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**Analysis of Financial Statements**

Chapter 17 Analysis of Financial Statements Chapter 17: Analysis of Financial Statements

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Basics of Analysis C 1 Reduces uncertainty Application of analytical tools Involves transforming data Financial statement analysis helps users make better decisions. Internal Users Managers Officers Internal Auditors External Users Shareholders Lenders Customers Financial statement analysis applies analytical tools to general-purpose financial statements and related data for making business decisions. It provides us an effective and systematic basis for making business decisions. These techniques help us to better understand the company and reduce uncertainty associated with financial information. Financial statement analysis is used by many people within the organization. Managers find financial analysis helpful in planning and controlling operations. External users of financial statements are also interested in the results of comprehensive financial analysis. Shareholders, creditors, and customers all want to learn as much as possible about the financial health of a company. The goals include evaluating (1) past and current performance, (2) current financial position, and (3) future performance and risk.

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**Building Blocks of Analysis**

Liquidity and efficiency Solvency Profitability Market prospects Financial statement analysis focuses on one or more elements of a company’s financial condition or performance. These four areas are considered the building blocks of financial statement analysis: ■ Liquidity and efficiency—ability to meet short-term obligations and to efficiently generate revenues. ■ Solvency—ability to generate future revenues and meet long-term obligations. ■ Profitability—ability to provide financial rewards sufficient to attract and retain financing. ■ Market prospects—ability to generate positive market expectations.

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**Information for Analysis**

C 1 Income Statement (Statement of Comprehensive Income) Balance Sheet (Statement of Financial Position) Statement of Changes in Equity Statement of Cash Flows Notes to the Financial Statements Most users must rely on general purpose financial statements that include the (1) income statement, (2) balance sheet, (3) statement of shareholders’ equity (or statement of retained earnings), (4) statement of cash flows, and (5) notes to these statements. Financial reporting refers to the communication of financial information useful for making investment, credit, and other business decisions. Financial reporting includes not only general-purpose financial statements but also information from SEC 10-K or other filings, press releases, shareholders’ meetings, forecasts, management letters, auditors’ reports, and Webcasts. Management’s Discussion and Analysis (MD&A) is one example of useful information outside traditional financial statements.

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**Standards for Comparison**

When we interpret our analysis, it is essential to compare the results we obtained to other standards or benchmarks. Intracompany Competitors Industry Guidelines These include ■ Intracompany—The company under analysis can provide standards for comparisons based on its own prior performance. ■ Competitors—One or more direct competitors of the company being analyzed can provide standards for comparisons. ■ Industry—Industry statistics can provide standards of comparisons. Such statistics are available from services such as Dun & Bradstreet, Standard & Poor’s, and Moody’s. ■ Guidelines (rules of thumb)—General standards of comparisons can develop from experience. All of these comparison standards are useful when properly applied, yet measures taken from a selected competitor or group of competitors are often best.

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**Tools of Analysis Horizontal Analysis Vertical Analysis Ratio Analysis**

Comparing a company’s financial condition and performance across time. Vertical Analysis Comparing a company’s financial condition and performance to a base amount. Three of the most common tools of financial statement analysis are: 1. Horizontal analysis, which can be extremely helpful in learning more about a company. It is the process of properly preparing financial data in dollar and percentage formats. This information is usually shown side-by-side. 2. Vertical analysis, which is the process of comparing a company’s financial condition and results of operation in reference to a base amount. For example, we may wish to know the percentage of each expense account to sales revenue for the period. 3. Ratio analysis, which involves the use of key ratios to evaluate the strengths and weaknesses of a company. Ratio Analysis Measurement of key relations between financial statement items.

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Horizontal Analysis P 1 Horizontal analysis refers to examination of financial statement data across time. The term horizontal analysis arises from the left-to-right (or right-to-left) movement of our eyes as we review comparative financial statements across time. Comparing amounts for two or more successive periods often helps in analyzing financial statements. This comparison of the asset section of the Balance Sheet for Research in Motion’ illustrates horizontal analysis.

