17-1 Chapter 17 McGraw-Hill/Irwin Analysis of Financial Statements © The McGraw-Hill Companies, Inc., 2005 17-2 Learning objectives 1. Basics of analysis 2. Horizontal Analysis 3. Vertical Analysis 4. Ratio Analysis 5. Decision Analysis: Analysis reporting McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-3 1. Basics of analysis - Purpose of Analysis Financial statement analysis helps users make better decisions. Internal Users Managers Officers Internal Auditors McGraw-Hill/Irwin External Users Shareholders Lenders Customers © The McGraw-Hill Companies, Inc., 2005 17-4 1. Basics of analysis - Building Blocks of Analysis Ability to meet short-term obligations and to efficiently generate revenues Ability to provide financial rewards sufficient to attract and retain financing McGraw-Hill/Irwin Liquidity and Efficiency Solvency Market Profitability Prospects Ability to generate future revenues and meet long-term obligations Ability to generate positive market expectations © The McGraw-Hill Companies, Inc., 2005 17-5 1. Basics of analysis - Information for Analysis Income Statement Notes Balance Sheet Statement of Changes in Stockholders’ Equity Statement of Cash Flows McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-6 1. Basics of analysis - Benchmark for Comparison To help me interpret our financial statements, I use several standards of comparison. Intracompany Competitor Industry Guidelines McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-7 1. Basics of analysis - Tools of Analysis Horizontal Analysis Comparing a company’s financial condition and performance across time Time McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-8 1. Basics of analysis - Tools of Analysis Comparing a company’s financial condition and performance to a base amount V e r t i c a l A n a l y s i s McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-9 1. Basics of analysis - Tools of Analysis Using key relations among financial statement items McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-10 2. Horizontal Analysis Time McGraw-Hill/Irwin Now, let’s look at some ways to use horizontal analysis. © The McGraw-Hill Companies, Inc., 2005 17-11 CLOVER CORPORATION Comparative Balance Sheets December 31, 2004 Assets Current assets: Cash and equivalents Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets McGraw-Hill/Irwin Dollar Change 2003 $ 12,000 60,000 80,000 3,000 $ 155,000 $ 40,000 120,000 $ 160,000 $ 315,000 40,000 85,000 $ 125,000 $ 289,700 Percent Change 23,500 40,000 100,000 1,200 $ 164,700 © The McGraw-Hill Companies, Inc., 2005 17-12 2. Horizontal Analysis - Comparative Statements Calculate Change in Dollar Amount Dollar Change = Analysis Period Amount – Base Period Amount Since we are measuring the amount of the change between 2003 and 2004, the dollar amounts for 2003 become the “base” period amounts. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-13 Comparative Statements Calculate Change as a Percent Percent Change McGraw-Hill/Irwin = Dollar Change Base Period Amount × 100% © The McGraw-Hill Companies, Inc., 2005 17-14 CLOVER CORPORATION Comparative Balance Sheets December 31, 2004 2003 Dollar Change Percent Change* Assets Current assets: Cash and equivalents $ 12,000 $ 23,500 $ (11,500) (48.9) Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 $12,000 – $23,500 = $(11,500) Total current assets $ 155,000 $ 164,700 Property and equipment: ($11,500 ÷ $23,500) Land 40,000 40,000× 100% = 48.9% Buildings and equipment, net 120,000 85,000 Total property and equipment $ 160,000 $ 125,000 Total assets $ 315,000 $ 289,700 * Percent rounded to first decimal point. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-15 CLOVER CORPORATION Comparative Balance Sheets December 31, 2004 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 * Percent rounded to first decimal point. McGraw-Hill/Irwin 2003 Dollar Change Percent Change* $ 23,500 $ (11,500) 40,000 20,000 100,000 (20,000) 1,200 1,800 $ 164,700 $ (9,700) (48.9) 50.0 (20.0) 150.0 (5.9) 40,000 85,000 35,000 $ 125,000 $ 35,000 $ 289,700 $ 25,300 0.0 41.2 28.0 8.7 © The McGraw-Hill Companies, Inc., 2005 17-16 Now, let’s review the dollar and percent changes for the liabilities and shareholders’ equity accounts. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-17 CLOVER CORPORATION Comparative Balance Sheets December 31, 2004 Liabilities and Shareholders' Equity Current liabilities: Accounts payable Notes payable Total current liabilities Long-term liabilities: Bonds payable, 8% Total liabilities Shareholders' equity: Preferred stock Common stock Additional paid-in capital Total paid-in capital Retained earnings Total shareholders' equity Total liabilities and shareholders' equity * Percent rounded to first decimal point. McGraw-Hill/Irwin 2003 Dollar Change $ 67,000 $ 44,000 $ 23,000 3,000 6,000 (3,000) $ 70,000 $ 50,000 $ 20,000 75,000 $ 145,000 80,000 (5,000) $ 130,000 $ 15,000 20,000 20,000 60,000 60,000 10,000 10,000 $ 90,000 $ 90,000 80,000 69,700 10,300 $ 170,000 $ 159,700 $ 10,300 $ 315,000 $ 289,700 $ 25,300 Percent Change* 52.3 (50.0) 40.0 (6.3) 11.5 0.0 0.0 0.0 0.0 14.8 6.4 8.7 © The McGraw-Hill Companies, Inc., 2005 17-18 Now, let’s look at trend analysis! McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-19 2. Horizontal Analysis - Trend Analysis Trend analysis is used to reveal patterns in data covering successive periods. Trend Analysis Period Amount = Percent Base Period Amount McGraw-Hill/Irwin ×100% © The McGraw-Hill Companies, Inc., 2005 17-20 Trend Analysis Berry Products Income Information For the Years Ended December 31, Item Revenues Cost of sales Gross profit 2004 $ 400,000 285,000 115,000 2003 $ 355,000 250,000 105,000 2002 $ 320,000 225,000 95,000 2001 $ 290,000 198,000 92,000 2000 $ 275,000 190,000 85,000 2000 is the base period so its amounts will equal 100%. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-21 Trend Analysis Berry Products Income Information For the Years Ended December 31, Item Revenues Cost of sales Gross profit 2004 $ 400,000 285,000 115,000 2003 $ 355,000 250,000 105,000 2002 $ 320,000 225,000 95,000 Item Revenues Cost of sales Gross profit 2004 2003 2002 (290,000 ¸ 275,000) ´ (198,000 ¸ 190,000) ´ McGraw-Hill/Irwin (92,000 ¸ 85,000) ´ 100% = 105% 100% = 104% 100% = 108% 2001 $ 290,000 198,000 92,000 2001 105% 104% 108% 2000 $ 275,000 190,000 85,000 2000 100% 100% 100% © The McGraw-Hill Companies, Inc., 2005 17-22 Trend Analysis Berry Products Income Information For the Years Ended December 31, Item Revenues Cost of sales Gross profit Item Revenues Cost of sales Gross profit 2004 $ 400,000 285,000 115,000 2004 145% 150% 135% 2003 $ 355,000 250,000 105,000 2003 129% 132% 124% 2002 $ 320,000 225,000 95,000 2002 116% 118% 112% 2001 $ 290,000 198,000 92,000 2001 105% 104% 108% 2000 $ 275,000 190,000 85,000 2000 100% 100% 100% How would this trend analysis look on a line graph? McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-23 Trend Analysis 160 Percentage 150 We can use the trend percentages to construct a graph so we can see the trend over time. 140 130 Revenues Cost of Sales Gross Profit 120 110 100 2000 2001 2002 2003 2004 Year McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-24 V e r t i c a l A n a l y s i s McGraw-Hill/Irwin Now, let’s look at some vertical analysis tools! © The McGraw-Hill Companies, Inc., 2005 17-25 3. Vertical Analysis - Common-Size Statements Calculate Common-size Percent Common-size Percent McGraw-Hill/Irwin = Analysis Amount Base Amount × 100% Financial Statement Base Amount Balance Sheet Total Assets Income Statement Revenues © The McGraw-Hill Companies, Inc., 2005 CLOVER CORPORATION Comparative Balance Sheets December 31, 2004 2003 17-26 Common-size Percents* 2004 2003 Assets Current assets: Cash and equivalents $ 12,000 $ 23,500 3.8% 8.1% Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200 ($12,000 ÷ $315,000) = 3.8% Total current assets $ 155,000×$100% 164,700 Property and equipment: ($23,500 40,000 ÷ $289,700) × 100% = 8.1% Land 40,000 Buildings and equipment, net 120,000 85,000 Total property and equipment $ 160,000 $ 125,000 Total assets $ 315,000 $ 289,700 100.0% 100.0% *McGraw-Hill/Irwin Percent rounded to first decimal point. © The McGraw-Hill Companies, Inc., 2005 17-27 CLOVER CORPORATION Comparative Balance Sheets December 31, 2004 Assets Current assets: Cash and equivalents $ 12,000 Accounts receivable, net 60,000 Inventory 80,000 Prepaid expenses 3,000 Total current assets $ 155,000 Property and equipment: Land 40,000 Buildings and equipment, net 120,000 Total property and equipment $ 160,000 Total assets $ 315,000 *McGraw-Hill/Irwin Percent rounded to first decimal point. 