Financial Statement Analysis
Chapter 14
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Financial Statements Are
Designed for Analysis
Classified
Financial
Statements
Comparative
Financial
Statements
Consolidated
Financial
Statements
Items with certain
characteristics are
grouped together.
Amounts from
several years
appear side by side.
Information for the
parent and subsidiary
are presented.
Results
in standardized,
meaningful
subtotals.
Helps identify
significant
changes and
trends.
Presented as if
the two companies
are a single
business unit.
14-2
Tools of Analysis
Dollar &
Trend
Percentage
Percentages
Changes
Component
Percentages
Ratios
14-3
Dollar and Percentage Changes
Dollar Change:
Dollar
Change
=
Analysis Period
Amount
–
Base Period
Amount
Percentage Change:
Percent
Change
=
Dollar Change
÷
Base Period
Amount
14-4
Dollar and Percentage Changes
Evaluating Percentage Changes in
Sales and Earnings
Sales and earnings
should increase at
more than the rate
of inflation.
In measuring quarterly
changes, compare to
the same quarter in
the previous year.
Percentages may be
misleading when the
base amount is small.
14-5
Clover Limited
2008
Comparative2009
Balance Sheets
31 December
Dollar
Change
Percent
Change*
Assets
Property and equipment:
Dollar
Percent
Land
$ 2009
40,000 $2008
40,000 Change
Change*
Buildings and
equipment, net
120,000
85,000
Assets
Total property
and equipment
160,000
125,000
Property
and equipment:
Current
Land assets:
$ 40,000 $ 40,000
Inventoryand equipment, net
80,000
100,000
Buildings
120,000
85,000
Prepaid
expenses
3,000 $ 125,000
1,200
Total property
and equipment $ 160,000
Accounts
receivable, net
60,000
40,000
Current
assets:
$12,000 – $23,500 = $(11,500)
Cash
and
cash
equivalents
12,000
23,500
?
?
Inventory
$ 80,000 $ 100,000
Total current
assets
$ 155,000
$ 164,700
Prepaid
expenses
3,000
1,200
Total
assets
$ 60,000
315,000 $ 40,000
289,700
Accounts
receivable, net
* Cash
Percent
to one decimal point.
androunded
cash equivalents
12,000
23,500
(11,500)
?
Total current assets
$ 155,000 $ 164,700
Total assets
$ 315,000 $ 289,700
* Percent rounded to one decimal point.
14-6
Clover Limited
Comparative Balance Sheets
31 December
2009
Assets
Property and equipment:
Land
$ 40,000
Buildings and equipment, net
120,000
Total property and equipment $ 160,000
Current assets:
Inventory
$ 80,000
Prepaid expenses
3,000
Accounts receivable, net
60,000
Cash and cash equivalents
12,000
Total current assets
$ 155,000
Total assets
$ 315,000
* Percent rounded to one decimal point.
2008
Dollar
Change
Percent
Change*
$ 40,000
85,000
$ 125,000
Complete the
analysis for the
other assets.
$ 100,000
1,200
40,000
23,500
$ 164,700
$ 289,700
($11,500 ÷ $23,500) ×
100% = 48.94%
(11,500)
-48.9%
14-7
Clover Limited
Comparative Balance Sheets
31 December
2009
Assets
Property and equipment:
Land
$ 40,000
Buildings and equipment, net
120,000
Total property and equipment $ 160,000
Current assets:
Inventory
$ 80,000
Prepaid expenses
3,000
Accounts receivable, net
60,000
Cash and cash equivalents
12,000
Total current assets
$ 155,000
Total assets
$ 315,000
* Percent rounded to one decimal point.
2008
$ 40,000
85,000
$ 125,000
$ 100,000
1,200
40,000
23,500
$ 164,700
$ 289,700 $
Dollar
Change
Percent
Change*
35,000
35,000
0.0%
41.2%
28.0%
(20,000)
1,800
20,000
(11,500)
(9,700)
25,300
-20.0%
150.0%
50.0%
-48.9%
-5.9%
8.7%
14-8
Trend Percentages
Trend analysis is used to reveal patterns in
data covering successive periods.
