Lecture Principles of financial accouting - Chapter 17: Analysis of financial statements

After completing this chapter you should be able to: Explain the purpose and identify the building blocks of analysis, describe standards for comparisons in analysis, summarize and report results of analysis, explain and apply methods of horizontal analysis, describe and apply methods of vertical analysis, define and apply ratio analysis.

Chapter 17 ANALYSIS OF FINANCIAL STATEMENTS PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W Caldwell, D.B.A., CMA Jon A Booker, Ph.D., CPA, CIA Cynthia J Rooney, Ph.D., CPA Winston Kwok, Ph.D., CPA McGraw­Hill/Irwin         Copyright © 2011 by The McGraw­Hill Companies, Inc. All rights reserved 17 ­ 2 C 1 BASICS OF ANALYSIS Reduces Reduces uncertainty uncertainty Application Application of of analytical analytical tools tools Involves Involves transforming transforming data data Financial Financial statement statement analysis analysis helps helps users users make make better better decisions decisions Internal Users Managers Officers Internal Auditors External Users Shareholders Lenders Customers 17 ­ 3 C 1 BUILDING BLOCKS OF ANALYSIS Liquidity and efficiency Solvency Profitability Market prospects 17 ­ 4 C 1 INFORMATION FOR ANALYSIS Income Statement (Statement of Comprehensive Income) Balance Sheet (Statement of Financial Position) Statement of Changes in Equity Statement of Cash Flows Notes to the Financial Statements 17 ­ 5 C 1 STANDARDS FOR COMPARISON When we interpret our analysis, it is essential to compare the results we obtained to other standards or benchmarks Intracompany Competitors Industry Guidelines 17 ­ 6 C 2 TOOLS OF ANALYSIS Horizontal Analysis Comparing a company’s financial condition and performance across time Vertical Analysis Comparing a company’s financial condition and performance to a base amount Ratio Analysis Measurement of key relations between financial statement items 17 ­ 7 P 1 HORIZONTAL ANALYSIS 17 ­ 8 P 1 COMPARATIVE STATEMENTS Calculate Change in Dollar Amount Dollar Change = Analysis Period Amount – Base Period Amount When measuring measuring the the amount amount of the the change in dollar amounts, compare the analysis period period balance to the base period balance The analysis period is usually the current year while the base period is is usually the the prior year 17 ­ 9 P 1 COMPARATIVE STATEMENTS Calculate Change as a Percent Percent Change = Dollar Change Base Period Amount When calculating the change as a percentage, divide the amount of the dollar change by the base period amount, and then multiply by 100 to convert convert to a percentage × 100 17 ­ 10 P 1 HORIZONTAL ANALYSIS $1,550,861 $1,550,861 –– $835,546 $835,546 == $715,315 $715,315 ($715,315 ữ $835,546) ì 100 = 85.6% 17ư29 P 3 CASH CONVERSION CYCLE The sum of the days’ sales uncollected and the days’ sales in inventory subtracting the days’ purchases in accounts payable It represents the number of days a firm’s cash remains tied up within the operations of the business The lower the cash conversion cycle, the more healthy a company generally is 17 ­ 30 P 3 TOTAL ASSET TURNOVER Total asset turnover = Average assets = Net sales Average total assets (Beginning assets + Ending assets) This This ratio ratio reflects reflects aa company company’s ’s ability ability to to use use its its assets assets to to generate generate sales sales ItIt is is an an important important indication indication of of operating operating efficiency efficiency 17 ­ 31 P 3 SOLVENCY Debt Debt Ratio Ratio Equity Equity Ratio Ratio Pledged Pledged Assets Assets to to Secured Secured Liabilities Liabilities Times Times Interest Interest Earned Earned 17 ­ 32 P 3 DEBT AND EQUITY RATIOS Total liabilities Total equity Total liabilities and equity Amount $ 8,000,000 4,000,000 $ 12,000,000 Ratio 66.7% [Debt ratio] 33.3% [Equity ratio] 100.0% $8,000,000 $8,000,000 ÷÷ $12,000,000 $12,000,000 == 66.7% 66.7% The The debt debt ratio ratio expresses expresses total total liabilities liabilities as as aa percent percent of of