Outline Ch 17

Chapter 17

“How Well Am I Doing?”— Financial Statement Analysis

Learning Objectives

LO1. Prepare and interpret financial statements in comparative form and common-size form. LO2. Compute and interpret financial ratios that would be most useful to a common

stockholder.LO3. Compute and interpret financial ratios that would be most useful to a short-term

creditor.LO4. Compute and interpret financial ratios that would be most useful to a long-term

creditor.

New in this Edition• The material dealing with preferred stock versus debt as a source of financial leverage has

been deleted.• The wording in the chapter has been extensively reworked to improve readability.• Many new Business Focus boxes have been added.

Chapter Overview

A. Importance of Statement Analysis. The purpose of financial statement analysis is to assist statement users in assessing the financial condition of the company.

1. Importance of comparisons. Items from financial statements are usually not particularly informative when viewed in isolation. They are informative only when viewed in comparison with the results of other periods and, in some cases, with the results of other companies. Three techniques are commonly used to make comparisons and to detect trends. These are:• Dollar and percentage changes in financial statement items.• Common-size statements.• Ratios.

2. The need to look beyond comparisons. Although comparisons provide useful information, even the best prepared comparative analysis should never be regarded as conclusive in itself. Other sources of information should be used in order to make judgments about the future and to assess the adequacy of current operations. And unanticipated future events can always make even the best financial analysis largely irrelevant.

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B. Statements in Comparative and Common-Size Form. (Exercises 17-1 and 17-7.) Two basic approaches are often used to compare financial statements between companies or between different years for the same company: horizontal (trend) analysis and vertical (common-size) analysis.

1. Horizontal Analysis; dollar and percentage changes on statements. One approach to financial statement analysis is to simply place financial statements side-by-side. Two types of comparisons can then be made.

a. Trend percentages restate a time-series of financial data in terms of a base year. Particularly when plotted against time, this approach allows the analyst to quickly gauge the rate and direction of changes.

b. The difference (increase or decrease) between two statements can be shown in separate columns in both dollar and percentage form. Showing changes in dollar form helps to zero in on key factors that have materially affected profitability or financial position. Showing changes in percentage form helps to gain a feel for how unusual the changes might be.

2. Vertical Analysis; Common-size Statements. Key changes and trends can also be highlighted by the use of common-size statements (sometimes called “vertical analysis”). A common-size statement is one that shows each item as a percentage of a total rather than in dollar form. These kinds of statements make it much easier to compare companies of different sizes and to track balance sheet and income statement relationships within a company over time as its size changes.

a. When preparing common-size statements for the balance sheet, the various items on the balance sheet are typically stated as percentages of total assets.

b. When applying common-size techniques to the income statement, all items on the income statement are usually stated as a percentage of total sales dollars.

3. Gross Margin Percentage. The gross margin percentage is defined to be the gross margin as a percentage of sales revenue.

When a common-size income statement is created, the gross margin percentage will be computed as a matter of course. However, it is important in its own right and is often computed even when a common-size income statement is not produced. Interpretation of the number can be tricky—particularly in manufacturing companies. Due to the presence of fixed costs in cost of goods sold, the gross margin percentage can be expected to improve as sales increase. This occurs because fixed manufacturing costs are spread across more units.

C. Ratio Analysis—The Common Stockholder. (Exercises 17-2, 7-5, and 17-9.) The common stockholder has a residual claim on the profits and assets of a company after all creditor and preferred stockholder claims have been satisfied.

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1. Earnings Per Share. Earnings per share is closely monitored by investment analysts. Indeed, the emphasis this figure is given by investors and hence by CEOs has been criticized for many years. In particular, there is criticism of the perceived pressure to “turn in ever-increasing quarterly earnings per share.” (Interestingly, careful capital markets studies indicate that the stock market is far less focused on short-term earnings than CEOs typically think.) At any rate, earnings per share is computed as follows:

To keep things simple in the book, the average number of common shares outstanding is assumed to be computed by simply taking the average of the number of shares at the beginning of the year and at the end of the year.

2. Price-Earnings Ratio. The relation between the market price of a share of stock and the

stock’s current earnings per share is often stated in terms of a price-earnings ratio. This ratio tends to be high in companies that have good future growth prospects. The price-earnings ratio is computed as follows:

The price-earnings ratio is widely used by investors as a general guideline in gauging stock values. If the ratio is unusually high or low for a company in relation to its industry, an analyst may suspect that the stock is overvalued or undervalued.

3. Dividend Payout Ratio. The dividend payout ratio gauges the portion of current earnings

being paid out in dividends. This ratio is computed as follows:

A high or low dividend payout ratio is neither good nor bad taken by itself. A low payout ratio may be an indication that the company has excellent internal investment opportunities and therefore foregoes paying dividends.

