CHAPTER 4-5

1. ANALYSIS AND INTERPRETATIONOF FINANCIAL STATEMENTS CHAPTER 4-5

2. Financial Statement Analysis • Non-accounting majors, especially, should relate well to this chapter It looks at accounting information from users’ perspective • Relates very closely to topics you will study in your finance course Therefore, we will use a somewhat broader brush on this chapter • What is financial statement analysis? ”Tearingapart” the financial statements and looking at the relationships

3. Financial Statement Analysis 625 Who analyzes financial statements? • Internal users (i.e., management) • External users (emphasis of chapter) • Examples? • Investors, creditors, regulatory agencies & … • stock market analysts and • auditors

4. Financial Statement Analysis • What do internal users use it for? Planning, evaluating and controlling company operations • What do external users use it for? Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management • First sentence in chapter says...

5. 627 628 Financial Statement Analysis Information is available from • Published annual reports • (1) Financial statements • (2) Notes to financial statements • (3) Letters to stockholders • (4) Auditor’s report (Independent accountants) • (5) Management’s discussion and analysis • Reports filed with the government • e.g., Form 10-K, Form 10-Q and Form 8-K

6. 627 628 Financial Statement Analysis Information is available from • Other sources • (1) Newspapers (e.g., Wall Street Journal ) • (2) Periodicals (e.g. Forbes, Fortune) • (3) Financial information organizations such as: Moody’s, Standard & Poor’s, Dun & Bradstreet, Inc., and Robert Morris Associates • (4) Other business publications

7. Methods ofFinancial Statement Analysis • Horizontal Analysis • Vertical Analysis • Common-Size Statements • Trend Percentages • Ratio Analysis

8. Horizontal Analysis Using comparative financial statements to calculate dollar or percentage changes in a financial statement item from one period to the next

9. Vertical Analysis For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

10. Common-Size Statements Financial statements that show only percentages and no absolute dollar amounts

11. Trend Percentages Show changes over time in given financial statement items (can help evaluate financial information of several years)

12. Ratio Analysis Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

13. Horizontal Analysis Example The management of Clover Company provides you with comparative balance sheets of the years ended December 31, 1999 and 1998. Management asks you to prepare a horizontal analysis on the information.

15. Horizontal Analysis Example Calculating Change in Dollar Amounts Dollar Change Current Year Figure Base Year Figure = –

16. Horizontal Analysis Example Calculating Change in Dollar Amounts Dollar Change Current Year Figure Base Year Figure = – Since we are measuring the amount of the change between 1998 and 1999, the dollar amounts for 1998 become the “base” year figures.

17. Horizontal Analysis Example Calculating Change as a Percentage Percentage Change Dollar Change Base Year Figure × = 100%

18. Horizontal Analysis Example $12,000 – $23,500 = $(11,500)

19. Horizontal Analysis Example ($11,500 ÷ $23,500) × 100% = 48.9%

20. Horizontal Analysis Example

21. Horizontal Analysis Example Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet.

23. Horizontal Analysis Example Now, let’s apply the procedures to the income statement.

25. Sales increased by 8.3% while net income decreased by 21.9%.

26. There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

27. Vertical Analysis Example The management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company.

28. Vertical Analysis Example

29. Vertical Analysis Example $82,000 ÷ $483,000 = 17% rounded $30,000 ÷ $387,000 = 8% rounded

30. Vertical Analysis Example $76,000 ÷ $483,000 = 16% rounded

31. Trend Percentages Example Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.

32. Trend Percentages Example Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis. $1,991 - $1,820 = $171

33. Trend Percentages Example Using 1995 as the base year, we develop the following percentage relationships. $1,991 - $1,820 = $171 $171 ÷ $1,820 = 9% rounded

34. Trend line for Sales

35. Ratios Ratios can be expressed in three different ways: 1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of $2.25) CAUTION! “Using ratios and percentages without considering the underlying causes may be hazardous to your health!” lead to incorrect conclusions.”

36. Categories of Ratios • Liquidity Ratios Indicate a company’s short-term debt-paying ability • Equity (Long-Term Solvency) Ratios Show relationship between debt and equity financing in a company • Profitability Tests Relate income to other variables • Market Tests Help assess relative merits of stocks in the marketplace

37. 10 Ratios You Must Know Liquidity Ratios • Current (working capital) ratio • Acid-test (quick) ratio • Cash flow liquidity ratio • Accounts receivable turnover • Number of days’ sales in accounts receivable • Inventory turnover • Total assets turnover 651

38. 10 Ratios You Must Know Equity (Long-Term Solvency) Ratios • Equity (stockholders’ equity) ratio • Equity to debt

39. 10 Ratios You Must Know Profitability Tests • Return on operating assets • Net income to net sales (return on sales or “profit margin”) • Return on average common stockholders’ equity (ROE) • Cash flow margin • Earnings per share • Times interest earned • Times preferred dividends earned $

40. 10 Ratios You Must Know Market Tests • Earnings yield on common stock • Price-earnings ratio • Payout ratio on common stock • Dividend yield on common stock • Dividend yield on preferred stock • Cash flow per share of common stock

41. Now, let’s look at Norton Corporation’s 1999 and 1998 financial statements.

45. Now, let’s calculate the 10 ratios based on Norton’s financial statements.

46. We will use this information to calculatethe liquidity ratios for Norton.

47. Working Capital* The excess of current assets over current liabilities. * While this is not a ratio, it does give an indication of a company’s liquidity.

48. Current Ratio Current Assets Current Liabilities = Current Ratio $65,000 $42,000 = = 1.55 : 1 Current (Working Capital) Ratio #1 Measures the ability of the company to pay current debts as they become due.

49. Acid-Test Ratio Quick Assets Current Liabilities = Acid-Test (Quick) Ratio #2 Quick assets are Cash, Marketable Securities, Accounts Receivable (net) and current Notes Receivable.

50. Acid-Test Ratio Quick Assets Current Liabilities = Acid-Test (Quick) Ratio #2 Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000.