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17-1

FAR740@MACC UiTM

ANALYSIS AND

INTERPRETATION OF

FINANCIAL STATEMENTS

17-2

Financial Statement Analysis

Non-accounting majors, especially,


should relate well to this chapter
It looks at accounting information from
users perspective

Relates very closely to topics you will


study in your finance course
Therefore, we will use a somewhat broader
brush on this chapter

What is financial statement analysis?


Tearing apart the financial statements
and looking at the relationships

17-3

Financial Statement Analysis


Who analyzes financial statements?
Internal users (i.e., management)
External users (emphasis of chapter)

Examples?
Investors, creditors, regulatory agencies &
stock market analysts and
auditors

625

17-4

Financial Statement Analysis

What do internal users use it for?


Planning, evaluating and controlling
company operations

What do external users use it for?


Assessing past performance and current
financial position and making predictions
about the future profitability and solvency of
the company as well as evaluating the
effectiveness of management

First sentence in chapter says...

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Financial Statement Analysis


Information is available from

627 628

Published annual reports


(1)
Financial statements
(2)
Notes to financial statements
(3)
Letters to stockholders
(4)
Auditors report (Independent
accountants)
(5)
Managements discussion and analysis

Reports filed with the government


e.g., Form 10-K, Form 10-Q and Form 8-K

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Financial Statement Analysis


Information is available from

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Other sources
(1)
Newspapers (e.g., Wall Street Journal )
(2)
Periodicals (e.g. Forbes, Fortune)
(3)
Financial information organizations
such
as:
Moodys, Standard & Poors, Dun &
Bradstreet, Inc., and Robert Morris
Associates
(4)
Other business publications

Methods of
Financial Statement Analysis
Horizontal
Vertical

Analysis

Analysis

Common-Size
Trend
Ratio

Statements

Percentages
Analysis

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Horizontal Analysis
Using
Using comparative
comparative financial
financial
statements
statements to
to calculate
calculate dollar
dollar
or
or percentage
percentage changes
changes in
in aa
financial
financial statement
statement item
item from
from
one
one period
period to
to the
the next
next

17-9

Vertical Analysis
For
For aa single
single financial
financial
statement,
statement, each
each item
item
is
is expressed
expressed as
as aa
percentage
percentage of
of aa
significant
significant total,
total,
e.g.,
e.g., all
all income
income
statement
statement items
items are
are
expressed
expressed as
as aa
percentage
percentage of
of sales
sales

17-10

Common-Size Statements
Financial
Financial statements
statements that
that show
show
only
only percentages
percentages and
and no
no
absolute
absolute dollar
dollar amounts
amounts

17-11

Trend Percentages
Show
Show changes
changes over
over time
time in
in
given
given financial
financial statement
statement items
items
(can
(can help
help evaluate
evaluate financial
financial
information
information of
of several
several years)
years)

17-12

Ratio Analysis
Expression
Expression of
of logical
logical relationships
relationships
between
between items
items in
in aa financial
financial
statement
statement of
of aa single
single period
period
(e.g.,
(e.g., percentage
percentage relationship
relationship
between
between revenue
revenue and
and net
net income)
income)

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Horizontal Analysis Example


The management of Clover Company
provides you with comparative balance
sheets of the years ended December 31,
1999 and 1998. Management asks you to
prepare a horizontal analysis on the
information.

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17-15

Horizontal Analysis Example


Calculating Change in Dollar Amounts
Dollar
Change

Current Year
Figure

Base Year
Figure

17-16

Horizontal Analysis Example


Calculating Change in Dollar Amounts
Dollar
Change

Current Year
Figure

Base Year
Figure

Since we are measuring the amount of


the change between 1998 and 1999, the
dollar amounts for 1998 become the
base year figures.

17-17

Horizontal Analysis Example


Calculating Change as a Percentage
Percentage
Change

Dollar Change
Base Year Figure

100%

17-18

Horizontal Analysis Example

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

17-19

Horizontal Analysis Example

($11,500 $23,500) 100% = 48.9%

17-20

Horizontal Analysis Example

17-21

Horizontal Analysis Example


Lets apply the same
procedures to the
liability and stockholders
equity sections of the
balance sheet.

