1 Click to edit Master title style Financial Statement Analysis

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

3 Click to edit Master title style List basic financial statement analytical procedures. Objective

4 Click to edit Master title style Horizontal Analysis 17-1 The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis.

5 Click to edit Master title style Exhibit 1 Comparative Balance Sheets 17-1 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 Increase (Decrease) 5 Lincoln Company Comparative Balance Sheet December 31, 2008 and 2007

6 Click to edit Master title style 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%

7 Click to edit Master title style 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) 17-1 Horizontal Analysis: Horizontal Analysis: Difference$(82,500) Base year (2007)$177,500 = (46.5%)

8 Click to edit Master title style Exhibit 2 Comparative Schedule of Current Assets 17-1 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

9 Click to edit Master title style 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

10 Click to edit Master title style 10 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 17-1

11 Click to edit Master title style 11 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) 17-1 Horizontal Analysis: Horizontal Analysis: Increase amount$296,500 Base year (2007) $1,234,000 = 24.0%

12 Click to edit Master title style 12 Exhibit 4 Comparative RE Statement 17-1 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

13 Click to edit Master title style 13 Exhibit 4 Comparative RE Statement 17-1 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%

14 Click to edit Master title style 14 Example Exercise The comparative cash and accounts receivable for a company are provided below: Cash$62,500$50,000 Accounts receivable (net)74,40080,000 Based on this information, what is the amount and percentage of increase or decrease that would be shown in a balance sheet with horizontal analysis? 14

15 Click to edit Master title style 15 For Practice: PE 17-1A, PE 17-1B Follow My Example Cash$12,500 increase ($62,500 – $50,000), or 25% Accounts Receivable$5,600 decrease ($74,400 – $80,000) or –7%

16 Click to edit Master title style 16 Vertical Analysis 17-1 A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis.

17 Click to edit Master title style 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

18 Click to edit Master title style 18 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, %

19 Click to edit Master title style 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.

20 Click to edit Master title style 20 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%

21 Click to edit Master title style 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

22 Click to edit Master title style 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

23 Click to edit Master title style 23 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 Vertical Analysis: Vertical Analysis: Selling expenses $191,000 Net sales $1,498,000 = 12.8%

24 Click to edit Master title style Common-Size Statements In a common-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with with industry percentages.

25 Click to edit Master title style Common-Size Income Statement

26 Click to edit Master title style 26 Example Exercise Income statement information for Lee Corporation is provided below: Lee Corporation Sales$100,000 Cost of goods sold 65,000 Gross profit$ 35,000 Prepare a vertical analysis of the income statement for Lee Corporation. 26

27 Click to edit Master title style 27 For Practice: PE 17-2A, PE 17-2B Follow My Example Sales$100,000100%($100,000/$100,000) Cost of goods sold 65,000 65($65,000/$100,000) Gross profit35,00035%($35,000/$100,000) Amount Percentage

28 Click to edit Master title style 28 Apply financial statement analysis to assess the solvency of a business. Objective

29 Click to edit Master title style 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.

30 Click to edit Master title style 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.

31 Click to edit Master title style 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.

32 Click to edit Master title style 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. a.Total current assets$550,000 b. b.Current liabilities 210,000 Lincoln Company

33 Click to edit Master title style 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.

34 Click to edit Master title style 34 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

35 Click to edit Master title style Quick Ratio A ratio that measures the “instant’ debt-paying ability of a company is called the quick ratio or acid-test ratio.

