Financial Statement Analysis Chapter 9

Liquidity and Solvency Solvency – the ability of a business to pay its debts Liquidity – the ability of a business to convert assets into cash. Liquidity, solvency, and profitability are interrelated! All users of financial statements are interested in a company’s ability to maintain liquidity and solvency, and earn income. The ability to convert assets into cash is called liquidity, while the ability of a business to pay its debts is called solvency. Liquidity, solvency, and profitability are interrelated. A company that cannot pay its bills cannot obtain additional credit. Without additional credit, it is more difficult to grow a business in order to generate future sales and profits.  

Solvency Analysis Normally assessed by examining balance sheet relationships, using the following major analyses: Current position analysis Accounts receivable analysis Inventory analysis Ratio of fixed assets to long-term liabilities Ratio of liabilities to stockholders’ equity Number of times interest charges are earned Solvency analysis focuses on the ability of a company to pay its liabilities. Some ratios measure this ability for the short-term. Other ratios measure an organization’s financial structure and its impact on long-term solvency. Current position analysis, accounts receivable analysis and inventory analysis focus more on the short-term debt paying ability of an organization. The ratio of fixed assets to long-term liabilities, the ratio of liabilities to stockholders’ equity, and the number of times interest charges are earned are longer term measures of solvency. The common understanding is that if a company is carrying a significant amount of debt, it may spell trouble in the future. For example, if a company had a bad year, they still must pay their debts even if the company is not profitable.

Current Position Analysis Using measures to assess a business’s ability to pay its current liabilities Working capital – current assets less current liabilities Current ratio – current assets divided by current liabilities Quick ratio – total “quick” assets divided by current liabilities A company’s ability to pay its current liabilities is called current position analysis. This analysis is of special interest to short-term creditors and includes the computation and analysis of: Working capital Current ratio Quick ratio

Current Position Analysis – Working Capital and Current Ratio Mooney Company Current position analysis starts with a computation of an organization’s working capital. Working capital is computed by subtracting the current liabilities from the current assets of an organization. In the example presented, Mooney Company’s working capital is $340,000 for 2012 and $290,000 for 2011.   The greater the difference between current assets and current liabilities, the higher will be the working capital, and the ability to pay current liabilities as they come due. However, working capital is difficult to use when evaluating companies of different sizes. The current ratio which is sometimes called the working capital ratio states working capital as a proportion and is a more effective measure of a company’s ability to pay current liabilities. The current ratio is computed by dividing current assets by current liabilities. Mooney’s current ratio is 2.6 for 2012. This can be interpreted as, for every dollar of current liability owed by Mooney, there is $2.60 of current assets available to pay the current liability as it comes due.

Accounts Receivable Analysis Measures efficiency of collection Reflects liquidity Net Sales Average Accounts Receivable Accounts Receivable Turnover = Average Accounts Receivable Net Sales/365 Number of Days’ Sales in Receivables A company’s ability to collect its accounts receivable has a direct impact on their ability to pay current liabilities as they are due. Accounts receivable analysis measures a company’s ability to turn their accounts receivable into cash in a timely manner. The analysis is made up of the accounts receivable turnover and the number of days’ sales in receivables. =

Accounts Receivable Turnover Accounts receivable turnover is measured by dividing net sales for a year by the average accounts receivable balance during the year. Average accounts receivable is calculated by adding the accounts receivable balance at the beginning and the end of the year and dividing it by two. In the example given, the accounts receivable turnover is 12.7 times in 2012 and 9.2 times in 2011. The accounts receivable turnover indicates how many times receivables are “turned over” or collected each period, on average. This turnover is an indicator of the efficiency of a company with which the company collects the receivables and ultimately converts them back to cash. The higher the turnover, the better it is because it means less of the company’s assets are tied up in receivables. The improvement shown from 2011 to 2012 may be the result of how credit is granted, collection practices, or both.   The company increased its accounts receivable turnover by 38% measured in terms of the number of times receivables are collected within the year.

