Module 3: Financial Statement Analysis

ACG 2071Fall 2007

Created by M. Mari

Basic Analytical Procedures

The basic financial statements provide much of the information users need to make economic decisions about businesses.

In order to make decisions, we must analyze the financial statements.

Horizontal Analysis Percentage analysis of increases and

decreases in related items in comparative financial statements.

Comparing of income statements for two years Comparing of balance sheets for two years

Horizontal analysis

2006 2005 Amount Percent

Assets

Current assets $550,000 $533,000 $17,000 3.2%

Fixed assets $445,000 $470,000 -$25,000 -5.4%

Total assets $995,000 $1,003,000 -$8,000 -2.2%

Liabilities

Current liabilities $200,000 $150,000 $50,000 25%

Long term liabilities $100,000 $125,000 -$20,000 -20%

Total liabilities $300,000 $275,000 $30,000 5%

Equity

Common stock $500,000 $428,000 $72,000 17%

Retained earinings 195,000 $300,000 $105,000 -35%

Total equity $695,000 $728,000 $33,000 -18%

Total liab & equity $995,000 $1,003,000 - $8,000 -2.2%

Vertical Analysis

A percentage analysis may also be used to show the relationship of each component to the total within a single statement.

Balance sheet Each asset is shown as percentage of total

assets Each liability as percentage of total liabilities

Income statement Each item is shown as percentage of net

sales. Common size statements

Can be used to compare to companies in the same industry

Solvency Analysis

Solvency is the ability of a company to pay its debts. Profitability is the ability of a business to earn income.

They are interrelated. Solvency analysis focuses on the ability of a business to

pay or otherwise satisfy its current and noncurrent liabilities.

Assessed by examining balance sheet relationships Major analyses are:

Current position analysis Accounts receivable analysis Inventory analysis The ratio of fixed assets to long-term liabilities The number of times interest charges are earned.

Example

Company A Company B

2006 2005 2006 2005

Current Assets        

Cash $ 78,000.00 $ 82,500.00 $ 160,000.00 $ 112,500.00

Marketable Securities $ 52,000.00 $ 60,000.00 $ 85,000.00 $ 26,000.00

Accounts receivable $ 106,000.00 $ 152,000.00 $ 208,000.00 $ 172,000.00

Inventories $ 218,000.00 $ 260,000.00 $ 350,000.00 $ 312,500.00

Prepaid Expenses $ 6,000.00 $ 4,200.00 $ 10,000.00 $ 10,000.00

Total current assets $ 460,000.00 $ 558,700.00 $ 813,000.00 $ 633,000.00

Current liabilities $ 320,000.00 $ 480,000.00 $ 705,000.00 $ 375,000.00

Solvency Analysis

Current Position Analysis Measures to assess a business’s ability to pay

its current liabilities Special interest to short-term creditors Working Capital

Current assets minus current liabilities Used in evaluating a company’s ability to

meet currently maturing debts. Current Ratio

Working capital ratio or banker’s ratio Computed by dividing current assets by

current liabilities

Example

Company A   Company B  

2006 2005 2006 2005

Working Capital        

Current assets - current liabilities $ 140,000.00

$ 78,700.00

$ 108,000.00

$ 258,000.00

       

Current ratio 460000/320000 558700/480000 813000/705000 633000/375000

current assets/current liabilities 1.4 1.2 1.2 1.7

Solvency

Quick Ratio: A ratio that measures the instant debt paying

ability of a company Also called the acid test ratio Ratio of quick assets to total current liabilities

Quick assets are cash and other current assets that can be quickly converted to cash such as marketable securities and accounts receivables

Quick Ratio Example

Company A  

2006 2005

Current Assets    

Cash $ 78,000.00 $ 82,500.00

Marketable Securities $ 52,000.00 $ 60,000.00

Accounts receivable $ 106,000.00 $ 152,000.00

Total Quick Assets $ 236,000.00 $ 294,500.00

Total current liabilities $ 320,000.00 $ 480,000.00

   

Quick ratio 236000/320000 294500/480000

quick assets/ current liabilities 0.7 0.6

Accounts receivable analysis

The size and makeup of accounts receivable change constantly during business operations

Companies desire to collect receivables as promptly as possible

Cash collected from receivables improve solvency

Accounts receivable turnover Relationship between sales and accounts

receivable Computed by net sales divided by average net

accounts receivable Average of accounts receivable

Beginning balance plus ending balance divided by 2

Higher the turnover the better.

