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Financial Statement Analysis

PART III: Decision Tools. Lecture 27. Financial Statement Analysis. Instructor Adnan Shoaib. Discuss the need for comparative analysis. Identify the tools of financial statement analysis. Explain and apply horizontal analysis. Describe and apply vertical analysis.

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Financial Statement Analysis

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  1. PART III: Decision Tools Lecture 27 Financial Statement Analysis Instructor Adnan Shoaib

  2. Discuss the need for comparative analysis. Identify the tools of financial statement analysis. Explain and apply horizontal analysis. Describe and apply vertical analysis. Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Understand the concept of earning power, and how irregular items are presented. Understand the concept of quality of earnings. Learning Objectives

  3. Financial Statement Analysis Basics of Financial Statement Analysis Horizontal and Vertical Analysis Ratio Analysis Earning Power and Irregular Items Quality of Earnings Need for comparative analysis Tools of analysis Balance sheet Income statement Retained earnings statement Liquidity Profitability Solvency Summary Discontinued operations Extraordinary items Changes in accounting principle Comprehensive income Alternative accounting methods Pro forma income Improper recognition

  4. Basics of Financial Statement Analysis Analyzing financial statements involves: Characteristics Comparison Bases Tools of Analysis Liquidity Profitability Solvency Intracompany Industry averages Intercompany Horizontal Vertical Ratio LO 1 Discuss the need for comparative analysis. LO 2 Identify the tools of financial statement analysis.

  5. Horizontal Analysis Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place. Horizontal analysis is commonly applied to the balance sheet, income statement, and statement of retained earnings. LO 3 Explain and apply horizontal analysis.

  6. Horizontal Analysis These changes suggest that the company expanded its asset base during 2007 and financed this expansion primarily by retaining income rather than assuming additional long-term debt. LO 3 Explain and apply horizontal analysis.

  7. Horizontal Analysis Overall, gross profit and net income were up substantially. Gross profit increased 17.1%, and net income, 26.5%. Quality’s profit trend appears favorable. LO 3 Explain and apply horizontal analysis.

  8. Horizontal Analysis We saw in the horizontal analysis of the balance sheet that ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. LO 3 Explain and apply horizontal analysis.

  9. Vertical Analysis Vertical analysis, also called common-size analysis, is a technique that expresses each financial statement item as a percent of a base amount. On an income statement, we might say that selling expenses are 16% of net sales. Vertical analysis is commonly applied to the balance sheet and the income statement. LO 4 Describe and apply vertical analysis.

  10. Vertical Analysis These results reinforce the earlier observations that Quality is choosing to finance its growth through retention of earnings rather than through issuing additional debt. LO 4 Describe and apply vertical analysis.

  11. Vertical Analysis Quality appears to be a profitable enterprise that is becoming even more successful. LO 4 Describe and apply vertical analysis.

  12. Vertical Analysis Enables a comparison of companies of different sizes. J.C. Penney earned net income more than 4,208 times larger than Quality’s, J.C. Penney’s net income as a percent of each sales dollar (5.6%) is only 4% of Quality’s (12.6%). LO 4 Describe and apply vertical analysis.

