Financial Statement Analysis

Chapter 18

The Annual Report Usually Contains ...

financial statements. notes to the financial statements. a summary of accounting methods used. management discussion and analysis of the financial statements. an auditors report. comparative financial data for 5 to 10 years.

Objective 1
Perform a Horizontal Analysis of Financial Statements.

Horizontal Analysis
Increase/(Decrease) 2004 Amount Percent $37,850 $3,650 9.6% 36,900 3,100 8.4% 950 550 57.9%

Sales Expenses Net income

2005 $41,500 40,000 1,500

Horizontal Analysis
2005 $41,500 2004 Difference $37,850 $3,650

Sales

$3,650 $37,850 = .0964, or 9.6%

Trend Percentages...
are computed by selecting a base year whose amounts are set equal to 100%. The amounts of each following year are expressed as a percentage of the base amount.
Trend % = Any year $ Base year $

Trend Percentages
Year 2005 Revenues $27,611 Cost of sales 15,318 Gross profit $12,293 2003 is the base year. 2004 $24,215 14,709 $ 9,506 2003 $21,718 13,049 $ 8,669

What are the trend percentages?

Trend Percentages
Year Revenues Cost of sales Gross profit 2005 127% 117% 142% 2004 111% 113% 110% 2003 100% 100% 100%

These percentages were calculated by dividing each item by the base year.

Objective 2
Perform a Vertical Analysis of Financial Statements.

Vertical Analysis...
compares each item in a financial statement to a base number set to 100%. Every item on the financial statement is then reported as a percentage of that base.

Vertical Analysis
Revenues Cost of sales Gross profit Total operating expenses Operating income Other income Income before taxes Income taxes Net income 2005 $38,303 19,688 $18,615 13,209 $ 5,406 2,187 $ 7,593 2,827 $ 4,766 % 100.0 51.4 48.6 34.5 14.1 5.7 19.8 7.4 12.4

Vertical Analysis
Assets Current assets: Cash Receivables net Inventories Prepaid expenses Total current assets Plant and equipment, net Other assets Total assets 2005 $ 1,816 10,438 6,151 3,526 $21,931 6,847 9,997 $38,775 % 4.7 26.9 15.9 9.1 56.6 17.7 25.7 100.0

Objective 3 Understand Benchmarking

Common-size Statements
On the income statement, each item is expressed as a percentage of net sales. On the balance sheet, the common size is the total on each side of the accounting equation. Common-size statements are used to compare one company to other companies, and to the industry average.

Benchmarking
Percent of Net Sales Lucent Technologies 12.4%
7.4% 8.0% 43.0% 51.4% 28.8% 38.2%

MCI

10.8%

Cost of goods sold Income tax

Operating expenses Net income

Objective 4
Using Ratios

Ratio Classification
1 Measuring ability to pay current liabilities 2 Measuring ability to sell inventory and collect receivables 3 Measuring ability to pay short-term and long-term debt 4 Measuring profitability 5 Analyzing stock as an investment

Palisades Furniture Example

Net sales (Year 2005) Cost of goods sold Gross profit Total operating expenses Operating income Interest revenue Interest expense Income before taxes Income taxes Net income $858,000 513,000 $345,000 244,000 $101,000 4,000 (24,000) $ 81,000 33,000 $ 48,000

Palisades Furniture Example

Assets 20x5 20x4 Current assets: Cash $ 29,000 $ 32,000 Receivables net 114,000 85,000 Inventories 113,000 111,000 Prepaid expenses 6,000 8,000 Total current assets $262,000 $236,000 Long-term investments 18,000 9,000 Plant and equipment, net 507,000 399,000 Total assets $787,000 $644,000

Palisades Furniture Example

Liabilities Current liabilities: Notes payable Accounts payable Accrued liabilities Total current liabilities Long-term debt Total liabilities 20x5
$ 42,000 73,000 27,000 $142,000 289,000 $431,000

20x4
$ 27,000 68,000 31,000 $126,000 198,000 $324,000

Palisades Furniture Example

Stockholders Equity Common stock, no par Retained earnings Total stockholders equity Total liabilities and stockholders equity 20x5 $186,000 170,000 $356,000
$787,000

20x4 $186,000 134,000 $320,000

$644,000

Measuring Ability to Pay Current Liabilities

The current ratio measures the companys ability to pay current liabilities with current assets. Current ratio = Total current assets Total current liabilities

Measuring Ability to Pay Current Liabilities

Palisades current ratio: 20x4: $236,000 $126,000 = 1.87 20x5: $262,000 $142,000 = 1.85 The industry average is 1.50. The current ratio decreased slightly during 20x5.

Measuring Ability to Pay Current Liabilities

The acid-test ratio shows the companys ability to pay all current liabilities if they come due immediately.
Acid-test ratio = (Cash + Short-term investments + Net current receivables) Total current liabilities

Measuring Ability to Pay Current Liabilities

Palisades acid-test ratio: 20x4: ($32,000 + $85,000) $126,000 = .93 20x5: ($29,000 + $114,000) $142,000 = 1.01 The industry average is .40. The companys acid-test ratio improved considerably during 20x5.

