Financial Statement Analysis 17

Learning Objective Describe the nature of the adjusting process. Learning Objective Describe the nature of the adjusting process. Insert Chapter Objectives Financial Statement Analysis 1 Describe basic financial statement analytical methods. 2 Use financial statement analysis to assess the solvency of a business. After studying this chapter, you should be able to: 3 Use financial statement analysis to assess the profitability of a business. 4 Describe the contents of corporate annual reports. 17-2

Describe basic financial statement analytical methods. 17-3

Basic Analytical Methods Users analyze a company’s financial statements using a variety of analytical methods. Three such methods are as follows: 1.Horizontal analysis 2.Vertical analysis 3.Common-sized statements 1

Horizontal Analysis The percentage analysis of increases and decreases in related items using comparative financial statements is called horizontal analysis. 1

Comparative Balance Sheet— Horizontal Analysis 1 Exhibit 1

Horizontal Analysis: Horizontal Analysis: Difference $17,000 Base year (2009) $533,000 = 3.2% Exhibit 1 Comparative Balance Sheet— Horizontal Analysis

Comparative Schedule of Current Assets—Horizontal Analysis 1 Exhibit 2

Horizontal Analysis: Horizontal Analysis: Difference $25,800 Base year (2009) $64,700 = 39.9% 1 Comparative Schedule of Current Assets—Horizontal Analysis Exhibit 2

Comparative Income Statement— Horizontal Analysis 1 Exhibit 3

Horizontal Analysis: Horizontal Analysis: Increase amount$296,500 Base year (2009) $1,234,000 = 24.0% 1 Comparative Income Statement— Horizontal Analysis Exhibit 3

Comparative Retained Earnings Statement—Horizontal Analysis Horizontal Analysis: Horizontal Analysis: Increase amount$37,500 Base year (2009) $100,000 = 37.5% 1 Exhibit 4

Vertical Analysis A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis. 1

In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity. Vertical Analysis of Balance Sheet 1

Compar- ative Balance Sheet— Vertical Analysis 1 Exhibit 5

Compar- ative Balance Sheet— Vertical Analysis Vertical Analysis: Vertical Analysis: Current assets $550,000 Total assets $1,139,500 = 48.3% 1 Exhibit 5

In a vertical analysis of the income statement, each item is stated as a percent of net sales. Vertical Analysis of the Income Statement 1

Comparative Income Statement—Vertical Analysis 1 Exhibit 6

Vertical Analysis: Vertical Analysis: Selling expenses $191,000 Net sales $1,498,000 = 12.8% 1 Comparative Income Statement—Vertical Analysis Exhibit 6

Common-Size Statements In a common-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with with industry percentages. 1

Common-Sized Income Statement 1 Exhibit 7

Use financial statement analysis to assess the solvency of a business.

Solvency Analysis All users of financial statements are interested in the ability of a company to do the following: 1.Meet its financial obligations (debts), called solvency. 2.Earn income, called profitability. 2

Current Position Analysis Using measures to assess a business’s ability to pay its current liabilities is called current position analysis. Such analysis is of special interest to short-term creditors. 2

Working Capital The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company’s ability to pay current liabilities. 2

Working Capital = Current Assets – Current Liabilities Current assets$550,000$533,000 Current liabilities –210,000 –243,000 Working capital$340,000$290,000 2

Current Ratio The current ratio, sometimes called the working capital ratio or bankers’ ratio measures a company’s ability to pay its current liabilities. 2

Current assets$550,000$533,000 Current liabilities$210,000$243,000 Current ratio $550,000 $210,000 $533,000 $243,000 2 Current Ratio = Current Assets Current Liabilities

Quick Ratio A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio or acid- test ratio. 2

Quick ratio (a ÷ b) Quick assets: Cash$ 90,500$ 64,700 Temporary Investments 75,00060,000 Accounts receivable (net)115,000120,000 a. Total quick assets$280,500$244,700 b. Current liabilities$210,000$243,000 Quick assets are cash and other current assets that can be quickly converted to cash. 2

Accounts Receivable Turnover The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a company’s solvency. 2

Accounts receivable turnover (a ÷ b) a. Net sales $1,498,000$1,200,000 Accounts receivable (net): Beginning of year$ 120,000$ 140,000 End of year 115, ,000 Total$ 235,000$ 260,000 b.Average (Total ÷ 2)$ 117,500$ 130, Accounts Receivable Turnover = Net Sales Average Accounts Receivable 2

