CHAPTER 17

FINANCIAL STATEMENT ANALYSIS

LEARNING OBJECTIVES:
After studying the chapter, you should be able to:

1. List basic financial statement analytical procedures. 2. Apply financial statement analysis to assess the solvency of a business. 3. Apply financial statement analysis to assess the profitability of a business. 4. Describe the contents of corporate annual reports.

List basic financial statement analytical procedures.

FINANCIAL STATEMENT ANALYSIS

KEY TERMS
Common-Size Statements Horizontal Analysis Vertical Analysis

BASIC ANALYTICAL PROCEDURES

TYPES OF ANALYTICAL PROCEDURES:
Basically two types of analysis used: Horizontal analysis and Vertical analysis.

Each one provides a different type of analysis about the data. One is not better than the other-just different!

HORIZONTAL ANALYSIS:

Sometimes called trend analysis. It is used to compare changes in operating results from year to year. It shows the percentage increase/decrease in the accounts. Page 743,744 has good examples of this. One is the Balance Sheet and the other the Income Statement.

VERTICAL ANALYSIS:
Under vertical analysis, all financial statement items are shown as a percentage of a significant total on the statement. On an income statement, all items are shown as a percentage of net sales. On a balance sheet, all items are shown as a percentage of total assets or total liabilities and equity.

COMMON-SIZE STATEMENTS:
Common-size statements are a form of ratio analysis that allows the comparison of companies. It uses vertical analysis to show all items as percentages. Expressing financial statements as percentages is useful when comparing one

company with another or with industry averages. See the example on page 747.

Apply financial statement analysis to assess the solvency of a business.

COMPUTATION OF SPECIFIC RATIOS

KEY TERMS:
There are a lot of terms in this part of the chapter. Be sure that you have a working knowledge of these terms. It is important that you understand what the specific ratio tells you about a companys performance!

There is a wonderful summary chart on page 762 in the textbook. Please review it. 1. Solvency 2. Profitability 3. Working Capital 4. Acid-Test Ratio 5. Accounts Receivable Turnover 6. Quick Assets 7. Current Ratio 8. Ratio of Fixed Assets to Long-Term Liabilities 9. Inventory Turnover 10. Ratio of Liabilities to Stockholders Equity 11. Number of Days Sales in Inventory 12. Number of Days Sales in Receivables 13. Number of Times Interest Charges Earned

SOLVENCY ANALYSIS
SOLVENCY:
A company's ability to pay debts as they become due can be assessed through ratio analysis. There are six measures of solvency and each one has ratios to help assess the solvency. 1. 2. 3. 4. 5. 6. Current Position Analysis Accounts Receivable Analysis Inventory Analysis Ratio of Fixed Assets to Long-Term Liabilities Ratio of Liabilities to Stockholders Equity Number of Times Interest Charges Earned

CURRENT POSITION ANALYSIS:

Assesses a companys ability to pay it CURRENT liabilities.

There are three specific ratios used to illustrate a companys ability to pay current debts and obligation: 1. Working capital: the excess current assets over current Liabilities (You should have enough current assets available to pay off your current liabilities). 2. Current ratio: Sometimes called working capital ratio or bankers ratio. Computed by dividing total current assets by total current liabilities. Answer in terms of times. 3. Acid-test ratio: Sometimes called Quick ratio. Overcomes the weakness of the first two ratios above. Working capital and current ratios do not take into account the makeup of the

current assets. Acid-test is computed as total quick assets divided by total current liabilities. What are the quick assets? The cash and cash-like assets. You would include cash, A/R and marketable securities.

ACCOUNTS RECEIVABLE ANALYSIS

The ability of a company to convert their accounts receivable into cash in a timely manner is very important. (We want prompt and full collection of receivables!) The collection of receivable is a steady source of cash and therefore important to solvency. Obviously a companys credit terms as well as their ability to collect from customers will impact the ratios. Use credit sales since they give rise to accounts receivables. Two ratios which provide us insight on the relationship between credit sales and receivables are: 1. Accounts receivable turnover: Divide net credit sales by average net accounts receivables. Since it is difficult to compute the average net receivables throughout the year, we use a short-cut method. Just take the beginning and ending balances and divide by 2. The answer is in times.

