Copyright 2012 The McGraw-Hill Companies, Inc.

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
Financial Statement Analysis
Chapter 14
14-2
Results
in standardized,
meaningful
subtotals.
Items with certain
characteristics are
grouped together.
Classified
Financial
Statements
Helps identify
significant
changes and
trends.
Amounts from
several years
appear side by side.
Comparative
Financial
Statements
Presented as if
the two companies
are a single
business unit.
Information for the
parent and subsidiary
are presented.
Consolidated
Financial
Statements
Financial Statements Are
Designed for Analysis
14--3
Financial Statement Analysis
Financial statement analysis involves
at least 3 questions:
1. What are performances?
Performances for whom?
2. Which method to use?
3. What is the reference point
(standard)?
14--4
Objectives of this lesson
1. List, describe and apply methods of
financial statement analysis.
2. Compare advantages and
disadvantages of each method and
recognize their usefulness and
limitations.
3. Focus on the ratio analysis and Du
Pont model.
14-5
Dollar &
Percentage
Changes
Trend
Percentages
Component
Percentages
Ratios
Tools of Analysis
14-6
Dollar and Percentage
Changes
Dollar Change:
Analysis Period
Amount
Base Period
Amount
Dollar
Change
=
Percentage Change:
Dollar Change
Base Period
Amount
Percent
Change
=

14-7
Dollar and Percentage
Changes
Sales and earnings
should increase at
more than the rate
of inflation.
In measuring quarterly
changes, compare to
the same quarter in
the previous year.
Percentages may be
misleading when the
base amount is small.
Evaluating Percentage Changes in
Sales and Earnings
14-8
Clover, Inc.
Comparative Balance Sheets
December 31,
2011 2010 Dollar Change
Percent
Change*
Assets
Current assets:
Cash and equivalents 12,000 $ 23,500 $ (11,500) $ ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 $ 164,700 $
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 $ 125,000 $
Total assets 315,000 $ 289,700 $
* Percent rounded to one decimal point.
$12,000 $23,500 = $(11,500)
14-9
Clover, Inc.
Comparative Balance Sheets
December 31,
2011 2010 Dollar Change
Percent
Change*
Assets
Current assets:
Cash and equivalents 12,000 $ 23,500 $ (11,500) $ -48.9%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 $ 164,700 $
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 $ 125,000 $
Total assets 315,000 $ 289,700 $
* Percent rounded to one decimal point.
($11,500 $23,500) 100% = 48.94%
Complete the
analysis for
the other
assets.
14-10
Clover, Inc.
Comparative Balance Sheets
December 31,
2011 2010 Dollar Change
Percent
Change*
Assets
Current assets:
Cash and equivalents 12,000 $ 23,500 $ (11,500) $ -48.9%
Accounts receivable, net 60,000 40,000 20,000 50.0%
Inventory 80,000 100,000 (20,000) -20.0%
Prepaid expenses 3,000 1,200 1,800 150.0%
Total current assets 155,000 $ 164,700 $ (9,700) -5.9%
Property and equipment:
Land 40,000 40,000 - 0.0%
Buildings and equipment, net 120,000 85,000 35,000 41.2%
Total property and equipment 160,000 $ 125,000 $ 35,000 28.0%
Total assets 315,000 $ 289,700 $ 25,300 $ 8.7%
* Percent rounded to one decimal point.
14-11
Trend Percentages
Trend analysis is used to reveal patterns in
data covering successive periods.
Trend
Percentages
Analysis Period Amount
Base Period Amount
100% =
14-12
Berry Products
Income Information
For the Years Ended December 31,
Item 2011 2010 2009 2008 2007
Revenues 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000 $
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000
Item 2011 2010 2009 2008 2007
Revenues 145% 129% 116% 105% 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit 135% 124% 112% 108% 100%
(290,000 275,000) 100% = 105%
(198,000 190,000) 100% = 104%
(92,000 85,000) 100% = 108%
Trend Percentages
14-13
Component Percentages
Examine the relative size of each item in the
financial statements by computing component
(or common-sized) percentages.
Component
Percentage
100%
Analysis Amount
Base Amount
=

