Financial Statement Analysis

1. Financial Statement Analysis 12 PowerPoint Author: LuAnn Bean, Ph.D., CPA, CIA, CFE

2. Learning Objectives Understand the nature of financial statement analysis. Calculate and interpret horizontal and vertical analysis. Assess profitability through the calculation and interpretation of ratios.

3. Learning Objectives Assess liquidity through the calculation and interpretation of ratios. Assess solvency through the calculation and interpretation of ratios. Calculate and interpret a DuPont Analysis.

4. LOI Financial Statement Analysis All publicly traded companies must prepare audited financial statements each year and file them with the Securities and Exchange Commission. These statements include the income statement, the balance sheet, the statement of stockholders’ equity, and the statement of cash flows. Financial statements contain multiple years of data for comparative purposes and are the starting point for any analysis.

5. Financial Analysis Financial information Financial statement analysis is the process of applying analytical tools to a company’s financial statements to understand the company’s financial health and requires: Standards of comparison Analysis tools

6. Examples In this chapter, the financial information provided by Best Buy Co.,Inc. will be used to illustrate the process of financial analysis. For financial ratios, Best Buy will be compared to hhgregg’s ratios, since both companies are in a similar industry.

7. Standards of Comparison • Often called intracompany comparison (horizontal analysis) 1 • Often called intercompany comparison (vertical analysis) 2 3 To ignore product safety??

8. Analysis Tools • comparison of a company’s financial results across time. 1 • comparison of financial balances to a base account from the same company. 2 3 To ignore product safety??

9. LO2 Horizontal Analysis Horizontalanalysis is an analysis technique that calculates the change in an account balance from one period to the next and expresses that change in both dollar and percentage terms.

10. Balance Sheet – Horizontal – Best Buy (2008) $ Current Year - $ Base Year = $1,868 – 549 = 240.3% $ Base Year $549 $ Change = $1,868 – 549 = $1,319

11. Income Statement Horizontal – Best Buy (2008)

12. Vertical Analysis Vertical analysis is an analysis technique that states each account balance on a financial statement as a percentage of a base amount on the statement.

13. Balance Sheet Vertical – Best Buy (2008) Asset accounts are stated as a percentage of Total Assets (set at 100%). For example, on 2/28/09, Receivables is 11.8% of Total Assets (calculated as $1,868 ÷ $15,826).

14. Income Statement Vertical– Best Buy (2008) Overall Best Buy was profitable in 2008, but it was less profitable than in 2007 (3.5% in 2007 versus 2.2% in 2008). One reason for this was the increase in operating expenses.

15. LO3 Profitability Analysis

16. Profitability Ratios • Indicates the ability to make required principal and interest payments. • Indicates related stock price increases or dividends paid. To ignore product safety??

17. Profit Margin Ratio The profit margin ratio compares net income to net sales and measures the ability of a company to generate profits from sales. A higher ratio indicates a greater ability to generate profits from sales.

18. Return on Equity The return on equity ratio compares net income tothe average balance in stockholders’ equity during the year, showing how effectively a company uses the equity provided by stockholders during the year to generate additional equity for its owners. Stockholders naturally want this ratio to be as high as possible.

19. Return on Assets The return on assets ratio compares net income to average total assets during the year, representing a company’s ability to generate profits from its entire resource base (not just those resources provided by owners). Like the return on equity, investors would like the ratio as high as possible.

20. Earnings Per Share Earnings per share compares a company’s net income to the average number of shares of common stock outstanding during the year. The ratio represents the return on each share of stock owned by an investor.

21. Price to Earnings Ratio The price to earnings ratio compares net income to the current market price of the company’s common stock and provides an indication of investor perceptions of the company. A higher price to earnings ratio generally indicates that investors are more optimistic about the future prospects of a company.

22. Profitability Summary

23. LO4 Liquidity Analysis

24. Liquidity Ratios Liquidity ratios assess the ability of a company to meet its immediate or short-term financial obligations. Failing to do so can result in additional expenses and, ultimately, bankruptcy. Current Ratio Quick Ratio Inventory Turnover Ratio Receivables Turnover Ratio

25. Current Ratio The current ratio is one of the most frequently used ratios in financial analysis and compares current assets to current liabilities. As such, it compares assets that should be turned into cash within one year to liabilities that should be paid within one year. A higher ratio indicates greater liquidity.

26. Quick Ratio The quick ratio (sometimes called the acid-test ratio) compares a company’s cash and near-cash assets, or quick assets, to its current liabilities. Quick assets include cash, short-term investments, and accounts receivable. Since the quick ratio measures the degree to which a company could pay off its current liabilities immediately, a higher quick ratio indicates greater liquidity.

27. Receivables Turnover Ratio The receivables turnover ratio compares a company’s credit sales during a period to its average accounts receivable balance during that period. A higher ratio means that the company is better able to generate and collect sales, leading to better liquidity.

28. Inventory Turnover Ratio The inventory turnover ratio compares a company’s cost of goods sold during a period to its average inventory balance during that period. It reveals how many times a company is able to sell its inventory balance in a period. A higher ratio is better because it indicates that the company sold more inventory while maintaining less inventory on hand.

29. Liquidity Summary

30. Ethics and Decision Making Solvency Ratios Solvency focuses on capital structure and assesses the extent of borrowing needed. In today’s business environment, companies have to be aware not only of the economic impact of their decisions, but also of their ethical impact. • Solvency refers to a company’s ability to remain in business over the long term. Information being used for? To ignore product safety?? To exceed government limits?? To falsify records??

31. Solvency Analysis

32. Debt to Assets The debt to assets ratio compares a company’s total liabilities to its total assets and yields the percentage of assets provided by creditors. As such, the ratio provides a measure of a company’s capital structure. A decreasing ratio shows that a company is taking on a less risky capital structure over time.

33. Debt to Equity The debt to equity ratio compares a company’s total liabilities to its total equity. Higherdebt to equity ratios indicate a riskier capital structure and therefore greater risk of insolvency.

34. Times Interest Earned The times interest earned ratio compares a company’s net income to its interest expense. It shows how well a company can pay interest out of current-year earnings. A higher ratio indicates a greater ability to make payments, and therefore less risk of insolvency.

35. Solvency Summary

36. LO6 DuPont Analysis A DuPont analysis provides insight into how a company’s return on equity was generated by decomposing the return into three components: • operating efficiency, • asset effectiveness, and • capital structure.

37. DuPont Calculation The higher the ratio, the more efficient a company is in turning sales into profits. The higher the ratio, the more effective a company is in generating sales given its assets. The higher the ratio, the more a company is financing its assets with debt rather than equity (riskier). This is the leverage multiplier.

38. Best Buy’s DuPont Calculations The analysis shows clearly why Best Buy’s return to its owners decreased from 2007 to 2008. Profits from sales were down in 2008, resulting in a lower return on equity.

39. Benefit of DuPont Analysis One of the main benefits of a DuPont analysis is the ability to ask what-if questions. ??? What if Best Buy was able to squeeze out another $.02 of profit on each dollar of sales? How would that affect the return to owners? Answer: 2008 return would increase to 0.407 (0.042 X 2.84 X 3.41). What if the market for electronics took a significant downturn and Best Buy was only able to generate sales of 1.5 times assets on hand? Would that significantly affect the return to investors? Answer: 2008 return would fall almost in half to 0.113 (0.022 X 1.50 X 3.41).

40. End of Chapter 12