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©2006 Prentice Hall, Inc.
USING FIN STMT ANALYSIS TO
EVALUATE FIRM PERFORMANCE
 Learning
objectives
 A closer look at the income statement
 Horizontal and vertical analysis of
financial information
 Ratio analysis
 It’s more than just the numbers
 Business risk, control, and ethics
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©2006 Prentice Hall, Inc.
Learning Objectives
(1 of 2)
 Recognize
and explain the
components of net income
 Perform and interpret a horizontal
analysis and a vertical analysis of
financial statement information
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©2006 Prentice Hall, Inc.
Learning Objectives
(2 of 2)
 Perform
a basic ratio analysis of a set
of financial statements and explain
what the ratios mean
 Recognize the risks of investing in
stock and explain how to control
those risks
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©2006 Prentice Hall, Inc.
A Closer Look at the Income
Statement
 Why
does FASB require discontinued
operations and extraordinary items
to be reported separately?
 Discontinued operations
 Extraordinary items
 Reporting taxes
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©2006 Prentice Hall, Inc.
Discontinued Operations
(1 of 2)
 Parts
of a company’s operations that
are eliminated
A
one-time occurrence
 Income/loss
from discontinued
operations separately reported
Net
of taxes
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©2006 Prentice Hall, Inc.
Discontinued Operations
(2 of 2)
 Gain/loss
from disposal of
discontinued operations separately
reported
Net
of taxes
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©2006 Prentice Hall, Inc.
Extraordinary Items
(1 of 2)
 Events
that are
Unusual
in nature
Abnormal
Infrequent
in occurrence
Not
reasonably expected to occur again in
the foreseeable future
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©2006 Prentice Hall, Inc.
Extraordinary Items
(2 of 2)
 Much
judgment required to determine
if an event is an extraordinary item
Should
damage from a hurricane in
Miami be reported as an extraordinary
item?
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©2006 Prentice Hall, Inc.
Reporting Taxes
 Income
taxes shown as separate line
item
 Last item before income from
continuing operations
 Does not include tax expense/savings
from extraordinary items or
discontinued operations
©2006 Prentice Hall, Inc.
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Horizontal and Vertical Analysis
of Financial Information
 Three
primary ways to analyze
financial information
Horizontal
analysis
Vertical analysis
Ratio analysis
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©2006 Prentice Hall, Inc.
Horizontal Analysis
(1 of 3)
 Evaluating
time
financial statements across
Express
change in a financial statement
item in percentages instead of dollars
Current year amount – Base year amount
Base year amount
 Reported
as a percentage
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©2006 Prentice Hall, Inc.
Horizontal Analysis
(2 of 3)
 Two
ways to compute
Choose
a single year as base period for
all years analyzed
Use the prior year as base period
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©2006 Prentice Hall, Inc.
Horizontal Analysis
(3 of 3)
Accts Rec
2010
$5.5M
2011
$6.7M
2012
$6.1M
2013
$7.0M
 Compute
the change in accounts
receivable using
2010
as the base year
The prior year as the base year
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©2006 Prentice Hall, Inc.
Vertical Analysis
(1 of 2)
 Compares
items w/in single fin stmt
All
items expressed as a percent of a
common amount
Also
called common-sizing financial statements
Income
statement items
Percent
Balance
sheet
Percent
©2006 Prentice Hall, Inc.
of sales
of total assets
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Vertical Analysis
(2 of 2)
Net Sales
Cost of Goods Sold
Gross Profit
Operating Expenses:
Selling Expenses
Administrative Exp.
Total Oper. Exp.
Net Income
2011 % of Sales
$4,300
100%
2,900
1,400
650
525
1175
$225
2010 % of Sales
$3,500
100%
2,300
1,200
600
500
1100
$100
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©2006 Prentice Hall, Inc.
Ratio Analysis
A
review of all ratios
 DuPont formula
 Understanding ratio analysis
 Using ratio analysis
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©2006 Prentice Hall, Inc.
