© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 12: Financial Statement Analysis Cornerstones of Financial & Managerial Accounting, 2e

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Use of Financial Statements in Decisions 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. SEC Filings 2

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analyzing Financial Statements with Cross Sectional and Time Series Analysis ► Two general comparisons we make when analyzing financial statements are cross sectional analysis and time series (or trend) analysis. ► Cross sectional analysis compares one corporation to another corporation and to industry averages. ► Time series (or trend) analysis compares a single corporation across time. ► Year-to-year comparisons of important accounts and account groups help to identify the causes of changes in a company’s income or financial position. ► Knowing the causes of these changes is helpful in forecasting a company’s future profitability and financial position. 3

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analyzing The Financial Statements with Horizontal and Vertical Analysis ► The comparative financial statements included in the 10-K report the results in dollar amounts. ► This makes it easy to detect large changes between years in accounts or groups of accounts. ► These changes may indicate that the corporation is changing or that the conditions under which the corporation operates are changing. ► However, while comparative financial statements show changes in the amounts of financial statement items, analysts often prefer to restate the financial statements in percentages using common size statements. ► Common size statements express each financial statement line item in percentage terms, which highlights differences. 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Horizontal Analysis ► In horizontal analysis, each financial statement line item is expressed as a percent of the base year (typically the first year shown). ► Horizontal analysis is good for highlighting the growth (or shrinkage) in financial statement line items from year to year and is particularly useful for trend analysis. 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Vertical Analysis ► Vertical analysis, on the other hand, expresses each financial statement line item as a percent of the largest amount on the statement. ► On the income statement, this is net sales and on the balance sheet it is total assets. ► Vertical analysis helps distinguish between changes in account balances that result from growth and changes that are likely to have arisen from other causes. ► Identifying non-growth changes and their causes can help forecast a company’s future profitability or its future financial position. 4

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Analyzing the Financial Statements with Ratio Analysis ► Ratio analysis is an examination of financial statements conducted by preparing and evaluating a series of ratios. ► Ratios (or financial ratios), like other financial analysis data, normally provide meaningful information only when compared with ratios from previous periods for the same firm (i.e., time series, or trend analysis) or similar firms (i.e., cross-sectional analysis). ► Ratios help by removing most of the effects of size differences. ► When dollar amounts are used, size differences between firms may make a meaningful comparison impossible. ► However, properly constructed financial ratios permit the comparison of firms regardless of size. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short-Term Liquidity Ratios ► Short-term liquidity ratios are particularly helpful to short- term creditors, but all investors and creditors have an interest in these ratios. ► Analysts want to know the likelihood that a company will be able to pay its current obligations as they come due. ► Failure to pay current liabilities can lead to suppliers refusing to sell needed inventory and employees leaving. ► The cash necessary to pay current liabilities will come from existing cash or from receivables and inventory, which should turn into cash approximately at the same time the current liabilities become due. ► The short-term liquidity ratios compare some combination of current assets or operations to current liabilities. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary of Financial Ratios: Short-term Liquidity Ratios 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Debt Management Ratios ► Debt management ratios provide information on two aspects of debt. ► First, they provide information on the relative mix of debt and equity financing (often referred to as its capital structure). ► The primary advantages of debt over equity are as follows: ► Interest payments are tax-deductible. ► Creditors do not share in profits. ► Second, debt management ratios also try to show the corporation’s ability to meet, or cover its debt obligations through operations because interest and principal payments must be made as scheduled. ► Debt is riskier than equity, because unless the interest and principal payments are made when due, the firm may fall into bankruptcy. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary of Financial Ratios: Debt Management Ratios 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Asset Efficiency Ratios ► Asset efficiency ratios (or operating ratios) are measures of how efficiently a company uses its assets. ► The principal asset efficiency ratios are measures of turnover, that is, the average length of time required for assets to be consumed or replaced. ► The faster an asset is turned over, the more efficiently it is being used. ► These ratios provide managers and other users of a corporation’s financial statements with easily interpreted measures of the time required to turn receivables into cash, inventory into cost of goods sold, or total assets into sales. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary of Financial Ratios: Asset Efficiency Ratios 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Profitability Ratios ► Profitability ratios measure two aspects of a corporation’s profits: ► elements of operations that contribute to profit ► the relationship of profit to total investment and investment by stockholders ► The first group of profitability ratios, which includes gross profit (or gross margin) percentage, operating margin percentage, and net profit margin percentage, expresses income statement elements as percentages of net sales. ► The second group of profitability ratios, which includes return on assets and return on equity, divides measures of income by measures of investment. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary of Financial Ratios: Profitability Ratios 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stockholder Ratios ► Stockholders are primarily interested in two things: ► the creation of value ► the distribution of value ► Stockholder ratios such as earnings per share and return on common equity provide information about the creation of value for stockholders. ► Value is distributed to stockholders in one of two ways. ► Either the corporation issues dividends or repurchases stock. ► The remainder of the stockholder ratios—dividend yield, dividend payout, stock repurchase payout, and total payout— address this distribution of value. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary of Financial Ratios: Stockholder Ratios 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Dupont Analysis ► Return on common equity (or return on equity, ROE) is the most important measure of profitability for investors. ► It represents the amount of income generated per dollar of book value of equity or common equity. ► In that way, it is conceptually similar to an interest rate. ROE = Net income ÷ Average Equity ► Dupont analysis recognizes that ROE can be broken down into Net Profit Margin x Asset Turnover x Total Leverage. 5

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Data for Ratio Comparisons ► Developing information from financial ratios requires that comparisons be made among the ratios of the following: ► the same corporation over time ► similar corporations over time ► similar corporations at the present time ► Analysts rely on several sources to fulfill their need for a broad range of data for individual corporations as well as for industries and the economy. ► The best source of information about the corporation starts with the investor relations section of their website. ► Links to the corporation’s 10-K (and other SEC filings), analyst conference calls, and press releases are typically found there. 5