and the DuPont framework. 2.Recognize the potential impact that differing accounting methods can have on the financial ratios of otherwise essentially identical companies. 3.Understand how foreign companies report their financial results to U.S. investors. 4.Describe the purpose and format of the SEC’s Form 20-F. 5.Convert foreign currency financial statements into U.S. dollars using the translation method.

3. Framework for Financial Statement Analysis Financial statement analysis- the examination of the relationships among: –Financial statement numbers –The trends of the statement numbers over time. To analyze financial statements, analyst use: –Common sized financial statements –Ratio analysis

4. Framework for Financial Statement Analysis 1.When the presentations are in good form. 2.When the content of the statements is identical. 3.When accounting principles are not changed, or, if they are changed, the financial effects of the changes are disclosed. 4.When changes in circumstances or in the nature of the underlying transactions are disclosed. The APB stated that comparisons between financial statements are most informative—

5. Framework for Financial Statement Analysis Common-Size Financial Statements- analysis of a company’s single-year financial statements. Financial statements are standardized by a measure of size, either sales or total assets. All amounts are stated in terms of a percentage of the size measure. Ratio Analysis- Analysis of a company’s financial statements by computing ratios and comparing them against both trends and industry averages.

6. Common-Size Income Statement For common- size income statements, the denominator, the entire pie, is equal to net sales. 100% = Net Sales

7. Common-Size Financial Statements Net sales$5,700100.0 $6,600100.0 Cost of goods sold 4,000 70.2 4,800 72.7 Gross profit on sales $1,700 29.8 $1,800 27.3 Selling expense$1,12019.6 $1,20018.2 General expense 400 7.0 440 6.7 Total operating expenses $1,520 26.6 $1,640 24.9 Operating income (loss)$ 1803.2 $ 1602.4 Other revenue (expense) 80 1.4 130 2.0 Income before taxes $ 2604.6 $ 2904.4 Income tax 80 1.4 85 1.3 Net income$ 1803.2 $ 2053.1 Comparative Income Statements (in millions) 2008 % 2007 %

8. Common-Size Income Statement For common- size balance sheets, again the denominator, the entire pie, is equal to the net sales for the year. 100% = Net Sales

9. Common-Sized Balance Sheet Current assets$ 85515.0$ 955.514.5 Land, building, and equipment (net) 1,27522.41,075.024.4 Intangible assets1001.8100.01.5 Other assets 48 0.8 60.5 0.9 Total assets$2,27840.0$2,191.033.2 Comparative Balance Sheets (in millions) 2008 % 2007 % Assets

10. Common-Sized Balance Sheet Comparative Balance Sheets (in millions) Current liabilities$ 4107.2$ 5017.6 Noncurrent liabilities 400 7.0 600 9.1 Total liabilities$ 810 14.2$1,101 16.7 Paid-in capital$1,10019.3$ 80012.1 Retained earnings 368 6.5 290 4.4 Total stockholders’ equity$1,46825.8$1,090 16.5 Total liabilities and stockholders eq.$2,27840.0$2,19133.2 2008 % 2007 % Liab. & Shs’ Equity

11. Common Size Balance Sheet A common- size balance sheet can also be prepared using total assets to standardize each amount. 100% = Total Assets

12. Ratio Analysis DuPont Framework- Identifying factors that impact return on equity. Efficiency Ratios- How efficiently is the firm utilizing its assets? Leverage Ratios- To what degree is the company using other people’s money to purchase assets? Other Financial Ratios- Other indications of liquidity, cash management, and profitability.

13. DuPont Framework Developed internally at DuPont around 1920. Provides a systematic approach to identifying general factors causing ROE to deviate from normal. Establishes a framework for computing financial ratios to yield more in-depth analysis of a company’s areas of strength and weakness.

14. DuPont Framework DuPont: ROE can be decomposed into three components: ProfitabilityxEfficiencyxLeverage Return on xAssetxAssets-to- SalesTurnoverEquity Ratio Net IncomexSalesxAssets SalesAssetsEquity

15. DuPont Framework Net IncomexSalesxAssets SalesAssetsEquity The number of pennies in profits generated from each dollar of sales. The number of dollars in sales generated by each dollar of assets. The number of dollars of assets a company is able to acquire using each dollar invested by stockholders.

