2. 1 Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso, Trenholm KIMMEL

3. 2 Chapter 14 Financial Analysis: The Big Picture After studying Chapter 14, you should be able to: 1.Understand the concept of earning power and indicate how irregular items are presented. 2.Discuss the need for comparative analysis and identify the tools of financial statement analysis. 3.Explain and apply horizontal analysis. 4.Explain and apply vertical analysis.

4. 3 After studying Chapter 14, you should be able to: 5.Identify and calculate ratios and describe their purpose and use in analysing a firm's liquidity, solvency, and profitability. 6.Discuss the limitations of financial statement analysis. Chapter 14 Financial Analysis: The Big Picture

5. 4 Earning Power +Likely level of future cash flows generated by earnings +Earning power is net earnings adjusted for irregular items

6. 5 Irregular Items +Three types of irregular items are reported (all net of taxes) +Discontinued operations +Extraordinary items +Change in accounting principle Statement of retained earnings Statement of earnings

7. 6 Discontinued Operations +Disposal of a significant segment of a business +Report separately in statement of earnings +Earnings (loss) from continuing operations, and +Earnings (loss) from discontinued operations

8. 7 Discontinued Operations +Earnings (loss) from discontinued operations consists of +Earnings (loss) from operations and +Gain (loss) on disposal of the segment +Both components are reported net of applicable taxes in a section entitled Discontinued Operations, which follows Earnings from Continuing Operations

9. 8 Extraordinary Items +Events and transactions that are +Infrequent in occurrence +Unusual in nature +Not subject to management determination

10. ANY COMPANY INC. – SAMPLE PRESENTATION Statement of Earnings (Partial) For the Year Ended December 31, 2001 Earnings before income taxes$800,000 Income tax expense 240,000 Earnings from continuing operations 560,000 Discontinued operations Loss from operations of chemical division, net of $60,000 income tax saving$140,000 Loss from disposal of chemical division, net of $30,000 income tax saving 70,000 210,000 Net earnings before extraordinary item 350,000 Extraordinary item Expropriation of investment, net of $21,000 income tax saving 49,000 Net earnings $301,000

11. 10 Change in Accounting Principle +Occurs when the principle used in the current year is different from the one used in the preceding year +Is permitted, when +There has been a change in reporting circumstances, and +Management can show that the new principle is preferable to the old

12. 11 Change in Accounting Principle +Change in accounting principle affects reporting in four ways +Use new principle to report results of operations for current year +Disclose cumulative effect of the change net of applicable taxes as an adjustment to opening retained earnings in the statement of retained earnings +Restate prior period financial statements using new principle for comparability +Disclose effects of change in note to statements

13. 12 ANY COMPANY INC. – SAMPLE PRESENTATION Statement of Retained Earnings (Partial) For the Year Ended December 31, 2001 Balance, January 1, 2001, as previously reported Deduct: Cumulative effect of change in amortization method, net of $7,200 income tax savings Balance, January 1, 2001, as adjusted $500,000 (16,800) $483,200 Reporting Change in Accounting Principle

14. 13 Comparative Analysis +Three types of comparisons: +Intracompany basis +Intercompany basis +Industry averages

15. 14 Comparative Analysis +Three tools: +Horizontal analysis +Vertical analysis +Ratio analysis

16. 15 Horizontal Analysis 127%121%119%112%100% ANY COMPANY INC. Assumed Net Sales (in millions) 20032002200120001999 $ 6,562.8$ 6,295.4$ 6,190.6$ 5,786.6$ 5,181.4 Change since base period

17. Vertical Analysis +Expresses each item in a financial statement as a percent of a base amount (total assets or net sales) ANY COMPANY, INC. Condensed Balance Sheets December 31 (in millions) 2002 2001. AssetsAmountPercent AmountPercent Current assets$1,496.5 29.6$1,467.7 30.1 Capital assets 2,888.8 57.2 2,733.3 56.9 Other assets 666.2 13.2 636.6 13.0 Total assets$5,051.5100.0%$4,837.6 100.0%

18. 17 Liquidity Ratios Measure short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash Profitability Ratios Measure the earnings or operating success of an enterprise for a given period of time Solvency Ratios Measure the ability of the enterprise to survive over a long period of time RevenuesExpenses - = Net Earnings XYZ Co. Since 1892 Ratio Analysis

19. 18 Liquidity Ratios +Working capital +Current ratio +Acid-test (quick) ratio +Cash current debt coverage ratio +Credit risk ratio +Receivables turnover +Average collection period +Inventory turnover +Days in inventory

20. 19 Working Capital +Measures short-term debt-paying ability Working capital = Current assets – current liabilities (Discussed in Chapter 2)

21. 20 Current Ratio +Measures short-term debt-paying ability Current ratio = Current assets Current liabilities (Discussed in Chapter 2)

22. 21 Acid-Test Ratio +Measures immediate short-term debt-paying ability Acid test ratio = Cash + short-term investments + net receivables Current liabilities (Discussed in Chapter 10)

23. 22 Cash Current Debt Coverage Ratio +Measures short-term debt-paying ability (cash basis) Cash current debt coverage ratio = Cash provided by operating activities Average current liabilities (Discussed in Chapters 2, 13)

24. 23 Credit Risk Ratio +Measures overall credit risk Credit risk ratio = Allowance for doubtful accounts Accounts receivable (Discussed in Chapter 8)

25. 24 Receivables Turnover +Measures liquidity of receivables Receivables turnover = Net credit sales Average net receivables (Discussed in Chapter 8)

26. 25 Average Collection Period +Measures number of days receivables are outstanding Average collection period = 365 days Receivables turnover (Discussed in Chapter 8)

