1. Copyright © 2012 McGraw-Hill Ryerson Limited 14-1 PowerPoint Author: Robert G. Ducharme, MAcc, CA University of Waterloo, School of Accounting and Finance MANAGERIAL ACCOUNTING Ninth Canadian Edition GARRISON, CHESLEY, CARROLL, WEBB, LIBBY “How Well Am I Doing?” Financial Statement Analysis Chapter 14

2. 14-2 Copyright © 2012 McGraw-Hill Ryerson Limited Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult. We use the FIFO method to value inventory. We use the average cost method to value inventory. LO 1

3. 14-3 Copyright © 2012 McGraw-Hill Ryerson Limited Limitations of Financial Statement Analysis Analysts should look beyond the ratios. Economic factors Industry trends Changes within the company Technological changes Consumer tastes LO 1

4. 14-4 Copyright © 2012 McGraw-Hill Ryerson Limited Statements in Comparative and Common-Size Form  Dollar and percentage changes on statements changes on statements  Common-size statements statements  Ratios An item on a financial statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing comparisons. LO 1

5. 14-5 Copyright © 2012 McGraw-Hill Ryerson Limited Dollar and Percentage Changes on Statements dollarpercentage Horizontal analysis (or trend analysis) shows the changes between years in the financial data in both dollar and percentage form. LO 1

6. 14-6 Copyright © 2012 McGraw-Hill Ryerson Limited Example The following slides illustrate a horizontal analysis of Clover Corporation’s December 31, 2012 and 2011, comparative balance sheets and comparative income statements. Horizontal Analysis LO 1

7. 14-7 Copyright © 2012 McGraw-Hill Ryerson Limited Horizontal Analysis LO 1

8. 14-8 Copyright © 2012 McGraw-Hill Ryerson Limited Horizontal Analysis Dollar Change Current Year Figure Base Year Figure =– The dollar amounts for last year become the “base” year figures. Calculating Change in Dollar Amounts LO 1

9. 14-9 Copyright © 2012 McGraw-Hill Ryerson Limited Percentage Change Dollar Change Base Year Figure 100% = × Horizontal Analysis Calculating Change as a Percentage LO 1

10. 14-10 Copyright © 2012 McGraw-Hill Ryerson Limited Horizontal Analysis ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500) LO 1

11. 14-11 Copyright © 2012 McGraw-Hill Ryerson Limited Horizontal Analysis LO 1

12. 14-12 Copyright © 2012 McGraw-Hill Ryerson Limited Horizontal Analysis We could do this for the liabilities & shareholders’ equity, but now let’s look at the income statement accounts. LO 1

13. 14-13 Copyright © 2012 McGraw-Hill Ryerson Limited Horizontal Analysis LO 1

14. 14-14 Copyright © 2012 McGraw-Hill Ryerson Limited Horizontal Analysis LO 1

15. 14-15 Copyright © 2012 McGraw-Hill Ryerson Limited Horizontal Analysis Sales increased by 8.3%, yet net income decreased by 21.9%. LO 1

16. 14-16 Copyright © 2012 McGraw-Hill Ryerson Limited Horizontal Analysis There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income. LO 1

17. 14-17 Copyright © 2012 McGraw-Hill Ryerson Limited Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent. Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent. LO 1

18. 14-18 Copyright © 2012 McGraw-Hill Ryerson Limited Trend Analysis Trend Percentage Current Year Amount Base Year Amount 100% = × LO 1

19. 14-19 Copyright © 2012 McGraw-Hill Ryerson Limited Trend Analysis Example Look at the income information for Berry Products for the years 2008 through 2012. We will do a trend analysis on these amounts to see what we can learn about the company. LO 1

20. 14-20 Copyright © 2012 McGraw-Hill Ryerson Limited Trend Analysis The base year is 2008, and its amounts will equal 100%. Berry Products Income Information For the Years Ended December 31 LO 1

21. 14-21 Copyright © 2012 McGraw-Hill Ryerson Limited Trend Analysis 2009 Amount ÷ 2008 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108% Berry Products Income Information For the Years Ended December 31 LO 1

22. 14-22 Copyright © 2012 McGraw-Hill Ryerson Limited 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 LO 1

23. 14-23 Copyright © 2012 McGraw-Hill Ryerson Limited Trend Analysis We can use the trend percentages to construct a graph so we can see the trend over time. LO 1

24. 14-24 Copyright © 2012 McGraw-Hill Ryerson Limited Common-Size Statements 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. LO 1

25. 14-25 Copyright © 2012 McGraw-Hill Ryerson Limited Common-Size Statements In income statements, all items usually are expressed as a percentage of sales. LO 1

26. 14-26 Copyright © 2012 McGraw-Hill Ryerson Limited 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. LO 1

27. 14-27 Copyright © 2012 McGraw-Hill Ryerson Limited Common-Size Statements In balance sheets, all items usually are expressed as a percentage of total assets. LO 1

