1. 1 Click to edit Master title style 1 1 1 Financial Statement Analysis 15

2. 2 Click to edit Master title style 2 2 2 1. List basic financial statement analytical procedures. 2. Apply financial statement analysis to assess the solvency of a business. 3. Apply financial statement analysis to stress the profitability of a business. 4. Describe the contents of corporate annual reports. After studying this chapter, you should be able to:

3. 3 Click to edit Master title style 3 3 3 List basic financial statement analytical procedures. Objective 1 15-1

4. 4 Click to edit Master title style 4 4 4 Horizontal Analysis The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis. 15-1

5. 5 Click to edit Master title style 5 5 5 Exhibit 1 Comparative Balance Sheets Assets Current assets$ 550,000$ 533,000$ 17,000 3.2% Long-term investments95,000177,500(82,500)(46.5%) Prop., plant, and equip. (net)444,500470,000(25,500)(5.4%) Intangible assets 50,000 50,000 Total assets $1,139,500$1,230,500$ (91,000)(7.4%) Liabilities Current liabilities$ 210,000$ 243,000$ (33,000)(13.6%) Long-term liabilities 100,000 200,000 100,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000)(30.0%) Stockholders’ Equity Preferred 6% stock, $100 par$ 150,000$ 150,000— Common stock, $10 par500,000500,000— Retained earnings 179,500 137,500$ 42,000 30.5% Total stockholders’ equity $ 829,500$ 787,500$ 42,000 5.3% Total liab. & stockholders’ eq.$1,139,500$1,230,500$ (91,000)(7.4%) 20082007AmountPercent Increase (Decrease) 5 Lincoln Company Comparative Balance Sheet December 31, 2008 and 2007 15-1

6. 6 Click to edit Master title style 6 6 6 Assets Current assets$ 550,000$ 533,000$ 17,000 3.2% Long-term investments95,000177,500(82,500)(46.5%) Prop., plant, and equip. (net)444,500470,000(25,500)(5.4%) Intangible assets 50,000 50,000 Total assets $1,139,500$1,230,500$ (91,000)(7.4%) Liabilities Current liabilities$ 210,000$ 243,000$ (33,000)(13.6%) Long-term liabilities 100,000 200,000 100,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000)(30.0%) Stockholders’ Equity Preferred 6% stock, $100 par$ 150,000$ 150,000— Common stock, $10 par500,000500,000— Retained earnings 179,500 137,500$ 42,000 30.5% Total stockholders’ equity $ 829,500$ 787,500$ 42,000 5.3% Total liab. & stockholders’ eq.$1,139,500$1,230,500$ (91,000)(7.4%) 20082007AmountPercent Lincoln Company Comparative Balance Sheet December 31, 2008 and 2007 Increase (Decrease) 6 Horizontal Analysis: Horizontal Analysis: Difference$17,000 Base year (2007)$533,000 = 3.2% 15-1

7. 7 Click to edit Master title style 7 7 7 8 Comparative Schedule of Current Assets Lincoln Company Comparative Schedule of Current Assets December 31, 2008 and 2007 Increase (Decrease) Cash$ 90,500$ 64,700$ 25,80039.9% Marketable securities75,00060,00015,00025.0% Accounts receivable (net)115,000120,000(5,000)(4.2%) Inventories264,000283,000(19,000)(6.7%) Prepaid expenses 5,500 5,300 2003.8% Total current assets$550,000$533,000$17,0003.2% 20082007AmountPercent 15-1

8. 8 Click to edit Master title style 8 8 8 10 Lincoln Company Comparative Income Statement For the Year Ended December 31, 2008 and 2007 Sales$1,530,500$1,234,000$296,500 24.0% Sales returns and allowances 32,500 34,000 (1,500)(4.4%) Net sales$1,498,000$1,200,000$298,00024.8% Cost of goods sold 1,043,000 820,000 223,00027.2% Gross profit $ 455,000$ 380,000 $ 75,00019.7% Selling expenses$ 191,000$ 147,000$ 44,00029.9% Administrative expenses 104,000 97,400 6,6006.8% Total operating expenses$ 295,000$ 244,400$ 50,60020.7% Income from operations$ 160,000$ 135,600$ 24,40018.0% Other income 8,500 11,000 (2,500)(22.7%) $ 168,500$ 146,600$ 21,90014.9% Other expense (interest) 6,000 12,000 (6,000)(50.0%) Income before income tax$ 162,500$ 134,600$ 27,90020.7% Income tax expense 71,500 58,100 13,40023.1% Net income$ 91,000 $ 76,500$ 14,50019.0% 20082007AmountPercent Increase (Decrease) Comparative Income Statement 15-1

