Financial Statement Analysis CHAPTER 13 Financial Statement Analysis © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

FINANCIAL STATEMENT ANALYSIS The way to compare companies of different sizes is to use standard measures Financial ratios are standard measures that enable analysts to compare companies of different sizes © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

FINANCIAL STATEMENT ANALYSIS In addition to the financial statements, annual reports contain the following: Notes to the financial statements, including a summary of the accounting methods used Management’s discussion and analysis (MD&A) of the financial results The auditor’s report Comparative financial data for a series of years © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

FINANCIAL STATEMENT ANALYSIS For example, the graphs in the next exhibit show Bristol-Myers Squibb’s three-year trend of net sales, market value of the company’s stock, and cumulative return to the company’s stockholders © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Representative Financial Data of Bristol-Myers Squibb Company Net Sales $ Millions Market Value $ Millions Cumulative Return to Shareholders $20,000 15,000 10,000 5,000 $140,000 105,000 70,000 35,000 250% 200 150 100 50 96 97 98 96 97 98 96 97 98 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

FINANCIAL STATEMENT ANALYSIS The objectives of financial statement analysis are to help investors Predict their expected returns (see the previous graph) Assess the risks associated with those returns © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS The study of percentage changes in comparative statements is called horizontal analysis Computing a percentage change in comparative statements requires two steps: Computing the dollar amount of the change from the base period to the later period Dividing the dollar amount of change by the base-period amount © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Horizontal analysis is illustrated for Bristol-Myers Squibb as follows (dollar amounts in millions): Increase (Decrease) 1998 1997 Amount Percent Sales $18,284 $16,701 $1,583 9.5% Net income 3,141 3,205 (64) (2.0%) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Dollar amount of change The percentage change in Bristol-Myers Squibb’s sales during 1998 is 9.5%, computed as follows: Step 1. Compute the dollar amount of change in sales from 1997 to 1998: 1998 1997 Increase - = $18,284 $16,701 $1,583 Step 2. Divide the dollar amount of change by the base-period amount to compute the percentage change during the later period: Dollar amount of change Percentage Change = Base-year amount $1,583 = = 9.5% $16,701 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS Trend percentages Are a form of horizontal analysis that examine more than a two- or three-year period Use a selected base year whose amounts are set equal to 100 percent © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS To compute trend percentages, each item for following years is divided by the corresponding amount during the base year Any year $ Trend % = Base year $ © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS Bristol-Myers Squibb Company showed sales, cost of goods sold, and gross profit for the past six years as follows: © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS The base year is 1993 Trend percentages for Net sales are computed by dividing each net sales amount by the 1993 amount of $11,413 Trend percentages for Cost of products sold is computed by dividing by each cost of products sold amount by $3,029 Trend percentages for Gross profit use the base gross profit of $8,383 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS The resulting trend percentages follow: Sales, cost of products sold, and gross profit have trended upward at almost identical rates throughout the five-year period © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

VERTICAL ANALYSIS Vertical analysis of a financial statement reveals the relationship of each statement item to a specified base, which is the 100% figure Every other item on the financial statement is then reported as a percentage of that base When an income statement is analyzed vertically, net sales is usually the base © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

VERTICAL ANALYSIS Vertical analysis of balance sheet amounts are shown as a percentage of total assets The next exhibit shows the vertical analysis of Bristol-Myers Squibb’s income statement as a percentage of net sales Each income statement item Vertical analysis % = Net Sales © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

