Intermediate Financial Accounting Earl K. Stice James D. Stice Chapter 23 Analysis of Financial Statements 18th Edition Intermediate Financial Accounting Earl K. Stice James D. Stice PowerPoint presented by Douglas Cloud Professor Emeritus of Accounting, Pepperdine University © 2012 Cengage Learning

Framework for Financial Statement Analysis Financial statement analysis is the examination of both the relationships among financial statement numbers and the trends in those numbers over time. One purpose of financial statement analysis is to use the past performance of a company to predict its future profitability and cash flows. (continued)

Framework for Financial Statement Analysis Another purpose of financial statement analysis is to evaluate the performance of a company with an eye toward identifying problem areas. Most pieces of information are meaningful only when they can be compared to some benchmark; such as past values or with values for other firms in the same industry. (continued)

Framework for Financial Statement Analysis The Accounting Principles Board stated that comparisons between financial statements are most informative and useful under the following conditions: The presentations are in good form; that is, the arrangement within the statement is identical. The content of the statements is identical; that is, the same items from the underlying accounting records are classified under the same captions. (continued)

Framework for Financial Statement Analysis Accounting principles are not changed, or, if they are changed, the financial effects of the changes are disclosed. Changes in circumstances or in the nature of the underlying transactions are disclosed. To the extent that the foregoing criteria are not met, comparisons may be misleading. (continued)

Common-Size Financial Statements Financial statements are made comparable by dividing all financial statement numbers for a given year by sales for the year. The resulting financial statements are called common-size financial statements, with all amounts for a given year being shown as a percentage of sales for that year.

DuPont Framework The DuPont framework was developed internally at DuPont around 1920. It provides a systematic approach to identifying general factors causing return on equity (ROE) to deviate from normal. Return on equity (net income/equity) is the single measure that summarizes the financial health of a company.

DuPont Framework Return on equity for Colesville Corporation for the years 2013 and 2012 is computed as follows: 2013 2012 Net income $180,000 $205,000 Stockholders’ equity $1,468,000 $1,090,000 Return on equity 12.3% 18.8% (continued)

DuPont Framework Coleville’s ROE is 12.3% for 2013 and 18.8% for 2012.

Accounts Receivable Turnover Colesville Corporation Sales Average accounts receivable $6,600,000 ($333,500 + $375,000)/2 2012 = $354,250 = 18.6 times (continued)

Accounts Receivable Turnover Colesville Corporation Sales Average accounts receivable $5,700,000 ($375,000 + $420,000)/2 2013 = $397,500 = 14.3 times The higher the turnover, the more rapid is a firm’s average collection period for receivables.

Average Collection Period Colesville Corporation Average accounts receivable Average daily sales ($333,500 + $375,000)/2 $6,600,000/365 2012 = $354,250 $18,082 = 19.6 days (continued)

Average Collection Period Colesville Corporation Average accounts receivable Average daily sales ($375,000 + $420,000)/2 $5,700,000/365 2013 = $397,500 $15,616 = 25.5 days What constitutes a reasonable average collection period varies with individual businesses.

Colesville Corporation Inventory Turnover Colesville Corporation Cost of goods sold Average inventory $4,800,000 ($125,000 + $330,000)/2 2012 = $227,500 = 21.1 times (continued)

Colesville Corporation Inventory Turnover Colesville Corporation Cost of goods sold Average inventory $4,000,000 ($330,000 + $225,000)/2 2013 = $277,500 = 14.4 times Inventory turnover allows for evaluation of the firm’s inventory position and the appropriateness of the inventory size.

Number of Days’ Sales in Inventory Colesville Corporation 365 Inventory turnover 365 21.1 2012 = = 17.3 days (continued)

Number of Days’ Sales in Inventory Colesville Corporation 365 Inventory turnover 365 14.4 2013 = = 25.3 days Colesville is holding a 25-day supply of inventory in 2013 compared to a 17-day supply in 2012.

Colesville Corporation Fixed Asset Turnover Colesville Corporation Sales Average fixed assets $6,600,000 ($330,000 + $225,000)/2 2012 = ($925,000 + $1,075,000)/2 $1,000,000 = 6.60 times (continued)

Colesville Corporation Fixed Asset Turnover Colesville Corporation Sales Average fixed assets $5,700,000 ($330,000 + $225,000)/2 2013 = ($1,075,000 + $1,275,000)/2 $1,175,000 = 4.85 times The fixed asset turnover measures a firm’s efficiency in using fixed assets to generate sales.

