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					Chapter 19 - Financial statement analysis
CHAPTER OVERVIEW
Financial statements are the primary means an outsider uses to evaluate a particular company. Once completed, the results can be compared with other companies. There are a variety of tools used to evaluate performance. In this chapter you are introduced to some of these techniques. The learning objectives for the chapter are to: 1. 2. 3. 4. 5. 6. Perform a horizontal analysis of comparative financial statements. Perform a vertical analysis of financial statements. Prepare common-size financial statements. Calculate the standard financial ratios used for decision-making. Use ratios in decision-making. Measure economic value added by a company’s operations.

CHAPTER REVIEW
Financial statement analysis is based on information taken from the annual report, reports lodged with the ASIC, articles in the business press, and so on. The objective of financial statement analysis is to provide information to creditors and investors to help them 1) predict future returns and 2) assess the risk of those returns. Past performance is often a good indicator of future performance. Three categories of financial statement analysis are horizontal, vertical, and ratio analysis.

Objective 1 - Perform a horizontal analysis of comparative financial statements.
The study of percentage changes in comparative statements is called horizontal analysis. Horizontal analysis highlights changes over time. Calculating a percentage change in comparative statements requires two steps: 1) calculate the dollar amount of the change from the base period to the later period, and 2) divide the dollar amount of the change by the base period amount. The base period for horizontal analysis is the year prior to the year being considered. Suppose there are three years of data. The change from Year 1 to Year 2 is: $ YEAR 2 - $ YEAR 1 $ YEAR 1 and the change from Year 2 to Year 3 is: $ YEAR 3 - $ YEAR 2 $ YEAR 2 No percentage changes are calculated if the base-year amount is zero or negative. Exhibits 19-1 and 19-2 illustrate horizontal analysis on a statement of financial performance and statement of financial position. Trend percentages are a form of horizontal analysis. They indicate the direction of business activities by comparing numbers over a span of several years. Trend percentages are calculated by selecting a base year and expressing the amount of each item for each of the following years as a percentage of the base year’s amount. That sounds complicated - what it means is you take, say, sales in year four and divide it by sales in year one and that shows sales in the fourth year as a percentage of sales of the first year. See the example on pages 775-776 of your textbook.

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Objective 2 - Perform a vertical analysis of financial statements.
Vertical analysis of a financial statement reveals the percentage of the total that each statement item represents. Percentages on the comparative statement of financial performance are calculated by dividing all amounts by net sales. Percentages on the comparative statement of financial position are shown as either 1) a percentage of total assets or 2) a percentage of total liabilities and shareholders’ equity. Vertical analysis of the statement of financial performance highlights changes in such items as the gross profit percentage and net profit. Vertical analysis of the statement of financial position shows the composition of statement of financial position items. Trend analysis can be used to highlight year-to-year percentage changes. (Review Exhibits 19-3 and 19-4 in your text.)

Objective 3 - Prepare common-size financial statements.
Common-size statements report amounts in percentages only. The common-size statement is a form of vertical analysis. On a common-size statement of financial performance, each item is expressed as a percentage of the net sales amount. In the statement of financial position, the common-size is the total on each side of the accounting equation. Note that common-size percentages are the same percentages shown on financial statements using vertical analysis. (Review Exhibit 19-5 in your text). Benchmarking is the practice of comparing a company to a standard set by other companies. Benchmarking is used to compare a company’s results with the average for their industry. In addition, common-size statements can be compared with those of specific competitors within the industry. Exhibit 19-6 in your text illustrates this use of benchmarking. Common-size percentages can be used to compare financial statements of different companies or to compare one company’s financial statements to previous years or industry averages.

Objective 4 - Calculate the standard financial ratios used for decision-making.
There are many, many different ratios used in financial analysis. Sometimes a ratio is used alone but more frequently a group of ratios is calculated and used to analyse a particular issue. The ratios discussed in this section are grouped as follows: 1. 2. 3. 4. 5. ratios that measure the company’s ability to pay current liabilities ratios that measure the company’s ability to sell inventory and collect receivables ratios that measure the company’s ability to pay long-term debt ratios that measure the company’s profitability; and ratios used to analyse the company’s shares as an investment.