Example

Company A  

2006 2005

Net sales $ 1,500,000.00 $ 998,000.00

Accounts receivable    

Beginning of year $ 152,000.00 $ 208,000.00

End of Year $ 76,000.00 $ 152,000.00

Average Accounts Receivable (152000+76000)/2 (152000+208000)/2

$ 114,000.00 $ 180,000.00

Accounts receivable turnover 1500000/114000 998000/180000

13.2 5.5

Number of days sales in receivables

Ratio is computed by dividing the average accounts receivable by the average daily sales.

Average daily sales is net sales divided by 365 days

Lower the ratio the better

Example

Company A  

2006 2005

Net sales $ 1,500,000.00 $ 998,000.00

Accounts receivable    

Beginning of year $ 152,000.00 $ 208,000.00

End of Year $ 76,000.00 $ 152,000.00

Average Accounts Receivable (152000+76000)/2 (152000+208000)/2

  $ 114,000.00 $ 180,000.00

Average daily sales 1500000/365 998000/365

  $ 4,109.59 $ 2,734.25

Number of days sales in receivables 114000/4109.59 180000/2734.25

  27.7 65.8

Inventory Analysis

Inventory has to be managed carefully

Too little inventory can cause customers to seek the product from another supplier

Too much inventory can increase storage costs, insurance, and obsolescence.

Inventory Turnover

Relationship between the volume of goods sold and inventory

Computed by cost of goods sold divided by average inventory

Average inventory is beginning inventory plus ending inventory divided by 2

Higher the ratio the better

Example

Company A  

2006 2005

Cost of goods sold $ 765,000.00 $ 820,000.00

Inventories    

Beginning of year $ 312,000.00 $ 423,000.00

End of year $ 189,000.00 $ 312,000.00

Average inventory (312000+189000)/2 (312000+423000)/2

  $ 250,500.00 $ 367,500.00

Inventory Turnover 765000/250500 820000/367500

  3.1 2.2

Number of days’ sales in inventory

Relationship between cost of goods sold and inventory

Computed by dividing the average inventory by the average daily cost of goods sold ( COGS/365 days)

Rough measure of the length of time it takes to acquire, sell, and replace inventory

Lower the ratio the better

Example

Company A  

2006 2005

Cost of goods sold $ 765,000.00 $ 820,000.00

Inventories    

Beginning of year $ 312,000.00 $ 423,000.00

End of year $ 189,000.00 $ 312,000.00

Average inventory (312000+189000)/2 (312000+423000)/2

  $ 250,500.00 $ 367,500.00

Average COGS 765000/365 820000/365

  2,095.9 2,246.6

Number of days sales in inventory 250500/2095.9 367500/2246.6

  119.5 163.6

Ratio of fixed assets to long-term liabilities

Indicates the margin of safety of the noteholders or bondholders

Indicates the ability of the business to borrow additional funds on a long-term basis.

Higher the betterHigher the better

Company A  

2006 2005

Fixed assets (net)

$ 350,000.00

$ 480,000.00

Long-term liabilities

$ 175,000.00

$ 210,000.00

Ratio of fixed assets to long-term liabilities 2.0 2.3

Ratio of liabilities to stockholder’s equity

Claims against the total assets of a business are divided into two groups

Claims of creditors Claims of owners

the relationship between the total claims of the creditors and owners

solvency measure that indicates the margin of safety for creditors

indicates the ability of the business to withstand adverse business conditions when the claims of creditors are large in relation to the equity of the stockholders, there are usually significant interest payments.

If earnings decline to the point that company is unable to meet interest payments, creditors may take over the business.

lower the better

Example

Company A  

2006 2005

Total liabilities $

425,000.00 $

375,000.00

Total stockholder's Equity

$ 680,000.00

$ 503,000.00

Ratio of fixed assets to long-term liabilities 0.6 0.7

Number of times interest charges earned

Called the fixed charge coverage ratio The relative risk of the debtholders is

normally measured Higher the ratio, the lower the risk that

interest payments will not be made if earnings decrease.

Indicates general financial strength of the business

Example

Company A  

2006 2005

Income before taxes $ 150,000.00 $ 145,500.00

Add interest expense $ 4,500.00 $ 6,300.00

Amount available to meet interest charges 154,500.0 151,800.0

Number of times interest charges earned 154500/4500 151800/6300

  34.3 24.1

Profitability Analysis

The ability of a business to earn profits depends of the effectiveness and efficiency of its operations as well as the resources available to it.

