1. ANALYSIS AND FINANCIAL STATEMENTS
CHAPTER 17
ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS

2. Financial Statement Analysis
Non-accounting majors, especially, should relate well to this chapter
It looks at accounting information from users’ perspective
Relates very closely to topics you will study in your finance course
Therefore, we will use a somewhat broader brush on this chapter
What is financial statement analysis?
”Tearing apart” the financial statements and looking at the relationships

3. Financial Statement Analysis
625
Who analyzes financial statements?
Internal users (i.e., management)
External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors

4. Financial Statement Analysis
What do internal users use it for?
Planning, evaluating and controlling company operations
What do external users use it for?
Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management
First sentence in chapter says...

5. Financial Statement Analysis
Information is available from
Published annual reports
(1) Financial statements
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditor’s report (Independent accountants)
(5) Management’s discussion and analysis
Reports filed with the government
e.g., Form 10-K, Form 10-Q and Form 8-K

6. Financial Statement Analysis
Information is available from
Other sources
(1) Newspapers (e.g., Wall Street Journal )
(2) Periodicals (e.g. Forbes, Fortune)
(3) Financial information organizations such as: Moody’s, Standard & Poor’s, Dun & Bradstreet, Inc., and Robert Morris Associates
(4) Other business publications

7. Methods of Financial Statement Analysis
Horizontal Analysis
Vertical Analysis
Common-Size Statements
Trend Percentages
Ratio Analysis

8. Horizontal Analysis
Using comparative financial statements to calculate dollar or percentage changes in a financial statement item from one period to the next

9. Vertical Analysis
For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

10. Common-Size Statements
Financial statements that show only percentages and no absolute dollar amounts

11. Trend Percentages
Show changes over time in given financial statement items (can help evaluate financial information of several years)

12. Ratio Analysis
Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

13. Horizontal Analysis Example
The management of Clover Company provides you with comparative balance sheets of the years ended December 31, 1999 and Management asks you to prepare a horizontal analysis on the information.

15. Horizontal Analysis Example
Calculating Change in Dollar Amounts
Dollar
Change
Current Year
Figure
Base Year
Figure = –

16. Horizontal Analysis Example
Calculating Change in Dollar Amounts
Dollar
Change
Current Year
Figure
Base Year
Figure = –
Since we are measuring the amount of the change between 1998 and 1999, the dollar amounts for 1998 become the “base” year figures.

17. Horizontal Analysis Example
Calculating Change as a Percentage
Percentage
Change
Dollar Change
Base Year Figure × =
100%

18. Horizontal Analysis Example
$12,000 – $23,500 = $(11,500)

19. Horizontal Analysis Example
($11,500 ÷ $23,500) × 100% = 48.9%

20. Horizontal Analysis Example

21. Horizontal Analysis Example
Let’s apply the same
procedures to the
liability and stockholders’
equity sections of the
balance sheet.

23. Horizontal Analysis Example
Now, let’s apply the procedures to the
income statement.

25. Sales increased by 8.3% while net income decreased by 21.9%.

26. There were increases in both cost of goods sold (14
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.

27. Vertical Analysis Example
The management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company.

28. Vertical Analysis Example

29. Vertical Analysis Example
$82,000 ÷ $483,000 = 17% rounded
$30,000 ÷ $387,000 = 8% rounded

30. Vertical Analysis Example
$76,000 ÷ $483,000 = 16% rounded

31. Trend Percentages Example
Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.

32. Trend Percentages Example
Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.
$1, $1,820 = $171

33. Trend Percentages Example
Using 1995 as the base year, we develop the following percentage relationships.
$1, $1,820 = $171
$171 ÷ $1,820 = 9% rounded

34. Trend line
for Sales

35. Ratios Ratios can be expressed in three different ways: CAUTION!
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $ (e.g., EPS of $2.25)
CAUTION!
“Using ratios and percentages without considering the underlying causes may be hazardous to your health!”
lead to incorrect conclusions.”

