Financial statement analysis
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81554_1453957_Ch15FSAnal.pptxFinancial Statement Analysis
Chapter 15
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
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Limitations of Financial Statement Analysis-1
We use the LIFO method to value inventory.
We use the average cost method to value inventory.
Differences in accounting methods between companies sometimes may make comparisons difficult.
Inventory methods yield different profit for company
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Differences in accounting methods between companies sometimes make it difficult to compare their financial data. For example, if one company values its inventory using the LIFO method and another uses the average cost method, then direct comparisons of financial data, such as inventory valuations and cost of goods sold, may be misleading.
Even with this limitation in mind, comparing financial ratios with other companies or industry averages can provide useful insights.
Limitations of Financial Statement Analysis-2
Analysts should look beyond the Ratios.
Ch.15 focus on ratios
Economic factors
Industry trends
Changes within the company
Technological changes
Consumer tastes
Government
Regulations
Financial
or Market
Analyst
Political
Risk
News
Management
Consumer tastes
Consumer tastes
Growth
Stage of development
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Ratios should not be viewed as an end, but rather as a starting point. They raise many questions and point to opportunities for further analysis, but they rarely answer questions by themselves.
In addition to ratios, other sources of data should also be considered, such as industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the company itself.
Market Price & Expectations
Absolute performance, trends, markets, quality, market share, government regulation, growth, management et al are long term driving factors in share price
Performance to market expectation is a significant factor to short term share price
WHY???
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Statements in Comparative %/$ period-to–period change and Common-Size %-Sales = 100% Form
An item on a Financial Statement has little meaning by itself. The meaning of the numbers can be enhanced by drawing Comparisons.
Dollar and percentage
changes on statements
Common-size
statements [%s]
FinancialRatios
Compare: Prior Periods, Expectation/Forecast, Peer Group, Market as a whole…
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An item on a balance sheet or income statement has little meaning by itself. The meaning of the number can be enhanced by drawing comparisons. This chapter discusses three such means of enabling comparisons:
Dollar and percentage changes on statements (also known as horizontal analysis),
Common-size statements (also known as vertical analysis), and
Ratios.
Vertical-Horizontal-Trend
4
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Vertical Analysis-1
How do you compare Financial Statements from different companies or for the same company for different periods?
If you earn $100 in period 1 and $105 in period 2, have you done better?
What if you earned 12% of revenue in #1 and 6% in #2?
To normalize, we use Vertical Analysis which is look at the Income Statement & Balance Sheet as %’s; not as amounts
For IS Net Revenue is 100% and all other lines are a % of Net Revenue; for the BS, Assets are 100% and all other lines are a % of Assets
IS: divide all lines by Net Sales [Net Revenue]---- BS: divide all lines by Assets
As %’s = Common Size
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Vertical Analysis-2 Common-Size Statements
In Income Statements, all items usually are expressed as a percentage of sales [Net Sales].
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In income statements, all items are usually expressed as a percentage of sales.
Vertical Analysis-3 Common-Size Statements
In Balance Sheets, all items usually are expressed as a percentage of Total Assets.
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In balance sheets, all items are usually expressed as a percentage of total assets.
Vertical Analysis = Common-Size Statements-4 %’s, Net Sales = 100%
Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a Percentage
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Vertical analysis focuses on the relationships among financial statement items at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.
Vertical Analysis Common-Size Statements-5
Common-size financial statements are particularly useful when comparing data from different size companies or business units within same company.
McD Rev 4X > Wendy’s
BUT Wendy 50% > NI %
W <$S but bigger % so better performance even though less $s
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Common-size financial statements are particularly useful when comparing data from different companies. For example:
In 2002, Wendy’s net income was $219 million, whereas McDonald’s was $893 million. This comparison is misleading because of the different sizes of the two companies. Wendy’s net income as a percent of sales was about 8 percent and McDonald’s was about 5.8 percent. In this light, McDonald’s performance does not compare favorably with Wendy’s.
Vertical Analysis Common-Size Statements-6
What conclusions can we draw?
Better or
Worse
Why 2xx2
Worse?
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The common-size percentages for the remaining items on the income statement are as shown.