For example a turnover of 4.5 times means that we collect (or turnover) our receivables 4 times a year. If our credit terms are 30 days this is bad, but if our credit terms are 90 days, this is good. 2. Number of days sales in receivables: Computed by dividing the net accounts receivable at end of year by the average daily credit sales. The average daily credit sales is compute by another shortcut. Simply divide net credit sales by 365 days. The answer is in days. For example, a number of days sales in receivable of 45 means that it takes about 45 days to collect our receivables. If our credit terms are 30 days this is bad. It means that our receivables are being collected 25 days late. If our credit terms are 60 days, then this is good. We are being paid before the due date.

INVENTORY ANALYSIS

Inventory management is critical to a merchandising business. Need to balance having sufficient inventory on hand with the cost of storing excess inventory. There are two ratios that evaluate the management of inventory. 1. Inventory turnover: Computed by dividing the cost of goods sold by the average inventory. Again, we can use a shortcut to compute the average: inventory at beginning and end of the year and divide by two. The answer is in times, meaning how many times does the inventory turnover (come off the shelf) during the year. Generally speaking a high turnover is a sign of efficient management of inventory (the faster you sell, the less time you tie up your money in inventory) CAUTION: The type of inventory you have will impact your turnover. For example, a grocery store will should have a higher inventory turnover that a car dealer. Why? Food is perishable!

2. Number of days sales in inventory: Computed by dividing the inventory at end of year by the average daily cost of goods sold. The daily amount is compute by taking the cost of goods sold and divide it by 365. The answer is in days and tells us the number of days tit takes to buy, sell and re-stock the inventory. If this number is too high, we may be losing sales due to the fact we do not have inventory on the shelf to sell!

RATIO OF FIXED ASSETS TO LONG-TERM LIABILITIES

Since most long-term debt is incurred to acquire long-term assets, it helps to see the relationship between the two. This ratio is compute by dividing Net Fixed Assets by Long Term Liabilities.

Indicates the margin of safety of the long terms creditors. Used as an indicator to borrow additional funds. You want your fixed assets to be greater than your long-term debt! The larger the ratio the better and the smaller the risk is to the creditor.

RATIO OF LIABILITIES TO STOCKHOLDERS EQUITY

Who has claim to the assets of a business? The creditors and the owners. So it would be helpful to know the relationship between these two groups. Computed by dividing total liabilities by total stockholders equity and indicates the margin of safety for the creditors. If this ratio is too large, there is risk for the creditors.

NUMBER OF TIMES INTEREST CHARGES EARNED

When there is high debt ratio for accompany, creditors want to know how many times the Interest Expense on the debt is earned during the year. Can the company earn enough money to repay at least the interest expense on the debt.? (The principal is another story). The higher the ratio (the more times the company is able to earn enough to cover the interest) the lower the risk! Computed by dividing Income before Income Taxes and Interest Expense by Interest Expense

Apply financial statement analysis to assess the profitability of a business.

PROFITABILITY ANALYSIS
A company's ability to earn income is also assessed through ratio analysis.

PROFITABILITY:

There are 8 profitability measures! 1. Ratio of net sales to assets 2. Rate earned on total assets 3. Rate earned on stockholders equity 4. Rate earned on common stockholders equity 5. Earnings per share on common stock 6. Price-earnings ratio 7. Dividends per share of common stock 8. Dividend yield

RATIO OF NET SALES TO ASSETS

Shows how effectively a business uses its assets! It is computed by dividing net sales by the average total assets excluding long-term investments. Why exclude long-term investments? Normally these are not used in generating normal operating revenue.

RATE EARNED ON TOTAL ASSETS

Computed by dividing net income plus interest expense by the average total assets.

RATE EARNED ON STOCKHOLDERS EQUITY

Computed by dividing net income by average total stockholders equity. Tells us the rate income is earned on the amount invested by the owners (shareholders).

RATE EARNED ON COMMON STOCKHOLDERS EQUITY

Computed by dividing Net Income preferred dividends by average common stockholders equity.

EARNINGS PER SHARE ON COMMON STOCK

Computed by dividing Net Income less preferred dividends by the shares of common stock outstanding Tell us how much of the profits each share of common stock has earned.

PRICE-EARNINGS RATIO

Computed by dividing the Market price per share of common stock divide by the earning per share of common stock Tells us about the future earning potential of our stock! For example: a P/E ratio of 15 means the stock is selling for 15 times the amount of tee earnings per share of the stock.

DIVIDENDS PER SHARE OF COMMON STOCK

Computed by dividing Dividends by shares of common stock outstanding.

DIVIDEND YIELD

Computed by dividing the Dividends per share of common stock divide by the market price per share of common stock.

Examples of Corporate Balance sheets structure: Page 743, Page 746 Examples of Corporate Income statements structure: page 744, page 746.