Number of Days’ Sales in Receivables The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. Number of Days’ Sales in Receivables Average Accounts Receivable Average Daily Sales = Net Sales 365 2

Number of days’ sales in receivables (a ÷ b) a.Average accounts receivable (Total accounts receivable ÷ 2)$ 117,500$ 130,000 Net sales$1,498,000$1,200,000 b.Average daily sales (Sales ÷ 365)$ 4,104$ 3,

Inventory Turnover The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory. 2

Inventory Turnover = Cost of Goods Sold Average Inventory Inventory turnover (a ÷ b) a.Cost of goods sold$1,043,000$ 820,000 Inventories: Beginning of year$ 283,000$ 311,000 End of year 264, ,000 Total$ 547,000$ 594,000 b.Average (Total ÷ 2)$ 273,500$ 297,000 2

Number of Days’ Sales in Inventory The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory. 2

Number of Days’ Sales in Inventory Average Inventory Average Daily Cost of Goods Sold = Cost of Goods Sold 365 Number of days’ sales in inventory (a ÷ b) a.Average inventory (Total ÷ 2)$ 273,500$ 297,000 Cost of goods sold$1,043,000$ 820,000 b.Average daily cost of goods sold (COGS ÷ 365 days)$2,858$2,

Ratio of Fixed Assets to Long-Term Liabilities The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long- term basis. 2

Ratio of Fixed Assets to Long-Term Liabilities Fixed Assets (net) Long-Term Liabilities = Ratio of fixed assets to long-term liabilities (a ÷ b) a. Fixed assets (net)$444,500$470,000 b.Long-term liabilities$100,000$200,000 2

Ratio of Liabilities to Stockholders’ Equity The relationship between the total claims of the creditors and owners—the ratio of liabilities to stockholders’ equity—is a solvency measure that indicates the margin of safety for creditors. 2

Ratio of Liabilities to Stockholders’ Equity Total Liabilities Total Stockholders’ Equity = Ratio of liabilities to stockholders’ equity ( a÷ b) a.Total liabilities$310,000$443,000 b.Total stockholders’ equity$829,500$787,

Number of Times Interest Charges Earned Corporations in some industries normally have high ratios of debt to stockholders’ equity. For such corporations, the relative risk of the debtholders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio. 2

Number of Times Interest Charges Earned Income Before Income Tax + Interest Expense Interest Expense = Income before income tax$162,500$134,600 a.Add interest expense 6,000 12,000 b.Amount available to meet interest charges$168,500$146,600 Number of times interest charges earned (b ÷ a)

Number of Times Preferred Dividends Are Earned The number of times interest charges are earned can be adapted for use with dividends on preferred stock. Number of Times Preferred Dividends Are Earned Net Income Preferred Dividends = 2

Use financial statement analysis to assess the profitability of a business

Profitability Analysis Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business. 3

Ratio of Net Sales to Assets The ratio of net sales to assets is a profitability measure that shows how effectively a company utilizes its assets. 3

Ratio of Net Sales to Assets Net Sales Average Total Assets = a.Net sales $1,498,000$1,200,000 Total assets: Beginning of year$1,053,000$1,010,000 End of year 1,044,500 1,053,000 Total$2,097,500$2,063,000 b.Average (Total ÷ 2)$1,048,750$1,031,500 Excludes long-term investments 3

Ratio of Net Sales to Assets Net Sales Average Total Assets = a.Net sales $1,498,000$1,200,000 Total assets: Beginning of year$1,053,000$1,010,000 End of year 1,044,500 1,053,000 Total$2,097,500$2,063,000 b.Average (Total ÷ 2)$1,048,750$1,031,500 Ratio of net sales to assets (a ÷ b)

Rate Earned on Total Assets The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed. 3

Rate Earned on Total Assets Net Income + Interest Expense Average Total Assets = Rate earned on total assets (a ÷ b) 8.2% 7.3% Net income$ 91,000$ 76,500 Plus interest expense 6,000 12,000 a.Total$ 97,000$ 88,500 Total assets: Beginning of year$1,230,500$1,187,500 End of year 1,139,500 1,230,500 Total$2,370,000$2,418,000 b.Average (Total ÷ 2)$1,185,000$1,209,000 3

Rate Earned on Stockholders’ Equity The rate earned on stockholders’ equity measure emphasizes the rate of income earned on the amount invested by the stockholders. 3

