Financial Statement Analysis

Chapter 14

PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin Copyright 2012 The McGraw-Hill Companies, Inc.

Financial Statements Are Designed for Analysis

Classified Financial Statements
Items with certain characteristics are grouped together.

Comparative Financial Statements

Amounts from several years appear side by side.

Consolidated Financial Statements

Information for the parent and subsidiary are presented.

Results in standardized, meaningful subtotals.

Helps identify significant changes and trends.

Presented as if the two companies are a single business unit.

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Tools of Analysis

Dollar & Trend Percentage Percentages Changes

Component Percentages

Ratios

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Dollar and Percentage Changes

Dollar Change:
Dollar Change

Analysis Period Amount

Base Period Amount

Percentage Change:
Percent Change

Dollar Change

Base Period Amount

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Dollar and Percentage Changes

Evaluating Percentage Changes in Sales and Earnings

Sales and earnings should increase at more than the rate of inflation.

In measuring quarterly changes, compare to the same quarter in the previous year.

Percentages may be misleading when the base amount is small.

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Clover, Inc. Comparative Balance Sheets December 31, 2011 2010 Percent Dollar Change Change*

Assets Current assets: Cash and equivalents $ 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 $ 155,000 $ 164,700 $12,000 $23,500 = $(11,500) Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment $ 160,000 $ 125,000 Total assets $ 315,000 $ 289,700 * Percent rounded to one decimal point.

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Clover, Inc. Comparative Balance Sheets December 31, 2011 2010 Percent Dollar Change Change*

Assets Current assets: Cash and equivalents $ 12,000 $ 23,500 $ (11,500) -48.9% Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets $ 155,000 $ 164,700 ($11,500 $23,500) 100% = 48.94% Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Complete the Total property and equipment $ 160,000 $ 125,000 analysis for Total assets $ 315,000 $ 289,700 the other * Percent rounded to one decimal point.

assets.
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Clover, Inc. Comparative Balance Sheets December 31, 2011 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to one decimal point. 2010 Percent Dollar Change Change*

23,500 40,000 100,000 1,200 $ 164,700 40,000 85,000 $ 125,000 $ 289,700

(11,500) 20,000 (20,000) 1,800 (9,700) 35,000 35,000 25,300

-48.9% 50.0% -20.0% 150.0% -5.9% 0.0% 41.2% 28.0% 8.7%

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Trend Percentages

Trend analysis is used to reveal patterns in data covering successive periods.

Trend = Percentages Analysis Period Amount Base Period Amount 100%

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Trend Percentages
Berry Products Income Information For the Years Ended December 31,
Item Revenues Cost of sales Gross profit 2011 $400,000 285,000 115,000 2010 $355,000 250,000 105,000 2009 $320,000 225,000 95,000 2008 $290,000 198,000 92,000 2007 $275,000 190,000 85,000

Item Revenues Cost of sales Gross profit

2011 145% 150% 135%

2010 129% 132% 124%

2009 116% 118% 112%

2008 105% 104% 108%

2007 100% 100% 100%

(290,000 275,000) (198,000 190,000) (92,000 85,000)

100% = 105% 100% = 104% 100% = 108%

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Component Percentages
Examine the relative size of each item in the financial statements by computing component (or common-sized) percentages.
Component Percentage

Analysis Amount Base Amount

100%

Financial Statement Balance Sheet Income Statement

Base Amount Total Assets Revenues

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Clover, inc. Comparative Balance Sheets December 31,

Complete the common-size analysis for the other assets.

2011 2010

Common-size Percents* 2011 2010

Assets Current assets: Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1% Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets $ 155,000 $ 164,700 ($12,000 $315,000) 100% = 3.8% Property and equipment: Land 40,000 40,000 ($23,500 $289,700) 100% = 8.1% Buildings and equipment, net 120,000 85,000 Total property and equipment $ 160,000 $ 125,000 Total assets $ 315,000 $ 289,700 100.0% 100.0% * Percent rounded to first decimal point.
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Clover, Inc. Comparative Balance Sheets December 31, Common-size Percents* 2011 2010

2011 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to first decimal point.

