Chapter 14 Financial Statement Analysis Purpose of Analysis Financial statement analysis helps users make better decisions Internal Users Managers Officers Internal Auditors External Users Shareholders Lenders Customers 14-2 Financial Statements Are Designed for Analysis Classified Financial Statements Comparative Financial Statements Consolidated Financial Statements Items with certain characteristics are grouped together. Amounts from several years appear side by side. Information for the parent and subsidiary are presented. Results in standardized, meaningful subtotals. Helps identify significant changes and trends. Presented as if the two companies are a single business unit. 14-3 Techniques for Financial Analysis 1. Ratios 2. Dollar & Percentage Changes 3. Component Percentages 4. Trend Percentages 14-4 Tools of Analysis Using key relations among financial statement items 14-5 Building Blocks of Analysis Ability to meet short-term obligations and to efficiently generate revenues Liquidity and Efficiency Ability to provide financial rewards sufficient to attract and retain Profitability financing Solvency Market Prospects Ability to generate future revenues and meet long-term obligations Ability to generate positive market expectations 14-6 Let’s use the following financial statements for Norton Corporation for our ratio analysis. 14-7 NORTON CORPORATION Balance Sheet 2024 December 31, 2007 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets 2024 2007 2023 2006 $ 30,000 20,000 12,000 3,000 $ 65,000 $ 20,000 17,000 10,000 2,000 $ 49,000 165,000 116,390 $ 281,390 $ 346,390 123,000 128,000 $ 251,000 $ 300,000 14-8 NORTON CORPORATION Balance Sheet 2024 December 31, 2007 2007 2024 2006 2023 Liabilities and Shareholders' Equity Current liabilities: Accounts payable Notes payable, short-term Total current liabilities Long-term liabilities: Notes payable, long-term Total liabilities Shareholders' equity: Common stock, $1 par value Additional paid-in capital Total paid-in capital Retained earnings Total shareholders' equity 70,000 $ 112,000 78,000 $ 120,000 27,400 158,100 $ 185,500 48,890 $ 234,390 17,000 113,000 $ 130,000 50,000 $ 180,000 Total liabilities and shareholders' equity $ 346,390 $ 300,000 $ $ 39,000 3,000 42,000 $ $ 40,000 2,000 42,000 14-9 NORTON CORPORATION Income Statement 2024 For the Years Ended December 31, 2007 Revenues Cost of sales Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income 2024 2007 $ 494,000 140,000 $ 354,000 270,000 $ 84,000 7,300 $ 76,700 23,010 $ 53,690 2023 2006 $ 450,000 127,000 $ 323,000 249,000 $ 74,000 8,000 $ 66,000 19,800 $ 46,200 14-10 Liquidity and Efficiency Current Ratio Days’ Sales Uncollected Acid-test Ratio Inventory Turnover Accounts Receivable Turnover Total Asset Turnover Working Capital 14-11 Liquidity and Efficiency NORTON CORPORATION 2007 Use this information to calculate the liquidity and efficiency ratios for Norton Corporation. Cash $ 30,000 Accounts receivable, net Beginning of year 17,000 End of year 20,000 Inventory Beginning of year 10,000 End of year 12,000 Total current assets 65,000 Total current liabilities 42,000 Total assets Beginning of year 300,000 End of year 346,390 Revenues 494,000 Cost of sales 140,000 Current Ratio Current Current Assets = Ratio Current Liabilities This ratio measures the short-term debt-paying ability of the company. 14-13 Acid-Test Ratio Quick Assets Acid-Test = Current Liabilities Ratio Quick assets are Cash, Short-Term Investments, and Current Receivables. 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. 14-14 Working Capital Working capital is defined as current assets minus current liabilities. 2024 Dec. 31, 2007 Current assets $ Current liabilities Working capital $ 14-15 Inventory Turnover Inventory Turnover Cost of Goods Sold = Average Inventory This ratio measures the number of times merchandise is sold and replaced during the year. 14-16 Accounts Receivable Turnover Accounts Sales on Account Receivable= Average Accounts Receivable Turnover This ratio measures how many times a company converts its receivables into cash each year. 14-17 Days’ Sales Uncollected Days’ Sales = Uncollected 365 Accounts Receivable Turnover Accounts Receivable = Turnover This ratio measures the liquidity of receivables. 