COMMON-SIZE STATEMENTS A common-size statement simplifies the comparison of different companies because their amounts are stated in percentages On a common-size income statement, each item is expressed as a percentage of the net sales amount In the balance sheet, the common size is total assets or the sum of total liabilities and stockholders’ equity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BRISTOL-MYERS SQUIBB COMPANY Analysis of Current Assets December 31,1998 and 1997 Percent of Total Assets 1998 1997 Current Assets: Cash and cash equivalents Time deposits and marketable securities Receivables, net Inventories Prepaid expenses Total current assets Long-Term Assets Total Assets 13.8% 1.8 19.6 11.5 7.3 54.0 46.0 100.0% 9.7% 2.3 19.9 12.0 7.8 51.7 48.3 100.0% © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BENCHMARKING Benchmarking is the practice of comparing a company to a standard set by other companies, with a view toward improvement Benchmarking against the industry average Managers, investors, and creditors need to know how one company compares with similar companies © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BENCHMARKING The next exhibit gives the common-size income statement of Bristol-Myers Squibb Company compared with the average for the pharmaceuticals industry Its gross profit percentage is much higher than the industry average Its percentage of net income is significantly higher that the industry average © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BRISTOL-MYERS SQUIBB COMPANY Common-Size Income Statement for Comparison with Industry Average Year Ended December 31, 1998 Bristol-Myers Squibb Industry Average Net sales Cost of products sold Gross profit Operating expenses Earnings from continuing operation before income tax Income tax expense Earnings from continuing operations Special items (discontinued operations, extraordinary gains and losses, and effect of accounting changes) Net earnings 100.0% 26.6 73.4 50.1 23.3 6.1 17.2 17.2% 100.0% 54.7 45.3 36.5 8.8 2.3 6.5 1.4 5.1% © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BENCHMARKING Benchmarking against a key competitor Common-size statements are also used to compare the company to another specific company The next exhibit presents the common-size income statements of Bristol-Myers Squibb and Procter & Gamble Bristol-Myers Squibb has higher percentages of gross profit, earnings from continuing operations, and net earnings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BRISTOL-MYERS SQUIBB COMPANY Common-Size Income Statement for Comparison with Key Competitor Year Ended December 31, 1998 Bristol-Myers Squibb Proctor & Gamble Net sales Cost of products sold Gross profit Operating expenses Earnings from continuing operation before income tax Income tax expense Earnings from continuing operations Special items (discontinued operations, extraordinary gains and losses, and effect of accounting changes) Net earnings 100.0% 26.6 73.4 50.1 23.3 6.1 17.2 17.2% 100.0% 56.7 43.3 27.9 15.4 5.2 10.2 10.2% © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

STATEMENT OF CASH FLOWS IN DECISION MAKING The cash-flow statement summarizes sources and uses of the entity’s cash flows Internal and external decision makers want to see the majority of cash inflows coming from operating activities WHY? © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

STATEMENT OF CASH FLOWS IN DECISION MAKING A company cannot stay in business for long if it cannot generate enough cash from operations to cover operating expenses While borrowing and investing activities provide cash for business use, long-term reliance on these activities for sources of cash is not advised © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

USING RATIOS TO MAKE BUSINESS DECISIONS A ratio expresses the relationship of one number to another The ratios used to make business decisions may be classified as follows: Ratios that measure the company’s ability to pay current liabilities Ratios that measure the company’s ability to sell inventory and collect receivables © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

