Financial Statement Analysis - Chapter 14 PDF

1 Click to edit Master title style 1 Financial 5 Statement Analysis 1  2 Click to edit...

1 Click to edit Master title style 1 Financial 5 Statement Analysis 1  2 Click to edit Master title style After studying this chapter, you should be able to: 1. List basic financial statement analytical procedures. 2. Apply financial statement analysis to assess the solvency of a business. 3. Apply financial statement analysis to stress the profitability of a business. 4. Describe the contents of corporate annual reports. 2  3 Click to edit Master title style 15- 1 Objective Objective 11 List basic financial statement analytical procedures. 3  4 Click to edit Master title style Horizontal Analysis 15- 1 The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis. 4  5 Click to edit Master title style Exhibit 1 Comparative Balance Sheets Lincoln Company 15- 1 Comparative Balance Sheet December 31, 2008 and 2007 Increase (Decrease) 2008 2007 Amount Percent Assets Current assets $ 550,000 $ 533,000 $ 17,000 3.2% Long-term investments 95,000 177,500 (82,500) (46.5%) Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%) Intangible assets 50,000 50,000 Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%) Liabilities Current liabilities $ 210,000 $ 243,000 $ (33,000) (13.6%) Long-term liabilities 100,000 200,000 100,000) (50.0%) Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%) Stockholders’ Equity Preferred 6% stock, $100 par $ 150,000 $ 150,000 — Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500 $ 42,000 30.5% Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3% 55 Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%)  6 Click to edit Master title style Lincoln Company 15- 1 Comparative Balance Sheet December 31, 2008 and 2007 Increase (Decrease) 2008 2007 Amount Percent Assets Current assets $ 550,000 $ 533,000 $ 17,000 3.2% Long-term investments 95,000 177,500 (82,500) (46.5%) Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%) Intangible assets Horizontal 50,000 Analysis: 50,000 Total assets $1,139,500 $1,230,500 $ (91,000) (7.4%) Liabilities Difference $17,000 Current liabilities $ 210,000 $ 243,000 $ (33,000) = 3.2% (13.6%) Long-term liabilities Base year 100,000(2007) $533,000 200,000 100,000) (50.0%) Total liabilities $ 310,000 $ 443,000 $(133,000) (30.0%) Stockholders’ Equity Preferred 6% stock, $100 par $ 150,000 $ 150,000 — Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500 $ 42,000 30.5% Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3% 66 Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%)  7 Click to edit Master title style Lincoln Company 15- 1 Comparative Balance Sheet December 31, 2008 and 2007 Increase (Decrease) 2008 2007 Amount Percent Assets Current assets $ 550,000 $ 533,000 $ 17,000 3.2% Long-term investments 95,000 177,500 (82,500) (46.5%) Prop., plant, and equip. (net) 444,500 470,000 (25,500) (5.4%) Intangible assets 50,000 50,000 Total assets Horizontal Analysis: $1,139,500 $1,230,500 $ (91,000) (7.4%) Liabilities Current liabilities Difference $ 210,000 $(82,500) $ 243,000 $ (33,000) (13.6%) Long-term liabilities 100,000 200,000 = 100,000) (46.5%) (50.0%) Total liabilities Base year (2007)$ 443,000 $ 310,000 $177,500 $(133,000) (30.0%) Stockholders’ Equity Preferred 6% stock, $100 par $ 150,000 $ 150,000 — Common stock, $10 par 500,000 500,000 — Retained earnings 179,500 137,500 $ 42,000 30.5% Total stockholders’ equity $ 829,500 $ 787,500 $ 42,000 5.3% 77 Total liab. & stockholders’ eq. $1,139,500 $1,230,500 $ (91,000) (7.4%)  8 Click to edit Master title style Comparative Schedule of Current Assets 15- 1 Lincoln Company Comparative Schedule of Current Assets December 31, 2008 and 2007 Increase (Decrease) 2008 2007 Amount Percent Cash $ 90,500 $ 64,700 $ 25,800 39.9% Marketable securities 75,000 60,000 15,000 25.0% Accounts receivable (net) 115,000 120,000 (5,000) (4.2%) Inventories 264,000 283,000 (19,000) (6.7%) Prepaid expenses 5,500 5,300 200 3.8% Total current assets $550,000 $533,000 $17,000 3.2% 88  9 Click to edit Master title style 