Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Winston Kwok, Ph.D., CPA McGraw-Hill/I rwin Copyright 2011 by The McGraw-Hill Companies, I nc. All rights reserved. ANALYSIS OF FINANCIAL STATEMENTS Chapter 17 17 - 2 Application of analytical tools Involves transforming data Reduces uncertainty BASICS OF ANALYSIS Financial statement analysis helps users make better decisions. Internal Users Managers Officers Internal Auditors External Users Shareholders Lenders Customers C 1 17 - 3 BUILDING BLOCKS OF ANALYSIS C 1 Liquidity and efficiency Solvency Market prospects Profitability 17 - 4 INFORMATION FOR ANALYSIS C 1 1. Income Statement (Statement of Comprehensive Income) 2. Balance Sheet (Statement of Financial Position) 3. Statement of Changes in Equity 4. Statement of Cash Flows 5. Notes to the Financial Statements 17 - 5 Intracompany Competitors Industry Guidelines STANDARDS FOR COMPARISON C 1 When we interpret our analysis, it is essential to compare the results we obtained to other standards or benchmarks. 17 - 6 Horizontal Analysis Comparing a companys financial condition and performance across time. TOOLS OF ANALYSIS Vertical Analysis Comparing a companys financial condition and performance to a base amount. Ratio Analysis Measurement of key relations between financial statement items. C 2 17 - 7 HORIZONTAL ANALYSIS P 1 17 - 8 COMPARATIVE STATEMENTS Calculate Change in Dollar Amount Dollar Change Analysis Period Amount Base Period Amount = When measuring the amount of the change in dollar amounts, compare the analysis period balance to the base period balance. The analysis period is usually the current year while the base period is usually the prior year. P 1 17 - 9 COMPARATIVE STATEMENTS Calculate Change as a Percent Percent Change Dollar Change Base Period Amount 100 =
P 1 When calculating the change as a percentage, divide the amount of the dollar change by the base period amount, and then multiply by 100 to convert to a percentage. 17 - 10 $1,550,861 $835,546 = $715,315 P 1 ($715,315 $835,546) 100 = 85.6% HORIZONTAL ANALYSIS 17 - 11 HORIZONTAL ANALYSIS ($3,888,038 $11,065,186) 100 = 35.1% $14,953,224 $11,065,186 = $3,888,038 P 1 17 - 12 TREND ANALYSIS Trend analysis is used to reveal patterns in data covering successive periods. Trend Percent Analysis Period Amount Base Period Amount 100 =
P 1 17 - 13 TREND ANALYSIS Research in Motion Income Statement Information Using 2006 as the base year we will get the following trend information: Examples of 2006-2008 Calculations for Revenues: 2006 is base year. Set to 100% 2007: $3,037,103 $2,065,845 100 = 147.0% 2008: $6,009,395 $2,065,845 100 = 290.9% P 1 17 - 14 TREND ANALYSIS We can use the trend percentages to construct a graph so we can see the trend over time. P 1 17 - 15 VERTICAL ANALYSIS Common-Size Statements Common-size Percent Analysis Amount Base Amount 100 =
Financial Statement Base Amount Balance Sheet Total Assets Income Statement Revenues P 2 17 - 16 ($1,550,861 $10,204,409) 100 = 15.2% ($835,546 $8,101,372) 100 = 10.3% COMMON-SIZE BALANCE SHEET P 2 17 - 17 COMMON-SIZE INCOME STATEMENT P 2 ($8,368,958 $14,953,224) 100 = 56.0% 17 - 18 COMMON-SIZE GRAPHICS P 2 17 - 19 RATIO ANALYSIS P 3 Liquidity and efficiency Solvency Market prospects Profitability 17 - 20 Current Ratio Acid-test Ratio Accounts Receivable Turnover Inventory Turnover Days Sales Uncollected Days Sales in Inventory Total Asset Turnover LIQUIDITY AND EFFICIENCY P 3 Days Purchases in Accounts Payable 17 - 21 WORKING CAPITAL Working capital represents current assets financed from long-term capital sources that do not require near-term repayment. Current assets Current liabilities = Working capital
More working capital suggests a strong liquidity position and an ability to meet current obligations. P 3 17 - 22 This ratio measures the short-term debt- paying ability of the company. A higher current ratio suggests a strong liquidity position. CURRENT RATIO Current Ratio = Current Assets Current Liabilities P 3 17 - 23 This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash. ACID-TEST RATIO Acid-test ratio = Cash + Short-term investments + Current receivables Current Liabilities Referred to as Quick Assets P 3 17 - 24 This ratio measures how many times a company converts its receivables into cash each year. ACCOUNTS RECEIVABLE TURNOVER Accounts receivable = turnover