USING RATIOS TO MAKE BUSINESS DECISIONS Ratios that measure the company’s ability to pay long-term debt Ratios that measure the company’s profitability Ratios used to analyze the company’s stock as an investment © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING A COMPANY’S ABILITY TO PAY CURRENT LIABILITIES Working capital is defined as follows: Working capital = Current assets - Current liabilities © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING A COMPANY’S ABILITY TO PAY CURRENT LIABILITIES Working capital is widely used to measure a business’s ability to meet its short-term obligations with its current assets The larger the working capital, the better able is the business to pay its debts © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT RATIO The current ratio Is current assets divided by current liabilities Measures the ability of the company to pay current liabilities with current assets The following slides give the comparative income statement and balance sheet of Palisades Furniture, Inc. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The current ratio of Palisades Furniture, Inc The current ratio of Palisades Furniture, Inc., at December 31, 20X3 and 20X2, follow, along with the average for the retail furniture industry: Palisades’ Current Ratio Formula 20X3 20X2 Current assets $262,000 $236,000 Current ratio = = 1.85 = 1.87 Current liabilities $142,000 $126,000 In most industries a current ratio of 2.0 is considered good Industry Average = 1.70 In general, a higher current ratio indicates a stronger financial position © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACID TEST RATIO The acid-test (or quick) ratio Indicates whether the entity could pay all its current liabilities if they came due immediately Is computed by dividing cash, short-term investments, and net current receivables (accounts and notes receivable, net of allowances) by current liabilities © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades Furniture’s acid-test ratios for 20X3 and 20X2 are: Palisades’ Acid-Test Ratio Formula 20X3 20X2 Cash + short-term investments + net current receivables Acid-Test ratio = $29,000 + $0 + $114,000 $32,000 + $0 + $85,000 = 1.01 = 0.93 Current liabilities $142,000 $126,000 An acid-test ratio of 0.90 to 1.00 is acceptable in most industries Industry Average = 0.40 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING ABILITY TO SELL INVENTORY AND COLLECT RECEIVABLES Three ratios are presented that measure the company’s ability to sell inventory and collect receivables Inventory turnover Accounts receivable turnover Days’ sales in receivables © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INVENTORY TURNOVER Inventory turnover is A measure of the number of times a company sells its average level of inventory during a year Computed by dividing the cost of goods sold by the average inventory for the period © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INVENTORY TURNOVER A high rate of turnover indicates relative ease in selling inventory; a low turnover indicates difficulty in selling In general, companies prefer a high inventory turnover Inventory turnover varies widely with the nature of the business © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Inventory Turnover Palisades Furniture’s inventory turnover for 20X3 is: Palisades’ Inventory Turnover Formula Cost of goods sold $513,000 Inventory turnover = = 4.58 Average inventory $112,000 Industry Average = 3.00 Palisades Furniture’s turnover of 4.58 times a year is high for its industry, which has an average turnover of 3.00 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTS RECEIVABLE TURNOVER Measures a company’s ability to collect cash from credit customers Is computed by dividing net sales by average net accounts receivable The resulting ratio indicates how many times during the year the average level of receivables was turned into cash © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTS RECEIVABLE TURNOVER In general, the higher the ratio, the more successfully the business collects cash and the better off its operations A receivable turnover that is too high may indicate that credit is too tight, causing the loss of sales to good customers © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Accounts Receivable Turnover Palisades’ Furniture’s accounts receivable turnover ratio for 20X3 is computed as follows: Palisades’ Accounts Receivable Turnover Formula Accounts receivable = turnover Net credit sales $858,000 = 8.62 Average net accounts receivable $99,000 Industry Average = 31.3 Palisades’ receivable turnover of 8.62 is much lower than the industry average, possibly because larger stores sell their receivables © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DAYS’ SALES IN RECEIVABLES The days’-sales-in-receivables ratio tells How many days’ sales remain in Accounts Receivable Is computed by a two-step process First, divide net sales by 365 days to figure the average sales amount for one day Second, divide this average day’s sales amount into the average net accounts receivable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Days’ Sales in Accounts Receivable Formula Net sales $858,000 1. One day’s sales = = $2,351 365 days 365 days Average net accounts receivable Days’ sales in average accounts = receivable 2. $99,500 = 42 days One days’ sales $2,351 Industry Average = 2 days The day’s sales in receivables for Palisades is higher (worse) than the industry average because the company collects its own receivables © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING A COMPANY’S ABILITY TO PAY LONG-TERM DEBT Two indicators of a business’s ability to pay long-term liabilities are the Debt ratio Times-interest-earned ratio © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DEBT RATIO The debt ratio tells the proportion of the company’s assets that it has financed with debt The higher the debt ratio, the higher the strain of paying interest each year and the principal amount at maturity The lower the ratio, the lower the business’s future obligations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Calculation of the debt ratios for Palisades Furniture at the end of 20X3 and 20X2 is as follows: Palisades’ Debt Ratio Formula 20X3 20X2 Total liabilities $431,000 $324,000 Debt ratio = = 0.55 = 0.50 Total assets $787,000 $644,000 The average debt ratio for most companies ranges from 0.57- 0.67 Industry Average = 0.64 The company’s debt ratio indicates a fairly low-risk debt compared to the retail furniture industry average © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

