“How Well Am I Doing?

”
Financial Statement Analysis
 Limitations of Financial Statement Analysis

Differences in accounting methods between

companies sometimes make comparisons
difficult.

We use the FIFO method to We use the average cost

value inventory. method to value inventory.
 Limitations of Financial Statement Analysis

Changes within
the company
Industry Consumer
trends tastes

Technological
changes
Economic
factors

Analysts should look beyond

the ratios.
 Statements in Comparative and Common-Size
Form

ΠDollar and percentage

changes on statements

An item on a financial
statement has little  Common-size
meaning by itself. The statements
meaning of the numbers
can be enhanced by
drawing comparisons.
Ž Ratios
Dollar and Percentage Changes on Statements

Horizontal analysis (or trend analysis) shows the

changes between years in the financial data in
both dollar and percentage form.
 Horizontal Analysis
Example

The following slides illustrate a horizontal analysis

of Clover Corporation’s December 31, 2005 and
2004, comparative balance sheets and
comparative income statements.
 Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current 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
 Horizontal Analysis
Calculating Change in Dollar Amounts

Dollar Current Year Base Year

= –
Change Figure Figure

The dollar
amounts for
2004 become
the “base” year
figures.
 Horizontal Analysis
Calculating Change as a Percentage

Percentage Dollar Change

Change
=
Base Year Figure × 100%
 Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current 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 $12,000 –155,000
$23,500164,700
= $(11,500)
Property and equipment:
Land 40,000 40,000
($11,500
Buildings and equipment, net ÷ $23,500)
120,000 × 100% = 48.9%
85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
 Horizontal Analysis
CLOVER CORPORATION
Comparative Balance Sheets
December 31

Increase (Decrease)
2005 2004 Amount %
Assets
Current 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
Horizontal Analysis
We could do this for the liabilities
& stockholders’ equity, but now
let’s look at the income statement
accounts.
 Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 Amount %
Sales $ 520,000 $ 480,000
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
 Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 Amount %
Sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost 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 2.1
Net 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)
 Horizontal Analysis
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2005 2004 Amount %
Sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
OperatingSales increased
expenses by 8.3%126,000
128,600 yet 2,600 2.1
net income
Net operating incomedecreased
31,400by 21.9%.
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)
 Horizontal Analysis
There were increases in both
CLOVER cost of goods
CORPORATION
Comparative Income Statements
sold (14.3%) and operating expenses (2.1%).
For the Years Ended December 31
These increased costs more than offset theIncrease
increase in sales, yielding an overall (Decrease)
decrease in net income.2004
2005 Amount %
Sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost 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 2.1
Net 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)
 Trend Percentages

Trend percentages
state several years’
financial data in terms
of a base year, which
equals 100 percent.
 Trend Analysis

Trend = Current Year Amount

× 100%
Percentage Base Year Amount
 Trend Analysis

Example

Look at the income information for Berry Products

for the years 2001 through 2005. We will do a
trend analysis on these amounts to see what we
can learn about the company.
 Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
Year
Item 2005 2004 2003 2002 2001
Sales $ 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

The base
year is 2001, and its amounts
will equal 100%.
 Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
Year
Item 2005 2004 2003 2002 2001
Sales 105% 100%
Cost of goods sold 104% 100%
Gross margin 108% 100%

2002 Amount ÷ 2001 Amount × 100%

( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
 Trend Analysis
Berry Products
Income Information
For the Years Ended December 31
Year
Item 2005 2004 2003 2002 2001
Sales 145% 129% 116% 105% 100%
Cost of goods sold 150% 132% 118% 104% 100%
Gross margin 135% 124% 112% 108% 100%

By analyzing the trends for Berry Products, we

can see that cost of goods sold is increasing
faster than sales, which is slowing the increase
in gross margin.
 Trend Analysis

We can use the trend

160 percentages to construct a
graph so we can see the
150
trend over time.
140
Percentage

130

120 Sales
COGS
110 GM
100
2001 2002 2003 2004 2005
Year
 Common-Size Statements

Vertical analysis focuses

on the relationships
among financial statement
items at a given point in
time. A common-size
financial statement is a
vertical analysis in which
each financial statement
item is expressed as a
percentage.
Common-Size Statements

In income
statements, all
items are
usually
expressed as a
percentage of
sales.
Gross Margin Percentage

Gross Margin Gross Margin

=
Percentage Sales

This measure indicates how much

of each sales dollar is left after
deducting the cost of goods sold to
cover expenses and provide a profit.
Common-Size Statements

In balance
sheets, all items
are usually
expressed as a
percentage of
total assets.
 Common-Size Statements

Wendy's McDonald's
(dollars in millions) Dollars Percentage Dollars Percentage
2002 Net income $ 219 8.00% $ 893 5.80%

Common-size financial statements are

particularly useful when comparing
data from different companies.
 Common-Size Statements

