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Unformatted text preview: Accounting Principles: A Business Perspective, 8e
Chapter 17: Analysis and Interpretation of Financial Statements
REVISED 10/2007 KJ 1 Chapter 17 Objectives of Financial Statement Analysis
Assess PAST PERFORMANCE and CURRENT FINANCIAL POSITION. COMPARE firms to one another and to industry averages Discover and ASSESS TRENDS in financial performance Make predictions about FUTURE performance. FS Analysis involves making COMPARISONS.
2 Chapter 17 Types of Financial Statement Comparisons 3 Chapter 17 Users of Financial Statement Analysis EXTERNAL users of financial statements LENDERS, SHAREHOLDERS, REGULATORS Need information on LIQUIDITY
COMPANY'S ABILITY TO PAY CURRENTLY MATURING DEBTS MUST DECIDE WHETHER TO EXTEND OR RESTRICT CREDIT Need information on PROFITABILITY 4 COMPANY'S ABILITY TO GENERATE FUTURE Chapter 17 Users of Financial Statement Analysis INTERNAL users of financial statements MANAGEMENT Also need information on LIQUIDITY
MUST ADJUST OPERATIONS, INVESTING AND FINANCING STRATEGIES TO ASSURE COMPANY'S ABILITY TO PAY CURRENTLY MATURING DEBTS Also need information on PROFITABILITY
MUST ADJUST OPERATIONS, INVESTING AND FINANCING STRATEGIES TO ASSURE COMPANY'S ABILITY TO GENERATE FUTURE EARNINGS 5 Chapter 17 Financial Analysis Tools & Techniques HORIZONTAL ANALYSIS Comparison of financial statement amounts for one company for two or more successive periods Statements to be compared are arrayed in adjacent columns A new column is prepared showing the changes in the various component items from one period to the next Often a percentage change column is also computed Horizontal analysis may be applied to BALANCE SHEET, INCOME STATEMENT, or STATEMENT OF CASH FLOWS 6 Chapter 17 Horizontal Analysis Balance Sheet Illustration 17.1 7 Chapter 17 Horizontal Analysis Income Statement Illustration 17.2 8 Chapter 17 Horizontal Analysis: Exercise 171a 9 Chapter 17 Financial Analysis Tools & Techniques TREND ANALYSIS If we extend horizontal analysis for a single financial statement amount (such as net sales) for several years we can determine the quantity's TREND. To implement TREND ANALYSIS we select the earliest year as the base and assign it the value 100. This is called the Index Number. Each successive year is then expressed as 100 times the ratio of the current year's measurement to the base year measurement. For example, 112 means 112% of the base year amount. 10 Chapter 17 Financial Analysis Tools & Techniques TREND ANALYSIS example from p. 668 11 Chapter 17 Financial Analysis Tools & Techniques TREND ANALYSIS  CAUTION
Trend percentages from one period to another cannot be computed if the base year amount is zero or negative This is common for the net income of startup companies 12 Chapter 17 Financial Analysis Tools & Techniques VERTICAL ANALYSIS Also called COMMON SIZE analysis Analysis of financial statements of one company by expressing all amounts as percentages of a BASE AMOUNT Column of percentages is shown to the right of the column of actual amounts Vertical analysis may be applied to BALANCE SHEET or INCOME STATEMENT BASE AMOUNT for BALANCE SHEET is Total Assets BASE AMOUNT for INCOME STATEMENT is Net Sales 13 Chapter 17 Vertical Analysis Balance Sheet Illustration 17.1 14 Chapter 17 Vertical Analysis Income Statement Illustration 17.2 15 Chapter 17 Vertical Analysis: Exercise 171b 16 Chapter 17 Horizontal & Vertical Analysis: Interpret Results: Exercise 171c 17 Chapter 17 Financial Analysis Tools & Techniques FINANCIAL RATIO ANALYSIS Analysis of various financial statement relationships of one company by expressing two financial statement amounts as a RATIO (one item divided by another = ratio) For a single ratio, the two amounts may come from the same financial statement from two different financial statements from market information that is not in the financial statements 18 Ratio analysis may be applied to BALANCE SHEET, INCOME STATEMENT, and STATEMENT OF CASH FLOWS amounts Chapter 17 Financial Analysis Tools & Techniques FINANCIAL RATIO ANALYSIS Ratios are defined that assess LIQUIDITY (ability to pay debts)
