* copyright © 1999 by harcourt brace
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Copyright © 1999 by Harcourt Brace & Company. All rights reserved.
Chapter 13
Financial Statement Analysis
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Portions of this work were published in previous editions. Produced in the United States of America. 0-03-021353-3
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Stockholders
Financial Statement Analysis
Creditors
Management
Will I be paid?
How good is our investment? How are we
performing?
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Limitations of Financial Statement Analysis
Use of different accounting methods Changes in accounting methods
LIFO FIFO
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Limitations of Financial Statement Analysis
Failure to understand trends or use industry ratios
Difficulty of making industry comparisons (i.e. conglomerates)????
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Limitations of Financial Statement Analysis
Nonoperating items on income statement
Effects of inflation
=
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Horizontal Analysis
Net Sales
Earnings before factory closure
Net earnings
Increase (Decrease)
1996 1995 DollarsPercent
$1,836 $1,755 81 4.6%
243 224 19 8.5%
230 224 6 2.7%
Wm. Wrigley Jr. Company (in millions)
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Trend Analysis
Return onAvg. Equity
1996 1995 1994 19931992
27.2% 30.1% 36.5% 32.6%29.4%
Wm. Wrigley Jr. Company
Tracking items over a series of years
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Vertical Analysis
Common-size statements recast items as a percentage of a selected item
Allows comparisons of companies of different size
Compares percentages across years to identify trends
%
%
%
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Dollars %$60,000 100% 24,000 40 36,000 60 6,000 10 30,000 50 3,000 5 27,000 45 10,000 17$ 17,000 28%
Common-Size Statements
Sales revenueCost of goods sold Gross profitSelling & admin. exp. Operating incomeInterest expense Income before taxIncome tax expense Net income
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Analysis of Liquidity
Nearness to cash Ability to pay debts as they become due
Cash Ratios
TurnoverRatios
WorkingCapitalRatios
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Working Capital
Excess of current assets over current liabilities
Lacks meaningful comparisons for companies of different size
-
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Current Ratio
Measure of short-term financial health Consider composition of current assets
Rule of thumb2:1
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Acid-Test (Quick) Ratio
Stricter test of ability to pay debts Excludes inventories and prepaid assets
Quick AssetsCurrent Liabilities
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Cash Flow from Operations to Current Liabilities
Focuses on cash only Covers period of time
Net Cash Provided by Operating ActivitiesAverage Current Liabilities
A
FEDERAL RESERVE NOTE
THE UNITED STATES OF AMERICATHE UNITED STATES OF AMERICA
L70744629F
12
1212
12
L70744629F
ONE DOLLARONE DOLLAR
WASHINGTON, D.C.
THIS NOTE IS LEGAL TENDER
FOR ALL DEBTS, PUBLIC AND PRIVATE
SERIES
1985
H 293
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Accounts Receivable Turnover
Net Credit Sales
Average Accounts Receivable
Indicates how quickly a company is collecting (i.e.
turning over) its receivables
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Accounts Receivable Turnover
Too fast
credit policies too stringent; may be losing sales
Too slow
credit department not operating effectively; possible quality problems
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Days’ Sales in Receivables
Represents the average # of days accounts are outstanding
365 DaysAccts. Receivable Turnover
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 28 29 30 3127
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Days’ Sales in Receivables
If this company’s credit terms are net 30, what would this tell you about the efficiency
of the collection process?
365 Days5.6 Times
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 28 29 30 3127
= 65 days
Example:
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Inventory Turnover
Represents the number of times per period inventory is turned
over (i.e. sold).
Cost of Goods SoldAverage Inventory
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Inventory Turnover
Circuit City 4.3 times per yearSafeway 10.1 times per year
Can you compare the two ratios?
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# of Days’ Sales in Inventory
Represents the average # of days inventory is on hand before its sold
# of Days in PeriodInventory Turnover Ratio
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 28 29 30 3127
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# of Days’ Sales in Inventory
Circuit City 84 days
Safeway 36 days
Do these averages seem reasonable?
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 28 29 30 3127
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Cash Operating Cycle
Time between purchase of merchandise and collection from the sale
# of days sales in receivables +
# of days sales in inventory
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Analysis of Solvency
Ability to stay in business over the long-term
Debt-to-EquityRatio
DebtService
Coverage
TimesInterestEarned
Cash Flowto Capital
Expenditures
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Debt-to-Equity Ratio
Total liabilitiesTotal Stockholders’ Equity
How much have creditors
contributed compared to
owners?
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Debt-to-Equity Ratio
Total liabilitiesTotal Stockholders’ Equity = .60
For every dollar contributed by
owners, creditors have loaned $.60
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Times Interest Earned Ratio
Measures ability to meet current interest payments
The greater the coverage the better
Net Income + Interest Expense + Income Tax ExpenseInterest Expense
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Debt Service Coverage Ratio
Measures amount of cash from operations available to service the debt
Cash Flow from Operations before Interest & TaxesInterest and Principal Payments
P + i
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Cash Flow from Operations to Capital Expenditures Ratio
Measures company’s ability to use operations (vs. creditors and owners) to finance acquisitions of productive assets
Cash Flow from Operations - DividendsCash Paid for Capital Acquisitions
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Analysis of Profitability
Rate of Return on Assets Return on Common S/E EPS P/E Ratio Dividend Ratios
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Rate of Return on Assets
Measures return to all providers of capital (creditors and owners)
Net Income + Interest Expense, net of taxAverage Total Assets
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Return on Common Stockholders’ Equity
Net Income - Preferred DividendsAverage Common Stockholders’ Equity
The owners earned 15%on their investment
in ABC Co... Not bad!
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Earnings per Share
Presents profits on a per-share basis
Net Income - Preferred DividendsWtd. # of Common Shares Outstanding
Certificate of Stock
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Price-Earnings Ratio
Relates earnings to the market price of the stock
Current Market PriceEarnings per Share
very high P/Every low P/E
possibly overvaluedpossibly undervalued
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Price-Earnings Ratio
Both companies have earnings of $2 per share. So why the different P-E
ratios?
P-E Ratios
Co. A = 6 to 1Co. B = 8 to 1
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Dividend Payout Ratio
Common Dividends per ShareEarnings per Share
We need to decide what % of the firm’s income we can return to
owners.
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Dividend Yield Ratio
Investors willing to forgo dividends in lieu of price appreciation
Common Dividends per ShareMarket Price per Share
usually < 5%=
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