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Chapter 2
Financial Statements and Analysis
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Learning Goals
1. Review the contents of the stockholders’ report and the procedures for consolidating international financial statements.
2. Understand who uses financial ratios, and how.
3. Use ratios to analyze a firm’s liquidity and activity.
4. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firm’s debt.
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Learning Goals (cont.)
5. Use ratios to analyze a firm’s profitability and market value.
6. Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis.
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The Four Key Financial Statements: The Income Statement
• The income statement provides a financial summary of a company’s operating results during a specified period.
• Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.
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The Four Key Financial Statements
Table 2.1 Bartlett Company Income Statements ($000)
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The Four Key Financial Statements: The Balance Sheet
• The balance sheet presents a summary of a firm’s financial position at a given point in time.
• Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.
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The Four Key Financial Statements
Table 2.2a Bartlett Company Balance Sheets ($000)
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The Four Key Financial Statements (cont.)
Table 2.2b Bartlett Company Balance Sheets ($000)
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The Four Key Financial Statements: Statement of Retained Earnings
• The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.
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The Four Key Financial Statements
Table 2.3 Bartlett Company Statement of Retained Earnings ($000) for the Year Ended December 31, 2009
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The Four Key Financial Statements: Statement of Cash Flows
• The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended.
• This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.
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The Four Key Financial Statements
Table 2.4 Bartlett Company Statement of Cash Flows ($000) for the Year Ended December 31, 2009
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Using Financial Ratios: Interested Parties
• Ratio analysis involves methods of calculating and interpreting financial ratios to assess a firm’s financial condition and performance.
• It is of interest to shareholders, creditors, and the firm’s own management.
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Using Financial Ratios: Types of Ratio Comparisons
• Trend or time-series analysis
• Cross-sectional analysis
* Industry comparative analysis
* Benchmarking
* Combined
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Using Financial Ratios: Types of Ratio Comparisons (cont.)
Table 2.5 Industry Average Ratios for Selected Lines of Businessa
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Using Financial Ratios: Types of Ratio Comparisons (cont.)
Figure 2.1 Combined Analysis
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Using Financial Ratios: Cautions for Doing Ratio Analysis
1. Ratios must be considered together; a single ratio by itself means relatively little.
2. Financial statements that are being compared should be dated at the same point in time.
3. Use audited financial statements when possible.4. The financial data being compared should have been
developed in the same way.5. Be wary of inflation distortions.
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Ratio Analysis Example
• We will illustrate the use of financial ratios for analyzing financial statements using the Bartlett Company Income Statements and Balance Sheets presented earlier in Tables 2.1 and 2.2.
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Current ratio = total current assets
total current liabilities
Current ratio = $1,233,000 = 1.97
$620,000
Ratio Analysis
• Liquidity Ratios– Current Ratio
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Quick ratio = Total Current Assets - Inventory
total current liabilities
Quick ratio = $1,233,000 - $289,000 = 1.51
$620,000
Ratio Analysis (cont.)
• Liquidity Ratios– Current Ratio– Quick Ratio
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Inventory Turnover = Cost of Goods Sold
Inventory
Inventory Turnover = $2,088,000 = 7.2
$289,000
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios
– Inventory Turnover
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Average Age of Inventory = 365
Inventory Turnover
Inventory Turnover = 365 = 50.7 days
7.2
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios
– Average Age of Inventory
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ACP = Accounts Receivable
Net Sales/365
ACP = $503,000 = 59.7 days
$3,074,000/365
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios
– Average Collection Period
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APP = Accounts Payable
Annual Purchases/365
APP = $382,000 = 95.4 days (.70 x $2,088,000)/365
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios
– Average Payment Period
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Total Asset Turnover = Net Sales
Total Assets
Total Asset Turnover = $3,074,000 = .85
$3,597,000
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios
– Total Asset Turnover
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Ratio Analysis (cont.)
Table 2.6 Financial Statements Associated with Patty’s Alternatives
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Debt Ratio = Total Liabilities/Total Assets
Debt Ratio = $1,643,000/$3,597,000 = 45.7%
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Financial Leverage Ratios
– Debt Ratio
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Times Interest Earned = EBIT/Interest
Times Interest Earned = $418,000/$93,000 = 4.5
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios
– Times Interest Earned Ratio
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FPCR = EBIT + Lease Payments________________
Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}
FPCR = $418,000 + $35,000 = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios
– Fixed-Payment coverage Ratio (FPCR)
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Ratio Analysis (cont.)
• Liquidity Ratios
• Activity Ratios
• Leverage Ratios
• Profitability Ratios– Common-Size Income Statements
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Ratio Analysis (cont.)
Table 2.7 Bartlett Company Common-Size Income Statements
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GPM = Gross Profit/Net Sales
GPM = $986,000/$3,074,000 = 32.1%
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Gross Profit Margin
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OPM = EBIT/Net Sales
OPM = $418,000/$3,074,000 = 13.6%
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Operating Profit Margin (OPM)
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NPM = Earnings Available to Common Stockholders
Sales
NPM = $221,000/$3,074,000 = 7.2%
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Net Profit Margin (NPM)
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EPS = Earnings Available to Common Stockholders Number of Shares Outstanding
EPS = $221,000/76,262 = $2.90
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Earnings Per Share (EPS)
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ROA = Earnings Available to Common Stockholders
Total Assets
ROA = $221,000/$3,597,000 = 6.1%
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Return on Total Assets (ROA)
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ROE = $221,000/$1,754,000 = 12.6%
ROE = Earnings Available to Common Stockholders
Total Equity
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios
– Return on Equity (ROE)
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P/E = Market Price Per Share of Common Stock Earnings Per Share
P/E = $32.25/$2.90 = 11.1
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios• Market Ratios
– Price Earnings (P/E) Ratio
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BV/Share = Common Stock Equity Number of Shares of Common Stock
BV/Share = $1,754,000/72,262 = $23.00
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios• Market Ratios
– Market/Book (M/B) Ratio
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M/B Ratio = Market Price/Share of Common Stock Book Value/Share of Common Stock
M/B Ratio = $32.25/$23.00 = 1.40
Ratio Analysis (cont.)
• Liquidity Ratios• Activity Ratios• Leverage Ratios• Profitability Ratios• Market Ratios
– Market/Book (M/B) Ratio
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Summarizing All Ratios Table 2.8 Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)
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Summarizing All Ratios (cont.)Table 2.8 Summary of Bartlett Company Ratios (2007–2009, Including 2009 Industry Averages)
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DuPont System of Analysis
• The DuPont system of analysis is used to dissect the firm’s financial statements and to assess its financial condition.
• It merges the income statement and balance sheet into two summary measures of profitability.
• The Modified DuPont Formula relates the firm’s ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity:
• ROA and ROE as shown in the series of equations on the following slide and in Figure 2.2 on the following slide.
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DuPont System of Analysis
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DuPont System of Analysis (cont.)
Figure 2.2 DuPont System of Analysis
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ROE = 6.1% X 2.06 = 12.6%
Modified DuPont Formula (cont.)
• Use of the FLM to convert ROA into ROE reflects the impact of financial leverage on the owner’s return.
• Substituting the values for Bartlett Company’s ROA of 6.1 percent calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000 common stock equity) into the Modified DuPont formula yields: