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Chapter 15 Financial Statement Analysis

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Chapter 15Financial

Statement Analysis

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Learning Objectives

1. Explain how financial statements are used to analyze a business

2. Perform a horizontal analysis of financial statements

3. Perform a vertical analysis of financial statements

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Learning Objectives

4. Compute and evaluate the standard financial ratios

5. Complete a corporate income statement including earnings per share (Appendix 15A)

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Learning Objective 1

Explain how financial statements are used to analyze a business

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How Are Financial Statements Used to Analyze a Business?

• To determine the financial performance of a company, we compare its performance in the following ways:– From year to year– With a competing company– With the same industry as a whole

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Tools of Analysis

• There are three main ways to analyze financial statements:– Horizontal analysis provides a year-to-year

comparison of a company’s performance in different periods.

– Vertical analysis provides a way to compare different companies.

– Ratio analysis can be used to provide information about a company’s performance.

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Corporate Financial Reports

• Corporate financial reports include: – Annual reports– Management’s discussion and analysis of

financial conditions and results of operations (MD&A)

– Report of the independent auditors– Financial statements– Notes to financial statements

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Learning Objective 2

Perform a horizontal analysis of financial statements

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How Do We Use Horizontal Analysis to Analyze a Business?

• Many decisions hinge on whether the numbers are increasing or decreasing.

• Sales may have increased, but considered in isolation, this fact is not very helpful.

• Horizontal analysis is the study of percentage changes in comparative financial statements.

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How Do We Use Horizontal Analysis to Analyze a Business?

• Assume Smart Touch Learning has net sales of $858,000 in 2018 and $803,000 in 2017. Prepare the horizontal analysis:Step 1: Compute the dollar amount of change in sales from 2017-2018

Step 2: Divide the dollar amount of change by the base period amount and multiply by 100. This computes the percentage change for the period:

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Horizontal Analysis of the Income Statement

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Horizontal Analysis of the Balance Sheet

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Horizontal Analysis of the Balance Sheet

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Trend Analysis

• Trend analysis is a form of horizontal analysis.

• Trend percentages indicate the direction a business is taking.

• The formula for trend analysis is as follows:

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Trend Analysis

• Smart Touch Learning’s net sales were $750,000 for 2014 and rose to $858,000 in 2018. The base year is 2014, so that year’s percentage is set equal to 100.

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Learning Objective 3

Perform a vertical analysis of financial statements

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How Do We Use Vertical Analysis to Analyze a Business?

• Vertical analysis of a financial statement shows the relationship of each item to its base amount, the 100% figure.

• Every other item on the statement is then reported as a percentage of that base.

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Vertical Analysis of the Income Statement

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Vertical Analysis of the Balance Sheet

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Vertical Analysis of the Balance Sheet

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Common-Size Statements

• To compare one company to another company, we can use a common-size statement.

• A common-size statement reports only percentages.

• By reporting only percentages, it removes dollar value bias we see when comparing numbers in absolute terms (dollars).

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Common-Size Statements

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Benchmarking

• Benchmarking is the practice of comparing a company with other leading companies.

• There are two main types of benchmarking: – Benchmarking against a key competitor– Benchmarking against the industry average

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Benchmarking

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Learning Objective 4

Compute and evaluate the standard financial ratios

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How Do We Use Ratios to Analyze a Business?

• Different ratios explain different aspects of a company.

• Ratios are used for the following purposes:– Evaluating the ability to pay current

liabilities and long-term debit– Evaluating the ability to sell merchandise

inventory and collect receivables– Evaluating profitability– Evaluating stock as an investment

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How Do We Use Ratios

to Analyze a Business?

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How Do We Use Ratios

to Analyze a Business?

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Evaluating the Ability to Pay Current Liabilities

• Working capital measures the ability to meet short-term obligations with current assets. Working capital is defined as follows:

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Current Ratio

• The most widely used ratio is the current ratio. This ratio measures a company’s ability to pay its current liabilities with its current assets.

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Cash Ratio

• The cash ratio helps determine a company’s ability to meet its short-term obligations.

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Acid-Test (or Quick) Ratio

• The acid-test ratio (sometimes called the quick ratio) tells us whether a company can pay all its current liabilities if they come due immediately.

