Financial Statement Analysis

1
Financial Statement Analysis

• Chapter 18

2
Objectives

• Perform horizontal analysis of comparative
  financial statements
• Perform vertical analysis of financial statements
• Prepare and use common size financial statements
• Compute the standard financial ratios
• Measure economic value added

3
The Annual ReportUsually Contains ...

• Presidents letter to the Stockholders
• Management Discussion and Analysis of the
  financial statements
• Financial Statements
• Notes to the Financial Statements
• a summary of accounting methods used
• An Auditors Report
• Comparative Financial Data for 5 to 10 years

4
Horizontal Analysis

• Interested in the percent change
• Step 1 Figure the dollar amount change from the
  base period to the later period.
• Step 2 Divide the dollar amount of change by
  the base amount to get a percent change.

5
Horizontal 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
2005 2004 Difference Sales 41,500
37,850 3,650
3,650 37,850 .0964, or 9.6
6
Trend Percentages...

• are computed by selecting a base year whose
  amounts are set equal to 100.
• The amounts of each following year are expressed
  as a percentage of the base amount.

Trend Any year Base year
7
Trend Percentages

• Year 2005 2004 2003
• Revenues 27,611 24,215 21,718
• Cost of sales 15,318 14,709 13,049
• Gross profit 12,293 9,506 8,669
• 2003 is the base year.

What are the trend percentages?
8
Trend Percentages

• Year 2005 2004 2003
• Revenues
• Cost of sales
• Gross profit

These percentages were calculated by dividing
each item by the base year.
9
Vertical Analysis...

• compares each item in a financial statement to a
  base number set to 100.
• Every item on the financial statement is then
  reported as a percentage of that base.

each financial stmt item
base number
10
Vertical Analysis
2005 Revenues 38,303
100.0 Cost of sales 19,688 51.4 Gross
profit 18,615 48.6 Total operating
expenses 13,209 34.5 Operating
income 5,406 14.1 Other income
2,187 5.7 Income before taxes
7,593 19.8 Income taxes 2,827
7.4 Net income 4,766 12.4
11
Vertical Analysis
Assets 2005 Current
assets Cash 1,816
4.7 Receivables net 10,438
26.9 Inventories 6,151 15.9 Prepaid
expenses 3,526 9.1 Total current
assets 21,931 56.6 Plant and equipment,
net 6,847 17.7 Other assets
9,997 25.7 Total assets 38,775 100.0
12
Vertical Analysis
Liabilities 2005 Current
liabilities Accounts Payable 2,055
5.3 Other current liab 13,455
34.7 Total current liab 15,510
40.0 Long term liab 10,624 27.4 Total
liabilities 26,134 67.4 Owners
Equity Capital 12,641
32.6 Total Liabilities OE 38,775 100.0
13
Common-size Statements

• On the income statement, each item is expressed
  as a percentage of net sales.
• On the balance sheet, the common size is the
  total on each side of the accounting equation.
• Common-size statements are used to compare one
  company to other companies, and to the industry
  average.

14
Benchmarking
Percent of Net Sales
MCI
Lucent Technologies
? Cost of goods sold ? Operating expenses ?
Income tax ? Net income
15
Ratio Classification

• Measuring ability to pay current liabilities
• Measuring ability to sell inventory and collect
  receivables
• Measuring ability to pay short-term and long-term
  debt
• Measuring profitability
• Analyzing stock as an investment

16
Palisades Furniture Example
Net sales (Year 2005) 858,000 Cost of goods
sold 513,000 Gross profit 345,000
Total operating expenses 244,000 Operating
income 101,000 Interest revenue
4,000 Interest expense (24,000) Income
before taxes 81,000 Income taxes
33,000 Net income 48,000
17
Palisades Furniture Example
Assets 20x5 20x4 Current
assets Cash 29,000
32,000 Receivables net 114,000
85,000 Inventories 113,000
111,000 Prepaid expenses 6,000
8,000 Total current assets 262,000 236,000 Lo
ng-term investments 18,000
9,000 Plant and equipment, net 507,000
399,000 Total assets 787,000 644,000
18
Palisades Furniture Example
Liabilities 20x5 20x4 Current
liabilities Notes payable 42,000
27,000 Accounts payable 73,000
68,000 Accrued liabilities 27,000
31,000 Total current liabilities 142,000 126,0
00 Long-term debt 289,000 198,000 Total
liabilities 431,000 324,000
19
Palisades Furniture Example
Stockholders Equity 20x5
20x4 Common stock, no par 186,000 186,000 Ret
ained earnings 170,000 134,000 Total
stockholders equity 356,000 320,000 Total
liabilities and stockholders equity 787,000
644,000
20
Measuring Ability toPay Current Liabilities
The current ratio measures the companys ability
to pay current liabilities with current assets.
Current ratio Total current assets Total
current liabilities
21
Measuring Ability toPay Current Liabilities

• Palisades current ratio
• 20x4
• 20x5
• The industry average is 1.50.
• The current ratio decreased slightly during
  20x5.

22
Measuring Ability toPay Current Liabilities
The acid-test ratio shows the companys ability
to pay all current liabilities if they come due
immediately.
Acid-test ratio (Cash Short-term
investments Net current receivables) Total
current liabilities
23
Measuring Ability toPay Current Liabilities

• Palisades acid-test ratio
• 20x4
• 20x5
• The industry average is .40.
• The companys acid-test ratio improved
  considerably during 20x5.

