St Ice Skousen Analysis of Financial Statements Chapter

St. Ice |Skousen Analysis of Financial Statements Chapter 22 Intermediate Accounting 16 E Prepared by: Sarita Sheth | Santa Monica College COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Learning Objectives 1. 2. 3. 4. 5. Organize a systematic financial ratio analysis using common-size financial statements and the Du. Pont framework. Recognize the potential impact that differing accounting methods can have on the financial ratios of otherwise essentially identical companies. Understand how foreign companies report their financial results to U. S. investors. Describe the purpose and format of the SEC’s Form 20 -F. Convert foreign currency financial statements into U. S. dollars using the translation method.

Framework for Financial Statement Analysis • Financial statement analysis- the examination of the relationships among: – Financial statement numbers – The trends of the statement numbers over time. • To analyze financial statements, analyst use: – Common sized financial statements – Ratio analysis

Framework for Financial Statement Analysis The APB stated that comparisons between financial statements are most informative— 1. When the presentations are in good form. 2. When the content of the statements is identical. 3. When accounting principles are not changed, or, if they are changed, the financial effects of the changes are disclosed. 4. When changes in circumstances or in the nature of the underlying transactions are disclosed.

Framework for Financial Statement Analysis • Common-Size Financial Statements- analysis of a company’s single-year financial statements. Financial statements are standardized by a measure of size, either sales or total assets. All amounts are stated in terms of a percentage of the size measure. • Ratio Analysis- Analysis of a company’s financial statements by computing ratios and comparing them against both trends and industry averages.

Common-Size Income Statement For common-size income statements, the denominator, the entire pie, is equal to net sales. 100% = Net Sales

Common-Size Financial Statements Comparative Income Statements (in millions) 2008 % 2007 % Net sales $5, 700 100. 0 $6, 600 100. 0 Cost of goods sold 4, 000 70. 2 4, 800 72. 7 Gross profit on sales $1, 700 29. 8 $1, 800 27. 3 Selling expense $1, 120 19. 6 $1, 200 18. 2 General expense 400 7. 0 440 6. 7 Total operating expenses $1, 520 26. 6 $1, 640 24. 9 Operating income (loss) $ 180 3. 2 $ 160 2. 4 Other revenue (expense) 80 1. 4 130 Income before taxes $ 260 4. 6 $ 290 4. 4 Income tax 80 1. 4 85 1. 3 Net income $ 180 3. 2 $ 205 3. 1 2. 0

Common-Size Income Statement For common-size balance sheets, again the denominator, the entire pie, is equal to the net sales for the year. 100% = Net Sales

Common-Sized Balance Sheet Comparative Balance Sheets (in millions) Assets 2008 % 2007 $ 955. 5 14. 5 % Current assets $ 855 15. 0 Land, building, and equipment (net) 1, 275 22. 4 1, 075. 0 24. 4 Intangible assets 100 1. 8 100. 0 1. 5 Other assets 48 0. 8 60. 5 0. 9 Total assets$2, 278 40. 0 $2, 191. 0 33. 2

Common-Sized Balance Sheet Comparative Balance Sheets (in millions) Liab. & Shs’ Equity Current liabilities Noncurrent liabilities Total liabilities Paid-in capital Retained earnings Total stockholders’ equity Total liabilities and stockholders eq. 2008 % 2007 % $ 410 7. 2 $ 501 400 7. 0 600 $ 810 14. 2 $1, 101 $1, 100 19. 3 $ 800 368 6. 5 290 7. 6 9. 1 16. 7 12. 1 4. 4 $1, 468 25. 8 $1, 090 16. 5 $2, 278 40. 0 $2, 191 33. 2

Common Size Balance Sheet A common-size balance sheet can also be prepared using total assets to standardize each amount. 100% = Total Assets

Ratio Analysis • Du. Pont Framework- Identifying factors that impact return on equity. • Efficiency Ratios- How efficiently is the firm utilizing its assets? • Leverage Ratios- To what degree is the company using other people’s money to purchase assets? • Other Financial Ratios- Other indications of liquidity, cash management, and profitability.

Du. Pont Framework • Developed internally at Du. Pont around 1920. • Provides a systematic approach to identifying general factors causing ROE to deviate from normal. • Establishes a framework for computing financial ratios to yield more in-depth analysis of a company’s areas of strength and weakness.