Focuses primarily on the relationship between operating results as reported in the income statement and resources available to the business as reported in the balance sheet

Major analysis used Ratio of net sales to

assets Rate earned on total

assets Rate earned on

stockholder’s equity Rate earned on

common stockholder’s equity

Earnings per share on common stock

Price-earning ratio Dividends per share Dividend yield

Ratio of net sales to assets

Is a profitability measure that shows how effectively a firm utilizes its assets

Higher the ratio is better Computed by dividing net sales by

average total assets (beginning total assets + ending total assets)/2

Example

Company A  

2006 2005

Net sales $ 765,000.00 $ 820,000.00

Total assets    

Beginning of year $ 980,000.00 $ 800,000.00

End of year $ 1,020,000.00 $ 980,000.00

Average Total Assets (980000+1020000)/2 (980000+800000)/2

  $ 1,000,000.00 $ 890,000.00

Ratio of net sales to total assets 765000/1000000 820000/890000

  0.8 0.9

Rate earned on total assets

Measures the profitability of total assets without considering how the assets are financed.

Higher the ratio is better Computed by adding interest expense to

net income and then dividing by average total assets

Example Company A  

2006 2005

Net income $ 165,000.00 $ 250,000.00

Plus interest expense $ 6,000.00 $ 19,000.00

TOTAL $ 171,000.00 $ 269,000.00

Total assets    

Beginning of year $ 980,000.00 $ 800,000.00

End of year $ 1,020,000.00 $ 980,000.00

Average Total Assets (980000+1020000)/2 (980000+800000)/2

  $ 1,000,000.00 $ 890,000.00

Rate earned on total assets 171000/1000000 269000/890000

  0.2 0.3

Rate earned on stockholder’s equity

The measures emphasizes the rate of income earned on the amount invested by the stockholders.

Higher the ratio is better Computed by net income divided by average

stockholder’s equity The rate earned by a business on the equity of

its stockholders is usually higher than the rate earned on total assets.

Occurs when the amount earned on assets acquired with creditors’ funds is more than the interest paid to creditors

The difference in the rate on stockholder’s equity and the rate on total assets is called

LEVERAGE

Example

Company A  

2006 2005

Net income $ 165,000.00 $ 250,000.00

Stockholder's equity    

Beginning of year $ 1,250,000.00 $ 800,000.00

End of year $ 1,500,000.00 $ 1,250,000.00

Average Total Assets (1500000+1250000)/2 (1250000+800000)/2

  $ 1,375,000.00 $ 1,025,000.00

Rate earned on stockholder’s equity 171000/1000000 269000/890000

 Rate earned on assets 12% 24%

20% 30%

LEVERAGE 8% 6%

Rate earned on common stockholder’s equity

Common stockholder’s have a residual claim on earnings

This measure focuses only on the rate of profits earned on the amount invested by the common stockholders

Computed by subtracting the preferred dividends requirements from the net income and dividing by the average common stockholder’s equity. .

Higher the ratio is better

Example

Company A  

2006 2005

Net income $ 165,000.00 $ 250,000.00

Preferred dividends $ 9,000.00 $ 9,000.00

TOTAL $ 174,000.00 $ 259,000.00

Common Stockholder's equity    

Beginning of year $ 850,000.00 $ 600,000.00

End of year $ 950,000.00 $ 850,000.00

Average Total Assets (850000+950000)/2 (950000+600000)/2

  $ 900,000.00 $ 725,000.00

Rate earned on common stockholder's equity 174000/900000 259000/725000

  19% 36%

Earnings per share (EPS)

Normally reported in the income statement on corporate annual reports

Computed by dividing net income by the number of shares of stock outstanding

If preferred and common stock are outstanding, the net income is reduced by the amount of preferred stock dividends.

Example

Company A  

2006 2005

Net income $ 165,000.00 $ 250,000.00

Preferred dividends $ 9,000.00 $ 9,000.00

TOTAL $ 174,000.00 $ 259,000.00

Shares of common stock 50000 45000

EPS 174000/50000 259000/45000

  $ 3.48 $ 5.76

Price-Earnings Ratio

Indicator of a firm’s future earnings prospects

Computed by dividing the market price per share of common stock at a specific date by the annual earnings per share.

Company A  

2006 2005

Market price per share

$ 25.00

$ 17.50

Earnings per share

$ 1.52

$ 1.36

Price earnings ratio 16.45 12.87

Dividends per share and dividend yield

Indicator of a firm’s future earnings prospects

Computed by dividing the dividends per share by the market price

Company A  

2006 2005

Dividends per share

$ 0.80

$ 1.20

Market price per share

$ 25.00

$ 17.50

Dividend yield 0.03 0.07