1. Financial Statement Analysis
June 1
Financial Statement Analysis
Chapter 14: “How Well Am I Doing?” Financial Statement Analysis.
This chapter focuses on financial statement analysis which is used to assess the financial health of a company. It includes examining trends in key financial data, comparing financial data across companies, and analyzing financial ratios.

2. Today’s Agenda Financial Statement Analysis
Dollar and Percentage Changes
“Horizontal Analysis”
Common Sized Statements
“Vertical Analysis”
Ratio Analysis

3. Cautions
Be sure to recognize differences in accounting methods before coming to conclusions
Are costs skewed towards COGS?
Inventory valuation
Depreciation policy
Need to look beyond the numbers
Economic conditions
Industry trends, consumer tastes
Technical changes, changes within the company

4. Horizontal Analysis
Our first task is to establish the base year and to calculate changes using the base year.

5. Horizontal Analysis
How did you do? Notice that total assets increased by 8.7%, while our current assets decreased by 5.9%. The decrease in current assets may impact some of the ratios that we calculate later in the presentation.

6. Horizontal Analysis
Assume Clover has the comparative income statement amounts as shown.

7. Horizontal Analysis
We have calculated the dollar and percentage changes for the income statement following the guidelines established earlier. See if you can confirm the change in amounts and percentage increase or decrease of cost of goods sold and interest expense. If you are successful, we believe you have mastered the technique of horizontal analysis.

8. Trend Percentages and CAGR
Current year as a percentage of a base year
Is not comparable over different time periods
Y5 / Y1 *100 =(200/100 – 1) *100 = 100%
Cumulative Annual Growth Rated (CAGR)
Annualizes trends
(((Y5 /Y1) ^1/Years) -1) *100 =
= (((200/100)^1/5)-1) *100 = 14.9%

9. Trend Percentages
We can use the trend percentages to construct a graph so we can see the trend over time.
Some managers prefer to review trend information in chart form. Using Excel is an easy way to develop charts from our data. Here is the chart of the trend percentages for Berry Products. You can see the slow growth of gross margins clearly.

10. Common-Size Statements
Common Sized Statements help analyze individual components within a statement
On the Balance Sheet
Express as % of assets
On the Income Statement
Express as a % of Sales

11. Common-Size Statements
Common Size Statements can be especially useful in comparing different companies
Common-size financial statements are particularly useful when comparing data from different companies.
For example: In 2002, Wendy’s net income was $219 million, whereas McDonald’s was $894 million. This comparison is misleading because of the different sizes of the two companies.
Wendy’s net income as a percent of sales was about 8 percent and McDonald’s was about 5.8 percent. In this light, McDonald’s performance does not compare favorably with Wendy’s.

12. Common-Size Statements
What conclusions can we draw?
Here are the completed common size income statements for Clover Corporation. Look at the percentages, rather than the dollars, and see what conclusions you might be able to draw.
Did you see that the increase in the cost of goods sold percentage led to a decrease in the gross margin? While operating expenses were reduced as a percent of sales, the reduction was not sufficient to prevent a decrease in net income, as a percent of sales.

13. Ratio Analysis Ratios are prepared for different audiences
Shareholders
Creditors
Short term
Long term
Management

14. Average Number of Common Shares Outstanding
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.
Coke = $49/share
Nike= $57/share
The first ratio we will calculate is earnings per share. Earnings per share is equal to net income less preferred stock dividends, divided by the average number of common shares outstanding. The numerator of the equation is sometimes referred to as income available to common shareholders.
For those ratios that have a balance sheet measure in the denominator, we use an average balance sheet measure as the denominator value. Generally, the average balance sheet amount is determined by adding the beginning and ending balance in the account and dividing the total by two.

15. Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share
Earnings Per Share =
Part I
Once we know the earnings per share, we can calculate the price-earnings ratio, or P E ratio. We will divide the closing market price of the Norton’s common stock by earnings per share. The P E ratio is often used by investors to gauge the value of a stock. Usually, the higher the P E ratio, the more opportunity the company has for future growth.
Part II
Norton’s P E ratio is 8.26 times. This means that the stock is selling for 8.26 times its current earnings per share.

