Purpose of Analysis Financial statement analysis helps users

• Purpose of Analysis; Financial statement analysis helps users make better decisions • Financial Statements Are Designed for Analysis • Tools of Analysis – Dollar and Percentage Changes – Trend analysis is used to reveal patterns in data covering successive periods – Component Percentages • Horizontal Analysis, Vertical Analysis • Common Size Statements 1

Chapter 14 FINANCIAL STATEMENT ANALYSISRATIO ANALYSIS 2

Ratios 3

Use this information to calculate the liquidity ratios for Norton Corporation. 4

Working Capital Working capital is the excess of current assets over current liabilities. 5

Current Ratio This ratio measures the short-term debtpaying ability of the company. Current Assets = Ratio Current Liabilities Current = Ratio $65, 000 $42, 000 = 1. 55 : 1 6

Quick Ratio = Quick Assets Current Liabilities Quick assets are cash, marketable securities, and receivables. This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash. 7

Quick Ratio Quick Assets Current Liabilities = = $50, 000 $42, 000 = 1. 19 : 1 This ratio is like the current ratio but excludes current assets such as inventories that may be difficult to quickly convert into cash. 8

Debt Ratio A measure of creditor’s long-term risk. The smaller the percentage of assets that are financed by debt, the smaller the risk for creditors. 9

Uses and Limitations of Financial Ratios 10

Measures of Profitability An income statement can be prepared in either a multiple-step or single-step format. The single-step format is simpler. The multiple-step format provides more detailed information. 11

Income Statement (Multiple-Step) Example Proper Heading { { Gross Margin Operating Expenses Nonoperating Items { { Remember to compute EPS. 12

Income Statement (Single-Step) Example { Proper Heading Revenues & Gains Expenses & Losses { { Remember to compute EPS. 13

Use this information to calculate the profitability ratios for Norton Corporation. 14

Return On Assets (ROA) This ratio is generally considered the best overall measure of a company’s profitability. 15

Use this information to calculate the profitability ratios for Norton Corporation. 16

Return On Equity (ROE) This measure indicates how well the company employed the owners’ investments to earn income. 17

Sources of Financial Information 18

More Examples of Ratios in Different Perspective 19

Solvency Analysis § Solvency is the ability of a business to meet its financial obligations (debts) as they are due. § Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities. § This ability is normally assessed by examining balance sheet relationships. 20

Current Position Analysis Working Capital and Current Ratio Current assets Current liabilities Working capital Current ratio 2006 $550, 000 210, 000 $340, 000 2. 6 2005 $533, 000 243, 000 $290, 000 2. 2 Use: To indicate the ability to meet Divide currently maturing obligations. current assets by current liabilities 21

Current Position Analysis Quick Ratio Quick assets: Cash Marketable securities Accounts receivable (net) Total Current liabilities Quick ratio 2006 2005 $ 90, 500 75, 000 115, 000 $280, 500 $210, 000 1. 3 $ 64, 700 60, 000 120, 000 $244, 700 $243, 000 1. 0 Use: To indicate instant debt-paying ability. 22

Accounts Receivable Analysis Accounts Receivable Turnover Net sales on account Accounts receivable (net): Beginning of year End of year Total Average (Total ÷ 2) 2006 $1, 498, 000 2005 $1, 200, 000 $ 120, 000 115, 500 $ 235, 000 $ 117, 500 $ 140, 000 120, 000 $ 260, 000 $ 130, 000 Net sales on account Average accounts receivable 23

Accounts Receivable Analysis Accounts Receivable Turnover Net sales on account Accounts receivable (net): Beginning of year End of year Total Average Accounts receivable turnover 2006 $1, 498, 000 2005 $1, 200, 000 $ 120, 000 115, 500 $ 235, 000 $ 117, 500 12. 7 $ 140, 000 120, 000 $ 260, 000 $ 130, 000 9. 2 Use: To assess the efficiency in collecting receivables and in the management of credit. 24

Accounts Receivable Analysis Number of Days’ Sales in Receivables 2006 Accounts receivable (net), end of year Net sales on account Average daily sales on account (sales ÷ 365) 2005 $ 115, 000 $1, 498, 000 $ 120, 000 $1, 200, 000 $ $ 4, 104 3, 288 Accounts receivable, end of year Average daily sales on account 25