Number of Days’ Sales in Receivables The accounts receivable turnover ratio is often divided into the number of days in a business year to show the average collection period in days. This measure is called number of days’ sales in receivables and is computed by calculating average daily sales and taking that amount and dividing it into the average accounts receivable calculated in the accounts receivable turnover.   In this illustration, the number of days to collect a receivable has fallen from 39.5 days in 2011 to 28.6 days in 2012. This would be expected since the turnover ratio also improved. On average, this organization is collecting receivables in less than 30 days in 2012. The number of days’ sales in receivables is often compared to a company’s credit terms to evaluate collection practices and performance. The company improved its collections of accounts receivable by 10.9 days in 2012 measured in days receivables have been outstanding.

Inventory Analysis Measures inventory efficiency Reflects liquidity Avoid tying up funds in inventory Avoid obsolescence Reflects liquidity Cost of Goods Sold Average Inventory Inventory Turnover = A company’s ability to manage its inventory also has an impact on their ability to pay current liabilities as they are due. Inventory analysis measures a company’s ability to turn their inventory into sales and then, ultimately, cash in a timely manner. The analysis is made up of the inventory turnover and the number of days’ sales in inventory. A company with a higher turnover is generally considered more efficient and minimizes the chance of being stuck with obsolete inventory. In addition, excess inventory increases insurance expenses, property taxes, storage costs, and other related expenses. These expenses also reduce funds that could be used elsewhere to improve or expand operations. However, too high a turnover may indicate lost sales as a result of insufficient inventory in stock. Number of Days’ Sales in Inventory = Average Inventory Cost of Goods Sold/365

Inventory Turnover Inventory turnover is measured by dividing cost of goods sold for a year by the average inventory balance during the year. Average inventory is calculated by adding the inventory balance at the beginning of the year and at the end of the year, and dividing it by two.  In the example given, the inventory turnover is 3.8 times in 2012 and 2.8 times in 2011. The inventory turnover indicates how many times the inventory is “turned over” or sold each period, on average. The higher the turnover, the better because it means less investment in inventories, the company is more effective in converting inventory into sales, and the total time to sell inventory and collect the cash on the sales is smaller. The improvement shown from 2011 to 2012 indicates that the management of inventory has improved in 2012.   The company turned its inventory 1 time more in 2012, measured in terms of the number of times inventory turns over within the year.

Days’ Sales in Inventory The number of days sales in inventory divides the average inventory balance by the average daily cost of goods sold. The average daily cost of goods sold is computed by dividing total cost of goods sold for a year by the number of days in the year. The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory. Care should be taken when looking at days’ sales in inventory as seasonal factors could distort the calculation. The company reduced the time it held inventory by nearly 28% in 2012 measured in days the inventory was held in warehouses.

Profitability Analysis Normally assessed by examining the income statement and balance sheet resources, using the following major analyses: Rate earned on total assets Earnings per share on common stock Price-earnings ratio Dividends per share Dividend yield Profitability ratios serve as indicators of how effective a company has been in meeting the profit objectives of its owners. Profitability analysis focuses on the ability of a company to earn profits, especially relative to resources invested. The ability to earn profits is reflected in the company’s income statement. The resources invested to earn profits are reflected on a company’s balance sheet. Therefore, both the income statement and balance sheet are often used in evaluating profitability.

Rate Earned on Total Assets Measures the profitability of total assets without considering how the assets are financed. The rate earned on total assets measures the profitability of total assets, with consideration as to how the assets are financed. The rate earned on total assets is computed by adding interest expense back to net income. By adding interest expense back to net income, the effect of how the assets are financed, by creditors or by stockholders, is eliminated. Average total assets include long-term investments because net income would include any income earned from these investments.   In this illustration, this ratio improved to 8.2% in 2012 from 7.3% in 2011. While this is an improvement, the ratio should also be measured against any earning targets set internally by the company. It would also be a good idea to compare this rate with industry averages. Interest Expense + Net Income Avg. Total Assets

