Chapter 9 Financial Statement Analysis. Learning Objectives After studying this chapter, you should be able to… Describe basic financial statement analytical.

Chapter 9Chapter 9

Financial Statement AnalysisFinancial Statement AnalysisFinancial Statement AnalysisFinancial Statement Analysis

Learning ObjectivesLearning Objectives

After studying this chapter, you should be able to…

Describe basic financial statement analytical methods.

Use financial statement analysis to assess the solvency of a business.

Use financial statement analysis to assess the profitability of a business.

Describe the contents of corporate annual reports.

Learning Objective 1Learning Objective 1

Describe basic financial statement analytical procedures

Horizontal Analysis

• The percentage analysis of increases and decreases in related items in comparative financial statements

Vertical Analysis

• A percentage analysis used to show the relationship of each component to the total within a single statement

Benefits of Analysis

• Horizontal and vertical analysis are useful in assessing relationships and trends in financial conditions and operations of a business

• Vertical analysis is useful for comparing one company with another or with industry averages

• Both are made easier with common-size financial statements

Common-Size Statements

Learning Objective 2Learning Objective 2

Apply financial statement analysis to assess the solvency of a business

Solvency and Profitability

• Solvency – the ability to meet debt obligations as they become due

• Profitability – the ability to earn income

Solvency and Profitability are interrelated!Solvency and Profitability are interrelated!

Solvency Analysis

• Normally assessed by examining balance sheet relationships, using the following major analyses:– Current position analysis– Accounts receivable analysis– Inventory analysis– Ratio of fixed assets to long-term liabilities– Ratio of liabilities to stockholders’ equity– Number of times interest charges are earned

Current Position Analysis

• Using measures to assess a business’s ability to pay its current liabilities – Working capital – current assets less current liabilities– Current ratio – current assets divided by current liabilities– Quick ratio – total “quick” assets divided by current

liabilities

Current Position Analysis – Working Capital and Current Ratio

Lincoln CompanyLincoln Company

Current Position Analysis – Quick Ratio

Quick AssetsQuick Assets$280,500$280,500

Quick AssetsQuick Assets$160,000$160,000

Quick Ratio = Quick Assets / Current LiabilitiesLincoln Quick Ratio = $280,500 / $210,000 = 1.3Jefferson Quick Ratio = $160,000 / $210,000 = .77

Accounts Receivable Analysis

• Measures efficiency of collection• Reflects liquidity

Accounts receivable turnover = Accounts receivable turnover = Net SalesNet Sales Avg. A/RAvg. A/R

Days’ Sales in Receivables = Days’ Sales in Receivables = Avg. A/RAvg. A/R Net Sales/365Net Sales/365

Accounts Receivable Turnover

The company increased its accounts receivable turnover by 38% measured in terms of the number of times receivables are collected within the year.

Days’ Sales in Receivables

The company improved its collections of accounts receivable by 10.9 days in 2009 measured in days receivables have been outstanding.

Inventory Analysis

• Measures inventory efficiency– Avoid tying up funds in inventory.– Avoid obsolescence.

• Reflects liquidity

Inventory turnover = Inventory turnover = COGSCOGS Avg. InventoryAvg. Inventory

Days’ Sales in Inventory = Days’ Sales in Inventory = Avg. InventoryAvg. InventoryCOGS/365COGS/365

Inventory Turnover

The company turned its inventory 1 time more in 2009, measured in terms of the number of times inventory turns over within the year.

Days’ Sales in Inventory

The company reduced the time it held inventory by nearly 28% in 2009 measured in days the inventory was held in warehouses.

Ratio of Fixed Assets to Long-Term Liabilities

• Indicates the margin of safety for note-holders or bondholders• Indicates the ability to borrow additional funds on a long-term

basis

Fixed Assets (net)Fixed Assets (net) Long-term LiabilitiesLong-term Liabilities

Ratio of Fixed Assets to Long-Term Liabilities

The company increased its margin of safety in financing fixed assets mainly by lowering long-term debt.

Ratio of Liabilities to Stockholders’ Equity

• Indicates the margin of safety for creditors.• Indicates the ability to withstand adverse business conditions.

Total LiabilitiesTotal Liabilities Total Stockholders’ EquityTotal Stockholders’ Equity

Ratio of Liabilities to Stockholders’ Equity

The ratio shows an increasing margin of safety for creditors.

Number of Times Interest Charges Earned

• Indicates the general financial strength of the business. • Indicates the ability to withstand adverse business conditions.

Income before Taxes + Interest Expense Income before Taxes + Interest Expense Interest ExpenseInterest Expense

Number of Times Interest Charges Earned

The number of times interest charges are earned improved from 12.2 to 28.1, a significant measure of safety for creditors.

Learning Objective 3Learning Objective 3

Apply financial statement analysis to assess the profitability of a business

Profitability Analysis

• Normally assessed by examining the income statement and balance sheet resources, using the following major analyses:– Ratio of net sales to assets– Rate earned on total assets– Rate earned on stockholders’ equity– Rate earned on common stockholders’ equity– Earnings per share on common stock– Price-earnings ratio– Dividends per share– Dividend yield

Ratio of Net Sales to Assets

• Shows how effectively a firm utilizes its assets

Net SalesNet Sales Avg. Total Assets (excluding LT Investments)Avg. Total Assets (excluding LT Investments)

Rate Earned on Total Assets

Interest Expense + Net IncomeInterest Expense + Net Income Avg. Total AssetsAvg. Total Assets

• Measures the profitability of total assets without considering how the assets are financed.

Rate Earned on Stockholders’ Equity

Net IncomeNet Income Avg. Stockholders’ EquityAvg. Stockholders’ Equity

• Emphasizes the rate of income earned on the amount invested by the stockholders.

Leverage

The company’s leverage of 3.1% for 2009 compares favorably with the 2.7% leverage for 2008.

Rate Earned on Common Stockholders’ Equity

Net Income – Preferred DividendsNet Income – Preferred DividendsAvg. Common Stockholders’ EquityAvg. Common Stockholders’ Equity

• Focuses on the rate of profits earned on the amounts invested by the common stockholders.

Earnings Per Share on Common Stock

Net Income – Preferred DividendsNet Income – Preferred DividendsCommon Shares OutstandingCommon Shares Outstanding

• The income earned for each share of common stock.

Price-Earnings Ratio

Market Price Per Share of Common StockMarket Price Per Share of Common StockAnnual Earnings Per ShareAnnual Earnings Per Share

• Indicator of the firm’s future earnings prospects.

Dividends per Share and Earnings per Share

Dividends per Share = Common Dividends Dividends per Share = Common Dividends Common SharesCommon Shares

Dividends Per Share and Dividend Yield

Dividend Yield = Common Dividend/ShareDividend Yield = Common Dividend/Share Market Price/ShareMarket Price/Share

• Dividend yield shows the rate of return to common stockholders in terms of cash dividends.

Learning Objective 5Learning Objective 5

Describe the contents of corporate annual reports

Corporate Annual Reports

• Summarize operating activities for the past year and plans for the future.

• Many variations in the order and form, but all include:– Financial statements and notes– Management discussion and analysis– Independent auditors’ report

Management Discussion and Analysis (MDA)

• Provides critical information in interpreting the financial statements and assessing the future of the company.

• Includes an analysis about past performance and financial condition.

• Discusses management’s opinion about future performance. • Discusses significant risk exposure.

Independent Auditors’ Report

• Publicly traded companies must get an independent opinion on the fairness of the financial statements.

• This opinion must be included in the annual report along with an opinion on the accuracy of management’s internal control assertion.

End of Chapter 9End of Chapter 9