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## Financial Statement Analysis

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**Chapter**23 Financial Statement Analysis Section 1: Vertical Analysis Section Objectives • Use vertical analysis techniques to analyze a comparative income statement and balance sheet. McGraw-Hill © 2009 The McGraw-Hill Companies, Inc. All rights reserved.**Phases of Statement Analysis**• Computation Phase: • Vertical analysis • Horizontal analysis • Ratio analysis • Interpretation Phase:Comparison of ratios • Budgeted ratios • Industry Averages**Use vertical analysis techniques to analyze a comparative**income statement and balance sheet Cost of goods sold Net Sales $1,752,500 $2,969,000 = =59.0% Selling expenses Net Sales $526,425 $2,969,000 = = 17.7% Net income after taxes Net Sales $55,563 $2,969,000 = = 1.9% Objective 1 Each item is expressed as a percentage of the net sales figure.**Household Products, Inc.**Comparative Income Statement Year Ended December 31, 2010 and 2009 Amounts Percent of Net Sales 2010 2009 2010 2009 Revenue Sales 3,104,450 2,825,625 104.6 104.7 Less Sales Returns and Allowances 135,450125,625 4.6 4.7 Net Sales 2,969,000 2,700,000 100.0 100.0 Net Income After Income Taxes 55,563 23,750 1.9 .9 Comparative Statement**Household Products, Inc.**Comparative Income Statement Year Ended December 31, 2010 and 2009 Amounts Percent of Net Sales 2010 2009 2010 2009 Revenue Sales 3,105,650 2,850,625 104.6 104.6 Less Sales Returns and Allowances 135,450 125,625 4.6 4.6 Net Sales 2,970,200 2,725,000 100.0 100.0 Net Income After Income Taxes 56,578 41,250 1.9 1.5 Household Products, Inc. Comparative Income Statement Year Ended December 31, 2010 and 2009 Amounts Percent of Net Sales 2010 2009 2010 2009 Revenue Sales 3,104,450 2,825,625 104.6 104.7 Less Sales Returns and Allowances 135,450125,625 4.6 4.7 Net Sales 2,969,000 2,700,000 100.0 100.0 Net Income After Income Taxes 55,563 23,750 1.9 .9 Common-size Statement**Vertical Analysis of the Balance Sheet**Each item is expressed as either a percentage of total assets or of total liabilities plus stockholders’ equity. Cash Total assets $115,231 $555,711 = =20.7% Accounts payable total liabilities plus stkhldrs’ equity. $ 71,000 $ 555,711 = =12.8% $316,306 $ 555,711 Total stockholders’ equity total liabilities plus stkhldrs’ equity. = = 56.9%**Chapter**23 Financial Statement Analysis Section 2: Horizontal Analysis Section Objectives • Use horizontal analysis techniques to analyze a comparative income statement and balance sheet. • Use trend analysis to evaluate financial statements. • Interpret the results of statement analyses by comparison with industry averages. McGraw-Hill © 2009 The McGraw-Hill Companies, Inc. All rights reserved.**Use horizontal analysis techniques to analyze a**comparative income statement and balance sheet Objective 2 Horizontal Analysis • Evaluates financial statements for two or more periods. • Compares items in each line to determine the change in dollar amounts. • Uses the same method for both the income statement and the balance sheet. A percentage change can be shown by using the earlier figure as the base.**Sales for 2009 – 2,825,625**Increase $ 278,825 Increase in sales $ 278,825 9.9% = = $2,825,625 Sales for base year Horizontal Analysis of the Income Statement Sales for 2010 $3,104,450 Earlier year is the base year.**Current liabilities 12/31/10 $ 75,905**Current liabilities 12/31/09 – 88,240 $(12,335) Decrease in current liabilities $ (12,335) – 14.0% = = $ 88,240 Current liabilities in base year Horizontal Analysis of the Balance Sheet A decrease is expressed as a negative percentage.**QUESTION:**What is trend analysis? ANSWER: Trend analysis compares selected ratios and percentages over a period of time. Objective 3 Use trend analysis to evaluate financial statements Often the time period is five years.**2006 2007 2008**2009 2010 Net Sales 2,055,600 2,223,240 2,587,500 2,700,000 2,969,000 Cost of goods sold 1,059,9001,234,5601,495,6421,574,7211,752,500 Gross profit on sales 995,700 988,6801,091,8581,125,2791,216,500 Percentage of gross profit to net sales 48.4 44.5 42.2 41.7 41.0 Trend Analysis The increase in the percentage of gross profit to net sales is positive for the company.**Interpret the results of the statement analyses by**comparison with industry averages Objective 4 Using Industry Averages • Trade associations survey their members to obtain financial information and other data. • Data is converted to a uniform presentation, usually in common-size statements arranged by company size. • Individual companies compare their results to industry averages.**Chapter**23 Financial Statement Analysis Section 3: Ratios Section Objectives • Compute and interpret financial ratios that measure profitability, operating results, and efficiency. • Compute and interpret financial ratios that measure financial strength. • Compute and interpret financial ratios that measure liquidity • Recognize shortcomings in financial statement analysis. McGraw-Hill © 2009 The McGraw-Hill Companies, Inc. All rights reserved.