Example
Excel A
Vertical Analysis Common-Size Statements/Trend
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Let’s take another look at the information from the comparative income statements of Clover Corporation for 2007 and 2006. This time, let’s prepare common-size statements.
Trend Analysis-1
Horizontal Two types
Period to Period: use prior period to determine change from prior period
Base year: use base period to determine change from base period
Aka
Trend Analysis
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Horizontal Analysis-2 Dollar and Percentage Changes on Statements
Horizontal analysis shows the changes between periods in the financial data in both dollar and percentage form.
Aka
Trend Analysis
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Horizontal analysis (also known as trend analysis) involves analyzing financial data over time.
Quantifying dollar changes over time serves to highlight the changes that are the most important economically.
Quantifying percentage changes over time serves to highlight the changes that are the most unusual.
Calculating Change as a Percentage
Percentage
Change
Dollar Change [New – Old]
Base Year Figure [Old]
Base period trend
100%
=
×
Horizontal Analysis-3
More current period – Prior Period = $ Change
Change / Prior period = %
Period to Period change
Aka
Trend Analysis
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The percentage change in account balances is calculated as dollar change divided by the base year figure times 100 percent.
Example
The following slides illustrate a Horizontal Analysis of Clover Corporation’s December 31, 2xx2 and 2xx1, comparative Balance Sheets and comparative Income Statements.
Horizontal Analysis-4 Prior period to next period
Aka
Trend Analysis
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The following slides illustrate a horizontal analysis of Clover Corporation’s December 31, 2007 and 2006 comparative balance sheets and comparative income statements.
Horizontal Analysis-5 // Period to Period
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Assume the comparative asset account balances from the balance sheets as shown.
Horizontal Analysis-6 // Period to Period
14.3 % incr. in CoGS on 8.3% incr. in Sales
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The dollar and percentage changes for each account are as shown.
Quick Check
Which of the following statements describes Horizontal analysis?
a. A statement that shows items appearing on it in percentage and dollar form.
b. A side-by-side comparison of two or more years’ financial statements.
c. A comparison of the account balances on the current year’s financial statements.
d. None of the above.
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Which of the following statements describes horizontal analysis?
Horizontal Analysis
Go to Excel B1 & B2
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Trend Analysis [Trend Line]-1 Measured from a fixed base period
Do a trend analysis on these amounts [from Base period] to see what we can learn about the direction of the company.
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Look at the income information for Berry Products for the years 2003 through 2007. We will do a trend analysis on these amounts to see what we can learn about the company.
Trend Percentages-2
Trend percentages state several years’ financial data in terms of a base year, which equals 100 percent.
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Horizontal analysis can be even more useful when data from a number of years are used to compute trend percentages.
Trend Analysis-3
Trend
Percentage
Current Year Amount
Base Year Amount
[Base does not change]
100%
=
×
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To compute a trend percentage, a base year is selected and the data for all years are stated in terms of a percentage of that base year. The equation for computing a trend percentage is current year amount divided by base year amount times 100 percent.
Trend Analysis-4
The base
year is 2010, and its amounts
will equal 100%.
Base of 2010 does not change
ClassCo
Income Information
For the Years Ended December 31
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Assume the financial results as shown for 2003 through 2007. The base year is 2003 and its amounts will equal 100 percent.
Trend Analysis-5
By analyzing the trends for ClassCo, we can see that cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.
ClassCo
Income Information
For the Years Ended December 31
Yr. 2014 sales = 145% of Yr. 2010 Base yr.
Differs from horizontal
Yr. 2014 = 113% of Yr. 2013 Prior Yr.
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The trend percentages for the remaining years would be as shown. Notice that the cost of goods sold is increasing faster than sales, which is slowing the increase in gross margin.
Trend Analysis-6
Go to Excel C
K
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Liquidity
The degree to which an asset or security can be bought or sold in
the market without affecting the asset's price. Liquidity is characterized by a
high level of trading activity. A. The ability to convert an asset to cash quickly. It is safer to invest in liquid assets
than illiquid ones because it is easier for you to get your money out of the investment.
B. Ability to meet current debts.
Risk: The chance that an investment's actual return will be different than expected.
This includes the possibility of losing some or all of the original investment.
It is usually measured by calculating the standard deviation of the historical
returns or average returns of a specific investment. Higher profits mean higher
probability investor will receive a return on investment should circumstance
of the market deteriorate
Convert to cash ability to pay debts
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Leverage: A general term describing a financial ratio that compares some form of owner's equity (or capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds.**The higher a company's degree of leverage, the more the company is considered risky. As for most ratios, an acceptable level is determined by its comparison to ratios of companies in the same industry. The best known examples of gearing ratios include the debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and debt [aka debt to assets] ratio (total debt / total assets).
Degree of borrowing
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[1]
| Ch. 15 Ratios | |||||
| Ratio | Method of computation | Measure of | Significance | Better | |
| Operating Profit [Income] Margin | Operating Profit/Net Sales | Risk | Measures profit generated after consideration of operating expenses | 1 | é |
| Net Profit [Income] Margin | Net Profit/Net Sales | Risk | Measures profit generated after consideration of all expenses and revenues | 2 | é |
| Gross Profit Margin | Gross Profit /Net Sales | Risk | Measures profit generated after consideration of cost of products sold | 3 | é |
| Working Capital | Current assets - current liabilities | Liquidity | Measures ability to meet current obligations from current assets | 4 | é |
| Current Ratio | Current Assets/Current Liabilities | Liquidity | Measures short term liquidity, the ability of firm to meet needs for cash as they arise | 5 | é |
| Quick or Acid Test | Current Assets – Inventory/Current Liabilities | Liquidity | Measures short term liquidity more rigorously than the Current Ratio by eliminating inventory (usually the least liquid asset) | 6 | é |
| Accounts Receivable Turnover | Net Sales /Avge,Accounts Receivable | Asset utilization | Indicates how many times receivables are collected during a year on average | 7 | é |
| Average Collection Period | Avge. Receivable/Net Sales/365 OR 365/AR turnover | Asset utilization | Indicates days required to convert receivables into cash | 8 | ê |
| Inventory Turnover | Cost of Good Sold/Avge.Inventory | Asset utilization | Measures efficiency of the firm in managing and selling inventory | 9 | é |
| Days of Inventory | 365/Days of Inventory | Asset utilization | Measures efficiency of the firm in managing and selling inventory | 10 | ê |
| Total Asset Turnover | Net Sales/Total average Assets | Asset utilization | Measures efficiency of the firm in managing all assets | 11 | é |
Formulas-1
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[2]
Better
| Earnings Per Common Share | Net Earnings/Average Common Shares Outstanding | Market Price | Shows return to common stock holder for each share owned | 12 | é |
| Times Interest Earned | Operating Profit/Interest Expense | Risk | Measures how many times interest expense is covered by operating earnings | 13 | é |
| Return on Equity | Net Earnings/Avge.Stockholder’s Equity | Profitability | Measures rate of return on stockholders (owners) investment | 14 | é |
| Price to Earnings | Market Price of Common Stock/Earnings Per Share | Market Price | Expresses multiple that the stock market places on firm’s earnings | 15 | é |
| Dividend Payout | Dividends Per Share/Earnings Per Share | Market Price | Shows percentage of earnings paid to shareholders | 16 | é |
| Dividend Yield | Dividends Per Share/Market Price of Common Stock | Market Price | Shows rate earned by shareholders from dividends relative to current price of stock | 17 | é |
| Return on Assets aka Return on Investment | Net Earnings/Average Total Assets | Profitability Asset Utilization | Measures overall efficiency of firm in managing assets and generating profits | 18 | é |
| Return on Common Equity | Net Earnings-Preferred dividends/average common equity | Profitability | Measures rate of return on stockholders (owners) investment | 19 | é |
| Book Value per Share | Ending Common equity /Ending common shares | 20 | é | ||
| Financial Leverage | Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors. | 0 | Measures efficient use of debt and use of assets | 21 | é |
| Debt To Equity | Total Liabilities/Stockholder’s Equity | Risk | Measures debt relative to equity base | 22 | ê |
Formulas-2
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[3]
Better
| Debt Ratio | Total Liabilities/Total Assets | Risk | Shows proportion of all assets that are financed with debt | 23 | ê |
| Cash Flow Liquidity | Cash + Marketable Securities + Operating Cash Flows/Current Liabilities | Liquidity | Measure short term liquidity b considering as cash resources (numerator) cash plus cash equivalents plus cash flow from operating activities | 24 | é |
| Cash Flow Margin | Cash Flow from Operating Activities/Net Sales | Risk | Measures the ability of the firm to generate cash from sales | 25 | é |
| Cash Return on Assets | Cash Flow from Operating Activities/Average Total Assets | Asset Utilization | Measures the return on assets on a cash basis | 26 | é |
| Fixed Asset Turnover | Net Sales/Average Net Property, Plant and Equipment | Asset utilization | Measures efficiency of the firm in managing fixed assets | 27 | é |
| Fixed Charge Coverage | Operating Profit + Lease Payments/Interest Expense + Lease Payments | Risk | Measures coverage capability more broadly than times interest earned by including lease payments as fixed expenses | 28 | é |
| Long Term Debt to Total Capitalization | Long Term Debt/Long Term Debt + Stockholder’s Equity | Risk | Measures extent to which long term debt is used for permanent financing | 29 | ê |
Formulas-3
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Sample company
hand-out
[Ford]
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Operating Income %
Operating Income $
Net Sales
= OI %
Profitability/Risk
Higher is Better
Lower business risk
Greater increase in
Net Income for
change in sales
Go to Excel
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Net Income / Net Profit %
Net Income $
Net Sales
= NI %
Profitability/Risk
Higher is Better
Lower business risk
Greater increase in
Net Income for
change in sales
Go to Excel
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Gross Profit/Gross Margin $
Revenue minus CoGS
Higher is Better
Go to Excel
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Gross Profit / Gross Margin %
Gross Profit $
Net Sales
= GP %
Profitability/Risk
Higher is Better
Lower business risk
Greater increase in
Net Income for
change in sales
Go to Excel
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Ratio Analysis – Liquidity
The data and ratios that managers use to assess liquidity include working capital,
the current ratio,
and the acid-test (quick) ratio.
The information shown for Sample Co Corporation will be used to calculate the aforementioned liquidity ratios.
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WORKING CAPITAL
FORMULA:
The amount of capital the business has available for current operations.
CURRENT ASSETS
CURRENT LIABILITIES
–
Higher is Better
The excess of current assets over current liabilities is known as working capital.
Go to Excel
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CURRENT RATIO
Measures a firm’s ability to pay its current liabilities
“Rule of thumb” = 2 to 1
Many companies operate successfully with a current ratio of 1.5 to 1
It is better to compare an individual company to industry averages
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CURRENT RATIO
FORMULA:
CURRENT ASSETS
CURRENT LIABILITIES
Higher is Better
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QUICK ASSETS [aka Assets for Acid Test]
Cash and all other assets that can be converted into cash quickly
Examples:
Accounts receivable and temporary investments
Quick assets include Cash,
Marketable Securities, Accounts Receivable and current Notes Receivable. This ratio measures a company’s ability to meet obligations from its most liquid assets’ Inventory must be sold before converting to cash. A/R has already been sold
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QUICK RATIO or Acid Test
Gives a more defined picture of a firm’s ability to pay its current liabilities
“Rule of thumb” = 1 to 1
Many businesses operate successfully with a quick ratio of 0.6 to 1
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QUICK RATIO
FORMULA
:
QUICK ASSETS
CURRENT LIABILITIES
Higher is Better
Cash + marketable securities
+ A/R+ Current Notes Rec’ble
Go to Excel
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ACCOUNTS RECEIVABLE TURNOVER
A measure of the time required to collect cash from customers.
FORMULA:
NET CREDIT SALES FOR THE PERIOD
AVERAGE ACCOUNTS RECEIVABLE
Higher is Better
Asset utilization
Go to Excel
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AVERAGE COLLECTION PERIOD [1]
FORMULA:
NUMBER OF DAYS IN THE YEAR
RATE OF TURNOVER
365
1.76
207 days
The number of days credit customers are taking to pay for their purchases.
=
=
Lower is Better
Or A/R divided by
Credit Sales/Day
Comparing the average collection period
with a business’s credit terms offers an
indication of whether customers are
paying within the terms.
