Chapter
14
“How Well Am I Doing?”
Financial Statement
Analysis
Limitations of Financial Statement
Analysis
Differences in accounting methods
between companies sometimes make
comparisons difficult.
We use LIFO to value
inventory.
Irwin/McGraw-Hill
We use FIFO to value
inventory.
2
© The McGraw-Hill Companies, Inc., 2002
Limitations of Financial Statement
Analysis
Industry
trends
Changes within
the firm
Technological
changes
Consumer
tastes
Economic
factors
Analysts should look beyond the ratios.
Irwin/McGraw-Hill
3
© The McGraw-Hill Companies, Inc., 2002
Statements in Comparative and
Common-Size Form
Analytical
techniques used to
examine
relationships
among financial
statement items
Irwin/McGraw-Hill
 Dollar and percentage
changes on statements
 Common-size statements
 Ratios
4
© The McGraw-Hill Companies, Inc., 2002
Horizontal Analysis
Horizontal analysis shows the changes
between years in the financial data in
both dollar and percentage form.
Irwin/McGraw-Hill
5
© The McGraw-Hill Companies, Inc., 2002
Horizontal Analysis
Calculating Change in Dollar Amounts
Dollar
Change
=
Current Year
Figure
Base Year
Figure
–
2001 is the
base year.
Calculating Change as a Percentage
Percentage
Change
Irwin/McGraw-Hill
=
Dollar Change
Base Year Figure
6
×
100%
© The McGraw-Hill Companies, Inc., 2002
Horizontal Analysis
Information on the following slides illustrate
a horizontal analysis of Clover, Co’s
December 31, 2002 and 2001, comparative
balance sheets and income statements.
Irwin/McGraw-Hill
7
© The McGraw-Hill Companies, Inc., 2002
Horizontal Analysis
CLOVER CO.
Comparative Balance Sheets
December 31, 2002 and 2001
2002
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
Irwin/McGraw-Hill
$
12,000
60,000
80,000
3,000
155,000
40,000
120,000
160,000
$ 315,000
8
Increase (Decrease)
Amount
%
2001
$
23,500
40,000
100,000
1,200
164,700
40,000
85,000
125,000
$ 289,700
© The McGraw-Hill Companies, Inc., 2002
Horizontal Analysis
CLOVER CO.
Comparative Balance Sheets
December 31, 2002 and 2001
2002
2001
Increase (Decrease)
Amount
%
Assets
Current assets:
Cash
$ 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
Total current assets
$12,000 –155,000
$23,500164,700
= $(11,500)
Property and equipment:
Land
40,000
40,000
Buildings and equipment,
net
120,000
85,000
($11,500
÷ $23,500)
× 100% = 48.9%
Total property and equipment
160,000
125,000
Total assets
$ 315,000 $ 289,700
Irwin/McGraw-Hill
9
© The McGraw-Hill Companies, Inc., 2002
Horizontal Analysis
CLOVER CO.
Comparative Balance Sheets
December 31, 2002 and 2001
2002
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
Irwin/McGraw-Hill
$
12,000
60,000
80,000
3,000
155,000
40,000
120,000
160,000
$ 315,000
10
$
2001
Increase (Decrease)
Amount
%
23,500
40,000
100,000
1,200
164,700
$ (11,500)
20,000
(20,000)
1,800
(9,700)
(48.9)
50.0
(20.0)
150.0
(5.9)
35,000
35,000
$ 25,300
0.0
41.2
28.0
8.7
40,000
85,000
125,000
$ 289,700
© The McGraw-Hill Companies, Inc., 2002
Horizontal Analysis
Let’s move from the
Balance Sheet to the
Income Statement of
Clover Co.
Irwin/McGraw-Hill
11
© The McGraw-Hill Companies, Inc., 2002
Horizontal Analysis
CLOVER CO.
Comparative Income Statements
For the Years Ended December 31, 2002 and 2001
Increase
(Decrease)
2002
2001
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
Net operating income
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Net income before taxes
25,000
32,000
(7,000)
(21.9)
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $ (4,900)
(21.9)
Irwin/McGraw-Hill
12
© The McGraw-Hill Companies, Inc., 2002
Horizontal Analysis
CLOVER CO.
