Instructor: Michael Booth Cabrillo Collegecabrillo.edu/~mbooth/acct1a/Week 14 Financial...
Transcript of Instructor: Michael Booth Cabrillo Collegecabrillo.edu/~mbooth/acct1a/Week 14 Financial...
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Financial Analysis
Instructor: Michael Booth
Cabrillo College
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Factors in Communicating
Useful Information
Users
Types of
Decisions
Means of
Analysis
The primary objective of accounting is to provide
information useful for decision making. To provide
information that supports this objective, accountants must
consider the following:
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THREE TYPES OF FINANCIAL
STATEMENT INFORMATION
PastPerformance
PresentCondition
FuturePerformance
Income, sales
volume, cash
flows, return-
on-investments,
EPS.
Assets, debt,
inventory,
various ratios.
Sales and earnings
trends are good
indicators of future
performance.
Financial Statement Analysis
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Financial Statement Analysis
Examines a singlecompany to identify
trends over time.
Financial statement analysis
is based on comparisons.
Time series
analysis
Comparison with
similar companies
Google Finance
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Learning Objective
To differentiate
between horizontal
and vertical
analysis
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Methods of Analysis
Horizontal
Analysis
Vertical
Analysis
Ratio
Analysis
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Phases of Statement Analysis
1. Computation Phase:
Vertical analysis
Horizontal analysis
Trend analysis
2. Interpretation Phase:
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Vertical analysis is computing the
relationship between each item on a
financial statement to some base
amount on the statement.
ANSWER:
QUESTION:
What is vertical analysis?
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Horizontal analysis is computing the
percentage change for individual
items in the financial statements
from year to year.
ANSWER:
QUESTION:
What is horizontal analysis?
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A financial ratio is computing ratio
and percentage relationships of the
current year with those of the
immediately preceding year.
ANSWER:
QUESTION:
What is a financial ratio?
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Trend analysis is a better technique
than just analyzing ratios. It
compares selected ratios and
percentages over a period of time.
ANSWER:
QUESTION:
What is trend analysis?
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Comparative statements are
financial statements presented side
by side for two or more years.
ANSWER:
QUESTION:
What are comparative statements?
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Common-size statements are
financial statements with items
expressed as percentages of a base
amount.
•Net Sales -> Income Statement
•Assets -> Balance Sheet
ANSWER:
QUESTION:
What are common-size statements?
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California Products, Inc.
Comparative Income Statement
Year Ended December 31, 2008 and 2007
Amounts Percent of Net Sales
2008 2007 2008 2007
Revenue
Sales 3,105,650 2,850,625 104.6 104.6
Less Sales Returns and Allowances 135,450 125,625 4.6 4.6
Net Sales 2,970,200 2,725,000 100.0 100.0
Net Income After Income Taxes 56,578 41,250 1.9 1.5
Comparative Statement
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California Products, Inc.
Comparative Income Statement
Year Ended December 31, 2008 and 2007
Amounts Percent of Net Sales
2008 2007 2008 2007
Revenue
Sales 3,105,650 2,850,625 104.6 104.6
Less Sales Returns and Allowances 135,450 125,625 4.6 4.6
Net Sales 2,970,200 2,725,000 100.0 100.0
Net Income After Income Taxes 56,578 41,250 1.9 1.5
Common-size Statement
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California Products, Inc.
Comparative Income Statement
Year Ended December 31, 2008 and 2007
Amounts Percent of Net Sales
2008 2007 2008 2007
Revenue
Sales 3,105,650 2,850,625 104.6 104.6
Less Sales Returns and Allowances 135,450 125,625 4.6 4.6
Net Sales 2,970,200 2,725,000 100.0 100.0
Net Income After Income Taxes 56,578 41,250 1.9 1.5
Comparative Common-size Statement
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Each item is expressed as a percentage of the
net sales figure (Common Denominator).
