Chapter 18

CHAPTER 18

FINANCIAL STATEMENT ANALYSIS

CHAPTER 18

FINANCIAL STATEMENT ANALYSIS

F/S are historical data But we need estimated future data to make decisions However, we can start with historical data

actual and crediblecompiled by mgtaudited by independent CPA’smonitored by SECreviewed by investment analysts

So F/S provide actual numbers to benchmark to:PY’s; internal budgets; other companies,

Objectives of Financial Statement Analysis

Analyzing financial statements involves a Company’s

LiquidityProfitabilitySolvency.

Comparisons can be made on several difference bases

intracompany basisindustry averagesintercompany basis.

BASICS OF FINANCIAL STATEMENT ANALYSIS

BASICS OF FINANCIAL STATEMENT ANALYSIS

1 Horizontal analysis (trend analysis) evaluates a series of financial statement data over a period of time.

2 Vertical analysis evaluates financial statement data expressing each item in a financial statement as a percent of a base amount.

3 Ratio analysis expresses the relationship among selected items of financial statement data.

TOOLS OF FINANCIAL STATEMENT ANALYSIS

TOOLS OF FINANCIAL STATEMENT ANALYSIS

HORIZONTAL ANALYSIS –BALANCE SHEETS

HORIZONTAL ANALYSIS –BALANCE SHEETS

HORIZONTAL ANALYSIS – INCOME STATEMENTSHORIZONTAL ANALYSIS – INCOME STATEMENTS

HORIZONTAL ANALYSIS - RETAINED EARNINGS STATEMENTS

HORIZONTAL ANALYSIS - RETAINED EARNINGS STATEMENTS

VERTICAL ANALYSIS - BALANCE SHEETS

VERTICAL ANALYSIS - BALANCE SHEETS

VERTICAL ANALYSIS - INCOME STATEMENTSVERTICAL ANALYSIS - INCOME STATEMENTS

FINANCIAL RATIO CLASSIFICATIONSFINANCIAL RATIO CLASSIFICATIONS

Liquidity Ratios

Measures of short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash

Profitability Ratios

Measures of the income or operating success of an enterprise for a given period of time

Solvency Ratios

Measures of the ability of the enterprise to survive over a long period of time

(1) CURRENT RATIO(1) CURRENT RATIO

Current Assets Current Liabilities

CURRENT ASSETS OF QUALITY DEPARTMENT STORE

CURRENT ASSETS OF QUALITY DEPARTMENT STORE

(2) ACID-TEST RATIO(2) ACID-TEST RATIO

Quick Assets* Current Liabilities

* = Cash, Mkt Sec, A/R

(3) Receivables Turnover

Net Credit Sales

Average Net Receivables

2007 2006

2,097,000

(180,000 + 230,000) / 2 = 10.2x

1,837,000

(200,000 + 180,000) /2 = 9.7x

Industry average 10.8x

(4) Inventory Turnover

Cost of Good Sold

Average Inventory

2007 2006

1,281,000

(500,000 + 620,000) / 2 = 2.3x

1,140,000

(450,000 + 500,000) /2 = 2.4x

Industry average 6.7x

(5) PROFIT MARGIN RATIO(5) PROFIT MARGIN RATIO

Net Income Net Sales

(6) Asset Turnover

2007 2006

2,097,000

(1,595,000 + 1,835,000) / 2 = 1.2

1,837,000

(1,446,000 +1,595,000) /2 = 1.1

Industry Average = 2.34x

Net SalesAverage Assets

Measure of efficiency of assets to produce sales

(7) Return on Assets

2007 2006

263,800

(1,595,000 + 1,835,000) / 2 = 15.4

208,500

(1,446,000 +1,595,000) /2 = 13.7

Industry average 8.29

Guideline 10%

Net IncomeAverage Assets

(8) RETURN ON COMMON STOCKHOLDERS’ EQUITY(8) RETURN ON COMMON STOCKHOLDERS’ EQUITY

2007 2006 $263,800 $208,500 ——————————— = 29.3% ——————————— = 28.5% $795,000 + $1,003,000 $667,000 + $795,000 ——————————— ——————————— 2 2

[ ] [ ]

Net Income

Ave. Com. SH Equity

Guideline > 15%

(9) EARNINGS PER SHARE(9) EARNINGS PER SHARE

Net Income Wtd Ave Com. Shares

O/S

2007 2006

$263,800 $208,500————————— = $9.67 ————— = $7.72 27,000 + 27,540 27,000————————— 2

[ ]No Guideline – compare to PY – if >, it’s ok, drives stock market up and down.

