Financial Statement Analysis

Comparative Financial Statements • Investors and creditors cannot based decisions on one year’s data • Most financial statements cover at least two years so comparisons can be made • Horizontal analysis • Study of percent changes in accounts from year-to-year ©2008 Pearson Prentice Hall. All rights reserved.

Horizontal Analysis Step 1: Compute dollar change in account Step 2: Compute percent change in account Current year balance minus prior year balance Dollar change Prior year balance ©2008 Pearson Prentice Hall. All rights reserved.

Vertical Analysis • Shows relationship of each financial statement item and its base • For the income statement, base is total revenue • For the balance sheet, base is total assets • Each account is divided by its base • Expressed as a percent ©2008 Pearson Prentice Hall. All rights reserved.

Benchmarking • Compares company results to set standard • Goal is improvement • Example: • Company compares its common-size statements to an industry leader ©2008 Pearson Prentice Hall. All rights reserved.

Using the Statement of Cash Flows • Helpful for finding weaknesses than gauging strength • Cash flow signs of a healthy company • Operations are the major source of cash • Investing activities have more than purchases than sales of long-term assets • Financing activities are not dominated by borrowing ©2008 Pearson Prentice Hall. All rights reserved.

Measuring Ability to Pay Current Liabilities Current assets – current liabilities; Expressed as a $ amount Working capital Current assets Current liabilities Expressed as a ratio; Rule of thumb = 1.5 Current ratio Cash + ST investments + Net receivables Current liabilities Expressed as a ratio; Rule of thumb = .9 - 1.0 Acid-test ratio ©2008 Pearson Prentice Hall. All rights reserved.

Measuring Ability to Sell Inventory and Collect Receivables Cost of goods sold Average inventory Measures how often a company sell inventory; Varies greatly among industries Inventory turnover A grocery store would have a high inventory Turnover; a furniture store - low Accounts receivable turnover Net sales Average net accounts receivable Measures how often a company collects AR A receivable turnover of 12 would mean a company collects the AR balance once a month ©2008 Pearson Prentice Hall. All rights reserved.

Days’ Sales in Receivables Shows how many days’ sales remain in accounts receivable One day’s sales = Net sales 365 days Step one: Days’ Sales in Receivables = Average net accts rec. One day’s sales Step two: The fewer the days, the more quickly receivables are being converted to cash ©2008 Pearson Prentice Hall. All rights reserved.

Measuring Ability to Pay Debts Total liabilities Total assets Tells proportion of assets financed with debt; Average for most companies = .62 Debt ratio The higher the ratio, the greater the pressure to pay debt Times-Interest-Earned Income from operations Interest expense Measures # of times interest can cover interest High ratio indicates ease of paying interest; low indicates difficulty ©2008 Pearson Prentice Hall. All rights reserved.

Measuring Profitability Net Income/Net sales Shows percentage of each sales dollar that makes it to the “bottom line” Return on sales Net income + Interest expense Average total assets Measures success in using assets to earn a profit Return on total assets Return on equity Net Income – Preferred Dividends Average common stockholders’ equity How much income is earned for every dollar invested ©2008 Pearson Prentice Hall. All rights reserved.

Earnings per Share (EPS) Key measure of company’s success Net Income - Preferred Dividends Average number of common shares outstanding Most widely quoted ratio ©2008 Pearson Prentice Hall. All rights reserved.

Analyzing Stock Investments Price –Earnings Ratio Market price per share of common stock Earnings per share Compares market price to earnings Dividend per share Market price per share Compares dividends per share to market price Dividend yield Total stockholders’ equity – preferred equity # of common shares outstanding Book value per share ©2008 Pearson Prentice Hall. All rights reserved.

Economic Value Added ® (EVA) Measures if operations have increased stockholder wealth Other Measures EVA = Net income + Interest expense – Capital charge Capital charge = Notes payable + Current maturities of long-term debt + Long-term debt + Stockholders’ Equity X Cost of capital Average return demanded by investors and creditors ©2008 Pearson Prentice Hall. All rights reserved.

Red Flags in Financial Statement Analysis • Earnings problems • Decrease in net income over several years • Decreased cash flow • Operating cash flow consistently less than net income ©2008 Pearson Prentice Hall. All rights reserved.

Financial Statement Analysis