Prof. Asif Masood AhmadSuperior UniversityLahoreANALYSIS ANDINTERPRETATION OFFINANCIAL STATEMENTS

Non-accounting majors, especially, should relate well to this chapterIt looks at accounting information from users perspectiveRelates very closely to topics you will study in your finance courseTherefore, we will use a somewhat broader brush on this chapterWhat is financial statement analysis?

Tearing apart the financial statements and looking at the relationships

Who analyzes financial statements?Internal users (i.e., management)External users (emphasis of chapter)Examples?Investors, creditors, regulatory agencies & stock market analysts and auditors625

What do internal users use it for? Planning, evaluating and controlling company operationsWhat do external users use it for? Assessing past performance and current financial position and making predictions about the future profitability and solvency of the company as well as evaluating the effectiveness of management First sentence in chapter says...

Information is available fromPublished annual reports (1)Financial statements(2)Notes to financial statements(3)Letters to stockholders(4)Auditors report (Independent accountants)(5)Managements discussion and analysisReports filed with the governmente.g., Tax reports with government agencies and departments Form 10-K, Form 10-Q and Form 8-K

Information is available fromOther sources(1)Newspapers (e.g., Wall Street Journal )(2)Periodicals (e.g. Forbes, Fortune)(3)Financial information organizations such as: Moodys, Standard & Poors, Dun & Bradstreet, Inc., and Robert Morris Associates(4)Other business publications

Horizontal AnalysisVertical AnalysisCommon-Size StatementsTrend PercentagesRatio Analysis

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

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

Financial statements that show only percentages and no absolute dollar amounts

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

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

The management of Clover Company provides you with comparative balance sheets of the years ended December 31, 1999 and 1998. Management asks you to prepare a horizontal analysis on the information.

Calculating Change in Dollar AmountsDollarChangeCurrent YearFigureBase YearFigure=

Calculating Change in Dollar AmountsSince we are measuring the amount of the change between 1998 and 1999, the dollar amounts for 1998 become the base year figures.DollarChangeCurrent YearFigureBase YearFigure=

Calculating Change as a PercentagePercentageChangeDollar Change Base Year Figure 100%=

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

($11,500 $23,500) 100% = 48.9%

Lets apply the sameprocedures to theliability and stockholdersequity sections of thebalance sheet.

Now, lets apply the procedures to theincome 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.

The management of Sample Company asks you to prepare a vertical analysis for the comparative balance sheets of the company.

$82,000 $483,000 = 17% rounded$30,000 $387,000 = 8% rounded

$76,000 $483,000 = 16% rounded

Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.

Wheeler, Inc. provides you with the following operating data and asks that you prepare a trend analysis.$1,991 - $1,820 = $171

Using 1995 as the base year, we develop the following percentage relationships.$1,991 - $1,820 = $171$171 $1,820 = 9% rounded

Sheet1

Wheller, Inc.

Opeating Data

19991998199719961995

Revenues$2,405$2,244$2,112$1,991$1,820

Expenses2,0331,9661,8701,8031,701

Net income$372$278$242$188$119

Wheeler, Inc.

Operating Data

19991998199719961995

Revenues132%123%116%109%100%

Expenses120%116%110%106%100%

Net income313%234%203%158%100%

&A

Page &P

Sheet2

&A

Page &P

Sheet3

&A

Page &P

Sheet4

&A

Page &P

Sheet5

&A

Page &P

Sheet6

&A

Page &P

Trend linefor Sales

Sheet: Chart3

Sheet: Sheet1

Sheet: Sheet2

Sheet: Sheet3

Sheet: Sheet4

Sheet: Sheet5

Sheet: Sheet6

Sheet: Sheet7

Sheet: Sheet8

Sheet: Sheet9

Sheet: Sheet10

Sheet: Sheet11

Sheet: Sheet12

Sheet: Sheet13

Sheet: Sheet14

Sheet: Sheet15

Sheet: Sheet16

1995.0

1995.0

1996.0

1996.0

1997.0

1997.0

1998.0

1998.0

1999.0

1999.0

100.0

100.0

109.0

106.0

116.0

110.0

123.0

116.0

132.0

120.0

Sales

Expenses

Ratios can be expressed in three different ways: 1. Ratio (e.g., current ratio of 2:1) 2. % (e.g., profit margin of 2%) 3. $ (e.g., EPS of $2.25)CAUTION! Using ratios and percentages without considering the underlying causes may lead to incorrect conclusions.

Liquidity RatiosIndicate a companys short-term debt-paying abilityEquity (Long-Term Solvency) RatiosShow relationship between debt and equity financing in a companyProfitability TestsRelate income to other variablesMarket TestsHelp assess relative merits of stocks in the marketplace

Liquidity RatiosCurrent (working capital) ratioAcid-test (quick) ratioCash flow liquidity ratioAccounts receivable turnoverNumber of days sales in accounts receivableInventory turnoverTotal assets turnover651

Equity (Long-Term Solvency) RatiosEquity (stockholders equity) ratioEquity to debt

Profitability TestsReturn on operating assetsNet income to net sales (return on sales or profit margin)Return on average common stockholders equity (ROE)Cash flow marginEarnings per shareTimes interest earnedTimes preferred dividends earned$

Market TestsEarnings yield on common stockPrice-earnings ratioPayout ratio on common stockDividend yield on common stockDividend yield on preferred stockCash flow per share of common stock

Now, lets look at Norton Corporations 1999 and 1998 financial statements.

Now, lets calculate the 10 ratios based on Nortons financial statements.

We will use this informationto calculate the liquidity ratios for Norton.

Sheet1

NORTON CORPORATION

1999December 31, 19X4

Cash$30,000$20,000

Accounts receivable, net17,000

Beginning of year17,000

End of year20,000

Inventory10,000

Beginning of year10,000

End of year12,000

Total current assets$65,000$47,000

Total current liabilities42,00040,000

Sales on account$494,000

Cost of goods sold$140,000

&A

Page &P

Sheet2

&A

Page &P

Sheet3

&A

Page &P

Sheet4

&A

Page &P

Sheet5

&A

Page &P

Sheet6

&A

Page &P

Sheet7

&A

Page &P

Sheet8

&A

Page &P

Sheet9

&A

Page &P

Sheet10

&A

Page &P

Sheet11

&A

Page &P

Sheet12

&A

Page &P

Sheet13

&A

Page &P

Sheet14

&A

Page &P

Sheet15

&A

Page &P

Sheet16

&A

Page &P

The excess of current assets over current liabilities.* While this is not a ratio, it does give an indication of a companys liquidity.

#1Measures the abilityof the company to pay currentdebts as they become due.

#2Quick assets are Cash,Marketable Securities, Accounts Receivable (net) andcurrent Notes Receivable.

Norton Corporations quick assets consist of cash of $30,000 and accounts receivable of $20,000.#2

#2

#3This ratio measures how many times a company converts its receivables into cash each year.

#4Measures, on average, how many days it takes to collect an account receivable. Days Salesin AccountsReceivables= 365 Days Accounts Receivable Turnover

#4In practice, would 45 days be a desirable number of days in receivables?Days Salesin AccountsReceivables= 365 Days Accounts Receivable Turnover

#5Measures the number of timesinventory is sold andreplaced during the year.

#5Would 5 be a desirable number of times for inventory to turnover?

This is part of the information to calculate the equity, or long-term solvency ratios of Norton Corporation.

Sheet1

NORTON CORPORATION

1999December 31, 19X4

Net operating income$84,000$220,000

Net sales494,000

Interest expense$7,300

Total stockholders' equity$234,390

Total liabilities112,000

220,000

&A

Page &P

Sheet2

&A

Page &P

Sheet3

&A

Page &P

Sheet4

&A

Page &P

Sheet5

&A

Page &P

Sheet6

&A

Page &P

Sheet7

&A

Page &P

Sheet8

&A

Page &P

Sheet9

&A

Page &P

Sheet10

&A

Page &P

Sheet11

&A

Page &P

Sheet12

&A

Page &P

Sheet13

&A

Page &P

Sheet14

&A

Page &P

Sheet15

&A

Page &P

Sheet16

&A

Page &P

Here is therest of theinformationwe willuse.

Schedule

NORTON CORPORATION

1999

Common shares outstanding17,000

Beginning of year17,000

End of year27,400

Net income53,69057,500

Stockholders' equity

Beginning of year180,000216,000

End of year234,390220,000

Dividends per share28

Dec. 31 market price/share20

Interest expense7,300

Total assets

Beginning of year$300,000

End of year$346,390

&A

Page &P

#6Measures the proportionof total assets provided bystockholders.

#7Net IncometoNet Sales= Net Income Net SalesMeasures the proportion of the sales dollar which is retained as profit.

#7Net IncometoNet Sales= Net Income Net SalesNet IncometoNet Sales= $53,690 $494,000= 10.9%Would a 1% return on sales be good?

#8Return onStockholdersEquity= Net Income Average CommonStockholders EquityImportant measure of theincome-producing abilityof a company.

Earningsper ShareEarnings Available to Common StockholdersWeighted-Average Number of Common Shares Outstanding=The financial press regularly publishesactual and forecasted EPS amounts.#9

Whats new ? Weighted-average calculationThree alternatives for calculating weighted-average number of shares

Alternate #1Whats new? Weighted-average calculation

Alternate #3Alternate #2

#10Price-EarningsRatio Market Price Per Share EPS=Provides some measure of whether the stock is under or overpriced.

Need for comparable dataData is provided by Dun & Bradstreet, Standard & Poors etc.Must compare by industryIs EPS comparable?Influence of external factorsGeneral business conditionsSeasonal nature of business operationsImpact of inflation

The current ratio is a measure of liquidity that is computed by dividing total assets by total liabilities.a.Trueb.False

The current ratio is a measure of liquidity that is computed by dividing total assets by total liabilities.a.Trueb.FalseQuestionThe current ratio is a measure ofliquidity, but is computed by dividing current assets bycurrent liabilities

Quick assets are defined as Cash, Marketable Securities and net receivables.a.Trueb.False

Quick assets are defined as Cash, Marketable Securities and net receivables.a.Trueb.FalseQuestion