Financial Analysis. Instructor: Michael Booth Cabrillo College

Transcription

1 Financial Analysis Instructor: Michael Booth Cabrillo College

2 Factors in Communicating Useful Information The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the following: Users Types of Decisions Means of Analysis

3 Financial Statement Analysis THREE TYPES OF FINANCIAL STATEMENT INFORMATION Past Performance Present Condition Future Performance Income, sales volume, cash flows, returnon-investments, EPS. Assets, debt, inventory, various ratios. Sales and earnings trends are good indicators of future performance.

4 Financial Statement Analysis Financial statement analysis is based on comparisons. Time series analysis Examines a single company to identify trends over time. Comparison with similar companies Google Finance

5 Learning Objective To differentiate between horizontal and vertical analysis

6 Methods of Analysis Horizontal Analysis Vertical Analysis Ratio Analysis

7 Phases of Statement Analysis 1. Computation Phase: Vertical analysis Horizontal analysis Trend analysis 2. Interpretation Phase:

8 QUESTION: What is vertical analysis? ANSWER: Vertical analysis is computing the relationship between each item on a financial statement to some base amount on the statement.

9 QUESTION: What is horizontal analysis? ANSWER: Horizontal analysis is computing the percentage change for individual items in the financial statements from year to year.

10 QUESTION: What is a financial ratio? ANSWER: A financial ratio is computing ratio and percentage relationships of the current year with those of the immediately preceding year.

11 QUESTION: What is trend analysis? ANSWER: Trend analysis is a better technique than just analyzing ratios. It compares selected ratios and percentages over a period of time.

12 QUESTION: What are comparative statements? ANSWER: Comparative statements are financial statements presented side by side for two or more years.

13 QUESTION: What are common-size statements? ANSWER: Common-size statements are financial statements with items expressed as percentages of a base amount. Net Sales -> Income Statement Assets -> Balance Sheet

14 Comparative Statement California Products, Inc. Comparative Income Statement Year Ended December 31, 2008 and 2007 Amounts Percent of Net Sales Revenue Sales 3,105,650 2,850, Less Sales Returns and Allowances 135, , Net Sales 2,970,200 2,725, Net Income After Income Taxes 56,578 41,

15 Common-size Statement California Products, Inc. Comparative Income Statement Year Ended December 31, 2008 and 2007 Amounts Percent of Net Sales Revenue Sales 3,105,650 2,850, Less Sales Returns and Allowances 135, , Net Sales 2,970,200 2,725, Net Income After Income Taxes 56,578 41,

16 Comparative Common-size Statement California Products, Inc. Comparative Income Statement Year Ended December 31, 2008 and 2007 Amounts Percent of Net Sales Revenue Sales 3,105,650 2,850, Less Sales Returns and Allowances 135, , Net Sales 2,970,200 2,725, Net Income After Income Taxes 56,578 41,

17 Vertical Analysis of the Income Statement (Common Size) Each item is expressed as a percentage of the net sales figure (Common Denominator). Cost of goods sold Net Sales Selling expenses Net Sales = $1,775,000 $2,970,200 = 59.76% = $ 525,424 $ 2,970,200 = 17.69% Net income(profit) after taxes Net Sales = $ 56,578 $ 2,970,200 = 1.9%

18 Vertical Analysis of the Balance Sheet Each item is expressed as either a percentage of total assets or of total liabilities plus stockholders equity. Cash Total assets = $108,886 $553,016 = 19.7% Accounts payable total liabilities plus stkhldrs equity or (Total Assets) Total stockholders equity total liabilities plus stkhldrs equity or (Total Assets) = $ 72,090 $ 553,016 = $311,921 $553,016 = 13.0% = 56.4%

19 Horizontal Analysis Horizontal analysis techniques to analyze a comparative income statement and balance sheet. Trend analysis to evaluate financial statements. Interpret the results of statement analyses by comparison with industry averages. McGraw-Hill/Irwin 2007 The McGraw-Hill Companies, Inc. All rights reserved.

20 Horizontal Analysis Evaluates financial statements for two or more periods. Compares items in each line to determine the change in dollar amounts. Uses the same method for both the income statement and the balance sheet. A percentage change can be shown by using the earlier figure as the base.

