Chapter 3 Financial Statements and Ratio Analysis Copyright

Chapter 3 Financial Statements and Ratio Analysis Copyright

Chapter 3 Financial Statements and Ratio Analysis Copyright 2012 Pearson Prentice Hall. All rights reserved. Objectives Review the contents of the stockholders report and the procedures for consolidating financial statements.

Understand who uses financial ratios and how. Use ratios to analyze a firms liquidity and activity. Discuss the relationship between debt and financial leverage and the ratios used to analyze a firms debt.

Use ratios to analyze a firms profitability and its market value. Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis. 2012 Pearson Prentice Hall. All rights reserved.

3-2 The Stockholders Report Generally accepted accounting principles (GAAP) are the practice and procedure guidelines used to prepare and maintain financial records and reports; authorized by the Financial Accounting Standards Board (FASB). The Sarbanes-Oxley Act of 2002, passed to eliminate the many disclosure and conflict of interest problems of corporations, established the Public Company Accounting Oversight Board (PCAOB), which is a not-for-profit corporation that overseas auditors.

2012 Pearson Prentice Hall. All rights reserved. 3-3 The Stockholders Report (cont.) The PCAOB is charged with protecting the interests of investors and furthering the public interest in the preparation of informative, fair, and independent audit reports. Public corporations with more than $5 million in assets and more than 500 stockholders are required by the Securities and Exchange Commission (SEC) to provide

their stockholders with an annual stockholders report, which summarizes and documents the firms financial activities during the past year. 2012 Pearson Prentice Hall. All rights reserved. 3-4 The Four Key Financial Statements: The Income Statement The income statement provides a financial summary of a companys operating results during a specified period. Although they are prepared quarterly for reporting purposes, they are generally computed monthly by

management and quarterly for tax purposes. 2012 Pearson Prentice Hall. All rights reserved. 3-5 Bartlett Company Income Statements ($000) 2012 Pearson Prentice Hall. All rights reserved. 3-6

The Four Key Financial Statements: The Balance Sheet The balance sheet presents a summary of a firms financial position at a given point in time. The statement balances the firms assets (what it owns) against its financing, which can be either debt (what it owes) or equity (what was provided by owners). 2012 Pearson Prentice Hall. All rights reserved. 3-7 Bartlett Company

Balance Sheets ($000) 2012 Pearson Prentice Hall. All rights reserved. 3-8 Bartlett Company Balance Sheets ($000) 2012 Pearson Prentice Hall. All rights reserved. 3-9

Bartlett Company Statement of Retained Earnings for the Year Ended Dec. 31, 2012 The statement of retained earnings reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings between the start and the end of that year. 2012 Pearson Prentice Hall. All rights reserved. 3-10 The Four Key Financial Statements: Statement of Cash Flows The statement of cash flows provides a summary of the

firms operating, investment, and financing cash flows and reconciles them with changes in its cash and marketable securities during the period. This statement not only provides insight into a companys investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets. 2012 Pearson Prentice Hall. All rights reserved. 3-11 Bartlett Company Statement of Cash Flows

for the Year Ended December 31, 2012 2012 Pearson Prentice Hall. All rights reserved. 3-12 Using Financial Ratios: Interested Parties Ratio analysis involves methods of calculating and interpreting financial ratios to analyze and monitor the firms performance. Current and prospective shareholders are interested in the firms current and future level of risk and return, which directly affect share price.