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CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
1999
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities:
Bonds payable, 8%
Total liabilities
Stockholders' equity:
Preferred stock
Common stock
Additional paid-in capital
Total paid-in capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity

67,000 $
3,000
70,000

1998

Increase (Decrease)
Amount
%

44,000 $
6,000
50,000

23,000
(3,000)
20,000

52.3
(50.0)
40.0

75,000
145,000

80,000
130,000

(5,000)
15,000

(6.3)
11.5

20,000
60,000
10,000
90,000
80,000
170,000
315,000 $

20,000
60,000
10,000
90,000
69,700
159,700
289,700 $

10,300
10,300
25,300

0.0
0.0
0.0
0.0
14.8
6.4
8.7

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Horizontal Analysis Example


Now, lets apply the
procedures to the
income statement.

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CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
Net operating income
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Net income before taxes
25,000
32,000
(7,000)
(21.9)
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)

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CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
Net operating income
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Sales increased by
8.3% while
net
Net income before taxes
25,000
32,000
(7,000)
(21.9)
income decreased
by 21.9%.
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)

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There were increases in both cost of goods


sold (14.3%) and operating expenses (2.1%).
These increased costs
more
than offset the
CLOVER
CORPORATION
Income
increase inComparative
sales, yielding
anStatements
overall
Fordecrease
the Years Ended
in netDecember
income. 31, 1999 and 1998
Net sales
Cost of goods sold
Gross margin
Operating expenses
Net operating income
Interest expense
Net income before taxes
Less income taxes (30%)
Net income

1999
$ 520,000
360,000
160,000
128,600
31,400
6,400
25,000
7,500
$ 17,500

1998
$ 480,000
315,000
165,000
126,000
39,000
7,000
32,000
9,600
$ 22,400

Increase (Decrease)
Amount
%
$ 40,000
8.3
45,000
14.3
(5,000)
(3.0)
2,600
2.1
(7,600)
(19.5)
(600)
(8.6)
(7,000)
(21.9)
(2,100)
(21.9)
$
(4,900)
(21.9)

17-27

Vertical Analysis Example


The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.

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Vertical Analysis Example

17-29

Vertical Analysis Example

$82,000 $483,000 = 17% rounded


$30,000 $387,000 = 8% rounded

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Vertical Analysis Example

$76,000 $483,000 = 16% rounded

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Trend Percentages Example


Wheeler, Inc. provides you with the following
operating data and asks that you prepare a
trend analysis.

17-32

Trend Percentages Example


Wheeler, Inc. provides you with the following
operating data and asks that you prepare a
trend analysis.

$1,991 - $1,820 = $171

17-33

Trend Percentages Example


Using 1995 as the base year, we develop the
following percentage relationships.

$1,991 $171 $1,820

$1,820 = $171
= 9% rounded

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Trend line
for Sales

17-35

Ratios
Ratios can be expressed in three different
ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $
(e.g., EPS of $2.25)

CAUTION!
Using ratios and percentages without
considering the underlying causes may be
hazardous to your health!
lead to incorrect conclusions.

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Categories of Ratios

Liquidity Ratios
Indicate a companys short-term
debt-paying ability

Equity (Long-Term Solvency) Ratios


Show relationship between debt and equity
financing in a company

Profitability Tests
Relate income to other variables

Market Tests
Help assess relative merits of stocks in the
marketplace

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10 Ratios You Must Know


Liquidity Ratios
Current (working capital) ratio
Acid-test (quick) ratio
Cash flow liquidity ratio
Accounts receivable turnover
Number of days sales in accounts
receivable
Inventory turnover
Total assets turnover

651

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10 Ratios You Must Know


Equity (Long-Term Solvency) Ratios
Equity (stockholders equity) ratio

Equity to debt

17-39

10 Ratios You Must Know


Profitability Tests
Return on operating assets
Net income to net sales (return on
sales or profit margin)
margin
$
Return on average common
stockholders equity (ROE)
ROE
Cash flow margin
Earnings per share
Times interest earned
Times preferred dividends earned

17-40

10 Ratios You Must Know


Market Tests
Earnings yield on common stock
Price-earnings ratio
Payout ratio on common stock
Dividend yield on common stock
Dividend yield on preferred stock
Cash flow per share of common
stock

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Now, lets look at


Norton
Corporations 1999
and 1998 financial
statements.

