1 Analysis of Financial Statements

2  Organize a systematic financial ratio analysis using common-size financial statements and the DuPont framework.  Recognize the potential impact that differing accounting methods can have on the financial ratios of otherwise essentially identical companies.  Understand how foreign companies report their financial results to U.S. investors. Learning Objectives

3  Adjust reported financial statement numbers for the impact of inflation and for changes in the market values of specific assets. Learning Objectives EXPANDED MATERIAL  Convert foreign currency financial statements into U.S. dollars using the translation method.  Incorporate material from the entire text into the preparation of a statement of cash flows.

4 Analytical Objectives Common-Size Financial Statements Ratio Analysis Financial Statement Analysis is the examination of both the relationships among financial statement numbers and the trends of those numbers over time. Major Tools Include

5 Framework for Financial Statement Analysis Common-Size Financial Statements: Analysis of a company’s single-year financial statements. Financial statements are standardized by a measure of size, either sales or total assets. All amounts are stated in terms of a percentage of the size measure. Ratio Analysis: Analysis of a company’s financial statements by computing ratios and comparing them against both trends and industry averages.

6 Comparisons Between Financial Statements Are Most Useful:  When the presentations are in good form.  When the content of the statements is identical.  When accounting principles are not changed, or, if they are changed, the financial effects of the changes are disclosed.  When changes in circumstances or in the nature of the underlying transactions are disclosed.

7 Common-Size Income Statement For common- size income statements, the denominator, the entire pie, is equal to net sales. 100% = Net Sales

8 Condensed Comparative Income Statement 2002 Percent2001Percent Net sales$5, $6, Cost of goods sold 4, , Gross profit on sales $ 1, $1, Selling expense$1, $1, General expense Total operating expenses $1, $1, Operating income (loss)$ $ Other revenue (expense) Income before taxes $ $ Income tax Net income$ $ Common-Size Income Statement

9 Common-Size Balance Sheet For common- size balance sheets, the denominator, the entire pie, is equal to the total assets for the year. 100% = Total Assets

10 Condensed Comparative Balance Sheet 2002% 2001% Cash$ $ Inventory1, Land & building (net) 3, , Total assets$4, $4, Accounts payable$ $1, Long-term debt3, , Total equity , Total liab. & equity$4, $4, Common-Size Balance Sheet

11 Ratio Analysis DuPont Framework: Identifying factors that impact return on equity. Efficiency Ratios: How efficiently is the firm utilizing its assets? Leverage Ratios: To what degree is the company using other people’s money to purchase assets? Other Financial Ratios: Other indications of liquidity, cash management, and profitability.

12 DuPont Framework The DuPont framework was named after a system of ratio analysis developed by DuPont around 1920.

13 Analysis of ROE Using the DuPont Framework Return on Equity: ProfitabilityxEfficiencyxLeverage Return on xAssetxAssets-to- SalesTurnoverEquity Ratio Net IncomexSalesxAssets SalesAssetsEquity

14 Efficiency Ratios Accounts receivable turnover: Sales Average accounts receivable Average collection period: Average accounts receivable Average daily sales Inventory turnover: Cost of goods sold Average inventoryContinuedContinued

15 Efficiency Ratios Number of days’ sales in inventory: Average inventory Average daily cost of goods sold Fixed asset turnover: Sales Average fixed assets

16 Leverage Ratios More borrowing means that more assets can be purchased without any additional equity investment by owners. More assets means that more sales can be generated. More sales means that net income should increase. Higher leverage increases return on equity through the following chain of events:

17 Leverage Ratios Debt ratio: Total liabilities Total assets Debt-to-equity ratio: Total liabilities Total equity Times interest earned: Earnings before interest and taxes Interest expense

18 Other Common Ratios Current ratio: Current assets Current liabilities Historically, the rule of thumb was to have a current ratio of at least 2.0.

19 Other Common Ratios Current ratio: Current assets Current liabilities Advances in information technology have allowed successful firms to reduce this ratio to below 1.0.

20 Cash flow adequacy ratio: Cash flow from operating activities Total primary cash requirements Other Common Ratios The sum of dividend payments, long-term asset purchases, and long-term debt repayments.

21 Book-to-market ratio: Stockholders’ equity Market value of shares outstanding Earnings per share: Net income Weighted-number of share outstanding Dividend payout ratio: Cash dividends Net income Price-earnings ratio: Market price per share Earnings per share Other Common Ratios

22 Alternative Reporting of the Effects of Changing Prices Nominal Dollar Measurement Constant Dollar Measurement Historical Cost Valuation Current Cost Valuation Historical Cost/ Nominal Dollar Historical Cost/ Constant Dollar Current Cost/ Nominal Dollar Current Cost/ Constant Dollar (GAAP)

23 Alternative Reporting of the Effects of Changing Prices Nominal Dollar Measurement Constant Dollar Measurement Historical Cost Valuation Current Cost Valuation Historical Cost/ Nominal Dollar Historical Cost/ Constant Dollar Current Cost/ Nominal Dollar Current Cost/ Constant Dollar (GAAP)

24 Impact of Changing Prices on the Financial Statements Constant Dollar Amount = Nominal Dollar Amount x Index Converting To Index Converting From Assume: Index Converting To 125 Index Converting From 115 Nominal Dollar Amount$ 1,000 CDA = $1,000 x (125 ÷ 115) = $1,087

25 Purchasing Power Gains and Losses & Monetary Position Rising PricesDeclining Prices Positive Net Monetary Position Loss Gain Loss Negative Net Monetary Position

26 Alternative Reporting of the Effects of Changing Prices Nominal Dollar Measurement Constant Dollar Measurement Historical Cost Valuation Current Cost Valuation Historical Cost/ Nominal Dollar Historical Cost/ Constant Dollar Current Cost/ Nominal Dollar Current Cost/ Constant Dollar (GAAP) Current Cost/ Nominal Dollar

27 Current Cost/Nominal Dollar Example: Holding Gains Current cost of inventory$60,000 Historical cost of inventory 50,000 Total holding gain$10,000 Realized holding gain (50% of total holding gain) 5,000 Unrealized holding gain$ 5,000

28 Alternative Reporting of the Effects of Changing Prices Nominal Dollar Measurement Constant Dollar Measurement Historical Cost Valuation Current Cost Valuation Historical Cost/ Nominal Dollar Historical Cost/ Constant Dollar Current Cost/ Nominal Dollar Current Cost/ Constant Dollar (GAAP)

29 Current Cost/Constant Dollar Example: Basic Data Assume the following for Micro Computers, Corp. inventory account: –Replacement cost $50,000 –Inflation adjusted value40,000 –Historical cost30,000 Compute: –Total holding gain –Real component of holding gain –Inflationary component of holding gain

30 Current Cost/Constant Dollar Example: Calculations Replacement cost$50,000 HC/CD Cost$40,000 HC/ND Cost$30,000 $10,000 Real Component $10,000 Inflationary Component Total unrealized holding gain, $20,000

31 Foreign Currency Financial Statements Translation: Used when the foreign subsidiary is a relatively self-contained unit that is independent from the parent company’s operations. Remeasurement: Is appropriate when the subsidiary does not operate independently of the parent company. Functional currency: Currency of the primary economic environment of an entity.

32 The End

33 This electronic presentation was prepared by Douglas Cloud, Professor of Accounting, Pepperdine University