9. 9 Click to edit Master title style 9 9 9 12 Comparative Retained Earnings Statement A percentage analysis that shows the relationship of each component to the total within a single statement is called vertical analysis. Lincoln Company Comparative Retained Earnings Statement December 31, 2008 and 2007 Increase (Decrease) Retained earnings, Jan. 1$137,500$100,000$37,50037.5% Net income for year 91,000 76,500 14,50019.0% Total$228,500$176,500$52,00029.5%) Dividends: On preferred stock $ 9,000$ 9,000— On common stock 40,000 30,000 10,00033.3% Total$ 49,000$ 39,000$10,00025.6% Total current assets$179,500$137,500$42,00030.5% 20082007AmountPercent 15-1

10. 10 Click to edit Master title style 10 Vertical Analysis A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis. 15-1

11. 11 Click to edit Master title style 11 In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity. Vertical Analysis of Balance Sheet 15-1

12. 12 Click to edit Master title style 12 18 Lincoln Company Comparative Balance Sheet For the Years Ended December 31, 2008 and 2007 Assets Current assets$ 550,00048.3%$ 533,00043.3% Long-term investments95,0008.3177,50014.4 Property, plant, & equip. (net)444,50039.0470,00038.2 Intangible assets 50,0004.4 50,0004.1 Total assets$1,139,500100.0%$1,230,500100.0% Liabilities Current liabilities$ 210,00018.4%$ 243,00019.7% Long-term liabilities 100,0008.8 200,00016.3 Total liabilities$ 310,00027.2%$ 443,00036.0% Stockholders’ Equity Preferred 6% stock, $100 par$ 150,00013.2%$ 150,00012.2% 2.2% Common stock, $10 par500,00043.9500,00040.6 Retained earnings 179,50015.7 137,50011.2 Total stockholders’ equity$ 829,50072.8%$ 787,50064.0% Total liab. & Stockholders’ equity$1,139,500100.0%$1,230,500100.0% Amount Percent Amount Percent 2008 2007 Total assets $1,139,500 100.0%$1,230,500 100.0% Total liab. & stockholders’ equity $1,139,500 100.0%$1,230,500 100.0% 15-1

13. 13 Click to edit Master title style 13 20 Lincoln Company Comparative Balance Sheet For the Years Ended December 31, 2008 and 2007 Assets Current assets$ 550,00048.3%$ 533,00043.3% Long-term investments95,0008.3177,50014.4 Property, plant, & equip. (net)444,50039.0470,00038.2 Intangible assets 50,0004.4 50,0004.1 Total assets$1,139,500100.0%$1,230,500100.0% Liabilities Current liabilities$ 210,00018.4%$ 243,00019.7% Long-term liabilities 100,0008.8 200,00016.3 Total liabilities$ 310,00027.2%$ 443,00036.0% Stockholders’ Equity Preferred 6% stock, $100 par$ 150,00013.2%$ 150,0001 2.2% Common stock, $10 par500,00043.9500,00040.6 Retained earnings 179,50015.7 137,50011.2 Total stockholders’ equity$ 829,50072.8%$ 787,50064.0% Total liab. & Stockholders’ equity$1,139,500100.0%$1,230,500100.0% Amount Percent Amount Percent 2008 2007 Total assets $1,139,500 100.0%$1,230,500100.0% Total liab. & stockholders’ equity $1,139,500 100.0%$1,230,500100.0% Vertical Analysis: Vertical Analysis: Current assets $550,000 Total assets $1,139,500 = 48.3% 15-1

14. 14 Click to edit Master title style 14 In a vertical analysis of the income statement, each item is stated as a percent of net sales. Vertical Analysis of Income Statement 15-1

15. 15 Click to edit Master title style 15 22 Sales$1,530,500102.2% $1,234,000102.8% Sales returns and allow. 32,500 2.2 34,0002.8 Net sales$1,498,000100.0%$1,200,000100.0% Cost of goods sold 1,043,00069.6 820,00068.3 Gross profit $ 455,00030.4%$ 380,00031.7% Selling expenses$ 191,00012.8%$ 147,00012.3% Administrative expenses 104,0006.9 97,4008.1 Total operating expenses$ 295,00019.7%$ 244,40020.4% Income from operations$ 160,00010.7$ 135,60011.3% Other income 8,5000.6 11,0000.9 $ 168,50011.3%$ 146,60012.2% Other expense (interest) 6,0000.4 12,0001.0 Income before income tax$ 162,50010.9%$ 134,60011.2% Income tax expense 71,5004.8 58,1004.8 Net income$ 91,0006.1%$ 76,5006.4% 2008 2007 Amount Percent Amount Percent Lincoln Company Comparative Income Statement For the Years Ended December 31, 2008 and 2007 15-1 Comparative Income Statement

