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Objective 5.04 Analyze financial indicators and ratios to make business decisions. Financial analysis shows the relationship and changes between items on the financial statements. Common techniques used to evaluate the information presented on financial statements are horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis – comparison of the same items on a company’s financial statements for two or more periods. Comparability – financial information that can be compared from one accounting period to another or from one business to another. Base year – year used for comparison. Vertical analysis (component percentages) – requires each dollar amount reported on a financial statement to be stated as a percentage of another amount (base amount) appearing on the same statement. Percentages for the current year are compared to percentages of previous years or other companies in the same industry. Ratio analysis – comparison of two amounts on a financial statement and the evaluation of the relationship between these amounts. Ratio analysis is used to evaluate a company’s profitability, liquidity, and financial strength. Companies must decide on acceptable levels of financial performance for each type of analysis performed. Levels may vary due to different financial characteristics of the businesses being compared. CONTENT I. Horizontal Analysis A. Compare same items on a financial statement for two or more periods. B. Ex: 2009 Sales = $500,000; 2009 Sales = $400,000. C. Analysis determines the cause of the change. II. Vertical Analysis (component percentages) A. Show each amount as a percentage of another amount on the same financial statements. 1. Income statement items are shown as a percentage of sales. 2. Asset items are shown as a percentage of total assets. 3. Liability and equity items are shown as a percentage of total liabilities and stockholders’ equity. B. Compare to percentages of previous years or companies in the same industry. C. Analysis determines the cause of favorable or unfavorable changes. III. Ratio Analysis A. Liquidity ratios – measure the ability of a business to pay its current debts and provide cash for unexpected needs. 1. The higher the ratio, the more likely a company can meet its cash outflow needs. 2. Changes in the ratios need to be investigated for signs of downward trends. 3. Analysis determines the reasons behind increases and decreases to help management with decision making. B. Profitability ratios – evaluate the earnings performance of the business during the accounting period. 1. Companies look for consistent or increasing ratios as a sign of stable or increasing profitability. 2. Changes in the ratio need to be investigated for signs of downward trends. C. Financial strength ratios – measure the ability of a business to pay its debts in order to maintain credit standing and borrow funds in the future. 1. Creditors look for a high ratio. 2. Decreasing ratios need to be investigated for signs of downward trends. 3. Debt ratios measure the amount of debt in relation to total assets. Therefore, favorable ratios would be lower. As the ratio increases, the less favorable the ratio becomes. 5.04 Analyzing Financial Indicators and Ratios Page 1: Horizontal Analysis: Compare same items on a financial statement for two or more periods. Ex: 2009 Sales = $500,000; 2009 Sales = $400,000. Analysis determines the cause of the change. Vertical Analysis (component percentages) Show each amount as a percentage of another amount on the same financial statements. o Income statement items are shown as a percentage of sales. o Asset items are shown as a percentage of total assets. o Liability and equity items are shown as a percentage of total liabilities and stockholders’ equity. o Compare to percentages of previous years or companies in the same industry. Analysis determines the cause of favorable or unfavorable changes. Page 2: Ratio Analysis Liquidity Ratios – measures the ability of a business to pay its current debts and provide cash for unexpected needs. o The higher the ratio, the more likely a company can meet its cash outflow needs. o Changes in the ratios need to be investigated for signs of downward trends. o Analysis determines the reasons behind increases and decreases to help management with decision making. Profitability Ratios – evaluate the earnings performance of the business during the accounting period. o Companies look for consistent or increasing ratios as a sign of stable or increasing profitability. o Changes in the ratio need to be investigated for signs of downward trends. Financial Strength Ratios – measures the ability of a business to pay its debts in order to maintain credit standing and borrow funds in the future. o Creditors look for a high ratio. o Decreasing ratios need to be investigated for signs of downward trends. Debt ratios measure the amount of debt in relation to total assets. o Therefore, favorable ratios would be lower. o As the ratio increases, the less favorable the ratio becomes. 