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**Comparative Statements**

Calculate Change in Dollar Amount Dollar Change Analysis Period Amount Base Period Amount = – When measuring the amount of the change in dollar amounts, compare the analysis period balance to the base period balance. The analysis period is usually the current year while the base period is usually the prior year. To compare one year to another, the first task is to calculate the change in dollar amount. First, establish a base year (usually the prior year) and then calculate the amount of change by comparing the analysis period to the base period amount. The analysis period is usually the current year while the base period is usually the prior year.

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**Comparative Statements**

Calculate Change as a Percent Percent Change Dollar Change Base Period Amount × = 100 When calculating the change as a percentage, divide the amount of the dollar change by the base period amount, and then multiply by 100 to convert to a percentage. To calculate the amount of change as a percentage, divide the amount of the dollar change by the base period amount, and then multiply by 100 to convert to a percentage.

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**Horizontal Analysis $1,550,861 – $835,546 = $715,315**

P 1 $1,550,861 – $835,546 = $715,315 To illustrate the horizontal analysis, consider the amounts for cash and cash equivalents. To calculate the amount of dollar change, we subtract the 2009 base year amount from the 2010 current year amount. To determine the percentage change, we divide the amount of the dollar change by the 2009 base year amount and multiply by 100. The percentage change for cash is an increase of 85.6 percent. This process is completed for each line item on the balance sheet. ($715,315 ÷ $835,546) × 100 = 85.6%

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**Horizontal Analysis $14,953,224 – $11,065,186 = $3,888,038**

P 1 $14,953,224 – $11,065,186 = $3,888,038 Next, let’s consider comparative income statements. To calculate the amount of dollar change, we subtract the 2009 base year amount from the 2010 current year amount. To determine the percentage change, we divide the amount of the dollar change by the 2009 base year amount and multiply by 100. The percentage change for revenue is an increase of 35.1 percent. This process is completed for each line item on the income statement. ($3,888,038 ÷ $11,065,186) × 100 = 35.1%

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**Analysis Period Amount**

Trend Analysis P 1 Trend analysis is used to reveal patterns in data covering successive periods. Trend Percent Analysis Period Amount Base Period Amount 100 = × Trend analysis, also called trend percent analysis or index number trend analysis, is a form of horizontal analysis that can reveal patterns in data across successive periods. It involves computing trend percents for a series of financial numbers and is a variation on the use of percent changes. The difference is that trend analysis does not subtract the base period amount in the numerator. To compute trend percents, we do the following: 1. Select a base period and assign the base period a weight of 100%. 2. Express financial numbers as a percent of the base period number. All values will be expressed as a percentage increase or decrease from the base period. The base period is usually the oldest period shown.

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**Research in Motion Income Statement Information**

Trend Analysis P 1 Research in Motion Income Statement Information Using 2006 as the base year we will get the following trend information: We have developed some trend analysis using Income Statement information for Research in Motion from 2006 through Note that 2006 is the base year and is set to 100%. All of the other years are expressed as a percentage of the comparable 2006 base year. Examples of Calculations for Revenues: 2006 is base year. Set to 100% 2007: $3,037,103 ÷ $2,065,845 × 100 = 147.0% 2008: $6,009,395 ÷ $2,065,845 × 100 = 290.9%

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Trend Analysis P 1 Some managers prefer to review trend information in chart form. Using Excel is an easy way to develop charts from our data. Here is the chart of the trend percentages. We can use the trend percentages to construct a graph so we can see the trend over time.

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**Common-Size Statements**

Vertical Analysis P 2 Common-Size Statements Common-size Percent Analysis Amount Base Amount × = 100 Financial Statement Base Amount Balance Sheet Total Assets Income Statement Revenues Vertical analysis is a tool to evaluate individual financial statement items or a group of items in terms of a specific base amount. We usually define a key aggregate figure as the base, which for an income statement is usually revenue and for a balance sheet is usually total assets. The term vertical analysis arises from the up-down (or down-up) movement of our eyes as we review common-size financial statements. Vertical analysis is also called common-size analysis.

