Financial Statement Analysis 13-1
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1 Financial Statement Analysis 13-1
2 Business vital signs Liquidity Solvency Profitability Market 13-2
3 How do Internal Users use FS Analysis? Evaluate performance by comparing to Planned budget Last year s actuals Other companies within the same industry 13-3
4 How will the company improve performance? 13-4
5 How do External Users use FS Analysis? Evaluate performance by comparing Year to year Other companies within the same industry 13-5
6 What decisions will External Users make? Forecast future profits 13-6
7 Limitations of FS Analysis Analysts should look beyond the ratios Industry trends Changes within the company Consumer tastes Technological changes Economic factors 13-7
8 Trend analysis Comparative Form Horizontal Analysis Across time Uses comparative financial statements Focus on large percentage changes 13-8
9 Ralco Corporation Partial Income Statement For Years Ended November 30, 2011 and Amount of Increase /Decrease Net Sales $164,313 $105,027 $59,286 COGS 35,940 24,310 11,630 Gross Profit $128,373 $80,717 $47,
10 Ralco Corporation Partial Income Statement For Years Ended November 30, 2011 and Amount of Increase /Decrease Percent Increase /Decrease Net Sales $164,313 $105,027 $59, COGS 35,940 24,310 11, Gross Profit $128,373 $80,717 $47,
11 Illustration: Amount and Percentage Change Assume a company s year-end cash balances were $85,618 and $57,000 for 2011 and 2010 respectively. Dollar change = $85,618 - $57,000 = $28,618 Percent change = $85,618 - $57,000 $57,000 x 100 = 50.2% 13-11
12 Trend Percentages state several years financial data in terms of a base year, which equals 100 percent
13 Trend Analysis Net Sales $164,313 $105,027 $67,515 $52,242 $29,230 Cost of goods sold 35,940 24,310 19,459 7,735 6,015 Gross Profit $128,373 $80,717 $48,056 $44,507 $23, Net Sales 562.1% 359.3% 231.0% 178.7% 100.0% Cost of goods sold Gross Profit
14 EXERCISE Trend Percentages Starkey Company's sales, current assets, and current liabilities (all in thousands of dollars) have been reported as follows over the last five years (Year 5 is the most recent year): Required: 1.Express all of the asset, liability, and sales data in trend percentages. (Show percentages for each item.) Use Year 1 as the base year, and carry computations to one decimal place. 2.Comment on the results of your analysis
15 Example trend analysis Comment The trend percentages are: Year 5 Year 4 Year 3 Year 2 Year 1 Sales Current assets: Cash Accounts receivable Inventory Total current assets Current liabilities
16 Comment Sales: Assets: The sales are increasing at a steady rate, with a particularly strong gain in Year 4. Cash declined from Year 3 through Year 5. This may have been due to the growth in both inventories and accounts receivable. In particular, the accounts receivable grew far faster than sales in Year 5. The decline in cash may reflect delays in collecting receivables. This is a matter for management to investigate further. Liabilities: The current liabilities increased in Year 5. This was probably due to the buildup in accounts receivable in that the company doesn t have the cash needed to pay bills as they come due
17 Common-Size Statements - Vertical Analysis Base amount is usually defined as 100% Income statement % of revenues Balance sheet % of total assets 13-17
18 Common-Size Statements - Vertical Analysis Common- Size percent Analysis amount = 100% Base Amount Common-Size Percentages Net Sales $164,313 $105, Cost of goods sold 35,940 24, Gross Profit $128,373 $80,
19 Exercise 13-1 p This Year Last Year Sales 100.0% 100.0% Cost of goods sold 63.2% 60.0% Gross margin 36.8% 40.0% Selling and administrative expenses: Selling expenses 18.0% 17.5% Administrative expenses 13.6% 14.6% Total selling and administrative expenses 31.6% 32.1% Net operating income 5.2% 7.9% Interest expense 1.4% 1.0% Net income before taxes 3.8% 6.9% 13-19
20 Comment The NOI has decreased from 6.9% to 3.8% The company s major problem seems to be the increase in cost of goods sold, which increased from 60.0% of sales last year to 63.2% of sales this year. Why? This suggests that the company is not passing the increases in the costs of its products on to its customers. Or that prices have not increased as fast as costs. Gross margin has decreased as a result. Selling expenses and interest expense have both increased slightly during the year, which suggests that costs generally are going up in the company. The only exception is the administrative expenses, which have decreased from 14.6% of sales last year to 13.6% of sales this year. This probably is a result of the company s efforts to reduce administrative expenses during the year