A Review of All Ratios
(1 of 2)
 Liquidity
ratios
Measure
ability to pay current bills and
operating costs
 Solvency
ratios
Measure
ability to meet long-term
obligations and survive over long term
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©2006 Prentice Hall, Inc.
A Review of All Ratios
(2 of 2)
 Profitability
ratios
Measure
operating or income
performance
 Market
indicators
Ratios
relating current market price of
stock to earnings or dividends
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©2006 Prentice Hall, Inc.
Liquidity Ratios
 Current
ratio
 Quick ratio
 Working capital
 Inventory turnover ratio
 Accounts receivable turnover ratio
 Current cash debt coverage ratio
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©2006 Prentice Hall, Inc.
Current Ratio
Current Assets _
Current Liabilities
Measure
ability to pay current liabilities
with current assets
Helps creditors determine if a company
can meet its short-term obligations
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©2006 Prentice Hall, Inc.
Quick Ratio
Cash + s-t investments + A/R net
Current liabilities
Measure ability to meet short-term
obligations
Similar to the current ratio
Stricter
test because it limits numerator to
only very liquid assets
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©2006 Prentice Hall, Inc.
Working Capital
Current assets – Current liabilities
Measure
ability to meet short-term
obligations
 Not a ratio
Often measured as part of financial
statement analysis
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©2006 Prentice Hall, Inc.
Inventory Turnover Ratio
Cost of goods sold _
Average current liabilities
Measure how quickly a company is
selling its inventory
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©2006 Prentice Hall, Inc.
Accounts Receivable Turnover Ratio
Net credit sales
_
Average net accounts receivable
Measure ability to collect the cash from
its credit customers
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©2006 Prentice Hall, Inc.
Current Cash Debt Coverage Ratio
Net cash from operating activities
Average current liabilities
Measure ability to generate cash
needed to pay current liabilities from
company’s operations
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©2006 Prentice Hall, Inc.
Solvency Ratios
 Debt
to equity ratio
 Times interest earned ratio
 Cash flow adequacy ratio
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©2006 Prentice Hall, Inc.
Debt to Equity Ratio
Total liabilities
_
Total shareholders’ equity
Compare amount of company’s debt
with amount owners have invested in
the company
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©2006 Prentice Hall, Inc.
Times Interest Earned Ratio
Income from operations_
Interest expense
Compare amount of income earned in
an accounting period (before interest)
to interest obligation for same period
If
net income used in numerator, add back
interest expense and taxes
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©2006 Prentice Hall, Inc.
Cash Flow Adequacy Ratio
Net cash from operating activities _
Net cash required for investing activities
Cash
required for investing activities
 Cash
paid for capital expenditures and
acquisitions minus cash proceeds from disposal
of capital assets
Measures
the firm’s ability to generate
enough cash from operating activities
to pay for its capital expenditures
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©2006 Prentice Hall, Inc.
Profitability Ratios
 Return
on assets
 Asset turnover ratio
 Return on equity
 Gross profit ratio
 Profit margin ratio
 Earnings per share
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©2006 Prentice Hall, Inc.
Return on Assets
(1 of 2)
Net income + Interest expense_
Average total assets
Measure success in using assets to earn
income for owners and creditors
Those
who are financing the business
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©2006 Prentice Hall, Inc.
Return on Assets
(2 of 2)
Interest
added back to numerator
Interest
part of what has been earned to
pay creditors
Net income is return to the owners
Interest expense is return to creditors
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©2006 Prentice Hall, Inc.
Asset Turnover Ratio
Net sales
_
Average total assets
Measure how efficiently a company
uses its assets
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©2006 Prentice Hall, Inc.
Return on Equity
Net income – preferred dividends _
Average common shareholders’ equity
Measure how much income is earned
with the common shareholders’
investment in the company
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©2006 Prentice Hall, Inc.
