Download Analysis and Interpretation of Financial Statements

17-1
CHAPTER 17
ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
17-2
Financial Statement Analysis

Non-accounting majors, especially,
should relate well to this chapter
It looks at accounting information from
users’ perspective

Relates very closely to topics you
will study in your finance course
Therefore, we will use a somewhat
broader brush on this chapter

What is financial statement
analysis?
”Tearing apart” the financial statements
and looking at the relationships
17-3
Financial Statement Analysis
Who analyzes financial statements?
Internal users (i.e., management)
 External users (emphasis of chapter)

Examples?
Investors, creditors, regulatory agencies & …
stock market analysts and
auditors
625
17-4
Financial Statement Analysis

What do internal users use it for?
Planning, evaluating and controlling
company operations

What do external users use it for?
Assessing past performance and current
financial position and making predictions
about the future profitability and solvency
of the company as well as evaluating the
effectiveness of management

First sentence in chapter says...
17-5
Financial Statement Analysis
Information is available from

Published annual reports
(1)
(2)
(3)
(4)
(5)

627 628
Financial statements
Notes to financial statements
Letters to stockholders
Auditor’s report (Independent accountants)
Management’s discussion and analysis
Reports filed with the government
e.g., Form 10-K, Form 10-Q and Form 8-K
17-6
Financial Statement Analysis
Information is available from

