Chapter. How Well Am I Doing? Financial Statement Analysis

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1 Chapter 17 How Well Am I Doing? Financial Statement Analysis

2 17-2 LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Explain the need for and limitations of financial statement analysis. 2. Prepare financial statements in comparative form and explain how such statements are used. 3. Place the balance sheet and the income statement in common-size form and properly interpret the results. 4. Identify the ratios used to measure the wellbeing of the common shareholder and state each ratio s formula and interpretation.

3 17-3 LEARNING OBJECTIVES After studying this chapter, you should be able to: 5. Explain what is meant by the term financial leverage and show how financial leverage is measured. 6. Identify the ratios used to measure the wellbeing of the short-term creditor and state each ratio s formula and interpretation. 7. Identify the ratios used to measure the wellbeing of the long-term creditor and state each ratio s formula and interpretation.

4 Limitations of Financial Statement 17-4 Analysis Differences in accounting methods between companies sometimes make comparisons difficult. We use the FIFO method to value inventory. We use the LIFO method to value inventory.

5 Limitations of Financial Statement 17-5 Analysis Industry trends Technological changes Changes within the firm Consumer tastes Economic factors Analysts should look beyond the ratios.

6 Statements in Comparative and 17-6 Common-Size Form! Dollar and percentage changes on statements Analytical techniques used to examine relationships among financial statement items " Common-size statements # Ratios

7 Dollar and Percentage Changes on 17-7 Statements Comparing statements underscores movements and trends and may provide valuable clues about what to expect in the future. Horizontal analysis Trend analysis

8 17-8 Horizontal Analysis Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form.

9 17-9 Horizontal Analysis Example The following slides illustrate a horizontal analysis of Clover Corporation s December 31, 2000 and 1999 comparative balance sheets and comparative income statements.

10 17-10 Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31, 2000 and 1999 Increase (Decrease) Amount % Assets Current assets: Cash $ 12,000 $ 23,500 Accounts receivable, net 60,000 40,000 Inventory 80, ,000 Prepaid expenses 3,000 1,200 Total current assets 155, ,700 Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160, ,000 Total assets $ 315,000 $ 289,700

11 17-11 Horizontal Analysis Calculating Change in Dollar Amounts Dollar Change Current Year = Figure Base Year Figure The dollar amounts for 1999 become the base year figures.

12 17-12 Horizontal Analysis Calculating Change as a Percentage Percentage Change Dollar Change = Base Year Figure 100%

13 17-13 Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31, 2000 and 1999 Increase (Decrease) Amount % Assets Current assets: Cash $ 12,000 $ 23,500 $ (11,500) (48.9) Accounts receivable, net 60,000 40,000 Inventory 80, ,000 Prepaid expenses 3,000 1,200 Total current assets $12, ,000 $23, ,700 = $(11,500) Property and equipment: Land 40,000 40,000 Buildings and equipment, ($11,500 net 120,000 $23,500) 85, % = 48.9% Total property and equipment 160, ,000 Total assets $ 315,000 $ 289,700

14 17-14 Horizontal Analysis CLOVER CORPORATION Comparative Balance Sheets December 31, 2000 and 1999 Increase (Decrease) Amount % Assets Current assets: Cash $ 12,000 $ 23,500 $ (11,500) (48.9) Accounts receivable, net 60,000 40,000 20, Inventory 80, ,000 (20,000) (20.0) Prepaid expenses 3,000 1,200 1, Total current assets 155, ,700 (9,700) (5.9) Property and equipment: Land 40,000 40, Buildings and equipment, net 120,000 85,000 35, Total property and equipment 160, ,000 35, Total assets $ 315,000 $ 289,700 $ 25,

15 17-15 Horizontal Analysis We could do this for the liabilities & shareholders equity, but now let s look at the income statement accounts.

