Ch. 15 Financial Statement Analysis

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Ch. 15 Financial Statement Analysis

• Acct. 220, jpaquette

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Chapter 15 Learning Objectives

• Objectives(2) and Standards(3) and Sources (3) of
  Financial Statement analysis
• Comparative analysis (3)
• Ratio analysis (5)
• Limitations. . . .

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Objectives of FS Analysis

• Forensic. . . Assessment of Past Performance and
  Current position
• Future. . . Assessment of Future potential and
  related Risk

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Standards of FS Analysis

• Rule of thumb measures- use with caution
• Past performance of the company
• Industry norms, http//biz.yahoo.com/finance
• Difficulties in comparing
• Troubles with conglomerates
• Variations in Accounting procedures

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Sources

• Inside the company
• Outside the company
• Really outside the company

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Financial Statement Analysis

• Three basic tools are used in financial
  statement analysis
• 1. Horizontal analysis
• 2. Vertical analysis
• 3. Ratio analysis

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Horizontal Analysis

• Looking at the Trends
• In or
• From the base year

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Horizontal Analysis of a Balance Sheet

• KELLOGG COMPANY, INC.
• Condensed Balance Sheets
• December 31
• (In millions)
• Increase (Decrease)
• during 1998
  1998 1997 Amount Percent
• Assets
• Current Assets 1,496.5 1,467.7 28.8
  2.0
• Plant assets 2,888.8 2,773.3 115.5
  4.2
• Other assets 666.2 636.6 27.6
  4.6
• Total assets 5,051.5 4,877.6 173.9
  3.6

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Horizontal Analysis of a Balance Sheet
Increase (Decrease)
during 1998
1998 1997 Amount
Percent Liabilities and Stockholders'
Equity Current liabilities 1,718.5 1,657.3
61.2 3.7 Long-term liabilities
2,443.2 2,222.8 220.4 9.9 Total
liabilities 4,161.7 3,880.1 281.6
7.3 Stockholders' equity Common stock
208.8 196.3 12.5 6.4 Retained
earnings and other 1,075.3
958.5 116.8 12.2 Treasury stock
(394.3) (157.3) 237.0 (150.7) Total
stockholders' equity 889.8
997.5 (107.7) (10.8) Total liabilities and
stockholders' equity 5,051.5 4,877.6 173.9
3.6
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KELLOGG COMPANY, INC. Condensed Income
Statement For the Years Ended December 31 (In
millions)
Increase
(Decrease)
during 1998 1998 1997
Amount Percent Net sales 6,762.1 6,830.1
(68.0) (1.0) Cost of goods sold
3,282.6 3,270.1 12.5 0.4 Gross
profit 3,479.5 3,560.0
(80.5) (2.3) Selling Admin.
2,513.9 2,366.8 147.1 6.2 Nonrecurring
charges 70.5 184.1 (113.6)
(61.7) Income from operations 895.1
1,009.1 (114.0) (11.3) Interest expense
119.5 108.3 11.2 10.3 Other
income (expense), net 6.9
3.7 3.2 86.5 Income before taxes
782.5 904.5 (122.0) (13.5) Income
tax expense 279.9 340.5
(60.6) (17.8) Net income 502.6 564.0
(61.4) (10.9)
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What does it tell you?

• BALANCE SHEET
• What changed and in what direction?
• How was it financed?
• INCOME STATEMENT
• Are sales increasing?
• Are costs following sales? (growth, decline)

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Trend Analysis

• Same as Horizontal Analysis
• Year-to-year-to-year
• With the same base year
• 1996 compared to 1995
• 1997 compared to 1995
• 1998 compared to 1995

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Horizontal Analysis

• KELLOGG COMPANY
• Net Sales (in millions)
• Base Period 1994
• 1998 1997 1996 1995 1994
• 6,762.1 6,830.1 6,676.6 7,003.7 6,562.0

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Horizontal Analysis

• CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT
• BASE-YEAR AMOUNT
• 7,003.7 - 6,562.0 6.7
• 6,562.0
• Net sales for Kellogg company increased
  approximately 6.7 from 1994 to 1995.

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Percentage Change in Sales

• The percentage change in sales for each of the
  5 years, assuming 1994 as the base period is
• Kellogg Company
• Net Sales (in millions)
  Base Period 1994
• 1998 1997 1996 1995 1994
• 6,762.1 6,830.1 6,676.6 7,003.7 6,562.0
• 103.0 104.1 101.7 106.7 100.0

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What does it tell you?

• Tracks changes over time
• Tracks changes in one area (sales) compared to
  other areas (net income)

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Vertical Analysis

• Common size analysis
• What is your basis?
• Balance Sheet Total Assets
• Income Statement Net Sales (net revenues)

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• KELLOGG COMPANY, INC.
• Condensed Balance Sheets
• December 31
• (In millions)
• 1998
  1997 Assets
  Amount Percent Amount Percent
• Current Assets 1,496.5 29.6
  1,467.7 30.1
• Plant assets 2,888.8 57.2
  2,733.3 56.9
• Other assets 666.2 13.2
  636.6 13.0
• Total assets 5,051.5 100.0
  4,877.6 100.0

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KELLOGG COMPANY, INC. Condensed Balance
Sheets December 31 (In millions)

• 
  1998 1997
• Liabilities and Amount Percent
  Amount Percent
• Stockholders' Equity
• Current liabilities 1,718.5
  34.0 1,657.3 34.0
• Long-term liabilities 2,443.2
  48.4 2,222.8 45.5
• Total liabilities 4,161.7
  82.4 3,880.1 79.5
• Stockholders' equity
• Common stock 208 8
  4.1 196.3 4.0
• Retained earnings
• and other 1,075.3
  21.3 958.5 19.7
• Treasury stock (394.3) (
  7.8) (157.3) (3.2)
• Total stockholders'
• equity 889.8 17.6
  997.5 20.5
• Total liabilities and
• stockholders' equity 5,051.5
  100.0 4,877.6 100.0

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KELLOGG COMPANY, INC. Condensed Income
Statement For the Years Ended December 31 (In
millions)
1998 1997
Amount Percent Amount
Percent Net sales 6,762.1
100.0 6,830.1 100.0 Cost of goods
sold 3,282.6 48.6 3,270.1
47.9 Gross profit 3,479.5 51.4
3,560.0 52.1 Selling Admin.
2,513.9 37.2 2,366.8
34.6 Nonrecurring Chgs 70.5 1.0
184.1 2.7 Income operations
895.1 13.2 1,009.1
14.8 Interest expense 119.5
1.8 108.3 1.6 Other income
(expense),net 6.9 0.1
3.7 0.1 Income before income
taxes 782.5 11.5
904.5 13.3 Income tax expense 279.9
4.1 340.5 5.0 Net income
502.6 7.4
564.0 8.3
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Condensed Income StatementsFor the Year Ended
December 31,1998(in millions)

• The Quaker
• Kellogg Company, Inc. Oats Company
• Amount Percent Amount Percent
• Net sales 6,762.1 100.0 4,842.5
  100.0
• Cost of goods sold 3,282.6 48.6
  2,374.4 49.0
• Gross profit 3,479.5 51.4
  2,468.1 51.0
• Selling and administrative
• expenses 2,513.9 37.2
  1,872.5 38.7
• Nonrecurring charges 70.5 1.0
  128.5 2.6
• Income from operations 895.1 13.2
  467.1 9.7
• Other expenses and
• revenues (including
• income taxes) 392.5 5.8
  182.6 3.8
• Net income 502.6 7.4
  284.5 5.9

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What does it tell you?

• Relative size of things on the statement. . .
  .Over time
• Allows comparisons between companies

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Limitations Of Financial Analysis

• Estimates
• Cost
• Alternative Accounting
• Methods
• Atypical Data
• Diversification

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Estimates

• Financial statements are based on estimates.
• allowance for uncollectible accounts
• depreciation
• costs of warranties
• contingent losses
• To the extent that these estimates are
  inaccurate, the financial ratios and percentages
  are also inaccurate.

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Cost

• Traditional financial statements are based on
  historical cost and are not adjusted for price
  level changes.
• Comparisons of unadjusted financial data from
  different periods may be rendered invalid by
  significant inflation or deflation.

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Alternative Accounting Methods

• One company may use the FIFO method, while
  another company in the same industry may use
  LIFO.
• If the inventory is significant for both
  companies, it is unlikely that their current
  ratios are comparable.
• In addition to differences in inventory costing
  methods, differences also exist in reporting such
  items as depreciation, depletion, and
  amortization.

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Atypical Data

• Fiscal year-end data may not be typical of a
  company's financial condition during the year.

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Diversification

• Diversification in American industry also limits
  the usefulness of financial analysis.
• Many firms are so diverse they cannot be
  classified by industry.

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Ratio Analysis

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Ratios

• Types
• Liquidity ratios
• Solvency ratios
• Profitability ratios
• Adequacy of Flow
• Market Strength
• Can provide clues to underlying conditions that
  may not be apparent from an inspection of the
  individual components.
• Single ratio by itself is not very meaningful

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RATIO Analysis Galore!
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Liquidity Ratios

• Measure the short-term ability of the enterprise
  to pay its maturing obligations and to meet
  unexpected needs for cash.
• WHO CARES?
• Short-term creditors such as bankers and
  suppliers

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Liquidity Ratios

• Current ratio
• Acid-test ratio
• Current cash debt coverage ratio
• Receivables turnover ratio
• Average collection period
• Inventory turnover
• Average days in inventory

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Current Ratio

• Indicates short-term debt-paying ability

Current Assets Current Liabilities
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Acid-Test Ratio