Rate Earned on Stockholders’ Equity Net Income Average Total Stockholders’ Equity = Rate earned on stockholders’ equity (a ÷ b) 11.3% 10.0% a.Net income$ 91,000$ 76,500 Stockholders’ equity: Beginning of year$ 787,500$ 750,000 End of year 829, ,500 Total$1,617,000$1,537,500 b.Average (Total ÷ 2)$ 808,500$ 768,

The difference in the rate earned on stockholders’ equity and the rate earned on total assets is called leverage. Leverage 3

Exhibit 8Effect of Leverage

The rate earned on common stockholders’ equity focuses only on the rate of profits earned on the amount invested by the common stockholders. Rate Earned on Common Stockholders’ Equity 3

Rate Earned on Common Stockholders’ Equity Net Income – Preferred Dividends Average Common Stockholders’ Equity = Rate earned on common stockholders’ equity (a ÷ b) 12.5% 10.9% Net income$ 91,000$ 76,500 Less preferred dividends 9,000 9,000 a.Remainder—common stock$ 82,000$ 67,500 Common stockholders’ equity: Beginning of year $ 637,500$ 600,000 End of year 679, ,500 Total$1,317,000$1,237,500 b.Average (Total ÷ 2)$ 658,500$ 618,750 3

Earnings per Share on Common Stock Earning per share (EPS) on common stock measures the share of profits that are earned by share of common stock. GAAP require the reporting of earnings per share in the income statement. 3

Earnings per Share (EPS) on Common Stock Net Income – Preferred Dividends Shares of Common Stock Outstanding = Earnings per share on common stock (a ÷ b) $1.64 $ Net income$91,000$76,500 Preferred dividends 9,000 9,000 a.Remainder—identified with common stock$82,000$67,500 b.Shares of common stock50,00050,000 3

Price-Earnings Ratio Another profitability measure quoted by the financial press is the price-earnings (P/E) ratio on common stock. The price- earnings ratio on common stock measures a company’s future earnings prospects. 3

Price-earnings (P/E) ratio Market Price per Share of Common Stock Earnings per Share on Common Stock = Price-earnings ratio on common stock Market price per share of common stock$41.00$27.00 Earnings per share on common stock ÷ 1.64÷

Dividends per Share Dividends per share can be reported with earnings per share to indicate the relationship between dividends and earnings. Comparing these two per share amounts measures the extent to which earnings are being distributed to common shareholders. 3

Dividends per Share Dividends Shares of Common Stock Outstanding = Dividends per share of common stock (a ÷ b) $0.80 $ a. Dividends$40,000$30,000 b. Shares of common stock outstanding 50,00050,000 3

Dividends and Earnings per Share of Common Stock 3 Exhibit 9

The dividend yield on common stock measures the rate of return to common stockholders from cash dividends. Dividend Yield 3

Dividend Yield Dividends per Share of Common Stock Market Price per Share of Common Stock = Dividend yield on common stock 2.0% 2.2% a. Dividends per share of common stock$ 0.80$ 0.60 b. Market price per share of common stock

Summary of Analytical Methods Exhibit 10 Solvency Measures (continued) 4

Summary of Analytical Methods (continued) Exhibit 10 Profitability Measures

Describe the contents of corporate annual reports

Corporate Annual Reports In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections: Management discussion and analysis Report on adequacy of internal control Report on fairness of financial statements 4

The Management Discussion and Analysis (MD&A) includes an analysis of the results of operations and discusses management’s opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition. Management Discussion and Analysis 4

The Sarbanes-Oxley Act of 2002 requires a report stating management’s responsibility for establishing and maintaining internal control. In addition, management’s assessment of the effectiveness of internal controls over financial reporting is included in the report. Report on Internal Control 4

All publicly held corporations are required to have an independent audit (examination) of their financial statements. The CPA firm that conducts the audit renders an opinion on the fairness of the statements. Report on Fairness of Financial Statements 4

Appendix: Unusual Items on the Income Statement

Unusual Items Affecting the Current Period’s Income Statement Unusual items affecting the current period’s income statement include the following: Discontinued operations Extraordinary items

Discontinued Operations A company may discontinue a segment of its operations by selling or abandoning the operations. A note accompanying the income statement should describe the operations sold including such details as the date operations were discontinued, the assets sold, and the effect (if any) on current and future operations.

Extraordinary Items An extraordinary item is defined as an event or transaction with the following characteristics: Unusual in nature Infrequent in occurrence

Unusual Items in the Income Statement Exhibit 11

Income Statement with Earnings per ShareExhibit 12