Trend
=
Percentages
Analysis Period Amount
Base Period Amount
× 100%
14-9
Trend Percentages
Berry Products
Income Information
For the Years Ended 31 December
Item
Revenues
Cost of sales
Gross profit
Item
Revenues
Cost of sales
Gross profit
2009
$ 400,000
285,000
115,000
2008
$ 355,000
250,000
105,000
2007
$ 320,000
225,000
95,000
2006
$ 290,000
198,000
92,000
2009
2008
2007
2006
145%is the129%
116% so 105%
2005
base period
its
150%
132%
118%
104%
amounts124%
will equal
100%.108%
135%
112%
(290,000  275,000)
(198,000  190,000)
(92,000  85,000)



100% = 105%
100% = 104%
100% = 108%
2005
$ 275,000
190,000
85,000
2005
100%
100%
100%
14-10
Component Percentages
Examine the relative size of each item in the financial
statements by computing component
(or common-sized) percentages.
Component
Percentage
=
Analysis Amount
Base Amount
Financial Statement
Balance Sheet
Income Statement
×
100%
Base Amount
Total Assets
Revenues
14-11
Clover Limited
Comparative Balance Sheets
31 December
Complete the common-size analysis for the other
assets.
2009
Assets
Property and equipment:
Land
$ 40,000
Buildings and equipment, net
120,000
Total property and equipment
160,000
Current assets:
Inventory
$ 80,000
Prepaid expenses
3,000
Accounts receivable, net
60,000
Cash and cash equivalents
12,000
Total current assets
$ 155,000
Total assets
$ 315,000
* Percent rounded to first decimal point.
2008
$ 40,000
85,000
125,000
$ 100,000
1,200
40,000
23,500
$ 164,700
$ 289,700
Common-size
Percents*
2009
2008
($23,500 ÷
$289,700) ×
100% = 8.1%
($12,000 ÷
$315,000) ×
100% = 3.8%
3.8%
8.1%
100.0%
100.0%
14-12
Clover Limited
Comparative Balance Sheets
31 December
2009
Assets
Property and equipment:
Land
$ 40,000
Buildings and equipment, net
120,000
Total property and equipment
160,000
Current assets:
Inventory
$ 80,000
Prepaid expenses
3,000
Accounts receivable, net
60,000
Cash and cash equivalents
12,000
Total current assets
$ 155,000
Total assets
$ 315,000
* Percent rounded to first decimal point.
2008
$ 40,000
85,000
125,000
$ 100,000
1,200
40,000
23,500
$ 164,700
$ 289,700
Common-size
Percents*
2009
2008
12.7%
38.1%
50.8%
0.0%
25.4%
1.0%
19.0%
3.8%
49.2%
100.0%
13.8%
29.3%
43.1%
0.0%
34.5%
0.4%
13.8%
8.1%
56.9%
100.0%
14-13
Clover Limited
Comparative Income Statements
For the Years Ended 31 December
Common-size
Percents*
2009
2008
2009
2008
Revenues
$ 520,000 $ 480,000
100.0% 100.0%
Costs and expenses:
Cost of sales
360,000
315,000
69.2%
65.6%
Selling and admin.
128,600
126,000
24.7%
26.3%
Interest expense
6,400
7,000
1.2%
1.5%
Profit before taxes
$ 25,000 $ 32,000
4.8%
6.7%
Income taxes (30%)
7,500
9,600
1.4%
2.0%
Profit for the year
$ 17,500 $ 22,400
3.4%
4.7%
Earnings per share
$
0.79 $
1.01
Avg. # common shares
22,200
22,200
* Rounded to first decimal point.
14-14
Quality of Earnings
Investors are interest in companies that
demonstrate an ability to earn income at a
growing rate each year. Stability of earnings
growth helps investors predict future prospects
for the company.
Financial analyst often speak of the “quality of
earnings” at one company being higher than
another company in the same industry.
14-15
Quality of Assets and the Relative
Amount of Debt
While satisfactory earnings may be a
good indicator of a company’s ability to
pay its debts and dividends, we must also
consider the composition of assets, their
condition and liquidity, the timing of
repayment of liabilities, and the total
amount of debt outstanding
14-16
A Classified Balance Sheet
Matrix, Inc.