36 Click to edit Master title style 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 Click to edit Master title style 37 Example Exercise The following items are reported on a company’s balance sheet: Cash$300,000 Marketable securities100,000 Accounts receivable (net)200,000 Inventory200,000 Accounts payable400,000 Determine (a) the current ratio and (b) the quick ratio. 37

38 Click to edit Master title style 38 For Practice: PE 17-3A, PE 17-3B Follow My Example a. a.Current Ratio = Current Assets/Current Liabilities Current Ratio = ($300,000 + $100,000 + $200,000 + $200,000)/$400,000 Current Ratio = 2.0 b. b.Quick Ratio = Quick Assets (cash, marketable securities, and accounts receivable)/Current Liabilities (accounts payable) Quick Ratio = ($300,000 + $100,000 + $200,000)/$400,000 Quick Ratio =

39 Click to edit Master title style 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.

40 Click to edit Master title style Accounts receivable turnover (a/b) a. 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 b. b.Average (Total/2)$ 117,500$ 130, Lincoln Company

41 Click to edit Master title style 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.

42 Click to edit Master title style 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 42

43 Click to edit Master title style 43 Example Exercise A company reports the following: Net sales$960,000 Average accounts receivable (net) 48,000 Determine (a) the accounts receivable turnover and (b) the number of days’ sales in receivables. Round to one decimal place. 43

44 Click to edit Master title style 44 For Practice: PE 17-4A, PE 17-4B Follow My Example a. a.Accounts Receivable Turnover = Sales/Average accounts receivable Accounts Receivable Turnover = $960,000/$48,000 Accounts Receivable Turnover = 20.0 b. b.Number of Days’ Sales in Receivables = Average accounts receivable/Average daily sales Number of Days’ Sales in Receivables = $48,000/($960,000/ 365) Number of Days’ Sales in Receivables = $48,000/$2,630 Number of Days’ Sales in Receivables = 18.3 days

45 Click to edit Master title style 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.

46 Click to edit Master title style 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. b.Average (Total/2)$ 273,500$ 297,000 Lincoln Company

47 Click to edit Master title style 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. b.Average daily cost of goods sold (COGS/365 days)$2,858$2, Number of Days’ Sales in Inventory Lincoln Company

48 Click to edit Master title style 48 Example Exercise A company reports the following: Cost of goods sold$560,000 Average inventory112,000 Determine (a) the inventory turnover and (b) the number of days’ sales in inventory. Round to one decimal place. 48

49 Click to edit Master title style 49 For Practice: PE 17-5A, PE 17-5B Follow My Example a.Inventory Turnover = Cost of Goods Sold/Average Inventory Inventory Turnover = $560,000/$112,000 Inventory Turnover = 5.0 b. b.Number of Days’ Sales in Inventory = Average Inventory/ Average Daily Cost of Goods Sold Number of Days’ Sales in Inventory = $112,000/ ($560,000/365) Number of Days’ Sales in Inventory =$112,000/$1,534 Number of Days’ Sales in Inventory = 73.0 days

50 Click to edit Master title style 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.

51 Click to edit Master title style 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, Lincoln Company

52 Click to edit Master title style 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.

53 Click to edit Master title style 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

54 Click to edit Master title style 54 Example Exercise The following information was taken from Acme Company’s balance sheet: Fixed assets (net)$1,400,000 Long-term liabilities 400,000 Total liabilities 560,000 Total stockholders’ equity1,400,000 Determine the company’s (a) ratio of fixed assets to long-term liabilities and (b) ratio of liabilities to stockholders’ equity. 54

55 Click to edit Master title style 55 For Practice: PE 17-6A, PE 17-6B Follow My Example a. a.Ratio of Fixed Assets to Long-Term Liabilities = Fixed Assets/ Long-Term Liabilities Ratio of Fixed Assets to Long-Term Liabilities = $1,400,000/ $400,000 Ratio of Fixed Assets to Long-Term Liabilities = 3.5 b. b.Ratio of Liabilities to Total Stockholders’ Equity = Total Liabilities/Total Stockholders’ Equity Ratio of Liabilities to Total Stockholders’ Equity = $560,000/ $1,400,000 Ratio of Liabilities to Total Stockholders’ Equity = 0.4

56 Click to edit Master title style Number of Times Interest Charges Earned Corporations in some industries normally have high ratios of debt to stockholders’ equity. For such corporations, the relative risk of the debtholders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio.

