Financial Statement Analysis

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 FIFO method to value inventory.

Limitations of Financial Statement Analysis

Industry trends Technological changes Changes within the firm Consumer tastes

Economic factors

Analysts should look beyond the ratios.

Statements in Comparative and Common-Size Form

Dollar and percentage changes on statements Analytical techniques used to examine relationships among financial statement items Common-size statements

Ratios

Dollar and Percentage Changes on Statements

Comparing statements underscores movements and trends and may provide valuable clues about what to expect in the future.

Horizontal analysis

Trend analysis

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

Horizontal Analysis
Example
The following slides illustrate a horizontal analysis of Clover Corporations December 31, 2000 and 1999 comparative balance sheets and comparative income statements.

Horizontal Analysis
CLOVER CORPORATION Comparative Balance Sheets December 31, 2000 and 1999 2000 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets 1999 Increase (Decrease) Amount %

$ 12,000 $ 23,500 60,000 40,000 80,000 100,000 3,000 1,200 155,000 164,700 40,000 120,000 160,000 $ 315,000 $ 40,000 85,000 125,000 289,700

Horizontal Analysis
Calculating Change in Dollar Amounts
Dollar Change = Current Year Figure Base Year Figure

The dollar amounts for 1999 become the base year figures.

Horizontal Analysis
Calculating Change as a Percentage
Percentage Change = Dollar Change Base Year Figure

100%

Horizontal Analysis
CLOVER CORPORATION Comparative Balance Sheets December 31, 2000 and 1999 2000 1999 Increase (Decrease) Amount %

Assets Current assets: (48.9) Cash $ 12,000 $ 23,500 $ (11,500) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets $12,000 155,000 164,700 $23,500 = $(11,500) Property and equipment: Land 40,000 40,000 ($11,500 $23,500) 100% = 48.9% Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000 Total assets $ 315,000 $ 289,700

Horizontal Analysis
CLOVER CORPORATION Comparative Balance Sheets December 31, 2000 and 1999 2000 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets 1999 Increase (Decrease) Amount %

$ 12,000 $ 23,500 $ (11,500) 60,000 40,000 20,000 80,000 100,000 (20,000) 3,000 1,200 1,800 155,000 164,700 (9,700) 40,000 120,000 160,000 $ 315,000 $ 40,000 85,000 35,000 125,000 35,000 289,700 $ 25,300

(48.9) 50.0 (20.0) 150.0 (5.9) 0.0 41.2 28.0 8.7

Horizontal Analysis
We could do this for the liabilities & stockholders equity, but now lets look at the income statement accounts.

Horizontal Analysis
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Increase (Decrease) 2000 1999 Amount % Net sales $ 520,000 $ 480,000 $ 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) Operating expenses 128,600 126,000 2,600 2.1 Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

Horizontal Analysis
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Increase (Decrease) 2000 1999 Amount % Net sales $ 520,000 $ 480,000 $ 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) Operating expenses 128,600 126,000 2,600 2.1 Sales increased by 8.3% yet Net operating income 31,400 39,000 (7,600) (19.5) net income decreased by 21.9%. Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

Horizontal Analysis
CLOVER CORPORATION There were increases in both cost of goods Comparative Income Statements sold (14.3%) and operating expenses (2.1%). For the Years Ended December 31, 2000 and 1999 These increased costs more than offset the Increase increase in sales, yielding an overall (Decrease) 2000 1999 Amount % decrease in net income. Net sales $ 520,000 Cost of goods sold 360,000 Gross margin 160,000 Operating expenses 128,600 Net operating income 31,400 Interest expense 6,400 Net income before taxes 25,000 Less income taxes (30%) 7,500 Net income $ 17,500 $ 480,000 315,000 165,000 126,000 39,000 7,000 32,000 9,600 $ 22,400 $ 40,000 45,000 (5,000) 2,600 (7,600) (600) (7,000) (2,100) $ (4,900) 8.3 14.3 (3.0) 2.1 (19.5) (8.6) (21.9) (21.9) (21.9)

Trend Percentages

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

Trend Analysis
Trend = Percentage Current Year Amount Base Year Amount

100%

Trend Analysis
Example
Look at the income information for Berry Products for the years 1998 through 2002. We will do a trend analysis on these amounts to see what we can learn about the company.

