chapter 17 · pdf fileeach ratio’s formula and interpretation. ... 17-3 learning...

Chapter

17“How Well Am I Doing?”

Financial StatementAnalysis

© McGraw-Hill Ryerson Limited., 2001

17-2

LEARNING OBJECTIVES

1. Explain the need for and limitations of financialstatement analysis.

2. Prepare financial statements in comparativeform and explain how such statements are used.

3. Place the balance sheet and the incomestatement in common-size form and properlyinterpret the results.

4. Identify the ratios used to measure the well-being of the common shareholder and stateeach ratio’s formula and interpretation.

After studying this chapter, you should be able to:


17-3

LEARNING OBJECTIVES

5. Explain what is meant by the term financialleverage and show how financial leverage ismeasured.

6. Identify the ratios used to measure the well-being of the short-term creditor and state eachratio’s formula and interpretation.

7. Identify the ratios used to measure the well-being of the long-term creditor and state eachratio’s formula and interpretation.

After studying this chapter, you should be able to:


17-4

Limitations of Financial StatementAnalysis

Differences in accounting methods betweencompanies sometimes make comparisons

difficult.

We use the FIFO method tovalue inventory.

We use the LIFO method tovalue inventory.


17-5

Limitations of Financial StatementAnalysis

Analysts should look beyondthe ratios.

Economicfactors

Consumertastes

Industrytrends

Technologicalchanges

Changeswithin the firm


17-6

Statements in Comparative andCommon-Size Form

! Dollar and percentage changes on statements

" Common-size statements

# Ratios

Analyticaltechniques used to

examinerelationships amongfinancial statement

items


17-7

Dollar and Percentage Changes onStatements

Comparing statements underscoresmovements and trends and may provide

valuable clues about what to expect in thefuture.

Horizontalanalysis

Trendanalysis


17-8

Horizontal Analysis

Horizontal analysis shows the changesbetween years in the financial data in

both dollar and percentage form.


17-9

Horizontal Analysis

Example

The following slides illustrate a horizontalanalysis of Clover Corporation’s

December 31, 2000 and 1999 comparativebalance sheets and comparative income

statements.


17-10

Horizontal AnalysisCLOVER CORPORATION

Comparative Balance SheetsDecember 31, 2000 and 1999

Increase (Decrease)2000 1999 Amount %

AssetsCurrent assets: Cash 12,000$ 23,500$ Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700

Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000

Total assets 315,000$ 289,700$


17-11

Horizontal Analysis

Calculating Change in Dollar Amounts

DollarChange

Current YearFigure

Base YearFigure

= –

The dollaramounts for1999 become

the “base” yearfigures.


17-12

Calculating Change as a Percentage

PercentageChange

Dollar Change Base Year Figure

100%= ×

Horizontal Analysis


17-13




AssetsCurrent assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets 155,000 164,700

Property and equipment: Land 40,000 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment 160,000 125,000

Total assets 315,000$ 289,700$

($11,500 ÷ $23,500) × 100% = 48.9%

$12,000 – $23,500 = $(11,500)


17-14




AssetsCurrent assets: Cash 12,000$ 23,500$ (11,500)$ (48.9) Accounts receivable, net 60,000 40,000 20,000 50.0 Inventory 80,000 100,000 (20,000) (20.0) Prepaid expenses 3,000 1,200 1,800 150.0 Total current assets 155,000 164,700 (9,700) (5.9)

Property and equipment: Land 40,000 40,000 - 0.0 Buildings and equipment, net 120,000 85,000 35,000 41.2 Total property and equipment 160,000 125,000 35,000 28.0

Total assets 315,000$ 289,700$ 25,300$ 8.7


17-15

Horizontal Analysis

We could do this for the liabilities& shareholders’ equity, but now

let’s look at the income statementaccounts.


