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17-1

ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
17-2

Learning Competencies
1. Prepare financial statements.
2. Define the measurement levels, namely: liquidity,
solvency, stability and profitability.
3. perform vertical and horizontal analyses of
financial statements of a single proprietorship
4. compute, analyze, and interpret financial ratios
such as current ratio, working capital, gross
profit ratio, net profit ratio, receivable turnover,
inventory turnover, debt to- equity ratio, and the
like.
17-3

1. Prepare Financial Statements


Financial Statements:
summaries of the operating, financing,
and investment activities of a firm.
should provide sufficient information that
is useful to
investors and
creditors
in making their investment and
credit decisions in an informed
way.
17-4

The financial statements are expected to be


prepared in accordance with a set of standards
known as generally accepted accounting
principles (GAAP).
The financial statements of publicly traded firms
must be audited at least annually by
independent public accountants.
The auditors are expected to attest to the fact
that these financial statements of a firm have
been prepared in accordance with GAAP.
17-5

Basic Financial Statements


1. Income Statement
An income statement is a summary of the revenues and
expenses of a business over a period of time, usually either
one month, three months, or one year.
Summarizes the results of the firms operating and
financing decisions during that time.
Operating decisions of the company apply to production
and marketing such as sales/revenues, cost of goods sold,
administrative and general expenses (advertising, office
salaries)
Provides operating income/earnings before interest and
taxes (EBIT)
17-6

Results of financing decisions are


reflected in the remainder of the
income statement.
When interest expenses and taxes are
subtracted from EBIT, the result is net
income available to shareholders.
Net income does not necessarily equal
actual cash flow from operations and
financing.
17-7

Shows the results of a companys operations


over a period of time.
What goods were sold or services performed
that provided revenue for the company?
What costs were incurred in normal
operations to generate these revenues?
What are the earnings or company profit?
17-8

Revenues
Assets (cash or AR) created through
business operations
Expenses
Assets (cash or AP) consumed through
business operations
Net Income or (Net Loss)
Revenues - Expenses
17-9

The Example Company


Income Statement
For the Years Ended December 31, 2010 and 2011

2011 2010
Revenues:
Sales $100 $ 85
Other revenue 30 15
Total revenues $130 $100
Expenses:
Cost of goods sold $ 62 $ 58
Operating & admin. 16 12
Income tax 20 18
Total expenses $ 98 $ 88
Net Income $ 32 $ 12
17-10

Presented below are the components in


Slaughter Companys income statement.
Determine the following amounts.
SALES COGS GROSS OPERATING NET
PROFIT EXPENSES INCOME
75,000 ? 28,600 ? 10,800
108,000 70,000 ? ? 29,500
? 71,900 99,600 39,500 ?
17-11

Assume Kim Shin Company has the


following account balances: Sales
Php506,000, Sales Returns and
Allowances Php15,000, Cost of Goods
Sold, Php350,000, Selling Expenses
Php70,000,and Administrative Expenses
Php40,000. Prepare the income
statement for the month of June 30, 2017.
17-12

Statement of Retained Earnings

Beginning retained earnings An additional financial


+Net income statement that identifies
Dividends paid changes in retained
=Ending retained earnings earnings from one
accounting period to the
next.

Net income results in: Dividends result in:


Increase in net assets Decrease in net assets
Increase in retained earnings Decrease in retained
Increase in owners equity earnings
Decrease in owners equity
17-13

The Balance Sheet


A summary of the assets, liabilities, and equity of a business at a particular point in time, usually
at the end of the firms fiscal year.

Assets = Liabilities + Equity


(Resources of the (Obligations of (ownership left over
business enterprise) the business) Residual)

Fixed Assets Long-term Common stock outstanding


(Plant, Machinery, Equipment (Notes, bonds, & Additional paid-in capital
Buildings) Capital Lease Retained Earnings
Current Assets Obligation)
(Cash, Marketable Securities, Current Liabilities
Account Receivable, Inventories) (Accounts Payable,
Wages and salaries,
Short-term loans
Any portion of long-term
Indebtedness due in one-year)
17-14

Statement of Cash Flows


Reports the amount of cash collected
and paid out by a company in
operating, investing and financing
activities for a period of time.
How did the company receive cash?
How did the company use its cash?
Complementary to the income
statement.
Indicates ability of a company to
generate income in the future.
17-15

Cash inflows
Sell goods or services
Sell other assets or by borrowing
Receive cash from investments by
owners
Cash outflows
Pay operating expenses
Expand operations, repay loans
Pay owners a return on investment
17-16

Match Classification of
Cash Flows
Operating activities Transactions and
events that enter into the determination of
net income.
Investing activities Transactions and
events that involve the purchase and sale of
securities, property, plant, equipment, and
other assets not generally held for resale,
and the making and collecting of loans.
Financing activities Transactions and
events whereby resources and obtained
from, or repaid to, owners and creditors.
17-17

Operating Activities
Cash Inflow
Cash Outflow
Sale of goods or
Inventory
services
payments
Sale of investments
Interest
in trading securities
payments
Interest revenue
Wages
Dividend revenue
Utilities, rent

Taxes
17-18

Investing Activities
Cash Inflow Cash Outflow
Sale of plant Purchase of plant
assets assets
Sale of
Purchase of
securities, other
than trading securities, other
securities than trading
Collection of
securities
principal on Making of loans
loans to other entities
17-19

Financing Activities
Cash Inflow Cash Outflow
Issuance of own Dividend
stock payments
Borrowing Repaying
principal on
borrowing
Treasury stock
purchase
17-20

The Example Company


Statement of Cash Flows
December 31, 2011

Cash Flows From Operating Activities:


Receipts 48
Payments (43) 5

Cash Flows From Investing Activities:


Receipts 0
Payments (4) (4)

Cash Flows Used By Financing Activities:


Receipts 10
Payments (6) 4

Net Cash Flow 5


17-21

Notes to the Financial Statements


Notes are used to convey information
required by GAAP or to provide further
explanation.
17-22

Four general types of notes:


Summary of significant accounting
policies: assumptions and estimates.
Additional information about the
summary totals.
Disclosure of important information
that is not recognized in the financial
statements.
Supplementary information required by
the FASB or the SEC.
17-23

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?
Tearing apart the financial statements
and looking at the relationships
17-24

Financial Statement Analysis


625
Who analyzes financial statements?
Internalusers (i.e., management)
External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies &
stock market analysts and
auditors
17-25

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...
17-26

Financial Statement Analysis


Information is available from 627 628

Published annual reports


(1) Financial statements
(2) Notes to financial statements
(3) Letters to stockholders
(4) Auditors report (Independent accountants)
(5) Managements discussion and analysis
Reports filed with the government
e.g., Form 10-K, Form 10-Q and Form 8-K
17-27

Financial Statement Analysis


Information is available from 627 628

Other sources
(1) Newspapers (e.g., Wall Street Journal )
(2) Periodicals (e.g. Forbes, Fortune)
(3) Financial information organizations such
as: Moodys, Standard & Poors, Dun &
Bradstreet, Inc., and Robert Morris
Associates
(4) Other business publications
17-28

Methods of
Financial Statement Analysis
Horizontal Analysis
Vertical Analysis
Common-Size Statements
Trend Percentages
Ratio Analysis
17-29

Horizontal Analysis

Using comparative financial


statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
17-30

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
17-31

Common-Size Statements
Financial statements that show
only percentages and no
absolute dollar amounts
17-32

Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)
17-33

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)
17-34

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.
17-35
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Incre
1999 1998 Amo
Assets
Current assets:
Cash $ 12,000 $ 23,500
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
17-36

Horizontal Analysis Example


Calculating Change in Dollar Amounts

Dollar Current Year Base Year


=
Change Figure Figure
17-37

Horizontal Analysis Example


Calculating Change in Dollar Amounts

Dollar Current Year Base Year


=
Change Figure Figure

Since we are measuring the amount of


the change between 1998 and 1999, the
dollar amounts for 1998 become the
base year figures.
17-38

Horizontal Analysis Example


Calculating Change as a Percentage

Percentage Dollar Change


Change
=
Base Year Figure 100%
17-39

Horizontal Analysis Example


CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
$12,000 $23,500 = $(11,500)
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
17-40

