©2009 The McGraw-Hill Companies, Inc.
Chapter 12
Financial Statement
Analysis
©2009 The McGraw-Hill Companies, Inc.
Part A
Comparison of Financial
Accounting Information
12-3
Comparison of Financial Accounting
Information
Type of Comparison
1. Comparisons between companies
Under
Armour
Sales Growth
2010
Sales Growth
Under
Armour
Company Risk
Compare Under Armour’s earnings this year
with its earnings last year.
2009
3. Comparisons to industry
Under
Armour
Compare sales growth for Under Armour with
sales growth for Nike.
Nike
2. Comparisons over time
Under
Armour
Example
Industry
Industry Risk
Compare Under Armour’s level of risk with
the average degree of risk for the sports
apparel industry.
12-4
LO1 Vertical Analysis
We express each item in a financial statement as a percentage
of the same base amount
Under Armour and Nike
Common-Size Income Statements
For the Years Ended December 31, 2006 and May 31. 2007
($ in millions)
For the year ended:
Under Armour
Nike
December 31, 2006
May 31, 2007
Amount
Net Sales
%
Amount
%
$430.7
100.0
$16,325.9
100.0
Cost of goods sold
215.1
49.9
9,165.4
56.1
Gross profit
215.6
50.1
7,160.5
43.9
Operating expenses
158.3
36.8
5,028.7
30.8
57.3
13.3
2,131.8
13.1
1.8
.4
68.1
.4
Income before tax
59.1
13.7
2,199.9
13.5
Income tax expense
20.1
4.6
708.4
4.4
$39.0
9.1
$1,491.5
9.1
Operating income
Other income (expense)
Net income
12-5
Vertical Analysis
Under Armour and Nike
Common-Size Balance Sheets
December 31, 2006 and May 31. 2007
(in millions)
Under Armour
Nike
December 31, 2006
May 31, 2007
Amount
%
Amount
%
Assets
Current assets
$245.0
84.7
$8,076.5
75.6
29.9
10.3
1,678.3
15.7
Intangible assets
7.9
2.7
540.7
5.0
Other assets
6.6
2.3
392.8
3.7
$289.4
100.0
$10,688.3
100.0
$71.6
24.8
$2,584.0
24.2
3.4
1.2
1,078.6
10.1
148.0
51.1
2,140.5
20.0
66.4
22.9
4,885.2
45.7
$289.4
100.0
$10,688.3
100.0
Property and equipment
Total assets
Liabilities and Stockholders’ Equity
Current liabilities
Long-term liabilities
Common stock
Retained earnings
Total liabilities and stockholders’ equity
12-6
LO2 Horizontal Analysis
Analyze trends in financial statement data for a single
company over time
Under Armour
Income Statement
For the Years Ended December 31
(in millions)
Year
2006
Sales
Increase (Decrease)
2005
Amount
%
$430.7
$281.1
$149.6
53.2
Cost of goods sold
215.1
145.2
69.9
48.1
Gross profit
215.6
135.9
79.7
58.6
Operating expenses
158.3
100.0
58.3
58.3
57.3
35.9
21.4
59.6
1.8
(2.9)
4.7
N/A
Income before tax
59.1
33.0
26.1
79.1
Income tax expense
20.1
13.3
6.8
51.1
$39.0
$19.7
$19.3
98.0
Operating income
Other income (expense)
Net income
12-7
Horizontal Analysis
Under Armour
Balance Sheet
December 31
(in millions)
Year
2006
Increase (Decrease)
2005
Amount
%
Assets
Current assets
$245.0
$181.8
$63.2
34.8
29.9
20.9
9.0
43.1
Intangible assets
7.9
0
7.9
N/A
Other assets
6.6
1.0
5.6
560.0
$289.4
$203.7
$85.7
42.1
$71.6
$47.7
$23.9
50.1
3.4
5.2
(1.8)
(34.6)
148.0
122.7
25.3
20.6
66.4
28.1
38.3
136.3
$289.4
$203.7
$85.7
42.1
Property and equipment
Total assets
Liabilities and Stockholders’ Equity
Current liabilities
Long-term liabilities
Common stock
Retained earnings
Total liabilities and stockholders’ equity
©2009 The McGraw-Hill Companies, Inc.
