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## “How Well Am I Doing?” Financial Statement Analysis

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**Chapter14**“How Well Am I Doing?”Financial Statement Analysis**We use LIFO to value inventory.**We use FIFO to value inventory. Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult.**Changes within the firm**• Industry trends • Consumer tastes • Technological changes • Economic factors Limitations of Financial Statement Analysis Analysts should look beyond the ratios.**Statements in Comparative and Common-Size Form**Analytical techniques used to examine relationships among financial statement items • Dollar and percentage • changes on statements • Common-size statements • Ratios**Horizontal Analysis**Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.**Dollar**Change Current Year Figure Base Year Figure = – Percentage Change Dollar Change Base Year Figure × 100% = Horizontal Analysis Calculating Change in Dollar Amounts 2001 is the base year. Calculating Change as a Percentage**Horizontal Analysis**Information on the following slides illustrate a horizontal analysis of Clover, Co’s December 31, 2002 and 2001, comparative balance sheets and income statements.**Horizontal Analysis**$12,000 – $23,500 = $(11,500) ($11,500 ÷ $23,500) × 100% = 48.9%**Horizontal Analysis**Let’s move from the Balance Sheet to the Income Statement of Clover Co.**Horizontal Analysis**Sales increased by 8.3% yet net income decreased by 21.9%.**Horizontal Analysis**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.**Trend**Percentage Current Year Amount Base Year Amount × 100% = Trend Analysis Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.**Trend Analysis**Look at the income information for Berry, Inc. for the years 2002 through 2006. We will do a trend analysis on these amounts to see what we can learn about the company.**Trend Analysis**Berry, Inc.Income Information For the Years Ended December 31 The base year is 2002, and its amounts will equal 100%.**Trend Analysis**Berry, Inc.Income Information For the Years Ended December 31 2003 Amount ÷ 2002 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108%**Trend Analysis**Berry, Inc.Income Information For the Years Ended December 31 Trends at Berry, Inc., indicated that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.**We can use the trend percentages to construct a graph so we**can see the trend over time. Trend Analysis**Common-Size Statements**Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis. Let’s take another look at the information from the comparative income statements of Clover Co. for 2002 and 2001.**Common-Size Statements**Net sales is usually the base and is expressed as 100%.**2002 COGS ÷ 2002 Net Sales × 100%**( $360,000 ÷ $520,000 ) × 100% = 69.2% 2001 COGS ÷ 2001 Net Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6% Common-Size Statements**Gross Margin**Percentage Gross Margin Sales = Gross Margin Percentage Gross profit percentage indicates how much of each sales dollar is left after deducting the cost of goods sold to cover operating expenses and a profit.**Common-Size Statements**What conclusions can we draw?**Let’s use the financial statements of Norton Corporation**to complete a ratio analysis.**Ratio Analysis – The Common Stockholder**Use this information to calculate ratios to measure the well-being of the common stockholders of Norton Corporation.**Net Income – Preferred Dividends**Average Number of Common Shares Outstanding Earningsper Share = Earningsper Share $53,690 – $0 (17,000 + 27,400)/2 = = $2.42 Earnings Per Share Indicates how much income was earned for each share of common stock outstanding.**Price-Earnings**Ratio Market Price Per Share Earnings Per Share = Price-Earnings Ratio $20.00 $2.42 = = 8.26 times Price-Earnings Ratio This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth.**Dividend**Payout Ratio Dividends Per Share Earnings Per Share = $2.00 $2.42 Dividend Payout Ratio = 82.6% = Dividend Payout Ratio Gauges the portion of current earnings being paid out in dividends. Investors seeking current income would like this ratio to be large.**Dividend**Yield Ratio $2.00 $20.00 = = 10.00% Dividend Yield Ratio Dividend Yield Ratio Dividends Per Share Market Price Per Share = Identifies the return, in terms of cash dividends, on the current market price of the stock.**Return on**Total Assets Net Income + [Interest Expense × (1 – Tax Rate)] Average Total Assets = Return on Total Assets $53,690 +[7,300 × (1 – 0.30)] ($300,000 + $346,390) ÷ 2 = = 18.19% Return on Total Assets Measures how well assets have been employed.**Return on Common**Stockholders’ Equity Net Income – Preferred Dividends AverageStockholders’ Equity = $53,690 – $0 ($180,000 + $234,390) ÷ 2 Return on Common Stockholders’ Equity = = 25.91% Return on Common Stockholders’ Equity Indicates how well the company employed the owners’ investments to earn income.**Fixed rate of return on borrowed funds**Return on investment in assets Positivefinancial leverage > = Return on investment in assets Fixed rate of return on borrowed funds Negativefinancial leverage < = Financial Leverage Financial leverageinvolves acquiring assets with funds at a fixed rate of interest.**Book Value per Share**Common Stockholders’ Equity Number of Common Shares Outstanding = $234,390 27,400 Book Value per Share = $ 8.55 = Book Value Per Share Measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.**Ratio Analysis – The Short-Term Creditor**We will usethis information to calculate ratios to measure the well-being of the short-term creditors for Norton Corporation.**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.**Acid-Test**Ratio Quick Assets Current Liabilities = Acid-Test Ratio $50,000 $42,000 = = 1.19 : 1 Acid-Test (Quick) Ratio Quick assets are Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash.**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 Measures how many times a company converts its receivables into cash each year.**Average Collection Period**365 Days Accounts Receivable Turnover = Average Collection Period 365 Days 26.7 Times = = 13.67 days Average Collection Period Measures, on average, how many days it takes to collect an account receivable.**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 merchandise inventory is sold and replaced during the year.**Average Sale Period**365 Days Inventory Turnover = Average Sale Period 365 Days 12.73 Times = = 28.67 days Average Sale Period Measures how many days, on average, it takes to sell the inventory.**Referred to as net operating income.**Ratio Analysis – The Long-Term Creditor Use this information to calculate ratios to measure the well-being of the long-term creditors for Norton Corporation.**Times Interest Earned**Earnings before interest and taxesInterest expense = Times Interest Earned $84,000 7,300 = = 11.51 times Times Interest Earned Ratio The most common measure of the ability of a firm’s operations to provide protection to the long-term creditor.**Debt–to–**Equity Ratio Total Liabilities Stockholders’ Equity = Debt–to– Equity Ratio $112,000 $234,390 = = 0.48 to 1 Debt-to-Equity Ratio Measures the amount of assets being provided by creditors for each dollar of assets being provided by the owners of the company.