4. Dividend Yield Ratio. The dividend yield ratio is defined as follows:

The dividend yield ratio is primarily of interest to retirees and other stockholders who need a steady stream of cash income from their investments. Such stockholders “buy dividends” and compare dividend yields to the returns they could earn on bonds and other fixed income securities. Historically some stocks’ dividends have been so reliable that investing in the stock is believed to be almost as safe as putting money in the bank.

5. Return on Total Assets. The return on total assets is a measure of how profitably assets have been employed. It is computed as follows:

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The return on total assets attempts to measure what the return on total assets would be if the company had no long-term debt in its capital structure. The after-tax interest expense is added back to net income to eliminate the interest expense associated with debt.

6. Return on Common Stockholders’ Equity. The return on common stockholders’ equity

is a measure of the success of a company in generating income for common stockholders.

Common stockholders’ equity is stockholders’ equity less preferred stock. Average common stockholders’ equity is the average of the common stockholders’ equity at the beginning and end of the year. Net income less preferred dividends is referred to as “net income remaining for common stockholders” in the text.

7. Financial leverage. Financial leverage involves financing assets with funds that have been provided by creditors or preferred stockholders at a fixed rate of return. If assets in which the funds are invested earn a rate of return greater than the fixed rate of return required by the suppliers of the funds, then financial leverage is positive and the common stockholders benefit. The optimal capital structure of the company (that is, the optimal mix of common stock, preferred stock, and debt) continues to be an unresolved issue in finance.

8. Book Value Per Share. The book value per share measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off. The book value per share is computed as follows:

Because book values of assets can be quite out of date, this ratio is of limited use. The denominator in this ratio is the number of common shares outstanding at the end of the year rather than the average number of common shares outstanding. This is in contrast to the earnings per share computation. The reason is that the numerator in the book value per share is a balance sheet item (a stock) whereas the numerator in the earnings per share is an income statement item (a flow). With stocks, the end of year figure is used in the denominator. With flows, the average figure for the year is used in the denominator.

D. Ratio Analysis—The Short-term Creditor. (Exercises 17-3, 17-6, and 17-8.) A short-term creditor is concerned with the ability of the company to make payments on its debts. Thus, the short-term creditor is much more interested in cash flows and in working capital management than in how much accounting net income a company reports. 1. Working Capital. The excess of current assets over current liabilities is known as working

capital. A large working capital balance provides some security to short-term creditors.

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Working capital = Current assets – Current liabilities 2. Current Ratio. The current ratio is another way to express the relation between current

assets and current liabilities. It is computed as follows:

A current ratio of less than 1 may be considered unacceptable since in that case current liabilities would exceed current assets—a warning that there may soon be a cash flow problem..

3. Acid-Test Ratio. The acid-test ratio is a more rigorous test of a company’s ability to meet its short-term debts than the current ratio since it excludes less liquid current assets such as inventories and prepaid expenses. The acid-test ratio is computed as follows:

Note that “current receivables” includes any notes receivable as well as accounts receivable.

4. Accounts Receivable Turnover. Accounts receivable turnover is a measure of how

quickly accounts receivables are turned into cash. In its most intuitive form, the turnover figure is typically divided into 365 days and shown as the average number of days to collect an account (known as the average collection period). This ratio is used to evaluate credit management and account collection practices.

An increase in the accounts receivable turnover (and a decrease in the average collection period) would usually be considered favorable.

5. Inventory Turnover. The inventory turnover ratio measures how quickly inventory is converted into sales. In its most intuitive form, the average number of days required to sell inventory (the average sale period) is computed by dividing 365 days by the inventory turnover figure. This ratio is used to evaluate inventory management.

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An increase in the inventory turnover (and a decrease in the average sale period) would usually be considered favorable.

E. Ratio Analysis—The Long-term Creditor. (Exercises 17-4 and 17-8.) The long-term creditor is concerned with both the near-term and the long-term ability of a company to meet its commitments. Long-term creditors are usually protected to some degree by restrictive covenants, or rules, in loan agreements that restrict the company’s ability to take actions that are not in the best interests of the creditors. Before entering into a loan agreement, creditors very carefully examine the company’s financial condition and pay particular attention to the following two ratios. 1. Times Interest Earned. The times interest earned ratio indicates the relation between

interest payments and the earnings that are available to make those interest payments. This ratio is computed as follows:

Creditors would like to see a high times interest earned ratio. Note: Earnings before interest expense and income taxes is also referred to as “net operating income” in the text.

