Financial Statement Analysis

Chapter 14

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin Copyright © 2012 The McGraw-Hill Companies, Inc.
Financial Statements Are
Designed for Analysis
Classified Comparative Consolidated
Financial Financial Financial
Statements Statements Statements

Items with certain Amounts from Information for the

characteristics are several years parent and subsidiary
grouped together. appear side by side. are presented.

Results Helps identify Presented as if

in standardized, significant the two companies
meaningful changes and are a single
subtotals. trends. business unit.

14-2
Tools of Analysis

Dollar &
Trend
Percentage
Percentages
Changes

Component
Percentages
Ratios

14-3
Dollar and Percentage Changes
Dollar Change:
Dollar Analysis Period Base Period
Change = Amount – Amount

Percentage Change:

÷
Percent Base Period
Change = Dollar Change
Amount

14-4
Dollar and Percentage Changes
Evaluating Percentage Changes in
Sales and Earnings

Sales and earnings In measuring quarterly

should increase at changes, compare to
more than the rate the same quarter in
of inflation. the previous year.

Percentages may be
misleading when the
base amount is small.

14-5
 Clover, Inc.
Comparative Balance Sheets
December 31,
Percent
2011 2010 Dollar Change Change*
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 $ (11,500) ?
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: $12,000 – $23,500 = $(11,500)
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
* Percent rounded to one decimal point.

14-6
 Clover, Inc.
Comparative Balance Sheets
December 31,
Percent
2011 2010 Dollar Change Change*
Assets
Current assets:
Cash and equivalents $ 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
($11,500 ÷ $23,500) × 100% = 48.94%
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000 Complete the
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700
analysis for
* Percent rounded to one decimal point. the other
assets.

14-7
 Clover, Inc.
Comparative Balance Sheets
December 31,
Percent
2011 2010 Dollar Change Change*
Assets
Current assets:
Cash and equivalents $ 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%
* Percent rounded to one decimal point.

14-8
 Trend Percentages

Trend analysis is used to reveal patterns in

data covering successive periods.

Trend Analysis Period Amount

= × 100%
Percentages Base Period Amount

14-9
 Trend Percentages
Berry Products
Income Information
For the Years Ended December 31,
Item 2011 2010 2009 2008 2007
Revenues $400,000 $355,000 $320,000 $290,000 $275,000
Cost of sales 285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000
Item 2011 2010 2009 2008 2007
Revenues 145% 129% 116% 105% 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit 135% 124% 112% 108% 100%

(290,000 ÷ 275,000) × 100% = 105%

(198,000 ÷ 190,000) × 100% = 104%
(92,000 ÷ 85,000) × 100% = 108% 14-10
Component Percentages
Examine the relative size of each item in the financial
statements by computing component
(or common-sized) percentages.

Component Analysis Amount

Percentage
= Base Amount × 100%

Financial Statement Base Amount

Balance Sheet Total Assets
Income Statement Revenues

14-11
 Clover, inc.
Comparative Balance Sheets
December 31,
Complete the common-size analysis for the other Common-size
assets. Percents*
2011 2010 2011 2010
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets $ 155,000× 100%
($12,000 ÷ $315,000) $ 164,700
= 3.8%
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net
($23,500 ÷ $289,700)
120,000
× 100% = 8.1%
85,000
Total property and equipment $ 160,000 $ 125,000
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.
14-12
 Clover, Inc.
Comparative Balance Sheets
December 31,
Common-size
Percents*
2011 2010 2011 2010
Assets
Current assets:
Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.6%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets $ 155,000 $ 164,700 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment $ 160,000 $ 125,000 50.8% 43.1%
Total assets $ 315,000 $ 289,700 100.0% 100.0%
* Percent rounded to first decimal point.

14-13
 Clover, Inc.
Comparative Income Statements
For the Years Ended December 31,
Common-size
Percents*
2011 2010 2011 2010
Revenues $ 520,000 $ 480,000 100.0% 100.0%
Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes $ 25,000 $ 32,000 4.8% 6.7%
Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income $ 17,500 $ 22,400 3.4% 4.7%
Net income per share $ 0.79 $ 1.01
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.

14-14
Quality of Earnings
Investors are interest in companies that
demonstrate an ability to earn income at a
growing rate each year. Stability of earnings
growth helps investors predict future prospects
for the company.

