copyright © 2009 pearson prentice hall. all rights reserved

Copyright © 2009 Pearson Prentice Hall. All rights reserved.

Chapter 2

Financial Statements and Analysis

Copyright © 2009 Pearson Prentice Hall. All rights reserved. 2-2

Learning Goals

1. Review the contents of the stockholders’ report and the procedures for consolidating international financial statements.

2. Understand who uses financial ratios, and how.

3. Use ratios to analyze a firm’s liquidity and activity.

4. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt.


Learning Goals (cont.)

5. Use ratios to analyze a firm’s profitability and market value.

6. Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis.


The Stockholders’ Report

• The guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP).

• GAAP is authorized by the Financial Accounting Standards Board (FASB).

• The Sarbanes-Oxley Act of 2002, passed to eliminate the many disclosure and conflict of interest problems of corporations, established the Public Company Accounting Oversight Board (PCAOB), which is a not-for-profit corporation that overseas auditors.


The Stockholders’ Report (cont.)

• The PCAOB is charged with protecting the interests of investors and furthering the public interest in the preparation of informative, fair, and independent audit reports.

• Public corporations with more than $5 million in assets and more than 500 stockholders are required by the SEC to provide their stockholders with an annual stockholders report.


The Four Key Financial Statements: The Income Statement

• The income statement provides a financial summary of a company’s operating results during a specified period.

• Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.


The Four Key Financial Statements

Table 2.1 Bartlett Company Income Statements ($000)


The Four Key Financial Statements: The Balance Sheet

• The balance sheet presents a summary of a firm’s financial position at a given point in time.

• Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.



Table 2.2a Bartlett Company Balance Sheets ($000)


The Four Key Financial Statements (cont.)

Table 2.2b Bartlett Company Balance Sheets ($000)


The Four Key Financial Statements: Statement of Retained Earnings

• The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.



Table 2.3 Bartlett Company Statement of Retained Earnings ($000) for the Year Ended December 31, 2009


The Four Key Financial Statements: Statement of Cash Flows

• The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended.

• This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.



Table 2.4 Bartlett Company Statement of Cash Flows ($000) for the Year Ended December 31, 2009


Consolidating International Financial Statements

• FASB 52 mandated that U.S. based companies translate their foreign-currency denominated assets and liabilities into dollars using the current rate (translation) method.

• Under the translation method, companies translate all foreign-currency-denominated assets and liabilities into dollars at the exchange rate prevailing at the fiscal year ending date (the current rate).

• Income statement items are usually treated similarly.


Consolidating International Financial Statements (cont.)

• Equity accounts, on the other hand, are translated into dollars by using the exchange rate that prevailed when the parent’s equity investment was made (the historical rate).

• Retained earnings are adjusted to reflect each year’s operating profits (or losses).


Using Financial Ratios: Interested Parties

• Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance.

• It is of interest to shareholders, creditors, and the firm’s own management.


Using Financial Ratios: Types of Ratio Comparisons

• Trend or time-series analysis

– Used to evaluate a firm’s performance over time


Using Financial Ratios: Types of Ratio Comparisons (cont.)


• Cross-sectional analysis

– Used to compare different firms at the same point in time





– Industry comparative analysis

• One specific type of cross sectional analysis. Used to compare one firm’s financial performance to the industry’s average performance





– Benchmarking

• A type of cross sectional analysis in which the firm’s ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate





• Combined Analysis– Combined analysis simply uses a combination of

both time series analysis and cross-sectional analysis



Table 2.5 Industry Average Ratios for Selected Lines of Businessa



Figure 2.1 Combined Analysis


Using Financial Ratios: Cautions for Doing Ratio Analysis

1. Ratios must be considered together; a single ratio by itself means relatively little.

2. Financial statements that are being compared should be dated at the same point in time.

3. Use audited financial statements when possible.

4. The financial data being compared should have been developed in the same way.

5. Be wary of inflation distortions.


Ratio Analysis Example

• We will illustrate the use of financial ratios for analyzing financial statements using the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2.


Current ratio = total current assets

total current liabilities

Current ratio = $1,233,000 = 1.97

$620,000

Ratio Analysis

• Liquidity Ratios– Current Ratio


Quick ratio = Total Current Assets - Inventory

total current liabilities

Quick ratio = $1,233,000 - $289,000 = 1.51

$620,000

Ratio Analysis (cont.)

