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Financial Statement Analysis

17. Financial Statement Analysis. Student Version. 1. Describe basic financial statement analytical methods. 17-2. 1. Horizontal Analysis. The percentage analysis of increases and decreases in related items using comparative financial statements is called horizontal analysis. Exhibit 1.

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Financial Statement Analysis

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  1. 17 Financial Statement Analysis Student Version

  2. 1 Describe basic financial statement analytical methods. 17-2

  3. 1 Horizontal Analysis The percentage analysis of increases and decreases in related items using comparative financial statements is called horizontal analysis.

  4. Exhibit 1 1 Comparative Balance Sheet—Horizontal Analysis Horizontal Analysis: Difference$17,000 Base year (2009)$533,000 = 3.2%

  5. Exhibit 2 1 Comparative Schedule of Current Assets—Horizontal Analysis Horizontal Analysis: Difference$25,800 Base year (2009)$64,700 = 39.9%

  6. Exhibit 3 1 Comparative Income Statement—Horizontal Analysis Horizontal Analysis: Increase amount$296,500 Base year (2009) $1,234,000 = 24.0%

  7. Exhibit 4 1 Comparative Retained Earnings Statement—Horizontal Analysis Horizontal Analysis: Increase amount$37,500 Base year (2009)$100,000 = 37.5%

  8. X – whatever you are comparing X to* X *also known as the “base”

  9. Horizontal analysis shows trends over time. • Cautions about horizontal analysis • Many people will think of a simple linear regression when they see a trend, which is not always the case • Many people will make predictions based on too few observations, and their predictions may seem reasonable given their limited frame of reference

  10. 1 Vertical Analysis A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis.

  11. 1 Vertical Analysis of Balance Sheet In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity.

  12. Exhibit 5 Vertical Analysis: Current assets $550,000 Total assets $1,139,500 = 48.3% 1 Compar-ative Balance Sheet—Vertical Analysis

  13. 1 Vertical Analysis of the Income Statement In a vertical analysis of the income statement, each item is stated as a percent of net sales.

  14. Exhibit 6 1 Comparative Income Statement—Vertical Analysis Vertical Analysis: Selling expenses $191,000 Net sales $1,498,000 = 12.8%

  15. 1 Common-Size Statements In acommon-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with with industry percentages.

  16. Exhibit 7 1 Common-Sized Income Statement

  17. 2 Use financial statement analysis to assess the solvency of a business. 17-15

  18. Measures of solvency are important to determine the ability of a business to pay its creditors. If a business can’t pay it’s creditors, it is technically BANKRUPT. So, solvency is a very important topic!

  19. 2 Working Capital The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company’s ability to pay current liabilities.

  20. 2010 2009 Current assets $550,000 $533,000 Current liabilities –210,000–243,000 Working capital $340,000 $290,000 2 Working Capital = Current Assets – Current Liabilities Indicates the ability to pay bills as they come due and pay for current operations. Does not tell you what current expenses are.

  21. 2 Current Ratio The current ratio, sometimes called the working capital ratio or bankers’ ratio measures a company’s ability to pay its current liabilities.

  22. $550,000 $210,000 $533,000 $243,000 2 Current Assets Current Liabilities Current Ratio = Shows the number of times assets could cover liabilities. Indicates likelihood of payment of liabilities. 2010 2009 Current assets $550,000 $533,000 Current liabilities $210,000 $243,000 Current ratio 2.6 2.2 Again, however, it does not address expenses.

  23. 2 Quick Ratio A ratio that measures the “instant” debt-paying ability of a company is called the quick ratio or acid-test ratio.

  24. 2 The quick ratio deducts inventory and uncollectible accounts allowances from assets to determine the cash available to repay debts. Quick assets are cash and other current assets that can be quickly converted to cash. 2010 2009 Quick assets: Cash $ 90,500 $ 64,700 Temporary Investments 75,000 60,000 Accounts receivable (net) 115,000 120,000 a. Total quick assets $280,500 $244,700 b. Current liabilities $210,000 $243,000 Quick ratio (a ÷ b) 1.3 1.0

  25. Analysis Example Step 1: Descriptions Select the facts that give the reader a Comprehensive and fair view of the company’s operations. This section should be primarily descriptive. Write the narrative from an internal accountant’s perspective.

  26. Lincoln Company had net sales of $1,480,000 in 2010, with operating expenses of $290,000. Lincoln currently has $340,000 in working capital, an increase of $50,000 over last year. Our current ratio has improved from 2.2 to 2.6, and our quick ratio has improved from 1.0 to 1.3.

  27. Analysis Example Step 2: Comparisons Make comparisons to other companies and industry.

  28. Lincoln’s primary competitors are Madison Company, Sugarland Inc. and Bowland Ltd. The quick ratio for competitors and the industry overall are displayed in the table below.