21 Income statement common-size analysis. Comment Start with qualifying the change in Net Operating Income. Find what created the change. Is the Cost of goods sold change significant? If yes, how did it effect the Gross Margin? What could have caused the change? 13-21
22 Horizontal Vertical Over time Base = year of reference Base: B.S. % Assets I.S. % Sales Trend Analysis : in both cases 13-22
23 Ratio Analysis User Common stockholder Short-Term Creditor Relevant ratios Earnings per share Price-Earnings Dividend Payout Yield Return on Total Assets Return on Common Stockholders' Equity Book Value per Share Working Capital Current Acid Test Accounts Receivable Turnover Average Collection period Inventory Turnover Average Sales Period Long-Term Creditor Times Interest Earned Debt to Equity 13-23
24 The Common Stockholder Hopes to realize a return 13-24
25 1. One million non-cumulative,preferred shares issued and outstanding no new shares were issued during 2010 or Dividends $5 per share. 2. There were 25 million common shares issued and outstanding; no new shares were issued during There are no dividends in arrears. Dividends totalling $62 million were declared and paid during
26 13-26
27 Earnings per share = Net Income Preferred Dividends Average Number of Common Shares Outstanding This measure indicates how much income was earned for each share of common stock outstanding
28 Question: Compute Delmar s EPS for $3 = ($80M $5M)/25M Notes: Deduct Preferred Dividends from the Net Income because that is what will be available to common stockholders. $5 * 1 million Use the average number of common shares outstanding (This year + Last year ) /
29 Price-Earnings Ratio = Market Price per Share Earnings per Share A higher price-earnings ratio means that investors are willing to pay a premium for a company s stock because of optimistic future growth prospects
30 ABC Inc.'s common shares have a market value of $60 per share and its EPS is $3.50. XYZ Inc.'s common shares have a market value of $85 per share and its EPS is $4.10. You have done thorough research and are considering purchasing the shares of one of these companies. Required (a) Calculate the price earnings ratio for each company (round to two decimal places). (b) Which company's shares will you purchase based on your calculations in (a) above? 13-30
31 Price-earnings ratio (a) Price-earnings ratio ABC Inc. 60/3.5 = XYZ Inc. 85/4.10 = (b) ABC Inc. s shares seem to be the better buy (lower price) since its PE is lower than XYZ
32 Dividend Payout Ratio = Dividends per Share Earnings per Share 2.29 = $8/$3.50 ABC declared and paid an $8 per share cash dividend and its EPS is $
33 Dividend Payout Investors seeking market price growth would like this ratio to be small. Companies with excellent prospects of profit growth pay little or no dividends
34 Dividend Payout Investors seeking dividends would like this ratio to be large. Companies with little opportunity of profitable growth but with steady earnings tend to payout dividends from their cash flows
35 Dividend Yield Ratio = Dividends per Share x 100% Market Price per Share This ratio measures the rate of return (in the form of cash dividends only) that would be earned by an investor who buys common stock at the current market price
36 Question ABC declared and paid an $8 per share cash dividend on its Common shares during the current accounting period. The current market value of the ABC s shares is $56 per share. Is ABC classified as growth shares or income (dividend paying) shares in the eyes of the stockholder? Answer: The ABC Company shares would be classified as income shares because the rate is sufficient to justify as providing income % = $8/$
37 13-37
38 1. One million non-cumulative,preferred shares issued and outstanding no new shares were issued during 2010 or Dividends $5 per share. 2. There were 25 million common shares issued and outstanding; no new shares were issued during There are no dividends in arrears. Dividends totalling $62 million were declared and paid during