Current Ratio Acid Test Ratio (also called Quick Ratio) Cash Flow Liquidity Ratio Accounts Receivable Turnover Ratio Number of Days Sales in Accounts Receivable Inventory Turnover Ratio 19 Chapter 17 Financial Ratio Analysis  Liquidity CURRENT RATIO Also called Working Capital Ratio Current Ratio = 20 Chapter 17 Current Ratio Exercise 172a 21 Chapter 17 Current Ratio Exercise 172 b&c 22 Chapter 17 Financial Ratio Analysis  Liquidity ACID TEST RATIO Also called Quick Ratio Numerator is QUICK ASSETS defined as: Cash + Marketable Securities + Net Receivables Denominator is: Current Liabilities Acid Test Ratio measures ability to pay bills without relying on sales of inventory to generate any cash 23 Chapter 17 Financial Ratio Analysis  Liquidity ACID TEST RATIO 24 Chapter 17 Financial Ratio Analysis  Liquidity CASH FLOW LIQUIDITY RATIO = Measures company's ability to raise cash by selling inventory and collecting receivables generated by operations Applies this cash to task of paying current debts 25 Chapter 17 Financial Ratio Analysis  Liquidity ACCOUNTS RECEIVABLE TURNOVER Assesses the effectiveness of the company's collection activities by relating Credit Sales to the average balance of such sales that are unpaid How often is the AVERAGE RECEIVABLES BALANCE collected each year? AR Turnover = 26 Note: This ratio uses an INCOME STATEMENT amount Chapter 17 Financial Ratio Analysis  Liquidity ACCOUNTS RECEIVABLE TURNOVER Is closely related to NUMBER OF DAYS' SALES IN ACCOUNTS RECEIVABLE Number of Days' Sales in Accounts Receivable = Thus, if AR Turnover is 5, Then, on average, 365 / 5 = 73 days of credit sales are in AR 27 Chapter 17 Financial Ratio Analysis Liquidity
Exercise 173 ACCOUNTS RECEIVABLE TURNOVER & NUMBER OF DAYS' SALES IN ACCOUNTS RECEIVABLE 28 Chapter 17 Financial Ratio Analysis  Liquidity INVENTORY TURNOVER Assesses how well the company is able to convert inventory into sales How often is the AVERAGE INVENTORY BALANCE sold each year? Inventory Turnover =
Note: This ratio uses an INCOME STATEMENT amount and a BALANCE SHEET amount 29 Chapter 17 Financial Ratio Analysis Liquidity
Exercise 175  INVENTORY TURNOVER RATIO 30 Chapter 17 Analyzing Turnover Ratios
A Low ACCOUNTS RECEIVABLE TURNOVER ratio indicates difficulty in collecting receivables Often this is caused by overly liberal credit policies put in place to boost faltering sales may indicate an adverse selection problem as customers who can't get credit elsewhere flock to this merchant 31 A Low INVENTORY TURNOVER ratio often indicates the presence of obsolete inventory Low Turnover ratios are often excellent early predictors of BUSINESS FAILURE. Chapter 17 Financial Ratio Analysis Activity
Sales Activity is a precursor to Profits TOTAL ASSET TURNOVER Assesses how well the company is able to generate sales revenue from its investment in assets Total Asset Turnover = Note: This ratio uses an INCOME STATEMENT amount and a BALANCE SHEET amount 32 Chapter 17 Financial Ratio Analysis Activity
Sales Activity is a precursor to Profits TOTAL ASSET TURNOVER 33 Chapter 17 Financial Ratio Analysis Leverage
The Use of Debt can help Owners to Enhance Income EQUITY RATIO Measures the proportion of the total asset base that is provided by the STOCKHOLDERS The Remaining portion is provided by CREDITORS such as bondholders Buy using debt to help support some assets, the stockholders LEVER or multiply the power of their investment Owners often favor LOW EQUITY RATIOS which can indicate valuable financial leverage 34 Chapter 17 Financial Ratio Analysis Leverage
The Use of Debt can help Owners to Enhance Income EQUITY RATIO Defined as total equity divided by total assets Equity Ratio =
See Walt Disney Company Balance Sheet on p.702 and compute EQUITY RATIO: 35 Chapter 17 Financial Ratio Analysis Leverage
