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Chapter 23

19th
Edition

Analysis of
Financial
Statements

Intermediate
Accounting
James D. Stice

Earl K. Stice
PowerPoint presented by Douglas Cloud
Professor Emeritus of Accounting, Pepperdine
University
2014 Cengage Learning

23-1

Framework for Financial


Statement Analysis

Financial statement analysis is the


examination of both the relationships
among financial statement numbers and
the trends in those numbers over time.

One purpose of financial statement


analysis is to use the past performance of
a company to predict its future profitability
and cash flows.
(continued)
23-2

Framework for Financial


Statement Analysis

Another purpose of financial statement


analysis is to evaluate the performance
of a company with an eye toward
identifying problem areas.

Most pieces of information are


meaningful only when they can be
compared to some benchmark; such as
past values or with values for other firms
in the same industry.
(continued)
23-3

Framework for Financial


Statement Analysis
The Accounting Principles Board stated that
comparisons between financial statements are
most informative and useful under the following
conditions:
1. The presentations are in good form; that is,
the arrangement within the statement is
identical.
2. The content of the statements is identical; that
is, the same items from the underlying
accounting records are classified under the
same captions.
(continued)

23-4

Framework for Financial


Statement Analysis
3. Accounting principles are not changed, or, if
they are changed, the financial effects of the
changes are disclosed.
4. Changes in circumstances or in the nature of
the underlying transactions are disclosed.
To
Tothe
theextent
extent that
that the
the
foregoing
foregoingcriteria
criteriaare
arenot
notmet,
met,
comparisons
comparisonsmay
maybe
be
misleading.
misleading.
(continued)

23-5

Common-Size Financial Statements

Financial statements are made


comparable by dividing all financial
statement numbers for a given year by
sales for the year.
The resulting financial statements are
called common-size financial
statements, with all amounts for a
given year being shown as a
percentage of sales for that year.
23-6

DuPont Framework

The DuPont framework was developed


internally at DuPont around 1920.
It provides a systematic approach to
identifying general factors causing return on
equity (ROE) to deviate from normal.
Return on equity (net income/equity) is the
single measure that summarizes the financial
health of a company.

23-7

DuPont Framework
Return on equity for Colesville Corporation for
the years 2013 and 2012 is computed as
follows:
2013

2012

Net income
$180,000
$205,000
Stockholders equity $1,468,000 $1,090,000
Return on equity
12.3%
18.8%

(continued)
23-8

DuPont Framework

Colevilles ROE is 12.3% for 2013 and 18.8% for


2012.

23-9

Accounts Receivable Turnover


Colesville
ColesvilleCorporation
Corporation
Sales
Average accounts
receivable

$6,600,000
2012 =
($333,500
+ $375,000)/2
$354,250
= 18.6 times
(continued)
23-10

Accounts Receivable Turnover


Colesville
ColesvilleCorporation
Corporation
Sales
Average accounts
receivable

$5,700,000
2013 =
($375,000
+ $420,000)/2
$397,500
= 14.3 times
The
Thehigher
higherthe
theturnover,
turnover,the
themore
morerapid
rapidisisaa
firms
firmsaverage
averagecollection
collectionperiod
periodfor
forreceivables.
receivables.
23-11

Average Collection Period


Colesville
ColesvilleCorporation
Corporation

Average accounts receivable


Average daily sales
2012 =

($333,500
$354,250
+ $375,000)/2
$6,600,000/365
$18,082

= 19.6 days

(continued)

23-12

Average Collection Period


Colesville
ColesvilleCorporation
Corporation

Average accounts receivable


Average daily sales
2013 =

($375,000
+ $420,000)/2
$397,500
$5,700,000/365
$15,616

= 25.5 days
What
What constitutes
constitutesaareasonable
reasonableaverage
average collection
collection
period
periodvaries
varieswith
withindividual
individualbusinesses.
businesses.
23-13

Inventory Turnover
Colesville
ColesvilleCorporation
Corporation

Cost of goods sold


Average inventory
$4,800,000
2012 =
($125,000
+ $330,000)/2
$227,500
= 21.1 times

(continued)
23-14

Inventory Turnover
Colesville
ColesvilleCorporation
Corporation

Cost of goods sold


Average inventory
$4,000,000
2013 =
($330,000
+ $225,000)/2
$277,500
= 14.4 times
Inventory
Inventory turnover
turnover allows
allows for
for evaluation
evaluation
of
of the
the firms
firms inventory
inventory position
position and
and the
the
appropriateness
appropriateness of
of the
the inventory
inventory size.
size.
23-15

