Copyright © 2012 The McGraw-Hill Companies, Inc.

PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

McGraw-Hill/Irwin

Financial Statement Financial Statement AnalysisAnalysis

Chapter 14

14-2

Resultsin standardized,

m eaningfulsubtotals.

Item s w ith certaincharacteristics aregrouped together.

C lass ifiedF in an c ial

S ta tem en ts

Helps identifysignificant

changes andtrends.

Am ounts fromseveral years

appear side by side.

C o m p ara tiveF in an c ial

S ta tem en ts

Presented as ifthe two companies

are a singlebusiness unit.

Inform ation for theparent and subsidiary

are presented.

C o nso lida tedF in an c ial

S ta tem en ts

Financial Statements Are Financial Statements Are Designed for AnalysisDesigned for Analysis

14-3

Dollar & Percentage

Changes

Trend Percentages

Component Percentages Ratios

Tools of AnalysisTools of Analysis

14-4

Dollar and Percentage Dollar and Percentage ChangesChanges

Dollar Change:

Analysis Period Amount

Base PeriodAmount

DollarChange = –

Percentage Change:

Dollar Change Base PeriodAmount

PercentChange = ÷

14-5

Dollar and Percentage Dollar and Percentage ChangesChanges

Sales and earningsshould increase at

more than the rateof inflation.

In measuring quarterlychanges, compare tothe same quarter inthe previous year.

Percentages may bemisleading when the

base amount is small.

Evaluating Percentage Changes in Sales and Earnings

14-6

Clover, Inc.Comparative Balance Sheets

December 31,

2011 2010 Dollar ChangePercent Change*

AssetsCurrent assets: Cash and equivalents 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: 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$ * Percent rounded to one decimal point.

$12,000 – $23,500 = $(11,500)$12,000 – $23,500 = $(11,500)

14-7

Clover, Inc.Comparative Balance Sheets

December 31,

2011 2010 Dollar ChangePercent Change*

AssetsCurrent assets: Cash and equivalents 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: 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$ * Percent rounded to one decimal point.

($11,500 ÷ $23,500) × 100% = 48.94%($11,500 ÷ $23,500) × 100% = 48.94%

Complete the analysis for

the other assets.

Complete the analysis for

the other assets.

14-8

Clover, Inc.Comparative Balance Sheets

December 31,

2011 2010 Dollar ChangePercent Change*

AssetsCurrent assets: Cash and equivalents 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%* Percent rounded to one decimal point.

14-9

Trend PercentagesTrend Percentages

Trend analysis is used to reveal patterns in data covering successive periods.

Trend analysis is used to reveal patterns in data covering successive periods.

TrendPercentages

Analysis Period Amount Base Period Amount

100%= ×

14-10

Berry ProductsIncome Information

For the Years Ended December 31,

Item 2011 2010 2009 2008 2007Revenues 400,000$ 355,000$ 320,000$ 290,000$ 275,000$ Cost of sales 285,000 250,000 225,000 198,000 190,000 Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2011 2010 2009 2008 2007Revenues 145% 129% 116% 105% 100%Cost of sales 150% 132% 118% 104% 100%Gross profit 135% 124% 112% 108% 100%

(290,000 275,000) 100% = 105%(198,000 190,000) 100% = 104%(92,000 85,000) 100% = 108%

Trend PercentagesTrend Percentages

14-11

Component PercentagesComponent PercentagesExamine the relative size of each item in the financial statements by computing component

(or common-sized) percentages.

Component Percentage

100%Analysis Amount

Base Amount= ×

Financial Statement Base Amount

Balance Sheet Total Assets

Income Statement Revenues

Financial Statement Base Amount

Balance Sheet Total Assets

Income Statement Revenues

14-12

Clover, inc.Comparative Balance Sheets

December 31, Common-size

Percents*2011 2010 2011 2010

AssetsCurrent assets: Cash and equivalents 12,000$ 23,500$ 3.8% 8.1% 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$ 100.0% 100.0%* Percent rounded to first decimal point.

Complete the common-size analysis for the other assets.

($12,000 ÷ $315,000) × 100% = 3.8%($12,000 ÷ $315,000) × 100% = 3.8%

($23,500 ÷ $289,700) × 100% = 8.1%($23,500 ÷ $289,700) × 100% = 8.1%

14-13

Clover, Inc.Comparative Balance Sheets

December 31,

Common-size

Percents*2011 2010 2011 2010

AssetsCurrent assets: Cash and equivalents 12,000$ 23,500$ 3.8% 8.1% Accounts receivable, net 60,000 40,000 19.0% 13.8% Inventory 80,000 100,000 25.4% 34.6% Prepaid expenses 3,000 1,200 1.0% 0.4% Total current assets 155,000$ 164,700$ 49.2% 56.9%Property and equipment: Land 40,000 40,000 12.7% 13.8% Buildings and equipment, net 120,000 85,000 38.1% 29.3% Total property and equipment 160,000$ 125,000$ 50.8% 43.1%Total assets 315,000$ 289,700$ 100.0% 100.0%* Percent rounded to first decimal point.

