Fin ST Analysis

Financial Statement Analysis Chapter 18
2002 Prentice Hall, Inc.
Business Publishing
Accounting, 5/E
Horngren/Harrison/Bamber
18 - 1
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.
Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 18 - 2
Objective 1
Perform a horizontal analysis of financial statements.
Business Publishing
Accounting, 5/E
18 - 3
Horizontal Analysis
Sales Expenses Net income
2002 $41,500 40,000 1,500
Increase/(Decrease) 2001 Amount Percent $37,850 $3,650 9.6% 36,900 3,100 8.4% 950 550 57.9%
Business Publishing
Accounting, 5/E
18 - 4
Horizontal Analysis
Sales
2002 $41,500
2001 Difference $37,850 $3,650
$3,650 $37,850 = .0964, or 9.6%
Business Publishing
Accounting, 5/E
18 - 5
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 $

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 18 - 6
Trend Percentages
Year 2000 Revenues $27,611 Cost of sales 15,318 Gross profit $12,293 1998 is the base year. 1999 $24,215 14,709 $ 9,506 1998 $21,718 13,049 $ 8,669
What are the trend percentages?
Business Publishing
Accounting, 5/E
18 - 7
Trend Percentages
Year Revenues Cost of sales Gross profit 2000 127% 117% 142% 1999 111% 113% 110% 1998 100% 100% 100%
These percentages were calculated by dividing each item by the base year.
Objective 2
Perform a vertical analysis of financial statements.
Business Publishing
Accounting, 5/E
18 - 9
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.
Business Publishing
Accounting, 5/E
Horngren/Harrison/Bamber 18 - 10
Vertical Analysis
1999 $38,303 19,688 $18,615 13,209 $ 5,406 2,187 $ 7,593 2,827 $ 4,766
Accounting, 5/E
Revenues Cost of sales Gross profit Total operating expenses Operating income Other income Income before taxes Income taxes Net income
2002 Prentice Hall, Inc. Business Publishing
% 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
1999 $ 1,816 10,438 6,151 3,526 $21,931 6,847 9,997 $38,775

Accounting, 5/E
% 4.7 26.9 15.9 9.1 56.6 17.7 25.7 100.0
Objective 3
Prepare common-size financial statements.
Business Publishing
Accounting, 5/E
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% 10.8% 8.0% 43.0% 51.4% 28.8% 38.2%
MCI
Cost of goods sold Income tax

Operating expenses Net income

Accounting, 5/E Horngren/Harrison/Bamber 18 - 15
Objective 4
Compute the standard financial ratios.
Business Publishing
Accounting, 5/E
Ratio Classification
1 2
Measuring ability to pay current liabilities Measuring ability to sell inventory and collect receivables Measuring ability to pay short-term and long-term debt Measuring profitability Analyzing stock as an investment
Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 18 - 17
Palisades Furniture Example

Net sales (Year 2002) Cost of goods sold Gross profit Total operating expenses Operating income Interest revenue Interest expense Income before taxes Income taxes Net income
2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E
$858,000 513,000 $345,000 244,000 $101,000 4,000 (24,000) $ 81,000 33,000 $ 48,000

Assets 20x2 20x1 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

Liabilities Current liabilities: Notes payable Accounts payable Accrued liabilities Total current liabilities Long-term debt Total liabilities 20x2
$ 42,000 73,000 27,000 $142,000 289,000 $431,000
20x1
$ 27,000 68,000 31,000 $126,000 198,000 $324,000
Business Publishing
Accounting, 5/E

Stockholders Equity Common stock, no par Retained earnings Total stockholders equity Total liabilities and stockholders equity 20x2 $186,000 170,000 $356,000
$787,000
20x1 $186,000 134,000 $320,000

$644,000
Business Publishing
Accounting, 5/E
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
Business Publishing
Accounting, 5/E

Palisades current ratio: 20x1: $236,000 $126,000 = 1.87 20x2: $262,000 $142,000 = 1.85 The industry average is 1.80. The current ratio decreased slightly during 20x2.
Business Publishing
Accounting, 5/E

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

Palisades acid-test ratio: 20x1: ($32,000 + $85,000) $126,000 = .93 20x2: ($29,000 + $114,000) $142,000 = 1.01 The industry average is .60. The companys acid-test ratio improved considerably during 20x2.
Business Publishing
Accounting, 5/E
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
Business Publishing
Accounting, 5/E
Measuring Ability to Sell Inventory

Palisades inventory turnover: 20x2: $513,000 $112,000 = 4.58 The industry average is 2.70. A high number indicates an ability to quickly sell inventory.
Business Publishing
Accounting, 5/E
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
Business Publishing
Accounting, 5/E

Palisades accounts receivable turnover: 20x2: $858,000 $99,500 = 8.62 times The industry average is 22.2 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.