15- 1 Lincoln Company Comparative Schedule of Current Assets December 31, 2008 and 2007 Increase (Decrease) 2008 2007 Amount Percent Cash $ 90,500 $ 64,700 $ 25,800 39.9% Marketable securities 75,000 60,000 15,000 25.0% Accounts receivable (net)Horizontal 115,000 Analysis: 120,000 (5,000) (4.2%) Inventories 264,000 283,000 (19,000) (6.7%) Prepaid expenses Difference 5,500 5,300 $25,800 200 3.8% Total current assets $550,000 $533,000 $17,000 = 39.9%3.2% Base year (2007) $64,700 99 9  10 Click to edit Master title style Comparative Income Statement Lincoln Company 15- 1 Comparative Income Statement For the Year Ended December 31, 2008 and 2007 Increase (Decrease) 2008 2007 Amount Percent Sales $1,530,500 $1,234,000 $296,500 24.0% Sales returns and allowances 32,500 34,000 (1,500) (4.4%) Net sales $1,498,000 $1,200,000 $298,000 24.8% Cost of goods sold 1,043,000 820,000 223,000 27.2% Gross profit $ 455,000 $ 380,000 $ 75,000 19.7% Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9% Administrative expenses 104,000 97,400 6,600 6.8% Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7% Income from operations $ 160,000 $ 135,600 $ 24,400 18.0% Other income 8,500 11,000 (2,500) (22.7%) $ 168,500 $ 146,600 $ 21,900 14.9% Other expense (interest) 6,000 12,000 (6,000) (50.0%) Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7% Income tax expense 71,500 58,100 13,400 23.1% 1010 Net income $ 91,000 $ 76,500 $ 14,500 19.0%  11 Click to edit Master title style Lincoln Company 15- 1 Comparative Income Statement For the Year Ended December 31, 2008 and 2007 Increase (Decrease) 2008 2007 Amount Percent Current assets $1,530,500 $1,234,000 $296,500 24.0% Sales returns and allowances 32,500 34,000 (1,500) (4.4%) Net sales $1,498,000 $1,200,000 $298,000 24.8% Cost of goods sold 1,043,000 820,000 223,000 27.2% Gross profit $ 455,000 $ 380,000 $ 75,000 19.7% Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9% Administrative expensesHorizontal104,000 Analysis: 97,400 6,600 6,.8% Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7% Income from operations Increase amount$ 135,600 $ 160,000 $296,500$ 24,400 18.0% Other income 8,500 11,000 = 24.0%(22.7%) (2,500) Base year (2007)$$1,234,000 $ 168,500 146,600 $ 21,900 14.9% Other expense (interest) 6,000 12,000 (6,000) (50.0%) Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7% Income tax expense 71,500 58,100 13,400 23.1% 1111 Net income $ 91,000 $ 76,500 $ 14,500 19.0%  12 Comparative Retained Click to edit Master title style Earnings Statement 15- 1 Lincoln Company Comparative Retained Earnings Statement December 31, 2008 and 2007 A percentage analysis that Increase (Decrease) shows the relationship 2008 2007 ofAmount each Percent component Net income for year to the 91,000 total 76,500 within Retained earnings, Jan. 1 $137,500 $100,000 $37,500 14,500 37.5% 19.0% Total a single statement is called $228,500 $176,500 $52,000 29.5%) Dividends: On preferred stock vertical analysis. $ 9,000 $ 9,000 — On common stock 40,000 30,000 10,000 33.3% Total $ 49,000 $ 39,000 $10,000 25.6% Total current assets $179,500 $137,500 $42,000 30.5% 12 12  13 Click to edit Master title style 15- 1 Lincoln Company Comparative Retained Earnings Statement December 31, 2008 and 2007 A percentage analysis that Increase (Decrease) shows the relationship 2008 2007 ofAmount each Percent component Net income for year to the 91,000 total 76,500 within Retained earnings, Jan. 1 $137,500 $100,000 $37,500 14,500 37.5% 19.0% Total a single statement is called $228,500 $176,500 $52,000 29.5%) Dividends: On preferred stock vertical analysis. $ 9,000 $ 9,000 — Horizontal Analysis: On common stock 40,000 30,000 10,000 33.3% Total $ 49,000 Increase amount$ 39,000 $10,000 $37,500 25.6% Total current assets $179,500 $137,500 $42,000 = 37.5% 30.5% Base year (2007) $100,000 13 13  14 15- 1 Click to edit Master title style Example Exercise 15-1 The comparative cash and accounts receivable for a company are provided below: 2008 2007 Cash $62,500 $50,000 Accounts receivable (net) 74,400 80,000 Based on this information, what is the amount and percentage of increase or decrease that would be shown in a balance sheet with horizontal analysis? 