Financial Statement Analysis

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Financial Statement Analysis
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PowerPoint Author LuAnn Bean, Ph.D., CPA,
CIA, CFE
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Learning Objectives

• Understand the nature of financial statement
  analysis.
• Calculate and interpret horizontal and vertical
  analysis.
• Assess profitability through the calculation and
  interpretation of ratios.

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Learning Objectives

1. Assess liquidity through the calculation and
   interpretation of ratios.
2. Assess solvency through the calculation and
   interpretation of ratios.
3. Calculate and interpret a DuPont Analysis.

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Financial Statement Analysis
LOI
All publicly traded companies must prepare
audited financial statements each year and file
them with the Securities and Exchange Commission.
These statements include the income statement,
the balance sheet, the statement of stockholders
equity, and the statement of cash flows.
Financial statements contain multiple years of
data for comparative purposes and are the
starting point for any analysis.
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Financial Analysis
Financial information
Financial statement analysis is the process of
applying analytical tools to a companys
financial statements to understand the
companys financial health and requires
Standards of comparison
Analysis tools
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Examples
In this chapter, the financial information
provided by Best Buy Co., Inc. will be used to
illustrate the process of financial analysis. For
financial ratios, Best Buy will be compared to
hhgreggs ratios, since both companies are in a
similar industry.
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Standards of Comparison

• Often called intracompany comparison (horizontal
  analysis)

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• Often called intercompany comparison (vertical
  analysis)

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To ignore product safety??
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Analysis Tools

• comparison of a companys financial results
  across time.

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• comparison of financial balances to a base
  account from the same company.

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3
To ignore product safety??
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Horizontal Analysis
LO2
Horizontal analysis is an analysis technique that
calculates the change in an account balance from
one period to the next and expresses that change
in both dollar and percentage terms.
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Balance Sheet Horizontal Best Buy (2008)
Best Buy ( in millions, except per share amounts 2/28/09 3/1/08 Change Change
Current Assets Cash and cash equivalents 498 1,438 (940) -65.4
Receivables 1,868 549 1,319 240.3
Merchandise Inventories 4,753 4,708 45 1.0
Other current assets 1,073 647 426 65.8
Total Current Assets 8,192 7,342 850 11.6
Property and Equipment, net 4,174 3,306 868 26.3
Goodwill 2,203 1,088 1,115 102.5
Other Assets 1,257 1,022 235 23.0
Total Assets 80,000 67,000 13,000 24.1
Current Year - Base Year 1,868 549
240.3 Base Year
549 Change 1,868 549 1,319
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Income Statement Horizontal Best Buy (2008)
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Vertical Analysis
Vertical analysis is an analysis technique that
states each account balance on a financial
statement as a percentage of a base amount on the
statement.
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Balance Sheet Vertical Best Buy (2008)
Asset accounts are stated as a percentage of
Total Assets (set at 100). For example, on
2/28/09, Receivables is 11.8 of Total Assets
(calculated as 1,868 15,826).
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Income Statement Vertical Best Buy (2008)
Overall Best Buy was profitable in 2008, but it
was less profitable than in 2007 (3.5 in 2007
versus 2.2 in 2008). One reason for this was the
increase in operating expenses.
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Profitability Analysis
LO3
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Profitability Ratios

• Indicates the ability to make required principal
  and interest payments.

• Indicates related stock price increases or
  dividends paid.

