fel aryel<-tames] Financial Statement Analysis A recent issue of Forbes magazine listed Warren Buffett asthe richest person in the world His estimated wealth was $62 yy give oF take 3 few millon. How much is $62 bilion? if you invested $62 billon in an investment ezring just 48, you oul spend $6.8 milion per day—every day-—forever. So, how does Butfett spend his money? Basically, he doesn't! He stl vs in the same house that he purchased in Omaha, Nebraska, in 1958 for $31,500. He sil drives his own car (a Cadilac DTS), And, in case you believe that his kids are riding the road to Easy Street, think again. Buffett has committed to donate virtually al of his money to charity before he dis. How did Buffett amass ths wealth? Through careful investing. He applies the basic techniques he learned in the 19505 fem the great value investor Benjamin Graham. Buffett looks for companies that have good long-term potential but are currently underprced. He invests in companies that have low exposure to debt and that reinvest their earings for future growth. He des ‘not get caught up in fads or the latest trends. For exemple, Buffett sat out on the dot-com mania in the 1980s. When other investors put lots of money into fledgling high-tech firms, Buffett didn’t bite because the dot-com companies failed to meet his criteria. He didn't get to enjoy the stock price boom on the way up, but en the other hand, ne didn’t have to suffer the plummet back down to Earth. When the dot-com bubble burst, everyone else suffered from investment shock. Buffett swooped in and scooped up deals on companies that he had been following for years. In 2012, when the stock market reached near record highs, Buffett's returns significantly lagged behind the market, Only 26% of his investments at that time were in stock, and he was sitting on $38 billion in cash. One commentator noted that “ifthe pasts any guide, just when Buffett seems to look most lke a loser, the party is about to end.” Hf you think you went to follow Buffets example and transform your humble nest egg into @ mountain of caéh, be warned. He techniques have been widaly circulated and emulated, but never practiced with the same degree of success. You should probably stat by honing your financial analysis skills. A good way for you to begin your career as a successful investors to ‘master the fundamentals of financial analysis discussed inthis chapter. Source: ison ve Ble Out Sap,” Wal Set cual May 7.2012) LEARNING OBJECTIVES @ -pply horizontal and vertical analysis to financial statements. @) Apply the concept of sustainable income. @ Anaiyze a company’s performance using ratio analysis. :Apply horizontal and vertical analysi: ga @ nancial statements involves evaluating three characteristics: a com- fnancoltablity, and solvency. A short-terym creditor sxch oo sasnily interested in liquidity—the ability of the borrower to pay obi fe rey come due. The liquidity of the borrower is extremely import. 208 pctng the safety ofa loan. A long-term creditor, such as a bondholdes, sew oaluet piltyand solvency measures that indicate the company’ ability 6 10 Pa long period of time. Long-term creditors consider such measures Wikb- suance SHEET seontal analysis, we will use the nancial statenients of Alper illustrate hodeotee a Hctional retailer, Mlustration 18-5 presents & Big. Deparemne its ewo-year condensed balance sheets, showing dollar and changes marcas: Increase or (Decrease) Daring 2013 2013 2012. Amount Percent ets: $1,020,000 $945,000 $.75,000- 1.9% Plast assets (net) += 800,000 + © -1632,500. 167,800... 26.89% Berle sets 243,000 5°" 1173500. 2,500), 44.940) ‘Total assets $835,000 $1,585,000 $240,000 18.0% > -: wt . Saabilities Current liabilities $344,500 $ 303,000 $ 41,500 13.7% iong-term lsbilities 487,500. 497,000 _-(9,500) (1.9%) ‘Tota! liabilities 32,000 4.0% ‘Stockholders! Equity, 5 Fang ‘Common stock, $1 par (275,400, 270,000, ‘5,400 20% Rerained eyrmings, 727,600 __$25000 202,600 38.6% ‘Total etockholdérs'equity 1,003,000. _795,000 208,000 26.2% ‘Total lisbilities and Troctholdery equity $1,835,000 $1,595,000 $240,000 18.0% | The comparative balance sheets in Ulustration 18-5 show that a number of significant changes have occurred in Quality Department Store's financial struc- ‘ware from 2012 te 2013: tn tn shed gion lent assets (net) increased $167,500, or 26.5%: «In the liabilities section, current liabilities increased $41,500, or 13.7%. “in the stockholder’ equ seston retained earnings Increased $202,600, 5 OF 38.6%. ‘ } i ‘These changes sugyssttist the company expanded ite. asset base during 2013 and financed this expansion primatily by retaining tucome rather than assuming ‘additional long-term debt. s INCOME STATEMENT _ ‘ Ulustration 18-6 (page 628) presents a horizontal analysis of the two-year con- densed income statements of Quality Department Store Inc. for the years 2013 mad 2012; Horizontal analysis of the income statements shows the following. * Net sales increased $260,000, or 142% (260,000 ++ $1,837,000), * Cost of goods sold increased $141,000, or 12,4% ($141,000 > $1,140,000). * Total operating expenses increased $37,000, or 11.6% ($37,000 + $320,000).628 4B Financial Statement Analysis + income were up substantially. Gross prof, ind net Quality’s profit trend appears favors, ay. 26.5% ‘Overall, gross profit a 17.1%, and net income, antitinanea aman ance lustration 18-6 = eens zontal ana of ncome nei ane ere Increase or We : Dating 20°) 2013. 2012 _ Amount “5 sate sou Ssow Tismd Hssom BS Sales TEENS allowances 98,000» _123.000 8.000) pene, Zo97,000 "1,837,000 260,000, Cost of goods old 281,000 1,140,000» 141,009 He Gross profit 816,000 11900. 4 : sanag aoe 253,000 41500. ‘Administrative expenses 108,000 4500, Tosa operating expenses 357000 37,000 ge Income from operations 459,000 ae Otherrevenes and gaics Turest and dividends 9,000 iy ‘Other expenses and loses x Taterest expense 36.000 cing) Income before income taxes 432,000 Ht Income ix expense 2a Net income es RETAINED EARNINGS STATEMENT _, Mlustration 18-7 presents a horizontal analysis of Quality Departmen: Stas comparative retained earnings statements. Analyzed horizontally a xox increased $55,300, or 26.5%, whereas dividends on the common stock increased ‘only $1,200, or 2%, We saw in the horizontal analysis of the bakince shat tat ending retained earnings increased 38.6%. As indicated earlier, the company __ retained a significant portion of net income to finance additional pan ites ‘Mlustration 18-7 re rs Mecoal avterci ni enna eee aca sings sateen Poe ncat : Gaia a , Increase or Dee) = = __ During 2013 — 2013, 2012 ‘Amount Retained earnings, Jan. 1 $525,000 - $376,500. $148,500} ‘Add: Net incocme ae s0n. 6. a08bo rad . Z 788,800 585,000 ri Deduct: Dividends “61200 ogo 420 Retained earnings, Dec. 31 $727,600 $525,000 $202,600 pie vantfotal analysis of changes from period to period is rltv co Third and is quite useful. But, complications ean occur in making the OPE uel in tem has no value in a base year or preceding year but does has® *a Horizontal and Vertical Analysis 629 fon an income statement, we might sa selling expenses are 16% of net sales —net sales being the base some et e amount. BALANCE SHEET Mlustration 18-8 presents the vertical analysis of Quality Department Store Inc’s comparative balance sheets. The base for the asset items is total assets, The base for the liability and stockholders’ equity items is total liabilities and stockholders’ equity. ‘Mlustration 18-8 Verical analysis of balance sheets Crimes tutes atts 201 TAmowst Percent Assets Current assets $945,000 Plant assets (net) 632,500 Intangible assers 17,500 y ‘Total assets 1,56 Lisbilities ‘Current liabilities $ 344,500 $ 303,000 “19.0% | Long-terti abilities + _487;500 497,000. _31.2% Total ifabilities 832,000, 800,000 80.2% ‘Stockholders’ Equity ‘Common stock, $1 par 273,400 270,000 16.9% Retained earnings 727,500 % 525,000 _32.9% ‘Total stockholders’ equity 1,003,000 _$4.7% 795,000 49.8% Total liabilities and slockholderstequity “$1,835,000 100.0% $1,595,000 100.0% Vertical analysis shows the relative size of each category in the balance sheet. Italso can show the percentage change in the individual asset, liability, and stockholders’ equity items. For example, we can see that current assets decreased from 59.2% of total assets in 2012 to 55.6% in 2013 (even though the absolute dollar amount increased $75,000 in that time), Plant assets (net) have increased from 39.7% to 43.6% of total assets. Retained earnings have increased from - 32.99% to 39.7% of total liabilities and. stockholders’ equity. These results reinforce the earlier observations that Quality Department Store is choosing to finance fe vee through retention of earnings rather than through issuing addi- ional debt, INCOME STATEMENT Mlustration 18-9 (page 639) shows vertical analysis of Quality Department Sores income statements, Cost of goods sold as a percentage of net sales declineMustration 18-9 Vercal anal of icome statemes 30 $B Financial Statement Analys's Banca rrerrar “Amount es revere $2,195,000 . SEE atonaader "38.000 s Net sales > 72,097,000 ios Cost of goods sold [281,000 ime igh Seer 253,000 2009 Re selling expenses z ee ae Administrative expenses 104,000 ae Total operating expenses 357,000 cae an Income from operations 459,000 a Be Other revenues and gas Interest and dividends 9,000 0.48% ‘loge ‘other expenses and losses te, “ngerest expense 36,000 am none before income taxes. 