1. Financial Statement Analysis Chapter 13
Adapted by Cynthia Fortin, CPA, CMA
Introduction to Managerial Accounting, Brewer, Garrison,Noreen
Chapter 9: Performance Measurement in Decentralized Organizations
Managers in large organizations have to delegate some decisions to those who are at lower levels in the organization. This chapter explains how responsibility accounting systems, return on investment (ROI), residual income, operating performance measures, and the balanced scorecard are used to help control decentralized organizations.

2. Human vital signs

3. Business vital signs
Liquidity
Solvency
Profitability
Market

4. How do Internal Users use FS Analysis?
Evaluate performance by comparing to
Planned budget
Last year’s actuals
other companies within the same industry

6. How will the company improve performance?

7. How do External Users use FS Analysis?
Evaluate performance by comparing
year to year
other companies within the same industry

8. What decisions will External Users make? Forecast future profits
Creditos can xtend credit
Stockholders can buy more stock
Forecast future profits I

9. Limitations of FS Analysis
Analysts should look beyond the ratios
Changes within the company
Industry trends
Consumer tastes
Technological changes
Ratios should not be viewed as an end, but rather as a starting point. They raise many questions and point to opportunities for further analysis, but they rarely answer questions by themselves.
In addition to ratios, other sources of data should also be considered, such as industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the company itself.
Economic factors

11. How do we get to our vision with our strategy
How do we get to our vision with our strategy? Successful strategies adress these 4 elements.

13. Comparative Form - Horizontal Analysis
Across time
Uses comparative financial statements
Focus on large percentage changes
Horizontal analysis (also known as trend analysis) involves analyzing financial data over time.
Quantifying dollar changes over time serves to highlight the changes that are the most important economically.
Quantifying percentage changes over time serves to highlight the changes that are the most unusual.

14. Partial Income Statement For Years Ended November 30, 2011 and 2010
Ralco Corporation
Partial Income Statement
For Years Ended November 30, 2011 and 2010
2011
2010
Amount of Increase /Decrease
Percent Increase /Decrease
Net Sales
$164,313
$105,027
$59,286
56.4
COGS
35,940
24,310
11,630
47.8
Gross Profit
$128,373
$80,717
$47,656
59.0
© 2010 McGraw-Hill Ryerson Limited.
LO 2

15. Illustration: Amount and Percentage Change
Assume a company’s year-end cash balances were $85,618 and $57,000 for 2011 and 2010 respectively.
Dollar change = $85,618 - $57,000
= $28,618
$85,618 - $57,000
Percent change =
x 100
$57,000
= 50.2%
© 2010 McGraw-Hill Ryerson Limited.
LO 2

16. financial data in terms of
Trend Percentages
state several years’
financial data in terms of
a base year, which
equals 100 percent.
Horizontal analysis can be even more useful when data from a number of years are used to compute trend percentages.

17. © 2010 McGraw-Hill Ryerson Limited.
Trend Analysis
2011
2010
2009
2008
2007
Net Sales
$164,313
$105,027
$67,515
$52,242
$29,230
Cost of goods sold
35,940
24,310
19,459
7,735
6,015
Gross Profit
$128,373
$80,717
$48,056
$44,507
$23,215
2011
2010
2009
2008
2007
Net Sales
562.1%
359.3%
231.0%
178.7%
100.0%
Cost of goods sold
597.5
404.2
323.5
128.6
100.0
Gross Profit
553.0
347.7
207.0
191.7
LO 2
© 2010 McGraw-Hill Ryerson Limited.

18. EXERCISE 13–10 Trend Percentages
13-10
Starkey Company's sales, current assets, and current liabilities (all in thousands of dollars) have been reported as follows over the last five years (Year 5 is the most recent year):
Required:
Express all of the asset, liability, and sales data in trend percentages. (Show percentages for each item.) Use Year 1 as the base year, and carry computations to one decimal place.
Comment on the results of your analysis.

19. Example trend analysis 13-10
Comment

20. Comment

21. Common-Size Statements - Vertical Analysis
Base amount is usually defined as 100%
Income statement % of revenues
Balance sheet % of total assets
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.

