MA-16-How Well Am I Doing - Financial Statement Analysis

How Well Am I Doing?
Financial Statement Analysis

Chapter Sixteen
McGraw-Hill/Irwin
Copyright 2008, The McGraw-Hill Companies, Inc.
16-2
Limitations of Financial Statement Analysis

Differences in accounting methods between companies sometimes make comparisons difficult.
We use the LIFO method to value inventory.

McGraw-Hill/Irwin
We use the average cost method to value inventory.

16-3
Limitations of Financial Statement Analysis
Industry trends Technological changes
Changes within the company
Consumer tastes
Economic factors
Analysts should look beyond the ratios.

McGraw-Hill/Irwin Copyright 2008, The McGraw-Hill Companies, Inc.
16-4
Learning Objective 1
Prepare and interpret financial statements in comparative and commoncommon-size form.
McGraw-Hill/Irwin
16-5
Statements in Comparative and CommonSize Form
Dollar and percentage changes on statements

An item on a financial statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing comparisons.
CommonCommon-size statements
Ratios
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16-6
Dollar and Percentage Changes on Statements

Horizontal analysis (or trend analysis) shows the changes between years in the financial data in both dollar and percentage form.
McGraw-Hill/Irwin
16-7
Horizontal Analysis
Example
The following slides illustrate a horizontal analysis of Clover Corporations December 31, 2007 and 2006, comparative balance sheets and comparative income statements.
McGraw-Hill/Irwin
16-8
Horizontal Analysis
C OVER CORPORATION Comparative Balance Sheets December 1 Increase (Decrease) Amount %
6 Assets Current assets: Cash Accounts receivable net Inventory Prepaid expenses Total current assets Property and equipment: and Buildings and equipment net Total property and equipment Total assets
McGraw-Hill/Irwin
1 6 8 1
$ 1 1 16
1 16 $ 1
8 1 $ 89
16-
Horizontal Analysis
Calculating Change in Dollar Amounts
Dollar Change Current Year Figure Base Year Figure
The dollar amounts for 2006 become the base year figures.
16-10
Horizontal Analysis
Calculating Change as a Percentage
Percentage Change = Dollar Change Base Year Figure
100
McGraw-Hill/Irwin
16-11
Horizontal Analysis
6 Assets Current assets: Cash Accounts receivable net Inventory Prepaid expenses Total current assets $1 Property and equipment: and Buildings and equipment($11 net Total property and equipment Total assets
McGraw-Hill/Irwin
1 6
$ 1
$ (11
.9)
$ $
1 16 =
$(11
) %= .9%
1 16 $ 1
)1
1 $ 9
16-12
Horizontal Analysis
2 Assets Current assets: Cash Accounts receivable net Inventory Prepaid expenses Total current assets Property and equipment: and Buildings and equipment net Total property and equipment Total assets
McGraw-Hill/Irwin
12 6
2 1
12 16
$ (11 2 (2 1 (9 -
) ) )
.9) . (2 . ) 1 . ( .9) . 1.2 2 . .
12 16 $ 1
12 $ 2 9
$ 2
16-13
Horizontal Analysis
We could do this for the liabilities & stockholders equity, but now lets look at the income statement accounts.
McGraw-Hill/Irwin
16-14
Horizontal Analysis
L o parati n o For th ars nd d A tat N nts b r 31 n r as r as A ount %
2007 2006 al s $ 520,000 $ 4 0,000 ost o goods sold 360,000 315,000 160,000 165,000 Gross argin p rating p ns s 128,600 126,000 N t op rating in o 31,400 39,000 nt r st p ns 6,400 7,000 b or ta s 25,000 32,000 N t in o L ss in o ta s 30% 7,500 9,600 N t in o $ 17,500 $ 22,400
McGraw-Hill/Irwin
16-15
Horizontal Analysis
L o parati n o For th ars nd d A tat N nts b r 31 n r as r as A ount % $ 40,000 83 45,000 14 3 5,000 30 2,600 21 7,600 19 5 600 86 7,000 21 9 2,100 21 9 $ 4,900 21 9
2007 2006 al s $ 520,000 $ 480,000 ost o goods sold 360,000 315,000 160,000 165,000 Gross argin p rating p ns s 128,600 126,000 N t op rating in o 31,400 39,000 nt r st p ns 6,400 7,000 N t in o b or ta s 25,000 32,000 L ss in o ta s 30% 7,500 9,600 N t in o $ 17,500 $ 22,400
McGraw-Hill/Irwin
16-16
Ho zon
L o p Fo h n o nd d
n y
N n b 31 n
2007 2006 un $ 520,000 $ 480,000 $ 40,000 o o good o d 360,000 315,000 45,000 gn 160,000 165,000 5,000 G o n d by 8 3%, y p ng p n 128,600 126,000 2,600 n n o d d by 21 9% N op ng n o 31,400 39,000 7,600 n p n 6,400 7,000 600 N n o b o 25,000 32,000 7,000 L n o 30% 7,500 9,600 2,100 N n o $ 17,500 $ 22,400 $ 4,900
McGraw-Hill/Irwin
% 83 14 3 30 21 19 5 86 21 9 21 9 21 9
16-17
Ho zon
n y
L h w n n bo h o o Ngood o p n n 1% o d 14 3% nd op ng o p n 2 Fo h h n d o ond d n o b 31h h n n n , y d ng n o d n n 2007 o 2006 n un $ 520,000 $ 480,000 $ 40,000 o o good o d 360,000 315,000 45,000 gn 160,000 165,000 5,000 G o p ng p n 128,600 126,000 2,600 N op ng n o 31,400 39,000 7,600 n p n 6,400 7,000 600 N n o b o 25,000 32,000 7,000 L n o 30% 7,500 9,600 2,100 N n o $ 17,500 $ 22,400 $ 4,900
McGraw-Hill/Irwin
% 83 14 3 30 21 19 5 86 21 9 21 9 21 9
16-18
Trend Percentages
Trend percentages state several years financial data in terms year, of a base year, which equals 100 percent.
McGraw-Hill/Irwin
16-1
Trend Analysis
Trend = Percentage
Current Year Amount Base Year Amount
100
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16-20
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.
McGraw-Hill/Irwin
16-21
Trend Analysis
Berry Products Income Information For the Years Ended December 31
Ite m a le s ost of oods sold ross m a r in 200 00,000 2 ,000 11 ,000 2006 3 ,000 2 0,000 10 ,000 Ye a r 200 320,000 22 ,000 ,000 200 2 0,000 1 ,000 2,000 2003 2 ,000 1 0,000 ,000
The base year is 2003, and its amounts will equal 100 .
16-22
T
B c h Y
2 f G
A
yP f E
2 6
y
uc D c
Y 2
b
2
1
2 1 1 1 1 1 1
2 A ( 2 , ( 1 , ( 2,
McGraw-Hill/Irwin
2 2 , 1 , ,
A u )1 )1 )1
1 =1 =1 =1
16-23
Trend Analysis
Berry Products ncome nformation For the Years Ended December 31
te m a le s ost of goods sold Gross m a rgin 2 1 1 13 2 6 12 132 12 Ye a r 2 116 11 112 2 1 1 1 2 1 1 1 3
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.
16-24
Trend Analysis
We can use the trend percentages to construct a graph so we can see the trend over time.
160 150 ercentage 140 130 120 110 100 2003
ales M 2004 2005 ear 2006 2007
McGraw-Hill/Irwin
16-25
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.
16-26
Common-Size Statements In income statements, all items usually are expressed as a percentage of sales.
McGraw-Hill/Irwin
16-27
ross
argin Percentage
ross argin = Percentage
ross argin 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.
McGraw-Hill/Irwin
16-28
In balance sheets, all items usually are expressed as a percentage of total assets.
McGraw-Hill/Irwin
16-2
en 's ona 's Dollars Percentage Dollars Percentage (dollars in millions) 2002 Net income $ 219 8.00% $ 893 5.80%
Common-size financial statements are particularly useful when comparing data from different companies.
McGraw-Hill/Irwin
16-30
Example
Lets take another look at the information from the comparative income statements of Clover Corporation for 2007 and 2006. This time, lets prepare common-size commonstatements.
McGraw-Hill/Irwin
16-31
on- z
L p Fo h n o nd d n b 31
o o good o d o gn p ng p n op ng n o n p n n o b o n o 30 L n o
McGraw-Hill/Irwin
2007 2006 $ 520,000 $ 480,000 360,000 315,000 160,000 165,000 128,600 126,000 31,400 39,000 6,400 7,000 25,000 32,000 7,500 9,600 $ 17,500 $ 22,400
n- z n g 2007 2006 100 0 100 0
u u b p
y h nd d 100
16-32
on- z
L p Fo h n o nd d n b 31
2007 2006 $ 520,000 $ 480,000 o o good o d 360,000 315,000 n 160,000 165,000 p ng p n 128,600 126,000 2007 o 2007 100 op ng n o 31,400 39,000 $360,000 $520,000 100 = 69 2 n p n 6,400 7,000 n o b o 2006 25,000 2006 32,000 100 n o 30 7,500 9,600 L $315,000 $480,000 100 n o $ 17,500 $ 22,400
McGraw-Hill/Irwin
n- z n g 2007 2006 100 0 100 0 69 2 65 6
= 65 6
16-33
CL C Compa ati e n ome Statements Fo the ea s nded e embe 31 Common-Size What conclusions can we draw? e entages 2007 2006 2007 2006 Sa es $ 520,000 $ 480,000 100 0 100 0 360,000 315,000 69 2 65 6 Cost o goods so d oss ma gin 160,000 165,000 30 8 34 4 pe ating e penses 128,600 126,000 24 8 26 2 et ope ating in ome 31,400 39,000 60 82 nte est e pense 6,400 7,000 12 15 et in ome be o e ta es 25,000 32,000 48 67 7,500 9,600 14 20 Less in ome ta es 30 et in ome $ 17,500 $ 22,400 34 47
16-34
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 years financial statements. d. one of the above.
McGraw-Hill/Irwin
16-35
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 Horizontal years financial statements. the current analysis shows the changes between years in the financial data in both d. one of the above. dollar and percentage form.
16-36
ow, lets look at orton Corporations 2007 and 2006 financial statements.
McGraw-Hill/Irwin
16-37
Balance Sheets December 31 2007 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
McGraw-Hill/Irwin
2006
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
16-38
Balance Sheets December 31 2007 Liabilities and Stockholders' Equity Current liabilities: Accounts payable Notes payable, short-term Total current liabilities Long-term liabilities: Notes payable, long-term Total liabilities Stockholders' equity: Common stock, $1 par value Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equity 2006
39,000 3,000 42,000 70,000 112,000 27,400 158,100 185,500 48,890 234,390
40,000 2,000 42,000 78,000 120,000 17,000 113,000 130,000 50,000 180,000
Total liabilities and stockholders' equity $ 346,390

