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Chapter 9Chapter 9
Financial Statement AnalysisFinancial Statement AnalysisFinancial Statement AnalysisFinancial Statement Analysis
Learning ObjectivesLearning Objectives
After studying this chapter, you should be able to…
Describe basic financial statement analytical methods.
Use financial statement analysis to assess the solvency of a business.
Use financial statement analysis to assess the profitability of a business.
Describe the contents of corporate annual reports.
Learning Objective 1Learning Objective 1
Describe basic financial statement analytical procedures
Horizontal Analysis
• The percentage analysis of increases and decreases in related items in comparative financial statements
Vertical Analysis
• A percentage analysis used to show the relationship of each component to the total within a single statement
Benefits of Analysis
• Horizontal and vertical analysis are useful in assessing relationships and trends in financial conditions and operations of a business
• Vertical analysis is useful for comparing one company with another or with industry averages
• Both are made easier with common-size financial statements
Common-Size Statements
Learning Objective 2Learning Objective 2
Apply financial statement analysis to assess the solvency of a business
Solvency and Profitability
• Solvency – the ability to meet debt obligations as they become due
• Profitability – the ability to earn income
Solvency and Profitability are interrelated!Solvency and Profitability are interrelated!
Solvency Analysis
• Normally assessed by examining balance sheet relationships, using the following major analyses:– Current position analysis– Accounts receivable analysis– Inventory analysis– Ratio of fixed assets to long-term liabilities– Ratio of liabilities to stockholders’ equity– Number of times interest charges are earned
Current Position Analysis
• Using measures to assess a business’s ability to pay its current liabilities – Working capital – current assets less current liabilities– Current ratio – current assets divided by current liabilities– Quick ratio – total “quick” assets divided by current
liabilities
Current Position Analysis – Working Capital and Current Ratio
Lincoln CompanyLincoln Company
Current Position Analysis – Quick Ratio
Quick AssetsQuick Assets$280,500$280,500
Quick AssetsQuick Assets$160,000$160,000
Quick Ratio = Quick Assets / Current LiabilitiesLincoln Quick Ratio = $280,500 / $210,000 = 1.3Jefferson Quick Ratio = $160,000 / $210,000 = .77
Accounts Receivable Analysis
• Measures efficiency of collection• Reflects liquidity
Accounts receivable turnover = Accounts receivable turnover = Net SalesNet Sales Avg. A/RAvg. A/R
Days’ Sales in Receivables = Days’ Sales in Receivables = Avg. A/RAvg. A/R Net Sales/365Net Sales/365
Accounts Receivable Turnover
The company increased its accounts receivable turnover by 38% measured in terms of the number of times receivables are collected within the year.
Days’ Sales in Receivables
The company improved its collections of accounts receivable by 10.9 days in 2009 measured in days receivables have been outstanding.
Inventory Analysis
• Measures inventory efficiency– Avoid tying up funds in inventory.– Avoid obsolescence.
• Reflects liquidity
Inventory turnover = Inventory turnover = COGSCOGS Avg. InventoryAvg. Inventory
Days’ Sales in Inventory = Days’ Sales in Inventory = Avg. InventoryAvg. InventoryCOGS/365COGS/365
Inventory Turnover
The company turned its inventory 1 time more in 2009, measured in terms of the number of times inventory turns over within the year.
Days’ Sales in Inventory
The company reduced the time it held inventory by nearly 28% in 2009 measured in days the inventory was held in warehouses.
Ratio of Fixed Assets to Long-Term Liabilities
• Indicates the margin of safety for note-holders or bondholders• Indicates the ability to borrow additional funds on a long-term
basis
Fixed Assets (net)Fixed Assets (net) Long-term LiabilitiesLong-term Liabilities
Ratio of Fixed Assets to Long-Term Liabilities
The company increased its margin of safety in financing fixed assets mainly by lowering long-term debt.
Ratio of Liabilities to Stockholders’ Equity
• Indicates the margin of safety for creditors.• Indicates the ability to withstand adverse business conditions.
Total LiabilitiesTotal Liabilities Total Stockholders’ EquityTotal Stockholders’ Equity
Ratio of Liabilities to Stockholders’ Equity
The ratio shows an increasing margin of safety for creditors.
Number of Times Interest Charges Earned
• Indicates the general financial strength of the business. • Indicates the ability to withstand adverse business conditions.
Income before Taxes + Interest Expense Income before Taxes + Interest Expense Interest ExpenseInterest Expense
Number of Times Interest Charges Earned
The number of times interest charges are earned improved from 12.2 to 28.1, a significant measure of safety for creditors.
Learning Objective 3Learning Objective 3
Apply financial statement analysis to assess the profitability of a business
Profitability Analysis
• Normally assessed by examining the income statement and balance sheet resources, using the following major analyses:– Ratio of net sales to assets– Rate earned on total assets– Rate earned on stockholders’ equity– Rate earned on common stockholders’ equity– Earnings per share on common stock– Price-earnings ratio– Dividends per share– Dividend yield
Ratio of Net Sales to Assets
• Shows how effectively a firm utilizes its assets
Net SalesNet Sales Avg. Total Assets (excluding LT Investments)Avg. Total Assets (excluding LT Investments)
Rate Earned on Total Assets
Interest Expense + Net IncomeInterest Expense + Net Income Avg. Total AssetsAvg. Total Assets
• Measures the profitability of total assets without considering how the assets are financed.
Rate Earned on Stockholders’ Equity
Net IncomeNet Income Avg. Stockholders’ EquityAvg. Stockholders’ Equity
• Emphasizes the rate of income earned on the amount invested by the stockholders.
Leverage
The company’s leverage of 3.1% for 2009 compares favorably with the 2.7% leverage for 2008.
Rate Earned on Common Stockholders’ Equity
Net Income – Preferred DividendsNet Income – Preferred DividendsAvg. Common Stockholders’ EquityAvg. Common Stockholders’ Equity
• Focuses on the rate of profits earned on the amounts invested by the common stockholders.
Earnings Per Share on Common Stock
Net Income – Preferred DividendsNet Income – Preferred DividendsCommon Shares OutstandingCommon Shares Outstanding
• The income earned for each share of common stock.
Price-Earnings Ratio
Market Price Per Share of Common StockMarket Price Per Share of Common StockAnnual Earnings Per ShareAnnual Earnings Per Share
• Indicator of the firm’s future earnings prospects.
Dividends per Share and Earnings per Share
Dividends per Share = Common Dividends Dividends per Share = Common Dividends Common SharesCommon Shares
Dividends Per Share and Dividend Yield
Dividend Yield = Common Dividend/ShareDividend Yield = Common Dividend/Share Market Price/ShareMarket Price/Share
• Dividend yield shows the rate of return to common stockholders in terms of cash dividends.
Learning Objective 5Learning Objective 5
Describe the contents of corporate annual reports
Corporate Annual Reports
• Summarize operating activities for the past year and plans for the future.
• Many variations in the order and form, but all include:– Financial statements and notes– Management discussion and analysis– Independent auditors’ report
Management Discussion and Analysis (MDA)
• Provides critical information in interpreting the financial statements and assessing the future of the company.
• Includes an analysis about past performance and financial condition.
• Discusses management’s opinion about future performance. • Discusses significant risk exposure.
Independent Auditors’ Report
• Publicly traded companies must get an independent opinion on the fairness of the financial statements.
• This opinion must be included in the annual report along with an opinion on the accuracy of management’s internal control assertion.
End of Chapter 9End of Chapter 9