Du. Pont Framework • Du. Pont: ROE can be decomposed into three components: Profitability x Efficiency x Leverage Return on x Assets-to. Sales Turnover Equity Ratio Net Income x Sales Assets x Equity Assets

Du. Pont Framework Net Income x Sales Assets x Equity Assets The number of dollars pennies in profits dollars in sales of assets a company is generated from eachgenerated by each able to acquire using each dollar invested dollar of sales. dollar of assets. by stockholders.

Colesville Corporation ROE Net Income Sales 2008 x $180, 000 x 3. 16% $5, 700, 000 Sales Assets x Assets Equity $5, 700, 000 x 2. 50 $2, 278, 000 1. 55 $1, 468, 000 $6, 600, 000 3. 01 x $2, 191, 000 2. 01 $1, 090, 000 Return on Equity = 12. 3% $205, 000 3. 11% x $6, 600, 000 Return on Equity = 18. 8% 2007

Efficiency Ratios Accounts receivable turnover: Sales Average accounts receivable Colesville Corporation 2007 = $6, 600, 000 ($333, 500 + $375, 000)/2 $354, 250 = 18. 6 times

Efficiency Ratios Accounts receivable turnover: Sales Average accounts receivable Colesville Corporation 2008 = $5, 700, 000 ($375, 000 + 420, 000)/2 $354, 250 The ratios show thattimes Colesville collected its = 14. 3 receivables more rapidly in 2007 than in 2008.

Efficiency Ratios Accounts receivable turnover: Average accounts receivable Average daily sales Colesville Corporation 2007 = $354, 250 ($6, 600, 000)/365 $18, 082 = 19. 6 days

Efficiency Ratios Accounts receivable turnover: Average accounts receivable Average daily sales Colesville Corporation 2008 = $397, 500 ($5, 700, 000)/365 $18, 082 Some analyst like to express the accounts receivable turnover in terms of days. Average collection period = 25. 5 days serves this purpose.

Efficiency Ratios Inventory turnover: Cost of goods sold Average inventory For Colesville Corporation 2007 = $4, 800, 000 ($125, 000 + $330, 000)/2 $227, 500 = 21. 1 times

Efficiency Ratios Inventory turnover: Cost of goods sold Average inventory For. Colesville. Corporation 2008 = $4, 000 ($330, 000 + $225, 000)/2 $277, 500 Inventory turnover allows for evaluation of the firm’s inventory=position and the appropriateness of the 14. 4 times inventory size.

Efficiency Ratios Inventory turnover: 365 Inventory inventory For Colesville Corporation 2007 = 365 21. 1 times = 17. 3 times

Efficiency Ratios Inventory turnover: 365 Inventory inventory For Colesville Corporation 2008 = 365 14. 4 times In 2007, a typical item of inventory remained unsold for 17. 3 days. This number increased to 25. 3 days in 2008. = 25. 3 times

Stop and Think You have probably heard of just-in-time inventory systems. What would a just-intime system do to a company’s number of days’ sales in inventory?

Efficiency Ratios Fixed Asset turnover: Sales Average fixed assets For Colesville Corporation 2007 = $6, 600, 000 ($925, 000 + $1, 075, 000)/2 $1, 000 = 6. 60 times

Efficiency Ratios Fixed Asset turnover: Sales Average fixed assets For Colesville Corporation 2008 = $5, 700, 000 ($1, 075, 000 + $1, 275, 000)/2 $1, 175, 000 Colesville is much less efficient in using its fixed assets to generate salestimes in 2008 than it was in 2007. = 4. 85

Margin vs. Turnover The profitability of each dollar in sales is sometimes called a company’s margin. The degree to which assets are used to generate sales is called turnover.

Leverage Ratios • Higher leverage increases ROE through the following chain of events: 1. More borrowing means that more assets can be purchased without any additional equity investment by owners. 2. More assets means that more sales can be generated. 3. More sales means that net income should increase

Leverage Ratios Debt ratio: Total liabilities Total assets For Colesville Corporation 2007 = $1, 101, 000 $2, 191, 000 = 50. 3%

Leverage Ratios Debt ratio: Total liabilities Total assets For Colesville Corporation 2008 = $810, 000 $2, 278, 000 The debt ratio is the percentage of total funds, both borrowed and invested, that a company acquires through = 35. 6% borrowing.

