Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Credit analysis on the Financial Statements Next chapter

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult. We use the LIFO method to value inventory. We use the average cost method to value inventory.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Limitations of Financial Statement Analysis Analysts should look beyond the ratios. Economic factors Industry trends Changes within the company Technological changes Consumer tastes

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Statements in Comparative and Common- Size Form  Dollar and percentage changes on statements  Common-size statements  Ratios An item on a financial statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing comparisons.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Dollar and Percentage Changes on Statements Horizontal analysis (or trend analysis) shows the changes between years in the financial data in both dollar and percentage form.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Example The following slides illustrate a horizontal analysis of Clover Corporation’s December 31, 2005 and 2004, comparative balance sheets and comparative income statements. Horizontal Analysis

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Horizontal Analysis

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Horizontal Analysis Calculating Change in Dollar Amounts Dollar Change Current Year Figure Base Year Figure =– The dollar amounts for 2004 become the “base” year figures.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Calculating Change as a Percentage Percentage Change Dollar Change Base Year Figure 100% = × Horizontal Analysis

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Horizontal Analysis ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500)

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Horizontal Analysis

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Horizontal Analysis We could do this for the liabilities & stockholders’ equity, but now let’s look at the income statement accounts.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Horizontal Analysis

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Horizontal Analysis

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Horizontal Analysis Sales increased by 8.3% yet net income decreased by 21.9%.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Trend Analysis Trend Percentage Current Year Amount Base Year Amount 100% = ×

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Trend Analysis Example Look at the income information for Berry Products for the years 2001 through We will do a trend analysis on these amounts to see what we can learn about the company.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Trend Analysis The base year is 2001, and its amounts will equal 100%. Berry Products Income Information For the Years Ended December 31

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Trend Analysis Berry Products Income Information For the Years Ended December Amount ÷ 2001 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108%

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Trend Analysis We can use the trend percentages to construct a graph so we can see the trend over time.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Common-Size Statements Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Common-Size Statements In income statements, all items are usually expressed as a percentage of sales.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Common-Size Statements In balance sheets, all items are usually expressed as a percentage of total assets.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Common-Size Statements Common-size financial statements are particularly useful when comparing data from different companies.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Example Let’s take another look at the information from the comparative income statements of Clover Corporation for 2005 and This time let’s prepare common-size statements. Common-Size Statements

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Common-Size Statements Sales Sales is usually the base and is expressed as 100%.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Common-Size Statements 2004 Cost ÷ 2004 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6% 2005 Cost ÷ 2005 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2%

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Common-Size Statements What conclusions can we draw?

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Now, let’s look at Norton Corporation’s 2005 and 2004 financial statements.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Standardize numbers; facilitate comparisons Used to highlight weaknesses and strengths Why are ratios useful?

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Liquidity: Can we make required payments as they fall due? Asset management: Do we have the right amount of assets for the level of sales? What are the five major categories of ratios, and what questions do they answer? (More…)

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Debt management: Do we have the right mix of debt and equity? Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM, ROE, and ROA? Market value: Do investors like what they see as reflected in P/E and M/B ratios?

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Calculate the firm’s forecasted current and quick ratios for CR 02 = = = 1.85x. QR 02 = = = 0.67x. CA CL $2,680 - $1,716 $1,445 CA - Inv. CL

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Expected to improve but still below the industry average. Liquidity position is weak. Comments on CR and QR 2002E Ind. CR1.85x1.1x2.3x2.7x QR0.67x0.4x0.8x1.0x

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Ratio Analysis – The Common Stockholder The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholders’ equities.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 share of common stock outstanding.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 stock because of optimistic future growth prospects.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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).

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 stock.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 =

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Return on Common Stockholders’ Equity Return on Common Stockholders’ Equity Net Income – Preferred Dividends Average Stockholders’ Equity = Return on Common Stockholders’ 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin ROA is lowered by debt--interest expense lowers net income, which also lowers ROA. However, the use of debt lowers equity, and if equity is lowered more than net income, ROE would increase. Effects of Debt on ROA and ROE

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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. 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 =

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Book Value Per Share Book Value per Share Common Stockholders’ 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 and if all creditors were paid off. = $ 8.55 Book Value per Share $234,390 27,400 =

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Book Value Per Share Book Value per Share Common Stockholders’ Equity Number of Common Shares Outstanding == $ 8.55 Book Value per Share $234,390 27,400 = 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Working Capital

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 =

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $65,000 $42,000 ==1.55

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 =

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Average Collection Period = 365 Days Accounts Receivable Turnover This ratio measures, on average, how many days it takes to collect an account receivable. = days Average Collection Period = 365 Days 26.7 Times

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Inventory Turnover Cost of Goods Sold Average Inventory 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 sorts of inventory.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover == times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover =

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Average Sale Period = 365 Days Inventory Turnover This ratio measures how many days, on average, it takes to sell the inventory. = days Average Sale Period = 365 Days Times

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin 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 == times

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Debt-to-Equity Ratio This ratio indicates the relative proportions of debt to equity on a company’s balance sheet. Stockholders like a lot of debt if the company can take advantage of positive financial leverage. Total Liabilities Stockholders’ Equity Debt–to– Equity Ratio = Creditors prefer less debt and more equity because equity represents a buffer of protection.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity Debt–to– Equity Ratio = $112,000 $234,390 Debt–to– Equity Ratio == 0.48

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Too much debt, but projected to improve. How do the debt management ratios compare with industry averages? 2002E Ind. D/A55.6%95.4%54.8%50.0% TIE6.3x-3.9x3.3x6.2x EC5.5x-2.5x2.6x8.0x

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Typical industry average P/E ratios * Because many internet companies have negative earnings and no P/E, there was only a small sample of internet companies. Industry P/E ratio Banking Computer Software Services Drug Electric Utilities (Eastern U.S.) Internet Services* Semiconductors Steel Tobacco Water Utilities 21.84

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Potential use of freed up cash Repurchase stock. Higher ROE, higher EPS. Expand business. Higher profits. Reduce debt. Better debt ratio; lower interest, hence higher NI. (More…)

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Would you lend money to this company? Maybe. The situation could improve, and the loan, with a high interest rate to reflect the risk, could be a good investment. However, company should not have relied so heavily on debt financing in the past.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin What are some potential problems and limitations of financial ratio analysis? Comparison with industry averages is difficult if the firm operates many different divisions. “Average” performance is not necessarily good. Seasonal factors can distort ratios. (More…)

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons. Sometimes it is difficult to tell if a ratio value is “good” or “bad.” Often, different ratios give different signals, so it is difficult to tell, on balance, whether a company is in a strong or weak financial condition.

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin What are some qualitative factors analysts should consider when evaluating a company’s likely future financial performance? Are the company’s revenues tied to a single customer? To what extent are the company’s revenues tied to a single product? To what extent does the company rely on a single supplier? (More…)

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin What percentage of the company’s business is generated overseas? What is the competitive situation? What does the future have in store? What is the company’s legal and regulatory environment?

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Copyright © 2006, The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin End of Chapter