Comparative Income Statements
For the Years Ended December 31, 2002 and 2001
Increase
(Decrease)
2002
2001
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
OperatingSales
expenses
128,600
2,600
2.1
increased
by 8.3%126,000
yet
Net operating income
31,400
39,000
(7,600)
(19.5)
net income decreased
by 21.9%.
Interest expense
6,400
7,000
(600)
(8.6)
Net income before taxes
25,000
32,000
(7,000)
(21.9)
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $ (4,900)
(21.9)
Irwin/McGraw-Hill
13
© The McGraw-Hill Companies, Inc., 2002
Horizontal Analysis
There were increasesCLOVER
in both CO.
cost of goods sold
Comparative
Income Statements
(14.3%) and operating
expenses
(2.1%). These
the Years Ended December 31, 2002 and 2001
increasedFor
costs
more than offset the increase in sales,
Increase
yielding an overall decrease in net income.
(Decrease)
2002
Net sales
$ 520,000
Cost of goods sold
360,000
Gross margin
160,000
Operating expenses
128,600
Net operating income
31,400
Interest expense
6,400
Net income before taxes
25,000
Less income taxes (30%)
7,500
Net income
$ 17,500
Irwin/McGraw-Hill
14
2001
$ 480,000
315,000
165,000
126,000
39,000
7,000
32,000
9,600
$ 22,400
Amount
$ 40,000
45,000
(5,000)
2,600
(7,600)
(600)
(7,000)
(2,100)
$ (4,900)
%
8.3
14.3
(3.0)
2.1
(19.5)
(8.6)
(21.9)
(21.9)
(21.9)
© The McGraw-Hill Companies, Inc., 2002
Trend Analysis
Trend percentages state several years’
financial data in terms of a base year,
which equals 100 percent.
Trend
=
Percentage
Irwin/McGraw-Hill
Current Year Amount
Base Year Amount
15
× 100%
© The McGraw-Hill Companies, Inc., 2002
Trend Analysis
Look at the income information for Berry,
Inc. for the years 2002 through 2006. We
will do a trend analysis on these amounts
to see what we can learn about the
company.
Irwin/McGraw-Hill
16
© The McGraw-Hill Companies, Inc., 2002
Trend Analysis
Berry, Inc.
Income Information
For the Years Ended December 31
Item
Sales
Cost of goods sold
Gross margin
2006
$ 400,000
285,000
115,000
2005
$ 355,000
250,000
105,000
Year
2004
$ 320,000
225,000
95,000
2003
$ 290,000
198,000
92,000
2002
$ 275,000
190,000
85,000
The base year is 2002, and its amounts
will equal 100%.
Irwin/McGraw-Hill
17
© The McGraw-Hill Companies, Inc., 2002
Trend Analysis
Berry, Inc.
Income Information
For the Years Ended December 31
Item
2006
2005
Year
2004
Sales
Cost of goods sold
Gross margin
2003
105%
104%
108%
2002
100%
100%
100%
2003 Amount ÷ 2002 Amount × 100%
( $290,000 ÷ $275,000 ) × 100% = 105%
( $198,000 ÷ $190,000 ) × 100% = 104%
( $ 92,000 ÷ $ 85,000 ) × 100% = 108%
Irwin/McGraw-Hill
18
© The McGraw-Hill Companies, Inc., 2002
Trend Analysis
Berry, Inc.
Income Information
For the Years Ended December 31
Item
Sales
Cost of goods sold
Gross margin
2006
145%
150%
135%
2005
129%
132%
124%
Year
2004
116%
118%
112%
2003
105%
104%
108%
2002
100%
100%
100%
Trends at Berry, Inc., indicated that cost of goods sold
is increasing faster than sales, which is slowing the
increase in gross margin.
Irwin/McGraw-Hill
19
© The McGraw-Hill Companies, Inc., 2002
Trend Analysis
We can use the trend percentages to construct a
graph so we can see the trend over time.
160
Percentage
150
140
130
Sales
COGS
GM
120
110
100
2002
2003
2004
2005
2006
Year
Irwin/McGraw-Hill
20
© The McGraw-Hill Companies, Inc., 2002
Common-Size Statements
Common-size statements use percentages to
express the relationship of individual components
to a total within a single period. This is also known
as vertical analysis.
Let’s take another look at the information
from the comparative income statements of
Clover Co. for 2002 and 2001.