McGraw-Hill/Irwin
$ 300,000
16-3
Income Statements For the Years Ended December 31
Sales Cost of goods sold Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income
2007 2006 $ 494,000 $ 450,000 140,000 127,000 354,000 323,000 270,000 249,000 84,000 74,000 7,300 8,000 76,700 66,000 23,010 19,800 $ 53,690 $ 46,200
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16-40
Compute and interpret financial ratios that would be useful to a common stockholder.
McGraw-Hill/Irwin
16-41
Ratio Analysis The Common Stockholder

RT C R RAT
The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholders equities.
McGraw-Hill/Irwin
um er of common shares outstandin e innin of year nd of year et income Stockholders equity e innin of year nd of year ividends er share ec. 1 market rice er share nterest e ense
1 , ,4 ,6 1 , 4,
, , 46,
Total assets e innin of year nd of year
16-42
Earnings Per Share
Earnings per Share =
et Income Preferred Dividends Average umber 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.
16-43
Earnings Per Share
et Income Preferred Dividends Average umber of Common Shares Outstanding 53,6 0 0 ( 17,000 + 27,400)/2 = 2.42
This measure indicates how much income was earned for each share of common stock outstanding.
McGraw-Hill/Irwin
16-44
Price-Earnings Ratio
arket Price Per Share Earnings Per Share
20.00 2.42
= 8.26 times
A higher price-earnings ratio means that investors are willing to pay a premium for a companys stock because of optimistic future growth prospects.
16-45
Dividend Payout Ratio
Dividends Per Share Earnings Per Share
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).
McGraw-Hill/Irwin
16-46
Dividend Yield Ratio
Dividend Yield Ratio Dividend Yield Ratio
Dividends Per Share arket 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.
16-47
Return on Total Assets
Return on = Total Assets
et Income + [Interest Expense (1 Tax Rate)] Average Total Assets
Return on = Total Assets
53,6 0 + [ 7,300 (1 .30)] = 18.1 ( 300,000 + 346,3 0) 2

Adding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity.
McGraw-Hill/Irwin
16-48
Return on Common Stockholders Equity
Return on Common = Stockholders Equity
et Income Preferred Dividends Average Stockholders Equity
53,6 0 0 Return on Common = = 25. 1 Stockholders Equity ( 180,000 + 234,3 0) 2
This measure indicates how well the company used the owners investments to earn income.
McGraw-Hill/Irwin
16-4
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 Fixed rate of return on borrowed funds Positive = financial leverage
Return on investment in < assets

McGraw-Hill/Irwin
egative = financial leverage

16-50
Quick Check
Which of the following statements is true? a. egative financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a companys 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.
16-51
Quick Check
Which of the following statements is true? a. egative financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a companys 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.
16-52
Book Value Per Share
Book Value per Share Book Value per Share
Common Stockholders Equity umber of Common Shares Outstanding 234,3 0 27,400
8.55
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.
16-53
Book Value Per Share
Book Value per Share Book Value per Share
Common Stockholders Equity umber of Common Shares Outstanding 234,3 0 27,400
8.55
otice 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.
16-54
Compute and interpret financial ratios that would be useful to a short-term shortcreditor.
McGraw-Hill/Irwin
16-55
Ratio Analysis The ShortTerm Creditor

RT Cash A o nts re ei a le net e innin o year nd o year n entory e innin o year nd o year Total Total Cost o
McGraw-Hill/Irwin
ShortShort-term reditors s h as s ppliers want to e paid on time. There ore they o s on the ompanys ash lows and workin apital.
C R
RAT
1 1 65
rrent assets rrent lia ilities o nt oods sold
Sales on a
1
16-56
Working Capital
The excess of current assets over current liabilities is known as working capital.
Working capital is not free. It must be financed with longterm debt and equity.
McGraw-Hill/Irwin
16-57
Working Capital
r 1 7 Curr nt a t 65 Curr nt lia iliti W orking apital
McGraw-Hill/Irwin
16-58
Current Ratio
Current Ratio = Current Assets Current Liabilities
The current ratio measures a companys short-term debt paying ability.

A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories.
McGraw-Hill/Irwin
16-5
Current Ratio
Current Ratio Current Ratio
Current Assets Current Liabilities 65,000 42,000 = 1.55
McGraw-Hill/Irwin
16-60
Acid-Test (Quick) Ratio
Acid-Test = Ratio Acid-Test = Ratio
Quick Assets Current Liabilities 50,000 42,000 = 1.1
Quick assets include Cash, Marketable Securities, Accounts Receivable and current otes Receivable. This ratio measures a companys ability to meet obligations without having to liquidate inventory.
16-61
Accounts Receivable Turnover

Accounts Receivable Turnover
Sales on Account Average Accounts Receivable
Accounts 4 4,000 Receivable = = 26.7 times ( 17,000 + 20,000) 2 Turnover This ratio measures how many times a company converts its receivables into cash each year.
McGraw-Hill/Irwin
16-62
Average Collection Period

