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Financial Statement Financial Statement AnalysisAnalysis

Chapter Chapter 1818

ObjectivesObjectives Perform horizontal analysis of Perform horizontal analysis of

comparative financial statementscomparative financial statements Perform vertical analysis of financial Perform vertical analysis of financial

statementsstatements Prepare and use common size Prepare and use common size

financial statementsfinancial statements Compute the standard financial ratiosCompute the standard financial ratios Measure economic value addedMeasure economic value added

The Annual ReportThe Annual ReportUsually Contains ...Usually Contains ...

− President’s letter to the StockholdersPresident’s letter to the Stockholders– Management Discussion and Analysis of Management Discussion and Analysis of

the financial statementsthe financial statements− Financial StatementsFinancial Statements– Notes to the Financial StatementsNotes to the Financial Statements

– a summary of accounting methods useda summary of accounting methods used– An Auditor’s ReportAn Auditor’s Report– Comparative Financial Data for 5 to 10 Comparative Financial Data for 5 to 10

yearsyears

Horizontal AnalysisHorizontal Analysis

Interested in the percent changeInterested in the percent change Step 1: Figure the dollar amount Step 1: Figure the dollar amount

change from the base period to the change from the base period to the later period.later period.

Step 2: Divide the dollar amount of Step 2: Divide the dollar amount of change by the base amount to get change by the base amount to get a percent change.a percent change.

2005 2004 DifferenceSales $41,500 $37,850 $3,650

$3,650 ÷ $37,850 = .0964, or 9.6%

Horizontal AnalysisHorizontal Analysis

Increase/(Decrease) 2005 2004 Amount Percent

Sales $41,500 $37,850 $3,650 9.6%Expenses 40,000 36,900 3,100 8.4%Net income 1,500 950 550 57.9%

Trend Trend Percentages...Percentages...

……are computed by selecting a base year are computed by selecting a base year whose amounts are set equal to 100%.whose amounts are set equal to 100%.

The amounts of each following year The amounts of each following year are expressed as a percentage of the are expressed as a percentage of the base amount.base amount.

Trend % = Any year $ ÷ Base year $

YearYear 2005 2004 2005 2004 2003 2003RevenuesRevenues $27,611$27,611 $24,215$24,215

$21,718$21,718Cost of salesCost of sales 15,318 15,318 14,709 14,709

13,04913,049Gross profitGross profit $12,293$12,293 $ 9,506$ 9,506 $ $

8,6698,6692003 is the base year.2003 is the base year.

What are the trend percentages?

Trend Trend PercentagesPercentages

YearYear 20052005 20042004 2003 2003RevenuesRevenues % % % % % %Cost of salesCost of sales % % % % % %Gross profitGross profit % % % % % %

Trend Trend PercentagesPercentages

These percentages were calculated bydividing each item by the base year.

Vertical Analysis...Vertical Analysis...

……compares each item in a financial compares each item in a financial statement to a base number set to statement to a base number set to 100%.100%.

Every item on the financial Every item on the financial statement is then reported as a statement is then reported as a percentage of that base.percentage of that base.

% = each financial stmt item base number

Vertical AnalysisVertical Analysis

2005 %Revenues $38,303 100.0Cost of sales 19,688 51.4Gross profit $18,615 48.6Total operating expenses 13,209 34.5Operating income $ 5,406 14.1Other income 2,187 5.7Income before taxes $ 7,593 19.8Income taxes 2,827 7.4Net income $ 4,766 12.4


Assets 2005 %Current assets:Cash $ 1,816 4.7Receivables net 10,438 26.9Inventories 6,151 15.9Prepaid expenses 3,526 9.1Total current assets $21,931 56.6Plant and equipment, net 6,847 17.7Other assets 9,997 25.7Total assets $38,775 100.0


Liabilities 2005 %Current liabilities:Accounts Payable $ 2,055 5.3Other current liab 13,455 34.7Total current liab 15,510 40.0Long term liab 10,624 27.4Total liabilities 26,134 67.4

Owner’s Equity Capital 12,641 32.6Total Liabilities & OE $38,775 100.0

Common-size Common-size StatementsStatements

On the income statement, each item is On the income statement, each item is expressed as a percentage of net sales.expressed as a percentage of net sales.

On the balance sheet, the common size On the balance sheet, the common size is the total on each side of the is the total on each side of the accounting equation.accounting equation.

Common-size statements are used to Common-size statements are used to compare one company to other compare one company to other companies, and to the industry companies, and to the industry average.average.