22. Common-Size Statements - Vertical Analysis
Size percent
Analysis amount
Base Amount × =
100%
Common-Size Percentages
2011
2010
Net Sales
$164,313
$105,027
100.0
Cost of goods sold
35,940
24,310
21.9
23.1
Gross Profit
$128,373
$80,717
78.1
76.9
© 2010 McGraw-Hill Ryerson Limited.

23. Selling and administrative expenses: Selling expenses 18.0% 17.5%
Exercise p. 606 1.
This Year
Last Year
Sales
100.0%
Cost of goods sold
 63.2%
 60.0%
Gross margin
 36.8%
 40.0%
Selling and administrative expenses:
Selling expenses
18.0%
17.5%
Administrative expenses
 13.6%
 14.6%
Total selling and administrative expenses
 31.6%
 32.1%
Net operating income
5.2%
7.9%
Interest expense
  1.4%
  1.0%
Net income before taxes
  3.8%
  6.9%

24. Comment
The NOI has decreased from 6.9% to 3.8% The company’s major problem seems to be the increase in cost of goods sold, which increased from 60.0% of sales last year to 63.2% of sales this year.
Why? This suggests that the company is not passing the increases in the costs of its products on to its customers.
Or that prices have not increased as fast as costs.
Gross margin has decreased as a result.
Selling expenses and interest expense have both increased slightly during the year, which suggests that costs generally are going up in the company.
The only exception is the administrative expenses, which have decreased from 14.6% of sales last year to 13.6% of sales this year. This probably is a result of the company’s efforts to reduce administrative expenses during the year.

25. Income statement common-size analysis.
Comment
Start with qualifying the change in Net Operating Income.
Find what created the change.
Is the Cost of goods sold change significant?
If yes, how did it effect the Gross Margin?
What could have caused the change?

26. Horizontal Vertical Trend Analysis : in both cases Base: B.S. % Assets
I.S. % Sales
Over time
Base = year of reference
Trend Analysis : in both cases

27. Ratio Analysis User Earnings per share Price-Earnings Dividend Payout
Yield
Return on Total Assets
Return on Common Stockholders' Equity
Book Value per Share
Working Capital
Current
Acid Test
Accounts Receivable Turnover
Average Collection period
Inventory Turnover
Average Sales Period
Times Interest Earned
Debt to Equity
Common stockholder
Short-Term Creditor
Long-Term Creditor
Relevant ratios
Learning objective number 2 is to compute and interpret financial ratios that would be useful to a common stockholder.

28. The Common Stockholder
Hopes to realize a return
Either as a regular dividend and or increase stock value

29. One million non-cumulative,preferred shares issued and outstanding
no new shares were issued during 2010 or Dividends $5 per share.
2. There were 25 million common shares issued and outstanding;
no new shares were issued during
3. There are no dividends in arrears. Dividends totalling $62 million
were declared and paid during 2011.

31. Earnings per share
Net Income – Preferred Dividends Average Number of Common Shares Outstanding =
Earnings per share is computed as shown.
The average number of common shares outstanding is computed by adding the shares outstanding at the beginning of the year to the shares outstanding at the end of the year and dividing by two.
Investors are interested in this ratio because earnings form the basis for dividend payments and future increases in the value of shares of stock.
This measure indicates how much income was earned for each share of common stock outstanding.

32. Compute Delmar’s EPS for 2011.
Question:
Compute Delmar’s EPS for 2011.
$ = ($80M – $5M)/25M
Notes:
Deduct Preferred Dividends from the Net Income because
that is what will be available to common stockholders. $5 * 1 million
Use the average number of common shares outstanding
(This year + Last year ) / 2

33. Price-Earnings Ratio Market Price per Share Earnings per Share=
A higher price-earnings ratio means that investors are willing to pay a premium for a company’s stock because of optimistic future growth prospects.
The price-earnings ratio is computed as shown.
A higher price-earnings ratio means that investors are willing to pay a premium for a company’s stock because of its optimistic future growth prospects.
Norton Corporation’s price-earnings ratio is 8.26 times.

34. ABC Inc.'s common shares have a market value of $60 per share and its EPS is $3.50.
XYZ Inc.'s common shares have a market value of $85 per share and its EPS is $4.10.
You have done thorough research and are considering purchasing the shares of one of these companies.
Required
(a) Calculate the price–earnings ratio for each company (round to two decimal places).
(b) Which company's shares will you purchase based on your calculations in (a) above?

