Chapter14 FINANCIAL STATEMENT ANALYSIS
Managers Officers Internal Auditors Shareholders Lenders Customers Purpose of Analysis Financial statement analysis helps users make better decisions. Internal Users External Users
Learning Objective To explain the uses of dollar and percentage changes, trend percentages, component percentages and ratios. LO1
Tools of Analysis Dollar & Percentage Changes Trend Percentages Component Percentages Ratios
Dollar Change: Dollar Change Analysis Period Amount Base Period Amount = – Dollar and Percentage Changes Percentage Change: % Percent Change Base Period Amount ÷ = Dollar Change
Evaluating Percentage Changes in Sales and Earnings Sales and earnings In measuring quarterly should increase at changes, compare to more than the rate the same quarter in of inflation. the previous year. Percentages may be misleading when the base amount is small. Dollar and Percentage Changes
Let’s look at the asset section of Clover, Inc. comparative balance sheet and income statement for 2007 and 2006. Compute the dollar change and the percentage change for cash. Dollar and Percentage Changes
($11,500 ÷ $23,500) × 100% = 48.94% Complete the analysis for the other assets.
Trend Percentages Trend analysis is used to reveal patterns in data covering successive periods. Analysis Period Amount Base Period Amount Trend Percentages × 100% =
Trend Percentages Berry Products Income Information For the Years Ended December 31, 2003 is the base period so its amounts will equal 100%.
Examine the relative size of each item in the financial statements by computing component(or common-sized) percentages. Analysis Amount Base Amount Component Percentages Component Percentage × = 100% Financial Statement Base Amount Balance Sheet Total Assets Income Statement Revenues
($12,000 ÷ $315,000) × 100% = 3.8% ($23,500 ÷ $289,700) × 100% = 8.1%
Learning Objective To discuss the quality of a company’s earnings, assets, and working capital. LO2
Quality of Earnings Investors are interest in companies that demonstrate an ability to earn income at a growing rate each year. Stability of earnings growth helps investors predict future prospects for the company. Financial analyst often speak of the “quality of earnings” at one company being higher than another company in the same industry.
Quality of Earnings While satisfactory earnings may be a good indicator of a company’s ability to pay its debts and dividends, we must also consider the composition of assets, their condition and liquidity, the timing of repayment of liabilities, and the total amount of debt outstanding
Learning Objective To explain the nature and purpose of classifications in financial statements. LO3
A Classified Balance Sheet Asset Section of the Balance Sheet
A Classified Balance Sheet Liability and Stockholders’ Equity Section of the Balance Sheet
Learning Objective To prepare a classified balance sheet and compute widely used measures of liquidity and credit risk. LO4
Use this information to calculate the liquidity ratios for Babson Builders, Inc.
Working Capital Working capitalis the excess of current assets over current liabilities.
Current Ratio Current Assets Current Liabilities = Current Ratio $65,000 $42,000 = Current Ratio This ratio measures the short-term debt-paying ability of the company. = 1.55 : 1
Quick Assets Current Liabilities Quick Ratio = Quick Ratio Quick assetsare cash, marketable securities, and receivables. This ratio is like the current ratio but excludescurrent assets such as inventories that may be difficult to quickly convert into cash.
Quick Assets Current Liabilities Quick Ratio = $50,000 $42,000 Quick Ratio = = 1.19 : 1 Quick Ratio This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash.
Learning Objective To prepare a multiple-step and a single-step income statement and compute widely used measures of profitability. LO5
Measures of Profitability An income statement can be prepared in either a multiple-step or single-step format. The single-step format is simpler. The multiple-step format provides more detailed information.
Income Statement (Multiple-Step) Proper Heading Gross Margin Operating Expenses Non-operating Items Remember to compute EPS.
Income Statement (Single-Step) Proper Heading Remember to compute EPS. Revenues & Gains Expenses & Losses
Use this information to calculate the profitability ratios for Babson Builders, Inc.
Learning Objective To put a company’s net income into perspective by relating it to sales, assets, and stockholders’ equity. LO6
Net IncomeAverage Shares of Capital Stock Outstanding = EPS $53,69027,400 = $1.96 Earning Per Share Look back at the information from Babson and get the values we need to calculate earning per share.
Current Market Price of one Share of StockEarnings Per Share = P/E $15.25$1.96 = 7.78 Price-Earnings Ratio
Learning Objective To compute the ratios widely used in financial statement analysis and explain the significance of each. LO7
Return On Investment (ROI) This ratio is a good measure of the efficiency of utilization of assets by the business.
Return On Assets (ROA) This ratio is generally considered the best overall measure of a company’s profitability.
Return On Equity (ROE) This measure indicates how well the company employed the owners’ investments to earn income.
Learning Objective To analyze financial statements from the viewpoints of common stockholders, creditors, and others. LO8
Dividend Yield Ratio Dividends Per Share Market Price Per Share = Dividend Yield Ratio $1.50 $15.25 = = 9.84% Dividend Yield Babson Builders pays an annual dividend of $1.50 per share of capital stock. The market price of the company’s capital stock was $15.25 at the end of 2007. This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
Use this information to calculate ratios to measure the well-being of the long-term creditors for Babson Builders. Analysis by Long-Term Creditors This is also referred to as net operating income.
Times Interest Earned Operating income before Interest and Income Taxes Annual Interest Expense = Times Interest Earned $84,000 7,300 = = 11.5 times Interest Coverage Ratio This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor.