Financial Statement Analysis at different Stages

1. List basic financial statement analytical procedures. 2. Apply financial statement analysis to assess the solvency of a business. 3. Apply financial statement analysis to stress the profitability of a business. 4. Describe the contents of corporate annual reports. After studying this chapter, you should be able to:

 WHY?

 WHEN?

 HOW?

 How much money does the company need?  When is the money needed?  When will the company make money?  How much money will they make? When?  Shareholders equity, how much needed?  Credit, how much needed?

 How much money does the company need?  When is the money needed?  When will the company make money?  How much money will they make? When?  Shareholders equity, is the mix correct?  Credit, are current arrangements correct?  Are actuals inline with forecasts?

 How much money does the company need?  When is the money needed?  When will the company make money?  How much money will they make? When?  Shareholders equity, is the mix correct?  Credit, are current arrangements correct?  Are actuals inline with forecasts?  How to fund growth?

 Internal Users ◦ Management ◦ Owner (s)  External Users ◦ Investors ◦ Creditors ◦ Government ◦ Customers ◦ Labour Unions (employees) ◦ Public

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

Assets Current assets$ 550,000$ 533,000$ 17, % Long-term investments95,000177,500(82,500)(46.5%) Prop., plant, and equip. (net)444,500470,000(25,500)(5.4%) Intangible assets 50,000 50,000 Total assets $1,139,500$1,230,500$ (91,000)(7.4%) Liabilities Current liabilities$ 210,000$ 243,000$ (33,000)(13.6%) Long-term liabilities 100, , ,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000)(30.0%) Stockholders’ Equity Preferred 6% stock, $100 par$ 150,000$ 150,000— Common stock, $10 par500,000500,000— Retained earnings 179, ,500$ 42, % Total stockholders’ equity $ 829,500$ 787,500$ 42, % Total liab. & stockholders’ eq.$1,139,500$1,230,500$ (91,000)(7.4%) 11 Exhibit 1 Comparative Balance Sheets AmountPercent Increase (Decrease) Lincoln Company Comparative Balance Sheet December 31, 2008 and 2007

12 Assets Current assets$ 550,000$ 533,000$ 17, % Long-term investments95,000177,500(82,500)(46.5%) Prop., plant, and equip. (net)444,500470,000(25,500)(5.4%) Intangible assets 50,000 50,000 Total assets $1,139,500$1,230,500$ (91,000)(7.4%) Liabilities Current liabilities$ 210,000$ 243,000$ (33,000)(13.6%) Long-term liabilities 100, , ,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000)(30.0%) Stockholders’ Equity Preferred 6% stock, $100 par$ 150,000$ 150,000— Common stock, $10 par500,000500,000— Retained earnings 179, ,500$ 42, % Total stockholders’ equity $ 829,500$ 787,500$ 42, % Total liab. & stockholders’ eq.$1,139,500$1,230,500$ (91,000)(7.4%) AmountPercent Lincoln Company Comparative Balance Sheet December 31, 2008 and 2007 Increase (Decrease) Horizontal Analysis: Horizontal Analysis: Difference$17,000 Base year (2007)$533,000 = 3.2%

13 Assets Current assets$ 550,000$ 533,000$ 17, % Long-term investments95,000177,500(82,500)(46.5%) Prop., plant, and equip. (net)444,500470,000(25,500)(5.4%) Intangible assets 50,000 50,000 Total assets $1,139,500$1,230,500$ (91,000)(7.4%) Liabilities Current liabilities$ 210,000$ 243,000$ (33,000)(13.6%) Long-term liabilities 100, , ,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000)(30.0%) Stockholders’ Equity Preferred 6% stock, $100 par$ 150,000$ 150,000— Common stock, $10 par500,000500,000— Retained earnings 179, ,500$ 42, % Total stockholders’ equity $ 829,500$ 787,500$ 42, % Total liab. & stockholders’ eq.$1,139,500$1,230,500$ (91,000)(7.4%) AmountPercent Lincoln Company Comparative Balance Sheet December 31, 2008 and 2007 Increase (Decrease) Horizontal Analysis: Horizontal Analysis: Difference$(82,500) Base year (2007)$177,500 = (46.5%)

14 Exhibit 2 Comparative Schedule of Current Assets Lincoln Company Comparative Schedule of Current Assets December 31, 2008 and 2007 Increase (Decrease) Cash$ 90,500$ 64,700$ 25, % Marketable securities75,00060,00015, % Accounts receivable (net)115,000120,000(5,000)(4.2%) Inventories264,000283,000(19,000)(6.7%) Prepaid expenses 5,500 5, % Total current assets$550,000$533,000$17,0003.2% AmountPercent

15 9 Lincoln Company Comparative Schedule of Current Assets December 31, 2008 and 2007 Increase (Decrease) Cash$ 90,500$ 64,700$ 25, % Marketable securities75,00060,00015, % Accounts receivable (net)115,000120,000(5,000)(4.2%) Inventories264,000283,000(19,000)(6.7%) Prepaid expenses 5,500 5, % Total current assets$550,000$533,000$17,0003.2% AmountPercent Horizontal Analysis: Horizontal Analysis: Difference$25,800 Base year (2007)$64,700 = 39.9% 9

16 Lincoln Company Comparative Income Statement For the Year Ended December 31, 2008 and 2007 Sales$1,530,500$1,234,000$296, % Sales returns and allowances 32,500 34,000 (1,500)(4.4%) Net sales$1,498,000$1,200,000$298, % Cost of goods sold 1,043, , , % Gross profit $ 455,000$ 380,000 $ 75, % Selling expenses$ 191,000$ 147,000$ 44, % Administrative expenses 104,000 97,400 6,6006.8% Total operating expenses$ 295,000$ 244,400$ 50, % Income from operations$ 160,000$ 135,600$ 24, % Other income 8,500 11,000 (2,500)(22.7%) $ 168,500$ 146,600$ 21, % Other expense (interest) 6,000 12,000 (6,000)(50.0%) Income before income tax$ 162,500$ 134,600$ 27, % Income tax expense 71,500 58,100 13, % Net income$ 91,000 $ 76,500$ 14, % AmountPercent Increase (Decrease) Exhibit 3 Comparative Income Statement

17 Lincoln Company Comparative Income Statement For the Year Ended December 31, 2008 and 2007 Current assets$1,530,500$1,234,000$296, % Sales returns and allowances 32,500 34,000 (1,500)(4.4%) Net sales$1,498,000$1,200,000$298, % Cost of goods sold 1,043, , , % Gross profit $ 455,000$ 380,000 $ 75, % Selling expenses$ 191,000$ 147,000$ 44, % Administrative expenses 104,000 97,400 6,6006,.8% Total operating expenses$ 295,000$ 244,400$ 50, % Income from operations$ 160,000$ 135,600$ 24, % Other income 8,500 11,000 (2,500)(22.7%) $ 168,500$ 146,600$ 21, % Other expense (interest) 6,000 12,000 (6,000)(50.0%) Income before income tax$ 162,500$ 134,600$ 27, % Income tax expense 71,500 58,100 13, % Net income$ 91,000 $ 76,500$ 14, % AmountPercent Increase (Decrease) Horizontal Analysis: Horizontal Analysis: Increase amount$296,500 Base year (2007) $1,234,000 = 24.0%

18 Exhibit 4 Comparative RE Statement A percentage analysis that shows the relationship of each component to the total within a single statement is called vertical analysis. Lincoln Company Comparative Retained Earnings Statement December 31, 2008 and 2007 Increase (Decrease) Retained earnings, Jan. 1$137,500$100,000$37, % Net income for year 91,000 76,500 14, % Total$228,500$176,500$52, %) Dividends: On preferred stock $ 9,000$ 9,000— On common stock 40,000 30,000 10, % Total$ 49,000$ 39,000$10, % Total current assets$179,500$137,500$42, % AmountPercent

19 Exhibit 4 Comparative RE Statement A percentage analysis that shows the relationship of each component to the total within a single statement is called vertical analysis. Lincoln Company Comparative Retained Earnings Statement December 31, 2008 and 2007 Increase (Decrease) Retained earnings, Jan. 1$137,500$100,000$37, % Net income for year 91,000 76,500 14, % Total$228,500$176,500$52, %) Dividends: On preferred stock $ 9,000$ 9,000— On common stock 40,000 30,000 10, % Total$ 49,000$ 39,000$10, % Total current assets$179,500$137,500$42, % AmountPercent Horizontal Analysis: Horizontal Analysis: Increase amount$37,500 Base year (2007) $100,000 = 37.5%

