Financial Statement Analysis at different Stages

Financial Statement Analysis at different Stages

1. List basic financial statement analytical procedures.

2. Apply financial statement analysis to assess the solvency of a business.

3. Apply financial statement analysis to stress the profitability of a business.

4. Describe the contents of corporate annual reports.

After studying this chapter, you should be able to:

WHY?

WHEN?

HOW?

How much money does the company need? When is the money needed? When will the company make money? How much money will they make? When? Shareholders equity, how much needed? Credit, how much needed?

How much money does the company need? When is the money needed? When will the company make money? How much money will they make? When? Shareholders equity, is the mix correct? Credit, are current arrangements correct? Are actuals inline with forecasts?

How much money does the company need? When is the money needed? When will the company make money? How much money will they make? When? Shareholders equity, is the mix correct? Credit, are current arrangements correct? Are actuals inline with forecasts? How to fund growth?

Internal Users◦ Management◦ Owner (s)

External Users◦ Investors◦ Creditors◦ Government◦ Customers◦ Labour Unions

(employees)◦ Public

10

Horizontal Analysis

The percentage analysis of increases and decreases in related items in comparative

financial statements is called horizontal analysis.

AssetsCurrent assets $ 550,000$ 533,000$ 17,000 3.2%Long-term investments 95,000 177,500 (82,500) (46.5%)Prop., plant, and equip. (net)444,500470,000(25,500) (5.4%)Intangible assets 50,000 50,000Total assets $1,139,500$1,230,500$ (91,000) (7.4%) LiabilitiesCurrent liabilities $ 210,000$ 243,000$ (33,000) (13.6%)Long-term liabilities 100,000 200,000 100,000)(50.0%) Total liabilities $ 310,000$ 443,000$(133,000) (30.0%) Stockholders’ EquityPreferred 6% stock, $100 par$ 150,000$ 150,000— Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500$ 42,000 30.5%Total stockholders’ equity $ 829,500$ 787,500$ 42,000 5.3%Total liab. & stockholders’ eq.$1,139,500$1,230,500$ (91,000)(7.4%)

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Exhibit 1 Comparative Balance Sheets

2008 2007 Amount Percent

Increase (Decrease)

Lincoln CompanyComparative Balance Sheet

December 31, 2008 and 2007

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December 31, 2008 and 2007Increase (Decrease)

Horizontal Analysis: Horizontal Analysis:

Difference $17,000

Base year (2007) $533,000 = 3.2%

13


7



December 31, 2008 and 2007Increase (Decrease)


Difference $(82,500)

Base year (2007) $177,500 = (46.5%)

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Exhibit 2 Comparative Schedule of Current Assets

Lincoln CompanyComparative Schedule of Current Assets


Increase (Decrease)

Cash $ 90,500 $ 64,700 $ 25,800 39.9%Marketable securities 75,000 60,000 15,000 25.0%Accounts receivable (net) 115,000 120,000 (5,000) (4.2%)Inventories 264,000 283,000 (19,000) (6.7%)Prepaid expenses 5,500 5,300 200 3.8%Total current assets $550,000 $533,000 $17,000 3.2%


15

9

Lincoln CompanyComparative Schedule of Current Assets


Increase (Decrease)

Cash $ 90,500 $ 64,700 $ 25,800 39.9%Marketable securities 75,000 60,000 15,000 25.0%Accounts receivable (net) 115,000 120,000 (5,000) (4.2%)Inventories 264,000 283,000 (19,000) (6.7%)Prepaid expenses 5,500 5,300 200 3.8%Total current assets $550,000 $533,000 $17,000 3.2%



Difference $25,800

Base year (2007) $64,700 = 39.9%

9

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Lincoln CompanyComparative Income Statement

For the Year Ended December 31, 2008 and 2007

Sales $1,530,500 $1,234,000 $296,500 24.0%Sales returns and allowances 32,500 34,000 (1,500) (4.4%)Net sales $1,498,000 $1,200,000 $298,000 24.8%Cost of goods sold 1,043,000 820,000 223,000 27.2%Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%Administrative expenses 104,000 97,400 6,600 6.8%Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7%Income from operations $ 160,000 $ 135,600 $ 24,400 18.0%Other income 8,500 11,000 (2,500) (22.7%)

$ 168,500 $ 146,600 $ 21,900 14.9%Other expense (interest) 6,000 12,000 (6,000) (50.0%)Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%Income tax expense 71,500 58,100 13,400 23.1%Net income $ 91,000 $ 76,500 $ 14,500 19.0%


Increase (Decrease)

Exhibit 3 Comparative Income Statement

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For the Year Ended December 31, 2008 and 2007