16. Colesville Corporation ROE Net IncomexSalesxAssets SalesAssetsEquity 2008 x x $180,000$5,700,000$2,278,000 $5,700,000$2,278,000$1,468,000 2007 x x $205,000$6,600,000$2,191,000 $6,600,000$2,191,000$1,090,000 Return on Equity = 12.3% 3.16%2.501.55 3.11%3.012.01 Return on Equity = 18.8%

17. Efficiency Ratios Accounts receivable turnover: Sales Average accounts receivable Colesville Corporation $6,600,000 ($333,500 + $375,000)/2 2007 = $354,250 = 18.6 times

18. Efficiency Ratios Accounts receivable turnover: Sales Average accounts receivable Colesville Corporation $5,700,000 ($375,000 + 420,000)/2 2008 = $354,250 = 14.3 times The ratios show that Colesville collected its receivables more rapidly in 2007 than in 2008.

19. Efficiency Ratios Accounts receivable turnover: Average accounts receivable Average daily sales Colesville Corporation $354,250 ($6,600,000)/365 2007 = $18,082 = 19.6 days

20. Efficiency Ratios Accounts receivable turnover: Average accounts receivable Average daily sales Colesville Corporation $397,500 ($5,700,000)/365 2008 = $18,082 = 25.5 days Some analyst like to express the accounts receivable turnover in terms of days. Average collection period serves this purpose.

21. Efficiency Ratios $4,800,000 ($125,000 + $330,000)/2 2007 = $227,500 = 21.1 times For Colesville Corporation Inventory turnover: Cost of goods sold Average inventory Colesville Corporation

22. Efficiency Ratios $4,000,000 ($330,000 + $225,000)/2 2008 = $277,500 = 14.4 times For Colesville Corporation Inventory turnover: Cost of goods sold Average inventory Colesville Corporation Inventory turnover allows for evaluation of the firm’s inventory position and the appropriateness of the inventory size.

23. Efficiency Ratios 365 21.1 times 2007 = = 17.3 times For Colesville Corporation Inventory turnover: 365 Inventory inventory Colesville Corporation

24. Efficiency Ratios 365 14.4 times 2008 = = 25.3 times For Colesville Corporation Inventory turnover: 365 Inventory inventory Colesville Corporation In 2007, a typical item of inventory remained unsold for 17.3 days. This number increased to 25.3 days in 2008.

25. Stop and Think You have probably heard of just-in- time inventory systems. What would a just-in- time system do to a company’s number of days’ sales in inventory?

26. Efficiency Ratios $6,600,000 ($925,000 + $1,075,000)/2 2007 = = 6.60 times For Colesville Corporation Fixed Asset turnover: Sales Average fixed assets Colesville Corporation $1,000,000

27. Efficiency Ratios $5,700,000 ($1,075,000 + $1,275,000)/2 2008 = = 4.85 times For Colesville Corporation Fixed Asset turnover: Sales Average fixed assets Colesville Corporation $1,175,000 Colesville is much less efficient in using its fixed assets to generate sales in 2008 than it was in 2007.

28. Margin vs. Turnover The profitability of each dollar in sales is sometimes called a company’s margin. The degree to which assets are used to generate sales is called turnover.

29. Leverage Ratios Higher leverage increases ROE through the following chain of events: 1.More borrowing means that more assets can be purchased without any additional equity investment by owners. 2.More assets means that more sales can be generated. 3.More sales means that net income should increase

30. Leverage Ratios $1,101,000 $2,191,000 2007 = = 50.3% For Colesville Corporation Debt ratio: Total liabilities Total assets Colesville Corporation

31. Leverage Ratios $810,000 $2,278,000 2008 = = 35.6% For Colesville Corporation Debt ratio: Total liabilities Total assets Colesville Corporation The debt ratio is the percentage of total funds, both borrowed and invested, that a company acquires through borrowing.

32. Leverage Ratios $1,101,000 $1,090,000 2007 = = 1.01 For Colesville Corporation Debt-to-equity ratio: Total liabilities Stockholders’ equity Colesville Corporation

33. Leverage Ratios $810,000 $1,468,000 2008 = = 0.55 For Colesville Corporation Debt-to-equity ratio: Total liabilities Stockholders’ equity Colesville Corporation The debt ratio and the debt-to-equity ratio measure the same thing—the level of borrowing relative to funds used to finance the company.

