Chapter 15 Financial Statement Analysis Financial Managerial Accounting

Chapter 15 Financial Statement Analysis Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 1 of 23

Financial Statement Analysis • To make informed decisions about a company – – – Helpful in managing the company Comparison with competition Charting a company’s progress, measure performance Establish financial health Used for investment decisions • Generally based on comparative financial data – From one year to the next – With a competing company – With the industry as a whole. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 2 of 23

Financial Statement Analysis • Three main ways to analyze financial statements • Horizontal analysis • Vertical analysis • Using industry averages Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 3 of 23

Horizontal Analysis • The study of percentage changes in comparative statements – Compute dollar changes – Compute percentage changes Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 4 of 23

Example: Income Statement • Step 1 • Step 2 Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 5 of 23

Example: Balance Sheet (partial) Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 6 of 23

Trend Percentages • Form of horizontal analysis • Select a period of three to five years • Base year, earliest year, is selected and set equal to 100% • Subsequent years expressed as a percentage of the base period Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 7 of 23

E 15 -13: HORIZONTAL ANALYSIS—INCOME STATEMENT Data for Mariner Designs, Inc. , follow: MARINER DESIGNS, INC. Comparative Income Statement Years Ended December 31, 2012 and 2011 Net sales revenue 2012 $ 431, 000 $ 372, 350 $ 200, 000 $ 187, 550 99, 000 91, 050 Other expense 8, 350 6, 850 Total expenses $ 307, 350 $ 285, 450 $ 123, 650 $ 86, 900 Expenses: Cost of goods sold Selling and general expenses Net income 1. Prepare a horizontal analysis of the comparative income statement of Mariner Designs, Inc. Round percentage changes to one decimal place. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 8 of 23

E 15 -13: HORIZONTAL ANALYSIS—INCOME STATEMENT MARINER DESIGNS, INC. Comparative Income Statement Years Ended December 31, 2012 and 2011 Increase (Decrease) 2011 Net sales revenue 2012 Amount Percent $ 431, 000 $ 372, 350 $ 58, 650 15. 8 % $ 200, 000 $ 187, 550 $ 12, 450 6. 6 % Expenses: Cost of goods sold Selling and general expenses Other expense Total expenses Net income 99, 000 91, 050 7, 950 8. 7 % 8, 350 6, 850 1, 500 21. 9 % $ 307, 350 $ 285, 450 21, 900 7. 7 % $ 36, 750 42. 3 % $ 123, 650 $ 86, 900 Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 9 of 23

E 15 -13: HORIZONTAL ANALYSIS—INCOME STATEMENT Data for Mariner Designs, Inc. , follow: 2. Why did 2012 net income increase by a higher percentage than net sales revenue? Revenues increase at a higher rate than total expenses. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 10 of 23

Vertical Analysis • Shows relationship of each item to a base amount on financial statements – Income statement–each item expressed as percentage of net sales – Balance sheet–each item expressed as percentage of total assets or total liabilities and equity. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 11 of 23

Example: Income Statement • Base amount • Percentage of the base amount Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 12 of 23

Example: Balance Sheet • Base amount • Percentage of base Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 13 of 23

S 15 -3 : VERTICAL ANALYSIS Tri-State Optical Company reported the following amounts on its balance sheet at December 31, 2012 and 2011: 2012 2011 $ 54, 530 $ 46, 860 42, 435 32, 670 108, 035 85, 470 $ 205, 000 $ 165, 000 Cash and receivables Inventory Property, plant, and equipment, net Total assets Prepare a vertical analysis of Tri-State assets for 2012 and 2011. 2012 % of total 2011 % of total 26. 6 $ 46, 860 28. 4 Inventory 42, 435 32, 670 20. 7 19. 8 Property, plant, and equipment, net 108, 035 85, 470 52. 7 51. 8 Total assets $ 205, 000 100. 0 $ 165, 000 100. 0 Cash and receivables $ 54, 530 Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 14 of 23

Common-Size Statements • Common-size statements compare one company to another Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 15 of 23

Benchmarking • Comparing a company with another leading company • Two main types: – Against a key competitor – Against the industry average Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 16 of 23

