© the mcgraw-hill companies, inc., 2008 mcgraw-hill/irwin financial statement analysis

© The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin

FINANCIAL STATEMENT ANALYSIS


Internal Users External Users

Financial statement analysis helps users make better decisions.

Financial statement analysis helps users make better decisions.

ManagersOfficers

Internal Auditors

ShareholdersLenders

Customers

Purpose of AnalysisPurpose of Analysis


Comparative Horizontal Analysis

Trend Percentages

Common-size Vertical

Analysis

Ratios

Tools of AnalysisTools of Analysis


Dollar Change:

Analysis Period Amount

Base PeriodAmount

DollarChange = –

Percentage Change:

Dollar Change Base PeriodAmount

PercentChange = ÷%%%%

Comparative Horizontal AnalysisComparative Horizontal Analysis


Let’s look at the asset Let’s look at the asset section of Clover, Inc. section of Clover, Inc.

comparative balance sheet comparative balance sheet and income statement for and income statement for

2007 and 2006.2007 and 2006.Compute the dollar change Compute the dollar change and the percentage change and the percentage change

for cash.for cash.

Let’s look at the asset Let’s look at the asset section of Clover, Inc. section of Clover, Inc.

comparative balance sheet comparative balance sheet and income statement for and income statement for

2007 and 2006.2007 and 2006.Compute the dollar change Compute the dollar change and the percentage change and the percentage change

for cash.for cash.

Comparative Horizontal AnalysisComparative Horizontal Analysis


Clover, Inc.Comparative Balance Sheets

December 31,

2007 2006Dollar

ChangePercent Change*

AssetsCurrent assets: Cash and equivalents 12,000$ 23,500$ ? ? Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200

Total current assets 155,000$ 164,700$

Property and equipment: Land 40,000 40,000 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 one decimal point.



December 31,

2007 2006Dollar


AssetsCurrent assets: Cash and equivalents 12,000$ 23,500$ (11,500)$ ? Accounts receivable, net 60,000 40,000 Inventory 80,000 100,000 Prepaid expenses 3,000 1,200




Total assets 315,000$ 289,700$


$12,000 – $23,500 = $(11,500)$12,000 – $23,500 = $(11,500)



December 31,

2007 2006Dollar


AssetsCurrent 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




Total assets 315,000$ 289,700$


($11,500 ÷ $23,500) × 100% = 48.94%($11,500 ÷ $23,500) × 100% = 48.94%



December 31,

2007 2006Dollar


AssetsCurrent assets: Cash and equivalents 12,000$ 23,500$ (11,500)$ -48.9% Accounts receivable, net 60,000 40,000 20,000 50.0% Inventory 80,000 100,000 (20,000) -20.0% Prepaid expenses 3,000 1,200 1,800 150.0%

Total current assets 155,000$ 164,700$ (9,700) -5.9%

Property and equipment: Land 40,000 40,000 - 0.0% Buildings and equipment, net 120,000 85,000 35,000 41.2%

Total property and equipment 160,000$ 125,000$ 35,000 28.0%

Total assets 315,000$ 289,700$ 25,300$ 8.7%



Examine the relative size of each item in the financial statements by computing component

(or common-sized) percentages.

Common-size Percentage

100%Analysis Amount

Base Amount= ×

Financial Statement Base Amount

Balance Sheet Total Assets

Income Statement Revenues

Financial Statement Base Amount

Balance Sheet Total Assets

Income Statement Revenues

Common-size Vertical AnalysisCommon-size Vertical Analysis


Clover, inc.Comparative Balance Sheets

December 31, Common-size

Percents*2007 2006 2007 2006

AssetsCurrent 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




Total assets 315,000$ 289,700$ 100.0% 100.0%

* Percent rounded to first decimal point.

Complete the common-size analysis for the other assets.