57 Click to edit Master title style Income before income tax$162,500$134,600 a.Add interest expense 6,000 12,000 b. b.Amount available to meet interest charges$168,500$146, Lincoln Company Number of times interest charges earned (b/a) charges earned (b/a)

58 Click to edit Master title style 58 Example Exercise A company reports the following: Income before income tax$250,000 Interest expense100,000 Determine the number of times interest charges are earned. 58

59 Click to edit Master title style 59 For Practice: PE 17-7A, PE 17-7B Follow My Example Number of Times Interest Charges are Earned = (Income Before Income Tax + Interest Expense)/ Interest Expense Number of Times Interest Charges are Earned = ($250,000 + $100,000)/$100,000 Number of Times Interest Charges are Earned = 3.5

60 Click to edit Master title style 60 Apply financial statement analysis to assess the profitability of a business. Objective

61 Click to edit Master title style 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.

62 Click to edit Master title style 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.

63 Click to edit Master title style 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, Lincoln Company Excludes long-term investments

64 Click to edit Master title style 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, Lincoln Company Ratio of net sales to assets (a/b) Ratio of net sales to assets (a/b)

65 Click to edit Master title style 65 Example Exercise A company reports the following: Net sales$2,250,000 Average total sales1,500,000 Determine the ratio of net sales to assets. 65 Follow My Example 17-8 Ratio of Net Sales to Total Assets = Net Sales/Average Total Assets Ratio of Net Sales to Total Assets = $2,250,000/$1,500,000 Ratio of Net Sales to Total Assets = 1.5 For Practice: PE 17-8A, PE 17-8B

66 Click to edit Master title style Rate Earned on Total Assets The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed.

67 Click to edit Master title style Rate earned on total Rate earned on total assets (a/b) 8.2% 7.3% assets (a/b) 8.2% 7.3% Net income$ 91,000$ 76,500 Plus interest expense 6,000 12,000 a.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 b.Average (Total/2)$1,185,000$1,209, Lincoln Company

68 Click to edit Master title style 68 Example Exercise A company reports the following income statement and balance sheet information for the current year: Net income$ 125,000 Interest expense 25,000 Average total assets2,000,000 Determine the rate earned on total assets. 68

69 Click to edit Master title style 69 For Practice: PE 17-9A, PE 17-9B Follow My Example Rate Earned on Total Assets = (Net Income + Interest Expense)/Average Total Assets Rate Earned on Total Assets = ($125,000 + $25,000)/$2,000,000 Rate Earned on Total Assets = 7.5%

70 Click to edit Master title style Rate Earned on Stockholders’ Equity The rate earned on stockholders’ equity measure emphasizes the rate of income earned on the amount invested by the stockholders.

71 Click to edit Master title style 71 Rate earned on stockholders’ equity (a/b) 11.3% 10.0% a.Net income$ 91,000$ 76,500 Stockholders’ equity: Beginning of year$ 787,500$ 750,000 End of year 829, ,500 Total$1,617,000$1,537,500 b.Average (Total/2)$ 808,500$ 768, Lincoln Company

72 Click to edit Master title style The difference in the rate earned on stockholders’ equity and the rate earned on total assets is called leverage. Leverage

73 Click to edit Master title style 73 10% 5% 0% Rate earned on total assets Rate earned on stockholders’ equity 8.2% 11.3% Leverage 3.1% % 10.0% Leverage 2.7% Exhibit 8 Leverage

74 Click to edit Master title style The rate earned on common stockholders’ equity focuses only on the rate of profits earned on the amount invested by the common stockholders. Rate Earned on Common Stockholders’ Equity