627 628
Other sources
(1)
Newspapers (e.g., Wall Street Journal )
(2)
Periodicals (e.g. Forbes, Fortune)
(3)
Financial information organizations such
as: Moody’s, Standard & Poor’s, Dun &
Bradstreet, Inc., and Robert Morris
Associates
(4)
Other business publications
Methods of
Financial Statement Analysis
 Horizontal
 Vertical
Analysis
Analysis
 Common-Size
 Trend
 Ratio
Statements
Percentages
Analysis
17-7
17-8
Horizontal Analysis
Using comparative financial
statements to calculate dollar
or percentage changes in a
financial statement item from
one period to the next
17-9
Vertical Analysis
For a single financial
statement, each item
is expressed as a
percentage of a
significant total,
e.g., all income
statement items are
expressed as a
percentage of sales
17-10
Common-Size Statements
Financial statements that show
only percentages and no
absolute dollar amounts
17-11
Trend Percentages
Show changes over time in
given financial statement items
(can help evaluate financial
information of several years)
17-12
Ratio Analysis
Expression of logical relationships
between items in a financial
statement of a single period
(e.g., percentage relationship
between revenue and net income)
17-13
Horizontal Analysis Example
The management of Clover Company
provides you with comparative balance
sheets of the years ended December 31,
1999 and 1998. Management asks you to
prepare a horizontal analysis on the
information.
17-14
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
1999
1998
Assets
Current assets:
Cash
$
12,000
$
23,500
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
3,000
1,200
155,000
164,700
40,000
40,000
120,000
85,000
160,000
125,000
Prepaid expenses
Total current assets
Property and equipment:
Land
Buildings and equipment, net
Total property and equipment
Total assets
$
315,000
$
289,700
Incre
Am
17-15
Horizontal Analysis Example
Calculating Change in Dollar Amounts
Dollar
Change
=
Current Year
Figure
–
Base Year
Figure
17-16
Horizontal Analysis Example
Calculating Change in Dollar Amounts
Dollar
Change
=
Current Year
Figure
–
Base Year
Figure
Since we are measuring the amount of
the change between 1998 and 1999, the
dollar amounts for 1998 become the
“base” year figures.
17-17
Horizontal Analysis Example
Calculating Change as a Percentage
Percentage
Change
=
Dollar Change
Base Year Figure
×
100%
17-18
Horizontal Analysis Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
1999
1998
Increase (Decrease)
Amount
%
Assets
Current assets:
Cash
$
12,000 $
23,500 $ (11,500)
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
Total current assets
155,000
164,700
$12,000
–
$23,500
= $(11,500)
Property and equipment:
Land
40,000
40,000
Buildings and equipment, net
120,000
85,000
Total property and equipment
160,000
125,000
Total assets
$ 315,000 $ 289,700
17-19
Horizontal Analysis Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
1999
1998
Increase (Decrease)
Amount
%
Assets
Current assets:
Cash
$
12,000 $
23,500 $ (11,500)
(48.9)
Accounts receivable, net
60,000
40,000
Inventory
80,000
100,000
Prepaid expenses
3,000
1,200
Total current assets
155,000
164,700
($11,500
÷
$23,500)
× 100% = 48.9%
Property and equipment:
Land
40,000
40,000
Buildings and equipment, net
120,000
85,000
Total property and equipment
160,000
125,000
Total assets
$ 315,000 $ 289,700
17-20
Horizontal Analysis Example
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
1999
1998
Increase (Decrease)
Amount
%
Assets
Current assets:
Cash
Accounts receivable, net
Inventory
Prepaid expenses
Total current assets
Property and equipment:
Land
Buildings and equipment, net
Total property and equipment
Total assets
$
$
12,000
60,000
80,000
3,000
155,000
40,000
120,000
160,000
315,000
$
$
23,500 $ (11,500)
40,000
20,000
100,000
(20,000)
1,200
1,800
164,700
(9,700)
40,000
85,000
125,000
289,700
$
35,000
35,000
25,300
(48.9)
50.0
(20.0)
150.0
(5.9)
0.0
41.2
28.0
8.7
17-21
Horizontal Analysis Example
Let’s apply the same
procedures to the
liability and stockholders’
equity sections of the
balance sheet.
17-22
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
1999
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities:
Bonds payable, 8%
Total liabilities
Stockholders' equity:
Preferred stock
Common stock
Additional paid-in capital
Total paid-in capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$
$