14-14

Clover, Inc.Comparative Income Statements

For the Years Ended December 31,Common-size

Percents*2011 2010 2011 2010

Revenues 520,000$ 480,000$ 100.0% 100.0%Costs and expenses: Cost of sales 360,000 315,000 69.2% 65.6% Selling and admin. 128,600 126,000 24.7% 26.3% Interest expense 6,400 7,000 1.2% 1.5%Income before taxes 25,000$ 32,000$ 4.8% 6.7%Income taxes (30%) 7,500 9,600 1.4% 2.0%Net income 17,500$ 22,400$ 3.4% 4.7%Net income per share 0.79$ 1.01$ Avg. # common shares 22,200 22,200 * Rounded to first decimal point.

14-15

Quality of EarningsQuality 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.

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.

Financial analyst often speak of the “quality of earnings” at one company being higher than

another company in the same industry.

14-16

Quality of Assets and the Quality of Assets and the Relative Amount of DebtRelative 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

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

14-17

A Classified Balance SheetA Classified Balance Sheet

Current assets: Cash 30,000$ Notes receivable 16,000 Accounts receivable 60,000 Inventory 70,000 Prepaid expenses 4,000 Total current assets 180,000 Plant and equipment: Land 150,000$ Building 121,000$ Less: Accumulated depreciation (10,000) 111,000 Equipment and Fixtures 46,000 Less: Accumulated depreciation (27,000) 19,000 Total plant and equipment 280,000 Other assets: Patents 170,000 Total assets 630,000$

Matrix, Inc.Asset Section: Classified Balance Sheet

December 31, 2011

14-18

Past performance topresent perform ance.

O ther com panies toyour com pany.

Along w ith dollar and percentage changes,trend percentages, and com ponent percentages,

ratios can be used to compare:

A ratio is a sim ple m athematical expressionof the relationship betw een one item and another.

RatiosRatios

14-19

Use this information to calculate the liquidity ratios for Babson Builders.

Babson Builders, Inc.2011

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 15,000 Total current assets 65,000 Total current liabilities 42,000 Total liabilities 103,917 Total assets Beginning of year 300,000 End of year 346,390 Revenues 494,000

14-20

Working capital is the excess of current assets over current liabilities.

Working capital is the excess of current assets over current liabilities.

Working CapitalWorking Capital

12/31/11

Current assets 65,000$

Current liabilities (42,000)

Working capital 23,000$

14-21

CurrentRatio

Current Assets Current Liabilities

=

= 1.55 : 1

This ratio measures the short-term debt-paying ability of the company.

This ratio measures the short-term debt-paying ability of the company.

Current RatioCurrent Ratio

CurrentRatio

$65,000

$42,000

=

14-22

Quick assets are cash, marketable securities, and receivables.

Quick assets are cash, marketable securities, and receivables.

This ratio is like the currentratio but excludes current assets such as inventories that may be

difficult to quickly convert into cash.

This ratio is like the currentratio but excludes current assets such as inventories that may be

difficult to quickly convert into cash.

Quick AssetsCurrent Liabilities

=QuickRatio

Quick RatioQuick Ratio

14-23

Quick RatioQuick Ratio

$50,000 $42,000

= 1.19 : 1=QuickRatio

Quick AssetsCurrent Liabilities

=QuickRatio

14-24

Ratios help usersunderstand

financial re lationships.

Ratios provide forquick com parison

of companies.

U ses

M anagem ent may enterinto transactions m erely

to im prove the ratios.

Ratios do not help w ithanalysis of the company's

progress tow ardnonfinancial goals.

Lim itations

Uses and Limitations of Uses and Limitations of Financial RatiosFinancial Ratios

14-25

An income statement can be prepared in either a multiple-step or single-step format.

An income statement can be prepared in either a multiple-step or single-step format.

The single-step formatis simpler. The multiple-step

format provides more detailed information.

The single-step formatis simpler. The multiple-step

format provides more detailed information.

Measures of ProfitabilityMeasures of Profitability

14-26

Proper Heading

Gross Margin

Operating Expenses

Non-operating Items

Remember to compute

EPS.

Remember to compute

EPS.

Income Statement Income Statement (Multiple-Step)(Multiple-Step)

14-27

Babson Builders, Inc.Income Statement

For the Year Ended 12/31/11

Revenues and gains: Sales, net 785,250$ Interest income 62,187 Gain on sale of plant assets 24,600 Total revenues and gains 872,037$

Expenses and losses: Cost of goods sold 351,800$ Selling Expenses 197,350 General and Admin. Exp. 78,500 Depreciation 17,500 Interest 27,000 Income taxes 62,500 Loss: sale of investment 9,000 Total expenses & losses 743,650 Operating income 128,387$

Proper Heading

Expenses& Losses

Revenues & Gains

Income Statement (Single-Income Statement (Single-Step)Step)

Remember to compute

EPS.