Example

Let’s take another look at the information from

the comparative income statements of Clover
Corporation for 2005 and 2004.
This time let’s prepare common-size statements.
 Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005 2004 2005 2004
Sales $ 520,000 $ 480,000 100.0 100.0
Cost of goods sold 360,000 315,000
Gross margin 160,000 165,000 Sales is
Operating expenses 128,600 126,000 usually the
Net operating income 31,400 39,000 base and is
Interest expense 6,400 7,000 expressed
Net income before taxes 25,000 32,000
as 100%.
Less income taxes (30%) 7,500 9,600
Net income $ 17,500 $ 22,400
 Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2005 2004 2005 2004
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
2005 Cost
Net operating ÷ 2005 Sales
income 31,400× 100%
39,000
( $360,000
Interest expense ÷ $520,000 ) × 100%
6,400 = 69.2%
7,000
Net income before taxes 25,000 32,000
Less income 2004 Cost ÷ 2004
taxes (30%) 7,500 Sales × 100%
9,600
Net income ( $315,000 $÷17,500 $480,000 ) × 100% = 65.6%
$ 22,400
 Common-Size Statements
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
What conclusions can we draw? Percentages
2005 2004 2005 2004
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
 Quick Check ü
Which of the following statements describes
horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c. A comparison of the account balances on
the current year’s financial statements.
d. None of the above.
 Quick Check ü
Which of the following statements describes
horizontal analysis?
a. A statement that shows items appearing
on it in percentage and dollar form.
b. A side-by-side comparison of two or
more years’ financial statements.
c.Horizontal
A comparison of theshows
analysis account
thebalances
changes on
the current
between yearsyear’s
in thefinancial
financialstatements.
data in both
d. Nonedollar
of theand
above.
percentage form.
Now, let’s look at
Norton
Corporation’s
2005 and 2004
financial
statements.
 NORTON CORPORATION
Balance Sheets
December 31

2005 2004
Assets
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
 NORTON CORPORATION
Balance Sheets
December 31

2005 2004
Liabilities and Stockholders' 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
Stockholders' equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000

Total liabilities and stockholders' equity $ 346,390 $ 300,000

 NORTON CORPORATION
Income Statements
For the Years Ended December 31

2005 2004
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
 Ratio Analysis – The Common Stockholder

NORTON CORPORATION
2005
Number of common shares
outstanding
The ratios that are of the Beginning of year 17,000
most interest to End of year 27,400

stockholders include Net income $ 53,690

those ratios that focus Stockholders' equity

on net income, Beginning of year 180,000

dividends, and End of year 234,390

stockholders’ equities. Dividends per share 2

Dec. 31 market price per share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
 Earnings Per Share
Net Income – Preferred Dividends
Earnings per Share =
Average Number of Common
Shares Outstanding

Whenever a ratio divides an income statement

balance by a balance sheet balance, the average
for the year is used in the denominator.

Earnings form the basis for dividend payments

and future increases in the value of shares of
stock.
 Earnings Per Share
Net Income – Preferred Dividends
Earnings per Share =
Average Number of Common
Shares Outstanding

Earnings per Share = $53,690 – $0 = $2.42

(17,000 + 27,400)/2

This measure indicates how much

income was earned for each share of
common stock outstanding.
 Price-Earnings Ratio
Price-Earnings Market Price Per Share
=
Ratio Earnings Per Share

Price-Earnings $20.00
= = 8.26 times
Ratio $2.42

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.
 Dividend Payout Ratio

Dividend Dividends Per Share

=
Payout Ratio Earnings Per Share

Dividend $2.00
= = 82.6%
Payout Ratio $2.42

This ratio gauges the portion of current

earnings being paid out in dividends.
Investors seeking dividends (market price
growth) would like this ratio to be large
(small).
 Dividend Yield Ratio

Dividend Dividends Per Share

=
Yield Ratio Market Price Per Share

Dividend $2.00
= = 10.00%
Yield Ratio $20.00

This ratio identifies the return, in terms

of cash dividends, on the current
market price of the stock.
 Return on Total Assets
Return on Net Income + [Interest Expense × (1 – Tax Rate)]
=
Total Assets Average Total Assets

Return on $53,690 +[$7,300 × (1 – .30)]

= = 18.19%
Total Assets ($300,000 + $346,390) ÷ 2
Adding interest expense back to net
income enables the return on assets
to be compared for companies with
different amounts of debt or over
time for a single company that has
changed its mix of debt and equity.
 Return on Common Stockholders’ Equity

Return on Common = Net Income – Preferred Dividends

Stockholders’ Equity Average Stockholders’ Equity

Return on Common = $53,690 – $0 = 25.91%

Stockholders’ Equity ($180,000 + $234,390) ÷ 2

This measure indicates how well the

company used the owners’
investments to earn income.
 Financial Leverage
Financial leverage results from the difference between the
rate of return the company earns on investments in its own
assets and the rate of return that the company must pay its
creditors.

