“How Well Am I Doing?” Financial Statement Analysis

“How Well Am I Doing?” Financial Statement Analysis
Chapter 14 “How Well Am I Doing?” 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.

Limitations of Financial Statement Analysis
Differences in accounting methods between companies sometimes make comparisons difficult. Differences in accounting methods between companies sometimes make it difficult to compare their financial data. For example: If one company values its inventory using the LIFO method and another uses the average cost method, then direct comparisons of financial data, such as inventory valuations and cost of goods sold, may be misleading. Even with such limitations, comparing financial ratios with other companies or industry averages can provide useful insights. We use the LIFO method to value inventory. We use the FIFO method to value inventory.

Limitations of Financial Statement Analysis
Changes within the company Industry trends Consumer tastes Technological changes Economic factors Ratios should not be viewed as an end, but rather as a starting point. They raise many questions and point to opportunities for further analysis, but they rarely answer questions by themselves. In addition to ratios, other sources of data should also be considered, such as industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the company itself. Analysts should look beyond the ratios.

Statements in Comparative and Common-Size Form
Dollar and percentage changes on statements Analytical techniques used to examine relationships among financial statement items Common-size statements An item on a balance sheet or income statement has little meaning by itself. The meaning of the number can be enhanced by drawing comparisons. This chapter discusses three such means of enabling comparisons: Dollar and percentage changes on statements (also known as horizontal analysis); Common-size statements (also known as vertical analysis); and Ratios. Ratios

Learning Objective 1 Prepare and interpret financial statements in comparative and common-size form. Learning objective number 1 is to prepare and interpret financial statements in comparative and common-size form.

Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form. Horizontal analysis can be extremely helpful in learning more about a company. It is the process of properly preparing financial data in dollar and percentage formats. This information is usually shown side-by-side. Quantifying dollar changes over time serves to highlight the changes that are the most important economically. Quantifying percentage changes over time serves to highlight the changes that are the most unusual.

Horizontal Analysis Example The following slides illustrate a horizontal analysis of Clover Corporation’s December 31, 2008 and 2007 comparative balance sheets and comparative income statements. On the next slide, we will see the comparative balance sheet of Clover Corporation. Let’s begin our horizontal analysis by calculating the dollar change in account balances and the percentage change.

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

Horizontal Analysis Calculating Change in Dollar Amounts Dollar Change
Current Year Figure Base Year Figure = – In horizontal analysis, we use the oldest year shown as the base year and determine the dollar change between the current year and the base year. For Clover Corporation, 2007 serves as the base year. The dollar amounts for 2007 become the “base” year figures.

Calculating Change as a Percentage
Horizontal Analysis Calculating Change as a Percentage Percentage Change Dollar Change Base Year Figure × = 100% Once we establish the base year, we can calculate the percentage change by dividing the dollar change (shown on the previous screen) by the base year amount and multiplying by 100%. With this background, let’s get started with our work on the Clover Corporation’s comparative balance sheet.

Horizontal Analysis $12,000 – $23,500 = $(11,500)
For the dollar change in cash, we subtract the base year amount of $23,500 from the current year amount of $12,000 to determine that the change in cash was negative $11,500. We know the percentage change will be negative. To determine the percentage change, we divide the ($11,500) change by the base year of $23,500 and multiple by 100%. The percentage change is a decrease in cash of 48.9%. Why don’t you take a few minutes and see if you can calculate the dollar and percentage changes for accounts receivable and inventory. When you are done, go to the next slide. $12,000 – $23,500 = $(11,500) ($11,500 ÷ $23,500) × 100% = 48.9%

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.

Horizontal Analysis We could do this for the liabilities & stockholders’ equity, but instead, let’s look at the income statement. We could prepare this analysis for the liabilities and equities of Clover Corporation, but instead, let's move on to the income statement.

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

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.

Sales increased by 8.3%, yet net income decreased by 21.9%.
Horizontal Analysis Sales increased by 8.3%, yet net income decreased by 21.9%. While there are many questions we could ask about the income statement, let’s look at the change in sales and net income. Sales increased by 8.3% from last year to the current year. During the same period, income decreased by 21.9%. Management will want to understand why this happened. It would seem logical that net income would have increased, given that sales had increased.

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. Both cost of goods sold and operating expenses increased from last year to the current year. These increases more than offset the increase in sales. These accounts should be evaluated to determine the causes, so we can ascertain how to control these costs more effectively.

Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent. Horizontal analysis can be even more useful when data from a number of years are used to compute trend percentages. Trend analysis helps us analyze changes in financial information over a number of years. Such changes are normally presented using a percentage format.

