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Financial Statement Analysis

Pick a U.S. company;
Find financial statements for this company;
Where to find?
http://www.sec.gov/edgar/searchedgar/companysearch.html
Company website under investor relations
Look for Income Statements and Balance Sheets over past four to five years.
Compile comparative financial statements into one excel file, year by year

Preparation

© 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Tools of Analysis

Horizontal Analysis

Comparing a company’s financial condition and performance across time.

Vertical Analysis

Comparing a company’s financial condition and performance to a base amount.

Ratio Analysis

Measurement of key relations between financial statement items.

Common tools of financial statement analysis are:

Horizontal analysis—comparison of a company’s financial condition and performance across time.

Vertical analysis—comparison of a company’s financial condition and performance to a base amount.

Ratio analysis—measurement of key relations between financial statement items.

Horizontal Analysis

Horizontal analysis refers to examination of financial statement data across time.

Horizontal analysis refers to examination of financial statement data across time. (The term horizontal analysis arises from the left-to-right [or right-to-left] movement of our eyes as we review comparative financial statements across time.)

Comparative Statements

Calculate Change as a Percent

Percent

change

Dollar change

Base period amount

100

When calculating the change as a percentage, divide the amount of the dollar change by the base period amount, and then multiply by 100 to convert to a percentage.

We compute the percent change by dividing the dollar change by the base period amount and then multiplying this quantity by 100 as shown.

Comparative Balance Sheets

Comparative balance sheets consist of amounts from two or more balance sheet dates arranged side by side. This method of analysis is improved by showing each item’s dollar change and percent change to highlight large changes.

Analysis of comparative financial statements begins by focusing on large dollar or percent changes. We then identify the reasons for these changes and, if possible, determine whether they are favorable or unfavorable. We also follow up on items with small changes when we expected the changes to be large.

Exhibit 13.1 shows comparative balance sheets for Apple Inc. (Nasdaq: AAPL). A few items stand out on the asset side. Apple’s cash and cash equivalents increased by 52.6% and short-term marketable securities increased by 82.3%. This is a substantial increase in liquid assets. In response, Apple raised its 2016 dividend 9.6% and increased its share repurchase plan by 25%. Dividends and share repurchase plans are likely to slow its growth of cash and short-term securities. Other notable increases occur with (1) other current assets, partially related to derivatives; (2) vendor non-trade receivables; and (3) long-term marketable securities. Interestingly, accounts receivable decreased by 3.5% while sales increased by 27.9%. This suggests Apple is improving its collection of receivables, a positive trend.

On Apple’s financing side, we see its overall 25.3% increase is driven by a 42.3% increase in liabilities; equity increased only 7.0%. The largest increase is due to long-term debt which increased by $24,476 million or 84.4%. Much of this increase results from bond offerings by Apple to take advantage of low interest rates. We also see a modest increase of 5.9% ($5,132) in retained earnings even though income is $53,394, which is mainly because of its cash dividends and stock repurchases.

Comparative Income Statements

Comparative income statements are prepared similarly to comparative balance sheets. Amounts for two or more periods are placed side by side, with additional columns for dollar and percent changes. This slide shows Apple’s comparative income statements.

Apple reports substantial sales growth of 27.9% in 2015.This finding helps support management’s 25.3% growth in assets as reflected in comparative balance sheets. The 24.8% growth in cost of sales in light of the larger 27.9% sales increase suggests greater control over its costs. Additionally, the 24.2% increase in operating expenses is less than the 27.9% sales growth, which again is good news. Much of the 24.2% increase in operating expenses is driven by greater research and development costs, from which management/investors hope to reap future income. Apple currently reports an increase of 35.1% in income, which is mainly driven by its $23,089 million growth in gross margin.

Take important items on the Income Statement and Balance Sheet;
Compare with last year numbers by computing growth rate; Indicate the trend of growth rate change;
How?

Horizontal Analysis

Vertical Analysis

Common-Size Statements

Common-size

percent

Analysis amount

Base amount

100

Financial Statement Base Amount

Balance Sheet Total Assets

Income Statement Revenues

Vertical analysis is a tool to evaluate individual financial statement items or a group of items in terms of a specific base amount. We usually define a key aggregate figure as the base, which for an income statement is usually revenue and for a balance sheet is usually total assets. This section explains vertical analysis and applies it to Apple. (The term vertical analysis arises from the up-down [or down-up] movement of our eyes as we review common-size financial statements. Vertical analysis is also called common-size analysis.

