Chapter 17

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CHAPTER 17
ANALYSIS AND
INTERPRETATION OF
FINANCIAL STATEMENTS
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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
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Who analyzes financial statements?
Internal
625
users (i.e., management) External users (emphasis of chapter)

Examples? Investors, creditors, regulatory agencies & stock market analysts and auditors
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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...
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Information is available from
Published
627 628
annual reports
(1) (2) (3) (4) (5)
Financial statements Notes to financial statements Letters to stockholders Auditors report (Independent accountants) Managements discussion and analysis
Reports
filed with the government
e.g., Form 10-K, Form 10-Q and Form 8-K
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Information is available from
Other
627 628
sources
(1) Newspapers (e.g., Wall Street Journal ) (2) Periodicals (e.g. Forbes, Fortune) (3) Financial information organizations such as: Moodys, Standard & Poors, Dun & Bradstreet, Inc., and Robert Morris Associates (4) Other business publications
Methods of Financial Statement Analysis

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Horizontal Analysis Vertical Analysis Common-Size Statements Trend Percentages Ratio Analysis
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Horizontal Analysis
Using comparative financial statements to calculate dollar or percentage changes in a financial statement item from one period to the next
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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
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CommonCommon-Size Statements
Financial statements that show only percentages and no absolute dollar amounts
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Trend Percentages
Show changes over time in given financial statement items (can help evaluate financial information of several years)
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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)
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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.
CLOVER CORPORATION Comparative Balance Sheets December 31, 1999 and 1998 1999 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 $ 40,000 120,000 160,000 315,000 $ 40,000 85,000 125,000 289,700 $ 12,000 60,000 80,000 3,000 155,000 $ 23,500 40,000 100,000 1,200 164,700 1998
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Increa Amou
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Calculating Change in Dollar Amounts
Dollar Change = Current Year Figure Base Year Figure
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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.
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Calculating Change as a Percentage
Percentage Change = Dollar Change Base Year Figure
100%
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CLOVER CORPORATION Comparative Balance Sheets December 31, 1999 and 1998 1999 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 1998 Increase (Decrease) Amount %
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CLOVER CORPORATION Comparative Balance Sheets December 31, 1999 and 1998 1999 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 1998 Increase (Decrease) Amount %
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CLOVER CORPORATION Comparative Balance Sheets December 31, 1999 and 1998 1999 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 1998 Increase (Decrease) Amount %
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Lets apply the same procedures to the liability and stockholders equity sections of the balance sheet.
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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 1998 Increase (Decrease) Amount %
67,000 $ 3,000 70,000 75,000 145,000 20,000 60,000 10,000 90,000 80,000 170,000 315,000 $
44,000 $ 6,000 50,000 80,000 130,000 20,000 60,000 10,000 90,000 69,700 159,700 289,700 $
23,000 (3,000) 20,000 (5,000) 15,000 10,300 10,300 25,300
52.3 (50.0) 40.0 (6.3) 11.5 0.0 0.0 0.0 0.0 14.8 6.4 8.7
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Now, lets apply the procedures to the income statement.
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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)
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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)
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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 increase inComparative Income Statements sales, yielding an overall For the Years Ended December 31, 1999 and 1998 decrease in net income.
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)
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Vertical Analysis Example

The management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company.
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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%
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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 $387,000 100,000 rounded = 8% Equipment 110,000 23% 26% Accum. Depr. (17,000) (15,000) -4% -4% Total $ 483,000 $ 387,000 100% 100%
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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% $76,000 $483,000 = 50,000 rounded 13% 16% Common Stock 170,000 160,000 35% 41% Retained Earnings 154,000 100,000 32% 26% Total $ 483,000 $ 387,000 100% 100%
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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
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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
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Using 1995 as the base year, we develop the following percentage relationships.
1999 132% 120% 313% Wheeler, Inc. Operating Data 1998 1997 123% 116% 116% 110% 234% 203% 1996 109% 106% 158% 1995 100% 100% 100%
Revenues Expenses Net income
$1,991 - $1,820 = $171 $171 $1,820 = 9% rounded
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140 130 % of 100 Base 120 110 100 90 Sales Expenses 1995 1996 1997 Years 1998 1999
Trend line for Sales
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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%) (e.g., EPS of $2.25) 3. $
CAUTION!
Using ratios and percentages without considering the underlying causes may be hazardous to your health! lead to incorrect conclusions.
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Categories of Ratios