Part B
Using Ratios to assess Risk
and Profitability
12-9
LO3 Risk Analysis
Risk Ratios
Chapter
Calculations
Receivable turnover ratio
5
Credit sales
Average net receivables
Average collection period
5
365 days
Receivable turnover ratio
Inventory turnover ratio
6
Cost of goods sold
Average inventory
Average days in inventory
6
365 days
Inventory turnover ratio
Current ratio
8
Current assets
Current liabilities
Acid-test ratio
8
Cash + net receivables + current investments
Current liabilities
Debt to equity ratio
9
Total liabilities
Total stockholders’ equity
Times interest earned
ratio
9
Net income + interest expense + tax expense
Interest expense
Liquidity
A company’s
ability to pay
its current
liabilities
A
company’s
ability to
pay its
long-term
liabilities
Solvency
12-10
Common Mistake
In comparing an income statement account with a
balance sheet account, some students use the
balance sheet account’s ending balance, rather
than the average of its beginning and ending
balances. Since income statement accounts are
measured over a period of time, comparisons to
related balance sheet accounts also need to be
over time by taking the average of the beginning
and ending points in time.
12-11
Receivable Turnover Ratio
Measures how many times, on average, a company collects its
receivables during the year
HIGH RATIO
Receivable turnover
ratio
Net credit sales
Average net receivables
A company can quickly
turn its receivables into
cash
Under Armour
$430.7
($84.3 + $60.0) / 2
= 6.0 times
Nike
6.1 times
12-12
Average Collection Period
Converts the receivable turnover ratio into days
LOW RATIO
The shorter the average
collection period, the
better.
Average collection period
365 days
Receivable turnover ratio
Under Armour
365
6.0
= 60.8 days
Nike
59.8 days
12-13
Inventory Turnover Ratio
Measures how many times, on average, a company sells its entire
inventory during the year
HIGH RATIO
Inventory is selling more
quickly, less cash is tied up
in inventory, and the risk of
outdated inventory is lower
Inventory turnover ratio
Under Armour
Cost of goods sold
Average inventory
$215.1
= 3.2 times
($81.0 + $53.6) / 2
Nike
4.4 times
12-14
Average Days in Inventory
Converts the inventory turnover ratio into days
LOW RATIO
Average days in inventory
365 days
Inventory turnover ratio
Companies try to
minimize the number
of days they hold
inventory
Under Armour
365
3.2
= 114.1 days
Nike
83.0 days
12-15
Current Ratio
Compares current assets to current liabilities
HIGH RATIO
Current ratio
Current assets
Current liabilities
A company has
sufficient current assets
to pay current liabilities
as they become due
Under Armour
$245.0
$71.6
= 3.4 to 1
Nike
3.1 to 1
12-16
Acid-Test Ratio
Based on a more conservative measure of current assets available
to pay current liabilities, the acid-test ratio provides a better
indication of a company’s liquidity than does the current ratio
HIGH RATIO
Acid-test ratio
Cash +net receivables + current investments
Current liabilities
A company has sufficient
current assets (excluding
inventories and prepaid
expenses) to pay current
liabilities as they become due
Under Armour
$70.7 + $84.3 + $0
$71.6
Nike
= 2.2
2.2
12-17
Debt-to-Equity Ratio
Compares liabilities to stockholders’ equity
LOW RATIO
Debt to equity ratio
Total liabilities
Total stockholders’ equity
Lower debt compared to
equity, results in lower risk of