16. 16 Click to edit Master title style 16 Common-Size Statements In a common-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with with industry percentages. 15-1

17. 17 Click to edit Master title style 17 25 Common-Size Income Statement 15-1

18. 18 Click to edit Master title style 18 Apply financial statement analysis to assess the solvency of a business. Objective 2 15-2

19. 19 Click to edit Master title style 19 Solvency Analysis The ability of a business to meet its financial obligations (debts) is called solvency. The ability of a business to earn income is called profitability. 15-2

20. 20 Click to edit Master title style 20 Current Position Analysis Using measures to assess a business’s ability to pay its current liabilities is called current position analysis. Such analysis is of special interest to short-term creditors. 15-2

21. 21 Click to edit Master title style 21 Working Capital The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company’s ability to meet currently maturing debts. 15-2

22. 22 Click to edit Master title style 22 32 Working capital (a – b) $340,000 Current asset: Cash$ 90,500 Marketable securities 75,000 Accounts receivable (net)115,000 Inventories 264,000 Prepaid expenses 5,500 a.Total current assets$550,000 b.Current liabilities 210,000 Lincoln Company 15-2

23. 23 Click to edit Master title style 23 Current Ratio The current ratio, sometimes called the working capital ratio or bankers’ ratio, is computed by dividing the total current assets by the total current liabilities. 15-2

24. 24 Click to edit Master title style 24 Current ratio (a/b) 2.6 2.2 Current ratio (a/b) 2.6 2.2 a. Current assets $550,000$533,000 b. Current liabilities 210,000 243,000 Working capital (a – b)$340,000$290,000 2008 2007 34 Lincoln Company 15-2

25. 25 Click to edit Master title style 25 Quick Ratio A ratio that measures the “instant’ debt-paying ability of a company is called the quick ratio or acid-test ratio. 15-2

26. 26 Click to edit Master title style 26 36 20082007 Quick ratio (a/b) 1.3 1.0 Quick assets: Cash$ 90,500$ 64,700 Marketable securities 75,00060,000 Accounts receivable (net)115,000120,000 a. Total quick assets$280,500$244,700 b. Current liabilities$210,000$243,000 Lincoln Company Quick assets are cash and other current assets that can be quickly converted to cash. 15-2

27. 27 Click to edit Master title style 27 Accounts Receivable Turnover The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. The ratio is to assess the efficiency of the firm in collecting receivables and in the managing of credit. 15-2

28. 28 Click to edit Master title style 28 40 Accounts receivable turnover (a/b) 12.7 9.2 a. Net sales $1,498,000$1,200,000 Accounts receivable (net): Beginning of year$ 120,000$ 140,000 End of year 115,500 120,000 Total$ 235,000$ 260,000 b.Average (Total/2)$ 117,500$ 130,000 20082007 Lincoln Company 15-2

29. 29 Click to edit Master title style 29 Number of Days’ Sales in Receivables The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. Comparing this measure with the credit terms provides information on the efficiency in collecting receivables. 15-2

30. 30 Click to edit Master title style 30 Number of days’ sales in receivables (a/b) 28.6 39.5 receivables (a/b) 28.6 39.5 a.Average (Total/2)$ 117,500$ 130,000 Net sales$1,498,000$1,200,000 b.Average daily sales on account (Sales/365)$ 4,104$ 3,288 20082007 Lincoln Company 42 15-2

31. 31 Click to edit Master title style 31 Inventory Turnover The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory. 15-2

32. 32 Click to edit Master title style 32 46 20082007 Inventory turnover (a/b) 3.8 2.8 Inventory turnover (a/b) 3.8 2.8 a.Cost of goods sold$1,043,000$ 820,000 Inventories: Beginning of year$ 283,000$ 311,000 End of year 264,000 283,000 Total$ 547,000$ 594,000 b.Average (Total/2)$ 273,500$ 297,000 Lincoln Company 15-2