Earnings Per Share on Common Stock The income earned for each share of common stock. Earnings per share (EPS) on common stock measures the share of profits that are earned by a share of common stock. Generally accepted accounting principles require the reporting of EPS on the income statement. EPS figures are also reported in the financial press and followed closely by investors. In general, earnings per share is computed by dividing net income by the average number of shares of common stock outstanding during a fiscal period. When preferred and common stock are outstanding, preferred dividends are subtracted from net income to determine income related to common shares.   In this illustration, a share of common stock earned more in 2012 than it did in 2011. Since the common stock outstanding remained the same between the two years, the increase was due solely to improved earnings. Trends in EPS are important because EPS is considered to be the best measure that summarizes the performance of a company, particularly for common shareholders. The amount of earnings per share, the change in earnings per share from the previous period, and the trend in earnings per share are all important indicators of the success or failure of a company. Net Income – Preferred Dividends Common Shares Outstanding

Market Price Per Share of Common Stock Annual Earnings Per Share Price-Earnings Ratio Indicator of the firm’s future earnings prospects. The price-earnings ratio measures a company’s future earnings prospects. It is another measure quoted and closely followed by the financial press and investors. The calculation of the price-earnings ratio is computed by dividing the market price per share of common stock by the EPS on a common share.   In this illustration, the price-earnings ratio has increased from 20 to 25. This means that the stock was selling at 25 times the earnings per share. This is a good thing as it indicates the market expects favorable earnings in the future. Market Price Per Share of Common Stock Annual Earnings Per Share

Dividends per Share and Earnings per Share Dividends and Earnings per Share of Common Stock Dividends per share measures the extent to which earnings are being distributed to common shareholders. It is computed by dividing dividends paid by the shares of common stock outstanding. Dividends per share are often compared to earnings per share. Comparing the two per-share amounts indicates the extent to which earnings are being retained in the operations for use in operations. Dividends Shares of Common Stock Outstanding Dividends per Share =

Dividends Per Share and Dividend Yield Dividend yield shows the rate of return to common stockholders in terms of cash dividends. The dividend yield on common stock measure the rate of return to common stockholders from cash dividends. This measurement is of special interest to investors when the investors’ objective is to earn revenue in the form of dividends from their investment. Dividend yield is computed by dividing the dividend per share of common stock by the market price per share.   The dividend yield in this illustration decreased because the stock price rose more than the dividend. Dividends per Share of Common Stock Market Price per Share of Common Stock Dividend Yield =

Corporate Annual Reports Summarize operating activities for the past year and plans for the future. Many variations in the order and form, but all include: Management’s discussion and analysis Report on internal control Report on fairness of the financial statements Public corporations issue annual reports summarizing their operating activities for the past year and plans for the future. The annual report is accompanied by notes having disclosures about methods used in determining accounting information. Companies also include management’s discussion and analysis, report on internal control and report on fairness of the financial statements in their annual report.

Management Discussion and Analysis (MD&A) Provides critical information in interpreting the financial statements and assessing the future of the company Includes an analysis about past performance and financial condition Discusses management’s opinion about future performance Discusses significant risk exposure Management’s Discussion and Analysis is required in annual reports filed with the Securities and Exchange commission. It includes management’s analysis of current operations and its plans for the future. This report also explains important events and changes in performance during the years presented in the financial statements. Typical issues in the report include comparison of operating results, liquidity and cash flow measures, major business risks, financial risks and changes in accounting methods.

Independent Auditors’ Report Publicly traded companies must get an independent opinion on the fairness of the financial statements. This opinion must be included in the annual report along with an opinion on the accuracy of management’s internal control assertion. All publicly held corporations are required to have an independent audit of their financial statements. An opinion stating that the financial statements present fairly the financial position, results of operations, and cash flows of the company is said to be an unqualified or clean opinion. Any report other than an unqualified opinion raises a “red flag” for financial statement users. However, in light of the many accounting scandals that have rocked the financial world over the past years, an unqualified opinion is not always a clean bill of health for an organization. A stakehol