© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Financial Statements Analysis and Interpretation

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-2 Application of analytical tools Involves transforming data Reduces uncertainty Basics of Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-3 Internal UsersExternal Users Financial statement analysis helps users make better decisions. Managers Officers Internal Auditors Shareholders Lenders Customers Purpose of Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-4 Liquidity and Efficiency Solvency Profitability Market Ability to meet short-term obligations and to efficiently generate revenues Ability to generate future revenues and meet long-term obligations Ability to generate positive market expectations Ability to provide financial rewards sufficient to attract and retain financing Building Blocks of Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-5 Income Statement Balance Sheet Statement of Changes in Stockholders’ Equity Statement of Cash Flows Notes Information for Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-6 To help me interpret our financial statements, I use several standards of comparison.  Intracompany  Competitor  Industry  Guidelines Standards for Comparison

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-7 Horizontal Analysis Time Comparing a company’s financial condition and performance across time Tools of Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-8 VerticalAnalysisVerticalAnalysis VerticalAnalysisVerticalAnalysis Comparing a company’s financial condition and performance to a base amount Tools of Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-9 Using key relations among financial statement items Tools of Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Time Now, let’s look at some ways to use horizontal analysis. Horizontal Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-11

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Calculate Change in Dollar Amount Dollar Change Analysis Period Amount Base Period Amount =– Since we are measuring the amount of the change between 2001 and 2002, the dollar amounts for 2001 become the “base” period amounts. Comparative Statements

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Calculate Change as a Percent Percent Change Dollar Change Base Period Amount 100% = × Comparative Statements

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500)

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-15

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Now, let’s review the dollar and percent changes for the liabilities and shareholders’ equity accounts.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-17

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Now, let’s look at trend analysis!

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Trend analysis is used to reveal patterns in data covering successive periods. Trend Percent Analysis Period Amount Base Period Amount 100% = × Trend Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Berry Products Income Information For the Years Ended December 31, 1998 is the base period so its amounts will equal 100%. Trend Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Berry Products Income Information For the Years Ended December 31, Trend Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Berry Products Income Information For the Years Ended December 31, How would this trend analysis look on a line graph? Trend Analysis

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Trend Analysis We can use the trend percentages to construct a graph so we can see the trend over time.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide VerticalAnalysisVerticalAnalysis VerticalAnalysisVerticalAnalysis Now, let’s look at some vertical analysis tools!

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Calculate Common-size Percent Common-size Percent Analysis Amount Base Amount 100% = × Financial StatementBase Amount Balance SheetTotal Assets Income StatementRevenues Financial StatementBase Amount Balance SheetTotal Assets Income StatementRevenues Common-Size Statements

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide ($12,000 ÷ $315,000) × 100% = 3.8% ($23,500 ÷ $289,700) × 100% = 8.1%

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-27

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-28

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-29

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This is a graphical analysis of Clover Corporation’s common-size income statement for Common-Size Graphics

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Liquidity and Efficiency Solvency ProfitabilityMarket Let’s use the following financial statements for Norton Corporation for our ratio analysis.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-32

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© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide 13-34

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Current Ratio Current Ratio Acid-test Ratio Acid-test Ratio Accounts Receivable Turnover Inventory Turnover Days’ Sales Uncollected Days’ Sales in Inventory Total Asset Turnover Liquidity and Efficiency

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Use this information to calculate the liquidity and efficiency ratios for Norton Corporation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Working capital represents current assets financed from long-term capital sources that do not require near-term repayment. Working Capital

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Current Ratio Current Assets Current Liabilities = This ratio measures the short-term debt-paying ability of the company. Current Ratio Current Ratio $65,000 $42,000 ==1.55 : 1

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Quick assets are Cash, Short-Term Investments, Accounts Receivable and Notes Receivable. This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash. Acid-Test Ratio Quick Assets Current Liabilities = Acid-Test Ratio $50,000 $42,000 =1.19 : 1= Acid-Test Ratio

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio measures how many times a company converts its receivables into cash each year. Accounts Receivable Turnover Sales on Account Average Accounts Receivable Accounts Receivable Turnover = = 26.7 times $494,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover =