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**Common-Size Balance Sheet**

P 2 ($1,550,861 ÷ $10,204,409) × 100 = 15.2% Here is the asset section of the comparative balance sheets of Research in Motion. For common-size analysis of the Balance Sheet, set total assets equal to 100 percent and express all other items as a percentage of total assets. To illustrate, calculate the percentage that cash and cash equivalents are of total assets. Divide the total cash and cash equivalents for 2010 by the total assets for 2010, and multiply the result by 100 percent. At the end of 2010, cash and cash equivalents made up 15.2% of total assets. For 2009, the percentage was 10.3%. Each line item is expressed as a percentage of total assets. ($835,546 ÷ $8,101,372) × 100 = 10.3%

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**Common-Size Income Statement**

P 2 Here are the common-size income statements for Research in Motion. Revenues are set to 100% and all other items are expressed as a percentage of revenues. At Research in Motion, cost of sales is about 56% of revenues in 2010, but was only 53.9% of revenue in Net income as a percentage of revenue has decreased slightly from 17.1% to 16.4%. In 2010, this can be interpreted as, on average, for every one dollar of revenue, the company earns about 16.4 cents in net income. ($8,368,958 ÷ $14,953,224) × 100 = 56.0%

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**Common-Size Graphics P 2**

Some individuals prefer graphs and charts rather than the raw numbers. The pie chart on the left illustrates RIM’s common size income statement in graphical form. All percentages are expressed in term of sales revenue. This pie chart highlights the contribution of each cost component of revenue for net income, excluding investment income. As noted earlier, cost of sales was about 56% of total revenue in 2010. Graphical analysis is also useful in identifying (1) sources of financing including the distribution among current liabilities, noncurrent liabilities, and equity capital and (2) focuses of investing activities, including the distribution among current and noncurrent assets. To illustrate, the graph on the right on this slide shows a common-size graphical display of RIM’s assets. Common-size balance sheet analysis can be extended to examine the composition of these subgroups.

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**Liquidity and efficiency**

Ratio Analysis P 3 Liquidity and efficiency Solvency Profitability Market prospects Ratios are among the more widely used tools of financial analysis because they provide clues to and symptoms of underlying conditions. A ratio can help us uncover conditions and trends difficult to detect by inspecting individual components making up the ratio. Ratios, like other analysis tools, are usually future oriented; that is, they are often adjusted for their probable future trend and magnitude, and their usefulness depends on skillful interpretation. A ratio expresses a mathematical relation between two quantities. It can be expressed as a percent, rate, or proportion. For instance, a change in an account balance from $100 to $250 can be expressed as (1) 150%, (2) 2.5 times, or (3) 2.5 to 1. The ratios are organized into the four building blocks of financial statement analysis: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects.

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**Liquidity and Efficiency**

P 3 Current Ratio Inventory Turnover Acid-test Ratio Days’ Sales Uncollected Days’ Purchases in Accounts Payable Accounts Receivable Turnover Days’ Sales in Inventory Liquidity refers to the availability of resources to meet short-term cash requirements. It is affected by the timing of cash inflows and outflows along with prospects for future performance. Analysis of liquidity is aimed at a company’s funding requirements. Efficiency refers to how productive a company is in using its assets. Efficiency is usually measured relative to how much revenue is generated from a certain level of assets. Total Asset Turnover

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Working Capital P 3 Working capital represents current assets financed from long-term capital sources that do not require near-term repayment. Current assets – Current liabilities = Working capital Working capital is defined as current assets minus current liabilities. It is a critical measure for all types of businesses. Positive working capital means the company will have enough assets converted into cash within the next year to pay its current obligations. More working capital suggests a strong liquidity position and an ability to meet current obligations.

