Financial Statement Analysis Chapter 15 ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-1

Learning Objectives 1.Explain how financial statements are used to analyze a business. 2.Perform a horizontal analysis of financial statements. 3.Perform a vertical analysis of financial statements. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-2

Learning Objectives 4.Compute and evaluate the standard financial ratios. 5.Complete a corporate income statement including earnings per share (Appendix 15A). ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-3

Learning Objective 1 Explain how financial statements are used to analyze a business. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-4

Different Comparisons Financial performance analysis allows us to make several comparisons Year-to-Year. –Use Horizontal Analysis vs. a Competing Company. –Use Vertical Analysis with the industry or other companies in the industry. –Use Ratio Analysis ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-5

Sources for Information Annual Reports Management Discussion and Analysis Report of the Independent Auditors Financial Statements Notes to Financial Statements ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-6

Sources for Information Annual ReportsAnnual Reports Management Discussion and Analysis Report of the Independent Auditors Financial Statements Notes to Financial Statements A report required by the Securities and Exchange Commission that provides information about a company’s financial condition. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-7

Sources for Information Annual Reports Management Discussion and AnalysisManagement Discussion and Analysis Report of the Independent Auditors Financial Statements Notes to Financial Statements The section of the annual report that is intended to help investors understand the result of operations and the financial condition of the company. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-8

Sources for Information Annual Reports Management Discussion and Analysis Report of the Independent AuditorsReport of the Independent Auditors Financial Statements Notes to Financial Statements The report that gives reasonable assurance that the financial statements are presented fairly in accordance with generally accepted accounting principles. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-9

Sources for Information Annual Reports Management Discussion and Analysis Report of the Independent Auditors Financial StatementsFinancial Statements Notes to Financial Statements Includes: Income StatementIncome Statement Statement of Stockholders’ EquityStatement of Stockholders’ Equity Balance SheetBalance Sheet Statement of Cash Flows.Statement of Cash Flows. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-10

Sources for Information Annual Reports Management Discussion and Analysis Report of the Independent Auditors Financial Statements Notes to Financial StatementsNotes to Financial Statements Required disclosures included with the financial statements that provide additional information about the statement amounts. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-11

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Learning Objective 2 Perform a horizontal analysis of financial statements. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-17

Horizontal Analysis Defined: The study of percentage changes in comparative financial statements.Defined: The study of percentage changes in comparative financial statements. Requires two steps:Requires two steps: 1.Compute the $-amount of the change from the earlier period to the later period. 2.Divide the $-amount of change by the earlier period amount (base period). ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-18

Horizontal Analysis Assume Smart Touch Learning has net sales in 2016 of $858,000 and $803,000 in Prepare the horizontal analysis: ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-19

Horizontal Analysis Assume Smart Touch Learning has net sales in 2016 of $858,000 and $803,000 in Prepare the horizontal analysis: Step  Step  ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-20

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Trend Analysis Defined: A special form of horizontal analysis that looks at how ratios change over time.Defined: A special form of horizontal analysis that looks at how ratios change over time. Requires two steps:Requires two steps: 1.Identify a base period amount. 2.All subsequent amounts are stated as a % of the base period amount. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-24

Trend Analysis Smart Touch Learning’s Net Sales were $750,000 for 2012 and rose to $858,000 in Compute the trend percentages for each year from 2012 to First, compute the trend % for the base period of ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-25

Trend Analysis Smart Touch Learning’s Net Sales were $750,000 for 2012 and rose to $858,000 in Compute the trend percentages for each year from 2012 to The base year trend % is always 100%. Now compute the trend % for ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-26

Trend Analysis Smart Touch Learning’s Net Sales were $750,000 for 2012 and rose to $858,000 in Next compute the trend percentages for 2014 to ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-27

Trend Analysis Smart Touch Learning’s Net Sales were $750,000 for 2012 and rose to $858,000 in An assessment of the increase in sales, as a percentage of 2012 sales can show whether sales are moving in the desire direction. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-28

Prepare a horizontal analysis of revenues, cost of goods sold, and gross profit in $ and % for 2016 and ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-29

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Learning Objective 3 Perform a vertical analysis of financial statements. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-32

Vertical Analysis Defined: shows the percentage relationship of each item in the financial statement to its base amount.Defined: shows the percentage relationship of each item in the financial statement to its base amount. Requires two steps:Requires two steps: 1.Identify the base amount on the statement. 2.Divide all other amounts in the statement by the base amount. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-33

©2014 Pearson Education, Inc. Publishing as Prentice Hall15-34 Use Net Sales as the base amount.