33. 33 Click to edit Master title style 33 47 Number of days’ sales in inventory (a/b) 95.7 132.2 inventory (a/b) 95.7 132.2 a.Average (Total/2)$ 273,500$ 297,000 Cost of goods sold$1,043,000$ 820,000 b.Average daily cost of goods sold (COGS/365 days)$2,858$2,247 20082007 Number of Days’ Sales in Inventory Lincoln Company 15-2

34. 34 Click to edit Master title style 34 Ratio of Fixed Assets to Long-Term Liabilities The ratio of fixed assets to long- term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis. 15-2

35. 35 Click to edit Master title style 35 51 20082007 Ratio of fixed assets to Ratio of fixed assets to long-term liabilities (a/b) 4.4 2.4 long-term liabilities (a/b) 4.4 2.4 a. Fixed assets (net)$444,500$470,000 b.Long-term liabilities$100,000$200,000 Lincoln Company 15-2

36. 36 Click to edit Master title style 36 Ratio of Liabilities to Stockholders’ Equity The relationship between the total claims of the creditors and owners—the ratio of liabilities to stockholders’ equity—is a solvency measure that indicates the margin of safety for creditors. 15-2

37. 37 Click to edit Master title style 37 53 Ratio of liabilities to Ratio of liabilities to stockholders’ equity (a/b) 0.4 0.6 stockholders’ equity (a/b) 0.4 0.6 a.Total liabilities$310,000$443,000 b.Total stockholders’ equity$829,500$787,500 20082007 Lincoln Company 15-2

38. 38 Click to edit Master title style 38 Number of Times Interest Charges Earned Corporations in some industries normally have high ratios of debt to stockholders’ equity. For such corporations, the relative risk of the debtholders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio. 15-2

39. 39 Click to edit Master title style 39 57 2008 2007 Income before income tax$162,500$134,600 a.Add interest expense 6,000 12,000 b.Amount available to meet interest charges$168,500$146,600 Lincoln Company Number of times interest charges earned (b/a) 28.1 12.2 charges earned (b/a) 28.1 12.2 15-2

40. 40 Click to edit Master title style 40 Apply financial statement analysis to assess the profitability of a business. Objective 3 15-3

41. 41 Click to edit Master title style 41 Profitability Analysis  Profitability is the ability of an entity to earn profits.  This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available as reported in the balance sheet.  Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet. 15-3

42. 42 Click to edit Master title style 42 Ratio of Net Sales to Assets The ratio of net sales to assets is a profitability measure that shows how effectively a firm utilizes its assets. 15-3

43. 43 Click to edit Master title style 43 63 20082007 a.Net sales $1,498,000$1,200,000 Total assets: Beginning of year$1,053,000$1,010,000 End of year 1,044,500 1,053,000 Total$2,097,500$2,063,000 b.Average (Total/2)$1,048,750$1,031,500 Lincoln Company Excludes long-term investments 15-3

44. 44 Click to edit Master title style 44 64 20082007 a.Net sales $1,498,000$1,200,000 Total assets: Beginning of year$1,053,000$1,010,000 End of year 1,044,500 1,053,000 Total$2,097,500$2,063,000 b.Average (Total/2)$1,048,750$1,031,500 Lincoln Company Ratio of net sales to assets (a/b) 1.4 1.2 Ratio of net sales to assets (a/b) 1.4 1.2 15-3

45. 45 Click to edit Master title style 45 Rate Earned on Total Assets The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed. 15-3

46. 46 Click to edit Master title style 46 67 20082007 Rate earned on total Rate earned on total assets (a/b) 8.2% 7.3% assets (a/b) 8.2% 7.3% Net income$ 91,000$ 76,500 Plus interest expense 6,000 12,000 a.Total$ 97,000$ 88,500 Total assets: Beginning of year$1,230,500$1,187,500 End of year 1,139,500 1,230,500 Total$2,370,000$2,418,000 b.Average (Total/2)$1,185,000$1,209,000 Lincoln Company 15-3

47. 47 Click to edit Master title style 47 Rate Earned on Stockholders’ Equity The rate earned on stockholders’ equity measure emphasizes the rate of income earned on the amount invested by the stockholders. 15-3

48. 48 Click to edit Master title style 48 71 Rate earned on stockholders’ equity (a/b) 11.3% 10.0% a.Net income$ 91,000$ 76,500 Stockholders’ equity: Beginning of year$ 787,500$ 750,000 End of year 829,500 787,500 Total$1,617,000$1,537,500 b.Average (Total/2)$ 808,500$ 768,750 20082007 Lincoln Company 15-3