Accounts Receivable Analysis Number of Days’ Sales in Receivables 2006 Accounts receivable (net), end of year Net sales on account Average daily sales on account (sales ÷ 365) Number of days’ sales in receivables 2005 $ 115, 000 $1, 498, 000 $ 120, 000 $1, 200, 000 $ $ 4, 104 28. 0 3, 288 36. 5 Use: To assess the efficiency in collecting receivables and in the management of credit. 26

Inventory Analysis Inventory Turnover Cost of goods sold Inventories: Beginning of year End of year Total Average (Total ÷ 2) Inventory turnover = 2006 $1, 043, 000 2005 $ 820, 000 $ 283, 000 264, 000 $ 547, 000 $ 273, 500 $ 311, 000 283, 000 $ 594, 000 $ 297, 000 Cost of goods sold Average inventory 27

Inventory Analysis Inventory Turnover Cost of goods sold Inventories: Beginning of year End of year Total Average (Total ÷ 2) Inventory turnover 2006 $1, 043, 000 2005 $ 820, 000 $ 283, 000 264, 000 $ 547, 000 $ 273, 500 3. 8 $ 311, 000 283, 000 $ 594, 000 $ 297, 000 2. 8 Use: To assess the efficiency in the management of inventory. 28

Inventory Analysis Number of Days’ Sales in Inventory Inventories, end of year Cost of goods sold Average daily cost of goods sold (COGS ÷ 365) Number of Days’ Sales = in Inventory 2006 $ 264, 000 $1, 043, 000 2005 $283, 000 $820, 000 $ $ 2, 858 2, 247 Inventories, end of year Average daily cost of goods sold 29

Inventory Analysis Number of Days’ Sales in Inventory Inventories, end of year Cost of goods sold Average daily cost of goods sold (COGS ÷ 365) Number of days’ sales in inventory 2006 $ 264, 000 $1, 043, 000 2005 $283, 000 $820, 000 $ $ 2, 858 92. 4 2, 247 125. 9 Use: To assess the efficiency in the management of inventory. 30

Long-Term Creditors Ratio of Fixed Assets to Long-Term Liabilities Fixed assets (net) Long-term liabilities Ratio of fixed assets to long-term liabilities 2006 $444, 500 $100, 000 4. 4 2005 $470, 000 $200, 000 2. 4 Use: To indicate the margin of safety to long-term creditors. 31

Long-Term Creditors Ratio of Liabilities to Stockholders’ Equity Total liabilities Total stockholders’ equity Ratio of liabilities to stockholders’ equity 2006 $310, 000 $829, 500 2005 $443, 000 $787, 500 0. 37 0. 56 Use: To indicate the margin of safety to creditors. 32

Long-Term Creditors Number of Times Interest Charges Earned Income before income tax Add interest expense Amount available for interest Number of Times Interest = Charges Earned 2006 2005 $ 900, 000 $ 800, 000 300, 000 250, 000 $1, 200, 000 $1, 050, 000 Income before income tax + interest expense Interest expense 33

Long-Term Creditors Number of Times Interest Charges Earned Income before income tax Add interest expense Amount available for interest Number of times earned 2006 2005 $ 900, 000 $ 800, 000 300, 000 250, 000 $1, 200, 000 $1, 050, 000 4. 2 Use: To assess the risk to debtholders in terms of number of times interest charges were earned. 34

Profitability Analysis § Profitability is the ability of an entity to earn profits. § This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available. § Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet. 35

The Common Stockholder Ratio of Net Sales to Assets Net sales Total assets: Beginning of year End of year Total Average (Total ÷ 2) 2006 $1, 498, 000 2005 $1, 200, 000 $1, 053, 000 1, 044, 500 $2, 097, 500 $1, 048, 750 $1, 010, 000 1, 053, 000 $2, 063, 000 $1, 031, 500 Excludes long-term investments 36

