Financial Accounting Ratios PDF

Financial Accounting IFRS 4th Edition Weygandt Kimmel Kieso Chater 15 Financial Analysis: The Big Picture Chapter Outline Learning Objectives LO 1 Apply horizontal analysis and vertical analysis to financial statements. LO 2 Analyze a company’s performance us...

Financial Accounting IFRS 4th Edition Weygandt Kimmel Kieso Chater 15 Financial Analysis: The Big Picture Chapter Outline Learning Objectives LO 1 Apply horizontal analysis and vertical analysis to financial statements. LO 2 Analyze a company’s performance using ratio analysis. LO 3 Apply the concept of sustainable income. Copyright ©2019 John Wiley & Son, I 2 nc.  Basics of Financial Statement Analysis Need for Comparative Analysis Every item reported in a financial statement has significance. Various analytical techniques are used to evaluate the significance of financial statement data. LO 1 Copyright ©2019 John Wiley & Son, I 3 nc.  Basics of Financial Statement Analysis Characteristi Comparison Tools of cs Bases Analysis Liquidity Intracompa Horizontal Profitability ny Vertical Solvency Industry Ratio averages Intercompa ny LO 1 Copyright ©2019 John Wiley & Son, I 4 nc.  Learning Objective 2 Analyze a Company’s Performance Using Ratio Analysis LO 2 Copyright ©2019 John Wiley & Sons, I 5 nc.  Ratio Analysis Ratio analysis expresses the relationship among selected items of financial statement data. Liquidity Profitability Ratios Solvency Ratios Ratios Measure short- Measure the Measure the term ability of the income or ability of the company to pay operating success company to its maturing of a company for survive over a obligations and to a given period of long period of meet unexpected time. time. needs for cash. LO 2 Copyright ©2019 John Wiley & Son, I 6 nc.  Liquidity Ratios Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity. Ratios include the current ratio, the acid-test ratio, accounts receivable turnover, and inventory turnover. LO 2 Copyright ©2019 John Wiley & Son, I 7 nc.  Current Ratio Current Assets Current = Current Liabilities Ratio Quality Department Store 2020 2019 €1,020,000 €945,000 = 2.96:1 = 3.12:1 €344,500 €303,000 Industry average 1.70:1 The 2020 ratio of 2.96:1 means that for every euro of current liabilities, Quality has €2.96 of current assets. LO 2 Copyright ©2019 John Wiley & Son, I 8 nc. Acid-Test Ratio (1 of 2) Quality Department Store Statement of Financial Position (partial) 2020 2019 Current assets Prepaid expenses €50,000 €40,000 Inventory 620,000 500,000 Accounts receivable 230,000 180,000 (net*) Short-term 20,000 70,000 investments Cash 100,000 155,000 Total current assets €1,020,000 €945,000 *Allowance for doubtful accounts is €10,000 at the end of2 each year LO Copyright ©2019 John Wiley & Son, I nc. 9  Acid-Test Ratio (2 of 2) Cash + Short-Term Investments + Acid-Test Ratio = Receivables (net) Current Liabilities Quality Department Store 2020 2019 €100,000 + €20,000 + €155,000 + €70,000 + €230,000 = 1.02:1 €180,000 = 1.34:1 €344,500 €303,000 Industry average 0.70:1 The acid-test ratio measures immediate liquidity. LO 2 Copyright ©2019 John Wiley & Son, I 10 nc.  Statement of Financial Position (1 of 3) Quality Department Store Condensed Statements of Financial Position December 31 Increase or (Decrease) during 2020 2020 2019 Amoun Perce t nt Assets Intangible assets € € € (14.3 15,000 17,500 (2,500) %) Plant assets (net) 800,000 632,500 167,500 26.5% Current Assets 7.9% 1,020,000 945,000 75,000 Total assets €1,835,00 €1,595,00 € 15.0% 0 0 240,000 LO 1 Copyright ©2019 John Wiley & Son, I 11 nc.  Statement of Financial Position (2 of 3) Quality Department Store Condensed Statements of Financial Position December 31 Increase or (Decrease) during 2020 2020 2019 Amount Perce nt Equity Share capital—ordinary, €1 € € 270,000 € 5,400 2.0% par 275,400 Retained earnings 525,000 202,600 38.6% 727,600 Total equity 1,003,000 795,000 208,000 26.2% Liabilities Non-current liabilities € € 497,000 € (9,500) (1.9%) 487,500 Current liabilities 303,000 41,500 13.7% LO 1 Copyright ©2019 John Wiley & Son, I 12 nc. 344,500  Income Statement Quality Department Store Condensed Income Statements For the Years Ended December 31 Increase or (Decrease) during 2020 Overall, gross 2020 2019 Amount Perce profit and net nt income were Sales revenue € € € 12.0% 2,195,000 1,960,000 235,000 up Sales returns and 123,000 (25,000) (20.3%) substantially. allowances 98,000 Gross profit Net sales 2,097,000 1,837,000 260,000 14.2% increased Cost of goods sold 1,140,000 12.4% 17.1%, and net 1,281,000 141,000 income, Gross profit 697,000 119,000 17.1% 26.5%. 