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1
Analysis of Analysis of Financial Financial
StatementStatementss
2
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
3
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)
23Alternative 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)
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
26Alternative 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)
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
28Alternative 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)
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