($12,000 ÷ $315,000) × 100% = 3.8%($12,000 ÷ $315,000) × 100% = 3.8%

($23,500 ÷ $289,700) × 100% = 8.1%($23,500 ÷ $289,700) × 100% = 8.1%



December 31,

Common-size

Percents*2007 2006 2007 2006

AssetsCurrent assets: Cash and equivalents 12,000$ 23,500$ 3.8% 8.1% Accounts receivable, net 60,000 40,000 19.0% 13.8% Inventory 80,000 100,000 25.4% 34.6% Prepaid expenses 3,000 1,200 1.0% 0.4%

Total current assets 155,000$ 164,700$ 49.2% 56.9%

Property and equipment: Land 40,000 40,000 12.7% 13.8% Buildings and equipment, net 120,000 85,000 38.1% 29.3%

Total property and equipment 160,000$ 125,000$ 50.8% 43.1%

Total assets 315,000$ 289,700$ 100.0% 100.0%

* Percent rounded to first decimal point.


Trend analysis is used to reveal patterns in data covering successive periods.

Trend analysis is used to reveal patterns in data covering successive periods.

TrendIndex

Analysis Period Amount Base Period Amount 100%= ×

Trend Index AnalysisTrend Index Analysis


2003 is the base period so its amounts will equal 100%.

2003 is the base period so its amounts will equal 100%.

Berry ProductsIncome Information

For the Years Ended December 31, Item 2007 2006 2005 2004 2003

Revenues 400,000$ 355,000$ 320,000$ 290,000$ 275,000$ Cost of sales 285,000 250,000 225,000 198,000 190,000 Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2007 2006 2005 2004 2003Revenues 145% 129% 116% 105% 100%Cost of sales 150% 132% 118% 104% 100%Gross profit 135% 124% 112% 108% 100%

(290,000 275,000) 100% = 105%(198,000 190,000) 100% = 104%(92,000 85,000) 100% = 108%

Trend IndexTrend Index


TrendPercentage

Analysis Period – Previous Period Previous Period Amount

100%= ×

Trend PercentageTrend Percentage


2003 is the base period so its amounts will equal 0.

2003 is the base period so its amounts will equal 0.

Berry ProductsIncome Information

For the Years Ended December 31, Item 2007 2006 2005 2004 2003

Revenues 400,000$ 355,000$ 320,000$ 290,000$ 275,000$ Cost of sales 285,000 250,000 225,000 198,000 190,000 Gross profit 115,000 105,000 95,000 92,000 85,000

Item 2007 2006 2005 2004 2003Revenues 12.68% 10.94% 10.34% 5.45% - Cost of sales 14% 11.11% 13.64% 4.21% - Gross profit 9.52% 10.53% 3.26% 8.24% -

(290,000 - 275,000)275,000

100% = 5.45%

Trend PercentageTrend Percentage


C h a rt T it le

Past performance topresent perform ance.

Industry averages toyour com pany.

Other com panies toyour com pany.

Along w ith dollar and percentage changes,and trend percentages,

ratios can be used to compare:

A ratio is a sim ple m athematical expressionof the relationship betw een one item and another.

RatiosRatios


Ratios help usersunderstand

financial re lationships.

Ratios provide forquick com parison

of companies.

U ses

M anagem ent may enterinto transactions m erely

to im prove the ratios.

Ratios do not help w ithanalysis of the company's

progress tow ardnonfinancial goals.

Lim itations

Uses and Limitations of Financial RatiosUses and Limitations of Financial Ratios


Ratio CategoriesRatio Categories Liquidity Ratio

assess the ability of a company to meet its short term liabilities

Solvency Ratio Measure the ability of a company to to meet its long-

term liabilities Profitability Ratio

Assess management’s effectiveness in achieving profitability

Activity Ratio Reflects management’s ability in using the assets

Operating Ratio To analyze the operations of a company


Liquidity RatioLiquidity RatioRatios Formula Users Comparing Standards Basic Analysis

Current Ratio Current Assets Current Liabilities

Creditors

Owners

Management

- Normally 2 : 1- Hotel 1.5 : 1 and Motel 1 : 1 (less inventory)

Creditors prefer higher ratio for safety

Owners prefer lower ratio for productivity

Management try to satisfy both

Acid-Test Ratio

(Quick Ratio)

(Cash + Receivables + Marketable Securities)

Current Liabilities

Creditors

Owners

management

Lower than current ratio and most quick ratios

are less than 1 : 1

Only consider the assets that can be readily convert to cash.

