c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Financial Statement Analysis Chapter 17

Learning Objectives 1. Describe basic financial statement analytical methods. 2. Use financial statement analysis to assess the solvency of a business. 3. Use financial statement analysis to assess the profitability of a business. 4. Describe the contents of corporate annual reports.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe basic financial statement analytical methods. 1

Basic Analytical Methods o Users analyze a company’s financial statements using a variety of analytical methods. Three such methods are as follows:  Horizontal analysis  Vertical analysis  Common-sized statements

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

H ORIZONTAL A NALYSIS

Horizontal Analysis: Difference $17,000 Base year (2013) $533,000 = 3.2% H ORIZONTAL A NALYSIS

Horizontal Analysis: Difference $25,800 Base year (2013) $64,700 = 39.9%

H ORIZONTAL A NALYSIS

Horizontal Analysis: Difference $296,500 Base year (2013) $1,234,000 = 24.0%

H ORIZONTAL A NALYSIS

Horizontal Analysis: Difference $37,500 Base year (2013) $ 100,000 = 37.5% H ORIZONTAL A NALYSIS

Vertical Analysis o A percentage analysis used to show the relationship of each component to the total within a single financial statement is called vertical analysis.

Vertical Analysis o In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. o Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.

V ERTICAL A NALYSIS

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

Vertical Analysis o In a vertical analysis of the income statement, each item is stated as a percent of net sales.

V ERTICAL A NALYSIS

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

Common-Sized Statements o In a common-sized statement, all items are expressed as percentages with no dollar amounts shown. o Common-sized statements are useful for comparing the current period with prior periods, individual businesses with one another, or one business with industry averages.

C OMMON -S IZED S TATEMENTS

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Use financial statement analysis to assess the solvency of a business. 2

Solvency Analysis o All users of financial statements are interested in the ability of a company to do the following:  Meet its financial obligations (debts), called solvency.  Earn income, called profitability.

Solvency Analysis o Solvency analysis focuses on the ability of a business to pay its current and noncurrent liabilities. o Solvency and profitability are interrelated. A company that cannot pay its debts will have difficulty obtaining credit, which can decrease its profitability.

Current Position Analysis o A company’s ability to pay its current liabilities is called current position analysis. It is of special interest to short-term creditors.

Working Capital o 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. o Working capital is computed as follows: Working Capital = Current Assets – Current Liabilities

Current Ratio o The current ratio, sometimes called the working capital ratio, also measures a company’s ability to pay its current liabilities. o The current ratio is computed as follows: Current Ratio = Current Assets Current Liabilities

Current assets$550,000$533,000 Current liabilities$210,000$243,000 Current ratio $550,000 $210,000 $533,000 $243,000 Current Ratio o The current ratio for Lincoln Company is computed below.

Quick Ratio o 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 o The quick ratio for Lincoln Company is computed below Quick ratio Quick assets: Cash$ 90,500$ 64,700 Temporary Investments 75,00060,000 Accounts receivable (net) 115, ,000 Total quick assets $280,500$244,700 Current liabilities $210,000$243,000 $280,500 $210,000 $244,700 $243,000

Accounts Receivable Turnover o 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 solvency. o The accounts receivable turnover is computed as follows: Accounts Receivable Turnover = Net Sales Average Accounts Receivable

Accounts receivable turnover Net sales $1,498,000$1,200,000 Accounts receivable (net): Beginning of year$ 120,000$ 140,000 End of year 115, ,000 Total$ 235,000$ 260,000 Average (Total ÷ 2)$ 117,500$ 130, Accounts Receivable Turnover o The accounts receivable turnover for Lincoln Company is computed below. $1,498,000 $117,500 $1,200,000 $130,000

Number of Days’ Sales in Receivables o 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 o The number of days’ sales in receivables for Lincoln Company is computed below. Number of days’ sales in receivables 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, $117,500 $4,104 $130,000 $3,288

Inventory Turnover o 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. o The inventory turnover is computed as follows: Inventory Turnover = Cost of Goods Sold Average Inventory

Inventory turnover Cost of goods sold$1,043,000$820,000 Inventories: Beginning of year$ 283,000$311,000 End of year 264, ,000 Total$ 547,000$594,000 Average (Total ÷ 2)$ 273,500$297,000 $1,043,000 $273,500 $820,000 $297,000 Inventory Turnover o Lincoln’s inventory balance at the beginning of 2013 is $311,000.