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17-43

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Now, lets calculate


the 10 ratios based
on Nortons financial
statements.

NORTON CORPORATION
1999
Cash

$ 30,000

Accounts receivable, net

We will
use this
information
to calculate
the liquidity
ratios for
Norton.

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

494,000

Cost of goods sold

140,000

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Working Capital*
The excess of current assets over
current liabilities.

12/31/99
Current assets

Current liabilities
Working capital

65,000
(42,000)

23,000

* While this is not a ratio, it does give an


indication of a companys liquidity.

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Current (Working Capital) Ratio


#1
Current
Ratio

Current Assets
Current Liabilities

Current
Ratio

$65,000
$42,000

1.55 : 1

Measures the ability


of the company to pay current
debts as they become due.

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Acid-Test (Quick) Ratio


#2
Acid-Test
=
Ratio

Quick Assets
Current Liabilities
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.

17-50

Acid-Test (Quick) Ratio


#2
Acid-Test
=
Ratio

Quick Assets
Current Liabilities
Norton Corporations quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.

17-51

Acid-Test (Quick) Ratio


#2
Acid-Test
=
Ratio
Acid-Test
=
Ratio

Quick Assets
Current Liabilities
$50,000
$42,000

= 1.19 : 1

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Accounts Receivable Turnover


Net, credit sales
Accounts
Receivable =
Turnover

#3

Average, net accounts


receivable

Sales on Account
Average Accounts Receivable

Accounts
$494,000
= 26.70 times
Receivable =
($17,000 + $20,000) 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.

Number of Days Sales


in Accounts Receivable
#4
Days Sales
in Accounts =
Receivables
Days Sales
in Accounts =
Receivables

365 Days
Accounts Receivable Turnover
365 Days
26.70 Times

= 13.67 days

Measures, on average, how many


days it takes to collect an
account receivable.

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Number of Days Sales


in Accounts Receivable
#4
Days Sales
in Accounts =
Receivables
Days Sales
in Accounts =
Receivables

365 Days
Accounts Receivable Turnover
365 Days
26.70 Times

= 13.67 days

In practice, would 45 days be a


desirable number of days in
receivables?

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17-55

Inventory Turnover
#5
Inventory
Turnover
Inventory
Turnover

Cost of Goods Sold


Average Inventory

$140,000
=
= 12.73 times
($10,000 + $12,000) 2

Measures the number of times


inventory is sold and
replaced during the year.

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Inventory Turnover
#5
Inventory
Turnover
Inventory
Turnover

Cost of Goods Sold


Average Inventory

$140,000
=
= 12.73 times
($10,000 + $12,000) 2

Would 5 be a
desirable number of times
for inventory to turnover?

Equity, or LongTerm
Solvency Ratios
This is part of the information to
calculate the equity, or long-term
solvency ratios of Norton Corporation.
NORTON CORPORATION
1999
Net operating income
Net sales
Interest expense
Total stockholders' equity

$ 84,000
494,000
7,300
234,390

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17-58

NORTON CORPORATION
1999
Common shares outstanding
Beginning of year
End of year
Net income

Here is the
rest of the
information
we will
use.

17,000
27,400
$ 53,690

Stockholders' equity
Beginning of year

180,000

End of year

234,390

Dividends per share


Dec. 31 market price/share
Interest expense

2
20
7,300

Total assets
Beginning of year

300,000

End of year

346,390

17-59

Equity Ratio
#6
Equity
=
Ratio
Equity
=
Ratio

Stockholders Equity
Total Assets
$234,390
$346,390

Measures the proportion


of total assets provided by
stockholders.