Fixed rate of
Return on return on Positive
investment in > = financial
borrowed
assets funds leverage

Return on Fixed rate of Negative

investment in < return on = financial
assets borrowed leverage
funds
 Quick Check ü
Which of the following statements is true?
a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
 Quick Check ü
Which of the following statements is true?
a. Negative financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
b. Positive financial leverage is when the
fixed return to a company’s creditors and
preferred stockholders is greater than the
return on total assets.
c. Financial leverage is the expression of
several years’ financial data in
percentage form in terms of a base year.
 Book Value Per Share
Book Value Common Stockholders’ Equity
=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

This ratio measures the amount that would be

distributed to holders of each share of common
stock if all assets were sold at their balance sheet
carrying amounts and if all creditors were paid off.
 Book Value Per Share
Book Value Common Stockholders’ Equity
=
per Share Number of Common Shares Outstanding

Book Value $234,390

= = $ 8.55
per Share 27,400

Notice that the book value per share of $8.55 does

not equal the market value per share of $20. This
is because the market price reflects expectations
about future earnings and dividends, whereas the
book value per share is based on historical cost.
 Ratio Analysis – The Short–Term Creditor

NORTON CORPORATION
2005

Short-term creditors, Cash $ 30,000

such as suppliers, want Accounts receivable, net

to be paid on time. Beginning of year 17,000
Therefore, they focus on End of year 20,000
the company’s cash Inventory
flows and working Beginning of year 10,000
capital. End of year 12,000
Total current assets 65,000
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000
 Working Capital
The excess of current assets over
current liabilities is known as
working capital.

Working capital is not

free. It must be
financed with long-term
debt and equity.
 Working Capital
December 31,
2005
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
 Current Ratio

Current = Current Assets

Ratio Current Liabilities

The current ratio measures a

company’s short-term debt paying
ability.
A declining ratio may be a
sign of deteriorating
financial condition, or it
might result from eliminating
obsolete inventories.
 Current Ratio

Current = Current Assets

Ratio Current Liabilities

Current = $65,000 = 1.55

Ratio $42,000
 Acid-Test (Quick) Ratio
Acid-Test Quick Assets
=
Ratio Current Liabilities

Acid-Test $50,000
= = 1.19
Ratio $42,000
Quick assets include Cash,
Marketable Securities, Accounts
Receivable and current Notes
Receivable.
This ratio measures a company’s ability
to meet obligations without having to
liquidate inventory.
Accounts Receivable Turnover
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover

Accounts
$494,000
Receivable = = 26.7 times
($17,000 + $20,000) ÷ 2
Turnover

This ratio measures how many

times a company converts its
receivables into cash each year.
 Average Collection Period
Average 365 Days
Collection = Accounts Receivable Turnover
Period

Average
365 Days
Collection = = 13.67 days
26.7 Times
Period

This ratio measures, on average,

how many days it takes to collect
an account receivable.
 Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory

This ratio measures how many times a

company’s inventory has been sold and
replaced during the year.
If a company’s inventory
turnover Is less than its
industry average, it either
has excessive inventory or
the wrong sorts of inventory.
 Inventory Turnover

Inventory Cost of Goods Sold

=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2
 Average Sale Period
Average 365 Days
=
Sale Period Inventory Turnover

Average 365 Days

= = 28.67 days
Sale Period 12.73 Times

This ratio measures how many

days, on average, it takes to sell
the inventory.
 Ratio Analysis – The Long–Term Creditor

Long-term creditors are concerned with a

company’s ability to repay its loans over the
long-run.

NORTON CORPORATION
2005
Earnings before interest
expense and income taxes $ 84,000
This is also referred Interest expense 7,300
to as net operating Total stockholders' equity 234,390
income. Total liabilities 112,000
Times Interest Earned Ratio
Earnings before Interest Expense
Times and Income Taxes
Interest = Interest Expense
Earned

Times
$84,000
Interest = = 11.51 times
$7,300
Earned

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.
 Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio

This ratio indicates the relative

proportions of debt to equity on a
company’s balance sheet.
Stockholders like a lot of Creditors prefer less
debt if the company can debt and more equity
take advantage of because equity
positive financial represents a buffer of
leverage. protection.
Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio

Debt–to–
$112,000
Equity = = 0.48
$234,390
Ratio
 Sources of Financial Ratios
Source Source
Almanac of Business and Industrial Financial Hoover's Online . Hoovers, Inc. Web site that is
Ratios. Prentice-Hall. Published annually. updated continuously. www.hoovers.com
Annual Statement Studies. Robert Morris Key Business Ratios. Dun & Bradstreet.
Associates. Published annually. Published annually.
www.rmahq.org/Ann_Studies/assstudies.html
Business & Company ASAP . Database that is Moody's Industrial Manual and Moody's Bank
updated continuously. and Finance Manual . Dun & Bradstreet.
Published annually.
EDGAR . Securities and Exchange PricewaterhouseCoopers Web site that is
Commission. Web site that is updated updated continuously.
continuously. www.sec.gov www.edgarscan.tc.pw.com
EBSCOhost (Business Source Elite index) . Standard & Poor's Industry Survey . Standard &
EBSCO publishing. Database that is updated Poor's. Published annually.
continuously.
FreeEDGAR . EDGAR Online, Inc. Web site
that is updated continuously.
www.freeedgar.com
End