Financial Statement Analysis Chapter 13

1. Financial Statement AnalysisChapter 13 Introduction to ManagerialAccounting, Brewer, Garrison,Noreen Power Points fromwebsite - adapted by Cynthia Fortin, CPA, CMA http://highered.mheducation.com/sites/0078025419/student_view0/chapter13/index.html

2. Human vital signs

3. Business vital signs • Liquidity • Solvency • Profitability • Market

4. How do Internal Users use FS Analysis? Evaluate performance by comparing to • Planned budget • Last year’s actuals • Other companies within the same industry

6. How will the company improve performance?

7. How do ExternalUsers use FS Analysis? Evaluate performance by comparing • Year to year • Other companies within the same industry

8. Whatdecisionswill ExternalUsersmake? Forecast future profits

9. Industry trends • Changes within the company • Consumer tastes • Technological changes • Economic factors Limitations of FS Analysis Analysts should look beyond the ratios

11. How do we get to our vision with our strategy? Successful strategies address these 4 elements.

13. Trend analysis Comparative Form Horizontal Analysis • Across time • Uses comparative financial statements • Focus on large percentage changes

16. Illustration: Amount and Percentage Change Assume a company’s year-end cash balances were $85,618 and $57,000 for 2011 and 2010 respectively. Dollar change = $85,618 - $57,000 = $28,618 $85,618 - $57,000 Percent change = x 100 $57,000 = 50.2%

17. Trend Percentages state several years’ financial data in terms of a base year, which equals 100 percent.

18. Trend Analysis

19. EXERCISE 13–10Trend Percentages 13-10 Starkey Company's sales, current assets, and current liabilities (all in thousands of dollars) have been reported as follows over the last five years (Year 5 is the most recent year): Required: • Express all of the asset, liability, and sales data in trend percentages. (Show percentages for each item.) Use Year 1 as the base year, and carry computations to one decimal place. • Comment on the results of your analysis.

20. Example trend analysis 13-10 Comment

21. Comment

22. Common-Size Statements - Vertical Analysis • Base amount is usually defined as 100% • Income statement % of revenues • Balance sheet % of total assets

23. Common-Size Statements - Vertical Analysis Common- Size percent Analysis amount Base Amount × 100% =

24. Exercise 13-1 p. 606

25. Comment • The NOI has decreased from 6.9% to 3.8% The company’s major problem seems to be the increasein cost of goods sold, which increased from 60.0% of sales last year to 63.2% of sales this year. • Why? This suggests that the company is not passing the increases in the costs of its products on to its customers. Or that prices have not increased as fast as costs. • Gross margin has decreased as a result. • Selling expenses and interest expense have both increased slightly during the year, which suggests that costs generally are going up in the company. • The only exception is the administrative expenses, which have decreased from 14.6% of sales last year to 13.6% of sales this year. This probably is a result of the company’s efforts to reduceadministrativeexpenses during the year.

26. Income statement common-size analysis. Comment • Start with qualifying the change in Net Operating Income. • Find what created the change. • Is the Cost of goods sold change significant? • If yes, how did it effect the Gross Margin? • What could have caused the change?

27. Horizontal Vertical Base: B.S. % Assets I.S. % Sales Overtime Base = year of reference Trend Analysis : in both cases

28. User Relevant ratios Earnings per share Price-Earnings Dividend Payout Common stockholder Yield Return on Total Assets Return on Common Stockholders' Equity Book Value per Share Working Capital Current Acid Test Short-Term Creditor Accounts Receivable Turnover Average Collection period Inventory Turnover Average Sales Period Times Interest Earned Long-Term Creditor Debt to Equity Ratio Analysis

29. The Common Stockholder Hopes to realize a return

30. One million non-cumulative,preferredsharesissued and outstanding • no new shareswereissuedduring 2010 or 2011. Dividends $5 per share. • 2. There were 25 million commonsharesissued and outstanding; • no new shareswereissuedduring 2010-2011. • 3. There are no dividends in arrears. Dividendstotalling $62 million • weredeclared and paidduring 2011.

32. = Net Income – Preferred Dividends Average Number of Common Shares Outstanding Earnings per share This measure indicates how much income was earned for each share of common stock outstanding.

33. Question: Compute Delmar’s EPS for 2011. $3 = ($80M – $5M)/25M Notes: Deduct Preferred Dividends from the Net Income because that is what will be available to common stockholders. $5 * 1 million Use the average number of common shares outstanding (This year + Last year ) / 2

34. = Market Price per Share Earnings per Share Price-Earnings Ratio A higher price-earnings ratio means that investors are willing to pay a premium for a company’s stock because of optimistic future growth prospects.

