CHAPTER 11

1. CHAPTER 11 FINANCIAL STATEMENT ANALYSIS McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

2. Learning Objectives • How can liquidity measures be influenced by the inventory cost-flow assumption used? • How do suppliers and creditors use a customer’s payment practices to judge liquidity? • What are the influences of alternative inventory cost-flow assumptions and depreciation methods on turnover ratios? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

3. Learning Objectives • How are the number of days’ sales in accounts receivable and inventory used to evaluate the effectiveness of the management of receivables and inventory? • What is the significance of the price/earnings ratio in the evaluation of the market price of a company’s stock? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

4. Learning Objectives • How are dividend yield and the dividend payout ratio used by investors to evaluate a company’s common stock? • What is financial leverage, and why is it significant to management, creditors, and owners? • What is book value per share of common stock, how is it calculated, and why is it not a very meaningful amount for most companies? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

5. Learning Objectives • How can common size financial statements be used to evaluate a firm’s financial position and results of operations over a number of years? • How can operating statistics using physical, or non-financial data, be used to help management evaluate the results of the firm’s activities? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

6. Learning Objective 1 • How can liquidity measures be influenced by the inventory cost-flow assumption used? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

7. Financial Statement Analysis Ratios • Used to facilitate the interpretation of an entity’ financial position and results of operations • Can be classified into four groups: • Liquidity • Activity • Profitability • Debt, or financial leverage McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

8. Liquidity Measures • The balance sheet carrying values of inventory will depend on the cost-flow assumption used • Cannot compare firms using different inventory cost-flow assumptions • Firms often report the LIFO reserve – the difference between LIFO an FIFO inventory values McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

9. Liquidity Ratios • Working capital = Current assets – Current liabilities • Current ratio = Current assets Current liabilities • Acid-test ratio = Cash + Accounts receivable Current liabilities McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

10. Learning Objective 2 • How do suppliers and creditors use a customer’s payment practices to judge liquidity? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

11. Customer’s Payment Practices • Suppliers and creditors want to know if a firm is paying its bills promptly • This information may be obtained from other suppliers, credit bureaus, and Dun & Bradstreet reports • Credit bureaus and credit rating agencies provide a graded rating for firms McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

12. Learning Objective 3 • What are the influences of alternative inventory cost-flow assumptions and depreciation methods on turnover ratios? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

13. Activity Measures • Focus primarily on the relationshipbetween assets and sales • In computing activity measures, average assets is used • Average asset amounts include inventory and fixed assets • The values of inventory (based on cost-flow assumptions) and fixed assets (based on book cost less accumulated depreciation) depend on the cost-flow assumptions and depreciation methods used McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

14. Activity Ratios • Total asset turnover = Sales Average total assets • Inventory turnover = Cost of goods sold Average inventories • Number of days’ sales in accounts receivable = Accounts receivable Average days’ sales McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

15. More Activity Ratios • Average days’ sales = Annual sales 365 • Number of days’ sales in inventory = Inventory Average days’ cost of goods sold • Average days’ cost of goods sold = Average cost of goods sold 365 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

16. Learning Objective 4 • How are the number of days’ sales in accounts receivable and inventory used to evaluate the effectiveness of the management of receivables and inventory? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

17. Number of Days’ Sales in Accounts Receivable • Assesses the efficiency of managing accounts receivable • The sooner accounts receivable are collected, the sooner cash is available for use in the business • Generally, the higher the turnover and lower the number in days’ sales, the better • An increase in the age of accounts receivable is a warning that profitability and liquidity may be weakening McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

18. Number of Days’ Sales in Inventory • Assesses the efficiency of managing inventory • The lower that inventories can be maintained relative to sales,the less inventory that needs to be financed with debt and the greater the return on investment • Trend in the efficiency of managing inventory is the important factor McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

19. Profitability Measures • Operating income is frequently used in ROI calculations because it is a more direct measure of management’s activities • Average ROI based on net income for most American firms is between 7% and 10% • Again, trends are important McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

20. Profitability Ratios • ROI = Return (Net income) Investment (Average total assets) • DuPont model = Margin x Turnover Net income x Sales Sales Average total assets McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