21 Horizontal Analysis of the Income Statement (know as growth or % change) Sales for 2008 $3,105,650 Sales for ,850,625 Increase $ 255,025 Earlier year is the base year. Increase in sales Sales for base year = $ 255,025 $2,850,625 = 8.9%

22 California Products, Inc. Comparative Income Statement (Partial) (Horizontal Analysis) Years Ended December 31, 2008 and 2007 Amounts Increase or (Decrease) Amount Percent Revenue Sales 3,105,650 2,850, , Less Sales Returns and Allowances 135, ,625 9, Net Sales 2,970,200 2,725, ,

23 Horizontal Analysis of the Balance Sheet Current liabilities 12/31/08 $ 77,595 Current liabilities 12/31/07 97,599 $(20,004) Decrease in current liabilities Current liabilities in base year = $ (20,044) $ 97,599 = 20.53% A decrease is expressed as a negative percentage.

24 Interpretation of the Percentages Horizontal analysis is especially useful in identifying items that need further investigation. Interpretation is easier if some basis of comparison is available. Company budget Industry averages

25 QUESTION: What are industry averages? ANSWER: Industry averages are the financial ratios and percentages that reflect averages for similar companies. BiZminer Financial Ratio Sample

26 Use trend analysis to evaluate financial statements.

27 QUESTION: What is trend analysis? ANSWER: Trend analysis compares selected ratios and percentages over a period of time. Often the time period is five years.

28 Trend Analysis Net Sales 2,050,650 2,223,240 2,587,500 2,725,000 2,970,200 Cost of goods sold 1,059,900 1,234,560 1,495,642 1,574,721 1,755,000 Gross profit on sales 990, ,680 1,091,858 1,150,279 1,215,200 Percentage of gross profit to net sales This decrease is significant and should be investigated.

29 Interpret the results of the statement analyses by comparison with industry averages.

30 Using Industry Averages Trade associations survey their members to obtain financial information and other data. Data is converted to a uniform presentation, usually in common-size statements arranged by company size. Individual companies compare their results to industry averages.

31 In comparing to industry averages, keep in mind the following: Different businesses keep different types of accounts and do not classify items in the same manner. No two businesses are exactly alike. The industry figures could include data from corporations, partnerships, and sole proprietorships. SBA

32 Learning Objective To explain ratio analysis

33 Ratio Analysis Financial ratios have three classifications: 1. Profitability, operating results, and efficiency 2. Financial strength 3. Liquidity

34 Ratio Analysis Ratio analysis involves studying various relationships between different items reported in a set of financial statements.

35 Liquidity Ratios Liquidity ratios indicate a company s ability to pay shortterm debts. They focus on current assets and current liabilities. 1. Working Capital 2. Cash Ratio 3. Current Ratio 4. Quick Ratio 5. Accounts Receivable Ratios 6. Inventory Ratios

36 QUESTION: What is liquidity? ANSWER: Liquidity is a measure of the ability of a business to pay its debts when due. Conversion of assets to cash to meet the operational cash requirements of the business.

37 Cash Ratio Cash Ratio = Cash + Cash Equivalents Current Liabilities Cash Ratio = $2,826 $9,554 = to 1 This ratio measures the adequacy of available cash. This must be viewed in conjunction with Cash Flow from operating activity, inventory turns, and A/R turns.

38 Working Capital Measures the ability of a company to meet its current obligations. Formula: Current assets Current liabilities Working capital Example: $168,000 46,000 $122,000

39 Working Capital The excess of current assets over current liabilities is known as working capital.

40 Current Ratio Measures the ability of a business to pay its debts using current assets. Formula: Current assets Current liabilities = Current ratio Example: $418,056 $ 77,595 = 5.39:1 In retail and manufacturing businesses, a popular guideline is a current ratio of at least 2 to 1. Note: This is shifted prior to 2007/2008 to accept levels lower, based on cash flow, inventory turns, A/R turns

41 Current Ratio Current Ratio = Current Assets Current Liabilities The current ratio measures a company s short-term debt paying ability. A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories.

42 Current Ratio

43 Acid-Test Ratio (Quick Ratio) Measures immediate liquidity. Formula: Quick assets Current liabilities = Acid-test ratio Quick assets are cash, receivables, and marketable securities. Example: Cash Receivables 94,000 Marketable securities $94,000 $46,000 = 2.04:1 A general guideline is that the acid-test ratio should be at least 1 : 1

44 Quick (Acid-Test) Ratio

45 Accounts Receivable Turnover Measures the speed with which sales on account are collected. Formula: Net credit sales Average receivables = Accounts receivable turnover Procedure: Step 1: Compute average accounts receivable. Step 2: Divide net credit sales by average accounts receivable.