816,000 Quality’s profit Selling expenses 253,000 211,500 41,500 19.6% trend appears Administrative expenses 108,500 (4,500) (4.1%) 104,000 favorable. Total operating 320,000 11.6% expenses 357,000 37,000 Income from operations 459,000 377,000 21.8% 82,000 Other income and expense LO 1 Copyright ©2019 John Wiley & Son, I 13 Interest and 9,000nc. 11,000 (2,000) (18.2%)  Retained Earnings Statement Quality Department Store Retained Earnings Statements For the Years Ended December 31 Increase or (Decrease) during 2020 2020 2019 Amount Perce nt Retained earnings, Jan. 1 € 525,000 € 376,500 € 148,500 39.4% Add: Net income 263,800 208,500 55,300 26.5% 585,000 203,800 788,800 Deduct Dividends 61,200 60,000 1,200 2.0% Retained In Earnings, Dec. the horizontal 31 analysis €of 727,600 €,525,000 the statement € 202,600 of financial 38.6% position the ending retained earnings increased 38.6%. As indicated earlier, the company retained a significant portion of net income to finance additional plant facilities. LO 1 Copyright ©2019 John Wiley & Son, I 14 nc.  Accounts Receivable Turnover (1 of 2) Net Credit Sales Accounts Receivable = Average Net Accounts Turnover Receivable Quality Department Store 2020 2019 €2,097,000 €1,837,000 €180,000 + = 10.2 times €200,000 + = 9.7 times €230,000 €180,000 2 2 Industry average 46.4 times Measures the number of times, on average, the company collects receivables during the period. LO 2 Copyright ©2019 John Wiley & Son, I 15 nc.  Accounts Receivable Turnover (2 of 2) €2,097,000 Accounts Receivable Turnover €180,000 + = 10.2 times €230,000 ÷ 2 A variant of the Accounts Receivable Turnover ratio is to convert it to an average collection period in terms of days. 365 days ÷ 10.2 times = 35.78 days Receivables are collected, on average, every 36 days. LO 2 Copyright ©2019 John Wiley & Son, I 16 nc.  Inventory Turnover (1 of 2) Cost of Goods Sold Inventory Turnover = Average Inventory Quality Department Store 2020 2019 €1,281,000 €1,140,000 €500,000 + = 2.3 times €450,000 + = 2.4 times €620,000 €500,000 2 2 Industry average 4.3 times Measures the number of times, on average, inventory is sold during the period. LO 2 Copyright ©2019 John Wiley & Son, I 17 nc.  Inventory Turnover (2 of 2) €1,281,000 Inventory Turnover €500,000 + = 2.3 times €620,000 ÷ 2 A variant of the Inventory Turnover ratio is the Days in Inventory. 365 days ÷ 2.3 times = every 159 days Inventory turnover ratios vary considerable among industries. LO 2 Copyright ©2019 John Wiley & Son, I 18 nc.  Profitability Ratios Measure the income or operating success of a company for a given period of time. Income, or the lack of it, affects the company’s ability to obtain debt and equity financing, liquidity position, and the ability to grow. Ratios include the profit margin, asset turnover, return on assets, return on ordinary shareholders’ equity, earnings per share, price-earnings, and payout ratio. LO 2 Copyright ©2019 John Wiley & Son, I 19 nc.  Profit Margin Net Income Profit Margin = Net Sales Quality Department Store 2020 2019 €263,800 €208,500 = 12.6% = 11.4% €2,097,000 €1,837,000 Industry average 8.0% Measures the percentage of each dollar of sales that results in net income. LO 2 Copyright ©2019 John Wiley & Son, I 20 nc.  Asset Turnover Net Sales Asset = Average Turnover Assets Quality Department Store 2020 2019 €2,097,000 €1,837,000 €1,595,000 + = 1.2 times €1,446,000 + = 1.2 times €1,835,000 €1,595,000 2 2 Industry average 1.4 times Measures how efficiently a company uses its assets to generate sales. LO 2 Copyright ©2019 John Wiley & Son, I 21 nc.  Return on Assets Net Income Return on Assets = Average Assets Quality Department Store 2020 2019 €263,800 €208,500 €1,595,000 + = 15.4% €1,446,000 + = 13.7% €1,835,000 €1,595,000 2 2 Industry average 8.9% An overall measure of profitability. LO 2 Copyright ©2019 John Wiley & Son, I 22 nc.  