S 15 -4 : COMMON-SIZE INCOME STATEMENT Data for Martinez, Inc. , and Rosado, Corp. , follow: Net sales Cost of goods sold Other expenses Net income Martinez $ 10, 600 6, 455 3, 541 $ 604 Rosado $ 18, 600 13, 522 4, 185 $ 893 1. Prepare common-size income statements. Net sales Cost of goods sold Other expenses Martinez 100 % 60. 9 % 33. 4 % Rosado 100 % 72. 7 % 22. 5 % 5. 7 % 4. 8 % Net income Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 17 of 23

S 15 -4 : COMMON-SIZE INCOME STATEMENT (Continued) Net sales Cost of goods sold Other expenses Net income Martinez 100 % 60. 9 % 33. 4 % Rosado 100 % 72. 7 % 22. 5 % 5. 7 % 4. 8 % 2. Which company earns more net income? Rosado 3. Which company’s net income is a higher percentage of its Martinez net sales? Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 18 of 23

Financial Ratios • No single ratio tells the whole picture • Different ratios explain different aspects Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 19 of 23

Ability to Pay Current Liabilities • Working capital = Current assets – Current liabilities • Current ratio Current assets Current ratio = Current liabilities Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 20 of 23

Ability to Pay Current Liabilities • Acid-test ratio Acid-test Cash + Short-term investments + Net current receivables Ratio = Current liabilities Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 21 of 23

Ability to Sell Inventory and Collect Receivables • Inventory turnover ratio • Formula Inventory turnover = Cost of goods sold Average inventory Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 22 of 23

Ability to Sell Inventory and Collect Receivables • Days in inventory ratio • Formula 365 days Days in inventory = Inventory turnover ratio Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 23 of 23

Ability to Sell Inventory and Collect Receivables • Gross profit percentage • Formula Gross profit percentage = Net sales Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 24 of 23

Ability to Sell Inventory and Collect Receivables • Accounts receivable turnover ratio • Formula Accounts receivable turnover = Net credit sales Average net accounts receivable Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 25 of 23

Ability to Sell Inventory and Collect Receivables • Days’ sales in receivables ratio • Formula Days’ sales in 365 days average accounts = Accounts receivable turnover ratio Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 26 of 23

Ability to Pay Long-Term Debt • Debt ratio • Formula Debt ratio = Total liabilities Total assets • Average debt ratio ranges from 57% to 67% Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 27 of 23

Ability to Pay Long-Term Debt • Debt to equity ratio • Formula Total liabilities Debt to equity = Total equity Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 28 of 23

Ability to Pay Long-Term Debt • Times-interest-earned ratio • Formula Times-interest Earnings Before Interest and Taxes = Interest expense earned ratio Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 29 of 23

Measuring Profitability • Return on net sales • Formula Rate of return Net income = on net sales Net sales Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 30 of 23

Measuring Profitability • Return on total assets • Formula Rate of return Net income + Interest expense = on total assets Average total assets Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 31 of 23

Measuring Profitability • Asset turnover ratio • Formula Asset turnover ratio = Net sales Average total assets Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 32 of 23

Measuring Profitability • Return on common stockholders’ equity • Formula Rate of return on common Net income – Preferred dividends = stockholders’ equity Average common stockholders’ equity Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 33 of 23

Leverage • Trading on the equity • Increases profits during goods times • Compounds losses during bad times Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 34 of 23

Measuring Profitability • Earnings per share • Formula Earnings per share = of common stock Net income – Preferred Dividends Number of shares of common stock outstanding Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 35 of 23

Analyzing Stock Investments • Price/earnings ratio (P/E) P/E ratio = Market price per share of common stock Earnings per share • Formula Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 36 of 23

Analyzing Stock Investments • Dividend yield • Formula Dividend yield on Annual dividends per share of common stock = common stock Market price per share of common stock Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 37 of 23

Analyzing Stock Investments • Dividend Payout • Formula Annual dividends per share Dividend Payout = Earnings per share Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 38 of 23

Analyzing Stock Investments • Book value • Formula Book value per share Total stockholders’ equity – Preferred equity = of common stock Number of shares of common stock outstanding Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 39 of 23

S 15 -5: EVALUATING CURRENT RATIO Win’s Companies, a home improvement store chain, reported the following summarized figures: Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 40 of 23

