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18 - Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harriso Financial Statement Analysis Chapter 18

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Page 1: 18 - 1 ©2002 Prentice Hall, Inc. Business Publishing

18 - 1©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Financial Statement Analysis

Chapter 18

Page 2: 18 - 1 ©2002 Prentice Hall, Inc. Business Publishing

18 - 2©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

The Annual ReportUsually

Contains ...– financial statements.– notes to the financial statements.– a summary of accounting methods used.– management discussion and analysis of the

financial statements.– an auditor’s report.– comparative financial data for 5 to 10 years.

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18 - 3©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Objective 1

Perform a horizontal analysis

of financial statements.

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18 - 4©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Horizontal Analysis

Increase/(Decrease) 2002 2001 Amount Percent

Sales $41,500 $37,850 $3,650 9.6%Expenses 40,000 36,900 3,100 8.4%Net income 1,500 950 550 57.9%

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18 - 5©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

2002 2001 DifferenceSales $41,500 $37,850 $3,650

$3,650 ÷ $37,850 = .0964, or 9.6%

Horizontal Analysis

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Trend Percentages...

– are computed by selecting a base year whose amounts are set equal to 100%.

The amounts of each following year are expressed as a percentage of the base amount.

Trend % = Any year $ ÷ Base year $

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18 - 7©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Year 2000 1999 1998Revenues $27,611 $24,215 $21,718Cost of sales 15,318 14,709 13,049Gross profit $12,293 $ 9,506 $ 8,6691998 is the base year.

What are the trend percentages?

Trend Percentages

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18 - 8©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Year 2000 1999 1998Revenues 127% 111% 100%Cost of sales 117% 113% 100%Gross profit 142% 110% 100%

Trend Percentages

These percentages were calculated bydividing each item by the base year.

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18 - 9©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Objective 2

Perform a vertical analysis

of financial statements.

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18 - 10©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Vertical Analysis...

– compares each item in a financial statement to a base number set to 100%.

Every item on the financial statement is then reported as a percentage of that base.

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Vertical Analysis

1999 %Revenues $38,303 100.0Cost of sales 19,688 51.4Gross profit $18,615 48.6Total operating expenses 13,209 34.5Operating income $ 5,406 14.1Other income 2,187 5.7Income before taxes $ 7,593 19.8Income taxes 2,827 7.4Net income $ 4,766 12.4

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18 - 12©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Vertical Analysis

Assets 1999 %Current assets:Cash $ 1,816 4.7Receivables net 10,438 26.9Inventories 6,151 15.9Prepaid expenses 3,526 9.1Total current assets $21,931 56.6Plant and equipment, net 6,847 17.7Other assets 9,997 25.7Total assets $38,775 100.0

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18 - 13©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Objective 3

Prepare common-size

financial statements.

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18 - 14©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Common-size Statements

On the income statement, each item is expressed as a percentage of net sales.

On the balance sheet, the common size is the total on each side of the accounting equation.

Common-size statements are used to compare one company to other companies, and to the industry average.

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Benchmarking

43.0%

38.2%

8.0%

10.8%

51.4%

28.8%

7.4%

12.4%

Percent of Net Sales

MCILucent Technologies

Cost of goods sold Operating expenses Income tax Net income

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18 - 16©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Objective 4

Compute the standard

financial ratios.

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18 - 17©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Ratio Classification

1 Measuring ability to pay current liabilities2 Measuring ability to sell inventory and

collect receivables3 Measuring ability to pay short-term and

long-term debt4 Measuring profitability5 Analyzing stock as an investment

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18 - 18©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Palisades Furniture Example

Net sales (Year 2002) $858,000Cost of goods sold 513,000Gross profit $345,000Total operating expenses 244,000Operating income $101,000Interest revenue 4,000Interest expense (24,000)Income before taxes $ 81,000Income taxes 33,000Net income $ 48,000

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Palisades Furniture Example

Assets 20x2 20x1Current assets:Cash $ 29,000 $ 32,000Receivables net 114,000 85,000Inventories 113,000 111,000Prepaid expenses 6,000 8,000Total current assets $262,000 $236,000Long-term investments 18,000 9,000Plant and equipment, net 507,000 399,000Total assets $787,000 $644,000

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18 - 20©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Palisades Furniture Example

Liabilities 20x2 20x1Current liabilities:Notes payable $ 42,000 $ 27,000Accounts payable 73,000 68,000Accrued liabilities 27,000 31,000Total current liabilities $142,000 $126,000Long-term debt 289,000 198,000Total liabilities $431,000 $324,000

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Stockholders’ Equity 20x2 20x1Common stock, no par $186,000 $186,000Retained earnings 170,000 134,000Total stockholders’ equity $356,000 $320,000

Total liabilities andstockholders’ equity $787,000 $644,000

Palisades Furniture Example

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18 - 22©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Current ratio =Total current assets ÷ Total current liabilities

Current ratio =Total current assets ÷ Total current liabilities

The current ratio measuresthe company’s ability to pay

current liabilities with current assets.