TIMES-INTEREST-EARNED RATIO The times-interest-earned ratio measures the number of times that operating income can cover interest expense A high times-interest-earned ratio indicates ease in paying interest expense A low value suggests difficulty © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Times-Interest-Earned Ratio Calculation of Palisades’ times-interest-earned ratio is as follows: Palisades’ Times-Interest-Earned Ratio Formula 20X3 20X2 Income from operations Times-interest-earned ratio = $101,000 $57,000 = 4.21 = 4.07 Interest expense $24,000 $14,000 The norm for U.S. business ranges from 2.0 - 3.0 for most companies Industry Average = 2.30 The company’s times-interest-earned ratio of around 4.00 is significantly better than the industry average for furniture retailers © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING A COMPANY’S PROFITABILITY There are four rate-of-return measurements that help evaluate a company’s profitability: Rate of return on net sales Rate of return on total assets Rate of return on common stockholders’ equity Earnings per share of common stock © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RATE OF RETURN ON NET SALES The rate of return on net sales shows the percentage of each sales dollar earned as net income The higher the rate of return, the more net sales dollars are providing income to the business and the fewer net sales dollars are absorbed by expenses © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Rate of Return on Sales The rate-of-return-on-sales ratios for Palisades Furniture are calculated as follows: Palisades’ Rate of Return on Sales Formula 20X3 20X2 Rate of return on sales Net income $48,000 $26,000 = = 0.056 = 0.032 Net Sales $858,000 $803,000 Industry Average = 0.008 The increase in Palisades Furniture’s return on sales identifies the company as more successful than the average furniture store © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RATE OF RETURN ON TOTAL ASSETS The rate of return on total assets (return on assets) measures a company’s success in using its assets to earn a profit The sum of interest expense and net income in the numerator is the return to creditors and shareholders who have financed the company’s operations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ 20X3 Rate of Return on Total Assets Computation of the return-on-assets ratio for Palisades Furniture is as follows: Palisades’ 20X3 Rate of Return on Total Assets Formula Net income Interest Expense Rate of return on assets + $48,000 + $24,000 = = 0.101 Average total assets $715,000 Industry Average = 0.042 The increase in Palisades Furniture’s return on assets is higher than the industry average © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY Rate of return on stockholders’ equity (return on equity) Shows the relationship between net income and common stockholders’ investment in the company Is calculated by dividing net income available to common stockholders by the average stockholders’ equity during the year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ 20X3 Rate of Return on Common Stockholders’ Equity The rate of return on common stockholders’ equity for Palisades Furniture is calculated as follows: Palisades’ 20X3 Rate of Return on Common Stockholders’ Equity Formula Rate of return on common stockholders’ equity Net income Preferred Dividends - $48,000 - $0 0.142 = = Average common stockholders’ equity $338,000 Industry Average = 0.121 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY Palisades’ return on equity (0.142) is higher than its return on assets (0.101). This difference results from borrowing at one rate (8%) and investing the funds to earn a higher rate (14.2%) This practice is called trading on the equity or using financial leverage © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EARNINGS PER SHARE OF COMMON STOCK Earnings per share (EPS) is The amount of net income per share of the company’s outstanding common stock Computed by dividing net income available to common stockholders by the number of common shares outstanding during the year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Earnings Per Share Computation of the firm’s EPS for 20X3 and 20X2 follows, assuming the company had 10,000 share of common stock outstanding Palisades’ Earnings Per Share Formula 20X3 20X2 Net income Preferred Dividends Earnings per share of common stock - $48,000 - $0 $26,000 - $0 = = $4.80 = $2.60 Number of shares of common stock outstanding 10,000 10,000 Most companies strive to increase EPS by 10 -15% annually Palisades Furniture’s EPS increased 85 percent © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ANALYZING A COMPANY’S STOCK AS AN INVESTMENT Investors purchase stock to earn a return on their investment, which consists of two parts: Gains (or losses) from selling the stock at a price that differs from the investors’ purchase price Dividends, the periodic distributions to stockholders © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

