Chapter 3: FIN 350: Financial Statements and Ratio Analysis

Income Statement Items

(revenues and expenses) are usually treated similarly.

Advantages to time-series Analysis

+Comparison of current to past performance, using ratios, enables analysts to assess the firm's progress. +Developing trends can be seen by using multiyear comparisons. +The most informative approach to ratio analysis combines cross-sectional and time-series analyses

Parties involved with Financial Ratios

+Current and prospective shareholders are interested in the firm's 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 firm's financial situation, and it attempts to produce financial ratios that will be considered favorable by both owners and creditors.

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. Results can be distorted by inflation.

Caldwell Manufacturing's calculated inventory turnover for 2015 and the average inventory turnover were as follows:

Inventory turnover '15 Caldwell Manufacturing 14.8 Industry average 9.7

Inventory Turnover

Inventory turnover = Cost of goods sold ÷ Inventory

Securities and Exchange Commission (SEC)

Public corporations with more than $5 million in assets and more than 500 stockholders are required by the ______________ to provide their stockholders with an annual stockholders' report, which summarizes and documents the firm's financial activities during the past year

Focus on Ethics

Take Earnings Reports at Face Value Near the end of each quarter, many companies unveil their quarterly performance. Firms that beat analyst estimates often see their share prices jump, while those that miss estimates by even a small amount, tend to suffer price declines. The practice of manipulating earnings in order to mislead investors is known as earnings management.

Du Pont System of Analysis

The DuPont system first brings together the net profit margin, which measures the firm's 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, look up formula

Du pont system with the modified DuPont formula

The modified DuPont Formula relates the firm's 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,

Total asset turnover

Total asset turnover = Sales ÷ Total assets

Current Rate (Translation) Method

a technique used by U.S.-based companies to translate their foreign-currency-denominated assets and liabilities into dollars, for consolidation with the parent company's financial statements, using the year-end (current) exchange rate.

Retained Earnings

are adjusted to reflect each year's operating profits (or losses).

International Financial Reporting Standards (IFRS

are established by the International Accounting Standards Board (IASB). More than 80 countries now require listed firms to comply with IFRS, and dozens more permit or require firms to follow IFRS to some degree. In the United States, public companies are required to report financial results using GAAP, which requires more detail than IFRS.

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).

Average age of inventory

average # of day's sales in inventory Average Age of Inventory = 365 ÷ Inventory turnover

Average Payment Period

average amount of time needed to pay A.P A.P/ (annual purchases/365) = ____ days

Liquidity Ratio

dividing total liquid assets by total current debt =($2,225/$21,539) = 0.1033, or 10.3% Therefore, can cover only about 10 percent of their existing 1-year debt obligations with their current liquid assets.

Quick (acid-test) Ratio

excludes inventory, which is generally the least liquid current asset. current assets-inventory/ current liabilities

Ratio Analysis

involves methods of calculating and interpreting financial ratios to analyze and monitor the firm's performance.

Benchmarking

is a type of cross-sectional analysis in which the firm's ratio values are compared to those of a key competitor or group of competitors that it wishes to emulate.

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.

Cross-Sectional Analysis

is the comparison of different firms' financial ratios at the same point in time; involves comparing the firm's ratios to those of other firms in its industry or to industry averages

Time-series Analysis

is the evaluation of the firm's financial performance over time using financial ratio analysis

FASB 52

mandates that U.S.-based companies translate their foreign-currency-denominated assets and liabilities into dollars, for consolidation with the parent company's financial statements. This is done by using the current rate (translation) method

Current Ratio

measures the ability of the firm to meet its short-term obligations. Current ratio = Current assets ÷ Current liabilities The current ratio for Bartlett Company in 2015 is: $1,223,000 ÷ $620,000 = 1.97

Price/earning (P/E) ratio

measures the amount that investors are willing to pay for each dollar of a firm's earnings. Price Earnings (P/E) Ratio = Market price per share of common stock ÷ Earnings per share If Bartlett Company's common stock at the end of 2015 was selling at $32.25, using the EPS of $2.90, the P/E ratio at year-end 2015 is: $32.25 ÷ $2.90 = 11.12

times interest earned ratio

measures the firm's ability to make contractual interest payments; sometimes called the interest coverage ratio. Times interest earned ratio = EBIT ÷ taxes 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 2015 value: $418,000 ÷ $93,000 = 4.49

Fixed-payment coverage ratio

measures the firm's ability to meet all fixed-payment obligations. Fixed-Payment coverage Ratio (FPCR) earnrings before interest and taxes + lease payments/ (interest+lease payments+ (principle payments + perferred stock dividends)*[1/(1-T)]

Return on total assets

measures the overall effectiveness of management in generating profits with its available assets. Return on total assets (ROA) = Earnings available for common stockholders ÷ Total assets

Operating profit margin

measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and preferred stock dividends are deducted. Operating profit margin = Operating profits ÷ sales

Net profit margin

measures the percentage of each sales dollar remaining after all costs and expenses, including interest, taxes, and preferred stock dividends, have been deducted. Net profit margin = Earnings available for common stockholders ÷ Sales

Gross profit margin

measures the percentage of each sales dollar remaining after the firm has paid for its goods. =sales -COGS/ sales =gross profit/ sales

Debt Ratio

measures the proportion of total assets financed by the firm's creditors. Debt ratio = Total liabilities ÷ Total assets

Debt-to-equity ratio

measures the relative proportion of total liabilities and common stock equity used to finance the firm's total assets. Debt to equity = Total liabilities ÷ Common stock equity

Return on Equity

measures the return earned on common stockholders' investment in the firm. Return on Equity (ROE) = Earnings available for common stockholders ÷ Common stock equity This ratio for Bartlett Company in 2015 is: $221,000 ÷ $1,754,000 = 0.126 = 12.6%

Du Pont System

of analysis is used to dissect the firm's 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 firm's 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.

Equity Accounts

on the other hand, are translated into dollars by using the exchange rate that prevailed when the parent's equity investment was made (the historical rate).

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.

Average Collection

period is the avg. amount of time needed to collect A.R A.R./ (annual sales/365)

Balance Sheet

presents a summary of a firm's financial position at a given point in time. The statement balances the firm's assets (what it owns) against its financing, which can be either debt (what it owes) or equity (what was provided by owners).

Income Statement

provides a financial summary of a company's 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.

The statement of cash flows

provides a summary of the firm's 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 company's investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

Market/Book (M/B) ratio

provides an assessment of how investors view the firm's performance. =market price per share of common stock/ book value per share of common stock

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.

Earnings per share

represents the number of dollars earned during the period on the behalf of each outstanding share of common stock. = earnings avaliable for common stockholders/ # of shares of common stock outstanding