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Chapter

14

FINANCIAL STATEMENT ANALYSIS

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Purpose of Analysis
Financial statement analysis helps users make better decisions.

Internal Users Managers Officers Internal Auditors

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External Users Shareholders Lenders Customers

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Purpose of Analysis
Financial measures are often used to rank corporate performance. Example measures include:
Growth in sales Return to stockholders Profit margins Return on equity

Determined by analyzing the financial statements.

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Financial Statements Are Designed for Analysis

Classified Financial Statements
Comparative Financial Statements
Amounts from several years appear side by side.

Consolidated Financial Statements

Information for the parent and subsidiary are presented.

Items with certain characteristics are grouped together.

Results in standardized, meaningful subtotals.

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Helps identify significant changes and trends.

Presented as if the two companies are a single business unit.

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Tools of Analysis

Dollar & Percentage Changes

Trend Percentages

Component Percentages

Ratios

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Dollar and Percentage Changes

Dollar Change:
Dollar Change

Analysis Period Amount

Base Period Amount

Percentage Change:

Percent Change

Dollar Change

Base Period Amount

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Slide 14-7

Dollar and Percentage Changes

Evaluating Percentage Changes in Sales and Earnings
Sales and earnings should increase at more that 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.

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Slide 14-8

Dollar and Percentage Changes Example

Lets look at the asset section of Clover Corporations comparative balance sheet and income statement for 2003 and 2002. Compute the dollar change and the percentage for cash.

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CLOVER CORPORATION Comparative Balance Sheets December 31, 2003 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to one decimal point.
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2002

Dollar Change

Percent Change*

$ 23,500 40,000 100,000 1,200 $ 164,700 40,000 85,000 $ 125,000 $ 289,700

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Slide 14-10

CLOVER CORPORATION Comparative Balance Sheets December 31, 2003 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 $12,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to one decimal point.
McGraw-Hill/Irwin

2002

Dollar Change

Percent Change*

$ 23,500 $ (11,500) 40,000 100,000 1,200 $23,500 = $(11,500) $ 164,700 40,000 85,000 $ 125,000 $ 289,700

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CLOVER CORPORATION Comparative Balance Sheets December 31, 2003 2002 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 ($11,500 $23,500) 100% = 48.94% Total current assets $ 155,000 $ 164,700 Property and equipment: Land 40,000 40,000 Complete the Buildings and equipment, net 120,000 85,000 analysis for Total property and equipment $ 160,000 $ 125,000 the other Total assets $ 315,000 $ 289,700 assets. * Percent rounded to one decimal point.
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Slide 14-12

CLOVER CORPORATION Comparative Balance Sheets December 31, 2003 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to one decimal point.
McGraw-Hill/Irwin

2002

Dollar Change

Percent Change*

$ 23,500 $ 40,000 100,000 1,200 $ 164,700 40,000 85,000 $ 125,000 $ 289,700 $

(11,500) 20,000 (20,000) 1,800 (9,700) 35,000 35,000 25,300

-48.9% 50.0% -20.0% 150.0% -5.9% 0.0% 41.2% 28.0% 8.7%

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Trend Analysis

Trend analysis is used to reveal patterns in data covering successive periods.

Trend Analysis Period Amount = Percent Base Period Amount

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100%

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Trend Analysis - Example

Berry Products Income Information For the Years Ended December 31,
Item Revenues Cost of sales Gross profit 2003 $ 400,000 285,000 115,000 2002 $ 355,000 250,000 105,000 2001 $ 320,000 225,000 95,000 2000 $ 290,000 198,000 92,000 1999 $ 275,000 190,000 85,000

Item Revenues Cost of sales Gross profit

2003 2002 2001 2000 145% 129% 116% 1999 is the base period so 105% its 150% 132% 118% 104% amounts will equal 100%. 135% 124% 112% 108%

1999 100% 100% 100%

(290,000 275,000) (198,000 190,000) (92,000 McGraw-Hill/Irwin 85,000)

100% = 105% 100% = 104% 100% = 108%

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Component Percentages
Examine the relative size of each item in the financial statements by computing component (or commonsized) percentages.

Component Percent

Analysis Amount Base Amount

100%

Financial Statement Balance Sheet Income Statement

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Base Amount Total Assets Revenues

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CLOVER CORPORATION Comparative Balance Sheets December 31,

13-16

Complete the common-size analysis for the other assets.