Irwin/McGraw-Hill
21
© The McGraw-Hill Companies, Inc., 2002
Common-Size Statements
CLOVER CO.
Comparative Income Statements
For the Years Ended December 31, 2002 and 2001
Common-Size
Percentages
2002
2001
2002
2001
Net sales
$ 520,000 $ 480,000
100.0
100.0
Cost of goods sold
360,000
315,000
Net
sales is usually the base
and is
expressed as 100%.
Gross margin
160,000
165,000
Operating expenses
128,600
126,000
Net operating income
31,400
39,000
Interest expense
6,400
7,000
Net income before taxes
25,000
32,000
Less income taxes (30%)
7,500
9,600
Net income
$ 17,500 $ 22,400
Irwin/McGraw-Hill
22
© The McGraw-Hill Companies, Inc., 2002
Common-Size Statements
CLOVER CO.
Comparative Income Statements
For the Years Ended December 31, 2002 and 2001
Common-Size
Percentages
2002
2001
2002
2001
Net sales
$ 520,000 $ 480,000
100.0
100.0
Cost of goods sold
360,000
315,000
69.2
65.6
Gross margin
160,000
165,000
Operating expenses
128,600
126,000
2002 COGS
÷ 2002 Net
Sales39,000
× 100%
Net operating
income
31,400
Interest
expense ÷ $520,000
6,400
7,000
( $360,000
) × 100%
= 69.2%
Net income before taxes
25,000
32,000
Less income 2001
taxes (30%)
COGS ÷7,500
2001 Net9,600
Sales × 100%
Net income ( $315,000 $÷17,500
$ 22,400
$480,000
) × 100% = 65.6%
Irwin/McGraw-Hill
23
© The McGraw-Hill Companies, Inc., 2002
Gross Margin Percentage
Gross Margin = Gross Margin
Percentage
Sales
Gross profit percentage indicates how
much of each sales dollar is left after deducting
the cost of goods sold to cover operating
expenses and a profit.
Irwin/McGraw-Hill
24
© The McGraw-Hill Companies, Inc., 2002
Common-Size Statements
CLOVER CO.
Comparative Income Statements
For the Years Ended December 31, 2002 and 2001
Common-Size
Percentages
2002
2001
2002
2001
Net sales
$ 520,000 $ 480,000
100.0
100.0
Cost of goods sold
360,000
315,000
69.2
65.6
Gross margin
160,000
165,000
30.8
34.4
Operating expenses
128,600
126,000
24.8
26.2
Net operating income
31,400
39,000
6.0
8.2
Interest expense
6,400
7,000
1.2
1.5
Net income before taxes
25,000
32,000
4.8
6.7
Less income taxes (30%)
7,500
9,600
1.4
2.0
Net income
$ 17,500 $ 22,400
3.4
4.7
What conclusions can we draw?
Irwin/McGraw-Hill
25
© The McGraw-Hill Companies, Inc., 2002
Let’s use the financial statements
of Norton Corporation to complete
a ratio analysis.
Irwin/McGraw-Hill
26
© The McGraw-Hill Companies, Inc., 2002
NORTON CORPORATION
Balance Sheets
December 31, 2002 and 2001
2002
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
Irwin/McGraw-Hill
27
$
30,000
20,000
12,000
3,000
65,000
165,000
116,390
281,390
$ 346,390
2001
$
20,000
17,000
10,000
2,000
49,000
123,000
128,000
251,000
$ 300,000
© The McGraw-Hill Companies, Inc., 2002
NORTON CORPORATION
Balance Sheets
December 31, 2002 and 2001
2002
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
Notes payable, short-term
Total current liabilities
Long-term liabilities:
Notes payable, long-term
Total liabilities
Stockholders' equity:
Common stock, $1 par value
Additional paid-in capital
Total paid-in capital
Retained earnings
Total stockholders' equity
$
39,000
3,000
42,000
2001
$
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 stockholders' equity $ 346,390
$ 300,000
Irwin/McGraw-Hill
28
© The McGraw-Hill Companies, Inc., 2002
NORTON CORPORATION
Income Statements
For the Years Ended December 31, 2002 and 2001
Net sales
Cost of goods sold
Gross margin
Operating expenses
Net operating income
Interest expense
Net income before taxes
Less income taxes (30%)
Net income
Irwin/McGraw-Hill
29
2002
$ 494,000
140,000
354,000
270,000
84,000
7,300
76,700
23,010
$ 53,690
2001
$ 450,000
127,000
323,000
249,000
74,000
8,000
66,000
19,800
$ 46,200
© The McGraw-Hill Companies, Inc., 2002
Ratio Analysis – The Common
Stockholder
NORTON CORPORATION
2002
Number of common shares
outstanding
Beginning of year
End of year
Use this information to
calculate ratios to
measure the wellbeing of the common
stockholders of
Norton Corporation.