bankruptcy
Under Armour
$71.6 + $3.4
$214.4
= 35.0%
Nike
52.1%
12-18
Times Interest Earned Ratio
Compares interest payments with a company’s income
available to pay those charges
HIGH RATIO
Times interest earned ratio
Net income + interest expense + tax expense
Interest expense
Company generates enough
income to cover its interest
payments
Under Armour
$39.0 + $0.5 + $20.1
$0.5
Nike
= 119.2
37.7
12-19
LO4 Profitability Analysis
Profitability Ratios
Chapter
Calculations
Gross profit ratio
6
Gross profit
Sales
Return on assets
7
Net income
Average total assets
Profit margin
7
Net income
Sales
Asset turnover
7
Sales
Average total assets
Return on equity
9
Net income
Average stockholders’ equity
Price-earnings ratio
10
Stock price
Earnings per share
12-20
Gross Profit Ratio
Indicates the portion of each dollar of sales above its cost of
goods sold
HIGH RATIO
Gross profit ratio
Gross profit
Sales
Higher the gross
profit, the better it is
Under Armour
$215.6
$430.7
= 50.1%
Nike
43.9%
12-21
Return on Assets
Measures the income the company earns on each dollar
invested in assets
HIGH RATIO
Return on assets
Net income
Average total assets
Higher the return on
assets, the better it is
Under Armour
$39.0
($289.4 + $203.7) / 2
= 15.8%
Nike
14.5%
12-22
Profit Margin
Measures the income earned on each dollar of sales
Higher the margin,
the better it is
HIGH RATIO
Profit margin
Net income
Sales
Under Armour
$39.0
$430.7
= 9.1%
Nike
9.1%
12-23
Asset Turnover
Measures sales volume in relation to the investment in assets
HIGH RATIO
Asset turnover
Sales
Average total assets
Higher the sales for every
dollar it invests in assets,
the better it is
Under Armour
$430.7
($289.4 + $203.7) / 2
= 1.7 times
Nike
1.6
times
12-24
Return on Equity
Measures the income earned for each dollar in
stockholders’ equity
HIGH RATIO
Return on equity
Net income
Average stockholders’ equity
Higher the income
earned for each dollar in
stockholders’ equity, the
better it is
Under Armour
$39.0
($214.4 + $150.8) / 2
Nike
= 21.4%
22.4%
12-25
Price-Earnings Ratio
Compares a company’s share price
with its earnings per share
HIGH RATIO
Price-earnings ratio
Stock price
Earnings per share
Investors have high
expectations of future
earnings for the company
Under Armour
$50.45
$0.87
= 58.0
Nike
19.4
©2009 The McGraw-Hill Companies, Inc.
Part C
Earnings Persistence and
Earnings Quality
12-27
LO5 Earnings Persistence and
One-Time Income Items
Earnings
Persistence
One-Time
Income Items
Current earnings that will
continue or persist into
future years.
Certain items are part of
net income in the current
year but are not expected
to persist
Discontinued
operations
Extraordinary
items
12-28
Discontinued Operations
The sale or disposal of a significant component
of a company’s operations
Federer Sports Apparel
Income Statement
For the Year Ended December 31, 2010
Revenues
$ 15,500,000
Cost of goods sold
7,000,000
Gross profit
8,500,000
Operating expenses
1,200,000
Depreciation expense
1,000,000
Other revenues and expenses
300,000
Income before tax
6,000,000
Income tax expense
2,000,000
Income from continuing operations
4,000,000
Discontinued operation:
Loss from disposal of tennis shoe segment, net of tax
2,500,000
Net income
$ 1,500,000
12-29
Extraordinary Items
An event that produces a gain or loss; and is
(1) unusual in nature and (2) infrequent in occurrence.