Trend Analysis
Berry Products Income Information For the Years Ended December 31,
Ite m Sa le s Cost of goods sold Gross m a rgin 2002 $ 400,000 285,000 115,000 2001 $ 355,000 250,000 105,000 Ye a r 2000 $ 320,000 225,000 95,000 1999 $ 290,000 198,000 92,000 1998 $ 275,000 190,000 85,000

The base year is 1998, and its amounts will equal 100%.

Trend Analysis
Berry Products Income Information For the Years Ended December 31,
Ite m Sa le s Cost of goods sold Gross m a rgin 2002 2001 Ye a r 2000 1999 105% 104% 108% 1998 100% 100% 100%

1999 Amount 1998 Amount 100% ( $290,000 $275,000 ) 100% = 105% ( $198,000 $190,000 ) 100% = 104% ( $ 92,000 $ 85,000 ) 100% = 108%

Trend Analysis
Berry Products Income Information For the Years Ended December 31,
Ite m Sa le s Cost of goods sold Gross m a rgin 2002 145% 150% 135% 2001 129% 132% 124% Ye a r 2000 116% 118% 112% 1999 105% 104% 108% 1998 100% 100% 100%

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.

Trend Analysis
160 150 Percentage 140 130 120 110 100 1998 Sales COGS GM

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

1999

2000 Year

2001

2002

Common-Size Statements
Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis. analysis

Common-Size Statements
Example
Lets take another look at the information from the comparative income statements of Clover Corporation for 2000 and 1999. This time lets prepare common-size statements.

Common-Size Statements
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Common-Size Percentages 2000 1999 2000 1999 Net sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Net sales is Operating expenses 128,600 126,000 usually the Net operating income 31,400 39,000 base and is Interest expense 6,400 7,000 expressed Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 as 100%. Net income $ 17,500 $ 22,400

Common-Size Statements
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Common-Size Percentages 2000 1999 2000 1999 Net sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 39,000 2000 COGS 2000 31,400 Net Sales 100% Interest expense $520,000 6,400 7,000 ( $360,000 ) 100% = 69.2% Net income before taxes 25,000 32,000 Less income taxes 9,600 1999(30%) COGS 7,500 1999 Net Sales 100% Net income $ 17,500 $ 22,400

( $315,000 $480,000 ) 100% = 65.6%

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 operating expenses and a profit.

Common-Size Statements
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Common-Size What conclusions can we draw? Percentages 2000 1999 2000 1999 Net sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0 Net income $ 17,500 $ 22,400 3.4 4.7

Now, lets look at Norton Corporations 2000 and 1999 financial statements.

NORTON CORPORATION Balance Sheets December 31, 2000 and 1999 2000 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets 1999

30,000 20,000 12,000 3,000 65,000

20,000 17,000 10,000 2,000 49,000

165,000 116,390 281,390 $ 346,390

123,000 128,000 251,000 $ 300,000

NORTON CORPORATION Balance Sheets December 31, 2000 and 1999 2000 Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 39,000 Notes payable, short-term 3,000 Total current liabilities 42,000 Long-term liabilities: Notes payable, long-term 70,000 Total liabilities 112,000 Stockholders' equity: Common stock, $1 par value 27,400 Additional paid-in capital 158,100 Total paid-in capital 185,500 Retained earnings 48,890 Total stockholders' equity 234,390 Total liabilities and stockholders' equity $ 346,390 1999

40,000 2,000 42,000 78,000 120,000

17,000 113,000 130,000 50,000 180,000 $ 300,000

NORTON CORPORATION Income Sta te me nts For the Ye a rs Ende d De ce mbe r 31, 2000 a nd 1999

Net sales Cost of goods sold Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income

2000 $ 494,000 140,000 354,000 270,000 84,000 7,300 76,700 23,010 $ 53,690

1999 $ 450,000 127,000 323,000 249,000 74,000 8,000 66,000 19,800 $ 46,200

Now, lets calculate some ratios based on Norton Corporations financial statements.