Financial Statement Base Amount
Balance Sheet Total Assets
Income Statement Revenues
14-14
Clover, inc.
Comparative Balance Sheets
December 31,
Common-size
Percents*
2011 2010 2011 2010
Assets
Current assets:
Cash and equivalents 12,000 $ 23,500 $ 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 $ 164,700 $
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 $ 125,000 $
Total assets 315,000 $ 289,700 $ 100.0% 100.0%
* Percent rounded to first decimal point.
Complete the common-size analysis for the other
assets.
($12,000 $315,000) 100% = 3.8%
($23,500 $289,700) 100% = 8.1%
14-15
Clover, Inc.
Comparative Balance Sheets
December 31,

Common-size
Percents*
2011 2010 2011 2010
Assets
Current assets:
Cash and equivalents 12,000 $ 23,500 $ 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.6%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets 155,000 $ 164,700 $ 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment 160,000 $ 125,000 $ 50.8% 43.1%
Total assets 315,000 $ 289,700 $ 100.0% 100.0%
* Percent rounded to first decimal point.
14-16
Clover, Inc.
Comparative Income Statements
For the Years Ended December 31,
Common-size
Percents*
2011 2010 2011 2010
Revenues 520,000 $ 480,000 $ 100.0% 100.0%
Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes 25,000 $ 32,000 $ 4.8% 6.7%
Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income 17,500 $ 22,400 $ 3.4% 4.7%
Net income per share 0.79 $ 1.01 $
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.
14-17
Quality of Earnings
Investors are interest in companies that
demonstrate an ability to earn income at a
growing rate each year. Stability of earnings
growth helps investors predict future prospects
for the company.
Financial analyst often speak of the quality of
earnings at one company being higher than
another company in the same industry.
14-18
Quality of Assets and the
Relative Amount of Debt
While satisfactory earnings may be a
good indicator of a companys ability to
pay its debts and dividends, we must also
consider the composition of assets, their
condition and liquidity, the timing of
repayment of liabilities, and the total
amount of debt outstanding
14-19
A Classified Balance Sheet
Current assets:
Cash 30,000 $
Notes receivable 16,000
Accounts receivable 60,000
Inventory 70,000
Prepaid expenses 4,000
Total current assets 180,000
Plant and equipment:
Land 150,000 $
Building 121,000 $
Less: Accumulated depreciation (10,000) 111,000
Equipment and Fixtures 46,000
Less: Accumulated depreciation (27,000) 19,000
Total plant and equipment 280,000
Other assets:
Patents 170,000
Total assets 630,000 $
Matrix, Inc.
Asset Section: Classified Balance Sheet
December 31, 2011
14-20
Past performance to
present performance.
Other companies to
your company.
Along with dollar and percentage changes,
trend percentages, and component percentages,
ratios can be used to compare:
A ratio is a simple mathematical expression
of the relationship between one item and another.
Ratios
14--21
Ratios
1. What do they measure?
Liquidity
Solvency
Efficiency
Profitability
Market value
2. Standards for comparison
past performance
benchmark (comparable company or average)
budget
14--22
Using Financial Ratios
Question Category of Ratios Used
1. How liquid is the firm? Will it be
able to pay its bills as they
become due?
Liquidity ratios
2. How has the firm financed the
purchase of its assets?
Capital structure ratios

