Financial Statement Analysis Chapter 15

Learning Objectives Describe basic financial statement analytical methods. Use financial statement analysis to assess the solvency of a business. Use financial statement analysis to assess the profitability of a business. Describe the contents of corporate annual reports.

Learning Objective 1 Describe basic financial statement analytical methods.

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

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

Horizontal Analysis

Horizontal Analysis Horizontal Analysis: Difference $17,000 Base year (2013) $533,000 = 3.2%

Horizontal Analysis

Horizontal Analysis Horizontal Analysis: Difference $25,800 Base year (2013) $64,700 = 39.9%

Horizontal Analysis

Horizontal Analysis Horizontal Analysis: Difference $296,500 Base year (2013) $1,234,000 = 24.0%

Horizontal Analysis

Horizontal Analysis Horizontal Analysis: Difference $37,500 Base year (2013) $ 100,000 = 37.5%

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

Vertical Analysis 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

Vertical Analysis Vertical Analysis: Current Assets $550,000 Total Assets $ 1,139,500 = 48.3%

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

Vertical Analysis

Vertical Analysis Vertical Analysis: Selling expenses $191,000 Net sales $1,498,000 = 12.8%

Common-Sized Statements In a common-sized statement, all items are expressed as percentages with no dollar amounts shown. Common-sized statements are useful for comparing the current period with prior periods, individual businesses with one another, or one business with industry averages.

Common-Sized Statements

Learning Objective 2 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: Meet its financial obligations (debts), called solvency. Earn income, called profitability.

Solvency Analysis Solvency analysis focuses on the ability of a business to pay its current and noncurrent liabilities. Solvency and profitability are interrelated. A company that cannot pay its debts will have difficulty obtaining credit, which can decrease its profitability.

Current Position Analysis A company’s ability to pay its current liabilities is called current position analysis. It is of special interest to short-term creditors.

Working Capital The excess of current assets over current liabilities is called working capital. Working capital is often used to evaluate a company’s ability to pay current liabilities. Working capital is computed as follows: Working Capital = Current Assets – Current Liabilities

Current Ratio The current ratio, sometimes called the working capital ratio, also measures a company’s ability to pay its current liabilities. The current ratio is computed as follows: Current Ratio = Current Assets Current Liabilities

Current Ratio The current ratio for Lincoln Company is computed below. 2014 2013 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

Quick Ratio A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio, or acid-test ratio. It is computed as follows: Quick Ratio = Quick Assets Current Liabilities Quick assets are cash and other assets that can be easily converted to cash.

Quick Assets The quick ratio for Lincoln Company is computed below. 2014 2013 Quick assets: Cash $ 90,500 $ 64,700 Temporary Investments 75,000 60,000 Accounts receivable (net) 115,000 120,000 Total quick assets $280,500 $244,700 Current liabilities $210,000 $243,000 Quick ratio 1.3 1.0 $280,500 $210,000 $244,700 $243,000

Accounts Receivable Turnover The relationship between sales and accounts receivable may be stated as accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a company’s solvency. The accounts receivable turnover is computed as follows: Accounts Receivable Turnover = Net Sales Average Accounts Receivable

Accounts Receivable Turnover The accounts receivable turnover for Lincoln Company is computed below. 2014 2013 Net sales $1,498,000 $1,200,000 Accounts receivable (net): Beginning of year $ 120,000 $ 140,000 End of year 115,000 120,000 Total $ 235,000 $ 260,000 Average (Total ÷ 2) $ 117,500 $ 130,000 Accounts receivable turnover 12.7 9.2 $1,498,000 $117,500 $1,200,000 $130,000

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. It is computed as follows: Number of Days’ Sales in Receivables Average Accounts Receivable Average Daily Sales = Net Sales 365

Number of Days’ Sales in Receivables The number of days’ sales in receivables for Lincoln Company is computed below. Average accounts receivable (Total accounts receivable ÷ 2) $ 117,500 $ 130,000 Net sales $1,498,000 $1,200,000 Average daily sales (Net sales ÷ 365) $ 4,104 $ 3,288 2014 2013 Number of days’ sales in receivables 28.6 39.5 $117,500 $4,104 $130,000 $3,288

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 a firm in managing its inventory. The inventory turnover is computed as follows: Inventory Turnover = Cost of Goods Sold Average Inventory

Inventory Turnover Lincoln’s inventory balance at the beginning of 2013 is $311,000. 2014 2013 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 3.8 2.8 $1,043,000 $273,500 $820,000 $297,000