Horizontal Analysis Example


CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000 164,700
Property and equipment:
($11,500 $23,500) 100% = 48.9%
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment 160,000 125,000
Total assets $ 315,000 $ 289,700
17-41

Horizontal Analysis Example


CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Assets
Current assets:
Cash $ 12,000 $ 23,500 $ (11,500) (48.9)
Accounts receivable, net 60,000 40,000 20,000 50.0
Inventory 80,000 100,000 (20,000) (20.0)
Prepaid expenses 3,000 1,200 1,800 150.0
Total current assets 155,000 164,700 (9,700) (5.9)
Property and equipment:
Land 40,000 40,000 - 0.0
Buildings and equipment, net 120,000 85,000 35,000 41.2
Total property and equipment 160,000 125,000 35,000 28.0
Total assets $ 315,000 $ 289,700 $ 25,300 8.7
17-42

Horizontal Analysis Example


Lets apply the same
procedures to the
liability and stockholders
equity sections of the
balance sheet.
17-43

CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
17-44

Horizontal Analysis Example


Now, lets apply the
procedures to the
income statement.
17-45

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
17-46

CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense
Sales increased by 6,400 7,000net
8.3% while (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
income decreased by 21.9%.
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
17-47

There were increases in both cost of goods


sold (14.3%) and operating expenses (2.1%).
These increased costs
CLOVERmore than offset the
CORPORATION
increase inComparative
sales, yielding anStatements
Income overall
Fordecrease
the Years Ended
in netDecember
income. 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Net sales $ 520,000 $ 480,000 $ 40,000 8.3
Cost of goods sold 360,000 315,000 45,000 14.3
Gross margin 160,000 165,000 (5,000) (3.0)
Operating expenses 128,600 126,000 2,600 2.1
Net operating income 31,400 39,000 (7,600) (19.5)
Interest expense 6,400 7,000 (600) (8.6)
Net income before taxes 25,000 32,000 (7,000) (21.9)
Less income taxes (30%) 7,500 9,600 (2,100) (21.9)
Net income $ 17,500 $ 22,400 $ (4,900) (21.9)
17-48

Vertical Analysis Example


The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.
17-49

Vertical Analysis Example


Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
Land 101,000 90,000 21% 23%
Equipment 110,000 100,000 23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
17-50

Vertical Analysis Example


Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Cash $ 82,000 $ 30,000 17% 8%
Accts. Rec. 120,000 100,000 25% 26%
Inventory 87,000 82,000 18% 21%
$82,000 $483,000 = 17% rounded
Land 101,000 90,000 21% 23%
Equipment
$387,000 100,000
$30,000110,000 = 8% rounded
23% 26%
Accum. Depr. (17,000) (15,000) -4% -4%
Total $ 483,000 $ 387,000 100% 100%
17-51

Vertical Analysis Example


Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 1999 and 1998
% of Total Assets
1999 1998 1999 1998
Acts. Payable $ 76,000 $ 60,000 16% 16%
Wages Payable 33,000 17,000 7% 4%
Notes Payable 50,000
$76,000 $483,000 = 50,000 10%
16% rounded 13%
Common Stock 170,000 160,000 35% 41%
Retained Earnings 154,000 100,000 32% 26%
Total $ 483,000 $ 387,000 100% 100%
17-52

Trend Percentages Example


Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119
17-53

Trend Percentages Example


Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues $ 2,405 $ 2,244 $ 2,112 $ 1,991 $ 1,820
Expenses 2,033 1,966 1,870 1,803 1,701
Net income $ 372 $ 278 $ 242 $ 188 $ 119

$1,991 - $1,820 = $171


17-54

Trend Percentages Example


Using 1995 as the base year, we develop
the following percentage relationships.
Wheeler, Inc.
Operating Data
1999 1998 1997 1996 1995
Revenues 132% 123% 116% 109% 100%
Expenses 120% 116% 110% 106% 100%
Net income 313% 234% 203% 158% 100%

$1,991 - $1,820 = $171


$171 $1,820 = 9% rounded
17-55

140
Trend line
130 for Sales
% of 100 Base

120

110

100

90
1995 1996 1997 1998 1999
Sales
Years
Expenses
17-56

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.
17-57

Categories of Ratios
Liquidity Ratios
Indicate a companys 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
17-58