27. 26 Inventory Turnover +Measures liquidity of inventory Inventory turnover = Cost of goods sold Average inventory (Discussed in Chapter 6)

28. 27 Days in Inventory +Measures number of days inventory is on hand Days in inventory = 365 days Inventory turnover (Discussed in Chapter 6)

29. 28 Solvency Ratios +Debt to total assets +Times interest earned ratio +Cash interest coverage ratio +Cash total debt coverage ratio +Free cash flow +Capital expenditure ratio

30. 29 Debt to Total Assets Ratio +Measures % of total assets provided by creditors Debt to total assets = Total liabilities Total assets (Discussed in Chapters 2, 10)

31. 30 Times Interest Earned +Measures ability to meet interest payments as they come due Times interest earned = Earnings before interest expense and income tax expense (EBIT) Interest expense (Discussed in Chapter 10)

32. 31 Cash Interest Coverage Ratio +Measures cash available to meet interest payments as they come due (cash basis) Cash interest coverage ratio = Earnings before interest expense, income tax expense, and amortization expense (EBITDA) Interest expense (Discussed in Chapter 10)

33. 32 Cash Total Debt Coverage Ratio +Measures long-term debt-paying ability (cash basis) Cash total debt coverage ratio = Cash provided by operating activities Average total liabilities (Discussed in Chapters 2, 13)

34. 33 Free Cash Flow +Measures cash available for paying dividends or expanding operations Cash provided by operating activities - Capital expenditures - Dividends paid = Free cash flow (Discussed in Chapters 7, 13)

35. 34 Capital Expenditure Ratio +Measures ability to generate sufficient cash to finance new capital assets Capital expenditure ratio = Cash provided by operating activities Capital expenditures (Discussed in Chapter 13)

36. 35 Profitability Ratios +Average useful life of capital assets +Average age of capital assets +Return on common shareholders’ equity +Return on assets +Profit margin +Asset turnover +Gross profit rate +Operating expenses to sales ratio +Cash to daily cash expenses ratio +Cash return on sales ratio +Earnings per share (EPS) +Book value per share +Cash flow per share +Price-earnings (P-E) ratio +Payout ratio +Dividend yield

37. 36 Average Useful Life +Estimates average useful life of capital assets Average useful life = Average cost of capital assets Amortization expense (Discussed in Chapter 9)

38. 37 Average Age +Approximates average age of capital assets (assumes straight-line amortization) Average age = Accumulated amortization Amortization expense (Discussed in Chapter 9)

39. 38 Return on Common Shareholders’ Equity Ratio +Measures profitability of common shareholders’ investment Return on common shareholders’ equity = Net earnings – preferred dividends Average common shareholders’ equity (Discussed in Chapter 11)

40. Return on Common Shareholders’ Equity Relationships Illustration 14-24

41. 40 Return On Assets Ratio +Measures overall profitability of assets Return on assets = Net earnings Average total assets (Discussed in Chapter 2)

42. 41 Profit Margin Ratio +Measures net earnings generated by each dollar of sales (Discussed in Chapter 2) Profit margin ratio = Net earnings Net sales

43. 42 Asset Turnover Ratio +Measures how efficiently assets are used to generate sales (Discussed in Chapter 9) Asset turnover = Net sales Average total assets

44. 43 Gross Profit Rate +Measures margin between selling price and cost of goods sold (Discussed in Chapter 5) Gross profit rate = Gross profit Net sales

45. 44 Operating Expenses to Sales Ratio +Measures the cost incurred to support each dollar of sales (Discussed in Chapter 5) Operating expenses to sales ratio = Operating expenses Net sales

46. 45 Cash to Daily Expenses Ratio +Measures the number of days of cash expenses that cash on hand can cover Cash to daily cash expenses ratio = Cash and cash equivalents Average daily cash expenses* * Subtract amortization from total expenses. Divide by 365 days (Discussed in Chapter 7)

47. 46 Cash Return on Sales Ratio +Measures net cash flow generated by each dollar of sales (Discussed in Chapter 13) Cash return on sales = Cash provided by operating activities Net sales

48. 47 Earnings Per Share (EPS) +Measures net earnings earned on each common share (Discussed in Chapter 11) Earnings per share = Earnings available to common shareholders Average number of common shares outstanding

49. 48 Book Value Per Share +Measures the equity (net assets) per common share Book value per share = Common shareholders’ equity Number of common shares outstanding (Discussed in Chapter 14)

50. 49 Cash Flow Per Share +Measures the net cash flow per common share Cash flow per share = Net cash flow from all activities Average number of common shares outstanding (Discussed in Chapter 14)

51. 50 Price-Earnings (P-E) Ratio +Measures relationship between market price per share and earnings per share (Discussed in Chapter 11) Price-earnings ratio = Share price Earnings per share

52. 51 Payout Ratio +Measures % of earnings distributed in the form of cash dividends (Discussed in Chapter 11) Payout ratio = Cash dividends Net earnings

53. 52 Dividend Yield +Measures rate of return earned from dividends (Discussed in Chapter 11) Dividend yield = Cash dividends per common share Year end share price

54. 53 +Estimates +Historical cost +Alternative accounting methods +Atypical data +Diversification Limitations of Financial Analysis

55. 54 Decision Checkpoints +Has the company sold any major lines of business? +Has the company experienced any extraordinary events or transactions? +Has the company changed any of its accounting principles? +How do the company’s financial position and operating results compare with those of the previous period?

56. 55 Decision Checkpoints (continued) +How do the relationships between items in this year’s financial statements compare with those of last year or those of competitors? +Are efforts to evaluate the company significantly hampered by any of the common limitations of financial analysis?

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