1. “How Well Am I Doing?” Financial Statement Analysis Instructor masum Bangladesh University of Textiles

2. How Well Am I Doing

3. Three commonly used tools are utilized to evaluate the significance of financial statement data. 1) Horizontal analysis (trend analysis) evaluates a series of financial statement data over a period of time. 2) Vertical analysis evaluates financial statement data expressing each item in a financial statement as a percent of a base amount. 3) Ratio analysis expresses the relationship among selected items of financial statement data. TOOLS OF FINANCIAL STATEMENT ANALYSIS

4. Learning Objective 1 Prepare and interpret financial statements in comparative and common-size form.

5. Statements in Comparative and Common- Size Form  Dollar and percentage changes on statements changes on statements  Common-size statements statements  Ratios An item on a financial statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing comparisons.

6. Dollar and Percentage Changes on Statements dollarpercentage Horizontal analysis (or trend analysis) shows the changes between years in the financial data in both dollar and percentage form.

7. Example The following slides illustrate a horizontal analysis of Clover Corporation’s December 31, 2007 and 2006, comparative balance sheets and comparative income statements. Horizontal Analysis

9. Calculating Change in Dollar Amounts Dollar Change Current Year Figure Base Year Figure =– The dollar amounts for 2006 become the “base” year figures.

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

11. ($11,500 ÷ $23,500) × 100% = 48.9% $12,000 – $23,500 = $(11,500)

12. Horizontal Analysis

13. We could do this for the liabilities & stockholders’ equity, but now let’s look at the income statement accounts.

14. Horizontal Analysis

16. Sales increased by 8.3%, yet net income decreased by 21.9%.

17. 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.

18. Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent. Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.

19. Trend Analysis Trend Percentage Current Year Amount Base Year Amount 100% = ×

20. Trend Analysis Example Look at the income information for Berry Products for the years 2003 through 2007. We will do a trend analysis on these amounts to see what we can learn about the company.

21. Trend Analysis The base year is 2003, and its amounts will equal 100%. Berry Products Income Information For the Years Ended December 31

22. Trend Analysis 2004 Amount ÷ 2003 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108% Berry Products Income Information For the Years Ended December 31

23. Trend Analysis 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. Berry Products Income Information For the Years Ended December 31

24. Trend Analysis We can use the trend percentages to construct a graph so we can see the trend over time.

25. Common-Size Statements Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.

26. Common-Size Statements In income statements, all items usually are expressed as a percentage of sales.

27. Gross Margin Percentage Gross Margin Percentage Gross Margin 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.

28. Common-Size Statements In balance sheets, all items usually are expressed as a percentage of total assets.

29. Common-Size Statements Common-size financial statements are particularly useful when comparing data from different companies.

30. Example Let’s take another look at the information from the comparative income statements of Clover Corporation for 2007 and 2006. This time, let’s prepare common-size statements. Common-Size Statements

31. Sales Sales is usually the base and is expressed as 100%.

32. Common-Size Statements 2006 Cost ÷ 2006 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6% 2007 Cost ÷ 2007 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2%

33. Common-Size Statements What conclusions can we draw?

34. 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.

35. 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. Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

36. RATIO ANALYSIS Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. A single ratio by itself is not very meaningful, in the upcoming illustrations we will use: 1) Intracompany comparisons 2) Industry average comparisons 3) Intercompany comparisons

37. Key Financial Ratios LIQUIDITY RATIOS Current Ratio = Current Assets/Current Liabilities Quick (Acid Test) Ratio = (Current Assets – Inventories)/Current Liabilities Working Capital Percentage = (Current Assets-Current Liabilities)/Net Sales LEVERAGE RATIOS Debt to Assets Ratio = Total Liabilities/Total Assets Debt to Equity Ratio = Total Liabilities/Total Equity Times Interest Earned = Operating Income/Interest Expense ACTIVITY RATIOS Accounts Receivable Turnover = Credit Sales/Accounts Receivable Average Collection Period = (Accounts Receivable x 365)/Net Sales Inventory Turnover = Cost of Goods Sold/Finished Goods Inventory Asset Turnover = Net Sales/Total Assets PROFITABILITY RATIOS Return on Assets = Operating Income/Total Assets Return on Equity = Net Income/Total Equity Net Profit Margin = Net Income/Net Sales

38. Learning Objective 2 Compute and interpret financial ratios that would be useful to a common stockholder.

39. Now, let’s look at Norton Corporation’s 2007 and 2006 financial statements.

43. Ratio Analysis – The Common Stockholder The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholders’ equities. The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholders’ equities.

44. 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. Earnings form the basis for dividend payments and future increases in the value of shares of stock.

45. Earnings Per Share Earnings per Share Net Income – Preferred Dividends Average Number of Common Shares Outstanding = Earnings per Share $53,690 – $0 ($17,000 + $27,400)/2 == $2.42 This measure indicates how much income was earned for each share of common stock outstanding.

46. Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share Earnings Per Share = Price-Earnings Ratio $20.00 $2.42 == 8.26 times A higher price-earnings ratio means that investors are willing to pay a premium for a company’s stock because of optimistic future growth prospects.

47. Dividend Payout Ratio Dividend Payout Ratio Dividends Per Share Earnings Per Share = Dividend Payout Ratio $2.00 $2.42 == 82.6% This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking dividends (market price growth) would like this ratio to be large (small).

48. Dividend Yield Ratio Dividend Yield Ratio Dividends Per Share Market Price Per Share = Dividend Yield Ratio $2.00 $20.00 == 10.00% This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

49. Fixed Assets and Total Assets Turnover Ratios vs. the Industry Average FA turnover= Sales/Net fixed assets = $7,036/$817 = 8.61x TA turnover= Sales/Total assets = $7,036/$3,497 = 2.01x 4-49

50. Profitability Ratios: Return on Assets and Return on Equity ROA= Net income/Total assets = $253.6/$3,497 = 7.3% ROE= Net income/Total common equity = $253.6/$1,952 = 13.0% 4-50

51. Evaluating the FA Turnover and TA Turnover Ratios 2009E20082007Ind. FA TO8.6x6.4x10.0x7.0x TA TO2.0x2.1x2.3x2.6x  FA turnover projected to exceed the industry average.  TA turnover below the industry average. Caused by excessive currents assets 4-51

52. Return on Common Stockholders’ Equity 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% This measure indicates how well the company used the owners’ investments to earn income.

53. The DuPont System  Focuses on expense control (PM), asset utilization (TA TO), and debt utilization (equity multiplier). 4-53

54. 54 The DuPont System

55. 55 The DuPont System

56. 56 The DuPont System

57. 57 The DuPont System

58. DuPont Equation: Breaking Down Return on Equity PMTA TOEMROE 20072.6%2.32.213.3% 2008-2.7%2.15.8-32.5% 2009E3.6%2.01.813.0% Ind.3.5%2.62.018.2% ROE= (NI/Sales) x (Sales/TA) x (TA/Equity) = 3.6% x 2 x 1.8 = 13.0% 4-58

59. Financial Leverage 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. Return on investment in assets > Fixed rate of return on borrowed funds Positive financial leverage = Return on investment in assets < Fixed rate of return on borrowed funds Negative financial leverage =

60. 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.

61. 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. Quick Check

62. 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 after all creditors were paid off. = $ 8.55 Book Value per Share $234,390 27,400 =

63. Book Value Per Share 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. Book Value per Share Common Stockholders’ Equity Number of Common Shares Outstanding == $ 8.55 Book Value per Share $234,390 27,400 =

64. Learning Objective 3 Compute and interpret financial ratios that would be useful to a short-term creditor.

65. Ratio Analysis – The Short–Term Creditor Short-term creditors, such as suppliers, want to be paid on time. Therefore, they focus on the company’s cash flows and working capital. Short-term creditors, such as suppliers, want to be paid on time. Therefore, they focus on the company’s cash flows and working capital.

66. Working Capital The excess of current assets over current liabilities is known as net working capital. Working capital is not free. It must be financed with /short term or long-term debt and equity.

67. Working Capital

68. Current Ratio 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. Current Ratio Current Assets Current Liabilities =

69. Current Ratio Current Ratio Current Assets Current Liabilities = Current Ratio $65,000 $42,000 ==1.55

70. Acid-Test (Quick) Ratio Quick Assets Current Liabilities = Acid-Test Ratio Quick assets include Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory. $50,000 $42,000 =1.19= Acid-Test Ratio

71. RECEIVABLES TURNOVER NET CREDIT SALES RECEIVABLES TURNOVER = ——————————————— AVERAGE NET RECEIVABLES The receivables turnover ratio is used to assess the liquidity of the receivables. It measures the number of times, on average, receivables are collected during the period. The ratio is computed by dividing net credit sales by average net receivables.

72. 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. = 26.7 times $494,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover =

73. Average Collection Period = 365 Days Accounts Receivable Turnover This ratio measures, on average, how many days it takes to collect an account receivable. = 13.67 days Average Collection Period = 365 Days 26.7 Times

74. 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 types of inventory. Cost of Goods Sold Average Inventory Inventory Turnover =

75. Inventory Turnover Cost of Goods Sold Average Inventory Inventory Turnover == 12.73 times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover =

76. Average Sale Period = 365 Days Inventory Turnover This ratio measures how many days, on average, it takes to sell the inventory. = 28.67 days Average Sale Period = 365 Days 12.73 Times

77. Learning Objective 4 Compute and interpret financial ratios that would be useful to a long-term creditor.

78. Ratio Analysis – The Long–Term Creditor Long-term creditors are concerned with a company’s ability to repay its loans over the long-run. This is also referred to as net operating income.

79. Times Interest Earned Ratio This is the most common measure of a company’s ability to provide protection for its long- term creditors. A ratio of less than 1.0 is inadequate. Times Interest Earned Earnings before Interest Expense and Income Taxes Interest Expense = Times Interest Earned $84,000 $7,300 == 11.51 times

80. 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. Total Liabilities Stockholders’ Equity Debt–to– Equity Ratio =

81. Debt-to-Equity Ratio $112,000 $234,390 Debt–to– Equity Ratio == 0.48 Total Liabilities Stockholders’ Equity Debt–to– Equity Ratio =

82. Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult. We use the LIFO method to value inventory. We use the average cost method to value inventory.

83. Limitations of Financial Statement Analysis Analysts should look beyond the ratios. Economic factors Industry trends Changes within the company Technological changes Consumer tastes

84. SolutionsSolutions