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INVENTORY TURNOVER
FORMULA:
Represents the number of times merchandise inventory was turned over (sold) during the accounting period.
COST OF GOODS SOLD FOR THE PERIOD
AVERAGE INVENTORY
Go to Excel
Higher is Better
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FORMULA:
NUMBER OF DAYS IN THE YEAR
Inventory TURNOVER
Or Average Inventory
Divided by
COGS/day
Lower
is Better
Aka: Days of Inventory
Go to Excel
Average Sale Period or AVERAGE DAYS TO SELL INVENTORY
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Operating Cycle
Average Sale Period
+
Average Collection Period
=
Operating Cycle
This ratio measures the elapsed time from when inventory is received from suppliers to when cash is received from customers.
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Total Asset Turnover
FORMULA:
Net sales
Total Assets
Relationship of assets required to
generate sales
Higher Better
Go to Excel
This ratio measures how efficiently a company’s assets are being used to generate sales. This ratio expands beyond current assets to include noncurrent assets.
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Averages: 13 point---5 point---2 point
| Months | Qtrs | Years | ||
| Amt | 13 | 5 | 2 | |
| 100 | Dec Beginning | |||
| 90 | Jan | |||
| 80 | Feb | |||
| 80 | Mar | |||
| 80 | Apr | |||
| 70 | May | |||
| 70 | Jun | |||
| 80 | Jul | |||
| 90 | Aug | |||
| 115 | Sep | |||
| 120 | Oct | |||
| 110 | Nov | |||
| 100 | Dec | |||
| Average | 91 | 93 | 100 |
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EPS-Earnings Per Share [of common]
Earnings per Share
Net Income – Preferred Dividends
Average Number of Common Shares Outstanding
=
Earnings form the basis for dividend payments and future increases in the value of shares of stock.
This measure indicates how much income was earned for each share of common stock outstanding.
Dilution
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Earnings per share is computed as shown.
The average number of common shares outstanding is computed by adding the shares outstanding at the beginning of the year to the shares outstanding at the end of the year and dividing by two.
Investors are interested in this ratio because earnings form the basis for dividend payments and future increases in the value of shares of stock.
EPS with Preferred
Deduct Preferred dividend before EPS
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Income before interest expense& taxes
*divided by*
Interest
Times Interest Expense
This is the most common measure of a company’s ability to provide protection for its long-term creditors. A ratio of less than 1.0 is inadequate.
Go to Excel
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RETURN ON OWNER’S EQUITY
FORMULA:
NET INCOME
AVERAGE OWNER’S EQUITY
Higher is Better
Go to Excel
This measure indicates how well the company used the owners’ investments to earn income.
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PE--Price-Earnings Ratio
Price-Earnings
Ratio
Market Price Per Share
Earnings Per Common Share
=
A higher price-earnings ratio means that investors are willing to pay a premium for a company’s stock because of optimistic future growth prospects.
Theoretical value of the NPV of future cash flows
Go to Excel
Higher is Better
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The price-earnings ratio is computed as shown.
A higher price-earnings ratio means that investors are willing to pay a premium for a company’s stock because of its optimistic future growth prospects.
Norton Corporation’s price earnings ratio is 8.26 times.
Dividend Payout Ratio
Dividend
Payout Ratio
Dividends Per Share
Earnings Per Share
=
This ratio gauges the portion of current earnings being paid out in dividends. Investors seeking dividends (market price growth) would like this ratio to be large.
Dividends is a distribution of Retained Earnings [usually.]
If seeking dividend payout then Higher is Better.
If high growth stock then possibly retaining earnings [lower] is better.
In absence of above qualifier assume Higher is Better.
Go to Excel
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The dividend payout ratio is computed as shown.
Investors who seek market price growth would like this ratio to be small, whereas investors who seek dividends prefer it to be large.
Norton Corporation’s dividend payout ratio is 82.6 percent.
Dividend Yield Ratio [Common]
Dividend
Yield Ratio
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.
Go to Excel
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The dividend yield ratio is computed as shown.
This ratio measures the rate of return (in the form of cash dividends only) that would be earned by an investor who buys common stock at the current market price.
Norton Corporation’s dividend yield ratio is 10 percent.