The Common Stockholder Ratio of Net Sales to Assets Net sales Total assets: Beginning of year End of year Total Average (Total ÷ 2) Ratio of net sales to assets 2006 $1, 498, 000 2005 $1, 200, 000 $1, 053, 000 1, 044, 500 $2, 097, 500 $1, 048, 750 $1, 010, 000 1, 053, 000 $2, 063, 000 $1, 031, 500 1. 4 1. 2 Use: To assess the effectiveness of the use of assets. 37

The Common Stockholder Rate Earned on Total Assets Net income Plus interest expense Total assets: Beginning of year End of year Total Average (Total ÷ 2) Rate earned on total assets 2006 $ 91, 000 6, 000 $ 97, 000 2005 $ 76, 500 12, 000 $ 88, 500 $1, 230, 500 1, 139, 500 $2, 370, 000 $1, 185, 000 8. 2% $1, 187, 500 1, 230, 500 $2, 418, 000 $1, 209, 000 7. 3% Use: To assess the profitability of the assets. 38

The Common Stockholder Rate Earned on Stockholders’ Equity Net income Stockholders’ equity: Beginning of year End of year Total Average (Total ÷ 2) Rate earned on stockholders’ equity 2006 $ 91, 000 2005 $ 76, 500 $ 787, 500 829, 500 $1, 617, 000 $ 808, 500 $ 750, 000 787, 500 $1, 537, 500 $ 768, 750 11. 3% 10. 0% Use: To assess the profitability of the investment by stockholders. 39

Leverage 11. 3% 10. 0% Leverage 3. 1% 10% 8. 2% 7. 3% Leverage 2. 7% 5% 0% 2006 Rate earned on total assets 2005 Rate earned on stockholders’ equity 40

The Common Stockholder Rate Earned on Common Stockholders’ Equity Net income Less preferred dividends Remainder—common stock Common stockholders’ equity: Beginning of year End of year Total Average (Total ÷ 2) $ $ 2006 91, 000 9, 000 82, 000 $ 637, 500 679, 500 $1, 317, 000 $ 658, 500 $ $ 2005 76, 500 9, 000 67, 500 $ 600, 000 637, 500 $1, 237, 500 $ 618, 750 41

The Common Stockholder Rate Earned on Common Stockholders’ Equity Net income Less preferred dividends Remainder—common stock Common stockholders’ equity: Beginning of year End of year Total Average (Total ÷ 2) Rate earned on common stockholders’ equity $ $ 2006 91, 000 9, 000 82, 000 $ $ 2005 76, 500 9, 000 67, 500 $ 637, 500 679, 500 $1, 317, 000 $ 658, 500 $ 600, 000 637, 500 $1, 237, 500 $ 618, 750 12. 5% 10. 9% Use: To assess the profitability of the investment by common stockholders. 42

The Common Stockholder Earnings Per Share on Common Stock Net income Less preferred dividends Remainder—common stock Shares of common stock 2006 $ 91, 000 9, 000 $ 82, 000 50, 000 Earnings per share on common stock $1. 64 2005 $ 76, 500 9, 000 $ 67, 500 50, 000 $1. 35 Use: To assess the profitability of the investment by common stockholders. 43

The Common Stockholder Price-Earnings Ratio 2006 Market price per share of common $41. 00 Earnings per share on common ÷ 1. 64 Price-earnings ratio on common stock 25 2005 $27. 00 ÷ 1. 35 20 Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings. 44

Dividends and Earnings Per Share $2. 00 Per $1. 50 share $1. 00 $1. 64 $1. 35 $0. 80 $0. 60 $0. 50 $0. 00 2006 Dividends 2005 Earnings 45

The Common Stockholder Dividend Yield on Common Stock Dividends per share of common Market price per share of common Dividend yield on common stock 2006 $ 0. 80 ÷ 41. 00 1. 95% 2005 $ 0. 60 ÷ 27. 00 2. 22% Use: To indicate the rate of return to common stockholders in terms of dividends. 46

Corporate Annual Reports In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report. The MDA includes an analysis of the results of operations and discusses management’s opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition. 47

Corporate Annual Reports In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report. Before issuing annual statements, all publicly held corporations are required to have an independent audit of their financial statements. The CPAs who conduct the audit render an opinion as to the fairness of the statements. 48

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