34. Stop and Think Company Z has an assets-to- equity ratio of 2.5. What are its debt and debt-to-equity ratios?

35. Leverage Ratios $290,000 + $60,000 $60,000 2007 = = 5.8 times For Colesville Corporation Times interest earned: Earnings before income taxes Interest expense Colesville Corporation

36. Leverage Ratios $260,000 + $40,000 $40,000 2008 = = 7.5 times For Colesville Corporation Times interest earned: Earnings before income taxes Interest expense Colesville Corporation Times interest earned reflects the company’s ability to meet interest payments and the degree of safety afforded the creditors.

37. Other Common Ratios $955,500 $501,000 2007 = = 1.91 For Colesville Corporation Current Ratio: Current assets Current liabilities Colesville Corporation

38. Other Common Ratios $855,500 $410,000 2007 = = 2.09 For Colesville Corporation Current Ratio: Current assets Current liabilities Colesville Corporation Historically, the rule of thumb was to have a current ratio of at least 2.0. In 2008, Colesville Corporation is in good shape.

39. Current Ratios: 2004 Company Current Ratio Coca-Cola1.10 Delta Airlines0.61 Home Depot1.35 McDonald’s0.81 Wal-Mart0.90 Advances in information technology have allowed successful firms to reduce this ratio to below 1.0.

40. Other Common Ratios $424,500 $375,000 2007 = = 1.13 Cash flow adequacy ratio: Cash from operating activities Total primary cash requirements For Colesville Corporation Colesville Corporation The sum of dividend payments, long-term asset purchases, and long-term debt repayments.

41. Other Common Ratios Book-to-market ratio: Stockholders’ equity Market value of shares outstanding Earnings per share: Net income Weighted-number of share outstanding Dividend payout ratio: Cash dividends Net income Price-earnings ratio: Market price per share Earnings per share

42. Summary of Selected Financial Ratios Insert Exhibit 22-7

43. Impact of Alternative Accounting Methods If companies are using differing accounting practices, it will impact the ratios. Careful financial statement users should make adjustments for accounting differences among the companies being analyzed.

44. Foreign Reporting to U.S. Investors Firms such as DaimlerChrysler and Disney must produce financial statements for users not only in their own countries but also in other countries. The significant differences in accounting standards around the world complicate both the preparation of financial statements and the understanding of these statements for users. These divergent national accounting practices can have an extremely significant impact on reported financial statements. The good news is that the demands of international users are forcing companies to provide disclosure so that users can recognize and reconcile the differing accounting standards.

45. Meeting the Needs of International Users Some multinational firms respond to users in other countries simply by taking their financial statements or annual reports and translating them into the language of the user.

46. Meeting the Needs of International Users Another response to the international users is to denominate the financial statements in the currency of the country where the financial statements will be used.

47. Meeting the Needs of International Users Some multinationals partially or completely restate the financial statements to the accounting principles of the financial statement users’ country.

48. Meeting the Needs of International Users Mutual recognition involves one country accepting the financial statements of another country in return for that country accepting its financial statements for all regulatory purposes.

49. Form 20-F provides the reconciliation. The SEC’s Form 20-F The SEC requires foreign companies that list shares on U.S. to provide: 1.Complete U.S. GAAP financial statements. 2.Reconcile their reported net income to what income would be according to U.S. GAAP.

50. Foreign Currency Financial Statements Translation- Used when the foreign subsidiary is a relatively self-contained unit that is independent from the parent company’s operations. Remeasurement- Is appropriate when the subsidiary does not operate independently of the parent company. Functional currency- Currency of the primary economic environment of an entity.

51. Foreign Currency Financial Statements Assets and liabilities are translated using the current exchange rate prevailing as of the balance sheet date. Income statement items are translated at the average exchange rate for the year. Dividends are translated using the exchange rate prevailing on the date the dividends were declared. Translation

52. Foreign Currency Financial Statements Capital stock is translated at the historical rate, the rate prevailing on the date the subsidiary was acquired or the stock was issued. Retained earnings is translated in the first year using historical rates. In subsequent years, take the balance in Retained Earnings from the prior period’s translated financial statements and add translated net income and subtracting translated dividends. Translation