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Analyzing Financial Statements. Individuals Some Users of Financial Statements Businesses Investors and creditors Government regulatory agencies Taxing.

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Presentation on theme: "Analyzing Financial Statements. Individuals Some Users of Financial Statements Businesses Investors and creditors Government regulatory agencies Taxing."— Presentation transcript:

1 Analyzing Financial Statements

2 Individuals Some Users of Financial Statements Businesses Investors and creditors Government regulatory agencies Taxing authorities Nonprofit organizations

3 Economy-wide Factors Industry Factors Individual Company Factors Lend? Sell on credit? Invest? Invest?Invest? NoYes Understanding The Business

4 Analyzing Financial Statements  Dollar and percentage changes on statements (Horizontal Analysis)/ Trend Analysis  Common-size statements (Vertical Analysis)  Ratios Analytical techniques used to examine relationships among financial statement items

5 Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

6 Horizontal Analysis ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500)

7 Horizontal Analysis

8

9 Trend Analysis

10 Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.

11 Trend Analysis Trend Percentage Current Year Amount Base Year Amount 100% = ×

12 Trend Analysis By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin. Berry Products Income Information For the Years Ended December 31

13 Vertical Analysis Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.

14 Common-Size Statements Sales Sales is usually the base and is expressed as 100%.

15 Common-Size Statements

16 In balance sheets, all items usually are expressed as a percentage of total assets (or total liabilities+equity).

17 Ratio Analysis

18 Interpreting Ratios Ratios may be interpreted by comparison with ratios of earlier periods, other companies, or with industry average ratios. Ratios may vary because of the company’s industry characteristics, nature of operations, size, and accounting policies. Ratios may be interpreted by comparison with ratios of earlier periods, other companies, or with industry average ratios. Ratios may vary because of the company’s industry characteristics, nature of operations, size, and accounting policies.

19 Limitations of Financial Statement Analysis We use the LIFO method to value inventory. We use the average cost method to value inventory. Differences in accounting methods between companies sometimes make comparisons difficult.

20 Limitations of Ratio Analysis Analysts should look beyond the ratios. Economic factors Industry trends Changes within the company Technological changes Consumer tastes

21 Profitability Ratios (The Common Stockholder)

22 Gross Margin Percentage Gross Margin Percentage Gross Margin Sales = This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.

23 Earnings per (Common) Share (EPS) EPS $5,761 (1, ) ÷ 2 == $2.81 Earnings per share is probably the single most widely watched financial ratio. Average number of shares based on the number of shares at the beginning and end of the year. Net Income* Average Number of Shares Outstanding for the Period EPS = *If there are preferred dividends, the amount is subtracted from net income.

24 Price/Earnings (P/E) Ratio P/E Ratio = Current Market Price Per Share Earnings Per Share P/E Ratio = $45 $2.35 = 19X This ratio measures the relationship between the current market price of the stock and its earnings per share. A recent price for Home Depot stock was $45 per share. Market tests relate the current market price of a share of stock to an indicator of the return that might accrue to the investor.

25 Dividend Payout Ratio Dividend Payout Ratio Dividends Per Share Earnings Per Share = Dividend Payout Ratio $2.00 $2.42 == 82.6% This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking dividends (market price growth) would like this ratio to be large (small).

26 Dividend Yield Ratio Dividend Yield Dividends Per Share Market Price Per Share = Dividend Yield $0.675 $34 = = 2 % This ratio is often used to compare the dividend- paying performance of different investment alternatives. Home Depot paid dividends of $.675 per share when the market price was $34 per share.

27 Return on Total Assets Return on Assets Net Income + Interest Expense (net of tax) Average Total Assets = Return on Assets $5,761 + ($392 × (1 -.34)) ($52,263 + $44,405) ÷ 2 = = 12.5% This ratio is generally considered a measure of a company’s profitability. Corporate tax rate is 34%.

28 Return on Common Stockholders’ Equity Return on Common Stockholders’ Equity Net Income – Preferred Dividends Average Stockholders’ Equity = Return on Common Stockholders’ Equity $53,690 – $0 ($180,000 + $234,390) ÷ 2 == 25.91% This measure indicates how well the company used the owners’ investments to earn income.

29 Book Value Per Share Book Value per Share Common Stockholders’ Equity Number of Common Shares Outstanding = This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts after all creditors were paid off. = $8.55 Book Value per Share $234,390 27,400 =

30 Financial Leverage Financial leverage Financial leverage involves acquiring assets with borrowed funds. Return on investment in assets > Interest rate on borrowed funds Positive financial leverage = Return on investment in assets < Interest rate on borrowed funds Negative financial leverage =

31 Financial Leverage Percentage Financial Leverage Return on Equity – Return on Assets= 9.7% = 22.2% – 12.5% Financial leverage is the advantage or disadvantage that occurs as the result of earning a return on equity that is different from the return on assets.

32 Liquidity Ratios (The Short-Term Creditor)

33 Working Capital Working capital is not free. It must be financed with long-term debt and equity. The excess of current assets over current liabilities is known as working capital.

34 Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $18,000 $12,931 = =1.39 to 1 This ratio measures the ability of the company to pay current debts as they become due. This ratio measures the ability of the company to pay current debts as they become due.

35 Quick Ratio (Acid Test) Quick Assets Current Liabilities = Quick Ratio $3,837 $9,554 =0.40 to 1= Quick Ratio This ratio is like the current ratio but measures the company’s immediate ability to pay debts. This ratio is like the current ratio but measures the company’s immediate ability to pay debts.

36 Receivable Turnover Net Credit Sales Average Net Receivables Receivable Turnover = $90,837 ($3,223 + $2,396) ÷ 2 = 32.3 Times = This ratio measures how quickly a company collects its accounts receivable.

37 Average Collection Period Days in Year Receivable Turnover Average Collection Period = = 11.3 Days Average Collection Period = This ratio measures the average number of days it takes to collect receivables.

38 Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = $61,054 ($12,822 + $11,401) ÷ 2 = 5.0 Times = This ratio measures how quickly the company sells its inventory.

39 Average Sale Period Days in Year Inventory Turnover Average Sale Period == 73 Days = Average Sale Period This ratio measures the average number of days it takes to sell the inventory.

40 Solvency Ratios (The Long-Term Creditor)

41 This ratio indicates a margin of protection for creditors. Times Interest Earned Net Interest Income Tax Income Expense Expense Interest Expense Times Interest Earned = ++ $5,761 + $392 + $3,547 $392 Times Interest Earned = = 24.7 Times Tests of solvency measure a company’s ability to meet its long-term obligations.

42 Debt-to-Equity Ratio This ratio measures the amount of liabilities that exists for each $1 invested by the owners. $27,233 $25,030 = 1.09= Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity Debt-to-Equity Ratio =

43 End of Chapter 15


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