1. COPYRIGHT © 2008 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 1 Chapter 14 Financial Statement Analysis Albrecht, Stice, Stice, Swain

2. 2 Why Perform Financial Statement Analysis? Using financial statement analysis –To predict a company’s future probability and cash flows from its past performance. –To evaluate the performance of a company with an eye toward identifying problem areas. Financial statement analysis users –Investors –Creditors –Management

3. 3 Financial Ratios Financial ratios –Relationships between financial statement amounts. Information is revealed when companies: –Compare ratio values with past ratio values. –Compare ratio values with ratio values for similar companies in the same industry.

4. 4 Widely Used Ratios Debt ratio –Represents the amount of assets financed through debt. Current Ratio –Measures a company’s liquidity or ability to pay debt obligations in the short run. Total Liabilities Total Assets Current Assets Current Liabilities

5. 5 Widely Used Ratios Return on Sales –Measures the amount of profit earned per dollar of sales. Asset Turnover –A measure of the company’s efficiency. Net Income Total Sales Total Assets

6. 6 Widely Used Ratios Return on Equity –Measures the amount of profit earned per dollar of investment. Price-Earnings Ratio –A measure of growth potential, earnings stability, and management capabilities. Net Income Total Stockholders’ Equity Market Value of Shares Net Income Price Per Share Earnings Per Share OR

7. 7 Matching Financial Ratios Debt ratio Total liabilities Total assets Current assets Current liabilities Sales Total assets Net income Sales Net income Owners’ equity Market price per share Earnings per share Current ratio Asset turnover Return on sales Return on equity Price-earnings ratio

8. 8 Common-Size Financial Statements Common-size financial statements –Generated by dividing all financial statement amounts for a given year by sales for that year. Common-size income statement –Reveals the number of pennies of each expense for each dollar of sales. Common-size balance sheet –Asset section reveals the number of pennies of each asset that are needed to generate each dollar of sales.

9. 9 Common-Size Income Statement Example Goodrich Company Common-Size Income Statement For the Year Ended 12/31/09 Revenues................$10,000100% Cost of sales............5,000 50 Selling & admin. exp...... 1,500 15 Income before taxes........$ 3,500 35% Income tax expense........ 1,000 10 Net income...............$ 2,500 25%

10. 10 The DuPont Framework –A systematic approach for breaking down return on equity into three components. Profitability. Efficiency. Leverage. –Identifies factors that cause return on equity to deviate from normal.

11. 11 Breaking Down Return on Equity Return on Equity = Net Income Equity Net Income x Revenue x Assets Revenue Assets Equity Asset Assets-to- Turnover Equity Ratio xx Profit Margin Profitability x Efficiency x Leverage

12. 12 Efficiency Ratios—Receivables Accounts Receivable Turnover –How many times during the year a company collects its receivables. Average Collection Period –The average number of days it takes to collect a credit sale. Sales Revenue Average Accounts Receivable 365 Accounts Receivable Turnover

13. 13 Efficiency Ratios—Inventory Inventory Turnover –How many times during the year a company sells all of its inventory. Number of Days’ Sales in Inventory –How many days worth of sales the company has in inventory. Cost of Goods Sold Average Inventory 365 Inventory Turnover

14. 14 Efficiency Ratios—Fixed Assets Fixed Asset Turnover –The amount of dollars in sales generated by each dollar of fixed assets. –Standard values for this ratio differ from industry to industry. Sales Average PP&E

15. 15 Leverage Ratios Debt-to-equity ratio –The number of dollars of debt for every dollar invested by stockholders. Times Interest Earned Ratio –The ratio of income that is available for interest payments. Total Liabilities Total Stockholders’ Equity Earnings Before Interest and Taxes Interest Expense

16. 16 Cash Flow Ratios Why aren’t cash flow ratios standard for financial statement analysis? –The statement of cash flows is relatively recent. –Cash flow ratios are not included in the DuPont framework. Usefulness of cash flow ratios. –Large non-cash expenditures. –Rapid growth. –Window dressing time.

17. 17 Cash Flow Ratios Cash flow-to-net income ratio –Reflects the extent to which accrual accounting assumptions and adjustments have been included in computing net income. Cash flow adequacy ratio –Measures a company’s ability to finance its capital expansion through cash from operations. Cash Flow from Operations Net Income Cash Flow from Operations Cash Paid for Capital Expenditures

18. 18 Potential Pitfalls Financial statements don’t contain all the information about a company. –All information is not numerical. Lack of comparability between companies. –Different accounting practices. –Conglomerates. Problems are not always readily apparent. Financial statement analysis is based off of past information.