1. Chapter 15 Financial Statement Analysis

2. Learning Objectives 1.Explain how financial statements are used to analyze a business 2.Perform a horizontal analysis of financial statements 3.Perform a vertical analysis of financial statements 15-2 © Pearson Education, Inc.

3. Learning Objectives 4.Compute and evaluate the standard financial ratios 5.Complete a corporate income statement including earnings per share (Appendix 15A) 15-3 © Pearson Education, Inc.

4. Learning Objective 1 Explain how financial statements are used to analyze a business 15-4 © Pearson Education, Inc.

5. How Are Financial Statements Used to Analyze a Business? To determine the financial performance of a company, we compare its performance in the following ways: – From year to year – With a competing company – With the same industry as a whole 15-5 © Pearson Education, Inc.

6. Tools of Analysis There are three main ways to analyze financial statements: – Horizontal analysis provides a year-to-year comparison of a company’s performance in different periods. – Vertical analysis provides a way to compare different companies. – Ratio analysis can be used to provide information about a company’s performance. 15-6 © Pearson Education, Inc.

7. Corporate Financial Reports Corporate financial reports include: – Annual reports – Management’s discussion and analysis of financial conditions and results of operations (MD&A) – Report of the independent auditors – Financial statements – Notes to financial statements 15-7 © Pearson Education, Inc.

8. Learning Objective 2 Perform a horizontal analysis of financial statements 15-8 © Pearson Education, Inc.

9. How Do We Use Horizontal Analysis to Analyze a Business? Many decisions hinge on whether the numbers are increasing or decreasing. Sales may have increased, but considered in isolation, this fact is not very helpful. Horizontal analysis is the study of percentage changes in comparative financial statements. 15-9 © Pearson Education, Inc.

10. How Do We Use Horizontal Analysis to Analyze a Business? Assume Smart Touch Learning has net sales of $858,000 in 2018 and $803,000 in 2017. Prepare the horizontal analysis: Step 1: Compute the dollar amount of change in sales from 2017-2018 Step 2: Divide the dollar amount of change by the base period amount and multiply by 100. This computes the percentage change for the period: 15-10 © Pearson Education, Inc.

11. Horizontal Analysis of the Income Statement 15-11 © Pearson Education, Inc.

12. Horizontal Analysis of the Balance Sheet 15-12 © Pearson Education, Inc.

13. Horizontal Analysis of the Balance Sheet 15-13 © Pearson Education, Inc.

14. Trend Analysis Trend analysis is a form of horizontal analysis. Trend percentages indicate the direction a business is taking. The formula for trend analysis is as follows: 15-14 © Pearson Education, Inc.

15. Trend Analysis Smart Touch Learning’s net sales were $750,000 for 2014 and rose to $858,000 in 2018. The base year is 2014, so that year’s percentage is set equal to 100. 15-15 © Pearson Education, Inc.

16. Learning Objective 3 Perform a vertical analysis of financial statements 15-16 © Pearson Education, Inc.

17. How Do We Use Vertical Analysis to Analyze a Business? Vertical analysis of a financial statement shows the relationship of each item to its base amount, the 100% figure. Every other item on the statement is then reported as a percentage of that base. 15-17 © Pearson Education, Inc.

18. Vertical Analysis of the Income Statement 15-18 © Pearson Education, Inc.

19. Vertical Analysis of the Balance Sheet 15-19 © Pearson Education, Inc.

20. Vertical Analysis of the Balance Sheet 15-20 © Pearson Education, Inc.

21. Common-Size Statements To compare one company to another company, we can use a common-size statement. A common-size statement reports only percentages. By reporting only percentages, it removes dollar value bias we see when comparing numbers in absolute terms (dollars). 15-21 © Pearson Education, Inc.

22. Common-Size Statements 15-22 © Pearson Education, Inc.

23. Benchmarking Benchmarking is the practice of comparing a company with other leading companies. There are two main types of benchmarking: – Benchmarking against a key competitor – Benchmarking against the industry average 15-23 © Pearson Education, Inc.

24. Benchmarking 15-24 © Pearson Education, Inc.

25. Learning Objective 4 Compute and evaluate the standard financial ratios 15-25 © Pearson Education, Inc.

26. How Do We Use Ratios to Analyze a Business? Different ratios explain different aspects of a company. Ratios are used for the following purposes: – Evaluating the ability to pay current liabilities and long-term debit – Evaluating the ability to sell merchandise inventory and collect receivables – Evaluating profitability – Evaluating stock as an investment 15-26 © Pearson Education, Inc.

27. How Do We Use Ratios to Analyze a Business? 15-27 © Pearson Education, Inc.

28. How Do We Use Ratios to Analyze a Business? 15-28 © Pearson Education, Inc.

29. Evaluating the Ability to Pay Current Liabilities Working capital measures the ability to meet short-term obligations with current assets. Working capital is defined as follows: 15-29 © Pearson Education, Inc.

30. Current Ratio The most widely used ratio is the current ratio. This ratio measures a company’s ability to pay its current liabilities with its current assets. 15-30 © Pearson Education, Inc.

31. Cash Ratio The cash ratio helps determine a company’s ability to meet its short-term obligations. 15-31 © Pearson Education, Inc.

32. Acid-Test (or Quick) Ratio The acid-test ratio (sometimes called the quick ratio) tells us whether a company can pay all its current liabilities if they come due immediately. 15-32 © Pearson Education, Inc.