Liquidity Ratios
Indicate a companys 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
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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
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Equity (Long-Term Solvency) Ratios
Equity (stockholders equity) ratio Equity to debt
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Profitability Tests
Return
on operating assets Net income to net sales (return on sales or profit margin margin) $ Return on average common stockholders equity (ROE ROE) Cash flow margin Earnings per share Times interest earned Times preferred dividends earned
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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
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Now, lets look at Norton Corporations 1999 and 1998 financial statements.
NORTON CORPORATION Balance Sheets December 31, 1999 and 1998 1999 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 $ 165,000 116,390 281,390 346,390 $ $ 30,000 20,000 12,000 3,000 65,000 $
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1998
20,000 17,000 10,000 2,000 49,000 123,000 128,000 251,000 300,000
NORTON CORPORATION Balance Sheets December 31, 1999 and 1998 1999 Liabilities and Stockholders' Equity Current liabilities: Accounts payable Notes payable, short-term Total current liabilities 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 27,400 158,100 185,500 48,890 234,390 $ 346,390 70,000 112,000 $ 39,000 3,000 42,000 $
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1998
40,000 2,000 42,000 78,000 120,000 17,000 113,000 130,000 50,000 180,000
$ 300,000
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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
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Now, lets calculate the 10 ratios based on Nortons financial statements.
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NORTON CORPORATION 1999 Cash Accounts receivable, net $ 30,000 17,000 20,000 10,000 12,000 65,000 42,000 494,000 140,000
We will use this information to calculate the liquidity ratios for Norton.
Beginning of year End of year Inventory Beginning of year End of year Total current assets Total current liabilities Sales on account Cost of goods sold
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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 companys liquidity.
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Current (Working Capital) Ratio

#1
Current Ratio Current Ratio = = Current Assets Current Liabilities $65,000 $42,000 = 1.55 : 1
Measures the ability of the company to pay current debts as they become due.
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AcidAcid-Test (Quick) Ratio

#2
Acid-Test = Ratio Quick Assets Current Liabilities Quick assets are Cash, Marketable Securities, Accounts Receivable (net) and current Notes Receivable.
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#2
Acid-Test = Ratio Quick Assets Current Liabilities Norton Corporations quick assets consist of cash of $30,000 and accounts receivable of $20,000.
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#2
Acid-Test = Ratio Acid-Test = Ratio Quick Assets Current Liabilities $50,000 $42,000 = 1.19 : 1
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Accounts Receivable Turnover

Net, credit sales Accounts Receivable = Turnover
#3
Average, net accounts receivable
Sales on Account Average Accounts Receivable
Accounts $494,000 Receivable = = 26.70 times ($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
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= 13.67 days
Measures, on average, how many days it takes to collect an account receivable.
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
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= 13.67 days
In practice, would 45 days be a desirable number of days in receivables?
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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.
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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 LongTerm Long 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
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NORTON CORPORATION 1999 Common shares outstanding Beginning of year End of year Net income 17,000 27,400 $ 53,690 180,000 234,390 2 20 7,300 300,000 346,390
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Here is the rest of the information we will use.
Stockholders' equity Beginning of year End of year Dividends per share Dec. 31 market price/share Interest expense Total assets Beginning of year End of year
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Equity Ratio
#6
Equity = Ratio Equity = Ratio Stockholders Equity Total Assets $234,390 $346,390 = 67.7%
Measures the proportion of total assets provided by stockholders.
Net Income to Net Sales

#7
Net Income to = Net Sales Net Income to = Net Sales Net Income Net Sales $53,690 $494,000 = 10.9%
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A/K/A Return on Sales or Profit Margin
Measures the proportion of the sales dollar which is retained as profit.
Net Income to Net Sales