2. Debt-to-Equity Ratio. Long-term creditors would like a reasonable balance between the

capital provided by creditors and the capital provided by stockholders. This balance is measured by the debt-to-equity ratio:

Creditors would like the debt-to-equity ratio to be relatively low. Stockholders’ equity represents the excess of the book value of assets over the book value of liabilities. This is a safety margin for creditors and they would like this safety margin (i.e., stockholders’ equity) to be as large as possible relative to the size of the liabilities.

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Assignment Materials

Assignment TopicLevel of

DifficultySuggested

TimeExercise 17-1 Common-size income statement.........................................................Basic 15 min.Exercise 17-2 Financial ratios for common stockholders..........................................Basic 30 min.Exercise 17-3 Financial ratios for short-term creditors.............................................Basic 30 min.Exercise 17-4 Financial ratios for long-term creditors..............................................Basic 15 min.Exercise 17-5 Selected financial ratios for common stockholders............................Basic 15 min.Exercise 17-6 Selected financial measures for short-term creditors..........................Basic 15 min.Exercise 17-7 Trend percentages...............................................................................Basic 15 min.Exercise 17-8 Selected financial ratios......................................................................Basic 30 min.Exercise 17-9 Selected financial ratios for common stockholders............................Basic 20 min.Exercise 17-10 Selected financial ratios for common stockholders............................Basic 20 min.Problem 17-11 Effects of transactions on various ratios.............................................Basic 30 min.Problem 17-12 Common-size statements and financial ratios for creditors................Basic 60 min.Problem 17-13 Financial ratios for common stockholders..........................................Basic 45 min.Problem 17-14 Comprehensive ratio analysis.............................................................Medium 90 min.Problem 17-15 Common-size financial statements.....................................................Medium 30 min.Problem 17-16 Interpretation of financial ratios..........................................................Medium 30 min.Problem 17-17 Effects of transactions on various financial ratios..............................Medium 45 min.Problem 17-18 Ethics and the manager.......................................................................Difficult 45 min.Problem 17-19 Incomplete statements; analysis of ratios...........................................Difficult 60+ min.Problem 17-20 Comprehensive problem—Part I: Financial ratios for

common stockholders....................................................................Difficult 60 min.Problem 17-21 Comprehensive problem—Part II: Creditor ratios..............................Difficult 45 min.Problem 17-22 Comprehensive problem—Part III: Common-size

statements.......................................................................................Difficult 30 min.

Essential Problems: Problem 17-11, Problem 17-12 and Problem 17-13, Problem 17-14 and

Problem 17-15, Problem 17-17.Supplementary Problems: Problem 17-16, Problem 17-20 and Problem 17-21 and Problem 17-

22, Problem 17-18, Problem 17-19.

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Chapter 17Lecture Notes

Helpful Hint: Before beginning the lecture, show students the 20th segment from the third tape of the McGraw-Hill/Irwin Managerial/Cost Accounting video library. This segment introduces students to many of the concepts discussed in chapter 17. The lecture notes reinforce the concepts introduced in the video.

Chapter theme: This chapter focuses upon financial statement analysis which is used to assess the financial health of a company. It includes examining trends in key financial data, comparing financial data across companies, and analyzing financial ratios.

I. Limitations of financial statement analysis

A. Comparison of financial data

i. Differences in accounting methods between companies sometimes make it difficult to compare their financial data. For example:

1. If one company values its inventory using

the LIFO method and another uses the average cost method, then direct comparisons of financial data such as inventory valuations and cost of goods sold may be misleading.

a. Even with this limitation in mind, comparing financial ratios with other companies or industry averages can provide useful insights.

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B. The need to look beyond ratios

i. Ratios should not be viewed as an end, but rather as a starting point. They raise many questions and point to opportunities for further analysis, but they rarely answer questions by themselves.

1. In addition to ratios, other sources of data should also be considered such as industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the company itself.

Helpful Hint: Some skepticism is healthy when dealing with financial statement analysis. Reinforce the limitations of relying on financial statements by identifying events that would make the financial statements doubtful as a predictor of the future. Such an event would be a change in oil prices that occurs after the financial statements are issued. An increase in oil prices would be favorable for companies with large stocks of petroleum and unfavorable for companies that use large quantities of petroleum feedstocks in their manufacturing processes.

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II. Statements in comparative and common-size form

A. Key concept

i. An item on a balance sheet or income statement has little meaning by itself. The meaning of the number can be enhanced by drawing comparisons. This chapter discusses three such means of enabling comparisons.