× Trend Percentages Current Year Amount Trend 100% Percentage
Base Year Amount 100% = × To compute the trend percentage, we divide the current period amount by the base period amount and multiply by 100%. All values are expressed as a percentage increase or decrease, relative to the base year, which is usually the oldest period shown.

Example Trend Percentages
Look at the information for Berry Products for the years 2003 through We will complete a trend analysis using these amounts to see what we can learn about the company. We have developed some information for Berry Products for the years 2003 through Let’s analyze this information using trend analysis.

For the Years Ended December 31
Trend Percentages Berry Products Income Information For the Years Ended December 31 The base period will be the year We convert the dollar values to percentages, using 2003 amounts as 100%. The base year is 2003, and its amounts will equal 100%.

Trend Percentages Berry Products Income Information For the Years Ended December 31 To determine the percentage increase for 2004 sales, we divide the $290,000 sales by the 2003 sales of $275,000 and multiple by 100%. Sales for 2004 are 105% of 2003 sales. We use the same procedure to calculate the percentages for cost of goods sold and gross margin. Next, we complete the remaining years on our table. Before going to the next slide, see if you can calculate the 2005 sales percent. 2004 Amount ÷ 2003 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108%

Trend Percentages Berry Products Income Information For the Years Ended December 31 How did you do in your calculation? Now that the table is complete we can see that cost of goods sold is increasing faster than the increase in sales, which accounts for why the gross margin is increasing at a slower pace. Better cost control is needed to increase the gross margins. 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.

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.

Common-Size Statements
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. Common size financial statements are prepared for a single period. We express all items on a given statement in terms of a component of that statement. For the income statement, we normally express all items as a percent of total sales. For the balance sheet, we generally express all items as a percentage of total assets.

In income statements, all items are expressed as a percentage of net sales. In income statements, all items are expressed as a percentage of net sales.

Gross Margin Percentage
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. Managers often pay close attention to the gross margin percentage, which is computed as gross margin divided by sales. The gross margin percentage tends to be more stable for retailing companies because cost of goods sold excludes fixed costs.

In balance sheets, all items are expressed as a percentage of total assets. In balance sheets, all items are expressed as a percentage of total assets.

Common-size financial statements are particularly useful when comparing data from 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.

Example Let’s take another look at the information from the comparative income statements of Clover Corporation for 2007 and 2008. This time, let’s prepare common-size statements. Let’s go back and look at the comparative income statements of Clover Corporation and complete our common size calculations.

Net sales is the base and is expressed as 100%. We will express all line-items on the income statement as a percent of net sales. We begin by setting net sales equal to 100%.

We begin the calculation by determining the cost of goods sold percentages. For 2008, divide cost of goods sold of $360,000 by sales of $520,000 and multiply by 100%. For 2008, cost of goods sold was 69.2% of total sales. Before moving to the next slide, calculate the gross margin percent for each year. It will be good practice. 2008 Cost ÷ 2008 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2% 2007 Cost ÷ 2007 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6%

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.

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. Which of the following statements describes horizontal analysis?

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. The answer is B. Horizontal analysis shows the changes between years in the financial data, in both dollar and percentage form. Horizontal analysis shows the changes between years in the financial data, in both dollar and percentage form.

Common Stockholders Short-term Creditors Long-term Creditors
Ratios Common Stockholders Short-term Creditors We are going to examine ratios that are useful to common stockholders, short-term creditors, and long-term creditors. Long-term Creditors

Now, let’s look at Norton Corporation’s 2006 and 2007 financial statements.
To facilitate our discussion, we are going to use financial data from 2006 and 2007 for Norton Corporation.

Here is the asset section of Norton’s comparative balance sheets.

With this slide, we complete the presentation of the company’s balance sheet by providing the liabilities and stockholders’ equity sections.

Finally, we have the comparative income statement of Norton.

Learning Objective 2 Compute and interpret financial ratios that would be useful to a common stockholder. Learning objective number 2 is to compute and interpret financial ratios that would be useful to a common stockholder.

Ratio Analysis – The Common Stockholder
Use this information to calculate ratios to measure the well-being of the common stockholders of Norton Corporation. The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholders’ equity. The information shown for Norton Corporation will be used to calculate ratios of interest to common stockholders. The supplemental information includes data about the number of common shares outstanding, the dividends paid, and the closing market price of the common stock.

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. 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.

