23-1 intermediate accounting,17e stice | stice | skousen © 2010 cengage learning powerpoint...

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Intermediate Accounting,17E

Stice | Stice | Skousen

© 2010 Cengage Learning

PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University

Analysis of Financial Statements

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Framework for Financial Statement Analysis

• Financial statement analysis is the examination of both the relationships among financial statement numbers and the trends in those numbers over time.

• One purpose of financial statement analysis is to use the past performance of a company to predict its future profitability and cash flows.

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Framework for Financial Statement Analysis

• Another purpose of financial statement analysis is to evaluate the performance of a company with an eye toward identifying problem areas.

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Framework for Financial Statement Analysis

The APB stated that comparisons between financial statements are most informative and useful under the following conditions:1. The presentations are in good form; that

is, the arrangement within the statement is identical.

2. The content of the statements is identical; that is, the same items from the underlying accounting records are classified under the same captions.

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Framework for Financial Statement Analysis

3. Accounting principles are not changed, or, if they are changed, the financial effects of the changes are disclosed.

4. Changes in circumstances or in the nature of the underlying transactions are disclosed.

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Framework for Financial Statement Analysis

To analyze financial statements, analysts use common-size financial statements and ratio analysis.

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Common-Size Financial Statements

Financial statements are standardized by dividing all financial statement numbers for a given year by sales for the year. The resulting financial statements are called common-size financial statements, with all amounts for a given year being shown as a percentage of sales for that year.

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Interpreting Ratios

As you calculate the ratios in this chapter, you probably will wonder whether the ratio is good or bad. While there are a few “rules of thumb” that can be followed, the best way to interpret a ratio is to compare the value calculated to the same firm in previous years and/or to different companies in the same industry.

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DuPont Framework

• The DuPont framework was developed internally at DuPont around 1920.

• It provides a systematic approach to identifying general factors causing ROE to deviate from normal.

• It establishes a framework for computing financial ratios to yield more in-depth analysis of a company’s areas of strength and weakness.

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The number of pennies in profits generated from

each dollar of sales

The number of dollars in sales generated by each dollar of assets

The number of dollars of assets a company is able to acquire using each dollar invested by

stockholders

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$180,000

$5,700,000

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$5,700,000

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$5,700,000

$2,278,000

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$2,278,000

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$2,278,000

$1,468,000

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DuPont Framework

Coleville’s ROE for 2011 is 12.3%. The ROE for 2010 would be calculated the same way.

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Accounts Receivable Turnover

Colesville Corporation

$6,600,000

($333,500 + $375,000)/22010 =

$354,250

= 18.6 times

Sales

Average accounts receivable

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Colesville Corporation

$5,700,000

($375,000 + $420,000)/22011 =

$397,500 = 14.3 times

Sales

Average accounts receivable

The higher the turnover, the more rapid is a firm’s average collection period for receivables.

Accounts Receivable Turnover

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Average Collection Period

Colesville Corporation

Average accounts receivable

Average daily sales

($333,500 + $375,000)/2

$6,600,000/3652010 =

$18,082

$354,250

= 19.6 days

(continues)

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Average Collection Period

Colesville Corporation

Average accounts receivable

Average daily sales

($375,000 + $420,000)/2

$5,700,000/3652011 =

$15,616

$397,500

= 25.5 days

What constitutes a reasonable average collection period varies with individual businesses.

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Inventory Turnover

Colesville Corporation

$4,800,000

($125,000 + $330,000)/22010 =

$227,500

= 21.1 times

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Cost of goods soldAverage inventory

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Inventory Turnover

Colesville Corporation

Cost of goods soldAverage inventory

$4,000,000

($330,000 + $225,000)/22011 =

$277,500

= 14.4 times

Inventory turnover allows for evaluation of the firm’s inventory position and the appropriateness of the inventory size.

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Number of Days’ Sales in Inventory

Colesville Corporation

365Inventory turnover

365

21.12010 =

= 17.3 days

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Number of Days’ Sales in Inventory

Colesville CorporationColesville Corporation

365Inventory turnover

365

14.42011 =

= 25.3 days

Colesville is holding a 25-day supply of inventory in 2011 compared to a 17-day supply in 2010.

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Fixed Asset Turnover

Colesville Corporation

SalesAverage fixed assets

$6,600,000

($330,000 + $225,000)/22010 =

($925,000 + $1,075,000)/2 $1,000,000

= 6.60 times

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Fixed Asset Turnover

Colesville Corporation

$5,700,000

($330,000 + $225,000)/22011 =

($1,075,000 + $1,275,000)/2 $1,175,000

= 4.85 times

Colesville was less efficient at using its fixed assets to generate sales in 2011 than it was in 2010.

SalesAverage fixed assets

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Margin vs. Turnover

• The profitability of each dollar in sales is sometimes called a company’s margin.

