Chapter TitlePowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA
McGraw-Hill/Irwin
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What are performances? Performances for whom?
Which method to use?
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Compare advantages and disadvantages of each method and recognize their usefulness and limitations.
Focus on the ratio analysis and Du Pont model.
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Tools of Analysis
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Evaluating Percentage Changes in Sales and Earnings
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$12,000 – $23,500 = $(11,500)
Here are the comparative balance sheets of Clover Incorporated. Let’s begin the horizontal analysis by calculating the dollar change and the percentage change in account balances.
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Complete the analysis for the other assets.
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Trend Percentages
Trend analysis is used to reveal patterns in data covering successive periods.
Trend
Percentages
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Trend Percentages
This slide shows income information for Berry Products for the years 2007 through 2011. Let’s analyze this information using trend percentages.
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Component Percentages
Examine the relative size of each item in the financial statements by computing component
(or common-sized) percentages.
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Component percentages express all items on a financial statement in terms of one component of that statement. For the balance sheet, items are generally expressed as a percent of total assets. For the income statement, items are normally expressed as a percentage of total revenues.
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($12,000 ÷ $315,000) × 100% = 3.8%
($23,500 ÷ $289,700) × 100% = 8.1%
This slide shows the asset section of Clover Incorporated’s comparative balance sheets. All line-items on this financial statement should be expressed in terms of total assets. Total assets are equal to 100%.
Let’s calculate the percentage of total assets made up of cash and cash equivalents. Divide the total cash and cash equivalents for 2009 by the total assets for 2009, and multiply the result by 100%. At the end of 2009, cash and cash equivalents make up 3.8% of total assets. The same measure shows the percentage for 2008 to be 8.1%.
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Common-size Percents*
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Let’s go back to the comparative income statements of Clover Incorporated and complete our component calculations.
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Common-size Percents*
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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.
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Quality of Assets and the Relative Amount of Debt
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A Classified Balance Sheet
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December 31, 2011
$ 630,000
Sheet2
Sheet3
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Ratios
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Liquidity
Solvency
Efficiency
Profitability
budget
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Category of Ratios Used
1. How liquid is the firm? Will it be able to pay its bills as they become due?
Liquidity ratios
2. How has the firm financed the purchase of its assets?
Capital structure ratios
3. How efficient has the firm’s management been in utilizing it assets to generate sales?
Asset management efficiency ratios
4. Has the firm earned adequate returns on its investments?
Profitability ratios
5. Are the firm’s managers creating value for shareholders?
Market value ratios
Liquidity Ratios
Liquidity ratios address a basic question: How liquid is the firm?
A firm is financially liquid if it is able to pay its bills on time.
In order to be liquid it has to have enough cash and cash-alike assets.
Does the net income tells us about the liquidity?
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Use this information to calculate the liquidity ratios for Babson Builders.
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Working capital is the excess of current assets over current liabilities.
Working Capital
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This ratio measures the short-term debt-paying ability of the company.
Current Ratio
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Perhaps the most significant measure of a company’s ability to pay current obligations is the current ratio. It is merely current assets divided by current liabilities.
At Babson, the current ratio is 1.55 to 1. This means that for every dollar of current liability that falls due, $1.55 is available to pay that obligation.
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This ratio is like the current
ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash.
Quick Ratio
Quick Assets
Current Liabilities
Quick
Ratio
The quick ratio is a more stringent measure than the current ratio. Calculate the quick ratio by dividing quick assets by current liabilities. Quick assets include cash, marketable securities, current accounts, and notes receivable. Review the given information for Babson and you will see that they have quick assets of cash and accounts receivable.
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Quick
Ratio
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An income statement can be prepared in either a multiple-step or single-step format.
The single-step format
Measures of Profitability
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Income Statement (Multiple-Step)
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Sales, net
Remember to compute EPS.
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Revenues and gains:
24,600
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Use this information to calculate the profitability ratios for Babson Builders, Inc.
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$ 15.25
27,400
17,000
Earning Per Share
Look back at the information from Babson and get the values we need to calculate earning per share.
$53,690
27,400
= $1.96
= EPS
Earnings per share is perhaps the most widely quotes financial statistic in the business world. We calculate earnings per share by dividing net income by the average number of capital shares outstanding during the period. Go back to the previous screen and get the information you will need to calculate earnings per share for Babson.
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Price-Earnings Ratio
The measure shows us the relationship between earning of the company and the market price of its stock.
Current Market Price of one Share of Stock
Earnings Per Share
= P/E
$15.25
$1.96
= 7.78
We calculate the price-earnings ratio by dividing the current market price of one share of the company’s capital stock by earning per share. The measure shows us the relationship between earning of the company and the market price of its stock.
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When do we say that the value is created/destroyed?
- Managers versus owners
Which resources create value?
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This ratio is a good measure of the efficiency of utilization of assets by the business.
Return On Investment (ROI)
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Average amount invested
the best overall measure of a
company’s profitability.