67,000 $
3,000
70,000
1998
Increase (Decrease)
Amount
%
44,000 $
6,000
50,000
23,000
(3,000)
20,000
52.3
(50.0)
40.0
75,000
145,000
80,000
130,000
(5,000)
15,000
(6.3)
11.5
20,000
60,000
10,000
90,000
80,000
170,000
315,000 $
20,000
60,000
10,000
90,000
69,700
159,700
289,700 $
10,300
10,300
25,300
0.0
0.0
0.0
0.0
14.8
6.4
8.7
17-23
Horizontal Analysis Example
Now, let’s apply the
procedures to the
income statement.
17-24
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
Net operating income
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Net income before taxes
25,000
32,000
(7,000)
(21.9)
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)
17-25
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
Net operating income
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Sales increased by
8.3% while
net
Net income before taxes
25,000
32,000
(7,000)
(21.9)
income decreased
by 21.9%.
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)
17-26
There were increases in both cost of goods
sold (14.3%) and operating expenses (2.1%).
These increased costs
more
than offset the
CLOVER
CORPORATION
Income
increase inComparative
sales, yielding
anStatements
overall
Fordecrease
the Years Ended
in netDecember
income. 31, 1999 and 1998
Net sales
Cost of goods sold
Gross margin
Operating expenses
Net operating income
Interest expense
Net income before taxes
Less income taxes (30%)
Net income
1999
$ 520,000
360,000
160,000
128,600
31,400
6,400
25,000
7,500
$ 17,500
1998
$ 480,000
315,000
165,000
126,000
39,000
7,000
32,000
9,600
$ 22,400
Increase (Decrease)
Amount
%
$ 40,000
8.3
45,000
14.3
(5,000)
(3.0)
2,600
2.1
(7,600)
(19.5)
(600)
(8.6)
(7,000)
(21.9)
(2,100)
(21.9)
$
(4,900)
(21.9)
17-27
Vertical Analysis Example
The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.
17-28
Vertical Analysis Example
Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999
1998
1999
1998
Cash
$ 82,000
$ 30,000
17%
8%
Accts. Rec.
120,000
100,000
25%
26%
Inventory
87,000
82,000
18%
21%
Land
101,000
90,000
21%
23%
Equipment
110,000
100,000
23%
26%
Accum. Depr.
(17,000)
(15,000)
-4%
-4%
Total
$ 483,000
$ 387,000
100%
100%
17-29
Vertical Analysis Example
Sample Company
Balance Sheet (Assets)
At December 31, 1999 and 1998
% of Total Assets
1999
1998
1999
1998
Cash
$ 82,000
$ 30,000
17%
8%
Accts. Rec.
120,000
100,000
25%
26%
Inventory
87,000
82,000
18%
21%
$82,000 ÷ $483,000 = 17% rounded
Land
101,000
90,000
21%
23%
$30,000
÷
$387,000
=
8%
rounded
Equipment
110,000
100,000
23%
26%
Accum. Depr.
(17,000)
(15,000)
-4%
-4%
Total
$ 483,000
$ 387,000
100%
100%
17-30
Vertical Analysis Example
Sample Company
Balance Sheet (Liabilities & Stockholders' Equity)
At December 31, 1999 and 1998
% of Total Assets
1999
1998
1999
1998
Acts. Payable
$ 76,000
$ 60,000
16%
16%
Wages Payable
33,000
17,000
7%
4%
Notes Payable
50,000
10%
13%
$76,000 ÷ $483,000
= 50,000
16% rounded
Common Stock
170,000
160,000
35%
41%
Retained Earnings
154,000
100,000
32%
26%
Total
$ 483,000
$ 387,000
100%
100%
17-31
Trend Percentages Example
Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
1999
Revenues $ 2,405
Expenses
2,033
Net income $
372
Wheeler, Inc.
Operating Data
1998
1997
$ 2,244
$ 2,112
1,966
1,870
$
278
$
242
1996
$ 1,991
1,803
$
188
1995
$ 1,820
1,701
$
119
17-32
Trend Percentages Example
Wheeler, Inc. provides you with the
following operating data and asks that
you prepare a trend analysis.
1999
Revenues $ 2,405
Expenses
2,033
Net income $
372
Wheeler, Inc.
Operating Data
1998
1997
$ 2,244
$ 2,112
1,966
1,870
$
278
$
242
1996
$ 1,991
1,803
$
188
1995
$ 1,820
1,701
$
119
$1,991 - $1,820 = $171
17-33
Trend Percentages Example
Using 1995 as the base year, we develop the
following percentage relationships.
Revenues
Expenses
Net income
1999
132%
120%
313%
Wheeler, Inc.
Operating Data
1998
1997
123%
116%
116%
110%
234%
203%
1996
109%
106%
158%
1995
100%
100%
100%
$1,991 - $1,820 = $171
$171 ÷ $1,820 = 9% rounded
17-34
140
Trend line
for Sales
% of 100 Base
130
120
110
100
90
Sales
Expenses
1995
1996
1997
Years
1998
1999
17-35
Ratios
Ratios can be expressed in three
different ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $
(e.g., EPS of $2.25)
CAUTION!
“Using ratios and percentages without
considering the underlying causes may
be hazardous to your health!”
lead to incorrect conclusions.”
17-36
Categories of Ratios

