Financial Statement Analysis

1
Financial Statement Analysis
Creditors
Stockholders
Management
2
Limitations of Financial Statement Analysis

• Use of different accounting methods
• Changes in accounting methods

LIFO
FIFO
3
Limitations of Financial Statement Analysis

• Failure to understand trends or use industry
  ratios
• Difficulty of making industry comparisons (i.e.,
  conglomerates)

4
Limitations of Financial Statement Analysis

• Nonoperating items on income statement
• Effects of inflation

5
Horizontal Analysis
Wm. Wrigley Jr. Company (in millions)

• Increase (Decrease)
• 2002 2001 Dollars Percent
• 2,746 2,401 345 14.4
• 1,596 1,404 192 13.7
• 402 363 39 10.7

• Net Sales
• Gross Profit
• Net Earnings

6
Trend Analysis
Wm. Wrigley Jr. Company

• 2002 2001 2000 1999 1998
• 28.7 30.1 29.0 26.8 28.4

• Return on
• Avg. Equity

Tracking items over a series of years
7
Vertical Analysis

• Common-size statements recast items as a
  percentage of a selected item
• Allows comparisons of companies of different size
• Compares percentages across years to identify
  trends

8
Common-Size Statements
Dollars Percent 24,000 100.0 18,000
75.0 6,000 25.0 3,000 12.5
3,000 12.5 140 0.6
2,860 11.9 1,140 4.8 1,720 7.1

• Sales revenue
• Cost of goods sold
• Gross profit
• Selling admin. exp.
• Operating income
• Interest expense
• Income before tax
• Income tax expense
• Net income

9
Liquidity Analysis

• Nearness to cash
• Ability to pay debts as they become due

10
Current Ratio

• Measure of short-term financial health
• Consider composition of current assets

Rule of thumb 21
11
Acid-Test (Quick) Ratio

• Stricter test of ability to pay debts
• Excludes inventories and prepaid assets

Quick Assets Current Liabilities
12
Accounts Receivable Turnover Ratio

• Net Sales
• Average Accounts Receivable

Indicates how quickly a company is collecting
(i.e., turning over) its receivables
13
Accounts Receivable Turnover Ratio

• Too fast
• Credit policies too stringent may be losing
  sales

• Too slow
• Credit department not operating effectively
  possible quality problems

14
Number of Days Sales in Receivables
365 Days
. Accts. Receivable Turnover
Represents the average of days accounts are
outstanding
Some analysts use 360 days.
15
Number of Days Sales in Receivables
Example
365 Days 4.8 Times
76 days

• If this companys credit terms are net 30, what
  would this tell you about the efficiency of the
  collection process?

16
Inventory Turnover Ratio
Cost of Goods Sold Average Inventory
Represents the number of times per period
inventory is turned over (i.e., sold).

17
Inventory Turnover Ratio

• Circuit City 5.8 times per year
• Safeway 9.2 times per year
• Can you compare the two ratios?

18
of Days Sales in Inventory
365 Days Inventory Turnover Ratio
Represents the average of days inventory is on
hand before its sold
19
of Days Sales in Inventory

• Circuit City 62 days
• Safeway 39 days
• Do these averages seem reasonable?

20
Asset Turnover

• Net Sales/Avg. Total Assets
• Indicates how effectively company is utilizing
  assets to generate sales
• Higher, better
• Varies widely between industries

21
Solvency Analysis

• Ability to stay in business over the long-term

Times Interest Earned
Debt-to-Equity Ratio
Cash Flow to Capital Expenditures
Debt Service Coverage
22
Debt-to-Equity Ratio
How much have creditors contributed compared to
owners?
Total Liabilities Total Stockholders
Equity
23
Debt-to-Equity Ratio
Total Liabilities Total Stockholders Equity
.60
24
Times Interest Earned Ratio

• Measures ability to meet current interest
  payments
• The greater the coverage the better

Net Income Interest Exp. Income Tax Exp.
(EBIT) Interest Expense
25
Profitability Analysis

