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Accounting Principles Second Canadian Edition Prepared by: Carole Bowman, Sheridan College Weygandt · Kieso · Kimmel · Trenholm

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FINANCIAL STATEMENT ANALYSIS CHAPTER 20

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Analysing financial statements involves evaluating three characteristics of a company: 1. its liquidity 2. its profitability 3. its solvency BASICS OF FINANCIAL STATEMENT ANALYSIS

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COMPARATIVE ANALYSIS Three types of comparisons: –Intracompany basis –Intercompany basis –Industry averages

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COMPARATIVE ANALYSIS Three tools: –Horizontal analysis –Vertical analysis –Ratio analysis

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HORIZONTAL ANALYSIS 127%121%119%112%100% ANY COMPANY INC. Assumed Net Sales For the Year Ended December 31 (in millions) 20032002200120001999 $ 6,562.8$ 6,295.4$ 6,190.6$ 5,786.6$ 5,181.4 Change since base period

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VERTICAL ANALYSIS 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 (Partial) 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%

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RATIO ANALYSIS 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 income or operating success of an enterprise for a given period of time. RevenuesExpenses - = Net Income Solvency Ratios Measure the ability of the enterprise to survive over a long period of time. XYZ Co. Since 1892

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LIQUIDITY RATIOS LIQUIDITY RATIOS Current ratio Acid test ratio Cash current debt coverage ratio Receivables turnover ratio Collection period ratio Inventory turnover Days sales in inventory

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CURRENT RATIO CURRENT ASSETS CURRENT RATIO = ——————————— CURRENT LIABILITIES The current ratio (working capital ratio) is a widely used measure for evaluating a company’s liquidity and short-term debt-paying ability. i.e. Measures short-term debt-paying ability

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ACID TEST RATIO The acid test ratio (quick ratio) is a measure of a company’s short-term liquidity. i.e. Measures immediate short-term debt-paying ability Acid test ratio = Cash + temporary investments + net receivables Current liabilities

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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

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ACCOUNTS RECEIVABLE TURNOVER RATIO The ratio used to assess the liquidity of the receivables is the receivables turnover ratio. Net Credit Average Net Receivables Sales Receivables Turnover =

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COLLECTION PERIOD The collection period in days is a variant of the receivables turnover ratio and makes liquidity even more evident. The general rule is that the collection period should not exceed the credit term period. Measures number of days receivables are outstanding Collection period = 365 days Receivables turnover

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USING THE INFORMATION IN THE FINANCIAL STATEMENTS It is a large current asset on the balance sheet It becomes a large expense on the income statement It is vulnerable to theft or misuse Inventory is particularly important because:

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USING THE INFORMATION IN THE FINANCIAL STATEMENTS A balancing act is needed to ensure that a sufficient, but not excessive, quantity of inventory is on hand. Two ratios help evaluate the management of inventory: –Inventory turnover –Days sales in inventory

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INVENTORY TURNOVER INVENTORY TURNOVER Measures liquidity of inventory Inventory turnover = Cost of goods sold Average inventory

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DAYS SALES IN INVENTORY Measures number of days inventory is on hand Days sales in inventory = 365 days Inventory turnover

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PROFITABILITY RATIOS Profit margin Gross profit margin Cash return on sales Asset turnover Return on assets Return on common shareholders’ equity Book value per share Cash flow per share Earnings per share (EPS) Price-earnings (PE) ratio Payout ratio Dividend yield

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PROFIT MARGIN Measures net income generated by each dollar of sales Profit margin = Net income Net sales

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GROSS PROFIT MARGIN Measures margin between selling price and cost of goods sold generated by each dollar of sales Gross profit margin = Gross profit Net sales

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CASH RETURN ON SALES Measures net cash flow generated by each dollar of sales Cash return on sales = Net cash provided by operating activities Net sales

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ASSET TURNOVER The ratio that shows how efficiently a company uses its assets to generate sales is the asset turnover ratio. Asset turnover = Net sales Average total assets

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RETURN ON ASSETS The ratio that measures overall profitability of assets used in the earnings process is the return on assets. Return on assets = Net income Average total assets

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RETURN ON COMMON SHAREHOLDERS’ EQUITY Measures profitability of common shareholders’ investment Return on common shareholders’ equity = Net income Average common shareholders’ equity

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BOOK VALUE PER SHARE Measures the equity (net assets) per common share Book value per share = Common shareholders’ equity Number of common shares

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CASH FLOW PER SHARE Measures the net cash flow per common share Cash flow per share = Net cash provided by all activities Number of common shares

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EARNINGS PER SHARE (EPS) Measures net income earned on each common share Earnings per share = Net income Number of common shares

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PRICE-EARNINGS (PE) RATIO Measures relationship between market price per share and earnings per share Price-earnings ratio = Share price Earnings per share

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PAYOUT RATIO Measures % of earnings distributed in the form of cash dividends Payout ratio = Cash dividends Net income

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DIVIDEND YIELD Measures rate of return earned from dividends Dividend yield = Cash dividends per share Share price

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SOLVENCY RATIOS SOLVENCY RATIOS Debt to total assets Interest coverage Cash interest coverage Cash total debt coverage

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DEBT TO TOTAL ASSETS Measures % of total assets provided by creditors Debt to total assets = Total liabilities Total assets

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INTEREST COVERAGE Measures ability to meet interest payments as they come due Interest coverage = Income before interest expense and income tax expense (EBIT) Interest expense

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CASH INTEREST COVERAGE Measures cash available to meet interest payments as they come due (cash basis) Cash interest coverage = Income before interest expense, income tax expense, and amortization expense (EBITDA) Interest expense

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CASH TOTAL DEBT COVERAGE Measures long-term debt-paying ability (cash basis) Cash total debt coverage ratio = Net cash provided by operating activities Average total liabilities

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Estimates – are they inaccurate or biased? Historical cost – inflation not accounted for in comparison between years Alternative accounting methods – one company may use LIFO another FIFO which reduces comparability; comparisons across countries difficult if use different accounting practices Atypical data – year-end data may not be typical of the financial condition during the year Diversification - limits analysis usefulness; so diversified they cannot be classified by industry LIMITATIONS OF FINANCIAL ANALYSIS

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Would you buy stock in this company? How much would you pay for a share of common stock in this company? QUESTIONS TO ASK Are the companies similar to do a comparative analysis? Which company is performing better? Which company would you buy shares in?

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COPYRIGHT Copyright © 2002 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by CANCOPY (Canadian Reprography Collective) is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his / her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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