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

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

22 Lincoln Company Comparative Balance Sheet For the Years Ended December 31, 2008 and 2007 Assets Current assets$ 550, %$ 533, % Long-term investments95, , Property, plant, & equip. (net)444, , Intangible assets 50, , Total assets$1,139, %$1,230, % Liabilities Current liabilities$ 210, %$ 243, % Long-term liabilities 100, , Total liabilities$ 310, %$ 443, % Stockholders’ Equity Preferred 6% stock, $100 par$ 150, %$ 150, % 2.2% Common stock, $10 par500, , Retained earnings 179, , Total stockholders’ equity$ 829, %$ 787, % Total liab. & Stockholders’ equity$1,139, %$1,230, % Amount Percent Amount Percent Total assets $1,139, %$1,230, % Total liab. & stockholders’ equity $1,139, %$1,230, %

23 To demonstrate how vertical analysis percentages are calculated for the balance sheet, let’s see how the 48.3 percent was calculated for the 2008 current assets in the next slide.

24 Lincoln Company Comparative Balance Sheet For the Years Ended December 31, 2008 and 2007 Assets Current assets$ 550, %$ 533, % Long-term investments95, , Property, plant, & equip. (net)444, , Intangible assets 50, , Total assets$1,139, %$1,230, % Liabilities Current liabilities$ 210, %$ 243, % Long-term liabilities 100, , Total liabilities$ 310, %$ 443, % Stockholders’ Equity Preferred 6% stock, $100 par$ 150, %$ 150, % Common stock, $10 par500, , Retained earnings 179, , Total stockholders’ equity$ 829, %$ 787, % Total liab. & Stockholders’ equity$1,139, %$1,230, % Amount Percent Amount Percent Total assets $1,139, %$1,230, % Total liab. & stockholders’ equity $1,139, %$1,230, % Vertical Analysis: Vertical Analysis: Current assets $550,000 Total assets $1,139,500 = 48.3%

25 In a vertical analysis of the income statement, each item is stated as a percent of net sales. As an example, let’s see how the percent of 12.8% was calculated for 2008 selling expenses. Vertical Analysis of Income Statement

26 Sales$1,530, % $1,234, % Sales returns and allow. 32, , Net sales$1,498, %$1,200, % Cost of goods sold 1,043, , Gross profit $ 455, %$ 380, % Selling expenses$ 191, %$ 147, % Administrative expenses 104, , Total operating expenses$ 295, %$ 244, % Income from operations$ 160, $ 135, % Other income 8, , $ 168, %$ 146, % Other expense (interest) 6, , Income before income tax$ 162, %$ 134, % Income tax expense 71, , Net income$ 91,0006.1%$ 76,5006.4% Amount Percent Amount Percent Lincoln Company Comparative Income Statement For the Years Ended December 31, 2008 and 2007

27 Sales$1,530, % $1,234, % Sales returns and allow. 32, , Net sales$1,498, %$1,200, % Cost of goods sold 1,043, , Gross profit $ 455, %$ 380, % Selling expenses$ 191, %$ 147, % Administrative expenses 104, , Total operating expenses$ 295, %$ 244, % Income from operations$ 160, $ 135, % Other income 8, , $ 168, %$ 146, % Other expense (interest) 6, , Income before income tax$ 162, %$ 134, % Income tax expense 71, , Net income$ 91,0006.1%$ 76,5006.4% Amount Percent Amount Percent Lincoln Company Comparative Income Statement For the Years Ended December 31, 2008 and 2007 Vertical Analysis: Vertical Analysis: Selling expenses $191,000 Net sales $1,498,000 = 12.8%

28 Solvency Analysis The ability of a business to meet its financial obligations (debts) is called solvency. The ability of a business to earn income is called profitability.

29 Current Position Analysis Using measures to assess a business’s ability to pay its current liabilities is called current position analysis. Such analysis is of special interest to short-term creditors.

30 Working Capital The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company’s ability to meet currently maturing debts.

31 Working capital (a – b) $340,000 Current asset: Cash$ 90,500 Marketable securities 75,000 Accounts receivable (net)115,000 Inventories 264,000 Prepaid expenses 5,500 a.Total current assets$550,000 b.Current liabilities 210,000 Lincoln Company

32 Current Ratio The current ratio, sometimes called the working capital ratio or bankers’ ratio, is computed by dividing the total current assets by the total current liabilities.