3. How efficient has the firms
management been in utilizing it
assets to generate sales?
Asset management efficiency
ratios
4. Has the firm earned adequate
returns on its investments?
Profitability ratios
5. Are the firms managers creating
value for shareholders?
Market value ratios
14--23
Liquidity Ratios
Liquidity ratios address a basic
question: How liquid is the firm?
A firm is financially liquid if it is able to
pay its bills on time.
In order to be liquid it has to have
enough cash and cash-alike assets.
Does the net income tells us about the
liquidity?
14-24
Use this information to calculate the liquidity
ratios for Babson Builders.
Babson Builders, Inc.
2011
Cash 30,000 $
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 15,000
Total current assets 65,000
Total current liabilities 42,000
Total liabilities 103,917
Total assets
Beginning of year 300,000
End of year 346,390
Revenues 494,000
14-25
Working capital is the excess of current
assets over current liabilities.
Working Capital
12/31/11
Current assets 65,000 $
Current liabilities (42,000)
Working capital 23,000 $
14-26
Current
Ratio
Current Assets
Current Liabilities
=
= 1.55 : 1
This ratio measures the
short-term debt-paying
ability of the company.
Current Ratio
Current
Ratio
$65,000
$42,000
=
14-27
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.
Quick Assets
Current Liabilities
=
Quick
Ratio
Quick Ratio
14-28
Quick Ratio
$50,000
$42,000
= 1.19 : 1 =
Quick
Ratio
Quick Assets
Current Liabilities
=
Quick
Ratio
14-29
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.
Measures of Profitability
14-30
Babson Builders, Inc.
Income Statement
For the Year Ended 12/31/11
Sales, net 785.250 $
Cost of goods sold 351.800
Gross margin 433.450 $
Operating expenses:
Selling expenses 197.350 $
General & Admin. 78.500
Depreciation 17.500 293.350
Income from Operations 140.100 $
Other revenues & gains:
Interest income 62.187 $
Gain 24.600 86.787
Other expenses:
Interest 27.000 $
Loss 9.000 (36.000)
Income before taxes 190.887 $
Income taxes 62.500
Net income 128.387 $
Proper Heading
Gross Margin
Operating Expenses
Non-operating Items
Remember
to compute
EPS.
Income Statement (Multiple-
Step)
14-31
Babson Builders, Inc.
Income Statement
For the Year Ended 12/31/11
Revenues and gains:
Sales, net 785,250 $
Interest income 62,187
Gain on sale of plant assets 24,600
Total revenues and gains 872,037 $
Expenses and losses:
Cost of goods sold 351,800 $
Selling Expenses 197,350
General and Admin. Exp. 78,500
Depreciation 17,500
Interest 27,000
Income taxes 62,500
Loss: sale of investment 9,000
Total expenses & losses 743,650
Operating income 128,387 $
Proper Heading
Expenses
& Losses
Revenues
& Gains
Income Statement (Single-
Step)
Remember
to compute
EPS.
14--32
Profitability ratios
Gross profit rate
Operating income rate
Net income rate

14-33
Use this information to calculate the
profitability ratios for Babson Builders,
Inc.
Babson Builders, Inc.
2011
Ending market price per share 15.25 $
Number of common shares
outstanding all of 2007 27,400
Net income 53,690 $
Total shareholders' equity
Beginning of year 180,000
End of year 234,390
Revenues 494,000
Cost of sales 140,000
Total assets
Beginning of year 300,000
End of year 346,390
14-34
Earning Per Share


Net Income
Average Shares of Capital Stock Outstanding
= EPS
Look back at the information from Babson and get the
values we need to calculate earning per share.
$53,690
27,400
= $1.96
14-35
Price-Earnings Ratio


Current Market Price of one Share of Stock
Earnings Per Share
= P/E
$15.25
$1.96
= 7.78
The measure shows us the relationship between earning
of the company and the market price of its stock.
14--36
Reflection questions
1. What is the value for shareholders?
2. When do we say that the value is
created/destroyed?
- Managers versus owners
- Short versus long term
- Concept of value

3. Which resources create value?


14-37
This ratio is a good measure of
the efficiency of utilization of
assets by the business.
Return On Investment (ROI)
Annual return (profit) from and investment
Average amount invested
ROI =
14-38
ROA =
Operating
Income
Average total assets
=
53,690 $

($300,000 + $346,390) 2
=
16.61%
This ratio is generally considered
the best overall measure of a
companys profitability.
Return On Assets (ROA)
ROA =
Operating
Income
Average total assets
=
53,690 $

($300,000 + $346,390) 2
=
16.61%
14-39
ROE = Net income Average total equity
=
53.690 $