Number of Days
Sales in Inventory
Colesville
ColesvilleCorporation
Corporation

365
Inventory turnover

2012 =

365
21.1

= 17.3 days
(continued)
23-16

Number of Days
Sales in Inventory
Colesville
ColesvilleCorporation
Corporation

365
Inventory turnover
2013 =

365
14.4

= 25.3 days
Colesville
Colesville isis holding
holding aa 25-day
25-day supply
supply
of
of inventory
inventory in
in 2013
2013 compared
compared to
to aa
17-day
17-day supply
supply in
in 2012.
2012.
23-17

Fixed Asset Turnover


Colesville
ColesvilleCorporation
Corporation

Sales
Average fixed assets
$6,600,000
2012 =
($330,000
$225,000)/2
$1,000,000
($925,000
++ $1,075,000)/2
= 6.60 times

(continued)

23-18

Fixed Asset Turnover


Colesville
ColesvilleCorporation
Corporation

Sales
Average fixed assets
$5,700,000
2013 =
($330,000
++ $225,000)/2
($1,075,000
$1,275,000)/2
$1,175,000
= 4.85 times
The
The fixed
fixed asset
asset turnover
turnover measures
measures aa firms
firms
efficiency
efficiency in
in using
using fixed
fixed assets
assets to
to generate
generate sales.
sales.
23-19

Margin vs. Turnover


Profitability and efficiency combine to determine
a companys return on assets.
Colesville
ColesvilleCorporation
Corporation

Net income
ROAAverage
=
total assets
$205,000
2012 =
($2,191,000
++ $2,278,000)/2
$1,975,500
($1,760,000
$2,191,000)/2
= 10.4%
23-20

Margin vs. Turnover


Profitability and efficiency combine to determine
a companys return on assets.
Colesville
ColesvilleCorporation
Corporation

Net income
ROAAverage
=
total assets
$180,000
2013 =
($2,191,000
++ $2,278,000)/2
$2,234,500
($2,191,000
$2,278,000)/2
= 8.1%
(continued)

23-21

Margin vs. Turnover

The profitability of each dollar in sales is


sometimes called a companys margin.

The degree to which assets are used to


generate sales is called turnover.

Margin isnt everything, nor is turnover


everything.

The important thing is how margin and


turnover combine to generate return on
assets.
(continued)

23-22

Leverage Ratios
Higher leverage increases return on equity
through the following chain of events:

1. More borrowing means that more assets can be


purchased without any additional equity
investment by stockholders.
2. More assets means that more sales can be
generated.
3. More sales means that net income should
increase.
23-23

Debt Ratio
Colesville
ColesvilleCorporation
Corporation

Total liabilities
Total assets
2012 =

$1,101,000
= 50.3%
$2,191,000

2013 =

$810,000
= 35.6%
$2,278,000

Debt
Debtratio
ratioisisaameasure
measureof
ofthe
thelevel
levelof
ofborrowing
borrowing
relative
relativeto
tofunds
fundsused
usedto
tofinance
financethe
thecompany.
company.
23-24

Debt-to-Equity Ratio
Colesville
ColesvilleCorporation
Corporation

Total liabilities
Stockholders equity
2012 =

$1,101,000
= 1.01
$1,090,000

2013 =

$810,000
= 0.55
$1,468,000

Another
Anothercommon
commonway
wayto
to measure
measure the
the level
level
of
ofleverage
leverageisisthe
thedebt-to-equity
debt-to-equityratio.
ratio.
23-25

Times Interest Earned


Colesville
ColesvilleCorporation
Corporation

Income before interest or income taxes


Interest expense
$350,000
$290,000
+ $60,000
2012 =
$60,000
= 5.8 times

$600,000
$600,000 xx
0.10
0.10

(continued)
23-26

Times Interest Earned


Colesville
ColesvilleCorporation
Corporation

Income before interest or income taxes


Interest expense
$300,000
$260,000
+ $40,000
2013 =
$40,000
= 7.5 times

$400,000
$400,000 xx
0.10
This
the
This isis aa measure
measure of
of0.10
the debt
debt position
position of
of aa

company
company in
in relation
relation to
to its
its earnings
earnings ability.
ability.

