“How Well Am I Doing?” Financial Statement Analysis

1. “How Well Am I Doing?” Financial Statement Analysis

2. Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult. We use the LIFO method to value inventory. We use the FIFO method to value inventory.

3. Limitations of Financial Statement Analysis Changes within the company Industry trends Consumer tastes Technological changes Economic factors Analysts should look beyond the ratios.

4. Statements in Comparative and Common-Size Form • Dollar and percentage changes on statements Analytical techniques used to examine relationships among financial statement items • Common-size statements • Ratios

5. Learning Objective LO1 To prepare and interpret financial statements in comparative and common-size form

6. Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

7. Horizontal Analysis Example The following slides illustrate a horizontal analysis of Clover Corporation’s December 31, 2005 and 2004 comparative balance sheets and comparative income statements.

8. Horizontal Analysis

9. Horizontal Analysis Calculating Change in Dollar Amounts Dollar Change Current Year Figure Base Year Figure = – The dollar amounts for 2004 become the “base” year figures.

10. Horizontal Analysis Calculating Change as a Percentage Percentage Change Dollar Change Base Year Figure × 100% =

11. Horizontal Analysis $12,000 – $23,500 = $(11,500) ($11,500 ÷ $23,500) × 100% = 48.9%

12. Horizontal Analysis

13. Horizontal Analysis We could do this for the liabilities & stockholders’ equity, but now, let’s look at the income statement accounts.

14. Horizontal Analysis

15. Horizontal Analysis

16. Horizontal Analysis Sales increased by 8.3%, yet net income decreased by 21.9%.

17. 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.

18. Trend Percentages Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.

19. Trend Percentages Trend Percentage Current Year Amount Base Year Amount × 100% =

20. Trend Percentages Example Look at the income information for Berry Products for the years 2001 through 2005. We will do a trend analysis on these amounts to see what we can learn about the company.

21. Trend Percentages Berry Products Income Information For the Years Ended December 31 The base year is 2001, and its amounts will equal 100%.

22. Trend Percentages Berry Products Income Information For the Years Ended December 31 2002 Amount ÷ 2001 Amount × 100% ( $290,000 ÷ $275,000 ) × 100% = 105% ( $198,000 ÷ $190,000 ) × 100% = 104% ( $ 92,000 ÷ $ 85,000 ) × 100% = 108%

23. Trend Percentages Berry Products Income Information For the Years Ended December 31 By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.

24. Trend Percentages We can use the trend percentages to construct a graph so we can see the trend over time.

25. 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.

26. Common-Size Statements In income statements, all items are expressed as a percentage of net sales.

27. Gross Margin Percentage Gross Margin Percentage Gross Margin Sales = This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit.

28. Common-Size Statements In balance sheets, all items are expressed as a percentage of total assets.

29. Common-Size Statements Common-size financial statements are particularly useful when comparing data from different companies.

30. Common-Size Statements Example Let’s take another look at the information from the comparative income statements of Clover Corporation for 2005 and 2004. This time let’s prepare common-size statements.

31. Common-Size Statements Net sales is the base and is expressed as 100%.

32. Common-Size Statements 2005 Cost ÷ 2005 Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2% 2004 Cost ÷ 2004 Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6%

33. Common-Size Statements What conclusions can we draw?

34. Quick Check  Which of the following statements describes horizontal analysis? • a. A statement that shows items appearing on it in percentage and dollar form. • b. A side-by-side comparison of two or more years’ financial statements. • c. A comparison of the account balances on the current year’s financial statements. • d. None of the above.

35. Quick Check  Which of the following statements describes horizontal analysis? • a. A statement that shows items appearing on it in percentage and dollar form. • b. A side-by-side comparison of two or more years’ financial statements. • c. A comparison of the account balances on the current year’s financial statements. • d. None of the above. Horizontal analysis shows the changes between years in the financial data, in both dollar and percentage form.

36. Ratios Common Stockholders Short-term Creditors Long-term Creditors

37. Now, let’s look at Norton Corporation’s recent financial statements.

41. Learning Objective LO2 To compute and interpret financial ratios that would be useful to a common stockholder

42. Ratio Analysis – The Common Stockholder Use this information to calculate ratios to measure the well-being of the common stockholders of Norton Corporation.

43. Earnings Per Share Net Income – Preferred Dividends Average Number of Common Shares Outstanding Earnings per Share = Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

44. Earnings Per Share Net Income – Preferred Dividends Average Number of Common Shares Outstanding Earnings per Share = $53,690 – 0 (17,000 + 27,400)/2 Earnings per Share = = $2.42 This measure indicates how much income was earned for each share of common stock outstanding.

45. Price-Earnings Ratio Price-Earnings Ratio Market Price Per Share Earnings Per Share = Price-Earnings Ratio $20.00 $2.42 = = 8.26 times 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.

46. Dividend Payout Ratio Dividend Payout Ratio Dividends Per Share Earnings Per Share = Dividend Payout Ratio $2.00 $2.42 = = 82.6% This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking current income would like this ratio to be large.

47. Dividend Yield Ratio Dividend Yield Ratio Dividends Per Share Market Price Per Share = Dividend Yield Ratio $2.00 $20.00 = = 10.00% This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

48. Return on Total Assets Return on Total Assets Net Income + [Interest Expense × (1 – Tax Rate)] Average Total Assets = Return on Total Assets $53,690 +[7,300 × (1 – .30)] ($300,000 + $346,390) ÷ 2 = = 18.19% This ratio measures how well assets have been employed.

49. Return on Common Stockholders’ Equity Return on Common Stockholders’ Equity Net Income – Preferred Dividends AverageStockholders’ Equity = Return on Common Stockholders’ Equity $53,690 – 0 ($180,000 + $234,390) ÷ 2 = = 25.91% This measure indicates how well the company employed the owners’ investments to earn income.

50. Financial Leverage Financial leverageinvolves acquiring assets with funds at a fixed rate of interest. Fixed rate of return on borrowed funds Return on investment in assets Positive financial leverage > = Fixed rate of return on borrowed funds Return on investment in assets Negative financial leverage < =