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Chapter 13Financial Statement Analysis
Using Financial Accounting Information: The Alternative to Debits and Credits, 6th
byGary A. Porter and Curtis L. Norton
Copyright © 2009 South-Western, a part of Cengage Learning.
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Stockholders
Financial Statement Analysis
Creditors
Management
Will I be paid?
How good is our investment? How are we
performing?
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LIFO FIFO
Limitations of Financial Statement Analysis
Use of different accounting methods Changes in accounting methods
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Limitations of Financial Statement Analysis
Failure to understand trends or use industry ratios
Difficulty of making industry comparisons (i.e., conglomerates)????
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Limitations of Financial Statement Analysis
Nonoperating items on income statement
Effects of inflation
=
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Horizontal Analysis
Net SalesGross ProfitNet Earnings
Increase (Decrease)
2002 2001 DollarsPercent
$2,746 $2,401 $345 14.4 %
1,596 1,404 192 13.7 402 363 39 10.7
Wm. Wrigley Jr. Company (in millions)
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Trend Analysis
Return onAvg. Equity
2002 2001 2000 19991998
28.7% 30.1% 29.0% 26.8%28.4%
Wm. Wrigley Jr. Company
Tracking items over a series of years
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Vertical Analysis
Common-size statements recast items as a percentage of a selected item
Allows comparisons of companies of different size
Compares percentages across years to identify trends
%
%
%
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Dollars Percent$24,000 100.0% 18,000 75.0$ 6,000 25.0% 3,000 12.5$ 3,000 12.5% 140 0.6$ 2,860 11.9% 1,140 4.8$ 1,720 7.1%
Common-Size Statements
Sales revenueCost of goods sold Gross profitSelling & admin. exp. Operating incomeInterest expense Income before taxIncome tax expense Net income
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Liquidity Analysis
Nearness to cash Ability to pay debts as they become due
CashRatios
TurnoverRatios
WorkingCapitalRatios
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Current Ratio
Measure of short-term financial health Consider composition of current assets
Rule of thumb2:1
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Acid-Test (Quick) Ratio
Stricter test of ability to pay debts Excludes inventories and prepaid assets
Quick AssetsCurrent Liabilities
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Accounts Receivable Turnover Ratio
Net Sales
Average Accounts Receivable
Indicates how quickly a company is collecting (i.e.,
turning over) its receivables
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Accounts Receivable Turnover Ratio
Too fast
Credit policies too stringent; may be losing sales
Too slow
Credit department not operating effectively; possible quality problems
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Number of Days’ Sales in Receivables
Represents the average # of days accounts are outstanding
365 Days . Accts. Receivable Turnover
*Some analysts use 360 days.
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Number of Days’ Sales in Receivables
If this company’s credit terms are net 30, what would this tell you about the efficiency
of the collection process?
365 Days4.8 Times = 76 days
Example:
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Inventory Turnover Ratio
Represents the number of times per period inventory is turned
over (i.e., sold).
Cost of Goods SoldAverage Inventory
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Inventory Turnover Ratio
Circuit City 5.8 times per yearSafeway 9.2 times per year
Can you compare the two ratios?
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# of Days’ Sales in Inventory
Represents the average # of days inventory is on hand before it’s sold
365 DaysInventory Turnover Ratio
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 28 29 30 3127
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# of Days’ Sales in Inventory
Circuit City 62 days
Safeway 39 days
Do these averages seem reasonable?
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 28 29 30 3127
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Solvency Analysis
Ability to stay in business over the long-term
Debt-to-EquityRatio
DebtService
Coverage
TimesInterestEarned
Cash Flowto Capital
Expenditures
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Debt-to-Equity Ratio
Total Liabilities Total Stockholders’ Equity
How much have creditors
contributed compared to
owners?