Measuring Ability to Sell Inventory

Inventory turnover is a measure of the number of times the average level of inventory is sold during a year.

Inventory turnover = Cost of goods sold Average inventory

Measuring Ability to Sell Inventory

Palisades inventory turnover: 20x5: $513,000 $112,000 = 4.58 The industry average is 3.4. A high number indicates an ability to quickly sell inventory.

Measuring Ability to Collect Receivables

Accounts receivable turnover measures a companys ability to collect cash from credit customers. Accounts receivable turnover = Net credit sales Average accounts receivable

Measuring Ability to Collect Receivables

Palisades accounts receivable turnover: 20x5: $858,000 $99,500 = 8.62 times The industry average is 51 times. Palisades receivable turnover is much lower than the industry average. The company is a home-town store that sells to local people who tend to pay their bills over a lengthy period of time.

Measuring Ability to Collect Receivables

Days sales in receivable ratio measures how many days sales remain in Accounts Receivable.
One days sales = Net sales 365 days Days sales in Accounts Receivable = Average net Accounts Receivable One days sales

Measuring Ability to Collect Receivables

Palisades days sales in Accounts Receivable for 20x5: One days sales: $858,000 365 = $2,351 Days sales in Accounts Receivable: $99,500 $2,351 = 42 days The industry average is 7 days.

Measuring Ability to Pay Debt

The debt ratio indicates the proportion of assets financed with debt. Total liabilities Total assets

Measuring Ability to Pay Debt

Palisades debt ratio: 20x4: $324,000 $644,000 = 0.50 20x5: $431,000 $787,000 = 0.55 The industry average is 0.64. Palisades Furniture expanded operations during 20x5 by financing through borrowing.

Measuring Ability to Pay Debt

Times-interest-earned ratio measures the number of times operating income can cover interest expense. Times-interest-earned = Income from operations Interest expense

Measuring Ability to Pay Debt

Palisades times-interest-earned ratio: 20x4: $ 57,000 $14,000 = 4.07 20x5: $101,000 $24,000 = 4.21 The industry average is 2.80. The companys times-interest-earned ratio increased in 20x5. This is a favorable sign.

Measuring Profitability
Rate of return on net sales shows the percentage of each sales dollar earned as net income. Rate of return on net sales = Net income Net sales

Measuring Profitability
Palisades rate of return on sales: 20x4: $26,000 $803,000 = 0.032 20x5: $48,000 $858,000 = 0.056 The industry average is 0.008. The increase is significant in itself and also because it is much better than the industry average.

Measuring Profitability
Rate of return on total assets measures how profitably a company uses its assets. Rate of return on total assets = (Net income + interest expense) Average total assets

Measuring Profitability
Palisades rate of return on total assets for 20x5: ($48,000 + $24,000) $715,500 = 0.101 The industry average is 0.078. How does Palisades compare to the industry? Very favorably.

Measuring Profitability
Common equity includes additional paid-in capital on common stock and retained earnings. Rate of return on common stockholders equity = (Net income preferred dividends) Average common stockholders equity

Measuring Profitability
Palisades rate of return on common stockholders equity for 20x5: ($48,000 $0) $338,000 = 0.142 The industry average is 0.121. Why is this ratio larger than the return on total assets (.101)? Because Palisades uses leverage.

Measuring Profitability

Earnings per share of common stock = (Net income Preferred dividends) Number of shares of common stock outstanding

Measuring Profitability
Palisades earnings per share: 20x4: ($26,000 $0) 10,000 = $2.60 20x5: ($48,000 $0) 10,000 = $4.80 This large increase in EPS is considered very unusual.

Analyzing Stock as an Investment

Price/earning ratio is the ratio of market price per share to earnings per share. 20x4: $35 $2.60 = 13.5 20x5: $60 $4.80 = 12.5 Given Palisades Furnitures 20x5 P/E ratio of 12.5, we would say that the companys stock is selling at 12.5 times earnings.

Analyzing Stock as an Investment

Dividend yield shows the percentage of a stocks market value returned as dividends to stockholders each period.
Dividend per share of common (or preferred) stock Market price per share of common (or preferred) stock

Analyzing Stock as an Investment

Dividend yield on Palisades common stock: 20x4: $1.00 $35.00 = .029 (2.9%) 20x5: $1.20 $60.00 = .020 (2%) An investor who buys Palisades Furniture common stock for $60 can expect to receive 2% of the investment annually in the form of cash dividends.

Analyzing Stock as an Investment

Book value per share of common stock = (Total stockholders equity Preferred equity) Number of shares of common stock outstanding

Analyzing Stock as an Investment

Book value per share of Palisades common stock: 20x4: ($320,000 $0) 10,000 = $32.00 20x5: ($356,000 $0) 10,000 = $35.60 Book value bears no relationship to market value.

Limitations of Financial Analysis

Business decisions are made in a world of uncertainty. No single ratio or one-year figure should be relied upon to provide an assessment of a companys performance.

Objective 5
Other Evaluation Tools

Economic Value Added (EVA)

Economic value added (EVA) combines accounting income and corporate finance to measure whether the companys operations have increased stockholder wealth. EVA = Net income + Interest expense Capital charge

End of Chapter 18