1. Dollar and percentage changes on statements (horizontal analysis).

2. Common-size statements (vertical analysis).

3. Ratios.

B. Dollar and percentage changes on statements

i. Horizontal analysis (also known as trend analysis) involves analyzing financial data over time.

1. Quantifying dollar changes over time serves to highlight the changes that are the most important economically.

2. Quantifying percentage changes over time serves to highlight the changes that are the most unusual.

ii. Clover Corporation – an example

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1. Assume the comparative asset account balances from the balance sheet as shown.

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a. The dollar change in account balances is calculated as shown. Notice:

2004 serves as the base year.b. The percentage change in account

balances is calculated as shown.c. The dollar ($11,500) and percentage

(48.9%) changes in the cash account are computed as shown.

d. The dollar and percentage changes for the remaining asset accounts are as shown.

2. We could do this for the liabilities and stockholder’s equity, but instead let’s look at the income statement.

a. Assume Clover has the comparative income statement amounts as shown.

b. The dollar and percentage changes for each account are as shown. Notice:

Sales increased by 8.3% yet net income decreased by 21.9%.

There were increases in cost of goods sold (14.3%) and operating expenses (2.1%) that offset the increase in sales.

iii. Horizontal analysis can be even more useful when data from a number of years are used to compute trend percentages.

1. To compute a trend percentage, a base year is selected and the data for all years are

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stated in terms of a percentage of that base year.

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a. The equation for computing a trend percentage is as shown.

iv. Berry Products – an example

1. Assume the financial results as shown for 2001-2005. Notice:

a. The base year is 2000 and its amounts will equal 100%.

2. The 2001 results restated in trend percentages would be computed as shown.

3. The trend percentages for the remaining years would be as shown. Notice:

a. Cost of goods sold is increasing faster than sales.

4. The trend percentages can also be used to construct a graph as shown.

C. Common-size statements

i. Vertical analysis focuses on the relations among financial statement items at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.

1. In income statements, all items are usually expressed as a percentage of sales.

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a. Managers often pay close attention to the gross margin percentage, which is computed as shown.

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The gross margin percentage tends to be more stable for retailing companies because cost of goods sold excludes fixed costs.

“In Business Insights”Managers and investors pay close attention to the gross margin percentage. For example:

“Gross Margins Can Make the Difference” (page 793) After announcing a 42% increase in quarterly

profits, Dell Computer Corp.’s shares fell over 6%. Why?

According to the Wall Street Journal, investors focused on the company’s eroding profit margins. “Analysts…said that a decline in gross margins was larger than they had expected and indicated a difficult pricing environment. Gross margins fell nearly a full percentage point to 21.5% of sales, from 22.4%.”

Dell had cut its prices to increase its market share, which worked, but at the cost of lowered profitability.

2. In balance sheets, all items are usually expressed as a percentage of total assets.

3. Common-size financial statements are particularly useful when comparing data from different companies. For example:

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a. In 2002, Wendy’s net income was $219 million, whereas McDonald’s

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was $893 million. This comparison is misleading because of the different sizes of the two companies.

Wendy’s net income as a percent of sales was about 8% and McDonald’s was about 5.8%. In this light, McDonald’s performance does not compare favorably with Wendy’s.

ii. Clover Corporation – an example

1. Let’s revisit the comparative income statements as shown. Notice:

a. As previously mentioned, sales is usually the base and is expressed as 100%.

2. The cost of goods sold as a percentage of sales for 2004 (65.6%) and 2005 (69.2%) are calculated as shown.

3. The common-size percentages for the remaining items on the income statement are as shown.

Quick Check – horizontal versus vertical analysis

III. Norton Corporation – data for calculating ratios

A. We are going to examine ratios that are useful to common stockholders, short-term creditors, and long-term creditors.

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i. To facilitate our discussion, we are going to use 2004 and 2005 financial data from Norton Corporation:

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1. The asset side of Norton’s balance sheets is as shown.

2. The liabilities and stockholder’s equity side of Norton’s balance sheets is as shown.

3. Norton’s income statements are as shown.

Helpful Hint: To exercise students’ understanding of ratios, after defining each ratio, ask students whether an increase in the ratio would generally be consider good news or bad news and why.

Helpful Hint: Impress on students that the ratios discussed in this chapter cannot be analyzed in a vacuum. Comparisons with industry averages and prior years are essential as is reading the notes to the financial statements to determine management’s accounting policies.

IV. Ratio analysis – the common stockholder

A. The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholder’s equities. The information shown for Norton Corporation will be used to calculate ratios of interest to common stockholders.

i. Earnings per share

1. Earnings per share is computed as shown.a. The average number of common

shares outstanding is computed by

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adding the shares outstanding at the beginning of the year to the shares

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outstanding at the end of the year and dividing by two.

b. Investors are interested in this ratio because earnings form the basis for dividend payments and future increases in the value of shares of stock.

