02 Financial Statements and Analysis

Chapter 2Financial Statements and Analysis

Learning GoalsReview the contents of the stockholders report and the procedures for consolidating international financial statements.Understand who uses financial ratios, and how.Use ratios to analyze a firms liquidity and activity.Discuss the relationship between debt and financial leverage and the ratios used to analyze a firms debt.

Learning Goals (cont.)Use ratios to analyze a firms profitability and market value.Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis.

The Stockholders ReportThe guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP).GAAP is authorized by the Financial Accounting Standards Board (FASB).The Sarbanes-Oxley Act of 2002, passed to eliminate the many disclosure and conflict of interest problems of corporations, established the Public Company Accounting Oversight Board (PCAOB), which is a not-for-profit corporation that overseas auditors.

The Stockholders Report (cont.)The PCAOB is charged with protecting the interests of investors and furthering the public interest in the preparation of informative, fair, and independent audit reports.Public corporations with more than $5 million in assets and more than 500 stockholders are required by the SEC to provide their stockholders with an annual stockholders report.

The Four Key Financial Statements: The Income StatementThe income statement provides a financial summary of a companys operating results during a specified period.Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.

The Four Key Financial Statements

The Four Key Financial Statements: The Balance SheetThe balance sheet presents a summary of a firms financial position at a given point in time.Assets indicate what the firm owns, equity represents the owners investment, and liabilities indicate what the firm has borrowed.

The Four Key Financial Statements

The Four Key Financial Statements (cont.)

The Four Key Financial Statements: Statement of Retained EarningsThe statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.

The Four Key Financial Statements

The Four Key Financial Statements: Statement of Cash FlowsThe statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended.This statement not only provides insight into a companys investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

The Four Key Financial Statements

Consolidating International Financial StatementsFASB 52 mandated that U.S. based companies translate their foreign-currency denominated assets and liabilities into dollars using the current rate (translation) method.Under the translation method, companies translate all foreign-currency-denominated assets and liabilities into dollars at the exchange rate prevailing at the fiscal year ending date (the current rate).Income statement items are usually treated similarly.

Consolidating International Financial Statements (cont.)Equity accounts, on the other hand, are translated into dollars by using the exchange rate that prevailed when the parents equity investment was made (the historical rate).Retained earnings are adjusted to reflect each years operating profits (or losses).

Using Financial Ratios: Interested PartiesRatio analysis involves methods of calculating and interpreting financial ratios to assess a firms financial condition and performance.It is of interest to shareholders, creditors, and the firms own management.

Using Financial Ratios: Types of Ratio ComparisonsTrend or time-series analysisUsed to evaluate a firms performance over time

Using Financial Ratios: Types of Ratio Comparisons (cont.)Trend or time-series analysisCross-sectional analysisUsed to compare different firms at the same point in time

Using Financial Ratios: Types of Ratio Comparisons (cont.)Trend or time-series analysisCross-sectional analysisIndustry comparative analysisOne specific type of cross sectional analysis. Used to compare one firms financial performance to the industrys average performance

Using Financial Ratios: Types of Ratio Comparisons (cont.)Trend or time-series analysisCross-sectional analysisBenchmarkingA type of cross sectional analysis in which the firms ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate

Using Financial Ratios: Types of Ratio Comparisons (cont.)Trend or time-series analysisCross-sectional analysisCombined AnalysisCombined analysis simply uses a combination of both time series analysis and cross-sectional analysis

Using Financial Ratios: Types of Ratio Comparisons (cont.)

Using Financial Ratios: Types of Ratio Comparisons (cont.)

Using Financial Ratios: Cautions for Doing Ratio AnalysisRatios must be considered together; a single ratio by itself means relatively little.Financial statements that are being compared should be dated at the same point in time.Use audited financial statements when possible.The financial data being compared should have been developed in the same way.Be wary of inflation distortions.

Ratio Analysis ExampleWe will illustrate the use of financial ratios for analyzing financial statements using the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2.

