1. Previous Lecture
Purpose of Analysis; Financial statement analysis helps users make better decisions
Financial Statements Are Designed for Analysis
Tools of Analysis
Dollar and Percentage Changes
Trend analysis is used to reveal patterns in data covering successive periods
Component Percentages
Horizontal Analysis, Vertical Analysis
Common Size Statements

2. FINANCIAL STATEMENT ANALYSISRATIO ANALYSIS
Chapter 14 2

3. Ratios

4. Use this information to calculate the liquidity ratios for Norton Corporation.

5. Working Capital
Working capital is the excess of current assets over current liabilities.

6. This ratio measures the short-term debt-paying ability of the company.
Current Ratio
This ratio measures the short-term debt-paying ability of the company.
Current
Ratio
Current Assets
Current Liabilities =
Current
Ratio
$65,000
$42,000 = =
1.55 : 1

7. Quick Ratio Quick Assets Quick = Current Liabilities Ratio
Quick assets are cash, marketable securities, and receivables.
This ratio is like the current
ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash.

8. This ratio is like the current
Quick Ratio
Quick Assets
Current Liabilities =
Quick
Ratio
$50,000
$42,000 =
1.19 : 1
Quick
Ratio
This ratio is like the current
ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash.

9. A measure of creditor’s long-term risk.
Debt Ratio
A measure of creditor’s long-term risk.
The smaller the percentage of assets that are financed by debt, the smaller the risk for creditors.

10. Uses and Limitations of Financial Ratios

11. Measures of Profitability
An income statement can be prepared in either a multiple-step or single-step format.
The single-step format is simpler.
The multiple-step format provides more detailed information.

12. Income Statement (Multiple-Step) Example Remember to compute EPS.{
Proper Heading {
Gross Margin {
Operating Expenses {
Non- operating Items
Remember to compute EPS.

13. Income Statement (Single-Step) Example Remember to compute EPS.{
Proper Heading {
Revenues & Gains {
Expenses & Losses
Remember to compute EPS.

14. Use this information to calculate the profitability ratios for Norton Corporation.

15. Return On Assets (ROA) This ratio is generally considered
the best overall measure of a
company’s profitability.

16. Use this information to calculate the profitability ratios for Norton Corporation.

17. Return On Equity (ROE)
This measure indicates how well the company employed the owners’ investments to earn income.

18. Sources of Financial Information

19. More Examples of Ratios in Different Perspective

20. Solvency Analysis
Solvency is the ability of a business to meet its financial obligations (debts) as they are due.
Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities.
This ability is normally assessed by examining balance sheet relationships.

21. Current Position Analysis
Working Capital and Current Ratio
Current assets $550,000 $533,000
Current liabilities , ,000
Working capital $340,000 $290,000
Current ratio
Divide current assets by current liabilities
Use: To indicate the ability to meet currently maturing obligations.

22. Current Position Analysis
Quick Ratio
Quick assets:
Cash $ 90,500 $ 64,700
Marketable securities 75,000 60,000
Accounts receivable (net) 115, ,000
Total $280,500 $244,700
Current liabilities $210,000 $243,000
Quick ratio
Use: To indicate instant debt-paying ability.

23. Accounts Receivable Analysis
Accounts Receivable Turnover
Net sales on account $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year 115, ,000
Total $ 235,000 $ 260,000
Average (Total ÷ 2) $ 117,500 $ 130,000
Net sales on account
Average accounts receivable

24. Accounts Receivable Analysis
Accounts Receivable Turnover
Net sales on account $1,498,000 $1,200,000
Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000
End of year 115, ,000
Total $ 235,000 $ 260,000
Average $ 117,500 $ 130,000
Accounts receivable turnover
Use: To assess the efficiency in collecting receivables and in the management of credit.

25. Accounts Receivable Analysis
Number of Days’ Sales in Receivables
Accounts receivable (net),
end of year $ 115,000 $ 120,000
Net sales on account $1,498,000 $1,200,000
Average daily sales on
account (sales ÷ 365) $ ,104 $ ,288
Accounts receivable, end of year
Average daily sales on account

26. Accounts Receivable Analysis
Number of Days’ Sales in Receivables
Accounts receivable (net),
end of year $ 115,000 $ 120,000
Net sales on account $1,498,000 $1,200,000
Average daily sales on
account (sales ÷ 365) $ ,104 $ ,288
Number of days’ sales in
receivables
Use: To assess the efficiency in collecting receivables and in the management of credit.

27. Inventory Analysis Inventory Turnover Cost of goods sold
Cost of goods sold $1,043,000 $ 820,000
Inventories:
Beginning of year $ 283,000 $ 311,000
End of year 264, ,000
Total $ 547,000 $ 594,000
Average (Total ÷ 2) $ 273,500 $ 297,000
Cost of goods sold
Average inventory
Inventory turnover =

28. Inventory Analysis
Inventory Turnover
Cost of goods sold $1,043,000 $ 820,000
Inventories:
Beginning of year $ 283,000 $ 311,000
End of year 264, ,000
Total $ 547,000 $ 594,000
Average (Total ÷ 2) $ 273,500 $ 297,000
Inventory turnover
Use: To assess the efficiency in the management of inventory.

