Financial Statement Analysis K.R. Subramanyam Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 1-26 Balance Sheets 1-27 Balance Sheet Total Investing = Total Financing = Creditor Financing + Owner Financing Colgate Financing (in $billions) $12.724 = $10.183 + $2.541 1-28 Income Statement Revenues – Cost of goods sold = Gross Profit Gross profit – Operating expenses = Operating Profit Colgate’s Profitability (in $billions) $16.734 - $7.144 = $9.590 Gross Profit $9.590 - $5.749= $3.841 Operating profit 1-29 Income Statement 1-31 Statement of Cash Flow 1-32 Retained Earnings, Comprehensive Income, and Changes in Capital Accounts 1-33 Retained Earnings, Comprehensive Income, and Changes in Capital Accounts 1-34 In which of the previous financial statements would an analyst find the investing, financing and operating activities reflected? 1-36 Comparative Income Statements 1-38 Common Size Balance Sheets 1-39 Common Size Income Statements 1-45 Analysis Preview Debt (Bond) Valuation Bt is the value of the bond at time t It +n is the interest payment in period t+n F is the principal payment (usually the debt’s face value) r is the investor’s required interest rate (yield to maturity) 1-46 Analysis Preview Equity Valuation Vt is the value of an equity security at time t Dt +n is the dividend in period t+n k is the cost of capital E refers to expected dividends 1-47 Analysis Preview Equity Valuation - Free Cash Flow to Equity Model FCFt+n is the free cash flow in the period t + n [often defined as cash flow from operations less capital expenditures] k is the cost of capital E refers to an expectation 1-48 Analysis Preview Equity Valuation - Residual Income Model BV is the book value at the end of period t Rit+n is the residual income in period t + n [defined as net income, NI, minus a charge on beginning book value, BV, or RIt = NIt - (k x BVt-1)] k is the cost of capital E refers to an expectation t Chapter Nine Financial Statement Analysis © 2015 McGraw-Hill Education. Factors in Communicating Useful Information The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the following: Users Types of Decisions Information Analysis 9-2 LO 1 LO 1 Differentiate between horizontal and vertical analysis. 9-3 Methods of Analysis Horizontal Analysis Percentage Analysis Vertical Analysis Ratio Analysis 9-4 Milavec Company Financial Statements 9-5 Milavec Company Financial Statements 2015 2014 9-6 Horizontal and Percentage Analysis Horizontal analysis (or trend analysis) refers to studying the behavior of individual financial statement items over several accounting periods. Absolute Amounts Percentage Analysis 9-7 Milavec Company Horizontal Analysis 2015 2014 9-8 Vertical Analysis Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage. 9-9 Vertical Analysis of Income Statement In income statements, all items are usually expressed as a percentage of sales. 9-10 Milavec Company Vertical Analysis 2012 2011 9-11 Vertical Analysis of Balance Sheet In balance sheets, all items are usually expressed as a percentage of total assets. 9-12 2012 2011 9-13 Ratio Analysis Ratio analysis involves studying various relationships between different items reported in a set of financial statements. 9-14 LO 1 LO 1 Calculate ratios for assessing a company’s liquidity. 9-15 Liquidity Ratios Liquidity ratios indicate a company’s ability to pay shortterm debts. They focus on current assets and current liabilities. 1. Working Capital 2. Current Ratio 3. Quick Ratio 4. Accounts Receivable Ratios 5. Inventory Ratios 9-16 Working Capital The excess of current assets over current liabilities is known as working capital. 2012 2011 9-17 Current Ratio Current Ratio = Current Assets Current Liabilities The current ratio measures a company’s short-term debt paying ability. A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories. 9-18 Current Ratio 9-19 Quick (Acid-Test) Ratio AcidTest = Ratio Quick Assets Current Liabilities Quick assets include Cash, Current Marketable Securities, and Accounts Receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory. 9-20 Quick (Acid-Test) Ratio 9-21 Accounts Receivable Turnover Accounts Receivable Turnover = Net Credit Sales Average Accounts Receivable This ratio measures how many times a company converts its receivables into cash each year. 9-22 Accounts Receivable Turnover 9-23 Average Days to Collect Receivables Average Collection Period Average Collection Period = = 365 Days Accounts Receivable Turnover 365 Days 16.98 Times = 21 days This ratio measures, on average, how many days it takes to collect an accounts receivable. 