Creditors are interested in the short-term liquidity of the company and its ability to make interest and principal payments. Management is concerned with all aspects of the firms financial situation, and it attempts to produce financial ratios that will be considered favorable by both owners and creditors. 2012 Pearson Prentice Hall. All rights reserved. 3-13 Using Financial Ratios: Types of Ratio Comparisons Cross-sectional analysis is the comparison of different firms

financial ratios at the same point in time; involves comparing the firms ratios to those of other firms in its industry or to industry averages Benchmarking is a type of cross-sectional analysis in which the firms ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate. Comparison to industry averages is also popular, as in the following example. 2012 Pearson Prentice Hall. All rights reserved. 3-14

Table 3.5 Financial Ratios for Selected Firms and Their Industry Median Values 2012 Pearson Prentice Hall. All rights reserved. 3-15 Using Financial Ratios: Types of Ratio Comparisons (cont.) Time-series analysis is the evaluation of the firms financial performance over time using financial ratio analysis Comparison of current to past performance, using ratios,

enables analysts to assess the firms progress. Developing trends can be seen by using multiyear comparisons. The most informative approach to ratio analysis combines cross-sectional and time-series analyses. 2012 Pearson Prentice Hall. All rights reserved. 3-16 Combined Analysis 2012 Pearson Prentice Hall. All rights reserved. 3-17

Using Financial Ratios: Cautions about Using Ratio Analysis 1. Ratios that reveal large deviations from the norm merely indicate the possibility of a problem. 2. A single ratio does not generally provide sufficient information from which to judge the overall performance of the firm. 3. The ratios being compared should be calculated using financial statements dated at the same point in time during the year. 4. It is preferable to use audited financial statements. 5. The financial data being compared should have been developed in the same way. 6. Results can be distorted by inflation.

2012 Pearson Prentice Hall. All rights reserved. 3-18 Ratio Analysis Liquidity Ratios: Current ratio = Current assets Current liabilities The current ratio for Bartlett Company in 2012 is: $1,223,000 $620,000 = 1.97 The higher the current ratio, the greater the ability of the firm to meet its short term obligations. 2012 Pearson Prentice Hall. All rights reserved.

3-19 Ratio Analysis (cont.) Liquidity Ratios The quick ratio for Bartlett Company in 2012 is: The liquidity ratio above provides a better measure than the current ratio only when inventory cannot be easily converted to cash. 2012 Pearson Prentice Hall. All rights reserved.

3-20 Ratio Analysis (cont.) Activity Ratios: Inventory turnover = Cost of goods sold Inventory Applying this relationship to Bartlett Company in 2012 yields: $2,088,000 $289,000 = 7.2 The turnover ratio varies by industry depending upon unique factors specific to the industry such as frequency of sale and the perishability of product. Average Age of Inventory = 365 Inventory turnover For Bartlett Company, the average age of inventory in 2012 is: 365 7.2 = 50.7 days

2012 Pearson Prentice Hall. All rights reserved. 3-21 Ratio Analysis (cont.) Activity Ratios The average collection period for Bartlett Company in 2012 is: If the firm grants credit terms as net 30 days, the credit and collections department would be considered poorly managed. 2012 Pearson Prentice Hall. All rights reserved.

3-22 Ratio Analysis (cont.) Activity Ratios: If we assume that Bartlett Companys purchases equaled 70 percent of its cost of goods sold in 2012, its average payment period is: If credit terms granted by a supplier was net 30 days, Bartlett Company would be delinquent in its payables. 2012 Pearson Prentice Hall. All rights reserved.

3-23 Ratio Analysis (cont.) Activity Ratios: Total asset turnover = Sales Total assets The value of Bartlett Companys total asset turnover in 2012 is: $3,074,000 $3,597,000 = 0.85 The ratio indicates the efficiency with which the firm uses its assets to generate sales. The higher a firms turnover ratio, the more efficiently its assets have been used. 2012 Pearson Prentice Hall. All rights reserved.