($180,000 + $234,390) 2
=
25,91%
This measure indicates how well the
company employed the owners
investments to earn income.
Return On Equity (ROE)
14--40
Reflection question
How the difference between ROA and
ROE can be explained?
Calculate other ratios if needed to
support your answer.
14-41
Dividend Yield
This ratio identifies the return, in
terms of cash dividends, on the
current market price of the stock.
Dividend
Yield Ratio
Dividends Per Share
Market Price Per Share
=
Babson Builders pays an annual dividend of
$1.50 per share of capital stock. The market
price of the companys capital stock was
$15.25 at the end of 2011.
14-42
Dividend
Yield Ratio
$1.50
$15.25
= = 9.84%
Dividend Yield
This ratio identifies the return, in
terms of cash dividends, on the
current market price of the stock.
Dividend
Yield Ratio
Dividends Per Share
Market Price Per Share
=
14-43
Analysis by Long-Term
Creditors
Use this information to calculate ratios to
measure the well-being of the long-term
creditors for Babson Builders.
Babson Builders, Inc.
2011
Earnings before interest
expense and income taxes 84,000 $
Interest expense 7,300
Total assets 346,390
Total stockholders' equity 234,390
Total liabilities 112,000
This is also
referred to as
net operating
income.
14-44
Interest Coverage Ratio
This is the most common
measure of the ability of a firms
operations to provide protection
to the long-term creditor.
Times
Interest
Earned
Operating income before Interest
and Income Taxes
Annual Interest Expense
=
Times
Interest
Earned
$84,000
7,300
= =
11.5 times
14-45
Debt
Ratio
=
Total
Liabilities
Total Assets
=
$112,000

$346,390
=
32.33%
A measure of creditors long-term risk.
The smaller the percentage of assets
that are financed by debt, the smaller
the risk for creditors.
Debt Ratio
Debt
Ratio
=
Total
Liabilities
Total Assets
=
$112,000

$346,390
=
32.33%
14-46
Analysis by Short-Term
Creditors
Use this
information to
calculate ratios
to measure the
well-being of
the short-term
creditors for
Babson
Builders, Inc.
Babson Builders, Inc.
2011
Cash 30,000 $
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 12,000
Total current assets 65,000
Total current liabilities 42,000
Sales on account 500,000
Cost of goods sold 140,000
14-47
Accounts Receivable Turnover
Rate
This ratio measures how many
times a company converts its
receivables into cash each year.
Net Sales
Average Accounts Receivable
Accounts
Receivable
Turnover
=
= 27.03 times
$500,000
($17,000 + $20,000) 2
Accounts
Receivable
Turnover
=
14-48
Inventory Turnover Rate
This ratio measures the
number of times merchandise
inventory is sold and replaced
during the year.
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
= 12.73 times
$140,000
($10,000 + $12,000) 2
Inventory
Turnover
=
14-49
Operating Cycle
Cash
Inventory
Accounts
Receivable
2. Sale of merchandise on account
14-50
DuPont model - example
14-51

ROCE
Operating income
Capital employed
Operating income
Sales
multiplied by
Sales
Capital employed
Income before
interest and taxes
divided by
Sales
Sales divided by
Capital
employed
Sales
minus Operating expenses
Net current assets plus Fixed assets Direct labor
Raw materials
Operating support costs
Depreciation
Inventories
Accounts
receivable
Accounts payable
Net cash
minus
14-52
Ratios help users
understand
financial relationships.
Ratios provide for
quick comparison
of companies.
Uses
Management may enter
into transactions merely
to improve the ratios.
Ratios do not help with
analysis of the company's
progress toward
nonfinancial goals.
Limitations
Uses and Limitations of
Financial Ratios
14-53
Exercises
140. Shown below are various financial measurements for two
companies which are similar in size and sell similar products:

Instructions: You are to enter code letters in the spaces provided in the two
right-hand columns. In the first column, indicate which of the following three
groups probably would be most interested in the specified financial
measurement. Identify one group, using the following code letters: STC =
indicating short-term creditors, LTC = indicating long-term creditors, and S =
indicating stockholders. In the second column, enter an X or a Y to indicate
whether your "most interested group" would prefer the measurement results
reported by Co. X or Co. Y.

14--54
Discussion
144. Improving the current ratio
Carter Corporation financed construction of a
new addition to its facilities with a large long-term
note payable. As a condition of obtaining the
loan, Carter agreed to maintain a current ratio at
year-end of at least 1.7 to 1. If Carter fails to
maintain this ratio, the lender may demand
immediate repayment of the principal amount of
the note and all unpaid accrued interest. As the
end of the year approaches, Carter is concerned
about the magnitude of its current ratio. Suggest
some actions that the company might take to
increase the magnitude of the current ratio.

14--55
Problems
Problem 14.6A (15
e
, p. 678)
14--56
Critical Thinking Cases
Case 14.2 (15
e
, p. 685)
14-57
End of Chapter 14