46 Accounts Receivable Turnover Accounts Receivable Turnover = Net Credit Sales Average Accounts Receivable This ratio measures how many times a company converts its receivables into cash each year.

47 Accounts Receivable Turnover

48 Average Days to Collect Receivables Average Collection Period = 365 Days Accounts Receivable Turnover Average Collection Period = 365 Days Times = 21 days This ratio measures, on average, how many days it takes to collect an accounts receivable.

49 Inventory Turnover Measures the number of times the inventory is replaced during the period. Formula: Cost of goods sold Average inventory = Inventory turnover Procedure: Step 1: Compute the average inventory. Step 2: Divide the cost of goods sold by the average inventory.

50 Inventory Turnover Inventory Turnover = Cost of Goods Sold Average Inventory This ratio measures how many times a company s inventory has been sold and replaced during the year.

51 Inventory Turnover INSERT Insert 20, p. 543, Text Box here

52 Average Days to Sell Inventory Average Sale Period = 365 Days Inventory Turnover Average Sale Period = 365 Days Times = 34 days This ratio measures how many days, on average, it takes to sell the inventory.

53 Learning Objective To calculate ratios for assessing a company s solvency

54 Solvency Ratios Solvency ratios are used to analyze a company s long-term debtpaying ability and its financing structure. 1. Debt to Assets Ratio 2. Debt to Equity Ratio 3. Number of Times Interest Earned 4. Plant Assets to Long-Term Liabilities

55 Debt to Assets Ratio Debt to Assets Ratio = Total Liabilities Total Assets This ratio measures the percentage of a company s assets that are financed by debt.

56 Debt to Equity Ratio Debt to Equity Ratio = Total Liabilities Stockholders Equity This ratio indicates the relative proportions of debt to equity on a company s balance sheet. Stockholders like a lot of debt if the company can take advantage of positive financial leverage. Creditors prefer less debt and more equity because equity represents a buffer of protection.

57 Debt to Assets and Debt to Equity Ratios Note: Liabilities + SE = Total Assets

58 Number of Times Interest is Earned Ratio (Bond or Long term debt) Times Interest Earned = Earnings before Interest Expense and Income Taxes Interest Expense This is the most common measure of a company s ability to provide protection for its longterm creditors.

59 Number of Times Bond Interest Earned Measures the ability of net income to cover the required bond interest payments. Formula: Income before bond interest and income taxes Bond interest cash requirement = Times bond interest earned Procedure: Step 1: Compute the income before bond interest and income taxes. Step 2: Compute the cash required to pay bond interest. Step 3: Compute the ratio.

60 Number of Times Interest Earned Ratio Note: this is the issue with the failing banks, GM, Ford, etc Call on Credit Default Swaps

61 Plant Assets to Long-Term Liabilities Plant Assets to Long-Term Liabilities = Net Plant Assets Long-Term Liabilities This ratio suggests how well long-term debt is managed to finance long-term assets.

62 Plant Assets to Long-Term Liabilities

63 Learning Objective To calculate ratios for assessing company management s effectiveness

64 Profitability Ratios Profitability ratios measure a company s ability to generate earnings. 1. Net Margin (or Return on Sales) 2. Asset Turnover Ratio 3. Return on Investment 4. Return on Equity 5. Quality of Income

65 Net Margin Net Margin = Net Income Net Sales This measure describes the percent remaining of each sales dollar after subtracting other expenses as well as cost of goods sold.

66 Net Margin

67 Asset Turnover Ratio Asset Turnover = Net Sales Average Total Assets This ratio measures how many sales dollars were generated for each dollar of assets invested.

68 Asset Turnover Ratio

69 Return on Investment or Return on Assets (ROI) Return on Investment Net Income before interest & tax = Average Total Assets This is the ratio of wealth generated (net income) to the amount invested (average total assets).

70 Rate of Return on Total Assets Measures the rate of return on the assets used by the company. Formula: Income before interest expense and income taxes Total assets Example: Income before income taxes $ 80,826 Add back interest expense 11,500 Income before interest and taxes $ 92,326 Avg assets $557,016 = Rate of return on total assets $92,326 $557,016 = 16.6%

71 Return on Equity Return on Equity = Net Income Average Total Stockholders Equity This measure is often used to measure the profitability of the stockholders investment.

