accounting
usaksa
chapter_13.pptxChapter Thirteen
Financial Statement Analysis
McGraw-Hill Education
Copyright © 2016 by McGraw-Hill Education. All rights reserved.
0
Expressing financial statement information in the form of ratios enhances its usefulness. Ratios permit comparisons over time and among companies, highlighting similarities, differences, and trends. This chapter addresses the importance of proficiency with common financial statement analysis techniques that benefit both internal and external users.
Factors in Communicating Useful Information
Users
Types of Decisions
Information
Analysis
The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the following:
13-1
1
The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the following:
The users
The types of decisions and
Information analysis.
LO 1
Differentiate between horizontal and vertical analysis.
13-2
Learning Objective 1: Differentiate between horizontal and vertical analysis.
2
Methods of Analysis
Horizontal Analysis
Vertical Analysis
Ratio Analysis
13-3
3
This chapter discusses three categories of analysis methods: horizontal, vertical and ratio.
Let’s look at the financial statements for Milavec for 2015 and 2014. We will refer to these financial statements in the examples of analysis techniques in this chapter.
Milavec Company Financial Statements
13-4
4
Here are the comparative income statements and statements of retained earnings for Milavec Company.
Milavec Company Financial Statements
13-5
5
Here are the comparative balance sheets for Milavec Company.
Horizontal Analysis
Horizontal analysis (or trend analysis) refers to studying the behavior of individual financial statement items over several accounting periods.
Absolute Amounts
Percentage Analysis
13-6
6
Part I
Horizontal analysis (also known as trend analysis) involves analyzing financial data over several accounting periods.
Part II
The absolute amounts of particular financial statement items have many uses. For example, financial statement users may use absolute amounts reported for research and development costs to judge whether a company is spending excessively or conservatively. However, it is difficult to judge the materiality of an absolute financial statement amount without considering the size of the company reporting it.
Part III
Percentage analysis involves computing the percentage relationship between two amounts. In horizontal percentage analysis, a financial statement item is expressed as a percentage of the previous balance for the same item.
Milavec Company Horizontal Analysis
13-7
2012
2011
7
This exhibit presents a condensed version of Milavec’s income statement with horizontal percentages for each item. The percentages disclose that, even though Milavec’s net income rose slightly more than total sales, products may be underpriced. Cost of goods sold increased much more than sales, resulting in a lower gross margin. Users would also want to investigate why operating expenses decreased substantially despite the increase in sales volume.
Vertical Analysis
Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.
13-8
8
Vertical analysis uses percentages to compare individual components of financial statements to a key statement figure. Horizontal analysis compares items over many time periods; vertical analysis compares many items within the same time period.
A common-size financial statement is a vertical analysis in which each financial statement item is expressed as a percentage.
Vertical Analysis of Income Statement
In income statements, all items are usually expressed as a percentage of sales.
13-9
9
In income statements, all items are usually expressed as a percentage of sales.
Milavec Company Vertical Analysis
13-10
2012
2011
10
This exhibit presents Milavec’s income statements, along with vertical percentages, for 2015 and 2014. This analysis discloses that cost of goods sold increased significantly as a percentage of sales. Operating expenses and income taxes, however, decreased in relation to sales.
Vertical Analysis of Balance Sheet
In balance sheets, all items are usually expressed as a percentage of total assets.
13-11
11
In balance sheets, all items are usually expressed as a percentage of total assets.
13-12
2012
2011
Vertical Analysis of Balance Sheet
12
This exhibit presents Milavec’s balance sheets, along with vertical percentages, for 2015 and 2014. This analysis discloses few large percentage changes from the preceding year. Even small individual percentage changes, however, may represent substantial dollar increases. For example, inventory has increased from 9.5% of total assets to 13.8% of total assets from 2014 to 2015, which may have unfavorable consequences. Careful analysis requires considering changes in both percentages and absolute amounts.
Ratio Analysis
Ratio analysis involves studying various relationships between different items reported in a set of financial statements.
13-13
13
Ratio analysis involves studying various relationships between different items reported in a set of financial statements.
LO 2
Calculate ratios for assessing a company’s liquidity.
13-14
Learning Objective 2: Calculate ratios for assessing a company’s liquidity.
14
Liquidity Ratios
Liquidity ratios indicate a company’s ability to pay short-term debts. They focus on current assets and current liabilities.