14-18 Days’ Sales Uncollected Days’ Sales = Uncollected 365 Accounts Receivable Turnover Days’ Sales = Uncollected This ratio measures the liquidity of receivables. 14-19 Total Asset Turnover Total Asset Net Sales = Turnover Average Total Assets Total Asset = Turnover This ratio measures the efficiency of assets in producing sales. 14-20 Solvency Debt Ratio Equity Ratio Debt to Equity Ratio Times Interest Earned 14-21 Solvency Use this information to calculate the solvency ratios for Norton Corporation. NORTON CORPORATION 2007 Net income before interest expense and income taxes Interest expense $ 84,000 7,300 Total shareholders' equity 234,390 Total liabilities 112,000 Total assets 346,390 Debt Ratio Total Liabilities Debt = Ratio Total Assets Debt Ratio This ratio measures what portion of a company’s assets are contributed by creditors. 14-23 Equity Ratio Total Equity Equity = Ratio Total Assets Equity Ratio This ratio measures what portion of a company’s assets are contributed by owners. 14-24 Times Interest Earned Times Interest = Earned Net Income before Interest Expense and Income Taxes Interest Expense Times Interest = Earned This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor. 14-25 Profitability Profit Margin Gross Margin Return on average Total Assets/Equity Basic Earnings per Share Return on Common Stockholders’ Equity 14-26 Profitability Use this information to calculate the profitability ratios for Norton Corporation. NORTON CORPORATION 2024 2007 Number of common shares outstanding all year Net income 27,400 $ 53,690 Shareholders' equity Beginning of year 180,000 End of year 234,390 Revenues 494,000 Cost of sales 140,000 Total assets Beginning of year 300,000 End of year 346,390 Profit Margin Profit = Margin Net Income Net Sales Profit = Margin This ratio describes a company’s ability to earn a net income from sales. 14-28 Gross Profit Margin Gross Net Sales - Cost of Sales = Margin Net Sales Gross = Margin This ratio measures the amount remaining from $1 in sales that is left to cover operating expenses and a profit after considering cost of sales. 14-29 Return on Total Assets Return on = Net Income Total Assets Average Total Assets Return on Total Assets = This ratio is generally considered the best overall measure of a company’s profitability. 14-30 Return on Common Stockholders’ Equity Return on Net Income - Preferred Dividends Common = Stockholders’ Average Common Stockholders’ Equity Equity Return on Common = Stockholders’ Equity This measure indicates how well the company employed the owners’ investments to earn income. 14-31 Earnings per Share Earnings Net Income Preferred Dividends per = Weighted-Average Common Share Shares Outstanding Earnings per = Share This measure indicates how much income was earned for each share of common stock outstanding. 14-32 Market Prospects PriceEarnings Ratio Dividend Yield 14-33 Market Prospects Use this information to calculate the market ratios for Norton Corporation. NORTON CORPORATION 2024 December 31, 2007 Earnings per Share $ 1.96 Market Price 15.00 Annual Dividend per Share 2.00 14-34 Price-Earnings Ratio Price-Earnings Market Price Per Share = Ratio Earnings Per Share Price-Earnings = Ratio This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth. 14-35 Dividend Yield Dividend Annual Dividends Per Share = Yield Market Price Per Share = This ratio identifies the return, in terms of cash dividends, on the current market price of the stock. 14-36 Uses and Limitations of Financial Ratios Uses Limitations Ratios help users understand financial relationships. Management may enter into transactions merely to improve the ratios. Ratios provide for quick comparison of companies. Ratios do not help with analysis of the company's progress toward nonfinancial goals. 