• The degree to which assets are used to generate sales is called turnover.

• Margin isn’t everything, nor is turnover everything.

• The important thing is how margin and turnover combine to generate return on assets.

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Leverage Ratios

1. More borrowing means that more assets can be purchased without any additional equity investment by owners.

2. More assets means that more sales can be generated.

3. More sales means that net income should increase.

Higher leverage increases ROE through the following chain of events:

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Debt Ratio

Colesville Corporation

Total liabilitiesTotal assets

$1,101,000

$2,191,0002010 = = 50.3%

$810,000

$2,278,0002011 = = 35.6%

This is a measure of the level of borrowing relative to funds used to finance the company.

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Debt-to-Equity Ratio

Colesville Corporation

Total liabilitiesStockholders’ equity

$1,101,000

$1,090,0002010 = = 1.01

$810,000

$1,468,0002011 = = 0.55

Measures the same thing as the debt ratio.

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Times Interest Earned

Colesville Corporation

Income before interest or income taxesInterest expense

$290,000 + $60,000

$60,0002010 =

$350,000

= 5.8 times

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Times Interest Earned

Colesville Corporation

Income before interest or income taxesInterest expense

$260,000 + $40,000

$40,0002011 =

$300,000

= 7.5 times

This is a measure of the debt position of a company in relation to its earnings ability.

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Current Ratio

Colesville Corporation

Current assetsCurrent liabilities

$955,500

$501,0002010 = = 1.91

$855,000

$410,0002011 = = 2.09

The current ratio is a test of liquidity, or the firm’s ability to meet its current obligations.

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Cash Flow Adequacy Ratio

Cash from operating activitiesTotal primary cash requirements

The formula:

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Cash Flow Adequacy Ratio

Colesville Corporation

$424,500

$375,0002010 = = 1.13

$249,000

$602,0002011 = = 0.41

Because the cash flow adequacy ratio in 2011 is less than 1.0, Colesville was not able to satisfy its primary cash requirements with cash generated by operations.

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Earnings per Share

Colesville Corporation

Net incomeWeighted shares outstanding

$205,000

$75,0002010 = = 2.73

$180,000

$90,0002011 = = 2.00

This well-known ratio shows the size of the dividend per share of common stock if all the net income is distributed.

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Dividend Payout Ratio

Colesville Corporation

Cash dividendsNet income

$145,000

$205,0002010 = = 70.7%

$102,000

$180,0002011 = = 56.7%

In general, high-growth firms have low dividend payout ratios.In general, low-growth stable firms have higher dividend payout ratios.

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Price-Earnings Ratio

Colesville Corporation

Market value per shareEarnings per share

$60.00

$2.732010 = = 22.0

$29.00

$2.002011 = = 14.5

High P/E ratios are generally associated with firms for which strong future growth is predicted.

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Book-to-Market Ratio

Colesville Corporation

Book value of stockholders’ equityTotal market value of equity

$1,090,000

$4,200,0002010 = = 0.26

$1,468,000

$2,900,0002011 = = 0.51

This ratio reflects the difference between a company’s balance sheet value and the company’s actual market value.

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Impact of Alternative Accounting Methods

• If companies are using different accounting practices, it will impact the comparability of ratios.

• Financial statement users should make adjustments for accounting differences among the companies being analyzed.

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Introduction to Equity Valuation

The following information for McDonald’s will be used for a simple valuation model:

2007 2006 2005 2004Diluted EPS $1.98 $2.83 $2.04 $1.79Dividends per share 1.50 1.00 0.67 0.55

Assume the required rate of return on equity capital is 15%.

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Constant Future Dividends

The appropriate formula is as follows:

Price =Dividends

Required rate of return on equity capital

Price =$1.50

0.15= $10.00

Thus, the implied price per share for McDonald’s for 2007 was $10.00.

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Constant Dividend Growth

Using the Gordon growth model, the formula is modified to include a growth rate of 11.1 percent in dividends (excluding the large dividends given in 2006 and 2007).

Price = Dividends

Required rate of return on equity – Expected future dividend growth rate

Price = $1.50

0.150 – 0.111= $38.46

given

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Price-Earnings MultipleAn investor can value a company’s share by using the information in the P/E ratio as follows:

Price = Earnings × P/E ratio

P/E ratios of McDonald’s competitors average 25.4. Using McDonald’s 2007 diluted EPS, the implied price per share for McDonald’s is calculated as follows:

Price = $1.98 × 25.4 = $50.29

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Discounted Free Cash Flow

Free cash flow is defined as:

Cash from operating activities– Cash paid for capital expenditures= Free cash flow

Free cash flow for McDonald’s was computed as follows:

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Comparison of the Valuation Models

The actual market price of a share of McDonald’s stock at the end of 2007 was $58.91.