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1. Ratios that measure the company’s ability to pay current liabilities Working capital is used to measure a business’s ability to meet its short-term obligations with its current assets. WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES The current ratio is used to measure the availability of sufficient current assets to maintain normal business operations. CURRENT RATIO = CURRENT ASSETS CURRENT LIABILITIES

The acid-test (or quick) ratio measures the ability of a business to pay all of its current liabilities if they came due immediately. CASH + SHORT-TERM + NET CURRENT INVESTMENTS RECEIVABLES CURRENT LIABILITIES

ACID-TEST RATIO

=

Study Tip: Inventory and prepaid expenses are not used to calculate the acid-test ratio. 2. Ratios that measure the company’s ability to sell inventory and collect receivables Inventory turnover is a measure of the number of times a company sells an average level of inventory during a year. INVENTORY TURNOVER = COST OF GOODS SOLD AVERAGE INVENTORY

AVERAGE INVENTORY

=

BEGINNING INVENTORY + ENDING INVENTORY 2

Accounts receivable turnover measures the ability of a company to collect cash from its credit customers. ACCOUNTS RECEIVABLE TURNOVER AVERAGE NET ACCOUNTS RECEIVABLE

=

NET CREDIT SALES AVERAGE NET ACCOUNTS RECEIVABLE

=

BEGINNING ENDING ACCOUNTS RECEIVABLE + ACCOUNTS RECEIVABLE 2

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Days’ sales in receivables measures in sales days the value of accounts receivable; it tells how many days’ sales remain uncollected (in accounts receivable). ONE DAY’S SALES DAYS’ SALES IN ACCOUNTS RECEIVABLE

=

NET SALES 365

=

AVERAGE NET ACCOUNTS RECEIVABLE ONE DAY’S SALES

To calculate the ratio for the beginning of the year, substitute beginning net Accounts Receivable for average net Accounts Receivable. To calculate the ratio for the end of the year, substitute ending net Accounts Receivable for average net Accounts Receivable. 3. Ratios that measure the company’s ability to pay long-term debt The debt ratio measures the relationship between total liabilities and total assets. DEBT RATIO = TOTAL LIABILITIES TOTAL ASSETS

The times-interest-earned ratio measures the ability of a business to pay interest expense. TIMESINTEREST-EARNED RATIO PROFITS BEFORE BOTH INCOME TAX AND INTEREST EXPENSE INTEREST EXPENSE

=

Remember that profits before income tax and interest expense is what profits would be if we paid no interest expenses or tax. 4. Ratios that measure the company’s profitability Rate of return on net sales measures the relationship between net profit and sales. RATE OF RETURN ON NET SALES

=

NET PROFIT NET SALES

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Rate of return on total assets measures the success a company has in using its assets to earn a profit. RATE OF RETURN ON TOTAL ASSETS NET PROFIT BEFORE BOTH INCOME TAX AND INTEREST EXPENSE AVERAGE TOTAL ASSETS

=

AVERAGE TOTAL ASSETS

=

BEGINNING TOTAL ASSETS + ENDING TOTAL ASSETS 2

The rate of return on ordinary shareholders’ equity shows the relationship between net profit and the ordinary shareholders’ investment in the company. RATE OF RETURN ON ORDINARY SHAREHOLDERS’ EQUITY

=

NET PROFIT - PREFERENCE DIVIDENDS AVERAGE ORDINARY SHAREHOLDERS’ EQUITY

AVERAGE ORDINARY SHAREHOLDERS’ EQUITY

= BEGINNING + ENDING ORDINARY SHAREHOLDERS’ EQUITY 2

Earnings per share (EPS) is the amount of net profit per share of the company’s ordinary share. EPS = NET PROFIT - PREFERENCE DIVIDENDS NUMBER OF SHARES OF ORDINARY SHARE ISSUED

Study Tip: Remember, if the number of shares issued has changed during the year, the denominator is changed to reflect the weighted average number of shares issued. 5. Ratios used to analyse the company’s shares as an investment The price/earnings (P/E) ratio is the ratio of the market price of an ordinary share to the company’s EPS. PRICE/ EARNINGS RATIO

=

MARKET PRICE PER SHARE OF ORDINARY SHARE EARNINGS PER SHARE

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Dividend yield is the ratio of dividends per share to the share’s market price per share. DIVIDENDS YIELD ON ORDINARY SHARES = DIVIDENDS PER ORDINARY SHARE MARKET PRICE PER ORDINARY SHARE