Current assets $1,530,500 $1,234,000 $296,500 24.0%Sales returns and allowances 32,500 34,000 (1,500) (4.4%)Net sales $1,498,000 $1,200,000 $298,000 24.8%Cost of goods sold 1,043,000 820,000 223,000 27.2%Gross profit $ 455,000 $ 380,000 $ 75,000 19.7%Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9%Administrative expenses 104,000 97,400 6,600 6,.8%Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7%Income from operations $ 160,000 $ 135,600 $ 24,400 18.0%Other income 8,500 11,000 (2,500) (22.7%)

$ 168,500 $ 146,600 $ 21,900 14.9%Other expense (interest) 6,000 12,000 (6,000) (50.0%)Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7%Income tax expense 71,500 58,100 13,400 23.1%Net income $ 91,000 $ 76,500 $ 14,500 19.0%


Increase (Decrease)

Horizontal Analysis:Horizontal Analysis:

Increase amount $296,500

Base year (2007) $1,234,000 = 24.0%

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Exhibit 4 Comparative RE Statement

A percentage analysis that shows the relationship of each component to the

total within a single statement is called vertical

analysis.

Lincoln CompanyComparative Retained Earnings Statement


Increase (Decrease)

Retained earnings, Jan. 1 $137,500 $100,000 $37,500 37.5%Net income for year 91,000 76,500 14,500 19.0%Total $228,500 $176,500 $52,000 29.5%)Dividends:

On preferred stock $ 9,000 $ 9,000 —On common stock 40,000 30,000 10,000 33.3%

Total $ 49,000 $ 39,000 $10,000 25.6%Total current assets $179,500 $137,500 $42,000 30.5%


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Exhibit 4 Comparative RE Statement

A percentage analysis that shows the relationship of each component to the

total within a single statement is called vertical

analysis.

Lincoln CompanyComparative Retained Earnings Statement


Increase (Decrease)

Retained earnings, Jan. 1 $137,500 $100,000 $37,500 37.5%Net income for year 91,000 76,500 14,500 19.0%Total $228,500 $176,500 $52,000 29.5%)Dividends:

On preferred stock $ 9,000 $ 9,000 —On common stock 40,000 30,000 10,000 33.3%

Total $ 49,000 $ 39,000 $10,000 25.6%Total current assets $179,500 $137,500 $42,000 30.5%


Horizontal Analysis:Horizontal Analysis:

Increase amount $37,500

Base year (2007) $100,000 = 37.5%

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Vertical Analysis

A percentage analysis used to show the relationship of

each component to the total within a single statement is

called vertical analysis.

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In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each

liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’

equity.

Vertical Analysis of Balance Sheet

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For the Years Ended December 31, 2008 and 2007

AssetsCurrent assets $ 550,000 48.3% $ 533,000 43.3%Long-term investments 95,000 8.3 177,500 14.4Property, plant, & equip. (net) 444,500 39.0 470,000 38.2Intangible assets 50,000 4.4 50,000 4.1

Total assets $1,139,500 100.0% $1,230,500 100.0% LiabilitiesCurrent liabilities $ 210,000 18.4% $ 243,000 19.7%Long-term liabilities 100,000 8.8 200,000 16.3Total liabilities $ 310,000 27.2% $ 443,000 36.0% Stockholders’ EquityPreferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2%2.2% Common stock, $10 par 500,000 43.9 500,000 40.6Retained earnings 179,500 15.7 137,500 11.2Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0% Total liab. & Stockholders’ equity $1,139,500 100.0% $1,230,500 100.0%

Amount Percent Amount Percent 2008 2007

Total assets $1,139,500 100.0%$1,230,500100.0%

Total liab. & stockholders’ equity $1,139,500 100.0% $1,230,500100.0%

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To demonstrate how vertical analysis percentages are calculated for the balance

sheet, let’s see how the 48.3 percent was calculated for the

2008 current assets in the next slide.

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AssetsCurrent assets $ 550,000 48.3% $ 533,000 43.3%Long-term investments 95,000 8.3 177,500 14.4Property, plant, & equip. (net) 444,500 39.0 470,000 38.2Intangible assets 50,000 4.4 50,000 4.1

Total assets $1,139,500 100.0% $1,230,500 100.0% LiabilitiesCurrent liabilities $ 210,000 18.4% $ 243,000 19.7%Long-term liabilities 100,000 8.8 200,000 16.3Total liabilities $ 310,000 27.2% $ 443,000 36.0% Stockholders’ EquityPreferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2% Common stock, $10 par 500,000 43.9 500,000 40.6Retained earnings 179,500 15.7 137,500 11.2Total stockholders’ equity $ 829,500 72.8% $ 787,500 64.0% Total liab. & Stockholders’ equity $1,139,500 100.0% $1,230,500 100.0%

Amount Percent Amount Percent 2008 2007

Total assets $1,139,500 100.0%$1,230,500100.0%

Total liab. & stockholders’ equity $1,139,500 100.0% $1,230,500100.0%

Vertical Analysis: Vertical Analysis:

Current assets $550,000

Total assets $1,139,500 = 48.3%

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In a vertical analysis of the income statement, each item is stated as a percent of net sales. As an example, let’s

see how the percent of 12.8% was calculated for 2008

selling expenses.