33 Current ratio (a/b) Current ratio (a/b) a. Current assets $550,000$533,000 b. Current liabilities 210, ,000 Working capital (a – b)$340,000$290, Lincoln Company

34 Quick Ratio A ratio that measures the “instant’ debt-paying ability of a company is called the quick ratio or acid-test ratio.

Quick ratio (a/b) Quick assets: Cash$ 90,500$ 64,700 Marketable securities 75,00060,000 Accounts receivable (net)115,000120,000 a. Total quick assets$280,500$244,700 b. Current liabilities$210,000$243,000 Lincoln Company Quick assets are cash and other current assets that can be quickly converted to cash.

37 Accounts Receivable Turnover The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. The ratio is to assess the efficiency of the firm in collecting receivables and in the managing of credit.

38 Number of Days’ Sales in Receivables The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. Comparing this measure with the credit terms provides information on the efficiency in collecting receivables.

39 Number of days’ sales in receivables (a/b) receivables (a/b) a.Average (Total/2)$ 117,500$ 130,000 Net sales$1,498,000$1,200,000 b.Average daily sales on account (Sales/365)$ 4,104$ 3, Lincoln Company

Financial Statement Analysis at different Stages 2

41 Inventory Turnover 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 the firm in managing its inventory.

Inventory turnover (a/b) Inventory turnover (a/b) a.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 b.Average (Total/2)$ 273,500$ 297,000 Lincoln Company

43 Number of days’ sales in inventory (a/b) inventory (a/b) a.Average (Total/2)$ 273,500$ 297,000 Cost of goods sold$1,043,000$ 820,000 b.Average daily cost of goods sold (COGS/365 days)$2,858$2, Number of Days’ Sales in Inventory Lincoln Company

44 Ratio of Fixed Assets to Long-Term Liabilities The ratio of fixed assets to long- term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis.

Ratio of fixed assets to Ratio of fixed assets to long-term liabilities (a/b) long-term liabilities (a/b) a. Fixed assets (net)$444,500$470,000 b.Long-term liabilities$100,000$200,000 Lincoln Company

46 Ratio of Liabilities to Stockholders’ Equity The relationship between the total claims of the creditors and owners—the ratio of liabilities to stockholders’ equity—is a solvency measure that indicates the margin of safety for creditors.

47 Ratio of liabilities to Ratio of liabilities to stockholders’ equity (a/b) stockholders’ equity (a/b) a.Total liabilities$310,000$443,000 b.Total stockholders’ equity$829,500$787, Lincoln Company

48 Profitability Analysis  Profitability is the ability of an entity to earn profits.  This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available as reported in the balance sheet.  Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet.

49 Ratio of Net Sales to Assets The ratio of net sales to assets is a profitability measure that shows how effectively a firm utilizes its assets.

a.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 b.Average (Total/2)$1,048,750$1,031,500 Lincoln Company Excludes long-term investments

a.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 b.Average (Total/2)$1,048,750$1,031,500 Lincoln Company Ratio of net sales to assets (a/b) Ratio of net sales to assets (a/b)

52 Leverage is a business term that refers to borrowing. If a business is "leveraged," it means that the business has borrowed money to finance the purchase of assets. The other way to purchase assets is through use of owner funds, or equity.equity. One way to determine leverage is to calculate the Debt-to- Equity ratio, showing how much of the assets of the business are financed by debt and how much by equity(ownership).Debt-to- Equity ratio, Leverage is not necessarily a bad thing. Leverage is useful to fund company growth and development through the purchase of assets. But if the company has too much borrowing, it may not be able to pay back all of its debts. Leverage

53 Earnings per Share on Common Stock One of the profitability measures often quoted by the financial press is earning per share (EPS) on common stock. It is also normally reported in the income statement in corporate annual reports.

Earnings per share on common Earnings per share on common stock (a/b) $1.64 $1.35 stock (a/b) $1.64 $1.35 Net income$ 91,000$ 76,500 Preferred dividends 9,000 9,000 a.Remainder—identified with common stock$ 82,000$ 67,500 b.Shares of common stock50,00050,000 Lincoln Company

55 Price-Earnings Ratio Another profitability measure quoted by the financial press is the price- earnings (P/E) ratio on common stock. The price- earnings ratio is an indicator of a firm’s future earnings prospects.