16 17-16 Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Increase (Decrease) Amount % Net sales $ 520,000 $ 480,000 $ 40, Cost of goods sold 360, ,000 45, Gross margin 160, ,000 (5,000) (3.0) Operating expenses 128, ,000 2, Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

17 17-17 Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Increase (Decrease) Amount % Net sales $ 520,000 $ 480,000 $ 40, Cost of goods sold 360, ,000 45, Gross margin 160, ,000 (5,000) (3.0) Operating expenses 128, ,000 2, Sales increased by 8.3% yet Net operating income 31,400 39,000 (7,600) (19.5) net income decreased by 21.9%. Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9)

18 17-18 Horizontal Analysis CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Increase increase in sales, yielding an overall (Decrease) decrease in net income Amount % Net sales $ 520,000 $ 480,000 $ 40, Cost of goods sold 360, ,000 45, Gross margin 160, ,000 (5,000) (3.0) Operating expenses 128, ,000 2, Net operating income 31,400 39,000 (7,600) (19.5) Interest expense 6,400 7,000 (600) (8.6) Net income before taxes 25,000 32,000 (7,000) (21.9) Less income taxes (30%) 7,500 9,600 (2,100) (21.9) Net income $ 17,500 $ 22,400 $ (4,900) (21.9) There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the

19 17-19 Trend Percentages Trend percentages state several years financial data in terms of a base year, which equals 100 percent.

20 17-20 Trend Analysis Trend Percentage Current Year Amount Base Year Amount = 100%

21 17-21 Trend Analysis Example Look at the income information for Berry Products for the years 1998 through We will do a trend analysis on these amounts to see what we can learn about the company.

22 17-22 Trend Analysis Berry Products Income Information For the Years Ended December 31, Year Item Sales $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000 Cost of goods sold 285, , , , ,000 Gross margin 115, ,000 95,000 92,000 85,000 The base year is 1998, and its amounts will equal 100%.

23 17-23 Trend Analysis Berry Products Income Information For the Years Ended December 31, Year Item Sales 105% 100% Cost of goods sold 104% 100% Gross margin 108% 100% 1999 Amount 1998 Amount 100% ( $290,000 $275,000 ) 100% = 105% ( $198,000 $190,000 ) 100% = 104% ( $ 92,000 $ 85,000 ) 100% = 108%

24 17-24 Trend Analysis Berry Products Income Information For the Years Ended December 31, Year Item Sa le s 145% 129% 116% 105% 100% Cost of goods sold 150% 132% 118% 104% 100% Gross margin 135% 124% 112% 108% 100% By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.

25 17-25 Trend Analysis We can use the trend percentages to construct a graph so we can see the trend over time. Percentage Sales COGS GM Year

26 17-26 Common-Size Statements Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis.

27 17-27 Common-Size Statements Example Let s take another look at the information from the comparative income statements of Clover Corporation for 2000 and This time let s prepare common-size statements.

28 17-28 Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Common-Size Percentages Net sales $ 520,000 $ 480, Cost of goods sold 360, ,000 Gross margin 160, ,000 Operating expenses 128, ,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income $ 17,500 $ 22,400 Net sales Net sales is usually the base and is expressed as 100%.

29 17-29 Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Common-Size Percentages Net sales $ 520,000 $ 480, Cost of goods sold 360, , Gross margin 160, ,000 Operating expenses 128, ,000 Net operating 2000 COGS income 2000 Net 31,400 Sales 39, % Interest ( $360,000 expense $520,000 6,400 ) 100% 7,000 = 69.2% Net income before taxes 25,000 32,000 Less income taxes 1999 (30%) COGS 7, Net 9,600 Sales 100% Net income $ 17,500 $ 22,400 ( $315,000 $480,000 ) 100% = 65.6%

30 17-30 Gross Margin Percentage Gross Margin Percentage = Gross Margin Sales This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover operating expenses and a profit.