9-24 Inventory Turnover Inventory Turnover = Cost of Goods Sold Average Inventory This ratio measures how many times a company’s inventory has been sold and replaced during the year. 9-25 Inventory Turnover 9-26 Average Days to Sell Inventory Average Sale Period Average = Sale Period 365 Days = Inventory Turnover 365 Days 10.80 Times = 34 days This ratio measures how many days, on average, it takes to sell the inventory. 9-27 LO 3 LO 1 Calculate ratios for assessing a company’s solvency. 9-28 Solvency Ratios Solvency ratios are used to analyze a company’s long-term debtpaying ability and its financing structure. 1. Debt to Assets Ratio 2. Debt to Equity Ratio 3. Number of Times Interest Earned 4. Plant Assets to Long-Term Liabilities 9-29 Debt to Assets Ratio Debt to Assets Ratio = Total Liabilities Total Assets This ratio measures the percentage of a company’s assets that are financed by debt. 9-30 Debt to Equity Ratio Debt to Equity Ratio = Total Liabilities Total Stockholders’ Equity This ratio indicates the relative proportions of debt to equity on a company’s balance sheet. Stockholders like a lot of debt if the company can take advantage of positive financial leverage. Creditors prefer less debt and more equity because equity represents a buffer of protection. 9-31 Debt to Assets and Debt to Equity Ratios 9-32 Number of Times Interest is Earned Ratio Times Interest Earned = Earnings before Interest Expense and Income Taxes Interest Expense This is the most common measure of a company’s ability to provide protection for its longterm creditors. 9-33 Number of Times Interest Earned Ratio 9-34 Plant Assets to Long-Term Liabilities Plant Assets to Long-Term Liabilities = Net Plant Assets Long-Term Liabilities This ratio suggests how well long-term debt is managed to finance long-term assets. 9-35 Plant Assets to Long-Term Liabilities 9-36 LO 4 LO 1 Calculate ratios for assessing company management’s effectiveness. 9-37 Profitability Ratios Profitability ratios measure a company’s ability to generate earnings. 1. Net Margin (or Return on Sales) 2. Asset Turnover Ratio 3. Return on Investment 4. Return on Equity 9-38 Net Margin Net = Margin Net Income Net Sales This measure describes the percent remaining of each sales dollar after subtracting other expenses as well as cost of goods sold. 9-39 Net Margin 9-40 Asset Turnover Ratio Asset Turnover = Net Sales Average Total Assets This ratio measures how many sales dollars were generated for each dollar of assets invested. 9-41 Asset Turnover Ratio 9-42 Return on Investment (ROI) Return on Investment Net Income = Average Total Assets This is the ratio of wealth generated (net income) to the amount invested (average total assets). 9-43 Return on Investment (ROI) For Milavec, ROI was as follows. 2012 $25,000 ÷ $481,500* = 5.19% 2011 $22,000 ÷ $437,500* = 5.03% * The computation of average assets is calculated as beginning assets plus ending assets divided by 2. 9-44 Return on Equity Return on Equity = Net Income Average Total Stockholders’ Equity This measure is often used to measure the profitability of the stockholders’ investment. 9-45 Return on Equity 9-46 LO 5 LO 1 Calculate ratios for assessing a company’s position in the stock market. 9-47 Stock Market Ratios Stock market ratios analyze the earnings and dividends of a company. 1. Earnings Per Share 2. Book Value 3. Price-Earnings (PE) Ratio 4. Dividend Yield 9-48 Earnings Per Share Earnings per Share = Net Earnings Available for Common Stock Average Number of Outstanding Common Shares This measure indicates how much income was earned for each share of common stock outstanding. 9-49 Earnings Per Share $25,000 (net income) - $3,000 (preferred dividend) = $1.60 per share (15,000 + 12,500)/2 (average outstanding common shares) 9-50 Book Value Per Share Book Value per Share Stockholders’ Equity - Preferred Dividends Outstanding Common Shares = This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off. 9-51 Book Value Per Share $362,000 - $50,000 15,000 = $20.80 per share 9-52 Price-Earnings Ratio Price-Earnings = Ratio Market Price Per Share Earnings Per Share This ratio compares the earnings of a company to the market price for a share of the company’s stock. 9-53 Dividend Yield Dividend Yield = Dividends Per Share Market Price Per Share This ratio identifies the return, in terms of cash dividends, on the current market price of the stock. 9-54 Limitations of Financial Statement Analysis Different Industries Changing Economic Environment Accounting Principles 9-55 End of Chapter Nine 9-56
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