StIce | StIce |Skousen

Analysis of Financial
Statements
Chapter 22
Intermediate Accounting
16E

Prepared by: Sarita Sheth | Santa Monica College

COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
 Learning Objectives
1. Organize a systematic financial ratio analysis
using common-size financial statements and the
DuPont framework.
2. Recognize the potential impact that differing
accounting methods can have on the financial
ratios of otherwise essentially identical
companies.
3. Understand how foreign companies report their
financial results to U.S. investors.
4. Describe the purpose and format of the SEC’s
Form 20-F.
5. Convert foreign currency financial statements
into U.S. dollars using the translation method.
 Framework for Financial
Statement Analysis
• Financial statement analysis- the
examination of the relationships
among:
– Financial statement numbers
– The trends of the statement numbers
over time.
• To analyze financial statements,
analyst use:
– Common sized financial statements
– Ratio analysis
 Framework for Financial
Statement Analysis
The APB stated that comparisons between
financial statements are most informative—
1. When the presentations are in good
form.
2. When the content of the statements is
identical.
3. When accounting principles are not
changed, or, if they are changed, the
financial effects of the changes are
disclosed.
4. When changes in circumstances or in
the nature of the underlying transactions
are disclosed.
 Framework for Financial
Statement Analysis
• Common-Size Financial Statements- analysis
of a company’s single-year financial
statements. Financial statements are
standardized by a measure of size, either
sales or total assets. All amounts are
stated in terms of a percentage of the size
measure.
• Ratio Analysis- Analysis of a company’s
financial statements by computing ratios
and comparing them against both trends
and industry averages.
Common-Size Income Statement

For common-
size income
statements, the
denominator,
the entire pie, is
100% = Net Sales equal to net
sales.
 Common-Size Financial
Statements
Comparative Income Statements (in millions)
2008 % 2007 %
Net sales $5,700 100.0 $6,600 100.0
Cost of goods sold 4,000 70.2 4,800 72.7
Gross profit on sales $1,700 29.8 $1,800 27.3
Selling expense $1,120 19.6 $1,200 18.2
General expense 400 7.0 440 6.7
Total operating expenses $1,520 26.6 $1,640 24.9
Operating income (loss) $ 180 3.2 $ 160 2.4
Other revenue (expense) 80 1.4 130 2.0
Income before taxes $ 260 4.6 $ 290 4.4
Income tax 80 1.4 85 1.3
Net income $ 180 3.2 $ 205 3.1
 Common-Size Income
Statement
For common-
size balance
sheets, again
the
denominator,
the entire pie, is
equal to the net
sales for the
year.
100% = Net Sales
 Common-Sized Balance Sheet
Comparative Balance Sheets (in millions)

Assets 2008 % 2007 %

Current assets $ 855 15.0 $ 955.5 14.5
Land, building, and
equipment (net) 1,275 22.4 1,075.0 24.4
Intangible assets 100 1.8 100.0 1.5
Other assets 48 0.8 60.5 0.9
Total assets $2,278 40.0 $2,191.0 33.2
 Common-Sized Balance Sheet

Comparative Balance Sheets (in millions)

Liab. & Shs’ Equity 2008 % 2007 %
Current liabilities $ 410 7.2 $ 501 7.6
Noncurrent liabilities 400 7.0 600 9.1
Total liabilities $ 810 14.2 $1,101 16.7
Paid-in capital $1,100 19.3 $ 800 12.1
Retained earnings 368 6.5 290 4.4
Total stockholders’
equity $1,468 25.8 $1,090 16.5
Total liabilities and
stockholders eq. $2,278 40.0 $2,191 33.2
Common Size Balance Sheet
A common-
size balance
sheet can also
be prepared
using total
assets to
standardize
each amount. 100% = Total Assets
 Ratio Analysis
• DuPont Framework- Identifying factors that
impact return on equity.
• Efficiency Ratios- How efficiently is the firm
utilizing its assets?
• Leverage Ratios- To what degree is the
company using other people’s money to
purchase assets?
• Other Financial Ratios- Other indications of
liquidity, cash management, and
profitability.
 DuPont Framework
• Developed internally at DuPont
around 1920.
• Provides a systematic approach to
identifying general factors causing
ROE to deviate from normal.
• Establishes a framework for
computing financial ratios to yield
more in-depth analysis of a company’s
areas of strength and weakness.
 DuPont Framework
• DuPont: ROE can be decomposed into
three components:

Profitability x Efficiency x Leverage

Return on x Asset x Assets-to-
Sales Turnover Equity Ratio
Net Income x Sales x Assets
Sales Assets Equity
 DuPont Framework
Net Income x Sales x Assets
Sales Assets Equity