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Evaluating the Ability to Sell Merchandise Inventory and Collect Receivables

• Five ratios that measure a company’s ability to sell merchandise inventory and collect receivables are:– Inventory turnover– Days’ sales in inventory– Gross profit percentage– Accounts receivable turnover ratio– Days’ sales in receivables

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Inventory Turnover

• The inventory turnover ratio measures the number of times a company sells its average level of merchandise inventory during a year.

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Days’ Sales in Inventory

• Days’ sales in inventory measures the average number of days merchandise inventory is held by the company.

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Gross Profit Percentage

• The gross profit percentage measures the profitability of each net sales dollar above the cost of goods sold.

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Accounts Receivable Turnover Ratio

• The accounts receivable turnover ratio measures the number of times the company collects the average receivables balance in a year.

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Days’ Sales in Receivables

• Days’ sales in receivables indicates how many days it takes to collect the average level of receivables.

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Evaluating the Ability to Pay Long-Term Debt

• Most businesses have long-term debt. • Three key indicators of a business’s ability

to pay long-term liabilities are the: – Debt ratio– Debt to equity ratio– Times-interest-earned ratio

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Debt Ratio

• The debt ratio shows the proportion of assets financed with debt and is calculated by dividing total liabilities by total assets.

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Debt to Equity Ratio

• The debt to equity ratio shows the proportion of total liabilities relative to total equity.

• This ratio measures financial leverage.

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Times-Interest-Earned Ratio

• The times-interest-earned ratio evaluates a business’s ability to pay interest expense. This ratio is also called the interest coverage ratio.

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Evaluating Profitability

• Five ratios used to evaluate a company’s profitability are:– Profit margin ratio– Rate of return on total assets– Asset turnover ratio– Rate of return on common stockholders’ equity– Earnings per share

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Profit Margin Ratio

• The profit margin ratio shows how much net income a business earns on every $1 of sales.

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Rate of Return on Total Assets

• The rate of return on total assets measures a company’s success in using assets to earn a profit.

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Asset Turnover Ratio

• The asset turnover ratio measures the amount of net sales generated for each average dollar of total assets invested.

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Rate of Return on Common Stockholders’ Equity

• The rate of return on common stockholders’ equity shows how much income is earned for each $1 invested by the common shareholders.

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Rate of Return on Common Stockholders’ Equity

• When a company has a higher rate of return on stockholders’ equity than its rate of return on total assets, this is called trading on the equity.

• Trading on the equity is earning more income on borrowed money than the related interest expense, thereby increasing the earnings for the owners of the business.

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Earnings per Share (EPS)

• The earnings per share (EPS) reports the amount of net income (loss) for each share of the company’s outstanding common stock.

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Evaluating Stock as an Investment

• Investors purchase stock to earn a return on their investment.

• This return consists of two parts: – Gains (or losses) from selling the stock at a

price above (or below) purchase price– Dividends

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Price/Earnings Ratio

• The price/earnings ratio is the ratio of the market price of a share of common stock to the company’s earnings per share.

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Dividend Yield

• The dividend yield measures the percentage of a stock’s market value that is returned annually as dividends to shareholders.

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Dividend Payout

• The dividend payout measures the percentage of earnings paid annually to common shareholders as cash dividends.

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Red Flags in Financial Statement Analysis

• Analysts look for red flags in financial statements that may signal financial trouble. Examples: – Movement of sales, merchandise inventory,

and receivables– Earnings problems– Decreased cash flow– Too much debt– Inability to collect receivables – Buildup of merchandise inventories

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Summary of Ratios Used in Financial Statement Analysis

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Summary of Ratios Used in Financial Statement Analysis

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Summary of Ratios used in Financial Statement Analysis

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Summary of Ratios Used in Financial Statement Analysis

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Learning Objective 5

Complete a corporate income statement including earnings per share (Appendix 15A)

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How Is the Complete Corporate Income Statement Prepared?

• A corporation’s income statement reports income from continuing operations to help investors make predications about future earnings.

• The income statement also includes unique items, such as:– Discontinued operations– Extraordinary items

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How Is the Complete Corporate

Income Statement Prepared?

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Discontinued Operations

• Most corporations engage in several lines of business.

• A company may sell a segment of its business. This is reported as a discontinued operation.

• Discontinued operations are reported immediately after income from continuing operations.

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Extraordinary Items

• Extraordinary gains and losses, called extraordinary items, are both:– Unusual– Infrequent

• GAAP defines an event as infrequent if it is not expected to recur in the foreseeable future.

• These items are reported separately from continuing operations.

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