GITMAN Chapter 2 Financial Statement Analysis

Chapter 2

Financial Statements and Analysis

Learning Goals

1. Review the contents of the stockholders’ report and the procedures for consolidating international financial statements.

2. Understand who uses financial ratios, and how.

3. Use ratios to analyze a firm’s liquidity and activity.

4. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt.

Learning Goals (cont.)

5. Use ratios to analyze a firm’s profitability and market value.

6. Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis.

The Four Key Financial Statements: The Income Statement

• The income statement provides a financial summary of a company’s 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

Table 2.1 Bartlett Company Income Statements ($000)

The Four Key Financial Statements: The Balance Sheet

• The balance sheet presents a summary of a firm’s 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.

Table 2.2a Bartlett Company Balance Sheets ($000)

The Four Key Financial Statements (cont.)

Table 2.2b Bartlett Company Balance Sheets ($000)

The Four Key Financial Statements: Statement of Retained Earnings

• The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.

Table 2.3 Bartlett Company Statement of Retained Earnings ($000) for the Year Ended December 31, 2009

The Four Key Financial Statements: Statement of Cash Flows

• The 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 company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

Table 2.4 Bartlett Company Statement of Cash Flows ($000) for the Year Ended December 31, 2009

Using Financial Ratios: Interested Parties

• Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance.

• It is of interest to shareholders, creditors, and the firm’s own management.

Using Financial Ratios: Types of Ratio Comparisons

• Trend or time-series analysis

• Cross-sectional analysis

* Industry comparative analysis

* Benchmarking

* Combined

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

Table 2.5 Industry Average Ratios for Selected Lines of Businessa

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

Figure 2.1 Combined Analysis

Using Financial Ratios: Cautions for Doing Ratio Analysis

1. Ratios must be considered together; a single ratio by itself means relatively little.

2. Financial statements that are being compared should be dated at the same point in time.

3. Use audited financial statements when possible.4. The financial data being compared should have been

developed in the same way.5. Be wary of inflation distortions.

Ratio Analysis Example

• We 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.

Current ratio = total current assets

total current liabilities

Current ratio = $1,233,000 = 1.97

$620,000

Ratio Analysis

• Liquidity Ratios– Current Ratio

Quick ratio = Total Current Assets - Inventory

total current liabilities

Quick ratio = $1,233,000 - $289,000 = 1.51

$620,000

Ratio Analysis (cont.)

• Liquidity Ratios– Current Ratio– Quick Ratio

Inventory Turnover = Cost of Goods Sold

Inventory

Inventory Turnover = $2,088,000 = 7.2

$289,000

• Liquidity Ratios• Activity Ratios

– Inventory Turnover

Average Age of Inventory = 365

Inventory Turnover

Inventory Turnover = 365 = 50.7 days

– Average Age of Inventory

ACP = Accounts Receivable

Net Sales/365

ACP = $503,000 = 59.7 days

$3,074,000/365

– Average Collection Period

APP = Accounts Payable

Annual Purchases/365

APP = $382,000 = 95.4 days (.70 x $2,088,000)/365

– Average Payment Period

Total Asset Turnover = Net Sales

Total Assets

Total Asset Turnover = $3,074,000 = .85

$3,597,000

– Total Asset Turnover

Table 2.6 Financial Statements Associated with Patty’s Alternatives

Debt Ratio = Total Liabilities/Total Assets

Debt Ratio = $1,643,000/$3,597,000 = 45.7%

• Liquidity Ratios• Activity Ratios• Financial Leverage Ratios

– Debt Ratio

Times Interest Earned = EBIT/Interest

Times Interest Earned = $418,000/$93,000 = 4.5

• Liquidity Ratios• Activity Ratios• Leverage Ratios

– Times Interest Earned Ratio

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)]}

• Liquidity Ratios• Activity Ratios• Leverage Ratios

– Fixed-Payment coverage Ratio (FPCR)

• Liquidity Ratios

• Activity Ratios

• Leverage Ratios

• Profitability Ratios– Common-Size Income Statements

Table 2.7 Bartlett Company Common-Size Income Statements

GPM = Gross Profit/Net Sales

GPM = $986,000/$3,074,000 = 32.1%

• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios

– Gross Profit Margin

OPM = EBIT/Net Sales

OPM = $418,000/$3,074,000 = 13.6%

– Operating Profit Margin (OPM)

NPM = Earnings Available to Common Stockholders

NPM = $221,000/$3,074,000 = 7.2%

– Net Profit Margin (NPM)

EPS = Earnings Available to Common Stockholders Number of Shares Outstanding

EPS = $221,000/76,262 = $2.90

– Earnings Per Share (EPS)

ROA = Earnings Available to Common Stockholders

Total Assets

ROA = $221,000/$3,597,000 = 6.1%

– Return on Total Assets (ROA)

ROE = $221,000/$1,754,000 = 12.6%

ROE = Earnings Available to Common Stockholders

Total Equity

– Return on Equity (ROE)

P/E = Market Price Per Share of Common Stock Earnings Per Share

P/E = $32.25/$2.90 = 11.1

• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios• Market Ratios

– Price Earnings (P/E) Ratio

BV/Share = Common Stock Equity Number of Shares of Common Stock

BV/Share = $1,754,000/72,262 = $23.00

– Market/Book (M/B) Ratio

M/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common Stock

M/B Ratio = $32.25/$23.00 = 1.40

– Market/Book (M/B) Ratio

Summarizing All Ratios Table 2.8 Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)

Summarizing All Ratios (cont.)Table 2.8 Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)

DuPont System of Analysis

• The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition.

• It merges the income statement and balance sheet into two summary measures of profitability.

• The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:

• ROA and ROE as shown in the series of equations on the following slide and in Figure 2.2 on the following slide.

DuPont System of Analysis

DuPont System of Analysis (cont.)

Figure 2.2 DuPont System of Analysis

ROE = 6.1% X 2.06 = 12.6%

Modified DuPont Formula (cont.)

• Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner’s return.

• Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the Modified DuPont formula yields:

GITMAN Chapter 2 Financial Statement Analysis

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