14-1 Today s Agenda Management Accounting Lecture 3 (Chapter 14) Financial Statement Analysis Bangor University Transfer Abroad Programme n Financial Statement Analysis n Dollar and Percentage Changes n n Common Sized Statements n Vertical Analysis n Analysis Cautions n Be sure to recognize differences in accounting methods before coming to conclusions n Are costs skewed towards COGS? n Inventory valuation n Depreciation policy Limitations of Financial Statement Analysis Differences in accounting methods between companies sometimes make comparisons difficult. n Need to look beyond the numbers n Economic conditions n Industry trends, consumer tastes n Technical changes, changes within the company We use the LIFO method to value inventory. We use the FIFO method to value inventory. Limitations of Financial Statement Analysis Statements in Comparative and Common-Size Form Industry trends Technological changes Changes within the company Analysts should look beyond the ratios. Consumer tastes Economic factors Analytical techniques used to examine relationships among financial statement items Dollar and percentage changes on statements Common-size statements s
14-2 Horizontal analysis shows the changes between years in the financial data in both dollar and percentage form. Calculating Change in Dollar Amounts Dollar Change Current Year Figure Base Year Figure The dollar amounts for 2007 become the base year figures. Calculating Change as a Percentage Comparative Balance Sheets December 31 Percentage Change Dollar Change Base Year Figure 100% Increase (Decrease) 2008 2007 Amount % Assets Current assets: Cash $ 12,000 $ 23,500 $ (11,500) (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 Total current assets $12,000 155,000 $23,500 164,700 $(11,500) Property and equipment: Land 40,000 40,000 Buildings and equipment, ($11,500 net 120,000 $23,500) 85,000 100% 48.9% Total property and equipment 160,000 125,000 Total assets $ 315,000 $ 289,700 We could do this for the liabilities & stockholders equity, but instead, let s look at the income statement. Increase (Decrease) 2008 2007 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 Sales increased 160,000 by 8.3%, 165,000 yet (5,000) (3.0) Operating net expenses income decreased 128,600 by 126,000 21.9%. 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)
14-3 There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the Increase increase in sales, yielding an overall (Decrease) decrease in net 2008 income. 2007 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) Trend percentages state several years financial data in terms of a base year, which equals 100 percent. Trend Current Year Amount 100% Percentage Base Year Amount Berry Products Income Information Year Item 2007 2006 2005 2004 2003 Sales $ 400,000 $ 355,000 $ 320,000 $ 290,000 $ 275,000 Cost of goods sold 285,000 250,000 225,000 198,000 190,000 Gross margin 115,000 105,000 95,000 92,000 85,000 The base year is 2003, and its amounts will equal 100%. Berry Products Income Information Year Item 2007 2006 2005 2004 2003 Sales 105% 100% Cost of goods sold 104% 100% Gross margin 108% 100% 2004 Amount 2003 Amount 100% ( $290,000 $275,000 ) 100% 105% ( $198,000 $190,000 ) 100% 104% ( $ 92,000 $ 85,000 ) 100% 108% Berry Products Income Information Year Item 2007 2006 2005 2004 2003 Sales 145% 129% 116% 105% 100% Cost of goods sold 150% 132% 118% 104% 100% Gross margin 135% 124% 112% 108% 100% By analyzing the trends for Berry Products, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.
14-4 Percentage 160 150 140 130 120 110 100 We can use the trend percentages to construct a graph so we can see the trend over time. 2003 2004 2005 2006 2007 Year Sales COGS GM Common-size statements use percentages to express the relationship of individual components to a total within a single period. This is also known as vertical analysis. Gross Margin Percentage Gross Margin Percentage Gross Margin Sales This measure indicates how much of each sales dollar is left after deducting the cost of goods sold to cover expenses and provide a profit. In balance sheets, all items are expressed as a percentage of total assets. Wendy's McDonald's (dollars in millions) Dollars Percentage Dollars Percentage 2002 Net income $ 219 8.00% $ 894 5.80% Common-size financial statements are particularly useful when comparing data from different companies. Common-Size Percentages 2008 2007 2008 2007 Net sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating income 31,400 39,000 Interest expense 6,400 7,000 Net income before taxes 25,000 32,000 Less income taxes (30%) 7,500 9,600 Net income $ 17,500 $ 22,400 Net sales is the base and is expressed as 100%.