  13. Ratio Analysis Ratio analysisexpresses the relationship among selected items of financial statement data. Financial Ratio Classifications Liquidity Profitability Solvency Measures short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Measures the income or operating success of a company for a given period of time. Measures the ability of the company to survive over a long period of time. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  14. Ratio Analysis A single ratio by itself is not very meaningful. The discussion of ratios will include the following types of comparisons. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  15. Ratio Analysis Liquidity Ratios • Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. • Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. • Ratios include the current ratio, the acid-test ratio, receivables turnover, and inventory turnover. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  16. Liquidity Ratios Ratio Analysis Compute the Current Ratio for 2007. Current Assets = Current Ratio Current Liabilities $1,020,000 = 2.96 : 1 $344,500 The ratio of 2.96:1 means that for every dollar of current liabilities, Quality has $2.96 of current assets. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  17. Liquidity Ratios Ratio Analysis Compute the Acid-Test Ratio for 2007. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  18. Liquidity Ratios Ratio Analysis Compute the Acid-Test Ratio for 2007. Cash + Short-Term Investments + Receivables (Net) Acid-Test Ratio = Current Liabilities $100,000 + $20,000 + $230,000 = 1.02 : 1 $344.500 The acid-test ratio measures immediate liquidity. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  19. Liquidity Ratios Ratio Analysis Compute the Receivables Turnoverratio for 2007. Net Credit Sales Receivables Turnover = Average Net Receivables $2,097,000 = 10.2 times ($180,000 + $230,000) / 2 It measures the number of times, on average, the company collects receivables during the period. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  20. Liquidity Ratios Ratio Analysis Receivables Turnover $2,097,000 = 10.2 times ($180,000 + $230,000) / 2 A variant of the receivables turnover ratio is to convert it to an average collection periodin terms of days. 365 days / 10.2 times = every 35.78 days This means that receivables are collected on average every 36 days. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  21. Liquidity Ratios Ratio Analysis Compute the Inventory Turnoverratio for 2007. Cost of Good Sold Inventory Turnover = Average Inventory $1,281,000 = 2.31 times ($500,000 + $620,000) / 2 Inventory turnover measures the number of times, on average, the inventory is sold during the period. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  22. Liquidity Ratios Ratio Analysis Inventory Turnover $1,281,000 = 2.3 times ($500,000 + $620,000) / 2 A variant of inventory turnover is the days in inventory. 365 days / 2.3 times = every 159 days Inventory turnover ratios vary considerably among industries. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  23. Ratio Analysis Profitability Ratios • Measure the income or operating success of a company for a given period of time. • Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow. • Ratios include the profit margin, asset turnover, return on assets, return on common stockholders’ equity, earnings per share, price-earnings, and payout ratio. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  24. Profitability Ratios Ratio Analysis Compute the Profit Marginratio for 2007. Net Income Profit Margin = Net Sales $263,800 = 12.6% $2,097,000 Measures the percentage of each dollar of sales that results in net income. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  25. Profitability Ratios Ratio Analysis Compute the Asset Turnoverratio for 2007. Net Sales Asset Turnover = Average Assets $2,097,000 = 1.22 times ($1,95,000 + $1,835,000) / 2 Measures how efficiently a company uses its assets to generate sales. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  26. Profitability Ratios Ratio Analysis Compute the Return on Assetsratio for 2007. Net Income Return on Assets = Average Assets $263,800 = 15.4% ($1,595,000 + $1,835,000) / 2 An overall measure of profitability. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  27. Profitability Ratios Ratio Analysis Compute the Return on Common Stockholders’ Equity ratio for 2007. Return on Common Stockholders’ Equity Net Income – Preferred Dividends = Average Common Stockholders’ Equity $263,000 - $0 = 29.3% ($795,000 + $1,003,000) / 2 Shows how many dollars of net income the company earned for each dollar invested by the owners. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  28. Profitability Ratios Ratio Analysis Compute the Earnings Per Share for 2007. Net Income Earnings Per Share = Weighted Average Common Shares Outstanding $263,800 = $0.97 per share 270,000 + 275,400 / 2 A measure of the net income earned on each share of common stock. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  29. Profitability Ratios Ratio Analysis Compute the Price Earnings Ratio for 2007. Price Earnings Ratio Market Price per Share of Stock = Earnings Per Share $12.00 = 12.4 times $0.97 The price-earnings (PE) ratio reflects investors’ assessments of a company’s future earnings. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  30. Profitability Ratios Ratio Analysis Compute the Payout Ratio for 2007. Cash Dividends Payout Ratio = Net Income * $61,200 = 23.2% $263,800 Measures the percentage of earnings distributed in the form of cash dividends. * From analysis of retained earnings. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  31. 2010 2009 a. Dividends per share of common stock $ 0.80 $ 0.60 b. Market price per share of common stock 41.0027.00 3 Profitability Ratios Ratio Analysis Dividends per Share of Common Stock Market Price per Share of Common Stock Dividend Yield = Dividend yield on common stock 2.0% 2.2%

  32. Operating Profitability Ratios Profitability Ratios Ratio Analysis 3 This is the operating profit return on total assets. To consider the negative effects of financial leverage, we examine the effect of interest expense as a percentage of total assets Du Pont

  33. Operating Profitability Ratios Profitability Ratios Ratio Analysis We consider the positive effect of financial leverage with the financial leverage multiplier Du Pont

  34. Operating Profitability Ratios Profitability Ratios Ratio Analysis This indicates the pretax return on equity. To arrive at ROE we must consider the tax rate effect. Du Pont

