1. 12-1 ©2006 Prentice Hall, Inc.

2. 12-2 ©2006 Prentice Hall, Inc. USING FIN STMT ANALYSIS TO EVALUATE FIRM PERFORMANCE  Learning objectives Learning objectives  A closer look at the income statement A closer look at the income statement  Horizontal and vertical analysis of financial information Horizontal and vertical analysis of financial information  Ratio analysis Ratio analysis  It’s more than just the numbers It’s more than just the numbers  Business risk, control, and ethics Business risk, control, and ethics

3. 12-3 ©2006 Prentice Hall, Inc. Learning Objectives (1 of 2)  Recognize and explain the components of net income  Perform and interpret a horizontal analysis and a vertical analysis of financial statement information

4. 12-4 ©2006 Prentice Hall, Inc. Learning Objectives (2 of 2)  Perform a basic ratio analysis of a set of financial statements and explain what the ratios mean  Recognize the risks of investing in stock and explain how to control those risks

5. 12-5 ©2006 Prentice Hall, Inc. A Closer Look at the Income Statement  Why does FASB require discontinued operations and extraordinary items to be reported separately?  Discontinued operations Discontinued operations  Extraordinary items Extraordinary items  Reporting taxes Reporting taxes

6. 12-6 ©2006 Prentice Hall, Inc. Discontinued Operations (1 of 2)  Parts of a company’s operations that are eliminated  A one-time occurrence  Income/loss from discontinued operations separately reported  Net of taxes

7. 12-7 ©2006 Prentice Hall, Inc. Discontinued Operations (2 of 2)  Gain/loss from disposal of discontinued operations separately reported  Net of taxes

8. 12-8 ©2006 Prentice Hall, Inc. Extraordinary Items (1 of 2)  Events that are  Unusual in nature  Abnormal  Infrequent in occurrence  Not reasonably expected to occur again in the foreseeable future

9. 12-9 ©2006 Prentice Hall, Inc. Extraordinary Items (2 of 2)  Much judgment required to determine if an event is an extraordinary item  Should damage from a hurricane in Miami be reported as an extraordinary item?

10. 12-10 ©2006 Prentice Hall, Inc. Reporting Taxes  Income taxes shown as separate line item  Last item before income from continuing operations  Does not include tax expense/savings from extraordinary items or discontinued operations

11. 12-11 ©2006 Prentice Hall, Inc. Horizontal and Vertical Analysis of Financial Information  Three primary ways to analyze financial information  Horizontal analysis Horizontal analysis  Vertical analysis Vertical analysis  Ratio analysis Ratio analysis

12. 12-12 ©2006 Prentice Hall, Inc. Horizontal Analysis (1 of 3)  Evaluating financial statements across time  Express change in a financial statement item in percentages instead of dollars Current year amount – Base year amount Base year amount  Reported as a percentage

13. 12-13 ©2006 Prentice Hall, Inc. Horizontal Analysis (2 of 3)  Two ways to compute  Choose a single year as base period for all years analyzed  Use the prior year as base period

14. 12-14 ©2006 Prentice Hall, Inc. Horizontal Analysis (3 of 3)  Compute the change in accounts receivable using  2010 as the base year  The prior year as the base year

15. 12-15 ©2006 Prentice Hall, Inc. Vertical Analysis (1 of 2)  Compares items w/in single fin stmt  All items expressed as a percent of a common amount  Also called common-sizing financial statements  Income statement items  Percent of sales  Balance sheet  Percent of total assets

16. 12-16 ©2006 Prentice Hall, Inc. Vertical Analysis (2 of 2)

17. 12-17 ©2006 Prentice Hall, Inc. Ratio Analysis  A review of all ratios A review of all ratios  DuPont formula DuPont formula  Understanding ratio analysis Understanding ratio analysis  Using ratio analysis Using ratio analysis

18. 12-18 ©2006 Prentice Hall, Inc. A Review of All Ratios (1 of 2)  Liquidity Liquidity ratios  Measure ability to pay current bills and operating costs  Solvency Solvency ratios  Measure ability to meet long-term obligations and survive over long term

19. 12-19 ©2006 Prentice Hall, Inc. A Review of All Ratios (2 of 2)  Profitability ratios Profitability ratios  Measure operating or income performance  Market indicators Market indicators  Ratios relating current market price of stock to earnings or dividends

20. 12-20 ©2006 Prentice Hall, Inc. Liquidity Ratios  Current ratio Current ratio  Quick ratio Quick ratio  Working capital Working capital  Inventory turnover ratio Inventory turnover ratio  Accounts receivable turnover ratio Accounts receivable turnover ratio  Current cash debt coverage ratio Current cash debt coverage ratio

21. 12-21 ©2006 Prentice Hall, Inc. Current Ratio Current Assets _ Current Liabilities  Measure ability to pay current liabilities with current assets  Helps creditors determine if a company can meet its short-term obligations

22. 12-22 ©2006 Prentice Hall, Inc. Quick Ratio Cash + s-t investments + A/R net Current liabilities  Measure ability to meet short-term obligations  Similar to the current ratio  Stricter test because it limits numerator to only very liquid assets

23. 12-23 ©2006 Prentice Hall, Inc. Working Capital Current assets – Current liabilities  Measure ability to meet short-term obligations  Not a ratio  Often measured as part of financial statement analysis

24. 12-24 ©2006 Prentice Hall, Inc. Inventory Turnover Ratio Cost of goods sold _ Average current liabilities  Measure how quickly a company is selling its inventory