We use common-size financial statements to reveal changes in the relative importance of each financial statement item. All individual amounts in common-size statements are redefined in terms of common-size percents. A common-size percent is measured by dividing each individual financial statement amount under analysis by its base amount as shown in this slide.

Common-Size Balance Sheet

Common-size statements express each item as a percent of a base amount, which for a common-size balance sheet is usually total assets. The base amount is assigned a value of 100%. (This implies that the total amount of liabilities plus equity equals 100% since this amount equals total assets.) We then compute a common-size percent for each asset, liability, and equity item using total assets as the base amount. When we present a company’s successive balance sheets in this way, changes in the mixture of assets, liabilities, and equity are apparent.

Exhibit 13.8 shows common-size comparative balance sheets for Apple. Some relations that stand out on both a magnitude and percentage basis include a new issuance of $24,476 million in long-term debt—a 5.9% increase, the largest of any liability; and (2) a 5.8% decrease in percent of retained earnings—likely the result of dividends and share repurchases. The absence of other substantial changes in Apple’s balance sheet suggests a mature company, but with some lack of focus as evidenced by the large and increasing amount of long-term securities. This buildup in securities is a concern as the return on securities is historically smaller than the return on operating assets. Time will tell whether Apple can continue to generate sufficient revenue and income from its expanding asset base.

Common-Size Income Statement

Analysis also benefits from use of a common-size income statement. Revenue is usually the base amount, which is assigned a value of 100%. Each common-size income statement item appears as a percent of revenue. If we think of the 100% revenue amount as representing one sales dollar, the remaining items show how each revenue dollar is distributed among costs, expenses, and income.

Exhibit 13.9 shows common-size comparative income statements for each dollar of Apple’s revenue. The past two years’ common-size numbers are similar with a few exceptions. One item is the decrease of 1.5 cent in the cost of sales, which is a positive development. Another positive is the decrease of 0.3 cent in total operating expenses. This was achieved in spite of an increase of 0.2 cent in research and development costs (an operating expense). In sum, analysis shows that common-size percents for successive income statements can uncover key changes in cost management and growth. (Evidence of no changes, especially when changes are expected, is also useful.)

Common-Size Graphics

Common-Size Graphic of

Asset Components

Common-Size Graphic of

Income Statement

Two tools of common-size analysis are trend analysis of common-size statements and graphical analysis. The trend analysis of common-size statements is similar to that of comparative statements discussed under vertical analysis. It is not illustrated here because the only difference is the substitution of common-size percents for trend percents. Instead, this section discusses graphical analysis of common-size statements. The graph on the left shows Apple’s 2015 common-size income statement in graphical form. This pie chart highlights the contribution of each cost component of net sales for net income (for this graph, “other income, net” is included in selling, general, administrative, and other costs).

The graph on the right shows a common-size graphical display of Apple’s assets. Common-size balance sheet analysis can be extended to examine the composition of these subgroups. For instance, in assessing liquidity of current assets, knowing what proportion of current assets consists of inventories is usually important, and not simply what proportion inventories are of total assets.

Review what you have learned in the following NEED-TO-KNOW Slide.

Common-size income statement
/Net sales
Common-size Balance Sheet
/ Total Assets
Exclude the different size effect of companies

Vertical Analysis

Ratio Analysis

Liquidity and efficiency

Solvency

Market prospects

Profitability

Ratios are widely used in financial analysis because they help us uncover conditions and trends difficult to detect by inspecting individual amounts.

A ratio expresses a mathematical relation between two quantities. It can be expressed as a percent, rate, or proportion. For instance, a change in an account balance from $100 to $250 can be expressed as (1) 150% increase, (2) 2.5 times, or (3) 2.5 to 1 (or 2.5:1).

This section describes important financial ratios and their application. The ratios are organized into the four building blocks of financial statement analysis: (1) liquidity and efficiency, (2) solvency, (3) profitability, and (4) market prospects. All of these ratios were explained at relevant points in prior chapters. The purpose here is to organize and apply them under a summary framework. We use four common standards, for comparisons: intracompany, competitor, industry, and guidelines.

Current

Ratio

Acid-test

Ratio

Accounts Receivable Turnover

Inventory Turnover

Days’ Sales Uncollected

Days’ Sales in Inventory

Total Asset Turnover

Liquidity and Efficiency

Liquidity refers to the availability of resources to meet short-term cash requirements. It is affected by the timing of cash inflows and outflows along with prospects for future performance. Efficiency refers to how productive a company is in using its assets. Efficiency is usually measured relative to how much revenue is generated from a certain assets.

