IQRA UNIVERSITY CITY CAMPUS

How Well Am I Doing? Financial Statement Analysis

INTISAR M.USMANI FCMA
FIRST HABIB MODARABA

McGraw-Hill /Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Limitations of Financial Statement Analysis

Differences in accounting methods between companies sometimes make comparisons difficult.

We use the LIFO method to value inventory.

We use the FIFO method to value inventory.

Limitations of Financial Statement Analysis

Changes within the company

Industry trends
Technological changes

Consumer tastes

Economic factors

Analysts should look beyond the ratios.

Statements in Comparative and Common-Size Form

Dollar and percentage changes on statements

Analytical techniques used to examine relationships among financial statement items

Common-size statements

Ratios

Learning Objective 1

Prepare and interpret financial statements in comparative and common-size form.

Horizontal Analysis

Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

Horizontal Analysis

Example
The following slides illustrate a horizontal analysis of Clover Corporations December 31, 2008 and 2007 comparative balance sheets and comparative income statements.

Horizontal Analysis
CLOVER CORPORATION Comparative Balance Sheets December 31 Increase (Decrease) Amount %

2008 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets

2007

12,000 60,000 80,000 3,000 155,000

23,500 40,000 100,000 1,200 164,700

40,000 120,000 160,000 $ 315,000

40,000 85,000 125,000 $ 289,700

Horizontal Analysis
Calculating Change in Dollar Amounts
Dollar Change Current Year Figure Base Year Figure

The dollar amounts for 2007 become the base year figures.

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Horizontal Analysis
Calculating Change as a Percentage
Percentage Change Dollar Change Base Year Figure

100%

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Horizontal Analysis
CLOVER CORPORATION Comparative Balance Sheets December 31 Increase (Decrease) Amount %

2008

2007

Assets Current assets: Cash $ 12,000 $ 23,500 $ (11,500) (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets $12,000 155,000 $23,500164,700 = $(11,500) Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 ($11,500 $23,500) 100% = 48.9% Total property and equipment 160,000 125,000 Total assets $ 315,000 $ 289,700

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Horizontal Analysis
CLOVER CORPORATION Comparative Balance Sheets December 31 Increase (Decrease) Amount %

2008 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets

2007

12,000 60,000 80,000 3,000 155,000

23,500 40,000 100,000 1,200 164,700

$ (11,500) 20,000 (20,000) 1,800 (9,700) 35,000 35,000 $ 25,300

(48.9) 50.0 (20.0) 150.0 (5.9) 0.0 41.2 28.0 8.7

40,000 120,000 160,000 $ 315,000

40,000 85,000 125,000 $ 289,700

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Horizontal Analysis

We could do this for the liabilities & stockholders equity, but instead, lets look at the income statement.

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Horizontal Analysis
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Increase (Decrease) Amount %

2008 2007 Net sales $ 520,000 $ 480,000 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income $ 17,500 $ 22,400

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Horizontal Analysis
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Increase (Decrease) Amount % $ 40,000 8.3 45,000 14.3 (5,000) (3.0) 2,600 2.1 (7,600) (19.5) (600) (8.6) (7,000) (21.9) (2,100) (21.9) $ (4,900) (21.9)

2008 2007 Net sales $ 520,000 $ 480,000 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income $ 17,500 $ 22,400

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Horizontal Analysis
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Increase (Decrease) 2008 2007 Amount % Net sales $ 520,000 $ 480,000 $ 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) Sales increased by 8.3%, yet Operating expenses 128,600 by126,000 2,600 2.1 net income decreased 21.9%. Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

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Horizontal Analysis
CLOVER CORPORATION There were increases in both cost of goods Comparative Income Statements sold (14.3%) and operating expenses (2.1%). For the Years Ended December 31 These increased costs more than offset the Increase increase in sales, yielding an overall (Decrease) decrease in net income. 2008 2007 Amount % Net sales $ 520,000 $ 480,000 $ 40,000 Cost of goods sold 360,000 315,000 45,000 Gross margin 160,000 165,000 (5,000) Operating expenses 128,600 126,000 2,600 Net operating income 31,400 39,000 (7,600) Interest expense 6,400 7,000 (600) Net income before taxes 25,000 32,000 (7,000) Less income taxes (30%) 7,500 9,600 (2,100) Net income $ 17,500 $ 22,400 $ (4,900) 8.3 14.3 (3.0) 2.1 (19.5) (8.6) (21.9) (21.9) (21.9)

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Trend Percentages

Trend percentages state several years financial data in terms of a base year, which equals 100 percent.

