Financial Statement Analysis Chapter 19 HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT

Objectives 1. Perform a horizontal analysis of comparative financial statements 2. Perform vertical analysis of financial statements 3. Prepare common size financial statements 4. Calculate the standard financial ratios used for decision-makers 5. Use ratios in decision-making 6. Measure economic value added by a company’s operations

The Annual Report Usually Contains ... financial statements. footnotes to the financial statements. a summary of accounting methods used. management discussion and analysis of the financial results. an auditor’s report. comparative financial data for series of year.

analysis of comparative Objective 1 Perform a horizontal analysis of comparative financial statements.

Horizontal Analysis Increase/(Decrease) 2004 2003 Amount Percent Sales $41,500 $37,850 $3,650 9.6% Expenses 40,000 36,900 3,100 8.4% Net profit 1,500 950 550 57.9%

Horizontal Analysis 2004 2003 Difference Sales $41,500 $37,850 $3,650

Trend % = Any year $ ÷ Base year $ Trend Percentages... are calculated by selecting a base year whose amounts are set equal to 100%. The amounts of each following year are expressed as a percentage of the base amount. Trend % = Any year $ ÷ Base year $

What are the trend percentages? Year 2004 2003 2002 Revenues $27,611 $24,215 $21,718 Cost of sales 15,318 14,709 13,049 Gross profit $12,293 $ 9,506 $ 8,669 2002 is the base year. What are the trend percentages?

Trend Percentages These percentages were calculated by Year 2004 2003 2002 Revenues 127% 111% 100% Cost of sales 117% 113% 100% Gross profit 142% 110% 100% These percentages were calculated by dividing each item by the base year.

Perform a vertical analysis of financial statements. Objective 2 Perform a vertical analysis of financial statements.

Vertical Analysis... compares each item in a financial statement to a base number set to 100%. Every item on the financial statement is then reported as a percentage of that base.

Vertical Analysis 2004 % Revenues $38,303 100.0 2004 % Revenues $38,303 100.0 Cost of sales 19,688 51.4 Gross profit $18,615 48.6 Total operating expenses 13,209 34.5 Operating profit $ 5,406 14.1 Other income 2,187 5.7 Income before taxes $ 7,593 19.8 Income taxes 2,827 7.4 Net profit $ 4,766 12.4

Vertical Analysis Assets 2004 % Current assets: Cash $ 1,816 4.7 Receivables net 10,438 26.9 Inventories 6,151 15.9 Prepaid expenses 3,526 9.1 Total current assets $21,931 56.6 Plant and equipment, net 6,847 17.7 Other assets 9,997 25.7 Total assets $38,775 100.0

Objective 3 Prepare common-size financial statements.

Common-size Statements On the statement of financial performance, each item is expressed as a percentage of net sales. On the statement of financial position, the common size is the total on each side of the accounting equation. Common-size statements are used to compare one company to other companies, and to the industry average.

Benchmarking Percent of Net Sales Technology Limited Enterprise Limited  Cost of goods sold  Operating expenses  Income tax  Net profit

Calculate the standard Objective 4 Calculate the standard financial ratios used by decision-makers.

Ratio Classification Measuring ability to pay current liabilities Measuring ability to sell inventory and collect receivables Measuring ability to pay long-term debt Measuring profitability Analysing shares as an investment

The Data (Exhibit 19-1 Lucent Technology 20X7) Net sales (Year 2004) $858,000 Cost of goods sold 513,000 Gross profit $345,000 Total operating expenses 244,000 Plus Interest revenue 4,000 Interest expense (24,000) Profits before taxes $ 81,000 Income tax 33,000 Net profits $ 48,000

The Data (Exhibit 19-2 Lucent Technology 20X7 and 20X6) Assets 2004 2003 Current assets: Cash $ 29,000 $ 32,000 Receivables net 114,000 85,000 Inventories 113,000 111,000 Prepaid expenses 6,000 8,000 Total current assets $262,000 $236,000 Long-term investments 18,000 9,000 Plant and equipment, net 507,000 399,000 Total assets $787,000 $644,000