35. Price-earnings ratio (a) Price-earnings ratio ABC Inc. 60/3.5 = 17.14
XYZ Inc. 85/4.10 = 20.73
(b) ABC Inc.’s shares seem to be the better buy (lower price) since its PE is lower than XYZ.

36. Dividend Payout Ratio 2.29 = $8/$3.50
Dividends per Share
Earnings per Share
= $8/$3.50
ABC declared and paid an $8 per share cash dividend and its EPS is $3.50.
The dividend payout ratio is computed as shown.
Investors who seek market price growth would like this ratio to be small, whereas investors who seek dividends prefer it to be large.
Norton Corporation’s dividend payout ratio is 82.6 percent.

37. Dividend Payout
Investors seeking market price growth would like this ratio to be small.
Companies with excellent prospects of profit growth pay little or no dividends.

38. Dividend Payout
Investors seeking dividends would like this ratio to be large.
Companies with little opportunity of profitable growth but with steady earnings tend to payout dividends from their cash flows.

39. Dividend Yield Ratio = Dividends per Share x 100%
Market Price per Share =
The dividend yield ratio is computed as shown.
This ratio measures the rate of return (in the form of cash dividends only) that would be earned by an investor who buys common stock at the current market price.
This ratio measures the rate of return (in the form of cash dividends only) that would be earned by an investor who buys common stock at the current market price.

40. Question
ABC declared and paid an $8 per share cash dividend on its Common shares during the current accounting period. The current market value of the ABC’s shares is $56 per share.
Is ABC classified as growth shares or income (dividend paying) shares in the eyes of the stockholder?
Answer: The ABC Company shares would be classified as income shares because the rate is sufficient to justify as providing income.
14.29% = $8/$56

42. One million non-cumulative,preferred shares issued and outstanding
no new shares were issued during 2010 or Dividends $5 per share.
2. There were 25 million common shares issued and outstanding;
no new shares were issued during
3. There are no dividends in arrears. Dividends totalling $62 million
were declared and paid during 2011.

43. Net Income + (Interest Expense X (1-tax rate))
Return on Total Assets
Net Income + (Interest Expense X (1-tax rate))
Average Total Assets =
The return on total assets is computed as shown.
Adding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity.
Measures how effectively a company is using its assets to generate earnings before contractual obligations must be paid. 

44. Question:
Compute Delmar’s return on total assets for 2011 and compare it to the Industry average of 20%. Interest expense was $4.8 million .
Answer: Delmar’s return on total assets for 2011 is 18.01* which is unfavourable when compared to the industry average of 20%. Delmar earned only cents for each $1.00 invested in average assets during 2011; the greater the return on total assets, the better.
*(80+(4.8*1-(10/90)))/[( )/2] × 100 = 18.01%

45. Return on Common Stockholders’ Equity
Net Income – Preferred Dividends
Average Common Stockholders’ Equity =
The return on common stockholders’ equity is computed as shown.
This measure indicates how well the company used the owners’ investments to earn net income.
This measure indicates how well the company used the owners’ investments to earn net income.

46. Question:
Compute Delmar’s return on Common Stockholders’ Equity for 2011 and compare it to the Industry average of 32.7%.
Answer: Delmar’s return on total common shareholders’ equity for 2011 is 22.06% which is unfavourable when compared to the industry average of 32.7%. Delmar earned cents for each $1.00 of equity invested in the company by common shareholders.; the greater the return on total common shareholders’ equity, the better.
*(80 – 5)/[( )/2] × 100 = 22.06%

47. Return to common stockholders
Financial Leverage
Difference between the rate of return of total average assets in its own assets and the rate of return on common stockholders’ equity.
Return to common stockholders
Return on
Total average
assets
Positive leverage
> =
Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors.
Positive financial leverage exists if the rate of return on the company’s assets exceeds the rate of return the company pays its creditors. In this case, having some debt in a company’s capital structure can benefit its shareholders.
Negative financial leverage exists if the rate of return on the company’s assets is less than the rate of return the company pays its creditors. In this case, the common stockholder suffers by having debt in the capital structure.
Positive leverage can be due to factors such as: company’s current liabilities, which may carry no interest cost, to long term liabilities which carry after tax interest at a rate lower than the return on total assets and/or preferred stock which carry dividends % lower than the return on total assets.

