Chapter 15 Financial Statement Analysis Chapter 15 Learning

Chapter 15 Financial Statement Analysis

Chapter 15 Learning Objectives 1. Explain how financial statements are used to analyze a business 2. Perform a horizontal analysis of financial statements © 2018 Pearson Education, Inc. 15 -2

Chapter 15 Learning Objectives 3. Perform a vertical analysis of financial statements 4. Compute and evaluate the standard financial ratios © 2018 Pearson Education, Inc. 15 -3

Learning Objective 1 Explain how financial statements are used to analyze a business © 2018 Pearson Education, Inc. 15 -4

HOW ARE FINANCIAL STATEMENTS USED TO ANALYZE A BUSINESS? • To determine the financial performance of a company, we compare its performance in the following ways: – From year to year – With a competing company – With the same industry as a whole © 2018 Pearson Education, Inc. 15 -5

Tools of Analysis • There are three main ways to analyze financial statements: – Horizontal analysis provides a year-to-year comparison of a company’s performance in different periods. – Vertical analysis provides a way to compare different companies. – Ratio analysis can be used to provide information about a company’s performance. © 2018 Pearson Education, Inc. 15 -6

Corporate Financial Reports • An annual report provides information about a company’s financial condition. – Management’s discussion and analysis of financial conditions and results of operations (MD&A) – Report of the independent auditors – Financial statements – Notes to financial statements © 2018 Pearson Education, Inc. 15 -7

Learning Objective 2 Perform a horizontal analysis of financial statements © 2018 Pearson Education, Inc. 15 -8

HOW DO WE USE HORIZONTAL ANALYSIS TO ANALYZE A BUSINESS? • Many decisions hinge on whether the numbers are increasing or decreasing. • Sales may have increased, but considered in isolation, this fact is not very helpful. • Horizontal analysis is the study of percentage changes in line items from comparative financial statements. © 2018 Pearson Education, Inc. 15 -9

HOW DO WE USE HORIZONTAL ANALYSIS TO ANALYZE A BUSINESS? Smart Touch Learning has net sales of $858, 000 in 2020 and $803, 000 in 2019. Prepare the horizontal analysis: • Step 1: Compute the dollar amount of change in sales from 2019 to 2020 • Step 2: Divide the dollar amount of change by the base period amount and multiply by 100. This computes the percentage change for the period: © 2018 Pearson Education, Inc. 15 -10

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Horizontal Analysis of the Balance Sheet © 2018 Pearson Education, Inc. 15 -12

Trend Analysis • Trend analysis is a form of horizontal analysis. • Trend percentages indicate the direction a business is taking. • The formula for trend analysis is as follows: © 2018 Pearson Education, Inc. 15 -13

Trend Analysis Smart Touch Learning’s Net Sales Revenue was $750, 000 in 2016 and rose to $858, 000 in 2020. The trend percentage for 2017 is calculated as follows: © 2018 Pearson Education, Inc. 15 -14

Learning Objective 3 Perform a vertical analysis of financial statements © 2018 Pearson Education, Inc. 15 -15

HOW DO WE USE VERTICAL ANALYSIS TO ANALYZE A BUSINESS? • Vertical analysis of a financial statement shows the relationship of each item to its base amount, the 100% figure. • Every other item on the statement is then reported as a percentage of that base. © 2018 Pearson Education, Inc. 15 -16

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Vertical Analysis of the Balance Sheet © 2018 Pearson Education, Inc. 15 -18

Common-Size Statements • To compare one company to another company, we can use a common-size statement. • A common-size statement reports only percentages. • By reporting only percentages, it removes the dollar value bias we see when comparing numbers in absolute terms (dollars). © 2018 Pearson Education, Inc. 15 -19

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Benchmarking • Benchmarking is the practice of comparing a company with other leading companies. • There are two main types of benchmarking: – Benchmarking against a key competitor – Benchmarking against the industry average © 2018 Pearson Education, Inc. 15 -21

Benchmarking © 2018 Pearson Education, Inc. 15 -22

Learning Objective 4 Compute and evaluate the standard financial ratios © 2018 Pearson Education, Inc. 15 -23

HOW DO WE USE RATIOS TO ANALYZE A BUSINESS? • Different ratios explain different aspects of a company. • Ratios are used for the following purposes: – Evaluating the ability to pay current liabilities and long-term debt – Evaluating the ability to sell merchandise inventory and collect receivables – Evaluating profitability – Evaluating stock as an investment © 2018 Pearson Education, Inc. 15 -24

HOW DO WE USE RATIOS TO ANALYZE A BUSINESS? © 2018 Pearson Education, Inc. 15 -25

HOW DO WE USE RATIOS TO ANALYZE A BUSINESS? © 2018 Pearson Education, Inc. 15 -26

Evaluating the Ability to Pay Current Liabilities • We discuss one equation and three ratios that measure a company’s ability to pay current liabilities: – – Working capital Cash ratio Acid-test (or quick) ratio Current ratio © 2018 Pearson Education, Inc. 15 -27

Working Capital • Working capital measures the ability to meet short-term obligations with current assets. Working capital is defined as follows: © 2018 Pearson Education, Inc. 15 -28

