17-1
CHAPTER 17
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
625
Who analyzes financial statements?
Internal users (i.e., management)
External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors
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...
17-5
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) Auditor’s report (Independent
accountants)
(5) Management’s discussion and analysis
Reports filed with the government
e.g., Form 10-K, Form 10-Q and Form 8-K
17-6
Financial Statement Analysis
Information is available from 627 628
Other sources
(1) Newspapers (e.g., Wall Street Journal )
(2) Periodicals (e.g. Forbes, Fortune)
(3) Financial information organizations
such
as:
Moody’s, Standard & Poor’s, Dun &
Bradstreet, Inc., and Robert Morris
Associates
(4) Other business publications
Methods of
17-7
Financial Statement Analysis
Horizontal Analysis
Vertical Analysis
Common-Size Statements
Trend Percentages
Ratio Analysis
17-8
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 areare
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 ofof aa single
single period
period
(e.g.,
(e.g., percentage
percentage relationship
relationship
between
between revenue
revenue andand netnet income)
income)
17-13
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.
17-14
17-15
Horizontal Analysis Example
Calculating Change in Dollar Amounts
Dollar Current Year Base Year
= –
Change Figure Figure
17-16
Horizontal Analysis Example
Calculating Change in Dollar Amounts
Dollar Current Year Base Year
= –
Change Figure 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 Dollar Change
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
Let’s apply the same
procedures to the
liability and stockholders’
equity sections of the
balance sheet.
17-22
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
Increase (Decrease)
1999 1998 Amount %
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 67,000 $ 44,000 $ 23,000 52.3
Notes payable 3,000 6,000 (3,000) (50.0)
Total current liabilities 70,000 50,000 20,000 40.0
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 (5,000) (6.3)
Total liabilities 145,000 130,000 15,000 11.5
Stockholders' equity:
Preferred stock 20,000 20,000 - 0.0
Common stock 60,000 60,000 - 0.0
Additional paid-in capital 10,000 10,000 - 0.0
Total paid-in capital 90,000 90,000 - 0.0
Retained earnings 80,000 69,700 10,300 14.8
Total stockholders' equity 170,000 159,700 10,300 6.4
Total liabilities and stockholders' equity $ 315,000 $ 289,700 $ 25,300 8.7
17-23
Horizontal Analysis Example
Now, let’s apply the
procedures to the
income statement.
17-24
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)
17-25
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
Less income taxes (30%) 7,500
by 21.9%.
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
CLOVERmore than offset the
CORPORATION
increase inComparative
sales, yielding anStatements
Income overall
Fordecrease
the Years Ended
in netDecember
income. 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)
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
17-30
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 - $1,820 = $171
$171 ÷ $1,820 = 9% rounded
17-34
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.”
17-36
Categories of Ratios
Liquidity Ratios
Indicate a company’s 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
17-37
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 651
Total assets turnover
17-38
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
17-41
Now, let’s look at
Norton
Corporation’s 1999
and 1998 financial
statements.
17-42
17-43
17-44
17-45
Now, let’s calculate
the 10 ratios based
on Norton’s financial
statements.
17-46
NORTON CORPORATION
1999
Cash $ 30,000
Accounts receivable, net
We will Beginning of year 17,000
use this End of year 20,000
information Inventory
to calculate Beginning of year 10,000
the liquidity
End of year 12,000
ratios for
Total current assets 65,000
Norton.
Total current liabilities 42,000
Sales on account 494,000
Cost of goods sold 140,000
17-47
Working Capital*
The excess of current assets over
current liabilities.
12/31/99
Current assets $ 65,000
Current liabilities (42,000)
Working capital $ 23,000
* While this is not a ratio, it does give an
indication of a company’s liquidity.
17-48
Current (Working Capital) Ratio
#1
Current Current Assets
=
Ratio Current Liabilities
Current = $65,000 = 1.55 : 1
Ratio $42,000
Measures the ability
of the company to pay current
debts as they become due.
17-49
Acid-Test (Quick) Ratio
#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
17-50
Acid-Test (Quick) Ratio
#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Norton Corporation’s quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.
17-51
Acid-Test (Quick) Ratio
#2
Acid-Test Quick Assets
=
Ratio Current Liabilities
Acid-Test $50,000
= = 1.19 : 1
Ratio $42,000
17-52
Accounts Receivable Turnover
Net, credit sales #3 Average, net accounts
receivable
Accounts
Sales on Account
Receivable =
Average Accounts Receivable
Turnover
Accounts
$494,000
Receivable = = 26.70 times
($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
17-53
in Accounts Receivable
#4
Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables
Measures, on average, how many
days it takes to collect an
account receivable.
