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Financial statement analysis and interpretation. What is financial statement analysis?

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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

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

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

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

Financial statement analysis and interpretation

Information is available from

- Other sources
- Newspapers
- Periodicals
- Financial information organizations
- Other business publications

Methods of financial statement analysis

- Horizontal analysis
- Vertical analysis
- Ratio analysis
- Common-size statements
- Trend percentages

Horizontal analysis

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

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

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)

Common-size statements

Financial statements that show only percentages and no absolute currency amounts

Trend percentages

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

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

Horizontal analysis example

Calculating change in currency amounts

Money

amount

change

Current year

figure

Previous year

figure

=

–

Horizontal analysis example

Calculating change as a percentage

Percentage

change

Money amount change

Previous year figure

×

=

100%

Horizontal analysis example

(11,500 ÷ 23,500) × 100% = 48.9%

Horizontal analysis example

Let’s apply the same

procedures to the

liability and stockholders’ equity sections of the balance sheet

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.

Vertical analysis example

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

Vertical analysis example

76,000 ÷ 483,000 = 16% rounded

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

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

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

Debt & Equity ratios

(long-term Solvency)

- Debt to Equity ratio

or Debt to TOTAL ‘long term’ funds (D+E)

- Equity ratio (stockholders’ equity)

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)

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

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

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

Ratio

Current Assets

Current Liabilities

=

Current

Ratio

65,000

42,000

=

=

1.55 : 1

Current ratioMeasures the ability

of the company to pay current

debts as they become due

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 ratioThis ratio is often and confusingly also referred to

as the “acid-test”

ratio

Liquid Assets

Current Liabilities

=

Liquid

Ratio

30,000

42,000

=

=

.71 : 1

Liquid (‘acid-test’) ratioLiquid assets are cash,

and current marketable securities

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 turnoverThis ratio measures how many times a company converts its receivables into cash each year

in accounts

receivables

365 days

26.70 times

=

= 13.67 days

Number of days in accounts receivabledays 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 ?

turnover

Cost of Goods sold

Average inventory

=

Inventory

turnover

140,000

(10,000 + 12,000) ÷ 2

=

= 12.73 times

Inventory turnoverMeasures the number of times

inventory is sold and

replaced during the year

What would be a desirable number of times for inventory to turnover ?

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

Equity

Long term Debt

Total Assets

=

Debt to

Equity

70,000

234,390

=

=

0.30

Debt to Equity ratioMeasures the ‘risk’

ratio

Equity

Total assets

=

Equity

ratio

234,390

346,390

=

=

67.7%

Equity ratioMeasures the proportion

of total assets provided by

stockholders

ROCE

PBIT

Equity + Debt (average)

Earning Before Interest and Tax

Equity + Debt (average)

=

=

76,700

346,390

ROCE

=

=

22.1%

Return On Capital Employed ROCEto

Net Sales

53,690

494,000

=

= 10.9%

Net Income to Net Sales(Return on Sales or Profit Margin)Net Income

to

Net Sales

net income

net sales

=

Measures the proportion of the sales dollarwhich is retained as profit

equity

53,690

(180,000 + 234,390) ÷ 2

=

= 25.9%

Return on Equity ROE (return on common stockholders funds)net income

Common equity (average)

Return on

equity funds

=

Important measure of the

income-producing ability of a company

per Share

53,690

(17,000 + 27,400) ÷ 2

=

= $2.42

Earnings Per ShareEarnings Available to Common Stockholders

Weighted Average Number of Common Shares Outstanding

Earnings

per Share

=

The financial press regularly publishes

actual and forecasted EPS amounts

common stockholders

EPS of common stock = _______________________

Weighted average number of

common shares outstanding

Earnings Per Share- Weighted average calculation

Earnings Per Share

EPS and Stock Dividends or Splits

Why restate all prior calculations of EPS?

Comparability - i.e., no additional capital was generated by the dividend or split

Basic EPS and Diluted EPS IAS 33

Ratio

$20.00

$ 2.42

=

= 8.3 : 1

Price-Earnings Ratio ( P/E Multiple )Price-Earnings

Ratio

Market Price Per Share

EPS

=

Provides some measure of whether the stock is under or overpriced

Trend Percentages Example

Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis

Trend Percentages Example

Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis

1,991 - 1,820 = 171

Trend Percentages Example

Using 2008 as the base year, we develop the following percentage relationships

1,991 - 1,820 = 171

171 ÷ 1,820 = 9% rounded

for Sales

Important Considerations

- Need for comparable data
- Data is provided by the media etc.
- Must compare by industry
- Is EPS comparable?

- Influence of external factors
- General business conditions
- Seasonal nature of business operations

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