Too Much Debt exposes creditors to possible losses EQUITY RATIO The portion of the total assets that is supported by debt is of interest to CREDITORS such as bankers and bondholders These Creditors may become concerned that the repayment of their loans and bonds might be in jeopardy if they sense that the EQUITY RATIO is TOO LOW 36 Chapter 17 Financial Ratio Analysis Leverage
Alternative ways to present the Leverage Relationship EQUITY RATIO LAST THREE SLIDES Defined as TOTAL EQUITY divided by TOTAL ASSETS Commonly used and reported EQUITY TO DEBT RATIO Defined as TOTAL EQUITY divided by TOTAL DEBT Not commonly reported 37 DEBT TO EQUITY RATIO Chapter 17 Financial Ratio Analysis Profitability
Assessing the Income Generating Ability of the Company OPERATING MARGIN Defined as NET OPERATING INCOME divided by NET SALES NOI excludes income and expense items that are not related to the operation of the company's business e.g. interest expense Q1: What percentage of a SALES $ becomes a PROFIT $? A1: NOI is $400, SALES are $2500, thus OM = 16% 38 Chapter 17 Financial Ratio Analysis Profitability
Assessing the Income Generating Ability of the Company TURNOVER OF OPERATING ASSETS Defined as NET SALES divided by OPERATING ASSETS OA excludes asset items that are not related to the operation of
the company's business e.g. Investments in other companies Q2: How often are the ASSETS used in the business recovered through SALES ? 39 A2: SALES are $2500, OA are $2000, thus TOA = 1.25 Chapter 17 Financial Ratio Analysis Profitability
Assessing the Income Generating Ability of the Company ROA or Rate of Return on Operating Assets Defined as OPERATING MARGIN multiplied by TURNOVER OF OPERATING ASSETS ROA = 40 ROA = Chapter 17 Financial Ratio Analysis Profitability
Assessing the Income Generating Ability of the Company ROA or Rate of Return on Operating Assets ROA = EX 176 41 Chapter 17 Financial Ratio Analysis Profitability
Assessing the Income Generating Ability of the Company ROE or Rate of Return on Stockholders' Equity Q3: Who provided the assets for earning ROA ? A3: If Stockholders provided all the assets, ROE = ROA, but if some leverage was employed by using debt to support some of the assets, then ROE will be enhanced. ROE is defined as NET INCOME divided by Average STOCKHOLDERS' EQUITY 42 Chapter 17 Financial Ratio Analysis Profitability
Assessing the Income Generating Ability of the Company ROE or Rate of Return on Stockholders' Equity EX 177 43 Chapter 17 Financial Ratio Analysis Efficiency
Assessing the Company's Ability to Convert Sales to Cash CASH FLOW MARGIN Measures company's ability to generate cash to service debt, pay dividends, and invest in new capital assets Defined as CASH FLOW FROM OPERATING ACTIVITIES divided by NET SALES 44 Chapter 17 Financial Ratio Analysis Efficiency
Assessing the Company's Ability to Convert Sales to Cash CASH FLOW MARGIN
174 EX 45 Chapter 17 Financial Ratio Analysis Profitability
Assessing the per share Earnings of the Company EPS or Earnings per Share of Common Stock Widely cited measure of a Company's overall performance Growth rate from yeartoyear a common measure of managerial effectiveness TREND ANALYSIS often applied to EPS Defined as EARNINGS AVAILABLE TO COMMON SHS divided by AVERAGE NUMBER OF SHARES OUTSTANDING 46 Chapter 17 Financial Ratio Analysis Profitability
Assessing the per share Earnings of the Company EPS or Earnings per Share of Common Stock
7 Ex 17 47 Chapter 17 Financial Ratio Analysis Profitability
Assessing the per share Earnings of the Company EPS or Earnings per Share of Common Stock Defined as EARNINGS AVAILABLE TO COMMON SHS divided by AVERAGE NUMBER OF SHARES OUTSTANDING Actually, the number of shares is a WEIGHTED Average number we must weight each share by the portion of the year that it was outstanding
Thus, a share outstanding for the entire year gets a weight of 1 While a share outstanding for just nine months is weighted 48 Chapter 17 Financial Ratio Analysis Profitability
Assessing the per share Earnings of the Company WEIGHTED AVERAGE number of Shares