Vertical Analysis of Income Statement

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Sales $1,530,500 102.2% $1,234,000 102.8%Sales returns and allow. 32,500 2.2 34,000 2.8

Net sales $1,498,000 100.0% $1,200,000 100.0%Cost of goods sold 1,043,000 69.6 820,000 68.3Gross profit $ 455,000 30.4% $ 380,000 31.7%Selling expenses $ 191,000 12.8% $ 147,000 12.3%Administrative expenses 104,000 6.9 97,400 8.1Total operating expenses $ 295,000 19.7% $ 244,400 20.4%Income from operations $ 160,000 10.7 $ 135,600 11.3%Other income 8,500 0.6 11,000 0.9 $ 168,500 11.3% $ 146,600 12.2%Other expense (interest) 6,000 0.4 12,000 1.0Income before income tax $ 162,500 10.9% $ 134,600 11.2%Income tax expense 71,500 4.8 58,100 4.8Net income $ 91,000 6.1% $ 76,500 6.4%

2008 2007

Amount Percent Amount Percent



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Sales $1,530,500 102.2% $1,234,000 102.8%Sales returns and allow. 32,500 2.2 34,000 2.8

Net sales $1,498,000 100.0% $1,200,000 100.0%Cost of goods sold 1,043,000 69.6 820,000 68.3Gross profit $ 455,000 30.4% $ 380,000 31.7%Selling expenses $ 191,000 12.8% $ 147,000 12.3%Administrative expenses 104,000 6.9 97,400 8.1Total operating expenses $ 295,000 19.7% $ 244,400 20.4%Income from operations $ 160,000 10.7 $ 135,600 11.3%Other income 8,500 0.6 11,000 0.9 $ 168,500 11.3% $ 146,600 12.2%Other expense (interest) 6,000 0.4 12,000 1.0Income before income tax $ 162,500 10.9% $ 134,600 11.2%Income tax expense 71,500 4.8 58,100 4.8Net income $ 91,000 6.1% $ 76,500 6.4%

2008 2007

Amount Percent Amount Percent



Vertical Analysis: Vertical Analysis:

Selling expenses $191,000

Net sales $1,498,000 = 12.8%

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Solvency Analysis

The ability of a business to meet its financial obligations (debts) is called solvency.

The ability of a business to earn income is called

profitability.

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Current Position Analysis

Using measures to assess a business’s ability to pay its current liabilities is called current position analysis. Such analysis is of special

interest to short-term creditors.

30

Working Capital

The excess of current assets of a business over its current liabilities is called working

capital. The working capital is often used in evaluating a company’s ability to meet currently maturing debts.

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Working capital (a Working capital (a – b) $340,000 – b) $340,000

Current asset:Cash $ 90,500Marketable securities 75,000

Accounts receivable (net) 115,000Inventories 264,000Prepaid expenses 5,500

a. Total current assets $550,000b. Current liabilities 210,000

Lincoln CompanyLincoln Company

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Current Ratio

The current ratio, sometimes called the

working capital ratio or bankers’ ratio, is computed by dividing the total current assets by the total current

liabilities.

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Current ratio (a/Current ratio (a/b) 2.6 2.2b) 2.6 2.2

a. Current assets $550,000 $533,000b. Current liabilities 210,000 243,000Working capital (a – b) $340,000 $290,000

2008 2007


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Quick Ratio

A ratio that measures the “instant’ debt-paying ability of a company is called the

quick ratio or acid-test ratio.

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2008 2007

Quick ratio (a/Quick ratio (a/b) 1.3 1.0b) 1.3 1.0

Quick assets:Cash $ 90,500 $ 64,700Marketable securities 75,000 60,000Accounts receivable (net) 115,000 120,000 a. Total quick assets $280,500 $244,700

b. Current liabilities $210,000 $243,000


Quick assets are cash and other

current assets that can be quickly

converted to cash.

Quick assets are cash and other

current assets that can be quickly

converted to cash.

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Accounts Receivable Turnover

The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. The ratio is to assess

the efficiency of the firm in collecting receivables and in the

managing of credit.

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Number of Days’ Sales in Receivables

The number of days’ sales in receivables is an estimate of the

length of time (in days) the accounts receivable have been outstanding. Comparing this measure with the

credit terms provides information on the efficiency in collecting

receivables.

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Number of days’ sales inNumber of days’ sales in receivables (a/receivables (a/b) 28.6 39.5b) 28.6 39.5

a. Average (Total/2) $ 117,500$ 130,000

Net sales $1,498,000$1,200,000

b. Average daily sales onaccount (Sales/365) $ 4,104

$ 3,288

2008 2007Lincoln CompanyLincoln Company

Financial Statement Analysis at different Stages 2

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Inventory Turnover

The relationship between the volume of goods

(merchandise) sold and inventory may be stated as the

inventory turnover. The purpose of this ratio is to

assess the efficiency of the firm in managing its inventory.

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2008 2007

Inventory turnover (a/Inventory turnover (a/b) 3.8 2.8b) 3.8 2.8

a. Cost of goods sold $1,043,000$ 820,000

Inventories:Beginning of year $ 283,000

$ 311,000End of year 264,000

283,000Total $ 547,000

$ 594,000

b. Average (Total/2) $ 273,500$ 297,000


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Number of days’ sales inNumber of days’ sales in inventory (a/inventory (a/b) 95.7 132.2b) 95.7 132.2

a. Average (Total/2) $ 273,500 $ 297,000Cost of goods sold $1,043,000 $ 820,000

b. Average daily cost of goodssold (COGS/365 days) $2,858 $2,247

2008 2007

Number of Days’ Sales in Inventory


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Ratio of Fixed Assets to Long-Term Liabilities

The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the

margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis.

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2008 2007

Ratio of fixed assets toRatio of fixed assets to long-term liabilities (a/long-term liabilities (a/b) 4.4 2.4b) 4.4 2.4

a. Fixed assets (net) $444,500 $470,000b. Long-term liabilities $100,000 $200,000


46

Ratio of Liabilities to Stockholders’ Equity

The relationship between the total claims of the creditors and owners—the ratio of liabilities to stockholders’

equity—is a solvency measure that indicates the margin of

safety for creditors.

47

Ratio of liabilities toRatio of liabilities to stockholders’ equity (a/stockholders’ equity (a/b) 0.4 0.6b) 0.4 0.6

a. Total liabilities $310,000 $443,000b. Total stockholders’ equity $829,500 $787,500

2008 2007


48

Profitability Analysis

Profitability is the ability of an entity to earn profits.

This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available as reported in the balance sheet.

Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet.

49

Ratio of Net Sales to Assets

The ratio of net sales to assets is a profitability

measure that shows how effectively a firm utilizes its

assets.

50

2008 2007

a. Net sales $1,498,000 $1,200,000Total assets:

Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000

b. Average (Total/2) $1,048,750 $1,031,500


Excludes long-term investmentsExcludes long-term investments

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2008 2007

a. Net sales $1,498,000 $1,200,000Total assets:

Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000

b. Average (Total/2) $1,048,750 $1,031,500


Ratio of net sales to assets (a/Ratio of net sales to assets (a/b)b) 1.4 1.2 1.4 1.2

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Leverage is a business term that refers to borrowing. If a business is "leveraged," it means that the business has borrowed money to finance the purchase of assets. The other way to purchase assets is through use of owner funds, or equity.One way to determine leverage is to calculate the Debt-to-Equity ratio, showing how much of the assets of the business are financed by debt and how much by equity(ownership).Leverage is not necessarily a bad thing. Leverage is useful to fund company growth and development through the purchase of assets. But if the company has too much borrowing, it may not be able to pay back all of its debts.

Leverage

53

Earnings per Share on Common Stock

One of the profitability measures often quoted by

the financial press is earning per share (EPS) on common

stock. It is also normally reported in the income statement in corporate

annual reports.

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2008 2007

Earnings per share on common Earnings per share on common stock (a/b) $1.64 $1.35stock (a/b) $1.64 $1.35

Net income $ 91,000$ 76,500

Preferred dividends 9,000 9,000

a. Remainder—identified with common stock $ 82,000$ 67,500

b. Shares of common stock 50,00050,000


55

Price-Earnings Ratio

Another profitability measure quoted by the

financial press is the price-earnings (P/E) ratio on

common stock. The price-earnings ratio is an

indicator of a firm’s future earnings prospects.

56

2008 2007

Price-earnings ratio onPrice-earnings ratio on common stock 25 20common stock 25 20

Market price per share of common stock $41.00 $27.00

Earnings per share on commonstock ÷ 1.64 ÷ 1.35


57

The dividend yield on common stock is a

profitability measure that shows the rate of return to common stockholders in terms of cash dividends.

Dividend Yield

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2008 2007

Dividend yield onDividend yield on common stock 2.0% 2.2% common stock 2.0% 2.2%

Dividends per share ofcommon stock $ 0.80$ 0.60

Market price per share of common stock ÷41.00÷27.00


59

Corporate Annual Reports

In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections: Management Discussion and Analysis Report on adequacy of internal control Report on fairness of financial statements

Accounting

Accounting is the process of measuring, interpreting, and communicating financial information to support internal and

external business decision making.

Business Activities

Involving

Accounting Financing activities provide necessary

funds to start a business and expand it after it begins operating.

Investing activities provide valuable assets required to run a business.

Operating activities focus on selling goods and services, but they also consider expenses as important elements of sound financial management.

• Generally accepted accounting principles (GAAP) encompass the conventions, rules, and procedures for determining acceptable accounting practices at a particular time.

• Financial Accounting Standards Board (FASB) is primarily responsible for evaluating, setting, or modifying GAAP in the U.S.

• Sarbanes-Oxley Act responded to cases of accounting fraud.– Created the Public Accounting Oversight Board, which sets audit

standards and investigates and sanctions accounting firms that certify the books of publicly traded firms.

– Senior executives must personally certify that the financial information reported by the company is correct.

– Resulted in increase in demand for accountants.

The Foundation of

Accounting Systems

The Accounting

Cycle

Accounting process - set of activities involved in converting information about transactions

into financial statements.

• Assets - anything of value owned or leased by a business.• Liability - claim against a firm’s assets by a creditor.• Owner’s equity - all claims of the proprietor, partners, or

stockholders against the assets of a firm, equal to the excess of assets over liabilities.

• Basic accounting equation - relationship that states that assets equal liabilities plus owners’ equity.

• Double-entry bookkeeping - process by which accounting transactions are entered; each individual transaction always has an offsetting transaction.

The Accounting

Equation

Balance sheet - statement of a firm’s financial position—what it owns and the claims against its assets—at a particular point in time.

Photograph of firm’s assets together with its liabilities and owner’s equity

Follows the accounting equation

Balance Sheet

Sample Balance

Sheet

Income Statement - financial record of a company’s revenues and expenses, and profits over a period of time.

Firm’s financial performance in terms of revenues, expenses, and profits over a given time period.

Reports profit or loss.

Focus on revenues and costs associated with revenues.

Sample Income

Statement

Statement of

Owner’s Equity

Statement of Owner’s Equity - is designed to show the components of the change in equity from the end of one fiscal year to the end of the next.

Begins with the amount of equity shown on the balance sheet.

Net income is added, and cash dividends paid to owners are subtracted.

Sample Statement

of

Owner’s Equity

The Statement of

Cash Flows

Statement of cash flows - a firm’s cash receipts and cash payments that presents information on its sources and uses of cash.

Accrual accounting - method that records revenue and expenses when they occur, not necessarily when cash actually changes hands.

Sample Statement

of Cash Flows

Financial Ratios

Analysis

Ratio analysis - tool for measuring a firm’s liquidity, profitability, and reliance on debt financing, as well as the effectiveness of

management’s resource utilization.

Liquidity Ratios

Acid-test (or quick) ratio measures the

ability of a firm to meet its debt payments on

short notice.

Cash and equivalents + short-term investments + accounts receivable

Total current liabilities

Current ratio compares current assets to current liabilities.

Total current assets

Total current liabilities

Activity Ratios

Inventory turnover ratio indicates the number of times

merchandise moves through a business.

Net sales

Average of inventory

Total asset turnover ratio indicates how much in

sales each dollar invested in assets generates.

Net sales

Average of total assets

Profitability

RatiosProfitability ratios measure the organization’s overall financial

performance by evaluating its ability to generate revenues in excess of operating costs and other expenses.

• Leverage ratios measure the extent to which a firm relies on debt financing.

• Total liabilities to total assets ratio > 50 percent indicates that a firm is relying more on borrowed money than owners’ equity.

Leverage Ratios

• Budget - planning and control tool that reflects a firm’s expected sales revenues, operating expenses, and cash receipts and outlays.

• Management estimates of expected sales, cash inflows and outflows, and costs.

• Budgets are a financial blueprint that serves as a financial plan.

• Cash budget - tracks the firm’s cash inflows and outflows.

Budgets

Sample Budget

Documents

Financial Statement Analysis at different Stages