17-16


Comparative Income StatementsFor the Years Ended December 31, 2000 and 1999

Increase (Decrease)

2000 1999 Amount %Net sales 520,000$ 480,000$ 40,000$ 8.3Cost of goods sold 360,000 315,000 45,000 14.3

Gross margin 160,000 165,000 (5,000) (3.0)Operating expenses 128,600 126,000 2,600 2.1Net 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



Increase (Decrease)



Net income 17,500$ 22,400$ (4,900)$ (21.9)

Sales increased by 8.3% yetnet income decreased by 21.9%.


17-18



Increase (Decrease)



Net income 17,500$ 22,400$ (4,900)$ (21.9)

There were increases in both cost of goodssold (14.3%) and operating expenses (2.1%).These increased costs more than offset the

increase in sales, yielding an overalldecrease in net income.


17-19

Trend Percentages

Trend percentagesstate several years’

financial data in termsof a base year, whichequals 100 percent.


17-20

Trend Analysis

TrendPercentage

Current Year Amount Base Year Amount

100%= ×


17-21

Trend Analysis

Example

Look at the income information forBerry Products for the years 1998through 2002. We will do a trend

analysis on these amounts to seewhat we can learn about the company.


17-22

Trend Analysis

Berry ProductsIncome Information

For the Years Ended December 31,

The baseyear is 1998, and its amounts

will equal 100%.

YearItem 2002 2001 2000 1999 1998

Sa les 400,000$ 355,000$ 320,000$ 290,000$ 275,000$Cost of goods sold 285,000 250,000 225,000 198,000 190,000 Gross margin 115,000 105,000 95,000 92,000 85,000


17-23

Trend Analysis


For the Years Ended December 31,Year

Item 2002 2001 2000 1999 1998Sa les 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%


17-24

Trend Analysis

By analyzing the trends for Berry Products, wecan see that cost of goods sold is increasing

faster than sales, which is slowing the increasein gross margin.


For the Years Ended December 31,Year

Item 2002 2001 2000 1999 1998Sa les 145% 129% 116% 105% 100%Cost of goods sold 150% 132% 118% 104% 100%Gross margin 135% 124% 112% 108% 100%


17-25

Trend Analysis

We can use the trendpercentages to construct a

graph so we can see thetrend over time.

100

110

120

130

140

150

160

1998 1999 2000 2001 2002

Year

Per

cen

tag

e

SalesCOGSGM


17-26

Common-Size Statements

Common-sizeCommon-sizestatements use

percentages to expressthe relationship of

individual components toa total within a singlesingleperiod. This is alsoknown as verticalvertical

analysisanalysis.


17-27

Common-Size Statements

Example

Let’s take another look at theinformation from the comparative

income statements of CloverCorporation for 2000 and 1999.

This time let’s prepare common-sizestatements.


17-28

Common-Size StatementsCLOVER CORPORATION


Common-Size Percentages

2000 1999 2000 1999Net sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000

Gross margin 160,000 165,000 Operating expenses 128,600 126,000 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 isusually thebase and isexpressedas 100%.


17-29




2000 1999 2000 1999Net sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6

Gross margin 160,000 165,000 Operating expenses 128,600 126,000 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$ 1999 COGS ÷ 1999 Net Sales × 100% ( $315,000 ÷ $480,000 ) × 100% = 65.6%

2000 COGS ÷ 2000 Net Sales × 100% ( $360,000 ÷ $520,000 ) × 100% = 69.2%


17-30

Gross Margin Percentage

Gross Margin Percentage

Gross Margin Sales

=

This measure indicates how muchof each sales dollar is left after

deducting the cost of goods sold tocover operating expenses and a profit.


17-31




2000 1999 2000 1999Net sales 520,000$ 480,000$ 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6

Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0

Net income 17,500$ 22,400$ 3.4 4.7

What conclusions can we draw?


17-32

Now, let’s look atNorton

Corporation’s2000 and 1999

financialstatements.


17-33

NORTON CORPORATIONBalance Sheets

December 31, 2000 and 1999

2000 1999Assets

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 165,000 123,000 Buildings and equipment, net 116,390 128,000 Total property and equipment 281,390 251,000 Total assets 346,390$ 300,000$


17-34

December 31, 2000 and 1999

2000 1999Liabilities 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 112,000 120,000

Shareholders' equity: Common stock, $1 par value 27,400 17,000 Contributed surplus 158,100 113,000

Total capital 185,500 130,000 Retained earnings 48,890 50,000

Total shareholders' equity 234,390 180,000 Total liabilities and shareholders' equity 346,390$ 300,000$


17-35

NORTON CORPORATION

Income Statements

For the Years Ended December 31, 2000 and 1999

2000 1999Net sales 494,000$ 450,000$ Cost of goods sold 140,000 127,000 Gross margin 354,000 323,000 Operating expenses 270,000 249,000

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$


17-36

Now, let’s calculatesome ratios based

on NortonCorporation’s

financialstatements.


17-37

Ratio Analysis – The CommonShareholder

Use this informationto calculate ratios

to measure the well-being of the

commonshareholders of

Norton Corporation.

NORTON CORPORATION

2000Number 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



17-38

Earnings Per Share

Earnings per ShareNet Income – Preferred Dividends

Average Number of CommonShares Outstanding

=

Earnings per Share $53,690 – $0 (17,000 + 27,400)/2

= = $2.42

This measure indicates how muchincome was earned for each share of

common stock outstanding.


17-39

Price-Earnings Ratio

Price-EarningsRatio

Market Price Per Share Earnings Per Share

=

Price-EarningsRatio

$20.00 $2.42

= = 8.26 times

This measure is often used by investorsas a general guideline in gauging stockvalues. Generally, the higher the price-earnings ratio, the more opportunity a

company has for growth.


17-40

Dividend Payout Ratio

DividendPayout Ratio

Dividends Per Share Earnings Per Share

=

DividendPayout Ratio

$2.00 $2.42

= = 82.6%

This ratio gauges the portion of currentearnings being paid out in dividends.

Investors seeking current income wouldlike this ratio to be large.


17-41

Dividend Yield Ratio

DividendYield Ratio

Dividends Per Share Market Price Per Share

=

DividendYield Ratio

$2.00 $20.00

= = 10.00%

This ratio identifies the return, in terms ofcash dividends, on the current market

price of the stock.


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 statementbalance by a balance sheet balance, the average

for the year is used in the denominator.


17-43

Return on Total Assets

This ratio measures how well assetshave been employed.

Return on

Total Assets

$53,690 +[7,300 × (1 – 0.30)]

($300,000 + $346,390) ÷ 2= = 18.19%

Return on

Total Assets

Net Income + [Interest Expense × (1 – Tax Rate)]

Average Total Assets=


17-44

Return on Common Shareholders’Equity

Return on CommonShareholders’ Equity

Net Income – Preferred DividendsAverage Shareholders’ Equity

=

Return on CommonShareholders’ Equity

$53,690 – $0 ($180,000 + $234,390) ÷ 2

= = 25.91%

This measure indicates how well thecompany employed the owners’

investments to earn income.


17-45

Financial Leverage

Financial leverage Financial leverage involves acquiringassets with funds at a fixed rate of

interest.

Return oninvestment in

assets>

Fixed rate ofreturn onborrowed

funds

Positivefinancialleverage

=

Return oninvestment in

assets<

Fixed rate ofreturn onborrowed

funds

Negativefinancialleverage

=


17-46

Book Value Per Share

Book Valueper Share

Common Shareholders’ Equity Number of Common Shares Outstanding

=

This ratio measures the amount that would bedistributed to holders of each share of common

stock if all assets were sold at their balance sheetcarrying amounts and if all creditors were paid off.

= $ 8.55Book Valueper Share

$234,390 27,400

=


17-47

Ratio Analysis – The Short– TermCreditor

NORTON CORPORATION

2000

Cash 30,000$

Accounts receivable , ne t


End of ye ar 20,000

Inventory


End of ye ar 12,000

Tota l current assets 65,000

Tota l current liabilitie s 42,000

Sales on account 500,000

Cost of goods sold 140,000

Use this informationto calculate ratios

to measure thewell-being of the

short-termcreditors for Norton

Corporation.