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**Current Ratio Current Assets Current Ratio = Current Liabilities**

P 3 Current Ratio = Current Assets Current Liabilities Perhaps the most significant measure of a company’s ability to pay current obligations is the current ratio. It is merely current assets divided by current liabilities. As a short-term creditor, you would be vitally interested in a company’s current ratio. If the ratio continues to lower over time, you may be less likely to be paid in full. A higher current ratio suggests a strong liquidity position and an ability to meet current obligations. This ratio measures the short-term debt-paying ability of the company. A higher current ratio suggests a strong liquidity position.

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**Acid-Test Ratio Cash + Short-term investments + Current receivables**

P 3 Acid-test ratio = Cash + Short-term investments + Current receivables Current Liabilities Referred to as Quick Assets This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash. The acid-test ratio is a more stringent measure than the current ratio. We calculate the ratio by dividing quick assets by current liabilities. Quick assets include cash, short-term investments, and current accounts and notes receivable. The acid test ratio is generally lower than the current ratio because we have reduced the numerator. We have removed inventory accounts from the numerator that generally require a period of time to convert into cash. For example, for some companies’ inventories may take a significant amount of time to be converted into cash. Before we can reach a meaningful conclusion about the acid-test ratio, it is important to look at how quickly a given company converts its inventory to cash.

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**Accounts Receivable Turnover**

P 3 Accounts receivable = turnover Net sales Average accounts receivable, net Average accounts receivable = (Beginning acct. rec. + Ending acct. rec.) 2 This ratio measures how many times a company converts its receivables into cash each year. We calculate accounts receivable turnover by dividing our net credit sales, or sales on account, by average accounts receivable. This is an example of a ratio that contains an income measure in the numerator and a balance sheet measure in the denominator. Remember, in this type of ratio, we always use an average amount in the denominator. Our average accounts receivable, net is equal to the beginning accounts receivable plus the ending accounts receivable and the total divided by 2. This ratio helps us get a feel for the number of times per year a company can convert its accounts receivable into cash. For any company, the higher the turnover, the faster the cash collection on accounts receivable.

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**(Beginning inventory + Ending inventory)**

Inventory Turnover P 3 Inventory turnover = Cost of goods sold Average inventory Average inventory = (Beginning inventory + Ending inventory) 2 This ratio measures the number of times merchandise is sold and replaced during the year. Like receivables turnover, we can also calculate the inventory turnover. Inventory turnover is calculated by dividing cost of goods sold for the period by the average inventory. The inventory turnover ratio measures the number of times inventory is sold and replaced during the year. Higher inventory turnover helps protect a company from obsolete inventory items.

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**DAYS’ SALES UNCOLLECTED**

P 3 Day's sales = uncollected Accounts receivable, net × 365 Net sales Provides insight into how frequently a company collects its accounts receivable. Days’ sales uncollected is calculated by dividing ending accounts receivable, net by net sales, and multiplying this amount by 365 days. If a company offers a two-ten, net thirty cash discount, many customers would pay off the receivable balance close to the ten-day discount period and reduce the days’ sales uncollected ratio.

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**DAYS’ SALES IN INVENTORY**

P3 Day's sales in = Inventory Ending inventory × 365 Cost of goods sold This ratio is a useful measure in evaluating inventory liquidity. If a product is demanded by customers, this formula estimates how long it takes to sell the inventory. We can also calculate the days’ sales in inventory by dividing ending inventory by cost of goods sold, and multiplying this amount by 365 days. This ratio is a useful measure in evaluating inventory liquidity. If a product is demanded by customers, this formula estimates how long it takes to sell the inventory. The greater the demand for the product, the quicker it will be sold. By combining information about the days’ sales in inventory and the accounts receivable turnover, we get additional insights about the sale of a product and the collection of the related receivable into cash.