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 651

Total assets turnover


17-59

10 Ratios You Must Know


Equity (Long-Term Solvency) Ratios
Equity (stockholders equity) ratio
Equity to debt
17-60

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


17-61

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
17-62

Now, lets look at


Norton
Corporations 1999
and 1998 financial
statements.
17-63
NORTON CORPORATION
Balance Sheets
December 31, 1999 and 1998
1999 1998
Assets
Current assets:
Cash $ 30,000 $ 20,000
Accounts receivable, net 20,000 17,000
Inventory 12,000 10,000
Prepaid expenses 3,000 2,000
Total current assets 65,000 49,000
Property and equipment:
Land 165,000 123,000
Buildings and equipment, net 116,390 128,000
Total property and equipment 281,390 251,000
Total assets $ 346,390 $ 300,000
17-64
NORTON CORPORATION
Balance Sheets
December 31, 1999 and 1998
1999 1998
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 39,000 $ 40,000
Notes payable, short-term 3,000 2,000
Total current liabilities 42,000 42,000
Long-term liabilities:
Notes payable, long-term 70,000 78,000
Total liabilities 112,000 120,000
Stockholders' equity:
Common stock, $1 par value 27,400 17,000
Additional paid-in capital 158,100 113,000
Total paid-in capital 185,500 130,000
Retained earnings 48,890 50,000
Total stockholders' equity 234,390 180,000
Total liabilities and stockholders' equity $ 346,390 $ 300,000
17-65

NORTON CORPORATION
Income Statements
For the Years Ended December 31, 1999 and 1998
1999 1998
Net sales $ 494,000 $ 450,000
Cost of goods sold 140,000 127,000
Gross margin 354,000 323,000
Operating expenses 270,000 249,000
Net operating income 84,000 74,000
Interest expense 7,300 8,000
Net income before taxes 76,700 66,000
Less income taxes (30%) 23,010 19,800
Net income $ 53,690 $ 46,200
17-66

Now, lets calculate


the 10 ratios based
on Nortons financial
statements.
17-67
NORTON CORPORATION
1999
Cash $ 30,000
Accounts receivable, net
We will Beginning of year 17,000
use this End of year 20,000
information Inventory
to calculate Beginning of year 10,000
the liquidity
End of year 12,000
ratios for
Total current assets 65,000
Norton.
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000
17-68

Working Capital*
The excess of current assets over
current liabilities.
12/31/99
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
* While this is not a ratio, it does give an
indication of a companys liquidity.
17-69

Current (Working Capital) Ratio


#1
Current Current Assets
=
Ratio Current Liabilities

Current $65,000
= = 1.55 : 1
Ratio $42,000

Measures the ability


of the company to pay current
debts as they become due.
17-70

Acid-Test (Quick) Ratio


#2
Acid-Test Quick Assets
=
Ratio Current Liabilities

Quick assets are Cash,


Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
17-71

Acid-Test (Quick) Ratio


#2
Acid-Test Quick Assets
=
Ratio Current Liabilities

Norton Corporations quick


assets consist of cash of
$30,000 and accounts
receivable of $20,000.
17-72

Acid-Test (Quick) Ratio


#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Acid-Test $50,000
= = 1.19 : 1
Ratio $42,000
17-73

Accounts Receivable Turnover


Net, credit sales #3 Average, net accounts
receivable
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover
Accounts
$494,000
Receivable = = 26.70 times
($17,000 + $20,000) 2
Turnover

This ratio measures how many


times a company converts its
receivables into cash each year.
Number of Days Sales
17-74

in Accounts Receivable
#4
Days Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables

Measures, on average, how many


days it takes to collect an
account receivable.
Number of Days Sales
17-75

in Accounts Receivable
#4
Days Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables

In practice, would 45 days be a


desirable number of days in
receivables?
17-76

Inventory Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) 2

Measures the number of times


inventory is sold and
replaced during the year.
17-77

Inventory Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory

Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) 2

Would 5 be a
desirable number of times
for inventory to turnover?
17-78

Equity, or LongTerm
Solvency Ratios
This is part of the information to
calculate the equity, or long-term
solvency ratios of Norton Corporation.
NORTON CORPORATION
1999
Net operating income $ 84,000
Net sales 494,000
Interest expense 7,300
Total stockholders' equity 234,390
17-79
NORTON CORPORATION
1999
Common shares outstanding
Beginning of year 17,000
End of year 27,400
Net income $ 53,690
Here is the Stockholders' equity
rest of the
Beginning of year 180,000
information
we will End of year 234,390
use. Dividends per share 2
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
17-80

Equity Ratio
#6
Equity Stockholders Equity
=
Ratio Total Assets

Equity $234,390
= = 67.7%
Ratio $346,390

Measures the proportion


of total assets provided by
stockholders.
17-81

Net Income to Net Sales


A/K/A Return on Sales or Profit Margin
#7
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales

Measures the proportion of the sales dollar


which is retained as profit.
17-82

Net Income to Net Sales


A/K/A Return on Sales or Profit Margin
#7
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales

Would a 1% return on sales be good?


17-83

Return on Average Common


Stockholders Equity (ROE)
#8

Return on Net Income


Stockholders = Average Common
Equity Stockholders Equity

Return on
$53,690
Stockholders = = 25.9%
($180,000 + $234,390) 2
Equity
Important measure of the
income-producing ability
of a company.
17-84

Earnings Per Share


#9
Earnings Available to Common Stockholders
Earnings
= Weighted-Average Number of Common
per Share
Shares Outstanding

Earnings $53,690
= = $2.42
per Share (17,000 + 27,400) 2

The financial press regularly publishes


actual and forecasted EPS amounts.
17-85

Earnings Per Share


Whats new from Chap. 15? 644
Weighted-average calculation
Earnings available to
common stockholders
EPS of common stock = _______________________
Weighted-average number of
common shares outstanding
Three alternatives for calculating
weighted-average number of shares
17-86

Earnings Per Share


Whats new from Chap. 15? 645
Weighted-average calculation
Earnings available to
common stockholders
EPS of common stock = _______________________
Weighted-average number of
Alternate #1 common shares outstanding
17-87

Earnings Per Share


645
Alternate #2

Alternate #3
17-88

Earnings Per Share


646

EPS and Stock Dividends or Splits


Why restate all prior calculations of EPS?
Comparability - i.e., no additional capital was
generated by the dividend or split
Primary EPS and Fully Diluted EPS
APB Opinion No. 15
I mentioned this 17-page pronouncement that
required a 100-page explanation in the lecture
for chapter 13.
17-89

Price-Earnings Ratio
A/K/A P/E Multiple
#10

Price-Earnings Market Price Per Share


=
Ratio EPS
Price-Earnings $20.00
= = 8.3 : 1
Ratio $ 2.42

Provides some measure of whether the


stock is under or overpriced.
17-90

Important Considerations
Need for comparable data
Data is provided by Dun &
Bradstreet, Standard & Poors etc.
Must compare by industry

Is EPS comparable?

Influence of external factors


Generalbusiness conditions
Seasonal nature of business operations

Impact of inflation
17-91

Question
The current ratio is a measure of
liquidity that is computed by dividing
total assets by total liabilities.
a. True
b. False
17-92

Question
The current ratio is a measure of
liquidity that is computed by dividing
total assets by total liabilities.
a. True
b. False The current ratio is a measure of
liquidity, but is computed by
dividing current assets by
current liabilities
17-93

Question
Quick assets are defined as Cash,
Marketable Securities and net
receivables.
a. True
b. False
17-94

Question
Quick assets are defined as Cash,
Marketable Securities and net
receivables.
a. True
b. False
17-95

No more ratios, please!


17-96

About Test #1
Will be challenging because the
material covered is challenging
All questions are T/F or M/C
Questions are 5-pt., 3-pt. & 1-pt.
No tricks such as patterns in answers
Order of answers is random
Coverage is even over the 4 chapters
Time allowed: 75 minutes
17-97

About Test #1
Best way to study
Notes first
Study guide and/or Hermanson tutorials

Calculators will be provided


Must wait outside classroom
Have your questions ready for next
actual class
See course home page for office hours