Price-earnings ratio on Price-earnings ratio on common stock common stock Market price per share of common stock$41.00$27.00 Earnings per share on common stock ÷ 1.64÷ 1.35 Lincoln Company

57 The dividend yield on common stock is a profitability measure that shows the rate of return to common stockholders in terms of cash dividends. Dividend Yield

Dividend yield on Dividend yield on common stock 2.0% 2.2% 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 Lincoln Company

59 Corporate Annual Reports In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections:  Management Discussion and Analysis  Report on adequacy of internal control  Report on fairness of financial statements

Accounting Accounting is the process of measuring, interpreting, and communicating financial information to support internal and external business decision making.

Business Activities Involving Accounting  Financing activities provide necessary funds to start a business and expand it after it begins operating.  Investing activities provide valuable assets required to run a business.  Operating activities focus on selling goods and services, but they also consider expenses as important elements of sound financial management.

Generally accepted accounting principles (GAAP) encompass the conventions, rules, and procedures for determining acceptable accounting practices at a particular time.GAAP Financial Accounting Standards Board (FASB) is primarily responsible for evaluating, setting, or modifying GAAP in the U.S.FASB Sarbanes-Oxley Act responded to cases of accounting fraud. –Created the Public Accounting Oversight Board, which sets audit standards and investigates and sanctions accounting firms that certify the books of publicly traded firms. –Senior executives must personally certify that the financial information reported by the company is correct. –Resulted in increase in demand for accountants. The Foundation of Accounting Systems

The Accounting Cycle Accounting process - set of activities involved in converting information about transactions into financial statements.

Assets - anything of value owned or leased by a business. Liability - claim against a firm’s assets by a creditor. Owner’s equity - all claims of the proprietor, partners, or stockholders against the assets of a firm, equal to the excess of assets over liabilities. Basic accounting equation - relationship that states that assets equal liabilities plus owners’ equity. Double-entry bookkeeping - process by which accounting transactions are entered; each individual transaction always has an offsetting transaction. The Accounting Equation

Balance sheet - statement of a firm’s financial position—what it owns and the claims against its assets—at a particular point in time. Photograph of firm’s assets together with its liabilities and owner’s equity Follows the accounting equation Balance Sheet

Sample Balance Sheet

Income Statement - financial record of a company’s revenues and expenses, and profits over a period of time. Firm’s financial performance in terms of revenues, expenses, and profits over a given time period. Reports profit or loss. Focus on revenues and costs associated with revenues.

Sample Income Statement

Statement of Owner’s Equity Statement of Owner’s Equity - is designed to show the components of the change in equity from the end of one fiscal year to the end of the next. Begins with the amount of equity shown on the balance sheet. Net income is added, and cash dividends paid to owners are subtracted.

Sample Statement of Owner’s Equity

The Statement of Cash Flows Statement of cash flows - a firm’s cash receipts and cash payments that presents information on its sources and uses of cash. Accrual accounting - method that records revenue and expenses when they occur, not necessarily when cash actually changes hands.

Sample Statement of Cash Flows

Financial Ratios Analysis Ratio analysis - tool for measuring a firm’s liquidity, profitability, and reliance on debt financing, as well as the effectiveness of management’s resource utilization.

Liquidity Ratios Acid-test (or quick) ratio measures the ability of a firm to meet its debt payments on short notice. Cash and equivalents + short-term investments + accounts receivable Total current liabilities Current ratio compares current assets to current liabilities. Total current assets Total current liabilities

Activity Ratios Inventory turnover ratio indicates the number of times merchandise moves through a business. Net sales Average of inventory Total asset turnover ratio indicates how much in sales each dollar invested in assets generates. Net sales Average of total assets

Profitability Ratios Profitability ratios measure the organization’s overall financial performance by evaluating its ability to generate revenues in excess of operating costs and other expenses.

Leverage ratios measure the extent to which a firm relies on debt financing. Total liabilities to total assets ratio > 50 percent indicates that a firm is relying more on borrowed money than owners’ equity. Leverage Ratios

Budget - planning and control tool that reflects a firm’s expected sales revenues, operating expenses, and cash receipts and outlays. Management estimates of expected sales, cash inflows and outflows, and costs. Budgets are a financial blueprint that serves as a financial plan. Cash budget - tracks the firm’s cash inflows and outflows. Budgets

Sample Budget