Working capital
Current ratio
Quick ratio
Accounts receivable ratios
Inventory ratios
13-15
15
Liquidity ratios indicate a company’s ability to pay short-term debts. They focus on current assets and current liabilities.
The liquidity ratios we will review are
Working capital
Current ratio
Quick ratio
Accounts receivable ratios
Inventory ratios
Working Capital
The excess of current assets over current liabilities is known as working capital.
13-16
16
Working capital is not actually a ratio. It is calculated as current assets minus current liabilities. Current assets include assets most likely to be converted into cash in the current operating period. Current liabilities represent debts that must be satisfied in the current period. Working capital therefore measures the excess funds the company will have available for operations, excluding any new funds it generates during the year.
Milavec’s working capital dramatically increased from 2014 to 2015, but the numbers themselves say little without also considering Milavec’s size, industry, and other economic factors.
Current Ratio
The current ratio measures a company’s short-term debt paying ability.
A declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories.
Current
Ratio
Current Assets
Current Liabilities
=
13-17
17
The current ratio is computed as shown.
It measures a company’s short-term debt paying ability.
It must be interpreted with care. For example, a declining ratio may be a sign of deteriorating financial condition, or it might result from eliminating obsolete inventories or other stagnant current assets.
Current Ratio
13-18
18
To illustrate using the current ratio for comparisons, consider Milavec’s current position relative to Laroque’s, a larger firm with current assets of $500,000 and current liabilities of $378,000.
There is no single ideal current ratio that suits all companies. In recent years the average current ratio of the 30 companies that comprise the Dow Jones Industrial Average was around 1.38 to 1; the individual company ratios, however, ranged from .65 to 1 to 2.60 to 1.
Quick (Acid-Test) Ratio
Quick Assets
Current Liabilities
=
Acid-Test
Ratio
Quick assets include cash,
current marketable securities, and accounts receivable. This ratio measures a company’s ability to meet obligations without having to liquidate inventory.
13-19
19
The quick, or acid-test, ratio is computed as shown.
It is a conservative variation of the current ratio because it only includes cash, receivables, and current marketable securities.
It measures a company’s ability to meet its obligations without having to liquidate its inventory.
Quick (Acid-Test) Ratio
13-20
20
Here are Milavec Company’s current ratios and quick ratios for 2015 and 2014.
Accounts Receivable Turnover
Net Credit Sales
Average Accounts Receivable
Accounts Receivable
Turnover
=
This ratio measures how many times a company converts its receivables into cash each year.
13-21
21
The accounts receivable turnover is calculated as shown.
It measures how quickly credit sales are converted to cash.
Accounts Receivable Turnover
13-22
22
Milavec’s accounts receivable turnover is presented here. The 2015 ratio of 16.98 indicates that Milavec collected its average receivables almost 17 times that year. The higher the turnover, the faster the collection.
Average Days to Collect Receivables
Average Collection Period
=
365 Days
Accounts Receivable Turnover
This ratio measures, on average, how many days it takes to collect an accounts receivable.
= 21 days
Average Collection Period
=
365 Days
16.98 Times
13-23
23
Part I
A related measure called the average days to collect receivables is computed as shown.
It measures how many days, on average, it takes to collect an accounts receivable.
It should be interpreted relative to the credit terms offered to customers.
Part II
For 2015, Milavec’s average collection period was 21 days.
Inventory Turnover
Cost of Goods Sold
Average Inventory
Inventory
Turnover
=
This ratio measures how many times a company’s inventory has been sold and replaced during the year.
13-24
24
The inventory turnover is computed as shown.
It measures how many times a company’s inventory has been sold and replaced during the year.
Inventory Turnover
13-25
25
Here is the inventory turnover for Milavec. Generally, the higher turnover indicates that merchandise is being handled more efficiently. Trying to compare firms in different industries, however, can be misleading. Inventory for grocery stores and many retail outlets is higher than inventory turnover for appliance and jewelry stores.
Average Days to Sell Inventory
Average Sale Period
=
365 Days
Inventory Turnover
This ratio measures how many days, on average, it takes to sell the inventory.
= 34 days
Average Sale Period
=
365 Days
10.80 Times
13-26
26
Part I
A related measure called the average days to sell inventory is computed as shown.
It measures the number of days being taken, on average, to sell the entire inventory one time.
Part II
In 2015, Milavec’s average days to sell inventory was 34 days.
