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ma7e_apx_a_041014.pptx© Cambridge Business Publishers, 2015
Managerial Analysis of Financial Statements
Appendix A
MANAGERIAL ACCOUNTING
7e
Al L. Hartgraves Wayne J. Morse
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Describe the importance of analyzing financial statements.
1
Learning Objective
Management’s Analysis
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Primary reason to analyze
Evaluate the overall performance of the firm
Especially as seen by those external to the firm
Should be aware of total company performance, in addition to each manager’s own responsibility area
Analysis helps managers understand
How the firm is performing, and
How the firm is perceived
Financial Performance
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General purpose financial statements
Provide an overall measure of firm’s performance
Enable comparison of the firm with similar firms
Can help identify potential weaknesses
Internal reporting system limited to component performance
Important for monitoring lending restrictions
To ensure compliance
Allows managers to see the firm as outsiders see it
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Identify factors that influence financial statements and their analysis.
2
Learning Objective
Factors Impacting Financial Statement Analysis
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No single financial statement analysis measure can summarize an organization’s performance
Manager must know which alternative accounting procedures the firm uses
Such as depreciation methods and inventory costing
Inflation/deflation effects can distort comparisons between periods because statements are based on historical dollars
Continued
Factors Impacting Financial Statement Analysis
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Changes in product mix can distort a comparison of financial statements
Because individual products have unique profit margins and a change in mix influences the firm’s profit margin
Changes in organizational structure should be reviewed as part of financial analysis
Mergers and acquisitions
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Specify alternative standards useful in financial statement analysis.
3
Learning Objective
Financial Analysis Standards
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Vertical analysis
Restatement of amounts in the current financial statements as a percentage of some base measure
Horizontal analysis
Comparison of a firm’s current financial measures to those of previous periods
Competitor analysis
Comparison of a firm’s financial measures to similar measures for other firms in the industry or to industry averages
Comparison of a firm’s financial measures to its budgeted measures
Beginning the Financial Analysis
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Vertical analysis
Conversion of all amounts to percentages of a base amount
Base amount on income statement is sales
Base amount on balance sheet is total assets
Common size statements
After all accounts of a particular statement are converted into percentages
Useful for
Detecting items that are out of line
Detecting deviations from preset amounts
Detecting other problems
Evaluating Against Comparable Measures
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Beneficial to managers to compare against other firms in the same industry
Financial information services publish averages for all major industries
Dun and Bradstreet
Standard & Poors
Moody’s
Awareness of differences between firms is necessary, such as
Geographical effects
Accounting practices
Other Measures
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Beginning amount + Ending amount
2
Measures of solvency and performance
Should be compared to industry norms
Comparison of three successive periods is helpful
Determining averages for a period
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Describe vertical and horizontal analysis, and their difference.
4
Learning Objective
Common Size Income Statement
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Useful for analyzing changes over time
Source: https://corporate.target.com/annual-reports/2012
Common Size Balance Sheet Asset Section
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Useful for analyzing changes over time
Source: https://corporate.target.com/annual-reports/2012
Common Size Balance Sheet Liabilities and Stockholders’ Equity Section
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Useful for analyzing changes over time
Source: https://corporate.target.com/annual-reports/2012
Vertical Analysis
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Uses sales from the income statement and total assets from the balance sheet
Both set at 100%
Helps to identify
Significant changes that have taken place during the period, and
Determine whether the changes have favorable or unfavorable impacts on solvency and performance
Determine if the company’s operating goals are met
Horizontal Analysis
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Used to evaluate trends in the financial condition of an organization
Allows current year common size statements to be compared
To those of prior years, and
To the organization’s goals and objectives
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Explain the analysis of a firm’s solvency.
5
Learning Objective
Solvency Analysis
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A firm’s ability to pay its debts as they come due
Primary measures
Short-term solvency
Current ratio
Working capital
Acid test ratio
Inventory turnover
Days sales in receivables
Long-term solvency
Debt-to-equity ratio
Times-interest-earned
Current Ratio
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Measures the relation between current assets and current liabilities
Indicates the extent to which current assets are available to cover current liabilities
Current assets
Current liabilities
Current ratio =
$16,388 million
$14,031 million
Current ratio for Target =
= 1.17
Target Corp. has $1.17 of current assets for each $1 of current liabilities.
Source: https://corporate.target.com/annual-reports/2012
Working Capital
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The net amount of working funds available in the short run
Current ratio = Current assets – Current liabilities
Working capital for Target =
$16,388 million – $14,031 million = $2,357 million
Target Corp. has $2,357 million available in the short-run for operations.