Financial analyst often speak of the “quality of

earnings” at one company being higher than
another company in the same industry.

14-15
Quality of Assets and the Relative
Amount of Debt
While satisfactory earnings may be a
good indicator of a company’s ability to
pay its debts and dividends, we must also
consider the composition of assets, their
condition and liquidity, the timing of
repayment of liabilities, and the total
amount of debt outstanding

14-16
A Classified Balance Sheet
Matrix, Inc.
Asset Section: Classified Balance Sheet
December 31, 2011
Current assets:
Cash $ 30,000
Notes receivable 16,000
Accounts receivable 60,000
Inventory 70,000
Prepaid expenses 4,000
Total current assets 180,000
Plant and equipment:
Land $ 150,000
Building $ 121,000
Less: Accumulated depreciation (10,000) 111,000
Equipment and Fixtures 46,000
Less: Accumulated depreciation (27,000) 19,000
Total plant and equipment 280,000
Other assets:
Patents 170,000
Total assets $ 630,000
14-17
Ratios
A ratio is a simple mathematical expression
of the relationship between one item and another.

Along with dollar and percentage changes,

trend percentages, and component percentages,
ratios can be used to compare:

Past performance to Other companies to

present performance. your company.

14-18
Use this information to calculate the liquidity
ratios for Babson Builders.
Babson Builders, Inc.
2011
Cash $ 30,000
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 15,000
Total current assets 65,000
Total current liabilities 42,000
Total liabilities 103,917
Total assets
Beginning of year 300,000
End of year 346,390
Revenues 494,000 14-19
Working Capital
Working capital is the excess of current
assets over current liabilities.

12/31/11
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000

14-20
Current Ratio
This ratio measures the
short-term debt-paying
ability of the company.

Current Current Assets

=
Ratio Current Liabilities

Current $65,000
= = 1.55 : 1
Ratio $42,000

14-21
Quick Ratio

Quick Quick Assets

=
Ratio Current Liabilities

Quick assets are cash, marketable

securities, and receivables.
This ratio is like the current
ratio but excludes current assets
such as inventories that may be
difficult to quickly convert into cash.

14-22
Quick Ratio
Quick Quick Assets
=
Ratio Current Liabilities

Quick $50,000
= = 1.19 : 1
Ratio $42,000

14-23
Uses and Limitations of Financial
Ratios
Uses Limitations

Ratios help users Management may enter

understand into transactions merely
financial relationships. to improve the ratios.

Ratios provide for Ratios do not help with

quick comparison analysis of the company's
of companies. progress toward
nonfinancial goals.

14-24
Measures of Profitability

An income statement can be prepared in either a

multiple-step or single-step format.

The single-step format

is simpler. The multiple-step
format provides more detailed
information.

14-25
 Income Statement (Multiple-Step)
Babson Builders, Inc.
Proper Heading Income Statement
For the Year Ended 12/31/11
Sales, net $ 785,250
Gross Margin Cost of goods sold 351,800
Gross margin $ 433,450
Operating expenses:
Selling expenses $ 197,350
Operating Expenses General & Admin. 78,500
Depreciation 17,500 293,350
Income from Operations $ 140,100
Other revenues & gains:
Interest income $ 62,187
Gain 24,600 86,787
Non-operating Items Other expenses:
Interest $ 27,000
Remember Loss 9,000 (36,000)
Income before taxes $ 190,887
to compute Income taxes 62,500
EPS. Net income $ 128,387
14-26
Income Statement (Single-Step)
Babson Builders, Inc.
Proper Heading Income Statement
For the Year Ended 12/31/11
Revenues and gains:
Revenues Sales, net $ 785,250
& Gains Interest income 62,187
Gain on sale of plant assets 24,600
Total revenues and gains $ 872,037

Expenses and losses:

Cost of goods sold $ 351,800
Selling Expenses 197,350
Expenses General and Admin. Exp. 78,500
Depreciation 17,500
& Losses
Interest 27,000
Income taxes 62,500
Remember Loss: sale of investment 9,000
Total expenses & losses 743,650
to compute Operating income $ 128,387
EPS.
14-27
 Use this information to calculate the
profitability ratios for Babson Builders, Inc.
Babson Builders, Inc.
2011
Ending market price per share $ 15.25
Number of common shares
outstanding all of 2007 27,400
Net income $ 53,690
Total shareholders' equity
Beginning of year 180,000
End of year 234,390
Revenues 494,000
Cost of sales 140,000
Total assets
Beginning of year 300,000
End of year 346,390 14-28
Earning Per Share

Net Income
= EPS
Average Shares of Capital Stock Outstanding

Look back at the information from Babson and get the

values we need to calculate earning per share.