3-24 Ratio Analysis (cont.) Debt Ratios: Debt ratio = Total liabilities Total assets The debt ratio for Bartlett Company in 2012 is $1,643,000 $3,597,000 = 0.457 = 45.7% The firm has financed half its assets with debt. The higher the ratio, the more indebtedness of the firm and the more leverage. 2012 Pearson Prentice Hall. All rights reserved. 3-25

Ratio Analysis (cont.) Debt Ratios: Times interest earned ratio = EBIT Interest The figure for earnings before interest and taxes (EBIT) is the same as that for operating profits shown in the income statement. Applying this ratio to Bartlett Company yields the following 2012 value: $418,000 $93,000 = 4.5x A value of at least 3 and preferably closer to 5 is suggested. 2012 Pearson Prentice Hall. All rights reserved. 3-26

Ratio Analysis (cont.) Debt Ratios: Fixed-Payment coverage Ratio (FPCR) Applying the formula to Bartlett Companys 2012 data yields: The firm has almost twice the earnings available to meet its fixed payment obligations and appears safe. 2012 Pearson Prentice Hall. All rights reserved. 3-27

Bartlett Company Common-Size Income Statements 2012 Pearson Prentice Hall. All rights reserved. 3-28 Ratio Analysis (cont.) Profitability Ratios: Bartlett Companys gross profit margin for 2012 is:

Gross profit margin measures the percentage of each sales dollar remaining after the firm has paid for its goods produced. 2012 Pearson Prentice Hall. All rights reserved. 3-29 Ratio Analysis (cont.) Profitability Ratios: Operating profit margin = Operating profits sales Bartlett Companys operating profit margin for 2012 is: $418,000 $3,074,000 = 13.6% Operating profit margin measures the percentage sales remaining after all costs and expenses other than interest, taxes and preferred

dividends are deducted. Net profit margin = Earnings available for common stockholders Sales. The Bartlett Companys net profit margin for 2012 is: $221,000 $3,074,000 = 0.072 = 7.2% 2012 Pearson Prentice Hall. All rights reserved. 3-30 Ratio Analysis (cont.) Profitability Ratios: Bartlett Companys earnings per share (EPS) in 2012 is: $221,000 76,262 = $2.90

EPS is the dollar amount earned on for each share outstanding Return on total assets (ROA) = Earnings available for common stockholders Total assets Bartlett Companys return on total assets in 2012 is: $221,000 $3,597,000 = 0.061 = 6.1% 2012 Pearson Prentice Hall. All rights reserved. 3-31 Ratio Analysis (cont.) Profitability Ratios: Return on Equity (ROE) = Earnings available for common stockholders Common stock equity

This ratio for Bartlett Company in 2012 is: $221,000 $1,754,000 = 0.126 = 12.6% ROE measures the return earned on the common stockholders investment in the firm. The higher the ratio, the greater the return to the shareholder. 2012 Pearson Prentice Hall. All rights reserved. 3-32 Ratio Analysis (cont.) Market Ratios: Price Earnings (P/E) Ratio = Market price per share of common stock Earnings per share

If Bartlett Companys common stock at the end of 2012 was selling at $32.25, using the EPS of $2.90, the P/E ratio at year-end 2012 is: $32.25 $2.90 = 11.1x P/E measures the amount investors are willing to pay for each dollar of the firms earnings. It can also be useful as a comparison to a broad index. Ex: The S&P 500 currently trades at 12X earnings. 2012 Pearson Prentice Hall. All rights reserved. 3-33 Ratio Analysis (cont.)

Market Ratios: where, The market to book ratio provides an assessment of how investors view the firms performance. It relates the market value of the firms shares to its book value. 2012 Pearson Prentice Hall. All rights reserved. 3-34 Ratio Analysis (cont.) Substituting the appropriate values for Bartlett Company from its

2012 balance sheet, we get: Substituting Bartlett Companys end of 2012 common stock price of $32.25 and its $23.00 book value per share of common stock (calculated above) into the M/B ratio formula, we get: $32.25 $23.00 = 1.40. This means that investors are paying $1.40 for each $1.00 of book value of the firms stock. It is selling at a 40% premium over its book value per share. 2012 Pearson Prentice Hall. All rights reserved. 3-35 Summary of

Bartlett Company Ratios 2012 Pearson Prentice Hall. All rights reserved. 3-36 Summary of Bartlett Company Ratios 2012 Pearson Prentice Hall. All rights reserved. 3-37

DuPont System of Analysis The DuPont system of analysis is used to dissect the firms financial statements and to assess its financial condition. It merges the income statement and balance sheet into two summary measures of profitability. The Modified DuPont Formula relates the firms ROA to its ROE using the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity: ROA and ROE as shown in the series of equations on the following slide. 2012 Pearson Prentice Hall. All rights reserved.