The current ratio measuresthe company’s ability to pay

current liabilities with current assets.

Measuring Ability toPay Current Liabilities

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Measuring Ability toPay Current Liabilities

Palisades’ current ratio: 20x1: $236,000 ÷ $126,000 = 1.87 20x2: $262,000 ÷ $142,000 = 1.85 The industry average is 1.80. The current ratio decreased slightly

during 20x2.

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18 - 24©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Acid-test ratio =(Cash + Short-term investments

+ Net current receivables)÷ Total current liabilities

Acid-test ratio =(Cash + Short-term investments

+ Net current receivables)÷ Total current liabilities

Measuring Ability toPay Current Liabilities

The acid-test ratio shows the company’sability to pay all current liabilities

if they come due immediately.

The acid-test ratio shows the company’sability to pay all current liabilities

if they come due immediately.

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Measuring Ability toPay Current Liabilities

Palisades’ acid-test ratio: 20x1: ($32,000 + $85,000) ÷ $126,000 = .93 20x2: ($29,000 + $114,000) ÷ $142,000 = 1.01 The industry average is .60. The company’s acid-test ratio improved

considerably during 20x2.

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18 - 26©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Inventory turnover = Cost of goods sold÷ Average inventory

Inventory turnover = Cost of goods sold÷ Average inventory

Inventory turnover is a measureof the number of times the average

level of inventory is sold during a year.

Inventory turnover is a measureof the number of times the average

level of inventory is sold during a year.

Measuring Ability to

Sell Inventory

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18 - 27©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Measuring Ability to

Sell Inventory Palisades’ inventory turnover: 20x2: $513,000 ÷ $112,000 = 4.58 The industry average is 2.70. A high number indicates an ability to

quickly sell inventory.

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18 - 28©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Accounts receivable turnover =Net credit sales ÷ Average accounts receivable

Accounts receivable turnover =Net credit sales ÷ Average accounts receivable

Accounts receivable turnover measures a company’sability to collect cash from credit customers.

Accounts receivable turnover measures a company’sability to collect cash from credit customers.

Measuring Ability to

Collect Receivables

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Measuring Ability to

Collect Receivables Palisades’ accounts receivable turnover: 20x2: $858,000 ÷ $99,500 = 8.62 times The industry average is 22.2 times. Palisades’ receivable turnover is much lower

than the industry average. The company is a home-town store that sells

to local people who tend to pay their bills over a lengthy period of time.

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18 - 30©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

One day’s sales = Net sales ÷ 365 daysOne day’s sales = Net sales ÷ 365 days

Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales

Days’ sales in Accounts Receivable =Average net Accounts Receivable ÷ One day’s sales

Measuring Ability to

Collect Receivables

Days’ sales in receivable ratio measures howmany day’s sales remain in Accounts Receivable.

Days’ sales in receivable ratio measures howmany day’s sales remain in Accounts Receivable.

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Measuring Ability to

Collect Receivables Palisades’ days’ sales in Accounts

Receivable for 20x2: One day’s sales: $858,000 ÷ 365 = $2,351 Days’ sales in Accounts Receivable: $99,500 ÷ $2,351 = 42 days The industry average is 16 days.

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Total liabilities ÷ Total assetsTotal liabilities ÷ Total assets

Measuring Ability to

Pay Debt

The debt ratio indicates the proportionof assets financed with debt.

The debt ratio indicates the proportionof assets financed with debt.

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Measuring Ability to

Pay Debt Palisades’ debt ratio: 20x1: $324,000 ÷ $644,000 = 0.50 20x2: $431,000 ÷ $787,000 = 0.55 The industry average is 0.61. Palisades Furniture expanded operations

during 20x2 by financing through borrowing.

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Times-interest-earned= Income from operations

÷ Interest expense

Times-interest-earned= Income from operations

÷ Interest expense

Measuring Ability to

Pay Debt

Times-interest-earned ratiomeasures the number of times

operating income can cover interest expense.

Times-interest-earned ratiomeasures the number of times

operating income can cover interest expense.

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Measuring Ability to

Pay Debt Palisades’ times-interest-earned ratio: 20x1: $ 57,000 ÷ $14,000 = 4.07 20x2: $101,000 ÷ $24,000 = 4.21 The industry average is 2.00. The company’s times-interest-earned ratio

increased in 20x2. This is a favorable sign.

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18 - 36©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Rate of return on net sales =Net income ÷ Net sales

Rate of return on net sales =Net income ÷ Net sales

Measuring Profitability

Rate of return on net sales shows the percentageof each sales dollar earned as net income.

Rate of return on net sales shows the percentageof each sales dollar earned as net income.

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Measuring Profitability

Palisades’ rate of return on sales: 20x1: $26,000 ÷ $803,000 = 0.032 20x2: $48,000 ÷ $858,000 = 0.056 The industry average is 0.008. The increase is significant in itself and also

because it is much better than the industry average.

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Rate of return on total assets = (Net income + interest expense) ÷ Average total assets

Rate of return on total assets = (Net income + interest expense) ÷ Average total assets

Measuring Profitability

Rate of return on total assets measureshow profitably a company uses its assets.

Rate of return on total assets measureshow profitably a company uses its assets.

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Measuring Profitability

Palisades’ rate of return on total assets for 20x2:

($48,000 + $24,000) ÷ $715,500 = 0.101 The industry average is 0.049. How does Palisades compare to the

industry? Very favorably.

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Rate of return on common stockholders’ equity= (Net income – preferred dividends)

÷ Average common stockholders’ equity

Rate of return on common stockholders’ equity= (Net income – preferred dividends)

÷ Average common stockholders’ equity

Measuring Profitability

Common equity includes additionalpaid-in capital on commonstock and retained earnings.

Common equity includes additionalpaid-in capital on commonstock and retained earnings.

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Measuring Profitability

Palisades’ rate of return on common stockholders’ equity for 20x2:

($48,000 – $0) ÷ $338,000 = 0.142 The industry average is 0.093. Why is this ratio larger than the return on

total assets (.101)? Because Palisades uses leverage.

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Measuring Profitability

Earnings per share of common stock= (Net income – Preferred dividends)

÷ Number of shares of common stock outstanding

Earnings per share of common stock= (Net income – Preferred dividends)

÷ Number of shares of common stock outstanding

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Measuring Profitability

Palisades’ earnings per share: 20x1: ($26,000 – $0) ÷ 10,000 = $2.60 20x2: ($48,000 – $0) ÷ 10,000 = $4.80 This large increase in EPS is considered

very unusual.

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Analyzing Stock as an Investment

Price/earning ratio is the ratio of market price per share to earnings per share.

20x1: $35 ÷ $2.60 = 13.5 20x2: $50 ÷ $4.80 = 10.4 Given Palisades Furniture’s 20x2 P/E ratio

of 10.4, we would say that the company’s stock is selling at 10.4 times earnings.

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Dividend per share of common(or preferred) stock ÷ Market price per share

of common (or preferred) stock

Dividend per share of common(or preferred) stock ÷ Market price per share

of common (or preferred) stock

Analyzing Stock as an Investment

Dividend yield shows the percentageof a stock’s market value returned as

dividends to stockholders each period.

Dividend yield shows the percentageof a stock’s market value returned as

dividends to stockholders each period.

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Analyzing Stock as an Investment

Dividend yield on Palisades’ common stock: 20x1: $1.00 ÷ $35.00 = .029 (2.9%) 20x2: $1.20 ÷ $50.00 = .024 (2.4%) An investor who buys Palisades Furniture

common stock for $50 can expect to receive 2.4% of the investment annually in the form of cash dividends.

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18 - 47©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Analyzing Stock as an Investment

Book value per share of common stock= (Total stockholders’ equity – Preferred equity)

÷ Number of shares of common stock outstanding

Book value per share of common stock= (Total stockholders’ equity – Preferred equity)

÷ Number of shares of common stock outstanding

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Analyzing Stock as an Investment

Book value per share of palisades’ common stock:

20x1: ($320,000 – $0) ÷ 10,000 = $32.00 20x2: ($356,000 – $0) ÷ 10,000 = $35.60 Book value bears no relationship to market

value.

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Objective 5

Use ratios in decision making.

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Limitations of Financial Analysis

Business decisions are made in a world of uncertainty.

No single ratio or one-year figure should be relied upon to provide an assessment of a company’s performance.

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Objective 6

Measure economic value added.

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Economic Value Added (EVA®)

Economic value added (EVA®) combines accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth.

EVA® = Net income + Interest expense – Capital charge

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End of Chapter 18