Vertical Analysis of the Income
Statement (Common Size)
Cost of goods sold
Net Sales=
$1,775,000
$2,970,200= 59.76%
Selling expenses
Net Sales=
$ 525,424
$ 2,970,200= 17.69%
=Net income(profit) after taxes
Net Sales
$ 56,578
$ 2,970,200= 1.9%
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Each item is expressed as either a percentage of
total assets or of total liabilities plus stockholders’
equity.
Vertical Analysis of the Balance
Sheet
Cash
Total assets=
$108,886
$553,016= 19.7%
Accounts payabletotal liabilities plus stkhldrs’ equity or
(Total Assets)
=$ 72,090
$ 553,016= 13.0%
Total stockholders’ equitytotal liabilities plus stkhldrs’ equity
or (Total Assets)
= $311,921
$553,016= 56.4%
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Horizontal Analysis
• Horizontal analysis techniques to analyze a
comparative income statement and balance
sheet.
• Trend analysis to evaluate financial
statements.
• Interpret the results of statement analyses by
comparison with industry averages.
McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc. All rights reserved.
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Evaluates financial statements for two or more
periods.
Compares items in each line to determine the
change in dollar amounts.
Uses the same method for both the income
statement and the balance sheet.
Horizontal Analysis
A percentage change can be shown by using
the earlier figure as the base.
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Sales for 2008 $3,105,650
Horizontal Analysis of the
Income Statement (know as
growth or % change)
Earlier year is the base year.
Increase in sales
Sales for base year=
$ 255,025
$2,850,6258.9%=
Sales for 2007 – 2,850,625
Increase $ 255,025
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California Products, Inc.
Comparative Income Statement (Partial) (Horizontal Analysis)
Years Ended December 31, 2008 and 2007
Amounts Increase or (Decrease)
2008 2007 Amount Percent
Revenue
Sales 3,105,650 2,850,625 255,025 8.9
Less Sales Returns and Allowances 135,450 125,625 9,825 7.8
Net Sales 2,970,200 2,725,000 245,200 9.0
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Horizontal Analysis of the
Balance Sheet
A decrease is expressed as a negative percentage.
Decrease in current liabilities
Current liabilities in base year=
$ (20,044)
$ 97,599– 20.53%=
Current liabilities 12/31/08 $ 77,595
Current liabilities 12/31/07 – 97,599
$(20,004)
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Horizontal analysis is especially useful in
identifying items that need further investigation.
Interpretation is easier if some basis of
comparison is available.
Company budget
Industry averages
Interpretation of the
Percentages
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Industry averages are the financial
ratios and percentages that reflect
averages for similar companies.
BiZminer Financial Ratio Sample
ANSWER:
QUESTION:
What are industry averages?
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Use trend analysis to evaluate
financial statements.
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Trend analysis compares selected
ratios and percentages over a period
of time.
ANSWER:
QUESTION:
What is trend analysis?
Often the time period is five years.
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This decrease is significant and should be investigated.
Net Sales 2,050,650 2,223,240 2,587,500 2,725,000 2,970,200
Cost of goods sold 1,059,900 1,234,560 1,495,642 1,574,721 1,755,000
Gross profit on sales 990,750 988,680 1,091,858 1,150,279 1,215,200
2004 2005 2006 2007 2008
Percentage of
gross profit to net sales 48.3 44.5 42.2 42.2 40.9
Trend Analysis
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Interpret the results of the
statement analyses by
comparison with industry
averages.
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Using Industry Averages
Trade associations survey their members to
obtain financial information and other data.
Data is converted to a uniform presentation,
usually in common-size statements arranged
by company size.
Individual companies compare their results to
industry averages.
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In comparing to industry averages, keep in
mind the following:
Different businesses keep different types of
accounts and do not classify items in the
same manner.
No two businesses are exactly alike.
The industry figures could include data from
corporations, partnerships, and sole
proprietorships.
