16: Chapter Financial Statement Analysis
Cornerstones of Managerial Accounting, 4e
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Learning Objectives
1. Analyze financial statements using two forms of common-size analysis: horizontal analysis and vertical analysis. 2. Explain why historical standards and industrial averages are important for ratio analysis. 3. Calculate and use liquidity ratios to assess the ability of a company to meet its current obligations. 4. Calculate and use leverage ratios to assess the ability of a company to meet its long- and short-term obligations. 5. Calculate and use profitability ratios to assess the extent to which a company's resources are being used efficiently.
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CommonSize Analysis
To make the analysis more meaningful, percentages can be used. Common-size analysis expresses line items or accounts in the financial statements as percentages. The two major forms of common-size analysis are horizontal analysis and vertical analysis.
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Horizontal Analysis
Also called trend analysis, horizontal analysis expresses a line item as a percentage of some prior-period amount. This approach allows the trend over time to be assessed. In horizontal analysis, line items are expressed as a percentage of a base period amount. The base period can be the immediately preceding period, or it can be a period further in the past.
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Preparing CommonSize Income Statements by Using Base Period Horizontal Analysis
Cornerstone 161
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Preparing CommonSize Income Statements by Using Base Period Horizontal Analysis
(continued)
Cornerstone 161
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Vertical Analysis
While horizontal analysis involves relationships among items over time, vertical analysis is concerned with relationships among items within a particular time period. Vertical analysis expresses the line item as a percentage of some other line item for the same period. With this approach, within-period relationships can be assessed. Line items on income statements often are expressed as percentages of net sales. Items on the balance sheet often are expressed as a percentage of total assets.
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Preparing Income Statements by Using Net Sales as the Base: Vertical Analysis
Cornerstone 162
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Preparing Income Statements by Using Net Sales as the Base: Vertical Analysis (continued)
Cornerstone 162
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Percentage and Size Effects
The use of common-size analysis makes comparisons more meaningful because percentages eliminate the effects of size. For example, Heisman Company earns $100,000 and Casciani Company earns $1 million, which company is more profitable? The answer depends to a large extent on the assets employed to earn the profits. If Heisman used an investment of $1 million to earn the $100,000, then the return expressed as a percentage of dollars is 10 percent ($100,000 $1,000,000). If Casciani used an investment of $20 million to earn its $1 million, the percentage return is only 5 percent ($1,000,000 $20,000,000). By using percentages, it is easy to see that the first firm is 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a relatively morecertain product or service or otherwise on asecond. website for classroom use. license distributed with a profitable than the password-protected
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Ratio Analysis
Ratio analysis is the second major technique for financial statement analysis. Ratios are fractions or percentages computed by dividing one account or line-item amount by another. For example, operating income divided by sales produces a ratio that measures the profit margin on sales.
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Standards for Comparison
Ratios by themselves tell little about the financial well-being of a company. For meaningful analysis, the ratios should be compared with a standard. Only through comparison can someone using a financial statement assess the financial health of a company. Two standards commonly used are the past history of the company and industrial averages.
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Classification of Ratios
Ratios generally are classified into one of three categories: liquidity, borrowing capacity or leverage, and profitability.
Liquidity ratios measure the ability of a company to meet its current obligations. Leverage ratios measure the ability of a company to meet its long- and short-term obligations. These ratios provide a measure of the degree of protection provided to a company's creditors. Profitability ratios measure the earning ability of a company. These ratios allow investors, creditors, and managers to evaluate the extent to which invested funds are being used efficiently.
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Liquidity Ratios
Liquidity ratios are used to assess the short-term debtpaying ability of a company. If a company does not have the short-term financial strength to meet its current obligations, it is likely to have difficulty meeting its long-term obligations. Although there are numerous liquidity ratios, the most common ones include:
current ratio quick or acid-test ratio accounts receivable turnover ratio inventory turnover ratio
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3
Current Ratio
The current ratio is a measure of the ability of a company to pay its short-term liabilities out of short-term assets. The current ratio is computed as follows:
Since current liabilities must be paid within an operating cycle (usually within a year) and current assets can be converted to cash within an operating cycle, the current ratio provides a direct measure of the ability of a company to meet its short-term obligations. 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
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3
Current Ratio
(continued)
Many creditors use the rule of thumb that a 2.0 ratio is needed to provide good debt-paying ability, but the rule has many exceptions. A declining current ratio is not necessarily bad, particularly if it is falling from a high value. A high current ratio may signal excessive investment in current resources. A declining current ratio may signal a move toward more efficient utilization of resources. However, a declining current ratio coupled with a current ratio lower than that of other firms in the industry supports the judgment that a company is having liquidity problems.
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Quick or AcidTest Ratio
The quick or acid-test ratio is a measure of liquidity that compares only the most liquid assets with current liabilities. Excluded from the quick ratio are non-liquid current assets such as inventories. The numerator of the quick ratio includes only the most liquid assets (cash, marketable securities, and accounts receivable).