Return On Assets (ROA)
The ratio to determine the return a company earns on its total assets is calculated by dividing operating income by the average total assets for the period. Gather the information necessary to calculate Babson’s return on assets.
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This measure indicates how well the company employed the owners’ investments to earn income.
Return On Equity (ROE)
Return on equity measures how well the company employed the owners’ investments to earn income. This ratio is calculated as net income divided by average total stockholders’ equity.
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How the difference between ROA and ROE can be explained?
Calculate other ratios if needed to support your answer.
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Dividend Yield
This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
Dividend
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Babson Builders pays an annual dividend of $1.50 per share of capital stock. The market price of the company’s capital stock was $15.25 at the end of 2011.
To determine the dividend yield we divide the dividends per share by the closing market price per share of the company’s common stock.
At Babson the dividend yield is 9.84%. If we purchase the stock today for $15.25 per share and receive an annual dividend of $1.50, we will earn a return of 9.84% on our investment.
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Dividend Yield
This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
Dividend
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At Babson the dividend yield is 9.84%. If we purchase the stock today for $15.25 per share and receive an annual dividend of $1.50, we will earn a return of 9.84% on our investment.
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Analysis by Long-Term Creditors
Use this information to calculate ratios to measure the well-being of the long-term creditors for Babson Builders.
This is also referred to as net operating income.
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$ 84,000
$ 220,000
Interest Coverage Ratio
This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor.
Times Interest Earned
11.5 times
As a long-term creditor you would be particularly interested in the ability of a company meet periodic interest payments. Interest coverage ratio is important to long-term creditors. The ratio is calculated by dividing earnings before interest and taxes by interest expense for the period.
At Babson Builders interest was earned 11.5 times during the year.
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A measure of creditor’s long-term risk.
The smaller the percentage of assets that are financed by debt, the smaller the risk for creditors.
Debt Ratio
The debt ratio is determined by dividing a company’s total liabilities by its total assets.
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Analysis by Short-Term Creditors
Use this information to calculate ratios to measure the well-being of the short-term creditors for Babson Builders, Inc.
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Accounts Receivable Turnover Rate
This ratio measures how many times a company converts its receivables into cash each year.
Net Sales
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Inventory Turnover Rate
This ratio measures the number of times merchandise inventory is sold and replaced during the year.
Cost of Goods Sold
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Like receivables turnover we can also calculate the inventory turnover. Inventory turnover is calculated by dividing cost of goods sold for the period by the average inventory.
At Babson Builders inventory turnover is 12.73 times. So, inventory is turned-over about 13 times per year.
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3. Collection of
accounts receivable
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Uses and Limitations of Financial Ratios
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328.bin
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Exercises
 
 
144. Improving the current ratio
Carter Corporation financed construction of a new addition to its facilities with a large long-term note payable. As a condition of obtaining the loan, Carter agreed to maintain a current ratio at year-end of at least 1.7 to 1. If Carter fails to maintain this ratio, the lender may demand immediate repayment of the principal amount of the note and all unpaid accrued interest. As the end of the year approaches, Carter is concerned about the magnitude of its current ratio. Suggest some actions that the company might take to increase the magnitude of the current ratio. 
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Problems
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Accounts receivable, net60,000 40,000
Total assets315,000$ 289,700$
Clover, Inc.
Accounts receivable, net60,000 40,000
Total assets315,000$ 289,700$
Clover, Inc.
Inventory80,000 100,000 (20,000) -20.0%
Total current assets155,000$ 164,700$ (9,700) -5.9%
Property and equipment:
Land40,000 40,000 - 0.0%
Total assets315,000$ 289,700$ 25,300$ 8.7%
* Percent rounded to one decimal point.
Item20112010200920082007
Cost of sales285,000 250,000 225,000 198,000 190,000
Gross profit115,000 105,000 95,000 92,000 85,000
Item20112010200920082007
Cost of sales150%132%118%104%100%
Gross profit135%124%112%108%100%
(290,000
Accounts receivable, net60,000 40,000
* Percent rounded to first decimal point.
Complete the common-size analysis for the other
assets.
Inventory80,000 100,000 25.4%34.6%
Total current assets155,000$ 164,700$ 49.2%56.9%
Property and equipment:
Total assets315,000$ 289,700$ 100.0%100.0%
* Percent rounded to first decimal point.
Clover, Inc.
Common-size
Percents*
2011201020112010
Interest expense6,400 7,000 1.2%1.5%
Income before taxes25,000$ 32,000$ 4.8%6.7%
Income taxes (30%)7,500 9,600 1.4%2.0%
Net income17,500$ 22,400$ 3.4%4.7%
Net income per share0.79$ 1.01$
Avg. # common shares22,200 22,200
Current assets:
December 31, 2011
Past performance to
trend percentages, and component percentages,
ratios can be used to compare:
A ratio is a simple mathematical expression
of the relationship between one item and another.
Babson Builders, Inc.
Sales, net785.250$
Revenues and gains:
Total revenues and gains872,037$
Number of common shares
Net income53,690$
Average amount invested
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analysis of the company's