Git3e CH 02

Chapter 2
Financial Statement Analysis

Copyright 2003 Pearson Education, Inc.
Slide 2-1
Learning Goals
1.Review the contents of the stockholders report, and the procedures for consolidating financial statements. 2.Understand who uses financial ratios and how. 3.Use ratios to analyze a firms liquidity and activity. 4.Discuss the relationship between debt and financial leverage and the ratios used to analyze a firms debt.
Slide 2-2
Learning Goals
5. Use ratios to analyze a firms profitability and its market value. 6. Use a summary of financial ratios and the DuPont system of analysis to perform a complete ratio analysis.
Slide 2-3
The guidelines used to prepare and maintain financial records and reports are known as generally accepted accounting principles (GAAP). GAAP is authorized by the Financial Accounting Standards Board (FASB). Public corporations with more than $5 million in assets and more than 500 stockholders are required by the
The Stockholders Report
SEC to provide heir stockholders with an annual

stockholders report.
Slide 2-4
The letter to stockholders is the primary communication from management.
The Stockholders Report
It describes:
the events considered to have the greatest impact on the firm during the year, and management philosophy, strategy, and plans for the coming year. The four key financial statements required by the SEC for reporting to shareholders are the income statement, balance sheet, statement of retained earnings, and statement of cash flows.
Slide 2-5
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 annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.
Slide 2-6
Slide 2-7

The Balance Sheet
The balance sheet presents a summary of a firms financial position at a given point in time. Assets indicate what the firm owns, equity represents
the owners investment, and liabilities indicate what

the firm has borrowed.
Slide 2-8
Slide 2-9
Slide 2-10

Statement of Retained Earnings
The statement of retained earnings reconciles the net income earned and dividends paid during the year, with the change in retained earnings.
Slide 2-11

Statement of Cash Flows
The statement of cash flows provides a summary of
the cash flows over the period of concern, typically the year just ended. 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.
Slide 2-12
Slide 2-13
Notes to the Financial Statements

Notes to the financial statements provide detailed
information on the accounting policies, procedures,

calculations, and transactions underlying various entries in the financial statements.
Common issues include revenue recognition, income

taxes, breakdowns of fixed asset accounts, debt and lease terms, and contingencies.
Slide 2-14
FASB 52 mandated that U.S. based companies translate their foreign-currency denominated assets into dollars for consolidation with the parent companys financial statements. This is done by converting parent company foreign currency denominated assets and liabilities into dollars using the exchange rage prevailing at the fiscal hear ending date. Income statement items are usually treated similarly, but equity accounts are translated into dollars using the exchange rate that prevailed when the parent companys equity investment was made.
Consolidating International Financial Statements
Slide 2-15
Using Financial Ratios

Interested Parties
Ratio analysis involves methods of calculating and
interpreting financial ratios to assess a firms financial condition and performance. It is of interest to shareholders, creditors, and the firms own management.
Slide 2-16

Types of Ratio Comparisons
Trend or time-series analysis
Used to evaluate a firms performance over time
Slide 2-17

Types of Ratio Comparisons Trend or time-series analysis
cross-sectional analysis
Used to compare different firms at the same point in time
Slide 2-18

Trend or time-series analysis
industry comparative analysis One specific type of cross sectional analysis. Used to compare one firms financial performance to the industrys average performance
Slide 2-19

Types of Ratio Comparisons Trend or time-series analysis
industry comparative analysis
Combined Analysis
Combined analysis simply uses a combination of both time series analysis and cross-sectional analysis
Slide 2-20

Slide 2-21

Slide 2-22

Cautions About Using Ratio Analysis
Ratios must be considered together; a single ratio by
itself means relatively little. Financial statements that are being compared should be dated at the same point in time.
Use audited financial statements when possible.

The financial data being compared should have been
developed in the same way.

Be wary of inflation distortions.
Slide 2-23
Ratio Analysis Example

Using Bartlett Company Financial Statements
Slide 2-24
Ratio Analysis
Liquidity Ratios
Current Ratio Current ratio = total current assets total current liabilities $1,233,000 = 1.97 $620,000
Current ratio
Slide 2-25
Ratio Analysis
Liquidity Ratios
Current Ratio Quick Ratio
Quick ratio
= Total Current Assets - Inventory total current liabilities

= $1,233,000 - $289,000 = 1.51 $620,000
Quick ratio
Slide 2-26
Ratio Analysis
Liquidity Ratios Activity Ratios
Inventory Turnover Inventory Turnover = Cost of Goods Sold Inventory Inventory Turnover = $2,088,000 = 7.2 $289,000
Slide 2-27
Ratio Analysis
Average Collection Period ACP = Accounts Receivable Net Sales/360 ACP = $503,000 = 58.9 days $3,074,000/360
Slide 2-28
Ratio Analysis
Average Payment Period APP = Accounts Payable Annual Purchases/360 $382,000 = 94.1 days (.70 x $2,088,000)/360
Slide 2-29
APP =
Ratio Analysis
Total Asset Turnover Total Asset Turnover = Net Sales Total Assets
Total Asset Turnover
= $3,074,000 = .85 $3,579,000
Slide 2-30
Ratio Analysis
Financial Leverage Ratios
Debt Ratio Debt Ratio = Total Liabilities/Total Assets Debt Ratio = $1,643,000/$3,597,000 = 45.7%
Slide 2-31
Ratio Analysis
Liquidity Ratios Activity Ratios Leverage Ratios
Times Interest Earned Ratio Times Interest Earned = EBIT/Interest Times Interest Earned = $418,000/$93,000 = 4.5
Slide 2-32
Ratio Analysis
Fixed-Payment coverage Ratio (FPCR)
FPCR = EBIT + Lease Pymts
Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

