Financial Statement Analysis

Financial Statement Analysis
Chapter 15

Financial Statement Analysis To make informed decisions about a company Helpful in managing the company Comparison with competition Charting a company’s progress, measure performance Establish financial health Used for investment decisions Generally based on comparative financial data From one year to the next With a competing company With the industry as a whole.

Financial Statement Analysis Three main ways to analyze financial statements Horizontal analysis Year-to-year comparison Vertical analysis Compare different companies Using industry averages Compare company’s performance against the industry averages

Horizontal Analysis The study of percentage changes in comparative statements Compute dollar changes Compute percentage changes

Example: Income Statement Step 1 Step 2

Example: Balance Sheet (partial)

Trend Percentages Form of horizontal analysis Indicates business direction How have things changed over the years? Select a period of three to five years Base year, earliest year, is selected and set equal to 100% Subsequent years expressed as a percentage of the base period

E15-13: Horizontal analysis—income statement Data for Mariner Designs, Inc., follow: 1. Prepare a horizontal analysis of the comparative income statement of Mariner Designs, Inc. Round percentage changes to one decimal place.

E15-13: Horizontal Analysis—Income Statement

Vertical Analysis Shows relationship of each item to a base amount on financial statements Income statement–each item expressed as percentage of net sales Balance sheet–each item expressed as percentage of total assets or total liabilities and equity. Remember total assets = total liabilities and equity

Example: Income Statement Base amount Percentage of the base amount

Example: Balance Sheet Base amount Percentage of base

S15-3 : Vertical analysis Tri-State Optical Company reported the following amounts on its balance sheet at December 31, 2012 and 2011: Prepare a vertical analysis of Tri-State assets for 2012 and 2011. 26.6 20.7 52.7 100.0 28.4 19.8 51.8 100.0

Common-Size Statements Common-size statements compare one company to another Report only percentages (same as vertical analysis) Remove dollar value bias

Benchmarking Comparing a company with another leading company Two main types: Against a key competitor Against the industry average

S15-4 :Common-size income statement Data for Martinez, Inc., and Rosado, Corp., follow: 1. Prepare common-size income statements.

S15-4 :Common-size income statement (Continued) 2. Which company earns more net income? 3. Which company’s net income is a higher percentage of its net sales? Rosado Martinez

Financial Ratios No single ratio tells the whole picture Different ratios explain different aspects Types: Evaluating ability to pay current liabilities Evaluating ability to sell inventory and collect receivables Evaluating ability to pay long-term debt Evaluating profitability Evaluating stock as an investment

Following examples based Greg’s Tunes

Ability to Pay Current Liabilities Working capital Measures ability to meet short-term obligations Working capital = Current assets – Current liabilities Current ratio Proportion of current assets to current liabilities Current assets Current liabilities Current ratio =

Ability to Pay Current Liabilities Acid-test ratio Tells if company could pay all its current liabilities immediately Normal range 0.20 to 1.00 depending upon industry Acid-test Ratio Cash + Short-term investments + Net current receivables Current liabilities =

Ability to Sell Inventory and Collect Receivables Inventory turnover ratio Measures number of times a company sells inventory during a year High rate indicates ease in selling Low rate indicates difficulty in selling Formula Cost of goods sold Average inventory Inventory turnover = Average Inventory 113,000 + 111,0002

Ability to Sell Inventory and Collect Receivables Days in inventory ratio Measures the average number of days inventory is held by the company Formula Days in inventory = 365 days Inventory turnover ratio

Ability to Sell Inventory and Collect Receivables Gross profit percentage Measures the profitability of each net sales dollar Formula Gross profitNet sales Gross profit percentage =

Ability to Sell Inventory and Collect Receivables Accounts receivable turnover ratio Measures ability to collect cash from credit customers Formula Net credit sales Average net accounts receivable Accounts receivable turnover = Average Net A/R 114,000 + 85,0002

Ability to Sell Inventory and Collect Receivables Days’ sales in receivables ratio Measures ability to collect receivables Formula Days’ sales in average accounts = receivable 365 days Accounts receivable turnover ratio

Following examples based Greg’s Tunes

Ability to Pay Long-Term Debt Debt ratio Shows portion of assets financed with debt The higher the ratio, the higher the risk Formula Average debt ratio ranges from 57% to 67% Total liabilities Total assets Debt ratio =

Ability to Pay Long-Term Debt Debt to equity ratio The proportion of total liabilities to the proportion of total equity that is financing the company’s assets Formula Total liabilities Total equity Debt to equity =

Ability to Pay Long-Term Debt Times-interest-earned ratio Measures number of times income can cover interest expense High ratio indicates ease in paying interest Formula Earnings Before Interest and Taxes Interest expense Times-interest earned ratio =

Measuring Profitability Return on net sales(Profit Margin) Percent of each sales dollar earned as net income Formula Rate of return on net sales Net income Net sales =

Measuring Profitability Return on total assets Measures success in using assets to earn a profit Formula Rate of return on total assets Net income + Interest expense Average total assets = Average Total Assets 787,000 + 644,0002

Measuring Profitability Asset turnover ratio Measures the amount of net sales generated for each average dollar of total assets invested Formula Net sales Average total assets Asset turnover ratio =

Measuring Profitability Return on common stockholders’ equity How much income is earned for each dollar invested by common shareholders Formula Rate of return on common stockholders’ equity Net income – Preferred dividends Average common stockholders’ equity = Average Total Assets 356,000 + 320,0002

Measuring Profitability Earnings per share Net income earned for each share of outstanding common stock Outstanding stock = Issued stock – Treasury stock Formula Net income – Preferred Dividends Number of shares of common stock outstanding Earnings per shareof common stock = Note: 10,000 shares assumed for this example

Analyzing Stock Investments Price/earnings ratio (P/E) Market price compared to earnings per share Formula Market price per share of common stock Earnings per share P/E ratio =

Analyzing Stock Investments Dividend yield Percentage of market value that is returned as dividends Formula Dividend yield on common stock Annual dividends per share of common stock Market price per share of common stock =

Analyzing Stock Investments Dividend Payout The ratio of annual dividends declared relative to the earnings per share of the company Formula Annual dividends per share Earnings per share Dividend Payout =

Analyzing Stock Investments Book value Common equity per share Some argue its relevance to investors Formula Book value per share of common stock Total stockholders’ equity – Preferred equity Number of shares of common stock outstanding =

Note: Book value is not an indication of market Value of the stock Balance sheet to the right is for Apple Computer Book Value(09/29/2012) 118,210,000,000/939,208,000= $125.86 Market price per share at end of day on 12/27/2012 $510.94

Eastman Chemical (partial balance sheet as of 12/31,2011 & 12/31/2010) Book Value @ 12/31/2011 is approximately $13.64 Closing market price on 12/27/2012 $66.00 Dollar in millions

Red Flags Analysts look for red flags that may signal financial trouble Recent accounting scandals highlight the importance of: Movement of sales, inventory, and receivables Earnings problems Decreased cash flow Too much debt Inability to collect receivables Buildup of inventory

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Financial Statement Analysis