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Financial Statement Analysis

Learn how to analyze financial statements effectively using tools such as dollar change, percentage change, and trend percentages. Explore ratios and evaluate earnings quality, asset quality, and liquidity. Calculate profitability, efficiency, and investor return ratios.

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Financial Statement Analysis

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  1. Financial Statement Analysis Chapter 14

  2. Financial Statements Are Designed for Analysis

  3. Tools of Analysis Dollar & Percentage Changes Trend Percentages Component Percentages Ratios

  4. Dollar Change: Dollar Change Analysis Period Amount Base Period Amount = – Dollar and Percentage Changes Percentage Change: Percent Change Base Period Amount ÷ = Dollar Change

  5. 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.

  6. $12,000 – $23,500 = $(11,500)

  7. Complete the analysis for the other assets. ($11,500 ÷ $23,500) × 100% = 48.94%

  8. Trend Percentages Trend analysis is used to reveal patterns in data covering successive periods. Trend Percentages Analysis Period Amount Base Period Amount = × 100%

  9. Trend Percentages Berry Products Income Information For the Years Ended 31 December 2005 is the base period so its amounts will equal 100%.

  10. Examine the relative size of each item in the financial statements by computing component(or common-sized) percentages. Analysis Amount Base Amount Component Percentages Component Percentage × = 100% Financial Statement Base Amount Balance Sheet Total Assets Income Statement Revenues

  11. ($23,500 ÷ $289,700) × 100% = 8.1% ($12,000 ÷ $315,000) × 100% = 3.8%

  12. 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.

  13. 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. A Classified Balance Sheet

  15. Ratios

  16. Use this information to calculate the liquidity ratios for Babson Builders.

  17. Working Capital Working capitalis the excess of current assets over current liabilities.

  18. Current Ratio Current Assets Current Liabilities = Current Ratio $65,000 $42,000 = Current Ratio This ratio measures the short-term debt-paying ability of the company. = 1.55 : 1

  19. Quick Assets Current Liabilities Quick Ratio = Quick Ratio Quick assetsare 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.

  20. Quick Assets Current Liabilities Quick Ratio = $50,000 $42,000 Quick Ratio = = 1.19 : 1 Quick Ratio

  21. Uses and Limitations of Financial Ratios

  22. Measures of Profitability An income statement can be prepared in either a multiple-step or single-step format. The single-step formatis simpler. The multiple-step format provides more detailed information.

  23. Income Statement (Multiple-Step) Proper Heading Gross Margin Operating Expenses Non-operating Items Remember to compute EPS.

  24. Income Statement (Single-Step) Proper Heading Revenues & Gains Expenses& Losses Remember to compute EPS.

  25. Use this information to calculate the profitability ratios for Babson Builders Limited

  26. Profit for the yearAverage No. of Ordinary Shares Outstanding = EPS Earning Per Share Look back at the information from Babson and get the values we need to calculate earning per share. $53,69027,400 = $1.96

  27. Current Market Price of one Share Earnings Per Share = P/E $15.25$1.96 = 7.78 Price-Earnings Ratio The measure shows us the relationship between earning of the company and the market price of its share.

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

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

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

  31. Dividend Yield Dividend Yield Ratio Dividends Per Share Market Price Per Share = Babson Builders pays an annual dividend of $1.50 per share. The market price of the company’s share was $15.25 at the end of 2009. Dividend Yield Ratio $1.50 $15.25 = = 9.84% This ratio identifies the return, in terms of cash dividends, on the current market price of the share.

  32. Use this information to calculate ratios to measure the well-being of the long-term creditors for Babson Builders. Analysis by Long-Term Creditors This is also referred to as net operating profit.

  33. Times Interest Earned Operating Profit before Interest and Income Taxes Annual Interest Expense = Times Interest Earned $84,000 7,300 = = 11.5 times Interest Coverage Ratio This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor.

  34. 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.

  35. Use this information to calculate ratios to measure the well-being of the short-term creditors for Babson Builders Limited Analysis by Short-Term Creditors

  36. Accounts Receivable Turnover Net SalesAverageAccounts Receivable = Accounts Receivable Turnover $500,000 ($17,000 + $20,000) ÷ 2 = = 27.03 times Accounts Receivable Turnover Rate This ratio measures how many times a company converts its receivables into cash each year.

  37. Inventory Turnover Cost of Goods SoldAverage Inventory = Inventory Turnover $140,000($10,000 + $12,000) ÷ 2 = = 12.73 times Inventory Turnover Rate This ratio measures the number of times merchandise inventory is sold and replaced during the year.

  38. Operating Cycle 3. Collection ofaccounts receivable Cash 1. Purchase of Merchandise AccountsReceivable Inventory 2. Sale of merchandise on account

  39. End of Chapter 14

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