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©2014 Pearson Education, Inc. Publishing as Prentice Hall15-36 Prepare the vertical analysis for 2015.

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©2014 Pearson Education, Inc. Publishing as Prentice Hall15-38 Prepare the vertical analysis for 2016.

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Common-Size Statements Defined: Compares companies by looking only at the vertical analysis percentages for each company.Defined: Compares companies by looking only at the vertical analysis percentages for each company. Requires two steps:Requires two steps: 1.Identify two companies for comparison. 2.Compute the vertical analysis percentages for each company. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-44

©2014 Pearson Education, Inc. Publishing as Prentice Hall15-45 Common- size statements allow comparison of different sized companies.

Learning Objective 4 Compute and evaluate the standard financial ratios. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-46

Working Capital Measures the ability to meet short-term obligations with current assets. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-47

Current Ratio Measures a company’s ability to pay its current liabilities with its current assets. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-48

Cash Ratio Helps to determine a company’s ability to meet its short-term obligations. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-49

Acid-test or Quick Ratio Measures whether a company can pay all its current liabilities if they came due immediately. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-50

Inventory Turnover Measures the number of times a company sells its average level of merchandise inventory during a year. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-51

Days’ Sales in Inventory Measures the average number of days merchandise inventory is held by the company. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-52

Gross Profit Percentage Measures the profitability of each net sales dollar above the cost of goods sold. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-53

Accounts Receivable Turnover Ratio Measures the number of times the company collects the average receivables balance in a year. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-54

Days’ Sales in Receivables Indicates how many days it takes to collect the average level of receivables. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-55

Debt Ratio Shows the proportion of assets financed with debt and is calculated by dividing total liabilities by total assets. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-56

Debt to Equity Ratio Shows the proportion of total liabilities relative to total equity. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-57

Times-Interest-Earned Ratio Measures the number of times earnings before interest and taxes (EBIT) can cover interest expense. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-58

Profit Margin Ratio Shows how much net income a business earns on every $1.00 of sales. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-59

Rate of Return on Total Assets Measures a company’s success in using assets to earn a profit. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-60

Asset Turnover Ratio Measures the amount of net sales generated for each average dollar of total assets invested. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-61

Rate of Return on Common Stockholders’ Equity Shows the relationship between net income available to common stockholders and their average common equity invested in the company. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-62

Earnings per Share (EPS) Reports the amount of net income for each share of the company. This is the only ratio that must appear on the face of the income statement. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-63

Price-Earnings Ratio Shows the market price of $1 of earnings. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-64

Dividend Yield Measures the percentage of a stock’s market value that is returned annually as dividends to shareholders. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-65

Dividend Payout Measures the percentage of earnings paid annually to common shareholders as cash dividends. ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-66

Learning Objective 5 Complete a corporate income statement including earnings per share (Appendix 15A). ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-67

The Complete Corporate Income Statement Continuing OperationsContinuing Operations –Revenue –Cost of Goods Sold –Operating Expenses & Income –Gains & Losses –Income Taxes –Operating Income Special ItemsSpecial Items –Discontinued Operations –Extraordinary Items Net IncomeNet Income Earnings Per ShareEarnings Per Share –Continuing Operations –Discontinued Ops –Extraordinary Items –Net Income ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-68

Rocky Corporation’s accounting records include the following items, listed in no particular order, at December 31, 2015: ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-69

©2014 Pearson Education, Inc. Publishing as Prentice Hall15-70 Note the various interim amounts, such as: Gross ProfitGross Profit Income from Continuing OperationsIncome from Continuing Operations Income Before Extraordinary ItemsIncome Before Extraordinary Items Net IncomeNet Income

End of Chapter 15 ©2014 Pearson Education, Inc. Publishing as Prentice Hall15-71