$53,690
= $1.96
27,400

14-29
Price-Earnings Ratio
Current Market Price of one Share of Stock
= P/E
Earnings Per Share

$15.25
= 7.78
$1.96

The measure shows us the relationship between earning

of the company and the market price of its stock.

14-30
Return On Investment (ROI)
This ratio is a good measure of
the efficiency of utilization of
assets by the business.

Annual return (profit) from and investment

ROI =
Average amount invested

14-31
Return On Assets (ROA)
This ratio is generally considered
the best overall measure of a
company’s profitability.

Operating
ROA = Net Income ÷ Average total assets
Income
= $ 53,690 ÷ ($300,000 + $346,390) ÷ 2
= 16.61%

14-32
Return On Equity (ROE)
This measure indicates how well the
company employed the owners’
investments to earn income.

ROE = Net income ÷ average total equity

= $ 53,690 ÷ ($180,000+$234,390)÷2
= 25.91 %

14-33
Dividend Yield
Dividend = Dividends Per Share
Yield Ratio Market Price Per Share

Babson Builders pays an annual dividend of

$1.50 per share of capital stock. The market
price of the company’s capital stock was
$15.25 at the end of 2011.

This ratio identifies the return, in

terms of cash dividends, on the
current market price of the stock.

14-34
Dividend Yield
Dividend = Dividends Per Share
Yield Ratio Market Price Per Share

Dividend $1.50
= = 9.84%
Yield Ratio $15.25

This ratio identifies the return, in

terms of cash dividends, on the
current market price of the stock.

14-35
Analysis by Long-Term Creditors
Use this information to calculate ratios to
measure the well-being of the long-term
creditors for Babson Builders.
Babson Builders, Inc.
2011
Earnings before interest
expense and income taxes $ 84,000
This is also Interest expense 7,300
referred to as Total assets 346,390
net operating Total stockholders' equity 234,390
income. Total liabilities 112,000

14-36
Interest Coverage Ratio
Times Operating income before Interest
Interest = and Income Taxes
Earned Annual Interest Expense

Times
= $84,000 =
Interest 11.5 times
7,300
Earned

This is the most common

measure of the ability of a firm’s
operations to provide protection
to the long-term creditor.

14-37
Debt Ratio
A measure of creditor’s long-term risk.
The smaller the percentage of assets
that are financed by debt, the smaller
the risk for creditors.

Debt Total
= ÷ Total Assets
Ratio Liabilities
= $112,000 ÷ $346,390
= 32.33%

14-38
Analysis by Short-Term Creditors
Babson Builders, Inc.
2011
Use this Cash $ 30,000
information to Accounts receivable, net
calculate ratios Beginning of year 17,000
to measure the End of year 20,000
well-being of Inventory
the short-term Beginning of year 10,000

creditors for End of year 12,000

Total current assets 65,000
Babson
Total current liabilities 42,000
Builders, Inc.
Sales on account 500,000
Cost of goods sold 140,000
14-39
 Accounts Receivable Turnover
Rate
Accounts
Net Credit Sales
Receivable =
Average Accounts Receivable
Turnover

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

This ratio measures how many

times a company converts its
receivables into cash each year.
14-40
Number of Days to Collect Receivables

Average 365 Days

Collection = Accounts Receivable Turnover
Period

Average
Collection 365 Days
= 27.03 Times = 13.50 days
Period

This ratio measures, on average,

how many days it takes to collect
an account receivable.

14-41
 Inventory Turnover Rate
Inventory Cost of Goods Sold
=
Turnover Average Inventory

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

This ratio measures the

number of times merchandise
inventory is sold and replaced
during the year.

14-42
Average Days Sales In Inventory
Average Sale 365 Days
Period = Inventory Turnover

Average Sale 365 Days

Period = 12.73 Times = 28.67 days

This ratio measures how many

days, on average, it takes to
sell the inventory.

14-43
Operating Cycle

Cash

Accounts
Inventory
Receivable

2. Sale of merchandise on account

14-44
End of Chapter 14

14-45