Ratio AnalysisLiquidity RatiosCurrent RatioCurrent ratio = total current assets total current liabilitiesCurrent ratio = $1,233,000 = 1.97 $620,000

Ratio Analysis (cont.)Liquidity RatiosCurrent RatioQuick RatioQuick ratio = Total Current Assets - Inventory total current liabilitiesQuick ratio = $1,233,000 - $289,000= 1.51 $620,000

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosInventory TurnoverInventory Turnover = Cost of Goods Sold InventoryInventory Turnover = $2,088,000 = 7.2 $289,000

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosAverage Age of InventoryAverage Age of Inventory = 365 Inventory TurnoverInventory Turnover = 365 = 50.7 days 7.2

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosAverage Collection PeriodACP = Accounts Receivable Net Sales/365ACP = $503,000 = 59.7 days $3,074,000/365

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosAverage Payment PeriodAPP = Accounts Payable Annual Purchases/365APP = $382,000 = 95.4 days (.70 x $2,088,000)/365

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosTotal Asset TurnoverTotal Asset Turnover= Net Sales Total AssetsTotal Asset Turnover= $3,074,000 = .85 $3,597,000

Ratio Analysis (cont.)Insert Table 2.6 here

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosFinancial Leverage RatiosDebt RatioDebt Ratio = Total Liabilities/Total AssetsDebt Ratio = $1,643,000/$3,597,000 = 45.7%

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosTimes Interest Earned RatioTimes Interest Earned = EBIT/InterestTimes Interest Earned = $418,000/$93,000 = 4.5

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosFixed-Payment coverage Ratio (FPCR)FPCR = EBIT + Lease Payments Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}FPCR = $418,000 + $35,000= 1.9 $93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosProfitability RatiosCommon-Size Income Statements

Ratio Analysis (cont.)

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosProfitability RatiosGross Profit MarginGPM = Gross Profit/Net SalesGPM = $986,000/$3,074,000 = 32.1%

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosProfitability RatiosOperating Profit Margin (OPM)OPM = EBIT/Net SalesOPM = $418,000/$3,074,000 = 13.6%

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosProfitability RatiosNet Profit Margin (NPM)NPM = Earnings Available to Common Stockholders SalesNPM = $221,000/$3,074,000 = 7.2%

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosProfitability RatiosEarnings Per Share (EPS)EPS= Earnings Available to Common Stockholders Number of Shares OutstandingEPS = $221,000/76,262 = $2.90

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosProfitability RatiosReturn on Total Assets (ROA)ROA= Earnings Available to Common Stockholders Total AssetsROA= $221,000/$3,597,000 = 6.1%

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosProfitability RatiosReturn on Equity (ROE)ROE= $221,000/$1,754,000 = 12.6%ROE= Earnings Available to Common Stockholders Total Equity

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosProfitability RatiosMarket RatiosPrice Earnings (P/E) RatioP/E= Market Price Per Share of Common Stock Earnings Per Share P/E = $32.25/$2.90 = 11.1

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosProfitability RatiosMarket RatiosMarket/Book (M/B) RatioBV/Share = Common Stock Equity Number of Shares of Common Stock BV/Share = $1,754,000/72,262 = $23.00

Ratio Analysis (cont.)Liquidity RatiosActivity RatiosLeverage RatiosProfitability RatiosMarket RatiosMarket/Book (M/B) RatioM/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common StockM/B Ratio = $32.25/$23.00 = 1.40

Summarizing All Ratios

Summarizing All Ratios (cont.)

Summarizing All Ratios (cont.)

Summarizing All Ratios (cont.)

DuPont System of AnalysisThe DuPont system of analysis is used to dissect the firms financial statements and to assess its financial condition.It merges the income statement and balance sheet into two summary measures of profitability: ROA and ROE as shown in the equation below and in Figure 2.2 on the following slide.

DuPont System of Analysis (cont.)

Modified DuPont FormulaThe Modified DuPont Formula relates the firms ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:

Modified DuPont Formula (cont.)Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owners return.Substituting the values for Bartlett Companys ROA of 6.1 percent calculated earlier, and Bartletts FLM of 2.06 ($3,597,000 total assets $1,754,000 common stock equity) into the Modified DuPont formula yields:ROE = 6.1% X 2.06 = 12.6%