2. Norton Corporation’s earning per share for 2005 ($2.42) is computed as shown.

ii. Price-earnings ratio

1. The price-earnings ratio is computed as shown.

a. A higher price-earnings ratio means that investors are willing to pay a premium for a company’s stock because of its optimistic future growth prospects.

2. Norton Corporation’s price earnings ratio for 2005 (8.26 times) is computed as shown.

iii. Dividend payout ratio

1. The dividend payout ratio is computed as shown.

a. Investors who seek market price growth would like this ratio to be small, whereas investors who seek dividends prefer it to be large.

2. Norton Corporation’s dividend payout ratio for 2005 (82.6%) is computed as shown.

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iv. Dividend yield ratio

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1. The dividend yield ratio is computed as shown.

a. This ratio measures the rate of return (in the form of cash dividends only) that would be earned by an investor who buys common stock at the current market price.

2. Norton Corporation’s dividend yield ratio for 2005 (10%) is computed as shown.

v. Return on total assets

1. The return on total assets is computed as shown.

a. Adding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity.

2. Norton Corporation’s return on assets for 2005 (18.19%) is computed as shown.

vi. Return on common stockholder’s equity

1. The return on common stockholder’s equity is computed as shown.

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a. This measure indicates how well the company used the owners’ investments to earn net income.

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2. Norton Corporation’s return on common stockholder’s equity for 2005 (25.91%) is computed as shown.

“In Business Insights”Comparing return on assets and return on common stockholder’s equity across companies can be insightful. For example:

“Comparing Banks” (page 797) Deutsche Bank, the German banking giant, fares

poorly in comparisons with its global rivals. Its return on assets is only 0.26%, while its peers such as Citigroup and Credit Suisse have ratios of up to 0.92%.

Its return on equity is only 10%, whereas the return on equity of almost all of its peers is in the 14% to 16% range.

One reason for Deutsche Bank’s anemic performance is its bloated payroll. Deutsche Bank’s earnings average about $23,000 per employee. At HSBC (Hong Kong and Shanghai Banking Corporation), the figure is $32,000 per employee and at Credit Suisse it is $34,000.

vii. Financial leverage

1. Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors.

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a. Positive financial leverage exists if the rate of return on the company’s

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assets exceeds the rate of return the company pays its creditors.

In this case, having some debt in a company’s capital structure can benefit its shareholders.

b. Negative financial leverage exists if the rate of return on the company’s assets is less than the rate of return the company pays its creditors.

In this case, the common stockholder suffers by having debt in the capital structure.

Quick Check – financial leverage

viii. Book value per share

1. The book value per share is computed as shown.

a. It measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.

This measure is based entirely on historical cost.

2. Norton Corporation’s book value per share at the end of 2005 ($8.55) is computed as shown. Notice:

a. The book value per share of $8.55 does not equal the market value per share of $20. This is because the

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dividends, whereas the book value per share is based on historical cost.

V. Ratio analysis – the short-term creditor

A. Short-term creditors, such as suppliers, want to be paid on time. Therefore, they focus on the company’s cash flows and on its working capital. The information shown for Norton Corporation will be used to calculate ratios of interest to short-term creditors.

i. Working capital

1. The excess of current assets over current liabilities is known as working capital.

a. Working capital is not free. It must be financed with long-term debt and equity. Therefore, managers often seek to minimize working capital.

b. A large and growing working capital balance may not be a good sign. For example:

It could be the result of unwarranted growth in inventories.

2. Norton Corporation’s working capital ($23,000) is calculated as shown.

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ii. Current ratio

1. The current ratio is computed as shown.a. It measures a company’s short-term

debt paying ability. b. It must be interpreted with care. For

example: A declining ratio may be a sign

of deteriorating financial condition, or it might result from eliminating obsolete inventories or other stagnant current assets.

2. Norton Corporation’s current ratio of 1.55 is calculated as shown.

iii. Acid-test (quick) ratio

1. The acid-test ratio is computed as shown.a. It is a more rigorous measure of

short-term debt paying ability because it only includes cash, marketable securities, accounts receivable, and current notes receivable.

b. It measures a company’s ability to meet its obligations without having to liquidate its inventory.

2. Norton Corporation’s acid-test (quick) ratio of 1.19 is computed as shown.

a. Each dollar of liabilities should be backed by at least $1 of quick assets. Norton satisfies this condition.