Federer Sports Apparel
Income Statement
For the Year Ended December 31, 2010
Revenues
$ 15,500,000
Cost of goods sold
7,000,000
Gross profit
8,500,000
Operating expenses
1,200,000
Depreciation expense
1,000,000
Other revenues and expenses
300,000
Income before tax
6,000,000
Income tax expense
2,000,000
Income from continuing operations
4,000,000
Discontinued operation:
Loss from disposal of tennis shoe segment, net of tax
2,500,000
Extraordinary item:
Loss from earthquake damage, net of tax
Net income
600,000
$ 900,000
12-30
Other Revenues and Expenses
Extraordinary Items
Other Revenues and Expenses
“Unusual in nature” and
“Infrequent”
“Unusual in nature” or
“Infrequent”
Examples
Examples
1. Uninsured losses from a
natural disaster such as a flood,
earthquake, or hurricane.
1. Losses due to the write-down
of receivables, inventory, or longterm assets.
2. Takeover of property by a
foreign government.
2. Gains or losses on the sale of
long-term assets.
3. Losses due to an employee
strike.
4. Losses due to business
restructuring.
12-31
LO6 Quality of Earnings
The ability of reported earnings to reflect the company’s true
earnings, as well as the usefulness of reported earnings to
predict future earnings.
Conservative
Accounting Practices
Result in reporting
lower income,
lower assets, and
higher liabilities
Aggressive
Accounting Practices
Result in reporting
higher income,
higher assets, and
lower liabilities
12-32
Financial Statements by Mr. Sampras
Federer Sports Apparel
Income Statement
For the Year Ended December 31, 2011
Revenues
$ 18,800,000
Cost of goods sold
13,200,000
Gross profit
5,600,000
Operating expenses
1,600,000
Depreciation expense
1,000,000
Inventory write-down
200,000
Litigation expense
1,500,000
Income before tax
1,300,000
Income tax expense
Net income
450,000
$
850,000
12-33
Financial Statements by Mr. Sampras
Federer Sports Apparel
Balance Sheet
December 31
2011
Cash
$ 2,300,000
2010
$
800,000
Accounts receivable
1,500,000
1,200,000
Inventory
2,800,000
1,700,000
Buildings
11,000,000
11,000,000
Less: Accumulated depreciation
(2,000,000)
(1,000,000)
Total assets
$15,600,000
$13,700,000
Accounts payable
$ 1,450,000
$ 1,700,000
Litigation liability
1,500,000
0
Common stock
8,000,000
8,000,000
Retained earnings
4,650,000
4,000,000
$15,600,000
$13,700,000
Total liabilities and stockholders’ equity
12-34
Financial Statements by Mr. Sampras
Federer Sports Apparel
Statement of Cash Flows
For the Year Ended December 31, 2011
Cash Flows from Operating Activities
Net income
$850,000
Adjustments
Depreciation expense
1,000,000
Increase in accounts receivable
(300,000)
Increase in inventory
(1,100,000)
Decrease in accounts payable
(250,000)
Increase in litigation liability
1,500,000
Net cash flows from operating activities
1,700,000
Cash Flows from Investing Activities
Net cash flows from investing activities
0
Cash Flows from Financing Activities
Payment of cash dividends
(200,000)
Net cash flows from financing activities
(200,000)
Net increase (decrease) in cash
1,500,000
Cash at the beginning of the period
Cash at the end of the period
800,000
$ 2,300,000
12-35
Sampras Retired and McEnroe hired
Mr. McEnroe’s Proposed Changes
1. Estimate of bad debt. At the end of 2011, Mr. Sampras estimated that future
bad debts will be 6% to 10% of current accounts receivable. He decided to play it
safe and recorded an allowance equal to 10% or $150,000. Mr. McEnroe proposes
changing the estimate to be 6% of accounts receivable or $90,000. This change
would increase net accounts receivable and decrease bad debt expense by
$60,000.
2. Write-down of inventory. Mr. Sampras recorded a $200,000 write-down of
inventory with the following entry.