14-5 Common-Size Percentages 2008 2007 2008 2007 Net sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 Operating expenses 128,600 126,000 Net operating 2008 Cost income 2008 Sales 31,400 100% 39,000 Interest ( $360,000 expense $520,000 6,400 ) 100% 7,000 69.2% Net income before taxes 25,000 32,000 Less income 2007 taxes (30%) Cost 2007 7,500Sales 9,600 100% Net income ( $315,000 $ 17,500 $480,000 $ 22,400 ) 100% 65.6% What conclusions can we draw? Common-Size Percentages 2008 2007 2008 2007 Net sales $ 520,000 $ 480,000 100.0 100.0 Cost of goods sold 360,000 315,000 69.2 65.6 Gross margin 160,000 165,000 30.8 34.4 Operating expenses 128,600 126,000 24.8 26.2 Net operating income 31,400 39,000 6.0 8.2 Interest expense 6,400 7,000 1.2 1.5 Net income before taxes 25,000 32,000 4.8 6.7 Less income taxes (30%) 7,500 9,600 1.4 2.0 Net income $ 17,500 $ 22,400 3.4 4.7 s Earnings Per Share Common Stockholders Earnings per Share Net Income Preferred Dividends Average Number of Common Shares Outstanding Short-term Creditors Whenever a ratio divides an income statement balance by a balance sheet balance, the average for the year is used in the denominator. Long-term Creditors Earnings Per Share Price-Earnings Earnings per Share Earnings per Share Net Income Preferred Dividends Average Number of Common Shares Outstanding $53,690 0 $2.42 (17,000 + 27,400)/2 Price-Earnings Price-Earnings Market Price Per Share Earnings Per Share $20.00 8.26 times $2.42 This measure indicates how much income was earned for each share of common stock outstanding. This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the priceearnings ratio, the more opportunity a company has for growth.
14-6 Dividend Payout Dividend Yield Dividend Payout Dividends Per Share Earnings Per Share Dividend Yield Dividends Per Share Market Price Per Share Dividend Payout $2.00 82.6% $2.42 Dividend Yield $2.00 10.00% $20.00 This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking current income would like this ratio to be large. This ratio identifies the return, in terms of cash dividends, on the current market price of the stock. Return on Total Assets Return on Common Stockholders Equity Return on Total Assets Net Income + [Interest Expense (1 Tax Rate)] Average Total Assets Return on Common Stockholders Equity Net Income Preferred Dividends Average Stockholders Equity Return on Total Assets $53,690 +[7,300 (1.30)] 18.19% ($300,000 + $346,390) 2 Return on Common $53,690 0 25.91% Stockholders Equity ($180,000 + $234,390) 2 This ratio measures how well assets have been employed. This measure indicates how well the company employed the owners investments to earn income. Financial Leverage Book Value Per Share Financial leverage involves acquiring assets with funds at a fixed rate of interest. Book Value per Share Common Stockholders Equity Number of Common Shares Outstanding Return on investment in assets Return on investment in assets > < Fixed rate of return on borrowed funds Fixed rate of return on borrowed funds Positive financial leverage Negative financial leverage This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off. Book Value per Share $234,390 27,400 $ 8.55
14-7 Book Value Per Share Working Capital Book Value per Share Common Stockholders Equity Number of Common Shares Outstanding The excess of current assets over current liabilities is known as working capital. Book Value per Share $234,390 27,400 $ 8.55 Notice that the book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost. Working capital is not free. It must be financed with long-term debt and equity. Working Capital Current Norton Corporation December 31, 2007 Current assets $ 65,000 Current liabilities (42,000) Working capital $ 23,000 Current 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. Current Acid-Test (Quick) Current Current Assets Current Liabilities Acid-Test Quick Assets Current Liabilities Current $65,000 1.55 $42,000 The current ratio measures a company s short-term debt paying ability. Quick assets include Cash, Marketable Securities, Accounts Receivable and current Notes Receivable. The quick ratio measures a company s ability to meet obligations without having to liquidate inventory. Acid-Test $50,000 $42,000 1.19 Norton Corporation s quick assets consist of cash of $30,000 and accounts receivable of $20,000.
14-8 Accounts Receivable Average Collection Period Accounts Receivable Sales on Account Average Accounts Receivable Average Collection Period 365 Days Accounts Receivable Accounts Receivable $500,000 ($17,000 + $20,000) 2 27.03 times Average Collection Period 365 Days 27.03 Times 13.50 days This ratio measures how many times a company converts its receivables into cash each year. This ratio measures, on average, how many days it takes to collect an account receivable. Inventory Inventory Inventory Cost of Goods Sold Average Inventory Inventory Cost of Goods Sold Average Inventory This ratio measures how many times a company s inventory has been sold and replaced during the year. Inventory $140,000 ($10,000 + $12,000) 2 12.73 times If a company s inventory turnover Is less than its industry average, it either has excessive inventory or the wrong sorts of inventory. This ratio measures how many times a company s inventory has been sold and replaced during the year. Average Sale Period Times Interest Earned Average Sale Period 365 Days Inventory Times Interest Earned Earnings before Interest Expense plus Income Taxes Interest Expense Average Sale Period 365 Days 12.73 Times This ratio measures how many days, on average, it takes to sell the inventory. 28.67 days Times Interest Earned $84,000 11.5 times 7,300 The times interest earned ratio is the most common measure of a company s ability to protect its long-term creditors.
14-9 Debt-to-Equity Debt to 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. Total Liabilities Stockholders Equity Creditors prefer less debt and more equity because equity represents a buffer of protection. In practice, debt-to-equity ratios from 0.0 to 3.0 are common. Debt-to-Equity Debt to Equity Debt to Equity Total Liabilities Stockholders Equity $112,000 0.48 $234,390 This ratio indicates the relative proportions of debt to equity on a company s balance sheet. Review Tutorial n Financial Statement Analysis n Dollar and Percentage Changes n n Common Sized Statements n Vertical Analysis n Analysis n Review of today s lecture n Complete Review Problems n 14-3 n 14-6