Financial Statement Analysis Chapter 13 Financial Statement Analysis Financial Accounting, Alternate 4e by Porter and Norton

Financial Statement Analysis Will I be paid? How good is our investment? Creditors How are we performing? Stockholders Management

Limitations of Financial Statement Analysis Use of different accounting methods Changes in accounting methods LIFO FIFO

Limitations of Financial Statement Analysis Failure to understand trends or use industry ratios Difficulty of making industry comparisons (i.e., conglomerates) ????

Limitations of Financial Statement Analysis Nonoperating items on income statement Effects of inflation =

Horizontal Analysis Wm. Wrigley Jr. Company (in millions) Increase (Decrease) 2002 2001 Dollars Percent $2,746 $2,401 $345 14.4 % 1,596 1,404 192 13.7 402 363 39 10.7 Net Sales Gross Profit Net Earnings

Tracking items over a series of years Trend Analysis Wm. Wrigley Jr. Company 2002 2001 2000 1999 1998 28.7% 30.1% 29.0% 26.8% 28.4% Return on Avg. Equity Tracking items over a series of years

Vertical Analysis Common-size statements recast items as a percentage of a selected item Allows comparisons of companies of different size Compares percentages across years to identify trends % % %

Common-Size Statements Dollars Percent $24,000 100.0% 18,000 75.0 $ 6,000 25.0% 3,000 12.5 $ 3,000 12.5% 140 0.6 $ 2,860 11.9% 1,140 4.8 $ 1,720 7.1% Sales revenue Cost of goods sold Gross profit Selling & admin. exp. Operating income Interest expense Income before tax Income tax expense Net income

Liquidity Analysis Nearness to cash Ability to pay debts as they become due Turnover Ratios Working Capital Ratios Cash Ratios

- Working Capital Excess of current assets over current liabilities Lacks meaningful comparisons for companies of different size -

Current Ratio Measure of short-term financial health Consider composition of current assets Rule of thumb 2:1

Acid-Test (Quick) Ratio Stricter test of ability to pay debts Excludes inventories and prepaid assets Quick Assets Current Liabilities

Cash Flow from Operations to Current Liabilities Ratio Focuses on cash only Covers period of time Net Cash Provided by Operating Activities Average Current Liabilities

Accounts Receivable Turnover Ratio Net Credit Sales Average Accounts Receivable Indicates how quickly a company is collecting (i.e., turning over) its receivables

Accounts Receivable Turnover Ratio Too fast Credit policies too stringent; may be losing sales Too slow Credit department not operating effectively; possible quality problems

Number of Days’ Sales in Receivables Accts. Receivable Turnover Represents the average # of days accounts are outstanding *Some analysts use 365 days.

Number of Days’ Sales in Receivables Example: 360 Days 4.8 Times = 75 days If this company’s credit terms are net 30, what would this tell you about the efficiency of the collection process?

Inventory Turnover Ratio Cost of Goods Sold Average Inventory Represents the number of times per period inventory is turned over (i.e., sold).

Inventory Turnover Ratio Circuit City 5.8 times per year Safeway 9.2 times per year Can you compare the two ratios?

# of Days’ Sales in Inventory 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27 # of Days’ Sales in Inventory # of Days in Period Inventory Turnover Ratio Represents the average # of days inventory is on hand before it’s sold

# of Days’ Sales in Inventory 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 27 # of Days’ Sales in Inventory Circuit City 62 days Safeway 39 days Do these averages seem reasonable?

# of days sales in receivables # of days sales in inventory Cash Operating Cycle Time between purchase of merchandise and collection from the sale # of days sales in receivables + # of days sales in inventory

Solvency Analysis Ability to stay in business over the long-term Times Interest Earned Debt-to-Equity Ratio Cash Flow to Capital Expenditures Debt Service Coverage

Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity How much have creditors contributed compared to owners? Total Liabilities Total Stockholders’ Equity

Total Stockholders’ Equity Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity = .60 For every dollar contributed by owners, creditors have loaned $.60

Times Interest Earned Ratio Measures ability to meet current interest payments The greater the coverage the better Net Income + Interest Expense + Income Tax Expense Interest Expense

Debt Service Coverage Ratio Measures amount of cash from operations available to service the debt Cash Flow from Operations before Interest & Taxes Interest and Principal Payments P + i

Cash Flow from Operations to Capital Expenditures Ratio Measures company’s ability to use operations (vs. creditors and owners) to finance acquisitions of productive assets Cash Flow from Operations – Dividends Paid Cash Paid for Capital Acquisitions

Profitability Analysis Rate of Return on Assets Return on Common S/E EPS P/E Ratio Dividend Ratios

Net Income + Interest Expense, Net of Tax Return on Assets Ratio Measures return to all providers of capital (creditors and owners) Net Income + Interest Expense, Net of Tax Average Total Assets

Return on Common Stockholders’ Equity Net Income - Preferred Dividends Average Common Stockholders’ Equity The owners earned 15% on their investment in ABC Co... Not bad!

Earnings per Share Presents profits on a per-share basis Net Income - Preferred Dividends Weighted Avg. # of Common Shares Outstanding Certificate of Stock

Price/Earnings Ratio Current Market Price Earnings per Share Relates earnings to the market price of the stock Current Market Price Earnings per Share very high P/E very low P/E possibly overvalued possibly undervalued

Price/Earnings Ratio Both companies have earnings of $2 per share. So why the different P/E ratios? P/E Ratios Co. A = 10 to 1 Co. B = 7 to 1

Common Dividends per Share Dividend Payout Ratio Common Dividends per Share Earnings per Share We need to decide what % of the firm’s income we can return to owners.

Common Dividends per Share Dividend Yield Ratio Investors willing to forgo dividends in lieu of price appreciation Common Dividends per Share Market Price per Share usually < 5% =

Reporting and Analyzing Other Income Statement Items Appendix Accounting Tools: Reporting and Analyzing Other Income Statement Items

Common Characteristics All such items are reported after income from continuing operations Reported separately Shown net of tax effects Most analysts ignore these items, since they are not likely to reoccur

Discontinued Operations Any gain or loss from disposal of a division or segment of the business Any net income or loss from operating this portion until the date of disposal

Extraordinary Items Gain or loss due to an event that is Unusual in nature AND Infrequent in occurrence

Cumulative Effect of a Change in Accounting Principle Reflects a change in a company’s accounting principles, practices, or methods Reports the difference in income in all prior years between the old method and the new method Sometimes such a change is dictated by new accounting standards

End of Chapter 13