Average Number of Common Shares Outstanding
Earnings Per Share Earnings per Share Net Income – Preferred Dividends Average Number of Common Shares Outstanding = Earnings per Share $53,690 – 0 (17, ,400)/2 = = $2.42 Part I Let’s use the information from Norton to calculate earnings per share for the most recent year. Earnings per share is one of the most widely quoted financial ratios calculated. It is a measure of the company’s ability to produce income for each common share outstanding. As an investor, we will want to track this ratio carefully. Part II Norton's earnings per share for 2007 is $2.42 per common share. Notice that Norton had no preferred dividend to impact the numerator. This measure indicates how much income was earned for each share of common stock outstanding.

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

Dividend Payout Ratio Dividend Payout Ratio Dividends Per Share
Earnings Per Share = Dividend Payout Ratio $2.00 $2.42 = = 82.6% 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. 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 Yield Ratio Dividend Yield Ratio Dividends Per Share Market Price Per Share = Dividend Yield Ratio $2.00 $20.00 = = % Part I To determine the dividend yield ratio, we divide the dividends per share by the closing market price per share of the company’s common stock. Once again, if you are an investor who requires current income you will want to look for common shares with a high dividend yield. If you are willing to accept less current income, for the possibility of growth in the market price per share, you will want to look for a company with a lower dividend yield. Part II At Norton, the dividend yield is 10%. If we purchase the stock today for $20 per share and receive an annual dividend of $2, we will earn a return of 10% on our investment. This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

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 = Return on Total Assets $53,690 +[7,300 × (1 – .30)] ($300,000 + $346,390) ÷ 2 = = % 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%. This ratio measures how well assets have been employed.

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

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 =

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. Which of the following statements is true?

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. The answer is 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.

Common Stockholders’ Equity Number of Common Shares Outstanding
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 = 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. 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.

Common Stockholders’ Equity Number of Common Shares Outstanding
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 = 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. 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.

Learning Objective 3 Compute and interpret financial ratios that would be useful to a short-term creditor. Learning objective number 3 is to compute and interpret financial ratios that would be useful to a short-term creditor.

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. We will turn our attention to ratios that provide information about the well-being of short term creditors. Some additional information is provided to help us complete this analysis.

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. 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. Therefore, managers often seek to minimize working capital. A large and growing working capital balance may not be a good sign. For example, it could be the result of unwarranted growth in inventories.

Working Capital Norton Corporation
Norton’s working capital is calculated as shown.

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. A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories. 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.

The current ratio measures a company’s short-term debt paying ability.
Current Assets Current Liabilities = Current Ratio $65,000 $42,000 = 1.55 Norton’s current ratio of is calculated as shown. The current ratio measures a company’s short-term debt paying ability.

Acid-Test (Quick) Ratio
Quick Assets Current Liabilities = Acid-Test Ratio $50,000 $42,000 = 1.19 Acid-Test Ratio Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000. 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.

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

Average Collection Period
= 365 Days Accounts Receivable Turnover = days Average Collection Period = 365 Days 27.03 Times 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. This ratio measures, on average, how many days it takes to collect an account receivable.

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. If a company’s inventory turnover Is less than its industry average, it either has excessive inventory or the wrong sorts of inventory. 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.

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

Average Sale Period Average Sale Period = 365 Days Inventory Turnover = days Average Sale Period = 365 Days 12.73 Times 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. This ratio measures how many days, on average, it takes to sell the inventory.

Learning Objective 4 Compute and interpret financial ratios that would be useful to a long-term creditor. Learning objective number 4 is to compute and interpret financial ratios that would be useful to a long-term creditor.

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. Long-term creditors are concerned with a company’s ability to repay its loans over the long-run. Creditors often seek protection by requiring that borrowers agree to various restrictive covenants, or rules. Long-term creditors usually include bond and mortgage holders. This screen contains some new supplemental information for Norton Corporation that will help us calculate the ratios that follow. One quick note: earnings before interest and taxes (EBIT) is often referred to as net operating income. EBIT is also referred to as net operating income.

Times Interest Earned Ratio
Earnings before Interest Expense plus Income Taxes Interest Expense = Times Interest Earned $84,000 7,300 = 11.5 times 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. The times interest earned ratio is the most common measure of a company’s ability to protect its long-term creditors.

In practice, debt-to-equity ratios from 0.0 to 3.0 are common.
Total Liabilities Stockholders’ Equity 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. Creditors prefer less debt and more equity because equity represents a buffer of protection. 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. In practice, debt-to-equity ratios from 0.0 to 3.0 are common.

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

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

End of Chapter 14 End of chapter 14.

“How Well Am I Doing?” Financial Statement Analysis

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