The Data (Exhibit 19-2 Lucent Technology 20X7 and 20X8) Liabilities 2004 2003 Current liabilities: Bills payable $ 42,000 $ 27,000 Accounts payable 73,000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities $142,000 $126,000 Long-term debt 289,000 198,000 Total liabilities $431,000 $324,000

The Data (Exhibit 19-1 Lucent Technology 20X7 and 20X8) Shareholders’ Equity 2004 2003 Ordinary shares (93,000) $186,000 $186,000 Retained earnings 170,000 134,000 Total shareholders’ equity $356,000 $320,000 Total liabilities and shareholders’ equity $787,000 $644,000

Measuring Ability to Pay Current Liabilities The current ratio measures the company’s ability to pay current liabilities with current assets. Current ratio = Total current assets ÷ Total current liabilities

Measuring Ability to Pay Current Liabilities Lucent’s current ratio: 2003: $236,000 ÷ $126,000 = 1.87 2004: $262,000 ÷ $142,000 = 1.85 If the industry average is 1.80. What does this tell us? The current ratio decreased slightly during 2004 but it is still slightly higher than the industry average.

Measuring Ability to Pay Current Liabilities The acid-test ratio shows the company’s ability to pay all current liabilities if they come due immediately. Acid-test ratio = (Cash + Short-term investments + Net current receivables) ÷ Total current liabilities

Measuring Ability to Pay Current Liabilities Lucent’s acid-test ratio: 2003: ($32,000 + $85,000) ÷ $126,000 = .93 2004: ($29,000 + $114,000) ÷ $142,000 = 1.01 If the industry average is .60. The company’s acid-test ratio improved considerably during 2004 and is well above the industry average.

Measuring Ability to Sell Inventory Inventory turnover is a measure of the number of times the average level of inventory is sold during a year. Inventory turnover = Cost of goods sold ÷ Average inventory

Measuring Ability to Sell Inventory Inventory turnover: 2004: $513,000 ÷ $112,000* = 4.58 If the industry average is 2.70. A high number indicates an ability to quickly sell inventory, but it might indicate stock-outs! * Average inventory ($113,000 + $111,000) ÷ 2

Measuring Ability to Collect Receivables Accounts receivable turnover measures a company’s ability to collect cash from credit customers. Accounts receivable turnover = Net credit sales ÷ Average accounts receivable

Measuring Ability to Collect Receivables Lucent’s accounts receivable turnover: 2004: $858,000 ÷ $99,500 = 8.62 times If the industry average is 22.2 times. Lucent’s receivable turnover is much lower than the industry average. If the company is a rural store that sells to local people who tend to pay their bills over a lengthy period of time – then?

Measuring Ability to Collect Receivables Days’ sales in receivable ratio measures how many day’s sales remain in Accounts Receivable. One day’s sales = Net sales ÷ 365 days Days’ sales in Accounts Receivable = Average net Accounts Receivable ÷ One day’s sales

Measuring Ability to Collect Receivables Days’ sales in Accounts Receivable for 2004: One day’s sales: $858,000 ÷ 365 = $2,351 Days’ sales in Accounts Receivable: $99,500 ÷ $2,351 = 42 days What is the industry average - 365/22.2

Measuring Ability to Pay Debt The debt ratio indicates the proportion of assets financed with debt. Total liabilities ÷ Total assets

Measuring Ability to Pay Debt Lucent’s debt ratio: 2003: $324,000 ÷ $644,000 = 0.50 2004: $431,000 ÷ $787,000 = 0.55 Industry average 0.61. Lucent expanded operations during 2004 by financing through borrowing – but it is still lower than the industry.

