Chapter 17 Financial Statement Analysis

Terms:

Ratio: A comparison between two numbers showing how many times one number exceeds the other.

Working Capital:  The amount of total current assets less total current liabilties.

Current Ratio:  A ratio that shows the numeric relationship of current assets to current liabilities.

Quick Assets:  Those current assets that are cash or that can be quickly turned into cash.

Acid-Test Ratio:  A ratio that shows the numeric relationship of quick assets to current liabilities.

Debt Ratio:  The ratio found by dividing total liabilities by total assets.

Equity Ratio:  The ratio found by dividing stockholders' equity by total assets.

Notes:

The main goal for this chapter's content is to show the importance of being able to utilize financial statement information for analysis.  What analysis allows a manager or accountant to do is to make calculations showing relationships between statement items.

FINANCIAL ANALYSIS INVOLVES 4 MAIN QUESTIONS:

1.  What are the objectives for making the analysis?
2.  What sources of information are needed?
3.  What kind of analysis is to be made?
4.  What level of performance is acceptable?

OBJECTIVES FOR ANALYSIS:

Examination of strengths and weaknesses are important.
1.  Profitability
2.  Efficiency
3.  Short-Term Financial Strength
4.  Long-Term Financial Strength

SOURCES OF INFORMATION FOR ANALYSIS:

Financial statements with the supporting schedules will serve mostly as the main  source for information.  Also statements showing more than one year will be helpful.

ANALYSIS PROCEDURE:

Analyzers are interested in current, past, and future information.  Financial statements are analyzed to predict future outcomes.  There are three common comparisons:  1. ratio analysis, 2.  trend analysis, and 3. component percentage analysis.

Ratios can be stated as 10:1 or 10 to 1 or percentage, or fractional.

Trend analysis requires you have more than one years financial information.  Trend analysis is a comparison of the relationship of one item for more than one year.  This is also known as horizontal analysis.  This can be used to analyze any item

Component percentage analysis is the percentage relationship between one financial statement item and the total that includes that item is known as a component percentage.  For example dividing every item on the income statement by net sales is common.  This is referred to also as vertical analysis.

ACCEPTABLE LEVELS OF FINANCIAL PERFORMANCE:

In order for analysis to be useful acceptable levels of performance must be established.  Many businesses use two major guides to determine acceptable levels of performance.  1.  Trends are compared with prior company performances. 2.  Company results are compared with industry standards that are published by industry organizations.  Other sources are financial and credit reporting companies(Dunn & Bradstreet), the company's planned financial objectives(budget schedules), current interest rates that could be earned by investing capital elsewhere.  Each companies manager must determine acceptable levels.

EARNINGS PERFORMANCE ANALYSIS:

Five Earning Performance Analysis Tools:

1.  Rate earned on average total assets

Step 1:  Beg. Total Assets + End. Total Assets / 2 = Average Total Assets

Step 2:  Net Income after FITax / Ave Total Assets = Rate Earned on Total Assets

2.  Rate Earned on Average Stockholders' Equity

Step 1:  Beg. Stockholders' Equity + End Stockholders' Equity / 2 = Ave Stockholders' Equity

Step 2:  NIAT / Ave Stockholder's Equity = Rate Earned on Ave. Stockholders' Equity

3.  Rate Earned on Net Sales

NIAT / Net Sales = Rate Earned on Net Sales

4.  Earnings Per Share

NIAT / Shares of Capital Stock OUTSTANDING =  Earnings/Share

5.  Price-Earnings Ratio

Market Price/Share / Earnings Per Share = Price-Earning Ratio

This relationship shows the earnings per share and the market value per share of stock.  The market price of the share is determined largely by what investors think earnings will be for the company in the next year.

EFFICIENCY ANALYSIS:

Profitability and growth of a business are influenced by how efficiently assets are used.  The operating cycle of a merchandising business involves 1. purchasing merchandise, 2, selling merchandise, many times on account, 3, collecting accounts.  Much of  the assets are in accounts receivables and inventories thus the sooner you can turn these into cash the better off you are.

Two ratios are used to check efficiency:

1.  Accounts Receivable Turnover Ratio:

Step 1:  Beg. Book Value of Acct. Rec. + End. Book Value of Acct. Rec / 2 = Ave Book Value of Acct. Rec.

Step 2:  Net Sales on Account / Ave. Book Value of Acct Rec = Accts. Rec. Turnover Ratio.

Days in a year(365) / Accts. Rec. Ratio = Ave Number of Days for Payment

2.  Merchandise Inventory Turnover Ratio:

It is important to convert your inventory into cash.

Step 1:  Beg Merchandise Inv + End. Merchandise Inv / 2 = Ave. Merchandise Inv.

Step 2:  Cost of Merchandise Sold / Ave Merchandise Inv = Merchandise Inv Turnover Ratio

Days in a year(365) / Merchandise Inventory Turnover Ratio = Ave Number of Days in Merchandise Inventory.

An optimum merchandise inventory turnover ratio is determined by two factors---amount of sales and number of days needed to replace inventory.  It is important to always be able to fill orders while waiting for new inventory.

SHORT TERM FINANCIAL STRENGTH:

A successful business has needs sufficient capital:  Capital comes from owner's investments and retained earnings as well as loans.  Some capital is needed short-term, some capital is needed long-term.

There are three short term financial measures:

1.  Working Capital:

Total Current Assets - Total Current Liabilities = Working Capital

2.  Current Ratio:

Total Current Assets / Total Current Liabilities = Current Ratio

Usually this ratio falls between 2 and 3.

3.  Acid Test Ratio:

Quick Assets include cash, accounts receivable, and marketable securities.  This ratio is designed to show if a company could pay all current liabilities immediately.   This ratio should be right at 1.

Total Quick Assets(Cash+Accts. Rec.) / Total Current Liabilities = Acid Test Ratio.

LONG TERM FINANCIAL STRENGTH ANALYSIS:

Long Term Financial Strength requires a balance between stockholders' capital and borrowed capital.  Three measures to analyze long-term strength are:

1.  Debt Ratio:

Total Liabilities / Total Assets = Debt Ratio

2.  Equity Ratio:

Total Stockholders' Equity / Total Assets = Equity Ratio

3.  Equity Per Share:

Total Stockholders' Equity / Share of Capital Stock OUTSTANDING = Equity Per Share.

Assignments:

Joint Projects:  17-1, 17-2, 17-3, 17-4, 17-5, 17-6.

Individual Projects:  17-M, 17-C.  Case Studies 1 & 2.  Study Guide 17