21. More Profitability Ratios • ROE = Net income Average total owners’ equity • Dividend yield = Annual dividend per share Market price per share of stock • Dividend payout ratio = Annual dividend per share Earnings per share McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

22. Learning Objective 5 • What is the significance of the price/earnings ratio in the evaluation of the market price of a company’s stock? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

23. Price/Earning Ratio • P/E ratio = Market price of a share of common stock Earnings per share of common stock • Used extensively to evaluate the market price of a firm’s common stock relative to that of other firms and the market as a whole • Also called earnings multiple McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

24. Importance of P/E Ratio • Investors can earn a return on stock two ways: • Through dividends • Through increases in the market value of the stock • Market price reflects expectations of future dividends – which depend on earnings • Typically, manufacturing firms’ P/E ratio ranges from 12 to 18 McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

25. Learning Objective 6 • How are dividend yield and the dividend payout ratio used by investors to evaluate a company’s common stock? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

26. Dividend Yield • Dividend yield = Annual dividend per share Market price per share of stock • Should be compared to the yield available on other investments • On common stock, historically this has ranged from 3% to 6% • On preferred stock, the range is 5% to 8% McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

27. Dividend Payout Ratio • Dividend payout ratio = Annual dividend per share Earnings per share • Reflects the dividend policy of the firm • Most firms pay a relatively constant portion of earnings and avoid fluctuations • Generally, ranges from 30% to 50% for manufacturing and merchandising firms McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

28. Preferred Dividend Coverage Ratio • Preferred dividend coverage ratio = Net income Preferred dividend requirement • Indicates the margin of safety of the preferred stock dividend McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

29. Learning Objective 7 • What is financial leverage, and why is it significant to management, creditors, and owners? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

30. Financial Leverage Measures • Refers to the use of debt to finance the assets of the entity • Adds risk to the operation of the firm • Also magnifies the return to owners relative to the return on assets • Firms want to borrow at a rate less than the rate of return on financed assets • Interest is a deductible expense; dividends are not deductible McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

31. Debt Ratio • Indicates the extent to which a firm is using financial leverage • Debt ratio = Total liabilities Total liabilities and owners’ equity • Indicates the percentage of financing that is done with debt McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

32. Debt/Equity Ratio • Another indicator of the extent to which a firm is using financial leverage • Debt/Equity ratio = Total liabilities Total owners’ equity • Indicates the percentage of financing that is done with debt • Since deferred taxes and current liabilities are not interest bearing, these items are often excluded from the computation McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

33. Times Interest Earned Ratio • A measure that shows the relationship of earnings before interest and taxes to interest expense • The greater the ratio, the more confident the debt holders are about the firm continuing to earn enough to cover interest payments • Times interest earned = Earnings before interest and taxes Interest expense McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

34. Learning Objective 8 • What is book value per share of common stock, how is it calculated, and why is it not a very meaningful amount for most companies? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

35. Book Value per Share of Common Stock • Easily misunderstood • Cannot be compared to market value due to book value reflects the application of generally accepted accounting principles and the specific accounting policies that the firm has selected • Book value per share of common stock = Common shareholders’ equity Number of shares of common stock outstanding McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

36. Learning Objective 9 • How can common size financial statements be used to evaluate a firm’s financial position and results of operations over a number of years? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

37. Common Size Financial Statements • Used when evaluating the operating results of a firm over a number of years • Each asset, liability, and owners’ equity account is expressed as a percentage of total assets • On the income statement, sales is set at 100%, and each item is expressed as a percentage of sales McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

38. Use of Common Size Financial Statements • Using percentages makes spotting trends easier • Can compare firms of different sizes • In horizontal analysis, several years’ financial data are stated in terms of a base year • Each item in the base year is 100%; the items in subsequent years are a percentage of the item in the base year McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

39. Learning Objective 10 • How can operating statistics using physical, or non-financial data, be used to help management evaluate the results of the firm’s activities? McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002

40. Other Operating Statistics • Physical measures also are useful • Sales in units removes hidden price changes • Total employees may be more useful than payroll costs • Usually analysts combine financial and physical measures to show trends and to make comparisons McGraw-Hill/Irwin ©The McGraw-Hill Companies, Inc., 2002