The formula for calculating book value per ordinary share is: BOOK VALUE PER ORDINARY SHARE = TOTAL SHAREHOLDERS’ EQUITY - PREFERENCE EQUITY NUMBER OF ORDINARY SHARES ISSUED

Objective 5 - Use ratios in decision-making.
Ratios should be 1) evaluated over a period of years, and 2) compared with industry standards. For example the inventory turnover of a florist would be very different to that of a bookshop. When a problem is found, the items used to calculate the ratio should be analysed to determine the nature of the problem. At that time, possible solutions to the problem can be suggested. Software packages are available to undertake financial statement analysis. Aspect Financial Pty Ltd www.aspectfinancial.com.au provides historical and current data and ratios on many listed companies. Data sorting can allow investors to select all companies with a particular characteristic or combination of characteristics, for example all companies with a P/E ratio of less than 8 and a dividend yield above 7%. In an efficient capital market, share prices reflect all information that is available to the public. Financial statement analysis helps to identify and evaluate the inherent risks in potential investments. Accounting manipulations may not fool investors on average, but this does not mean individuals may not be mislead, and fraudulent accounting is likely to mislead almost everyone - think Enron in the USA, HIH in Australia!

Objective 6 - Measure economic value added by a company’s operations.
Economic value added (EVA) is one measure many companies use to evaluate whether the company has increased shareholder wealth from operations. The formula for EVA is: Net profit + interest expense - capital charge Capital charge is bills payable plus loans payable plus long-term debt and shareholders’ equity all times the cost of capital. The cost of capital is the weighted average of the returns demanded by the company’s shareholders and lenders. Newer companies, because of the added risk, have a higher cost of capital compared with older, more established companies. The underlying assumption behind EVA is that returns to both shareholders and lenders should be greater than the company’s capital charge. If the calculation results in a positive value, the result indicates an increase in shareholder wealth. If negative, shareholders may consider selling the share that could lower the price of the share. Obviously, companies who use this measure strive to achieve a positive result.

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TEST YOURSELF
All the self-testing materials in this chapter focus on information and procedures that your instructor is likely to test in quizzes and examinations.

I. Matching
_____ 1. _____ 2. _____ 3. _____ 4. _____ 5. _____ 6. _____ 7. _____ 8. _____ 9. ____ 10. A. B. C. D. E. F. G. H. I. J. K. L. M. N. O. P. Q. R. S. T.

Match each numbered term with its lettered definition. _____ 11. _____ 12. _____ 13. _____ 14. _____ 15. _____ 16. _____ 17. _____ 18. _____ 19. _____ 20. current ratio debt ratio horizontal analysis price/earnings ratio return on net sales book value per ordinary share return on ordinary shareholders’ equity benchmarking cost of capital economic value added

days’ sales in receivables working capital common-size statements accounts receivable turnover dividend yield inventory turnover return on total assets times-interest-earned ratio efficient capital market acid-test ratio

it is assumed the share market reflects all publicly available information the practice of comparing a company with other companies with a view toward improvement current assets divided by current liabilities current assets minus current liabilities financial statements that report only percentages (no dollar amounts) measures the number of times that operating profit can cover interest expense measures the number of times a company sells its average level of inventory during a year ratio of the market price of an ordinary share to the company’s earnings per share measures the success a company has in using its assets to earn a profit net profit minus preference dividends, divided by average ordinary shareholders’ equity; a measure of profitability ratio of average net accounts receivable to one day’s sales ratio of dividends per share to the share’s market price per share ratio of net profit to net sales; a measure of profitability study of percentage changes in comparative financial statements tells the proportion of a company’s assets that it has financed with debt tells whether an entity could pay all its current liabilities if they came due immediately the ratio of net credit sales to average net accounts receivable; it measures ability to collect cash from credit customers used to measure if a company has increased shareholder wealth from operations ordinary shareholders’ equity divided by the number of ordinary share issued a weighted average of the returns demanded by the company’s shareholders and lenders

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II. Multiple Choice Circle the best answer.
1. Assume that a company’s current ratio is greater than one. If the company pays current liabilities with cash, the new current ratio: A. will increase B. will decrease C. will remain unchanged D. cannot be determined

2. Which of the following measures profitability? A. debt ratio B. current ratio C. dividend yield D. earnings per ordinary share

3. Which of the following current assets is not used to calculate the acid-test ratio? A. accounts receivable B. cash C. prepaid expenses D. short-term investments

4. Which of the following is a common measure of a firm’s ability to meet short-term obligations? A. working capital B. rate of return on sales C. net assets D. price/earnings ratio

5. The times-interest-earned ratio measures: A. profitability B. ability to pay interest expense on debt C. ability to pay current liabilities D. ability to collect receivables

6. The proportion of a firm’s assets financed by debt is measured by the: A. current ratio B. debt ratio C. debt yield ratio D. times-interest-earned ratio

7.

