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Copyright © 2009 Pearson Prentice Hall. All rights reserved.
Chapter 2
Financial Statements and Analysis
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-2
Learning Goals
1. Review the contents of the stockholders’ report and the procedures for consolidating international financial statements.
2. Understand who uses financial ratios, and how.
3. Use ratios to analyze a firm’s liquidity and activity.
4. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-3
Learning Goals (cont.)
5. Use ratios to analyze a firm’s profitability and market value.
6. Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-4
The Stockholders’ Report
• The guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP).
• GAAP is authorized by the Financial Accounting Standards Board (FASB).
• The Sarbanes-Oxley Act of 2002, passed to eliminate the many disclosure and conflict of interest problems of corporations, established the Public Company Accounting Oversight Board (PCAOB), which is a not-for-profit corporation that overseas auditors.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-5
The Stockholders’ Report (cont.)
• The PCAOB is charged with protecting the interests of investors and furthering the public interest in the preparation of informative, fair, and independent audit reports.
• Public corporations with more than $5 million in assets and more than 500 stockholders are required by the SEC to provide their stockholders with an annual stockholders report.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-6
The Four Key Financial Statements: The Income Statement
• The income statement provides a financial summary of a company’s operating results during a specified period.
• Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.
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The Four Key Financial Statements
Table 2.1 Bartlett Company Income Statements ($000)
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The Four Key Financial Statements: The Balance Sheet
• The balance sheet presents a summary of a firm’s financial position at a given point in time.
• Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.
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The Four Key Financial Statements
Table 2.2a Bartlett Company Balance Sheets ($000)
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The Four Key Financial Statements (cont.)
Table 2.2b Bartlett Company Balance Sheets ($000)
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The Four Key Financial Statements: Statement of Retained Earnings
• The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.
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The Four Key Financial Statements
Table 2.3 Bartlett Company Statement of Retained Earnings ($000) for the Year Ended December 31, 2009
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The Four Key Financial Statements: Statement of Cash Flows
• The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended.
• This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.
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The Four Key Financial Statements
Table 2.4 Bartlett Company Statement of Cash Flows ($000) for the Year Ended December 31, 2009
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-15
Consolidating International Financial Statements
• FASB 52 mandated that U.S. based companies translate their foreign-currency denominated assets and liabilities into dollars using the current rate (translation) method.
• Under the translation method, companies translate all foreign-currency-denominated assets and liabilities into dollars at the exchange rate prevailing at the fiscal year ending date (the current rate).
• Income statement items are usually treated similarly.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-16
Consolidating International Financial Statements (cont.)
• Equity accounts, on the other hand, are translated into dollars by using the exchange rate that prevailed when the parent’s equity investment was made (the historical rate).
• Retained earnings are adjusted to reflect each year’s operating profits (or losses).
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-17
Using Financial Ratios: Interested Parties
• Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance.
• It is of interest to shareholders, creditors, and the firm’s own management.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-18
Using Financial Ratios: Types of Ratio Comparisons
• Trend or time-series analysis
– Used to evaluate a firm’s performance over time
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Using Financial Ratios: Types of Ratio Comparisons (cont.)
• Trend or time-series analysis
• Cross-sectional analysis
– Used to compare different firms at the same point in time
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Using Financial Ratios: Types of Ratio Comparisons (cont.)
• Trend or time-series analysis
• Cross-sectional analysis
– Industry comparative analysis
• One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-21
Using Financial Ratios: Types of Ratio Comparisons (cont.)
• Trend or time-series analysis
• Cross-sectional analysis
– Benchmarking
• A type of cross sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-22
Using Financial Ratios: Types of Ratio Comparisons (cont.)
• Trend or time-series analysis
• Cross-sectional analysis
• Combined Analysis– Combined analysis simply uses a combination of
both time series analysis and cross-sectional analysis
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-23
Using Financial Ratios: Types of Ratio Comparisons (cont.)
Table 2.5 Industry Average Ratios for Selected Lines of Businessa
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Using Financial Ratios: Types of Ratio Comparisons (cont.)
Figure 2.1 Combined Analysis
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Using Financial Ratios: Cautions for Doing Ratio Analysis
1. Ratios must be considered together; a single ratio by itself means relatively little.
2. Financial statements that are being compared should be dated at the same point in time.
3. Use audited financial statements when possible.
4. The financial data being compared should have been developed in the same way.
5. Be wary of inflation distortions.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-26
Ratio Analysis Example
• We will illustrate the use of financial ratios for analyzing financial statements using the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2.