31 17-31 Common-Size Statements CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, 2000 and 1999 Common-Size What conclusions can we draw? Percentages Net sales $ 520,000 $ 480, Cost of goods sold 360, , Gross margin 160, , Operating expenses 128, , Net operating income 31,400 39, Interest expense 6,400 7, Net income before taxes 25,000 32, Less income taxes (30%) 7,500 9, Net income $ 17,500 $ 22,

32 Now, let s look at Norton Corporation s 2000 and 1999 financial statements

33 NORTON CORPORATION Balance Sheets December 31, 2000 and Asse ts Current assets: Cash $ 30,000 $ 20,000 Accounts receivable, net 20,000 17,000 Inventory 12,000 10,000 Prepaid expenses 3,000 2,000 Total current assets 65,000 49,000 Property and equipment: Land 165, ,000 Buildings and equipment, net 116, ,000 Total property and equipment 281, ,000 Total assets $ 346,390 $ 300,000

34 December 31, 2000 and Liabilities and Shareholders' Equity Current liabilities: Accounts payable $ 39,000 $ 40,000 Notes payable, short-term 3,000 2,000 Total current liabilities 42,000 42,000 Long-term liabilities: Notes payable, long-term 70,000 78,000 Total liabilities 112, ,000 Shareholders' equity: Common stock, $1 par value 27,400 17,000 Contributed surplus 158, ,000 Total capital 185, ,000 Retained earnings 48,890 50,000 Total shareholders' equity 234, ,000 Total liabilities and shareholders' equity $ 346,390 $ 300,000

35 17-35 NORTON CORPORATION Income Statements For the Years Ended December 31, 2000 and Net sales $ 494,000 $ 450,000 Cost of goods sold 140, ,000 Gross margin 354, ,000 Operating expenses 270, ,000 Net operating income 84,000 74,000 Interest expense 7,300 8,000 Net income before taxes 76,700 66,000 Less income taxes (30%) 23,010 19,800 Net income $ 53,690 $ 46,200

36 Now, let s calculate some ratios based on Norton Corporation s financial statements

37 Ratio Analysis The Common Shareholder Use this information to calculate ratios to measure the wellbeing of the common shareholders of Norton Corporation. NORTON CORPORATION 2000 Number of common shares outstanding Beginning of year 17,000 End of year 27,400 Net income $ 53,690 Shareholders' equity Beginning of year 180,000 End of year 234,390 Dividends per share 2 Dec. 31 market price per share 20 Interest expense 7,300 Total assets Beginning of year 300,000

38 17-38 Earnings Per Share Earnings per Share = Net Income Preferred Dividends Average Number of Common Shares Outstanding Earnings per Share = $53,690 $0 = $2.42 (17, ,400)/2 This measure indicates how much income was earned for each share of common stock outstanding.

39 17-39 Price-Earnings Ratio Price-Earnings Ratio = Market Price Per Share Earnings Per Share Price-Earnings Ratio $20.00 = = 8.26 times $2.42 This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the priceearnings ratio, the more opportunity a company has for growth.

40 17-40 Dividend Payout Ratio Dividend Payout Ratio = Dividends Per Share Earnings Per Share Dividend Payout Ratio $2.00 = = 82.6% $2.42 This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking current income would like this ratio to be large.

41 17-41 Dividend Yield Ratio Dividend Yield Ratio = Dividends Per Share Market Price Per Share Dividend Yield Ratio $2.00 = = 10.00% $20.00 This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

42 17-42 Return on Total Assets Return on Total Assets = Net Income + [Interest Expense (1 Tax Rate)] Average Total Assets Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator.

43 17-43 Return on Total Assets Return on Total Assets = Net Income + [Interest Expense (1 Tax Rate)] Average Total Assets Return on Total Assets $53,690 +[7,300 (1 0.30)] = = 18.19% ($300,000 + $346,390) 2 This ratio measures how well assets have been employed.

44 Return on Common Shareholders Equity Return on Common Shareholders Equity = Net Income Preferred Dividends Average Shareholders Equity Return on Common Shareholders Equity = $53,690 $0 = 25.91% ($180,000 + $234,390) 2 This measure indicates how well the company employed the owners investments to earn income.

45 17-45 Financial Leverage Financial leverage involves acquiring assets with funds at a fixed rate of interest. Return on investment in assets > Fixed rate of return on borrowed funds = Positive financial leverage Return on investment in assets < Fixed rate of return on borrowed funds = Negative financial leverage

46 17-46 Book Value Per Share Book Value per Share = Common Shareholders Equity Number of Common Shares Outstanding Book Value per Share = $234,390 27,400 = $ 8.55 This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.