In vertical analysis the relationship between net profit and net sales is shown by the: A. profit from operations percentage B. net profit percentage C. rate of return on sales D. gross profit percentage

8. The dividend yield evaluates: A. the ability to pay current debt B. profitability C. share as an investment D. ability to pay long-term debt

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9. The excess of current assets less current liabilities is: A. a measure of profitability B. economic value added C. a measure of short-term liquidity D. a measure of long-term debt-paying ability

10. Book value measures: A. profitability B. short-term liquidity C. long-term debt-paying ability D. share as an investment

III. Completion Complete each of the following statements.
1. The study of percentage changes in comparative financial statements is called __________________ analysis. 2. Vertical analysis percentages on the statement of financial performance are calculated by dividing all amounts by _____________________________________________. 3. Vertical analysis percentages on the statement of financial position are calculated by dividing all amounts by ____________________________. 4. Working capital is ___________________________________________________________. 5. _____________________ and ______________________are the two most common measures of firm size. 6. Leverage ________________________ the risk to ordinary shareholders. 7. The ______________________ ratio indicates the market price of one dollar of earnings. 8. The rate of return on total assets equals _________________________________________ _. 9. The most widely quoted of all financial statistics is __________________________________. 10. The __________________________________________ is the recorded accounting value of each ordinary share issued.

IV. Daily Exercises
1. Net profit was $900,000 in Year 1, $1,200,000 in Year 2, and $960,000 in Year 3. What were the percentage changes in net profit?

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2. A company had 300,000 ordinary shares issued at the beginning of the year. On March 1, 200,000 additional shares were sold and on June 30, 150,000 shares were exchanged when bonds were converted. On November 1, the company bought back 110,020 ordinary shares. Net profit for the year was $1,570,000. Calculate earnings per share.

3. Refer to The Complex Corporation Consolidated Statement of Financial Performance in Demonstration Problem #1 and complete a vertical analysis. Amount Net sales Cost of products sold Selling, delivery, and administration Advertising Research and development Interest expense Other (revenue) expense, net Total costs and expenses Profits before income taxes Income Taxes Net Profits 4. Examine your results in Daily Exercise #3, and calculate Complex’s gross profit rate for 2005. %

5. Presented below are The Complex Corporation’s net sales (in thousands) and net earnings (in thousands) for the past five years. Calculate trend percentages. 2005 2,532,651 249,442 2004 2,217,843 222,092 2003 1,984,170 200,832 2002 1,836,949 212,057 2001 1,634,171 167,051

Net sales Net earnings

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V. Exercises
1. Pham Industries had the following information for 2004: Cost of goods sold Beginning inventory Ending inventory Net credit sales Beginning accounts receivable Ending accounts receivable a. What is inventory turnover? $800,000 60,000 30,000 1,450,000 85,000 75,000

b. What is the accounts receivable turnover?

c. What is the days’ sales in average receivable?

2. The following information is given for Ramirez Corporation for 2005: Net sales Net profit Average ordinary shareholders’ equity Average total assets Interest expense Preference dividends Ordinary dividends Ordinary shares issued a. What is the rate of return on net sales? 240,000 shares $900,000 60,000 1,575,000 1,956,521 75,000 20,000 55,000

b. What is the rate of return on total assets?

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c. What is the rate of return on ordinary shareholders’ equity?

3. The following information is given for Chan Limited: Assets: Cash Marketable securities Accounts receivable Inventory Equipment Total assets Liabilities and shareholders’ equity: Accounts payable Salary payable Long-term bonds payable Ordinary shares Retained earnings Total liabilities and shareholders’ equity a. What is the current ratio?

$ 60,000 118,000 214,000 141,000 420,000 $953,000

$105,000 17,000 165,000 200,000 466,000 $953,000

b. What is the acid-test (quick) ratio?

c. What is the debt ratio?

4. The Calvin Lauren Company has a price/earnings ratio of 19, dividends of $1.50 per share, and earnings per share of $1.28. a. What is the market price per share?

b. What is the dividend yield?