total total assets assets The The equity equity ratio ratio provides provides complementary complementary information information by by expressing expressing total total equity equity as as aa percent percent of of total total assets assets 17 ­ 33 P 3 DEBT-TO-EQUITY RATIO Debt-to-equity ratio = Total liabilities Total equity This This ratio ratio measures measures what what portion portion of of aa company company’s ’s assets assets are are contributed contributed by by creditors creditors A A larger larger debt-todebt-toequity equity ratio ratio implies implies less less opportunity opportunity to to expand expand through through use use of of debt debt financing financing 17 ­ 34 P 3 TIMES INTEREST EARNED Times interest earned = Income before interest and taxes Interest expense Net income + Interest expense + Income taxes = Income before interest and taxes This This is is the the most most common common measure measure of of the the ability ability of of aa company company’s ’s operations operations to to provide provide protection protection to to long-term long-term creditors creditors 17 ­ 35 P 3 PROFITABILITY Profit Profit Margin Margin Return Return on on Total Total Assets Assets Return Return on on Ordinary Ordinary Shareholders Shareholders’’ Equity Equity 17 ­ 36 P 3 PROFIT MARGIN Profit margin = Net income Net sales This This ratio ratio describes describes aa company company’s ’s ability ability to to earn earn net net income income from from each each sales sales dollar dollar 17 ­ 37 P 3 RETURN ON TOTAL ASSETS Return on total asset = Net income Average total assets Return Return on on total total assets assets measures measures how how well well assets assets have have been been employed employed by by the the company company’s ’s management management 17 ­ 38 P 3 RETURN ON ORDINARY SHAREHOLDERS' EQUITY Return on ordinary shareholders' equity = Net income - Preference dividends Average ordinary shareholders' equity This This measure measure indicates indicates how how well well the the company company employed employed the the shareholders shareholders’’ equity equity to to earn earn net net income income 17 ­ 39 P 3 MARKET PROSPECTS Price-Earnings Price-Earnings Ratio Ratio Dividend Dividend Yield Yield 17 ­ 40 P 3 PRICE-EARNINGS RATIO Price-earnings ratio = Market price per ordinary share Earnings per share This This measure measure is is often often used used by by investors investors as as aa general general guideline guideline in in gauging gauging share share values values Generally, Generally, the the higher higher the the price-earnings price-earnings ratio, ratio, the the more more opportunity opportunity aa company company has has for for growth growth 17 ­ 41 P 3 DIVIDEND YIELD Dividend yield = Annual cash dividends per share Market price per share This This ratio ratio identifies identifies the the return, return, in in terms terms of of cash cash dividends, dividends, on on the the current current market market price price per per share share of of the the company company’s ’s ordinary ordinary shares shares 17 ­ 42 A1 ANALYSIS REPORTING The purpose of financial statement analyses is to reduce uncertainty in business decisions through a rigorous and sound evaluation A financial statement analysis report directly addresses the building blocks of analysis and documents the reasoning Executive Summary Analysis Overview Evidential Matter Assumptions Key Factors Inferences 17 ­ 43 END OF CHAPTER 17 ... percent of of total total assets assets 17 ­ 33 P 3 DEBT-TO-EQUITY RATIO Debt-to-equity ratio = Total liabilities Total equity This This ratio ratio measures measures what what portion portion of of... (Statement of Financial Position) Statement of Changes in Equity Statement of Cash Flows Notes to the Financial Statements 17 ­ 5 C 1 STANDARDS FOR COMPARISON When we interpret our analysis, it... measure of of the the ability ability of of aa company company’s ’s operations operations to to provide provide protection protection to to long-term long-term creditors creditors 17 ­ 35 P 3 PROFITABILITY