Return on Ordinary Shareholders’ Equity Net Income − Preference Return on Ordinary Dividends = Shareholders’ Equity Average Ordinary Shareholders’ Quality Department Store Equity 2020 2019 €263,800 − €0 €208,500 − €0 €795,000 + = 29.3% €667,000 + = 28.5% €1,003,000 €795,000 2 2 Industry average 18.3% Shows how many euros of net income the company earned for each euro invested by the owners. LO 2 Copyright ©2019 John Wiley & Son, I 23 nc.  Earnings per Share (EPS) Net Income − Preference Earnings per Dividends = Share Weighted-Average Ordinary Shares Outstanding Quality Department Store 2020 2019 €263,800 − €0 €208,500 − €0 270,000 + 275,400 = €0.97 270,000 = €0.77 2 A measure of the net income earned on each ordinary share. LO 2 Copyright ©2019 John Wiley & Son, I 24 nc.  Price-Earnings Ratio Market Price per Price-Earnings Ratio = Share Earnings per Share Quality Department Store 2020 2019 €12.00 12.4 €8.00 10.4 = = €0.97 times €0.77 times Industry average 21.3 times Reflects investors’ assessments of a company’s future earnings. LO 2 Copyright ©2019 John Wiley & Son, I 25 nc.  Payout Ratio Cash Dividends Declared on Payout Ratio = Ordinary Shares Net Income Quality Department Store 2020 2019 €61,200 €60,000 = 23.2% = 28.8% €263,800 €208,500 Industry average 16.1% Measures the percentage of earnings distributed in the form of cash dividends. LO 2 Copyright ©2019 John Wiley & Son, I 26 nc.  Solvency Ratios Solvency ratios measure the ability of a company to survive over a long period of time. Debt to Total Assets and Times Interest Earned are two ratios that provide information about debt-paying ability. LO 2 Copyright ©2019 John Wiley & Son, I 27 nc.  Debt to Assets Ratio Debt to Assets Total Liabilities = Ratio Total Assets Quality Department Store 2020 2019 €832,000 €800,000 = 45.3% = 50.2% €1,835,000 €1,595,000 Industry average 34.2% Measures the percentage of the total assets that creditors provide. LO 2 Copyright ©2019 John Wiley & Son, I 28 nc.  Times Interest Earned Net Income + Interest Expense + Times Income Tax Expense Interest = Interest Expense Earned Quality Department Store 2020 2019 €263,800 + €36,000 + €208,500 + €40,500 + €168,200 13 €139,000 9.6 = = times times €36,000 €40,500 Industry average 16.1 times Provides an indication of the company’s ability to meet interest payments as they come due. LO 2 Copyright ©2019 John Wiley & Son, I 29 nc.  Summary of Ratios (1 of 3) LO 2 Copyright ©2019 John Wiley & Son, I 30 nc.  Summary of Ratios (2 of 3) LO 2 Copyright ©2019 John Wiley & Son, I 31 nc.  Summary of Ratios (3 of 3) LO 2 Copyright ©2019 John Wiley & Son, I 32 nc.  DO IT! 2: Ratio Analysis (1 of 6) The condensed financial statements of John Cully Group, for the years ended June 30, 2020 and 2019 are presented below. John Cully Group Income Statements For the Year Ended June 30 (in thousands) 2020 2019 Sales revenue €6,336.3 €5,790.4 Costs and expenses Cost of goods sold 1,617.4 1,476.3 Selling and administrative 4,007.6 3,679.0 expenses Interest expense 13.9 27.1 Total costs and expenses 5,638.9 5,182.4 Income before income taxes 697.4 608.0 Income tax expense 291.3 232.6 Net income €406.1 €375.4 LO 2 Copyright ©2019 John Wiley & Son, I 33 nc.  DO IT! 2: Ratio Analysis (2 of 6) John Cully Group Statements of Financial Position June 30 (in thousands) Assets 2020 2019 Intangibles and other assets €876.7 €849.3 Property, plant, and 694.2 647.0 equipment (net) Investments 12.3 12.6 Current assets Prepaid expenses and €204.4 €269.2 other current assets Inventory 768.3 653.5 Accounts receivable (net) 776.6 664.9 Cash 553.3 611.6 2,199.2 2302.6 Total assets €3,708.1 LO 2 €3,885. Copyright ©2019 John Wiley & Son, I 34 nc. 8  DO IT! 2: Ratio Analysis (3 of 6) John Cully Group Statements of Financial Position June 30 Equity and Liabilities 2020 2019 Shareholders’ equity— €1,708.6 €1,749.0 ordinary Non-current liabilities 679.5 637.1 Current liabilities 1,497.7 1,322.0 Total equity and €3,885.8 €3,708.1 liabilities LO 2 Copyright ©2019 John Wiley & Son, I 35 nc.  DO IT! 2: Ratio Analysis (4 of 6) Compute the following ratios for 2020 and 2019. a. Current ratio b. Inventory turnover. (Inventory on 6/30/18 was €599.0). c. Profit margin. d. Return on assets. (Assets on 6/30/18 were €3,349.9.) e. Return on ordinary shareholders’ equity. (Equity on 6/30/18 was €1,795.9.) f. Debt to assets ratio. g. Times interest earned. LO 2 Copyright ©2019 John Wiley & Son, I 36 nc.