Liquidity Ratios
Indicate a company’s short-term
debt-paying ability

Equity (Long-Term Solvency) Ratios
Show relationship between debt and
equity financing in a company

Profitability Tests
Relate income to other variables

Market Tests
Help assess relative merits of stocks in
the marketplace
17-37
10 Ratios You Must Know
Liquidity Ratios
Current (working capital) ratio
Acid-test (quick) ratio
 Cash flow liquidity ratio
Accounts receivable turnover
Number of days’ sales in accounts
receivable
Inventory turnover
 Total assets turnover
651
17-38
10 Ratios You Must Know
Equity (Long-Term Solvency) Ratios
Equity (stockholders’ equity) ratio
 Equity to debt
17-39
10 Ratios You Must Know
Profitability Tests
Return on operating assets
Net income to net sales (return on
sales or “profit margin”)
$
Return on average common
stockholders’ equity (ROE)
 Cash flow margin
Earnings per share
 Times interest earned
 Times preferred dividends earned

17-40
10 Ratios You Must Know
Market Tests
Earnings yield on common stock
Price-earnings ratio
 Payout ratio on common stock
 Dividend yield on common stock
 Dividend yield on preferred stock
 Cash flow per share of common
stock

17-41
Now, let’s look at
Norton
Corporation’s 1999
and 1998 financial
statements.
17-42
NORTON CORPORATION
Balance Sheets
December 31, 1999 and 1998
1999
1998
Assets
Current assets:
Cash
$
30,000
$
20,000
Accounts receivable, net
20,000
17,000
Inventory
12,000
10,000
3,000
2,000
65,000
49,000
Land
165,000
123,000
Buildings and equipment, net
116,390
128,000
281,390
251,000
Prepaid expenses
Total current assets
Property and equipment:
Total property and equipment
Total assets
$
346,390
$
300,000
17-43
NORTON CORPORATION
Balance Sheets
December 31, 1999 and 1998
1999
1998
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
$
39,000
$
40,000
Notes payable, short-term
3,000
2,000
Total current liabilities
42,000
42,000
70,000
78,000
112,000
120,000
27,400
17,000
158,100
113,000
185,500
130,000
48,890
50,000
234,390
180,000
$ 346,390
$ 300,000
Long-term liabilities:
Notes payable, long-term
Total liabilities
Stockholders' equity:
Common stock, $1 par value
Additional paid-in capital
Total paid-in capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
17-44
NORTON CORPORATION
Income Statements
For the Years Ended December 31, 1999 and 1998
Net sales
Cost of goods sold
Gross margin
Operating expenses
Net operating income
Interest expense
Net income before taxes
Less income taxes (30%)
Net income
1999
$ 494,000
140,000
354,000
270,000
84,000
7,300
76,700
23,010
$ 53,690
1998
$ 450,000
127,000
323,000
249,000
74,000
8,000
66,000
19,800
$ 46,200
17-45
Now, let’s calculate
the 10 ratios based
on Norton’s financial
statements.
17-46
NORTON CORPORATION
1999
Cash
$ 30,000
Accounts receivable, net
We will
use this
information
to calculate
the liquidity
ratios for
Norton.
Beginning of year
17,000
End of year
20,000
Inventory
Beginning of year
10,000
End of year
12,000
Total current assets
65,000
Total current liabilities
42,000
Sales on account
494,000
Cost of goods sold
140,000
17-47
Working Capital*
The excess of current assets over
current liabilities.
12/31/99
Current assets
$
Current liabilities
Working capital
65,000
(42,000)
$
23,000
* While this is not a ratio, it does give an
indication of a company’s liquidity.
17-48
Current (Working Capital) Ratio
#1
Current
Ratio
=
Current Assets
Current Liabilities
Current
Ratio
=
$65,000
$42,000
=
1.55 : 1
Measures the ability
of the company to pay current
debts as they become due.
17-49
Acid-Test (Quick) Ratio
#2
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
Quick assets are Cash,
Marketable Securities,
Accounts Receivable (net) and
current Notes Receivable.
17-50
Acid-Test (Quick) Ratio
#2
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
Norton Corporation’s quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.
17-51
Acid-Test (Quick) Ratio
#2
Acid-Test
=
Ratio
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
$50,000
$42,000
= 1.19 : 1
17-52
Accounts Receivable Turnover
Net, credit sales
Accounts
Receivable =
Turnover
#3
Average, net accounts
receivable
Sales on Account
Average Accounts Receivable
Accounts
$494,000
= 26.70 times
Receivable =
($17,000 + $20,000) ÷ 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.
Number of Days’ Sales
in Accounts Receivable
#4
Days’ Sales
in Accounts =
Receivables
Days’ Sales
in Accounts =
Receivables
365 Days
Accounts Receivable Turnover
365 Days
26.70 Times
= 13.67 days
Measures, on average, how many
days it takes to collect an
account receivable.
17-53
Number of Days’ Sales
in Accounts Receivable
#4
Days’ Sales
in Accounts =
Receivables
Days’ Sales
in Accounts =
Receivables
365 Days
Accounts Receivable Turnover
365 Days
26.70 Times
= 13.67 days
In practice, would 45 days be a
desirable number of days in
receivables?
17-54
17-55
Inventory Turnover
#5
Inventory
Turnover
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
$140,000
=
= 12.73 times
($10,000 + $12,000) ÷ 2
Measures the number of times
inventory is sold and
replaced during the year.
17-56
Inventory Turnover
#5
Inventory
Turnover
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
$140,000
=
= 12.73 times
($10,000 + $12,000) ÷ 2
Would 5 be a
desirable number of times
for inventory to turnover?
Equity, or Long–Term
Solvency Ratios
This is part of the information to
calculate the equity, or long-term
solvency ratios of Norton Corporation.
NORTON CORPORATION
1999
Net operating income
Net sales
Interest expense
Total stockholders' equity
$ 84,000
494,000
7,300
234,390
17-57
17-58
NORTON CORPORATION
1999
Common shares outstanding
Beginning of year
End of year
Net income
Here is the
rest of the
information
we will
use.
17,000
27,400
$ 53,690
Stockholders' equity
Beginning of year
180,000
End of year
234,390
Dividends per share
Dec. 31 market price/share
Interest expense
2
20
7,300
Total assets
Beginning of year
300,000
End of year
346,390
17-59
Equity Ratio
#6
Equity
=
Ratio
Equity
=
Ratio
Stockholders’ Equity
Total Assets
$234,390
$346,390
Measures the proportion
of total assets provided by
stockholders.
= 67.7%
17-60
Net Income to Net Sales
A/K/A Return on Sales or Profit Margin
#7
Net Income
=
to
Net Sales
Net Income
Net Sales
Net Income
=
to
Net Sales
$53,690
$494,000
= 10.9%
Measures the proportion of the sales dollar
which is retained as profit.
17-61
Net Income to Net Sales
A/K/A Return on Sales or Profit Margin
#7
Net Income
=
to
Net Sales
Net Income
Net Sales
Net Income
=
to
Net Sales
$53,690
$494,000
= 10.9%
Would a 1% return on sales be good?
Return on Average Common
Stockholders’ Equity (ROE)
17-62
#8
Return on
Stockholders’ =
Equity
Return on
Stockholders’ =
Equity
Net Income
Average Common
Stockholders’ Equity
$53,690
($180,000 + $234,390) ÷ 2
Important measure of the
income-producing ability
of a company.
= 25.9%
17-63
Earnings Per Share
#9
Earnings Available to Common Stockholders
Earnings
=
Weighted-Average Number of Common
per Share
Shares Outstanding
Earnings
$53,690
=
per Share
(17,000 + 27,400) ÷ 2
= $2.42
The financial press regularly publishes
actual and forecasted EPS amounts.
17-64
Earnings Per Share