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Calculating the Current Ratio and the Quick (or AcidTest) Ratio
Cornerstone 163
Information: Bordner Company has current assets equal to $120,000. Of these, $15,000 is cash, $30,000 is accounts receivable, and the remainder is inventories. Current liabilities total $50,000. Required: 1. Calculate the current ratio. 2. Calculate the quick ratio (acid-test ratio). Solution: 1. Current ratio 2. Quick ratio = Current assets/Current liabilities = $120,000/$50,000 = 2.4 = (Cash + Marketable securities + Accounts Receivable) / Current liabilities = ($15,000 + 0 + $30,000)/ $50,000 = 0.90
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Accounts Receivable Turnover Ratio
The extent of a company's liquidity problem can be further investigated by examining the liquidity of its receivables, or how long it takes the company to turn its receivables into cash. A low liquidity of receivables signals more difficulty since the quick ratio would be overstated. The liquidity of receivables is measured by the accounts receivable turnover ratio, computed as follows:
Average accounts receivable is defined as follows:
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3 Accounts Receivable Turnover in Days
The accounts receivable turnover ratio can be taken further to determine the number of days the average balance of accounts receivable is outstanding before being converted into cash, which is calculated as follows:
Whether the result is good or bad depends to some extent on what other companies in the industry are experiencing. A low turnover ratio may suggest a need to modify credit and collection policies to speed up the conversion of receivables to cash. 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
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Calculating the Average Accounts Receivable, the Accounts Receivable Turnover Ratio, and the Accounts Receivable Turnover in Days
Cornerstone 164
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3
Calculating the Average Accounts Receivable, the Accounts Receivable Turnover Ratio, and the Accounts Receivable Turnover in Days
(continued)
Cornerstone 164
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3
Using Ratio Analysis to Improve Cash Management Decisions
You Decide
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Inventory Turnover Ratio
Inventory turnover is also an important liquidity measure. The inventory turnover ratio and average inventory is computed as follows:
This ratio tells an analyst how many times the average inventory turns over, or is sold, during the year. A low turnover ratio may signal the presence of too much inventory or sluggish sales. The number of days inventory is held before being sold can be computed as:
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365 Inventory Turnover Ratio = Turnover in Days
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Calculating the Average Inventory, Inventory Turnover Ratio, and the Inventory Turnover in Days
Information: Last year, Shuster Company had net sales of $750,000 and cost of goods sold of $400,000. Shuster had the following balances:
Cornerstone 165
Required: 1. Calculate the average inventory. 2. Calculate the inventory turnover ratio. 3. Calculate the inventory turnover in days.
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3
Calculating the Average Inventory, Inventory Turnover Ratio, and the Inventory Turnover in Days (continued)
Cornerstone 165
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4
Leverage Ratios
When a company incurs debt, it has the obligation to repay the principal and the interest. Holding debt increases the riskiness of a company. Leverage ratios can help an individual to evaluate a company's debt-carrying ability. The most common leverage ratios are:
Times interest earned ratio Debt ratio Debt-to-equity ratio
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TimesInterestEarned Ratio
The first leverage ratio uses the income statement to assess a company's ability to service its debt. This ratio, called the times-interest-earned ratio, is computed as follows:
Income before taxes must be recurring income; thus, unusual or infrequent items appearing on the income statement should be excluded in order to compute the ratio. Recurring income is used because it is the income that is available each year to cover interest payments.
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4
Calculating the TimesInterestEarned Ratio
Cornerstone 166
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Debt Ratio
Investors and creditors are the two major sources of capital. As percentage of assets financed by creditors increases, the riskiness of the company increases. The debt ratio measures this percentage and is computed as follows: Since total liabilities are compared with total assets, the ratio measures the degree of protection afforded to creditors in case of insolvency. Creditors often impose restrictions on the percentage of liabilities allowed. If this percentage is exceeded, the company is in default, 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product service or place. and foreclosure can ortake otherwise on a password-protected website for classroom use.
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DebttoEquity Ratio
Another ratio useful in assessing the leverage used by a company is the debt-to-equity ratio. This ratio compares the amount of debt that is financed by stockholders and is calculated as follows:
Creditors would like this ratio to be relatively low, indicating that stockholders have financed most of the assets of the firm. Stockholders, on the other hand, may wish this ratio to be higher because that indicates that the company is more highly leveraged and stockholders can reap the return of the creditors' financing.
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Calculating the Debt Ratio and the Debtto Equity Ratio
Information: Jemell Company's balance sheet shows total liabilities of $450,000, total stockholders' equity of $300,000, and total assets of $750,000. Required: 1. Calculate the debt ratio for Jemell. 2. Calculate the debt-to-equity ratio for Jemell.