3-38 DuPont System of Analysis The DuPont system first brings together the net profit margin, which measures the firms profitability on sales, with its total asset turnover, which indicates how efficiently the firm has used its assets to generate sales. ROA = Net profit margin Total asset turnover Substituting the appropriate formulas into the equation and simplifying results in the formula given earlier, 2012 Pearson Prentice Hall. All rights reserved.

3-39 DuPont System of Analysis (cont.) When the 2012 values of the net profit margin and total asset turnover for Bartlett Company, calculated earlier, are substituted into the DuPont formula, the result is: ROA = 7.2% 0.85 = 6.1% 2012 Pearson Prentice Hall. All rights reserved. 3-40

DuPont System of Analysis: Modified DuPont Formula The modified DuPont Formula relates the firms return on total assets to its return on common equity. The latter is calculated by multiplying the return on total assets (ROA) by the financial leverage multiplier (FLM), which is the ratio of total assets to common stock equity: ROE = ROA FLM Substituting the appropriate formulas into the equation and simplifying results in the formula given earlier, 2012 Pearson Prentice Hall. All rights reserved.

3-41 DuPont System of Analysis: Modified DuPont Formula (cont.) Substituting the values for Bartlett Companys ROA of 6.1 percent, calculated earlier, and Bartletts FLM of 2.06 ($3,597,000 total assets $1,754,000 common stock equity) into the modified DuPont formula yields: ROE = 6.1% 2.06 = 12.6% 2012 Pearson Prentice Hall. All rights reserved. 3-42

Chapter Summary The annual stockholders report, which publicly owned corporations must provide to stockholders, documents the firms financial activities of the past year. It includes the letter to stockholders and various subjective and factual information. It also contains four key financial statements: the income statement, the balance sheet, the statement of stockholders equity and the statement of cash flows. Ratio analysis enables stockholders, lenders, and the firms managers to evaluate the

firms financial performance. It can be performed on a cross-sectional or a time-series basis. Benchmarking is a popular type of cross-sectional analysis. Liquidity, or the ability of the firm to pay its bills as they come due, can be measured by the current ratio and the quick (acid-test) ratio. Activity ratios measure the speed with which accounts are converted into sales or cashinflows or outflows. The activity of inventory can be measured by its turnover, that of accounts receivable by the average collection period and that of accounts payable by the average payment period. Total asset turnover measures the efficiency with which the firm uses its assets to generate sales.

2012 Pearson Prentice Hall. All rights reserved. 3-43 Chapter Summary (contd) The more debt a firm uses, the greater its financial leverage, which magnifies both risk and return. A common measure of indebtedness is the debt ratio. The ability to pay fixed charges can be measured by times interest earned and fixed-payment coverage ratios. The common-size income statement, which shows all items as a percentage of sales, can be used to determine gross profit margin, operating profit margin, and net profit margin. Other measures of profitability include earnings per share, return on total assets, and return on common equity. Market ratios include the price/earnings ratio

and the market/book ratio. A summary of all ratios can be used to perform a complete ratio analysis using crosssectional and time-series analysis. The DuPont system of analysis is a diagnostic tool used to find the key areas responsible for the firms financial performance. It enables the firm to break the return on common equity into three components: profit on sales, efficiency of asset use, and use of financial leverage. 2012 Pearson Prentice Hall. All rights reserved. 3-44

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