CHAPTER 11 FINANCIAL STATEMENT ANALYSIS McGraw-Hill/Irwin©The McGraw-Hill Companies, Inc., 2002.

CHAPTER 11

FINANCIAL STATEMENT ANALYSIS

McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objectives 1. How can liquidity measures be

influenced by the inventory cost-flow assumption used?

2. How do suppliers and creditors use a customer’s payment practices to judge liquidity?

3. What are the influences of alternative inventory cost-flow assumptions and depreciation methods on turnover ratios?

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Learning Objectives

4. How are the number of days’ sales in accounts receivable and inventory used to evaluate the effectiveness of the management of receivables and inventory?

5. What is the significance of the price/earnings ratio in the evaluation of the market price of a company’s stock?

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Learning Objectives

6. How are dividend yield and the dividend payout ratio used by investors to evaluate a company’s common stock?

7. What is financial leverage, and why is it significant to management, creditors, and owners?

8. What is book value per share of common stock, how is it calculated, and why is it not a very meaningful amount for most companies?

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Learning Objectives

9. How can common size financial statements be used to evaluate a firm’s financial position and results of operations over a number of years?

10.How can operating statistics using physical, or non-financial data, be used to help management evaluate the results of the firm’s activities?

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Learning Objective 1

• How can liquidity measures be influenced by the inventory cost-flow assumption used?

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Financial Statement Analysis Ratios

• Used to facilitate the interpretation of an entity’ financial position and results of operations

• Can be classified into four groups:

– Liquidity

– Activity

– Profitability

– Debt, or financial leverageMcGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Liquidity Measures

• The balance sheet carrying values of inventory will depend on the cost-flow assumption used

• Cannot compare firms using different inventory cost-flow assumptions

• Firms often report the LIFO reserve – the difference between LIFO an FIFO inventory values

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Liquidity Ratios

• Working capital =

Current assets – Current liabilities

• Current ratio = Current assetsCurrent liabilities

• Acid-test ratio =

Cash + Accounts receivable Current liabilities

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Learning Objective 2

• How do suppliers and creditors use a customer’s payment practices to judge liquidity?

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Customer’s Payment Practices

• Suppliers and creditors want to know if a firm is paying its bills promptly

• This information may be obtained from other suppliers, credit bureaus, and Dun & Bradstreet reports

• Credit bureaus and credit rating agencies provide a graded rating for firms

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Learning Objective 3

• What are the influences of alternative inventory cost-flow assumptions and depreciation methods on turnover ratios?

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Activity Measures• Focus primarily on the relationship

between assets and sales

• In computing activity measures, average assets is used

• Average asset amounts include inventory and fixed assets

• The values of inventory (based on cost-flow assumptions) and fixed assets (based on book cost less accumulated depreciation) depend on the cost-flow assumptions and depreciation methods used

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Activity Ratios

• Total asset turnover = SalesAverage total assets

• Inventory turnover = Cost of goods sold Average inventories

• Number of days’ sales in accounts receivable = Accounts receivable

Average days’ sales

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More Activity Ratios

• Average days’ sales = Annual sales 365

• Number of days’ sales in inventory =

Inventory Average days’ cost of goods sold

• Average days’ cost of goods sold =

Average cost of goods sold 365

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Learning Objective 4

• How are the number of days’ sales in accounts receivable and inventory used to evaluate the effectiveness of the management of receivables and inventory?

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Number of Days’ Sales in Accounts Receivable

• Assesses the efficiency of managing accounts receivable

• The sooner accounts receivable are collected, the sooner cash is available for use in the business

• Generally, the higher the turnover and lower the number in days’ sales, the better

• An increase in the age of accounts receivable is a warning that profitability and liquidity may be weakening

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Number of Days’ Sales in Inventory

• Assesses the efficiency of managing inventory

• The lower that inventories can be maintained relative to sales,the less inventory that needs to be financed with debt and the greater the return on investment

• Trend in the efficiency of managing inventory is the important factor

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Profitability Measures

• Operating income is frequently used in ROI calculations because it is a more direct measure of management’s activities

• Average ROI based on net income for most American firms is between 7% and 10%

• Again, trends are important

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Profitability Ratios

• ROI =

Return (Net income) Investment (Average total assets)

• DuPont model =

Margin x Turnover

Net income

x Sales

Sales Average total assets

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More Profitability Ratios

• ROE = Net income Average total owners’ equity

• Dividend yield = Annual dividend per share Market price per share of stock

• Dividend payout ratio = Annual dividend per share Earnings per share

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Learning Objective 5

• What is the significance of the price/earnings ratio in the evaluation of the market price of a company’s stock?