2003 Common-size Percents* 2004 2003 $ 23,500 40,000 100,000 1,200 $ 164,700 3.8% 19.0% 25.4% 1.0% 49.2% 8.1% 13.8% 34.5% 0.4% 56.9% 40,000 85,000 $ 125,000 $ 289,700 12.7% 38.1% 50.8% 100.0% 13.8% 29.3% 43.1% 100.0% © The McGraw-Hill Companies, Inc., 2005 17-28 CLOVER CORPORATION Comparative Balance Sheets December 31, Liabilities and Shareholders' Equity Current liabilities: Accounts payable Notes payable Total current liabilities Long-term liabilities: Bonds payable, 8% Total liabilities Shareholders' equity: Preferred stock Common stock Additional paid-in capital Total paid-in capital Retained earnings Total shareholders' equity Total liabilities and shareholders' equity * Percent rounded McGraw-Hill/Irwin to first decimal point. Common-size Percents* 2004 2003 2004 2003 $ 67,000 3,000 $ 70,000 $ 44,000 6,000 $ 50,000 21.3% 1.0% 22.2% 15.2% 2.1% 17.3% 75,000 $ 145,000 80,000 $ 130,000 23.8% 46.0% 27.6% 44.9% 20,000 60,000 10,000 $ 90,000 80,000 $ 170,000 $ 315,000 20,000 60,000 10,000 $ 90,000 69,700 $ 159,700 $ 289,700 6.3% 19.0% 3.2% 28.6% 25.4% 54.0% 100.0% 6.9% 20.7% 3.5% 31.1% 24.1% 55.1% 100.0% © The McGraw-Hill Companies, Inc., 2005 17-29 CLOVER CORPORATION Comparative Income Statements For the Years Ended December 31, Common-size Percents* 2004 2003 2004 2003 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% Income before taxes $ 25,000 $ 32,000 4.8% 6.7% Income taxes (30%) 7,500 9,600 1.4% 2.0% Net income $ 17,500 $ 22,400 3.4% 4.7% Net income per share $ 0.79 $ 1.01 Avg. # common shares 22,200 22,200 * Rounded to first decimal point. © The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 17-30 Common-Size Graphics This is a graphical analysis of Clover Corporation’s common-size income statement for 2004. Interest expense 1.2% Selling and administrative 24.7% McGraw-Hill/Irwin Income taxes 1.4% Net income 3.4% Cost of sales 69.2% © The McGraw-Hill Companies, Inc., 2005 17-31 Liquidity and Efficiency Solvency Profitability Market Let’s use the following financial statements for Norton Corporation for our ratio analysis. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-32 NORTON CORPORATION Balance Sheet December 31, Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Buildings and equipment, net Total property and equipment Total assets McGraw-Hill/Irwin 2004 2003 $ 30,000 20,000 12,000 3,000 $ 65,000 $ 20,000 17,000 10,000 2,000 $ 49,000 165,000 116,390 $ 281,390 $ 346,390 123,000 128,000 $ 251,000 $ 300,000 © The McGraw-Hill Companies, Inc., 2005 17-33 NORTON CORPORATION Balance Sheet December 31, 2004 Liabilities and Shareholders' Equity Current liabilities: Accounts payable Notes payable, short-term Total current liabilities Long-term liabilities: Notes payable, long-term Total liabilities Shareholders' equity: Common stock, $1 par value Additional paid-in capital Total paid-in capital Retained earnings Total shareholders' equity $ $ 39,000 3,000 42,000 2003 $ $ 40,000 2,000 42,000 70,000 $ 112,000 78,000 $ 120,000 27,400 158,100 $ 185,500 48,890 $ 234,390 17,000 113,000 $ 130,000 50,000 $ 180,000 Total liabilities and shareholders' equity $ 346,390 $ 300,000 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 NORTON CORPORATION Income Statement For the Years Ended December 31, Revenues Cost of sales Gross margin Operating expenses Net operating income Interest expense Net income before taxes Less income taxes (30%) Net income McGraw-Hill/Irwin $ $ $ $ $ 2004 494,000 140,000 354,000 270,000 84,000 7,300 76,700 23,010 53,690 $ $ $ $ $ 17-34 2003 450,000 127,000 323,000 249,000 74,000 8,000 66,000 19,800 46,200 © The McGraw-Hill Companies, Inc., 2005 17-35 3. Ratio Analysis - Liquidity and Efficiency Current Ratio Inventory Turnover Days’ Sales Uncollected Acid-test Ratio Accounts Receivable Turnover Days’ Sales in Inventory Total Asset Turnover McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 NORTON CORPORATION 17-36 2004 Cash $ 30,000 Accounts receivable, net Use this information to calculate the liquidity and efficiency ratios for Norton Corporation. 