FINANCIAL STATEMENT ANALYSIS

Introduction to Managerial Accounting

• Chapter 14 of the Ninth edition, Copyright © 2022 McGraw Hill.

• All rights reserved; no reproduction or distribution without consent.

Limitations of Financial Statement Analysis

• Company Accounting Methods:

  • Company 1: Uses the LIFO method to value inventory.

  • Company 2: Uses the average cost method to value inventory.

• Impact of Accounting Methods: Differences in accounting methods between companies can complicate comparisons, making analysis more challenging.

Looking Beyond Ratios

• Managers should consider external factors beyond ratio analysis, including:

  • Technology changes

  • Industry trends

  • Internal company changes

  • Consumer tastes

  • Economic factors

Learning Objectives

Learning Objective 1

• Prepare and interpret financial statements in comparative and common-size form.

Key Concepts

• An item on a financial statement has limited meaning alone.

• Meaning can be enhanced through comparisons such as:

  • Dollar and percentage changes on statements

  • Common-size statements

  • Ratios

Dollar and Percentage Changes on Statements

• Horizontal Analysis (Trend Analysis):

  • Illustrates changes between years in financial data in dollar and percentage forms.

  • Highlights economically important dollar changes and unusual percentage changes.

Horizontal Analysis – Calculating Changes

Dollar Change Calculation

• $ext{Dollar Change} = ext{Current Year Figure} - ext{Base Year Figure}$

• Base year figures are the dollar amounts for the last year used for comparison.

Percentage Change Calculation

• ext{Percentage Change} = rac{ ext{Dollar Change}}{ ext{Base Year Figure}} imes 100 ext{ ext{%}}

• Example: rac{(-11,500)}{23,500} imes 100 ext{ ext{%}} = -48.9 ext{ ext{%}}

Income Statement Accounts Analysis

• Key observations may arise from analyzing liabilities and stockholders’ equity.

• An example shows sales increased by 8.3%, while net income decreased by 21.9% due to rising costs.

Trend Percentages

• Calculate based on a base year set to 100%.

• The formula is:

  • ext{Trend Percentage} = rac{ ext{Current Year Amount}}{ ext{Base Year Amount}} imes 100 ext{ ext{%}}

Trend Analysis with Berry Products

• Base Year: Year 1 (100% reference).

• Provided income information to conduct a trend analysis across five years.

Common-Size Statements

• Vertical Analysis: Focuses on item relationships at a single point in time.

• Common-Size Statements: Each item is expressed as a percentage:

  • In balance sheets, items expressed as a percentage of total assets.

  • In income statements, items expressed as a percentage of sales.

Comparative Income Statements for Clover Corporation

• Sales as the base expressed as 100%.

• Example Calculation:

  • This Year’s Operating Expenses ext{/ This Year’s Sales} imes 100 ext{ ext{%}}

  • Last Year’s Operating Expenses ext{/ Last Year’s Sales} imes 100 ext{ ext{%}}

Concept Check 1

• Question: Describes horizontal analysis:

  • A: Shows items in percentage and dollar form.

  • B: Side-by-side comparison of multiple years’ statements.

  • C: Comparison of current year balances.

  • Correct Answer: Horizontal analysis shows changes between years in financial data in both dollar and percentage forms.

Ratio Analysis – Liquidity

• Key Ratios for Liquidity:

  • Working Capital

  • Current Ratio

  • Acid-Test (Quick) Ratio

Working Capital

• Definition: Excess of current assets over current liabilities, financed with long-term debt and equity.

Current Ratio

• Calculation: $ext{Current Ratio} = rac{ ext{Current Assets}}{ ext{Current Liabilities}}$

• Indicates short-term debt-paying ability. A decline could signal a worsening financial condition. Example calculation resulted in a current ratio of 1.55.

Acid-Test (Quick) Ratio

• Formula: $ext{Acid-Test Ratio} = rac{ ext{Quick Assets}}{ ext{Current Liabilities}}$

• Defines quick assets as cash and equivalents that can meet obligations without liquidating inventories. The example showed a ratio of 1.19.

Learning Objective 3

• Compute and interpret asset management ratios.

Ratio Analysis – Asset Management

• Key ratios calculated include Accounts Receivable Turnover and Inventory Turnover.

Accounts Receivable Turnover

• Formula: $ext{Accounts Receivable Turnover} = rac{ ext{Sales on Account}}{ ext{Average Accounts Receivable}}$

• Measures the frequency of converting receivables to cash. Calculated to 26.7 times.

Average Collection Period

• Formula: $ext{Average Collection Period} = rac{365}{ ext{Accounts Receivable Turnover}}$

• Indicates the average days to collect receivables, calculated as 13.67 days.

Inventory Turnover

Part 1

• Formula: $ext{Inventory Turnover} = rac{ ext{Cost of Goods Sold}}{ ext{Average Inventory}}$

• Measures frequency of inventory sales.

Part 2

• Calculation example showed an inventory turnover of 12.73 times.