Asset Section: Classified Balance Sheet
31 December 2009
Noncurrent assets:
Property, plant and equipment:
Land
Building
Less: Accumulated depreciation
Equipment and Fixtures
Less: Accumulated depreciation
Total plant and equipment
Patents
Total noncurrent assets
Current assets:
Cash
Notes receivable
Accounts receivable
Inventory
Prepaid expenses
Total current assets
Total assets
$
$
121,000
(10,000)
46,000
(27,000)
150,000
111,000
19,000
$
$
280,000
170,000
450,000
30,000
16,000
60,000
70,000
4,000
180,000
630,000
14-17
Ratios
A ratio is a simple mathematical expression
of the relationship between one item and another.
Along with dollar and percentage changes,
trend percentages, and component percentages,
ratios can be used to compare:
Past performance to
present performance.
Other companies to
your company.
14-18
Use this information to calculate the liquidity
ratios for Babson Builders.
Babson Builders Limited
2009
Cash
$ 30,000
Accounts receivable, net
Beginning of year
17,000
End of year
20,000
Inventory
Beginning of year
10,000
End of year
15,000
Total current assets
65,000
Total current liabilities
42,000
Total liabilities
103,917
Total assets
Beginning of year
300,000
End of year
346,390
Revenues
494,000
14-19
Working Capital
Working capital is the excess of current
assets over current liabilities.
31/12/09
Current assets
Current liabilities
Working capital
$ 65,000
(42,000)
$ 23,000
14-20
Current Ratio
This ratio measures the
short-term debt-paying
ability of the company.
Current
=
Ratio
Current
=
Ratio
Current Assets
Current Liabilities
$65,000
$42,000
= 1.55 : 1
14-21
Quick Ratio
Quick
Ratio
Quick Assets
=
Current Liabilities
Quick assets are cash, marketable
securities, and receivables.
This ratio is like the current
ratio but excludes current assets
such as inventories that may be
difficult to quickly convert into cash.
14-22
Quick Ratio
Quick Assets
=
Current Liabilities
Quick
Ratio
Quick
Ratio
=
$50,000
$42,000
= 1.19 : 1
14-23
Uses and Limitations of Financial
Ratios
Uses
Limitations
Ratios help users
understand
financial relationships.
Management may enter
into transactions merely
to improve the ratios.
Ratios provide for
quick comparison
of companies.
Ratios do not help with
analysis of the company's
progress toward
nonfinancial goals.
14-24
Measures of Profitability
An income statement can be prepared in either a
multiple-step or single-step format.
The single-step format
is simpler. The multiple-step
format provides more detailed
information.
14-25
Income Statement (Multiple-Step)
Proper Heading
Gross Margin
Operating Expenses
Non-operating Items
Remember
to compute
EPS.
Babson Builders Limited
Income Statement
For the Year Ended 31/12/09
Sales
Cost of goods sold
Gross margin
Operating expenses:
Selling expenses
General & Admin.
Depreciation
Profit from Operations
Other revenues & gains:
Interest income
Gain
Other expenses:
Interest
Loss
Profit before taxes
Income taxes
Profit for the year
$
$
$
$
$
785,250
351,800
433,450
$
293,350
140,100
197,350
78,500
17,500
62,187
24,600
86,787
27,000
9,000
$
$
(36,000)
190,887
62,500
128,387
14-26
Income Statement (Single-Step)
Proper Heading
Revenues
& Gains
Expenses
& Losses
Remember
to compute
EPS.
Babson Builders Limited
Income Statement
For the Year Ended 31/12/09
Revenues and gains:
Sales
Interest income
Gain on sale of plant assets
Total revenues and gains
Expenses and losses:
Cost of goods sold
Selling Expenses
General and Admin. Exp.