LO 3
Calculate ratios for assessing a company’s solvency.
13-27
Learning Objective 3: Calculate ratios for assessing a company’s solvency.
27
Solvency Ratios
Solvency ratios are used to analyze a company’s long-term debt-paying ability and its financing structure.
Debt to assets ratio
Debt to equity ratio
Number of times interest earned
Plant assets to long-term liabilities
13-28
28
Solvency ratios are used to analyze a company’s long-term debt-paying ability and its financing structure.
The solvency ratios we will look at are
Debt to assets ratio
Debt to equity ratio
Number of times interest earned
Plant assets to long-term liabilities
Debt to Assets Ratio
This ratio measures the percentage of a company’s assets that are financed by debt.
Total Liabilities
Total Assets
Debt to Assets Ratio
=
13-29
29
The debt to assets ratio is computed as shown.
This ratio measures the percentage of a company’s assets that are financed by debt.
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.
Total Liabilities
Stockholders’ Equity
Debt to Equity Ratio
=
Creditors prefer less debt and more equity because equity represents a buffer of protection.
13-30
30
The debt to equity ratio is computed as shown.
This ratio indicates the relative proportions of debt to 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.
Debt to Assets and Debt to Equity Ratios
13-31
31
Here are the debt to assets ratio and the debt to equity ratio for Milavec for 2015 and 2014. Each year less than one-third of the company’s assets were financed with debt. The amount of liabilities per dollar of stockholders’ equity declined by 0.06.
Number of Times Interest is Earned Ratio
This is the most common measure of a company’s ability to provide protection for its long-term creditors.
Times Interest Earned
Earnings before Interest Expense
and Income Taxes
Interest Expense
=
13-32
32
The number of times interest is earned ratio is calculated as shown.
It is the most common measure of a company’s ability to protect its long-term creditors.
It is based on earnings before interest and income taxes because that is the amount of earnings that is available for making interest payments.
Number of Times Interest Earned Ratio
13-33
33
Here is the number of times interest earned ratio for Milavec for 2015 and 2014. Obviously interest is paid only once, but the more times it could be paid, the bigger the company’s safety net.
Plant Assets to Long-Term Liabilities
This ratio suggests how well long-term debt is managed to finance long-term assets.
Plant Assets to Long-Term Liabilities
Net Plant Assets
Long-Term Liabilities
=
13-34
34
Companies often pledge plant assets as collateral for long-term liabilities. This ratio suggests how well long-term debt is managed to finance long-term assets.
Plant Assets to Long-Term Liabilities
13-35
35
Here are the plant assets to long-term liabilities ratios for Milavec for 2015 and 2014. An increase in this ratio is a positive sign.
LO 4
Calculate ratios for assessing managerial effectiveness.
13-36
Learning Objective 4: Calculate ratios for assessing managerial effectiveness.
36
Profitability Ratios
Profitability ratios measure a company’s ability to generate earnings.
Net margin (or return on sales)
Asset turnover ratio
Return on investment
Return on equity
13-37
37
Profitability ratios measure a company’s ability to generate earnings.
The profitability ratios we will look at are:
Net margin (or return on sales)
Asset turnover ratio
Return on investment
Return on equity
Net Margin
This measure describes the percent remaining of each sales dollar after subtracting other expenses as well as cost of goods sold.
Net Margin
Net Income
Net Sales
=
13-38
38
Net margin is calculated as shown.
This measure describes the percent remaining of each sales dollar after subtracting other expenses, as well as cost of goods sold.
Net Margin
13-39
39
Here are the net margin calculations for Milavec for 2015 and 2014. Milavec has maintained approximately the same net margin. Obviously, the larger the percentage, the better.
Asset Turnover Ratio
Net Sales
Average Total Assets
Asset
Turnover
=
This ratio measures how many sales dollars were generated for each dollar of assets invested.
13-40
40
The asset turnover ratio is calculated as shown.
This ratio measures how many sales dollars were generated for each dollar of assets invested.
Asset Turnover Ratio
13-41
41
Here are the asset turnover ratios for Milavec for 2015 and 2014. As with most ratios, the implications of a given asset turnover ratio are affected by other considerations. Asset turnover will be high in an industry which requires only minimal investment to operate, such as real estate sales companies. On the other hand, industries that require large investments in plant and machinery, like the auto industry, are likely to have lower asset turnover ratios.
