Financial Statements and Analysis Chapter 2 Financial Statements and Analysis

The Four Key Financial Statements

The Four Key Financial Statements: The Balance Sheet The balance sheet presents a summary of a firm’s financial position at a given point in time. Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.

The Four Key Financial Statements

The Four Key Financial Statements (cont.)

The Four Key Financial Statements The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.

The Four Key Financial Statements: Statement of Cash Flows The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended. This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

The Four Key Financial Statements

Using Financial Ratios: Interested Parties Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance. It is of interest to shareholders, creditors, and the firm’s own management.

Using Financial Ratios: Types of Ratio Comparisons (cont.) Trend or time-series analysis Used to evaluate a firm’s performance over time Cross-sectional analysis Used to compare different firms at the same point in time Industry comparative analysis One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance

Using Financial Ratios: Types of Ratio Comparisons (cont.) Cross-sectional analysis Benchmarking A type of cross sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate Combined Analysis Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis

Using Financial Ratios: Types of Ratio Comparisons (cont.)

Using Financial Ratios: Types of Ratio Comparisons (cont.)

Using Financial Ratios: Cautions for Doing Ratio Analysis Ratios must be considered together; a single ratio by itself means relatively little. Financial statements that are being compared should be dated at the same point in time. Use audited financial statements when possible. The financial data being compared should have been developed in the same way. Be wary of inflation distortions.

Ratio Analysis Current ratio = total current assets We will illustrate the use of financial ratios for analyzing financial statements using the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2. Liquidity Ratios Current Ratio Current ratio = total current assets total current liabilities Current ratio = $1,233,000 = 1.97 $620,000

Ratio Analysis (cont.) Liquidity Ratios Current Ratio Quick Ratio Quick ratio = Total Current Assets - Inventory total current liabilities Quick ratio = $1,233,000 - $289,000 = 1.51 $620,000

Ratio Analysis (cont.) Activity Ratios Inventory Turnover Inventory Turnover = Cost of Goods Sold Inventory Inventory Turnover = $2,088,00 = 7.2 $289,000 Average Age of Inventory Average Age of Inventory = 365 Inventory Turnover Inventory Turnover = 365 = 50.7 days 7.2

Ratio Analysis (cont.) Average Payment Period Average Collection Period ACP = Accounts Receivable Net Sales/365 ACP = $503,000 = 59.7 days $3,074,000/365 Average Payment Period APP = Accounts Payable Annual Purchases/365 APP = $382,000 = 95.4 days (.70 x $2,088,000)/365

Ratio Analysis (cont.) Liquidity Ratios Activity Ratios Total Asset Turnover Total Asset Turnover = Net Sales Total Assets Total Asset Turnover = $3,074,000 = .85 $3,597,000

Ratio Analysis (cont.) Insert Table 2.6 here

Ratio Analysis (cont.) Times Interest Earned Ratio Debt Ratio Financial Leverage Ratios Debt Ratio Debt Ratio = Total Liabilities/Total Assets Debt Ratio = $1,643,000/$3,597,000 = 45.7% 45% of assets is financed by debt. Times Interest Earned Ratio Times Interest Earned = EBIT/Interest Times Interest Earned = $418,000/$93,000 = 4.5 The firm can generate 4.5 times operating income to cover its interest expenses. The higher the ratio, the better .Lower ratio shows a higher default risk for the firm.

Ratio Analysis (cont.) Liquidity Ratios Activity Ratios Leverage Ratios Profitability Ratios Common-Size Income Statements

Ratio Analysis (cont.)

GPM = Gross Profit/Net Sales Ratio Analysis (cont.) Profitability Ratios Gross Profit Margin GPM = Gross Profit/Net Sales GPM = $986,000/$3,074,000 = 32.1% Operating Profit Margin (OPM) OPM = EBIT/Net Sales OPM = $418,000/$3,074,000 = 13.6%

NPM = Earnings Available to Common Stockholders Sales Ratio Analysis (cont.) Profitability Ratios Net Profit Margin (NPM) NPM = Earnings Available to Common Stockholders Sales NPM = $221,000/$3,074,000 = 7.2% Earnings Per Share (EPS) EPS = Earnings Available to Common Stockholders Number of Shares Outstanding EPS = $221,000/76,262 = $2.90

Ratio Analysis (cont.) Return on Equity (ROE) Profitability Ratios Return on Total Assets (ROA) ROA = Earnings Available to Common Stockholders Total Assets ROA = $221,000/$3,597,000 = 6.1% Return on Equity (ROE) ROE = Earnings Available to Common Stockholders Total Equity ROE = $221,000/$1,754,000 = 12.6%

Ratio Analysis (cont.) Market Ratios Price Earnings (P/E) Ratio P/E = Market Price Per Share of Common Stock Earnings Per Share P/E = $32.25/$2.90 = 11.1 Market/Book (M/B) Ratio BV/Share = Common Stock Equity Number of Shares of Common Stock BV/Share = $1,754,000/72,262 = $23.00

Ratio Analysis (cont.) Market Ratios Market/Book (M/B) Ratio M/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common Stock M/B Ratio = $32.25/$23.00 = 1.40 Market Ratios are used to assess whether a firm’s stock is over/undervalued. A very high (low) Market Ratio might be a sign of an overvalued (undervalued) stock. Undervalued stocks are ideal candidates to buy whereas overvalued stocks are ideal for selling.

Summarizing All Ratios

Summarizing All Ratios (cont.)

Summarizing All Ratios (cont.)

DuPont System of Analysis The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition. It merges the income statement and balance sheet into two summary measures of profitability: ROA and ROE as shown in the equation below and in Figure 2.2 on the following slide.

DuPont System of Analysis (cont.)

Modified DuPont Formula The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:

Modified DuPont Formula (cont.) Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner’s return. Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the Modified DuPont formula yields: ROE = 6.1% X 2.06 = 12.6%