36. Categories of Ratios Liquidity Ratios
Indicate a company’s short-term debt-paying ability
Equity (Long-Term Solvency) Ratios
Show relationship between debt and equity financing in a company
Profitability Tests
Relate income to other variables
Market Tests
Help assess relative merits of stocks in the marketplace

37. 10 Ratios You Must Know Liquidity Ratios
Current (working capital) ratio
Acid-test (quick) ratio
Cash flow liquidity ratio
Accounts receivable turnover
Number of days’ sales in accounts receivable
Inventory turnover
Total assets turnover
651

38. Equity (Long-Term Solvency) Ratios
10 Ratios You Must Know
Equity (Long-Term Solvency) Ratios
Equity (stockholders’ equity) ratio
Equity to debt

39. 10 Ratios You Must Know Profitability Tests $
Return on operating assets
Net income to net sales (return on sales or “profit margin”)
Return on average common stockholders’ equity (ROE)
Cash flow margin
Earnings per share
Times interest earned
Times preferred dividends earned $

40. 10 Ratios You Must Know Market Tests Earnings yield on common stock
Price-earnings ratio
Payout ratio on common stock
Dividend yield on common stock
Dividend yield on preferred stock
Cash flow per share of common stock

41. Now, let’s look at Norton Corporation’s 1999 and 1998 financial statements.

45. Now, let’s calculate the 10 ratios based on Norton’s financial statements.

46. to calculate the liquidity ratios for Norton.
We will
use this
information
to calculate the liquidity ratios for Norton.

47. The excess of current assets over current liabilities.
Working Capital*
The excess of current assets over current liabilities.
* While this is not a ratio, it does give an indication of a company’s liquidity.

48. Current (Working Capital) Ratio#1
Current
Ratio
Current Assets
Current Liabilities =
Current
Ratio
$65,000
$42,000 =
1.55 : 1
Measures the ability
of the company to pay current
debts as they become due.

49. Acid-Test (Quick) Ratio#2
Quick Assets
Current Liabilities =
Acid-Test
Ratio
Quick assets are Cash,
Marketable Securities, Accounts Receivable (net) and
current Notes Receivable.

50. Acid-Test (Quick) Ratio#2
Quick Assets
Current Liabilities =
Acid-Test
Ratio
Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000.

51. Acid-Test (Quick) Ratio#2
Quick Assets
Current Liabilities =
Acid-Test
Ratio
$50,000
$42,000 =
1.19 : 1
Acid-Test
Ratio

52. Accounts Receivable Turnover#3
Net, credit sales
Average, net accounts receivable
Sales on Account
Average Accounts Receivable
Accounts Receivable
Turnover =
= times
$494,000
($17,000 + $20,000) ÷ 2
Accounts Receivable
Turnover =
This ratio measures how many times a company converts its receivables into cash each year.

53. Number of Days’ Sales in Accounts Receivable#4
Days’ Sales
in Accounts
Receivables
365 Days
Accounts Receivable Turnover =
= days =
365 Days
26.70 Times
Days’ Sales
in Accounts
Receivables
Measures, on average, how many days it takes to collect an account receivable.

54. Number of Days’ Sales in Accounts Receivable#4
Days’ Sales
in Accounts
Receivables
365 Days
Accounts Receivable Turnover =
= days =
365 Days
26.70 Times
Days’ Sales
in Accounts
Receivables
In practice, would 45 days be a desirable number of days in receivables?

55. Measures the number of times replaced during the year.
Inventory Turnover #5
Cost of Goods Sold
Average Inventory
Inventory
Turnover =
= times
$140,000
($10,000 + $12,000) ÷ 2
Inventory
Turnover =
Measures the number of times
inventory is sold and
replaced during the year.

56. Would 5 be a desirable number of times for inventory to turnover?
Inventory Turnover #5
Cost of Goods Sold
Average Inventory
Inventory
Turnover =
= times
$140,000
($10,000 + $12,000) ÷ 2
Inventory
Turnover =
Would 5 be a desirable number of times for inventory to turnover?

57. Equity, or Long–Term Solvency Ratios
This is part of the information to calculate the equity, or long-term solvency ratios of Norton Corporation.