Net Income + interest expense after tax
Average Assets
= ROA %
Higher
is Better
Ownership in receiving
Greater return for
the assets used by the
Business
Investing business
is good/bad v.
Other investing
opportunities
Return on Assets- Acctg.ROA [aka Acctg. ROI] [1]
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Two views with or without interest. Unless otherwise indicated use this definition
Adding interest expense back to net income enables the return on assets to be compared for companies with different amounts of debt or over time for a single company that has changed its mix of debt and equity. Return On Assets - ROA
What Does Return On Assets - ROA Mean?
An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment".
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Return on Common Stockholders’ Equity
Return on Common
Stockholders’ Equity
Net Income – Preferred Dividends
Average Stockholders’ Equity
=
This measure indicates how well the company used the owners’ investments to earn income.
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The return on common stockholder’s equity is computed as shown.
This measure indicates how well the company used the owners’ investments to earn net income.
Norton Corporation’s return on common stockholder’s equity is 25.91 percent.
Book Value Per Share
Book Value per Share
Common Stockholders’ Equity [not AVGE ]
Number of Common Shares Outstanding
=
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 after all creditors were paid off.
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The book value per share is computed as shown.
It 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 after all creditors were paid off. This measure is based entirely on historical cost.
Norton Corporation’s book value per share is $8.55.
Book Value Per Share
Notice that the book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost.
Book Value per Share
Common Stockholders’ Equity
Number of Common Shares Outstanding
=
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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 after all creditors were paid off.
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The book value per share of $8.55 does not equal the market value per share of $20. This is because the market price reflects expectations about future earnings and dividends, whereas the book value per share is based on historical cost.
Financial Leverage
Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors.
Return on investment in assets
ROA%
>
Fixed rate of return on borrowed funds
Interest %
Positive financial leverage
=
Return on investment in assets
<
Fixed rate of return on borrowed funds
Negative financial leverage
=
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Financial leverage results from the difference between the rate of return the company earns on investments in its own assets and the rate of return that the company must pay its creditors.
Positive financial leverage exists if the rate of return on the company’s assets exceed the rate of return the company pays its creditors. In this case, having some debt in a company’s capital structure can benefit its shareholders.
Negative financial leverage exists if the rate of return on the company’s assets is less than the rate of return the company pays its creditors. In this case, the common stockholder suffers by having debt in the capital structure.
Quick Check
Which of the following statements is true?
a. Negative financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets.
b. Positive financial leverage is when the fixed return to a company’s creditors and preferred stockholders is greater than the return on total assets.
c. Financial leverage is the expression of several years’ financial data in percentage form in terms of a base year.
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Which of the following statements is true?
Debt to Equity Ratio
Debt to Equity Ratio
aka Leverage Ratioi
PE Debt
PE Equity
= Debt/Equity Ratio
Lower is Better
What portion of business
is owned by creditors
or by ownership
Leverage ratio
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Debt to Assets
Debt to Assets Ratio [aka Debt Ratio]
PE Total Liabilities
PE Assets
= Debt/Asset Ratio
Lower is Better
What portion of business
is owned by creditors
or by ownership
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Ratio Analysis – The Long–Term Creditor
Long-term creditors are concerned with a company’s ability to repay its loans over the long-run.
This is also referred to as net operating income.
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Long-term creditors are concerned with a company’s ability to repay its loans over the long-run. Creditors often seek protection by requiring that borrowers agree to various restrictive covenants, or rules. The information shown for Norton Corporation will be used to calculate ratios of interest to long-term creditors.
Debt-to-Equity Ratio
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.
Total Liabilities
Stockholders’ Equity
Debt–to–
Equity Ratio
=
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The debt-to-equity ratio is computed as shown.
It indicates the relative proportions of debt and equity on a company’s balance sheet.
Creditors and stockholders have different views when defining the optimal debt-to-equity ratio.
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.
In practice, debt-to-equity ratios from 0.0 to 3.0 are common.
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This slide contains a listing of published sources that provide comparative ratio data organized by industry.
PUZZLE
What is the sum of the integers 1 through 199?
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End of Chapter 15
S T O P
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End of chapter 16.