48. Comments on leverage
If a company experiences big variations in net cash flows from operations, stockholders might be pleased that the company has no debt. In hard times, interest payments might be very difficult to meet.
if investments within a company can earn a rate of return that exceeds the interest rate on debt, stockholders would get the benefits of positive leverage if the company took on debt.

49. Book Value Per Share Stockholders’ Equity - Preferred Stock
Number of Common Shares Outstanding =
The book value per share is computed as shown.
It 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. This measure is based entirely on historical cost.
It measures the amount that would be distributed to stockholders if all assets were sold at their balance sheet carrying amounts after all creditors were paid off. This measure is based entirely on historical cost and not market price.
Assets – Liabilities = Equity

50. Question:
Compute Delmar’s Book Value per Share for 2011 and compare it to the Industry average of $8.63
Answer: Delmar’s book value per common share for 2011 is $13.96* which compares favourably against the industry average of $ ( )/25 = The book value per share reflects historical costs and not market price.

51. The Short–Term Creditors
Such as suppliers, want to be paid on time. Therefore, they focus on the company’s cash flows and working capital.
Short-term creditors, such as suppliers, want to be paid on time. Therefore, they focus on the company’s cash flows and on its working capital. The information shown for Norton Corporation will be used to calculate ratios of interest to short-term creditors.

52. Current Assets – Current Liabilities = Working Capital
The excess of current assets over current liabilities is known as working capital.
Working capital is not free. It must be financed with long-term debt and equity. Therefore, managers often seek to minimize working capital.
A large and growing working capital balance may not be a good sign. For example, it could be the result of unwarranted growth in inventories.

53. Ability to pay bills without stress.
Current Ratio
Current
Ratio
Current Assets
Current Liabilities =
Ability to pay bills without stress.
The current ratio is computed as shown.
It measures a company’s short-term debt paying ability.
It must be interpreted with care. For example, a declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories or other stagnant current assets.
A high ratio does not necessarily mean a good financial position; a high level of obsolete inventory could be fattening the current assets total.

54. Current ratio
Healthy business 2:1
Keep an eye on
inventory

55. Norton Corporation’s current ratio of 1.55 is calculated as shown.

56. Working capital = (15,000 + 4,000 + 3,800 + 2,500) – (10,000 + 7,000 + 1,000 + 3,000) = $4,300
b. Current ratio = (15, , , ,500)/(10, , , ,000) = 1.20:1
c. Working capital and the current ratio measure exactly the same thing; the difference between them is in how the result is expressed. Working capital expresses the result as a dollar amount whereas the current ratio expresses the result as a ratio. The current ratio, expressed as $X to $1, can be compared more easily to different sized companies than working capital which is a dollar value.
d. Favourable
Answer:

57. Quick Assets Current Liabilities Acid-Test Ratio=
Acid-Test
Ratio
Excludes inventories and prepaid expenses.
More rigorous than the current ratio.
It is a more rigorous measure of short-term debt paying ability because it only includes cash, marketable securities, accounts receivable, and current notes receivable.
It measures a company’s ability to meet its obligations without having to liquidate its inventory.
It measures a company’s ability to meet its obligations without having to liquidate its inventory.

58. Question:
With reference to the Demo data, calculate the Acid-Test Ratio. At the end of the last accounting period, this company's acid-test ratio was 0.82:1. Has the change in the acid-test ratio been favourable or unfavourable?
Answer:
a. (15, ,000)/ (10, , , ,000) = 0.90:1
b. Favourable

59. Average Accounts Receivable
Sales on Account
Average Accounts Receivable
Accounts Receivable
Turnover =
How many times a company converts its receivables into cash each year.
The accounts receivable turnover is calculated as shown.
It measures how quickly credit sales are converted to cash.
Norton Corporation’s accounts receivable turnover is 26.7.

60. Accounts receivable turnover............. 5.26* 6.37**
Accounts receivable turnover * 6.37**
*754,200/[(152, ,700)/2] = 5.26
**810,600/[(133, ,000)/2] = 6.37
The change in the turnover is unfavourable. Receivables are being collected more slowly in 2011 than Duncan’s turnover for 2011 compares favourably to the industry average since it is collecting receivables at a faster rate than average. The faster the receivables are collected, the more liquid the company since it needs cash to pay its day-to-day obligations.