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-27
Current ratio = total current assets
total current liabilities
Current ratio = $1,233,000 = 1.97
$620,000
Ratio Analysis
• Liquidity Ratios– Current Ratio
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-28
Quick ratio = Total Current Assets - Inventory
total current liabilities
Quick ratio = $1,233,000 - $289,000 = 1.51
$620,000
Ratio Analysis (cont.)
• Liquidity Ratios– Current Ratio– Quick Ratio
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-29
Inventory Turnover = Cost of Goods Sold
Inventory
Inventory Turnover = $2,088,000 = 7.2
$289,000
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios
– Inventory Turnover
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-30
Average Age of Inventory = 365
Inventory Turnover
Inventory Turnover = 365 = 50.7 days
7.2
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios
– Average Age of Inventory
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-31
ACP = Accounts Receivable
Net Sales/365
ACP = $503,000 = 59.7 days
$3,074,000/365
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios
– Average Collection Period
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-32
APP = Accounts Payable
Annual Purchases/365
APP = $382,000 = 95.4 days (.70 x $2,088,000)/365
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios
– Average Payment Period
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-33
Total Asset Turnover = Net Sales
Total Assets
Total Asset Turnover = $3,074,000 = .85
$3,597,000
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios
– Total Asset Turnover
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Ratio Analysis (cont.)
Table 2.6 Financial Statements Associated with Patty’s Alternatives
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Debt Ratio = Total Liabilities/Total Assets
Debt Ratio = $1,643,000/$3,597,000 = 45.7%
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Financial Leverage Ratios
– Debt Ratio
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Times Interest Earned = EBIT/Interest
Times Interest Earned = $418,000/$93,000 = 4.5
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios
– Times Interest Earned Ratio
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FPCR = EBIT + Lease Payments________________
Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}
FPCR = $418,000 + $35,000 = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios
– Fixed-Payment coverage Ratio (FPCR)
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios– Common-Size Income Statements
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Ratio Analysis (cont.)
Table 2.7 Bartlett Company Common-Size Income Statements
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GPM = Gross Profit/Net Sales
GPM = $986,000/$3,074,000 = 32.1%
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Gross Profit Margin
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-41
OPM = EBIT/Net Sales
OPM = $418,000/$3,074,000 = 13.6%
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Operating Profit Margin (OPM)
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NPM = Earnings Available to Common Stockholders
Sales
NPM = $221,000/$3,074,000 = 7.2%
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Net Profit Margin (NPM)
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-43
EPS = Earnings Available to Common Stockholders Number of Shares Outstanding
EPS = $221,000/76,262 = $2.90
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Earnings Per Share (EPS)
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ROA = Earnings Available to Common Stockholders
Total Assets
ROA = $221,000/$3,597,000 = 6.1%
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Return on Total Assets (ROA)
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ROE = $221,000/$1,754,000 = 12.6%
ROE = Earnings Available to Common Stockholders
Total Equity
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Return on Equity (ROE)
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P/E = Market Price Per Share of Common Stock Earnings Per Share
P/E = $32.25/$2.90 = 11.1
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios• Market Ratios
– Price Earnings (P/E) Ratio
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BV/Share = Common Stock Equity Number of Shares of Common Stock
BV/Share = $1,754,000/72,262 = $23.00
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios• Market Ratios
– Market/Book (M/B) Ratio
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M/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common Stock
M/B Ratio = $32.25/$23.00 = 1.40
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios• Market Ratios
– Market/Book (M/B) Ratio
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Summarizing All Ratios Table 2.8 Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)
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Summarizing All Ratios (cont.)Table 2.8 Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)
Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-51
DuPont System of Analysis
• The DuPont system of analysis is used to dissect the firm’s
financial statements and to assess its financial condition.
• It merges the income statement and balance sheet into two summary
measures of profitability.
• The Modified DuPont Formula relates the firm’s ROA to its ROE
using the financial leverage multiplier (FLM), which is the ratio of
total assets to common stock equity:
• ROA and ROE as shown in the series of equations on the following
slide and in Figure 2.2 on the following slide.
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DuPont System of Analysis
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DuPont System of Analysis (cont.)
Figure 2.2 DuPont System of Analysis
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ROE = 6.1% X 2.06 = 12.6%
Modified DuPont Formula (cont.)
• Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner’s return.
• Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the Modified DuPont formula yields: