StIce | StIce |Skousen
Analysis of Financial
Statements
Chapter 22
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Learning Objectives
1.
2.
3.
4.
5.
Organize a systematic financial ratio analysis
using common-size financial statements and the
DuPont framework.
Recognize the potential impact that differing
accounting methods can have on the financial
ratios of otherwise essentially identical
companies.
Understand how foreign companies report their
financial results to U.S. investors.
Describe the purpose and format of the SEC’s
Form 20-F.
Convert foreign currency financial statements
into U.S. dollars using the translation method.
Framework for Financial
Statement Analysis
• Financial statement analysis- the
examination of the relationships
among:
– Financial statement numbers
– The trends of the statement numbers
over time.
• To analyze financial statements,
analyst use:
– Common sized financial statements
– Ratio analysis
Framework for Financial
Statement Analysis
The APB stated that comparisons between
financial statements are most informative—
1. When the presentations are in good
form.
2. When the content of the statements is
identical.
3. When accounting principles are not
changed, or, if they are changed, the
financial effects of the changes are
disclosed.
4. When changes in circumstances or in
the nature of the underlying transactions
are disclosed.
Framework for Financial
Statement Analysis
• Common-Size Financial Statements- analysis
of a company’s single-year financial
statements. Financial statements are
standardized by a measure of size, either
sales or total assets. All amounts are
stated in terms of a percentage of the size
measure.
• Ratio Analysis- Analysis of a company’s
financial statements by computing ratios
and comparing them against both trends
and industry averages.
Common-Size Income Statement
100% = Net Sales
For commonsize income
statements, the
denominator,
the entire pie, is
equal to net
sales.
Common-Size Financial
Statements
Comparative Income Statements (in millions)
2008
%
2007
Net sales
$5,700 100.0 $6,600
Cost of goods sold
4,000
70.2
4,800
Gross profit on sales
$1,700
29.8 $1,800
Selling expense
$1,120
19.6 $1,200
General expense
400
7.0
440
Total operating expenses $1,520
26.6 $1,640
Operating income (loss) $ 180
3.2 $ 160
Other revenue (expense)
80
1.4
130
Income before taxes
$ 260
4.6 $ 290
Income tax
80
1.4
85
Net income
$ 180
3.2 $ 205
%
100.0
72.7
27.3
18.2
6.7
24.9
2.4
2.0
4.4
1.3
3.1
Common-Size Income
Statement
For commonsize balance
sheets, again
the
denominator,
the entire pie, is
equal to the net
sales for the
year.
100% = Net Sales
Common-Sized Balance Sheet
Comparative Balance Sheets (in millions)
Assets
Current assets
Land, building, and
equipment (net)
Intangible assets
Other assets
Total assets
2008
%
2007 %
$ 855 15.0 $ 955.5 14.5
1,275
100
48
$2,278
22.4 1,075.0 24.4
1.8
100.0
1.5
0.8
60.5 0.9
40.0 $2,191.0 33.2
Common-Sized Balance Sheet
Comparative Balance Sheets (in millions)
Liab. & Shs’ Equity
2008
Current liabilities
$ 410
Noncurrent liabilities
400
Total liabilities
$ 810
Paid-in capital
$1,100
Retained earnings
368
Total stockholders’
equity
$1,468
Total liabilities and
stockholders eq. $2,278
%
7.2
7.0
14.2
19.3
6.5
2007
%
$ 501 7.6
600 9.1
$1,101 16.7
$ 800 12.1
290 4.4
25.8
$1,090 16.5
40.0
$2,191 33.2
Common Size Balance Sheet
A commonsize balance
sheet can also
be prepared
using total
assets to
standardize
each amount.
100% = Total Assets
Ratio Analysis
• DuPont Framework- Identifying factors that
impact return on equity.
• Efficiency Ratios- How efficiently is the firm
utilizing its assets?
• Leverage Ratios- To what degree is the
company using other people’s money to
purchase assets?
• Other Financial Ratios- Other indications of
liquidity, cash management, and
profitability.
DuPont Framework
• Developed internally at DuPont
around 1920.
• Provides a systematic approach to
identifying general factors causing
ROE to deviate from normal.
• Establishes a framework for
computing financial ratios to yield
more in-depth analysis of a company’s
areas of strength and weakness.
DuPont Framework
• DuPont: ROE can be decomposed into
three components:
Profitability x Efficiency
x
Leverage
Return on x
Asset
Sales
Turnover
x
Assets-toEquity Ratio
Net Income x
Sales
x
Assets
Equity
Sales
Assets
DuPont Framework
Net Income x
Sales
Sales
Assets
x
Assets
Equity
The number of
The number of The number of
pennies in dollars in sales dollars of assets a
company is able
profits generated generated by
to acquire using
from each dollar each dollar of
each dollar
of sales.
assets.
invested by
stockholders.
Colesville Corporation ROE
Net Income x
Sales
Sales
Assets
x
Assets
Equity
2008
$180,000
x $5,700,000
3.16%
2.50
$5,700,000
$2,278,000
Return on Equity = 12.3%
x
$2,278,000
1.55
$1,468,000
$205,000
x $6,600,000
3.11%
3.01
$6,600,000
$2,191,000
Return on Equity = 18.8%
x
$2,191,000
2.01
$1,090,000
2007
Efficiency Ratios
Accounts receivable turnover:
Sales
Average accounts receivable
Colesville Corporation
2007 =
$6,600,000
($333,500
+ $375,000)/2
$354,250
= 18.6 times
Efficiency Ratios
Accounts receivable turnover:
Sales
Average accounts receivable
Colesville Corporation
2008 =
$5,700,000
($375,000
+ 420,000)/2
$354,250
The ratios show
that times
Colesville collected its
= 14.3
receivables more rapidly in 2007 than in
2008.
Efficiency Ratios
Accounts receivable turnover:
Average accounts receivable
Average daily sales
Colesville Corporation
2007 =
$354,250
($6,600,000)/365
$18,082
= 19.6 days
Efficiency Ratios
Accounts receivable turnover:
Average accounts receivable
Average daily sales
Colesville Corporation
2008 =
$397,500
($5,700,000)/365
$18,082
Some analyst like to express the accounts
receivable turnover
in days
terms of days. Average
= 25.5
collection period serves this purpose.
Efficiency Ratios
Inventory turnover:
Cost of goods sold
Average inventory
For
Colesville
Colesville
Corporation
Corporation
$4,800,000
2007 =
($125,000$227,500
+ $330,000)/2
= 21.1 times
Efficiency Ratios
Inventory turnover:
Cost of goods sold
Average inventory
ForColesville
ColesvilleCorporation
Corporation
$4,000,000
2008 =
($330,000
+ $225,000)/2
$277,500
Inventory turnover allows for evaluation of the
firm’s
position and the
= inventory
14.4 times
appropriateness of the inventory size.
Efficiency Ratios
Inventory turnover:
365
Inventory inventory
For
Colesville
Colesville
Corporation
Corporation
2007 =
365
21.1 times
= 17.3 times
Efficiency Ratios
Inventory turnover:
365
Inventory inventory
For
Colesville
Colesville
Corporation
Corporation
2008 =
365
14.4 times
In 2007, a typical item of inventory remained
unsold for=17.3
days.
This number increased
25.3
times
to 25.3 days in 2008.
Stop and Think
You have probably
heard of just-intime inventory
systems. What
would a just-intime system do to
a company’s
number of days’
sales in inventory?
Efficiency Ratios
Fixed Asset turnover:
Sales
Average fixed assets
For
Colesville
Colesville
Corporation
Corporation
$6,600,000
2007 =
($925,000$1,000,000
+ $1,075,000)/2
= 6.60 times
Efficiency Ratios
Fixed Asset turnover:
Sales
Average fixed assets
For
Colesville
Colesville
Corporation
Corporation
$5,700,000
2008 =
($1,075,000
+ $1,275,000)/2
$1,175,000
Colesville is much less efficient in using its
fixed assets
generate
= to
4.85
timessales in 2008 than it
was in 2007.
Margin vs. Turnover
The profitability of
each dollar in sales
is sometimes called
a company’s
The degree to
margin.
which assets are
used to generate
sales is called
turnover.
Leverage Ratios
•
Higher leverage increases ROE through
the following chain of events:
1. More borrowing means that more assets
can be purchased without any additional
equity investment by owners.
2. More assets means that more sales can be
generated.
3. More sales means that net income should
increase
Leverage Ratios
Debt ratio:
Total liabilities
Total assets
For
Colesville
Colesville
Corporation
Corporation
2007 =
$1,101,000
$2,191,000
= 50.3%
Leverage Ratios
Debt ratio:
Total liabilities
Total assets
For
Colesville
Colesville
Corporation
Corporation
2008 =
$810,000
$2,278,000
The debt ratio is the percentage of total funds,
both borrowed
and invested, that a company
= 35.6%
acquires through borrowing.
Leverage Ratios
Debt-to-equity ratio:
Total liabilities
Stockholders’ equity
For
Colesville
Colesville
Corporation
Corporation
2007 =
$1,101,000
$1,090,000
= 1.01
Leverage Ratios
Debt-to-equity ratio:
Total liabilities
Stockholders’ equity
For
Colesville
Colesville
Corporation
Corporation
2008 =
$810,000
$1,468,000
The debt ratio and the debt-to-equity ratio
measure the same
thing—the level of borrowing
= 0.55
relative to funds used to finance the company.