Average Sale Period

• Formula: $ext{Average Sale Period} = rac{365}{ ext{Inventory Turnover}}$

• Indicates average days to sell inventory, calculated as 28.67 days.

Operating Cycle

• Definition: Combination of average sale period and average collection period.

• Formula: $ext{Operating Cycle} = ext{Average Sale Period} + ext{Average Collection Period}$

• Example results in an operating cycle of 42.34 days.

Total Asset Turnover

• Formula: $ext{Total Asset Turnover} = rac{ ext{Sales}}{ ext{Average Total Assets}}$

• Measures efficiency of asset utilization for generating sales.

• Showed a total asset turnover of 1.53.

Learning Objective 4

• Compute and interpret financial ratios for debt management purposes.

Ratio Analysis – Debt Management

• Key ratios include Times Interest Earned and Debt-to-Equity Ratio.

Times Interest Earned Ratio

• Formula: $ext{Times Interest Earned} = rac{ ext{Earnings Before Interest Expense and Income Taxes}}{ ext{Interest Expense}}$

• Indicates ability to cover long-term creditor payments; example resulted in 11.5 times.

Debt-to-Equity Ratio

• Formula: $ext{Debt-to-Equity Ratio} = rac{ ext{Total Liabilities}}{ ext{Stockholders’ Equity}}$

• Indicates balance of debt versus equity on the balance sheet; example showed a ratio of 0.48.

The Equity Multiplier

• Formula: $ext{Equity Multiplier} = rac{ ext{Average Total Assets}}{ ext{Average Stockholders’ Equity}}$

• Indicates portion of assets funded by equity, calculated to be 1.56.

Learning Objective 5

• Compute and interpret profitability ratios.

Ratio Analysis – Profitability Ratios

• Includes metrics such as Gross Margin Percentage, Net Profit Margin Percentage, Return on Total Assets, and Return on Equity.

Gross Margin Percentage

• Formula: $ext{Gross Margin Percentage} = rac{ ext{Gross Margin}}{ ext{Sales}}$

• Indicates net profitability left after COGS, example resulted in 71.6%.

Net Profit Margin Percentage

• Formula: $ext{Net Profit Margin Percentage} = rac{ ext{Net Income}}{ ext{Sales}}$

• Examines the impact of all expenses on profitability; calculated as 10.9%.

Return on Total Assets

• Formula: $ext{Return on Total Assets} = rac{ ext{Net Income} + [ ext{Interest Expense} imes (1 - ext{Tax Rate})]}{ ext{Average Total Assets}}$

• Allows for comparable analysis across different debt levels; calculated as 18.19%.

Return on Equity

• Formula: $ext{Return on Equity} = rac{ ext{Net Income}}{ ext{Average Stockholders’ Equity}}$

• Reflects company's ability to utilize owner investments for income; calculated to 25.91%.

DuPont Formula

• Formula for breaking down return on equity:

  • $ext{Return on Equity} = ext{Net Profit Margin} imes ext{Total Asset Turnover} imes ext{Equity Multiplier}$

Financial Leverage

• Positive financial leverage occurs when return on assets exceeds the fixed cost of borrowed funds. Negatively impacts returns when the opposite is true.

Concept Check 2

• True Statements:

  • A: Negative financial leverage occurs if creditors’ fixed returns are greater than asset returns.

  • B: Positive financial leverage happens when asset returns exceed creditors’ fixed returns.

  • C: Financial leverage relates to expressing multi-year data in percentages based on a base year.

Learning Objective 6

• Compute and interpret market performance ratios.

Ratio Analysis – Market Performance

• Includes Earnings Per Share, Price-Earnings Ratio, Dividend Payout Ratio, Dividend Yield Ratio, Book Value Per Share.

Earnings Per Share

• Formula: $ext{Earnings Per Share} = rac{ ext{Net Income}}{ ext{Average Number of Common Shares Outstanding}}$

• Basis for dividends and share value growth; example calculation resulted in $2.42.

Price-Earnings Ratio

• Formula: $ext{Price-Earnings Ratio} = rac{ ext{Market Price Per Share}}{ ext{Earnings Per Share}}$

• Indicates investor willingness to pay; calculated as 8.26 times.

Dividend Payout Ratio

• Formula: $ext{Dividend Payout Ratio} = rac{ ext{Dividends Per Share}}{ ext{Earnings Per Share}}$

• Shows portion of earnings paid as dividends; calculated at 82.6%.

Dividend Yield Ratio

• Formula: $ext{Dividend Yield Ratio} = rac{ ext{Dividends Per Share}}{ ext{Market Price Per Share}}$

• Measures cash returns based on current stock prices; calculated as 10.00%.

Book Value Per Share

• Formula: $ext{Book Value per Share} = rac{ ext{Common Stockholders’ Equity}}{ ext{Number of Common Shares Outstanding}}$

• Provides estimated value per share after asset liquidation; calculated at $8.55.

Published Sources

• Sources that provide comparative ratio data.

End of Chapter 14