Measuring Ability to Pay Debt Times-interest-earned ratio measures the number of times profits before both interest and tax can cover interest expense. Times-interest-earned = Net Profits plus (interest expense and tax) ÷ Interest expense

Measuring Ability to Pay Debt Times-interest-earned ratio: 2004: ($81,000 + $24,000*) ÷ $24,000 = 4.37 The industry average is 2.00. This is a favorable sign. * Profits before tax are $81,000 (or $48,000 + $33,000) and if we paid no interest of $24,000 profits would be $105,000.

Measuring Profitability Rate of return on net sales shows the percentage of each sales dollar earned as net profits. Rate of return on net sales = Net profits ÷ Net sales

Measuring Profitability Lucent’s rate of return on sales: 2003: $26,000 ÷ $803,000 = 0.032 2004: $48,000 ÷ $858,000 = 0.056 The industry average is 0.008. The increase is significant in itself and also because it is much better than the industry average.

Measuring Profitability Rate of return on total assets measures how profitably a company uses its assets. Rate of return on total assets = (Net profits + income tax + interest expense) ÷ Average total assets

Measuring Profitability Rate of return on total assets for 2004: $105,000 ÷ $715,500* = 0.147 What if the industry average is 0.049. How does Lucent compare to the industry? * ($644,000 + $787,000) ÷ 2 = $715,500

Measuring Profitability Shareholders equity includes any additional issued ordinary shares and retained profits. Rate of return on ordinary shareholders’ equity = (Net profits – preferred dividends) ÷ Average ordinary shareholders’ equity

Measuring Profitability Lucent’s rate of return on ordinary shareholders’ equity for 2004: ($48,000 – $0) ÷ $338,000* = 0.142 Why is this ratio larger than the return on total assets (.101)? Because Lucent uses leverage or gearing. * ($356,000 + $320,000) ÷ 2 = $338,000

Gearing Example I borrow $90 (at 5%) and I put in $10 Invest $100 and earn 10% on it Revenue $10.00 ($100 x 10%) Expenses $ 4.50 ($90 x 5%) Profit $ 5.50 Not bad on the $10 I put in. But what if the assets only earned say 2% Loss of $2.50 Gearing is RISKY !

Measuring Profitability Earnings per share (EPS) = (Net profits – Preferred dividends) ÷ Number of ordinary shares issued

Measuring Profitability Lucent’s earnings per share: 2004: ($48,000 – $0) ÷ 93,000 = $0.52 EPS is important because it is becoming common to express the profit in this form rather than large dollar amounts. Only important in comparison to previous EPS not other companies EPS. Why?

Analysing Shares as an Investment Price/earning ratio is the ratio of market price per share ($5) to earnings per share. 2004: $5 ÷ $0.52 = 9.6 Given Lucent’s 2004 P/E ratio of 9.6, we would say that the company’s shares are selling at 9.6 times earnings. P/E ratios are commonly provided for listed companies.

Analysing Shares as an Investment Dividend yield shows the percentage of a share’s market value returned as dividends to shareholders each period. Dividend per ordinary share ÷ market price per ordinary shares

Analysing Shares as an Investment Dividend yield on Lucent’s ordinary shares: 2004: $0.12 ÷ $5.00 = .024 (2.4%) An investor who buys Lucent’s ordinary shares for $5 may expect to receive 2.4% of the investment annually in the form of cash dividends.

Analysing Shares as an Investment Book value per ordinary share = (Total ordinary shareholders’ equity) ÷ Number of ordinary shares issued

Analysing Shares as an Investment Book value per share of Lucent’s ordinary shares: 2003: ($320,000) ÷ 93,000 = $3.44 2004: ($356,000) ÷ 93,000 = $3.83 Book value bears no relationship to market value.

Use ratios in decision making. Objective 5 Use ratios in decision making.

Limitations of Financial Analysis Business decisions are made in a world of uncertainty. No single ratio or one-year figure should be relied upon to provide an assessment of a company’s performance.

Measure economic value added. Objective 6 Measure economic value added.

Economic Value Added (EVA®) Economic value added (EVA®) combines accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth. EVA® = Net profits + Interest expense – Capital charge

End of Chapter 19