Gross Profit Ratio
Gross profit_
Net sales
Describes percentage of sales price that
is gross profit
Carefully
watched by management
A small shift usually indicates a big change
in the profitability of the company’s sales
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©2006 Prentice Hall, Inc.
Profit Margin Ratio
Net income_
Net sales
Measure percentage of each sales dollar
that results in net income
 Where
in common sizing financial
statements can you find gross profit
and profit margin ratios?
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©2006 Prentice Hall, Inc.
Earnings Per Share
Net income – preferred dividends_
Weighted average # of shares of
common stock outstanding
Calculate net income per share of
common stock
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©2006 Prentice Hall, Inc.
Market Indicators
 Price-earnings
ratio
 Dividend yield ratio
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©2006 Prentice Hall, Inc.
Price-earnings Ratio
Market price per common share_
Earnings per share
Calculate market price for $1 of
earnings
Investors and analysts believe it
indicates future earnings potential
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©2006 Prentice Hall, Inc.
Dividend Yield Ratio
Dividends per share _
Market price per share
Calculate percentage return on
investment in a share of stock via
dividends
 How
else do investors earn a return
on their investment besides receiving
dividends?
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©2006 Prentice Hall, Inc.
DuPont Formula
(1 of 2)
ROE = ROA x Financial leverage
ROE = Net income x Assets
Assets
Equity
ROE = Asset x Profit margin x Financial
Turnover
Ratio
leverage
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©2006 Prentice Hall, Inc.
DuPont Formula
(2 of 2)
 Indicates
quality of ROE
If
ROE is due to high financial leverage,
what is the company’s prospects for
growth of its ROE?
Which component of formula would
you expect to be strongest for
A
grocery store?
A jewelry store?
©2006 Prentice Hall, Inc.
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Understanding Ratio Analysis
 Ratios
must be compared with
something to be useful
Same
company for prior periods
Other companies for same period
Industry average for same period
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©2006 Prentice Hall, Inc.
Using Ratio Analysis
(1 of 2)
FYE 2003
FYE 2004
Ratio
2.58
2.91
Current ratio
1.88
2.18
Quick ratio
$63.14M
$90.76M
Working capital
10.56
10.47
Inventory turnover ratio
Average days in inventory
9.78
9.76
Accounts rec turnover ratio
Avg days to collect AR
0.31
0.32
Debt to equity
273
311
Times interest earned ratio
8.71%
8.83%
Return on assets
11.33%
11.57%
Return on equity
34.24%
33.66%
Gross profit percentage
$2.26
$2.55
Earnings per share
17.70
16.47
Price-earnings ratio
No dividends paid
Dividend yield ratio
©2006 Prentice Hall, Inc.
Industry
Average
1.90
0.80
N/A
10.60
6.40
4.60%
10.00%
36.80%
N/A
19.80
N/A
Trend
+/-
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Using Ratio Analysis
(2 of 2)
 Fill
in the missing information
 Why is the current ratio so much
higher than the quick ratio?
 Why not compare working capital to
the industry average?
 What conclusions can you draw from
this information?
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©2006 Prentice Hall, Inc.
It’s More than Just the Numbers
 Information
found in notes to
financial statements
Inventory
cost flow methods
Depreciation methods
How various items are valued
Description of accounting policies
What other useful information can you
find in Wal-Mart’s and Target’s notes? 12-47
©2006 Prentice Hall, Inc.
Business Risk, Control, and Ethics
 Investor
perspective
How
do you minimize the risks of stock
ownership?
Consult
with a financial professional
Diversify your investments
 What
kinds of investments would make up a
diversified portfolio?
Can
you eliminate all investment risk?
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©2006 Prentice Hall, Inc.
Comments or questions about PowerPoint Slides?
Contact Dr. Richard Newmark at
University of Northern Colorado’s
Kenneth W. Monfort College of Business
richard.newmark@PhDuh.com
©2006 Prentice Hall, Inc.
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