Source: https://corporate.target.com/annual-reports/2012
Acid Test (Quick) Ratio
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Measures the availability of assets that can be quickly converted into cash to pay current liabilities
Cash + Marketable securities + Current accounts receivable
Current liabilities
Acid test ratio =
Acid test ratio for Target
$784 million + $5,841 million
$14,031 million
= 0.472
=
Target Corp. has about $0.47 of current monetary assets for each $1 of current liabilities.
Source: https://corporate.target.com/annual-reports/2012
Inventory Turnover
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Measures the approximate number of times the average stock of inventory is sold and replenished during the year
Inventory turnover for Target
$50,568 million
[($7,903 million + $7,918 million) / 2]
= 6.39
=
Cost of goods sold
Average inventory
Inventory turnover =
Target Corp.’s average stock of inventory was sold and replenished about 6.39 times during the year.
Source: https://corporate.target.com/annual-reports/2012
Days Sales in Receivables
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Measures the number of days, on average, it takes to generate the credit sales uncollected at any point in time
Accounts receivable
Average daily credit sales
Days sales in receivables
=
Days sales in receivables for Target
$5,841 million
[($73,301 million x 50%*) / 365]
58.17 days
=
=
Target Corp. takes approximately 58 days to convert its accounts receivable into cash.
*Estimated credit sales Source: https://corporate.target.com/annual-reports/2012
Debt-to-Equity Ratio
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Measures the degree to which a company relies on debt versus equity financing
Total liabilities
Total stockholders’ equity
Debt-to-equity ratio
=
Debt-to-equity ratio for Target =
$31,605 million
$16,558 million
= 1.91
Target Corp.’s debt-to-equity ratio indicates that its creditors have provided $1.91 of capital for each $1 that stockholders have provided.
Source: https://corporate.target.com/annual-reports/2012
Times-Interest-Earned
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Measures the adequacy of earnings to provide payment of interest charges
Times-interest-earned for Target =
$2,999 million + $762 million + $1,610 million
$762 million
= 7.05 times
Net income + Interest expense + Income taxes
Interest expense
Times-interest-earned =
Target Corp. has approximately 7 times the earnings needed to cover its annual interest costs.
Source: https://corporate.target.com/annual-reports/2012
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Explain the analysis of a firm’s performance.
6
Learning Objective
Performance Analysis
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Basic activities of a typical for-profit organization
Generating capital—equity and debt
Acquiring assets with capital
Using assets to generate sales and profits
Using profits to pay the cost of capital
Primary measures of performance
Asset turnover
Return on sales
Return on assets
Return on equity
Earnings per share
Asset Turnover
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Measures the firm’s ability to use its assets to generate sales
Asset turnover for Target
$73,301 million
[($48,163 million + $46,630 million) / 2]
= 1.55
=
Sales
Average total assets
Asset turnover =
Each $1 of Target Corp.’s assets during the year generated $1.55 of sales.
Source: https://corporate.target.com/annual-reports/2012
Return on Sales
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Measures the ability to generate profits from sales produced by the firm’s assets
Return on sales for Target =
$2,999 million + [$762 x (1 – 0.350*)]
$73,301 million
= 4.77%
Net income + Net-of-tax interest expense
Sales
Return on sales =
On average, 4.77% of each $1 of Target Corp.’s sales remained as profit after covering all expenses other than interest.
*Effective tax rate from Target’s annual report Source: https://corporate.target.com/annual-reports/2012
Return on Assets
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Measures the firm’s ability to use its assets to generate profits
Combines asset turnover and return on sales
Return on assets for Target =
$2,999 million + [$762 x (1 – 0.350*)]
[($48,163 million + $46,630 million) / 2]
= 7.37%
OR: Asset turnover x Return on sales
= 1.55 x 4.77% =7.39%
Difference due to rounding
Net income + Net-of-tax interest expense
Average total assets
Return on assets
=
*Effective tax rate from Target’s 2008 annual report
Source: https://corporate.target.com/annual-reports/2012
Return on Equity
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Measures the profits attributable to shareholders as a percentage of their equity in the firm
Return on equity for Target
$2,999 million
[($16,558 million + $15,821 million) / 2]
= 18.52%
=
Net income
Average stockholders’ equity
Return on equity =
Target Corp. generated approximately 19 cents of profit for each dollar o shareholders’ equity.
Source: https://corporate.target.com/annual-reports/2012
Financial Leverage
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A measure of the use of capital with a fixed interest or dividend rate
Interest expense
Average total liabilities
Average interest rate =
Target Corp. generated positive financial leverage totaling 4.93%.