This ratio measures the short-term debt-paying ability of the company. A higher current ratio suggests a strong liquidity position.

Current Ratio

Current ratio =	Current assets
Current liabilities

When evaluating a company’s working capital, we must not only look at the dollar amount of current assets less current liabilities, but also at their ratio. The current ratio is defined as shown.

A high current ratio suggests a strong liquidity position and an ability to meet current obligations. An excessively high current ratio means that the company has invested too much in current assets compared to its current obligations.

An excessive investment in current assets is not an efficient use of funds because current assets normally generate a low return on investment (compared with long-term assets).

Many users apply a guideline of 2:1 (or 1.5:1) for the current ratio. A 2:1 or higher ratio is judged a good credit risk in the short run. Any analysis of the current ratio must recognize at least three additional factors: (1) type of business, (2) composition of current assets, and (3) turnover rate of current asset components.

This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash.

Acid-Test Ratio

Referred to as Quick Assets

Acid-test ratio =	Cash + Short-term investments + Current receivables
Current liabilities

Quick assets are cash, short-term investments, and current receivables. These are the most liquid types of current assets. The acid-test ratio, also called quick ratio, and introduced in Chapter 5, reflects on a company’s short-term liquidity and is shown on this slide.

The acid-test ratio is a more stringent measure than the current ratio. We calculate the ratio by dividing quick assets by current liabilities. Quick assets include cash, short-term investments, and current accounts and notes receivable. The acid test ratio is generally lower than the current ratio because we have reduced the numerator. We have removed inventory accounts from the numerator that generally require a period of time to convert into cash. For example, for some companies’ inventories may take a significant amount of time to be converted into cash. Before we can reach a meaningful conclusion about the acid-test ratio, it is important to look at how quickly a given company converts its inventory to cash.

This ratio measures how many times a company converts its receivables into cash each year.

Accounts Receivable Turnover

Accounts receivable = turnover	Net sales
Average accounts receivable, net

Average accounts receivable =	(Beginning acct. rec. + Ending acct. rec.)
2

We can measure how frequently a company converts its receivables into cash by computing the accounts receivable turnover. This ratio is defined as shown.

Short-term receivables from customers are often included in the denominator along with accounts receivable. Also, accounts receivable turnover is more precise if credit sales are used for the numerator, but external users generally use net sales (or net revenues) because information about credit sales is typically not reported.

Accounts receivable turnover is high when accounts receivable are quickly collected. A high turnover is favorable because it means the company need not commit large amounts of funds to accounts receivable. However, an accounts receivable turnover can be too high; this can occur when credit terms are so restrictive that they negatively affect sales volume.

This ratio measures the number of times merchandise is sold and replaced during the year.

Inventory Turnover

Inventory turnover =	Cost of goods sold
Average inventory

Average inventory =	(Beginning inventory + Ending inventory)
2

How long a company holds inventory before selling it will affect working capital requirements. One measure of this effect is inventory turnover, also called merchandise turnover or merchandise inventory turnover, which is defined as shown.

A company with a high turnover requires a smaller investment in inventory than one producing the same sales with a lower turnover. Inventory turnover can be too high, however, if the inventory a company keeps is so small that it restricts sales volume.

Provides insight into how frequently a company collects its accounts receivable.

Days’ Sales Uncollected

Day's sales = uncollected	Accounts receivable, net	× 365
Net sales

Accounts receivable turnover provides insight into how frequently a company collects its accounts. Days’ sales uncollected is one measure of this activity, which is defined as shown.

Days’ sales uncollected is more meaningful if we know company credit terms. A rough guideline states that days’ sales uncollected should not exceed 11⁄3 times the days in its (1) credit period, if discounts are not offered or (2) discount period, if favorable discounts are offered.

Days’ Sales in Inventory

This ratio is a useful measure in evaluating inventory liquidity. If a product is demanded by customers, this formula estimates how long it takes to sell the inventory.

Day's sales in = Inventory	Ending inventory	× 365
Cost of goods sold

Days’ sales in inventory is a useful measure in evaluating inventory liquidity. We compute days’ sales in inventory as shown.

This ratio is a useful measure in evaluating inventory liquidity. If a product is demanded by customers, this formula estimates how long it takes to sell the inventory. The greater the demand for the product, the quicker it will be sold. By combining information about the days’ sales in inventory and the accounts receivable turnover, we get additional insights about the sale of a product and the collection of the related receivable into cash.

Total Asset Turnover

This ratio reflects a company’s ability to use its assets to generate sales. It is an important indication of operating efficiency.