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Debt-to-Equity Ratio
Total LiabilitiesTotal Stockholders’ Equity = .60
For every dollar contributed by
owners, creditors have loaned $.60
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Times Interest Earned Ratio
Measures ability to meet current interest payments
The greater the coverage the better
Net Income + Interest Exp. + Income Tax Exp. (EBIT)Interest Expense
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Profitability Analysis
Profit Margin % Gross Margin % Rate of Return on Assets Return on Common S/E EPS P/E Ratio Dividend Ratios
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Profit Margin %
Net Income/Net Sales
Shows how much profit is being earned per dollar of sales
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Gross Margin %
Gross Margin/Net Sales
(Gross Margin = Net Sales – COGS)
Shows the mark up % on goods sold
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Return on Assets Ratio
Measures return to all providers of capital (creditors and owners)
Net IncomeAverage Total Assets
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Return on Common Stockholders’ Equity
Net Income - Preferred DividendsAverage Common Stockholders’ Equity
The owners earned 15%on their investment
in ABC Co... Not bad!
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Earnings per Share
Presents profits on a per-share basis
Net Income - Preferred DividendsWeighted Avg. # of Common Shares Outstanding
Certificate of Stock
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Price/Earnings Ratio
Relates earnings to the market price of the stock
Current Market PriceEarnings per Share
very high P/Every low P/E
possibly overvaluedpossibly undervalued
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Dividend Payout Ratio
Common Dividends per ShareEarnings per Share
We need to decide what % of the firm’s income we can return to
owners.
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Appendix
Accounting Tools:
Non-Operating Income Statement Items (DEC)
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Common Characteristics
All such items are reported after income from continuing operations
Shown net of tax effects Most analysts ignore these items,
since they are not likely to reoccur
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Discontinued Operations
Any gain or loss from disposal of a division or segment of the business
Any net income or loss from operating this portion until the date of disposal
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Extraordinary Items
Gain or loss due to an event that is Unusual in nature AND Infrequent in occurrence
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Cumulative Effect of a Change in Accounting Principle
Reflects a change in a company’s accounting principles, practices, or methods
Reports the difference in income in all prior years between the old method and the new method
Sometimes such a change is dictated by new accounting standards
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Key Points Summary for Ch. 13• Why Analyze Financial Information?
•To make decisions – Ratios are tools of decision making
• Limitations of Financial Analysis:
• Different accounting methods
• Difficulty of making comparisons (conglomerates)
• Inflation/Non-operating income items
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Key Points Summary for Ch. 13• Horizontal/Trend Analysis: Year-to-year
• Vertical Analysis: Within one year
• Liquidity Analysis: Ability of company to operate in short-term
• Current Ratio = Current Assets/Current Liabilities
Ability of Co. to pay short-term debt
• Quick Ratio = Quick Assets/Current Liabilities
Ability of Co. to pay short-term debt (stricter)
(Quick Assets = Cash + A/R + ST investments)
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Key Points Summary for Ch. 13• Liquidity Analysis (cont’d)
• A/R Turnover = Credit Sales/Avg. A/R
# of times Co. collects A/R during year
• Days’ Sales in Receivables = 365/ A/R Turnover
Avg. collection period for receivables
• Inventory Turnover = COGS/Avg. Inventory
# of times Inventory is sold during year
•Days’ Sales in Inventory = 365/ Inv. Turnover
Avg. days to sell inventory
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Key Points Summary for Ch. 13• Solvency Analysis: Long-term ability of company to
stay in business
• Debt-to-Equity Ratio = Total Liab./Total Equity
Borrowing vs. Investments by owner
•Times Interest Earned = Net Income + Interest Exp. + Income Tax Exp. (EBIT)
Interest Expense
How many times over could Co. pay interest with current earnings
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Key Points Summary for Ch. 13
• Profitability Ratios: Ability of company to generate profits
• Profit margin % = Net Income/Net Sales
How much profit per $1 of sales
•Gross margin % = Gross Margin/Net Sales
Mark up on product sales
•Return on Assets = Net Income/Avg. Assets
Effectivess of Company at using assets
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Key Points Summary for Ch. 13
• Profitability Ratios (cont’d):
•Return on Common Equity = Net Income – Preferred Dividends/Common Stockholders’ Equity
Measures return on investment
•Earnings Per Share = Net Income/Avg Shares
Earnings amount per share of stock
• Non-operating Income Statement Items: DEC