29. Inventory Analysis Number of Days’ Sales in Inventory
Inventories, end of year $ 264,000 $283,000
Cost of goods sold $1,043,000 $820,000
Average daily cost of
goods sold
(COGS ÷ 365) $ ,858 $ 2,247
Inventories, end of year
Average daily cost of goods sold
Number of Days’ Sales in Inventory =

30. Inventory Analysis
Number of Days’ Sales in Inventory
Inventories, end of year $ 264,000 $283,000
Cost of goods sold $1,043,000 $820,000
Average daily cost of
goods sold
(COGS ÷ 365) $ ,858 $ 2,247
Number of days’ sales
in inventory
Use: To assess the efficiency in the management of inventory.

31. Long-Term Creditors
Ratio of Fixed Assets to Long-Term Liabilities
Fixed assets (net) $444,500 $470,000
Long-term liabilities $100,000 $200,000
Ratio of fixed assets to
long-term liabilities
Use: To indicate the margin of safety to long-term creditors.

32. Long-Term Creditors
Ratio of Liabilities to Stockholders’ Equity
Total liabilities $310,000 $443,000
Total stockholders’ equity $829,500 $787,500
Ratio of liabilities to
stockholders’ equity
Use: To indicate the margin of safety to creditors.

33. Long-Term Creditors Number of Times Interest Charges Earned
Income before income tax $ 900,000 $ 800,000
Add interest expense , ,000
Amount available for interest $1,200,000 $1,050,000
Income before
income tax + interest expense
Interest expense
Number of Times Interest Charges Earned =

34. Long-Term Creditors
Number of Times Interest Charges Earned
Income before income tax $ 900,000 $ 800,000
Add interest expense , ,000
Amount available for interest $1,200,000 $1,050,000
Number of times earned
Use: To assess the risk to debtholders in terms of number of times interest charges were earned.

35. Profitability Analysis
Profitability is the ability of an entity to earn profits.
This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available.
Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet.

36. The Common Stockholder
Ratio of Net Sales to Assets
Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
Average (Total ÷ 2) $1,048,750 $1,031,500
Excludes long-term investments

37. The Common Stockholder
Ratio of Net Sales to Assets
Net sales $1,498,000 $1,200,000
Total assets:
Beginning of year $1,053,000 $1,010,000
End of year 1,044,500 1,053,000
Total $2,097,500 $2,063,000
Average (Total ÷ 2) $1,048,750 $1,031,500
Ratio of net sales to assets
Use: To assess the effectiveness of the use of assets.

38. The Common Stockholder
Rate Earned on Total Assets
Net income $ 91,000 $ 76,500
Plus interest expense 6,000 12,000
Total $ 97,000 $ 88,500
Total assets:
Beginning of year $1,230,500 $1,187,500
End of year 1,139,500 1,230,500
Total $2,370,000 $2,418,000
Average (Total ÷ 2) $1,185,000 $1,209,000
Rate earned on total assets % %
Use: To assess the profitability of the assets.

39. The Common Stockholder
Rate Earned on Stockholders’ Equity
Net income $ 91,000 $ 76,500
Stockholders’ equity:
Beginning of year $ 787,500 $ 750,000
End of year 829, ,500
Total $1,617,000 $1,537,500
Average (Total ÷ 2) $ 808,500 $ 768,750
Rate earned on stockholders’
equity % %
Use: To assess the profitability of the investment by stockholders.

40. Leverage 11.3% 10.0% Leverage 3.1% Leverage 2.7% 8.2% 7.3%
10%
Leverage 2.7%
8.2%
7.3% 5% 0%
2006
2005
Rate earned on total assets
Rate earned on stockholders’ equity

41. The Common Stockholder
Rate Earned on Common Stockholders’ Equity
Net income $ ,000 $ ,500
Less preferred dividends 9,000 9,000
Remainder—common stock $ ,000 $ ,500
Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000
End of year 679, ,500
Total $1,317,000 $1,237,500
Average (Total ÷ 2) $ 658,500 $ 618,750

42. The Common Stockholder
Rate Earned on Common Stockholders’ Equity
Net income $ ,000 $ ,500
Less preferred dividends 9,000 9,000
Remainder—common stock $ ,000 $ ,500
Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000
End of year 679, ,500
Total $1,317,000 $1,237,500
Average (Total ÷ 2) $ 658,500 $ 618,750
Rate earned on common
stockholders’ equity % %
Use: To assess the profitability of the investment by common stockholders.

43. The Common Stockholder
Earnings Per Share on Common Stock
Net income $ 91,000 $ 76,500
Less preferred dividends 9,000 9,000
Remainder—common stock $ 82,000 $ 67,500
Shares of common stock 50,000 50,000
Earnings per share on common stock $ $1.35
Use: To assess the profitability of the investment by common stockholders.

44. The Common Stockholder
Price-Earnings Ratio
Market price per share of common $41.00 $27.00
Earnings per share on common ÷ 1.64 ÷ 1.35
Price-earnings ratio on common stock
Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings.

45. Dividends and Earnings Per Share
$2.00
$1.64
$1.50
Per share
$1.35
$1.00
$0.80
$0.60
$0.50
$0.00
2006
2005
Dividends
Earnings

46. The Common Stockholder
Dividend Yield on Common Stock
Dividends per share of common $ $
Market price per share of common ÷ ÷ 27.00
Dividend yield on common stock % %
Use: To indicate the rate of return to common stockholders in terms of dividends.

47. Corporate Annual Reports
In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report.
The MDA includes an analysis of the results of operations and discusses management’s opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition.

48. Corporate Annual Reports
In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report.
Before issuing annual statements, all publicly held corporations are required to have an independent audit of their financial statements. The CPAs who conduct the audit render an opinion as to the fairness of the statements.

49. End of Chapter 14
Allah Hafiz