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

Palisades days sales in Accounts Receivable for 20x2: One days sales: $858,000 365 = $2,351 Days sales in Accounts Receivable: $99,500 $2,351 = 42 days The industry average is 16 days.
Measuring Ability to Pay Debt

The debt ratio indicates the proportion of assets financed with debt. Total liabilities Total assets
Business Publishing
Accounting, 5/E

Palisades debt ratio: 20x1: $324,000 $644,000 = 0.50 20x2: $431,000 $787,000 = 0.55 The industry average is 0.61. Palisades Furniture expanded operations during 20x2 by financing through borrowing.

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

Palisades times-interest-earned ratio: 20x1: $ 57,000 $14,000 = 4.07 20x2: $101,000 $24,000 = 4.21 The industry average is 2.00. The companys times-interest-earned ratio increased in 20x2. 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
Business Publishing
Accounting, 5/E
Palisades rate of return on sales: 20x1: $26,000 $803,000 = 0.032 20x2: $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.
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
Business Publishing
Accounting, 5/E
Palisades rate of return on total assets for 20x2: ($48,000 + $24,000) $715,500 = 0.101 The industry average is 0.049. How does Palisades compare to the industry? Very favorably.
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
Palisades rate of return on common stockholders equity for 20x2: ($48,000 $0) $338,000 = 0.142 The industry average is 0.093. Why is this ratio larger than the return on total assets (.101)? Because Palisades uses leverage.
Earnings per share of common stock = (Net income Preferred dividends) Number of shares of common stock outstanding
Business Publishing
Accounting, 5/E
Palisades earnings per share: 20x1: ($26,000 $0) 10,000 = $2.60 20x2: ($48,000 $0) 10,000 = $4.80 This large increase in EPS is considered very unusual.
Business Publishing
Accounting, 5/E
Analyzing Stock as an Investment

Price/earning ratio is the ratio of market price per share to earnings per share. 20x1: $35 $2.60 = 13.5 20x2: $50 $4.80 = 10.4 Given Palisades Furnitures 20x2 P/E ratio of 10.4, we would say that the companys stock is selling at 10.4 times earnings.

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

Dividend yield on Palisades common stock: 20x1: $1.00 $35.00 = .029 (2.9%) 20x2: $1.20 $50.00 = .024 (2.4%) An investor who buys Palisades Furniture common stock for $50 can expect to receive 2.4% of the investment annually in the form of cash dividends.
Book value per share of common stock = (Total stockholders equity Preferred equity) Number of shares of common stock outstanding
Business Publishing
Accounting, 5/E

Book value per share of palisades common stock: 20x1: ($320,000 $0) 10,000 = $32.00 20x2: ($356,000 $0) 10,000 = $35.60 Book value bears no relationship to market value.
Business Publishing
Accounting, 5/E
Objective 5
Use ratios in decision making.
Business Publishing
Accounting, 5/E
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.
Business Publishing
Accounting, 5/E
Objective 6
Measure economic value added.
Business Publishing
Accounting, 5/E
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
Business Publishing
Accounting, 5/E
End of Chapter 18
Business Publishing
Accounting, 5/E

Fin ST Analysis

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Financial Statement Analysis Chapter 18

2002 Prentice Hall, Inc.

The Annual Report Usually Contains ...

2002 Prentice Hall, Inc.

Perform a horizontal analysis of financial statements.

2002 Prentice Hall, Inc.

Sales Expenses Net income

2002 $41,500 40,000 1,500

2002 Prentice Hall, Inc.

2001 Difference $37,850 $3,650

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

2002 Prentice Hall, Inc.

Trend % = Any year $ Base year $

What are the trend percentages?

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc.

% 100.0 51.4 48.6 34.5 14.1 5.7 19.8 7.4 12.4

1999 $ 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

Prepare common-size financial statements.

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 18 - 14

Cost of goods sold Income tax

Operating expenses Net income

Compute the standard financial ratios.

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc.

Palisades Furniture Example

Palisades Furniture Example

Palisades Furniture Example

2002 Prentice Hall, Inc.

Palisades Furniture Example

20x1 $186,000 134,000 $320,000

2002 Prentice Hall, Inc.

Measuring Ability to Pay Current Liabilities

2002 Prentice Hall, Inc.

Measuring Ability to Pay Current Liabilities

2002 Prentice Hall, Inc.

Measuring Ability to Pay Current Liabilities

Measuring Ability to Pay Current Liabilities

2002 Prentice Hall, Inc.

Measuring Ability to Sell Inventory

2002 Prentice Hall, Inc.

Measuring Ability to Sell Inventory

2002 Prentice Hall, Inc.

Measuring Ability to Collect Receivables

2002 Prentice Hall, Inc.

Measuring Ability to Collect Receivables

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 18 - 29

Measuring Ability to Collect Receivables

Measuring Ability to Collect Receivables

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 18 - 31

Measuring Ability to Pay Debt

2002 Prentice Hall, Inc.

Measuring Ability to Pay Debt

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 18 - 33

Measuring Ability to Pay Debt

Measuring Ability to Pay Debt

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 18 - 35

2002 Prentice Hall, Inc.

2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 18 - 37