chapter 13 financial statement analysis using financial accounting information: the alternative to...
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Chapter 13Financial Statement Analysis
Using Financial Accounting Information:
The Alternative to Debits and Credits, 6th
by
Gary A. Porter and Curtis L. Norton
Copyright © 2009 South-Western, a part of Cengage Learning.
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Stockholders
Financial Statement Analysis
Creditors
Management
Will I be paid?How
good is our investment?
How are weperforming?
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LIFO FIFO
Limitations of Financial Statement Analysis
Use of different accounting methods
Changes in accounting methods
LO1
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Limitations of FinancialStatement Analysis
Failure to recognize trends in ratios
Difficulty of making industry comparisons (i.e., conglomerates)
????
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Limitations of Financial Statement Analysis
Nonoperating items on income statement Effects of inflation
=Apples Oranges
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Horizontal Analysis A comparison of financial statement items
over a period of time Read right to left to compare one year’s
results with the next as a dollar amount of change and as a percentage of change from year to year
LO2
%$
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Horizontal Analysis
Cash $ 320 $1,350 $(1,030) (76)%
Accounts receivable 5,500 4,500 1,000 22
Inventory 4,750 2,750 2,000 73
Prepaid insurance 150 200 (50) (25)
Total current assets $10,720 $8,800 $ 1,920 22
December 31 Increase (Decrease)
2008 2007 Dollars Percent
Dollar change from year to year
Percentage changefrom one year to
the next year
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Trend Analysis
Return on Average Equity
2006 2005 2004 2003
23% 23.5% 24.7% 26.7%
Wm. Wrigley Jr. Company
Tracking items over a series of years
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Vertical Analysis
Common-size statements recast items as a percentage of a selected item
Allows comparisons of companies of different size
Compares percentages across years to identify trends
%
%
%
LO3
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Vertical Analysis
Cash $ 320 1.9% $ 1,350 9.8%
Accounts receivable 5,500 32.6 4,500 32.6
Inventory 4,750 28.1 2,750 19.9
Prepaid insurance 150 0.9 200 1.5
Total current assets $10,720 63.5% $8,800 63.8%
December 31, 2008 December 31, 2007
Dollars Percent Dollars Percent
Compare percentagesacross years to spotyear-to-year trends
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Liquidity Analysis
Nearness to cash Ability to pay debts as they become due
LO4
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Working Capital
Excess of current assets over current liabilities
Lacks meaningful comparisons for companies of different size
–
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Current Ratio
Measure of short-term financial health Consider composition of current assets
Rule of thumb2:1
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Acid-Test (Quick) Ratio
Stricter test of ability to pay debts Excludes inventories and prepaid assets
Quick AssetsCurrent Liabilities
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Cash Flow from Operations to Current Liabilities
Focuses on cash only Can be used to indicate the flow of cash
during the year to cover the debts due
Net Cash Provided by Operating ActivitiesAverage Current Liabilities
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Accounts Receivable Turnover Ratio
Net Credit SalesAverage Accounts Receivable
Indicates how quickly a company is collecting (i.e., turning over) its receivables
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Number of Days’ Sales in Receivables
Represents the average number of days an account is outstanding
Number of Days in the PeriodAccounts Receivable Turnover
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Number of Days’ Sales in Receivables
If this company’s credit terms are net 30, what would this tell you about the efficiency of the collection process?
360 days4.8 times
= 75 days
Example:
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Inventory Turnover Ratio
Represents the number of times per period inventory is turned over (i.e., sold).
Cost of Goods SoldAverage Inventory
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Number of Days’ Sales in Inventory
Represents the average number of days inventory is on hand before it’s sold
Number of Days in the PeriodInventory Turnover
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Cash Operating Cycle Time between the purchase of merchandise
and the collection of the from the sale
Number of Days’ Sales in Inventory +
Number of Days’ Sales in Receivables
Purchase of Inventory
Collection of Accounts Receivable
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Solvency Analysis
Ability to stay in business over the long-term
Debt-to-EquityRatio
DebtService
Coverage
TimesInterestEarned
Cash Flowfrom Operations
to CapitalExpenditures
LO5
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Debt-to-Equity Ratio
Total Liabilities Total Stockholders’ Equity
How much have creditors
contributed compared to
owners?
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Debt-to-Equity Ratio
Total LiabilitiesTotal Stockholders’ Equity = .89
For every dollar contributed by
owners, creditors have loaned $.89
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Times Interest Earned
Measures ability to meet current interest payments
The greater the coverage the better
Net Income + Interest Expense + Income Tax ExpenseInterest Expense
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Debt Service Coverage
Measures amount of cash from operating activities available to “service” the debt
Cash Flow from Operations Before Interest and Tax Payments
Interest and Principal Payments
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Cash Flow from Operations to Capital Expenditures Ratio
Measures company’s ability to use operations (vs. creditors and owners) to finance its acquisitions of productive assets
Cash Flow from Operations – Total Dividends PaidCash Paid for Acquisitions
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Profitability Analysis
Rate of Return on Assets Return on Common Stockholders’ Equity Earnings per Share Price/Earnings Ratio Dividend Ratios
LO6
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Return on Assets Ratio
Measures return to all providers of capital (creditors and owners)
Net Income + Interest Expense, Net of TaxAverage Total Assets
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Return on Common Stockholders’ Equity
Net Income – Preferred DividendsAverage Common Stockholders’ Equity
The owners earned 15%on their investment
in ABC Co... Not bad!
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Earnings per Share
Presents profits on a per-share basis
Net Income – Preferred DividendsWeighted Average Number of Common Shares Outstanding
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Price/Earnings Ratio
Relates earnings to the market price of the stock
Current Market PriceEarnings per Share
very high P/Every low P/E
possibly overpricedpossibly underpriced
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Price/Earnings Ratio
Both companies have earnings of $2 per share. So why the different P/E
ratios?
P/E Ratios
Co. A = 9 to 1Co. B = 8 to 1
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Dividend Payout Ratio
Common Dividends per ShareEarnings per Share
We need to decide what
percentage of the firm’s income we
can return to owners
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Dividend Yield Ratio
Investors willing to forgo dividends in lieu of price appreciation
Common Dividends per ShareMarket Price per Share
usually < 5%=
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AppendixAccounting Tools: Reporting and
Analyzing Other Income Statement Items
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Common Characteristics All such items are reported after income from
continuing operations Reported separately Shown net of tax effects Most analysts ignore these items, since they
are not likely to reoccur
LO7
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Discontinued Operations Any gain or loss from disposal of a division
or segment of the business Any net income or loss from operating this
portion until the date of disposal
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Extraordinary Items
Gain or loss due to an event that is Unusual in nature AND Infrequent in occurrence
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End of Chapter 13