Accounting Principles Second Canadian Edition Prepared by: Carole Bowman, Sheridan College Weygandt · Kieso · Kimmel · Trenholm

FINANCIAL STATEMENT ANALYSIS CHAPTER 19

Analysing financial statements involves evaluating three characteristics of a company: 1. its liquidity 2. its profitability 3. its solvency BASICS OF FINANCIAL STATEMENT ANALYSIS

COMPARATIVE ANALYSIS Three types of comparisons: –Intracompany basis –Intercompany basis –Industry averages

COMPARATIVE ANALYSIS Three tools: –Horizontal analysis –Vertical analysis –Ratio analysis

HORIZONTAL ANALYSIS 127%121%119%112%100% ANY COMPANY INC. Assumed Net Sales For the Year Ended December 31 (in millions) $ 6,562.8$ 6,295.4$ 6,190.6$ 5,786.6$ 5,181.4 Change since base period

VERTICAL ANALYSIS VERTICAL ANALYSIS Expresses each item in a financial statement as a percent of a base amount (total assets or net sales) ANY COMPANY, INC. Condensed Balance Sheets (Partial) December 31 (in millions) AssetsAmountPercent AmountPercent Current assets$1, $1, Capital assets 2, , Other assets Total assets$5, % $4, %

RATIO ANALYSIS Liquidity Ratios Measure short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. Profitability Ratios Measure the income or operating success of an enterprise for a given period of time. RevenuesExpenses - = Net Income Solvency Ratios Measure the ability of the enterprise to survive over a long period of time. XYZ Co. Since 1892

LIQUIDITY RATIOS LIQUIDITY RATIOS Current ratio Acid test ratio Cash current debt coverage ratio Receivables turnover Collection period Inventory turnover Days sales in inventory

CURRENT RATIO Measures short-term debt-paying ability Current ratio = Current assets Current liabilities (Discussed in Chapter 4)

ACID TEST RATIO Measures immediate short-term debt- paying ability Acid test ratio = Cash + temporary investments + net receivables Current liabilities (Discussed in Chapter 9)

CASH CURRENT DEBT COVERAGE RATIO Measures short-term debt-paying ability (cash basis) Cash current debt coverage ratio = Cash provided by operating activities Average current liabilities (Discussed in Chapter 18)

RECEIVABLES TURNOVER Measures liquidity of receivables Receivables turnover = Net credit sales Average net receivables (Discussed in Chapter 9)

COLLECTION PERIOD Measures number of days receivables are outstanding Collection period = 365 days Receivables turnover (Discussed in Chapter 9)

INVENTORY TURNOVER INVENTORY TURNOVER Measures liquidity of inventory Inventory turnover = Cost of goods sold Average inventory (Discussed in Chapter 5)

DAYS SALES IN INVENTORY Measures number of days inventory is on hand Days in inventory = 365 days Inventory turnover (Discussed in Chapter 5)

PROFITABILITY RATIOS Profit margin Gross profit margin Cash return on sales Asset turnover Return on assets Return on common shareholders’ equity Book value per share Cash flow per share Earnings per share (EPS) Price-earnings (PE) ratio Payout ratio Dividend yield

PROFIT MARGIN Measures net income generated by each dollar of sales (Discussed in Chapter 5) Profit margin = Net income Net sales

GROSS PROFIT MARGIN Measures margin between selling price and cost of goods sold generated by each dollar of sales (Discussed in Chapter 5) Gross profit margin = Gross profit Net sales

CASH RETURN ON SALES Measures net cash flow generated by each dollar of sales (Discussed in Chapter 18) Cash return on sales = Net cash provided by operating activities Net sales

ASSET TURNOVER Measures how efficiently assets are used to generate sales (Discussed in Chapter 10) Asset turnover = Net sales Average total assets

RETURN ON ASSETS Measures overall profitability of assets Return on assets = Net income Average total assets (Discussed in Chapter 10)

RETURN ON COMMON SHAREHOLDERS’ EQUITY Measures profitability of common shareholders’ investment Return on common shareholders’ equity = Net income Average common shareholders’ equity (Discussed in Chapter 14)

BOOK VALUE PER SHARE Measures the equity (net assets) per common share Book value per share = Common shareholders’ equity Number of common shares (Discussed in Chapter 14)

CASH FLOW PER SHARE Measures the net cash flow per common share Cash flow per share = Net cash provided by all activities Number of common shares (Discussed in Chapter 18)

EARNINGS PER SHARE (EPS) Measures net income earned on each common share (Discussed in Chapter 15) Earnings per share = Net income Number of common shares

PRICE-EARNINGS (PE) RATIO Measures relationship between market price per share and earnings per share (Discussed in Chapter 15) Price-earnings ratio = Share price Earnings per share

PAYOUT RATIO Measures % of earnings distributed in the form of cash dividends (Discussed in Chapter 15) Payout ratio = Cash dividends Net income

DIVIDEND YIELD Measures rate of return earned from dividends (Discussed in Chapter 15) Dividend yield = Cash dividends per share Share price

SOLVENCY RATIOS SOLVENCY RATIOS Debt to total assets Interest coverage Cash interest coverage Cash total debt coverage

DEBT TO TOTAL ASSETS Measures % of total assets provided by creditors Debt to total assets = Total liabilities Total assets (Discussed in Chapter 16)

INTEREST COVERAGE Measures ability to meet interest payments as they come due Interest coverage = Income before interest expense and income tax expense (EBIT) Interest expense (Discussed in Chapter 16)

CASH INTEREST COVERAGE Measures cash available to meet interest payments as they come due (cash basis) Cash interest coverage = Income before interest expense, income tax expense, and amortization expense (EBITDA) Interest expense (Discussed in Chapter 16)

CASH TOTAL DEBT COVERAGE Measures long-term debt-paying ability (cash basis) Cash total debt coverage ratio = Net cash provided by operating activities Average total liabilities (Discussed in Chapter 18)

Estimates Historical cost Alternative accounting methods Atypical data Diversification LIMITATIONS OF FINANCIAL ANALYSIS

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