(10) PRICE-EARNINGS RATIO

(10) PRICE-EARNINGS RATIO

MV per Share C/S

Earnings per Share

2007 2006

$145 $ 93——— = 15.0 times ——— = 12 times$ 9.67 7.72

Industry average————————

18 times

(11) PAYOUT RATIO(11) PAYOUT RATIO

Cash Dividends Net Income

Industry average————————

14.5%

(12) Debt to Total Assets Ratio

Total DebtTotal DebtTotal AssetsTotal Assets

20072007 20062006

832,000832,000 = 45.30 = 45.30 800,000800,000 = 50.20 = 50.201,835,000 1,595,000 1,835,000 1,595,000

Industry AverageIndustry Average38.0038.00

(13) TIMES INTEREST EARNED

(13) TIMES INTEREST EARNED

Income Before Income Tx & Int Exp Interest Expense

2007 2006

$468,000 $388,000———— = 13 times ———— = 9.6 times $36,000 $40,500

(14) GROSS PROFIT RATIO(14) GROSS PROFIT RATIO

Gross Profit

Net Sales2007 2006

$816,000 $697,000———— = 38.90% ———— = 37.92%

2,097,000 1,837,000

(15) OPERATING EXPENSE RATIO

(15) OPERATING EXPENSE RATIO

Operating Expenses (S,G&A) Net Sales

2007 2006

$357,000 $320,000———— = 17.02% ———— = 17.42%

2,097,000 1,837,000

11 Estimates: Estimates: Financial statements contain numerous estimatesFinancial statements contain numerous estimates22 Cost: Cost: Traditional financial statements are based on cost Traditional financial statements are based on cost and are not and are not adjusted for price-level changes. adjusted for price-level changes. 33 Alternative Accounting Methods Alternative Accounting Methods Variations among companies in the Variations among companies in the application of application of GAAPGAAP may hamper comparability. may hamper comparability. 44 Atypical Data Atypical Data Fiscal year-end data may not be typical of the financial Fiscal year-end data may not be typical of the financial condition during the year. condition during the year. 55..Diversification of Firms Diversification of Firms Diversification in industryDiversification in industry restricts usefulness of restricts usefulness of financial analysis. financial analysis.

LIMITATIONS OF FINANCIAL ANALYSIS

LIMITATIONS OF FINANCIAL ANALYSIS

Irregular Items

“Irregular” items are separately identified on the income statement:

1. Discontinued operations

2. Extraordinary items

These items are added to NI and EPS (but separately disclosed)

I nterest expense (21,000) Total other (4,000)

I ncome bef ore taxes 79,000 I ncome tax expense 24,000 I ncome from continuing operations 55,000

Discontinued operations:

Loss from operations, net of tax 315

Loss on disposal, net of tax 189

Total loss on discontinued operations 504

I ncome before extraordinary item 54,496

Extraordinary loss, net of tax 539

Net income 53,957$

I ncome Statement (in thousands)

Sales 285,000$

Cost of goods sold 149,000

Reporting when both Reporting when both

Discontinued Discontinued

Operations and Operations and

Extraordinary Items Extraordinary Items

are present. are present.

Discontinued OperationsDiscontinued Operations

Extraordinary ItemExtraordinary Item

LO 6 Understand the concept of earning power, and how irregular items are presented.

Earning Power and Irregular ItemsEarning Power and Irregular ItemsEarning Power and Irregular ItemsEarning Power and Irregular Items

Change in Accounting Principle

Occurs when the principle used in the current year is different from the one used in the preceding year.

Accounting rules permit a change if justified.

Changes are reported retroactively.

Example would include a change in inventory costing method such as FIFO to average cost.

Extraordinary ItemsExtraordinary ItemsExtraordinary ItemsExtraordinary Items

Companies have incentives to manage income to meet or beat Wall Street expectations, so that

the market price of stock increases and

the value of stock options increase.

A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements.

Quality of EarningsQuality of EarningsQuality of EarningsQuality of Earnings

LO 7 Understand the concept of quality of earnings.

Alternative Accounting Methods

Variations among companies in the application of GAAP may hamper comparability and reduce quality of earnings.

Quality of EarningsQuality of EarningsQuality of EarningsQuality of Earnings

LO 7 Understand the concept of quality of earnings.

Pro Forma Income

Pro forma income usually excludes items that the company thinks are unusual or nonrecurring.

Some companies have abused the flexibility that pro forma numbers allow.

Improper Recognition

Some managers have felt pressure to continually increase earnings and have manipulated the earnings numbers to meet these expectations.

Abuses include:

Improper recognition of revenue (channel stuffing).

Improper capitalization of operating expenses (WorldCom).

Failure to report all liabilities (Enron).

Quality of EarningsQuality of EarningsQuality of EarningsQuality of Earnings