Average 365 Days Collection = Accounts Receivable Turnover Period Average Collection = Period 365 Days 26.7 Times = 13.67 days
This ratio measures, on average, how many days it takes to collect an account receivable.
16-63
Inventory Turnover
Inventory Turnover Cost of oods Sold Average Inventory
This ratio measures how many times a companys inventory has been sold and replaced during the year.
If a companys inventory turnover Is less than its industry average, it either has excessive inventory or the wrong types of inventory.
16-64
Inventory Turnover
Inventory Turnover Inventory Turnover
Cost of oods Sold Average Inventory 140,000 = 12.73 times ( 10,000 + 12,000) 2
McGraw-Hill/Irwin
16-65
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.
McGraw-Hill/Irwin
16-66
Compute and interpret financial ratios that would be useful to a long-term longcreditor.
McGraw-Hill/Irwin
16-67
Ratio Analysis The LongTerm Creditor

Long-term creditors are concerned with a companys ability to repay its loans over the long-run.
RT C R RAT
7 arnings be ore interest e pense and income ta es nterest e pense 7 11 Total stoc holders e uity Total liabilities
This is also re erred to as net operating income.

McGraw-Hill/Irwin
16-68
Times Interest Earned Ratio

Times Interest = Earned Times Interest = Earned Earnings before Interest Expense and Income Taxes Interest Expense
84,000 = 11.51 times 7,300
This is the most common measure of a companys ability to provide protection for its longterm creditors. A ratio of less than 1.0 is inadequate.
16-6
Debt-to-Equity Ratio
Debtto Total Liabilities Equity = Stockholders Equity Ratio
This ratio indicates the relative proportions of debt to equity on a companys 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.
McGraw-Hill/Irwin
16-70
Debt-to-Equity Ratio
Debtto Total Liabilities Equity = Stockholders Equity Ratio Debtto Equity = Ratio 112,000 234,3 0 = 0.48
McGraw-Hill/Irwin
16-71
Published Sources That Provide Comparative Ratio Data
McGraw-Hill/Irwin
16-72
End of Chapter 16
McGraw-Hill/Irwin

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How Well Am I Doing?

Financial Statement Analysis

Copyright 2008, The McGraw-Hill Companies, Inc.

Limitations of Financial Statement Analysis

We use the LIFO method to value inventory.

We use the average cost method to value inventory.

Limitations of Financial Statement Analysis

Industry trends Technological changes

Changes within the company

Analysts should look beyond the ratios.

Prepare and interpret financial statements in comparative and commoncommon-size form.

Copyright 2008, The McGraw-Hill Companies, Inc.

Statements in Comparative and CommonSize Form

Dollar and percentage changes on statements

Copyright 2008, The McGraw-Hill Companies, Inc.

Dollar and Percentage Changes on Statements

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

.9) . (2 . ) 1 . ( .9) . 1.2 2 . .

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Current Year Amount Base Year Amount

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

160 150 ercentage 140 130 120 110 100 2003

ales M 2004 2005 ear 2006 2007

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

ross argin = Percentage

ross argin Sales

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

n- z n g 2007 2006 100 0 100 0

Copyright 2008, The McGraw-Hill Companies, Inc.

n- z n g 2007 2006 100 0 100 0 69 2 65 6

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

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

Copyright 2008, The McGraw-Hill Companies, Inc.

Total liabilities and stockholders' equity $ 346,390

Copyright 2008, The McGraw-Hill Companies, Inc.

Income Statements For the Years Ended December 31

Copyright 2008, The McGraw-Hill Companies, Inc.

Copyright 2008, The McGraw-Hill Companies, Inc.

Ratio Analysis The Common Stockholder

Total assets e innin of year nd of year

Earnings Per Share

Earnings per Share =

et Income Preferred Dividends Average umber of Common Shares Outstanding

Earnings Per Share