39 Return on Total Assets = Net Income + (Interest Expense X (1-tax rate)) Average Total Assets Measures how effectively a company is using its assets to generate earnings before contractual obligations must be paid
40 Question: Compute Delmar s return on total assets for 2011 and compare it to the Industry average of 20%. Interest expense was $4.8 million. Answer: Delmar s return on total assets for 2011 is 18.01* which is unfavourable when compared to the industry average of 20%. Delmar earned only cents for each $1.00 invested in average assets during 2011; the greater the return on total assets, the better. *(80+(4.8*1-(10/90)))/[( )/2] 100 = 18.01% 13-40
41 Return on Common Stockholders Equity = Net Income Preferred Dividends Average Common Stockholders Equity This measure indicates how well the company used the owners investments to earn net income
42 Question: Compute Delmar s return on Common Stockholders Equity for 2011 and compare it to the Industry average of 32.7%. Answer: Delmar s return on total common shareholders equity for 2011 is 22.06% which is unfavourable when compared to the industry average of 32.7%. Delmar earned cents for each $1.00 of equity invested in the company by common shareholders.; the greater the return on total common shareholders equity, the better. *(80 5)/[( )/2] 100 = 22.06% 13-42
43 Financial Leverage Difference between the rate of return of total average assets in its own assets and the rate of return on common stockholders equity. Return to common stockholders > Return on Total average assets = Positive leverage Positive leverage can be due to factors such as: company s current liabilities, which may carry no interest cost, to long term liabilities which carry after tax interest at a rate lower than the return on total assets and/or preferred stock which carry dividends % lower than the return on total assets
44 Comments on leverage If a company experiences big variations in net cash flows from operations, stockholders might be pleased that the company has no debt. In hard times, interest payments might be very difficult to meet. if investments within a company can earn a rate of return that exceeds the interest rate on debt, stockholders would get the benefits of positive leverage if the company took on debt
45 Book Value Per Share = Stockholders Equity - Preferred Stock Number of Common Shares Outstanding It measures the amount that would be distributed to stockholders if all assets were sold at their balance sheet carrying amounts after all creditors were paid off. This measure is based entirely on historical cost and not market price. Assets Liabilities = Equity 13-45
46 Question: Compute Delmar s Book Value per Share for 2011 and compare it to the Industry average of $8.63 Answer: Delmar s book value per common share for 2011 is $13.96* which compares favourably against the industry average of $8.63. ( )/25 = The book value per share reflects historical costs and not market price
47 The Short Term Creditors Such as suppliers, want to be paid on time. Therefore, they focus on the company s cash flows and working capital
48 Current Assets Current Liabilities = Working Capital 13-48
49 Current Ratio Current Ratio = Current Assets Current Liabilities Ability to pay bills without stress
50 Current ratio Healthy business 2:1 Keep an eye on inventory 13-50
51 Working capital and current ratio Using the information below, calculate the: Working capital Current ratio Round calculations to two decimal places. What is the difference between working capital and the current ratio? Assuming this company's current ratio was 1.12:1 in the last accounting period, does the result of the calculation in part (a) above represent a favourable or unfavourable change? 13-51
52 Answer: a. Working capital = (15, , , ,500) (10, , , ,000) = $4,300 b. Current ratio = (15, , , ,500)/(10, , , ,000) = 1.20:1 c. Working capital and the current ratio measure exactly the same thing; the difference between them is in how the result is expressed. Working capital expresses the result as a dollar amount whereas the current ratio expresses the result as a ratio. The current ratio, expressed as $X to $1, can be compared more easily to different sized companies than working capital which is a dollar value. d. Favourable 13-52
53 Acid- Test Ratio = Quick Assets Current Liabilities Excludes inventories and prepaid expenses. It measures a company s ability to meet its obligations without having to liquidate its inventory