35. ABC Inc.'s common shares have a market value of $60 per share and its EPS is $3.50. XYZ Inc.'s common shares have a market value of $85 per share and its EPS is $4.10. You have done thorough research and are considering purchasing the shares of one of these companies. Required (a) Calculate the price–earnings ratio for each company (round to two decimal places). (b) Which company's shares will you purchase based on your calculations in (a) above?

36. Price-earnings ratio (a) Price-earnings ratio ABC Inc. 60/3.5 = 17.14 XYZ Inc. 85/4.10 = 20.73 (b) ABC Inc.’s shares seem to be the better buy (lower price) since its PE is lower than XYZ.

37. Dividend Payout Ratio = Dividends per Share Earnings per Share 2.29 = $8/$3.50 ABC declared and paid an $8 per share cash dividend and its EPS is $3.50.

38. Dividend Payout Investors seeking marketpricegrowth would like this ratio to be small. Companies with excellent prospects of profitgrowth pay little or nodividends.

39. Dividend Payout Investors seeking dividends would like this ratio to be large. Companies with littleopportunity of profitable growth but with steadyearnings tend to payoutdividends from their cash flows.

40. = Dividends per Share x 100% Market Price per Share Dividend Yield Ratio This ratio measures the rate of return (in the form of cash dividends only) that would be earned by an investor who buys common stock at the current market price.

41. Question ABC declared and paid an $8 per share cash dividend on its Common sharesduring the currentaccountingperiod. The currentmarket value of the ABC’ssharesis $56 per share. Is ABC classified as growthshares or income (dividendpaying) shares in the eyes of the stockholder? Answer: The ABC Company shares would be classified as income shares because the rate is sufficient to justify as providing income. 14.29% = $8/$56

43. One million non-cumulative,preferredsharesissued and outstanding no new shareswereissuedduring 2010 or 2011. Dividends $5 per share. 2. There were 25 million commonsharesissued and outstanding; no new shareswereissuedduring 2010-2011. 3. There are no dividends in arrears. Dividendstotalling $62 million weredeclared and paidduring 2011.

44. = Net Income + (Interest Expense X (1-tax rate)) Average Total Assets Return on Total Assets Measures how effectively a company is using its assets to generate earnings before contractual obligations must be paid. 

45. Question: ComputeDelmar’s return on total assets for 2011 and compare it to the Industryaverage of 20%. Interestexpensewas $4.8 million . Answer: Delmar’s return on total assets for 2011 is 18.01* which is unfavourable when compared to the industry average of 20%. Delmar earned only 18.01 cents for each $1.00 invested in average assets during 2011; the greater the return on total assets, the better. *(80+(4.8*1-(10/90)))/[(25 + 46 + 80 + 30 + 300 + 5 + 20 + 95 + 15 + 320)/2] × 100 = 18.01%

46. = Net Income – Preferred Dividends Average Common Stockholders’ Equity Return on Common Stockholders’ Equity This measure indicates how well the company used the owners’ investments to earn net income.

47. Question: ComputeDelmar’s return on Common Stockholders’ Equity for 2011 and compare it to the Industryaverage of 32.7%. Answer: Delmar’s return on total common shareholders’ equity for 2011 is 22.06% which is unfavourable when compared to the industry average of 32.7%. Delmar earned 22.06 cents for each $1.00 of equity invested in the company by common shareholders.; the greater the return on total common shareholders’ equity, the better. *(80 – 5)/[(100 + 249 + 100 + 231)/2] × 100 = 22.06%

48. Financial Leverage Difference between the rate of return of total average assets in its own assets and the rate of return on common stockholders’ equity. Return to common stockholders Return on Total average assets Positive leverage > = Positive leverage can be due to factors such as: company’s current liabilities, which may carry no interest cost, to long term liabilities which carry after tax interest at a rate lower than the return on total assets and/or preferred stock which carry dividends % lower than the return on total assets.

49. Comments on leverage • If a company experiences big variations in net cash flows from operations, stockholders might be pleased that the company has no debt. In hard times, interest payments might be very difficult to meet. • if investments within a company can earn a rate of return that exceeds the interest rate on debt, stockholders would get the benefits of positive leverage if the company took on debt.

50. = Stockholders’ Equity - Preferred Stock Number of Common Shares Outstanding Book Value Per Share It measures the amount that would be distributed to stockholders if all assets were sold at their balance sheet carrying amounts after all creditors were paid off. This measure is based entirely on historical cost and not market price. Assets – Liabilities = Equity