To ignore product safety??
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Profit Margin Ratio
The profit margin ratio compares net income to
net sales and measures the ability of a company
to generate profits from sales. A higher ratio
indicates a greater ability to generate profits
from sales.
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Return on Equity
The return on equity ratio compares net income to
the average balance in stockholders equity
during the year, showing how effectively a
company uses the equity provided by stockholders
during the year to generate additional equity for
its owners. Stockholders naturally want this
ratio to be as high as possible.
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Return on Assets
The return on assets ratio compares net income to
average total assets during the year,
representing a companys ability to generate
profits from its entire resource base (not just
those resources provided by owners). Like the
return on equity, investors would like the ratio
as high as possible.
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Earnings Per Share
Earnings per share compares a companys net
income to the average number of shares of common
stock outstanding during the year. The ratio
represents the return on each share of stock
owned by an investor.
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Price to Earnings Ratio
The price to earnings ratio compares net income
to the current market price of the companys
common stock and provides an indication of
investor perceptions of the company. A higher
price to earnings ratio generally indicates that
investors are more optimistic about the future
prospects of a company.
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Profitability Summary
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Liquidity Analysis
LO4
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Liquidity Ratios
Liquidity ratios assess the ability of a
company to meet its immediate or short-term
financial obligations. Failing to do so can
result in additional expenses and, ultimately,
bankruptcy.
Current Ratio
Quick Ratio
Inventory Turnover Ratio
Receivables Turnover Ratio
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Current Ratio
The current ratio is one of the most frequently
used ratios in financial analysis and compares
current assets to current liabilities. As such,
it compares assets that should be turned into
cash within one year to liabilities that should
be paid within one year. A higher ratio indicates
greater liquidity.
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Quick Ratio
The quick ratio (sometimes called the acid-test
ratio) compares a companys cash and near-cash
assets, or quick assets, to its current
liabilities. Quick assets include cash,
short-term investments, and accounts receivable.
Since the quick ratio measures the degree to
which a company could pay off its current
liabilities immediately, a higher quick ratio
indicates greater liquidity.
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Receivables Turnover Ratio
The receivables turnover ratio compares a
companys credit sales during a period to its
average accounts receivable balance during that
period. A higher ratio means that the company is
better able to generate and collect sales,
leading to better liquidity.
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Inventory Turnover Ratio
The inventory turnover ratio compares a companys
cost of goods sold during a period to its average
inventory balance during that period. It reveals
how many times a company is able to sell its
inventory balance in a period. A higher ratio is
better because it indicates that the company sold
more inventory while maintaining less inventory
on hand.
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Liquidity Summary
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Ethics and Decision Making
Solvency Ratios
Solvency focuses on capital structure and
assesses the extent of borrowing needed.
In todays business environment, companies have
to be aware not only of the economic impact of
their decisions, but also of their ethical impact.

• Solvency refers to a companys ability to remain
  in business over the long term.

Information being used for?
To ignore product safety??
To exceed government limits??
To falsify records??
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Solvency Analysis
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Debt to Assets
The debt to assets ratio compares a companys
total liabilities to its total assets and yields
the percentage of assets provided by creditors.
As such, the ratio provides a measure of a
companys capital structure. A decreasing ratio
shows that a company is taking on a less risky
capital structure over time.
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Debt to Equity
The debt to equity ratio compares a companys
total liabilities to its total equity. Higher
debt to equity ratios indicate a riskier capital
structure and therefore greater risk of
insolvency.
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Times Interest Earned
The times interest earned ratio compares a
companys net income to its interest expense. It
shows how well a company can pay interest out of
current-year earnings. A higher ratio indicates a
greater ability to make payments, and therefore
less risk of insolvency.
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Solvency Summary
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DuPont Analysis
LO6

• A DuPont analysis provides insight into how a
  companys return on equity was generated by
  decomposing the return into three components
• operating efficiency,
• asset effectiveness, and
• capital structure.

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DuPont Calculation
The higher the ratio, the more efficient a
company is in turning sales into profits.
The higher the ratio, the more effective a
company is in generating sales given its assets.
The higher the ratio, the more a company is
financing its assets with debt rather than equity
(riskier). This is the leverage multiplier.
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Best Buys DuPont Calculations
The analysis shows clearly why Best Buys return
to its owners decreased from 2007 to 2008.
Profits from sales were down in 2008, resulting
in a lower return on equity.
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Benefit of DuPont Analysis
One of the main benefits of a DuPont analysis is
the ability to ask what-if questions.
???
What if Best Buy was able to squeeze out another
.02 of profit on each dollar of sales? How would
that affect the return to owners? Answer 2008
return would increase to 0.407 (0.042 X 2.84 X
3.41).
What if the market for electronics took a
significant downturn and Best Buy was only able
to generate sales of 1.5 times assets on hand?
Would that significantly affect the return to
investors? Answer 2008 return would fall almost
in half to 0.113 (0.022 X 1.50 X 3.41).
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End of Chapter 12