14 14  15 15- 1 Click to edit Master title style Follow My Example 15-1 Cash $12,500 increase ($62,500 – $50,000), or 25% Accounts Receivable $5,600 decrease ($74,400 – $80,000) or –7% 15 15 For Practice: PE 15-1A, PE 15-1B  16 Click to edit Master title style Vertical Analysis 15- 1 A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis. 16  17 Click to edit Master title style Vertical Analysis of Balance Sheet 15- 1 In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders’ equity item is stated as a percent of the total liabilities and stockholders’ equity. 17  18 Click to edit Master title style Lincoln Company Comparative Balance Sheet 15- 1 For the Years Ended December 31, 2008 and 2007 2008 2007 Amount Percent Amount Percent Assets Current assets $ 550,00048.3%$ 533,000 43.3% Long-term investments 95,0008.3177,500 14.4 Property, plant, & equip. (net) 444,50039.0470,000 38.2 Intangible assets 50,0004.4 50,000 4.1 Total assets $1,139,500 100.0%$1,230,500 100.0% Total assets $1,139,500 100.0% $1,230,500100.0% Liabilities Current liabilities $ 210,00018.4%$ 243,000 19.7% Long-term liabilities 100,0008.8 200,000 16.3 Total liabilities $ 310,00027.2%$ 443,000 36.0% Stockholders’ Equity Preferred 6% stock, $100 par $ 150,00013.2%$ 150,000 12.2% 2.2% Common stock, $10 par 500,00043.9500,000 40.6 Retained earnings 179,50015.7 137,500 11.2 Total stockholders’ equity $ 829,50072.8%$ 787,500 64.0% Total liab. & Stockholders’ equity $1,139,500100.0% $1,230,500 100.0% 18 18 Total liab. & stockholders’ equity $1,139,500 100.0% $1,230,500100.0%  19 Click to edit Master title style 15- 1 To demonstrate how vertical analysis percentages are calculated for the balance sheet, let’s see how the 48.3 percent was calculated for the 2008 current assets in the next slide. 19  20 Click to edit Master title style Lincoln Company Comparative Balance Sheet 15- 1 For the Years Ended December 31, 2008 and 2007 2008 2007 Amount Percent Amount Percent Assets Current assets $ 550,00048.3%$ 533,000 43.3% Long-term investments 95,0008.3177,500 14.4 Property, plant, & equip. (net) 444,50039.0470,000 38.2 Intangible assets 50,0004.4 50,000 4.1 Total assets $1,139,500 100.0%$1,230,500 100.0% TotalLiabilities assets $1,139,500 100.0% $1,230,500100.0% Current liabilities $ 210,00018.4%$ 243,000 19.7% Long-term liabilities 100,0008.8 200,000 16.3 Total liabilities $ 310,00027.2%$ 443,000 36.0% Stockholders’ Equity Vertical Analysis: Preferred 6% stock, $100 par $ 150,00013.2%$ 150,000 1 2.2% Common stock, $10 par 500,00043.9500,000 40.6 Current assets Retained earnings $550,000 179,50015.7 137,500 11.2 Total stockholders’ equity = 48.3% $ 829,50072.8%$ 787,500 64.0% Total assets $1,139,500 Total liab. & Stockholders’ equity $1,139,500100.0% $1,230,500 100.0% 20 20 Total liab. & stockholders’ equity $1,139,500 100.0% $1,230,500100.0%  21 Click to edit Master title style Vertical Analysis of Income Statement 15- 1 In a vertical analysis of the income statement, each item is stated as a percent of net sales. As an example, let’s see how the percent of 12.8% was calculated for 2008 selling expenses. 21  22 Click to edit Master title style Lincoln Company 15- Comparative Income Statement For the Years Ended December 31, 2008 and 2007 1 2008 2007 Amount Percent Amount Percent Sales $1,530,500 102.2% $1,234,000 102.8% Sales returns and allow. 32,500 2.2 34,000 2.8 Net sales $1,498,000 100.0% $1,200,000 100.0% Cost of goods sold 1,043,000 69.6 820,000 68.3 Gross profit $ 455,000 30.4% $ 380,000 31.7% Selling expenses $ 191,000 12.8% $ 147,000 12.3% Administrative expenses 104,000 6.9 97,400 8.1 Total operating expenses $ 295,000 19.7% $ 244,400 20.4% Income from operations $ 160,000 10.7 $ 135,600 11.3% Other income 8,500 0.6 11,000 0.9 $ 168,500 11.3% $ 146,600 12.2% Other expense (interest) 6,000 0.4 12,000 1.0 Income before income tax $ 162,500 10.9% $ 134,600 11.2% Income tax expense 71,500 4.8 58,100 4.8 Net income $ 91,000 6.1% $ 76,500 6.4% 22 22 Comparative Income Statement  23 Click to edit Master title style Lincoln Company 15- Comparative Income Statement For the Years Ended December 31, 2008 and 2007 1 2008 2007 Amount Percent Amount Percent Sales $1,530,500 102.2% $1,234,000 102.8% Sales returns and allow. 