Financial Statement Analysis Chapter 19 HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT.
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Financial Statement Analysis
Chapter 19
HORNGREN ♦ HARRISON ♦ BAMBER ♦ BEST ♦ FRASER ♦ WILLETT
19 - 2Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Objectives
1. Perform a horizontal analysis of comparative financial statements
2. Perform vertical analysis of financial statements
3. Prepare common size financial statements
4. Calculate the standard financial ratios used for decision-makers
5. Use ratios in decision-making
6. Measure economic value added by a company’s operations
19 - 3Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
The Annual ReportUsually
Contains ...– financial statements.– footnotes to the financial statements.– a summary of accounting methods used.– management discussion and analysis of
the financial results.– an auditor’s report.– comparative financial data for series of
year.
19 - 4Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Objective 1
Perform a horizontal analysis of comparative
financial statements.
19 - 5Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Horizontal Analysis
Increase/(Decrease) 2004 2003 Amount Percent
Sales $41,500 $37,850 $3,650 9.6%Expenses 40,000 36,900 3,100 8.4%Net profit 1,500 950 550 57.9%
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2004 2003 DifferenceSales $41,500 $37,850 $3,650
$3,650 ÷ $37,850 = .0964, or 9.6%
Horizontal Analysis
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Trend Percentages...
– are calculated by selecting a base year whose amounts are set equal to 100%.
The amounts of each following year are expressed as a percentage of the base amount.
Trend % = Any year $ ÷ Base year $
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Year 2004 2003 2002
Revenues $27,611 $24,215 $21,718 Cost of sales 15,318 14,709 13,049 Gross profit $12,293 $ 9,506 $
8,669
2002 is the base year.What are the trend percentages?
Trend Percentages
19 - 9Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Year 2004 2003 2002
Revenues 127% 111% 100% Cost of sales 117% 113% 100% Gross profit 142% 110% 100%
Trend Percentages
These percentages were calculated bydividing each item by the base year.
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Objective 2
Perform a vertical analysis
of financial statements.
19 - 11Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Vertical Analysis...
– compares each item in a financial statement to a base number set to 100%.
Every item on the financial statement is then reported as a percentage of that base.
19 - 12Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Vertical Analysis
2004 %
Revenues $38,303 100.0 Cost of sales 19,688 51.4 Gross profit $18,615 48.6 Total operating expenses 13,209 34.5 Operating profit $ 5,406 14.1 Other income 2,187 5.7 Income before taxes $ 7,593 19.8 Income taxes 2,827 7.4 Net profit $ 4,766 12.4
19 - 13Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Vertical Analysis
Assets 2004 % Current assets: Cash $ 1,816 4.7 Receivables net 10,438 26.9 Inventories 6,151 15.9 Prepaid expenses 3,526 9.1 Total current assets $21,931 56.6 Plant and equipment, net 6,847 17.7 Other assets 9,997 25.7 Total assets $38,775 100.0
19 - 14Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Objective 3
Prepare common-size
financial statements.
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Common-size Statements
On the statement of financial performance, each item is expressed as a percentage of net sales.
On the statement of financial position, the common size is the total on each side of the accounting equation.
Common-size statements are used to compare one company to other companies, and to the industry average.
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Benchmarking
43.0%
38.2%
8.0%
10.8%
51.4%
28.8%
7.4%
12.4%
Percent of Net Sales
Enterprise LimitedTechnology Limited
Cost of goods sold Operating expenses Income tax Net profit
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Objective 4
Calculate the standardfinancial ratios usedby decision-makers.
19 - 18Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Ratio Classification
1 Measuring ability to pay current liabilities
2 Measuring ability to sell inventory and collect receivables
3 Measuring ability to pay long-term debt4 Measuring profitability5 Analysing shares as an investment
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The Data(Exhibit 19-1 Lucent Technology 20X7)
Net sales (Year 2004) $858,000 Cost of goods sold 513,000 Gross profit $345,000 Total operating expenses 244,000 Plus Interest revenue 4,000 Interest expense (24,000) Profits before taxes $ 81,000 Income tax 33,000 Net profits $ 48,000
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The Data(Exhibit 19-2 Lucent Technology 20X7 and 20X6)
Assets 2004 2003 Current assets: Cash $ 29,000 $ 32,000 Receivables net 114,000 85,000 Inventories 113,000 111,000 Prepaid expenses 6,000 8,000 Total current assets $262,000 $236,000 Long-term investments 18,000 9,000 Plant and equipment, net 507,000 399,000 Total assets $787,000 $644,000
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The Data(Exhibit 19-2 Lucent Technology 20X7 and 20X8)
Liabilities 2004 2003 Current liabilities: Bills payable $ 42,000 $ 27,000 Accounts payable 73,000 68,000 Accrued liabilities 27,000 31,000 Total current liabilities $142,000 $126,000 Long-term debt 289,000 198,000 Total liabilities $431,000 $324,000
19 - 22Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Shareholders’ Equity 2004 2003
Ordinary shares (93,000) $186,000 $186,000 Retained earnings 170,000 134,000 Total shareholders’ equity $356,000 $320,000
Total liabilities andshareholders’ equity $787,000 $644,000
The Data(Exhibit 19-1 Lucent Technology 20X7 and 20X8)
19 - 23Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Current ratio =Total current assets ÷ Total current liabilities
Current ratio =Total current assets ÷ Total current liabilities
The current ratio measuresthe company’s ability to pay
current liabilities with current assets.