BenchmarkinBenchmarkingg

43.0%

38.2%

8.0%

10.8%

51.4%

28.8%

7.4%

12.4%

Percent of Net Sales

MCILucent Technologies

Cost of goods sold Operating expenses Income tax Net income

Ratio ClassificationRatio Classification

1 Measuring ability to pay current Measuring ability to pay current liabilitiesliabilities

2 Measuring ability to sell inventory and Measuring ability to sell inventory and collect receivablescollect receivables

3 Measuring ability to pay short-term Measuring ability to pay short-term and long-term debtand long-term debt

4 Measuring profitabilityMeasuring profitability5 Analyzing stock as an investmentAnalyzing stock as an investment

Palisades Furniture Palisades Furniture ExampleExample

Net sales (Year 2005) $858,000Cost of goods sold 513,000Gross profit $345,000Total operating expenses 244,000Operating income $101,000Interest revenue 4,000Interest expense (24,000)Income before taxes $ 81,000Income taxes 33,000Net income $ 48,000


Assets 20x5 20x4Current assets:Cash $ 29,000 $ 32,000Receivables net 114,000 85,000Inventories 113,000 111,000Prepaid expenses 6,000 8,000Total current assets $262,000 $236,000Long-term investments 18,000 9,000Plant and equipment, net 507,000 399,000Total assets $787,000 $644,000


Liabilities 20x5 20x4Current liabilities:Notes payable $ 42,000 $ 27,000Accounts payable 73,000 68,000Accrued liabilities 27,000 31,000Total current liabilities $142,000 $126,000Long-term debt 289,000 198,000Total liabilities $431,000 $324,000

Stockholders’ Equity 20x5 20x4Common stock, no par $186,000 $186,000Retained earnings 170,000 134,000Total stockholders’ equity $356,000 $320,000

Total liabilities andstockholders’ equity $787,000 $644,000


Current ratio =Total current assets ÷ Total current liabilities

The current ratio measuresthe company’s ability to pay

current liabilities with current assets.

Measuring Ability toMeasuring Ability toPay Current Pay Current LiabilitiesLiabilities

Measuring Ability Measuring Ability toto

Pay Current Pay Current LiabilitiesLiabilities

Palisades’ current ratio:Palisades’ current ratio: 20x4: 20x4: 20x5: 20x5: The industry average is 1.50.The industry average is 1.50. The current ratio decreased slightly The current ratio decreased slightly

during 20x5. during 20x5.

Acid-test ratio =(Cash + Short-term investments

+ Net current receivables)÷ Total current liabilities


The acid-test ratio shows the company’sability to pay all current liabilities

if they come due immediately.


Palisades’ acid-test ratio:Palisades’ acid-test ratio: 20x4: 20x4: 20x5: 20x5: The industry average is .40.The industry average is .40. The company’s acid-test ratio The company’s acid-test ratio

improved considerably during improved considerably during 20x5.20x5.

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.


Sell InventorySell Inventory


Sell InventorySell Inventory Palisades’ inventory turnover:Palisades’ inventory turnover: 20x5:20x5: The industry average is 3.4.The industry average is 3.4. A high number indicates an ability to A high number indicates an ability to

quickly sell inventory.quickly sell inventory.

Accounts receivable turnover =Net credit sales ÷ Average accounts receivable

Accounts receivable turnover measures a company’sability to collect cash from credit customers.


Collect ReceivablesCollect Receivables


Collect Collect ReceivablesReceivables

Palisades’ accounts receivable Palisades’ accounts receivable turnover:turnover:

20x5:20x5: The industry average is 51 times.The industry average is 51 times. Palisades’ receivable turnover is much Palisades’ receivable turnover is much

lower than the industry average.lower than the industry average. The company is a home-town store that The company is a home-town store that

sells to local people who tend to pay sells to local people who tend to pay their bills over a lengthy period of time.their bills over a lengthy period of time.

One day’s sales = Net sales ÷ 365 days

Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales


Collect Collect ReceivablesReceivables

Days’ sales in receivable ratio measures howmany day’s sales remain in Accounts Receivable.


Collect ReceivablesCollect Receivables Palisades’ days’ sales in Accounts Palisades’ days’ sales in Accounts

Receivable for 20x5:Receivable for 20x5: One day’s sales:One day’s sales:

Days’ sales in Accounts Receivable:Days’ sales in Accounts Receivable:

The industry average is 7 days.The industry average is 7 days.

Total liabilities ÷ Total assets


Pay DebtPay Debt

The debt ratio indicates the proportionof assets financed with debt.


Pay DebtPay Debt Palisades’ debt ratio:Palisades’ debt ratio: 20x4: 20x4: 20x5: 20x5: The industry average is 0.64.The industry average is 0.64. Palisades Furniture expanded Palisades Furniture expanded

operations during 20x5 by financing operations during 20x5 by financing through borrowing.through borrowing.

Times-interest-earned= Income from operations

÷ Interest expense

Measuring Ability toMeasuring Ability toPay DebtPay Debt

Times-interest-earned ratiomeasures the number of times

operating income can cover interest expense.


Pay DebtPay Debt Palisades’ times-interest-earned ratio:Palisades’ times-interest-earned ratio: 20x4: 20x4: 20x5:20x5: The industry average is 2.80.The industry average is 2.80. The company’s times-interest-earned The company’s times-interest-earned

ratio increased in 20x5.ratio increased in 20x5. This is a favorable sign.This is a favorable sign.