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio measures the number of times merchandise is sold and replaced during the year. Cost of Goods Sold Average Inventory Inventory Turnover == times $140,000 ($10,000 + $12,000) ÷ 2 = Inventory Turnover Inventory Turnover

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio measures the liquidity of receivables. Days’ Sales Uncollected = Accounts Receivable Net Sales  365 Days’ Sales Uncollected = $20,000 $494,000  365 = 14.8 days Days’ Sales Uncollected

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio measures the liquidity of inventory. Days’ Sales in Inventory = Ending Inventory Cost of Goods Sold  365 Days’ Sales in Inventory = $12,000 $140,000  365 = days Days’ Sales in Inventory

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio measures the efficiency of assets in producing sales. Total Asset Turnover = Net Sales Average Total Assets = 1.53 times $494,000 ($300,000 + $346,390) ÷ 2 = Total Asset Turnover Total Asset Turnover

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Debt Ratio Debt Ratio Equity Ratio Equity Ratio Pledged Assets to Secured Liabilities Times Interest Earned Solvency

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Use this information to calculate the solvency ratios for Norton Corporation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Total Liabilities = Total Assets Debt Ratio This ratio measures what portion of a company’s assets are contributed by creditors. $112,000 = $346,390 Debt Ratio = 32.3% Debt Ratio

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio measures what portion of a company’s assets are contributed by owners. Total Equity = Total Assets Equity Ratio $234,390 = $346,390 Equity Ratio = 67.7% Equity Ratio

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio measures the protection to secured creditors. Book Value of Pledged Assets = Book Value of Secured Liabilities Pledged Assets to Secured Liabilities

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor. Times Interest Earned Net Income before Interest Expense and Income Taxes Interest Expense = Times Interest Earned $84,000 $7,300 == Times Interest Earned

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Profit Margin Profit Margin Gross Margin Return on Total Assets Basic Earnings per Share Book Value per Common Share Return on Common Stockholders’ Equity Profitability

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Use this information to calculate the profitability ratios for Norton Corporation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio describes a company’s ability to earn a net income from sales. Profit Margin Net Income Net Sales = = 10.87% Profit Margin $53,690 $494,000 = Profit Margin

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio measures the amount remaining from $1 in sales that is left to cover operating expenses and a profit after considering cost of sales. Gross Margin Net Sales - Cost of Sales Net Sales = = 71.66% Gross Margin $494,000 - $140,000 $494,000 = Gross Margin

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio is generally considered the best overall measure of a company’s profitability. = 16.61% $53,690 ($300,000 + $346,390) ÷ 2 = Return on Total Assets Return on Total Assets Net Income Average Total Assets = Return on Total Assets

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Return on Common Stockholders’ Equity Net Income - Preferred Dividends Average Common Stockholders’ Equity = = 25.9% $53, ($180,000 + $234,390) ÷ 2 = Return on Common Stockholders’ Equity This measure indicates how well the company employed the owners’ investments to earn income. Return on Common Stockholders’ Equity

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Book Value per Common Share Shareholders’ Equity Applicable to Common Shares Number of Common Shares Outstanding = This ratio measures liquidation at reported amounts. Book Value per Common Share

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This measure indicates how much income was earned for each share of common stock outstanding. Basic Earnings per Share Net Income - Preferred Dividends Weighted-Average Common Shares Outstanding = Basic Earnings per Share $53, ,400 == $1.96 per share Basic Earnings per Share

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Price- Earnings Ratio Dividend Yield Market

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide Use this information to calculate the market ratios for Norton Corporation.

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth. Price-Earnings Ratio Market Price Per Share Earnings Per Share = Price-Earnings Ratio $15.00 $1.96 == 7.65 times Price-Earnings Ratio

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide This ratio identifies the return, in terms of cash dividends, on the current market price of the stock. Dividend Yield Annual Dividends Per Share Market Price Per Share = Dividend Yield $2.00 $15.00 == 13.3% Dividend Yield

© The McGraw-Hill Companies, Inc., 2003 McGraw-Hill/Irwin Slide End of Chapter 13