Number of Days’ Sales in Inventory o 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. o 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

Average Inventory$273,500$297,000 $547,000 ÷ 2 $594,000 ÷ (continued) Number of Days’ Sales in Inventory o The number of days’ sales in inventory for Lincoln Company is computed below.

Average Inventory$273,500$297,000 Average daily cost of goods sold$2,858$2, $1,043,000 ÷ 365 $820,000 ÷ 365 $820,000 ÷ 365 Number of days’ sales in inventory $273,500 $2,858 $297,000 $2,247 Number of Days’ Sales in Inventory o The number of days’ sales in inventory for Lincoln Company is computed below.

Ratio of Fixed Assets to Long-Term Liabilities o 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. o 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 Fixed assets (net) $444,500$470,000 Long-term liabilities $100,000$200,000 $444,500 $100,000 $470,000 $200,000 Ratio of Fixed Assets to Long-Term Liabilities o To illustrate, the ratio of fixed assets to long- term liabilities for Lincoln Company is computed below.

Ratio of Liabilities to Stockholders’ Equity o 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. o The ratio is computed as follows: Ratio of Liabilities to Stockholders’ Equity Total Liabilities Total Stockholders’ Equity =

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

Number of Times Interest Charges Earned o 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 o 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 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 $168,500 $6,000 $146,600 $12,000 Number of Times Interest Charges Earned o The number of times interest charges are earned for Lincoln Company is computed below.

Number of Times Interest Charges Earned o The number of times interest charges are earned can be adapted for use with dividends on preferred stock. o The number of times preferred dividends are earned is computed as follows: Number of Times Preferred Dividends Are Earned Net Income Preferred Dividends =

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Use financial statement analysis to assess the profitability of a business. 3

Profitability Analysis o Profitability analysis focuses primarily on the relationship between operating results and the resources available to a business.

Ratio of Net Sales to Assets o The ratio of net sales to assets is a profitability measure that shows how effectively a company utilizes its assets. o The ratio is computed as follows: Ratio of Net Sales to Assets Net Sales Average Total Assets (excluding long- term investments) =

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 (continued) Excludes long-term investments Ratio of Net Sales to Assets o The ratio of net sales to assets for Lincoln Company is computed below.

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 $1,498,000 $1,048,750 $1,200,000 $1,031,500 Ratio of Net Sales to Assets o The ratio of net sales to assets for Lincoln Company is computed below.

Rate Earned on Total Assets o The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed. o It is computed as follows: Rate Earned on Total Assets Net Income + Interest Expense Average Total Assets =

Rate Earned on Total Assets o This ratio for Lincoln Company is computed below. Total assets are $1,187,500 at the beginning of Rate earned on total assets 8.2% 7.3% Net income$ 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 $97,000 $1,185,000 $88,500 $1,209,000

Rate Earned on Stockholders’ Equity o The rate earned on stockholders’ equity measures the rate of income earned on the amount invested by the stockholders. o It is computed as follows: Rate Earned on Stockholders’ Equity Net Income Average Total Stockholders’ Equity =

Rate Earned on Stockholders’ Equity o The rate for Lincoln Company is computed below. Total stockholders’ equity is $750,000 at the beginning of Rate earned on stockholders’ equity 11.3% 10.0% Net income$ 91,000$ 76,500 Stockholders’ equity: Beginning of year$ 787,500$ 750,000 End of year 829, ,500 Total$1,617,000$1,537,500 Average (Total ÷ 2)$ 808,500$ 768, $91,000 $808,500 $76,500 $768,750

Rate Earned on Stockholders’ Equity o The difference between the rate earned on stockholders’ equity and the rate earned on total assets is called leverage.