432,000 Hie Income tax expense 168,200 _aso0y Netincome i280 - ase fae 5 = (62.1% vs. 61.19%), and total operating expenses declined 0:4% (17.486 1799, As a result, itis not surprising to see net income as a percentage of ns gg, increase from 11.4% to 12.6%. Quality Department Sioze appears to be apy, able business that is becoming even more successful. t "An associated benefit of vertical analysis is that it enables you to cana ‘companies of different sizes. For example, suppose Quality Department Son; main competitor is a Macys store in a vearby town. Using vertical analysis ye can compare the condensed income statements of Quality Department Siri, (@ small retail company) with Macy's, Inc.’ (@ giant international retale) as shown in Illustration 18-10. ene edeaneere ann —— $2,097 "100.0% §27,931,090 Coit oF sold ‘128% 611% 16,725,000 rss rt Wiis. sae | Sinem Se ES Stns eit emt trom _ gogo oman : Bere etoomaioen se asm 2765000 ulialeetncometas)” 9g oe yeaa ee ie Tem Exassom ~ 238 ire 2013 Annval Report‘ Macy, ne: (Cincinnati, Ohio,jay net sales are 13.220 times reat tan the ne cys artment Store. But vertical analysis eliminates this differece quality D Prcentages show that Quality’s and Macy's gross profit rates, were sist. THE Jp at 38.9% and 40.1%, respectively. However, the percentages related compare’, from operations were significantly different at 21.9% and.9,0%, to inceely. This disparity can be attributed to Quality’s selling and administra, respecthense percentage (179%) which is much lower than Macy's (30.2%), tie igh Macy's earned net income more than 5,629 times larger than Quality’, renet income &s a percentage of each sales dollar (5.3%) is only 42% of ain’: (12.6%). ales of relatively tiny LEARNING ‘OBJECTIVE Ratio analysis expresses the relationship among selected items of financial statement data, A ratio expresses the mathematical relationship between one quantity and another. The relationship is expres ied in terms of either a percentage, a rate, or a simple proportion. To illustrate, in, 2013 Nike, Inc. had current assets of $13,626 million and current liabilibies of $3,926 million. We can find the relationship between these two measures by dividing current assets by cur- rent lisbilities. The alternative means of expression are as follows. Percentage: Current assets are 347% of current liabilitie: Rater’ Current assets are 3.47 times current liabilities. Proportion: The relationship of current assets to liabilities is 3.47:1- To analyze the primary financial statements, we can use ratios to evalu- ate liquidity, profitability, and solvency. Illustration 18-11 describes these classifications. Liquidity Ratios Measure shore-term ability ‘of the company to pay its ‘maturing obligations and to ‘meat unexpécted needs for cash Profitability Ratios Measure the income or ‘operating success af a éeirizany for a given period of me Solvency Ratios Measure the ably of the tompany to survive ‘over a long period of time Ratios can provide clues to underlying conditions that may not be apparent satel financial statement components. However, a single ratio by itself ingful. i types of onrparian ‘hus, in the discussion of ratios we will use the following 1, by biivaend comparisons for two years for Quality Department Store. stores,” SVPARE Comparisons ‘based on median ratios for department e EO Rou Nn a tun cate aes Caer Ratio Analysis. 631 Illustration 18-11 Rrnancial ratio cassifications632. 