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Chapter 13

Chapter 13. Financial Statement Analysis. Financial Accounting, Alternate 4e by Porter and Norton. Will I be paid?. How good is our investment?. How are we performing?. Financial Statement Analysis. Creditors. Stockholders. Management. Limitations of Financial Statement Analysis.

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Chapter 13

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  1. Chapter 13 Financial Statement Analysis Financial Accounting, Alternate 4e by Porter and Norton

  2. Will I be paid? How good is our investment? How are we performing? Financial Statement Analysis Creditors Stockholders Management

  3. Limitations of Financial Statement Analysis • Use of different accounting methods • Changes in accounting methods LIFO FIFO

  4. ???? Limitations of Financial Statement Analysis • Failure to understand trends or use industry ratios • Difficulty of making industry comparisons (i.e., conglomerates)

  5. = Limitations of Financial Statement Analysis • Nonoperating items on income statement • Effects of inflation

  6. Net Sales Gross Profit Net Earnings Increase (Decrease) 20022001DollarsPercent $2,746 $2,401 $345 14.4 % 1,596 1,404 192 13.7 402 363 39 10.7 Horizontal Analysis Wm. Wrigley Jr. Company (in millions)

  7. Return on Avg. Equity 20022001200019991998 28.7% 30.1% 29.0% 26.8% 28.4% Trend Analysis Wm. Wrigley Jr. Company Tracking items over a series of years

  8. Vertical Analysis • Common-size statements recast items as a percentage of a selected item • Allows comparisons of companies of different size • Compares percentages across years to identify trends % % %

  9. Sales revenue Cost of goods sold Gross profit Selling & admin. exp. Operating income Interest expense Income before tax Income tax expense Net income Common-Size Statements DollarsPercent $24,000 100.0% 18,000 75.0 $ 6,000 25.0% 3,000 12.5 $ 3,000 12.5% 140 0.6 $ 2,860 11.9% 1,140 4.8 $ 1,720 7.1%

  10. Turnover Ratios Cash Ratios Working Capital Ratios Liquidity Analysis • Nearness to cash • Ability to pay debts as they become due

  11. Working Capital • Excess of current assets over current liabilities • Lacks meaningful comparisons for companies of different size -

  12. Current Ratio • Measure of short-term financial health • Consider composition of current assets Rule of thumb 2:1

  13. Acid-Test (Quick) Ratio • Stricter test of ability to pay debts • Excludes inventories and prepaid assets Quick Assets Current Liabilities

  14. Cash Flow from Operations to Current Liabilities Ratio • Focuses on cash only • Covers period of time Net Cash Provided by Operating Activities Average Current Liabilities

  15. Accounts Receivable Turnover Ratio Net Credit Sales Average Accounts Receivable Indicates how quickly a company is collecting (i.e., turning over) its receivables

  16. Too fast Credit policies too stringent; may be losing sales Too slow Credit department not operating effectively; possible quality problems Accounts Receivable Turnover Ratio

  17. Number of Days’ Sales in Receivables 360 Days* . Accts. Receivable Turnover Represents the average # of days accounts are outstanding *Some analysts use 365 days.

  18. Number of Days’ Sales in Receivables Example: If this company’s credit terms are net 30, what would this tell you about the efficiency of the collection process? 360 Days 4.8 Times = 75 days

  19. Inventory Turnover Ratio Cost of Goods Sold Average Inventory Represents the number of times per period inventory is turned over (i.e., sold).

  20. Inventory Turnover Ratio Circuit City 5.8 times per year Safeway 9.2 times per year Can you compare the two ratios?

  21. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 # of Days’ Sales in Inventory # of Days in Period Inventory Turnover Ratio Represents the average # of days inventory is on hand before it’s sold

  22. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 # of Days’ Sales in Inventory Circuit City 62 days Safeway 39 days Do these averages seem reasonable?

  23. Cash Operating Cycle • Time between purchase of merchandise and collection from the sale # of days sales in receivables + # of days sales in inventory

  24. Solvency Analysis • Ability to stay in business over the long-term Times Interest Earned Debt-to-Equity Ratio Cash Flow to Capital Expenditures Debt Service Coverage

  25. Debt-to-Equity Ratio How much have creditors contributed compared to owners? Total Liabilities Total Stockholders’ Equity

  26. For every dollar contributed by owners, creditors have loaned $.60 Debt-to-Equity Ratio Total Liabilities Total Stockholders’ Equity = .60

  27. Times Interest Earned Ratio • Measures ability to meet current interest payments • The greater the coverage the better Net Income + Interest Expense + Income Tax Expense Interest Expense

  28. P + i Debt Service Coverage Ratio • Measures amount of cash from operations available to service the debt Cash Flow from Operations before Interest & Taxes Interest and Principal Payments

  29. Cash Flow from Operations to Capital Expenditures Ratio • Measures company’s ability to use operations (vs. creditors and owners) to finance acquisitions of productive assets Cash Flow from Operations – Dividends Paid Cash Paid for Capital Acquisitions

  30. Profitability Analysis • Rate of Return on Assets • Return on Common S/E • EPS • P/E Ratio • Dividend Ratios

  31. Return on Assets Ratio • Measures return to all providers of capital (creditors and owners) Net Income + Interest Expense, Net of Tax Average Total Assets

  32. The owners earned 15% on their investment in ABC Co... Not bad! Return on Common Stockholders’ Equity Net Income - Preferred Dividends Average Common Stockholders’ Equity

  33. Certificate of Stock Earnings per Share • Presents profits on a per-share basis Net Income - Preferred Dividends Weighted Avg. # of Common Shares Outstanding

  34. Price/Earnings Ratio • Relates earnings to the market price of the stock Current Market Price Earnings per Share very high P/E very low P/E possibly overvalued possibly undervalued

  35. P/E Ratios Co. A = 10 to 1 Co. B = 7 to 1 Price/Earnings Ratio Both companies have earnings of $2 per share. So why the different P/E ratios?

  36. We need to decide what % of the firm’s income we can return to owners. Dividend Payout Ratio Common Dividends per Share Earnings per Share

  37. Dividend Yield Ratio • Investors willing to forgo dividends in lieu of price appreciation Common Dividends per Share Market Price per Share usually < 5% =

  38. Appendix Accounting Tools: Reporting and Analyzing Other Income Statement Items

  39. Common Characteristics • All such items are reported after income from continuing operations • Reported separately • Shown net of tax effects • Most analysts ignore these items, since they are not likely to reoccur

  40. Discontinued Operations • Any gain or loss from disposal of a division or segment of the business • Any net income or loss from operating this portion until the date of disposal

  41. Extraordinary Items Gain or loss due to an event that is • Unusual in nature AND • Infrequent in occurrence

  42. Cumulative Effect of a Change in Accounting Principle • Reflects a change in a company’s accounting principles, practices, or methods • Reports the difference in income in all prior years between the old method and the new method • Sometimes such a change is dictated by new accounting standards

  43. End of Chapter 13

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