Rate of return on net sales =Net income ÷ Net sales

Measuring ProfitabilityMeasuring Profitability

Rate of return on net sales shows the percentageof each sales dollar earned as net income.


Palisades’ rate of return on sales:Palisades’ rate of return on sales: 20x4:20x4: 20x5:20x5: The industry average is 0.008.The industry average is 0.008. The increase is significant in itself The increase is significant in itself

and also because it is much better and also because it is much better than the industry average.than the industry average.

Rate of return on total assets = (Net income + interest expense) ÷ Average total assets


Rate of return on total assets measureshow profitably a company uses its assets.


Palisades’ rate of return on total Palisades’ rate of return on total assets for 20x5:assets for 20x5:

The industry average is 0.078.The industry average is 0.078. How does Palisades compare to the How does Palisades compare to the

industry?industry?

Rate of return on common stockholders’ equity= (Net income – preferred dividends)

÷ Average common stockholders’ equity


Common equity includes additionalpaid-in capital on commonstock and retained earnings.


Palisades’ rate of return on common Palisades’ rate of return on common stockholders’ equity for 20x5:stockholders’ equity for 20x5:

The industry average is 0.121.The industry average is 0.121. Why is this ratio larger than the Why is this ratio larger than the

return on total assets (.101)?return on total assets (.101)?


Earnings per share of common stock= (Net income – Preferred dividends)

÷ Number of shares of common stock outstanding


Palisades’ earnings per share:Palisades’ earnings per share: 20x4: 20x4: 20x5: 20x5: This large increase in EPS is This large increase in EPS is

considered very unusual.considered very unusual.

Analyzing Stock as an Analyzing Stock as an InvestmentInvestment

Price/earning ratio is the ratio of market Price/earning ratio is the ratio of market price per share to earnings per share.price per share to earnings per share.

20x4:20x4: 20x5:20x5: Given Palisades Furniture’s 20x5 P/E Given Palisades Furniture’s 20x5 P/E

ratio of ____, we would say that the ratio of ____, we would say that the company’s stock is selling at ____ times company’s stock is selling at ____ times earnings.earnings.

Dividend per share of common(or preferred) stock ÷ Market price per share

of common (or preferred) stock


Dividend yield shows the percentageof a stock’s market value returned as

dividends to stockholders each period.


Dividend yield on Palisades’ common Dividend yield on Palisades’ common stock:stock:

20x4:20x4: 20x5:20x5: An investor who buys Palisades Furniture An investor who buys Palisades Furniture

common stock for $60 can expect to common stock for $60 can expect to receive ___% of the investment annually receive ___% of the investment annually in the form of cash dividends.in the form of cash dividends.


Book value per share of common stock= (Total stockholders’ equity – Preferred equity)

÷ Number of shares of common stock outstanding


Book value per share of Palisades’ Book value per share of Palisades’ common stock:common stock:

20x4:20x4: 20x5:20x5: Book value bears no relationship to Book value bears no relationship to

market value.market value.

Limitations of Financial Limitations of Financial AnalysisAnalysis

Business decisions are made in a Business decisions are made in a world of uncertainty.world of uncertainty.

No single ratio or one-year figure No single ratio or one-year figure should be relied upon to provide an should be relied upon to provide an assessment of a company’s assessment of a company’s performance.performance.

Economic Value Added Economic Value Added (EVA®)(EVA®)

Economic value added Economic value added (EVA®)(EVA®) combines accounting income and combines accounting income and corporate finance to measure corporate finance to measure whether the company’s operations whether the company’s operations have increased stockholder wealth.have increased stockholder wealth.

EVA® EVA® = Net income + Interest = Net income + Interest expense – Capital chargeexpense – Capital charge

Capital charge = (notes pay. + bonds Capital charge = (notes pay. + bonds pay. + stockholders’ equity) x cost of pay. + stockholders’ equity) x cost of capitalcapital

Red FlagsRed Flags

Earnings ProblemsEarnings Problems Decreased Cash FlowDecreased Cash Flow Too Much DebtToo Much Debt Inability to Collect ReceivablesInability to Collect Receivables Buildup of InventoryBuildup of Inventory Strange Movements of Sales, Strange Movements of Sales,

Inventories, and ReceivablesInventories, and Receivables

ReviewReview Horizontal AnalysisHorizontal Analysis Trend PercentagesTrend Percentages Vertical AnalysisVertical Analysis Common Size StatementCommon Size Statement BenchmarkingBenchmarking Ratio AnalysisRatio Analysis Other Evaluation ToolsOther Evaluation Tools

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Economy & Finance

total assets

total liabilities oe

vertical analysis liabilities

accrued liabilities

total operating expenses

base year

operating income

vertical analysis assets