Lecture Accounting: What the numbers mean (5/e) - Chapter 11: Financial statement analysis

After reading this chapter, you should be able to answer the following questions: How can liquidity measures be influenced by the inventory cost-flow assumption used? How do suppliers and creditors use a customer’s payment practices to judge liquidity? What are the influences of alternative inventory cost-flow assumptions and depreciation methods on turnover ratios?...

CHAPTER 11 FINANCIAL STATEMENT ANALYSIS McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objectives How can liquidity measures be influenced by the inventory cost-flow assumption used? How suppliers and creditors use a customer’s payment practices to judge liquidity? What are the influences of alternative inventory cost-flow assumptions and depreciation methods on turnover ratios? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objectives How are the number of days’ sales in accounts receivable and inventory used to evaluate the effectiveness of the management of receivables and inventory? What is the significance of the price/earnings ratio in the evaluation of the market price of a company’s stock? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objectives How are dividend yield and the dividend payout ratio used by investors to evaluate a company’s common stock? What is financial leverage, and why is it significant to management, creditors, and owners? What is book value per share of common stock, how is it calculated, and why is it not a very meaningful amount for most companies? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objectives How can common size financial statements be used to evaluate a firm’s financial position and results of operations over a number of years? 10 How can operating statistics using physical, or non-financial data, be used to help management evaluate the results of the firm’s activities? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objective • How can liquidity measures be influenced by the inventory cost-flow assumption used? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Financial Statement Analysis Ratios ã Used to facilitate the interpretation of an entity’ financial position and results of operations • Can be classified into four groups: – Liquidity – Activity – Profitability – Debt, or financial leverage McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Liquidity Measures ã The balance sheet carrying values of inventory will depend on the cost-flow assumption used • Cannot compare firms using different inventory cost-flow assumptions • Firms often report the LIFO reserve – the difference between LIFO an FIFO inventory values McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Liquidity Ratios • Working capital = Current assets – Current liabilities • Current ratio = Current assets Current liabilities • Acid-test ratio = Cash + Accounts receivable Current liabilities McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objective • How suppliers and creditors use a customer’s payment practices to judge liquidity? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Dividend Yield • Dividend yield = Annual dividend per share Market price per share of stock • Should be compared to the yield available on other investments • On common stock, historically this has ranged from 3% to 6% • On preferred stock, the range is 5% to 8% McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Dividend Payout Ratio • Dividend payout ratio = Annual dividend per share Earnings per share • Reflects the dividend policy of the firm • Most firms pay a relatively constant portion of earnings and avoid fluctuations • Generally, ranges from 30% to 50% for manufacturing and merchandising firms McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Preferred Dividend Coverage Ratio • Preferred dividend coverage ratio = Net income Preferred dividend requirement • Indicates the margin of safety of the preferred stock dividend McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objective • What is financial leverage, and why is it significant to management, creditors, and owners? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Financial Leverage Measures • Refers to the use of debt to finance the assets of the entity • Adds risk to the operation of the firm • Also magnifies the return to owners relative to the return on assets • Firms want to borrow at a rate less than the rate of return on financed assets • Interest is a deductible expense; dividends are not deductible McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Debt Ratio ã Indicates the extent to which a firm is using financial leverage • Debt ratio = Total liabilities Total liabilities and owners’ equity • Indicates the percentage of financing that is done with debt McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Debt/Equity Ratio ã Another indicator of the extent to which a firm is using financial leverage • Debt/Equity ratio = Total liabilities Total owners’ equity • Indicates the percentage of financing that is done with debt • Since deferred taxes and current liabilities are not interest bearing, these items are often excluded from the computation McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Times Interest Earned Ratio • A measure that shows the relationship of earnings before interest and taxes to interest expense • The greater the ratio, the more confident the debt holders are about the firm continuing to earn enough to cover interest payments • Times interest earned = McGraw­Hill/Irwin Earnings before interest and taxes Interest expense ©The McGraw­Hill Companies, Inc., 2002 Learning Objective • What is book value per share of common stock, how is it calculated, and why is it not a very meaningful amount for most companies? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Book Value per Share of Common Stock • Easily misunderstood • Cannot be compared to market value due to book value reflects the application of generally accepted accounting principles and the specific accounting policies that the firm has selected • • Book value per share of common stock = Common shareholders’ equity Number of shares of common stock outstanding McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objective • How can common size financial statements be used to evaluate a firm’s financial position and results of operations over a number of years? McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Common Size Financial Statements • Used when evaluating the operating results of a firm over a number of years • Each asset, liability, and owners’ equity account is expressed as a percentage of total assets • On the income statement, sales is set at 100%, and each item is expressed as a percentage of sales McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Use of Common Size Financial Statements • Using percentages makes spotting trends easier • Can compare firms of different sizes • In horizontal analysis, several years’ financial data are stated in terms of a base year • Each item in the base year is 100%; the items in subsequent years are a percentage of the item in the base year McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 Learning Objective 10 • How can operating statistics using physical, or non-financial data, be used to help management evaluate the results of the firms activities? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Other Operating Statistics ã Physical measures also are useful • Sales in units removes hidden price changes • Total employees may be more useful than payroll costs • Usually analysts combine financial and physical measures to show trends and to make comparisons McGraw­Hill/Irwin ©The McGraw­Hill Companies, Inc., 2002 ... by the inventory cost-flow assumption used? McGraw­Hill/Irwin ? ?The? ?McGraw­Hill Companies, Inc., 2002 Financial Statement Analysis Ratios • Used to facilitate the interpretation of an entity’ financial. .. ? ?The? ?McGraw­Hill Companies, Inc., 2002 Financial Leverage Measures • Refers to the use of debt to finance the assets of the entity • Adds risk to the operation of the firm • Also magnifies the return to owners relative to the. .. McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective ã What is the significance of the price/earnings ratio in the evaluation of the market price of a company’s stock? McGraw­Hill/Irwin ? ?The? ?McGraw­Hill Companies, Inc., 2002