PRICE EARNINGS RATIO The price earnings ratio is the ratio of the market price of a share of common stock to the company’s earnings The higher a stock’s P/E ratio, the higher its downside risk--the risk that the stock’s market price will fall © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Price/Earnings Ratio Calculations for the P/E ratio of Palisades Furniture, Inc., follow. The market price of its common stock was $50 at the end of 20X3 and $35 at the end of 20X2: Palisades’ Price/Earnings Ratio Formula 20X3 20X2 Market price per share of common stock $50.00 $35.00 P/E ratio = = 10.4 = 13.5 Earnings per share $4.80 $2.60 P/E ratios vary from industry to industry Palisades Furniture’s 20X3 P/E ratio indicates that the company’s stock is selling at 10.4 times earnings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DIVIDEND YIELD Dividend yield is the ratio of dividends per share of stock to the stock’s market price per share This ratio measures the percentage of a stock’s market value that is returned annually as dividends © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Dividend Yield on Palisades’ Common Stock Palisades Furniture paid annual cash dividends of $1.20 per share of common stock in 20X3 and $1.00 in 20X2, and market prices of the company’s common stock were $50 in 20X3 and $35 in 20X2. Calculation of the firm’s dividend yields on common stock is as follows: Dividend Yield on Palisades’ Common Stock Formula 20X3 20X2 Dividend yield on common stock Dividend per share of common stock $1.20 $1.00 = 0.024 $0.029 = = Market price per share of common stock $50.00 $35.00 Dividend yields vary widely, from 5% to 8% for older, established companies, down to the range of 0% to 3% for young growth-oriented companies © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BOOK VALUE PER SHARE OF COMMON STOCK Book value per share of common stock is common stockholders’ equity divided by the number of shares of common stock outstanding Some investors rank stock on the basis of the ratio of market price to book value To these investors, the lower the ratio the more attractive the stock © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Book Value per Share of Palisades’ Common Stock Calculations of book-value-per-share-of-common-stock ratios follows: Book Value per Share of Palisades’ Common Stock Formula 20X3 20X2 Total stockholders’ equity Book value per share of common stock Preferred equity - $356,000 - $0 $320,000 - $0 = = $35.60 = $32.00 Number of shares of common stock outstanding 10,000 10,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

LIMITATIONS OF FINANCIAL ANALYSIS Ratios have their limitations Financial analysis may indicate that something is wrong, but it may not identify the specific problem or show how to correct it Managers must evaluate data on all ratios in the light of other information about the company © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

LIMITATIONS OF FINANCIAL ANALYSIS Ratios should be analyzed over a period of years Any one year, or even any two years, may not be representative of the company’s performance over the long term © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ECONOMIC VALUE ADDED Economic value added (EVA) combines the concepts of accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth A positive EVA amount indicates An increase in stockholder wealth An attractive stock to investors © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ECONOMIC VALUE ADDED EVA = Net income + Interest expense - Capital charge Where Capital charge Notes payable Loans payable Long-term debt Stockholders’ equity Cost of capital = + + + x © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ECONOMIC VALUE ADDED The capital charge is the amount that stockholders and lenders charge a company for the use of their money The cost of capital is a weighted average of the returns demanded by the company’s stockholders and lenders The cost of capital varies with the company’s risk © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EFFICIENT MARKETS, MANAGEMENT ACTION, AND INVESTOR DECISIONS An efficient capital market is one in which market prices fully reflect all information available to the public Because stocks are priced in full recognition of all publicly accessible data, it can be argued that the stock market is efficient © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EFFICIENT MARKETS, MANAGEMENT ACTION, AND INVESTOR DECISIONS This means that managers cannot fool the market with accounting gimmicks For investors, an appropriate strategy seeks to manage risk, diversity, and minimize transaction costs The role of financial statement analysis consists mainly of identifying the risks of various stocks to manage the risk of the overall investment portfolio © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

END OF CHAPTER 13 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren