1. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. CHAPTER 11 Financial Statement Analysis McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

2. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-2 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-2 Financial Statement Ratios Ratios are used to interpret the financial position and results of operations of an entity and may be grouped in the following four categories: 1.Liquidity. 2.Activity. 3.Profitability. 4.Debt, or financial leverage.

3. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-3 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-3 Consideration When Using Ratios We should always look beyond the ratios. Economic factors Industry trends Changes within the firm Technological changes Consumer tastes

4. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-4 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-4 Consideration When Using Ratios Differences in accounting methods between companies sometimes make comparisons difficult. We use the LIFO method to value inventory. We use the FIFO method to value inventory. L O 1

5. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-5 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-5 Liquidity Measures The liquidity measures of working capital, current ratio and acid-test ratio were discussed in Chapter 3. L O 2

6. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-6 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-6 Liquidity Measures L O 2 Is the firm paying its bills promptly? Are all cash discounts taken? What are the firm’s working capital and liquidity ratios? Creditors Suppliers

7. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-7 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-7 Turnover Ratios Differences in inventory cost-flow assumptions and depreciation methods will affect comparability of turnover ratios. We use the LIFO method to value inventory and an accelerated depreciation method. We use the FIFO method to value inventory and the straight-line depreciation method. L O 3 We report lower inventory and net book value of depreciable assets. We have lower asset turnover ratios

8. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-8 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-8 Activity Measures Focus primarily on relationships between asset levels and sales. The general model for calculating turnover is: Turnover = Sales ÷ Average Assets Turnover is often calculated for (1) Accounts receivable; (2) Inventories; (3) Plant and equipment; (4) Total operating assets; and (5) Total assets. L O 3

9. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-9 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-9 Accounts Receivable Turnover Sales Sales Average Accounts Receivable Accounts Receivable Turnover= We will use these amounts to calculate our ratios! L O 3

10. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-10 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-10 Accounts Receivable Turnover A measure of how many times a company converts its receivables into cash each year. = 27.03 times $500,000 $500,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover= L O 3

11. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-11 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-11 Inventory Turnover Cost of Goods Sold Cost of Goods Sold Average Inventory InventoryTurnover= A measure of the number of times merchandise inventory is sold and replaced during the year. A measure of the number of times merchandise inventory is sold and replaced during the year. = 12.73 times $140,000 $140,000 ($10,000 + $12,000) ÷ 2 InventoryTurnover= L O 3

12. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-12 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-12 Plant and Equipment Turnover Sales AveragePlant and Equipment Average Plant and Equipment Plant and Equipment Turnover= Plant and Equipment = $500,000 Turnover ($300,000 + $346,390) ÷ 2 = 1.55 times L O 3

13. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-13 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-13 Other Activity Measures Days’ in Accounts Receivable = Accounts Receivable Annual Sales ÷ 365 Days Number of Days’ Sales in Accounts Receivable A measure, on average, of how many days it takes to collect an account receivable. = 14.6 days = $20,000 $20,000 $500,000 ÷ 365 Days’ in Accounts Receivable L O 4

14. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-14 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-14 Other Activity Measures Number of Days’ Sales in Inventory Days’ in Inventory =Inventory Cost of Goods Sold ÷ 365 Days = 31.28 days = $12,000 $12,000 $140,000 ÷ 365 Days’ in Inventory A measure, on average, of the number of times inventory is sold and replaced. A measure, on average, of the number of times inventory is sold and replaced. L O 4

15. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-15 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-15 Profitability Measures In Chapter 3, two significant profitability measures were presented: (1) Return on Investment (ROI); and (2) Return on Equity (ROE). Both ROI and ROE should be based on operating income rather than net income. L O 5

16. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-16 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-16 Price/Earnings RatioPrice/EarningsRatio Market Price Per Share Diluted Earnings Per Share Market Price Per Share Diluted Earnings Per Share= A measure often used by investors as a general guideline in gauging stock values. Price-EarningsRatio $21.50 $1.97 = = 10.91 times L O 5

17. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-17 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-17 Dividend Yield DividendYield Dividends Per Share Dividends Per Share Market Price Per Share = Identifies the return, in terms of cash dividends, on the current market price of the stock. $0.84 $0.84 $21.50 $21.50 = = 3.91% DividendYield L O 6

18. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-18 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-18 Dividend Payout RatioDividend Payout Ratio Annual Dividend Per Share Annual Dividend Per Share Earnings Per Share = A gauge of the portion of current earnings being paid out in dividends. Investors seeking current income would like this ratio to be high. Dividend Payout Ratio = = 42.64% $0.84 $1.97 $1.97 L O 6

19. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-19 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-19 Preferred Dividend Coverage Preferred Dividend Coverage Ratio Net Income Annual Preferred Dividend = Preferred Dividend Coverage Ratio = $55,650 $24,000 = 2.32 times A measure of the margin of safety for preferred shareholders. L O 6

20. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-20 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-20 Debt Ratio Total Liabilities Total Liabilities Total Liabilities + Owners’ Equity Debt Ratio = Measures the percent of assets being provided by creditors. Debt Ratio = = 32.33% $112,000 $112,000$346,390 L O 7

21. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-21 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-21 Financial Leverage Financial leverage involves acquiring assets with funds at a fixed rate of interest. 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 = Return on investment in assets < Fixed rate of return on borrowed funds Negative financial leverage = L O 7

22. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-22 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-22 Debt/Equity Ratio = Total Liabilities Total Liabilities Total Owners’ Equity Debt/Equity Ratio = = 47.78% $112,000 $112,000$234,390 Measures the relative proportion of contribution from owners and creditors. L O 7

23. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-23 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-23 Financial Leverage Here is selected financial information from Matrix, Inc. The management is considering the purchase of a tract of land by issuing $70,000 in long-term debt that requires annual interest of $7,300. Let’s see the impact of the acquisition on key financial leverage ratios. 30% tax rate L O 7

24. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-24 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-24 Without Financial Leverage ROI = $86,100 ÷ $276,390 = 31.15% ROE = $60,760 ÷ $234,390 = 25.92% L O 7

25. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-25 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-25 With Financial Leverage ROI = $86,100 ÷ $346,390 = 24.86% ROE = $55,650 ÷ $234,390 = 23.74% Both ROI and ROE are lower if we borrow the $70,000 to purchase the land. The cost of the long-term debt is too high to provide positive financial leverage. L O 7

26. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-26 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-26 Times Interest Earned Earnings Before Interest and Taxes Interest Expense = A common measure of the ability of a firm to provide protection to the long-term creditor. Times Interest Earned = = 11.79 times $86,100$7,300 L O 7

27. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-27 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-27 Other Analytical Techniques Book Value Per Share of Common Stock A measures of the amount that would be distributed to owners of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off. = $6.70 Book Value per Share $234,390 35,000 35,000= Book Value per Share Common Stockholders’ Equity Common Stockholders’ Equity Number of Common Shares Outstanding = L O 8

28. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-28 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-28 Common Size Financial Statements Let’s take a look at the information from the comparative income statements of Dodson Industries, Inc. for 2008 and 2007. We will prepare a common-size income statement. Net sales is usually the base and is expressed as 100%. L O 9

29. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-29 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-29 Common Size Financial Statements Let’s take a look at the information from the comparative income statements of Dodson Industries, Inc. for 2008 and 2007. We will prepare a common-size income statement. 2007 Cost ÷ 2007 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6% 2007 Cost ÷ 2007 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6% 2008 Cost ÷ 2008 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2% 2008 Cost ÷ 2008 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2% L O 9

30. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-30 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-30 Common Size Financial Statements Let’s take a look at the information from the comparative income statements of Dodson Industries, Inc. for 2008 and 2007. We will prepare a common-size income statement. We would perform the same calculations for the Balance Sheet and have total assets equal 100%. L O 9

31. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-31 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-31 Horizontal Analysis Let’s take a look at some selected information from Dodson Industries, Inc. for 2004 through 2008. We will prepare a horizontal analysis. The base year is 2004, and its amounts will equal 100%. The base year values will be the denominator in all calculations The base year is 2004, and its amounts will equal 100%. The base year values will be the denominator in all calculations L O 10

32. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-32 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-32 Horizontal Analysis 2005 Amount ÷ 2005 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108% 2005 Amount ÷ 2005 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108% Let’s take a look at some selected information from Dodson Industries, Inc. for 2004 through 2008. We will prepare a horizontal analysis. L O 10

33. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-33 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-33 Horizontal Analysis Let’s take a look at some selected information from Dodson Industries, Inc. for 2004 through 2008. We will prepare a horizontal analysis. From this analysis, we see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin. L O 10

34. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 1-34 McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-34 End of Chapter 11