Chapter 15 Financial Statement Analysis Student Version These slides should be viewed using the presentation mode (left click your mouse on the icon).

Describe basic financial statement analytical methods. Learning Objective 1 Describe basic financial statement analytical methods.

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

Horizontal Analysis LO 1 Horizontal Analysis: Difference $17,000 Lincoln Horizontal Analysis: Difference $17,000 Base year (2011) $533,000 = 3.2%

Horizontal Analysis LO 1 Horizontal Analysis: Difference $25,800 Lincoln Horizontal Analysis: Difference $25,800 Base year (2011) $64,700 = 39.9%

Horizontal Analysis LO 1 Horizontal Analysis: Difference $296,500 Lincoln Horizontal Analysis: Difference $296,500 Base year (2011) $1,234,000 = 24.0%

Horizontal Analysis LO 1 Horizontal Analysis: Difference $37,500 Lincoln Horizontal Analysis: Difference $37,500 Base year (2011) $ 100,000 = 37.5%

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

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

Common-Sized Statements LO 1 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.

Learning Objective 2 Use financial statement analysis to assess the liquidity and solvency of a business.

Liquidity and Solvency Analysis LO 2 Liquidity and Solvency Analysis All users of financial statements are interested in the ability of a company to do the following: Maintain liquidity and solvency. Earn income, called profitability.

Current Position Analysis LO 2 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 and includes the computation and analysis of the following: Working capital Current ratio Quick ratio

LO 2 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

LO 2 Current Ratio The current ratio, sometimes called the working capital ratio or bankers’ 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. 2012 2011 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

LO 2 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. 2012 2011 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 LO 2 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 liquidity. The accounts receivable turnover is computed as follows: Accounts Receivable Turnover = Net Sales Average Accounts Receivable

Accounts Receivable Turnover LO 2 Accounts Receivable Turnover Lincoln The accounts receivable turnover for Lincoln Company is computed below. 2012 2011 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 LO 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. 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 LO 2 Number of Days’ Sales in Receivables Lincoln 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 2012 2011 Number of days’ sales in receivables 28.6 39.5 $117,500 $4,104 $130,000 $3,288

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

LO 2 Inventory Turnover Lincoln Lincoln’s inventory balance at the beginning of 2011 is $311,000. 2012 2011 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 LO 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. 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 LO 2 Number of Days’ Sales in Inventory Lincoln The number of days’ sales in inventory for Lincoln Company is computed below. 2012 2011 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

Long-Term Liabilities 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. Lincoln 2012 2011 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 LO 2 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: Lincoln Ratio of Liabilities to Stockholders’ Equity Total Liabilities Total Stockholders’ Equity =

Ratio of Liabilities to Stockholders’ Equity LO 2 Ratio of Liabilities to Stockholders’ Equity The ratio of liabilities to stockholders’ equity for Lincoln Company is computed below. Lincoln Total liabilities $310,000 $443,000 Total stockholders’ equity $829,500 $787,500 2012 2011 Ratio of liabilities to stockholders’ equity 0.4 0.6 $310,000 $829,500 $443,000 $787,500

Number of Times Interest Charges Earned LO 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 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 LO 2 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 LO 2 Number of Times Interest Charges Earned The number of times interest charges are earned for Lincoln Company is computed below. Lincoln 2012 2011 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 Preferred Dividends Are Earned LO 2 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 LO 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 LO 3 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 LO 3 Ratio of Net Sales to Assets Lincoln The ratio of net sales to assets for Lincoln Company is computed below. 2012 2011 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 LO 3 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 LO 3 Rate Earned on Total Assets Lincoln This ratio for Lincoln Company is computed below. Total assets are $1,187,500 at the beginning of 2011. 2012 2011 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 LO 3 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 LO 3 Rate Earned on Stockholders’ Equity The rate for Lincoln Company is computed below. Total stockholders’ equity is $750,000 at the beginning of 2011. Lincoln 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 2012 2011 Rate earned on stockholders’ equity 11.3% 10.0% $91,000 $808,500 $76,500 $768,750

Rate Earned on Stockholders’ Equity LO 3 Rate Earned on Stockholders’ Equity The difference between the rate earned on stockholders’ equity and the rate earned on total assets is called leverage. For Lincoln Company, the effect of leverage is computed as follows: Lincoln 2012 2011 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 Common Stockholders’ Equity LO 3 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 LO 3 Rate Earned on Common Stockholders’ Equity Lincoln Company had $150,000 of 6% preferred stock outstanding on December 31, 2012 and 2011. Thus, preferred dividends of $9,000 ($150,000 x 6%) are deducted from net income. Lincoln’s common stockholders’ equity is determined as follows: Lincoln (continued)

Rate Earned on Common Stockholders’ Equity LO 3 Rate Earned on Common Stockholders’ Equity Lincoln 2012 2011 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 LO 3 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 LO 3 Earnings per Share on Common Stock Lincoln Earnings per share for Lincoln Company is computed below. 2012 2011 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

LO 3 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 =

LO 3 Price-Earnings Ratio Lincoln The price-earnings ratio for Lincoln Company is computed below. 2012 2010 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

LO 3 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 LO 3 Dividends per Share Lincoln Dividends per Share Dividends Shares of Common Stock Outstanding = 2012 2011 The dividends per share for Lincoln Company are computed below. 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

LO 3 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 =

LO 3 Dividend Yield Lincoln The dividend yield for Lincoln Company is computed below. 2012 2011 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

Describe the contents of corporate annual reports. Learning Objective 4 Describe the contents of corporate annual reports.

Corporate Annual Reports LO 4 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

Report on Internal Control LO 4 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 LO 4 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.

Financial Statement Analysis The End