1. Chapter 13, Slide #1 Using Financial Accounting Information: The Alternative to Debits and Credits Fifth Edition Gary A. Porter and Curtis L. Norton Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

2. Chapter 13, Slide #2 Stockholders Financial Statement Analysis Creditors Management “Will I be paid?” “How good is our investment?” “How are we performing?”

3. Chapter 13, Slide #3 LIFOFIFO Limitations of Financial Statement Analysis  Use of different accounting methods  Changes in accounting methods LO1

4. Chapter 13, Slide #4 Limitations of Financial Statement Analysis  Failure to recognize trends in ratios  Difficulty of making industry comparisons (i.e., conglomerates )

5. Chapter 13, Slide #5 Limitations of Financial Statement Analysis  Nonoperating items on income statement  Effects of inflation

6. Chapter 13, Slide #6 Horizontal Analysis  A comparison of financial statement items over a period of time  Read right to left to compare one year’s results with the next as a dollar amount of change and as a percentage of change from year to year LO2

7. Chapter 13, Slide #7 Horizontal Analysis Cash $ 320 $1,350 $(1,030) (76)% Accounts receivable 5,500 4,500 1,000 22 Inventory 4,750 2,750 2,000 73 Prepaid insurance 150 200 (50) (25) Total current assets $10,720 $8,800 $ 1,920 22 December 31 Increase (Decrease) 2007 2006 Dollars Percent Dollar change from year to year Percentage change from one year to the next year

8. Chapter 13, Slide #8 Trend Analysis Return on Average Equity 2004 2003 2002 2001 2000 24.7% 26.7% 28.7% 30.1% 29.0% Wm. Wrigley Jr. Company Tracking items over a series of years

9. Chapter 13, Slide #9 Vertical Analysis  Common-size statements recast items as a percentage of a selected item  Allows comparisons of companies of different size  Compares percentages across years to identify trends % % % LO3

10. Chapter 13, Slide #10 Vertical Analysis Cash $ 320 1.9% $ 1,350 9.8% Accounts receivable 5,500 32.6 4,500 32.6 Inventory 4,750 28.1 2,750 19.9 Prepaid insurance 150 0.9 (200) 1.5 Total current assets $10,720 63.5% $8,800 63.8% December 31, 2007 December 31, 2006 Dollars Percent Dollars Percent Compare percentages across years to spot year-to-year trends

11. Chapter 13, Slide #11 Liquidity Analysis  Nearness to cash  Ability to pay debts as they become due LO4

12. Chapter 13, Slide #12 Working Capital  Excess of current assets over current liabilities  Lacks meaningful comparisons for companies of different size CA – CL

13. Chapter 13, Slide #13 Current Ratio  Measure of short-term financial health  Consider composition of current assets Rule of thumb: 2:1 CA CL

14. Chapter 13, Slide #14 Acid-Test (Quick) Ratio  Stricter test of ability to pay debts  Excludes inventories and prepaid assets Quick Assets Current Liabilities

15. Chapter 13, Slide #15 Cash Flow from Operations to Current Liabilities  Focuses on cash only  Can be used to indicate the flow of cash during the year to cover the debts due Net Cash Provided by Operating Activities Average Current Liabilities

16. Chapter 13, Slide #16 Accounts Receivable Turnover Ratio Net Credit Sales Average Accounts Receivable Indicates how quickly a company is collecting (i.e., turning over) its receivables

17. Chapter 13, Slide #17 Number of Days’ Sales in Receivables Represents the average number of days an account is outstanding Number of Days in the Period Accounts Receivable Turnover

18. Chapter 13, Slide #18 Number of Days’ Sales in Receivables If this company’s credit terms are net 30, what would this tell you about the efficiency of the collection process? 360 days 4.8 times = 75 days Example:

19. Chapter 13, Slide #19 Inventory Turnover Ratio Represents the number of times per period inventory is turned over (i.e., sold). Cost of Goods Sold Average Inventory

