Analysis and Interpretation of Financial Statements

Transcription

1 Chapter 23 Analysis and Interpretation of Financial Statements o Prepare comparative financial statements using horizontal analysis o Prepare comparative financial statements using vertical analysis o Calculate trend percentages o Compute ratios and measures in order to accurately interpret financial statements 1

2 The Purpose of Financial Statement Analysis To provide information from which users of that information can make good judgments and decisions. Liquidity The ability of a business to pay its debts when they fall due. The ability of a business to convert its assets into cash, the most liquid asset. Profitability The ability of a business to earn a reasonable return on an owner s investment. 2

3 Each item in a company s financial statements in the current accounting period is compared with the same item from a previous accounting period. The changes can be expressed in Dollar Changes Percent Changes Horizontal Analysis 3

4 Horizontal Analysis (continued) 4

5 Each item in a company s financial statements is stated as a percent of a base figure. The percent is calculated as a dollar value of an item divided by the dollar value of the base. On the income statement, the base is net sales. Vertical Analysis On the balance sheet, the base is total assets. 5

6 Vertical Analysis (continued) 6

7 Trend Percentages A measure used to compare financial data over a period of years, in which one year is selected as the base year. Every other year s amount is expressed as a percent of the base year s amount. 7

8 Liquidity Analysis Liquidity: The ability of a business to meet its financial obligations as they fall due. Certain relationships on the balance sheet can indicate the ability of a company to pay its debts. These relationships are usually expressed as a ratio. A Ratio: A fractional relationship of one number to another number. Let s look at some short-term liquidity measures: o Working Capital = current assets current liabilities o Current Ratio = current assets current liabilities o Acid-Test Ratio = quick assets current liabilities 8

9 Working Capital Example Referring to Weeks Company s comparative balance sheet, we can compute working capital for 20X2 and 20X1: For 20X2 $318,700 - $86,400 = $232,300 For 20X1 $266,200 - $76,800 = $189,400 Current Ratio Example Company A Company B Current assets $60,000 $90,000 Current liabilities $30,000 $60,000 The current ratio for each company: Company A = $60,000 $30,000 = 2 to 1 Company B = $90,000 $60,000 = 1.5 to 1 Analysis: Company A appears to be in a better position to receive additional credit. Company A has $2 of current assets for every $1 of current liabilities. Company B has $1.50 of current assets for every $1 of current liabilities. 9

10 Acid-Test Ratio Quick assets include only the most liquid current assets: cash, marketable securities, and net receivables. Companies with the same working capital: Company A Company B Current assets $60,000 $90,000 Current liabilities $30,000 $60,000 The acid-test ratio for each company, assuming Company A has quick assets of $18,000 and Company B has quick assets of $60,000: Company A s = $18,000 $30,000 = 0.6 to 1 Company B s = $60,000 $60,000 = 1 to 1 Analysis: Company B is in a much better position to immediately pay any current debt that becomes due. 10

11 Accounts Receivable Turnover A measure that indicates how quickly a company is collecting cash from credit customers Accounts Receivable Turnover = Let s refer back to Weeks Company s comparative balance sheet to compute the accounts receivable turnover for 20X2: First we need to compute the average net accounts receivable for 20X2. Average Net Accounts Receivable = Beg. A/R + End. A/R 2 $109,800 + $128,900 2 $119,350 Assume net credit sales for Weeks Company for 20X2 amount to $586,300. The accounts receivable turnover = $586,300 $119,350 = 4.9 times. This figure means the Weeks Company turned average accounts receivable into cash 4.9 times during 20X2. 11 Net Credit Sales Average Net Accounts Receivable

12 Average Collection Period for Accounts Receivable A rough measure of the length of time accounts receivable has been outstanding. The average collection period = 365 days accounts receivable turnover. We know the accounts receivable turnover for Weeks Company for 20X2 is 4.9 times. The average collection period for Weeks Company for 20X2 = 365 days accounts receivable turnover = 365 days 4.9 = 75 days 12

13 Merchandise Inventory Turnover A measure of the number of times a firm s average inventory is sold during the year Merchandise Inventory Turnover = Let s refer back to Weeks Company s comparative income statement and balance sheet to compute the merchandise inventory turnover for 20X2. Compute the average merchandise inventory for 20X2: Merchandise inventory turnover = cost of goods sold average inventory = $375,000 $102,350 = 3.7 times Cost of Goods Sold Average Inventory Beg. Merch. Inv. + End. Merch. Inv. Average Merchandise Inventory = 2 $96,500 + $108,200 2 $102,350 This figure means the Weeks Company sold and replaced its merchandise inventory 3.7 times. 13

14 Number of Days in Merchandise Inventory A measure of the number of days that it takes a company to sell its inventory. Calculated as 365 days merchandise inventory turnover. We know the merchandise inventory turnover for Weeks Company for 20X2 is 3.7 times. The number of days in merchandise inventory for Weeks Company for 20X2 = 365 days 3.7 = 99 days 14