= 67.7%

Net Income to Net Sales

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A/K/A Return on Sales or Profit Margin


#7
Net Income
to
=
Net Sales

Net Income
Net Sales

Net Income
to
=
Net Sales

$53,690
$494,000

= 10.9%

Measures the proportion of the sales dollar


which is retained as profit.

Net Income to Net Sales

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A/K/A Return on Sales or Profit Margin


#7
Net Income
to
=
Net Sales

Net Income
Net Sales

Net Income
to
=
Net Sales

$53,690
$494,000

= 10.9%

Would a 1% return on sales be good?

Return on Average Common


Stockholders Equity (ROE)

17-62

#8
Return on
Stockholders =
Equity
Return on
Stockholders =
Equity

Net Income
Average Common
Stockholders Equity
$53,690
($180,000 + $234,390) 2
Important measure of the
income-producing ability
of a company.

= 25.9%

17-63

Earnings Per Share


#9
Earnings Available to Common Stockholders
Earnings
=
Weighted-Average Number of Common
per Share
Shares Outstanding
Earnings
$53,690
=
per Share
(17,000 + 27,400) 2

= $2.42

The financial press regularly publishes


actual and forecasted EPS amounts.

17-64

Earnings Per Share

Whats new from Chap. 15?

644

Weighted-average calculation
Earnings available to
EPS of common stock = _______________________
common stockholders
Weighted-average number of
common shares outstanding

Three alternatives for calculating


weighted-average number of shares

17-65

Earnings Per Share

Whats new from Chap. 15?

645

Weighted-average calculation
Earnings available to
EPS of common stock = _______________________
common stockholders
Weighted-average number of
common shares outstanding
Alternate #1

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Earnings Per Share


645
Alternate #2

Alternate #3

17-67

Earnings Per Share


646

EPS and Stock Dividends or Splits


Why restate all prior calculations of EPS?
Comparability - i.e., no additional capital was
generated by the dividend or split

Primary EPS and Fully Diluted EPS


APB Opinion No. 15
I mentioned this 17-page pronouncement that
required a 100-page explanation in the lecture
for chapter 13.

Price-Earnings Ratio
A/K/A P/E Multiple
#10
Price-Earnings
=
Ratio

Market Price Per Share


EPS

Price-Earnings
=
Ratio

$20.00
$ 2.42

= 8.3 : 1

Provides some measure of whether the


stock is under or overpriced.

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17-69

Important Considerations

Need for comparable data


Data is provided by Dun &
Bradstreet, Standard & Poors etc.
Must compare by industry
Is EPS comparable?

Influence of external factors


General business conditions
Seasonal nature of business operations

Impact of inflation

17-70

Question
The
The current
current ratio
ratio is
is aa measure
measure of
of
liquidity
liquidity that
that is
is computed
computed by
by dividing
dividing
total
total assets
assets by
by total
total liabilities.
liabilities.
a.
a. True
True
b.
b. False
False

17-71

Question
The
The current
current ratio
ratio is
is aa measure
measure of
of
liquidity
liquidity that
that is
is computed
computed by
by dividing
dividing
total
total assets
assets by
by total
total liabilities.
liabilities.
a.
a. True
True
The
b.
The current
current ratio
ratio is
is aa measure
measure of
of
b. False
False
liquidity,
liquidity,but
but is
is computed
computed by
by
dividing
dividing current
current assets
assets by
by
current
current liabilities
liabilities

17-72

Question

a.
a.
b.
b.

Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash,
Marketable
Marketable Securities
Securities and
and net
net
receivables.
receivables.
True
True
False
False

17-73

Question

a.
a.
b.
b.

Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash,
Marketable
Marketable Securities
Securities and
and net
net
receivables.
receivables.
True
True
False
False

17-74

Thank You