Financial statement analysis and interpretation

1. Financial statement analysis and interpretation What is financial statement analysis? Examining the financial statements from a users’ perspective and looking at relationships in the accounting information

2. Financial statement analysis and interpretation Who analyzes financial statements? • Internal users (i.e., management) • External users (emphasis of chapter) • Examples? • Investors, creditors, regulatory agencies & … • stock market analysts and • auditors

3. Financial statement analysis and interpretation • What do internal users use it for? Planning, evaluating and controlling company operations • What do external users use it for? Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management

4. Financial statement analysis and interpretation Information is available from • Published annual reports • Financial statements • Notes to financial statements • Letters to stockholders • Auditor’s report (Independent accountants) • Management’s discussion and analysis • Reports filed with governments

5. Financial statement analysis and interpretation Information is available from • Other sources • Newspapers • Periodicals • Financial information organizations • Other business publications

6. Methods of financial statement analysis • Horizontal analysis • Vertical analysis • Ratio analysis • Common-size statements • Trend percentages

7. Horizontal analysis Using comparative financial statements to calculate currency or percentage changes in a financial statement item from one period to the next

8. Vertical analysis For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

9. Ratio analysis Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

10. Common-size statements Financial statements that show only percentages and no absolute currency amounts

11. Trend percentages Show changes over time in given financial statement items (can help evaluate financial information of several years)

12. Horizontal analysis example The management of Example Company provides you with comparative balance sheets of the years ended December 31, 2012 and 2011. Management asks you to prepare a horizontal analysis on the information

13. Horizontal analysis example

14. Horizontal analysis example Calculating change in currency amounts Money amount change Current year figure Previous year figure = –

15. Horizontal analysis example Calculating change as a percentage Percentage change Money amount change Previous year figure × = 100%

16. Horizontal analysis example

17. Horizontal analysis example (11,500 ÷ 23,500) × 100% = 48.9%

18. Horizontal analysis example

19. Horizontal analysis example Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet

23. Sales increased by 8.3% while net income decreased by 21.9%.

24. There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

25. Vertical analysis example The management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company

26. Vertical analysis example

27. Vertical Analysis Example 82,000 ÷ 483,000 = 17% rounded 30,000 ÷ 387,000 = 8% rounded

28. Vertical analysis example

29. Vertical analysis example 76,000 ÷ 483,000 = 16% rounded

30. Ratios Ratios can be expressed in different ways: 1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of $2.25) CAUTION! Using ratios and percentages without considering the underlying causes may lead to incorrect conclusions

31. Categories of ratios • Liquidity ratios Indicate a company’s short-term debt-paying ability • Debt & Equity ratios (Long-term Solvency) Show relationship between debt and equity financing in a company • Profitability ratios & tests Relate income to other variables • Market ratios & tests Help assess relative merits of stocks in the marketplace

32. Liquidity ratios • Current (working capital) ratio • Quick ratio (‘acid test’) • Liquid (cash) ratio • Accounts receivable turnover • Number of days sales in accounts receivable • Inventory turnover • Total assets turnover

33. Debt & Equity ratios (long-term Solvency) • Debt to Equity ratio or Debt to TOTAL ‘long term’ funds (D+E) • Equity ratio (stockholders’ equity)

34. Profitability ratios & tests • Return on capital employed ROCE (ie. return on ‘operating assets’ • Net income to net sales (return on sales or ‘net profit margin’) • Gross profit percentage • Return on equity ROE (ie. common stockholders equity)

35. Market ratios & tests • Earnings per share • Times interest earned • Times preferred dividends earned • Earnings yield on common stock • Price-earnings ratio • Payout ratio on common stock • Dividend yield on common stock • Dividend yield on preferred stock • Cash flow per share of common stock

36. Ratios Now, let’s look at Aspect Corporation’s 2012 and 2011 financial statements

40. This Information will be used to calculateliquidity ratios for Aspect Co.

41. Working Capital* The excess of current assets over (ie. minus) current liabilities • While this is not a ratio, it does give an indication of a company’s liquidity

42. Current Ratio Current Assets Current Liabilities = Current Ratio 65,000 42,000 = = 1.55 : 1 Current ratio Measures the ability of the company to pay current debts as they become due

43. Quick Ratio Current Assets - Inventory Current Liabilities = Quick Ratio Quick Ratio 53,000 42,000 65,000 - 12000 42,000 = = = = 1.26 : 1 1.26 : 1 Quick ratio This ratio is often and confusingly also referred to as the “acid-test”

44. Acid-test ratio Liquid Assets Current Liabilities = Liquid Ratio 30,000 42,000 = = .71 : 1 Liquid (‘acid-test’) ratio Liquid assets are cash, and current marketable securities

45. Average, net accounts receivable Net, credit sales Accounts receivable turnover Sales on Account Average accounts receivable = Accounts receivable turnover 494,000 (17,000 + 20,000) ÷ 2 = = 26.70 times Accounts receivable turnover This ratio measures how many times a company converts its receivables into cash each year

46. days sales in accounts receivables 365 days 26.70 times = = 13.67 days Number of days in accounts receivable days sales in accounts receivables 365 Days Accounts receivable turnover = Measures, on average, how many days it takes to collect an account receivable What would be a desirable number of daysfor collection of accounts receivable ?

47. Inventory turnover Cost of Goods sold Average inventory = Inventory turnover 140,000 (10,000 + 12,000) ÷ 2 = = 12.73 times Inventory turnover Measures the number of times inventory is sold and replaced during the year What would be a desirable number of times for inventory to turnover ?

48. Debt to Equity, or long–term Solvency ratios This is part of the information to calculate the equity, or long-term solvency ratios of Aspect Corporation

49. Here is the rest of the information we will use

50. Debt to Equity Long term Debt Total Assets = Debt to Equity 70,000 234,390 = = 0.30 Debt to Equity ratio Measures the ‘risk’