15 Long-Term Liquidity Measures The ratios we have reviewed so far would be of value to the short-term creditor in determining the ability of a business to meet its current liabilities. Now let s look at three commonly used measures of particular interest to the long-term creditors. Ratio of Plant Assets to Long-Term Liabilities Indicates the margin of safety for those who hold such notes. The higher the ratio, the more secure the creditors. Calculated as plant assets long-term liabilities. Referring to Weeks Company s balance sheet for 20X2, we can calculate Weeks ratio of plant assets to long-term liabilities: = $219,100 $40,200 = 5.5 to 1 Weeks Company has a strong ratio of plant assets to long-term liabilities and is in a good position to secure additional long-term credit. 15

16 Ratio of Owner s Equity to Total Liabilities States the amount of owner s equity in relation to a company s total liabilities. Also referred to as the debit-equity ratio Calculated as owner s equity total liabilities Referring to Weeks Company s balance sheet for 20X2, we can calculate Weeks ratio of owner s equity to total liabilities: = $411,200 $126,600 = 3.2 to 1. As of December 31, 20X2, Weeks Company had $3.20 in owner s equity for each dollar in total liabilities. 16

17 Times Interest Earned A ratio used to determine a firm s ability to meets its interest payments. Shows the number of times that a firm has earned its interest expense. High ratio indicates ease in making interest payments. Low ratio indicates that a firm could have difficulty making interest payments. Times Interest Earned = Net Inc. + Interest Exp. + Inc. Taxes Interest Exp. Assume Wagnor Corporation reports income before interest and taxes of $1,340,000 and interest expense of $320,000 on its income statement for the year ending Dec. 31, 20X2. Times interest earned ratio = $1,340,000 $320,000 =

18 Profitability Analysis The ability of a firm to earn a reasonable return on the investment in the business. Of interest to the owners of the business rather than the creditors. Return on Total Assets Measures the profitability of a firm s assets; the amount of net income it earns in relation to the assets available for use during the year. Calculated as (net income + interest expense) average total assets. Referring to Weeks Company s income statement and balance sheet for 20X2, we can calculate Weeks return on total assets: Average total assets for 20X2 = (beginning 20X2 total assets + ending 20X2 total assets) 2 = ($483,800 + $537,800) 2 = $510,800 Return on total assets = ($90,642 + $6,800) $510,800 = 19.1% 18

19 Asset Turnover A measure of the amount of sales generated for each dollar of assets invested in the company. Calculated as net sales total assets (excluding investments). Referring to Weeks Company s income statement and balance sheet for 20X2, we can calculate Weeks asset turnover: $728,000 $537,800 = 1.4 times The higher the asset turnover rate, the better the firm is using its assets to generate sales. 19

20 Return on Stockholders Equity A measure of the return on each dollar invested by stockholders. A company with a high rate of return on stockholders equity would appear more attractive to investors than one with a low rate. Calculated as net income average stockholders equity. Average stockholders equity for 20X2 = (beginning 20X2 stockholders equity + ending 20X2 stockholders equity) 2 = ($346,000 + $411,200) 2 = $378,600 Return on stockholders equity = $90,642 $378,600 = 23.9% 20

21 Earnings per Share on Common Stock Represents the amount of net income available to the owner of each share of common stock. GAAP requires corporations to report earnings per share on the income statement. The only ratio that must appear on the face of the income statement. Calculated as net income number of common shares outstanding. Assume Weeks Company had 86,400 shares of common stock outstanding during 20X2. Referring to Weeks Company s income statement for the year ended December 31, 20X2, we know the net income was $90,642. EPS for 20X2 = $90,642 86,400 = $1.05 per share 21

22 Price/Earnings Ratio A measure of investors confidence in the future earnings potential of a company. Calculated as market price per share of stock earnings per share of stock. Assume Weeks Company common stock is selling for $21 per share on December 31, 20X2. We know Weeks Company s EPS for 20X2 is $1.05 per share. The P/E ratio on December 31, 20X2 = $21 $1.05 = 20 times A P/E ratio of 20 means Weeks stock was selling for 20 times the amount of EPS on December 31, 20X2. 22

23 Dividend Yield A profitability measure that tells the investor the rate earned on an investment. Calculated as dividend per share of common stock market price per share of common stock. Assume that Weeks Company paid $1.02 in dividends to common stockholders in 20X2 and the market price per share on December 31, 20X2, is $21 per share. The dividend yield on December 31, 20X2 = $1.02 $21 = 4.9% An investor who buys Weeks stock for $21 can expect an annual cash dividend yield of 4.9%. If bank interest savings rates are lower than 4.9%, the investor will receive more cash dividends than interest and have the prospect of additional growth in the value of the stock. 23

24 Equations Review Short-Term Liquidity Measures Long-Term Liquidity Measures 24

25 Equations Review (continued) Profitability Analysis 25

26 Analysis and Interpretation of Financial Statements 26