Net income
17,000
27,400
$
53,690
Stockholders' equity
Beginning of year
180,000
End of year
234,390
Dividends per share
Dec. 31 market price per share
Interest expense
2
20
7,300
Total assets
Beginning of year
Irwin/McGraw-Hill
30
300,000
© The McGraw-Hill Companies, Inc., 2002
Earnings Per Share
Earnings
=
per Share
Net Income – Preferred Dividends
Average Number of Common Shares
Outstanding
Earnings
=
per Share
$53,690 – $0
= $2.42
(17,000 + 27,400)/2
Indicates how much income was earned for each
share of common stock outstanding.
Irwin/McGraw-Hill
31
© The McGraw-Hill Companies, Inc., 2002
Price-Earnings Ratio
Price-Earnings
Ratio
Price-Earnings
Ratio
=
Market Price Per Share
Earnings Per Share
=
$20.00
= 8.26 times
$2.42
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.
Irwin/McGraw-Hill
32
© The McGraw-Hill Companies, Inc., 2002
Dividend Payout Ratio
Dividend
=
Payout Ratio
Dividends Per Share
Earnings Per Share
Dividend
=
Payout Ratio
$2.00
$2.42
= 82.6%
Gauges the portion of current earnings being paid out
in dividends. Investors seeking current income would
like this ratio to be large.
Irwin/McGraw-Hill
33
© The McGraw-Hill Companies, Inc., 2002
Dividend Yield Ratio
Dividend
=
Yield Ratio
Dividends Per Share
Market Price Per Share
Dividend
= $2.00 = 10.00%
Yield Ratio
$20.00
Identifies the return, in terms of cash dividends, on the
current market price of the stock.
Irwin/McGraw-Hill
34
© The McGraw-Hill Companies, Inc., 2002
Return on Total Assets
Return on
=
Total Assets
Return on
=
Total Assets
Net Income + [Interest Expense × (1 – Tax Rate)]
Average Total Assets
$53,690 +[7,300 × (1 – 0.30)]
($300,000 + $346,390) ÷ 2
= 18.19%
Measures how well assets have been employed.
Irwin/McGraw-Hill
35
© The McGraw-Hill Companies, Inc., 2002
Return on Common Stockholders’
Equity
Return on Common = Net Income – Preferred Dividends
Stockholders’ Equity
Average Stockholders’ Equity
$53,690 – $0
Return on Common
=
= 25.91%
Stockholders’ Equity ($180,000 + $234,390) ÷ 2
Indicates how well the company employed the owners’
investments to earn income.
Irwin/McGraw-Hill
36
© The McGraw-Hill Companies, Inc., 2002
Financial Leverage
Financial leverage involves acquiring assets
with funds at a fixed rate of interest.
Fixed rate of
Return on
return on
investment in >
borrowed funds
assets
Positive
= financial
leverage
Return on
Fixed rate of
investment in <
return on
assets
borrowed funds
Negative
= financial
leverage
Irwin/McGraw-Hill
37
© The McGraw-Hill Companies, Inc., 2002
Book Value Per Share
Book Value
Common Stockholders’ Equity
=
per Share
Number of Common Shares Outstanding
$234,390
Book Value
= $ 8.55
=
27,400
per Share
Measures the amount that would be distributed to
holders of each share of common stock if all assets
were sold at their balance sheet carrying amounts and
if all creditors were paid off.
Irwin/McGraw-Hill
38
© The McGraw-Hill Companies, Inc., 2002
Ratio Analysis – The Short-Term
Creditor
NORTON CORPORATION
2002
We will use this
information to
calculate ratios to
measure the wellbeing of the shortterm creditors for
Norton
Corporation.
