Financial Statement Analysis

Chapter 15

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright2015McGrawHillEducation.Allrightsreserved.NoreproductionordistributionwithoutthepriorwrittenconsentofMcGrawHillEducation.
 15-2

Limitations of Financial Statement

Analysis
Differences in accounting methods
between companies sometimes make
comparisons difficult.

We use the LIFO method to We use the average cost

value inventory. method to value inventory.
 15-3

Limitations of Financial Statement

Analysis
Managers should look beyond the ratios.
Changes within
Industry the company Consumer
trends tastes

Technological Economic
changes factors
 15-4

Learning Objective 1

Prepare and interpret

financial statements in
comparative and
common-size form.
 15-5

Statements in Comparative and

Common-Size Form

Dollar and percentage

changes on statements
An item on a financial
statement has little Common-size
meaning by itself. The statements
meaning of the numbers
can be enhanced by
drawing comparisons.
Ratios
 15-6

Dollar and Percentage Changes on

Statements
Horizontal analysis (or trend analysis) shows the
changes between years in the financial data in
both dollar and percentage form.

Quantifying dollar Quantifying

changes over time percentage
serves to highlight changes over time
the changes that are serves to highlight
the most important the changes that are
economically. the most unusual.
 15-7

Horizontal Analysis

The following slides illustrate a horizontal

analysis of Clover Corporations
comparative balance sheets and
comparative income statements for this
year and last year.
 15-8

Horizontal Analysis
 15-9

Horizontal Analysis
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

=
Change Figure Figure

The dollar
amounts for
last year
become the
base year
figures.
 15-10

Horizontal Analysis
Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure 100%
 15-11

Horizontal Analysis

$12,000 $23,500 = $(11,500)

($11,500 $23,500) 100% = (48.9%)

 15-12

Horizontal Analysis
 15-13

Horizontal Analysis

We could do this
for the liabilities
and stockholders
equity, but now
lets look at the
income statement
accounts.
 15-14

Horizontal Analysis
 15-15

Horizontal Analysis
 15-16

Horizontal Analysis

Sales increased by 8.3%, yet

net income decreased by 21.9%.
 15-17

Horizontal Analysis
There were increases in both cost of goods
sold (14.3%) and operating expenses (2.1%).
These increased costs more than offset the
increase in sales, yielding an overall
decrease in net income.
 15-18

Trend Percentages

Trend percentages
state several years
financial data in terms
of a base year, which
equals 100 percent.
 15-19

Trend Analysis

Trend = Current Year Amount

Percentage Base Year Amount
100%
 15-20

Trend Analysis

Look at the income information for Berry

Products for the years 2010 through 2014. We
will do a trend analysis on these amounts to
see what we can learn about the company.
 15-21

Trend Analysis

Berry Products
Income Information
For the Years Ended December 31

The base
year is 2010, and its amounts
will equal 100%.
 15-22

Trend Analysis

Berry Products
Income Information
For the Years Ended December 31

2011 Amount 2010 Amount 100%

( $290,000 $275,000 ) 100% = 105%
( $198,000 $190,000 ) 100% = 104%
( $ 92,000 $ 85,000 ) 100% = 108%
 15-23

Trend Analysis

Berry Products
Income Information
For the Years Ended December 31

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.
 15-24

Trend Analysis
We can use the trend
percentages to construct
a graph so we can see the
trend over time.
 15-25

Common-Size Statements
Vertical analysis focuses
on the relationships
among financial
statement items at a
given point in time. A
common-size financial
statement is a vertical
analysis in which each
financial statement item
is expressed as a
percentage.
 15-26

Common-Size Statements

In balance
sheets, all items
usually are
expressed as a
percentage of
total assets.
 15-27

Common-Size Statements

In income
statements, all
items usually are
expressed as a
percentage of
sales.
 15-28

Common-Size Statements

Lets take another look at the information

from the comparative income statements
of Clover Corporation for this year and
last year.

This time, lets prepare common-size

statements.
 15-29

Common-Size Statements

Sales is
usually the
base and is
expressed
as 100%.
 15-30

Common-Size Statements

This Years Operating Expenses This Years Sales 100%

( $128,600 $520,000 ) 100% = 24.8%

Last Years Operating Expenses Last Years Sales 100%

( $126,000 $480,000 ) 100% = 26.2%
 15-31

Common-Size Statements

What conclusions can we draw?

