1 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Financial Statement Analysis Chapter 13 2 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Perform a horizontal analysis 3 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Horizontal Analysis Study of percentage changes from year-to- year Two steps : 1. Compute dollar amount of change 2. Divide dollar amount of change by base- period amount 4 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Exercise 13-16A McMahon Music Company Comparative Income Statements Years Ended December 31, 2012 and $ Change% Change Total revenue $1,007,000$917,000 Expenses: Cost of goods sold$477,000$408,750 Selling & gen’l expense287,000265,000 Interest expense23,50013,500 Income tax expense105,50084,650 Total expenses893,000771,900 Net income$184,000$145,100 5 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Trend Percentages Form of horizontal analysis Base year selected and set equal to 100% ▫Amount of each following year stated as a percent of base 6 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. Trend % Any year Base year

Perform a vertical analysis 7 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Vertical Analysis Shows relationship of a financial-statement item to its base ▫For Income Statement, total revenue is the base ▫For Balance Sheet, total assets is the base 8 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. Vertical analysis % Total revenue Each income statement item

Prepare common-size financial statements 9 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Common-Size Statements Report only vertical analysis percents ▫No dollar amounts Help in the comparison of different companies ▫Financial results in terms of a common denominator 10 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Benchmarking Compares company to a standard set by others ▫Often a key competitor Facilitated by common-size statements Has goal of improvement 11 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Analyze the statement of cash flows 12 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Cash-Flow Signs of Healthy Company Operations are major source of cash Investing includes more purchases than sales Financing not dominated by borrowing 13 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Use ratios to make business decisions 14 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Ratio Categories Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 15 Ability to pay current liabilitiesTurnover and cash conversionLeverageProfitabilityAnalyze stock as an investment

Ability to Pay Current Liabilities Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 16 Working capital Current ratio Quick (Acid- test) ratio

Working Capital & Current Ratio 17 Working capital Current assets Current liabilities Current ratio Current assets Current liabilities Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Quick (Acid-Test) Ratio 18 Cash + Short-term investments + Net current receivables Current liabilities Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Measuring Turnover and the Cash Conversion Cycle Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 19 Inventory turnover Accounts receivable turnover Accounts payable turnover

Inventory Turnover Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 20 Cost of goods sold Average inventory (Beginning inventory + Ending inventory)/2) Days’ inventory outstanding 365 Inventory turnover

Accounts Receivable Turnover Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 21 Net sales Average net accounts receivable (Beginning net receivables + Ending net receivables)/2)

Days’-Sales-In-Receivables Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 22 One day’s sales Net sales 365 days Days’ sales in average accounts receivable Average net accounts receivable One day’s sales

Accounts Payables Turnover Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 23 Cost of goods sold Average accounts payable 365 Days’ payable outstanding Payables turnover

Cash Conversion Cycle Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 24 DIO DPO DSO DIO = Days’ Inventory Outstanding DSO = Days’ Sales Outstanding DPO = Days’ Payable Outstanding

Measuring Leverage: Overall Ability to Pay Debts Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 25 Debt ratio Times- interest- earned

Debt ratio Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 26 Total liabilities Total assets

Times-Interest-Earned Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 27 Income from operations Interest expense

Exercise 13-22A Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall Cash$50,000$49,000 Short-term investments28,00027,000 Net receivables115,000128,000 Inventory240,000268,000 Prepaid expenses22,0008,000 Total assets510,000540,000 Total current liabilities207,000262,000 Long-term debt97,000174,000 Income from operations301,000150,000 Interest expense41,00042,000

Exercise 13-22A 29 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. Working capital Current assets Current liabilities Current assets Cash + Short-term investments + Net receivables + Inventory + Prepaid expenses ? ? 2012 ? ? ? ? ? ?

Exercise 13-22A 30 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. Working capital Current assets Current liabilities Current assets Cash + Short-term investments + Net receivables + Inventory + Prepaid expenses $49, , , , , $480,000 $207,000 $248,000

Exercise 13-22A 31 Current ratio Current assets Current liabilities ? ? ? ? ? ? Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall ? ? ? ? ? ?

Exercise 13-22A 32 Cash + Short-term investments + Net current receivables Current liabilities Quick ratio 2012 = ? ? ? ? Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Exercise 13-22A 33 Cash + Short-term investments + Net current receivables Current liabilities Quick ratio 2011 = ? ? ? ? ? ? Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Exercise 13-22A Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 34 Debt ratio Total liabilities Total assets Current liabilities + Long-term debt ? ? ? ? ? ?

Exercise 13-22A Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 35 Income from operations Interest expense Times Interest Earned 2012 ? ? ? ? ? ? ? ? ? ? ? ? 2011

Measuring Profitability Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 36 Gross margin Operating income percentage DuPont Analysis Asset turnover Return on Assets Leverage ratio Return on equity Earnings per share

Gross margin & Operating profit Percentages Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 37 Operating profit % Net sales Gross margin Gross margin % Operating income Net sales

DuPont Analysis Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 38 Return on assets Net profit margin Asset turnover Leverage ratio Return on equity Leverage ratio Return on equity Net income Net sales Average total assets Average common equity Net income Average common equity

Rate of Return (Net Profit Margin) on Sales Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 39 Net income Net sales

Asset Turnover Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 40 Net sales Average total assets

Rate of Return on Total Assets Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 41 Rate of Return on Sales Asset turnover

Leverage (Equity Multiplier) Ratio Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 42 Average total assets Average common stockholders’ equity

Rate of Return on Common Equity Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 43 Net income – Preferred dividends Average common stockholders’ equity

Earnings per Share Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 44 Net income –Preferred dividends Average number of common shares outstanding

Use other measures to make investment decisions 45 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Analyzing Stock Investments Price/Earnings ratio Dividend yield Book value 46 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Price/Earnings Ratio Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 47 Market price per share of common stock Earnings per share

Dividend Yield Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 48 Dividend per share of common stock Market price per share of common stock

Book Value Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 49 Total stockholders’ equity Preferred equity Weighted-average number of common shares outstanding

Measure the economic value added by operations 50 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Economic Value Added (EVA ®) Combines accounting and finance data Measures if operations have increased stockholder wealth ▫Positive EVA® suggests increase in wealth 51 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. Net income Interest expense Capital charge

Cost of Capital Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall. 52 Notes payable Current maturities of long-term debt Long-term debt Stockholders’ equity Capital charge = Cost of capital

Red Flags in Financial Statement Analysis Earnings problems Decreased cash flow Too much debt Inability to collect receivables Buildup of inventories Trends of sales, inventory and receivables 53 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

Efficient Markets Market prices fully reflect all information ▫Managers cannot fool market with accounting manipulations ▫Market sets fair price for stock Appropriate investment strategy: ▫Manage risk ▫Diversify investments ▫Minimize transaction costs 54 Copyright ©2012 Pearson Education Inc. Publishing as Prentice Hall.

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