2010

23,500 40,000 100,000 1,200 $ 164,700 40,000 85,000 $ 125,000 $ 289,700

3.8% 19.0% 25.4% 1.0% 49.2% 12.7% 38.1% 50.8% 100.0%

8.1% 13.8% 34.6% 0.4% 56.9% 13.8% 29.3% 43.1% 100.0%

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Clover, Inc. Comparative Income Statements For the Years Ended December 31, Common-size Percents* 2011 2010 100.0% 100.0% 69.2% 24.7% 1.2% 4.8% 1.4% 3.4% 65.6% 26.3% 1.5% 6.7% 2.0% 4.7%

Revenues Costs and expenses: Cost of sales 360,000 Selling and admin. 128,600 Interest expense 6,400 Income before taxes $ 25,000 Income taxes (30%) 7,500 Net income $ 17,500 Net income per share $ 0.79 Avg. # common shares 22,200 * Rounded to first decimal point.

2011 $ 520,000

2010 $ 480,000 315,000 126,000 7,000 $ 32,000 9,600 $ 22,400 $ 1.01 22,200

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Quality of Earnings
Investors are interest in companies that demonstrate an ability to earn income at a growing rate each year. Stability of earnings growth helps investors predict future prospects for the company. Financial analyst often speak of the quality of earnings at one company being higher than another company in the same industry.

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Quality of Assets and the Relative Amount of Debt

While satisfactory earnings may be a good indicator of a companys ability to pay its debts and dividends, we must also consider the composition of assets, their condition and liquidity, the timing of repayment of liabilities, and the total amount of debt outstanding

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A Classified Balance Sheet

Matrix, Inc. Asset Section: Classified Balance Sheet December 31, 2011 Current assets: Cash Notes receivable Accounts receivable Inventory Prepaid expenses Total current assets Plant and equipment: Land Building Less: Accumulated depreciation Equipment and Fixtures Less: Accumulated depreciation Total plant and equipment Other assets: Patents Total assets $ 30,000 16,000 60,000 70,000 4,000 180,000

$ 150,000 $ 121,000 (10,000) 46,000 (27,000) 111,000 19,000 280,000 170,000 630,000
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Ratios
A ratio is a simple mathematical expression of the relationship between one item and another.

Along with dollar and percentage changes, trend percentages, and component percentages, ratios can be used to compare:

Past performance to present performance.

Other companies to your company.

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Use this information to calculate the liquidity ratios for Babson Builders.
Babson Builders, Inc. 2011 Cash $ 30,000 Accounts receivable, net Beginning of year 17,000 End of year 20,000 Inventory Beginning of year 10,000 End of year 15,000 Total current assets 65,000 Total current liabilities 42,000 Total liabilities 103,917 Total assets Beginning of year 300,000 End of year 346,390 Revenues 494,000

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Working Capital
Working capital is the excess of current assets over current liabilities.
12/31/11 Current assets Current liabilities Working capital $ 65,000 (42,000) $ 23,000

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Current Ratio
This ratio measures the short-term debt-paying ability of the company. Current = Ratio Current = Ratio Current Assets Current Liabilities $65,000 $42,000

= 1.55 : 1

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Quick Ratio
Quick Ratio Quick Assets = Current Liabilities

Quick assets are cash, marketable securities, and receivables.

This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash.
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Quick Ratio
Quick Ratio Quick Ratio = Quick Assets = Current Liabilities $50,000 $42,000 = 1.19 : 1

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Uses and Limitations of Financial Ratios

Uses
Ratios help users understand financial relationships.

Limitations
Management may enter into transactions merely to improve the ratios.

Ratios provide for quick comparison of companies.

Ratios do not help with analysis of the company's progress toward nonfinancial goals.

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Measures of Profitability
An income statement can be prepared in either a multiple-step or single-step format.

The single-step format is simpler. The multiple-step format provides more detailed information.

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Income Statement (MultipleStep)

Proper Heading
Babson Builders, Inc. Income Statement For the Year Ended 12/31/11

Gross Margin

Operating Expenses

Non-operating Items

Remember to compute EPS.

