23-1. financial statement analysis section 1: vertical analysis chapter 23 section objectives 1.use...

Financial Statement AnalysisFinancial Statement Analysis

Section 1: Vertical Analysis

Chapter

23

Section Objectives

1. Use vertical analysis techniques to analyze a comparative income statement and balance sheet.

McGraw-Hill © 2009 The McGraw-Hill Companies, Inc. All rights reserved.

23-3

Phases of Statement Analysis

1. Computation Phase: Vertical analysis

Horizontal analysis

Ratio analysis

2. Interpretation Phase: Comparison of ratios

Budgeted ratios

Industry Averages

23-4

Each item is expressed as a percentage of the net sales figure.

Cost of goods sold Net Sales

=$1,752,500$2,969,000

= 59.0%

Selling expensesNet Sales

=$526,425$2,969,000

= 17.7%

Net income after taxes

Net Sales

=$55,563$2,969,000

= 1.9%

Use vertical analysis techniques to analyze a comparative income statement and balance sheet

Objective 1

23-5

Household Products, Inc.Comparative Income Statement

Year Ended December 31, 2010 and 2009

Amounts Percent of Net Sales

2010 2009 2010 2009

RevenueSales 3,104,450 2,825,625 104.6 104.7Less Sales Returns and Allowances 135,450 125,625 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

23-6




2010 2009 2010 2009


Net Income After Income Taxes 56,578 41,250 1.9 1.5

Common-size Statement




2010 2009 2010 2009


Net Income After Income Taxes 55,563 23,750 1.9 .9

23-7

Each item is expressed as either a percentage of total assets or of total liabilities plus stockholders’ equity.

Vertical Analysis of the Balance Sheet

CashTotal assets =

$115,231$555,711

= 20.7%

Accounts payable total liabilities plus stkhldrs’ equity.

=$ 71,000$ 555,711

= 12.8%

Total stockholders’ equitytotal liabilities plus stkhldrs’ equity.

= $316,306$ 555,711

= 56.9%


Section 2: Horizontal Analysis

Chapter

23

Section Objectives2. Use horizontal analysis techniques to analyze

a comparative income statement and balance sheet.

3. Use trend analysis to evaluate financial statements.

4. Interpret the results of statement analyses by comparison with industry averages.


23-9

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.

Horizontal Analysis

A percentage change can be shown by using the earlier figure as the base.

Use horizontal analysis techniques to analyze a comparative income statement and balance sheet

Objective 2

23-10

Sales for 2010 $3,104,450

Horizontal Analysis of the Income Statement

Earlier year is the base year.

Increase in sales

Sales for base year=

$ 278,825

$2,825,6259.9%=

Sales for 2009 – 2,825,625 Increase $ 278,825

23-11

Horizontal Analysis of the Balance Sheet

A decrease is expressed as a negative percentage.

Decrease in current liabilities

Current liabilities in base year=

$ (12,335)

$ 88,240– 14.0%=

Current liabilities 12/31/10 $ 75,905

Current liabilities 12/31/09 – 88,240 $ (12,335)

23-12

Trend analysis compares selected ratios and percentages over a period of time.

ANSWER:

QUESTION:

What is trend analysis?

Often the time period is five years.

Use trend analysis to evaluate financial statements

Objective 3

23-13

Net Sales 2,055,600 2,223,240 2,587,500 2,700,000 2,969,000

Cost of goods sold 1,059,900 1,234,560 1,495,642 1,574,721 1,752,500

Gross profit on sales 995,700 988,680 1,091,858 1,125,279 1,216,500

2006 2007 2008 2009 2010

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.

23-14

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.

Interpret the results of the statement analyses by comparison with industry averages

Objective 4


Section 3: Ratios

Chapter

23

Section Objectives5. Compute and interpret financial ratios that measure

profitability, operating results, and efficiency.

6. Compute and interpret financial ratios that measure financial strength.

7. Compute and interpret financial ratios that measure liquidity

8. Recognize shortcomings in financial statement analysis.


23-16

Ratio Analysis

Financial ratios have three classifications:

1. Profitability, operating results, and efficiency

2. Financial strength

3. Liquidity

23-17

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.

Ratios Measuring Profitability, Operating Results, and Efficiency

Compute and interpret financial ratios that measure profitability, operating results, and efficiency

Objective 5

23-18

Measures what percentage of each sales dollar is net income.

Formula:

Rate of Return on Sales

The higher the rate of return on net sales, the more satisfactory are the business operations.

Example:

Net income

Net sales= Rate of return on net sales

$ 55,563

$ 2,969,000

= 1.9%

23-19

Measures how well the corporation is making a profit for its shareholders.

Formula:

Rate of Return on Common Stockholders’ Equity

Procedure:

Income available to common stockholders

Common stockholders’ equity

Return on common stockholders’ equity

=

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.

23-20



Net income after income taxes $55,563Less dividend requirements onpreferred stock 4,000

Income available to commonstockholders $51,563

23-21

Step 1: Income available to common stockholders = $51,563


Step 2: Compute the common stockholders’ equity.

Total stockholders’ equity $316,306

Preferred stockholders’ equity - 50,000

Common stockholders’ equity $266,306

23-22

Step 3: Divide the income available to common stockholders by the common stockholders’ equity.



Step 2: Common stockholders’ equity = $266,306

$51,563

$266,306 = 19.4%

23-23

Measures the profit accruing to each share of common stock owned.

Formula:

Earnings per Share of Common Stock

Analysts, stockholders, and creditors watch the earnings per share measurement very closely.

Earnings per share

=Income available to common stockholders

Average number of shares of common stock outstanding during year

23-24


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.


23-25


7,000 shares x 12 months = 7,000 shares 12 months 1,000 shares x 3 months = 250 shares 12 months


Step 2: Determine the average number of shares of common stock outstanding during the year.

Weighted Average 7,250 sharesnumber of shares

23-26

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.



Step 2: Average number of shares outstanding = 7,250

$51,563

7,250 shares = $7.11

23-27

Price-Earnings Ratio

Compares the current market value of common stock with the earnings per share of that stock.

Formula:

PE ratio = 12 to 1

The price-earnings ratio is an indicator of the attractiveness of a stock as an investment.

Example:

Price-earnings ratioMarket price per share Earnings per share

=

12 $144 $ 12

=

23-28

Yield on Common Stock

Relationship between the dividends received by the stockholders and the market value of each share.

Formula:

Yield on Common Stock Dividend per share

Market price per share=

Example:

10% $ 6 $ 60

=

23-29

Rate of Return on Total Assets

Measures the rate of return on the assets used by the company.

Formula:

Income before income taxes $ 79,375

Rate of return on total assets

Income before interest expense and income taxes Total assets

=

Example:

Income before interest and taxes $ 90,875

Total assets $555,711

16.4% $90,875

$555,711=

Add back interest expense 11,500

23-30

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.

23-31

Asset Turnover

The higher the asset turnover, the more effectively the assets of the company are being used.

Measures effective use of assets in making sales. Formula:

Asset Turnover Net sales

Total assets=

Example:

5.3 to 1 $ 2,969,000 $ 555,711

=

23-32

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.

Ratios Measuring Financial Strength

Compute and interpret financial ratios that measure financial strength

Objective 6

23-33

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.

Income before bond interest and income taxes Bond interest cash requirement

Times bond interest earned

=

23-34

Step 1: Compute income before bond interest and income taxes.

Income before tax $79,375

Add bond interest expense 9,500

Available for bond interest $88,875



23-35

Step 1: Income before bond interest and income taxes = $88,875

Step 2: Compute the cash required to pay bond interest.

$100,000

x 0.10

$ 10,000



23-36

$ 88,875

$ 10,000= 8.9 times

The income of Household Products, Inc. easily covers required bond payments.



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.

23-37

Ratio of Stockholders’ Equity to Total Equities

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 equities

Ratio of stockholders’ equity to total equities

=

$316,306

$555,711= 0.57 to 1

23-38

Example:

Ratio of Stockholders’ Equity to Total Liabilities

Ratio of Stockholders’ Equity to Total Liabilities

Also known as the ratio of owned capital to borrowed capital. Formula:

Stockholders’ equity Total liabilities

Ratio of stockholders’ equity to total liabilities

=

$316,306

$239,405= 1.32 to 1

23-39

Book Value per Share of StockBook 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.

