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Analysis of Analysis of Financial Financial

StatementStatementss

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Organize a systematic financial ratio analysis using common-size financial statements and the DuPont framework.

Recognize the potential impact that differing accounting methods can have on the financial ratios of otherwise essentially identical companies.

Understand how foreign companies report their financial results to U.S. investors.

Learning Objectives

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Adjust reported financial statement numbers for the impact of inflation and for changes in the market values of specific assets.

Learning Objectives

EXPANDED MATERIAL Convert foreign currency financial statements into U.S.

dollars using the translation method. Incorporate material from the entire text into the

preparation of a statement of cash flows.

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Analytical Objectives

• Common-Size Financial Statements

• Ratio Analysis

Financial Statement Analysis Financial Statement Analysis is the is the examination of both the relationships among examination of both the relationships among financial statement numbers and the trends financial statement numbers and the trends of those numbers over time.of those numbers over time.

Financial Statement Analysis Financial Statement Analysis is the is the examination of both the relationships among examination of both the relationships among financial statement numbers and the trends financial statement numbers and the trends of those numbers over time.of those numbers over time.

Major Tools Include

5Framework forFinancial Statement Analysis

• Common-Size Financial Statements: Analysis of a company’s single-year financial statements. Financial statements are standardized by a measure of size, either sales or total assets. All amounts are stated in terms of a percentage of the size measure.

• Ratio Analysis: Analysis of a company’s financial statements by computing ratios and comparing them against both trends and industry averages.

6Comparisons Between Financial Statements Are Most Useful:

When the presentations are in good form. When the content of the statements is identical. When accounting principles are not changed, or, if

they are changed, the financial effects of the changes are disclosed.

When changes in circumstances or in the nature of the underlying transactions are disclosed.

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Common-Size Income Statement

For common-size income

statements, the denominator, the

entire pie, is equal to net

sales.

For common-size income

statements, the denominator, the

entire pie, is equal to net

sales.

100% = Net Sales 100% = Net Sales

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Condensed Comparative Income Statement2002 Percent 2001 Percent

Net sales $5,700 100.0 $6,600 100.0 Cost of goods sold 4,000 70.2 4,800 72.7 Gross profit on sales $ 1,700 29.8 $1,800 27.3 Selling expense $1,120 19.6 $1,200 18.2 General expense 400 7.0 440 6.7 Total operating expenses $1,520 26.6 $1,640 24.9 Operating income (loss) $ 180 3.2 $ 160 2.4 Other revenue (expense) 80 1.4 130 2.0 Income before taxes $ 260 4.6 $ 290 4.4 Income tax 80 1.4 85 1.3 Net income $ 180 3.2 $ 205 3.1

Common-Size Income Statement

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Common-Size Balance Sheet

For common-size balance sheets, the

denominator, the entire pie, is

equal to the total assets for the

year.

For common-size balance sheets, the

denominator, the entire pie, is

equal to the total assets for the

year.100% = Total Assets

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Condensed Comparative Balance Sheet2002 % 2001 %

Cash $ 200 3.5 $ 300 4.5

Inventory 1,000 17.5 800 12.1

Land & building (net) 3,000 52.6 3,200 48.5

Total assets $4,200 73.6 $4,300 65.1

Accounts payable $ 800 14.0 $1,000 15.1

Long-term debt 3,000 52.6 1,500 22.7

Total equity 400 7.0 1,800 27.3

Total liab. & equity $4,200 73.6 $4,300 65.1

Common-Size Balance Sheet

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Ratio Analysis

• DuPont Framework: Identifying factors that impact return on equity.

• Efficiency Ratios: How efficiently is the firm utilizing its assets?

• Leverage Ratios: To what degree is the company using other people’s money to purchase assets?

• Other Financial Ratios: Other indications of liquidity, cash management, and profitability.

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DuPont Framework

The DuPont framework was named after a system of ratio

analysis developed by DuPont around 1920.

The DuPont framework was named after a system of ratio

analysis developed by DuPont around 1920.