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Trend Percentages

Trend = Percentage

Current Year Amount Base Year Amount

100%

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Trend Percentages

Example
Look at the information for Berry Products for the years 2003 through 2007. We will complete a trend analysis using these amounts to see what we can learn about the company.

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Trend Percentages

Berry Products Income Information For the Years Ended December 31

Item Sales Cost of goods sold Gross margin 2007 $ 400,000 285,000 115,000 2006 $ 355,000 250,000 105,000 Year 2005 $ 320,000 225,000 95,000 2004 $ 290,000 198,000 92,000 2003 $ 275,000 190,000 85,000

The base year is 2003, and its amounts will equal 100%.

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Trend Percentages
Berry Products Income Information For the Years Ended December 31
Item Sales Cost of goods sold Gross margin 2007 2006 Year 2005 2004 105% 104% 108% 2003 100% 100% 100%

2004 Amount 2003 Amount 100% ( $290,000 $275,000 ) 100% = 105% ( $198,000 $190,000 ) 100% = 104% ( $ 92,000 $ 85,000 ) 100% = 108%

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Trend Percentages
Berry Products Income Information For the Years Ended December 31
Item Sales Cost of goods sold Gross margin 2007 145% 150% 135% 2006 129% 132% 124% Year 2005 116% 118% 112% 2004 105% 104% 108% 2003 100% 100% 100%

By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.

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Trend Percentages
We can use the trend percentages to construct a graph so we can see the trend over time.

160 150

Percentage

140 130 120 110 100 2003 2004 2005 Year 2006 2007 Sales COGS GM

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Common-Size Statements Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis.

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Common-Size Statements

In income statements, all items are expressed as a percentage of net sales.

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Gross Margin Percentage

Gross Margin Percentage

Gross Margin Sales

This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.

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Common-Size Statements

In balance sheets, all items are expressed as a percentage of total assets.

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Common-Size Statements

Wendy's McDonald's (dollars in millions) Dollars Percentage Dollars Percentage 2002 Net income $ 219 8.00% $ 894 5.80%

Common-size financial statements are particularly useful when comparing data from different companies.

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Common-Size Statements

Example
Lets take another look at the information from the comparative income statements of Clover Corporation for 2007 and 2008. This time, lets prepare common-size statements.

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Common-Size Statements
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size Percentages 2008 2007 2008 2007 Net sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 Net sales is Gross margin 160,000 165,000 the base Operating expenses 128,600 126,000 Net operating income 31,400 39,000 and is Interest expense 6,400 7,000 expressed Net income before taxes 25,000 32,000 as 100%. Less income taxes (30%) 7,500 9,600 Net income $ 17,500 $ 22,400

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Common-Size Statements
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size Percentages 2008 2007 2008 2007 Net sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 2008 Cost 2008 Sales 100% Net operating income 31,400 39,000 ( $360,000 ) 100% = 69.2% Interest expense $520,000 6,400 7,000 Net income before taxes 25,000 32,000 Cost 2007 100% Less income 2007 taxes (30%) 7,500 Sales 9,600 $480,000 ) 100% = 65.6% Net income ( $315,000 $17,500 $ 22,400

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Common-Size Statements
CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size What conclusions can we draw? Percentages 2008 2007 2008 2007 Net sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0 Net income $ 17,500 $ 22,400 3.4 4.7

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Quick Check
Which of the following statements describes horizontal analysis? a. A statement that shows items appearing on it in percentage and dollar form. b. A side-by-side comparison of two or more years financial statements. c. A comparison of the account balances on the current years financial statements. d. None of the above.

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Quick Check
Which of the following statements describes horizontal analysis? a. A statement that shows items appearing on it in percentage and dollar form. b. A side-by-side comparison of two or more years financial statements. c.Horizontal A comparison of the account analysis shows thebalances changes on the current years financial statements. between years in the financial data, in d. None ofdollar the above. both and percentage form.

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Ratios
Common Stockholders

Short-term Creditors
Long-term Creditors

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Now, lets look at Norton Corporations 2006 and 2007 financial statements.