16. Dividend Payout Ratio Dividend Payout Ratio Dividends Per Share
Earnings Per Share =
This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking current income would like this ratio to be large.
Part I
Next, we will calculate the dividend payout ratio. This ratio is determined by dividing dividends per share by earnings per share. If you are an investor who requires current income, you will want to invest in a company with a high dividend payout ratio. But if you believe that a particular company can earn a higher return by reinvesting its earnings than you are able to otherwise earn, you will want to invest in a company with a low dividend payout ratio.
Part II
At Norton, the dividend payout ratio is 82.6%, which means that about $0.83 of every dollar of its earnings is paid out to its stockholders.

17. Net Income + [Interest Expense × (1 – Tax Rate)]
Return on Total Assets
Return on
Total Assets
Net Income + [Interest Expense × (1 – Tax Rate)]
Average Total Assets =
This ratio measures how well assets have been employed.
Part I
We can determine the return a company earns on its total assets. To calculate this ratio, we divide net income plus after-tax interest expense by the average total assets for the period. This is another example of an income measure in the numerator and a balance sheet measure in the denominator. We determine the after tax interest expense by multiplying the periodic interest expense by one minus the company’s tax rate. The numerator of the equation is net income before interest expense. Return on total assets measures how well assets have been employed by the management of Norton.
Part II
Norton"s return on its total assets is 18.19%. Please spend a few minutes going over the calculation of this ratio. It will be time well spent when your exam rolls around. If investors expect the company to earn higher returns, management must invest its assets in projects that will meet or exceed 18.19%.

18. 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.
Part I
Another ratio that we can compute is Norton's return on its common stockholders' equity. The numerator is the net income available to common shareholders (i.e., net income less preferred dividends), divided by the average stockholders' equity. This ratio is a measure of how well management at Norton employs common stockholders’ equity to earn income. As a common shareholder, we want to know that the funds we’ve invested are being effectively managed, given an acceptable degree of risk.
Part II
The return on common stockholders’ equity at Norton is 25.91%. Note that the return on equity is higher than the return on total assets.

19. 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 =
In previous chapters, we have calculated the financial leverage at a company. We will not calculate it again. Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors.
Positive financial leverage exists if the rate of return on the company’s assets exceeds the rate of return the company pays its creditors. In this case, having some debt in a company’s capital structure can benefit its shareholders.
Negative financial leverage exists if the rate of return on the company’s assets is less than the rate of return the company pays its creditors. In this case, the common stockholder suffers by having debt in the capital structure.
Return on investment in assets
<
Fixed rate of return on borrowed funds
Negative financial leverage =

20. Common Stockholders’ Equity Number of Common Shares Outstanding
Book Value Per Share
Book Value per Share
Common Stockholders’ Equity
Number of Common Shares Outstanding =
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.
Part I
Book value per share is calculated by dividing common stockholders’ equity by the number of common shares outstanding. Remember, we are including only common stockholders’ equity in the numerator. If you company has preferred shares outstanding, the total dollar amount will be deducted to determine the stockholders’ equity relating to the common shareholders.
If inflation is not present for an extended period of time, this ratio would measure the amount which would be distributable to common shareholders for each share of common stock owned. The ratio has meaning only when all assets could be sold for the amounts shown on the balance sheet and creditors were paid in full.
Part II
At Norton the book value per share is $8.55.

21. The current ratio measures a company’s short-term debt paying ability.
Current Assets
Current Liabilities =
The current ratio measures a company’s short-term debt paying ability.
The current ratio is computed as shown.
It measures the company's ability to pay its short-term debt.
It must be interpreted with care. For example, a declining ratio may be a sign of deteriorating financial condition, or it may be the result of eliminating obsolete inventories or other stagnant current assets.

22. Acid-Test (Quick) Ratio
Quick Assets
Current Liabilities =
Acid-Test
Ratio
Quick assets include Cash,
Marketable Securities, Accounts Receivable and current Notes Receivable. The quick ratio measures a company’s ability to meet obligations without having to liquidate inventory.
Part I
The acid-test ratio is computed as shown.
It is a more rigorous measure of a company's ability to pay its short-term debt because it only includes cash, marketable securities, accounts receivable, and current notes receivable.
It measures a company’s ability to meet its obligations without having to liquidate its inventory.
Each dollar of short-term debt should be backed by at least $1 of quick assets.
Part II
You can see that Norton has quick assets of $50,000 consisting of cash and accounts receivable. Norton’s acid-test ratio is 1.19.