28. 14-28 Copyright © 2012 McGraw-Hill Ryerson Limited Common-Size Statements Common-size financial statements are particularly useful when comparing data from different companies. LO 1

29. 14-29 Copyright © 2012 McGraw-Hill Ryerson Limited Example Let’s take another look at the information from the comparative income statements of Clover Corporation for 2011 and 2012. This time, let’s prepare common-size statements. Common-Size Statements LO 1

30. 14-30 Copyright © 2012 McGraw-Hill Ryerson Limited Common-Size Statements Sales Sales is usually the base and is expressed as 100%. LO 1

31. 14-31 Copyright © 2012 McGraw-Hill Ryerson Limited Common-Size Statements 2011 Cost ÷ 2011 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6% 2012 Cost ÷ 2012 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2% LO 1

32. 14-32 Copyright © 2012 McGraw-Hill Ryerson Limited Common-Size Statements What conclusions can we draw? LO 1

33. 14-33 Copyright © 2012 McGraw-Hill Ryerson Limited Quick Check Which of the following statements describes horizontal analysis? a. A statement that shows items appearing on it in percentage and dollar form. b. A side-by-side comparison of two or more years’ financial statements. c. A comparison of the account balances on the current year’s financial statements. d. None of the above. LO 1

34. 14-34 Copyright © 2012 McGraw-Hill Ryerson Limited Quick Check Which of the following statements describes horizontal analysis? a. A statement that shows items appearing on it in percentage and dollar form. b. A side-by-side comparison of two or more years’ financial statements. c. A comparison of the account balances on the current year’s financial statements. d. None of the above. Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form. LO 1

35. 14-35 Copyright © 2012 McGraw-Hill Ryerson Limited Now, let’s look at Norton Corporation’s 2012 and 2011 financial statements. LO 1

36. 14-36 Copyright © 2012 McGraw-Hill Ryerson Limited LO 2

37. 14-37 Copyright © 2012 McGraw-Hill Ryerson Limited LO 2

38. 14-38 Copyright © 2012 McGraw-Hill Ryerson Limited LO 2

39. 14-39 Copyright © 2012 McGraw-Hill Ryerson Limited Ratio Analysis – The Common Shareholder The ratios that are of the most interest to shareholders include those ratios that focus on net income, dividends, and shareholders’ equities. The ratios that are of the most interest to shareholders include those ratios that focus on net income, dividends, and shareholders’ equities. LO 2

40. 14-40 Copyright © 2012 McGraw-Hill Ryerson Limited Earnings Per Share Earnings per Share Net Income – Preferred Dividends Average Number of Common Shares Outstanding = Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. Earnings form the basis for dividend payments and future increases in the value of shares of stock. LO 2

41. 14-41 Copyright © 2012 McGraw-Hill Ryerson Limited Earnings Per Share Earnings per Share Net Income – Preferred Dividends Average Number of Common Shares Outstanding = Earnings per Share $53,690 – $0 ($17,000 + $27,400)/2 == $2.42 This measure indicates how much income was earned for each common share outstanding. LO 2

42. 14-42 Copyright © 2012 McGraw-Hill Ryerson Limited Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share Earnings Per Share = Price-Earnings Ratio $20.00 $2.42 == 8.26 times A higher price-earnings ratio means that investors are willing to pay a premium for a company’s shares because of optimistic future growth prospects. LO 2

43. 14-43 Copyright © 2012 McGraw-Hill Ryerson Limited 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). LO 2

44. 14-44 Copyright © 2012 McGraw-Hill Ryerson Limited Dividend Yield Ratio Dividend Yield Ratio Dividends Per Share Market Price Per Share = Dividend Yield Ratio $2.00 $20.00 == 10.00% This ratio identifies the return, in terms of cash dividends, on the current market price of the shares. LO 2

45. 14-45 Copyright © 2012 McGraw-Hill Ryerson Limited Return on Total Assets 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. Return on Total Assets $53,690 + [$7,300 × (1 –.30)] ($300,000 + $346,390) ÷ 2 == 18.19% Return on Total Assets Net Income + [Interest Expense × (1 – Tax Rate)] Average Total Assets = LO 2

46. 14-46 Copyright © 2012 McGraw-Hill Ryerson Limited Return on Common Shareholders’ Equity Return on Common Shareholders’ Equity Net Income – Preferred Dividends Average Shareholders’ Equity = Return on Common Shareholders’ 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. LO 2

47. 14-47 Copyright © 2012 McGraw-Hill Ryerson Limited Financial 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. Return on investment in assets > Fixed rate of return on borrowed funds Positive financial leverage = Return on investment in assets < Fixed rate of return on borrowed funds Negative financial leverage = LO 2

48. 14-48 Copyright © 2012 McGraw-Hill Ryerson Limited Quick Check Which of the following statements is true? a. Negative financial leverage is when the fixed return to a company’s creditors and preferred shareholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a company’s creditors and preferred shareholders is greater than the return on total assets. c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year. LO 2

