Chapter 14

1. Financial Statement Analysis Chapter 14

2. Objectives Discuss the need for comparative analysis and identify the tools of financial statement analysis. Explain and apply horizontal and vertical analysis. Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency. Understand the concept of earning power, and how irregular items are presented. Understand the concept of quality of earnings.

3. Objectives of FS Analysis • Forensic. . . Assessment of Past Performance and Current position • Future. . . Assessment of Future potential and related Risk

4. Sources • Inside the company • Outside the company • Really outside the company

5. Sources • Inside the company – 10K, website, press releases • Outside the company – external analysts, Standard and Poors, Valueline, Hoovers, Dun & Bradstreet, Moody’s, etc.

6. Financial Statement Analysis Three basic tools are used in financial statement analysis : 1. Horizontal (also called trend)analysis 2. Vertical analysis 3. Ratio analysis

7. Horizontal Analysis • Looking at the Trends over time…. • In $$$$$$$$$$ or %%%%%%%%%% • From the base year • Shows growth or decline • Used with Balance Sheet and Income Statement

8. Horizontal Analysis of a INCOME STATEMENT ITEMS Analysis: Look at the Trends, all of them What can you say about them?

9. Horizontal Analysis of a INCOME STATEMENT ITEMS Analysis: Sales grew in 2009 compared to 2008, however dipped in 2010. Net income grew each year; reviewing costs, Kellogg’s Operating Expenses grew at a much slower pace, which contributed to the Net Income growth. Also Kellogg’s gross profit improved in 2010, even though its sales did not. This suggests that Kellogg’s is controlling costs. Note: with more space, you would quote actual numbers and % for evidence.

10. Horizontal Analysis – Income Statement CURRENT-YEAR AMOUNT - BASE-YEAR AMOUNT BASE-YEAR AMOUNT 12,822.0 – 11,776= 108.88% 11,776.0 Net sales for Kellogg company increased 8.88% in 2011 compared to 2011.

11. Horizontal Analysis of a balance sheet ITEMS Analysis: Look at the Trends, all of them What can you say about them?

12. Horizontal Analysis of a balance sheet ITEMS Analysis: Total Assets are decreasing; Current Assets are decreasing at a faster rate, suggesting more funds are being dedicated to Long Term Assets. However, Long Term Liabilities are stable, suggesting that the company is maintaining the same debt levels. Retained Earnings has grown by almost 30% over the base year, indicating that the company has been profitable.

13. What does it tell you? • BALANCE SHEET: • What changed and in what direction? • How was it financed? • INCOME STATEMENT: • Are sales increasing? • Are costs following sales? (growth, decline)

14. What does it tell you? • Tracks changes over time • Tracks changes in one area (sales) compared to other areas (net income)

15. Vertical Analysis • Common size analysis • What is your basis? • Balance Sheet: Total Assets • Income Statement: Net Sales (net revenues)

16. Vertical Analysis – Income statement Note that Net Sales is always the 100% base figure for Vertical Analysis and all other items are a percentage of this Analysis: Look at the Trends, all of them What can you say about them?

17. Vertical Analysis – Income statement Note that Net Sales is always the 100% base figure for Vertical Analysis and all other items are a percentage of this Analysis: You can’t analyze Sales much, as it is the 100% number; so talk about the other numbers: Net Income as a percent of sales increased in 2009 compared to 2008. It dipped slightly in 2010 compared to 2009, but is still above 2008’s percentage level. Analysis: The improvements in Net Income were caused by reduction in Operating Expenses which reduced almost 1.5%, as a percentage of net sales) and Gross Profit (declined in 2008, but improved) in 2010

18. Vertical Analysis – Balance Sheet Note that Total Assets are the 100% base figure and all other items are a percentage of this

19. The years were 1998 and 1997 Let’s go back and look at Kellogg’s history

20. KELLOGG COMPANY, INC. Condensed Income Statement – Vertical Analysis For the Years Ended December 31 (In millions) 1998 1997 AmountPercentAmountPercent Net sales $6,762.1 100.0 $6,830.1 100.0 Cost of goods sold 3,282.6 48.6 3,270.1 47.9 Gross profit 3,479.5 51.4 3,560.0 52.1 Selling & Admin. 2,513.9 37.2 2,366.8 34.6 Nonrecurring Chgs 70.51.0 184.1 2.7 Income operations 895.1 13.2 1,009.1 14.8 Interest expense 119.5 1.8 108.3 1.6 Other income (expense),net 6.9 0.1 3.7 0.1 Income before income taxes 782.5 11.5 904.5 13.3 Income tax expense 279.9 4.1 340.55.0 Net income $502.6 7.4 $564.0 8.3