Number of Days’ Sales
17-54
in Accounts Receivable
#4
Days’ Sales
365 Days
in Accounts =
Accounts Receivable Turnover
Receivables
Days’ Sales
365 Days
in Accounts = = 13.67 days
26.70 Times
Receivables
In practice, would 45 days be a
desirable number of days in
receivables?
17-55
Inventory Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory
Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2
Measures the number of times
inventory is sold and
replaced during the year.
17-56
Inventory Turnover
#5
Inventory Cost of Goods Sold
=
Turnover Average Inventory
Inventory $140,000
= = 12.73 times
Turnover ($10,000 + $12,000) ÷ 2
Would 5 be a
desirable number of times
for inventory to turnover?
Equity, or Long–Term
17-57
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 $ 84,000
Net sales 494,000
Interest expense 7,300
Total stockholders' equity 234,390
17-58
NORTON CORPORATION
1999
Common shares outstanding
Beginning of year 17,000
End of year 27,400
Net income $ 53,690
Here is the Stockholders' equity
rest of the Beginning of year 180,000
information
we will End of year 234,390
use. Dividends per share 2
Dec. 31 market price/share 20
Interest expense 7,300
Total assets
Beginning of year 300,000
End of year 346,390
17-59
Equity Ratio
#6
Equity Stockholders’ Equity
=
Ratio Total Assets
Equity $234,390
= = 67.7%
Ratio $346,390
Measures the proportion
of total assets provided by
stockholders.
17-60
Net Income to Net Sales
A/K/A Return on Sales or Profit Margin
#7
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales
Measures the proportion of the sales dollar
which is retained as profit.
17-61
Net Income to Net Sales
A/K/A Return on Sales or Profit Margin
#7
Net Income
Net Income
to =
Net Sales
Net Sales
Net Income
$53,690
to = = 10.9%
$494,000
Net Sales
Would a 1% return on sales be good?
Return on Average Common
17-62
Stockholders’ Equity (ROE)
#8
Return on Net Income
Stockholders’ = Average Common
Equity Stockholders’ Equity
Return on
$53,690
Stockholders’ = = 25.9%
($180,000 + $234,390) ÷ 2
Equity
Important measure of the
income-producing ability
of a company.
17-63
Earnings Per Share
#9
Earnings Available to Common Stockholders
Earnings
= Weighted-Average Number of Common
per Share
Shares Outstanding
Earnings $53,690
= = $2.42
per Share (17,000 + 27,400) ÷ 2
The financial press regularly publishes
actual and forecasted EPS amounts.
17-64
Earnings Per Share
What’s new from Chap. 15? 644
Weighted-average calculation
Earnings available to
common stockholders
EPS of common stock = _______________________
Weighted-average number of
common shares outstanding
Three alternatives for calculating
weighted-average number of shares
17-65
Earnings Per Share
What’s new from Chap. 15? 645
Weighted-average calculation
Earnings available to
common stockholders
EPS of common stock = _______________________
Weighted-average number of
Alternate #1 common shares outstanding
17-66
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.
17-68
Price-Earnings Ratio
A/K/A P/E Multiple
#10
Price-Earnings Market Price Per Share
=
Ratio EPS
Price-Earnings $20.00
= = 8.3 : 1
Ratio $ 2.42
Provides some measure of whether the
stock is under or overpriced.
17-69
Important Considerations
Need for comparable data
Data is provided by Dun &
Bradstreet, Standard & Poor’s 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
b.
b. False
False The
The current
current ratio
ratio is
is aa measure
measure of
of
liquidity,
liquidity, but
but is
is computed
computed byby
dividing
dividing current
current assets
assets by
by
current
current liabilities
liabilities
17-72
Question
Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash,
Marketable
Marketable Securities
Securities and
and net
net
receivables.
receivables.
a.
a. True
True
b.
b. False
False
17-73
Question
Quick
Quick assets
assets are
are defined
defined as
as Cash,
Cash,
Marketable
Marketable Securities
Securities and
and net
net
receivables.
receivables.
a.
a. True
True
b.
b. False
False
17-74
No more ratios, please!
17-75
About Test #1
Will be challenging because the
material covered is challenging
All questions are T/F or M/C
Questions are 5-pt., 3-pt. & 1-pt.
No tricks such as patterns in answers
Order of answers is random
Coverage is even over the 4 chapters
Time allowed: 75 minutes
17-76
About Test #1
Best way to study
Notes first
Study guide and/or Hermanson tutorials
Calculators will be provided
Must wait outside classroom
Have your questions ready for next
actual class
See course home page for office hours