Financial Statement Analysis 15 Financial Statement Analysis Student Version

Describe basic financial statement analytical methods. 1 Describe basic financial statement analytical methods. 15-2

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

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

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

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

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

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

Vertical Analysis of Balance Sheet 1 Vertical Analysis of Balance Sheet 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.

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

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

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

Common-Size Statements 1 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 Exhibit 7 Common-Sized Income Statement

Use financial statement analysis to assess the solvency of a business. 2 Use financial statement analysis to assess the solvency of a business. 15-15

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.

Working Capital = Current Assets – Current Liabilities 2 Working Capital = Current Assets – Current Liabilities 2010 2009 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 Current Liabilities Current Ratio = 2010 2009 2010 2009 Current assets $550,000 $533,000 Current liabilities $210,000 $243,000 Current ratio 2.6 2.2 $550,000 $210,000 $533,000 $243,000

2 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 assets are cash and other current assets that can be quickly converted to cash. 2010 2009 Quick assets: Cash $ 90,500 $ 64,700 Temporary Investments 75,000 60,000 Accounts receivable (net) 115,000 120,000 a. Total quick assets $280,500 $244,700 b. Current liabilities $210,000 $243,000 Quick ratio (a ÷ b) 1.3 1.0

Accounts Receivable Turnover 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.

Average Accounts Receivable 2 Accounts Receivable Turnover = Net Sales Average Accounts Receivable 2010 2009 a. Net sales $1,498,000 $1,200,000 Accounts receivable (net): Beginning of year $ 120,000 $ 140,000 End of year 115,500 120,000 Total $ 235,000 $ 260,000 Average (Total ÷ 2) $ 117,500 $ 130,000 Accounts receivable turnover (a ÷ b) 12.7 9.2

Number of Days’ Sales in Receivables 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 2010 2009 Average accounts receivable (Total accounts 2010 2009 Average accounts receivable (Total accounts receivable ÷ 2) $ 117,500 $ 130,000 Net sales $1,498,000 $1,200,000 Average daily sales (Sales ÷ 365) $ 4,104 $ 3,288 Number of days’ sales in receivables (a ÷ b) 28.6 39.5

2 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 Cost of Goods Sold Average Inventory Inventory Turnover = 2010 2009 2010 2009 a. Cost of goods sold $1,043,000 $ 820,000 Inventories: Beginning of year $ 283,000 $ 311,000 End of year 264,000 283,000 Total $ 547,000 $ 594,000 Average (Total ÷ 2) $ 273,500 $ 297,000 Inventory turnover (a ÷ b) 3.8 2.8

Number of Days’ Sales in Inventory 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.

Average Daily Cost of Goods Sold 2 Average Inventory Average Daily Cost of Goods Sold Number of Days’ Sales in Inventory = Cost of Goods Sold 365 a. Average inventory (Total ÷ 2) $ 273,500 $ 297,000 Cost of goods sold $1,043,000 $ 820,000 Average daily cost of goods sold (COGS ÷ 365 days) $2,858 $2,247 2010 2009 Number of days’ sales in inventory (a ÷ b) 95.7 132.2

Ratio of Fixed Assets to Long-Term Liabilities 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.

Long-Term Liabilities 2 Ratio of Fixed Assets to Long-Term Liabilities Fixed Assets (net) Long-Term Liabilities = 2010 2009 a. Fixed assets (net) $444,500 $470,000 b. Long-term liabilities $100,000 $200,000 Ratio of fixed assets to long-term liabilities (a ÷ b) 4.4 2.4

Ratio of Liabilities to Stockholders’ Equity 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.

Total Stockholders’ Equity 2 Total Liabilities Total Stockholders’ Equity Ratio of Liabilities to Stockholders’ Equity = 2010 2009 a. Total liabilities $310,000 $443,000 b. Total stockholders’ equity $829,500 $787,500 Ratio of liabilities to stockholders’ equity ( a÷ b) 0.4 0.6

Number of Times Interest Charges Earned 2 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 Income Before Income Tax + Interest Expense Number of Times Interest Charges Earned = 2010 2009 Income before income tax $162,500 $134,600 a. Add interest expense 6,000 12,000 Amount available to meet interest charges $168,500 $146,600 Number of times interest charges earned (b ÷ a) 28.1 12.2

Number of Times Preferred Dividends Are Earned 2 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 =

3 Use financial statement analysis to assess the profitability of a business. 15-37

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

Ratio of Net Sales to Assets 3 Net Sales Average Total Assets Ratio of Net Sales to Assets = 2010 2009 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

Ratio of Net Sales to Assets 3 Net Sales Average Total Assets Ratio of Net Sales to Assets = 2010 2009 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) 1.4 1.2

3 Net Income + Interest Expense Average Total Assets Rate Earned on Total Assets = 2010 2009 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 Rate earned on total assets (a ÷ b) 8.2% 7.3%

3 Net Income Rate Earned on Stockholders’ Equity Average Total Stockholders’ Equity Rate Earned on Stockholders’ Equity = a. Net income $ 91,000 $ 76,500 Stockholders’ equity: Beginning of year $ 787,500 $ 750,000 End of year 829,500 787,500 Total $1,617,000 $1,537,500 b. Average (Total ÷ 2) $ 808,500 $ 768,750 2010 2009 Rate earned on stockholders’ equity (a ÷ b) 11.3% 10.0%

3 Net Income – Preferred Dividends Average Common Stockholders’ Equity Rate Earned on Common Stockholders’ Equity = 2010 2009 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 679,500 637,500 Total $1,317,000 $1,237,500 b. Average (Total ÷ 2) $ 658,500 $ 618,750 Rate earned on common stockholders’ equity (a ÷ b) 12.5% 10.9%

3 Net Income – Preferred Dividends Shares of Common Stock Outstanding Earnings per Share (EPS) on Common Stock = 2010 2009 Net income $91,000 $76,500 Preferred dividends 9,000 9,000 Remainder—identified with common stock $82,000 $67,500 b. Shares of common stock 50,000 50,000 Earnings per share on common stock (a ÷ b) $1.64 $1.35

3 Market Price per Share of Common Stock Earnings per Share on Common Stock Price-earnings (P/E) ratio = 2010 2009 Market price per share of common stock $41.00 $27.00 Earnings per share on common stock ÷ 1.64 ÷ 1.35 Price-earnings ratio on common stock 25 20

Shares of Common Stock Outstanding 3 Dividends Shares of Common Stock Outstanding Dividends per Share = 2010 2009 a. Dividends $40,000 $30,000 b. Shares of common stock outstanding 50,000 50,000 Dividends per share of common stock (a ÷ b) $0.80 $0.60

3 Dividend yield on Dividends per Share of Common Stock Market Price per Share of Common Stock Dividend Yield = 2010 2009 a. Dividends per share of common stock $ 0.80 $ 0.60 b. Market price per share of common stock 41.00 27.00 Dividend yield on common stock 2.0% 2.2%