• Profit Margin
• Gross Margin
• Rate of Return on Assets
• Return on Common S/E
• EPS
• P/E Ratio
• Dividend Ratios

26
Profit Margin

• Net Income/Net Sales
• Shows how much profit is being earned per dollar
  of sales

27
Gross Margin

• Gross Margin/Net Sales
• (Gross Margin Net Sales COGS)
• Shows the mark up on goods sold

28
Return on Assets Ratio

• Measures return to all providers of capital
  (creditors and owners)

Net Income Average Total Assets
29
Return on Stockholders Equity
Net Income Average Stockholders Equity
30
Earnings per Share

• Presents profits on a per-share basis

Net Income Weighted Avg. of Common Shares
Outstanding
31
Price/Earnings Ratio

• Relates earnings to the market price of the stock

Current Market Price Earnings per Share
very high P/E very low P/E
possibly overvalued possibly undervalued
32
Dividend Payout Ratio
Common Dividends per Share Earnings per Share
33
Appendix

• Accounting Tools
• Non-Operating Income Statement Items (DEC)

34
Common Characteristics

• All such items are reported after income from
  continuing operations
• Shown net of tax effects
• Most analysts ignore these items, since they are
  not likely to reoccur

35
Discontinued Operations

• Any gain or loss from disposal of a division or
  segment of the business
• Any net income or loss from operating this
  portion until the date of disposal

36
Extraordinary Items

• Gain or loss due to an event that is
• Unusual in nature AND
• Infrequent in occurrence

37
Cumulative Effect of a Change in Accounting
Principle

• Reflects a change in a companys accounting
  principles, practices, or methods
• Reports the difference in income in all prior
  years between the old method and the new method
• Sometimes such a change is dictated by new
  accounting standards

38
End of Chapter 13
39
Key Points Summary for Ch. 13

• Why Analyze Financial Information?
• To make decisions Ratios are tools of decision
  making
• Limitations of Financial Analysis
• Different accounting methods
• Difficulty of making comparisons (conglomerates)
• Inflation/Non-operating income items

40
Key Points Summary for Ch. 13

• Horizontal/Trend Analysis Year-to-year
• Vertical Analysis Within one year
• Liquidity Analysis Ability of company to
  operate in short-term
• Current Ratio Current Assets/Current
  Liabilities
• Ability of Co. to pay short-term debt
• Quick Ratio Quick Assets/Current Liabilities
• Ability of Co. to pay short-term debt (stricter)
• (Quick Assets Cash A/R ST investments)

41
Key Points Summary for Ch. 13

• Liquidity Analysis (contd)
• A/R Turnover Credit Sales/Avg. A/R
• of times Co. collects A/R during year
• Days Sales in Receivables 365/ A/R Turnover
• Avg. collection period for receivables
• Inventory Turnover COGS/Avg. Inventory
• of times Inventory is sold during year
• Days Sales in Inventory 365/ Inv. Turnover
• Avg. days to sell inventory

42
Key Points Summary for Ch. 13

• Solvency Analysis Long-term ability of
  company to stay in business
• Debt-to-Equity Ratio Total Liab./Total Equity
• Borrowing vs. Investments by owner
• Times Interest Earned
• Net Income Interest Exp. Income Tax Exp.
  (EBIT)
• Interest Expense
• How many times over could Co. pay interest with
  current earnings

43
Key Points Summary for Ch. 13

• Profitability Ratios Ability of company to
  generate profits
• Profit margin Net Income/Net Sales
• How much profit per 1 of sales
• Gross margin Gross Margin/Net Sales
• Mark up on product sales
• Return on Assets Net Income/Avg. Assets
• Effectivess of Company at using assets

44
Key Points Summary for Ch. 13

• Profitability Ratios (contd)
• Return on Common Equity Net Income Preferred
  Dividends/Common Stockholders Equity
• Measures return on investment
• Earnings Per Share Net Income/Avg Shares
• Earnings amount per share of stock
• Non-operating Income Statement Items DEC