32,500 2.2 34,000 2.8 Net sales $1,498,000 100.0% $1,200,000 100.0% Cost of goods sold 1,043,000 69.6 820,000 68.3 Gross profit $ 455,000 30.4% $ 380,000 31.7% Selling expenses $ 191,000 12.8% $ 147,000 12.3% Administrative expenses 104,000 6.9 97,400 8.1 Total operating expenses $ 295,000 19.7% $ 244,400 20.4% Income from operations $ 160,000 10.7 $ 135,600 11.3% Other income 8,500 0.6 11,000 0.9 $ 168,500 11.3% $ 146,600 12.2% Vertical Analysis: Other expense (interest) 6,000 0.4 12,000 1.0 Income before income tax $ 162,500 10.9% $ 134,600 11.2% Selling expenses Income tax expense $191,000 71,500 4.8 58,100 4.8 Net income $ 91,000 =6.1% 12.8%$ 76,500 6.4% Net sales $1,498,000 23 23  24 Click to edit Master title style Common-Size Statements 15- 1 In a common-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with with industry percentages. 24  25 Click Statement to edit Master title style Common-Size Income 15- 1 25 25  26 15- 1 Click to edit Master title style Example Exercise 15-2 Income statement information for Lee Corporation is provided below: Lee Corporation Sales $100,000 Cost of goods sold Prepare a vertical analysis of the income statement for Lee Corporation. 65,000 Gross profit 26 26 $ 35,000  27 15- 1 Click to edit Master title style Follow My Example 15-2 Amount Percentage Sales $100,000 100% ($100,000/$100,000) Cost of goods sold 65,000 65 ($65,000/$100,000) Gross profit 35,000 35% ($35,000/$100,000) 27 27 For Practice: PE 15-2A, PE 15-2B  28 Click to edit Master title style 15- 2 Objective Objective 22 Apply financial statement analysis to assess the solvency of a business. 28  29 Click to edit Master title style Solvency Analysis 15- 2 The ability of a business to meet its financial obligations (debts) is called solvency. The ability of a business to earn income is called profitability. 29  30 Click to edit Master title style Current Position Analysis 15- 2 Using measures to assess a business’s ability to pay its current liabilities is called current position analysis. Such analysis is of special interest to short-term creditors. 30  31 Click to edit Master title style Working Capital 15- 2 The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a company’s ability to meet currently maturing debts. 31  32 Click to edit Master title style 15- 2 Lincoln Company Current asset: Cash $ 90,500 Marketable securities 75,000 Accounts receivable (net) 115,000 Inventories 264,000 Prepaid expenses 5,500 a. Total current Working assets capital (a – b) $550,000 $340,000 b. Current liabilities 210,000 32 32  33 Click to edit Master title style Current Ratio 15- 2 The current ratio, sometimes called the working capital ratio or bankers’ ratio, is computed by dividing the total current assets by the total current liabilities. 33  34 Click to edit Master title style 15- 2 Lincoln Company 2008 2007 a. Current assets $550,000 $533,000 b. Current liabilities 210,000 243,000 Working capital (a – b) $340,000 $290,000 Current ratio (a/b) 2.6 2.2 34 34  35 Click to edit Master title style Quick Ratio 15- 2 A ratio that measures the “instant’ debt-paying ability of a company is called the quick ratio or acid-test ratio. 35  36 Click to edit Master title style assetsare arecash Quick Quickassets cash 15- and andother othercurrent currentassets assets 2 that thatcan canbe bequickly quickly converted cash.. convertedtotocash Lincoln Company 2008 2007 Quick assets: Cash $ 90,500 $ 64,700 Marketable securities 75,000 60,000 Accounts receivable (net) 115,000 120,000 a. Total quick assets $280,500 $244,700 b. Current liabilities $210,000 $243,000 Quick ratio (a/b) 1.3 1.0 36 36  37 15- 2 Click to edit Master title style Example Exercise 15-3 The following items are reported on a company’s balance sheet: Cash $300,000 Marketable securities 100,000 Determine (a) the current ratio and (b) the quick