Cornerstone 167
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Profitability Ratios
Investors earn a return through the receipt of dividends and appreciation of the market value of their stock. Both dividends and market price of shares are related to the profits generated by companies. Since they are the source of debt-servicing payments, profits also are of concern to creditors. Managers also have a vested interest in profits. Bonuses, promotions, and salary increases often are tied to reported profits. Profitability ratios, therefore, are given particular attention by both internal and external users of financial statements.
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Return on Sales
Return on sales is the profit margin on sales. It represents the percentage of each sales dollar that is left over as net income after all expenses have been subtracted. Return on sales is one measure of the efficiency of a firm and is computed as follows:
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Information for Cornerstone Calculations
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5
Information for Cornerstone Calculations (continued)
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5
Calculating the Return on Sales
Cornerstone 168
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Return on Total Assets
Return on assets measures how efficiently assets are used by calculating the return on total assets used to generate profits. Return on total assets and average total assets is computed as follows:
By adding back the after-tax cost of interest, this measure reflects only how the assets were employed. It does not consider the manner in which they were financed (interest expense is a cost of obtaining the 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a assets, notwith a cost oforusing them). license distributed a certain product service or otherwise on a password-protected website for classroom use.
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Calculating the Average Total Assets and the Return on Assets
Cornerstone 169
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Return on Common Stockholders' Equity
Return on total assets is measured without regard to the source of invested funds. For common stockholders, however, the return that they receive on their investment is of paramount importance. Of special interest to common stockholders is how they are being treated relative to other suppliers of capital funds. The return on stockholders' equity provides a measure that can be used to compare against other return measures (e.g., preferred dividend rates and bond rates) and is computed as follows:
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5 Calculating the Average Common Stockholders'
Equity and the Return on Stockholders' Equity
Cornerstone 1610
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Earnings Per Share
Investors also pay considerable attention to a company's profitability on a per-share basis. Earnings per share is computed as follows:
Average common shares outstanding is computed by taking a weighted average of the common shares for the period under study.
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Computing Earnings Per Share
Cornerstone 1611
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5
PriceEarnings Ratio
The price-earnings ratio is calculated as follows:
Price-earnings ratios are viewed by many investors as important indicators of stock values. If investors believe that a company has good growth prospects, then the price-earnings ratio should be high. If investors believe that the current price-earnings ratio is low based on their view of future growth opportunities, the market price of the stock may be bid up. However, the price-earnings ratio should be interpreted with caution since it is comprised of stock price, which is a number that can be manipulated to meet certain targets involving analyst expectations, managerial bonuses, and other 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a organizationala goals. or service or otherwise on a password-protected website for classroom use. license distributed with certain product
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Computing the PriceEarnings Ratio
Cornerstone 1612
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Dividend Yield and Payout Ratios
The profitability measure called dividend yield is computed as follows:
By adding the dividend yield to the percentage change in stock price, a reasonable approximation of the total return accruing to an investor can be obtained. The dividend payout ratio is computed as follows:
The payout ratio tells an investor the proportion of earnings that a company pays in dividends. Investors who prefer regular cash payments instead of returns through price appreciation will want to invest in companies with a high payout ratio; investors who prefer gains through appreciation 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a will license distributed with a certain product or service or otherwise ratio. generally prefer a lower payout on a password-protected website for classroom use.
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Cornerstone 1613 Computing the Dividend Yield and the Dividend Payout Ratio
Information: Assume that the market price per common share is $15. Refer to the information for Payne Company. Required: 1. Compute the dividends per share. 2. Compute the dividend yield. 3. Compute the dividend payout ratio.
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Impact of the JustinTime Manufacturing Environment
In the just-in-time (JIT) manufacturing environment, reducing inventories and increasing quality are critical activities. Both activities are essential for many companies to retain their competitive ability. Accordingly, users of financial statements should have a special interest in ratios that measure a company's progress in achieving the goals of zero inventories and total quality. As a company reduces its inventory, the inventory turnover ratio should increase dramatically. High turnover is interpreted as a signal of success--of 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a achieving the certain product or service or otherwise on a password-protected website for classroom use. goal of zero inventories with all of the license distributed with a efficiency associated with that state.
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Other Ratio Considerations for the JIT Manufacturing Environment
Since many lenders require a 2.0 current ratio to grant and control a loan, some reevaluation of the use of this ratio is needed for customers with a JIT system. It may be necessary to rely more on the quick ratio or other alternative ratios (such as cash flow divided by current maturities of long-term debt). A ratio that says something about quality also is desirable for JIT firms. The usual approach is to express quality costs as a percentage of sales. External users, however, may not have access to quality costs as a separate category.
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The Importance of Profitability Ratios to External Users of the Financial Statements
Of course, for ratio analysis to be useful, it is critically important that the underlying financial information be accurate. The purpose of financial statements prepared for outside users is to fairly represent the underlying economic position of the firm. A look back at the past five to ten years shows many instances where corporate leaders, knowing the importance of various ratios, took unethical steps to make the information fit the desired ratio results rather than letting the ratios come from fairly generated information. Enron is a good example.
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