The number of The number of The number of

pennies in dollars in sales dollars of assets a
company is able
profits generated generated by
to acquire using
from each dollar each dollar of
each dollar
of sales. assets.
invested by
stockholders.
 Colesville Corporation ROE
Net Income x Sales x Assets
Sales Assets Equity
2008 $180,000 x $5,700,000 x $2,278,000
3.16% 2.50 1.55
$5,700,000 $2,278,000 $1,468,000
Return on Equity = 12.3%

2007 $205,000
3.11% x $6,600,000
3.01 x $2,191,000
2.01
$6,600,000 $2,191,000 $1,090,000
Return on Equity = 18.8%
 Efficiency Ratios
Accounts receivable turnover:
Sales
Average accounts receivable

Colesville Corporation

$6,600,000
2007 =
($333,500 + $375,000)/2
$354,250

= 18.6 times
 Efficiency Ratios
Accounts receivable turnover:
Sales
Average accounts receivable

Colesville Corporation

$5,700,000
2008 =
($375,000 + 420,000)/2
$354,250
The ratios show that times
= 14.3 Colesville collected its
receivables more rapidly in 2007 than in
2008.
 Efficiency Ratios
Accounts receivable turnover:
Average accounts receivable
Average daily sales

Colesville Corporation

$354,250
2007 =
($6,600,000)/365
$18,082

= 19.6 days
 Efficiency Ratios
Accounts receivable turnover:
Average accounts receivable
Average daily sales

Colesville Corporation

$397,500
2008 =
($5,700,000)/365
$18,082
Some analyst like to express the accounts
receivable turnover
= 25.5 in days
terms of days. Average
collection period serves this purpose.
 Efficiency Ratios
Inventory turnover:
Cost of goods sold
Average inventory

For
Colesville
Colesville
Corporation
Corporation

$4,800,000
2007 =
($125,000$227,500
+ $330,000)/2

= 21.1 times
 Efficiency Ratios
Inventory turnover:
Cost of goods sold
Average inventory

ForColesville
ColesvilleCorporation
Corporation

$4,000,000
2008 =
($330,000 + $225,000)/2
$277,500
Inventory turnover allows for evaluation of the
= inventory
firm’s 14.4 times
position and the
appropriateness of the inventory size.
 Efficiency Ratios
Inventory turnover:
365
Inventory inventory

For
Colesville
Colesville
Corporation
Corporation

365
2007 =
21.1 times

= 17.3 times
 Efficiency Ratios
Inventory turnover:
365
Inventory inventory

For
Colesville
Colesville
Corporation
Corporation

365
2008 =
14.4 times
In 2007, a typical item of inventory remained
unsold for=17.3
25.3 times
days. This number increased
to 25.3 days in 2008.
 Stop and Think
You have probably
heard of just-in-
time inventory
systems. What
would a just-in-
time system do to
a company’s
number of days’
sales in inventory?
 Efficiency Ratios
Fixed Asset turnover:
Sales
Average fixed assets

For
Colesville
Colesville
Corporation
Corporation

$6,600,000
2007 =
($925,000$1,000,000
+ $1,075,000)/2

= 6.60 times
 Efficiency Ratios
Fixed Asset turnover:
Sales
Average fixed assets

For
Colesville
Colesville
Corporation
Corporation

$5,700,000
2008 =
($1,075,000 + $1,275,000)/2
$1,175,000
Colesville is much less efficient in using its
= to
fixed assets 4.85 timessales in 2008 than it
generate
was in 2007.
 Margin vs. Turnover

The profitability of
each dollar in sales
is sometimes called
a company’s
margin. The degree to
which assets are
used to generate
sales is called
turnover.
 Leverage Ratios
• Higher leverage increases ROE through
the following chain of events:
1. More borrowing means that more assets
can be purchased without any additional
equity investment by owners.
2. More assets means that more sales can be
generated.
3. More sales means that net income should
increase
 Leverage Ratios
Debt ratio:
Total liabilities
Total assets

For
Colesville
Colesville
Corporation
Corporation

$1,101,000
2007 =
$2,191,000

= 50.3%
 Leverage Ratios
Debt ratio:
Total liabilities
Total assets

For
Colesville
Colesville
Corporation
Corporation

$810,000
2008 =
$2,278,000
The debt ratio is the percentage of total funds,
= 35.6%
both borrowed and invested, that a company
acquires through borrowing.
 Leverage Ratios
Debt-to-equity ratio:
Total liabilities
Stockholders’ equity

For
Colesville
Colesville
Corporation
Corporation

$1,101,000
2007 =
$1,090,000

= 1.01
 Leverage Ratios
Debt-to-equity ratio:
Total liabilities
Stockholders’ equity

For
Colesville
Colesville
Corporation
Corporation

$810,000
2008 =
$1,468,000
The debt ratio and the debt-to-equity ratio
= 0.55
measure the same thing—the level of borrowing
relative to funds used to finance the company.
Stop and Think