ratio. Accounts receivable (net) 37 37 200,000 Inventory  38 15- 2 Click to edit Follow My Example 15-3 Master title style a. Current Ratio = Current Assets/Current Liabilities Current Ratio = ($300,000 + $100,000 + $200,000 + $200,000)/$400,000 Current Ratio = 2.0 b. Quick Ratio = Quick Assets (cash, marketable securities, and accounts receivable)/Current Liabilities (accounts payable) Quick Ratio = ($300,000 + $100,000 + $200,000)/$400,000 Quick Ratio = 1.5 38 38 For Practice: PE 15-3A, PE 15-3B  39 Click to edit Master title style Accounts Receivable Turnover 15- 2 The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. The ratio is to assess the efficiency of the firm in collecting receivables and in the managing of credit. 39  40 Click to edit Master title style 15- 2 Lincoln Company 2008 2007 a. Net sales $1,498,000 $1,200,000 Accounts receivable (net): Beginning of year $ 120,000 $ 140,000 End of year 115,500 120,000 Accounts Total receivable $ 235,000turnover $ 260,000 (a/b) 12.7 9.2 b. Average (Total/2) $ 117,500 $ 130,000 40 40  41 Click to edit Master title style Number of Days’ Sales in Receivables 15- 2 The number of days’ sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. Comparing this measure with the credit terms provides information on the efficiency in collecting receivables. 41  42 Click to edit Master Lincoln Companytitle style 15- 2 2008 2007 a. Average (Total/2) $ 117,500 $ 130,000 Net sales $1,498,000 $1,200,000 b. Average daily sales on Number of days’ account sales in (Sales/365) $ 4,104 receivables $ (a/b) 3,288 28.6 39.5 42 42  43 15- 2 Click to edit Master title style Example Exercise 15-4 A company reports the following: Net sales $960,000 Determine (a) the accounts receivable turnover and (b) Averageofaccounts the number receivable days’ sales (net) Round to one in receivables. decimal place. 48,000 43 43  44 15- 2 Click to edit Follow My Example 15-4 Master title style a. Accounts Receivable Turnover = Sales/Average accounts receivable Accounts Receivable Turnover = $960,000/$48,000 Accounts Receivable Turnover = 20.0 b. Number of Days’ Sales in Receivables = Average accounts receivable/Average daily sales Number of Days’ Sales in Receivables = $48,000/($960,000/ 365) Number of Days’ Sales in Receivables = $48,000/$2,630 Number of Days’ Sales in Receivables = 18.3 days 44 44 For Practice: PE 15-4A, PE 15-4B  45 Click to edit Master title style Inventory Turnover 15- 2 The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory. 45  46 Click to edit Master title style 15- 2 Lincoln Company 2008 2007 a. Cost of goods sold $1,043,000 $ 820,000 Inventories: Beginning of year $ 283,000 $ 311,000 End of year 264,000 283,000 Inventory turnover (a/b) 3.8 2.8 Total $ 547,000 $ 594,000 46 46 b. Average (Total/2) $ 273,500 $ 297,000  47 Click to edit Master title style Number of Days’ Sales in Inventory 15- 2 Lincoln Company 2008 2007 a. Average (Total/2) $ 273,500 $ 297,000 Cost of goods sold $1,043,000 $ 820,000 b. Average daily cost of goods sold (COGS/365 days) $2,858 $2,247 Number of days’ sales in inventory (a/b) 95.7 132.2 47 47  48 15- 2 Click to edit Master title style Example Exercise 15-5 A company reports the following: Cost of goods sold Determine (a) the inventory turnover and $560,000 (b) the number Average of days’ sales in inventory. inventory Round to one decimal place. 112,000 48 48  49 15- 2 Click to edit Master title style Follow My Example 15-5 a. Inventory Turnover = Cost of Goods Sold/Average Inventory Inventory Turnover = $560,000/$112,000 Inventory Turnover = 5.0 b. Number of Days’ Sales in Inventory = Average Inventory/ Average Daily Cost of Goods Sold Number of Days’ Sales in Inventory = $112,000/ ($560,000/365) Number of Days’ Sales in Inventory = $112,000/$1,534 Number of Days’ Sales in Inventory = 73.0 days 49 49 For Practice: PE 15-5A, PE 15-5B  50 Click to edit Master title style Ratio of Fixed Assets to Long-Term Liabilities 15- 2 The ratio of fixed assets to long- term liabilities is a solvency measure that indicates the margin of safety of the noteholders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis. 50  51 Click to edit Master title style 15- 2 Lincoln Company 2008 2007 a. Fixed assets (net) $444,500 $470,000 b. Long-term liabilities $100,000 $200,000 Ratio of fixed assets to long-term liabilities (a/b) 4.4 2.4 51 51  52 Click to edit Master title style Ratio of Liabilities to Stockholders’ Equity 15- 2 The relationship between the total claims of the creditors and owners—the ratio of liabilities to stockholders’ equity—is a solvency measure that indicates the margin of safety for creditors. 