18-1

18-2 CHAPTER18 Financial Statement Analysis

18-3 PreviewofCHAPTER18

18-4 Analyzing financial statements involves: Characteristics Comparison Bases Tools of Analysis  Liquidity  Profitability  Solvency  Intracompany  Industry averages  Intercompany  Horizontal  Vertical  Ratio SO 1 Discuss the need for comparative analysis. SO 2 Identify the tools of financial statement analysis. Basics of Financial Statement Analysis

18-5 SO 3 Explain and apply horizontal analysis. Horizontal Analysis Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time.  Purpose is to determine the increase or decrease that has taken place.  Commonly applied to the balance sheet, income statement, and statement of retained earnings.

18-6 SO 3 Explain and apply horizontal analysis. Changes suggest that the company expanded its asset base during 2009 and financed this expansion primarily by retaining income rather than assuming additional long-term debt. Illustration 18-5 Horizontal analysis of balance sheets Horizontal Analysis

18-7 SO 3 Explain and apply horizontal analysis. Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorable. Illustration 18-6 Horizontal analysis of Income statements Horizontal Analysis

18-8 SO 3 Explain and apply horizontal analysis. In the horizontal analysis of the balance sheet the ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. Illustration 18-7 Horizontal analysis of retained earnings statements Horizontal Analysis

18-9 SO 4 Describe and apply vertical analysis. Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount.  On an income statement, we might say that selling expenses are 16% of net sales.  Vertical analysis is commonly applied to the balance sheet and the income statement. Vertical Analysis

18-10 These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. Illustration 18-8 Vertical analysis of balance sheets SO 4 Describe and apply vertical analysis. Vertical Analysis

18-11 Quality appears to be a profitable enterprise that is becoming even more successful. Illustration 18-9 Vertical analysis of Income statements SO 4 Describe and apply vertical analysis. Vertical Analysis

18-12 Enables a comparison of companies of different sizes. Illustration Intercompany income statement comparison SO 4 Describe and apply vertical analysis. Vertical Analysis

18-13 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio analysis expresses the relationship among selected items of financial statement data. LiquidityProfitabilitySolvency Measures short- term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Financial Ratio Classifications Measures the income or operating success of a company for a given period of time. Measures the ability of the company to survive over a long period of time. Ratio Analysis

18-14 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. The discussion of ratios will include the following types of comparisons. A single ratio by itself is not very meaningful. Ratio Analysis

18-15

18-16 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Liquidity Ratios Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash.  Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.  Ratios include the current ratio, the acid-test ratio, receivables turnover, and inventory turnover. Ratio Analysis

18-17 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets. Ratio Analysis Liquidity Ratios 1. Current Ratio Illustration 18-12

18-18 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Illustration Ratio Analysis 2. Acid-Test / Quick Ratio Liquidity Ratios

18-19 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Illustration Ratio Analysis 2. Acid-Test Ratio Liquidity Ratios Acid-test ratio measures immediate liquidity.

18-20

18-21 SO 5 Illustration Ratio Analysis 3. Receivables Turnover Liquidity Ratios Measures the number of times, on average, the company collects receivables during the period.

18-22 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. A variant of the receivables turnover ratio is to convert it to an average collection period in terms of days. Receivables are collected on average every 36 days. $2,097,000 ($180,000 + $230,000) / 2 = 10.2 times 365 days / 10.2 times = every days Receivables Turnover Ratio Analysis Liquidity Ratios

18-23 SO 5 Illustration Ratio Analysis 4. Inventory Turnover Liquidity Ratios Measures the number of times, on average, the inventory is sold during the period.

18-24 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. A variant of inventory turnover is the days in inventory. Inventory turnover ratios vary considerably among industries. 365 days / 2.3 times = every 159 days $1,281,000 ($500,000 + $620,000) / 2 = 2.3 times Inventory Turnover Ratio Analysis Liquidity Ratios

18-25 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Profitability Ratios Measure the income or operating success of a company for a given period of time.  Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow.  Ratios include the profit margin, asset turnover, return on assets, return on common stockholders’ equity, earnings per share, price-earnings, and payout ratio. Ratio Analysis

18-26 Illustration Ratio Analysis 5. Profit Margin Measures the percentage of each dollar of sales that results in net income. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Profitability Ratios

18-27 Illustration Ratio Analysis 6. Asset Turnover Measures how efficiently a company uses its assets to generate sales. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Profitability Ratios

18-28 Illustration Ratio Analysis 7. Return on Asset An overall measure of profitability. SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Profitability Ratios

18-29 Illustration Ratio Analysis 8. Return on Common Stockholders’ Equity Shows how many dollars of net income the company earned for each dollar invested by the owners. Profitability Ratios SO 5

18-30 Illustration Ratio Analysis 9. Earnings Per Share (EPS) A measure of the net income earned on each share of common stock. Profitability Ratios SO 5

18-31 Illustration Ratio Analysis 10. Price-Earnings Ratio Measures the net income earned on each share of common stock. Profitability Ratios SO 5

18-32 Illustration Ratio Analysis 11. Payout Ratio Measures the percentage of earnings distributed in the form of cash dividends. Profitability Ratios SO 5

18-33 SO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Solvency Ratios Solvency ratios measure the ability of a company to survive over a long period of time.  Debt to Total Assets and  Times Interest Earned are two ratios that provide information about debt-paying ability. Ratio Analysis

18-34 Illustration Ratio Analysis 12. Debt to Total Assets Ratio Measures the percentage of the total assets that creditors provide. SO 5 Solvency Ratios

18-35 Illustration Ratio Analysis 13. Times Interest Earned Provides an indication of the company’s ability to meet interest payments as they come due. SO 5 Solvency Ratios

18-36 Illustration Ratio Analysis SO 5 Summary of Ratios

18-37 Illustration Summary of Ratios SO 5

18-38 “Copyright © 2011 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.” Copyright