14-37 Dollar and Percentage Changes The dollar amount of any change is the difference between the amount for a comparison year and the amount for a base year. Dollar Change = Analysis Period Amount – Base Period Amount The percentage change is computed by dividing the amount of the dollar change between years by the amount for the previous year. Percent Change = Dollar Change ÷ Base Period Amount 14-38 Dollar and Percentage Changes Evaluating Percentage Changes in Sales and Earnings Sales and earnings should increase at more than the rate of inflation. In measuring quarterly changes, compare to the same quarter in the previous year. Percentages may be misleading when the base amount is small. 14-39 Dollar and Percentage Changes 14-40 Evaluating Percentage Changes in Sales and Earnings Computing the percentage changes in sales, gross profit, and net income from one year to the next provides insight into a company’s rate of growth. In measuring the dollar or percentage change in quarterly sales or earnings, it is customary to compare the results of the current quarter with those of the same quarter in the preceding year, in order to prevent seasonal distortions. 14-41 Percentages Become Misleading When the Base Is Small Percentage changes may create a misleading impression when the dollar amount used as a base is unusually small. EXAMPLE: Year 1 Income: $100,000 Year 2 Income: $10,000 (Possibly due to an extraordinary transaction, like tornado losses) Year 3 Income: $100,000 From Year 2 to Year 3: 900% increase in net income. 14-42 Trend Percentages The changes in financial statement items from a base year to following years are sometimes expressed as trend percentages to show the extent and direction of change. Two steps are necessary to compute trend percentages. 1. First, a base year is selected and each item in the financial statements for the base year is given a weight of 100 percent. 2. The second step is to express each item in the financial statements for following years as a percentage of its base-year amount. This computation consists of dividing an item such as sales in the years after the base year by the amount of sales in the base year. 14-43 Trend Percentages Trend analysis is used to reveal patterns in data covering successive periods. Trend = Percentages Analysis Period Amount Base Period Amount × 100% 14-44 Component Percentages Examine the relative size of each item in the financial statements by computing component (or common-sized) percentages. Component Percentage = Analysis Amount Base Amount Financial Statement Balance Sheet Income Statement × 100% Base Amount Total Assets Revenues 14-45 Component Percentages Income Statement 14-46 Quality of Earnings Investors are interest in companies that demonstrate an ability to earn income at a growing rate each year. Stability of earnings growth helps investors predict future prospects for the company. Financial analyst often speak of the “quality of earnings” at one company being higher than another company in the same industry. 14-47 Quality of Assets and the Relative Amount of Debt While satisfactory earnings may be a good indicator of a company’s ability to pay its debts and dividends, we must also consider the composition of assets, their condition and liquidity, the timing of repayment of liabilities, and the total amount of debt outstanding 14-48 A Classified Balance Sheet COMPUTER CITY Asset Section: Classified Balance Sheet December 31, 20152024 Current assets: Cash Marketable Securities Notes Receivable Accounts Receivable Inventory Prepaid Expenses Total current assets Plant and equipment: Land Building $ Less: Accumulated depreciation Equipment and Fixtures Less: Accumulated depreciation Total plant and equipment Other assets: Land held as a future building site Total assets $ 30,000 11,000 5,000 60,000 70,000 4,000 180,000 $ 151,000 120,000 (9,000) 45,000 (27,000) 111,000 18,000 280,000 $ 170,000 630,000 14-49 Your Turn: Financial Analyst Assume that you are a financial analyst and that two of your clients are requesting your advice on certain companies as potential investments. Both clients are interested in purchasing common stock. One is primarily interested in the dividends to be received from the investment. The second is primarily interested in the growth of the market value of the stock. What information would you advise your clients to focus on in their respective analyses? 14-50 End of Chapter 14 14-51