SBA http://www.sba.gov
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Learning Objective
To explain ratio
analysis
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Ratio Analysis
Financial ratios have three classifications:
1. Profitability, operating results, and
efficiency
2. Financial strength
3. Liquidity
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Ratio Analysis
Ratio analysis involves studying
various relationships between
different items reported in a set of
financial statements.
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Liquidity RatiosLiquidity ratios indicate a
company’s ability to pay short-
term debts. They focus on
current assets and current
liabilities.
1. Working Capital
2. Cash Ratio
3. Current Ratio
4. Quick Ratio
5. Accounts Receivable Ratios
6. Inventory Ratios
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Liquidity is a measure of the ability of a
business to pay its debts when due.
Conversion of assets to cash to meet
the operational cash requirements of
the business.
ANSWER:
QUESTION:
What is liquidity?
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Cash Ratio
Cash
Ratio
Cash + Cash Equivalents
Current Liabilities=
= 0.296 to 1Cash
Ratio
$2,826
$9,554=
This ratio measures the
adequacy of available cash. This must be viewed in
conjunction with Cash Flow from operating activity, inventory
turns, and A/R turns.
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Working Capital
Measures the ability of a company to meet its
current obligations.
Formula:
Example:
Current assets
– Current liabilities
Working capital
$168,000
– 46,000
$122,000
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Working CapitalThe excess of current assets over
current liabilities is known as working capital.
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Current Ratio
Measures the ability of a business to pay its
debts using current assets.
Formula:
Example:
Current assets ÷ Current liabilities = Current ratio
$418,056
$ 77,595= 5.39:1
In retail and manufacturing businesses, a popular
guideline is a current ratio of at least 2 to 1.
Note: This is shifted prior to 2007/2008 to accept levels
lower, based on cash flow, inventory turns, A/R turns
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Current Ratio
The current ratio measures a
company’s short-term debt paying
ability.
A declining ratio may be a
sign of deteriorating
financial condition, or it
might result from eliminating
obsolete inventories.
Current
Ratio
Current Assets
Current Liabilities=
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Current Ratio
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Measures immediate liquidity.
Formula:
Acid-Test Ratio (Quick Ratio)
Quick assets are cash, receivables, and marketable securities.
Example:
A general guideline is that the acid-test ratio should be at least 1 : 1
CashReceivables 94,000Marketable securities
$94,000
$46,000= 2.04:1
Quick assets ÷ Current liabilities = Acid-test ratio
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Quick (Acid-Test) Ratio
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Accounts Receivable Turnover
Measures the speed with which sales on
account are collected.
Formula:
Procedure:
Step 1: Compute average accounts receivable.
Step 2: Divide net credit sales by average
accounts receivable.
Net credit sales ÷ Average receivables = Accounts receivable turnover
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Accounts Receivable Turnover
Net Credit Sales
Average Accounts Receivable
Accounts
Receivable
Turnover
=
This ratio measures how many
times a company converts its
receivables into cash each year.
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Accounts Receivable Turnover
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Average Days to Collect
Receivables
Average
Collection
Period
=365 Days
Accounts Receivable Turnover
This ratio measures, on average, how many days it
takes to collect an accounts receivable.
= 21 days
Average
Collection
Period
=365 Days
16.98 Times
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Inventory Turnover
Measures the number of times the inventory
is replaced during the period.
Formula:
Procedure:
Step 1: Compute the average inventory.
Step 2: Divide the cost of goods sold by the average
inventory.
Cost of goods sold ÷ Average inventory = Inventory turnover
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Inventory Turnover
Cost of Goods Sold
Average Inventory
Inventory
Turnover=
This ratio measures how many times a
company’s inventory has been sold and
replaced during the year.
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Inventory Turnover
INSERT Insert 20, p. 543,
Text Box here
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Average Days to Sell Inventory
Average
Sale Period=
365 Days
Inventory Turnover
This ratio measures how many
days, on average, it takes to sell
the inventory.
= 34 daysAverage
Sale Period=
365 Days
10.80 Times
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Learning Objective
To calculate ratios
for assessing a
company’s solvency
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Solvency Ratios
Solvency ratios are used to analyze
a company’s long-term debt-
paying ability and its financing
structure.