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VI. Beyond the Numbers
The operating cycle is the length of time between the purchase of inventory and its conversion to cash following the sale and receipt of payment (you were introduced to the operating cycle in Chapter 5). Using the information in Exercise 1 above, calculate the operating cycle for Pham Industries. ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ __________________ ______________________________________________________________________________ ______________________________________________________________________________ ______ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ ______________________________________________________________________________ _______________

VII. Demonstration Problems
Demonstration Problem #1 The Complex Company, headquartered in Perth, Western Australia, manufactures household products. Figures from its 2005 annual report (slightly modified for ease of presentation) follow: The Complex Company Consolidated Statement of Financial Performance For Year Ended June 30, 2005 (In thousands) Net sales Cost and expenses Cost of products sold Selling, delivery, and administration Advertising Research and development Interest expense Other (income) expense, net Total costs and expenses Profits before income taxes Income taxes $2,532,651

1,123,459 543,804 348,521 50,489 55,623 (5,260) 2,116,636 416,015 166,573 Financial statement 13

analysis

Net profits

$ 249,442

The Complex Company Consolidated Statement of Financial Position June 30, 2004 and June 30, 2005 (In thousands) 2005 2004 Assets Current assets: Cash and short-term investments Accounts receivable, less allowance Inventories Prepaid expenses Future income tax benefit Total current assets Property, plant, and equipment - net Brands, trademarks, patents and other intangibles - net Investment in affiliates Other assets Total assets

101,046 356,996 170,340 22,534 22,581 673,497 570,645 1,186,951 93,004 253,855 $2,777,952

90,828 315,106 138,848 18,076 10,987 573,845 551,437 704,669 99,033 249,910 $2,178,894

Liabilities and shareholders’ equity Current liabilities: Accounts payable Accrued liabilities Short-term debt Income tax payable Current maturity of long-term debt Total current liabilities Non-current liabilities Other obligations Deferred tax liability Total liabilities Shareholders’ equity Ordinary shares - issued: 110,844,594 shares Preference shares - issued 66,803,000 shares Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity

$ 143,360 358,785 369,973 17,049 3,551 892,718 565,926 112,539 170,723 1,741,906

$ 155,366 266,192 192,683 9,354 291 623,886 356,267 100,246 148,408 1,228,807

110,844 66,803 858,399 1,036,046 $2,777,952

110,844 66,803 772,440 950,087 $2,178,894

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Required: Assume annual dividends of $1.16 (for both preference and ordinary shares) and a market price of $19.83 per share. Calculate the following for 2005: a. working capital

b. current ratio

c. acid-test (quick) ratio

d. inventory turnover

e. accounts receivable turnover

f.

days’ sales in receivables

g. debt ratio

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h. times-interest-earned ratio

i.

rate of return on sales

j.

rate of return on total assets

k. rate of return on ordinary shareholders’ equity

l.

earnings per share

m. price/earnings ratio

n. dividend yield

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o. book value per ordinary share

Demonstration Problem #2 Celine Cidade’s statement of financial positions and statement of financial performances are presented below. Required: 1. Prepare a horizontal analysis for 2006 of the statement of financial position, using the 2005 amounts as the base. Celine Cidade Company Statement of Financial Position Years 2006 and 2005 Amount Increase (Decrease)

2006 Assets Current assets: Cash Short-term investments Receivables, net Inventories Prepaid expenses Total current assets Property, plant, and equipment - net Land Intangibles and other assets Total assets Liabilities and shareholders’ equity Current liabilities: Bills payable Current instalments of long-term debt Accounts payable-trade Accrued liabilities Total current liabilities Long-term debt, less current instalments Capital lease obligations, less current portion Deferred income and deferred income taxes Total ordinary shareholders’ equity Total liabilities and shareholders’ equity

2005

% Change

$ 13,300 8,200 26,000 45,000 2,500 95,000 185,680 40,000 2,400 $323,080

$ 20,350 8,000 24,000 40,000 4,650 97,000 196,500 35,000 2,400 $330,900

$ 10,000 3,550 14,447 3,670 31,667 95,500 1,100 4,813 190,000 $323,080

$ 10,500 3,445 18,500 1,605 34,050 93,330 2,150 4,370 197,000 $330,900

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2. Convert the 2005 and 2004 statement of financial performances to common-size statements, using net sales as the base figures. Celine Cidade Company Profit Statements Years 2006 and 2005 2006 Amount $416,500 2005 Amount $406,316

%

%

Net sales Cost and expenses: Cost of goods sold Operating expenses Total costs and expenses Profit from operations Interest expense Profits before income taxes Income taxes Net profit

322,593 41,219 363,812 52,688 3,251 49,437 7,437 $ 42,000

315,812 43,200 359,012 47,304 3,150 44,154 6,554 $ 37,600

SOLUTIONS I. Matching
1. 2. 3. 4. K D E Q 5. 6. 7. 8. L G I F 9. A 10. P 11. C 12. O 13. 14. 15. 16. N H M S 17. 18. 19. 20. J B T R

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II. Multiple Choice
1. A Let’s use a simple numerical example CA = $150 and CL = $100. Current ratio 150/100 = 1.5 If you pay off $50 of debt, CA = $100 and CL = $50; therefore Current ratio 100/50 = 2.0 Study Tip: In a firm with current assets greater than current liabilities, the current ratio can be improved by using cash to pay current liabilities. 2. D Debt ratio measures the ability to pay long-term debts. Current ratio measures ability to pay current liabilities. Dividend yield is used in analysing share as an investment. Only the most liquid current assets are used to calculate the acid-test ratio. Working capital is current assets less current liabilities. It measures a firm’s ability to meet short-term obligations.

3. 4.

C A

5.

B

Times-interest-earned measures how many times profit before interest and tax is greater than interest expense. Current ratio measures the ability to pay current liabilities. Debt yield ratio has no meaning. Times-interest-earned ratio measures ability to pay interest on debt. The debt ratio is total liabilities / total assets. The rate of return on sale is net profit / net sales. Dividend yield compares the amount of dividend per share with the current market price and therefore is one way to evaluate a share as a potential investment. Working capital (the excess of current assets over current liabilities) measures short-term liquidity. Book value indicates the value of each share of ordinary share issued and is one way to analyse a share investment.

6.

B

7. 8.

C C

9.

C

10.

D

III. Completion
1. 2. 3. 4. 5. 6. horizontal net sales total assets (or total liabilities plus shareholders’ equity) current assets minus current liabilities Net sales, total assets increases (Leverage or gearing is the practice of increasing the debt financing of an entity with respect to owner financing. Leverage is a two-edged sword, increasing profits (and returns to shareholders) during good times but compounding losses during bad times - increases risk.) price/earnings (net profit plus interest expense) / average total assets earnings per share book value per ordinary share

7. 8. 9. 10.

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IV. Daily Exercises
1. Year 2 = $300,000 / $900,000 = 33.33% Year 3 = ($240,000) / $1,200,000 = (20%)

2.

300,000  2/12 500,000  4/12 650,000  4/12 539,980  2/12

= = = =

50,000 166,667 216,667 89,997 523,331

$1,570,000  523,331 = $3.00)

Study Tip: When the number of issued shares has changed during the year, the denominator must reflect the weighted-average number of shares.

3. Net sales Cost of products sold Selling, delivery, and administration Advertising Research and development Interest expense Other (revenue) expense, net Total costs and expenses Profits before income taxes Income taxes Net profits Amount $2,532,651 1,123,459 543,804 348,521 50,489 55,623 (5,260) 2,116,636 416,015 166,573 $ 249,442 % 100% 44.4% 21.5% 13.8% 2.0% 2.2% (0.2%) 83.6% 16.4% 6.6% 9.8%

4. If cost of products sold is 44.4% of net sales, the gross profit (gross profit = net sales - cost of products sold) must be 55.6% (100% - 44.4%).

5. Net sales Net earnings 2005 155% 149% 2004 136% 133% 2003 121% 120% 2002 112% 127% 2001 100% 100%

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V. Exercises
1. a. Cost of goods / Average inventory = [$800,000 / ($30,000 + $60,000) / 2] = 17.78 b. Net credit sales / Average accounts receivable = [$1,450,000 / ($75,000 + $85,000) / 2] = 18.13 c. Average accounts receivable / One day’s sales = [($75,000 + $85,000) / 2] / ($1,450,000 / 365) = 20.15 days