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NORTON CORPORATION Balance Sheets December 31 2007 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets 2006

30,000 20,000 12,000 3,000 65,000

20,000 17,000 10,000 2,000 49,000

165,000 116,390 281,390 $ 346,390

123,000 128,000 251,000 $ 300,000

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NORTON CORPORATION Balance Sheets December 31 2007 Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 39,000 $ Notes payable, short-term 3,000 Total current liabilities 42,000 Long-term liabilities: Notes payable, long-term 70,000 Total liabilities 112,000 Stockholders' equity: Common stock, $1 par value 27,400 Additional paid-in capital 158,100 Total paid-in capital 185,500 Retained earnings 48,890 Total stockholders' equity 234,390 Total liabilities and stockholders' equity $ 346,390 $ 2006

40,000 2,000 42,000 78,000 120,000 17,000 113,000 130,000 50,000 180,000 300,000

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NORTON CORPORATION Income Statements For the Years Ended December 31

Net sales Cost of goods sold Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income

2007 2006 $ 494,000 $ 450,000 140,000 127,000 354,000 323,000 270,000 249,000 84,000 74,000 7,300 8,000 76,700 66,000 23,010 19,800 $ 53,690 $ 46,200

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Learning Objective 2

Compute and interpret financial ratios that would be useful to a common stockholder.

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Ratio Analysis The Common Stockholder

Use this information to calculate ratios to measure the well-being of the common stockholders of Norton Corporation.
NORTON CORPORATION 2007
Number of common shares outstanding Beginning of year End of year Net income Stockholders' equity Beginning of year End of year Dividends per share Dec. 31 market price per share Interest expense Total assets Beginning of year End of year 300,000 346,390 180,000 234,390 2 20 7,300 $

17,000 27,400 53,690

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Earnings Per Share

Net Income Preferred Dividends Average Number of Common Shares Outstanding

Earnings per Share =

Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

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Earnings Per Share

Net Income Preferred Dividends Average Number of Common Shares Outstanding
$53,690 0 (17,000 + 27,400)/2 = $2.42

Earnings per Share =

Earnings per Share =

This measure indicates how much income was earned for each share of common stock outstanding.

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Price-Earnings Ratio
Price-Earnings Ratio = Market Price Per Share Earnings Per Share

Price-Earnings Ratio

$20.00 = 8.26 times $2.42

This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the priceearnings ratio, the more opportunity a company has for growth.

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Dividend Payout Ratio

Dividend Payout Ratio = Dividends Per Share Earnings Per Share

Dividend Payout Ratio

$2.00 = 82.6% $2.42

This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking current income would like this ratio to be large.

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Dividend Yield Ratio

Dividend Yield Ratio = Dividends Per Share Market Price Per Share

Dividend Yield Ratio

$2.00 = 10.00% $20.00

This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

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Return on Total Assets

Return on = Total Assets Net Income + [Interest Expense (1 Tax Rate)] Average Total Assets

Return on = Total Assets

$53,690 +[7,300 (1 .30)] = 18.19% ($300,000 + $346,390) 2

This ratio measures how well assets have been employed.

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Return on Common Stockholders Equity

Return on Common = Net Income Preferred Dividends Stockholders Equity Average Stockholders Equity

Return on Common = $53,690 0 = 25.91% Stockholders Equity ($180,000 + $234,390) 2

This measure indicates how well the company employed the owners investments to earn income.

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Financial Leverage

Financial leverage involves acquiring assets with funds at a fixed rate of interest.
Fixed rate of Return on return on investment in > borrowed assets funds Return on investment in < assets Positive = financial leverage

Fixed rate of return on borrowed funds

Negative = financial leverage

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Quick Check
Which of the following statements is true? a. Negative financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets. c. Financial leverage is the expression of several years financial data in percentage form in terms of a base year.

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Quick Check
Which of the following statements is true? a. Negative financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets. c. Financial leverage is the expression of several years financial data in percentage form in terms of a base year.

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Book Value Per Share

Book Value per Share Common Stockholders Equity Number of Common Shares Outstanding

Book Value per Share

$234,390 27,400

= $ 8.55

This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.