17-48

Working Capital

December 31, 2000

Current assets 65,000$

Current liabilities (42,000)

W orking capital 23,000$


17-49

Current Ratio

CurrentRatio

Current Assets Current Liabilities

=

CurrentRatio

$65,000 $42,000

= = 1.55 : 1

This ratio measures the abilityof the company to pay current

debts as they become due.


17-50

Acid-Test (Quick) Ratio

Quick Assets Current Liabilities

=Acid-Test

Ratio

Quick assets are Cash,Marketable Securities,

Accounts Receivable andcurrent Notes Receivable.

Norton Corporation’s quickassets consist of cash of

$30,000 and accountsreceivable of $20,000.


17-51

Acid-Test (Quick) Ratio

Quick Assets Current Liabilities

=Acid-Test

Ratio

This ratio is like the currentratio but excludes current assets suchas inventories that may be difficult to

quickly convert into cash.

$50,000 $42,000

= 1.19 : 1=Acid-Test

Ratio


17-52

Accounts Receivable Turnover

Sales on Account Average Accounts Receivable

AccountsReceivableTurnover

=

This ratio measures how manytimes a company converts its

receivables into cash each year.

= 27.03 times $500,000 ($17,000 + $20,000) ÷ 2

AccountsReceivableTurnover

=


17-53

Average Collection Period

AverageCollection

Period=

365 Days Accounts Receivable Turnover

This ratio measures, on average,how many days it takes to collect

an account receivable.

= 13.50 daysAverage

CollectionPeriod

= 365 Days 27.03 Times


17-54

Inventory Turnover

Cost of Goods Sold Average Inventory

InventoryTurnover

=

This ratio measures the numberof times merchandise inventory

is sold and replaced during the year.

= 12.73 times $140,000 ($10,000 + $12,000) ÷ 2

InventoryTurnover

=


17-55

Average Sale Period

AverageSale Period

= 365 Days Inventory Turnover

This ratio measures how manydays, on average, it takes to sell

the inventory.

= 28.67 daysAverage

Sale Period=

365 Days 12.73 Times


17-56

Ratio Analysis – The Long– TermCreditor

Use this information to calculate ratiosto measure the well-being of the

long-term creditors for NortonCorporation.

NORTON CORPORATION

2000Earnings before interest 84,000$ expense and income taxes

Interest expense 7,300

Total shareholders' equity 234,390

Total liabilities 112,000

This is alsoreferred to as netoperating income.


17-57

Times Interest Earned Ratio

This is the most commonmeasure of the ability of a firm’soperations to provide protection

to the long-term creditor.

TimesInterestEarned

$84,0007,300

= = 11.5 times

TimesInterestEarned

Earnings before Interest Expense and Income Taxes (EBIT)

Interest Expense=


17-58

Debt-to-Equity Ratio

Total Liabilities Shareholders’ Equity

Debt–to–EquityRatio

=

This ratio measures the amount of assetsbeing provided by creditors for each dollarof assets being provided by the owners of

the company.

$112,000 $234,390

Debt–to–EquityRatio

= = 0.48 to 1


17-59

Return on Investment (ROI)

Net Operating IncomeSalesROI =

This ratio measures the amountof income earned for each

dollar of assets.

x SalesAverage Operating

Assets

=Net Operating Income (EBIT)

Average Operating Assets

=84,000

(300,000+346,390) ÷÷÷÷ 2= 26%


17-60

Published Sources of Financial RatiosSource Content

Industrial Corporations, Financial Statistics

Financial statements of different sectors

Moody's Bond RecordPerformance of corporate, convertible, government and municiple bonds

Corporate Taxation Statistics

Taxable income and taxes payable by Canadian corporations

Dun & Bradstreets' Canadian Key Directory

Business profile on top 3% of Canadian companies

Financial Post's Dividend Record

Record of dividends

Financial Post's "500"Largest 500 companies, by sales, in Canada


17-61

End of Chapter 17

chapter 17 · pdf fileeach ratio’s formula and interpretation. ... 17-3 learning...

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