49. 49 Click to edit Master title style 49 The difference in the rate earned on stockholders’ equity and the rate earned on total assets is called leverage. Leverage 15-3

50. 50 Click to edit Master title style 50 73 10% 5% 0% Rate earned on total assets Rate earned on stockholders’ equity 8.2% 11.3% Leverage 3.1% 2008 7.3% 10.0% Leverage 2.7% 2007 Leverage 15-3

51. 51 Click to edit Master title style 51 The rate earned on common stockholders’ equity focuses only on the rate of profits earned on the amount invested by the common stockholders. Rate Earned on Common Stockholders’ Equity 15-3

52. 52 Click to edit Master title style 52 20082007 Net income$ 91,000$ 76,500 Less preferred dividends 9,000 9,000 a.Remainder—common stock$ 82,000$ 67,500 Common stockholders’ equity: Beginning of year $ 637,500$ 600,000 End of year 679,500 637,500 Total$1,317,000$1,237,500 b.Average (Total/2)$ 658,500$ 618,750 Rate earned on common Rate earned on common stockholders’ equity (a/b) 12.5% 10.9% stockholders’ equity (a/b) 12.5% 10.9% Lincoln Company 75 15-3

53. 53 Click to edit Master title style 53 Earnings per Share on Common Stock One of the profitability measures often quoted by the financial press is earning per share (EPS) on common stock. It is also normally reported in the income statement in corporate annual reports. 15-3

54. 54 Click to edit Master title style 54 79 2008 2007 Earnings per share on common Earnings per share on common stock (a/b) $1.64 $1.35 stock (a/b) $1.64 $1.35 Net income$ 91,000$ 76,500 Preferred dividends 9,000 9,000 a.Remainder—identified with common stock$ 82,000$ 67,500 b.Shares of common stock50,00050,000 Lincoln Company 15-3

55. 55 Click to edit Master title style 55 Price-Earnings Ratio Another profitability measure quoted by the financial press is the price-earnings (P/E) ratio on common stock. The price-earnings ratio is an indicator of a firm’s future earnings prospects. 15-3

56. 56 Click to edit Master title style 56 81 2008 2007 Price-earnings ratio on Price-earnings ratio on common stock 25 20 common stock 25 20 Market price per share of common stock$41.00$27.00 Earnings per share on common stock / 1.64/ 1.35 Lincoln Company 15-3

57. 57 Click to edit Master title style 57 Dividends per Share Dividends per share can be reported with earnings per share to indicate the relationship between dividends and earnings. Comparing these two per share amounts indicates the extent to which the corporation is retaining its earnings for use in operations. 15-3

58. 58 Click to edit Master title style 58 86 Dividends Earnings $0.80 $1.64 2008 $0.60 $1.35 2007 Per share $2.00 $1.50 $1.00 $0.50 $ 0.00 Lincoln Company Dividends and Earning per Share of Common Stock 15-3

59. 59 Click to edit Master title style 59 The dividend yield on common stock is a profitability measure that shows the rate of return to common stockholders in terms of cash dividends. Dividend Yield 15-3

60. 60 Click to edit Master title style 60 88 20082007 Dividend yield on Dividend yield on common stock 2.0% 2.2% common stock 2.0% 2.2% Dividends per share of common stock$ 0.80$ 0.60 Market price per share of common stock/41.00/27.00 Lincoln Company 15-3

61. 61 Click to edit Master title style 61 Describe the contents of corporate annual reports. Objective 4 15-4

62. 62 Click to edit Master title style 62 Corporate Annual Reports In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections:  Management Discussion and Analysis  Report on adequacy of internal control  Report on fairness of financial statements 15-4

63. 63 Click to edit Master title style 63 The Management Discussion and Analysis (MD&A) includes an analysis of the results of operations and discusses management’s opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition. Management Discussion and Analysis 15-4

64. 64 Click to edit Master title style 64 Management is required by the Sarbanes- Oxley Act of 2002 to provide a report stating their responsibility for establishing and maintaining internal control. In addition, the report must state management’s conclusion concerning the effectiveness of internal controls over financial reporting. Report on Adequacy of Internal Control 15-4

65. 65 Click to edit Master title style 65 All publicly held corporations are required to have an independent audit (examination) of their financial statements. The CPAs who conduct the audit render an opinion on the fairness of the statements. Report on Fairness of Financial Statements 15-4