Depreciation
Interest
Income taxes
Loss: sale of investment
Total expenses & losses
Operating profit
$
$
$
785,250
62,187
24,600
872,037
$
743,650
128,387
351,800
197,350
78,500
17,500
27,000
62,500
9,000
14-27
Use this information to calculate the
profitability ratios for Babson Builders
Limited
Babson Builders Limited
2009
Ending market price per share
Number of common shares
outstanding all of 2007
Profit
Total shareholders' equity
Beginning of year
End of year
Revenues
Cost of sales
Total assets
Beginning of year
End of year
$
15.25
$
27,400
53,690
180,000
234,390
494,000
140,000
300,000
346,390
14-28
Earning Per Share
Profit for the year
= EPS
Average No. of Ordinary Shares Outstanding
Look back at the information from Babson and get the
values we need to calculate earning per share.
$53,690
= $1.96
27,400
14-29
Price-Earnings Ratio
Current Market Price of one Share
Earnings Per Share
= P/E
$15.25
= 7.78
$1.96
The measure shows us the relationship between earning
of the company and the market price of its share.
14-30
Return On Investment (ROI)
This ratio is a good measure of
the efficiency of utilization of
assets by the business.
ROI
=
Annual return (profit) from and investment
Average amount invested
14-31
Return On Assets (ROA)
This ratio is generally considered
the best overall measure of a
company’s profitability.
ROA
Operating
=
÷ Average total assets
profit
Income
= $ 53,690 ÷ ($300,000 + $346,390) ÷ 2
=
16.61%
14-32
Return On Equity (ROE)
This measure indicates how well the
company employed the owners’
investments to earn income.
ROA
=
Profit
÷ Average total equity
= $ 53,690 ÷ ($180,000 + $234,390) ÷ 2
=
25.91%
14-33
Dividend Yield
Dividend
Yield Ratio
=
Dividends Per Share
Market Price Per Share
Babson Builders pays an annual dividend of
$1.50Dividend
per share. The $1.50
market price of the
=
= 9.84%
Yield Ratio
company’s
share was$15.25
$15.25 at the end of
2009.
This ratio identifies the return, in
terms of cash dividends, on the
current market price of the share.
14-34
Analysis by Long-Term Creditors
Use this information to calculate ratios to
measure the well-being of the long-term
creditors for Babson Builders.
Babson Builders Limited
2009
Earnings before interest
expense and income taxes
This is also
referred to as
net operating
profit.
Interest expense
$
84,000
7,300
Total assets
346,390
Total shareholders' equity
234,390
Total liabilities
112,000
14-35
Interest Coverage Ratio
Times
Interest
Earned
Operating Profit before Interest
and Income Taxes
Annual Interest Expense
=
Times
Interest
Earned
=
$84,000
7,300
=
11.5 times
This is the most common
measure of the ability of a firm’s
operations to provide protection
to the long-term creditor.
14-36
Debt Ratio
A measure of creditor’s long-term risk.
The smaller the percentage of assets
that are financed by debt, the smaller
the risk for creditors.
Debt
Ratio
=
Total
Liabilities
÷ Total Assets
=
$112,000 ÷
=
32.33%
$346,390
14-37
Analysis by Short-Term Creditors
Babson Builders Limited
Use this
information to
calculate ratios
to measure the
well-being of
the short-term
creditors for
Babson
Builders
Limited
2009
Cash
$
30,000
Accounts receivable, net
Beginning of year
17,000
End of year
20,000
Inventory
Beginning of year
10,000
End of year
12,000
Total current assets
65,000
Total current liabilities
42,000
Sales on account
500,000
Cost of goods sold
140,000
14-38
Accounts Receivable Turnover
Rate
Accounts
Receivable
Turnover
=
Net Sales
Average Accounts Receivable
Accounts
$500,000
= 27.03 times
Receivable =
($17,000 + $20,000) ÷ 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.
14-39
Inventory Turnover Rate
Inventory
Turnover
Inventory
Turnover
=
Cost of Goods Sold
Average Inventory
$140,000
=
= 12.73 times
($10,000 + $12,000) ÷ 2
This ratio measures the
number of times merchandise
inventory is sold and replaced
during the year.
14-40
Operating Cycle
Cash
Accounts
Receivable
Inventory
2. Sale of merchandise on account
14-41
End of Chapter 14
14-42