20. Chapter 13, Slide #20 Number of Days’ Sales in Inventory Represents the average number of days inventory is on hand before it’s sold Number of Days in the Period Inventory Turnover

21. Chapter 13, Slide #21 Cash Operating Cycle  Time between the purchase of merchandise and the collection of the from the sale Number of Days’ Sales in Inventory + Number of Days’ Sales in Receivables

22. Chapter 13, Slide #22 Solvency Analysis  Ability to stay in business over the long-term Debt-to- Equity Ratio Debt Service Coverage Times Interest Earned Cash Flow from Operations to Capital Expenditures LO5

23. Chapter 13, Slide #23 Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed compared to owners?

24. Chapter 13, Slide #24 Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity =.60 “For every dollar contributed by owners, creditors have loaned $.60”

25. Chapter 13, Slide #25 Times Interest Earned  Measures ability to meet current interest payments  The greater the coverage the better Net Income + Interest Expense + Income Tax Expense Interest Expense

26. Chapter 13, Slide #26 Debt Service Coverage  Measures amount of cash from operating activities available to “service” the debt Cash Flow from Operations Before Interest and Tax Payments Interest and Principal Payments

27. Chapter 13, Slide #27 Cash Flow from Operations to Capital Expenditures Ratio  Measures company’s ability to use operations (vs. creditors and owners) to finance its acquisitions of productive assets Cash Flow from Operations – Total Dividends Paid Cash Paid for Acquisitions

28. Chapter 13, Slide #28 Profitability Analysis  Rate of Return on Assets  Return on Common Stockholders’ Equity  Earnings per Share  Price/Earnings Ratio  Dividend Ratios LO6

29. Chapter 13, Slide #29 Return on Assets Ratio  Measures return to all providers of capital (creditors and owners ) Net Income + Interest Expense, Net of Tax Average Total Assets

30. Chapter 13, Slide #30 Return on Common Stockholders’ Equity Net Income – Preferred Dividends Average Common Stockholders’ Equity “The owners earned 15% on their investment in ABC Co... Not bad!”

31. Chapter 13, Slide #31 Earnings per Share  Presents profits on a per-share basis Net Income – Preferred Dividends Weighted Average Number of Common Shares Outstanding

32. Chapter 13, Slide #32 Price/Earnings Ratio  Relates earnings to the market price of the stock Current Market Price Earnings per Share very high P/E very low P/E possibly overpriced possibly underpriced

33. Chapter 13, Slide #33 Price/Earnings Ratio Both companies have earnings of $2 per share. So why the different P/E ratios? P/E Ratios Co. A=10 to 1 Co. B= 7 to 1

34. Chapter 13, Slide #34 Dividend Payout Ratio Common Dividends per Share Earnings per Share “We need to decide what percentage of the firm’s income we can return to owners.”

35. Chapter 13, Slide #35 Dividend Yield Ratio  Investors willing to forgo dividends in lieu of price appreciation Common Dividends per Share Market Price per Share usually < 5% =

36. Chapter 13, Slide #36 Appendix Accounting Tools: Reporting and Analyzing Other Income Statement Items

37. Chapter 13, Slide #37 Common Characteristics  All such items are reported after income from continuing operations  Reported separately  Shown net of tax effects  Most analysts ignore these items, since they are not likely to reoccur LO7

38. Chapter 13, Slide #38 Discontinued Operations  Any gain or loss from disposal of a division or segment of the business  Any net income or loss from operating this portion until the date of disposal

39. Chapter 13, Slide #39 Extraordinary Items Gain or loss due to an event that is  Unusual in nature AND  Infrequent in occurrence

40. Chapter 13, Slide #40 Cumulative Effect of a Change in Accounting Principle  Reflects a change in a company’s accounting principles, practices, or methods  Reports the difference in income in all prior years between the old method and the new method  Sometimes such a change is dictated by a new accounting standard

41. Chapter 13, Slide #41 End of Chapter 13