Analysis of Financial Statements

Chapter 17 Analysis of Financial Statements

Basics of Analysis C 1 Reduces uncertainty Application of analytical tools Involves transforming data Financial statement analysis helps users make better decisions. Internal UsersManagersOfficersInternal Auditors External UsersShareholdersLendersCustomers

Building Blocks of Analysis C 1 Liquidity and efficiency Solvency Profitability Market prospects

Information for Analysis C 1 Income Statement Balance Sheet Statement of Stockholders’ Equity Statement of Cash Flows Notes to the Financial Statements

Standards for Comparison C 1 When we interpret our analysis, it is essential to compare the results we obtained to other standards or benchmarks. • Intracompany • Competitors • Industry • Guidelines

Tools of Analysis C 2 Horizontal Analysis Comparing a company’s financial condition and performance across time. Vertical Analysis Comparing a company’s financial condition and performance to a base amount. Ratio Analysis Measurement of key relations between financial statement items.

Horizontal Analysis P 1

Calculate Change in Dollar Amount Comparative Statements P 1 Dollar Change Analysis Period Amount Base Period Amount = – When measuring the amount of the change in dollar amounts, compare the analysis period balance to the base period balance. The analysis period is usually the current year while the base period is usually the prior year.

Calculate Change as a Percent Comparative Statements P 1 Percent Change Dollar Change Base Period Amount × 100 = When calculating the change as a percentage, divide the amount of the dollar change by the base period amount, and then multiply by 100 to convert to a percentage.

Horizontal Analysis P 1 $1,550,861 – $835,546 = $715,315 ($715,315 ÷ $835,546) × 100 = 85.6%

Horizontal Analysis P 1 $14,953,224 – $11,065,186 = $3,888,038 ($3,888,038 ÷ $11,065,186) × 100 = 35.1%

Trend Percent Analysis Period Amount Base Period Amount × 100 = Trend Analysis P 1 Trend analysis is used to reveal patterns in data covering successive periods.

Trend Analysis P 1 Research in MotionIncome Statement Information Using 2006 as the base year we will get the following trend information: Examples of 2006-2008 Calculations for Revenues: 2006 is base year. Set to 100% 2007: $3,037,103 ÷ $2,065,845 × 100 = 147.0% 2008: $6,009,395 ÷ $2,065,845 × 100 = 290.9%

Trend Analysis P 1 We can use the trend percentages to construct a graph so we can see the trend over time.

Common-Size Statements Financial StatementBase Amount Balance Sheet Total Assets Income Statement Revenues Vertical Analysis P 2 Common-size Percent Analysis Amount Base Amount × = 100

Common-Size Balance Sheet P 2 ($1,550,861 ÷ $10,204,409) × 100 = 15.2% ($835,546 ÷ $8,101,372) × 100 = 10.3%

Common-Size Income Statement P 2 ($8,368,958 ÷ $14,953,224) × 100 = 56.0%

Common-Size Graphics P 2

Ratio Analysis P 3 Liquidity and efficiency Solvency Profitability Market prospects

Liquidity and Efficiency P 3 Current Ratio Inventory Turnover Acid-test Ratio Days’ Sales Uncollected Accounts Receivable Turnover Days’ Sales in Inventory Total Asset Turnover

Working capitalrepresents current assets financed from long-term capital sources that do not require near-term repayment. Working Capital P 3 More working capital suggests a strong liquidity position and an ability to meet current obligations.

Current Ratio P 3 This ratio measures the short-term debt-paying ability of the company. A higher current ratio suggests a strong liquidity position.

Acid-Test Ratio P 3 Referred to as Quick Assets This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash.

Accounts Receivable Turnover P 3 This ratio measures how many times a company converts its receivables into cash each year.

Inventory Turnover P 3 This ratio measures the number of times merchandise is sold and replaced during the year.

Days’ Sales Uncollected P 3 Provides insight into how frequently a company collects its accounts receivable.

Days’ Sales in Inventory P3 This ratio is a useful measure in evaluating inventory liquidity. If a product is demanded by customers, this formula estimates how long it takes to sell the inventory.

Total Asset Turnover P 3 This ratio reflects a company’s ability to use its assets to generate sales. It is an important indication of operating efficiency.

Solvency P 3 Debt Ratio Equity Ratio Pledged Assets to Secured Liabilities Times Interest Earned

Debt and Equity Ratios P 3 $8,000,000 ÷ $12,000,000 = 66.7% The debt ratio expresses total liabilities as a percent of total assets. The equity ratio provides complementary information by expressing total equity as a percent of total assets.

Debt-to-Equity Ratio P 3 This ratio measures what portion of a company’s assets are contributed by creditors. A larger debt-to-equity ratio implies less opportunity to expand through use of debt financing.

Times Interest Earned P 3 This is the most common measure of the ability of a company’s operations to provide protection to long-term creditors.

Profitability P 3 Profit Margin Return on Total Assets Return on Common Stockholders’ Equity

Profit Margin P 3 This ratio describes a company’s ability to earn net income from each sales dollar.

Return on Total Assets P 3 Return on total assets measures how well assets have been employed by the company’s management.

Return on Common Stockholders’ Equity P 3 This measure indicates how well the company employed the stockholders’ equity to earn net income.

Market Prospects P 3 Price-Earnings Ratio Dividend Yield

Price-Earnings Ratio P 3 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 Yield P 3 This ratio identifies the return, in terms of cash dividends, on the current market price per share of the company’s common stock.

Global View Horizontal and Vertical Analysis Horizontal and vertical analyses help eliminate many differences between U.S. GAAP and IFRS when analyzing and interpreting financial statements. However, when fundamental differences in reporting regimes impact financial statements, the user must exercise caution when drawing conclusions. Ratio Analysis Ratio analysis of financial statement also helps eliminate differences between U.S. GAAP and IFRS. Importantly, the use of ratio analysis is fine, with some possible changes in interpretation depending on what is and what is not included in certain accounting measures across U.S. GAAP and IFRS. Care must be taken in drawing inferences from a comparison of ratios across reporting regimes.

Analysis Reporting A1 The purpose of financial statement analyses is to reduce uncertainty in business decisions through a rigorous and sound evaluation. A financial statement analysis report directly addresses the building blocks of analysis and documents the reasoning. Executive Summary Analysis Overview Evidential Matter Assumptions Key Factors Inferences

Appendix 17A: Sustainable Income A 2 Extraordinary Items Discontinued Segments Net Income Continuing Operations

End of Chapter 17

Analysis of Financial Statements