49. 14-49 Copyright © 2012 McGraw-Hill Ryerson Limited Which of the following statements is true? a. Negative financial leverage is when the fixed return to a company’s creditors and preferred shareholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a company’s creditors and preferred shareholders is greater than the return on total assets. c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year. Quick Check LO 2

50. 14-50 Copyright © 2012 McGraw-Hill Ryerson Limited Book Value Per Share Book Value per Share Common Shareholders’ 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 = LO 2

51. 14-51 Copyright © 2012 McGraw-Hill Ryerson Limited Book Value Per Share Notice that the book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost. Book Value per Share Common Shareholders’ Equity Number of Common Shares Outstanding == $ 8.55 Book Value per Share $234,390 27,400 = LO 2

52. 14-52 Copyright © 2012 McGraw-Hill Ryerson Limited Ratio Analysis – The Short–Term Creditor 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 working capital. LO 3

53. 14-53 Copyright © 2012 McGraw-Hill Ryerson Limited 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. LO 3

54. 14-54 Copyright © 2012 McGraw-Hill Ryerson Limited Working Capital LO 3

55. 14-55 Copyright © 2012 McGraw-Hill Ryerson Limited Current Ratio The current ratio measures a company’s short-term debt paying ability. A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories. Current Ratio Current Assets Current Liabilities = LO 3

56. 14-56 Copyright © 2012 McGraw-Hill Ryerson Limited Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $65,000 $42,000 ==1.55 LO 3

57. 14-57 Copyright © 2012 McGraw-Hill Ryerson Limited Acid-Test (Quick) Ratio Quick Assets Current Liabilities = Acid-Test Ratio Quick assets include Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory. $50,000 $42,000 =1.19= Acid-Test Ratio LO 3

58. 14-58 Copyright © 2012 McGraw-Hill Ryerson Limited Accounts Receivable Turnover Sales on Account Average Accounts Receivable Accounts Receivable Turnover = This ratio measures how many times a company converts its receivables into cash each year. = 26.7 times $494,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover = LO 3

59. 14-59 Copyright © 2012 McGraw-Hill Ryerson Limited Average Collection Period = 365 Days Accounts Receivable Turnover This ratio measures, on average, how many days it takes to collect an account receivable. = 13.67 days Average Collection Period = 365 Days 26.7 Times LO 3

60. 14-60 Copyright © 2012 McGraw-Hill Ryerson Limited Inventory Turnover This ratio measures how many times a company’s inventory has been sold and replaced during the year. If a company’s inventory turnover Is less than its industry average, it either has excessive inventory or the wrong types of inventory. Cost of Goods Sold Average Inventory Inventory Turnover = LO 3

61. 14-61 Copyright © 2012 McGraw-Hill Ryerson Limited Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover == 12.73 times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover = LO 3

62. 14-62 Copyright © 2012 McGraw-Hill Ryerson Limited Average Sale Period = 365 Days Inventory Turnover This ratio measures how many days, on average, it takes to sell the inventory. = 28.67 days Average Sale Period = 365 Days 12.73 Times LO 3

63. 14-63 Copyright © 2012 McGraw-Hill Ryerson Limited Ratio Analysis – The Long–Term Creditor Long-term creditors are concerned with a company’s ability to repay its loans over the long-run. This is also referred to as net operating income. LO 4

64. 14-64 Copyright © 2012 McGraw-Hill Ryerson Limited Times Interest Earned Ratio 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. Times Interest Earned Earnings before Interest Expense and Income Taxes Interest Expense = Times Interest Earned $84,000 $7,300 == 11.51 times LO 4

65. 14-65 Copyright © 2012 McGraw-Hill Ryerson Limited Debt-to-Equity Ratio This ratio indicates the relative proportions of debt to equity on a company’s balance sheet. Shareholders 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. Total Liabilities Shareholders’ Equity Debt–to– Equity Ratio = LO 4

66. 14-66 Copyright © 2012 McGraw-Hill Ryerson Limited Debt-to-Equity Ratio $112,000 $234,390 Debt–to– Equity Ratio == 0.48 Total Liabilities Shareholders’ Equity Debt–to– Equity Ratio = LO 4

67. 14-67 Copyright © 2012 McGraw-Hill Ryerson Limited Proforma Earnings proforma earnings Management may present results according to the practice of proforma reporting, presenting “proforma earnings” in an “if then” context. “If we did not have these non-cash charges, then our earnings would have been $xxx.” Because these proforma income/earnings do not include all legitimate costs, expenses, and losses, and because they are not GAAP / IFRS, the users of such results can be misled. LO 4

68. 14-68 Copyright © 2012 McGraw-Hill Ryerson Limited Published Sources That Provide Comparative Ratio Data LO 4

69. 14-69 Copyright © 2012 McGraw-Hill Ryerson Limited End of Chapter 14