Source: https://corporate.target.com/annual-reports/2012
Financial leverage = Return on assets – Average interest rate
Financial leverage for Target =
$762 million
[($31,605 million + $30,809 million) / 2]
= 4.93%
= 7.37% –
Earnings per Share
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Must be disclosed on the face of the income statement
Presented separately for extraordinary sources of earnings or losses
Net income
Average # of common shares outstanding
Earnings per share
=
Earnings per share for Target
$2,999 million
656.7 million shares
= $4.57*
=
Target generated about $4.57 of profit for every share of common stock outstanding.
*$4.52 reported as diluted EPS Source: https://corporate.target.com/annual-reports/2012
Price Earnings Ratio
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A measure of profitability based on stock price
Market price per share
Earnings per share
Price earnings ratio =
=
Price earnings ratio for Target at end of Year 3
$61.96
$4.57
= 13.55
Source: https://corporate.target.com/annual-reports/2012
Cautions When Making Comparative Evaluations
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Avoid generalizations
Avoid using industry averages or medians as absolute guidelines for performance measurement
Overall industry performance may not compare to other industries
Analysis must consider homogeneity or diversity
Size influences how a firm compares to industry benchmarks
The End
Period Ending (in millions)
Total revenue73,301$ 100.0%69,865$ 100.0%67,390$ 100.0%
Cost of revenue50,568 69.0%47,860 68.5%45,725 67.9%
Gross profit22,733 31.0%22,005 31.5%21,665 32.1%
Operating expenses
Selling, gen, administrative14,914 20.3%14,106 20.2%13,469 20.0%
Other2,448 3.3%2,577 3.7%2,944 4.4%
Total operating expenses17,362 23.7%16,683 23.9%16,413 24.4%
Operating Income or Loss5,371 7.3%5,322 7.6%5,252 7.8%
Other income/expenses- 0.0%- 0.0%- 0.0%
Earnings before interest and taxes5,371 7.3%5,322 7.6%5,252 7.8%
Interest expense762 1.0%866 1.2%757 1.1%
Income before tax4,609 6.3%4,456 6.4%4,495 6.7%
Income tax expense1,610 2.2%1,527 2.2%1,575 2.3%
Net income 2,999$ 4.1%2,929$ 4.2%2,920$ 4.3%
Target Corporation
Comparative Income Statements
Year 3Year 2Year 1
in millions
Assets
Current assets
Cash and cash equivalents784$ 1.6%794$ 1.7%1,712$ 3.9%
Net receivables5,841 12.1%5,927 12.7%6,153 14.1%
Inventory7,903 16.4%7,918 17.0%7,596 17.4%
Other current assets1,860 3.9%1,810 3.9%1,752 4.0%
Total current assets16,388 34.0%16,449 35.3%17,213 39.4%
Long term investments- 0.0%- 0.0%0.0%
Property, plant and equipment (net)30,653 63.6%29,149 62.5%25,493 58.3%
Intangible assets0.0%0.0%0.0%
Other assets1,122 2.3%1,032 2.2%999 2.3%
Total assets48,163$ 100.0%46,630$ 100.0%43,705$ 100.0%
Target Corporation
Comparative Balance Sheets
Year 1Year 2Year 3
in millions
Liabilities
Current liabilities
Accounts payable7,056$ 14.7%6,857$ 14.7%6,625$ 15.2%
Current portion of long term debt2,994 6.2%3,786 8.1%119 0.3%
Other current liabilities3,981 8.3%3,644 7.8%3,326 7.6%
Total current liabilities14,031 29.1%14,287 30.6%10,070 23.0%
Long term debt14,654 30.4%13,447 28.8%11,653 26.7%
Other long-term liabilities2,920 6.1%3,075 6.6%6,495 14.9%
Total liabilities31,605 65.6%30,809 66.1%28,218 64.6%
Stockholders' equity
Common stock54 0.1%56 0.1%59 0.1%
Retained earnings13,155 27.3%12,959 27.8%12,698 29.1%
Additional paid-in capital3,925 8.1%3,487 7.5%3,311 7.6%
Other (576) -1.2%(681) -1.5%(581) -1.3%
Total stockholder equity16,558 34.4%15,821 33.9%15,487 35.4%
Total liabilities & stockholders' equity48,163$ 100.0%46,630$ 100.0%43,705$ 100.0%
Year 1Year 2Year 3
Target Corporation
Comparative Balance Sheets
