Analysis and interpretation of ratios

A NALYSIS A ND I NTERPRETATION O F F INANCIAL S TATEMENTS

[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Financial Statement Analysis

[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Financial Statement Analysis 625

[object Object],[object Object],[object Object],[object Object],[object Object],Financial Statement Analysis

[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Financial Statement Analysis 627 628

[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Financial Statement Analysis 627 628

[object Object],[object Object],[object Object],[object Object],[object Object],Methods of Financial Statement Analysis

Horizontal Analysis Using comparative financial statements to calculate dollar or percentage changes in a financial statement item from one period to the next

Vertical Analysis For a single financial statement, each item is expressed as a percentage of a significant total, e.g., all income statement items are expressed as a percentage of sales

Common-Size Statements Financial statements that show only percentages and no absolute dollar amounts

Trend Percentages Show changes over time in given financial statement items (can help evaluate financial information of several years)

Ratio Analysis Expression of logical relationships between items in a financial statement of a single period (e.g., percentage relationship between revenue and net income)

Horizontal Analysis Example ,[object Object]

[object Object],Horizontal Analysis Example Dollar Change Current Year Figure Base Year Figure = –

[object Object],Horizontal Analysis Example Since we are measuring the amount of the change between 1998 and 1999, the dollar amounts for 1998 become the “base” year figures. Dollar Change Current Year Figure Base Year Figure = –

[object Object],Horizontal Analysis Example Percentage Change Dollar Change Base Year Figure 100% = ×

Horizontal Analysis Example $12,000 – $23,500 = $(11,500)

Horizontal Analysis Example ($11,500 ÷ $23,500) × 100% = 48.9%

Horizontal Analysis Example Let’s apply the same procedures to the liability and stockholders’ equity sections of the balance sheet.

Horizontal Analysis Example Now, let’s apply the procedures to the income statement.

Sales increased by 8.3% while net income decreased by 21.9%.

There were increases in both cost of goods sold (14.3%) and operating expenses (2.1%). These increased costs more than offset the increase in sales, yielding an overall decrease in net income.

Vertical Analysis Example ,[object Object]

Vertical Analysis Example $82,000 ÷ $483,000 = 17% rounded $30,000 ÷ $387,000 = 8% rounded

Vertical Analysis Example $76,000 ÷ $483,000 = 16% rounded

Trend Percentages Example ,[object Object]

Trend Percentages Example ,[object Object],$1,991 - $1,820 = $171

Trend Percentages Example ,[object Object],$1,991 - $1,820 = $171 $171 ÷ $1,820 = 9% rounded

[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],Ratios

Categories of Ratios ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],10 Ratios You Must Know 651

[object Object],[object Object],[object Object],10 Ratios You Must Know

[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],10 Ratios You Must Know $

[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],10 Ratios You Must Know

Now, let’s look at Norton Corporation’s 1999 and 1998 financial statements.

Now, let’s calculate the 10 ratios based on Norton’s financial statements.

[object Object],[object Object],[object Object],[object Object]

Working Capital* ,[object Object],* While this is not a ratio, it does give an indication of a company’s liquidity.

Current (Working Capital) Ratio ,[object Object],Measures the ability of the company to pay current debts as they become due. Current Ratio $65,000 $42,000 = = 1.55 : 1 Current Ratio Current Assets Current Liabilities =

Acid-Test (Quick) Ratio ,[object Object],Quick assets are Cash, Marketable Securities, Accounts Receivable (net) and current Notes Receivable. Quick Assets Current Liabilities = Acid-Test Ratio

Acid-Test (Quick) Ratio ,[object Object],Norton Corporation’s quick assets consist of cash of $30,000 and accounts receivable of $20,000. Quick Assets Current Liabilities = Acid-Test Ratio

Acid-Test (Quick) Ratio ,[object Object],Quick Assets Current Liabilities = Acid-Test Ratio $50,000 $42,000 = 1.19 : 1 = Acid-Test Ratio

Accounts Receivable Turnover ,[object Object],This ratio measures how many times a company converts its receivables into cash each year. Sales on Account Average Accounts Receivable Accounts Receivable Turnover = = 26.70 times $494,000 ($17,000 + $20,000) ÷ 2 Accounts Receivable Turnover = Average, net accounts receivable Net, credit sales

Number of Days’ Sales in Accounts Receivable ,[object Object],Measures, on average, how many days it takes to collect an account receivable. Days’ Sales in Accounts Receivables = 365 Days Accounts Receivable Turnover = 13.67 days = 365 Days 26.70 Times Days’ Sales in Accounts Receivables

Number of Days’ Sales in Accounts Receivable ,[object Object],In practice, would 45 days be a desirable number of days in receivables? Days’ Sales in Accounts Receivables = 365 Days Accounts Receivable Turnover = 13.67 days = 365 Days 26.70 Times Days’ Sales in Accounts Receivables

Inventory Turnover ,[object Object],Measures the number of times inventory is sold and replaced during the year. Cost of Goods Sold Average Inventory Inventory Turnover = = 12.73 times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover =

Inventory Turnover ,[object Object],Would 5 be a desirable number of times for inventory to turnover? Cost of Goods Sold Average Inventory Inventory Turnover = = 12.73 times $140,000 ($10,000 + $12,000) ÷ 2 Inventory Turnover =

Equity, or Long–Term Solvency Ratios ,[object Object]

Here is the rest of the information we will use.

Equity Ratio ,[object Object],Measures the proportion of total assets provided by stockholders. Equity Ratio = Stockholders’ Equity Total Assets Equity Ratio = $234,390 $346,390 67.7% =

Net Income to Net Sales A/K/A Return on Sales or Profit Margin ,[object Object],Net Income to Net Sales = Net Income Net Sales Measures the proportion of the sales dollar which is retained as profit. Net Income to Net Sales = $53,690 $494,000 = 10.9%

Net Income to Net Sales A/K/A Return on Sales or Profit Margin ,[object Object],Net Income to Net Sales = Net Income Net Sales Net Income to Net Sales = $53,690 $494,000 = 10.9% Would a 1% return on sales be good?

Return on Average Common Stockholders’ Equity (ROE) ,[object Object],Return on Stockholders’ Equity = Net Income Average Common Stockholders’ Equity Important measure of the income-producing ability of a company. = $53,690 ($180,000 + $234,390) ÷ 2 = 25.9% Return on Stockholders’ Equity

[object Object],Earnings Per Share Earnings per Share Earnings Available to Common Stockholders Weighted-Average Number of Common Shares Outstanding = The financial press regularly publishes actual and forecasted EPS amounts. Earnings per Share $53,690 (17,000 + 27,400) ÷ 2 = = $2.42

[object Object],[object Object],Earnings Per Share ,[object Object],EPS of common stock = _______________________ Earnings available to common stockholders Weighted-average number of common shares outstanding 644

Earnings Per Share ,[object Object],[object Object],Alternate #1 EPS of common stock = _______________________ Earnings available to common stockholders Weighted-average number of common shares outstanding 645

Earnings Per Share Alternate #3 Alternate #2 645

[object Object],[object Object],[object Object],Earnings Per Share ¶ Primary EPS and Fully Diluted EPS APB Opinion No. 15 I mentioned this 17-page pronouncement that required a 100-page explanation in the lecture for chapter 13. 646

Price-Earnings Ratio A/K/A P/E Multiple ,[object Object],Price-Earnings Ratio Market Price Per Share EPS = Provides some measure of whether the stock is under or overpriced. Price-Earnings Ratio = $20.00 $ 2.42 = 8.3 : 1

Important Considerations ,[object Object],[object Object],[object Object],[object Object],Influence of external factors General business conditions Seasonal nature of business operations Impact of inflation

Question ,[object Object],[object Object],[object Object]

The current ratio is a measure of liquidity that is computed by dividing total assets by total liabilities. a. True b. False Question The current ratio is a measure of liquidity, but is computed by dividing current assets by current liabilities

Quick assets are defined as Cash, Marketable Securities and net receivables. a. True b. False Question

Analysis and interpretation of ratios

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Analysis and interpretation of ratios