Accounting Principles Second Canadian Edition Weygandt Kieso Kimmel

Accounting Principles Second Canadian Edition Weygandt · Kieso · Kimmel · Trenholm Prepared by: Carole Bowman, Sheridan College Edited by: Carolyn Doering, HHSS

CHAPTER 19 FINANCIAL STATEMENT ANALYSIS

BASICS OF FINANCIAL STATEMENT ANALYSIS • Analysing financial statements involves evaluating three characteristics of a company: 1. its liquidity 2. its profitability 3. its solvency

COMPARATIVE ANALYSIS • Three types of comparisons: – Intracompany basis (same company comparing 2 years) – Intercompany basis (comparing against a competitor) – Industry averages (compare against the average of several competitors)

COMPARATIVE ANALYSIS • Three tools: – Horizontal analysis (evaluates a series of financial statements over a period of time) (Trend Analysis and Comparative Statements) – Vertical analysis (evaluates financial statement data by expressing each item as a percentage of a base amount for the same period of time) (Common Sized Analysis) – Ratio analysis (expresses the relationship among selected items of financial statement data)

HORIZONTAL ANALYSIS Change since base period Change for Trend Analysis ANY COMPANY INC. Assumed Net Sales For the Year Ended December 31 (in millions) 2003 2002 2001 2000 1999 $ 6, 562. 8 $ 6, 295. 4 $ 6, 190. 6 $ 5, 786. 6 $ 5, 181. 4 127% 121% 119% 112% 100%

HORIZONTAL ANALYSIS • Financial Statements can also be compared using horizontal analysis – Comparative Balance Sheets (see page 893) – Comparative Income Statements (see page 894) – Comparative Statement of Retained Earnings (see page 894)

VERTICAL ANALYSIS • Expresses each item in a financial statement as a percent of a base amount (total assets on the Balance Sheet or net sales for the Income Statement) ANY COMPANY, INC. Condensed Balance Sheets (Partial) December 31 (in millions) Assets Current assets Capital assets Other assets Total assets 2002 Amount Percent $1, 496. 5 29. 6 2, 888. 8 57. 2 666. 2 13. 2 $5, 051. 5 100. 0% Amount $1, 467. 7 2, 733. 3 636. 6 $4, 837. 6 2001. Percent 30. 1 56. 9 13. 0 100. 0%

RATIO ANALYSIS Liquidity Ratios Measure short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. Revenues - Expenses Since 1892 = Profitability Ratios Net Income Measure the income or operating success of an enterprise for a given period of time. Solvency Ratios XYZ Co. Measure the ability of the enterprise to survive over a long period of time.

LIQUIDITY RATIOS • • Current ratio Acid test ratio Cash current debt coverage ratio Receivables turnover Collection period Inventory turnover Days sales in inventory

CURRENT RATIO • Measures short-term debt-paying ability (the number of dollars in CA to pay for every dollar of CL) • Also called Working Captial Ratio • Can be compared to previous years, other competitors and the industry average Current ratio = Current assets Current liabilities (Discussed in Chapter 4)

ACID TEST RATIO • Measures immediate short-term debtpaying ability Acid test ratio = Cash + temporary investments + net receivables Current liabilities (Discussed in Chapter 9)

CASH CURRENT DEBT COVERAGE RATIO • Measures short-term debt-paying ability (cash basis) Cash current debt coverage ratio = Cash provided by operating activities Average current liabilities (Discussed in Chapter 18)

RECEIVABLES TURNOVER • Measures liquidity of receivables Receivables turnover = Net credit sales Average net receivables (Discussed in Chapter 9)

COLLECTION PERIOD • Measures number of days receivables are outstanding Collection period = 365 days Receivables turnover (Discussed in Chapter 9)

INVENTORY TURNOVER • Measures liquidity of inventory Inventory turnover = Cost of goods sold Average inventory (Discussed in Chapter 5)

DAYS SALES IN INVENTORY • Measures number of days inventory is on hand Days in inventory = 365 days Inventory turnover (Discussed in Chapter 5)

PROFITABILITY RATIOS • • • Profit margin Gross profit margin Cash return on sales Asset turnover Return on assets Return on common shareholders’ equity • • • Book value per share Cash flow per share Earnings per share (EPS) Price-earnings (PE) ratio Payout ratio Dividend yield

PROFIT MARGIN • Measures net income generated by each dollar of sales Profit margin = Net income Net sales (Discussed in Chapter 5)

GROSS PROFIT MARGIN • Measures margin between selling price and cost of goods sold generated by each dollar of sales Gross profit margin = Gross profit Net sales (Discussed in Chapter 5)

CASH RETURN ON SALES • Measures net cash flow generated by each dollar of sales Cash return on sales = Net cash provided by operating activities Net sales (Discussed in Chapter 18)

ASSET TURNOVER • Measures how efficiently assets are used to generate sales Asset turnover = Net sales Average total assets (Discussed in Chapter 10)

RETURN ON ASSETS • Measures overall profitability of assets Return on assets = Net income Average total assets (Discussed in Chapter 10)

RETURN ON COMMON SHAREHOLDERS’ EQUITY • Measures profitability of common shareholders’ investment Return on common shareholders’ equity = Net income Average common shareholders’ equity (Discussed in Chapter 14)

BOOK VALUE PER SHARE • Measures the equity (net assets) per common share Book value per share = Common shareholders’ equity Number of common shares (Discussed in Chapter 14)

CASH FLOW PER SHARE • Measures the net cash flow per common share Cash flow per share = Net cash provided by all activities Number of common shares (Discussed in Chapter 18)

EARNINGS PER SHARE (EPS) • Measures net income earned on each common share Earnings per share = Net income Number of common shares (Discussed in Chapter 15)

PRICE-EARNINGS (PE) RATIO • Measures relationship between market price per share and earnings per share Price-earnings ratio = Share price Earnings per share (Discussed in Chapter 15)

PAYOUT RATIO • Measures % of earnings distributed in the form of cash dividends Payout ratio = Cash dividends Net income (Discussed in Chapter 15)

DIVIDEND YIELD • Measures rate of return earned from dividends Dividend yield = Cash dividends per share Share price (Discussed in Chapter 15)

SOLVENCY RATIOS • • Debt to total assets Interest coverage Cash interest coverage Cash total debt coverage

DEBT TO TOTAL ASSETS • Measures % of total assets provided by creditors Debt to total assets = Total liabilities Total assets (Discussed in Chapter 16)

INTEREST COVERAGE • Measures ability to meet interest payments as they come due Interest coverage = Income before interest expense and income tax expense (EBIT) Interest expense (Discussed in Chapter 16)

CASH INTEREST COVERAGE • Measures cash available to meet interest payments as they come due (cash basis) Cash interest coverage = Income before interest expense, income tax expense, and amortization expense (EBITDA) Interest expense (Discussed in Chapter 16)

CASH TOTAL DEBT COVERAGE • Measures long-term debt-paying ability (cash basis) Cash total debt coverage ratio = Net cash provided by operating activities Average total liabilities (Discussed in Chapter 18)

LIMITATIONS OF FINANCIAL ANALYSIS • Estimates • Historical cost • Alternative accounting methods • Atypical data • Diversification

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