• Indicates immediate short-term debt-paying
  ability

Cash Short-term Investments Net
Receivable Current
Liabilities
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Current Cash Debt Coverage Ratio

• Indicates short-term debt-paying ability (cash
  basis)
• Cash provided by operations Average
  current liabilities

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Receivables Turnover Ratio

• Indicates liquidity of receivables
• Net Credit Sales
• Average Net Receivables

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Average Collection Period

• Indicates liquidity of receivables and
  collection success
• 365 days
• Receivables Ratio Turnover

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Inventory Turnover Ratio
Indicates liquidity of inventory Cost of Goods
Sold Average Inventory
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Average Days in Inventory

• Indicates liquidity of inventory and inventory
  management
• 365 days
• Inventory Turnover Ratio

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Solvency Ratios

• Measure the ability of the enterprise to survive
  over a long period of time
• WHO CARES?
• Long-term creditors and stockholders

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Solvency Ratios

• Debt to total assets ratio
• Times interest earned ratio
• Cash debt coverage ratio
• Free cash flow

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Debt to Total Assets Ratio

• Indicates of total assets provided by creditors

Total Liabilities Total Assets
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Times Interest Earned Ratio

• Indicates companys ability to meet interest
  payments as they come due

Interest Before Interest Expense Income
Tax Interest Expense
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Cash Debt Coverage Ratio

• Indicates long-term debt-paying ability (cash
  basis)
• Cash provided by operations
• Average total liabilities

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Free Cash Flow

• Indicates cash available for paying dividends
  or expanding operations
• Cash Provided By Operations
• - Capital Expenditures
• - Dividends Paid
• Free Cash Flow

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Profitability Ratios

• Measure the income or operating success of an
  enterprise for a given period of time
• WHO CARES? Everybody
• WHY? A companys income affects
• its ability to obtain debt and equity financing
• its liquidity position
• its ability to grow

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Profitability Ratios

• Return on common stockholders equity ratio
• Return on assets ratio
• Profit margin ratio
• Assets turnover ratio
• Gross profit rate
• Operating expenses to sales ratio
• Cash return on sales ratio
• Earnings per share (EPS)
• Price-earnings ratio
• Payout ratio

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Relationships Among Profitability Measures
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Return on Common Stockholders Equity Ratio

• Indicates profitability of common stockholders
  investment
• Net income -preferred stock dividends
• Average common stockholders equity

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Return On Assets Ratio

• Reveals the amount of net income generated by
  each dollar invested

Net income Average total assets
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Profit Margin Ratio

• Indicates net income generated by each dollar of
  sales

Net income Net sales
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Asset Turnover Ratio

• Indicates how efficiently assets are used to
  generate sales
• Net sales
• Average total assets

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Gross Profit Rate

• Indicates margin between selling price and cost
  of good sold
• Gross profit
• Net sales

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Operating Expensesto Sales Ratio

• Indicates the cost incurred to support each
  dollar of sales
• Operating expenses
• Net sales

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Cash Return on Sales Ratio

• Indicates net cash flow generated by each
  dollar of sales

Cash provided by operations Net sales
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Earnings Per Share (EPS)

• Indicates net income earned on each share of
  common stock sales

Income available to common stockholders Average
number of outstanding common shares
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Price Earnings Ratio

• Indicates relationship between market price
  per share and earnings per share

Stock Price Earnings Per Share
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Payout Ratio

• Indicates of earnings distributed in the
  form of cash dividends

Cash Dividends Net Income
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Comparative Analysis

• Any item reported in a financial statement has
  significance
• Its inclusion indicates that the item exists at a
  given time and in a certain quantity.
• For example, when Kellogg Company reports 136.4
  million on its balance sheet as cash, we know
  that Kellogg did have cash and that the quantity
  was 136.4 million.

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Comparative Analysis

• Whether the amount represents an increase over
  prior years, or whether it is adequate in
  relation to the company's needs, cannot be
  determined from the amount alone.
• The amount must be compared with other financial
  data to provide more information.

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Comparative Analysis

• There are three types of comparisons to provide
  decision usefulness of financial information
• Intracompany basis
• Intercompany basis
• Industry averages

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Intracompany Basis

• Comparisons within a company are often useful to
  detect changes in financial relationships and
  significant trends.
• A comparison of Kellogg's current year's cash
  amount with the prior year's cash amount shows
  either an increase or a decrease.
• A comparison of Kellogg's year-end cash amount
  with the amount of total assets at year-end shows
  the proportion of total assets in the form of
  cash.

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Intercompany Basis

• Comparisons with other companies provide insight
  into a company's competitive position.
• Kellogg's total sales for the year can be
  compared with the total sales of its competitors
  such as Quaker Oats and General Mills.

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Industry Averages

• Comparisons with industry averages provide
  information about a company's relative position
  within the industry.
• Kellogg's financial data can be compared with the
  averages for its industry compiled by financial
  ratings organizations such as Dun Bradstreet,
  Moody's, and Standard Poor's.