52  53 Click to edit Master title style 15- 2 Lincoln Company 2008 2007 a. Total liabilities $310,000 $443,000 b. Total stockholders’ equity $829,500 $787,500 Ratio of liabilities to stockholders’ equity (a/b) 0.4 0.6 53 53  54 15- 2 Click to edit Master title style Example Exercise 15-6 The following information was taken from Acme Company’s balance sheet: Fixed assets (net) $1,400,000 Long-term liabilities Determine the company’s (a) ratio of fixed assets to 400,000 long-term liabilities and (b) ratio of liabilities to Total liabilities stockholders’ equity. 54 54 560,000 Total stockholders’ equity  55 15- 2 Click to edit Master title style Follow My Example 15-6 a. Ratio of Fixed Assets to Long-Term Liabilities = Fixed Assets/ Long- Term Liabilities Ratio of Fixed Assets to Long-Term Liabilities = $1,400,000/ $400,000 Ratio of Fixed Assets to Long-Term Liabilities = 3.5 b. Ratio of Liabilities to Total Stockholders’ Equity = Total Liabilities/Total Stockholders’ Equity Ratio of Liabilities to Total Stockholders’ Equity = $560,000/ $1,400,000 55 55 Ratio of Liabilities to Total Stockholders’ Equity = 0.4 For Practice: PE 15-6A, PE 15-6B  56 Click to edit Master title style Number of Times Interest Charges Earned 15- 2 Corporations in some industries normally have high ratios of debt to stockholders’ equity. For such corporations, the relative risk of the debtholders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio. 56  57 Click to edit Master title style 15- 2 Lincoln Company 2008 2007 Income before income tax $162,500 $134,600 a. Add interest expense 6,000 12,000 b. Amount Number available of times to meet interest interestearned charges charges(b/a) $168,500 28.1 12.2 $146,600 57 57  58 15- 2 Click to edit Master title style Example Exercise 15-7 A company reports the following: Income before income tax $250,000 Determine the number of times interest charges Interest expense are earned. 100,000 58 58  59 15- 2 Click to edit Master title style Follow My Example 15-7 Number of Times Interest Charges are Earned = (Income Before Income Tax + Interest Expense)/ Interest Expense Number of Times Interest Charges are Earned = ($250,000 + $100,000)/$100,000 Number of Times Interest Charges are Earned = 3.5 59 59 For Practice: PE 15-7A, PE 15-7B  60 Click to edit Master title style 15- 3 Objective Objective 33 Apply financial statement analysis to assess the profitability of a business. 60  61 Click to edit Master title style Profitability Analysis 15- 3  Profitability is the ability of an entity to earn profits.  This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available as reported in the balance sheet.  Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet. 61  62 Click to edit Master title style Ratio of Net Sales to Assets 15- 3 The ratio of net sales to assets is a profitability measure that shows how effectively a firm utilizes its assets. 62  63 Click to edit Master title style 15- 3 Lincoln Company 2008 2007 a. Net sales $1,498,000 $1,200,000 Total assets: Beginning of year $1,053,000 $1,010,000 End of year 1,044,500 1,053,000 Total $2,097,500 $2,063,000 b. Average (Total/2) $1,048,750 $1,031,500 Excludes Excludes long-term long-term investments investments 63 63  64 Click to edit Master title style 15- 3 Lincoln Company 2008 2007 a. Net sales $1,498,000 $1,200,000 Total assets: Beginning of year $1,053,000 $1,010,000 End of year 1,044,500 1,053,000 Total $2,097,500 $2,063,000 b. Average (Total/2) $1,048,750 $1,031,500 Ratio of net sales to assets (a/b) 1.4 1.2 64 64  65 15- 3 