2003 2002

Common-size Percents* 2003 2002

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 ($12,000 $315,000) 100% = 3.8% Total current assets $ 155,000 $ 164,700 Property and equipment: ($23,50040,000 $289,700) 100% = 8.1% Land 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. The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin

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CLOVER CORPORATION Comparative Balance Sheets December 31,

13-17

2003 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to first decimal point. McGraw-Hill/Irwin

2002

Common-size Percents* 2003 2002

$ 23,500 40,000 100,000 1,200 $ 164,700 40,000 85,000 $ 125,000 $ 289,700

3.8% 19.0% 25.4% 1.0% 49.2% 12.7% 38.1% 50.8% 100.0%

8.1% 13.8% 34.5% 0.4% 56.9% 13.8% 29.3% 43.1% 100.0%

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CLOVER CORPORATION 13-18 Comparative Balance Sheets December 31, Complete the common-size analysis for the liabilities and equity Common-size accounts. Percents* 2003 2002 2003 2002 Liabilities and Shareholders' Equity Current liabilities: Accounts payable $ 67,000 $ 44,000 21.3% 15.2% Notes payable 3,000 6,000 1.0% 2.1% Total current liabilities $ 70,000 $ 50,000 22.2% 17.3% Long-term liabilities: Bonds payable, 8% 75,000 80,000 23.8% 27.6% Total liabilities $ 145,000 $ 130,000 46.0% 44.9% Shareholders' equity: Preferred stock 20,000 20,000 6.3% 6.9% Common stock 60,000 60,000 19.0% 20.7% Additional paid-in capital 10,000 10,000 3.2% 3.5% Total paid-in capital $ 90,000 $ 90,000 28.6% 31.1% Retained earnings 80,000 69,700 25.4% 24.1% Total shareholders' equity $ 170,000 $ 159,700 54.0% 55.1% Total liabilities and shareholders' equity $ 315,000 $ 289,700 100.0% 100.0% The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin * Percent rounded to first decimal point.

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13-19 CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, Compute the common-size percentages for Common-size revenues and expenses. Percents* 2003 2002 2003 2002 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. The McGraw-Hill Companies, Inc., 2002 McGraw-Hill/Irwin

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Ratios
A ratio is a simple mathematical expression of the relationship between one item and another.

Along with dollar and percentage changes, trend percentages, and component percentages, ratios can be used to compare:

Past performance to present performance.

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Other companies to your company.

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Slide 14-21

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

NORTON CORPORATION 2003 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
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Working Capital
Working capital is the excess of current assets over current liabilities.

Dec. 31, 2003 Current assets Current liabilities Working capital

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$ $

65,000 (42,000) 23,000

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Slide 14-23

Current Ratio
This ratio measures the short-term debtpaying ability of the company. Current Current Assets = Ratio Current Liabilities Current = Ratio
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$65,000 $42,000

= 1.55 : 1
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Slide 14-24

Quick Ratio
Quick Ratio = Quick Assets Current Liabilities

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.
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Slide 14-25

Quick Ratio
Quick Ratio Quick Ratio = Quick Assets Current Liabilities = $50,000 $42,000 = 1.19 : 1

This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash.
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Debt Ratio
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

=
= $ =

Total Liabilities
103,917 30.00%

Total Assets
346,390

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Slide 14-27

Uses and Limitations of Financial Ratios

Uses
Ratios help users understand financial relationships.

Limitations
Management may enter into transactions merely to improve the ratios.

Ratios provide for quick comparison of companies.

Ratios do not help with analysis of the company's progress toward nonfinancial goals.
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Slide 14-28

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.

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Slide 14-29

Income Statement (Multiple-Step) Example

Proper Heading Gross Margin Operating Expenses Nonoperating Items

Central Company Income Statement For the Year Ended 12/31/03

$ $ $ 197,350 78,500 17,500 $ $ 62,187 24,600 27,000 9,000 $ $ 785,250 351,800 433,450

{ {

Remember to compute EPS.

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Sales, net Cost of goods sold Gross margin Operating expenses: Selling expenses General & Admin. Depreciation Income from Operations Other revenues & gains: Interest income Gain Other expenses: Interest Loss Income before taxes Income taxes Net income

293,350 140,100

86,787

(36,000) 190,887 62,500 128,387

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Income Statement (Single-Step) Example

Proper Heading

Central Company Income Statement For the Year Ended 12/31/03

$ 785,250 62,187 24,600 872,037

Revenues & Gains

Revenues and gains: Sales, net Interest income Gain on sale of plant assets Total revenues and gains Expenses and losses: Cost of goods sold Selling Expenses General and Admin. Exp. Depreciation Interest Income taxes Loss: sale of investment Total expenses & losses Operating income

Expenses & Losses Remember to compute EPS.

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351,800 197,350 78,500 17,500 27,000 62,500 9,000 $ 743,650 128,387

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NORTON CORPORATION 2003

Use this information to calculate the profitability ratios for Norton Corporation.
Number of common shares outstanding all of 2003 Net income Shareholders' equity Beginning of year End of year Revenues Cost of sales Total assets Beginning of year End of year

27,400 53,690 180,000 234,390 494,000 140,000 300,000 346,390

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Return On Assets (ROA)

This ratio is generally considered the best overall measure of a companys profitability.

ROA

Operating = income = $ 53,690 = 16.61%

Average total assets

($300,000 + $346,390) 2

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Return On Equity (ROE)

This measure indicates how well the company employed the owners investments to earn income.

ROE

Operating = income = $ 53,690 = 25.91%

Average total stockholders' equity ($180,000 + $234,390) 2

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Sources of Financial Information

Annual and quarterly financial reports.

Reports filed with the SEC by publicly owned companies.

Internet and other free sources.

Detailed analyses by financial analysts.

Can be audited or unaudited.

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End of Chapter 14
No more ratios, please!

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