FPCR = $418,000 + $35,000 = 1.9
$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}
Slide 2-33
Ratio Analysis
Slide 2-34
Ratio Analysis
Profitability Ratios
Common-Size Income Statements
Slide 2-35
Ratio Analysis
Slide 2-36
Ratio Analysis
Gross Profit Margin GPM = Gross Profit/Net Sales
GPM = $986,000/$3,074,000 = 32.1%
Slide 2-37
Ratio Analysis
Liquidity Ratios Activity Ratios Leverage Ratios Profitability Ratios
Operating Profit Margin
OPM = EBIT/Net Sales

OPM = $418,000/$3,074,000 = 13.6%
Slide 2-38
Ratio Analysis
Net Profit Margin
NPM = Net Profits After Taxes/Net Sales

NPM = $231,000/$3,074,000 = 7.5%
Slide 2-39
Ratio Analysis
Return on Total Assets (ROA)
ROA = Net Profits After Taxes/Total Assets

ROA = $231,000/$3,597,000 = 6.4%
Slide 2-40
Ratio Analysis
Return on Equity (ROE) ROE = Net Profits After Taxes/Stockholders Equity
ROE = $231,000/$1,954,000 = 11.8%
Slide 2-41
Ratio Analysis
Earnings Per Share (EPS) EPS = Earnings Available to Common Stockholders Number of Shares Outstanding
EPS = $221,000/76,262 = $2.90

Slide 2-42
Ratio Analysis
Liquidity Ratios Activity Ratios Leverage Ratios Profitability Ratios Market Ratios
Price/Earnings (P/E) Ratio
P/E = Market Price Per Share of Common Stock Earnings Per Share P/E = $32.25/$2.90 = 11.1
Slide 2-43
Ratio Analysis
Liquidity Ratios Activity Ratios Leverage Ratios Profitability Ratios Market Ratios
Market/Book (M/B) Ratio
M/B = Market Price Per Share of Common Stock Book Value Per Share of Common Stock M/B = $32.25/$23.00 = 1.40
Slide 2-44
Summarizing All Ratios
Slide 2-45
Summarizing All Ratios
Slide 2-46
DuPont System of Analysis

The DuPont system 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: ROA and ROE as shown in Figure 2.2 on the following slide. The top portion focuses on the income statement, and the bottom focuses on the balance sheet. The advantage of the DuPont system is that it allows you to break ROE into a profit on sales component, an efficiency-of-asset-use component, and a use-ofleverage component.
Slide 2-47
Slide 2-48

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Chapter 2

Financial Statement Analysis

Copyright 2003 Pearson Education, Inc.

The Stockholders Report

SEC to provide heir stockholders with an annual

The letter to stockholders is the primary communication from management.

The Stockholders Report

The Four Key Financial Statements

The Four Key Financial Statements

Copyright 2003 Pearson Education, Inc.

The Four Key Financial Statements

the owners investment, and liabilities indicate what

Copyright 2003 Pearson Education, Inc.

The Four Key Financial Statements

Copyright 2003 Pearson Education, Inc.

The Four Key Financial Statements

Copyright 2003 Pearson Education, Inc.

The Four Key Financial Statements

Copyright 2003 Pearson Education, Inc.

The Four Key Financial Statements

The Four Key Financial Statements

Copyright 2003 Pearson Education, Inc.

Notes to the Financial Statements

information on the accounting policies, procedures,

Common issues include revenue recognition, income

Consolidating International Financial Statements

Using Financial Ratios

Copyright 2003 Pearson Education, Inc.

Using Financial Ratios

Copyright 2003 Pearson Education, Inc.

Using Financial Ratios

Copyright 2003 Pearson Education, Inc.

Using Financial Ratios

Using Financial Ratios

Using Financial Ratios

Copyright 2003 Pearson Education, Inc.

Using Financial Ratios

Copyright 2003 Pearson Education, Inc.

Using Financial Ratios

Use audited financial statements when possible.

developed in the same way.

Ratio Analysis Example

Copyright 2003 Pearson Education, Inc.

Copyright 2003 Pearson Education, Inc.

= Total Current Assets - Inventory total current liabilities

Copyright 2003 Pearson Education, Inc.

Copyright 2003 Pearson Education, Inc.

Copyright 2003 Pearson Education, Inc.

Copyright 2003 Pearson Education, Inc.

Total Asset Turnover

= $3,074,000 = .85 $3,579,000

Copyright 2003 Pearson Education, Inc.

Copyright 2003 Pearson Education, Inc.

Copyright 2003 Pearson Education, Inc.

Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

$93,000 + $35,000 + {($71,000 + $10,000) x [1/(1-.29)]}

Copyright 2003 Pearson Education, Inc.

Copyright 2003 Pearson Education, Inc.

Copyright 2003 Pearson Education, Inc.

Copyright 2003 Pearson Education, Inc.

GPM = $986,000/$3,074,000 = 32.1%

Copyright 2003 Pearson Education, Inc.