24
Measuring Ability toSell Inventory
Inventory turnover is a measure of the number of
times the average level of inventory is sold
during a year.
Inventory turnover Cost of goods sold Average
inventory
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Measuring Ability toSell Inventory

• Palisades inventory turnover
• 20x5
• The industry average is 3.4.
• A high number indicates an ability to quickly
  sell inventory.

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Measuring Ability toCollect Receivables
Accounts receivable turnover measures a
companys ability to collect cash from credit
customers.
Accounts receivable turnover Net credit sales
Average accounts receivable
27
Measuring Ability toCollect Receivables

• Palisades accounts receivable turnover
• 20x5
• The industry average is 51 times.
• Palisades receivable turnover is much lower than
  the industry average.
• The company is a home-town store that sells to
  local people who tend to pay their bills over a
  lengthy period of time.

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Measuring Ability toCollect Receivables
Days sales in receivable ratio measures how many
days sales remain in Accounts Receivable.
One days sales Net sales 365 days
Days sales in Accounts Receivable Average net
Accounts Receivable One days sales
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Measuring Ability toCollect Receivables

• Palisades days sales in Accounts Receivable for
  20x5
• One days sales
• Days sales in Accounts Receivable
• The industry average is 7 days.

30
Measuring Ability toPay Debt
The debt ratio indicates the proportion of assets
financed with debt.
Total liabilities Total assets
31
Measuring Ability toPay Debt

• Palisades debt ratio
• 20x4
• 20x5
• The industry average is 0.64.
• Palisades Furniture expanded operations during
  20x5 by financing through borrowing.

32
Measuring Ability toPay Debt
Times-interest-earned ratio measures the number
of times operating income can cover interest
expense.
Times-interest-earned Income from operations
Interest expense
33
Measuring Ability toPay Debt

• Palisades times-interest-earned ratio
• 20x4
• 20x5
• The industry average is 2.80.
• The companys times-interest-earned ratio
  increased in 20x5.
• This is a favorable sign.

34
Measuring Profitability
Rate of return on net sales shows the
percentage of each sales dollar earned as net
income.
Rate of return on net sales Net income Net
sales
35
Measuring Profitability

• Palisades rate of return on sales
• 20x4
• 20x5
• The industry average is 0.008.
• The increase is significant in itself and also
  because it is much better than the industry
  average.

36
Measuring Profitability
Rate of return on total assets measures how
profitably a company uses its assets.
Rate of return on total assets (Net income
interest expense) Average total assets
37
Measuring Profitability

• Palisades rate of return on total assets
  for 20x5
• The industry average is 0.078.
• How does Palisades compare to the industry?

38
Measuring Profitability
Common equity includes additional paid-in capital
on common stock and retained earnings.
Rate of return on common stockholders equity
(Net income preferred dividends) Average
common stockholders equity
39
Measuring Profitability

• Palisades rate of return on common stockholders
  equity for 20x5
• The industry average is 0.121.
• Why is this ratio larger than the return on total
  assets (.101)?

40
Measuring Profitability
Earnings per share of common stock (Net income
Preferred dividends) Number of shares of
common stock outstanding
41
Measuring Profitability

• Palisades earnings per share
• 20x4
• 20x5
• This large increase in EPS is considered very
  unusual.

42
Analyzing Stock as an Investment

• Price/earning ratio is the ratio of market price
  per share to earnings per share.
• 20x4
• 20x5
• Given Palisades Furnitures 20x5 P/E ratio of
  ____, we would say that the companys stock is
  selling at ____ times earnings.

43
Analyzing Stock as an Investment
Dividend yield shows the percentage of a stocks
market value returned as dividends to
stockholders each period.
Dividend per share of common (or preferred) stock
Market price per share of common (or preferred)
stock
44
Analyzing Stock as an Investment

• Dividend yield on Palisades common stock
• 20x4
• 20x5
• An investor who buys Palisades Furniture common
  stock for 60 can expect to receive ___ of the
  investment annually in the form of cash dividends.

45
Analyzing Stock as an Investment
Book value per share of common stock (Total
stockholders equity Preferred equity) Number
of shares of common stock outstanding
46
Analyzing Stock as an Investment

• Book value per share of Palisades common stock
• 20x4
• 20x5
• Book value bears no relationship to market value.

47
Limitations of Financial Analysis

• Business decisions are made in a world of
  uncertainty.
• No single ratio or one-year figure should be
  relied upon to provide an assessment of a
  companys performance.

48
Economic Value Added (EVA)

• Economic value added (EVA) combines accounting
  income and corporate finance to measure whether
  the companys operations have increased
  stockholder wealth.
• EVA Net income Interest expense Capital
  charge
• Capital charge (notes pay. bonds pay.
  stockholders equity) x cost of capital

49
Red Flags

• Earnings Problems
• Decreased Cash Flow
• Too Much Debt
• Inability to Collect Receivables
• Buildup of Inventory
• Strange Movements of Sales, Inventories, and
  Receivables

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Review

• Horizontal Analysis
• Trend Percentages
• Vertical Analysis
• Common Size Statement
• Benchmarking
• Ratio Analysis
• Other Evaluation Tools