What’s new from Chap. 15?
644
Weighted-average calculation
Earnings available to
common stockholders
EPS of common stock = _______________________
Weighted-average number of
common shares outstanding

Three alternatives for calculating
weighted-average number of shares
17-65
Earnings Per Share

What’s new from Chap. 15?
645
Weighted-average calculation
Earnings available to
common stockholders
EPS of common stock = _______________________
Weighted-average number of
common shares outstanding
Alternate #1
17-66
Earnings Per Share
645
Alternate #2
Alternate #3
17-67
Earnings Per Share
646
¶ EPS and Stock Dividends or Splits
Why restate all prior calculations of EPS?
Comparability - i.e., no additional capital was
generated by the dividend or split
¶ Primary EPS and Fully Diluted EPS
APB Opinion No. 15
I mentioned this 17-page pronouncement that
required a 100-page explanation in the lecture
for chapter 13.
17-68
Price-Earnings Ratio
A/K/A P/E Multiple
#10
Price-Earnings
=
Ratio
Market Price Per Share
EPS
Price-Earnings
=
Ratio
$20.00
$ 2.42
= 8.3 : 1
Provides some measure of whether the
stock is under or overpriced.
17-69
Important Considerations

Need for comparable data
Data is provided by Dun &
Bradstreet, Standard & Poor’s etc.
 Must compare by industry
 Is EPS comparable?


Influence of external factors
General business conditions
 Seasonal nature of business operations


Impact of inflation
17-70
Question
The current ratio is a measure of
liquidity that is computed by dividing
total assets by total liabilities.
a. True
b. False
17-71
Question
The current ratio is a measure of
liquidity that is computed by dividing
total assets by total liabilities.
a. True
The current ratio is a measure of
b. False
liquidity, but is computed by
dividing current assets by
current liabilities
17-72
Question
Quick assets are defined as Cash,
Marketable Securities and net
receivables.
a. True
b. False
17-73
Question
Quick assets are defined as Cash,
Marketable Securities and net
receivables.
a. True
b. False
17-74
No more ratios, please!
17-75
About Test #1
Will be challenging because the
material covered is challenging
 All questions are T/F or M/C

Questions are 5-pt., 3-pt. & 1-pt.

No tricks such as patterns in answers
Order of answers is random
Coverage is even over the 4 chapters
 Time allowed: 75 minutes

17-76
About Test #1

Best way to study
Notes first
 Study guide and/or Hermanson tutorials

Calculators will be provided
 Must wait outside classroom
 Have your questions ready for next
actual class
 See course home page for office hours
