Financial Statement Analysis

1
Chapter 13

• Financial Statement Analysis

Financial Accounting, Alternate 4e by Porter and
Norton
2
Financial Statement Analysis
Creditors
Stockholders
Management
3
Limitations of Financial Statement Analysis

• Use of different accounting methods
• Changes in accounting methods

LIFO
FIFO
4
Limitations of Financial Statement Analysis

• Failure to understand trends or use industry
  ratios
• Difficulty of making industry comparisons (i.e.,
  conglomerates)

5
Limitations of Financial Statement Analysis

• Nonoperating items on income statement
• Effects of inflation

6
Horizontal Analysis
Wm. Wrigley Jr. Company (in millions)

• Increase (Decrease)
• 2002 2001 Dollars Percent
• 2,746 2,401 345 14.4
• 1,596 1,404 192 13.7
• 402 363 39 10.7

• Net Sales
• Gross Profit
• Net Earnings

7
Trend Analysis
Wm. Wrigley Jr. Company

• 2002 2001 2000 1999 1998
• 28.7 30.1 29.0 26.8 28.4

• Return on
• Avg. Equity

Tracking items over a series of years
8
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

9
Common-Size Statements
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

• Sales revenue
• Cost of goods sold
• Gross profit
• Selling admin. exp.
• Operating income
• Interest expense
• Income before tax
• Income tax expense
• Net income

10
Liquidity Analysis

• Nearness to cash
• Ability to pay debts as they become due

11
Working Capital

• Excess of current assets over current liabilities
• Lacks meaningful comparisons for companies of
  different size

-
12
Current Ratio

• Measure of short-term financial health
• Consider composition of current assets

Rule of thumb 21
13
Acid-Test (Quick) Ratio

• Stricter test of ability to pay debts
• Excludes inventories and prepaid assets

Quick Assets Current Liabilities
14
Cash Flow from Operations to Current Liabilities
Ratio

• Focuses on cash only
• Covers period of time

Net Cash Provided by Operating Activities Average
Current Liabilities
15
Accounts Receivable Turnover Ratio

• Net Credit Sales
• Average Accounts Receivable

Indicates how quickly a company is collecting
(i.e., turning over) its receivables
16
Accounts Receivable Turnover Ratio

• Too fast
• Credit policies too stringent may be losing
  sales

• Too slow
• Credit department not operating effectively
  possible quality problems

17
Number of Days Sales in Receivables
360 Days
. Accts. Receivable Turnover
Represents the average of days accounts are
outstanding
Some analysts use 365 days.
18
Number of Days Sales in Receivables
Example
360 Days 4.8 Times
75 days

• If this companys credit terms are net 30, what
  would this tell you about the efficiency of the
  collection process?

19
Inventory Turnover Ratio
Cost of Goods Sold Average Inventory
Represents the number of times per period
inventory is turned over (i.e., sold).

20
Inventory Turnover Ratio

• Circuit City 5.8 times per year
• Safeway 9.2 times per year
• Can you compare the two ratios?

21
of Days Sales in Inventory
of Days in Period Inventory Turnover Ratio
Represents the average of days inventory is on
hand before its sold
22
of Days Sales in Inventory

• Circuit City 62 days
• Safeway 39 days
• Do these averages seem reasonable?

23
Cash Operating Cycle

• Time between purchase of merchandise and
  collection from the sale

of days sales in receivables of days
sales in inventory
24
Solvency Analysis

• Ability to stay in business over the long-term

Times Interest Earned
Debt-to-Equity Ratio
Cash Flow to Capital Expenditures
Debt Service Coverage
25
Debt-to-Equity Ratio
How much have creditors contributed compared to
owners?
Total Liabilities Total Stockholders
Equity
26
Debt-to-Equity Ratio
Total Liabilities Total Stockholders Equity
.60
27
Times Interest Earned Ratio

• Measures ability to meet current interest
  payments
• The greater the coverage the better

Net Income Interest Expense Income Tax
Expense Interest Expense
28
Debt Service Coverage Ratio

• Measures amount of cash from operations available
  to service the debt

Cash Flow from Operations before Interest
Taxes Interest and Principal Payments
29
Cash Flow from Operations to Capital Expenditures
Ratio

• Measures companys ability to use operations (vs.
  creditors and owners) to finance acquisitions of
  productive assets

Cash Flow from Operations Dividends Paid Cash
Paid for Capital Acquisitions
30
Profitability Analysis

• Rate of Return on Assets
• Return on Common S/E
• EPS
• P/E Ratio
• Dividend Ratios

31
Return on Assets Ratio

• Measures return to all providers of capital
  (creditors and owners)

Net Income Interest Expense, Net of Tax Average
Total Assets
32
Return on Common Stockholders Equity
Net Income - Preferred Dividends Average Common
Stockholders Equity
33
Earnings per Share

• Presents profits on a per-share basis

Net Income - Preferred Dividends Weighted Avg.
of Common Shares Outstanding
34
Price/Earnings Ratio

• Relates earnings to the market price of the stock

Current Market Price Earnings per Share
very high P/E very low P/E
possibly overvalued possibly undervalued
35
Price/Earnings Ratio
Both companies have earnings of 2 per share. So
why the different P/E ratios?
36
Dividend Payout Ratio
Common Dividends per Share Earnings per Share
37
Dividend Yield Ratio

• Investors willing to forgo dividends in lieu of
  price appreciation

Common Dividends per Share Market Price per Share
usually

38
Appendix

• Accounting Tools
• Reporting and Analyzing
• Other Income Statement Items

39
Common Characteristics

• All such items are reported after income from
  continuing operations
• Reported separately
• Shown net of tax effects
• Most analysts ignore these items, since they are
  not likely to reoccur

40
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

41
Extraordinary Items

• Gain or loss due to an event that is
• Unusual in nature AND
• Infrequent in occurrence

42
Cumulative Effect of a Change in Accounting
Principle

• Reflects a change in a companys 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

43
End of Chapter 13