Leverage Ratios Debt-to-equity ratio: Total liabilities Stockholders’ equity For Colesville Corporation 2007 = $1, 101, 000 $1, 090, 000 = 1. 01

Leverage Ratios Debt-to-equity ratio: Total liabilities Stockholders’ equity For Colesville Corporation 2008 = $810, 000 $1, 468, 000 The debt ratio and the debt-to-equity ratio measure the same thing—the level=of 0. 55 borrowing relative to funds used to finance the company.

Stop and Think Company Z has an assets-to-equity ratio of 2. 5. What are its debt and debt-toequity ratios?

Leverage Ratios Times interest earned: Earnings before income taxes Interest expense For Colesville Corporation 2007 = $290, 000 + $60, 000 = 5. 8 times

Leverage Ratios Times interest earned: Earnings before income taxes Interest expense For Colesville Corporation 2008 = $260, 000 + $40, 000 Times interest earned reflects the company’s ability to meet interest payments degree of safety afforded the = and 7. 5 the times creditors.

Other Common Ratios Current Ratio: Current assets liabilities For Colesville Corporation 2007 = $955, 500 $501, 000 = 1. 91 Current

Other Common Ratios Current Ratio: Current assets Current liabilities For Colesville Corporation 2007 = $855, 500 $410, 000 Historically, the rule of thumb was to have a current ratio of at least 2. 0. = In 2. 09 2008, Colesville Corporation is in good shape.

Current Ratios: 2004 Advances in information technology have allowed successful firms to reduce this ratio to below 1. 0. Company Coca-Cola Delta Airlines Home Depot Mc. Donald’s Wal-Mart Current Ratio 1. 10 0. 61 1. 35 0. 81 0. 90

Other Common Ratios Cash flow adequacy ratio: Cash from operating activities Total primary cash requirements The sum. For of. Colesville dividend payments, long-term asset Corporation Colesville Corporation purchases, and long-term debt repayments. 2007 = $424, 500 $375, 000 = 1. 13

Other Common Ratios Earnings per share: Net income Weighted-number of share outstanding Market price per share Earnings per share Price-earnings ratio: Dividend payout ratio: Cash dividends Net income Book-to-market ratio: outstanding Stockholders’ equity Market value of shares

Summary of Selected Financial Ratios • Insert Exhibit 22 -7

Impact of Alternative Accounting Methods • If companies are using differing accounting practices, it will impact the ratios. • Careful financial statement users should make adjustments for accounting differences among the companies being analyzed.

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Meeting the Needs of International Users Some multinational firms respond to users in other countries simply by taking their financial statements or annual reports and translating them into the language of the user.

Meeting the Needs of International Users Another response to the international users is to denominate the financial statements in the currency of the country where the financial statements will be used.

Meeting the Needs of International Users Some multinationals partially or completely restate the financial statements to the accounting principles of the financial statement users’ country.

Meeting the Needs of International Users Mutual recognition involves one country accepting the financial statements of another country in return for that country accepting its financial statements for all regulatory purposes.

The SEC’s Form 20 -F • The SEC requires foreign companies that list shares on U. S. to provide: 1. Complete U. S. GAAP financial statements. 2. Reconcile their reported net income to what income would be according to U. S. GAAP. Form 20 -F provides the reconciliation.

Foreign Currency Financial Statements • Translation- Used when the foreign subsidiary is a relatively self-contained unit that is independent from the parent company’s operations. • Remeasurement- Is appropriate when the subsidiary does not operate independently of the parent company. • Functional currency- Currency of the primary economic environment of an entity.

Foreign Currency Financial Statements Translation • Assets and liabilities are translated using the current exchange rate prevailing as of the balance sheet date. • Income statement items are translated at the average exchange rate for the year. • Dividends are translated using the exchange rate prevailing on the date the dividends were declared.

Foreign Currency Financial Statements Translation • Capital stock is translated at the historical rate, the rate prevailing on the date the subsidiary was acquired or the stock was issued. • Retained earnings is translated in the first year using historical rates. • In subsequent years, take the balance in Retained Earnings from the prior period’s translated financial statements and add translated net income and subtracting translated dividends.