Net sales Average accounts receivable, net Average accounts receivable = (Beginning acct. rec. + Ending acct. rec.) 2 P 3 17 - 25 This ratio measures the number of times merchandise is sold and replaced during the year. INVENTORY TURNOVER Inventory turnover = Cost of goods sold Average inventory Average inventory = (Beginning inventory + Ending inventory) 2 P 3 17 - 26 Provides insight into how frequently a company collects its accounts receivable. DAYS SALES UNCOLLECTED Day's sales = uncollected Accounts receivable, net 365 Net sales P 3 17 - 27 DAYS SALES IN INVENTORY Day's sales in = Inventory Ending inventory 365 Cost of goods sold This ratio is a useful measure in evaluating inventory liquidity. If a product is demanded by customers, this formula estimates how long it takes to sell the inventory. P3 17 - 28 DAYS PURCHASES IN ACCOUNTS PAYABLE Accounts = Payable Accounts payable 365 Cost of goods sold This ratio is a useful measure in evaluating how long the business takes to pay its credit suppliers. P3 17 - 29 CASH CONVERSION CYCLE The sum of the days sales uncollected and the days sales in inventory subtracting the days purchases in accounts payable. It represents the number of days a firms cash remains tied up within the operations of the business. The lower the cash conversion cycle, the more healthy a company generally is. P 3 17 - 30 TOTAL ASSET TURNOVER Total asset turnover = Net sales Average total assets Average assets = (Beginning assets + Ending assets) 2 This ratio reflects a companys ability to use its assets to generate sales. It is an important indication of operating efficiency. P 3 17 - 31 Debt Ratio Equity Ratio Pledged Assets to Secured Liabilities Times Interest Earned SOLVENCY P 3 17 - 32 DEBT AND EQUITY RATIOS Amount Ratio Total liabilities $ 8,000,000 66.7% [Debt ratio] Total equity 4,000,000 33.3% [Equity ratio] Total liabilities and equity $ 12,000,000 100.0%
$8,000,000 $12,000,000 = 66.7% The debt ratio expresses total liabilities as a percent of total assets. The equity ratio provides complementary information by expressing total equity as a percent of total assets. P 3 17 - 33 DEBT-TO-EQUITY RATIO Debt-to-equity ratio = Total liabilities
Total equity
This ratio measures what portion of a companys assets are contributed by creditors. A larger debt-to- equity ratio implies less opportunity to expand through use of debt financing. P 3 17 - 34 TIMES INTEREST EARNED Times interest earned = Income before interest and taxes
Interest expense
This is the most common measure of the ability of a companys operations to provide protection to long-term creditors. Net income + Interest expense + Income taxes = Income before interest and taxes
P 3 17 - 35 Profit Margin Return on Total Assets Return on Ordinary Shareholders Equity PROFITABILITY P 3 17 - 36 PROFIT MARGIN Profit margin = Net income Net sales This ratio describes a companys ability to earn net income from each sales dollar. P 3 17 - 37 Return on total asset = Net income Average total assets RETURN ON TOTAL ASSETS Return on total assets measures how well assets have been employed by the companys management. P 3 17 - 38 RETURN ON ORDINARY SHAREHOLDERS' EQUITY Return on ordinary shareholders' equity = Net income - Preference dividends Average ordinary shareholders' equity This measure indicates how well the company employed the shareholders equity to earn net income. P 3 17 - 39 Price-Earnings Ratio Dividend Yield MARKET PROSPECTS P 3 17 - 40 PRICE-EARNINGS RATIO Price-earnings ratio = Market price per ordinary share
Earnings per share
This measure is often used by investors as a general guideline in gauging share values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth. P 3 17 - 41 DIVIDEND YIELD Dividend yield = Annual cash dividends per share
Market price per share
This ratio identifies the return, in terms of cash dividends, on the current market price per share of the companys ordinary shares. P 3 17 - 42 ANALYSIS REPORTING A1 1. Executive Summary 2. Analysis Overview 3. Evidential Matter 4. Assumptions 5. Key Factors 6. Inferences The purpose of financial statement analyses is to reduce uncertainty in business decisions through a rigorous and sound evaluation. A financial statement analysis report directly addresses the building blocks of analysis and documents the reasoning. 17 - 43 END OF CHAPTER 17