2. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 1 Chapter 11 Financial Statement Analysis – A Closer Look

3. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 2 Learning Objective 1 Identify the three major categories of users of financial statement analysis and describe the objectives of each.

4. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 3 Financial Statement Analysis – Who Does It and Why Creditors (short-term and long-term) Equity investors (present and potential) Company managers

5. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 4 Objectives of Creditors There are two major types of short-term creditors. Trade creditors No interest Lending institutions Interest

6. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 5 Objectives of Creditors Long-term creditors lend money to companies for relatively long time periods. Their principal objective in analyzing financial statements is to help them determine whether the company is likely to be financially healthy over the long haul.

7. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 6 Objectives of Equity Investors Equity investment Dividends Stock appreciation Their principal objective in analyzing financial statements is to determine whether it is likely that the combination of dividends and stock appreciation will provide an adequate return.

8. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 7 Objectives of Management Managers Managementaccounting Financialaccounting A corporate manager’s performance is evaluated in large part by the financial success of the company as reflected in the financial statements.

9. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 8 Learning Objective 2 Gather information to evaluate the political climate and general economic conditions and describe the ways each of them can affect business.

10. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 9 Gathering Background Information General economic conditions and expectations Political events and political climate Industry outlook

11. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 10 Learning Objective 3 Locate sources of information about specific industries.

12. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 11 Sources of Information Standard and Poor’s Industry Surveys U.S. Industry & Trade Outlook Mergent’s Industry Review

13. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 12 Learning Objective 4 Describe the two industry classification systems and explain what a NAICS code or a SIC code indicates.

14. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 13 Industry Classifications In the U.S. there are two widely used industry classification systems: North America Industry Classification Systems (NAICS) Standard Industrial Classification (SIC)

15. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 14 Industry Classifications The NAICS was developed by the governments of the U.S., Canada, and Mexico in 1997. The SIC was established by the United States Office of Management and Budget in 1987.

16. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 15 Preliminary Steps in Financial Statements Analysis Determine the industry classification Find peer companies Obtain industry averages

17. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 16 Learning Objective 5 Describe the purpose of ratio analysis and the four aspects of business it helps users evaluate.

18. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 17 Analyzing Financial Statements Profitability ratios Efficiency ratios Liquidity ratios Solvency ratios

19. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 18 Profitability Ratios Gross profit margin ratio = Gross profit ÷ Net sales Net profit margin ratio = Net profit ÷ Net sales Rate of return on assets ratio = Net income ÷ Average total assets

20. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 19 Profitability Ratios Rate of return on common equity ratio = (Net income – Total preferred dividends) ÷ Average common stockholders’ equity Dividend payout ratio = Total cash dividends ÷ Net income

21. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 20 Profitability Ratios Earnings per share = (Net income – Total preferred dividends) ÷ Average common shares outstanding Price earnings ratio = Average market price per share of stock ÷ Earnings per share

22. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 21 Efficiency Ratios Asset turnover ratio = Net sales ÷ Average total assets Receivables turnover ratio = Net sales ÷ Average accounts receivable Inventory turnover ratio = Cost of goods sold ÷ Average inventory

23. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 22 Current ratio = Current assets ÷ Current liabilities Liquidity Ratios Quick ratio = (Cash + Short-term investments + Current receivables) ÷ Current liabilities Operating cash flow to current debt ratio = Cash provided by operating activities ÷ Average current liabilities

24. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 23 Solvency Ratios Debt ratio = Total liabilities ÷ Total assets Debt-to-equity ratio = Total liabilities ÷ Total equity

25. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 24 Solvency Ratios Times interest-earned = Earnings before interest and income taxes ÷ Interest expense Operating cash flow coverage ratio = Cash provided by operating activities ÷ Average total liabilities

26. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 25 Learning Objective 6 Calculate and use financial ratios designed to measure a company’s profitability, liquidity, and solvency, and evaluate a company’s ratios compared to those of peer companies and industry averages.

27. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 26 Calculating Financial Ratios and Interpreting Their Results Ratio analysis is a method of analyzing the relationship between two items from a company’s financial statements for a given period.

28. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 27 Measuring Profitability Profitability is the ease with which a company generates income. Why do some managers try to improve their company’s apparent performance?

29. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 28 Measuring Profitability Managers may want to make the company’s financial results look more appealing to external decision makers. A portion of their compensation may be tied to these profitability ratios.

30. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 29 Gross Profit Margin Ratio

31. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 30 Net Profit Margin Ratio

32. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 31 Rate of Return on Assets

33. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 32 Rate of Return on Common Equity

34. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 33 Dividend Payout Ratio

35. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 34 Diluted Earnings Per Share

36. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 35 Price to Earnings Ratio

37. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 36 Measuring Efficiency The more business a company can generate with a given amount of assets, the better.

38. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 37 Asset Turnover Ratio

39. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 38 Average Accounts Receivable Collection Period

40. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 39 Average Inventory Holding Period

41. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 40 Measuring Liquidity Liquidity refers to a company’s ability to generate the cash needed to meet its short-term obligations.

42. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 41 Current Ratio

43. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 42 Quick (Acid Test) Ratio

44. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 43 Operating Cash Flow to Current Debt

45. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 44 Measuring Solvency Solvency refers to a company’s ability to meet its long-term financial obligations. Debt obligations include both paying back the amount borrowed and paying interest on the debt.

46. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 45 Debt Ratio

47. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 46 Debt-to-Equity Ratio

48. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 47 Times-Interest-Earned

49. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 48 Operating Cash Flow Coverage Ratio

50. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 49 Learning Objective 7 Describe the limitations of financial statement analysis.

51. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 50 Limitations of Financial Statement Analysis Attempting to predict the future using past results depends on the predictive value of the information used. The financial statements used to compute the ratios are based on historical cost. Figures used to calculate the ratios are year-end numbers.

52. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 51 Limitations of Financial Statement Analysis Industry peculiarities create difficulty in comparing the ratios of a company in one industry with those of a company in another industry. Lack of uniformity concerning what is to be included in the numerators and denominators of specific ratios makes comparisons extremely difficult.

53. ©2004 Prentice Hall Business Publishing Introduction to Financial Accounting, 3e by Werner/Jones11 - 52 End of Chapter 11