58. Here is the
rest of the
information
we will
use.

59. Measures the proportion of total assets provided by
Equity Ratio #6
Equity
Ratio =
Stockholders’ Equity
Total Assets
Equity
Ratio =
$234,390
$346,390
67.7%
Measures the proportion
of total assets provided by
stockholders.

60. Net Income to Net Sales A/K/A Return on Sales or Profit Margin#7
Net Income to
Net Sales
Net Income
Net Sales =
Net Income to
Net Sales =
$53,690
$494,000
= 10.9%
Measures the proportion of the sales dollar which is retained as profit.

61. Net Income to Net Sales A/K/A Return on Sales or Profit Margin#7
Net Income to
Net Sales
Net Income
Net Sales =
Net Income to
Net Sales
$53,690
$494,000 =
= 10.9%
Would a 1% return on sales be good?

62. Return on Average Common Stockholders’ Equity (ROE)#8
Return on
Stockholders’
Equity
Net Income
Average Common
Stockholders’ Equity = =
$53,690
($180,000 + $234,390) ÷ 2
= 25.9%
Return on
Stockholders’
Equity
Important measure of the
income-producing ability
of a company.

63. Earnings Per Share #9 Earnings Available to Common Stockholders
Weighted-Average Number of Common Shares Outstanding
Earnings
per Share =
Earnings
per Share
$53,690
(17, ,400) ÷ 2 =
= $2.42
The financial press regularly publishes
actual and forecasted EPS amounts.

64. Earnings Per Share What’s new from Chap. 15?
Weighted-average calculation
644
EPS of common stock = _______________________
Earnings available to
common stockholders
Weighted-average number of
common shares outstanding
Three alternatives for calculating weighted-average number of shares

65. Earnings Per Share What’s new from Chap. 15?
Weighted-average calculation
645
EPS of common stock = _______________________
Earnings available to
common stockholders
Weighted-average number of
common shares outstanding
Alternate #1

66. Earnings Per Share
645
Alternate #2
Alternate #3

67. Earnings Per Share ¶ EPS and Stock Dividends or Splits
646
¶ EPS and Stock Dividends or Splits
Why restate all prior calculations of EPS?
Comparability - i.e., no additional capital was generated by the dividend or split
¶ Primary EPS and Fully Diluted EPS
APB Opinion No. 15
I mentioned this 17-page pronouncement that required a 100-page explanation in the lecture for chapter 13.

68. Price-Earnings Ratio A/K/A P/E Multiple
#10
Price-Earnings
Ratio
Market Price Per Share
EPS =
Price-Earnings
Ratio =
$20.00
$ 2.42
= 8.3 : 1
Provides some measure of whether the stock is under or overpriced.

69. Important Considerations
Need for comparable data
Data is provided by Dun & Bradstreet, Standard & Poor’s etc.
Must compare by industry
Is EPS comparable?
Influence of external factors
General business conditions
Seasonal nature of business operations
Impact of inflation

70. Question
The current ratio is a measure of liquidity that is computed by dividing total assets by total liabilities.
a. True
b. False

71. Question
The current ratio is a measure of liquidity that is computed by dividing total assets by total liabilities.
a. True
b. False
The current ratio is a measure of
liquidity, but is computed by
dividing current assets by
current liabilities

72. Question
Quick assets are defined as Cash, Marketable Securities and net receivables.
a. True
b. False

73. Question
Quick assets are defined as Cash, Marketable Securities and net receivables.
a. True
b. False

74. No more ratios, please!

75. About Test #1
Will be challenging because the material covered is challenging
All questions are T/F or M/C
Questions are 5-pt., 3-pt. & 1-pt.
No tricks such as patterns in answers
Order of answers is random
Coverage is even over the 4 chapters
Time allowed: 75 minutes

76. About Test #1 Best way to study Calculators will be provided
Notes first
Study guide and/or Hermanson tutorials
Calculators will be provided
Must wait outside classroom
Have your questions ready for next actual class
See course home page for office hours