Financial Statement Analysis

FINANCIAL STATEMENT ANALYSIS

1. Comparative Financial Statements - Financial information reported side by side in vertical columns to see relationship and trends between years. Can be presented in horizontal or vertical analysis. -

Horizontal analysis shows dollar and percent changes from year to year.

2. Common Size Financial Statements - Each component of the statement is represented in terms of percentages. - Income statement Each item is calculated as a percent of net sales -

Balance sheet Each item is calculated as a percent of assets or total liabilities and stockholder’s equity.

NOTE: This analysis will minimize the distortion, which may exist when trying to compare companies with different financial strength and size. 3. All Financial Statement ratios should be compared to: -

Should analyze ratios based upon standards of comparison such as i. Industry ratios and standards ii. Similar businesses in the same industry (competition) iii. Past performance ratios. iv. Prior years operating results

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Financial Statement Ratios 1. Current ratio and Working Capital a. Measure of liquidity – short-term debt paying ability. b. Current Assets (will be consumed within 12 months or less). Current Liabilities (will be satisfied (paid) within 12 months or less). c. Working Capital = current assets – current liabilities. Amount of current assets that would remain after all debts have been paid off. d. Working capital is a measure of solvency e. A negative working capital (if current assets < current liabilities) would indicate that the company might not be able to pay off the maturing liabilities of the next year. 2. Acid Test or Quick Test a. Measure of short-term debt paying ability and liquidity. b. Quick Assets ÷ Current Liabilities Quick Assets include those assets, which can be converted to cash very quickly; usually include: The major exclusion is inventory, which is a current asset but not a quick asset. -

Cash and cash equivalents (those with a stable market with maturity values of 90 days or less). Examples: short-term treasury bills, commercial paper, certificates of deposits, etc.

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Accounts receivable (net of the allowance for doubtful accounts)

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Marketable securities (current assets valued at FMV with holding gains and losses recognized as equity adjustments.)

Note: The quick or acid test ratio will always be lower than the current ratio due to the exclusion of inventory.

3. Debt to Equity Ratio

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a. Total Liabilities ÷ Total Stockholder’s Equity b. Measure of assets being provided by creditors for each dollar of assets being provided by the stockholders. 4. Accounts Receivable Turnover & Days Sales a. Indicates how quickly receivables are completely collected. b. Increasing the turnover will generate more cash receipts on an annual basis. c. Credit sales ÷ Average Accounts Receivables ((beginning + end) ÷ 2) d. Days Sales in Accounts Receivable Indicates a measure of the number of days it takes on average to collect outstanding receivables. Accounts Receivables ÷ (Credit Sales ÷ 365) or Accounts Receivables ÷ Average Daily Credit Sales 5. Inventory Turnover a. Provides information relating to the potential salability of inventory and obsolescence problems. b. Indicates how quickly inventory is sold during the year. c. COGS ÷ Average Inventory ( beginning inventory + ending inventory) ÷ 2) 5A. Number of Day Sales in Inventory - Relationship between COGS and Inventory - Number of days sales in inventory = ending inventory ÷ average daily COGS (COGS ÷ 365) - A rough measure of the length of time it takes to acquire, sell and replace the inventory. 5B. Ratio of Plant Assets to Long Term Liabilities - A solvency measure that indicates the margin of safety of the noteholders or bondholders. -

Also indicates the ability of the business to borrow additional funds on a longterm basis.

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(Net) Plant Assets ÷ Long Term Liabilities

5C. Ratio of Liabilities to Stockholder’s Equity -

Assets = Claims

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Assets = Liabilities + Owner’s Equity

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The relationship between the total claims of the creditors and owners is a solvency measure that indicates the margin of safety for creditors.

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It also indicates the ability of the business to withstand adverse business conditions.

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Total Liabilities ÷ Total Stockholder’s Equity

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The higher the ratio of liabilities to stockholder’s equity would indicate the potential of high interest payments (assuming the existence of notes and/or loans).

6. Times Interest Earned (number of times interest charges earned) a. Indicates the relationship between interest expense to income. b. If this number is high then it provides protection to creditors because it indicates the ability of the company to generate income beyond the amount of interest expense. Earning Before Interest Taxes ÷ Interest Expense = Times Interest Earned c. Indicates the general financial strength of the business, which is of interest to stockholders, employees and creditors. 7. Book Value Per Share a. Indication of the net worth of the corporation. b. Total Stockholder’s Equity ÷ Common Stock O/S c. Usually compared to the market price of the stock. Profitability Analysis - Profitability is the ability of an entity to earn profits. -

Evaluates the effectiveness and efficiency of operations as well as resources available to the business. 4

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Relationship between the operating results as reported on the Income Statement and resources available to the business as reported on the Balance Sheet.

Ratio of Net Sales to Total Assets -

Net Sales ÷ Total Assets

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Shows how effectively a firm utilizes its assets.

8. Earning Per Share a. Represents the amount of earnings attributable to each share of stock of the corporation. b. Must be presented on the face of the income statement per GAAP. c.

(Net Income – Preferred Dividends) ÷ Number of Common Stock O/S

d. Tends to have an effect on market price of stock. 9. Dividend Payout Ratio a. Indicates how much earnings are paid out in dividends versus being reinvested. b. Dividends Per Share ÷ EPS. 10. Dividend Yield Ratio a. Shows the dividend return that each share of stock is generating in terms of cash dividends. b. Dividends Paid Per Share ÷ Market Price Per Share 11. Price Earnings Ratio a. Market Price Per Share ÷ EPS b. Value of stock in relation to its earnings c. Indicator of future earnings potential 12. Return on Total Assets a. Indicates how well the assets of the corporation are utilized to achieve a profit without considering how the assets are financed. Does not get affected by whether the assets are financed primarily by creditors or stockholders 5

b. Deals with the operating responsibilities of the business. c. Deals with earnings from continuing operations. d. If we start at net income we must add back interest expense net of tax to arrive at an amount that shows earnings before distribution made to creditors or stockholders. e. Earnings from Continuing Operations ÷ Average Total Assets Earnings from Continuing Operations = Net Income + (Interest Expense × (1- Tax Rate). (This computes interest expense on an after tax basis). 13. Return on Common Stockholder’s Equity a. This ratio removes the effect of funds that the corporation has borrowed. b. (Net Income – Preferred Dividends) ÷ Average Common Stockholder’s Equity (Average Total SE – Preferred Stock) 13A. Rate Earnings on Stockholder’s Equity - Net Income ÷ Average Stockholder’s Equity -

Measures the rate of income earned on the amount invested by the stockholders.

14. Financial Leverage a. Involves the financing of assets in a company with funds that have been acquired from creditors or from preferred stockholders at a fixed rate of return (monies to be paid in the form of liabilities and dividends). b. If the assets in which the funds are invested earn a greater return than the fixed rate of return required to satisfy the suppliers of the funds a positive financial leverage exists and the common stockholders benefit. c. Sources of financial leverage: -Long-term debt (bonds or notes payable) -Current liabilities -Preferred stock 6

d. If the assets cannot generate a greater return that the fixed rate of return then negative financial leverage exists and the common stockholders suffer.

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