75 Click to edit Master title style Net income$ 91,000$ 76,500 Less preferred dividends 9,000 9,000 a.Remainder—common stock$ 82,000$ 67,500 Common stockholders’ equity: Beginning of year $ 637,500$ 600,000 End of year 679, ,500 Total$1,317,000$1,237,500 b.Average (Total/2)$ 658,500$ 618,750 Rate earned on common Rate earned on common stockholders’ equity (a/b) 12.5% 10.9% stockholders’ equity (a/b) 12.5% 10.9% 17-3 Lincoln Company 75

76 Click to edit Master title style 76 Example Exercise A company reports the following: Net income$ 125,000 Preferred dividends 5,000 Average stockholders’ equity1,000,000 Average common stockholders’ equity 800,000 Determine (a) the rate earned on stockholders’ equity and (b) the rate earned on common stockholders’ equity. 76

77 Click to edit Master title style 77 For Practice: PE 17-10A, PE 17-10B Follow My Example a. Rate Earned on Stockholders’ Equity = Net Income/Average Stockholders’ Equity Rate Earned on Stockholders’ Equity = $125,000/$1,000,000 Rate Earned on Stockholders’ Equity = 12.5% b. Rate Earned on Common Stockholders’ Equity = (Net Income – Preferred Dividends)/Average Common Stockholders’ Equity Rate Earned on Common Stockholders’ Equity = ($125,000 – $5,000)/$800,000 Rate Earned on Common Stockholders’ Equity = 15%

78 Click to edit Master title style 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.

79 Click to edit Master title style 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. a.Remainder—identified with common stock$ 82,000$ 67,500 b.Shares of common stock50,00050,000 Lincoln Company 17-3

80 Click to edit Master title style 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.

81 Click to edit Master title style 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÷ Lincoln Company

82 Click to edit Master title style 82 Example Exercise A company reports the following: Net income$250,000 Preferred dividends$15,000 Shares of common stock outstanding20,000 Market price per share of common stock$35 a. a.Determine the company’s earnings per share on common stock. b. b.Determine the company’s price-earnings ratio. Round to one decimal place. 82

83 Click to edit Master title style 83 Follow My Example (a) Earnings Per Share of Common Stock = (Net Income – Preferred Dividends)/Shares of Common Stock Outstanding Earnings per Share of Common Stock = ($250,000 – $15,000)/20,000 Earnings per Share of Common Stock = $11.75 (Continued)

84 Click to edit Master title style (b) Price-Earnings Ratio = Market Price per Share of Common Stock/Earnings per Share on Common Stock Price-Earnings Ratio = $35.00/$11.75 Price-Earnings Ratio = 3.0 Follow My Example For Practice: PE 17-11A, PE 17-11B

85 Click to edit Master title style Dividends per Share Dividends per share can be reported with earnings per share to indicate the relationship between dividends and earnings. Comparing these two per share amounts indicates the extent to which the corporation is retaining its earnings for use in operations.

86 Click to edit Master title style 86 Dividends Earnings $0.80 $ $0.60 $ Per share $2.00 $1.50 $1.00 $0.50 $ Lincoln Company Exhibit 9: Dividends and Earning per Share of Common Stock

87 Click to edit Master title style 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

88 Click to edit Master title style 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÷ Lincoln Company

89 Click to edit Master title style 89 Describe the contents of corporate annual reports. Objective

90 Click to edit Master title style 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

91 Click to edit Master title style 91 The Management Discussion and Analysis (MD&A) includes an analysis of the results of operations and discusses management’s opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition Management Discussion and Analysis

92 Click to edit Master title style 92 Management is required by the Sarbanes- Oxley Act of 2002 to provide a report stating their responsibility for establishing and maintaining internal control. In addition, the report must state management’s conclusion concerning the effectiveness of internal controls over financial reporting Report on Adequacy of Internal Control

93 Click to edit Master title style 93 All publicly held corporations are required to have an independent audit (examination) of their financial statements. The CPAs who conduct the audit render an opinion on the fairness of the statements Report on Fairness of Financial Statements