61. Average Collection Period=
365 Days
Accounts Receivable Turnover
= 69.4 days
Average Collection Period =
365 Days
5.26 Times
A related measure called the average collection period is computed as shown.
It measures how many days, on average, it takes to collect an account receivable.
It should be interpreted relative to the credit terms offered to customers.
Norton Corporation’s average collection period is days.
This ratio measures, on average, how many days it takes to collect an account receivable.

62. Inventory Turnover Cost of Goods Sold Average Inventory Inventory=
This ratio measures how many times a company’s inventory has been sold and replaced during the year.
The inventory turnover is computed as shown.
It measures how many times a company’s inventory has been sold and replaced during the year.
It should increase for companies that adopt just-in-time methods.
It should be interpreted relative to a company’s industry. For example, grocery stores turn their inventory over quickly, whereas jewelry stores tend to turn their inventory over slowly.
If a company’s inventory turnover is less than its industry average, it either has excessive inventory or the wrong types of inventory.

63. Answer:
1,600,000/[(200, ,000)/2] = 7.44
this is favourable relative to the industry average of 4.
This means that Mamoon sells its inventory, on average, at the rate of 7.44 times per year which is 86% better than the industry average. Liquidity is positively affected by a high inventory turnover because the faster inventory is sold, the faster cash can flow back into the business from customers to allow for the payment of day-to-day obligations.
Comment: The caution behind a very high merchandise turnover is that Mamoon wants to ensure customers’ needs are being satisfied by current levels of inventory (or are customers leaving dissatisfied and buying goods elsewhere because Mamoon has run out of inventory?).

64. Average Sale Period Average Sale Period = 365 Days Inventory Turnover
7.44Times
A related measure called the average sale period is computed as shown.
It measures the number of days being taken, on average, to sell the entire inventory one time.
Norton Corporation’s average sale period is days.
This ratio measures how many days, on average, it takes to sell the entire inventory.

65. The long-term creditor
Concerned with a company’s ability to repay its loans over the long-run.
Learning objective number 4 is to compute and interpret financial ratios that would be useful to a long-term creditor.

66. Times Interest Earned Ratio=
Earnings Before Interest Expense
and Income Taxes
Interest Expense
The times interest earned ratio is calculated as shown.
It is the most common measure of a company’s ability to protect its long-term creditors.
It is based on earnings before interest and income taxes because that is the amount of earnings that is available for making interest payments.
A ratio of less than one is inadequate.
Norton Corporation’s times interest earned ratio is times.
This is the most common measure of a company’s ability to provide protection for its long-term creditors. A ratio of less than 1.0 is inadequate.

67. The following information is available for Best Appliance Inc.:
Calculate the times interest earned ratio for 2011 and compare it to the industry average of 50 times. Explain how it compares.
One guideline says that creditors are reasonably safe if the company earns its fixed interest expense two or more times each year.
Answer:
Times interest earned = income before interest and taxes/interest expense = 90/5 = 18. The larger this ratio, the less risky is the company for creditors. Although Best Appliance appears to have a favourable times interest earned ratio relative to this measure, it compares unfavourably to the industry average of 50 times.

68. Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity=
The debt-to-equity ratio is computed as shown.
It indicates the relative proportions of debt and equity on a company’s balance sheet.
Creditors and stockholders have different views when defining the optimal debt-to-equity ratio.
Stockholders like a lot of debt if the company can take advantage of positive financial leverage.
Creditors prefer less debt and more equity because equity represents a buffer of protection.
In practice, debt-to-equity ratios from 0.0 to 3.0 are common.
This ratio indicates the relative proportions of debt to equity on a company’s balance sheet.

69. Stockholders like a lot of debt if the company can take advantage of positive financial leverage.

70. Creditors prefer less debt and more equity because equity represents a buffer of protection.

71. Debt-to-Equity Ratio = Total Liabilities Stockholders’ Equity $112,000
Norton Corporation’s debt-to-equity ratio is 0.48.
$112,000
$234,390
Debt–to–
Equity Ratio =
= 0.48