Irwin/McGraw-Hill
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
494,000
Cost of goods sold
140,000
39
© The McGraw-Hill Companies, Inc., 2002
Working Capital
December 31,
2002
Current assets
$
Current liabilities
Working capital
Irwin/McGraw-Hill
(42,000)
$
40
65,000
23,000
© The McGraw-Hill Companies, Inc., 2002
Current Ratio
Current
Ratio
=
Current
Ratio
=
Current Assets
Current Liabilities
$65,000
$42,000
=
1.55 : 1
Measures the ability of the company to pay current
debts as they become due.
Irwin/McGraw-Hill
41
© The McGraw-Hill Companies, Inc., 2002
Acid-Test (Quick) Ratio
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
Quick assets are Cash,
Acid-TestSecurities,$50,000
Marketable
Accounts Receivable and
=
= 1.19 : 1
Ratio current Notes
$42,000
Receivable.
This ratio is like the current ratio but excludes
current assets such as inventories that may be
difficult to quickly convert into cash.
Irwin/McGraw-Hill
42
© The McGraw-Hill Companies, Inc., 2002
Accounts Receivable Turnover
Accounts
Receivable
Turnover
=
Sales on Account
Average Accounts Receivable
Accounts
$494,000
= 26.70 times
Receivable =
($17,000 + $20,000) ÷ 2
Turnover
Measures how many times a company converts its
receivables into cash each year.
Irwin/McGraw-Hill
43
© The McGraw-Hill Companies, Inc., 2002
Average Collection Period
Average
365 Days
Collection = Accounts Receivable Turnover
Period
Average
Collection =
Period
365 Days
26.7 Times
= 13.67 days
Measures, on average, how many days it takes to
collect an account receivable.
Irwin/McGraw-Hill
44
© The McGraw-Hill Companies, Inc., 2002
Inventory Turnover
Inventory
Turnover
Cost of Goods Sold
Average Inventory
=
Inventory
Turnover
$140,000
=
= 12.73 times
($10,000 + $12,000) ÷ 2
Measures the number of times merchandise
inventory is sold and replaced during the year.
Irwin/McGraw-Hill
45
© The McGraw-Hill Companies, Inc., 2002
Average Sale Period
Average
=
Sale Period
365 Days
Inventory Turnover
Average
=
Sale Period
365 Days
12.73 Times
= 28.67 days
Measures how many days, on average, it
takes to sell the inventory.
Irwin/McGraw-Hill
46
© The McGraw-Hill Companies, Inc., 2002
Ratio Analysis – The Long-Term
Creditor
Use this information to calculate ratios to
measure the well-being of the long-term
creditors for Norton Corporation.
NORTON CORPORATION
2002
Earnings before interest
and taxes
Referred to as net
operating income.
Irwin/McGraw-Hill
Interest expense
$
84,000
7,300
Total stockholders' equity
234,390
Total liabilities
112,000
47
© The McGraw-Hill Companies, Inc., 2002
Times Interest Earned Ratio
Times
Interest =
Earned
Earnings before interest and taxes
Interest expense
Times
Interest =
Earned
$84,000
=
7,300
11.51
times
The most common measure of the ability
of a firm’s operations to provide protection
to the long-term creditor.
Irwin/McGraw-Hill
48
© The McGraw-Hill Companies, Inc., 2002
Debt-to-Equity Ratio
Debt–to–
Total Liabilities
Equity =
Stockholders’ Equity
Ratio
Debt–to–
Equity =
Ratio
$112,000
$234,390
= 0.48 to 1
Measures the amount of assets being provided by
creditors for each dollar of assets being provided by
the owners of the company.
Irwin/McGraw-Hill
49
© The McGraw-Hill Companies, Inc., 2002
Published Sources of Financial Ratios
Source
Content
EDGAR SEC
www.sec.gov
Almanac of Business and
Industrial Financial Ratios
Annual Statements of Study
www.rmahq.org
Reports filed with the
SEC.
Common-size income
statements and ratios.
Common-size statements
arranged by industry.
Business articles and
Business & Company ASAP
periodicals.
Hoover's Online
Capsule profiles of 10,000
www.hoovers.com
U.S. companies.
Irwin/McGraw-Hill
50
© The McGraw-Hill Companies, Inc., 2002
End of Chapter 14
Irwin/McGraw-Hill
51
© The McGraw-Hill Companies, Inc., 2002