1. Financial Statement Analysis Chapter 15PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 15-2Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult.We use the LIFO method to value inventory.We use the average cost method to value inventory. 3. 15-3Limitations of Financial Statement Analysis Analysts should look beyond the ratios. Industry trends Technological changesChanges within the companyConsumer tastes Economic factors 4. 15-4Learning Objective 1 Prepare and interpret financial statements in comparative and common-size form. 5. 15-5Statements in Comparative and Common-Size Form Dollar and percentage changes on statements An item on a financial statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing comparisons. Common-size statements Ratios 6. 15-6Dollar and Percentage Changes on Statements Horizontal analysis (or trend analysis) shows the changes between years in the financial data in both dollar and percentage form. 7. 15-7Horizontal Analysis The following slides illustrate a horizontal analysis of Clover Corporations comparative balance sheets and comparative income statements for this year and last year. 8. 15-8Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31This Year Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assetsIncrease (Decrease) Last Year Amount %$$12,000 60,000 80,000 3,000 155,00040,000 120,000 160,000 $ 315,00023,500 40,000 100,000 1,200 164,70040,000 85,000 125,000 $ 289,700 9. 15-9Horizontal Analysis Calculating Change in Dollar Amounts Dollar Change=Current Year FigureBase Year FigureThe dollar amounts for last year become the base year figures. 10. 15-10Horizontal Analysis Calculating Change as a Percentage Percentage Change=Dollar Change Base Year Figure100% 11. 15-11Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31This YearIncrease (Decrease) Last Year Amount %Assets Current assets: Cash $ 12,000 $ 23,500 $ (11,500) (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700 Property and equipment: $12,000 $23,500 = $(11,500) Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 ($11,500 $23,500) 100% = (48.9%) Total property and equipment 160,000 125,000 Total assets $ 315,000 $ 289,700 12. 15-12Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31This Year Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assetsIncrease (Decrease) Last Year Amount %$$12,000 60,000 80,000 3,000 155,00040,000 120,000 160,000 $ 315,00023,500 40,000 100,000 1,200 164,70040,000 85,000 125,000 $ 289,700$ (11,500) 20,000 (20,000) 1,800 (9,700)(48.9) 50.0 (20.0) 150.0 (5.9)35,000 35,000 $ 25,3000.0 41.2 28.0 8.7 13. 15-13Horizontal Analysis We could do this for the liabilities and stockholders equity, but now lets look at the income statement accounts. 14. 15-14Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31This Year Last Year Sales $ 520,000 $ 480,000 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income $ 17,500 $ 22,400Increase (Decrease) Amount % 15. 15-15Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31This Year Last Year Sales $ 520,000 $ 480,000 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income $ 17,500 $ 22,400Increase (Decrease) Amount % $ 40,000 8.3 45,000 14.3 (5,000) (3.0) 2,600 2.1 (7,600) (19.5) (600) (8.6) (7,000) (21.9) (2,100) (21.9) $ (4,900) (21.9) 16. 15-16Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Increase (Decrease) This Year Last Year Amount % Sales $ 520,000 $ 480,000 $ 40,000 8.3 Cost of goods sold 360,000 315,000 45,000 14.3 Gross margin 160,000 165,000 (5,000) (3.0) OperatingSales increased by 8.3%, yet expenses 128,600 126,000 2,600 2.1 Net operating income decreased by 39,000 31,400 net income 21.9%. (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9) 17. 15-17Horizontal Analysis CLOVER CORPORATIONThere were increases in both cost of goods Comparative Income Statements sold (14.3%) and the Years Ended December 31 operating expenses (2.1%). For These increased costs more than offset the Increase increase in sales, yielding an overall (Decrease) % decrease inThis Year Last Year Amount net income. Sales $ 520,000 $ 480,000 $ 40,000 Cost of goods sold 360,000 315,000 45,000 Gross margin 160,000 165,000 (5,000) Operating expenses 128,600 126,000 2,600 Net operating income 31,400 39,000 (7,600) Interest expense 6,400 7,000 (600) Net income before taxes 25,000 32,000 (7,000) Less income taxes (30%) 7,500 9,600 (2,100) Net income $ 17,500 $ 22,400 $ (4,900)8.3 14.3 (3.0) 2.1 (19.5) (8.6) (21.9) (21.9) (21.9) 18. 15-18Trend Percentages Trend percentages state several years financial data in terms of a base year, which equals 100 percent. 19. 15-19Trend Analysis Trend = PercentageCurrent Year Amount Base Year Amount100% 20. 15-20Trend Analysis Look at the income information for Berry Products for the years 2007 through 2011. We will do a trend analysis on these amounts to see what we can learn about the company. 21. 15-21Trend Analysis Berry Products Income Information For the Years Ended December 31 Item Sales Cost of goods sold Gross margin2011 $ 400,000 285,000 115,0002010 $ 355,000 250,000 105,000Year 2009 $ 320,000 225,000 95,000The base year is 2007, and its amounts will equal 100%.2008 $ 290,000 198,000 92,0002007 $ 275,000 190,000 85,000 22. 15-22Trend Analysis Berry Products Income Information For the Years Ended December 31 Item20112010Year 2009Sales Cost of goods sold Gross margin2008 Amount 2007 Amount 100% ( $290,000 $275,000 ) 100% = 105% ( $198,000 $190,000 ) 100% = 104% ( $ 92,000 $ 85,000 ) 100% = 108%2008 105% 104% 108%2007 100% 100% 100% 23. 15-23Trend Analysis Berry Products Income Information For the Years Ended December 31 Item Sales Cost of goods sold Gross margin2011 145% 150% 135%2010 129% 132% 124%Year 2009 116% 118% 112%2008 105% 104% 108%By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.2007 100% 100% 100% 24. 15-24Trend Analysis 160PercentageWe can use the trend 150 percentages to construct a graph so we can see the 140 trend over time. 130Sales COGS120GM110100 200720082009 Year20102011 25. 15-25Common-Size Statements Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage. 26. 15-26Common-Size Statements In income statements, all items usually are expressed as a percentage of sales. 27. 15-27Gross Margin Percentage Gross Margin = PercentageGross Margin SalesThis measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit. 28. 15-28Common-Size Statements In balance sheets, all items usually are expressed as a percentage of total assets. 29. 15-29Common-Size StatementsBurger King McDonald's (dollars in millions) Dollars Percentage Dollars Percentage 2008 Net income $ 190 7.70% $ 4,313 18.30%Common-size financial statements are particularly useful when comparing data from different companies. 30. 15-30Common-Size Statements Lets take another look at the information from the comparative income statements of Clover Corporation for this year and last year. This time, lets prepare common-size statements. 31. 15-31Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size Percentages This Year Last Year This Year Last Year Sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Sales is Operating expenses 128,600 126,000 usually the Net operating income 31,400 39,000 base and is Interest expense 6,400 7,000 expressed Net income before taxes 25,000 32,000 as 100%. Less income taxes (30%) 7,500 9,600 Net income $ 17,500 $ 22,400 32. 15-32Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size Percentages This Year Last Year This Year Last Year Sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 This Years Net operating income Cost This Years Sales 100% 31,400 39,000 ( $360,000 $520,000 ) 7,000 = 69.2% 100% Interest expense 6,400 Net income before taxes 25,000 32,000 Last Years Cost Last Years Sales 100% Less income taxes (30%) 7,500 9,600 ( $315,000 $ $480,000 ) 100% = 65.6% Net income 17,500 $ 22,400 33. 15-33Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31 Common-Size What conclusions can we draw? Percentages This Year Last Year This Year Last Year Sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0 Net income $ 17,500 $ 22,400 3.4 4.7 34. 15-34Quick Check Which of the following statements describes horizontal analysis? a. A statement that shows items appearing on it in percentage and dollar form. b. A side-by-side comparison of two or more years financial statements. c. A comparison of the account balances on the current years financial statements. d. None of the above. 35. 15-35Quick Check Which of the following statements describes horizontal analysis? a. A statement that shows items appearing on it in percentage and dollar form. b. A side-by-side comparison of two or more years financial statements. c. A comparison of the account balances on Horizontal years financial statements. the current analysis shows the changes between years in the financial data in both d. None of the above. dollar and percentage form. 36. 15-36Now, lets look at Norton Corporations financial statements for this year and last year. 37. 15-37NORTON CORPORATION Balance Sheets December 31 This Year Last Year Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets$30,000 20,000 12,000 3,000 65,000165,000 116,390 281,390 $ 346,390$20,000 17,000 10,000 2,000 49,000123,000 128,000 251,000 $ 300,000 38. 15-38NORTON CORPORATION Balance Sheets December 31 This Year Liabilities and Stockholders' Equity Current liabilities: Accounts payable Notes payable, short-term Total current liabilities Long-term liabilities: Notes payable, long-term Total liabilities Stockholders' equity: Common stock, $1 par value Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equityLast Year$$39,000 3,000 42,00040,000 2,000 42,00070,000 112,00078,000 120,00027,400 158,100 185,500 48,890 234,39017,000 113,000 130,000 50,000 180,000Total liabilities and stockholders' equity $ 346,390$ 300,000 39. 15-39NORTON CORPORATION Income Statements For the Years Ended December 31Sales Cost of goods sold Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net incomeThis Year $ 494,000 140,000 354,000 270,000 84,000 7,300 76,700 23,010 $ 53,690Last Year $ 450,000 127,000 323,000 249,000 74,000 8,000 66,000 19,800 $ 46,200 40. 15-40Learning Objective 2 Compute and interpret financial ratios that would be useful to a common stockholder. 41. 15-41Ratio Analysis The Common Stockholder NORTON CORPORATION The ratios that are of the most interest to stockholders include those ratios that focus on net income, dividends, and stockholders equities.This Year Number of common shares outstanding Beginning of year End of year Net income17,000 27,400 $53,690Stockholders' equity Beginning of year180,000End of year234,390Dividends per share Dec. 31 market price per share Interest expense2 20 7,300Total assets Beginning of year300,000End of year346,390 42. 15-42Earnings Per Share Net Income Preferred Dividends Earnings per Share = Average Number of Common Shares Outstanding Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. Earnings form the basis for dividend payments and future increases in the value of shares of stock. 43. 15-43Earnings Per Share Net Income Preferred Dividends Earnings per Share = Average Number of Common Shares Outstanding Earnings per Share =$53,690 $0 ($17,000 + $27,400)/2= $2.42This measure indicates how much income was earned for each share of common stock outstanding. 44. 15-44Price-Earnings Ratio Price-Earnings Ratio Price-Earnings Ratio==Market Price Per Share Earnings Per Share $20.00 $2.42= 8.26 timesA higher price-earnings ratio means that investors are willing to pay a premium for a companys stock because of optimistic future growth prospects. 45. 15-45Dividend Payout Ratio Dividend Payout RatioDividend Payout Ratio=Dividends Per Share Earnings Per Share=$2.00 $2.42= 82.6%This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking dividends (market price growth) would like this ratio to be large (small). 46. 15-46Dividend Yield Ratio Dividend Yield Ratio Dividend Yield Ratio==Dividends Per Share Market Price Per Share $2.00 $20.00= 10.00%This ratio identifies the return, in terms of cash dividends, on the current market price of the stock. 47. 15-47Return on Total Assets Return on = Total AssetsNet Income + [Interest Expense (1 Tax Rate)] Average Total AssetsReturn on = Total Assets$53,690 + [$7,300 (1 .30)] = 18.19% ($300,000 + $346,390) 2 Adding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity. 48. 15-48Return on Common Stockholders Equity Return on Common = Net Income Preferred Dividends Stockholders Equity Average Stockholders Equity Return on Common = $53,690 $0 = 25.91% Stockholders Equity ($180,000 + $234,390) 2 This measure indicates how well the company used the owners investments to earn income. 49. 15-49Financial Leverage Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors. Return on investment in > assetsFixed rate of return on borrowed fundsPositive = financial leverageReturn on investment in < assetsFixed rate of return on borrowed fundsNegative = financial leverage 50. 15-50Quick Check Which of the following statements is true? a. Negative financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets. c. Financial leverage is the expression of several years financial data in percentage form in terms of a base year. 51. 15-51Quick Check Which of the following statements is true? a. Negative financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets. b. Positive financial leverage is when the fixed return to a companys creditors and preferred stockholders is greater than the return on total assets. c. Financial leverage is the expression of several years financial data in percentage form in terms of a base year. 52. 