• Liquidity Ratios– Current Ratio– Quick Ratio


Inventory Turnover = Cost of Goods Sold

Inventory

Inventory Turnover = $2,088,000 = 7.2

$289,000


• Liquidity Ratios• Activity Ratios

– Inventory Turnover


Average Age of Inventory = 365

Inventory Turnover

Inventory Turnover = 365 = 50.7 days

7.2



– Average Age of Inventory


ACP = Accounts Receivable

Net Sales/365

ACP = $503,000 = 59.7 days

$3,074,000/365



– Average Collection Period


APP = Accounts Payable

Annual Purchases/365

APP = $382,000 = 95.4 days (.70 x $2,088,000)/365



– Average Payment Period


Total Asset Turnover = Net Sales

Total Assets

Total Asset Turnover = $3,074,000 = .85

$3,597,000



– Total Asset Turnover



Table 2.6 Financial Statements Associated with Patty’s Alternatives


Debt Ratio = Total Liabilities/Total Assets

Debt Ratio = $1,643,000/$3,597,000 = 45.7%


• Liquidity Ratios• Activity Ratios• Financial Leverage Ratios

– Debt Ratio


Times Interest Earned = EBIT/Interest

Times Interest Earned = $418,000/$93,000 = 4.5


• Liquidity Ratios• Activity Ratios• Leverage Ratios

– Times Interest Earned Ratio


FPCR = EBIT + Lease Payments________________

Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

FPCR = $418,000 + $35,000 = 1.9

$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}


• Liquidity Ratios• Activity Ratios• Leverage Ratios

– Fixed-Payment coverage Ratio (FPCR)



• Liquidity Ratios

• Activity Ratios

• Leverage Ratios

• Profitability Ratios– Common-Size Income Statements



Table 2.7 Bartlett Company Common-Size Income Statements


GPM = Gross Profit/Net Sales

GPM = $986,000/$3,074,000 = 32.1%


• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios

– Gross Profit Margin


OPM = EBIT/Net Sales

OPM = $418,000/$3,074,000 = 13.6%



– Operating Profit Margin (OPM)


NPM = Earnings Available to Common Stockholders

Sales

NPM = $221,000/$3,074,000 = 7.2%



– Net Profit Margin (NPM)


EPS = Earnings Available to Common Stockholders Number of Shares Outstanding

EPS = $221,000/76,262 = $2.90



– Earnings Per Share (EPS)


ROA = Earnings Available to Common Stockholders

Total Assets

ROA = $221,000/$3,597,000 = 6.1%



– Return on Total Assets (ROA)


ROE = $221,000/$1,754,000 = 12.6%

ROE = Earnings Available to Common Stockholders

Total Equity



– Return on Equity (ROE)


P/E = Market Price Per Share of Common Stock Earnings Per Share

P/E = $32.25/$2.90 = 11.1


• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios• Market Ratios

– Price Earnings (P/E) Ratio


BV/Share = Common Stock Equity Number of Shares of Common Stock

BV/Share = $1,754,000/72,262 = $23.00



– Market/Book (M/B) Ratio


M/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common Stock

M/B Ratio = $32.25/$23.00 = 1.40



– Market/Book (M/B) Ratio


Summarizing All Ratios Table 2.8 Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)


Summarizing All Ratios (cont.)Table 2.8 Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)


DuPont System of Analysis

• The DuPont system of analysis is used to dissect the firm’s

financial statements and to assess its financial condition.

• It merges the income statement and balance sheet into two summary

measures of profitability.

• The Modified DuPont Formula relates the firm’s ROA to its ROE

using the financial leverage multiplier (FLM), which is the ratio of

total assets to common stock equity:

• ROA and ROE as shown in the series of equations on the following

slide and in Figure 2.2 on the following slide.


DuPont System of Analysis


DuPont System of Analysis (cont.)

Figure 2.2 DuPont System of Analysis


ROE = 6.1% X 2.06 = 12.6%

Modified DuPont Formula (cont.)

• Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner’s return.

• Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the Modified DuPont formula yields:

copyright © 2009 pearson prentice hall. all rights reserved

Business

financial summary

summary of financial

key financial statements

financial records

financial leverage

firms financial performance

firms financial position

firms financial condition