Ch.13 Financial Statement Analysis

Stockholders Financial Statement Analysis Creditors Will I be paid? How good is our investment?

F/S Analysis Requires Proper Comparisons  Over time for the same company Trend/horizontal analysis  With other companies in the same industry Ratio analysis  With industry average

Trend Analysis Return on Average Equity % 26.7% 28.7% 30.1% 29.0% Wm. Wrigley Jr. Company Tracking items over a series of years

Types of Analysis  Liquidity Analysis  Solvency Analysis  Profitability Analysis

Part I: Liquidity Analysis  Nearness to cash  Ability to pay short-term debts as they become due LO4

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  Focuses on cash only  Can be used to indicate the flow of cash during the year to cover the debts due 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

Number of Days’ Sales in Receivables Represents the average number of days an account is outstanding Number of Days in the Period Accounts Receivable Turnover

Number of Days’ Sales in Receivables 360 days 4.8 times = 75 days Example:

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

Number of Days’ Sales in Inventory Represents the average number of days inventory is on hand before it’s sold Number of Days in the Period Inventory Turnover

Cash Operating Cycle  Time between the purchase of merchandise and the collection of the from the sale Number of Days’ Sales in Inventory + Number of Days’ Sales in Receivables

Part II: Solvency Analysis  Ability to stay in business over the long-term. That is, the ability to pay all the liabilities LO5

Debt-to-Asset Ratio Total Liabilities Total Assets How much of the company’s assets were borrowed?

Debt-to-Equity Ratio Total Liabilities Total Assets =.60 60% of the company’s assets were borrowed, and only 40% were provided by owners.

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

Part III: Profitability Analysis  Rate of Return on Assets  Return on Common Stockholders’ Equity  Earnings per Share  Price/Earnings Ratio  Dividend Ratios LO6

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 Average Number of Common Shares Outstanding Certificate of Stock

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

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

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

LIFO FIFO Limitations of Financial Statement Analysis  Use of different accounting methods  Changes in accounting methods LO1

Limitations of Financial Statement Analysis  Difficulty of making industry comparisons (i.e., conglomerates ) ????

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