Liquidity
The degree to which an asset or security can be bought or sold in
the market without affecting the asset's price. Liquidity is characterized by a
high level of trading activity. A.The ability to convert an asset to cash quickly. It is safer to invest in liquid assets
than illiquid ones because it is easier for you to get your money out of the investment.
B. Ability to meet current debts.
Risk: The chance that an investment's actual return will be different than
expected. This includes the possibility of losing some or all of the original investment. It is usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. Higher profits mean higher probability investor will receive a return on investment should circumstance
of the market deteriorate
Leverage: A general term describing a financial ratio that compares some form of owner's equity (or capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds.**The higher a company's degree of leverage, the more the company is considered risky. As for most ratios, an acceptable level is determined by its comparison to ratios of companies in the same industry. The best known examples of gearing ratios include the debt-to-equity ratio (total debt / total equity), times interest earned (EBIT / total interest), equity ratio (equity / assets), and debt ratio (total debt / total assets).
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Ch. 15 Ratio Analysis-Financial Statement Analysis
VerticalHorizontalTrend
%
∆ from a base year
Period to Period
BSIS
∆ 2xx1 from 2xx0
TotalRevenueEither % or Amount or
Assets[orSalesBoth
[Assets]or Net Rev.]
∆ 2xx2from 2xx1
==
∆ 2xx3 from 2xx2
100%100%
∆ 2xx4 from 2xx3
∆ 2xx5 from 2xx5
∆ 2xx1 from 2xx0
∆ 2xx2 from 2xx0
∆ 2xx3 from 2xx0
∆ 2xx4 from 2xx0
∆ 2xx5 from 2xx0
2xx0
Base
2xx52xx42xx12xx22xx3
Wendy'sMcDonald's
(dollars in millions)
DollarsPercentageDollarsPercentage
Net income219$ 8.00%893$ 5.80%
Sheet1
| Wendy's | McDonald's | |||||
| (dollars in millions) | Dollars | Percentage | Dollars | Percentage | ||
| Net income | $ 219 | 8.00% | $ 893 | 5.80% |
Sheet2
Sheet3
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Common-Size
Percentages
2xx22xx12xx22xx1
Sales520,000$ 480,000$ 100.0 100.0
Cost of goods sold360,000 315,000 69.2 65.6
Gross margin160,000 165,000 30.8 34.4
Operating expenses128,600 126,000 24.8 26.2
Net operating income31,400 39,000 6.0 8.2
Interest expense6,400 7,000 1.2 1.5
Net income before taxes25,000 32,000 4.8 6.7
Less income taxes (30%)7,500 9,600 1.4 2.0
Net income17,500$ 22,400$ 3.4 4.7
Sheet1
| CLOVER CORPORATION | ||||
| Comparative Income Statements | ||||
| For the Years Ended December 31 | ||||
| Common-Size Percentages | ||||
| 2xx2 | 2xx1 | 2xx2 | 2xx1 | |
| Sales | $ 520,000 | $ 480,000 | 100.0 | 100.0 |
| Cost of goods sold | 360,000 | 315,000 | 69.2 | 65.6 |
| Gross margin | 160,000 | 165,000 | 30.8 | 34.4 |
| Operating expenses | 128,600 | 126,000 | 24.8 | 26.2 |
| Net operating income | 31,400 | 39,000 | 6.0 | 8.2 |
| Interest expense | 6,400 | 7,000 | 1.2 | 1.5 |
| Net income before taxes | 25,000 | 32,000 | 4.8 | 6.7 |
| Less income taxes (30%) | 7,500 | 9,600 | 1.4 | 2.0 |
| Net income | $ 17,500 | $ 22,400 | 3.4 | 4.7 |
CLOVER CORPORATION
Comparative Balance Sheets
December 31
Increase (Decrease)
2xx22xx1Amount%
Assets
Current assets:
Cash12,000$ 23,500$ (11,500)$ -49%
Accounts receivable, net60,000 40,000 20,000$ 50%
Inventory80,000 100,000 (20,000)$ -20%