Click to edit Master title style Example Exercise 15-8 A company reports the following: Net sales $2,250,000 Determine the ratio of net sales to assets. Average total sales Follow My Example 15-8 Ratio of1,500,000 Net Sales to Total Assets = Net Sales/Average Total Assets Ratio of Net Sales to Total Assets = $2,250,000/$1,500,000 Ratio of Net Sales to Total Assets = 1.5 65 65 For Practice: PE 15-8A, PE 15-8B  66 Click to edit Master title style Rate Earned on Total Assets 15- 3 The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed. 66  67 Click to edit Master title style 15- 3 Lincoln Company 2008 2007 Net income $ 91,000 $ 76,500 Plus interest expense 6,000 12,000 a. Total $ 97,000 $ 88,500 Total assets: Beginning of year $1,230,500 $1,187,500 End of year 1,139,500 1,230,500 Total $2,370,000 $2,418,000 b. Average (Total/2) $1,185,000 $1,209,000 Rate earned on total assets (a/b) 8.2% 7.3% 67 67  68 15- 3 Click to edit Master title style Example Exercise 15-9 A company reports the following income statement and balance sheet information for the current year: Net income $ 125,000 Interest expense Determine the rate earned on total assets. 25,000 Average total assets 2,000,000 68 68  69 15- 3 Click to edit Master title style Follow My Example 15-9 Rate Earned on Total Assets = (Net Income + Interest Expense)/Average Total Assets Rate Earned on Total Assets = ($125,000 + $25,000)/$2,000,000 Rate Earned on Total Assets = 7.5% 69 69 For Practice: PE 15-9A, PE 15-9B  70 Click to edit Master title style Rate Earned on Stockholders’ Equity 15- 3 The rate earned on stockholders’ equity measure emphasizes the rate of income earned on the amount invested by the stockholders. 70  71 Click to edit Master title style 15- 3 Lincoln Company 2008 2007 a. Net income $ 91,000 $ 76,500 Stockholders’ equity: Beginning of year $ 787,500 $ 750,000 End of year 829,500 787,500 Total $1,617,000 $1,537,500 b. Average (Total/2) $ 808,500 $ 768,750 Rate earned on stockholders’ equity (a/b) 11.3% 10.0% 71 71  72 Click to edit Master title style Leverage 15- 3 The difference in the rate earned on stockholders’ equity and the rate earned on total assets is called leverage. 72  73 Click to edit Master title style Leverage 15- 3 11.3% 10.0% 10% Leverage 8.2% Leverage 3.1% 7.3% 2.7% 5% 0% 2008 2007 Rate earned on Rate earned on 73 73 total assets stockholders’ equity  74 Click to edit Master title style Rate Earned on Common Stockholders’ Equity 15- 3 The rate earned on common stockholders’ equity focuses only on the rate of profits earned on the amount invested by the common stockholders. 74  75 Click to edit Master Lincoln Companytitle style 15- 3 2008 2007 Net income $ 91,000 $ 76,500 Less preferred dividends 9,000 9,000 a. Remainder—common stock $ 82,000 $ 67,500 Common stockholders’ equity: Beginning of year $ 637,500 $ 600,000 End of year 679,500 637,500 Total $1,317,000 $1,237,500 b. Average (Total/2) $ 658,500 $ 618,750 Rate earned on common stockholders’ equity (a/b) 12.5% 10.9% 75 75  76 15- 3 Click to edit Master title style Example Exercise 15-10 A company reports the following: Net income $ 125,000 Preferred dividends Determine5,000 (a) the rate earned on stockholders’ equity and Average stockholders’ (b) the rate equity stockholders’ earned on common equity. 1,000,000 Average common stockholders’ 76 76 equity  77 15- 3 Click to edit Master title style Follow My Example 15-10 a. Rate Earned on Stockholders’ Equity = Net Income/Average Stockholders’ Equity Rate Earned on Stockholders’ Equity = $125,000/$1,000,000 Rate Earned on Stockholders’ Equity = 12.5% b. Rate Earned on Common Stockholders’ Equity = (Net Income – Preferred Dividends)/Average Common Stockholders’ Equity Rate Earned on Common Stockholders’ Equity = ($125,000 – $5,000)/$800,000 Rate Earned on Common Stockholders’ Equity = 15% 77 77 For Practice: PE 15-10A, PE 15-10B  78 Click to edit Master title style Earnings per Share on Common Stock 15- 3 One of the profitability measures often quoted by the financial press is earning per share (EPS) on common stock. It is also normally reported in the income statement in corporate annual reports. 