Colesville Corporation Margin vs. Turnover Profitability and efficiency combine to determine a company’s return on assets. Colesville Corporation Net income Average total assets ROA = $205,000 ($2,191,000 + $2,278,000)/2 2012 = ($1,760,000 + $2,191,000)/2 $1,975,500 = 10.4%

Colesville Corporation Margin vs. Turnover Profitability and efficiency combine to determine a company’s return on assets. Colesville Corporation Net income Average total assets ROA = $180,000 ($2,191,000 + $2,278,000)/2 2013 = $2,234,500 = 8.1% (continued)

Margin vs. Turnover The profitability of each dollar in sales is sometimes called a company’s margin. The degree to which assets are used to generate sales is called turnover. Margin isn’t everything, nor is turnover everything. The important thing is how margin and turnover combine to generate return on assets. (continued)

Leverage Ratios Higher leverage increases return on equity through the following chain of events: More borrowing means that more assets can be purchased without any additional equity investment by stockholders. More assets means that more sales can be generated. More sales means that net income should increase.

Colesville Corporation Debt Ratio Colesville Corporation Total liabilities Total assets $1,101,000 $2,191,000 2012 = = 50.3% $810,000 $2,278,000 2013 = = 35.6% Debt ratio is a measure of the level of borrowing relative to funds used to finance the company.

Colesville Corporation Debt-to-Equity Ratio Colesville Corporation Total liabilities Stockholders’ equity $1,101,000 $1,090,000 2012 = = 1.01 $810,000 $1,468,000 2013 = = 0.55 Another common way to measure the level of leverage is the debt-to-equity ratio.

Colesville Corporation Times Interest Earned Colesville Corporation Income before interest or income taxes Interest expense $290,000 + $60,000 $60,000 2012 = $350,000 $600,000 x 0.10 = 5.8 times (continued)

Colesville Corporation Times Interest Earned Colesville Corporation Income before interest or income taxes Interest expense $260,000 + $40,000 $40,000 2013 = $300,000 $400,000 x 0.10 = 7.5 times This is a measure of the debt position of a company in relation to its earnings ability.

Colesville Corporation Current Ratio Colesville Corporation Current assets Current liabilities $955,500 $501,000 2012 = = 1.91 $855,000 $410,000 2013 = = 2.09 The current ratio is a test of liquidity, or the firm’s ability to meet its current obligations.

Cash Flow Adequacy Ratio Cash from operating activities Total primary cash requirements (continued) 23-29

Cash Flow Adequacy Ratio Colesville Corporation $424,500 $375,000 2012 = = 1.13 $249,000 $602,000 2013 = = 0.41 Because the cash flow adequacy ratio in 2013 is less than 1.0, Colesville was not able to satisfy its primary cash requirements with cash generated by operations.

Colesville Corporation Earnings per Share Colesville Corporation Net income Weighted shares outstanding $205,000 $75,000 2012 = = 2.73 $180,000 $90,000 2013 = = 2.00 This well-known ratio shows the size of the dividend per share of common stock if all the net income is distributed.

Colesville Corporation Dividend Payout Ratio Colesville Corporation Cash dividends Net income $145,000 $205,000 2012 = = 70.7% $102,000 $180,000 2013 = = 56.7% In general, high-growth stable firms have low dividend payout ratios.

Colesville Corporation Price-Earnings Ratio Colesville Corporation Market value per share Earnings per share $60.00 $2.73 2012 = = 22.0 $29.00 $2.00 2013 = = 14.5 High P/E ratios are generally associated with firms for which strong future growth is predicted.

Colesville Corporation Book-to-Market Ratio Colesville Corporation Book value of stockholders’ equity Total market value of equity $1,090,000 $4,200,000 2012 = = 0.26 $1,468,000 $2,900,000 2013 = = 0.51 The book-to-market ratio reflects the difference between a company’s balance sheet value and the company’s actual market value.

Impact of Alternative Accounting Methods If companies are using different accounting practices, it will impact the comparability of ratios.

Introduction to Equity Valuation The following information for McDonald’s will be used for a simple valuation model: Assume the required rate of return on equity capital for McDonald’s is 15%.

Constant Future Dividends The appropriate formula is as follows: Price = Dividends Required rate of return on equity capital Price = $2.05 0.15 = $13.67 Thus, the implied price per share for McDonald’s for 2009 was $13.67.

Constant Dividend Growth McDonald’s growth rate over the past 12 years has exceeded 20%. Assuming a slower future growth rate of 12%, the implied price per share is computed as follows: Price = Dividends Required rate of return on equity – Expected future dividend growth rate Price = $2.05 0.150 – 0.12 = $68.33

Price-Earnings Multiple An investor can value a company’s share by using the information in the P/E ratio as follows: Price = Earnings × P/E ratio P/E ratios for a selection of restaurant chains at the end of 2009 are as follows: (continued)

Price-Earnings Multiple Using the average of these ratios (27.0), the implied price per share 2009 for McDonald’s is computed as follows: Price = Earnings × P/E ratio Price = $4.11 × 27.0 = $110.97

Discounted Free Cash Flow Free cash flow is defined as: Cash from operating activities – Cash paid for capital expenditures = Free cash flow

Comparison of the Valuation Models The computed prices for McDonald’s shares at the end of 2009, using each of the four models are as follows: The actual market price of a share of McDonald’s stock at the end of 2009 was $61.91.

Chapter 23 ₵ The End $