25. 12-25 ©2006 Prentice Hall, Inc. Accounts Receivable Turnover Ratio Net credit sales _ Average net accounts receivable  Measure ability to collect the cash from its credit customers

26. 12-26 ©2006 Prentice Hall, Inc. Current Cash Debt Coverage Ratio Net cash from operating activities Average current liabilities  Measure ability to generate cash needed to pay current liabilities from company’s operations

27. 12-27 ©2006 Prentice Hall, Inc. Solvency Ratios  Debt to equity ratio Debt to equity ratio  Times interest earned ratio Times interest earned ratio  Cash flow adequacy ratio Cash flow adequacy ratio

28. 12-28 ©2006 Prentice Hall, Inc. Debt to Equity Ratio Total liabilities _ Total shareholders’ equity  Compare amount of company’s debt with amount owners have invested in the company

29. 12-29 ©2006 Prentice Hall, Inc. Times Interest Earned Ratio Income from operations_ Interest expense  Compare amount of income earned in an accounting period (before interest) to interest obligation for same period  If net income used in numerator, add back interest expense and taxes

30. 12-30 ©2006 Prentice Hall, Inc. Cash Flow Adequacy Ratio Net cash from operating activities _ Net cash required for investing activities  Cash required for investing activities  Cash paid for capital expenditures and acquisitions minus cash proceeds from disposal of capital assets  Measures the firm’s ability to generate enough cash from operating activities to pay for its capital expenditures

31. 12-31 ©2006 Prentice Hall, Inc. Profitability Ratios  Return on assets Return on assets  Asset turnover ratio Asset turnover ratio  Return on equity Return on equity  Gross profit ratio Gross profit ratio  Profit margin ratio Profit margin ratio  Earnings per share Earnings per share

32. 12-32 ©2006 Prentice Hall, Inc. Return on Assets (1 of 2) Net income + Interest expense_ Average total assets  Measure success in using assets to earn income for owners and creditors  Those who are financing the business

33. 12-33 ©2006 Prentice Hall, Inc. Return on Assets (2 of 2)  Interest added back to numerator  Interest part of what has been earned to pay creditors  Net income is return to the owners  Interest expense is return to creditors

34. 12-34 ©2006 Prentice Hall, Inc. Asset Turnover Ratio Net sales _ Average total assets  Measure how efficiently a company uses its assets

35. 12-35 ©2006 Prentice Hall, Inc. Return on Equity Net income – preferred dividends _ Average common shareholders’ equity  Measure how much income is earned with the common shareholders’ investment in the company

36. 12-36 ©2006 Prentice Hall, Inc. Gross Profit Ratio Gross profit_ Net sales  Describes percentage of sales price that is gross profit  Carefully watched by management  A small shift usually indicates a big change in the profitability of the company’s sales

37. 12-37 ©2006 Prentice Hall, Inc. Profit Margin Ratio Net income_ Net sales  Measure percentage of each sales dollar that results in net income  Where in common sizing financial statements can you find gross profit and profit margin ratios?

38. 12-38 ©2006 Prentice Hall, Inc. Earnings Per Share Net income – preferred dividends_ Weighted average # of shares of common stock outstanding  Calculate net income per share of common stock

39. 12-39 ©2006 Prentice Hall, Inc. Market Indicators  Price-earnings ratio Price-earnings ratio  Dividend yield ratio Dividend yield ratio

40. 12-40 ©2006 Prentice Hall, Inc. Price-earnings Ratio Market price per common share_ Earnings per share  Calculate market price for $1 of earnings  Investors and analysts believe it indicates future earnings potential

41. 12-41 ©2006 Prentice Hall, Inc. Dividend Yield Ratio Dividends per share _ Market price per share  Calculate percentage return on investment in a share of stock via dividends  How else do investors earn a return on their investment besides receiving dividends?

42. 12-42 ©2006 Prentice Hall, Inc. DuPont Formula (1 of 2) ROE = ROA x Financial leverage ROE = Net income x Assets Assets Equity ROE = Asset x Profit margin x Financial Turnover Ratio leverage

43. 12-43 ©2006 Prentice Hall, Inc. DuPont Formula (2 of 2)  Indicates quality of ROE  If ROE is due to high financial leverage, what is the company’s prospects for growth of its ROE?  Which component of formula would you expect to be strongest for  A grocery store?  A jewelry store?

44. 12-44 ©2006 Prentice Hall, Inc. Understanding Ratio Analysis  Ratios must be compared with something to be useful  Same company for prior periods  Other companies for same period  Industry average for same period

45. 12-45 ©2006 Prentice Hall, Inc. Using Ratio Analysis (1 of 2)

46. 12-46 ©2006 Prentice Hall, Inc. Using Ratio Analysis (2 of 2)  Fill in the missing information  Why is the current ratio so much higher than the quick ratio?  Why not compare working capital to the industry average?  What conclusions can you draw from this information?

47. 12-47 ©2006 Prentice Hall, Inc. It’s More than Just the Numbers  Information found in notes to financial statements  Inventory cost flow methods  Depreciation methods  How various items are valued  Description of accounting policies  What other useful information can you find in Wal-Mart’s and Target’s notes?

48. 12-48 ©2006 Prentice Hall, Inc. Business Risk, Control, and Ethics  Investor perspective  How do you minimize the risks of stock ownership?  Consult with a financial professional  Diversify your investments  What kinds of investments would make up a diversified portfolio?  Can you eliminate all investment risk?

49. Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard.newmark@PhDuh.com 12-49 ©2006 Prentice Hall, Inc.