2. a. Net profit / Net sales = $60,000 / $900,000 = 0.0666666666 = 6.67% b. (Net profit + Interest expense) / Average total assets = ($60,000 + $75,000) / $1,956,521 = 0.069 = 6.9% c. (Net profit - Preference dividends) / Average ordinary shareholders’ equity = ($60,000 - $20,000) / $1,575,000 = 0.02539 = 2.5%

3. a. Current assets / Current liabilities = ($60,000 + $118,000 + $214,000 + $141,000) / ($105,000 + $17,000) = 4.4 (rounded) b. (Cash + Short-term investments + Net current receivables) / Current liabilities = ($60,000 + $118,000 + $214,000) / ( $105,000 + $17,000) = 3.2 Study Tip: Remember only the assets that will convert to cash ‘quickly’ are called quick assets. Inventory does not do this. c. Total liabilities / Total assets = ($105,000 + $17,000 + $165,000) / $953,000 = 0.301 = 30.1%

4. a. Market price per ordinary share / Earnings per share = P / $1.28 = 19; P = $24.32 or $24 1/3. b. Dividends per ordinary share / Market price per share of ordinary share = $1.50 / $24.32 = 0.06 = 6%

VI. Beyond the Numbers
The operating cycle for Pham Industries is 81 days (rounded). Instruction (c) in the exercise asked you to calculate the days’ sales in average receivables. The correct figure was 40.3 days. Another way of characterising this result is to say that it takes approximately 40 days to collect an average account receivable. Instruction (a) asked you to calculate inventory turnover. The correct amount was 8.89 - in other words, inventory ‘turns’ slightly less than 9 times each year. Divide this result into 365 to convert it to days, or 41 days. In other words, on average it takes 41 days for an item to sell and 40 days on average to collect a receivable. Therefore, the operating cycle is 81 days.

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VII. Demonstration Problems
Demonstration Problem #1 Solved and Explained a. working capital = current assets - current liabilities = $673,497 - 892,718 = ($219,221) Study Tip: When current liabilities exceed current assets, the result is negative working capital. Negative working capital always exists when the current ratio is less than 1. b. current ratio = current assets  current liabilities = $673,497  $892,718 = 0.75 (rounded) quick assets  current liabilities ($101,046 + $356,996)  $892,718 = 0.51 (rounded)

c. acid-test (quick)

= =

This means Complex has 51 cents of quick assets (cash and short-term investment plus net accounts receivable) for every dollar of current liability.

d. inventory turnover = =

cost of goods sold / average inventory $1,123,459  [($138,848 + $170,340)  2] = 7.27 times

Complex ‘turns’ its inventory 7.27 times each year. Another way of stating this ratio is to convert it to days by dividing the ‘turn’ into 365. For Complex, the turnover averages 50 days (365  7.27). net credit sales  average accounts receivable $2,532,651  [($315,106 + $356,996)  2] = 7.54 times average net accounts receivable  one day’s sales $336,051  ($2,532,651  365) = 48.4 days

e. accounts receivable turnover

= =

f.

days’ sales in receivables

= =

The numerator for this ratio was the denominator for the previous ratio. total liabilities  total assets $1,741,906  $2,777,952 0.627 or 62.7%

g. debt ratio = = =

This means that 62.7% of the Complex assets were financed with debt. Notice the numerator (total liabilities) was not presented on the statement of financial position but had to be calculated by adding together total current liabilities, long-term debt, other obligations, and deferred income taxes.

h. times-interest-earned

= = =

profit before interest and tax / interest expense $471,638  $55,623 8.48 times

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Chapter 19

Note we used earnings before income taxes plus interest expense as the numerator because interest expense had already been deducted from the earnings before income taxes amount. net profit  net sales $249,442  $2,532,651 0.098 0r 9.8%

i.

rate of return on sales

= = =

j.

rate of return on total assets = (profit before interest and tax) / average total assets = $471,638  [($2,178,894 + $2,777,952)  2] = 0.1903 or 19 % This ratio measures the return on assets generated by this year’s operations. We use the same numerator as times-interest-earned.

k. rate of return on ordinary shareholders’ equity = (net profit - preference dividends)  average ordinary shareholders’ equity = ($249,442 - $77,491)  [($883,284 + $969,243)  2] = 0.186 or 18.6% Complex has preference share issued, so the numerator needs to deduct preference dividend ($1.16  66,803). Ordinary shareholders’ equity is total shareholders’ equity minus preference shareholders’ equity In 2005 this was $1,036,046 - $66,803. earnings per share = (net profit - preference dividends)  weighted average number of ordinary share issued = $171,951  110,844 = $1.55 (rounded)

l.