1. Debt to Assets Ratio
2. Debt to Equity Ratio
3. Number of Times Interest Earned
4. Plant Assets to Long-Term Liabilities
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Debt to Assets Ratio
This ratio measures the percentage of a company’s assets that are financed by
debt.
Total Liabilities
Total Assets
Debt to
Assets
Ratio
=
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Debt to Equity Ratio
This ratio indicates the relative proportions of debt to equity on a
company’s balance sheet.
Stockholders like a lot of
debt if the company can
take advantage of
positive financial
leverage.
Total Liabilities
Stockholders’ Equity
Debt to
Equity
Ratio
=
Creditors prefer less
debt and more equity
because equity
represents a buffer of
protection.
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Debt to Assets and Debt to
Equity Ratios
Note: Liabilities + SE = Total Assets
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Number of Times
Interest is Earned Ratio (Bond or
Long term debt)
This is the most common
measure of a company’s ability
to provide protection for its long-
term creditors.
Times
Interest
Earned
Earnings before Interest Expense
and Income Taxes
Interest Expense=
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Number of Times Bond Interest Earned
Measures the ability of net income to cover the required bond interest payments.
Formula:
Procedure:
Step 1: Compute the income before bond
interest and income taxes.
Step 2: Compute the cash required to pay bond
interest.
Step 3: Compute the ratio.
Income before bond interest and income taxes
Bond interest cash requirementTimes bond
interest earned=
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Number of Times Interest
Earned Ratio
Note: this is the issue with the failing banks, GM, Ford, etc
• Call on Credit Default Swaps
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Plant Assets to Long-Term
Liabilities
This ratio suggests how well
long-term debt is managed to
finance long-term assets.
Plant Assets
to Long-Term
Liabilities
Net Plant Assets
Long-Term Liabilities=
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Plant Assets to Long-Term
Liabilities
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Learning Objective
To calculate ratios
for assessing
company
management’s
effectiveness
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Profitability Ratios
Profitability ratios measure a
company’s ability to generate
earnings.
1. Net Margin (or Return on Sales)
2. Asset Turnover Ratio
3. Return on Investment
4. Return on Equity
5. Quality of Income
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Net Margin
This measure describes the percent
remaining of each sales dollar after
subtracting other expenses as well as
cost of goods sold.
Net
Margin
Net Income
Net Sales=
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Net Margin
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Asset Turnover Ratio
Net Sales
Average Total Assets
Asset
Turnover=
This ratio measures how many sales dollars were generated for each
dollar of assets invested.
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Asset Turnover Ratio
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Return on Investment or
Return on Assets (ROI)
This is the ratio of wealth generated
(net income) to the amount invested
(average total assets).
Return on
Investment
Net Income before interest & tax
Average Total Assets=
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Rate of Return on Total Assets
Measures the rate of return on the assets used by the
company.
Formula:
Income before income taxes $ 80,826
Rate of return
on total assets
Income before interest expense and income taxes
Total assets=
Example:
Income before interest and taxes $ 92,326
Avg assets $557,016
16.6%$92,326
$557,016=
Add back interest expense 11,500
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Return on Equity
This measure is often used to measure
the profitability of the stockholders’
investment.
Return on
Equity
Net Income
Average Total Stockholders’
Equity
=
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Return on Equity
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Quality of Income(see page 712 in text)
Quality
of Income
Cash Flow from Operating Activities
Net Income=
Cash Flow from Operating Activities
Net Income 4,304$
Add: Depreciation and Amortization 1,076
Decrease in Receivables, net 25
Increase in Accounts Payable 790
Increase in Deferred Revenue 279
Increase in Deferred Income Taxes 605
Other 186
Deduct: Increase in Merchandise Inventories (693)
Decrease in Income Taxes Payable (27)
Cash Flow from Operating Activities 6,545$
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Quality of Income
Quality
of Income
$6,545
$4,304= = 1.52
A ratio higher than 1 indicates
high-quality earnings.
Quality
of Income
Cash Flow from Operating Activities
Net Income=
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Learning Objective
To calculate ratios
for assessing a
company’s position
in the stock market
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Stock Market Ratios
Stock market ratios analyze the
earnings and dividends of a
company.
1. Earnings Per Share
2. Book Value
3. Price-Earnings (PE) Ratio
4. Dividend Yield
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Measures the profit accruing to each share of
common stock owned.
Formula:
Earnings per Share of Common
Stock
Analysts, stockholders, and creditors watch the
earnings per share measurement very closely.
Earnings
per share=
Income available to common stockholders
Average number of shares of common
stock outstanding during year
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Earnings Per Share
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Price-Earnings Ratio
Compares the current market value of common stock
with the earnings per share of that stock.
Formula:
PE ratio = 12 to 1
The price-earnings ratio is an indicator of the
attractiveness of a stock as an investment.
Example:
Price-earnings ratioMarket price per share
Earnings per share=
12$144
$ 12=
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Book Value per Share of Stock
Measures the financial strength underlying each
share of stock.
Formula:
Procedure:
Step 1: Compute the claims of preferred shareholders.
Step 2: Compute the claims of common stockholders.
Step 3: Divide the total claims of common
stockholders by the number of shares
outstanding.
Common stockholders’ equity
Number of common sharesBook value per share
of stock=
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Step 1: Compute the claims of
preferred stockholders.
For California Products, Inc. the book value of
preferred stock is the same as the par value,
$100 per share.
$ 100
x 500 shares outstanding
$50,000
Book Value per Share of Stock
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Step 2: Compute the claims of common
stockholders.
Stockholders’ equity $315,921
Less preferred stock equity 50,000
Claims of common stockholders $265,921
Step 1: Claims of preferred
stockholders = $50,000
Book Value per Share of Stock
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Step 1: Subtract the Claims of Preferred
Stockholders = $50,000
Step 2: Claims of common stockholders = $265,921
Step 3: Divide the total claims of common
stockholders by the number of shares
outstanding.
$265,921
6,000 shares= $44.32
Book Value per Share of Stock
Note this is for
common stock
shares Outstanding
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Book value and fair market value often are quite
different.
Book value per share does not indicate how much
the stockholder would receive if the assets were
sold and the corporation liquidated.
Book Value per Share
Fair Market Value
Definition
The price that an interested but not desperate buyer
would be willing to pay and an interested but not
desperate seller would be willing to accept on the open
market assuming a reasonable period of time for an
agreement to arise.
Book Value
Definition:1. It is the total value of the company's net assets that
shareholders would theoretically receive if a company
were liquidated, less total liabilities.
2. By being compared to the company's market value,
the book value can indicate whether a stock
is under- or overpriced.
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Dividend Yield
Dividend
Yield
Dividends Per Share
Market Price Per Share=
This ratio identifies the return, in terms
of cash dividends, on the current
market price of the stock.
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Yield on Common Stock
Relationship between the dividends received by the
stockholders and the market value of each share.
Formula:
Yield on Common StockDividend per share
Market price per share=
Example:
10%$ 6
$ 60=
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The limitations of
financial statement
analysis
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Financial statements use book values.
Book value depends on accounting policies and
procedures.
Businesses have choices about certain things,
such as depreciation methods and useful lives.
Financial statements assume that the dollar is a stable
monetary unit.
No two companies are exactly the same:
Different legal entities
Different product mixes
Different financing methods
Precautionary Notes on Statement Analysis
Financial statement analysis is useful only if these
limitations are understood.
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Limitations of Financial
Statement Analysis
Different
Industries
Changing
Economic
Environment
Accounting
Principles
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Assignments:
See web: http//www.cabrillo.edu/~mbooth
This will be updated weekly
Note: Use McGrawHill HOMEWORK manager to submit assignments