 15-32

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.
 15-33

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
Horizontal analysis shows the changes
between years
the current in the
years financial
financial data in both
statements.
dollar and percentage form.
d. None of the above.
 15-34

Now, lets look at

Norton
Corporations
financial statements
for this year and
last year.
15-35
15-36
15-37
 15-38

Learning Objective 2

Compute and interpret

financial ratios that
managers use to assess
liquidity.
 15-39

Ratio Analysis Liquidity

The data and ratios that

managers use to assess
liquidity include working
capital, the current ratio, and
the acid-test (quick) ratio.

The information shown for

Norton Corporation will be
used to calculate the
aforementioned liquidity
ratios.
 15-40

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.
 15-41

Working Capital
 15-42

Current Ratio
Current Current Assets
=
Ratio 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.
 15-43

Current Ratio
Current Current Assets
=
Ratio Current Liabilities

Current $65,000
= = 1.55
Ratio $42,000
 15-44

Acid-Test (Quick) Ratio

Acid-Test Quick Assets
=
Ratio Current Liabilities

Acid-Test $50,000
= = 1.19
Ratio $42,000

Quick assets include Cash,

Marketable Securities, Accounts Receivable, and
current Notes Receivable.
This ratio measures a companys ability to meet
obligations without having to liquidate inventory.
 15-45

Learning Objective 3

Compute and interpret

financial ratios that
managers use for asset
management purposes.
 15-46

Ratio Analysis Asset Management

Managers compute a
variety of ratios for
asset management
purposes. The
information shown for
Norton Corporation
will be used to
calculate the asset
management ratios.
Ensure that this slide
includes the necessary
data for all
forthcoming
calculations. Note: You may also use information provided in an
earlier slide for these computations.
 15-47

Accounts Receivable Turnover

Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover

Accounts
$494,000
Receivable = = 26.7 times
($17,000 + $20,000) 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
 15-48

Average Collection Period

Average 365 Days
Collection = Accounts Receivable Turnover
Period

Average
365 Days
Collection = = 13.67 days
26.7 Times
Period

This ratio measures, on average,

how many days it takes to collect
an account receivable.
 15-49

Inventory Turnover
Inventory Cost of Goods Sold
Turnover = 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 types of inventory.
 15-50

Inventory Turnover
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) 2
 15-51

Average Sale Period

Average 365 Days
=
Sale Period Inventory Turnover

Average 365 Days

= = 28.67 days
Sale Period 12.73 Times

This ratio measures how many

days, on average, it takes to sell
the entire inventory.
 15-52

Operating Cycle
Average Average Operating
+ =
Sale Period Collection Period Cycle

This ratio measures the elapsed

time from when inventory is
received from suppliers to when
cash is received from customers.
 15-53

Operating Cycle
Average Average Operating
+ =
Sale Period Collection Period Cycle

28.67 days + 13.67 days = 42.34 days

This ratio measures the elapsed

time from when inventory is
received from suppliers to when
cash is received from customers.
 15-54

Total Asset Turnover

Total Asset Sales
=
Turnover Average Total Assets

This ratio measures how efficiently a

companys assets are being used to
generate sales. This ratio expands
beyond current assets to include
noncurrent assets.
 15-55

Total Asset Turnover

Total Asset Sales
=
Turnover Average Total Assets

Total Asset $494,000

Turnover = ($300,000 + $346,390) 2 = 1.53

This ratio measures how efficiently a

companys assets are being used to
generate sales. This ratio expands
beyond current assets to include
noncurrent assets.
 15-56

Learning Objective 4

Compute and interpret

financial ratios that
managers use for debt
management purposes.
 15-57

Ratio Analysis Debt Management

Managers compute a variety of ratios for debt management
purposes. The information shown for Norton Corporation will be
used to calculate its debt management ratios Ensure that this slide
includes the necessary data for all forthcoming calculations.

This is also referred

to as net operating
income.
Note: You may also use information provided in an
earlier slide for these computations.
 15-58

Times Interest Earned Ratio

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

Times
$84,000
Interest = = 11.51 times
$7,300
Earned
This is the most common
measure of a companys ability
to provide protection for its
long-term creditors. A ratio of
less than 1.0 is inadequate.
 15-59

Debt-to-Equity Ratio
Debtto
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

Creditors prefer less debt
debt if the companys rate
and more equity because
of return on its assets
equity represents a buffer
exceeds the rate of return
of protection.
paid to creditors.
 15-60

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

Debtto
$112,000
Equity = = 0.48
$234,390
Ratio
 15-61

The Equity Multiplier

Equity = Average Total Assets
Multiplier Average Stockholders Equity

This ratio indicates the portion of a companys

assets that are funded by equity. It focuses on
average amounts maintained throughout the year
rather than amounts at one point in time.
 15-62