33. Evaluating the Ability to Sell Merchandise Inventory and Collect Receivables Five ratios that measure a company’s ability to sell merchandise inventory and collect receivables are: – Inventory turnover – Days’ sales in inventory – Gross profit percentage – Accounts receivable turnover ratio – Days’ sales in receivables 15-33 © Pearson Education, Inc.

34. Inventory Turnover The inventory turnover ratio measures the number of times a company sells its average level of merchandise inventory during a year. 15-34 © Pearson Education, Inc.

35. Days’ Sales in Inventory Days’ sales in inventory measures the average number of days merchandise inventory is held by the company. 15-35 © Pearson Education, Inc.

36. Gross Profit Percentage The gross profit percentage measures the profitability of each net sales dollar above the cost of goods sold. 15-36 © Pearson Education, Inc.

37. Accounts Receivable Turnover Ratio The accounts receivable turnover ratio measures the number of times the company collects the average receivables balance in a year. 15-37 © Pearson Education, Inc.

38. Days’ Sales in Receivables Days’ sales in receivables indicates how many days it takes to collect the average level of receivables. 15-38 © Pearson Education, Inc.

39. Evaluating the Ability to Pay Long-Term Debt Most businesses have long-term debt. Three key indicators of a business’s ability to pay long-term liabilities are the: – Debt ratio – Debt to equity ratio – Times-interest-earned ratio 15-39 © Pearson Education, Inc.

40. Debt Ratio The debt ratio shows the proportion of assets financed with debt and is calculated by dividing total liabilities by total assets. 15-40 © Pearson Education, Inc.

41. Debt to Equity Ratio The debt to equity ratio shows the proportion of total liabilities relative to total equity. This ratio measures financial leverage. 15-41 © Pearson Education, Inc.

42. Times-Interest-Earned Ratio The times-interest-earned ratio evaluates a business’s ability to pay interest expense. This ratio is also called the interest coverage ratio. 15-42 © Pearson Education, Inc.

43. Evaluating Profitability Five ratios used to evaluate a company’s profitability are: – Profit margin ratio – Rate of return on total assets – Asset turnover ratio – Rate of return on common stockholders’ equity – Earnings per share 15-43 © Pearson Education, Inc.

44. Profit Margin Ratio The profit margin ratio shows how much net income a business earns on every $1 of sales. 15-44 © Pearson Education, Inc.

45. Rate of Return on Total Assets The rate of return on total assets measures a company’s success in using assets to earn a profit. 15-45 © Pearson Education, Inc.

46. Asset Turnover Ratio The asset turnover ratio measures the amount of net sales generated for each average dollar of total assets invested. 15-46 © Pearson Education, Inc.

47. Rate of Return on Common Stockholders’ Equity The rate of return on common stockholders’ equity shows how much income is earned for each $1 invested by the common shareholders. 15-47 © Pearson Education, Inc.

48. Rate of Return on Common Stockholders’ Equity When a company has a higher rate of return on stockholders’ equity than its rate of return on total assets, this is called trading on the equity. Trading on the equity is earning more income on borrowed money than the related interest expense, thereby increasing the earnings for the owners of the business. 15-48 © Pearson Education, Inc.

49. Earnings per Share (EPS) The earnings per share (EPS) reports the amount of net income (loss) for each share of the company’s outstanding common stock. 15-49 © Pearson Education, Inc.

50. Evaluating Stock as an Investment Investors purchase stock to earn a return on their investment. This return consists of two parts: – Gains (or losses) from selling the stock at a price above (or below) purchase price – Dividends 15-50 © Pearson Education, Inc.

51. Price/Earnings Ratio The price/earnings ratio is the ratio of the market price of a share of common stock to the company’s earnings per share. 15-51 © Pearson Education, Inc.

52. Dividend Yield The dividend yield measures the percentage of a stock’s market value that is returned annually as dividends to shareholders. 15-52 © Pearson Education, Inc.

53. Dividend Payout The dividend payout measures the percentage of earnings paid annually to common shareholders as cash dividends. 15-53 © Pearson Education, Inc.

54. Red Flags in Financial Statement Analysis Analysts look for red flags in financial statements that may signal financial trouble. Examples: – Movement of sales, merchandise inventory, and receivables – Earnings problems – Decreased cash flow – Too much debt – Inability to collect receivables – Buildup of merchandise inventories 15-54 © Pearson Education, Inc.

55. 15-55 © Pearson Education, Inc. Summary of Ratios Used in Financial Statement Analysis

56. 15-56 © Pearson Education, Inc.

57. 15-57 © Pearson Education, Inc. Summary of Ratios used in Financial Statement Analysis

58. 15-58 © Pearson Education, Inc. Summary of Ratios Used in Financial Statement Analysis

59. Learning Objective 5 Complete a corporate income statement including earnings per share (Appendix 15A) 15-59 © Pearson Education, Inc.

60. How Is the Complete Corporate Income Statement Prepared? A corporation’s income statement reports income from continuing operations to help investors make predications about future earnings. The income statement also includes unique items, such as: – Discontinued operations – Extraordinary items 15-60 © Pearson Education, Inc.

61. 15-61 © Pearson Education, Inc. How Is the Complete Corporate Income Statement Prepared?

62. Discontinued Operations Most corporations engage in several lines of business. A company may sell a segment of its business. This is reported as a discontinued operation. Discontinued operations are reported immediately after income from continuing operations. 15-62 © Pearson Education, Inc.

63. Extraordinary Items Extraordinary gains and losses, called extraordinary items, are both: – Unusual – Infrequent GAAP defines an event as infrequent if it is not expected to recur in the foreseeable future. These items are reported separately from continuing operations. 15-63 © Pearson Education, Inc.

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