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“In Business Insights”In some cases, a company may actually accumulate too much cash in the eyes of some stakeholders. For example:

“Too Much Cash?” (page 800) Microsoft has accumulated an unprecedented

hoard of cash and cash equivalents – over $49 billion at the end of fiscal year 2003 and this cash hoard is growing at the rate of about $1 billion per month.

Critics argue that Microsoft is stockpiling too much cash and they claim that the company should payout a higher dividend.

Microsoft counters that the cash hoard is necessary to fund anti-trust lawsuits and that it enables the company to pursue risky but potentially rewarding new market opportunities such as the Xbox game console.

iv. Accounts receivable turnover

1. The accounts receivable turnover is calculated as shown.

a. It measures how quickly credit sales are converted to cash.

b. Norton Corporation’s accounts receivable turnover of 26.7 times is computed as shown.

2. A related measure called the average collection period is computed as shown.

a. It measures how many days, on average, it takes to collect an accounts receivable.

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It should interpreted relative to the credit terms offered to customers.

b. Norton Corporation’s average collection period of 13.67 days is computed as shown.

v. Inventory turnover

1. The inventory turnover is computed as shown.

a. It measures how many times a company’s inventory has been sold and replaced during the year.

b. It should increase for companies that adopt just-in-time methods.

c. It should be interpreted relative to a company’s industry. For example:

Grocery stores turn their inventory over quickly, whereas jewelry stores tend to turn their inventory over slowly.

1. If a company’s inventory turnover is less than its industry average, it either has excessive inventory or the wrong sorts of inventory.

d. Norton Corporation’s inventory turnover of 12.73 times is computed as shown.

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2. A related measure called the average sale period is computed as shown.

a. It measures the number of days being taken, on average, to sell the entire inventory one time.

b. Norton Corporation’s average sale period of 28.67 days is computed as shown.

Helpful Hint: Ask students to intuitively answer what happens to the turnover ratios when accounts receivable or inventory increase. Stress that understanding the ratio is preferred to memorizing the formula.

VI. Ratio analysis – the long-term creditor

A. Long-term creditors are concerned with a company’s ability to repay its loans over the long-run. Creditors often seek protection by requiring that borrowers agree to various restrictive covenants, or rules. The information shown for Norton Corporation will be used to calculate ratios of interest to long-term creditors.

i. Times interest earned ratio

1. The times interest earned ratio is calculated as shown.

a. It is the most common measure of a company’s ability to protect its long-term creditors.

b. It is based on earnings before interest and income taxes because that is the

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amount of earnings that is available for making interest payments.

c. A ratio of less than 1 is inadequate.2. Norton Corporation’s times interest earned

ratio of 11.5 times is computed as shown.

ii. Debt-to equity ratio

1. The debt-to-equity ratio is computed as shown.

a. It indicates the relative proportions of debt and equity on a company’s balance sheet.

b. Creditors and stockholders have different views when defining the optimal debt-to-equity ratio.

Stockholders like a lot of debt if the company can take advantage of positive financial leverage.

Creditors prefer less debt and more equity because equity represents a buffer of protection.

c. In practice, debt-to-equity ratios from 0.0 to 3.0 are common.

2. Norton Corporation’s debt-to-equity ratio of 0.48 is computed as shown.

VII. Summary of ratios and sources of comparative ratio data

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A. This slide contains a listing of published sources that provide comparative ratio data organized by industry.

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Chapter 17Transparency Masters

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TM 17-1

AGENDA: FINANCIAL STATEMENT ANALYSIS

1. Comparative analysis of financial statements.

a. Trend analysis. (Horizontal analysis)

b. Common-size statements. (Vertical analysis)

2. Ratio analysis—the common stockholder

a. Earnings per share

b. Gross margin percentage

c. Price-earnings ratio

d. Dividend payout ratio

e. Dividend yield ratio

f. Return on total assets

g. Return on common stockholders’ equity

h. Book value per share

3. Ratio analysis—the short-term creditor

a. Working capital

b. Current ratio

c. Acid-test (quick) ratio

d. Accounts receivable turnover and average collection period

e. Inventory turnover and average sale period

4. Ratio analysis—the long-term creditor

a. Times interest earned ratio

b. Debt-to-equity ratio

© The McGraw-Hill Companies, Inc., 2006. All rights reserved.

TM 17-2

FINANCIAL STATEMENT ANALYSIS

Few figures on financial statements have much significance by themselves. The relationship of one figure to another and the amounts and directions of changes are important.

Several techniques are commonly used to help analyze financial statements:

• Dollar and percentage changes.

• Common-size statements.

• Ratios.

Trend Percentages

Trend percentages state several years’ financial data in terms of a base year.