The Equity Multiplier

Equity = Average Total Assets
Multiplier Average Stockholders Equity

Equity ($300,000 + $346,390) 2

= = 1.56
Multiplier ($180,000 + $234,390) 2

This ratio indicates the portion of a companys

assets that are funded by equity. It focuses on
average amounts maintained throughout the year
rather than amounts at one point in time.
 15-63

Learning Objective 5

Compute and interpret

financial ratios that
managers use to assess
profitability.
 15-64

Ratio Analysis Profitability Ratios

The information
shown for
Norton
Corporation will
be used to
calculate its
profitability
ratios.

Note: You may also use information provided in an earlier slide for these computations.
 15-65

Gross Margin Percentage

Gross Margin = Gross Margin

Percentage 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.
 15-66

Gross Margin Percentage

Gross Margin = Gross Margin

Percentage Sales

Gross Margin = $494,000 - $140,000 = 71.6%

Percentage $494,000

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.
 15-67

Net Profit Margin Percentage

Net Profit Margin = Net Income

Percentage Sales

In addition to cost of goods sold, this

ratio also looks at how selling and
administrative expenses, interest
expense, and income tax expense
influence performance.
 15-68

Net Profit Margin Percentage

Net Profit Margin = Net Income

Percentage Sales

Net Profit Margin = $53,690

= 10.9%
Percentage $494,000

In addition to cost of goods sold, this

ratio also looks at how selling and
administrative expenses, interest
expense, and income tax expense
influence performance.
 15-69

Return on Total Assets

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

Return on $53,690 + [$7,300 (1 .30)]

= = 18.19%
Total Assets ($300,000 + $346,390) 2

Adding interest expense back to net income

enables the return on assets to be compared
for companies with different amounts of debt
or over time for a single company that has
changed its mix of debt and equity.
 15-70

Return on Equity

= Net Income
Return on Equity
Average Stockholders Equity

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

This measure indicates how well the

company used the owners
investments to earn income.
 15-71

DuPont Formula
Net Profit Total Asset Equity
Return on Equity =
Margin Turnover Multiplier

The return on equity can also be

computed using the DuPont Formula
shown here.
 15-72

Financial Leverage
Financial leverage results from the difference between
the rate of return the company earns on investments
in its own assets and the rate of return that the
company must pay its creditors.
 15-73

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.
 15-74

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.
 15-75

Learning Objective 6

Compute and interpret

financial ratios that
managers use to assess
market performance.
 15-76

Ratio Analysis Market Performance

The information
shown for
Norton
Corporation will
be used to
calculate its
profitability
Note: You may also use information provided in an
ratios. earlier slide for these computations.
 15-77

Earnings Per Share

Net Income
Earnings per Share =
Average Number of Common
Shares Outstanding

Whenever a ratio divides an income statement

balance by a balance sheet balance, the average
for the year is used in the denominator.

Earnings form the basis for dividend payments

and future increases in the value of shares of
stock.
 15-78

Earnings Per Share

Net Income
Earnings per Share =
Average Number of Common
Shares Outstanding

Earnings per Share = $53,690 = $2.42

($17,000 + $27,400)/2

This measure indicates how much

income was earned for each share of
common stock outstanding.
 15-79

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

Price-Earnings $20.00
= = 8.26 times
Ratio $2.42

A higher price-earnings ratio means that

investors are willing to pay a premium
for a companys stock because of
optimistic future growth prospects.
 15-80

Dividend Payout Ratio

Dividend Dividends Per Share

=
Payout Ratio Earnings Per Share

Dividend $2.00
= = 82.6%
Payout Ratio $2.42

This ratio gauges the portion of current

earnings being paid out in dividends. Investors
seeking dividends (market price growth) would
like this ratio to be large (small).
 15-81

Dividend Yield Ratio

Dividend Dividends Per Share

=
Yield Ratio Market Price Per Share

Dividend $2.00
= = 10.00%
Yield Ratio $20.00

This ratio identifies the return, in terms

of cash dividends, on the current
market price of the stock.
 15-82

Book Value Per Share

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

Book Value $234,390

= = $8.55
per Share 27,400

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 after all creditors were paid off.
 15-83

Book Value Per Share

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

Book Value $234,390

= = $8.55
per Share 27,400

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.
 15-84

Published Sources That Provide Comparative Ratio Data

 15-85

End of Chapter 15