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Book Value Per Share

Book Value per Share Common Stockholders Equity Number of Common Shares Outstanding

Book Value per Share

$234,390 27,400

= $ 8.55

Notice that the book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost.

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Learning Objective 3

Compute and interpret financial ratios that would be useful to a short-term creditor.

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Ratio Analysis The ShortTerm Creditor

NORTON CORPORATION

Use this information to calculate ratios to measure the well-being of the short-term creditors for Norton Corporation.

2007 Cash Accounts receivable, net Beginning of year End of year Inventory Beginning of year End of year Total current assets Total current liabilities Sales on account Cost of goods sold 10,000 12,000 65,000 42,000 500,000 140,000 17,000 20,000 $ 30,000

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Working Capital

The excess of current assets over current liabilities is known as working capital.
Working capital is not free. It must be financed with long-term debt and equity.

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Working Capital
Norton Corporation

December 31, 2007 $ $ 65,000 (42,000) 23,000

Current assets Current liabilities Working capital

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Current Ratio
Current Ratio = Current Assets Current Liabilities

The current ratio measures a companys short-term debt paying ability.

A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories.

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Current Ratio
Current Ratio Current Assets Current Liabilities

Current Ratio

$65,000 $42,000

1.55

The current ratio measures a companys short-term debt paying ability.

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Acid-Test (Quick) Ratio

Acid-Test = Ratio Quick Assets Current Liabilities

Acid-Test = Ratio

$50,000 $42,000

= 1.19

Quick assets include Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. The quick ratio measures a companys ability to meet obligations without having to liquidate inventory.

Norton Corporations quick assets consist of cash of $30,000 and accounts receivable of $20,000.

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Accounts Receivable Turnover

Accounts Receivable Turnover = Sales on Account Average Accounts Receivable

Accounts $500,000 = 27.03 times Receivable = ($17,000 + $20,000) 2 Turnover

This ratio measures how many times a company converts its receivables into cash each year.

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Average Collection Period

Average 365 Days Collection = Accounts Receivable Turnover Period

Average Collection = Period

365 Days 27.03 Times

= 13.50 days

This ratio measures, on average, how many days it takes to collect an account receivable.

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Inventory Turnover
Inventory Turnover = Cost of Goods Sold Average Inventory

This ratio measures how many times a companys inventory has been sold and replaced during the year.
If a companys inventory turnover Is less than its industry average, it either has excessive inventory or the wrong sorts of inventory.

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Inventory Turnover
Inventory Turnover = Cost of Goods Sold Average Inventory

Inventory Turnover

$140,000 = 12.73 times ($10,000 + $12,000) 2

This ratio measures how many times a companys inventory has been sold and replaced during the year.

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Average Sale Period

Average Sale Period = 365 Days Inventory Turnover

Average = Sale Period

365 Days 12.73 Times

= 28.67 days

This ratio measures how many days, on average, it takes to sell the inventory.

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Learning Objective 4

Compute and interpret financial ratios that would be useful to a long-term creditor.

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Ratio Analysis The LongTerm Creditor

Use this information to calculate ratios to measure the well-being of the long-term creditors for Norton Corporation.
NORTON CORPORATION 2007 Earnings before interest expense and income taxes

84,000 7,300 234,390 112,000

EBIT is also referred to as net operating income.

Interest expense Total stockholders' equity Total liabilities

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Times Interest Earned Ratio

Times Interest = Earned Earnings before Interest Expense plus Income Taxes Interest Expense

Times Interest = Earned

$84,000 = 11.5 times 7,300

The times interest earned ratio is the most common measure of a companys ability to protect its long-term creditors.

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Debt-to-Equity Ratio
Debt to Total Liabilities Equity = Stockholders Equity Ratio

This ratio indicates the relative proportions of debt to equity on a companys balance sheet.
Stockholders like a lot of debt if the company can take advantage of positive financial leverage. Creditors prefer less debt and more equity because equity represents a buffer of protection.

In practice, debt-to-equity ratios from 0.0 to 3.0 are common.

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Debt-to-Equity Ratio
Debt to Total Liabilities Equity = Stockholders Equity Ratio

Debt to Equity = Ratio

$112,000 $234,390

= 0.48

This ratio indicates the relative proportions of debt to equity on a companys balance sheet.

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Published Sources That Provide Comparative Ratio Data

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THANK YOU