Return on Investment (ROI)
This is the ratio of wealth generated (net income) to the amount invested (average total assets).
Return on
Investment
Net Income
Average Total Assets
=
13-42
42
The return on investment is computed as shown.
This is the ratio of wealth generated (net income) to the amount invested (average total assets).
2015: $25,000 ÷ $481,500* = 5.19%
2014: $22,000 ÷ $437,500* = 5.03%
* The computation of average assets
is calculated as beginning assets plus
ending assets divided by 2.
Return on Investment (ROI)
13-43
43
Here are Milavec’s return on investment ratios for 2015 and 2014. Generally, higher returns on investment suggest better performance.
Return on Equity
This measure is often used to measure the profitability of the stockholders’ investment.
Return on Equity
Net Income
Average Total Stockholders’ Equity
=
13-44
44
The return on common stockholders’ equity is computed as shown.
This measure is often used to measure the profitability of the stockholders’ investment.
Return on Equity
13-45
45
Here are Milavec’s return on equity ratios for 2015 and 2014.
The slight decrease in Milavec’s return on equity is due primarily to the increase in common stock.
LO 5
Calculate ratios for assessing a company’s position in the stock market.
13-46
Learning Objective 5: Calculate ratios for assessing a company’s position in the stock market.
46
Stock Market Ratios
Stock market ratios analyze the earnings and dividends of a company.
Earnings per share
Book value per share
Price-earnings (P/E) ratio
Dividend yield
13-47
47
Stock market ratios analyze the earnings and dividends of a company.
The stock market ratios we will look at are:
Earnings per share
Book value per share
Price-earnings (P/E) ratio
Dividend yield
Earnings Per Share
Earnings per Share
Net Earnings Available for Common Stock
Average Number of Outstanding Common Shares
=
This measure indicates how much
income was earned for each share of common stock outstanding.
13-48
48
Earnings per share is computed as shown.
The average number of outstanding common shares 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.
This measure indicates how much income was earned for each share of common stock outstanding.
Earnings Per Share
13-49
49
Here are Milavec’s earnings per share for 2015. Investors attribute a great deal of importance to this ratio. However, there are numerous opportunities to manipulate this ratio. Prudent investors consider this in deciding how much weight to attach to earnings per share.
Book Value Per Share
This ratio measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts and if all creditors were paid off.
Book Value per Share
Stockholders’ Equity - Preferred Rights
Outstanding Common Shares
=
13-50
50
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 and if all creditors were paid off. This measure is based entirely on historical cost.
Book Value Per Share
13-51
51
Here is Milavec’s book value per share ratio for 2015.
Price-Earnings Ratio
Price-Earnings
Ratio
Market Price Per Share
Earnings Per Share
=
This ratio compares the earnings of a company to the market price for a share of the company’s stock.
13-52
52
The price-earnings ratio is computed as shown.
This ratio compares the earnings of a company to the market price for a share of the company’s stock.
In general, a higher price-earnings ratio indicates the market is more optimistic about a company’s growth potential than it is about a company with a lower price-earnings ratio.
Dividend Yield
Dividend
Yield
Dividends per Share
Market Price per Share
=
This ratio identifies the return, in terms of cash dividends, on the current market price of the stock.
13-53
53
The dividend yield ratio is computed as shown.
There are two ways to profit from a stock investment. One, investors can sell the stock for more than they paid to purchase it (if the stock price rises). Two, the company that issued the stock can pay cash dividends to the shareholders. Most investors view rising stock prices as the primary reward for investing in stock. The importance of receiving dividends, however, should not be overlooked.
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.
Limitations of Financial Statement Analysis
Different Industries
Changing Economic Environment
Accounting Principles
13-54
54
Part I
External users can rely on financial statement analysis only as a general guide to the potential of a business. Many factors must be considered simultaneously before making any judgments.
For example, different industries may be affected by unique social policies, special accounting procedures, or other individual industry attributes.
Part II
When comparing firms, analysts must be alert to changes in general economic trends from year to year.
Part III
Financial statement analysis is only as reliable as the data on which it is based. Although most firms follow generally accepted accounting principles, a wide variety of acceptable accounting methods is available from which to choose, including different inventory and depreciation methods, different schedules for recognizing revenue, and different ways to account for oil and gas exploration costs. Analysts must keep these differences in mind when comparing companies.