Cash Ratio • The cash ratio helps determine a company’s ability to meet its short-term obligations. © 2018 Pearson Education, Inc. 15 -29

Acid-Test (or Quick) Ratio • The acid-test ratio (sometimes called the quick ratio) tells whether a company can pay all its current liabilities if they come due immediately. © 2018 Pearson Education, Inc. 15 -30

Current Ratio • The most widely used ratio is the current ratio, which is calculated as the total current assets divided by total current liabilities. • The current ratio measures a company’s ability to pay its current liabilities with its current assets. © 2018 Pearson Education, Inc. 15 -31

Evaluating the Ability to Sell Merchandise Inventory and Collect Receivables • We look at five ratios that measure a company’s ability to sell merchandise inventory and collect receivables: – – – Inventory turnover Days’ sales in inventory Gross profit percentage Accounts receivable turnover ratio Days’ sales in receivables © 2018 Pearson Education, Inc. 15 -32

Inventory Turnover • The inventory turnover ratio measures the number of times a company sells its average level of merchandise inventory during a year. © 2018 Pearson Education, Inc. 15 -33

Days’ Sales in Inventory • Days’ sales in inventory measures the average number of days merchandise inventory is held by the company. © 2018 Pearson Education, Inc. 15 -34

Gross Profit Percentage • The gross profit percentage measures the profitability of each net sales dollar above the cost of goods sold. © 2018 Pearson Education, Inc. 15 -35

Accounts Receivable Turnover Ratio • The accounts receivable turnover ratio measures the number of times the company collects the average receivables balance in a year. © 2018 Pearson Education, Inc. 15 -36

Days’ Sales in Receivables • Days’ sales in receivables indicates how many days it takes to collect the average level of receivables. © 2018 Pearson Education, Inc. 15 -37

Evaluating the Ability to Pay Long-term Debt • Most businesses have long-term debt. • There are three key indicators of a business’s ability to pay long-term liabilities: – Debt ratio – Debt to equity ratio – Times-interest-earned ratio © 2018 Pearson Education, Inc. 15 -38

Debt Ratio • The debt ratio shows the proportion of assets financed with debt and is calculated by dividing total liabilities by total assets. © 2018 Pearson Education, Inc. 15 -39

Debt to Equity Ratio • The debt to equity ratio shows the proportion of total liabilities relative to total equity. • This ratio measures financial leverage. © 2018 Pearson Education, Inc. 15 -40

Times-Interest-Earned Ratio • The times-interest-earned ratio evaluates a business’s ability to pay interest expense. This ratio is also called the interestcoverage ratio. © 2018 Pearson Education, Inc. 15 -41

Evaluating Profitability • We now look at five ratios that are used to evaluate a company’s profitability: – – – Profit margin ratio Rate of return on total assets Asset turnover ratio Rate of return on common stockholders’ equity Earnings per share © 2018 Pearson Education, Inc. 15 -42

Profit Margin Ratio • The profit margin ratio shows how much net income a business earns on every $1 of sales. © 2018 Pearson Education, Inc. 15 -43

Rate of Return on Total Assets • The rate of return on total assets measures a company’s success in using assets to earn a profit. © 2018 Pearson Education, Inc. 15 -44

Asset Turnover Ratio • The asset turnover ratio measures the amount of net sales generated for each average dollar of total assets invested. © 2018 Pearson Education, Inc. 15 -45

Rate of Return on Common Stockholders’ Equity • The rate of return on common stockholders’ equity shows how much income is earned for each $1 invested by the common shareholders. © 2018 Pearson Education, Inc. 15 -46

Rate of Return on Common Stockholders’ Equity • When a company has a higher rate of return on stockholders’ equity than its rate of return on total assets, this is called trading on the equity. • Trading on the equity is earning more income on borrowed money than the related interest expense, thereby increasing the earnings for the owners of the business. © 2018 Pearson Education, Inc. 15 -47

Earnings per Share (EPS) • Earnings per share (EPS) reports the amount of net income (loss) for each share of the company’s outstanding common stock. © 2018 Pearson Education, Inc. 15 -48

Evaluating Stock as an Investment • Investors purchase stock to earn a return on their investment. • This return consists of two parts: – Gains (or losses) from selling the stock at a price above (or below) purchase price – Dividends © 2018 Pearson Education, Inc. 15 -49

Price/Earnings Ratio • The price/earnings ratio is the ratio of the market price of a share of common stock to the company’s earnings per share. © 2018 Pearson Education, Inc. 15 -50

Dividend Yield • The dividend yield measures the percentage of a stock’s market value that is returned annually as dividends to shareholders. © 2018 Pearson Education, Inc. 15 -51

Dividend Payout • The dividend payout measures the percentage of earnings paid annually to common shareholders as cash dividends. © 2018 Pearson Education, Inc. 15 -52

Red Flags in Financial Statement Analyses • Analysts look for red flags in financial statements that may signal financial trouble. Examples: – Movement of sales, merchandise inventory, and receivables – Earnings problems – Decreased cash flow – Too much debt – Inability to collect receivables – Buildup of merchandise inventories © 2018 Pearson Education, Inc. 15 -53

HOW DO WE USE RATIOS TO ANALYZE A BUSINESS? © 2018 Pearson Education, Inc. 15 -54

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