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**DAYS’ PURCHASES IN ACCOUNTS PAYABLE**

× 365 Cost of goods sold This ratio is a useful measure in evaluating how long the business takes to pay its credit suppliers. This ratio is a useful measure in evaluating how long the business takes to pay its credit suppliers.

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CASH CONVERSION CYCLE P 3 The sum of the days’ sales uncollected and the days’ sales in inventory subtracting the days’ purchases in accounts payable. It represents the number of days a firm’s cash remains tied up within the operations of the business. The cash conversion cycle of a company is defined by the sum of the days’ sales uncollected and the days’ sales in inventory subtracting the days’ purchases in accounts payable. It represents the number of days a firm’s cash remains tied up within the operations of the business. It is also a powerful tool for assessing how well a company is man- aging its working capital. The lower the cash conversion cycle, the more healthy a company generally is. The lower the cash conversion cycle, the more healthy a company generally is.

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**(Beginning assets + Ending assets)**

Total Asset Turnover P 3 Total asset turnover = Net sales Average total assets Average assets = (Beginning assets + Ending assets) 2 This ratio reflects a company’s ability to use its assets to generate sales. It is an important indication of operating efficiency. Total asset turnover is equal to net sales divided by average total assets. Asset turnover is a measure of how efficiently management is using the available assets to generate sales.

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**Pledged Assets to Secured Liabilities**

Solvency P 3 Debt Ratio Equity Ratio Pledged Assets to Secured Liabilities Solvency refers to a company’s long-run financial viability and its ability to cover long-term obligations. One of the most important components of solvency analysis is the composition of a company’s capital structure. Capital structure refers to a company’s financing sources. Times Interest Earned

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Debt and Equity Ratios P 3 Amount Ratio Total liabilities $ 8,000,000 66.7% [Debt ratio] Total equity 4,000,000 33.3% [Equity ratio] Total liabilities and equity $ 12,000,000 100.0% $8,000,000 ÷ $12,000,000 = 66.7% The debt ratio expresses total liabilities as a percent of total assets. The equity ratio provides complementary information by expressing total equity as a percent of total assets. This debt ratio measures what portion of a company’s assets are contributed by creditors. A larger debt ratio implies less opportunity to expand through use of debt financing. The debt ratio expresses total liabilities as a percent of total assets. The equity ratio provides complementary information by expressing total equity as a percent of total assets.

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**Debt-to-equity ratio =**

P 3 Debt-to-equity ratio = Total liabilities Total equity This ratio measures what portion of a company’s assets are contributed by creditors. A larger debt-to-equity ratio implies less opportunity to expand through use of debt financing. The debt-to-equity ratio is designed to measure the solvency of a company. A calculation above one indicates the company has more liabilities than equity. The lower the calculation, the more solvency the company has. A larger debt-to-equity ratio implies less opportunity to expand through use of debt financing.

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**Times Interest Earned Income before interest and taxes **

P 3 Times interest earned = Income before interest and taxes Interest expense Net income + Interest expense Income taxes = Income before interest and taxes Long-term creditors are particularly interested in the ability of a company to meet periodic interest payments. Times interest earned is a ratio that would be important to long-term creditors. The ratio is calculated by dividing earnings before interest and taxes by interest expense for the period. The larger the ratio, the less risky the company is from the perspective of a long-term creditor. This is the most common measure of the ability of a company’s operations to provide protection to long-term creditors.

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**Return on Ordinary Shareholders’ Equity**

Profitability P 3 Profit Margin Return on Total Assets Profitability refers to a company’s ability to generate an adequate return on invested capital. Return is judged by assessing earnings relative to the level and sources of financing. Key profitability measures are profit margin, return on total assets, and return on ordinary shareholder’s equity. Return on Ordinary Shareholders’ Equity

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**Profit Margin Profit margin = Net income Net sales**

Net sales This ratio describes a company’s ability to earn net income from each sales dollar. Profit margin tells us how effective the company is at producing bottom line net income. The ratio is determined by dividing net income by net sales. We can determine the return a company earns on its total assets. To calculate this ratio, we divide net income by the average total assets for the period. Return on total assets measures how well assets have been employed by the company’s management.