  29. Analysis Example Step 3: Discussion Evaluate the result of your analysis and explain any differences (if you can) from media reports, competitor press releases, or general economic news.

  30. Our current ratio of 1.3 is average compared to our competitors and industry standards. Madison Company has been selling off its real estate holdings resulting in large inflows of cash for the last two years, resulting in a higher than normal current ratio.

  31. Lincoln Company had net sales of $1,480,000 in 2010, with operating expenses of $290,000. Lincoln currently has $340,000 in working capital, an increase of $50,000 over last year. Our current ratio has improved from 2.2 to 2.6, and our quick ratio has improved from 1.0 to 1.3.

  32. Analysis Example Step 4: Options Describe options available to improve the ratios.

  33. In order to improve our quick ratio, we could also sell off some of our fixed assets, as Madison is doing. We may also consider: ????? Brainstorming

  34. 2 Accounts Receivable Turnover The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. Collecting accounts receivable as quickly as possible improves a company’s solvency.

  35. Net Sales Average Accounts Receivable Accounts Receivable Turnover = 2 20102009 • a. Net sales $1,498,000$1,200,000 • Accounts receivable (net): • Beginning of year $ 120,000 $ 140,000 • End of year 115,500 120,000 • Total $ 235,000 $ 260,000 • Average (Total ÷ 2) $ 117,500 $ 130,000 Accounts receivable turnover (a ÷ b) 12.7 9.2

  36. If available, it is better to use credit sales rather than net sales as the numerator. This gives a more accurate picture of accounts receivable turnover.

  37. Average Accounts Receivable Average Daily Sales Number of Days’ Sales in Receivables = Net Sales 365 2 Average Collection Period The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding.

  38. 2 2010 2009 • Average accounts receivable • (Total accounts • receivable ÷ 2) $ 117,500 $ 130,000 • Net sales $1,498,000 $1,200,000 • Average daily sales • (Sales ÷ 365) $ 4,104 $ 3,288 Number of days’ sales in receivables (a ÷ b) 28.6 39.5

  39. The accounts receivables measures are helpful in determining how quickly the accounts receivables will generate cash. These measures are used to evaluate the effectiveness of the sales, credit, and collections policies and procedures of a company. To improve effectiveness in this area, changes to those areas may need attention.

  40. Days Payables Outstanding The number of days’ payables outstanding is an estimate of the length of time (in days) the accounts payables have been outstanding.

  41. 2010 2009 • Average accounts payable • (Total accounts • payable ÷ 2) $ 117,500 $ 130,000 • Cost of goods $1,498,000 $1,200,000 • Average cost of goods • (cogs ÷ 365) $ 4,104 $ 3,288 Number of days’ cogs in Payables (a ÷ b) 28.6 39.5

  42. To adjust the accounts payable cycle, what strategies might management consider?

  43. 2 Inventory Turnover The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory.

  44. 2010 2009 • a. Cost of goods sold $1,043,000 $ 820,000 • Inventories: • Beginning of year $ 283,000 $ 311,000 • End of year 264,000 283,000 • Total $ 547,000 $ 594,000 • Average (Total ÷ 2) $ 273,500 $ 297,000 2 Cost of Goods Sold Average Inventory Inventory Turnover = Inventory turnover (a ÷ b) 3.8 2.8

  45. 2 Number of Days’ Sales in Inventory The number of days’ sales in inventory is a rough measure of the length of time it takes to purchase, sell, and replace the inventory.

  46. Cost of Goods Sold 365 2010 2009 • a. Average inventory (Total ÷ 2) $ 273,500 $ 297,000 • Cost of goods sold $1,043,000 $ 820,000 • Average daily cost of goods • sold (COGS ÷ 365 days) $2,858 $2,247 2 Average Inventory Average Daily Cost of Goods Sold Number of Days’ Sales in Inventory = Number of days’ sales in inventory (a ÷ b) 95.7 132.2

  47. In order to improve the inventory measures, management may implement changes in product mix or inventory management. Further information would be needed to determine the correct course of action. Possible actions include: Offering more frequent sales promotions Discounting obsolete inventory Implementing just-in-time inventory practices Adjusting re-order points . . . More???

  48. The next three ratios measure the ability of the company to obtain long-term financing for fixed assets.

  49. 2 Ratio of Fixed Assets to Long-Term Liabilities The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis. . . . . “Collateral”

  50. Fixed Assets (net) Long-Term Liabilities Ratio of Fixed Assets to Long-Term Liabilities = 2 2010 2009 a. Fixed assets (net) $444,500 $470,000 b. Long-term liabilities $100,000 $200,000 Ratio of fixed assets to long-term liabilities (a ÷ b) 4.4 2.4

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