S 15 -5 : EVALUATING CURRENT RATIO (Continued) 1. Compute Win’s Companies’ current ratio at May 31, 2012 and 2011. Current assets Current ratio = Current liabilities 2012 - $ 54, 300, 000/$ 33, 000 = 1. 65 2011 - $ 25, 200, 000/$ 13, 100, 000 = 1. 92 2. Did Win’s Companies’ current ratio improve, deteriorate, or hold steady during 2012? Win’s Companies current ratio deteriorated. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 41 of 23

S 15 -6: COMPUTING INVENTORY, GROSS PROFIT, AND RECEIVABLES RATIOS Use the Win’s Companies data in Short Exercise 15 -5 to complete the following requirements. 1. Compute the rate of inventory turnover, days in inventory, and gross profit percentage for 2012. Cost of goods sold Inventory turnover = Average inventory $ 28, 400, 000/($6, 900, 000 + $8, 200, 000)/2 = 3. 76 365 days Days in inventory = Inventory turnover ratio 365/3. 76 = 97 days Gross profit percentage = Net sales $21, 800, 000/$50, 200, 000 = 43. 4 % Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 42 of 23

S 15 -6 : COMPUTING INVENTORY, GROSS PROFIT, AND RECEIVABLES RATIOS (Continued) 2. Compute days’ sales in average receivables during 2012. Round dollar amounts to three decimal places. Days’ sales in 365 days average accounts = Accounts receivable turnover ratio Net credit sales Accounts receivable turnover = Average net accounts receivable 365/($ 50, 200, 000/($7, 400, 000 + $5, 300, 000)/2 ) = 46 days Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 43 of 23

S 15 -7: MEASURING ABILITY TO PAY LIABILITIES Use the financial statements of Win’s Companies in Short Exercise 15 -5. 1. Compute the debt ratio and the debt to equity ratio at May 31, 2012. Debt ratio = Total liabilities Total assets $ 45, 300, 000 / $ 88, 300, 000 = 51. 3 Total liabilities Total equity $ 45, 300, 000 / $ 43, 000 = 1. 05 2. Is Win’s ability to pay its liabilities strong or weak? Explain your reasoning. The company’s ability to pay its liabilities is strong since the debt ratio is low. Debt to equity = Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 44 of 23

S 15 -8 : MEASURING PROFITABILITY Use the financial statements of Win’s Companies in Short Exercise 15 -5 to complete the following profitability measures for 2012. 1. Compute the rate of return on net sales. Rate of return = Net income on net sales Net sales $ 15, 500, 000 / $ 50, 200, 000 = 30. 9% 2. Compute the rate of return on total assets. Rate of return Net income + Interest expense = on total assets Average total assets $ 15, 500, 000 + 500, 000 / ($ 88, 300, 000 + $ 51, 200, 000)/2 = 22. 9% 3. Compute the asset turnover ratio. Net sales Asset turnover ratio = Average total assets $ 50, 200, 000 / ($ 88, 300, 000 + $ 51, 200, 000)/2 = 0. 72 Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 45 of 23

S 15 -8 : MEASURING PROFITABILITY (Continued) 4. Compute the rate of return on common stockholders’ equity. Rate of return on common Net income – Preferred dividends = stockholders’ equity Average common stockholders’ equity $ 15, 500, 000 – 0 / ($ 43, 000 + $ 27, 500, 000) /2 = 44. 0 % 5. Are these rates of return strong or weak? Explain your reasoning. These rates of return are strong considering that average companies present much lower rates of return. Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 46 of 23

S 15 -9 : COMPUTING EPS AND P/E RATIO Use the financial statements of Win’s Companies in Short Exercise 15 -5. Win’s has 500, 000 common shares outstanding during 2012. 1. Compute earnings per share (EPS) for Win’s. Round to the nearest cent. Earnings per share = Net income – Preferred Dividends Number of shares of of common stock outstanding $ 15, 500, 000 – 0/500, 000 = $31. 00 2. Compute Win’s Companies’ price/earnings ratio. The market price per share of Win’s stock is $68. 50. P/E ratio = Market price per share of common stock Earnings per share $68. 50/$31. 00 = 2. 2 times Financial & Managerial Accounting by C. Horngren, W. Harrison & M. S. Oliver, 3 rd ed. Pearson Slide 47 of 23