Users’ opinion the same as Current Ratio

Receivable Turnover

Ratio

Revenues

Average Receivable

Creditors

Management

Indicate how fast the receivable can be

converted into cash

Receivable Collection

Period

365

Receivable Turnover Ratio

Creditors

Management

Credit Cards less than 10 days

Account Receivable from 1 month – 3 months

How many days it takes to collect receivables


Solvency RatioSolvency RatioRatios Formula Users Comparing Standards Basic Analysis

Total assets to total

liabilities

(Solvency Ratio)

Total AssetsTotal Liabilities

Creditors 2:1Creditors prefer to see the ratio as high as possible

Total liabilities to total assets

(Debt Ratio)

Total Liabilities

Total AssetsCreditors

Normally <50%

Hospitality Industry usually 60% - 90%

Creditors prefer lower one for less risk.

Investors prefer lower ratio because their interests are better

protected.

Total liabilities to total equity

(Debt Equity Ratio)

Total Liabilities

Total Owner’s EquityCreditors

The lower the better

(% or ratio)

Creditors prefer lower one for less risk.

Investors prefer lower ratio because their interests are better

protected.

Number of times interest

earned

EBIT

Interest Expense

Creditors

Management

Owners

The higher the better (times)

All like to see this ratio as high as possible


Profitability RatioProfitability RatioRatios Formula Users Basic Analysis

Profit Margin/Gross Profit Margin

Net Income / Gross ProfitSales Revenues

Creditors

Management

Owners

Indicate management’s ability to generate Sales and control expenses (%)

Return on Assets

(ROA)

Net Income

Average Total Assets

Mostly Creditors

Management

Owners

Measures the effectiveness of management’s use of the company’s assets

Higher is better (>15%)

Return on Owner’s Equity

(ROE)

Net Income

Average Owner’s Equity

Creditors

Management

Mostly Owners

Measures the effectiveness of management’s use of equity funds

Higher is better, usually higher than interest rate (%)

Earning per Share

(EPS)

Net Income

Average Common Shares Outstanding

Creditors

Management

Owners

Higher is better (%)


Activity RatioActivity RatioRatios Formula Users Comparing Standards Basic Analysis

Inventory Turnover

Ratio

Cost of SalesAverage Inventory

Management

Food: Turnover from 2 – 4 times a month

Beverages: Turnover from 1 – 4 times a month

Shows how quickly the inventory is being used.

Although high turnover is good, it can be an indication of stockout problems

Inventory Holding Period

Operating days for the period

Inventory turnover for the period

Management

Food: should be 15 days at most and at least 1 week

Beverages: 1 month at most and 1 week at least

Fixed Assets Turnover

Ratio

Sales Revenue

Average Fixed Assets

Management

For hotel, this ratio vary from one half to two or more per year.

For food service, usually has a turnover of 4 – 5 times a year if the building is being rented

Higher ratio means an effective use of assets


Operating RatioOperating RatioRatios Formula Users

Comparing Standards

Basic Analysis

Food (Beverage)

cost %

Food (Beverage) CostFood (Beverage) Revenue

Management-A standard or a predetermined %

The difference should be investigated

Average Food (Beverage)

Check

Food (Beverage) Revenue

Number of food coversManagement

This ratio sometimes are calculated by each menu items. Help to find out the most attractive dishes to

guests & decide the menu items

Seat TurnoverGuest Served

Seats AvailableManagement

Analyze the trend for further improvement


Operating RatioOperating RatioRatios Formula Users Basic Analysis

Average Room Rate (Average Daily Rate)

ADR

Rooms Revenue

Rooms OccupiedManagement

Calculate the ratio by each market segment or by each room type. Higher result is

better when the occupancy % stay the same

Occupancy %Rooms Occupied

Rooms AvailableManagement

High result is better when the ADR stay the same

Revenue per Available Room

(REVPAR)

Rooms Revenue

Rooms Available

Or

ADR x Occup.

Management

Look at the combined effect of ADR and Occupancy % on the total revenue, an improvement

on ADR and Occupancy %

© the mcgraw-hill companies, inc., 2008 mcgraw-hill/irwin financial statement analysis

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