Total asset turnover =	Net sales
Average total assets

Average assets =	(Beginning assets + Ending assets)
2

Total asset turnover reflects a company’s ability to use its assets to generate sales and is an important indication of operating efficiency. The definition of this ratio shown.

Debt

Ratio

Equity

Ratio

Pledged Assets to Secured Liabilities

Times Interest Earned

Solvency

Solvency refers to a company’s long-run financial viability and its ability to cover long-term obligations. Analysis of solvency is long term and uses more encompassing measures than liquidity. An important component of solvency analysis is a company’s capital structure. Capital structure refers to a company’s makeup of equity and debt financing.

Debt and Equity Ratios

$83,451 ÷ $207,000 = 40.3%

The debt ratio expresses total liabilities as a percent of total assets. The equity ratio provides complementary information by expressing total equity as a percent of total assets.

In Millions	Amount		Ratio
Total liabilities	$ 83,451	40.3%	[Debt ratio]
Total equity	123,549		59.7%	[Equity ratio]
Total liabilities and equity	$ 207,000		100.0%

One element of solvency analysis is to assess the portion of a company’s assets contributed by its owners and the portion contributed by creditors. This relation is reflected in the debt ratio (also described in Chapter 2). The debt ratio expresses total liabilities as a percent of total assets. The equity ratio expresses total equity as a percent of total assets. Apple’s debt and equity ratios follow.

Apple’s financial statements reveal more equity than debt. A company is considered less risky if its capital structure (equity and long-term debt) contains more equity. One risk factor is the required payment for interest and principal when debt is outstanding. From the stockholders’ point of view, if a company earns a return on borrowed capital that is higher than the cost of borrowing, the difference represents increased income to stockholders. The inclusion of debt is described as financial leverage because debt can have the effect of increasing the return to stockholders. Companies are said to be highly leveraged if a large portion of their assets is financed by debt.

Debt-to-Equity Ratio

This ratio measures what portion of a company’s assets are contributed by creditors. A larger debt-to-equity ratio implies less opportunity to expand through use of debt financing.

Debt-to-equity ratio =	Total liabilities
Total equity

The ratio of total liabilities to equity is another measure of solvency. We compute the ratio as shown.

Recall that debt must be repaid with interest, while equity does not. These debt requirements can be burdensome when the industry and/or the economy experience a downturn. A larger debt-to-equity ratio also implies less opportunity to expand through use of debt financing.

Times Interest Earned

This is the most common measure of the ability of a company’s operations to provide protection to long-term creditors.

Times interest earned =	Income before interest and taxes
Interest expense

	Net income
+	Interest expense
+	Income taxes
=	Income before interest and taxes

The amount of income before deductions for interest expense and income taxes is the amount available to pay interest expense. The following times interest earned ratio reflects the creditors’ risk of loan repayments with interest.

The larger this ratio, the less risky is the company for creditors. One guideline says that creditors are reasonably safe if the company earns its fixed interest expense two or more times each year.

Profit

Margin

Return on Total Assets

Return on Common Stockholders’ Equity

Profitability

Profitability refers to a company’s ability to generate an adequate return on invested capital. Return is judged by assessing earnings relative to the level and sources of financing.

Profit Margin

This ratio describes a company’s ability to earn net income from each sales dollar.

Profit margin =	Net income
Net sales

A company’s operating efficiency and profitability can be expressed by two components. The first is profit margin, which reflects a company’s ability to earn net income from sales. It is measured by expressing net income as a percent of sales (sales and revenues are similar terms).

To evaluate profit margin, we must consider the industry. For instance, an appliance company might require a profit margin between 10% and 15%, whereas a retail supermarket might require a profit margin of 1% or 2%.

Return on Total Assets

Return on total assets measures how well assets have been employed by the company’s management.

Return on total asset =	Net income
Average total assets

Return on total assets is defined as shown.

We can determine the return a company earns on its total assets. To calculate this ratio, we divide net income by the average total assets for the period. Return on total assets measures how well assets have been employed by the company’s management.

Return on Common
Stockholders’ Equity

This measure indicates how well the company employed the stockholders’ equity to earn net income.

Return on common stockholders' equity =	Net income - Preferred dividends
Average common stockholders' equity

We can calculate the return on common stockholders’ equity. The numerator is net income available to common shareholders, which is net income less preferred dividends, divided by average common stockholders’ equity. Perhaps the most important goal in operating a company is to earn net income for its owner(s). Return on common stockholders’ equity measures a company’s success in reaching this goal and is defined as shown.