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. The number of days’ sales in inventory is computed as follows: 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 The number of days’ sales in inventory for Lincoln Company is computed below. 2014 2013 Average Inventory $273,500 $297,000 $547,000 ÷ 2 $594,000 ÷ 2 (continued)

Number of Days’ Sales in Inventory The number of days’ sales in inventory for Lincoln Company is computed below. 2014 2013 Average Inventory $273,500 $297,000 Average daily cost of goods sold $2,858 $2,247 $1,043,000 ÷ 365 $820,000 ÷ 365 Number of days’ sales in inventory 95.7 132.2 $273,500 $2,858 $297,000 $2,247

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 note-holders or bondholders. It also indicates the ability of the business to borrow additional funds on a long- term basis. The ratio is computed as follows: Ratio of Fixed Assets to Long-Term Liabilities Fixed Assets (net) Long-Term Liabilities =

Ratio of Fixed Assets to Long-Term Liabilities To illustrate, the ratio of fixed assets to long- term liabilities for Lincoln Company is computed below. 2014 2013 Fixed assets (net) $444,500 $470,000 Long-term liabilities $100,000 $200,000 Ratio of fixed assets to long-term liabilities 4.4 2.4 $444,500 $100,000 $470,000 $200,000

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

Ratio of Liabilities to Stockholders’ Equity The ratio of liabilities to stockholders’ equity for Lincoln Company is computed below. Total liabilities $310,000 $443,000 Total stockholders’ equity $829,500 $787,500 2014 2013 Ratio of liabilities to stockholders’ equity 0.4 0.6 $310,000 $829,500 $443,000 $787,500

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 debt- holders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio.

Number of Times Interest Charges Earned It is computed as follows: Number of Times Interest Charges Are Earned Income Before Income Tax + Interest Expense Interest Expense =

Number of Times Interest Charges Earned The number of times interest charges are earned for Lincoln Company is computed below. 2014 2013 Income before income tax $162,500 $134,600 Add interest expense 6,000 12,000 Amount available to meet interest charges $168,500 $146,600 Number of times interest charges earned 28.1 12.2 $146,600 $12,000 $168,500 $6,000

Number of Times Interest Charges Earned The number of times interest charges are earned can be adapted for use with dividends on preferred stock. The number of times preferred dividends are earned is computed as follows: Number of Times Preferred Dividends Are Earned Net Income Preferred Dividends =

Learning Objective 3 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.

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. The ratio is computed as follows: Ratio of Net Sales to Assets Net Sales Average Total Assets (excluding long-term investments) =

Ratio of Net Sales to Assets The ratio of net sales to assets for Lincoln Company is computed below. 2014 2013 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 Average (Total ÷ 2) $1,048,750 $1,031,500 Excludes long-term investments (continued)

Ratio of Net Sales to Assets The ratio of net sales to assets for Lincoln Company is computed below. 2014 2013 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 Average (Total ÷ 2) $1,048,750 $1,031,500 Ratio of net sales to assets 1.4 1.2 $1,498,000 $1,048,750 $1,200,000 $1,031,500

Rate Earned on Total Assets The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed. It is computed as follows: Rate Earned on Total Assets Net Income + Interest Expense Average Total Assets =

Rate Earned on Total Assets This ratio for Lincoln Company is computed below. Total assets are $1,187,500 at the beginning of 2013. 2014 2013 Net income $ 91,000 $ 76,500 Plus interest expense 6,000 12,000 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 Average (Total ÷ 2) $1,185,000 $1,209,000 Rate earned on total assets 8.2% 7.3% $97,000 $1,185,000 $88,500 $1,209,000

Rate Earned on Stockholders’ Equity The rate earned on stockholders’ equity measures the rate of income earned on the amount invested by the stockholders. It is computed as follows: Rate Earned on Stockholders’ Equity Net Income Average Total Stockholders’ Equity =

Rate Earned on Stockholders’ Equity The rate for Lincoln Company is computed below. Total stockholders’ equity is $750,000 at the beginning of 2013. 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 Average (Total ÷ 2) $ 808,500 $ 768,750 2014 2013 Rate earned on stockholders’ equity 11.3% 10.0% $91,000 $808,500 $76,500 $768,750

Rate Earned on Stockholders’ Equity The difference between the rate earned on stockholders’ equity and the rate earned on total assets is called leverage.

Rate Earned on Stockholders’ Equity For Lincoln Company, the effect of leverage is computed as follows: 2014 2013 Rate earned on stockholders’ equity 11.3% 10.0% Less rate earned on total assets 8.2 7.3 Effect of leverage 3.1% 2.7%

Rate Earned on Stockholders’ Equity

Rate Earned on Common Stockholders’ Equity The rate earned on common stockholders’ equity measures the rate of profits earned on the amount invested by the common stockholders. It is computed as follows: Rate Earned on Common Stockholders’ Equity Net Income – Preferred Dividends Average Common Stockholders’ Equity =

Rate Earned on Common Stockholders’ Equity Lincoln Company had $150,000 of 6% preferred stock outstanding on December 31, 2014 and 2013. Thus, preferred dividends of $9,000 ($150,000 x 6%) are deducted from net income. Lincoln’s common stockholders’ equity is determined as follows: (continued)

Rate Earned on Common Stockholders’ Equity 2014 2013 Net income $ 91,000 $ 76,500 Less preferred dividends 9,000 9,000 Total $ 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 Average (Total ÷ 2) $ 658,500 $ 618,750 Rate earned on common stockholders’ equity 12.5% 10.9% $82,000 $658,500 $67,500 $618,750

Earnings per Share on Common Stock Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock. GAAP requires the reporting of earnings per share in the income statement. It is computed as follows: Earnings per Share (EPS) on Common Stock Net Income – Preferred Dividends Shares of Common Stock Outstanding =

Earnings per Share on Common Stock EPS for Lincoln Company is computed below. 2014 2013 Net income $91,000 $76,500 Less preferred dividends 9,000 9,000 Total $82,000 $67,500 Shares of common stock 50,000 50,000 Earnings per share on common stock $1.64 $1.35 $82,000 50,000 $67,500 50,000

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. The price-earnings ratio is computed as follows: Price-earnings (P/E) ratio Market Price per Share of Common Stock Earnings per Share on Common Stock =

Price-Earnings Ratio The P/E ratio for Lincoln Company is computed below. 2014 2013 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

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. The ratio for dividends per share is at the top of the next slide. (continued)

Shares of Common Stock Outstanding Dividends per Share The dividends per share for Lincoln Company are computed below. Dividends per Share Dividends Shares of Common Stock Outstanding = 2014 2013 Dividends on common stock $40,000 $30,000 Shares of common stock outstanding ÷ 50,000 ÷ 50,000 Dividends per share of common stock $0.80 $0.60

Dividends and Earnings per Share

Dividend Yield The dividend yield on common stock measures the rate of return to common stockholders from cash dividends. It is of special interest to investors whose objective is to earn dividends from their investment. It is computed as follows: Dividend Yield Dividends per Share of Common Stock Market Price per Share of Common Stock =

Dividend Yield The dividend yield for Lincoln Company is computed below. 2014 2013 Dividends per share of common stock $ 0.80 $ 0.60 Market price per share of common stock $41.00 $27.00 Dividend yield on common stock 2.0% 2.2% $0.80 $41 $0.60 $27

Summary of Analytical Measures (continued)

Summary of Analytical Measures (concluded)

Learning Objective 4 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 internal control Report on fairness of the financial statements

Management Discussion and Analysis Management’s Discussion and Analysis (MD&A) is required in annual reports filed with the SEC. It contains management’s analysis of current operations and its plans for the future. Typical items included in the MD&A are: Management’s analysis and explanations of any significant changes between the current and prior year’s financial statements. (continued)

Management Discussion and Analysis Important accounting principles or policies that could affect interpretation of the financial statements. Management’s assessment of the company’s liquidity and the availability of capital to the company. Significant risk exposures that might affect the company. Any “off-balance-sheet” arrangements such as leases not included directly in the financial statements.

Report on Internal Control 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. It also requires a public accounting firm to verify management’s conclusions on internal control.

Report on Fairness of Financial Statements All publicly held corporations are required by the Sarbanes-Oxley Act of 2002 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.

Unusual Items on the Income Statement Appendix Unusual Items on the Income Statement

Unusual Items on the 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 segment’s 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.

Discontinued Operations Jones Corporation produces and sells electrical products, hardware supplies, and lawn equipment. Because of lack of profits, Jones discontinues its electrical products operation and sells the remaining inventory and other assets at a loss of $100,000. Exhibit 11 (next slide) illustrates the reporting of the loss on the discontinued operations.

Discontinued Operations

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

Extraordinary Items

Reporting Earnings per Share

Financial Statement Analysis The End