23. Accounts Receivable Turnover
Sales on Account
Average Accounts Receivable
Accounts Receivable
Turnover =
This ratio measures how many times a company converts its receivables into cash each year.
Part I
We calculate accounts receivable turnover by dividing our net credit sales, or sales on account, by average accounts receivable. This is another example of a ratio that contains an income measure in the numerator and a balance sheet measure in the denominator. Remember, in this type of ratio we always use an average amount in the denominator. This ratio measures the number of times per year a company converts its accounts receivable into cash. For any company, the higher the turnover, the faster the cash collection on accounts receivable.
Part II
Norton's accounts receivable turnover is 27.03, which means that the company turns its accounts receivable over about 27 times per year.

24. Average Collection Period=
365 Days
Accounts Receivable Turnover
This ratio measures, on average, how many days it takes to collect an account receivable.
Part I
Another way to evaluate accounts receivable is to calculate the average collection period in days. To compute this ratio, we divide 365 by the accounts receivable turnover. This ratio measures how many days, on average, it takes for the company to collect its accounts receivable. If the average days to collect its receivables is higher than the credit terms established by the company, management will want to develop a plan to improve its compliance.
Part II
At Norton the average collection period on accounts receivable is 13.5 days. If Norton offers terms of 2% 10-days or net 30, we can conclude that most of Norton's customers take advantage of the 10-day discount.

25. Inventory Turnover
Cost of Goods Sold
Average Inventory
Inventory
Turnover =
This ratio measures how many times a company’s inventory has been sold and replaced during the year.
The inventory turnover is computed as shown.
It measures how many times a company’s inventory has been sold and replaced during the year.
It should increase for companies that adopt just-in-time methods.
It should be interpreted relative to a company’s industry. For example, grocery stores turn their inventory over quickly, whereas jewelry stores tend to turn their inventory over slowly.
If a company’s inventory turnover is less than its industry average, it either has excessive inventory or the wrong sorts of inventory.

26. Average Sale Period (Days Inventory)=
365 Days
Inventory Turnover
This ratio measures how many days, on average, it takes to sell the inventory.
Part I
The average day's sales in inventory is computed by dividing 365 by the inventory turnover. This ratio measures the number of days, on average, to sell the inventory on time.
Part II
At Norton, the average days in inventory is days. In other words, inventory is sold about every 29 days, or less than one month.

27. Times Interest Earned Ratio (Interest Coverage)
EBIT
Interest Expense =
The times interest earned ratio is the most common measure of a company’s ability to protect its long-term creditors.
Part I
As a long-term creditor, you would be interested in the company's ability to meet its periodic interest payments. Times interest earned is a ratio that would be important to you. The ratio is calculated by dividing earnings before interest and taxes by interest expense for the period. A long-term creditor wants to lend to a debtor that has a high ratio. Certainly it appears that Norton will have no difficult making its periodic interest payments to long-term creditors.
Part II
Norton's times interest earned ratio is 11.5.

28. Debt-to-Equity Ratio
Total Liabilities
Stockholders’ Equity
Debt to–
Equity Ratio =
This ratio indicates the relative proportions of debt to equity on a company’s balance sheet.
The debt-to-equity ratio is computed as shown.
It indicates the relative proportions of debt and equity on a company’s balance sheet.
Creditors and stockholders have different views when defining the optimal debt-to-equity ratio.
Stockholders like a lot of debt if the company can take advantage of positive financial leverage.
Creditors prefer less debt and more equity because equity represents a buffer of protection.
In practice, debt-to-equity ratios from 0.0 to 3.0 are common.

29. Published Sources That Provide Comparative Ratio Data
This slide contains a listing of published sources that provide comparative ratio data organized by industry.

30. Review Financial Statement Analysis Dollar and Percentage Changes
“Horizontal Analysis”
Common Sized Statements
“Vertical Analysis”
Ratio Analysis

31. Tutorial Assignment Complete Review Problems
Apply Financial Ratio Analysis to Group Project Companies