Prepaid expenses3,000 1,200 1,800$ 150%
Total current assets155,000 164,700 (9,700)$ -6%
Property and equipment:
Land40,000 40,000 -$ 0%
Buildings and equipment, net120,000 85,000 35,000$ 41%
Total property and equipment160,000 125,000 35,000$ 28%
Total assets315,000$ 289,700$ 25,300$ 9%
Sheet1
| CLOVER CORPORATION | ||||
| Comparative Balance Sheets | ||||
| December 31 | ||||
| Increase (Decrease) | ||||
| 2xx2 | 2xx1 | Amount | % | |
| Assets | ||||
| Current assets: | ||||
| Cash | $ 12,000 | $ 23,500 | $ (11,500) | -49% |
| Accounts receivable, net | 60,000 | 40,000 | $ 20,000 | 50% |
| Inventory | 80,000 | 100,000 | $ (20,000) | -20% |
| Prepaid expenses | 3,000 | 1,200 | $ 1,800 | 150% |
| Total current assets | 155,000 | 164,700 | $ (9,700) | -6% |
| Property and equipment: | ||||
| Land | 40,000 | 40,000 | $ - 0 | 0% |
| Buildings and equipment, net | 120,000 | 85,000 | $ 35,000 | 41% |
| Total property and equipment | 160,000 | 125,000 | $ 35,000 | 28% |
| Total assets | $ 315,000 | $ 289,700 | $ 25,300 | 9% |
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31
Increase
(Decrease)
2xx22xx1Amount%
Sales520,000$ 480,000$ 40,000$ 8.3
Cost of goods sold360,000 315,000 45,000 14.3
Gross margin160,000 165,000 (5,000) (3.0)
Operating expenses128,600 126,000 2,600 2.1
Net operating income31,400 39,000 (7,600) (19.5)
Interest expense6,400 7,000 (600) (8.6)
Net income before taxes25,000 32,000 (7,000) (21.9)
Less income taxes (30%)7,500 9,600 (2,100) (21.9)
Net income17,500$ 22,400$ (4,900)$ (21.9)
Sheet1
| CLOVER CORPORATION | ||||
| Comparative Income Statements | ||||
| For the Years Ended December 31 | ||||
| Increase (Decrease) | ||||
| 2xx2 | 2xx1 | Amount | % | |
| 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) |
Year
Item20142013201220112010
Sales400,000$ 355,000$ 320,000$ 290,000$ 275,000$
Cost of goods sold285,000 250,000 225,000 198,000 190,000
Gross margin115,000 105,000 95,000 92,000 85,000
Sheet1
| Year | ||||||
| Item | 2014 | 2013 | 2012 | 2011 | 2010 | |
| Sales | $ 400,000 | $ 355,000 | $ 320,000 | $ 290,000 | $ 275,000 | |
| Cost of goods sold | 285,000 | 250,000 | 225,000 | 198,000 | 190,000 | |
| Gross margin | 115,000 | 105,000 | 95,000 | 92,000 | 85,000 |
Year
Item20142013201220112010
Sales145%129%116%105%100%
Cost of goods sold150%132%118%104%100%
Gross margin135%124%112%108%100%
Sheet1
| Year | ||||||
| Item | 2014 | 2013 | 2012 | 2011 | 2010 | |
| Sales | 145% | 129% | 116% | 105% | 100% | |
| Cost of goods sold | 150% | 132% | 118% | 104% | 100% | |
| Gross margin | 135% | 124% | 112% | 108% | 100% |
Example A
Net Income1,500,000$
Preferred shares115,000
Dividends per preferred share$1.20
Paid to preferred$138,000
Income for Common shares$1,362,000
Average # of Common shares950,000
EPS per common share$1.43
Example B
Net Income2,770,000$
Preferred shares1,200,000
Dividends per preferred share$2.00
Paid to preferred$2,400,000
Income for Common shares$370,000
Average # of Common shares1,300,000
EPS per common share$0.28
ClassCo CORPORATION
2014
Earnings before interest
expense and income taxes84,000$
Interest expense7,300
Total stockholders' equity234,390
Total liabilities112,000
Sheet1
| ClassCo CORPORATION | |||
| 2014 | December 31, 19X4 | ||
| Earnings before interest expense and income taxes | $ 84,000 | $ 220,000 | |
| Interest expense | 7,300 | ||
| Total stockholders' equity | 234,390 | ||
| Total liabilities | 112,000 | ||
| 220,000 |