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Price/Earning Ratio

• P/E ratio =

Market price of a share of common stock Earnings per share of common stock

• Used extensively to evaluate the market price of a firm’s common stock relative to that of other firms and the market as a whole

• Also called earnings multipleMcGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Importance of P/E Ratio

• Investors can earn a return on stock two ways:– Through dividends– Through increases in the market value

of the stock

• Market price reflects expectations of future dividends – which depend on earnings

• Typically, manufacturing firms’ P/E ratio ranges from 12 to 18

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Learning Objective 6

• How are dividend yield and the dividend payout ratio used by investors to evaluate a company’s common stock?

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Dividend Yield• Dividend yield =

Annual dividend per share Market price per share of stock

• Should be compared to the yield available on other investments

• On common stock, historically this has ranged from 3% to 6%

• On preferred stock, the range is 5% to 8%McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Dividend Payout Ratio

• Dividend payout ratio =

Annual dividend per share Earnings per share

• Reflects the dividend policy of the firm

• Most firms pay a relatively constant portion of earnings and avoid fluctuations

• Generally, ranges from 30% to 50% for manufacturing and merchandising firms

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Preferred Dividend Coverage Ratio

• Preferred dividend coverage ratio =

Net incomePreferred dividend requirement

• Indicates the margin of safety of the preferred stock dividend

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Learning Objective 7

• What is financial leverage, and why is it significant to management, creditors, and owners?

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Financial Leverage Measures• Refers to the use of debt to finance the

assets of the entity

• Adds risk to the operation of the firm

• Also magnifies the return to owners relative to the return on assets

• Firms want to borrow at a rate less than the rate of return on financed assets

• Interest is a deductible expense; dividends are not deductible

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Debt Ratio

• Indicates the extent to which a firm is using financial leverage

• Debt ratio = Total liabilities

Total liabilities and owners’ equity

• Indicates the percentage of financing that is done with debt

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Debt/Equity Ratio

• Another indicator of the extent to which a firm is using financial leverage

• Debt/Equity ratio = Total liabilities Total owners’ equity

• Indicates the percentage of financing that is done with debt

• Since deferred taxes and current liabilities are not interest bearing, these items are often excluded from the computation

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Times Interest Earned Ratio

• A measure that shows the relationship of earnings before interest and taxes to interest expense

• The greater the ratio, the more confident the debt holders are about the firm continuing to earn enough to cover interest payments

• Times interest earned =

Earnings before interest and taxes Interest expenseMcGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

Learning Objective 8

• What is book value per share of common stock, how is it calculated, and why is it not a very meaningful amount for most companies?

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Book Value per Share of Common Stock

• Easily misunderstood

• Cannot be compared to market value due to book value reflects the application of generally accepted accounting principles and the specific accounting policies that the firm has selected

•

• Book value per share of common stock =

Common shareholders’ equity Number of shares of common stock outstanding

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Learning Objective 9

• How can common size financial statements be used to evaluate a firm’s financial position and results of operations over a number of years?

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Common Size Financial Statements

• Used when evaluating the operating results of a firm over a number of years

• Each asset, liability, and owners’ equity account is expressed as a percentage of total assets

• On the income statement, sales is set at 100%, and each item is expressed as a percentage of sales

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Use of Common Size Financial Statements

• Using percentages makes spotting trends easier

• Can compare firms of different sizes

• In horizontal analysis, several years’ financial data are stated in terms of a base year

• Each item in the base year is 100%; the items in subsequent years are a percentage of the item in the base year

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Learning Objective 10

• How can operating statistics using physical, or non-financial data, be used to help management evaluate the results of the firm’s activities?

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Other Operating Statistics

• Physical measures also are useful

• Sales in units removes hidden price changes

• Total employees may be more useful than payroll costs

• Usually analysts combine financial and physical measures to show trends and to make comparisons

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