78  79 Click to edit Master title style 15- 3 Lincoln Company 2008 2007 Net income $ 91,000 $ 76,500 Preferred dividends 9,000 9,000 a. Remainder—identified with Earningscommon per sharestock on common $ 82,000 stock$(a/b) 67,500 $1.64 $1.35 b. Shares of common stock 50,000 50,000 79 79  80 Click to edit Master title style Price-Earnings Ratio 15- 3 Another profitability measure quoted by the financial press is the price-earnings (P/E) ratio on common stock. The price-earnings ratio is an indicator of a firm’s future earnings prospects. 80  81 Click to edit Master title style 15- 3 Lincoln Company 2008 2007 Market price per share of common stock $41.00 $27.00 Earnings per share on common stock / 1.64 / 1.35 Price-earnings ratio on common stock 25 20 81 81  82 15- 3 Click to edit Example Exercise 15-11 Master title style A company reports the following: Net income $250,000 Preferred dividends $15,000 Shares of common stock outstanding a. Determine the company’s earnings per share on 20,000 common stock. Market price b. Determine theper share of price-earnings ratio. company’s common Round to onestock decimal place. 82 82 $35  83 15- 3 Click to edit Master title style Follow My Example 15-11 (a) Earnings Per Share of Common Stock = (Net Income – Preferred Dividends)/Shares of Common Stock Outstanding Earnings per Share of Common Stock = ($250,000 – $15,000)/20,000 Earnings per Share of Common Stock = $11.75 83 83 (Continued)  84 15- 3 Click to edit Master title style Follow My Example 15-11 (b) Price-Earnings Ratio = Market Price per Share of Common Stock/Earnings per Share on Common Stock Price-Earnings Ratio = $35.00/$11.75 Price-Earnings Ratio = 3.0 (Concluded) 84 84 For Practice: PE 15-11A, PE 15-11B  85 Click to edit Master title style Dividends per Share 15- 3 Dividends per share can be reported with earnings per share to indicate the relationship between dividends and earnings. Comparing these two per share amounts indicates the extent to which the corporation is retaining its earnings for use in operations. 85  86 Click to edit Master title style Dividends and Earning per Share of Common Stock 15- 3 Lincoln Company $2.00 $1.64 Per $1.50 $1.35 share $1.00 $0.80 $0.60 $0.50 $0.00 2008 2007 Dividends Earnings 86 86  87 Click to edit Master title style Dividend Yield 15- 3 The dividend yield on common stock is a profitability measure that shows the rate of return to common stockholders in terms of cash dividends. 87  88 Click to edit Master title style 15- 3 Lincoln Company 2008 2007 Dividends per share of common stock $ 0.80 $ 0.60 Market price per share of common stock /41.00 Dividend yield on /27.00 common stock 2.0% 2.2% 88 88  89 Click to edit Master title style 15- 4 Objective Objective 44 Describe the contents of corporate annual reports. 89  90 Click to edit Master title style Corporate Annual Reports 15- 4 In addition to the financial statements and the accompanying notes, corporate annual reports usually include the following sections:  Management Discussion and Analysis  Report on adequacy of internal control  Report on fairness of financial statements 90  91 Click to edit Master title style Management Discussion and Analysis 15- 4 The Management Discussion and Analysis (MD&A) includes an analysis of the results of operations and discusses management’s opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition. 91  92 Click to edit Master title style Report on Adequacy of Internal Control 15- 4 Management is required by the Sarbanes- Oxley Act of 2002 to provide a report stating their responsibility for establishing and maintaining internal control. In addition, the report must state management’s conclusion concerning the effectiveness of internal controls over financial reporting. 92  93 Click to edit Master title style Report on Fairness of Financial Statements 15- 4 All publicly held corporations are required to have an independent audit (examination) of their financial statements. The CPAs who conduct the audit render an opinion on the fairness of the statements. 93