Ratio Analysis The Common NORTON CORPORATION Stockholder

2000
Number of common shares outstanding Beginning of year End of year Net income Stockholders' equity Beginning of year End of year Dividends per share Dec. 31 market price per share Interest expense Total assets Beginning of year End of year 300,000 346,390 180,000 234,390 2 20 7,300 $ 17,000 27,400 53,690

Use this information to calculate ratios to measure the wellbeing of the common stockholders of Norton Corporation.

Earnings Per Share

Earnings per Share = Net Income Preferred Dividends Average Number of Common Shares Outstanding $53,690 $0 (17,000 + 27,400)/2 = $2.42

Earnings per Share =

This measure indicates how much income was earned for each share of common stock outstanding.

Price-Earnings Ratio
Price-Earnings Ratio = Market Price Per Share Earnings Per Share

Price-Earnings Ratio

$20.00 $2.42

= 8.26 times

This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the priceearnings ratio, the more opportunity a company has for growth.

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 current income would like this ratio to be large.

Dividend Yield Ratio

Dividend Yield Ratio Dividend Yield Ratio = Dividends Per Share Market Price Per Share $2.00 $20.00

= 10.00%

This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

Financial Leverage
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 Fixed rate of return on borrowed funds Positive = financial leverage

Return on investment in < assets

Negative = financial leverage

Ratio Analysis The Short Term Creditor

NORTON CORPORATION 2000 Cash $ 30,000 17,000 20,000 10,000 12,000 65,000 42,000 500,000 140,000

Use this information to calculate ratios to measure the well-being of the short-term creditors for Norton Corporation.

Accounts receivable, net Beginning of year End of year Inventory Beginning of year End of year Total current assets Total current liabilities Sales on account Cost of goods sold

Working Capital
December 31, 2000 Current assets Current liabilities W orking capital $ $ 65,000 (42,000) 23,000

Current Ratio
Current Ratio Current Ratio = Current Assets Current Liabilities $65,000 $42,000

1.55 : 1

This ratio measures the ability of the company to pay current debts as they become due.

Acid-Test (Quick) Ratio

Acid-Test = Ratio Quick Assets Current Liabilities

Quick assets are Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. Norton Corporations quick assets consist of cash of $30,000 and accounts receivable of $20,000.

Acid-Test (Quick) Ratio

Acid-Test = Ratio Acid-Test = Ratio Quick Assets Current Liabilities $50,000 $42,000

= 1.19 : 1

This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash.

Accounts Receivable Turnover

Accounts Receivable Turnover = Sales on Account Average Accounts Receivable

Accounts $500,000 Receivable = = 27.03 times ($17,000 + $20,000) 2 Turnover

This ratio measures how many times a company converts its receivables into cash each year.

Average Collection Period

Average 365 Days Collection = Accounts Receivable Turnover Period Average Collection = Period 365 Days 27.03 Times

= 13.50 days

This ratio measures, on average, how many days it takes to collect an account receivable.

Inventory Turnover
Inventory Turnover Inventory Turnover = Cost of Goods Sold Average Inventory

$140,000 = = 12.73 times ($10,000 + $12,000) 2

This ratio measures the number of times merchandise inventory is sold and replaced during the year.

Average Sale Period

Average Sale Period = 365 Days Inventory Turnover

Average = Sale Period

365 Days 12.73 Times

= 28.67 days

This ratio measures how many days, on average, it takes to sell the inventory.

Ratio Analysis The Long Term Creditor

Use this information to calculate ratios to measure the well-being of the long-term creditors for Norton Corporation.
NORTON CORPORATION 2000 Earnings before interest expense and income taxes $ 84,000 7,300 234,390 112,000

This is also referred to as net operating income.

Interest expense Total stockholders' equity Total liabilities

Times Interest Earned Ratio

Times Interest = Earned Times Interest = Earned Earnings before Interest Expense and Income Taxes Interest Expense

$84,000 = 11.5 times 7,300

This is the most common measure of the ability of a firms operations to provide protection to the long-term creditor.

Debt-to-Equity Ratio
Debtto Total Liabilities Equity = Stockholders Equity Ratio Debtto Equity = Ratio $112,000 $234,390

= 0.48 to 1

This ratio measures the amount of assets being provided by creditors for each dollar of assets being provided by the owners of the company.