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**Return on Total Assets Return on total asset = Net income **

P 3 Return on total asset = Net income Average total assets Return on total assets measures how well assets have been employed by the company’s management. Profit margin tells us how effective the company is at producing bottom line net income. The ratio is determined by dividing net income by net sales. We can determine the return a company earns on its total assets. To calculate this ratio, we divide net income by the average total assets for the period. Return on total assets measures how well assets have been employed by the company’s management.

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**RETURN ON ORDINARY SHAREHOLDERS' EQUITY**

P 3 Return on ordinary shareholders' equity = Net income - Preference dividends Average ordinary shareholders' equity This measure indicates how well the company employed the shareholders’ equity to earn net income. We can calculate the return on ordinary shareholders’ equity. The numerator is net income available to ordinary shareholders, which is net income less preference dividends, divided by average ordinary shareholders’ equity. This measure indicates how well the company employed the shareholders’ equity to earn net income.

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**Market Prospects Price-Earnings Ratio Dividend Yield P 3**

Market measures are useful for analyzing corporations with publicly traded shares. These market measures use share price, which reflects the market’s (public’s) expectations for the company. This includes expectations of both company return and risk—as the market perceives it. Key measures of market prospects include the price-earnings ratio and dividend yield.

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**Price-Earnings Ratio Price-earnings ratio =**

Market price per ordinary share Earnings per share This measure is often used by investors as a general guideline in gauging share values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth. Once we know the earnings per share, we can calculate the price-earnings ratio, or PE ratio. We will divide the closing market price per share of a company’s ordinary shares by earnings per share. The ratio is used as an indicator of the future growth and risk of a company’s earnings as perceived by the share’s buyers and sellers.

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**Annual cash dividends per share**

Dividend Yield P 3 Dividend yield = Annual cash dividends per share Market price per share This ratio identifies the return, in terms of cash dividends, on the current market price per share of the company’s ordinary shares. If you are an investor who requires current income; you will want to look for companies with high dividend payout ratios. If you believe that a company can invest its funds and earn a higher return than you would be able to earn, you might look for a company with high growth and a low payout ratio. To determine the dividend yield ratio, we divide the annual dividend per share by the closing market price per share of the company’s ordinary shares.

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**Analysis Reporting Executive Summary Analysis Overview**

The purpose of financial statement analyses is to reduce uncertainty in business decisions through a rigorous and sound evaluation. A financial statement analysis report directly addresses the building blocks of analysis and documents the reasoning. Executive Summary Analysis Overview Evidential Matter Assumptions Key Factors Inferences The purpose of most financial statement analyses is to reduce uncertainty in business decisions through a rigorous and sound evaluation. A financial statement analysis report helps by directly addressing the building blocks of analysis and by identifying weaknesses in inference by requiring explanation: It forces us to organize our reasoning and to verify its flow and logic. A report helps us (re)evaluate evidence and refine conclusions on key building blocks. A good analysis report usually consists of six sections: 1. Executive summary—brief focus on important analysis results and conclusions. 2. Analysis overview—background on the company, its industry, and its economic setting. 3. Evidential matter—financial statements and information used in the analysis, including ratios, trends, comparisons, statistics, and all analytical measures assembled; often organized under the building blocks of analysis. 4. Assumptions—identification of important assumptions regarding a company’s industry and economic environment, and other important assumptions for estimates. 5. Key factors—list of important favorable and unfavorable factors, both quantitative and qualitative, for company performance; usually organized by areas of analysis. 6. Inferences—forecasts, estimates, interpretations, and conclusions drawing on all sections of the report.

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End of Chapter 17 End of Chapter 17.

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Analysis of Financial Statements

Analysis of Financial Statements

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