Stop and Think
Company Z has
an assets-toequity ratio of
2.5. What are
its debt and
debt-to-equity
ratios?
Leverage Ratios
Times interest earned:
Earnings before income taxes
Interest expense
For
Colesville
Colesville
Corporation
Corporation
2007 =
$290,000 + $60,000
$60,000
= 5.8 times
Leverage Ratios
Times interest earned:
Earnings before income taxes
Interest expense
For
Colesville
Colesville
Corporation
Corporation
2008 =
$260,000 + $40,000
$40,000
Times interest earned reflects the company’s
ability to meet =
interest
payments and the degree
7.5 times
of safety afforded the creditors.
Other Common Ratios
Current Ratio:
Current assets
Current liabilities
For
Colesville
Colesville
Corporation
Corporation
2007 =
$955,500
$501,000
= 1.91
Other Common Ratios
Current Ratio:
Current assets
Current liabilities
For
Colesville
Colesville
Corporation
Corporation
2007 =
$855,500
$410,000
Historically, the rule of thumb was to have a
current ratio
of at least 2.0. In 2008,
= 2.09
Colesville Corporation is in good shape.
Current Ratios: 2004
Advances in information technology have allowed
successful firms to reduce this ratio to below 1.0.
Company
Coca-Cola
Delta Airlines
Home Depot
McDonald’s
Wal-Mart
Current Ratio
1.10
0.61
1.35
0.81
0.90
Other Common Ratios
Cash flow adequacy ratio:
Cash from operating activities
Total primary cash requirements
The sum of dividend payments, long-term
Colesville
Corporation
Colesville
Corporation
asset For
purchases,
and
long-term debt
repayments.
2007 =
$424,500
$375,000
= 1.13
Other Common Ratios
Earnings per share:
Net income
Weighted-number of share outstanding
Price-earnings ratio:
Market price per share
Earnings per share
Dividend payout ratio:
Cash dividends
Net income
Book-to-market ratio:
Stockholders’ equity
Market value of shares outstanding
Summary of Selected Financial
Ratios
• Insert Exhibit 22-7
Impact of Alternative
Accounting Methods
• If companies are using differing
accounting practices, it will impact
the ratios.
• Careful financial statement users
should make adjustments for
accounting differences among the
companies being analyzed.
Foreign Reporting to U.S.
Investors
Firms such as
The good news is
DaimlerChrysler and that the demands of
These divergent
Disney
must
producedifferences
The
significant
nationalinternational
accounting users
financial
statementsstandards
in accounting
forcing
practices canare
have
an
for users around
not onlythe
incompanies
world
to provide
extremely
significant
their own
countriesboth
complicate
the
disclosure
so that
impact on
reported
but also
in other of users
preparation
can recognize
financialfinancial
statements.
countries.
statements and
the
and
reconcile the
understandingdiffering
of these accounting
statements for users.
standards.
Meeting the Needs of
International Users
Some multinational
firms respond to users
in other countries
simply by taking their
financial statements or
annual reports and
translating them into
the language of the
user.
Meeting the Needs of
International Users
Another response to the
international users is to
denominate the
financial statements in
the currency of the
country where the
financial statements
will be used.
Meeting the Needs of
International Users
Some multinationals
partially or completely
restate the financial
statements to the
accounting principles of
the financial statement
users’ country.
Meeting the Needs of
International Users
Mutual recognition
involves one country
accepting the financial
statements of another
country in return for that
country accepting its
financial statements for
all regulatory purposes.
The SEC’s Form 20-F
•
The SEC requires foreign companies
that list shares on U.S. to provide:
1. Complete U.S. GAAP financial
statements.
2. Reconcile their reported net income to
what income would be according to U.S.
GAAP.
Form 20-F
provides the
reconciliation.
Foreign Currency Financial
Statements
• Translation- Used when the foreign
subsidiary is a relatively self-contained unit
that is independent from the parent
company’s operations.
• Remeasurement- Is appropriate when the
subsidiary does not operate independently
of the parent company.
• Functional currency- Currency of the
primary economic environment of an entity.
Foreign Currency Financial
Statements
Translation
• Assets and liabilities are translated
using the current exchange rate
prevailing as of the balance sheet
date.
• Income statement items are translated
at the average exchange rate for the
year.
• Dividends are translated using the
exchange rate prevailing on the date
the dividends were declared.
Foreign Currency Financial
Statements
Translation
• Capital stock is translated at the historical
rate, the rate prevailing on the date the
subsidiary was acquired or the stock was
issued.
• Retained earnings is translated in the first year
using historical rates.
• In subsequent years, take the balance in
Retained Earnings from the prior period’s
translated financial statements and add
translated net income and subtracting
translated dividends.