72 Return on Equity

73 Quality of Income(see page 712 in text) Quality of Income = Cash Flow from Operating Activities Net Income Cash Flow from Operating Activities Net Income $ 4,304 Add: Depreciation and Amortization 1,076 Decrease in Receivables, net 25 Increase in Accounts Payable 790 Increase in Deferred Revenue 279 Increase in Deferred Income Taxes 605 Other 186 Deduct: Increase in Merchandise Inventories (693) Decrease in Income Taxes Payable (27) Cash Flow from Operating Activities $ 6,545

74 Quality of Income Quality of Income = Cash Flow from Operating Activities Net Income Quality of Income $6,545 = = 1.52 $4,304 A ratio higher than 1 indicates high-quality earnings.

75 Learning Objective To calculate ratios for assessing a company s position in the stock market

76 Stock Market Ratios Stock market ratios analyze the earnings and dividends of a company. 1. Earnings Per Share 2. Book Value 3. Price-Earnings (PE) Ratio 4. Dividend Yield

77 Earnings per Share of Common Measures the profit accruing to each share of common stock owned. Formula: Stock Income available to common stockholders Average number of shares of common stock outstanding during year = Earnings per share Analysts, stockholders, and creditors watch the earnings per share measurement very closely.

78 Earnings Per Share

79 Price-Earnings Ratio Compares the current market value of common stock with the earnings per share of that stock. Formula: Market price per share Earnings per share Example: = Price-earnings ratio $144 $ 12 = 12 PE ratio = 12 to 1 The price-earnings ratio is an indicator of the attractiveness of a stock as an investment.

80 Book Value per Share of Stock Measures the financial strength underlying each share of stock. Formula: Common stockholders equity Number of common shares = Book value per share of stock Procedure: Step 1: Compute the claims of preferred shareholders. Step 2: Compute the claims of common stockholders. Step 3: Divide the total claims of common stockholders by the number of shares outstanding.

81 Book Value per Share of Stock Step 1: Compute the claims of preferred stockholders. For California Products, Inc. the book value of preferred stock is the same as the par value, $100 per share. x $ 100 $50, shares outstanding

82 Book Value per Share of Stock Step 1: Claims of preferred stockholders = $50,000 Step 2: Compute the claims of common stockholders. Stockholders equity $315,921 Less preferred stock equity 50,000 Claims of common stockholders $265,921

83 Book Value per Share of Stock Step 1: Subtract the Claims of Preferred Stockholders = $50,000 Step 2: Claims of common stockholders = $265,921 Step 3: Divide the total claims of common stockholders by the number of shares outstanding. $265,921 6,000 shares = $44.32 Note this is for common stock shares Outstanding

84 Book Value per Share Book value and fair market value often are quite different. Book value per share does not indicate how much the stockholder would receive if the assets were sold and the corporation liquidated. Definition Fair Market Value The price that an interested but not desperate buyer would be willing to pay and an interested but not desperate seller would be willing to accept on the open market assuming a reasonable period of time for an agreement to arise. Book Value Definition: 1. It is the total value of the company's net assets that shareholders would theoretically receive if a company were liquidated, less total liabilities. 2. By being compared to the company's market value, the book value can indicate whether a stock is under- or overpriced.

85 Dividend Yield Dividend Yield = Dividends Per Share Market Price Per Share This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.

86 Yield on Common Stock Relationship between the dividends received by the stockholders and the market value of each share. Formula: Dividend per share Market price per share = Yield on Common Stock Example: $ 6 $ 60 = 10%

87 The limitations of financial statement analysis

88 Precautionary Notes on Statement Analysis Financial statements use book values. Book value depends on accounting policies and procedures. Businesses have choices about certain things, such as depreciation methods and useful lives. Financial statements assume that the dollar is a stable monetary unit. No two companies are exactly the same: Different legal entities Different product mixes Different financing methods Financial statement analysis is useful only if these limitations are understood.

89 Limitations of Financial Statement Analysis Different Industries Changing Economic Environment Accounting Principles

90 Assignments: See web: http// This will be updated weekly Note: Use McGrawHill HOMEWORK manager to submit assignments