23-27

Current Ratio
Colesville
ColesvilleCorporation
Corporation

Current assets
Current liabilities
2012 =
2013 =

$955,500
= 1.91
$501,000
$855,000
= 2.09
$410,000

The
The current
current ratio
ratio isis aa test
test of
of liquidity,
liquidity,or
or the
the
firms
firms ability
ability to
to meet
meet its
its current
current obligations.
obligations.
23-28

Cash Flow Adequacy Ratio

Cash from operating activities


Total primary cash requirements
(continued)

23-29

Cash Flow Adequacy Ratio


Colesville
ColesvilleCorporation
Corporation

2012 =

$424,500
= 1.13
$375,000

2013 =

$249,000
= 0.41
$602,000

Because
Becausethe
thecash
cashflow
flowadequacy
adequacyratio
ratioin
in2013
2013isisless
less
than
than1.0,
1.0,Colesville
Colesvillewas
wasnot
notable
ableto
tosatisfy
satisfyits
itsprimary
primary
cash
cashrequirements
requirementswith
withcash
cashgenerated
generatedby
byoperations.
operations.
23-30

Earnings per Share


Colesville
ColesvilleCorporation
Corporation

Net income
Weighted shares outstanding
2012 =

$205,000
= 2.73
$75,000

2013 =

$180,000
= 2.00
$90,000

This
Thiswell-known
well-knownratio
ratioshows
showsthe
thesize
sizeof
of
the
thedividend
dividendper
pershare
shareof
ofcommon
commonstock
stock
ififall
allthe
thenet
netincome
incomeisisdistributed.
distributed.

23-31

Dividend Payout Ratio


Colesville
ColesvilleCorporation
Corporation

Cash dividends
Net income
2012 =

$145,000
= 70.7%
$205,000

2013 =

$102,000 = 56.7%
$180,000

In
Ingeneral,
general,high-growth
high-growthstable
stablefirms
firms
have
havelow
lowdividend
dividendpayout
payoutratios.
ratios.
23-32

Price-Earnings Ratio
Colesville
ColesvilleCorporation
Corporation

Market value per share


Earnings per share
2012 =

$60.00
$2.73

= 22.0

2013 =

$29.00
$2.00

= 14.5

High
HighP/E
P/Eratios
ratiosare
aregenerally
generallyassociated
associatedwith
withfirms
firms
for
forwhich
whichstrong
strongfuture
futuregrowth
growthisispredicted.
predicted.
23-33

Book-to-Market Ratio
Colesville
ColesvilleCorporation
Corporation

Book value of stockholders equity


Total market value of equity
2012 =

$1,090,000
$4,200,000

= 0.26

2013 =

$1,468,000
$2,900,000

= 0.51

The
Thebook-to-market
book-to-marketratio
ratioreflects
reflectsthe
thedifference
difference
between
betweenaacompanys
companysbalance
balancesheet
sheetvalue
valueand
and
the
thecompanys
companysactual
actualmarket
marketvalue.
value.

23-34

Impact of Alternative
Accounting Methods

If companies are using different


accounting practices, it will impact the
comparability of ratios.

23-35

Introduction to Equity Valuation


The following information for McDonalds will
be used for a simple valuation model:

Assume the required rate of return on equity


capital for McDonalds is 15%.

23-36

Constant Future Dividends


The appropriate formula is as follows:
Price =

Price =

Dividends
Required rate of return on
equity capital
$2.05
= $13.67
0.15

Thus, the implied price per share for


McDonalds for 2009 was $13.67.

23-37

Constant Dividend Growth


McDonalds growth rate over the past 12
years has exceeded 20%. Assuming a slower
future growth rate of 12%, the implied price
per share is computed as follows:
Price =

Dividends
Required rate of return on equity
Expected future dividend growth rate

$2.05
Price =
0.150 0.12

= $68.33

23-38

Price-Earnings Multiple
An investor can value a companys share by
using the information in the P/E ratio as
follows:
Price = Earnings P/E ratio

P/E ratios for a selection of restaurant chains at


the end of 2009 are as follows:

(continued)
23-39

Price-Earnings Multiple
Using the average of these ratios (27.0), the
implied price per share 2009 for McDonalds is
computed as follows:
Price = Earnings P/E ratio
Price = $4.11 27.0 = $110.97

23-40

Discounted Free Cash Flow


Free cash flow is defined as:
Cash from operating activities
Cash paid for capital expenditures
= Free cash flow

23-41

Comparison of the
Valuation Models
The computed prices for McDonalds shares at
the end of 2009, using each of the four models
are as follows:

The actual market price of a share of McDonalds


stock at the end of 2009 was $61.91.
23-42

Chapter 23

The
The End
End

$
23-43

23-44