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Financial Statement Analysis. Chapter 13. Learning Objective 1. Perform a horizontal analysis of a company’s financial statements. Comparative Financial Statements. Investors and creditors cannot based decisions on one year’s data

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financial statement analysis

Financial Statement Analysis

Chapter 13

©2008 Pearson Prentice Hall. All rights reserved.

learning objective 1
Learning Objective 1

Perform a horizontal analysis of a company’s financial statements

©2008 Pearson Prentice Hall. All rights reserved.

comparative financial statements
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
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.

e13 15
E13-15

©2008 Pearson Prentice Hall. All rights reserved.

learning objective 2
Learning Objective 2

Perform a vertical analysis of a company’s financial statements

©2008 Pearson Prentice Hall. All rights reserved.

vertical analysis
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.

e13 17
E13-17

©2008 Pearson Prentice Hall. All rights reserved.

learning objective 3
Learning Objective 3

Prepare common-size financial statements

©2008 Pearson Prentice Hall. All rights reserved.

common size statements
Common-Size Statements
  • Financial statements expressed in percentages only
    • No dollar amounts
  • Percentages derived from vertical analysis

©2008 Pearson Prentice Hall. All rights reserved.

example of common size income statement
Example of Common-Size Income Statement

©2008 Pearson Prentice Hall. All rights reserved.

benchmarking
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.

learning objective 4
Learning Objective 4

Use the statement of cash flows for decisions

©2008 Pearson Prentice Hall. All rights reserved.

using the statement of cash flows
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.

learning objective 5
Learning Objective 5

Compute the standard financial ratios

©2008 Pearson Prentice Hall. All rights reserved.

measuring ability to pay current liabilities
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
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
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.

e13 20
E13-20

Located on the balance sheet

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e13 201
E13-20

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e13 202
E13-20

Located on the income statement

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e13 203
E13-20

(Current year + preceding year)/2

©2008 Pearson Prentice Hall. All rights reserved.

e13 204
E13-20

Use the amount computed for receivable turnover

©2008 Pearson Prentice Hall. All rights reserved.

measuring ability to pay debts
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
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
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.

learning objective 6
Learning Objective 6

Use ratios in decision making

©2008 Pearson Prentice Hall. All rights reserved.

analyzing stock investments
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.

other measures
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
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.

end of chapter 13
End of Chapter 13

©2008 Pearson Prentice Hall. All rights reserved.