Sales, net Cost of goods sold Gross margin Operating expenses: Selling expenses General & Admin. Depreciation Income from Operations Other revenues & gains: Interest income Gain Other expenses: Interest Loss Income before taxes Income taxes Net income

$ $ $ 197,350 78,500 17,500 $ $ 62,187 24,600 27,000 9,000 $ $

785,250 351,800 433,450

293,350 140,100

86,787

(36,000) 190,887 62,500 128,387

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Income Statement (SingleStep)

Proper Heading
Babson Builders, Inc. Income Statement For the Year Ended 12/31/11
Revenues and gains: Sales, net Interest income Gain on sale of plant assets Total revenues and gains Expenses and losses: Cost of goods sold Selling Expenses General and Admin. Exp. Depreciation Interest Income taxes Loss: sale of investment Total expenses & losses Operating income $ 785,250 62,187 24,600 872,037

Revenues & Gains

Expenses & Losses

Remember to compute EPS.

351,800 197,350 78,500 17,500 27,000 62,500 9,000 $ 743,650 128,387

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Use this information to calculate the profitability ratios for Babson Builders, Inc. Inc. Babson Builders,
2011
Ending market price per share Number of common shares outstanding all of 2007 Net income Total shareholders' equity Beginning of year End of year Revenues Cost of sales Total assets Beginning of year End of year $ 15.25 27,400 53,690 180,000 234,390 494,000 140,000 300,000 346,390

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Earning Per Share

Net Income = EPS Average Shares of Capital Stock Outstanding Look back at the information from Babson and get the values we need to calculate earning per share. $53,690 = $1.96 27,400

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Price-Earnings Ratio
Current Market Price of one Share of Stock = P/E Earnings Per Share $15.25 = 7.78 $1.96
The measure shows us the relationship between earning of the company and the market price of its stock.

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Return On Investment (ROI)

This ratio is a good measure of the efficiency of utilization of assets by the business.
Annual return (profit) from an investment Average amount invested

ROI

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Return On Assets (ROA)

This ratio is generally considered the best overall measure of a companys profitability.
ROA Operating = Average total assets Income = $ 53,690 ($300,000 + $346,390) 2 = 16.61%

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Return On Equity (ROE)

This measure indicates how well the company employed the owners investments to earn income.

ROA

= Net income Average total equity = $ = 53,690 25.91% ($180,000 + $234,390) 2

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Dividend Yield
Dividend Yield Ratio
=

Dividends Per Share Market Price Per Share

Babson Builders pays an annual dividend of $1.50 per share of capital stock. The market price of the companys capital stock was $15.25 at the end of 2011.
This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
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Dividend Yield
Dividend Yield Ratio
=

Dividends Per Share Market Price Per Share

Dividend = Yield Ratio

$1.50 = 9.84% $15.25

This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
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Analysis by Long-Term Creditors

Use this information to calculate ratios to measure the well-being of the long-term creditors for Babson Builders.
Babson Builders, Inc. 2011 Earnings before interest expense and income taxes

84,000 7,300 346,390 234,390 112,000

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This is also referred to as net operating income.

Interest expense Total assets Total stockholders' equity Total liabilities

Interest Coverage Ratio

Times Interest Earned
=

Operating income before Interest and Income Taxes Annual Interest Expense
=

Times Interest Earned

$84,000 7,300

11.5 times

This is the most common measure of the ability of a firms operations to provide protection to the long-term creditor.
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Debt Ratio
A measure of creditors long-term risk. The smaller the percentage of assets that are financed by debt, the smaller the risk for creditors.
Debt Ratio = = = Total Liabilities 32.33%
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Total Assets $346,390

$112,000

Analysis by Short-Term Creditors

Babson Builders, Inc.

Use this information to calculate ratios to measure the well-being of the short-term creditors for Babson Builders, Inc.

2011 Cash 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 10,000 12,000 65,000 42,000 500,000 140,000
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30,000 17,000 20,000

Accounts Receivable Turnover Rate

Accounts Receivable Turnover = Net Sales Average Accounts Receivable

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

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

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.
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Operating Cycle

Cash Accounts Receivable

Inventory

2. Sale of merchandise on account

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End of Chapter 14

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