179 Ex 49 Chapter 17 Financial Ratio Analysis Profitability
Assessing the per share Earnings of the Company EPS or Earnings per Share of Common Stock Ex 178 50 Chapter 17 Financial Ratio Analysis Profitability
Assessing the per share Earnings of the Company EPS or Earnings per Share of Common Stock If EPS is to be compared over time, it is necessary to make sure that the share bases on which the EPS are calculated are consistent Consider: A Firm earns $1000 in year 1 and $1200 in year 2 51 Chapter 17 Financial Ratio Analysis Profitability
Assessing the per share Earnings of the Company Adjusting prior EPS EX 1710 52 Chapter 17 Financial Ratio Analysis Solvency
Assessing the Company's ability to pay its longterm debts TIMES INTEREST EARNED is a measure of
the safety cushion a Company enjoys in regard to its debt service obligations It answers this Q: How many times would the Company have been able to pay the interest that it owed? TIMES INTEREST EARNED = 53 Chapter 17 Financial Ratio Analysis Solvency
Assessing the Company's ability to pay its longterm debts TIMES INTEREST EARNED
1711 EX TIE = 54 Chapter 17 Financial Ratio Analysis Solvency
Assessing the Company's ability to pay preferred dividends TIMES PREFERRED DIVIDENDS EARNED is a measure of the safety cushion a
Company enjoys in regard to its preferred dividend obligations It answers this Q: How many times would the Company have been able to pay the preferred dividends that it expects to declare? TIMES PREF. DIV. EARNED = 55 Chapter 17 Financial Ratio Analysis Solvency
Assessing the Company's ability to pay preferred dividends TIMES PREFERRED DIVIDENDS EARNED
1712A EX 56 Chapter 17 Financial Ratio Analysis Yield Assessing the Investor's Rate of Return on a Stock Investment DIVIDEND YIELD is a measure of the amount of
DIVIDEND CASH FLOW to be received as a percentage of the price that would be paid to acquire the stock DIVIDEND YIELD = DIVIDEND YIELD may be calculated for both common and preferred stock issues 57 Chapter 17 Financial Ratio Analysis Yield
DIVIDEND YIELD
1712B Assessing the Investor's Rate of Return on a Stock Investment EX 58 Chapter 17 Financial Ratio Analysis Yield Assessing the Investor's Rate of Return on a Stock Investment EARNINGS YIELD is a measure of the amount of
NET INCOME that is attributed to a share of stock (whether paid out or not) as a percentage of the price that would be paid to acquire the stock EARNINGS YIELD = EARNINGS YIELD is generally calculated for common, but not for preferred stock issues 59 Chapter 17 Financial Ratio Analysis Market Measures
The Market's assessment of the value of a stock's earning power PRICE EARNINGS RATIO is a measure of
the VALUE (Market Equilibrium Price) that investors place on EACH DOLLAR of a Company's earnings P/E = Note that the P/E ratio is the reciprocal of the EARNINGS YIELD P/E is routinely calculated for all publicly traded stocks and is a primary tool for comparing stocks of different firms 60 Chapter 17 Financial Ratio Analysis Market Measures
The Market's assessment of the value of a stock's earning power P/E RATIO EX 17 13B 61 Chapter 17 Financial Ratio Analysis Cash Flow Capability
Assessing the Company's ability to generate cash CASH FLOW PER SHARE OF COMMON STOCK This ratio expresses the company's CASH FLOW FROM OPERATING ACTIVITIES on a per share basis It is useful for determining dividend paying ability when there are also significant demands on cash for the payment of interest on outstanding bonds and notes 62 CF/SHARE OF CS = Financial Statement Analysis Summary Problem Chapter 17 A P177 63 Financial Statement Analysis Summary Problem Chapter 17 B P177 64 Financial Statement Analysis Summary Problem Chapter 17 C P177 65 Chapter 17 Ahhhh  Powder 66 ...
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This note was uploaded on 04/08/2008 for the course ACT 240 taught by Professor Janson during the Winter '08 term at N. Michigan.
 Winter '08
 Janson
 Accounting

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