Rate earned on stockholders’ equity11.3%10.0% Less rate earned on total assets Effect of leverage3.1%2.7% Rate Earned on Stockholders’ Equity o For Lincoln Company, the effect of leverage is computed as follows:

R ATE E ARNED ON S TOCKHOLDERS ’ E QUITY

Rate Earned on Common Stockholders’ Equity o The rate earned on common stockholders’ equity measures the rate of profits earned on the amount invested by the common stockholders. o It is computed as follows: Rate Earned on Common Stockholders’ Equity Net Income – Preferred Dividends Average Common Stockholders’ Equity =

(continued) Rate Earned on Common Stockholders’ Equity o Lincoln Company had $150,000 of 6% preferred stock outstanding on December 31, 2014 and Thus, preferred dividends of $9,000 ($150,000 x 6%) are deducted from net income. Lincoln’s common stockholders’ equity is determined as follows:

Rate earned on common stockholders’ equity 12.5% 10.9% 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 Total$1,317,000$1,237,500 Average (Total ÷ 2) $ 658,500$ 618,750 $82,000 $658,500 $67,500 $618,750 Rate Earned on Common Stockholders’ Equity

Earnings per Share on Common Stock o 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. o 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 o EPS for Lincoln Company is computed below. Earnings per share on common stock $1.64 $ Net income$91,000$76,500 Less preferred dividends 9,000 9,000 Total $82,000$67,500 Shares of common stock 50,00050,000 $82,000 50,000 $67,500 50,000

Price-Earnings Ratio o 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. o 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 =

Price-earnings ratio on common stock Market price per share of common stock$41.00$27.00 Earnings per share on common stock ÷ $1.64÷ $1.35 Price-Earnings Ratio o The P/E ratio for Lincoln Company is computed below.

Dividends per Share o Dividends per share can be reported with earnings per share to indicate the relationship between dividends and earnings. o 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)

Dividends per Share o The dividends per share for Lincoln Company are computed below. Dividends per Share Dividends Shares of Common Stock Outstanding = Dividends per share of common stock $0.80 $ Dividends on common stock$40,000$30,000 Shares of common stock outstanding ÷ 50,000÷ 50,000

D IVIDENDS AND E ARNINGS PER S HARE

Dividend Yield o The dividend yield on common stock measures the rate of return to common stockholders from cash dividends. o 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 =

Dividend Yield o The dividend yield for Lincoln Company is computed below. Dividend yield on common stock 2.0% 2.2% Dividends per share of common stock$ 0.80$ 0.60 Market price per share of common stock$41.00$27.00 $0.80 $41 $0.60 $27

S UMMARY OF A NALYTICAL M EASURES (continued)

S UMMARY OF A NALYTICAL M EASURES (concluded)

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Learning Objective Describe the contents of corporate annual reports. 4

Corporate Annual Reports o 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

Management Discussion and Analysis o Management’s Discussion and Analysis (MD&A) is required in annual reports filed with the SEC. o It contains management’s analysis of current operations and its plans for the future. o Typical items included in the MD&A are:  Management’s analysis and explanations of any significant changes between the current and prior year’s financial statements. (continued)

Management Discussion and Analysis  Important accounting principles or policies that could affect interpretation of the financial statements.  Management’s assessment of the company’s liquidity and the availability of capital to the company.  Significant risk exposures that might affect the company.  Any “off-balance-sheet” arrangements such as leases not included directly in the financial statements.

Report on Internal Control o 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. o It also requires a public accounting firm to verify management’s conclusions on internal control.

Report on Fairness of Financial Statements o 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.

c Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, or posted to a publicly accessible website, in whole or in part. Appendix Unusual Items on the Income Statement

o Unusual items affecting the current period’s income statement include the following:  Discontinued operations  Extraordinary items

Discontinued Operations o A company may discontinue a segment of its operations by selling or abandoning the segment’s operations. o A note accompanying the income statement should describe the operations sold, including such details as the date operations were discontinued, the assets sold, and the effect (if any) on current and future operations.

Discontinued Operations o Jones Corporation produces and sells electrical products, hardware supplies, and lawn equipment. Because of lack of profits, Jones discontinues its electrical products operation and sells the remaining inventory and other assets at a loss of $100,000. Exhibit 11 (next slide) illustrates the reporting of the loss on the discontinued operations.

D ISCONTINUED O PERATIONS

Extraordinary Items o An extraordinary item is defined as an event or transaction with both of the following characteristics:  Unusual in nature  Infrequent in occurrence

E XTRAORDINARY I TEMS

R EPORTING E ARNINGS PER S HARE

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