**Ratio Analysis**• Financial ratios have three classifications: • Profitability, operating results, and efficiency • Financial strength • Liquidity**Compute and interpret financial ratios that measure**profitability, operating results, and efficiency Objective 5 Ratios Measuring Profitability, Operating Results, and Efficiency • Rate of return on sales. • Rate of return on common stockholders’ equity. • Earnings per share of common stock (EPS). • Price-earnings ratio. • Yield on common stock. • Rate of return on total assets. • Asset turnover.**$ 55,563**= Rate of return on net sales $ 2,969,000 = 1.9% Net income Net sales Rate of Return on Sales • Measures what percentage of each sales dollar is net income. • Formula: • Example: The higher the rate of return on net sales, the more satisfactory are the business operations.**Return on**common stockholders’ equity Income available to common stockholders = Common stockholders’ equity Rate of Return on Common Stockholders’ Equity • Measures how well the corporation is making a profit for its shareholders. • Formula: • Procedure: Step 1: Compute income available to common stockholders. Step 2: Compute the common stockholders’ equity. Step 3: Divide the income available to common stockholders by the common stockholders’ equity.**Less dividend requirements onpreferred stock**4,000 Income available to common stockholders $51,563 Rate of Return on Common Stockholders’ Equity • Step 1: Compute income available to common stockholders. Net income after income taxes $55,563**Preferred stockholders’ equity - 50,000**Common stockholders’ equity $266,306 Rate of Return on Common Stockholders’ Equity • Step 1: Income available to common stockholders = $51,563 • Step 2: Compute the common stockholders’ equity. Total stockholders’ equity $316,306**$51,563**= 19.4% $266,306 Rate of Return on Common Stockholders’ Equity • Step 1: Income available to common stockholders = $51,563 • Step 2: Common stockholders’ equity = $266,306 • Step 3: Divide the income available to common stockholders by the common stockholders’ equity.**Income available to common stockholders**Earnings per share = Average number of shares of common stock outstanding during year Earnings per Share of Common Stock • Measures the profit accruing to each share of common stock owned. • Formula: Analysts, stockholders, and creditors watch the earnings per share measurement very closely.**Earnings per Share of Common Stock**Step 1: Compute income available to common stockholders. Step 2: Determine the average number of shares of common stock outstanding during the year. Step 3: Divide the income available to common stockholders by the average number of shares of common stock outstanding.**Weighted Average 7,250 shares**number of shares Earnings per Share of Common Stock • Step 1: Income available to common stockholders = $51,563 • Step 2: Determine the average number of shares of common stock outstanding during the year. 7,000 shares x 12 months = 7,000 shares 12 months 1,000 shares x 3 months = 250 shares 12 months**$51,563**= $7.11 7,250 shares Earnings per Share of Common Stock • Step 1: Income available to common stockholders = $51,563 • Step 2: Average number of shares outstanding = 7,250 • Step 3: Divide the income available to common stockholders by the average number of shares of common stock outstanding Earnings per share were $7.11.**Market price per share**Earnings per share Price-earnings ratio = $144 $ 12 12 = Price-Earnings Ratio • Compares the current market value of common stock with the earnings per share of that stock. • Formula: • Example: PE ratio = 12 to 1 The price-earnings ratio is an indicator of the attractiveness of a stock as an investment.**Dividend per share Market price per share**Yield on Common Stock = $ 6 $ 60 = 10% Yield on Common Stock • Relationship between the dividends received by the stockholders and the market value of each share. • Formula: • Example:**Income before interest expense and income taxesTotal**assets Rate of return on total assets = Add back interest expense 11,500 Income before interest and taxes $ 90,875 Total assets $555,711 $90,875 $555,711 = 16.4% Rate of Return on Total Assets • Measures the rate of return on the assets used by the company. • Formula: • Example: Income before income taxes $ 79,375**Rate of Return on Total Assets**• This rate helps the analyst to: • judge managerial performance, • measure the effectiveness of the assets used, • evaluate proposed capital expenditures. • Only income from normal business operations is considered.**Net salesTotal assets**Asset Turnover = $ 2,969,000 $ 555,711 5.3 to 1 = Asset Turnover • Measures effective use of assets in making sales. • Formula: • Example: The higher the asset turnover, the more effectively the assets of the company are being used.**Compute and interpret financial ratios that measure**financial strength Objective 6 Ratios Measuring Financial Strength • Number of times bond interest earned. • Ratio of stockholders’ equity to total equities. • Ratio of stockholders’ equity to total liabilities. • Book value per share of stock.