Common stockholders’ equity Number of common shares

Book value per share of stock

=

23-40

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.

$ 100

x 500 shares outstanding

$50,000


23-41

Step 2: Compute the claims of common stockholders.

Stockholders’ equity $316,306Less preferred stock equity 50,000Claims of common stockholders $266,306

Step 1: Claims of preferred stockholders = $50,000


23-42

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.

$266,306

8,000 shares= $33.29


23-43

Working capital

Current ratio

Acid-test ratio

Inventory turnover

Accounts receivable turnover

Ratios Measuring Liquidity

Compute and interpret financial ratios that measure liquidity

Objective 7

23-44

Working CapitalWorking Capital

Measures the ability of a company to meet its current obligations.

Formula:

Example:

Current assets– Current liabilities

Working capital

$423,931– 75,905

$348,026

23-45

Current RatioCurrent Ratio

Measures the ability of a business to pay its debts using current assets.

Formula:

Example:

Current assets ÷ Current liabilities = Current ratio

$423,931

$ 75,905= 5.59:1

In retail and manufacturing businesses, a desired guideline is a current ratio of at least 2 to 1.

23-46

Measures immediate liquidity. Formula:

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.

Cash $115,231Receivables 102,000Marketable securities – 0 – $ 217,231

$217,231

$ 75,905= 2.86:1

Quick assets ÷ Current liabilities = Acid-test ratio

23-47

Inventory TurnoverInventory Turnover

Measures the number of times the inventory is replaced during the period.

Formula:

Procedure:

Step 1: Compute the average inventory.

Step 2: Divide the cost of goods sold by the average inventory.

Cost of goods sold ÷ Average inventory = Inventory turnover

23-48

Step 1: Compute the average inventory.


Inventory, Jan. 1 $ 225,000

Inventory, Dec. 31 205,000

Totals $ 430,000÷ 2

Average inventory $ 215,000

23-49

Step 1: Average inventory = $215,000


Step 2: Divide the cost of goods sold by the average inventory.

$1,752,500

$ 215,000= 8.15 times

The inventory turnover ratio varies widely by industry.

23-50

Accounts Receivable TurnoverAccounts Receivable Turnover

Measures the speed with which sales on account are collected. Formula:

Procedure:

Step 1: Compute average accounts receivable.

Step 2: Divide net credit sales by average accounts receivable.

Net credit sales ÷ Average receivables = Accounts receivable turnover

23-51

Step 1: Compute average accounts receivable.

Accounts receivable, Jan.1 $ 73,500

Totals $175,500 Accounts receivable, Dec. 31 102,000

÷ 2Average accounts receivable $ 87,750


23-52

Step 1: Average accounts receivable = $87,750


Step 2: Divide net credit sales by average accounts receivable.

$2,700,000

$ 87,750= 30.8 times

The accounts receivable turnover can be used to determine the average collection period of accounts receivable.

23-53

The average collection period is the number of days’ sales in receivables.

ANSWER:

QUESTION:

What is the average collection period?

365 days

Accounts receivable turnoverAverage collection period

Formula: =

23-54

Financial statements use book values. Book value depends on accounting policies and procedures. Businesses have choices about certain things, such as

depreciation methods and useful lives. Financial statements assume that the dollar is a stable monetary unit. No two companies are exactly the same:

Different legal entities Different product mixes Different financing methods

Precautionary Notes on Statement Analysis

Financial statement analysis is useful only if these limitations are understood.

Recognize shortcomings in financial statement analysis

Objective 8

23-55

Thank Youfor using

College Accounting, 12th Edition

Price • Haddock • Farina

23-1. financial statement analysis section 1: vertical analysis chapter 23 section objectives 1.use...

Documents

net income

taxes net sales

comparative statement

net sales figure

expenses net sales

phases of statement

income taxes

revenue sales