The current ratio measuresthe company’s ability to pay
current liabilities with current assets.
Measuring Ability toPay Current
Liabilities
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Measuring Ability toPay Current
Liabilities Lucent’s current ratio: 2003: $236,000 ÷ $126,000 = 1.87 2004: $262,000 ÷ $142,000 = 1.85 If the industry average is 1.80. What does this tell us? The current ratio decreased slightly
during 2004 but it is still slightly higher than the industry average.
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Acid-test ratio =(Cash + Short-term investments
+ Net current receivables)÷ Total current liabilities
Acid-test ratio =(Cash + Short-term investments
+ Net current receivables)÷ Total current liabilities
Measuring Ability toPay Current
LiabilitiesThe acid-test ratio shows the company’s
ability to pay all current liabilitiesif they come due immediately.
The acid-test ratio shows the company’sability to pay all current liabilities
if they come due immediately.
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Measuring Ability toPay Current
Liabilities Lucent’s acid-test ratio: 2003: ($32,000 + $85,000) ÷ $126,000 = .93 2004: ($29,000 + $114,000) ÷ $142,000 = 1.01 If the industry average is .60. The company’s acid-test ratio improved
considerably during 2004 and is well above the industry average.
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Inventory turnover = Cost of goods sold÷ Average inventory
Inventory turnover = Cost of goods sold÷ Average inventory
Inventory turnover is a measureof the number of times the average
level of inventory is sold during a year.
Inventory turnover is a measureof the number of times the average
level of inventory is sold during a year.
Measuring Ability to
Sell Inventory
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Measuring Ability to
Sell Inventory Inventory turnover: 2004: $513,000 ÷ $112,000* = 4.58 If the industry average is 2.70. A high number indicates an ability to
quickly sell inventory, but it might indicate stock-outs!
* Average inventory ($113,000 + $111,000) ÷ 2
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Accounts receivable turnover =Net credit sales ÷ Average accounts receivable
Accounts receivable turnover =Net credit sales ÷ Average accounts receivable
Accounts receivable turnover measures a company’sability to collect cash from credit customers.
Accounts receivable turnover measures a company’sability to collect cash from credit customers.
Measuring Ability to
Collect Receivables
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Measuring Ability to
Collect Receivables Lucent’s accounts receivable turnover: 2004: $858,000 ÷ $99,500 = 8.62 times If the industry average is 22.2 times. Lucent’s receivable turnover is much
lower than the industry average. If the company is a rural store that sells to
local people who tend to pay their bills over a lengthy period of time – then?
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One day’s sales = Net sales ÷ 365 daysOne day’s sales = Net sales ÷ 365 days
Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales
Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales
Measuring Ability to
Collect Receivables
Days’ sales in receivable ratio measures howmany day’s sales remain in Accounts Receivable.
Days’ sales in receivable ratio measures howmany day’s sales remain in Accounts Receivable.
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Measuring Ability to
Collect Receivables Days’ sales in Accounts Receivable for
2004: One day’s sales: $858,000 ÷ 365 = $2,351 Days’ sales in Accounts Receivable: $99,500 ÷ $2,351 = 42 days What is the industry average - 365/22.2
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Total liabilities ÷ Total assetsTotal liabilities ÷ Total assets
Measuring Ability to
Pay Debt
The debt ratio indicates the proportionof assets financed with debt.
The debt ratio indicates the proportionof assets financed with debt.
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Measuring Ability to
Pay Debt Lucent’s debt ratio: 2003: $324,000 ÷ $644,000 = 0.50 2004: $431,000 ÷ $787,000 = 0.55 Industry average 0.61. Lucent expanded operations during
2004 by financing through borrowing – but it is still lower than the industry.
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Times-interest-earned= Net Profits plus (interest expense and tax)
÷ Interest expense
Times-interest-earned= Net Profits plus (interest expense and tax)
÷ Interest expense
Measuring Ability to
Pay Debt
Times-interest-earned ratio measures the number of times profits before both
interest and tax can cover interest expense.
Times-interest-earned ratio measures the number of times profits before both
interest and tax can cover interest expense.
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Measuring Ability to
Pay Debt Times-interest-earned ratio: 2004: ($81,000 + $24,000*) ÷ $24,000
= 4.37 The industry average is 2.00. This is a favorable sign.
* Profits before tax are $81,000 (or $48,000 + $33,000) and if we paid no interest of $24,000 profits would be $105,000.
* Profits before tax are $81,000 (or $48,000 + $33,000) and if we paid no interest of $24,000 profits would be $105,000.
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Rate of return on net sales =Net profits ÷ Net sales
Rate of return on net sales =Net profits ÷ Net sales
Measuring Profitability
Rate of return on net sales shows the percentageof each sales dollar earned as net profits.
Rate of return on net sales shows the percentageof each sales dollar earned as net profits.
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Measuring Profitability
Lucent’s rate of return on sales: 2003: $26,000 ÷ $803,000 = 0.032 2004: $48,000 ÷ $858,000 = 0.056 The industry average is 0.008. The increase is significant in itself and also
because it is much better than the industry average.
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Rate of return on total assets = (Net profits + income tax + interest expense)
÷ Average total assets
Rate of return on total assets = (Net profits + income tax + interest expense)
÷ Average total assets
Measuring Profitability
Rate of return on total assets measureshow profitably a company uses its assets.
Rate of return on total assets measureshow profitably a company uses its assets.
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Measuring Profitability
Rate of return on total assets for 2004: $105,000 ÷ $715,500* = 0.147 What if the industry average is 0.049. How does Lucent compare to the
industry?
* ($644,000 + $787,000) ÷ 2 = $715,500
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Rate of return on ordinary shareholders’ equity= (Net profits – preferred dividends)
÷ Average ordinary shareholders’ equity
Rate of return on ordinary shareholders’ equity= (Net profits – preferred dividends)
÷ Average ordinary shareholders’ equity
Measuring Profitability
Shareholders equity includes any additionalissued ordinary shares and retained profits.Shareholders equity includes any additionalissued ordinary shares and retained profits.
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Measuring Profitability
Lucent’s rate of return on ordinary shareholders’ equity for 2004:
($48,000 – $0) ÷ $338,000* = 0.142 Why is this ratio larger than the return
on total assets (.101)? Because Lucent uses leverage or
gearing.
* ($356,000 + $320,000) ÷ 2 = $338,000
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Gearing Example
I borrow $90 (at 5%) and I put in $10 Invest $100 and earn 10% on it
Revenue $10.00 ($100 x 10%)
Expenses $ 4.50 ($90 x 5%)
Profit $ 5.50 Not bad on the $10 I put in. But what if the assets only earned say 2% Loss of $2.50 Gearing is RISKY !
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Measuring Profitability
Earnings per share (EPS)= (Net profits – Preferred dividends)÷ Number of ordinary shares issued
Earnings per share (EPS)= (Net profits – Preferred dividends)÷ Number of ordinary shares issued
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Measuring Profitability
Lucent’s earnings per share: 2004: ($48,000 – $0) ÷ 93,000 = $0.52 EPS is important because it is becoming
common to express the profit in this form rather than large dollar amounts.
Only important in comparison to previous EPS not other companies EPS.
Why?
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Analysing Shares as an Investment
Price/earning ratio is the ratio of market price per share ($5) to earnings per share.
2004: $5 ÷ $0.52 = 9.6 Given Lucent’s 2004 P/E ratio of 9.6, we
would say that the company’s shares are selling at 9.6 times earnings.
P/E ratios are commonly provided for listed companies.
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Dividend per ordinary share ÷ market price per ordinary shares
Dividend per ordinary share ÷ market price per ordinary shares
Analysing Shares as an Investment
Dividend yield shows the percentageof a share’s market value returned as
dividends to shareholders each period.
Dividend yield shows the percentageof a share’s market value returned as
dividends to shareholders each period.
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Analysing Shares as an Investment
Dividend yield on Lucent’s ordinary shares:
2004: $0.12 ÷ $5.00 = .024 (2.4%) An investor who buys Lucent’s ordinary
shares for $5 may expect to receive 2.4% of the investment annually in the form of cash dividends.
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Analysing Shares as an Investment
Book value per ordinary share = (Total ordinary shareholders’ equity)
÷ Number of ordinary shares issued
Book value per ordinary share = (Total ordinary shareholders’ equity)
÷ Number of ordinary shares issued
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Analysing Shares as an Investment
Book value per share of Lucent’s ordinary shares:
2003: ($320,000) ÷ 93,000 = $3.44 2004: ($356,000) ÷ 93,000 = $3.83 Book value bears no relationship to
market value.
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Objective 5
Use ratios in decision making.
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Limitations of Financial Analysis
Business decisions are made in a world of uncertainty.
No single ratio or one-year figure should be relied upon to provide an assessment of a company’s performance.
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Objective 6
Measure economic value added.
19 - 54Horngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education AustraliaHorngren ♦ Harrison ♦ Bamber ♦ Best ♦ Fraser ♦ Willett, Accounting 4e Copyright © 2004 Pearson Education Australia
Economic Value Added (EVA®)
Economic value added (EVA®) combines accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth.
EVA® = Net profits + Interest expense – Capital charge
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End of Chapter 19
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