4B Financial Statement Analysis a: Intercompany comparisons based on Macy's, tne, Department Store’ principal competitor. * Qay International Note amore contin aon, icra courting fanca esi edt to conpare companies om ateren coun should rove However nena rarer open to wie 8.0% ‘ ‘ 33% < Quality experienced an increase in its profit margin from 2012 to 2013. Its Profit margin is unusually high in comparison with the industry, average of 8% and Macy's 5.3%. High-volume (high inventory turnover) businesses, such as grocery stores (Safeway or Kroger) and discount stores (Kmart or Wal-Mart), generally experi- ence low profit margins. In contrast, low-volume businesses, such as jewelry ‘Stores (Tiffany & Co.) or airplane manufacturers (Boeing Co.), have high profit 6. ASSET TURNOVER Asset turnover measures how efficiently a company uses its assets to generate sales. It is determined by dividing net sales by average total assets. The result- ing number shaws the dollars of sales produced by each dollar invested in Assets, Unless seasonal factors are significant, we can-use the beginning and ending balance of total assets to determine average total assets. Assuming thatrent Analyt inanca! itio is often judged in the li, 10 8 ve adequacy of this ratio is often, inthe light of the com, ‘The adediy, companies with relatively stable earnings (sues payee SS fave higher debt to assets ratios than cyclical companies Pblc ui, ses) Ming earnings (such as many high-tech companies) th widely 43, TIMES INTEREST EARNED Interest earned provides an indication of the companys a Batt fimns a thy come due. Wecompate tae IY ong, Mmeemtcnmedls tee Rogerest expense, and income tax expense by interest expense te Teg ntrest tion 18:26 shows the 2013 and 2012 ratios for Quality Deeg sees Mage west 2013 comparative data, Note that times interest earned ween see Store ay {Income tax expense and interest expense: This represents the amano belo cover interes. For Quality Deparnnent Store, the 2013 amour nut Mila, taking net income of $263,800 and addigg back the $36,000 ces ODUed and the $168,200 of income tax expense. 00 of interest expe” 1028 ire Earned ancora = tnverest Expense + income Tax Expens, interest Expense — ‘Quality Department Sto; Bt te etm $263,800 + $36,000 + $168,200 201 | ee SEO — mes $2OESHO + OSLO SIH 90 | Tee 540,500 “oem 16.1 times Moos. tne i 2 ee ‘Quality interest expenss is well ; | id Covered at 134i isk nian bia i ines. Tis less thaa the indy we mes but significantly exceeds Macys 6 tre oo : Summary of Ratios Mestation 18-27 Mlustration 18-27 summarize i Summary of iuiity, includes the formula and parvo Or un ofcaah alt Sees The sme ee " each ratio, ‘ Ratio Formula ‘Uguidity Ratios | Purpose of Use 1. Current ratio os -Cumfent assets 2 _ Current liabilities ‘Measures short-term debt-paying aii. fei eet ics © Cash + Shorctemnt (quick) ratio | investments + its receivable (ne*) | Measures immediate short-term li ‘Current liabilities 3. Accounts receivable __Net credit ! turnover Rep NStcteditsales + ‘ reciable ‘Average net accounts receivable __| Measures liquidity ofaccounts 4 Toventory tumover Cost of goods sold ' ‘Average inventory - ‘Measures liquidity of inventory, — . Profit margi a meee 53 Net ingore Meagures nt scome ena Papen Net sales eg dollar ofsales. “ot tumover Net sales “Measures how efficiently sty . Average total assets + to generate sales, =Sustainable Income 641 Ratio Formula Purpose or Use 3 Sinciane income Se SS inners ‘Net income ~ Preferred = 6. Retr on common patients Measyres profile of stockholders’ equity: Average common investinent., | stockholders equly Net income ~ Preferred : fed sasures net income earned on each Steve ror inn Weigistraverage common | Met ee “EPS) shares outstanding. . Market price Siecine ares the ratio ofthe market price : ep ___pecshare Measures the ato s ratio, Earnings per share. per share to earnings per share, jut rat Cash dividends declared on Measures percentage of earnings Ee common stock distributed in the form of cash. } ‘Net income dividends. oe et | wwanetsratio Total ibis easures the percentage of to ree “qoulesses assets provided by creditors. Ne income + Tiere expense 13, Time fret cared ‘income ax expense Measures ability to meet interest | ae Payments as they come de LEARNING ly the concept of sustainable incomé. Speen Apply the concept of sustainable income. ‘he value of a company like Google is a function.of the amount, timing, and ‘uncertainty ofits future cash flows. Google's current and past income statements ‘are particularly useful in helpirig analysts predict these future cash flows. In xing this approach, analysts must make sure that Gaogle’s past income numbers ‘eilect its sustainable Income, that is, do niot include unusual (out-of-the- frlsa) revenues, expenses, gains, and losses. Sustainable income is, there- in this statement are discontimued-operations and anal eusive income (highlighted in red), When estimating future cash lows, analys ‘usi{consider the implications ofeach ofthese compenena,