December 31, 2011
Debit
Loss on Inventory Write-down
200,000
Inventory
Credit
200,000
(Write-down of inventory)
Mr. McEnroe insists the write-down was not necessary because the decline in
inventory value was only temporary. Therefore, Mr. McEnroe proposes eliminating
this entry, which would increase inventory and decrease loss on inventory writedown by $200,000.
12-36
Sampras Retired and McEnroe hired
3. Change in depreciation estimate. A building was purchased for $11 million
at the beginning of 2010. Mr. Sampras recorded depreciation expense of $1
million in 2010 and 2011 using the straight-line method over 10 years and an
estimated salvage value of $1 million. Beginning in 2011, Mr. McEnroe proposes
calculating depreciation over 20 years instead of 10 and an estimated salvage
value of $500,000. The change decreases accumulated depreciation and
depreciation expense in 2011 by $500,000.
4. Loss contingency. At the end of 2011, the company’s lawyer advised Mr.
Sampras that there was a 70% chance of losing a litigation suit of $1,500,000
filed against the company. Mr. Sampras recorded the following entry.
December 31, 2011
Litigation Expense
Litigation Liability
Debit
Credit
1,500,000
1,500,000
(Litigation against the company)
Mr. McEnroe argues that the likelihood of losing the litigation is reasonably
possible, but not probable. Therefore, he proposes removing the litigation entry
from the accounting records. The change would decrease liabilities and litigation
expense by $1,500,000.
12-37
Mr. McEnroe’s Financial Statements
Federer Sports Apparel
Income Statement
For the Year Ended December 31, 2011
Sampras
Revenues
Changes
McEnroe
$ 18,800,000
$ 18,800,000
13,200,000
13,200,000
Gross profit
5,600,000
5,600,000
Operating expenses
1,600,000
(60,000)
1,540,000
Depreciation expense
1,000,000
(500,000)
500,000
200,000
(200,000)
0
Litigation expense
1,500,000
(1,500,000)
0
Income before tax
1,300,000
2,260,000
3,560,000
Cost of goods sold
Inventory write-down
Income tax expense
Net income
450,000
$ 850,000
450,000
2,260,000
$ 3,110,000
12-38
Mr. McEnroe’s Financial Statements
Federer Sports Apparel
Balance Sheet
December 31
Sampras
Changes
McEnroe
Assets
Cash
$ 2,300,000
$ 2,300,000
Accounts receivable
1,500,000
60,000
1,560,000
Inventory
2,800,000
200,000
3,000,000
Buildings
11,000,000
Less: Acc. depr.
(2,000,000)
500,000
(1,500,000)
$15,600,000
760,000
$16,360,000
Total Assets
11,000,000
Accounts payable
$1,450,000
Litigation liability
1,500,000
Common stock
8,000,000
Retained earnings
4,650,000
2,260,000
6,910,000
$15,600,000
760,000
$16,360,000
Total liabilities and
stockholders’ equity
$1,450,000
(1,500,000)
0
8,000,000
12-39
Mr. McEnroe’s Financial Statements
Federer Sports Apparel
Statement of Cash Flows
For the Year Ended December 31, 2011
Sampras
Changes
McEnroe
Operating Activities
Net income
$ 850,000
2,260,000
$3,110,000
Depreciation expense
1,000,000
(500,000)
500,000
Increase in accounts receivable
(300,000)
(60,000)
(360,000)
(1,100,000)
(200,000)
(1,300,000)
Adjustments
Increase in inventory
Decrease in accounts payable
(250,000)
Increase in litigation liability
1,500,000
(1,500,000)
0
Net cash flows from operating activities
1,700,000
0
1,700,000
Investing Activities
(250,000)
0
0
Payment of cash dividends
(200,000)
(200,000)
Net cash flows from financing activities
(200,000)
(200,000)
Net increase (decrease) in cash
1,500,000
1,500,000
800,000
800,000
$2,300,000
$2,300,000
Financing Activities
Cash at the beginning of the period
Cash at the end of the period
©2009 The McGraw-Hill Companies, Inc.
End of chapter 12