13Analysis of ROE Using the DuPont Framework

Return on Equity:

Profitability x Efficiency x Leverage

Return on x Asset x Assets-to-Sales Turnover Equity Ratio

Net Income x Sales x AssetsSales Assets Equity

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Efficiency Ratios

Accounts receivable turnover:

Sales Average accounts receivable

Average collection period:

Average accounts receivableAverage daily sales

Inventory turnover:

Cost of goods soldAverage inventory

ContinuedContinuedContinuedContinued

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Efficiency Ratios

Number of days’ sales in inventory:

Average inventory

Average daily cost of goods sold

Fixed asset turnover:

Sales Average fixed assets

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Leverage Ratios

• More borrowing means that more assets can be purchased without any additional equity investment by owners.

• More assets means that more sales can be generated.

• More sales means that net income should increase.

Higher leverage increases return on equity through the following chain of events:

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Leverage Ratios

Debt ratio:

Total liabilitiesTotal assets

Debt-to-equity ratio:

Total liabilities Total equity

Times interest earned:

Earnings before interest and taxesInterest expense

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Other Common Ratios

Current ratio: Current assets

Current liabilitiesHistorically, the rule of thumb was to have a current ratio of at

least 2.0.

Historically, the rule of thumb was to have a current ratio of at

least 2.0.

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Other Common Ratios

Current ratio: Current assets

Current liabilitiesAdvances in information technology have allowed successful firms to reduce

this ratio to below 1.0.

Advances in information technology have allowed successful firms to reduce

this ratio to below 1.0.

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Cash flow adequacy ratio:

Cash flow from operating activities

Total primary cash requirements

Other Common Ratios

The sum of dividend payments, long-term asset purchases, and long-term debt repayments.

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Book-to-market ratio:Stockholders’ equity

Market value of shares outstanding

Earnings per share: Net income Weighted-number of share outstanding

Dividend payout ratio:Cash dividends

Net income

Price-earnings ratio:Market price per share

Earnings per share

Other Common Ratios

22Alternative Reporting of the Effects of Changing Prices

NominalDollar

Measurement

ConstantDollar

Measurement

HistoricalCost

Valuation

CurrentCost

Valuation

Historical Cost/Nominal Dollar

Historical Cost/Constant Dollar

Current Cost/Nominal Dollar

Current Cost/Constant Dollar

(GAAP)


NominalDollar

Measurement

ConstantDollar

Measurement

HistoricalCost

Valuation

CurrentCost

Valuation





(GAAP)

24Impact of Changing Prices on the Financial Statements

ConstantDollar

Amount=

NominalDollar

Amountx

Index Converting ToIndex Converting From

Assume: Index Converting To 125 Index Converting From 115 Nominal Dollar Amount $ 1,000

CDA = $1,000 x (125 ÷ 115) = $1,087

25Purchasing Power Gains and Losses & Monetary Position

Rising Prices Declining Prices

Positive Net Monetary Position Loss

Gain

Gain

Loss

Negative Net Monetary Position


NominalDollar

Measurement

ConstantDollar

Measurement

HistoricalCost

Valuation

CurrentCost

Valuation





(GAAP)

Current Cost/ Nominal Dollar

27Current Cost/Nominal Dollar Example: Holding Gains

Current cost of inventory $60,000

Historical cost of inventory 50,000

Total holding gain $10,000

Realized holding gain

(50% of total holding gain) 5,000

Unrealized holding gain $ 5,000


NominalDollar

Measurement

ConstantDollar

Measurement

HistoricalCost

Valuation

CurrentCost

Valuation





(GAAP)

29Current Cost/Constant Dollar Example: Basic Data

• Assume the following for Micro Computers, Corp. inventory account:– Replacement cost $50,000– Inflation adjusted value 40,000– Historical cost 30,000

• Compute:– Total holding gain– Real component of holding gain– Inflationary component of holding gain

30Current Cost/Constant Dollar Example: Calculations

Replacement cost $50,000

HC/CD Cost $40,000

HC/ND Cost $30,000

$10,000RealComponent

$10,000 InflationaryComponent

Total unrealized holding gain, $20,000

31Foreign CurrencyFinancial Statements

• Translation: Used when the foreign subsidiary is a relatively self-contained unit that is independent from the parent company’s operations.

• Remeasurement: Is appropriate when the subsidiary does not operate independently of the parent company.

• Functional currency: Currency of the primary economic environment of an entity.

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The EndThe End

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This electronic presentation was

prepared by Douglas Cloud,

Professor of Accounting, Pepperdine University

Economy & Finance

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