15-52Book Value Per Share Book Value per Share Book Value per Share=Common Stockholders Equity Number of Common Shares Outstanding=$234,390 27,400= $8.55This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts after all creditors were paid off. 53. 15-53Book Value Per Share Book Value per Share Book Value per Share=Common Stockholders Equity Number of Common Shares Outstanding=$234,390 27,400= $8.55Notice that the book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost. 54. 15-54Learning Objective 3 Compute and interpret financial ratios that would be useful to a short-term creditor. 55. 15-55Ratio Analysis The ShortTerm Creditor NORTON CORPORATIONShort-term creditors, such as suppliers, want to be paid on time. Therefore, they focus on the companys cash flows and working capital.This Year Cash$30,000Accounts receivable, net Beginning of year17,000End of year20,000Inventory Beginning of year10,000End of year12,000Total current assets65,000Total current liabilities42,000Sales on account494,000Cost of goods sold140,000 56. 15-56Working Capital The excess of current assets over current liabilities is known as working capital. Working capital is not free. It must be financed with longterm debt and equity. 57. 15-57Working Capital December 31 This Year Current assets$Current liabilities Working capital65,000 (42,000)$23,000 58. 15-58Current Ratio Current Ratio=Current Assets Current LiabilitiesThe current ratio measures a companys short-term debt paying ability. A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories. 59. 15-59Current Ratio Current Ratio=Current Assets Current LiabilitiesCurrent Ratio=$65,000 $42,000=1.55 60. 15-60Acid-Test (Quick) Ratio Acid-Test = Ratio Acid-Test = RatioQuick Assets Current Liabilities $50,000 $42,000= 1.19Quick assets include Cash, Marketable Securities, Accounts Receivable, and current Notes Receivable. This ratio measures a companys ability to meet obligations without having to liquidate inventory. 61. 15-61Accounts Receivable Turnover Accounts Receivable Turnover=Sales on Account Average Accounts ReceivableAccounts $494,000 Receivable = = 26.7 times ($17,000 + $20,000) 2 Turnover This ratio measures how many times a company converts its receivables into cash each year. 62. 15-62Average Collection Period Average Collection = Period Average Collection = Period365 Days Accounts Receivable Turnover 365 Days 26.7 TimesThis ratio measures, on average, how many days it takes to collect an account receivable.= 13.67 days 63. 15-63Inventory Turnover Inventory Turnover=Cost of Goods Sold Average InventoryThis ratio measures how many times a companys inventory has been sold and replaced during the year. If a companys inventory turnover Is less than its industry average, it either has excessive inventory or the wrong types of inventory. 64. 15-64Inventory Turnover Inventory Turnover=Inventory Turnover=Cost of Goods Sold Average Inventory $140,000 = 12.73 times ($10,000 + $12,000) 2 65. 15-65Average Sale Period Average Sale Period=Average = Sale Period365 Days Inventory Turnover365 Days 12.73 TimesThis ratio measures how many days, on average, it takes to sell the entire inventory.= 28.67 days 66. 15-66Learning Objective 4 Compute and interpret financial ratios that would be useful to a long-term creditor. 67. 15-67Ratio Analysis The LongTerm Creditor Long-term creditors are concerned with a companys ability to repay its loans over the long-run. NORTON CORPORATION This Year Earnings before interest expense and income taxes Interest expenseThis is also referred to as net operating income.$84,000 7,300Total stockholders' equity234,390Total liabilities112,000 68. 15-68Times Interest Earned Ratio Times Interest = Earned Times Interest = EarnedEarnings Interest Expense and Income Taxes Interest Expense$84,000 = 11.51 times $7,300This is the most common measure of a companys ability to provide protection for its longterm creditors. A ratio of less than 1.0 is inadequate. 69. 15-69Debt-to-Equity Ratio Debtto Total Liabilities Equity = Stockholders Equity RatioThis ratio indicates the relative proportions of debt to equity on a companys balance sheet. Stockholders like a lot of debt if the company can take advantage of positive financial leverage.Creditors prefer less debt and more equity because equity represents a buffer of protection. 70. 15-70Debt-to-Equity Ratio Debtto Total Liabilities Equity = Stockholders Equity Ratio Debtto Equity = Ratio$112,000 = 0.48 $234,390 71. 15-71Published Sources That Provide Comparative Ratio Data 72. 15-72End of Chapter 15