The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin CHAPTER 13 Financial Statement Analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 13-2 Learning Objective LO1 To describe factors associated with communicating useful information

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 13-3 Factors in Communicating Useful Information Users Types of Decisions Means of Analysis The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the following:

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 13-4 Learning Objective LO2 To differentiate between horizontal and vertical analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 13-5 Methods of Analysis Horizontal Analysis Vertical Analysis Ratio Analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 13-6 Milavec Company Financial Statements

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 13-7 Milavec Company Financial Statements

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 13-8 Horizontal Analysis Horizontal analysis (or trend analysis) refers to studying the behavior of individual financial statement items over several accounting periods. Absolute Amounts Percentage Analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 13-9 Milavec Company Horizontal Analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Vertical Analysis Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. A common- size Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. A common- size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Vertical Analysis of Income Statement In income statements, all items are usually expressed as a percentage of sales.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Milavec Company Vertical Analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Vertical Analysis of Balance Sheet In balance sheets, all items are usually expressed as a percentage of total assets.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin 13-14

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Learning Objective LO3 To explain ratio analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Ratio Analysis Ratio analysis involves studying various relationships between different items reported in a set of financial statements.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Learning Objective LO4 To calculate ratios for assessing a company’s liquidity

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Liquidity Ratios Liquidity ratios indicate a company’s ability to pay short- term debts. They focus on current assets and current liabilities. 1.Working Capital 2.Current Ratio 3.Quick Ratio 4.Accounts Receivable Ratios 5.Inventory Ratios

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Working Capital The excess of current assets over current liabilities is known as working capital.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Current Ratio The current ratio measures a company’s short-term debt paying ability. A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories. Current Ratio Current Assets Current Liabilities =

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Current Ratio

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Quick (Acid-Test) Ratio Quick Assets Current Liabilities = Acid-Test Ratio Quick assets include Cash, Current Marketable Securities, and Accounts Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Quick (Acid-Test) Ratio

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Accounts Receivable Turnover Net Credit Sales Average Accounts Receivable Accounts Receivable Turnover = This ratio measures how many times a company converts its receivables into cash each year.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Accounts Receivable Turnover

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Average Days to Collect Receivables Average Collection Period = 365 Days Accounts Receivable Turnover This ratio measures, on average, how many days it takes to collect an accounts receivable. = 21 days Average Collection Period = 365 Days Times

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = This ratio measures how many times a company’s inventory has been sold and replaced during the year.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Inventory Turnover INSERT Insert 20, p. 543, Text Box here

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Average Days to Sell Inventory Average Sale Period = 365 Days Inventory Turnover This ratio measures how many days, on average, it takes to sell the inventory. = 34 days Average Sale Period = 365 Days Times

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Learning Objective LO5 To calculate ratios for assessing a company’s solvency

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Solvency Ratios Solvency ratios are used to analyze a company’s long-term debt- paying ability and its financing structure. 1.Debt to Assets Ratio 2.Debt to Equity Ratio 3.Number of Times Interest Earned 4.Plant Assets to Long-Term Liabilities

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Debt to Assets Ratio This ratio measures the percentage of a company’s assets that are financed by debt. Total Liabilities Total Assets Debt to Assets Ratio =

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Debt to Equity Ratio This ratio indicates the relative proportions of debt to equity on a company’s balance sheet. Stockholders like a lot of debt if the company can take advantage of positive financial leverage. Total Liabilities Stockholders’ Equity Debt to Equity Ratio = Creditors prefer less debt and more equity because equity represents a buffer of protection.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Debt to Assets and Debt to Equity Ratios

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Number of Times Interest is Earned Ratio This is the most common measure of a company’s ability to provide protection for its long- term creditors. Times Interest Earned Earnings before Interest Expense and Income Taxes Interest Expense =

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Number of Times Interest Earned Ratio

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Plant Assets to Long-Term Liabilities This ratio suggests how well long-term debt is managed to finance long-term assets. Plant Assets to Long-Term Liabilities Net Plant Assets Long-Term Liabilities =

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Plant Assets to Long-Term Liabilities

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Learning Objective LO6 To calculate ratios for assessing company management’s effectiveness

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Profitability Ratios Profitability ratios measure a company’s ability to generate earnings. 1.Net Margin (or Return on Sales) 2.Asset Turnover Ratio 3.Return on Investment 4.Return on Equity

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Net Margin This measure describes the percent remaining of each sales dollar after subtracting other expenses as well as cost of goods sold. Net Margin Net Income Net Sales =

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Net Margin

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Asset Turnover Ratio Net Sales Average Total Assets Asset Turnover = This ratio measures how many sales dollars were generated for each dollar of assets invested.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Asset Turnover Ratio

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Return on Investment (ROI) This is the ratio of wealth generated (net income) to the amount invested (average total assets). Return on Investment Net Income Average Total Assets =

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Return on Investment (ROI) * The computation of average assets is calculated as beginning assets plus ending assets divided by 2.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Return on Equity This measure is often used to measure the profitability of the stockholders’ investment. Return on Equity Net Income Average Total Stockholders’ Equity =

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Return on Equity

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Learning Objective LO7 To calculate ratios for assessing a company’s position in the stock market

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Stock Market Ratios Stock market ratios analyze the earnings and dividends of a company. 1.Earnings Per Share 2.Book Value 3.Price-Earnings (PE) Ratio 4.Dividend Yield

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Earnings Per Share Earnings per Share Net Earnings Available for Common Stock Average Number of Outstanding Common Shares = This measure indicates how much income was earned for each share of common stock outstanding.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Earnings Per Share

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Book Value Per Share This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off. Book Value per Share Stockholders’ Equity - Preferred Dividends Outstanding Common Shares =

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Book Value Per Share

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share Earnings Per Share = This ratio compares the earnings of a company to the market price for a share of the company’s stock.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Dividend Yield Dividend Yield Dividends Per Share Market Price Per Share = This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Learning Objective LO8 To explain the limitations of financial statement analysis

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Limitations of Financial Statement Analysis Different Industries Changing Economic Environment Accounting Principles

The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin End of Chapter 13