Company Z has
an assets-to-
equity ratio of
2.5. What are
its debt and
debt-to-equity
ratios?
 Leverage Ratios
Times interest earned:
Earnings before income taxes
Interest expense

For
Colesville
Colesville
Corporation
Corporation

$290,000 + $60,000
2007 =
$60,000

= 5.8 times
 Leverage Ratios
Times interest earned:
Earnings before income taxes
Interest expense

For
Colesville
Colesville
Corporation
Corporation

$260,000 + $40,000
2008 =
$40,000
Times interest earned reflects the company’s
ability to meet = 7.5 times
interest payments and the degree
of safety afforded the creditors.
 Other Common Ratios
Current Ratio:
Current assets
Current liabilities

For
Colesville
Colesville
Corporation
Corporation

$955,500
2007 =
$501,000

= 1.91
 Other Common Ratios
Current Ratio:
Current assets
Current liabilities

For
Colesville
Colesville
Corporation
Corporation

$855,500
2007 =
$410,000
Historically, the rule of thumb was to have a
= 2.09
current ratio of at least 2.0. In 2008,
Colesville Corporation is in good shape.
 Current Ratios: 2004
Advances in information technology have allowed
successful firms to reduce this ratio to below 1.0.

Company Current Ratio

Coca-Cola 1.10
Delta Airlines 0.61
Home Depot 1.35
McDonald’s 0.81
Wal-Mart 0.90
 Other Common Ratios
Cash flow adequacy ratio:
Cash from operating activities
Total primary cash requirements

The sum of dividend payments, long-term

Colesville
asset For
purchases, Corporation
Colesville Corporation
and long-term debt
repayments.
$424,500
2007 =
$375,000
= 1.13
 Other Common Ratios
Earnings per share:
Net income
Weighted-number of share outstanding
Price-earnings ratio:
Market price per share
Earnings per share
Dividend payout ratio:

Cash dividends
Net income
Book-to-market ratio:
Stockholders’ equity
Market value of shares outstanding
Summary of Selected Financial
Ratios
• Insert Exhibit 22-7
 Impact of Alternative
Accounting Methods
• If companies are using differing
accounting practices, it will impact
the ratios.
• Careful financial statement users
should make adjustments for
accounting differences among the
companies being analyzed.
 Foreign Reporting to U.S.
Investors
Firms such as The good news is
DaimlerChrysler and that the demands of
These divergent
Disney must
The producedifferences
significant
nationalinternational
accounting users
financial statementsstandards
in accounting
practices canare forcing
have an
for users around
not onlythe
incompanies
world to provide
extremely significant
their own countriesboth
complicate the
disclosure so that
impact on reported
but also in other of users
preparation
financialfinancial
can recognize
statements.
countries.
statements and andthe
reconcile the
understandingdiffering
of these accounting
statements for users.
standards.
 Meeting the Needs of
International Users
Some multinational
firms respond to users
in other countries
simply by taking their
financial statements or
annual reports and
translating them into
the language of the
user.
Meeting the Needs of
International Users

Another response to the

international users is to
denominate the
financial statements in
the currency of the
country where the
financial statements
will be used.
 Meeting the Needs of
International Users
Some multinationals
partially or completely
restate the financial
statements to the
accounting principles of
the financial statement
users’ country.
 Meeting the Needs of
International Users
Mutual recognition
involves one country
accepting the financial
statements of another
country in return for that
country accepting its
financial statements for
all regulatory purposes.
 The SEC’s Form 20-F
• The SEC requires foreign companies
that list shares on U.S. to provide:
1. Complete U.S. GAAP financial
statements.
2. Reconcile their reported net income to
what income would be according to U.S.
GAAP. Form 20-F
provides the
reconciliation.
 Foreign Currency Financial
Statements
• Translation- Used when the foreign
subsidiary is a relatively self-contained unit
that is independent from the parent
company’s operations.
• Remeasurement- Is appropriate when the
subsidiary does not operate independently
of the parent company.
• Functional currency- Currency of the
primary economic environment of an entity.
 Foreign Currency Financial
Statements
Translation
• Assets and liabilities are translated
using the current exchange rate
prevailing as of the balance sheet
date.
• Income statement items are translated
at the average exchange rate for the
year.
• Dividends are translated using the
exchange rate prevailing on the date
the dividends were declared.
 Foreign Currency Financial
Statements
Translation
• Capital stock is translated at the historical
rate, the rate prevailing on the date the
subsidiary was acquired or the stock was
issued.
• Retained earnings is translated in the first year
using historical rates.
• In subsequent years, take the balance in
Retained Earnings from the prior period’s
translated financial statements and add
translated net income and subtracting
translated dividends.