Financial Statement Analysis

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Chapter 13

• Financial Statement Analysis

Financial Accounting 4e by Porter and Norton
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Financial Statement Analysis
Creditors
Stockholders
Management
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Limitations of Financial Statement Analysis

• Use of different accounting methods
• Changes in accounting methods

LIFO
FIFO
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Limitations of Financial Statement Analysis

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

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Limitations of Financial Statement Analysis

• Nonoperating items on income statement
• Effects of inflation

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

• Increase (Decrease)
• 2001 2000 Change Change
• 2,430 2,146 284 13.2
• 1,433 1,242 191 15.4
• 363 329 34 10.3

• Net Sales
• Gross Profit
• Net Earnings

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Trend Analysis
Wm. Wrigley Jr. Company

• 2001 2000 1999 1998 1997
• 30.1 29.0 26.8 28.4 28.9

• Return on
• Avg. Equity

Tracking items over a series of years
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Vertical Analysis

• Common-size statements recast items as a
  percentage of a selected item
• Income Statement as of Revenues
• Balance Sheet as a of Total Assets
• Allows comparisons of companies of different
  size
• Compares percentages across years to identify
  trends

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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

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Liquidity Analysis

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

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Working Capital

• Excess of current assets over current liabilities
• Lacks meaningful comparisons for companies of
  different size

-
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Current Ratio

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

Rule of thumb 21
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Acid-Test (Quick) Ratio

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

Quick Assets Current Liabilities
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Cash Flow from Operations to Current Liabilities
Ratio

• Focuses on cash only
• Covers period of time

Net Cash Provided by Operating Activities Average
Current Liabilities
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Accounts Receivable Turnover Ratio

• Net Credit Sales
• Average Accounts Receivable

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

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

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

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

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

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

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Inventory Turnover Ratio

• Circuit City 5.9 times per year
• Safeway 9.3 times per year
• Can you compare the two ratios?

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

• Circuit City 61 days
• Safeway 39 days
• Do these averages seem reasonable?

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Cash Operating Cycle

• Time between purchase of merchandise and
  collection from the sale

of days sales in receivables of days
sales in inventory
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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
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Debt-to-Equity Ratio
How much have creditors contributed compared to
owners?
Total Liabilities Total Stockholders
Equity
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Debt-to-Equity Ratio
Total Liabilities Total Stockholders Equity
.60
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Times Interest Earned Ratio

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

Net Income Interest Expense Income Tax
Expense Interest Expense
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Debt Service Coverage Ratio

• Measures amount of cash from operations available
  to service the debt

Cash Flow from Operations before Interest
Taxes Interest and Principal Payments
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Profitability Analysis

• Rate of Return on Assets (ROA)
• Return on Common S/E (ROE)
• EPS
• P/E Ratio
• Dividend Ratios

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Return on Assets Ratio (ROA)

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

Net Income Interest Expense, Net of Tax Average
Total Assets
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Return on Common Stockholders Equity (ROE)
Net Income - Preferred Dividends Average Common
Stockholders Equity
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Earnings per Share (EPS)

• Presents profits on a per-share basis

Net Income - Preferred Dividends Weighted Avg.
of Common Shares Outstanding
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Price/Earnings Ratio (P/E)

• 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
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Price/Earnings Ratio
Both companies have earnings of 2 per share. So
why the different P/E ratios?
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Dividend Payout Ratio
Common Dividends per Share Earnings per Share
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Dividend Yield Ratio

• Some investors willing to forgo dividends in lieu
  of price appreciation

Common Dividends per Share Market Price per Share
usually lt 5

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Appendix

• Accounting Tools
• Reporting and Analyzing
• Other Income Statement Items

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Common Characteristics

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

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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

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Extraordinary Items

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

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Cumulative Effect of a Change in Accounting
Principle

• Reflects a change in a companys accounting
  principles e.g. Switch from accelerated
  depreciation to straight line
• 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

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End of Chapter 13