Chapter 14 © The McGraw-Hill Companies, Inc., 2007 McGraw-Hill /Irwin “How Well Am I Doing?” Financial Statement Analysis

14-2 Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult. We use the LIFO method to value inventory. We use the FIFO method to value inventory.

14-3 Limitations of Financial Statement Analysis Analysts should look beyond the ratios. Economic factors Industry trends Changes within the company Technological changes Consumer tastes

14-4 Statements in Comparative and Common-Size Form  Dollar and percentage changes on statements changes on statements  Common-size statements statements  Ratios Analytical techniques used to examine relationships among financial statement items

14-5 Learning Objective To prepare and interpret financial statements in comparative and common-size form LO1

14-6 Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

14-7 Horizontal Analysis Example The following slides illustrate a horizontal analysis of Clover Corporation’s December 31, 2005 and 2004 comparative balance sheets and comparative income statements.

14-8 Horizontal Analysis

14-9 Horizontal Analysis Calculating Change in Dollar Amounts DollarChangeDollarChange Current Year Figure Figure Base Year Figure Figure =– The dollar amounts for 2004 become the “base” year figures.

14-10 Horizontal Analysis Calculating Change as a Percentage Percentage Change Percentage Change Dollar Change Base Year Figure Dollar Change Base Year Figure 100% = ×

14-11 Horizontal Analysis ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500)

14-12 Horizontal Analysis

14-13 Horizontal Analysis We could do this for the liabilities & stockholders’ equity, but now, let’s look at the income statement accounts.

14-14 Horizontal Analysis

14-15 Horizontal Analysis

14-16 Horizontal Analysis Sales increased by 8.3%, yet net income decreased by 21.9%.

14-17 Horizontal Analysis There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

14-18 Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent. Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.

14-19 Trend Percentages Trend Percentage Current Year Amount Base Year Amount 100% = ×

14-20 Trend Percentages Example Look at the income information for Berry Products for the years 2001 through We will do a trend analysis on these amounts to see what we can learn about the company.

14-21 Trend Percentages The base year is 2001, and its amounts will equal 100%. The base year is 2001, and its amounts will equal 100%. Berry Products Income Information For the Years Ended December 31

14-22 Trend Percentages 2002 Amount ÷ 2001 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108% 2002 Amount ÷ 2001 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108% Berry Products Income Information For the Years Ended December 31

14-23 Trend Percentages By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin. Berry Products Income Information For the Years Ended December 31

14-24 Trend Percentages We can use the trend percentages to construct a graph so we can see the trend over time.

14-25 Common-Size Statements Common-size single vertical analysis Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis.

14-26 Common-Size Statements In income statements, all items are expressed as a percentage of net sales.

14-27 Gross Margin Percentage Gross Margin Percentage Gross Margin Sales = This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.

14-28 Common-Size Statements In balance sheets, all items are expressed as a percentage of total assets.

14-29 Common-Size Statements Common-size financial statements are particularly useful when comparing data from different companies.

14-30 Common-Size Statements Example Let’s take another look at the information from the comparative income statements of Clover Corporation for 2005 and Let’s take another look at the information from the comparative income statements of Clover Corporation for 2005 and This time let’s prepare common-size statements. This time let’s prepare common-size statements.

14-31 Common-Size Statements Net sales Net sales is the base and is expressed as 100%.

14-32 Common-Size Statements 2004 Cost ÷ 2004 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6% 2004 Cost ÷ 2004 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6% 2005 Cost ÷ 2005 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2% 2005 Cost ÷ 2005 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2%

14-33 Common-Size Statements What conclusions can we draw?

14-34 Quick Check Which of the following statements describes horizontal analysis? a. A statement that shows items appearing on it in percentage and dollar form. b. A side-by-side comparison of two or more years’ financial statements. c. A comparison of the account balances on the current year’s financial statements. d. None of the above.

14-35 Quick Check Which of the following statements describes horizontal analysis? a. A statement that shows items appearing on it in percentage and dollar form. b. A side-by-side comparison of two or more years’ financial statements. c. A comparison of the account balances on the current year’s financial statements. d. None of the above. Horizontal analysis shows the changes between years in the financial data, in both dollar and percentage form.

14-36 Common Stockholders Short-term Creditors Long-term Creditors Ratios

14-37 Now, let’s look at Norton Corporation’s recent financial statements.

14-38

14-39

14-40

14-41 Learning Objective To compute and interpret financial ratios that would be useful to a common stockholder LO2

14-42 Ratio Analysis – The Common Stockholder Use this information to calculate ratios to measure the well-being of the common stockholders of Norton Corporation. Use this information to calculate ratios to measure the well-being of the common stockholders of Norton Corporation.

