1. Financial Statement Analysis
Chapter 13
Financial Statement Analysis
Financial Accounting, Alternate 4e by Porter and Norton

2. Financial Statement Analysis
Will I
be paid?
How
good is our
investment?
Creditors
How are we
performing?
Stockholders
Management

3. Limitations of Financial Statement Analysis
Use of different accounting methods
Changes in accounting methods
LIFO
FIFO

4. Limitations of Financial Statement Analysis
Failure to understand trends or use industry ratios
Difficulty of making industry comparisons (i.e., conglomerates)
????

5. Limitations of Financial Statement Analysis
Nonoperating items on income statement
Effects of inflation =

6. Horizontal Analysis Wm. Wrigley Jr. Company (in millions)
Increase (Decrease)
Dollars Percent
$2,746 $2,401 $ %
1, ,
Net Sales
Gross Profit
Net Earnings

7. Tracking items over a series of years
Trend Analysis
Wm. Wrigley Jr. Company
28.7% 30.1% 29.0% 26.8% 28.4%
Return on
Avg. Equity
Tracking items over a series of years

8. Vertical Analysis
Common-size statements recast items as a percentage of a selected item
Allows comparisons of companies of different size
Compares percentages across years to identify trends % % %

9. Common-Size Statements
Dollars Percent
$24, %
18,
$ 6, % 3,
$ 3, %
$ 2, % 1,
$ 1, %
Sales revenue
Cost of goods sold
Gross profit
Selling & admin. exp.
Operating income
Interest expense
Income before tax
Income tax expense
Net income

10. Liquidity Analysis Nearness to cash
Ability to pay debts as they become due
Turnover
Ratios
Working
Capital
Ratios
Cash
Ratios

11. - Working Capital Excess of current assets over current liabilities
Lacks meaningful comparisons for companies of different size -

12. Current Ratio Measure of short-term financial health
Consider composition of current assets
Rule of thumb
2:1

13. Acid-Test (Quick) Ratio
Stricter test of ability to pay debts
Excludes inventories and prepaid assets
Quick Assets
Current Liabilities

14. Cash Flow from Operations to Current Liabilities Ratio
Focuses on cash only
Covers period of time
Net Cash Provided by Operating Activities
Average Current Liabilities

15. Accounts Receivable Turnover Ratio
Net Credit Sales
Average Accounts Receivable
Indicates how quickly a company is collecting (i.e., turning over) its receivables

16. Accounts Receivable Turnover Ratio
Too fast
Credit policies too stringent; may be losing sales
Too slow
Credit department not operating effectively; possible quality problems

17. Number of Days’ Sales in Receivables
Accts. Receivable Turnover
Represents the average # of days
accounts are outstanding
*Some analysts use 365 days.

18. Number of Days’ Sales in Receivables
Example:
360 Days
4.8 Times
= 75 days
If this company’s credit terms are net 30, what would this tell you about the efficiency of the collection process?

19. Inventory Turnover Ratio
Cost of Goods Sold
Average Inventory
Represents the number of times per period inventory is turned over (i.e., sold).

20. Inventory Turnover Ratio
Circuit City times per year
Safeway times per year
Can you compare the two ratios?

21. # of Days’ Sales in Inventory1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27
# of Days’ Sales in Inventory
# of Days in Period
Inventory Turnover Ratio
Represents the average # of days
inventory is on hand before it’s sold

22. # of Days’ Sales in Inventory1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27
# of Days’ Sales in Inventory
Circuit City 62 days
Safeway 39 days
Do these averages seem reasonable?

23. # of days sales in receivables # of days sales in inventory
Cash Operating Cycle
Time between purchase of merchandise and collection from the sale
# of days sales in receivables +
# of days sales in inventory

24. Solvency Analysis Ability to stay in business over the long-term Times
Interest
Earned
Debt-to-Equity
Ratio
Cash Flow
to Capital
Expenditures
Debt
Service
Coverage

25. Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity
How much have creditors contributed compared to owners?
Total Liabilities
Total Stockholders’ Equity

26. Total Stockholders’ Equity
Debt-to-Equity Ratio
Total Liabilities
Total Stockholders’ Equity
= .60
For every dollar contributed by owners, creditors have loaned $.60

27. Times Interest Earned Ratio
Measures ability to meet current interest payments
The greater the coverage the better
Net Income + Interest Expense + Income Tax Expense
Interest Expense

28. Debt Service Coverage Ratio
Measures amount of cash from operations available to service the debt
Cash Flow from Operations before Interest & Taxes
Interest and Principal Payments
P + i

29. Cash Flow from Operations to Capital Expenditures Ratio
Measures company’s ability to use operations (vs. creditors and owners) to finance acquisitions of productive assets
Cash Flow from Operations – Dividends Paid
Cash Paid for Capital Acquisitions

30. Profitability Analysis
Rate of Return on Assets
Return on Common S/E
EPS
P/E Ratio
Dividend Ratios

31. Net Income + Interest Expense, Net of Tax
Return on Assets Ratio
Measures return to all providers of capital (creditors and owners)
Net Income + Interest Expense, Net of Tax
Average Total Assets

32. Return on Common Stockholders’ Equity
Net Income - Preferred Dividends
Average Common Stockholders’ Equity
The owners
earned 15%
on their investment
in ABC Co...
Not bad!

33. Earnings per Share Presents profits on a per-share basis
Net Income - Preferred Dividends
Weighted Avg. # of Common Shares Outstanding
Certificate of Stock

34. Price/Earnings Ratio Current Market Price Earnings per Share
Relates earnings to the market price of the stock
Current Market Price
Earnings per Share
very high P/E
very low P/E
possibly overvalued
possibly undervalued

35. Price/Earnings Ratio
Both companies have earnings of $2 per share. So why the different P/E ratios?
P/E Ratios
Co. A = 10 to 1
Co. B = 7 to 1

36. Common Dividends per Share
Dividend Payout Ratio
Common Dividends per Share
Earnings per Share
We need to
decide what % of the firm’s income we can return to owners.

37. Common Dividends per Share
Dividend Yield Ratio
Investors willing to forgo dividends in lieu of price appreciation
Common Dividends per Share
Market Price per Share
usually
< 5% =

38. Reporting and Analyzing Other Income Statement Items
Appendix
Accounting Tools:
Reporting and Analyzing
Other Income Statement Items

39. Common Characteristics
All such items are reported after income from continuing operations
Reported separately
Shown net of tax effects
Most analysts ignore these items, since they are not likely to reoccur

40. Discontinued Operations
Any gain or loss from disposal of a division or segment of the business
Any net income or loss from operating this portion until the date of disposal

41. Extraordinary Items Gain or loss due to an event that is
Unusual in nature AND
Infrequent in occurrence

42. Cumulative Effect of a Change in Accounting Principle
Reflects a change in a company’s accounting principles, practices, or methods
Reports the difference in income in all prior years between the old method and the new method
Sometimes such a change is dictated by new accounting standards

43. End of Chapter 13