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 Total assets Beginning of year 300,000 End of year 346,390 Revenues McGraw-Hill/Irwin Cost of sales 494,000 140,000 © The McGraw-Hill Companies, Inc., 2005 17-37 Working Capital Working capital represents current assets financed from long-term capital sources that do not require near-term repayment. Dec. 31, 2004 Current assets $ Current liabilities Working capital McGraw-Hill/Irwin 65,000 (42,000) $ 23,000 © The McGraw-Hill Companies, Inc., 2005 17-38 Current Ratio Current Current Assets = Ratio Current Liabilities Current = Ratio $65,000 = 1.55 : 1 $42,000 This ratio measures the short-term debt-paying ability of the company. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-39 Acid-Test Ratio Quick Assets Acid-Test = Current Liabilities Ratio Quick assets are Cash, Short-Term Investments, and Current Receivables. Acid-Test = $50,000 = 1.19 : 1 $42,000 Ratio This ratio is like the current ratio but excludes current assets such as inventories and prepaid expenses that may be difficult to quickly convert into cash. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-40 Accounts Receivable Turnover Accounts Sales on Account Receivable = Average Accounts Receivable Turnover Accounts $494,000 Receivable =($17,000 + $20,000) ÷ 2 = 26.7 times Turnover This ratio measures how many times a company converts its receivables into cash each year. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-41 Inventory Turnover 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 is sold and replaced during the year. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-42 Days’ Sales Uncollected Days’ Sales Accounts Receivable = ´ 365 Uncollected Net Sales Days’ Sales $20,000 = ´ 365 = 14.8 days Uncollected $494,000 This ratio measures the liquidity of receivables. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-43 Days’ Sales in Inventory Days’ Sales = in Inventory Ending Inventory Cost of Goods Sold ´ 365 Days’ Sales $12,000 = ´ 365 = 31.29 days in Inventory $140,000 This ratio measures the liquidity of inventory. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-44 Total Asset Turnover Total Asset Net Sales = Turnover Average Total Assets Total Asset $494,000 = = 1.53 times Turnover ($300,000 + $346,390) ÷ 2 This ratio measures the efficiency of assets in producing sales. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-45 3. Ratio Analysis - Solvency Debt Ratio Equity Ratio Pledged Assets to Secured Liabilities Times Interest Earned McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-46 Use this information to calculate the solvency ratios for Norton Corporation. NORTON CORPORATION 2004 Net income before interest expense and income taxes Interest expense $ 84,000 7,300 Total shareholders' equity 234,390 Total liabilities 112,000 Total assets 346,390 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-47 Debt Ratio Total Liabilities Debt = Ratio Total Assets Debt = Ratio $112,000 = 32.3% $346,390 This ratio measures what portion of a company’s assets are contributed by creditors. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-48 Equity Ratio Total Equity Equity = Ratio Total Assets Equity = Ratio $234,390 = 67.7% $346,390 This ratio measures what portion of a company’s assets are contributed by owners. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-49 Pledged Assets to Secured Liabilities Pledged Assets to = Book Value of Pledged Assets Secured Book Value of Secured Liabilities Liabilities This ratio measures the protection to secured creditors. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-50 Times Interest Earned Times Interest = Earned Net Income before Interest Expense and Income Taxes Interest Expense Times $84,000 Interest = = 11.51 $7,300 Earned This is the most common measure of the ability of a firm’s operations to provide protection to the long-term creditor. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-51 3. Ratio Analysis - Profitability Profit Margin Basic Earnings per Share Gross Margin Return on Total Assets McGraw-Hill/Irwin Book Value per Common Share Return on Common Stockholders’ Equity © The McGraw-Hill Companies, Inc., 2005 17-52 NORTON CORPORATION 2004 Number of common shares outstanding all year Use this information to Net income calculate the profitability Shareholders' equity Beginning of year ratios for Norton End of year Corporation. 27,400 $ 53,690 180,000 234,390 Revenues 494,000 Cost of sales 140,000 Total assets McGraw-Hill/Irwin Beginning of year 300,000 End of year 346,390 © The McGraw-Hill Companies, Inc., 2005 17-53 Profit Margin Profit = Margin Net Income Net Sales $53,690 Profit = 10.87% = Margin $494,000 This ratio describes a company’s ability to earn a net income from sales. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-54 Gross Margin Gross Net Sales - Cost of Sales = Margin Net Sales Gross $494,000 - $140,000 = 71.66% = Margin $494,000 This ratio measures the amount remaining from $1 in sales that is left to cover operating expenses and a profit after considering cost of sales. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-55 Return on Total Assets Return on = Net Income Total Assets Average Total Assets Return on $53,690 = = 16.61% Total Assets ($300,000 + $346,390) ÷ 2 This ratio is generally considered the best overall measure of a company’s profitability. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-56 Return on Common Stockholders’ Equity Return on Common Net Income - Preferred Dividends = Stockholders’ Average Common Stockholders’ Equity Equity Return on $53,690 - 0 Common = = 25.9% Stockholders’ ($180,000 + $234,390) ÷ 2 Equity This measure indicates how well the company employed the owners’ investments to earn income. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-57 Book Value per Common Share Book Value Shareholders’ Equity Applicable to per Common Shares = Common Number of Common Shares Share Outstanding This ratio measures liquidation at reported amounts. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-58 Basic Earnings per Share Basic Earnings Net Income - Preferred Dividends = per Weighted-Average Common Share Shares Outstanding Basic Earnings $53,690 - 0 = = $1.96 per share per 27,400 Share This measure indicates how much income was earned for each share of common stock outstanding. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-59 3. Ratio Analysis - Market Prospects PriceEarnings Ratio Dividend Yield McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-60 Market Prospects Use this information to calculate the market ratios for Norton Corporation. McGraw-Hill/Irwin NORTON CORPORATION December 31, 2004 Earnings per Share $ Market Price 1.96 15.00 Annual Dividend per Share 2.00 © The McGraw-Hill Companies, Inc., 2005 17-61 Price-Earnings Ratio Price-Earnings Market Price Per Share = Ratio Earnings Per Share Price-Earnings $15.00 = = 7.65 times Ratio $1.96 This measure is often used by investors as a general guideline in gauging stock values. Generally, the higher the price-earnings ratio, the more opportunity a company has for growth. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-62 Dividend Yield Dividend Annual Dividends Per Share = Yield Market Price Per Share Dividend $2.00 = = 13.3% Yield $15.00 This ratio identifies the return, in terms of cash dividends, on the current market price of the stock. McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-63 5. Decision Analysis - Analysis reporting 1. Executive summary 2. Company background 3. Evidence matters 4. Key issues 5. Recommendation McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005 17-64 End of Chapter 17 McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2005