#7
Net Income to = Net Sales Net Income to = Net Sales Net Income Net Sales $53,690 $494,000 = 10.9%
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A/K/A Return on Sales or Profit Margin
Would a 1% return on sales be good?
Return on Average Common Stockholders Equity (ROE)

#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.
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= 25.9%
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Earnings Per Share

#9
Earnings Available to Common Stockholders Earnings = Weighted-Average Number of Common per Share Shares Outstanding Earnings $53,690 = (17,000 + 27,400) 2 per Share = $2.42
The financial press regularly publishes actual and forecasted EPS amounts.
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Earnings Per Share

Whats new from Chap. 15?
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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
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Earnings Per Share

Whats new from Chap. 15?
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Weighted-average calculation Earnings available to common stockholders EPS of common stock = _______________________ Weighted-average number of common shares outstanding Alternate #1
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Earnings Per Share

645 Alternate #2
Alternate #3
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Earnings Per Share

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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.
PricePrice-Earnings Ratio
A/K/A P/E Multiple #10
Price-Earnings = Ratio Price-Earnings = Ratio Market Price Per Share EPS $20.00 $ 2.42 = 8.3 : 1
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Provides some measure of whether the stock is under or overpriced.
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Important Considerations

Need for comparable data

Data
is provided by Dun & Bradstreet, Standard & Poors etc. Must compare by industry Is EPS comparable?

Influence of external factors

General
business conditions Seasonal nature of business operations

Impact of inflation
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Question
The current ratio is a measure of liquidity that is computed by dividing total assets by total liabilities. a. True b. False
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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
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Question
Quick assets are defined as Cash, Marketable Securities and net receivables. a. True b. False
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Question
Quick assets are defined as Cash, Marketable Securities and net receivables. a. True b. False
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No more ratios, please!
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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
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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

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17-1

Financial Statement Analysis

Non-accounting majors, especially, should relate well to this chapter

What is financial statement analysis?

Financial Statement Analysis

users (i.e., management)  External users (emphasis of chapter)

Financial Statement Analysis

What do internal users use it for?

What do external users use it for?

First sentence in chapter says...

Financial Statement Analysis

(1) (2) (3) (4) (5)

filed with the government

e.g., Form 10-K, Form 10-Q and Form 8-K

Financial Statement Analysis

Methods of Financial Statement Analysis

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

23,000 (3,000) 20,000 (5,000) 15,000 10,300 10,300 25,300

Horizontal Analysis Example

Vertical Analysis Example

Vertical Analysis Example

Vertical Analysis Example

Vertical Analysis Example

Trend Percentages Example

Trend Percentages Example

$1,991 - $1,820 = $171

Trend Percentages Example

Revenues Expenses Net income

$1,991 - $1,820 = $171 $171 $1,820 = 9% rounded

Trend line for Sales

Equity (Long-Term Solvency) Ratios

10 Ratios You Must Know

10 Ratios You Must Know

10 Ratios You Must Know

10 Ratios You Must Know

20,000 17,000 10,000 2,000 49,000 123,000 128,000 251,000 300,000

Now, lets calculate the 10 ratios based on Nortons financial statements.

* While this is not a ratio, it does give an indication of a companys liquidity.

Current (Working Capital) Ratio

AcidAcid-Test (Quick) Ratio

AcidAcid-Test (Quick) Ratio

AcidAcid-Test (Quick) Ratio

Accounts Receivable Turnover

Average, net accounts receivable

Sales on Account Average Accounts Receivable

Number of Days Sales in Accounts Receivable

Measures, on average, how many days it takes to collect an account receivable.

Number of Days Sales in Accounts Receivable

In practice, would 45 days be a desirable number of days in receivables?

$140,000 = 12.73 times ($10,000 + $12,000) 2

$140,000 = 12.73 times ($10,000 + $12,000) 2

Would 5 be a desirable number of times for inventory to turnover?

Equity, or LongTerm Long Solvency Ratios

users (i.e., management) External users (emphasis of chapter)

business conditions Seasonal nature of business operations

first Study guide and/or Hermanson tutorials