EXAMPLE: Translate the following data into trend percentages, using Year 1 as the base year. (All dollar amounts are in thousands.)

Year 4 Year 3 Year 2 Year 1Sales....................... $650 $600 $550 $500Accounts receivable $70 $52 $44 $40

These data in trend percentage form would be:

Year 4 Year 3 Year 2Year

1Sales....................... 130% 120% 110% * 100%Accounts receivable 175% 130% 110% 100%* $550 ÷ $500 = 110%, and so forth.


TM 17-3

COMPARATIVE STATEMENTS

EXAMPLE: Comparative financial statements covering the last two years for Molin Company follow (dollar amounts are in thousands).

Comparative Statements of Financial Position

This Last Change

Year YearAmoun

tPerce

ntAssetsCurrent assets:

Cash........................................... $ 90 $ 300$ (210

) (70.0)Accounts receivable................... 800 500 300 60.0 Inventory................................... 1,400 900 500 55.6 Prepaid expenses...................... 60 60 0 0.0

Total current assets..................... 2,350 1,760 590 33.5 Plant and equipment, net............. 2,650 2,240 410 18.3

Total assets..................................$5,00

0$4,00

0 $1,000 25.0

Liabilities and Stockholders’ Equity

Liabilities:

Current liabilities.......................$1,40

0 $ 750 $ 650 86.7 Bonds payable, 10%.................. 600 600 0 0.0

Total liabilities.............................. 2,000 1,350 650 48.1 Stockholders’ equity:

Preferred stock, $25 par, 7.5%. . 400 400 0 0.0 Common stock, $10 par............. 500 500 0 0.0 Retained earnings...................... 2,100 1,750 350 20.0

Total stockholders’ equity............ 3,000 2,650 350 13.2 Total liabilities and stockholders’

equity........................................$5,00

0$4,00

0 $1,000 25.0


TM 17-4

COMPARATIVE STATEMENTS (cont’d)

Comparative Income Statements

This Last Change

Year Year AmountPercen

tSales..................................... $9,000 $8,000 $1,000 12.5Cost of goods sold................. 5,930 5,100 830 16.3Gross margin......................... 3,070 2,900 170 5.9Less operating expenses....... 2,160 2,040 120 5.9Net operating income............ 910 860 50 5.8Less interest expense........... 60 60 0 0.0Net income before taxes....... 850 800 50 6.3Less income taxes (40%)...... 340 320 20 6.3Net income............................ $ 510 $ 480 $ 30 6.3

Comparative Retained Earnings Statements

This Last Change

Year Year AmountPerce

ntRetained earnings,

beginning............................ $1,750 $1,420 $330 23.2Add net income..................... 510 480 30 6.3Total...................................... 2,260 1,900 360 18.9Deduct dividends paid:

Preferred stock.................... 30 30 0 0.0Common stock.................... 130 120 10 8.3

Total dividends...................... 160 150 10 6.7Retained earnings, end......... $2,100 $1,750 $350 20.0


TM 17-5

COMMON-SIZE STATEMENTS

Common-size financial statements restate all items as a percentage of total assets (balance sheet) or of sales (income statement).

Common-Size Statements of Financial Position(Balance sheet items are stated as a percentage of Total Assets)

Common-SizePercentages

This Last This LastYear Year Year Year

AssetsCurrent assets:

Cash......................................... $ 90 $ 300 1.8 7.5Accounts receivable................. 800 500 16.0 12.5Inventory.................................. 1,400 900 28.0 22.5Prepaid expenses..................... 60 60 1.2 1.5

Total current assets.................... 2,350 1,760 47.0 44.0Plant and equipment, net........... 2,650 2,240 53.0 56.0

Total assets................................$5,00

0 $4,000 100.0 100.0

Liabilities and Stockholders’ EquityLiabilities:

Current liabilities......................$1,40

0 $ 750 28.0 18.8Bonds payable, 10%................ 600 600 12.0 15.0

Total liabilities............................ 2,000 1,350 40.0 33.8Stockholders’ equity:

Preferred stock, $25 par, 7.5% 400 400 8.0 10.0Common stock, $10 par........... 500 500 10.0 12.5Retained earnings.................... 2,100 1,750 42.0 43.7

Total stockholders’ equity.......... 3,000 2,650 60.0 66.2 Total liabilities and

stockholders’ equity.................$5,00

0 $4,000 100.0 100.0


TM 17-6

COMMON-SIZE STATEMENTS (cont’d)

Common-Size Income Statements(All income statement items are stated as a percentage of

Sales.)

Common-Size Percentages

This Last This LastYear Year Year Year

Sales................................... $9,000 $8,000 100.0 100.0Cost of goods sold.............. 5,930 5,100 65.9 63.7 Gross margin...................... 3,070 2,900 34.1 36.3Less operating expenses.... 2,160 2,040 24.0 25.5 Net operating income......... 910 860 10.1 10.8Less interest expense......... 60 60 0.7 0.8 Net income before taxes.... 850 800 9.4 10.0Less income taxes (40%). . . 340 320 3.8 4.0 Net income......................... $ 510 $ 480 5.7 6.0

Gross Margin Percentage

The gross margin percentage is often monitored by managers and investment analysts. It is computed as follows:

For this year, the gross margin percentage was:


TM 17-7

RATIO ANALYSIS—THE COMMON STOCKHOLDER

Earnings Per Share

Earnings per share (EPS) refers to the earnings that are available to the owners of common stock after preferred dividends have been paid. Earnings per share is defined as follows:

To compute Molin Company’s EPS, first determine the average common shares that were outstanding during the year. To do this, we examine how many shares were outstanding at the beginning of the year and at the end of the year. In this case, this can be determined by looking at the balance sheets.

This Year

Last Year

Common stock ($000)......... $500 $500÷ Par value per share......... $10 $10= Shares outstanding (000) 50 50

Average common shares outstanding = (50 + 50)/2 = 50

This Year Last Year


TM 17-8

Price-Earnings Ratio

The relation between the market price of a share of stock and the stock’s current earnings per share is often stated in terms of a price-earnings ratio. Assume that Molin Company’s stock is now selling for $72 per share and that last year it sold for $63 per share.

This Year Last Year

Dividend Payout Ratio

The dividend payout ratio shows what portion of current earnings were paid out as dividends to common stockholders. The dividend this year was $2.60 per share ($130 thousand ÷ 50 thousand shares), and last year it was $2.40 per share ($120 thousand ÷ 50 thousand shares).

This Year Last Year

There is no “right” dividend payout ratio, although companies in the same industry tend to have similar dividend payout ratios.


TM 17-9

Dividend Yield Ratio

The dividend yield ratio measures the cash return being provided by a stock.

This Year Last Year

A low dividend payout ratio and a low dividend yield ratio indicate that the company is retaining its earnings for internal reinvestment.

Return On Total Assets

The return on total assets is a measure of how well assets have been employed by management. Assume that total assets in Molin Company were $3,200,000 at the beginning of last year.

This Year Last Year

By adding interest expense back to net income, the return on assets is not influenced by the way in which the assets were financed.


TM 17-10

Return On Common Stockholders’ Equity

Common stockholders’ equity consists of total stockholders’ equity less preferred stock. Common stockholders’ equity in Molin Company was $1,920,000 at the beginning of last year.

This Year Last Year

Since the return on common stockholders’ equity is greater than the return on total assets, financial leverage is positive in both years.

Book Value Per Share

Book value per share shows the amount of common stockholders’ equity per share of common stock.

This Year Last Year


TM 17-11

RATIO ANALYSIS—THE SHORT-TERM CREDITOR

Working Capital

The excess of current assets over current liabilities is known as working capital. Molin Company’s working capital is:

This Year

Last Year

Current assets........ $2,350 $1,760Current liabilities.... 1,400 750 Working capital...... $ 950 $1,010

Working capital is viewed as a cushion of protection for short-term creditors.

Current Ratio

The relation between current assets and current liabilities can also be expressed in terms of the current ratio:

This Year Last Year

A declining current ratio may be a sign of a deteriorating financial condition.


TM 17-12

Acid-Test Ratio

The acid-test ratio (or quick ratio) provides a more rigorous test than the current ratio of a company’s ability to settle its short-term liabilities.

This Year Last Year

Accounts Receivable Turnover

The accounts receivable turnover indicates how quickly accounts receivables are collected. Assume that the accounts receivable balance was $300 thousand at the beginning of last year.

This Year Last Year


TM 17-13

Inventory Turnover

The inventory turnover ratio measures how quickly inventory is converted into sales. Assume that Molin Company’s inventory balance was $700 thousand at the beginning of last year.

This Year Last Year


TM 17-14

RATIO ANALYSIS—THE LONG-TERM CREDITOR

Times Interest Earned

The times interest earned ratio is a widely used measure of the ability of a company’s operations to provide protection for long-term creditors.

This Year Last Year

Debt-To-Equity Ratio

The debt-to-equity ratio measures the amount of assets being provided by creditors for each dollar of assets being provided by owners.

This Year Last Year

There is no “right” amount of debt for a company to carry. Since different industries face different risks, the level of debt that is appropriate will vary from industry to industry.


Outline Ch 17

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