14-43 Earnings Per Share Earnings per Share Net Income – Preferred Dividends Average Number of Common Shares Outstanding = Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

14-44 Earnings Per Share Earnings per Share Net Income – Preferred Dividends Average Number of Common Shares Outstanding = This measure indicates how much income was earned for each share of common stock outstanding. This measure indicates how much income was earned for each share of common stock outstanding. Earnings per Share $53,690 – 0 (17, ,400)/2 = $2.42 = $2.42

14-45 Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share Earnings Per Share = 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 $20.00 $2.42 = 8.26 times = 8.26 times

14-46 Dividend Payout Ratio This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking current income would like this ratio to be large. Dividend Payout Ratio Dividends Per Share Earnings Per Share = Dividend Payout Ratio $2.00 $2.42 = 82.6% = 82.6%

14-47 Dividend Yield Ratio This ratio identifies the return, in terms of cash dividends, on the current market price of the stock. Dividend Yield Ratio Dividends Per Share Market Price Per Share = Dividend Yield Ratio $2.00 $20.00 = 10.00% = 10.00%

14-48 Return on Total Assets This ratio measures how well assets have been employed. Return on Total Assets $53,690 +[7,300 × (1 –.30)] ($300,000 + $346,390) ÷ 2 = 18.19% = 18.19% Return on Total Assets Net Income + [Interest Expense × (1 – Tax Rate)] Average Total Assets =

14-49 Return on Common Stockholders’ Equity Return on Common Stockholders’ Equity Net Income – Preferred Dividends Average Stockholders’ Equity = This measure indicates how well the company employed the owners’ investments to earn income. Return on Common Stockholders’ Equity $53,690 – 0 ($180,000 + $234,390) ÷ 2 = 25.91% = 25.91%

14-50 Financial Leverage Financial leverage Financial leverage involves acquiring assets with funds at a fixed rate of interest. Return on investment in assets > Fixed rate of return on borrowed funds Positive financial leverage = Return on investment in assets < Fixed rate of return on borrowed funds Negative financial leverage =

14-51 Quick Check Which of the following statements is true? a. Negative financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets. c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year.

14-52 Which of the following statements is true? a. Negative financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets. c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year. Quick Check

14-53 Book Value Per Share This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off. Book Value per Share Common Stockholders’ Equity Number of Common Shares Outstanding = $ 8.55 = $ 8.55 Book Value per Share $234,390 27,400 =

14-54 Book Value Per Share Book Value per Share Common Stockholders’ Equity Number of Common Shares Outstanding == $ 8.55 Book Value per Share $234,390 27,400 = Notice that the book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost.

14-55 Learning Objective To compute and interpret financial ratios that would be useful to a short-term creditor LO3

14-56 Ratio Analysis – The Short–Term Creditor Use this information to calculate ratios to measure the well-being of the short-term creditors for Norton Corporation. Use this information to calculate ratios to measure the well-being of the short-term creditors for Norton Corporation.

14-57 Working Capital The excess of current assets over current liabilities is known as working capital. Working capital is not free. It must be financed with long-term debt and equity.

14-58 Working Capital

14-59 Current Ratio The current ratio measures a company’s short-term debt paying ability. A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories. Current Ratio Current Assets Current Liabilities =

14-60 Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $65,000 $42,000 == 1.55 : 1 The current ratio measures a company’s short-term debt paying ability.

14-61 Acid-Test (Quick) Ratio Quick Assets Current Liabilities = Acid-Test Ratio Quick assets include Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory. $50,000 $42,000 = 1.19 : 1 = Acid-Test Ratio Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000.

14-62 Accounts Receivable Turnover This ratio measures how many times a company converts its receivables into cash each year. Sales on Account Average Accounts Receivable Accounts Receivable Turnover = times = times $500,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover =

14-63 Average Collection Period This ratio measures, on average, how many days it takes to collect an account receivable. Average Collection Period = 365 Days Accounts Receivable Turnover days = days Average Collection Period = 365 Days Times

14-64 Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover = If a company’s inventory turnover Is less than its industry average, it either has excessive inventory or the wrong types of inventory. This ratio measures how many times a company’s inventory has been sold and replaced during the year.

14-65 Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover == times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover = This ratio measures how many times a company’s inventory has been sold and replaced during the year.

14-66 Average Sale Period This ratio measures how many days, on average, it takes to sell the inventory. Average Sale Period = 365 Days Inventory Turnover days = days Average Sale Period = 365 Days Times

14-67 Learning Objective To compute and interpret financial ratios that would be useful to a long-term creditor LO4

14-68 Ratio Analysis – The Long–Term Creditor Use this information to calculate ratios to measure the well-being of the long- term creditors for Norton Corporation. Use this information to calculate ratios to measure the well-being of the long- term creditors for Norton Corporation. This is also referred to as net operating income.

14-69 Times Interest Earned Ratio 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 Earnings before Interest Expense plus Income Taxes Interest Expense = Times Interest Earned $84,000 7,300 == 11.5 times

14-70 Debt-to-Equity Ratio This ratio indicates the relative proportions of debt to equity on a company’s balance sheet. Stockholders like a lot of debt if the company can take advantage of positive financial leverage. Total Liabilities Stockholders’ Equity Debt–to– Equity Ratio = Creditors prefer less debt and more equity because equity represents a buffer of protection.

14-71 Debt-to-Equity Ratio Total Liabilities Stockholders’ Equity Debt–to– Equity Ratio = $112,000 $234,390 Debt–to– Equity Ratio == 0.48 This ratio indicates the relative proportions of debt to equity on a company’s balance sheet.

14-72 Published Sources That Provide Comparative Ratio Data

14-73 End of Chapter 14