54 Question: With reference to the Demo data, calculate the Acid-Test Ratio. At the end of the last accounting period, this company's acid-test ratio was 0.82:1. Has the change in the acid-test ratio been favourable or unfavourable? Answer: a. (15, ,000)/ (10, , , ,000) = 0.90:1 b. Favourable 13-54
55 Accounts Receivable Turnover = Sales on Account Average Accounts Receivable How many times a company converts its receivables into cash each year
56 The following data are taken from the comparative balance sheets of Duncan Company. Calculate the accounts receivable turnover for 2011 and 2010 (round to two decimal places). Is the change favourable or unfavourable? Explain why. Compare Duncan's turnover to the industry average turnover for 2011 of Accounts receivable turnover * 6.37** *754,200/[(152, ,700)/2] = 5.26 **810,600/[(133, ,000)/2] = 6.37 The change in the turnover is unfavourable. Receivables are being collected more slowly in 2011 than Duncan s turnover for 2011 compares favourably to the industry average since it is collecting receivables at a faster rate than average. The faster the receivables are collected, the more liquid the company since it needs cash to pay its day-to-day obligations
57 Average Collection Period Average Collection Period = 365 Days Accounts Receivable Turnover Average Collection Period = 365 Days 5.26 Times = 69.4 days This ratio measures, on average, how many days it takes to collect an account receivable
58 Inventory Turnover Inventory Turnover = Cost of Goods Sold Average Inventory This ratio measures how many times a company s inventory has been sold and replaced during the year
59 Mamoon Company begins the year with $200,000 of goods in inventory. At year-end, the amount in inventory has increased to $230,000. Cost of goods sold for the year is $1,600,000. Calculate Mamoon's inventory turnover (round calculations to two decimal places). Assuming an industry average merchandise turnover of 4, what is your assessment of Mamoon's inventory management? Answer: 1,600,000/[(200, ,000)/2] = 7.44 this is favourable relative to the industry average of 4. This means that Mamoon sells its inventory, on average, at the rate of 7.44 times per year which is 86% better than the industry average. Liquidity is positively affected by a high inventory turnover because the faster inventory is sold, the faster cash can flow back into the business from customers to allow for the payment of day-to-day obligations. Comment: The caution behind a very high merchandise turnover is that Mamoon wants to ensure customers needs are being satisfied by current levels of inventory (or are customers leaving dissatisfied and buying goods elsewhere because Mamoon has run out of inventory?)
60 Average Sale Period Average Sale Period = 365 Days Inventory Turnover Average Sale Period = 365 Days 7.44Times = days This ratio measures how many days, on average, it takes to sell the entire inventory
61 The long-term creditor Concerned with a company s ability to repay its loans over the long-run
62 Times Interest Earned Ratio = Earnings Before Interest Expense and Income Taxes Interest Expense This is the most common measure of a company s ability to provide protection for its long-term creditors. A ratio of less than 1.0 is inadequate
63 The following information is available for Best Appliance Inc.: Calculate the times interest earned ratio for 2011 and compare it to the industry average of 50 times. Explain how it compares. Answer: Times interest earned = income before interest and taxes/interest expense = 90/5 = 18. The larger this ratio, the less risky is the company for creditors. Although Best Appliance appears to have a favourable times interest earned ratio relative to this measure, it compares unfavourably to the industry average of 50 times
64 Debt-to-Equity Ratio = Total Liabilities Stockholders Equity This ratio indicates the relative proportions of debt to equity on a company s balance sheet
65 Stockholders like a lot of debt if the company can take advantage of positive financial leverage
66 Creditors prefer less debt and more equity because equity represents a buffer of protection
67 Debt-to-Equity Ratio = Total Liabilities Stockholders Equity Debt to Equity Ratio $112,000 = = 0.48 $234,
68 13-68
69 References Introduction to Managerial Accounting, Brewer, Garrison,Noreen Power Points from website - adapted by Cynthia Fortin, CPA, CMA hapter13/index.html 13-69
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