21. Look at the changes in each year? • What is the trend in Sales? • Does Cost of Goods Sold follow the same trend? • What about other costs? You may not know the reason, but what are your questions as to WHY things do not look right? What is wrong with this picture See end of slides for solution

22. What does it tell you? • Relative size of things on the statement. . . .Over time • Allows comparisons between companies

23. End of Part 1

24. Limitations Of Financial Analysis • Estimates • Cost • Alternative Accounting Methods • Atypical Data • Diversification

25. Estimates • Financial statements are based on estimates. • allowance for uncollectible accounts • depreciation • costs of warranties • contingent losses To the extent that these estimates are inaccurate, the financial ratios and percentages are also inaccurate.

26. Cost • Traditional financial statements are based on historical cost and are not adjusted for price level changes. • Comparisons of unadjusted financial data from different periods may be rendered invalid by significant inflation or deflation.

27. Alternative Accounting Methods • One company may use the FIFO method, while another company in the same industry may use LIFO. • If the inventory is significant for both companies, it is unlikely that their current ratios are comparable. • In addition to differences in inventory costing methods, differences also exist in reporting such items as depreciation, depletion, and amortization.

28. Atypical Data Fiscal year-end data may not be typical of a company's financial condition during the year.

29. Diversification • Diversification in American industry also limits the usefulness of financial analysis. • Many firms are so diverse they cannot be classified by industry.

30. Ratio Analysis

31. Ratios • Types: • Liquidity ratios • Profitability ratios • Solvency ratios • Can provide clues to underlying conditions that may not be apparent from an inspection of the individual components. • Single ratio by itself is not very meaningful

32. RATIO Analysis – Galore!

33. Liquidity Ratios Measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. WHO CARES? Short-term creditors such as banks, suppliers, employees

34. Liquidity Ratios • Current ratio • Acid-test ratio • Receivables turnover ratio • Inventory turnover

35. Current Ratio Indicates short-term debt-paying ability Current Assets Current Liabilities

36. Acid-Test Ratio Indicates immediate short-term debt-paying ability Cash + Short-term Investments + Net Receivables Current Liabilities

37. Receivables Turnover Ratio Indicates liquidity of receivables Net Credit Sales Average Net Receivables

38. Average Collection Period Indicates liquidity of receivables and collection success 365 days Receivables Ratio Turnover

39. Inventory Turnover Ratio Indicates liquidity of inventory Cost of Goods Sold Average Inventory

40. Average Days in Inventory Indicates liquidity of inventory and inventory management 365 days Inventory Turnover Ratio

41. Profitability Ratios Measure the income or operating success of an enterprise for a given period of time WHO CARES? Everybody WHY? A company’s income affects: • its ability to obtain debt and equity financing • its liquidity position • its ability to grow

42. Profitability Ratios • Return on common stockholders’ equity ratio • Return on assets ratio • Profit margin ratio • Assets turnover ratio • Gross profit rate • Operating expenses to sales ratio • Cash return on sales ratio • Earnings per share (EPS) • Price-earnings ratio • Payout ratio

43. Return on Common Stockholders’ Equity Ratio Indicates profitability of common stockholders’ investment Net income -preferred stock dividends Average common stockholders’ equity

44. Higher value suggests favorable efficiency. Return On Assets Ratio Reveals the amount of net income generated by each dollar invested Net income Average total assets

45. Higher value suggests favorable return on each dollar of sales. Profit Margin Ratio Indicates net income generated by each dollar of sales Net income Net sales

46. Asset Turnover Ratio Indicates how efficiently assets are used to generate sales Net sales Average total assets

47. Gross Profit Rate Indicates margin between selling price and cost of good sold Gross profit Net sales

48. Operating Expensesto Sales Ratio Indicates the cost incurred to support each dollar of sales Operating expenses Net sales

49. Cash Return on Sales Ratio Indicates net cash flow generated by each dollar of sales Cash provided by operations Net sales

50. Earnings Per Share (EPS) Indicates net income earned on each share of common stock sales Income available to common stockholders Average number of outstanding common shares