Price-Earnings Ratio

Dividend Yield

Market Prospects

Market measures are useful for analyzing corporations with publicly traded stock. These market measures use stock price, which reflects the market’s (public’s) expectations for the company. This includes expectations of both company return and risk—as the market perceives it.

Key measures of market prospects include the price-earnings ratio and dividend yield.

Price-Earnings Ratio

This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth.

Price-earnings ratio =	Market price per common share
Earnings per share

Computation of the price-earnings ratio is shown.

Predicted earnings per share for the next period is often used in the denominator of this computation. Reported earnings per share for the most recent period is also commonly used. In both cases, the ratio is used as an indicator of the future growth and risk of a company’s earnings as perceived by the stock’s buyers and sellers.

Dividend Yield

This ratio identifies the return, in terms of cash dividends, on the current market price per share of the company’s common stock.

Dividend yield =	Annual cash dividends per share
Market price per share

Dividend yield is used to compare the dividend-paying performance of different investment alternatives. We compute dividend yield is shown.

Some companies, such as Google, do not declare and pay dividends because they wish to reinvest the cash to grow their businesses in the hope of generating greater future earnings and dividends.

Using Ratios to Analyze Performance

Analysts and other interested parties can gather qualitative information from financial statements by examining relationships between items on the statements and identifying trends in these relationships.

Ratio Analysis

Summary of Ratios

This slide summarizes the major financial statement analysis ratios illustrated in this chapter and throughout the book. This summary includes each ratio’s title, its formula, and the purpose for which it is commonly used.

Review what you have learned in the following NEED-TO-KNOW Slide.

ROE Analysis (Dupont Analysis)

Explain the change in ROE in terms of financial leverage, sales efficiency and Profit Margin Ratio
Find out the driving factors that contribute to the change of ROE and make improvements on it.

Return on Shareholders’ Equity—DuPont Framework

The DuPont framework provides an analysis that breaks the return on equity into three key components:

Profitability (Net income ÷ Sales)

Activity (Sales ÷ Average total assets)

Financial Leverage (Average total assets ÷ Average total equity)

LO4-10

Return on equity

Equity multiplier

Return on assets

Net income

Avg. total equity

Net income

Avg. total assets

Avg. total equity

Return on equity

Equity multiplier

Net income

Avg. total equity

Avg. total assets

Avg. total equity

Asset turnover

Profit margin

Net income

Total sales

Avg. total assets

Equity investors typically are concerned about the amount of profit that management can generate from the resources that owners provide. A closely watched measure that captures this concern is return on equity (ROE), calculated by dividing net income by average shareholders’ equity.

In addition to monitoring return on equity, investors want to understand how that return can be improved. The DuPont framework provides a convenient basis for analysis that breaks return on equity into three key components:

Profitability, measured by the profit margin (Net income ÷ Sales). As discussed already, a higher profit margin indicates that a company generates more profit from each dollar of sales.
Activity, measured by asset turnover (Sales ÷ Average total assets). As discussed already, higher asset turnover indicates that a company uses its assets efficiently to generate more sales from each dollar of assets.
Financial Leverage, measured by the equity multiplier (Average total assets ÷ Average total equity). A high equity multiplier indicates that relatively more of the company’s assets have been financed with debt; that is, the company is more leveraged. As discussed in Chapter 3, leverage can provide additional return to the company’s equity holders.

Notice that total sales and average total assets appear in the numerator of one ratio and the denominator of another, so they cancel to yield net income ÷ average total equity, or ROE.

We have already seen that ROA is determined by profit margin and asset turnover, so another way to compute ROE is by multiplying ROA by the equity multiplier.

We can see from this equation that an equity multiplier of greater than 1 will produce a return on equity that is higher than the return on assets. However, as with all ratio analysis, there are trade-offs. If leverage is too high, creditors become concerned about the potential for default on the company’s debt and require higher interest rates. Because interest is recognized as an expense, net income is reduced, so at some point the benefits of a higher equity multiplier are offset by a lower profit margin. Part of the challenge of managing a company is to identify the combination of profitability, activity, and leverage that produces the highest return for equity holders.

The equation form of the DuPont framework demonstrates this.

Summary of the company
Horizontal and vertical Analysis
Financial ratio trend analysis
Industry peer analysis used as a benchmark for comparison
Dupont analysis
(Bonus) Bankruptcy analysis based on Altman’s model
Recent news to support your analysis
Recommendation to buy or not
Not limited to the above aspects

Project Report