  35. Operating Profitability Ratios Profitability Ratios Ratio Analysis

  36. Ratio Analysis Solvency Ratios • Solvency ratios measure the ability of a company to survive over a long period of time. • Debt to total assets and times interest earned are two ratios that provide information about debt-paying ability. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  37. Solvency Ratios Ratio Analysis Compute the Debt to Total Assets Ratio for 2007. Debt to Total Assets Ratio Total Debt = Total Assets $832,000 = 45.3% $1,835,000 Measures the percentage of the total assets that creditors provide. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  38. Solvency Ratios Ratio Analysis Compute the Times Interest Earned ratio for 2007. Income before Income Taxes and Interest Expense Times Interest Earned = Interest Expense $468,000 = 13 times $36,000 Provides an indication of the company’s ability to meet interest payments as they come due. LO 5 Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

  39. Earning Power and Irregular Items • Earning powermeans the normal level of income to be obtained in the future. • “Irregular” items are separately identified on the income statement. Two types are: • Discontinued operations. • Extraordinary items. • These “irregular” items are reported net of income taxes. LO 6 Understand the concept of earning power, and how irregular items are presented.

  40. Earning Power and Irregular Items • Discontinued Operations • Refers to the disposal of a significant component of a business. • Report the income (loss) from discontinued operations in two parts: • income (loss) from operations (net of tax) and • gain (loss) on disposal (net of tax). LO 6 Understand the concept of earning power, and how irregular items are presented.

  41. Earning Power and Irregular Items Illustration:During 2010 Acro Energy Inc. has income from continuing operations of $560,000. During 2010 Acro discontinued and sold its unprofitable chemical division. The loss in 2010 from chemical operations (net of $60,000 taxes) was $140,000. The loss on disposal of the chemical division (net of $30,000 taxes) was $70,000. Assuming a 30% tax rate. Income from continuing operations $560,000 Discontinued operations: Loss from operations, net of $60,000 tax 140,000 Loss on disposal, net of $30,000 tax 70,000 Total loss on discontinued operations 210,000 Net income $350,000 LO 6 Understand the concept of earning power, and how irregular items are presented.

  42. Earning Power and Irregular Items Discontinued Operations are reported after “Income from continuing operations.” Previously labeled as “Net Income”. Moved to LO 6 Understand the concept of earning power, and how irregular items are presented.

  43. Earning Power and Irregular Items • Extraordinary items are nonrecurring material items that differ significantly from a company’s typical business activities. • An extraordinary item must be both of an • Unusual Nature and • Occur Infrequently • Company must consider the environment in which it operates. • Amounts reported “net of tax.” LO 6 Understand the concept of earning power, and how irregular items are presented.

  44. Earning Power and Irregular Items Are these considered Extraordinary Items? • (a) A large portion of a tobacco manufacturer’s crops are destroyed by a hail storm. Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare. • A citrus grower's Florida crop is damaged by frost. • Loss from sale of temporary investments. • Loss attributable to a labor strike. YES NO NO NO LO 6 Understand the concept of earning power, and how irregular items are presented.

  45. Earning Power and Irregular Items Are these considered Extraordinary Items? • (d) Loss from flood damage. (The nearby Black River floods every 2 to 3 years.) • (e) An earthquake destroys one of the oil refineries owned by a large multi-national oil company. Earthquakes are rare in this geographical location. • Write-down of obsolete inventory. • Expropriation of a factory by a foreign government. NO YES NO YES LO 6 Understand the concept of earning power, and how irregular items are presented.

  46. Earning Power and Irregular Items Illustration: In 2010 a foreign government expropriated property held as an investment by Acro Energy Inc. If the loss is $70,000 before applicable income taxes of $21,000, the income statement will report a deduction of $49,000.

  47. Earning Power and Irregular Items Extraordinary Items are reported after “Income from continuing operations.” Previously labeled as “Net Income”. Moved to LO 6 Understand the concept of earning power, and how irregular items are presented.

  48. Earning Power and Irregular Items Reporting when both Discontinued Operations and Extraordinary Items are present. Discontinued Operations Extraordinary Item LO 6 Understand the concept of earning power, and how irregular items are presented.

  49. Earning Power and Irregular Items • Change in Accounting Principle • Occurs when the principle used in the current year is different from the one used in the preceding year. • Accounting rules permit a change if justified. • Changes are reported retroactively. • Example would include a change in inventory costing method such as FIFO to average cost. LO 6 Understand the concept of earning power, and how irregular items are presented.

  50. Earning Power and Irregular Items Comprehensive Income All changes in stockholders’ equity except those resulting from investments by stockholders and distributions to stockholders. Reported in Stockholders’ Equity Unrealized gains and losses on available-for-sale securities. Plus other items + LO 6 Understand the concept of earning power, and how irregular items are presented.

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