Remember to compute

EPS.

14-28

Use this information to calculate the profitability ratios for Babson Builders, Inc.

Babson Builders, Inc.

2011

Ending market price per share 15.25$

Number of common shares outstanding all of 2007 27,400 Net income 53,690$ Total 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

14-29

Earning Per ShareEarning Per Share

Net IncomeAverage Shares of Capital Stock Outstanding

= EPS

Look back at the information from Babson and get the Look back at the information from Babson and get the values we need to calculate earning per share.values we need to calculate earning per share.

Look back at the information from Babson and get the Look back at the information from Babson and get the values we need to calculate earning per share.values we need to calculate earning per share.

$53,690$53,69027,40027,400 = $1.96= $1.96

14-30

Price-Earnings RatioPrice-Earnings Ratio

Current Market Price of one Share of StockEarnings Per Share

= P/E

$15.25$15.25$1.96$1.96 = 7.78= 7.78

The measure shows us the relationship between earning of the company and the market price of its stock.

The measure shows us the relationship between earning of the company and the market price of its stock.

14-31

This ratio is a good measure of the efficiency of utilization of

assets by the business.

This ratio is a good measure of the efficiency of utilization of

assets by the business.

Return On Investment Return On Investment (ROI)(ROI)

Annual return (profit) from an investment

Average amount investedROI =

14-32

This ratio is generally consideredThis ratio is generally consideredthe best overall measure of athe best overall measure of a

company’s profitability.company’s profitability.

This ratio is generally consideredThis ratio is generally consideredthe best overall measure of athe best overall measure of a

company’s profitability.company’s profitability.

Return On Assets (ROA)Return On Assets (ROA)

14-33

This measure indicates how well the company employed the owners’

investments to earn income.

This measure indicates how well the company employed the owners’

investments to earn income.

Return On Equity (ROE)Return On Equity (ROE)

14-34

Dividend YieldDividend Yield

This ratio identifies the return, in terms of cash dividends, on the

current market price of the stock.

This ratio identifies the return, in terms of cash dividends, on the

current market price of the stock.

DividendYield Ratio

Dividends Per Share Market Price Per Share

=

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.

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.

14-35

DividendYield Ratio

$1.50 $15.25

= = 9.84%9.84%

Dividend YieldDividend Yield

This ratio identifies the return, in terms of cash dividends, on the

current market price of the stock.

This ratio identifies the return, in terms of cash dividends, on the

current market price of the stock.

DividendYield Ratio

Dividends Per Share Market Price Per Share

=

14-36

Analysis by Long-Term Analysis by Long-Term CreditorsCreditors Use this information to calculate ratios to measure the well-being of the long-

term creditors for Babson Builders.

Babson Builders, Inc.

2011Earnings before interest expense and income taxes 84,000$

Interest expense 7,300

Total assets 346,390

Total stockholders' equity 234,390

Total liabilities 112,000

This is also referred to as net operating

income.

This is also referred to as net operating

income.

14-37

Interest Coverage RatioInterest Coverage Ratio

This is the most common measure of the ability of a firm’s operations to provide protection

to the long-term creditor.

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

Operating income before Interest and Income Taxes

Annual Interest Expense

=

Times Interest Earned

$84,0007,300

= = 11.5 times

14-38

Debt Ratio

=Total

Liabilities ÷ Total Assets

= $112,000 ÷ $346,390 = 32.33%

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.

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 RatioDebt Ratio

Debt Ratio

=Total

Liabilities ÷ Total Assets

= $112,000 ÷ $346,390 = 32.33%

14-39

Analysis by Short-Term Analysis by Short-Term CreditorsCreditors

Use this information to

calculate ratios to measure the

well-being of the short-term creditors for

Babson Builders, Inc.

Babson Builders, Inc.

2011

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

Sales on account 500,000

Cost of goods sold 140,000

14-40

Accounts Receivable Accounts Receivable Turnover RateTurnover Rate

This ratio measures how many times a company converts its

receivables into cash each year.

This ratio measures how many times a company converts its

receivables into cash each year.

Net SalesAverage Accounts Receivable

Accounts ReceivableTurnover

=

= 27.03 times $500,000

($17,000 + $20,000) ÷ 2

Accounts ReceivableTurnover

=

14-41

Inventory Turnover RateInventory Turnover Rate

This ratio measures the number of times merchandise inventory is sold and replaced

during the year.

This ratio measures the number of times merchandise inventory is sold and replaced

during the year.

Cost of Goods SoldAverage Inventory

InventoryTurnover

=

= 12.73 times$140,000

($10,000 + $12,000) ÷ 2InventoryTurnover

=

14-42

Operating CycleOperating Cycle

Cash

InventoryAccounts

Receivable

1. Purchase of Merchandise

2. Sale of merchandise on account

3. C

olle

ctio

n of

acco

unts

rece

ivabl

e

14-43

End of Chapter 14End of Chapter 14