47 Ratio Analysis The Short Term Creditor Use this information to calculate ratios to measure the well-being of the short-term creditors for Norton Corporation. NORTON CORPORATION 2000 Cash $ 30,000 Accounts receivable, net Beginning of year 17,000 End of year 20,000 Inventory Beginning of year 10,000 End of year 12,000 Total current assets 65,000 Tota l current liabilitie s 42,000 Sales on account 500,000 Cost of goods sold 140,000

48 17-48 Working Capital December 31, 2000 Current assets $ 65,000 Current liabilities (42,000) Working capital $ 23,000

49 17-49 Current Ratio Current Ratio = Current Assets Current Liabilities Current Ratio = $65,000 = 1.55 : 1 $42,000 This ratio measures the ability of the company to pay current debts as they become due.

50 17-50 Acid-Test (Quick) Ratio Acid-Test Ratio = Quick Assets Current Liabilities Quick assets are Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. Norton Corporation s quick assets consist of cash of $30,000 and accounts receivable of $20,000.

51 17-51 Acid-Test (Quick) Ratio Acid-Test Ratio = Quick Assets Current Liabilities Acid-Test Ratio = $50,000 $42,000 = 1.19 : 1 This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash.

52 17-52 Accounts Receivable Turnover Accounts Receivable Turnover = Sales on Account Average Accounts Receivable Accounts Receivable Turnover = $500,000 ($17,000 + $20,000) 2 = times This ratio measures how many times a company converts its receivables into cash each year.

53 17-53 Average Collection Period Average Collection Period = 365 Days Accounts Receivable Turnover Average Collection Period = 365 Days Times = days This ratio measures, on average, how many days it takes to collect an account receivable.

54 17-54 Inventory Turnover Inventory Turnover = Cost of Goods Sold Average Inventory Inventory Turnover = $140,000 ($10,000 + $12,000) 2 = times This ratio measures the number of times merchandise inventory is sold and replaced during the year.

55 17-55 Average Sale Period Average Sale Period = 365 Days Inventory Turnover Average Sale Period = 365 Days Times = days This ratio measures how many days, on average, it takes to sell the inventory.

56 Ratio Analysis The Long Term Creditor Use this information to calculate ratios to measure the well-being of the long-term creditors for Norton Corporation. This is also referred to as net operating income. NORTON CORPORATION 2000 Earnings before interest $ 84,000 expense and income taxes Interest expense 7,300 Total shareholders' equity 234,390 Total liabilities 112,000

57 17-57 Times Interest Earned Ratio Times Interest Earned = Earnings before Interest Expense and Income Taxes (EBIT) Interest Expense Times Interest Earned $84,000 = = 11.5 times 7,300 This is the most common measure of the ability of a firm s operations to provide protection to the long-term creditor.

58 17-58 Debt-to-Equity Ratio Debt to Equity Ratio = Total Liabilities Shareholders Equity Debt to Equity Ratio $112,000 = = 0.48 to 1 $234,390 This ratio measures the amount of assets being provided by creditors for each dollar of assets being provided by the owners of the company.

59 17-59 Return on Investment (ROI) ROI = = = Net Operating Income Sales Net Operating Income (EBIT) Average Operating Assets 84,000 (300, ,390) 2 x Sales Average Operating Assets = 26% This ratio measures the amount of income earned for each dollar of assets.

60 17-60 Published Sources of Financial Ratios Source Industrial Corporations, Financial Statistics Moody's Bond Record Corporate Taxation Statistics Dun & Bradstreets' Canadian Key Directory Financial Post's Dividend Record Financial Post's "500" Content Financial statements of different sectors Performance of corporate, convertible, government and municiple bonds Taxable income and taxes payable by Canadian corporations Business profile on top 3% of Canadian companies Record of dividends Largest 500 companies, by sales, in Canada

61 17-61 End of Chapter 17

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