m. price/earnings ratio = market price per ordinary share  earnings per share = $19.83  $1.55 = 12.8% (rounded) dividend per ordinary share  market price of ordinary share $1.16  $19.83 0.05849 or 5.85%

n. dividend yield = = =

o. book value per ordinary share = (total shareholders’ equity - preference equity)  number of ordinary share issued = 969,243  110,844 = $8.74 per share As emphasised in your text, these ratios would have more meaning if you did them over consecutive years. In addition, to properly evaluate a company you would also want to compare the ratios with those of competitors and with the industry as a whole.

Financial statement analysis

23

Demonstration Problem #2 Solved and Explained Requirement 1 Celine Cidade Company Statement of Financial Position Years 2006 and 2005 Amount Increase (Decrease)

2006 Assets Current assets: Cash Short-term investments Receivables, net Inventories Prepaid expenses Total current assets Property, plant, and equipment - net Land Intangibles and other assets Liabilities and shareholders’ equity Current liabilities: Bills payable Current instalments of long-term debt Accounts payable-trade Accrued liabilities Total current liabilities Long-term debt, less current instalments Capital lease obligations, less current portion Deferred income and deferred income taxes Total ordinary shareholders’ equity

2005

% Change

$ 13,300 8,200 26,000 45,000 2,500 95,000 185,680 40,000 2,400 $323,080

$ 20,350 8,000 24,000 40,000 4,650 97,000 196,500 35,000 2,400 $330,900

$(7,050) 200 2,000 5,000 (2,150) (2,000) (10,820) 5,000 0 $(7,820)

(34.6) 2.5 8.3 12.5 (46.2) (2.1) (5.5) 14.3 0 (2.4)

$ 10,000 3,550 14,447 3,670 31,667 95,500 1,100 4,813 190,000 $323,080

$ 10,500 3,445 18,500 1,605 34,050 93,330 2,150 4,370 197,000 $330,900

$ (500) 105 (4,053) 2,065 (2,383) 2,170 (1,050) 443 (7,000) $(7,820)

(5.0) 3.0 (21.9) 128.7 (7.0) 2.3 (48.9) 10.1 (3.6) (2.4)

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Chapter 19

Requirement 2 Celine Cidade Company Statement of Financial Performances Years 2006 and 2005 2006 Amount $416,500 2005 Amount $406,316

Net sales Cost and expenses: Cost of goods sold Operating expenses

% 100.0

% 100.0

322,593 41,219 363,812 52,688 3,251 49,437 7,437 $42,000

77.5 9.9

315,812 43,200 359,012 47,304 3,150 44,154 6,554 $37,600

77.7 10.6

Profit from operations Interest expense Profits before income taxes Income taxes Net profit Points to remember:

12.7 0.8 11.9 1.8 10.1

11.6 0.8 10.8 1.6 9.3

1. When presenting horizontal analysis, each year’s change is divided by the base-year amount (in this case 2005) and converted to a percentage. While the change in any single item in any single year may not be significant, applying horizontal analysis over a number of years may highlight significant changes. 2. Common-size statements for a single year are meaningful only when the results are compared to other companies or industry data. However, common-size statements covering two or more years permit analysis of the particular company being examined. In this case, we see that 2006 results improved over 2005 due to lower cost of goods sold and lower operating expenses. 3. Financial ratios are mathematical formulas that quantify the relationship between two or more items reported in the financial statements. Ratios are used to assess and compare a firm’s liquidity, profitability, rate of return, and ability to meet debt obligations. Study Tip: One of the most common mistakes students make is forgetting to use the average amount of inventory, accounts receivable, or shares issued in some of the formulas. It is important that an average be used to reduce distortions that might occur if only year-end balances were used.

Financial statement analysis

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Description: Financial statements are the primary means an outsider uses to evaluate a particular company. Once completed, the results can be compared with other companies. There are a variety of tools used to evaluate performance. In this chapter you are introduced to some of these techniques. The learning objectives for the chapter are to: 1. Perform a horizontal analysis of comparative financial statements. 2. Perform a vertical analysis of financial statements. 3. Prepare common-size financial statements. 4. Calculate the standard financial ratios used for decision-making. 5. Use ratios in decision-making. 6. Measure economic value added by a company’s operations.