5.04 Financial Analysis Guided Practice A You have been asked to analyze the income statement for Josh Walker Boots. In your analysis, you discover the following information. Josh Walker Boots Income Statement For the year ended December 31, 2010 Item Net sales Cost of merchandise sold Gross profit on sales Total operating expenses Net Income Increase from Prior Year 15% 22% 12% 10% 14% 1. What might be the reason for the large increase in the cost of merchandise sold? 2. List two ways to further increase net sales. 3. What strategies could Josh employ to improve net income? 5.04 Financial Analysis Guided Practice B Home Depot Current Ratio Receivables Turnover Return on Net Sales Inventory Turnover Year 1 2.5 8.1 6.2% 6.8 Year 2 2.7 8.8 6.4% 7.0 Year 3 2.9 9.2 6.3% 7.3 Based on the ratios given, explain the trends shown in the table above. Current Ratio: Receivables Turnover: Return on Net Sales: Inventory Turnover: 5.04 Financial Analysis Independent Practice – Page 1 Wal-Mart Current Ratio Receivables Turnover Return on Net Sales Inventory Turnover Year 1 1.9 8.2 4.6% 5.4 Year 2 2.3 7.8 4.8% 6.0 Year 3 2.5 6.5 4.9% 6.3 Target Current Ratio Receivables Turnover Return on Net Sales Inventory Turnover Year 1 3.3 3.5 6.5% 9.2 Year 2 2.9 3.7 4.3% 8.7 Year 3 2.3 4.1 6.8% 6.4 K-Mart Current Ratio Receivables Turnover Return on Net Sales Inventory Turnover Year 1 1.6 6.4 8.5% 12.2 Year 2 1.7 9.9 7.3% 12.1 Year 3 1.8 7.1 5.6% 12.2 Magic Mart Current Ratio Receivables Turnover Return on Net Sales Inventory Turnover Year 1 1.8 9.4 5.5% 3.8 Year 2 1.3 4.7 5.3% 6.4 Year 3 0.4 9.2 5.4% 5.9 Figure 1 1. Based on the current ratio in Figure 1, explain the trends for each company listed. Wal-Mart: Target: K-Mart: Magic Mart: 5.04 Financial Analysis Independent Practice – Page 2 2. Based on the receivables turnover ratio in Figure 1, explain the trends for each company listed. Wal-Mart: Target: K-Mart: Magic Mart: 3. Based on the return on net sales ratio in Figure 1, explain the trends for each company listed. Wal-Mart: Target: K-Mart: Magic Mart: 5.04 Financial Analysis Independent Practice – Page 3 4. Based on the return on inventory turnover ratio in Figure 1, explain the trends for each company listed. Wal-Mart: Target: K-Mart: Magic Mart: 5.04 Analyzing Financial Ratios – Page 1 Cooper Corporation Balance Sheet December 31, 2010 ASSETS Ca s h Ma rketa bl e Securi ties Accounts Recei va bl e Mercha ndi s e Inventory Prepa i d Expens es Property, Pl a nt & Equi pment (net) TOTAL ASSETS REVENUE Sa l es (net) TOTAL SALES $ 15,000.00 10,000.00 25,000.00 40,000.00 5,000.00 85,000.00 $ 180,000.00 $ 20,000.00 3,000.00 5,000.00 50,000.00 LIABILITIES & STOCKHOLDERS' EQUITY LIABILITIES Accounts Pa ya bl e Sa l a ri es Pa ya bl e Note Pa ya bl e - current Note Pa ya bl e - l ong-term TOTAL LIABILITIES 78,000.00 STOCKHOLDERS' EQUITY PAID-IN CAPITAL Common Stock ($1 pa r va l ue, 100,000 s ha res Addi tiona l Pa i d-In Ca pi ta l TOTAL PAID-IN CAPITAL Reta i ned Ea rni ngs 10,000.00 5,000.00 15,000.00 87,000.00 TOTAL STOCKHOLDERS' EQUITY TOTAL LIABILITIES & STOCKHOLDERS' EQUITY Cooper Corporation Income Statement December 31, 2010 $ 102,000.00 180,000.00 $ COST OF MERCHANDISE SOLD Begi nni ng Inventory Purcha s es Les s Endi ng Inventory TOTAL COST OF MERCHANDISE SOLD GROSS PROFIT OPERATING EXPENSES Advertis i ng Expens e Offi ce Expens e Sa l a ry Expens e Util i ties Expens e Vehi cl e Expens e TOTAL OPERATING EXPENSES NET INCOME (LOSS) Calculate the following. Current Ratio Merchandise Inventory Turnover Accounts Receivables Turnover Return on Stockholders’ Equity Earnings per Share Price-Earnings Ratio Return on Net Sales Debt Ratio Equity Ratio Equity per Share 155,000.00 155,000.00 35,000.00 70,000.00 40,000.00 65,000.00 90,000.00 2,000.00 4,000.00 35,000.00 7,000.00 6,000.00 54,000.00 $ 36,000.00 5.04 Analyzing Financial Ratios – Page 2 1. Current Ratio The Industry Standard for similar companies is 2.6:1. What can you determine based on the current ratio for Cooper Corporation? 2. Merchandise Inventory Turnover Cooper Corporation’s merchandise turnover rate for 2009 was 2.1. What can you determine, based on the 2010 ratio, about Cooper Corporation’s management of inventory? 3. Accounts Receivable Turnover Cooper Corporation’s accounts receivable turnover for 2009 was 7.22. Beginning Accounts Receivable for 2010 was $20,000. Based on a 365 day year, what can you determine about Cooper Corporation’s cash flow for 2010? 4. Return on Stockholders’ Equity Beginning Stockholders’ Equity for 2010 is $65,000. Return on Stockholders’ Equity for 2009 was 39%. What does the 2010 ratio tell the stockholders of Cooper Corporation? 5.04 Analyzing Financial Ratios – Page 3 5. Earnings per Share Earnings per share for the past two years was $3.50 per share for 2009 and $3.45 per share for 2008. Considering the current year’s Earnings per Share, what can investors determine is happening with Cooper Corporation? 6. Price-Earnings Ratio The current market price for Cooper Corporation stock is $5.75 per share. What can be determined by the priceearnings ratio? 7. Return on Net Sales The return on net sales for 2009 and 2008 was 24% and 23%, respectively. What can be determined by reviewing the return on net sales for the past three years? 8. Debt Ratio The industry standard for companies similar to Cooper Corporation is 41%. What can be determined by reviewing Cooper Corporation’s debt ratio? 5.04 Analyzing Financial Ratios – Page 4 9. Equity per Share The equity per share for 2009 was $8.75 and for 2008 was $9.82. What can be determined by Cooper Corporation’s equity per share for 2010? 10. Equity Ratio The industry standard for companies similar to Cooper Corporation is 59%. What can be determined by reviewing Cooper Corporation’s equity ratio? 5.04 Prototype Assessment Items – Page 1 These prototype assessment items illustrate the types of items used in the item bank for this objective. All items have been written to match the cognitive process of the analyze verb in the objective. These exact questions will not be used on the secure postassessment, but questions in similar formats will be used. 1. RWM Textiles has equity per share of $145.00 for the current year. The equity per share for the past two years was $115.00 and $126.00, respectively. Which of the following would MOST LIKELY explain the change in equity per share over the past three years? A. RWM has consistently increased net income over the past three years. B. RWM has issued a significant amount of notes receivable over the past three years. C. RWM has increased its operating expenses significantly over the past three years. D. RWM has had a significant decrease in sales over the past three years. Combination 1 Combination 2 Combination 3 Combination 4 Current Ratio Debt Ratio 1.0 51% 2.6 34% 1.5 49% 2.9 59% Return on Equity 11% 19% 16% 14% Figure 5.04-A 2. As a short-term creditor concerned with a company’s ability to meet its financial obligation to you, which one of the combinations of ratios shown in Figure 5.04 A, would you most likely prefer? A. B. C. D. Combination 1 Combination 2 Combination 3 Combination 4 5.04 Prototype Assessment Items – Page 2 3. Miller Manufacturing has a current ratio of 2.8:1. The industry standard for companies similar to Miller is 2.3:1. This means that Miller: A. B. C. D. Is in danger of filing bankruptcy due to lack of cash flow. Has the ability to pay all of its current liabilities. Does not have the ability to pay its current liabilities. Has greater than average financial risk when compared to other firms in its industry. 4. Parker Industries has a debt ratio of 49.2%. The industry average for companies similar to Parker is 42.5%. This means that Parker: A. B. C. D. Will not experience any difficulty with its creditors. Has less liquidity than other firms in the industry. Will be viewed as having high creditworthiness. Has greater than average financial risk when compared to other firms in its industry. Company A Price-earnings ratio Equity per share Inventory turnover Year 1 8.9 $3.71 5.4 Year 2 10.5 $2.57 6.0 Year 3 11.2 $2.38 6.3 Company B Price-earnings ratio Equity per share Inventory turnover Year 1 6.1 $1.24 9.2 Year 2 7.1 $1.19 8.7 Year 3 7.9 $1.05 6.4 Company C Price-earnings ratio Equity per share Inventory turnover Year 1 3.5 $8.75 12.2 Year 2 3.4 $9.45 12.1 Year 3 3.3 $10.36 12.2 Company D Price-earnings ratio Equity per share Inventory turnover Year 1 14.6 $9.66 3.8 Year 2 9.3 $2.54 6.4 Year 3 6.5 $8.55 5.9 Figure 5.04-B 5. Based on the price-earnings ratio in Figure 5.04-B, which company has the least favorable trend? A. Company A B. Company B C. Company C D. Company D