**Income before bond interest and income taxes**Bond interest cash requirement Times bond interest earned = Number of Times Bond Interest Earned • Measures the ability of net income to cover the required bond interest payments. • Formula: • Procedure: • Step 1: Compute the income before bond interest and income taxes. • Step 2: Compute the cash required to pay bond interest. • Step 3: Compute the ratio.**Add bond interest expense 9,500**Available for bond interest $88,875 Number of Times Bond Interest Earned • Step 1: Compute income before bond interest and income taxes. Income before tax $79,375**$100,000**x 0.10 $ 10,000 Number of Times Bond Interest Earned • Step 1: Income before bond interest and income taxes = $88,875 • Step 2: Compute the cash required to pay bond interest.**$ 88,875**$ 10,000 = 8.9 times Number of Times Bond Interest Earned • Step 1: Income before bond interest and income taxes = $88,875 • Step 2: Cash required to pay bond interest = $10,000 • Step 3: Compute the ratio. The income of Household Products, Inc. easily covers required bond payments.**Stockholders’ equity**Total equities Ratio of stockholders’ equity to total equities = $316,306 $555,711 = 0.57 to 1 Ratio of Stockholders’ Equity to Total Equities • Measures the portion of total capital provided by the stockholders and indicates the protection afforded creditors against possible losses. • Formula: • Example: A comparison with the industry average is important in determining a desirable ratio for a particular business.**Stockholders’ equity**Total liabilities Ratio of stockholders’ equity to total liabilities = $316,306 $239,405 1.32 to 1 = Ratio of Stockholders’ Equity to Total Liabilities • Also known as the ratio of owned capital to borrowed capital. • Formula: • Example:**Common stockholders’ equity**Number of common shares Book value per share of stock = Book Value per Share of Stock • Measures the financial strength underlying each share of stock. • Formula: • Procedure: Step 1: Compute the claims of preferred shareholders. Step 2: Compute the claims of common stockholders. Step 3: Divide the total claims of common stockholders by the number of shares outstanding.**$ 100**x 500 shares outstanding $50,000 Book Value per Share of Stock • Step 1: Compute the claims of preferred stockholders. For Household Products, Inc. the book value of preferred stock is the same as the par value, $100 per share.**Less preferred stock equity 50,000**Claims of common stockholders $266,306 Book Value per Share of Stock • Step 1: Claims of preferred stockholders = $50,000 • Step 2: Compute the claims of common stockholders. Stockholders’ equity $316,306**$33.29**= $266,306 8,000 shares Book Value per Share of Stock • Step 1: Claims of preferred stockholders = $50,000 • Step 2: Claims of common stockholders = $266,306 • Step 3: Divide the total claims of common stockholders by the number of shares outstanding.**Compute and interpret financial ratios that measure**liquidity Objective 7 Ratios Measuring Liquidity • Working capital • Current ratio • Acid-test ratio • Inventory turnover • Accounts receivable turnover**Current assets**– Current liabilities Working capital $423,931 –75,905 $348,026 Working Capital • Measures the ability of a company to meet its current obligations. • Formula: • Example:**$423,931**= 5.59:1 $ 75,905 Current Ratio • Measures the ability of a business to pay its debts using current assets. • Formula: Current assets ÷ Current liabilities = Current ratio • Example: In retail and manufacturing businesses, a desired guideline is a current ratio of at least 2 to 1.**Cash $115,231**• Receivables 102,000 • Marketable securities – 0 – • $217,231 $217,231 $ 75,905 = 2.86:1 Acid-Test Ratio • Measures immediate liquidity. • Formula: Quick assets ÷ Current liabilities = Acid-test ratio Quick assets are cash, receivables, and marketable securities. • Example: A general guideline is that the acid-test ratio should be at least 1 to 1.**Inventory Turnover**• Measures the number of times the inventory is replaced during the period. • Formula: Cost of goods sold ÷ Average inventory = Inventory turnover • Procedure: • Step 1: Compute the average inventory. • Step 2: Divide the cost of goods sold by the average inventory.**Inventory, Dec. 31 205,000**÷ 2 Average inventory $ 215,000 Inventory Turnover • Step 1: Compute the average inventory. Inventory, Jan. 1 $ 225,000 Totals $ 430,000**$1,752,500**$ 215,000 = 8.15 times Inventory Turnover • Step 1: Average inventory = $215,000 • Step 2: Divide the cost of goods sold by the average inventory. The inventory turnover ratio varies widely by industry.**Accounts Receivable Turnover**• Measures the speed with which sales on account are collected. • Formula: Net credit sales ÷ Average receivables = Accounts receivable turnover • Procedure: • Step 1: Compute average accounts receivable. • Step 2: Divide net credit sales by average accounts receivable.