Chapter 12 - Financial Statement Analysis
Ratios are an important way to compare (3 things)
1. One company to another company 2. one company to itself over time 3. one company to the industry average
Aggressive vs conservative
Aggressive = overstate assets, higher profitability/income, lower risk/debt Conservative = understating assets and income
Example of vertical analysis) what is the COGS relative to Net Sales?
COGS/Net sales Note: the lower the percentage, the higher COGS relative to net sales. Which means that the company spend less money to make the product
inventory turnover ratio
COGS/average inventory Note: the higher the better, it indicates that the inventory is selling quickly, but TOO high could mean that the company is losing sales due to shortages
Example of vertical analysis
Comparing Nike to Under Armor. It might seem like Nike reports higher N/I than Under Armour, but that is b/c it is a greater company. To better compare the two we use vertical analysis to express each income statement as a percentage of sales or each balance sheet as a percentage of assets
What is the average collection period?
Converting the receivable turnover ratio into days 365/receivables turnover ratio Note: The shorter the average collection period the better
Current ratio
Current assets/current liabilities
gross profit ratio
Gross Profit (net sales - COGS)/net sales Note: higher ratio, more profitability
Low vs. High current ratio
High - A high current ratio indicates that a company has sufficient current assets to pay current liabilities as they become due Low - company does not have sufficient current assets to pay liabilities
High vs. low debt to equity ratio
High - more risk Low - less risk
What does the receivables turnover ratio measure?
How many times on average a company collects its receivables during the year
Horizontal analysis formula
Increase (decrease) = current yr - prior year / prior year
What is vertical analysis?
It expresses in a financial statement as a percentage of the same bare amount
What is horizontal analysis?
It shows trends in the financial statement data for a single company over time (aka calculating the percentage change in an account from last year to this year)
Low vs. high receivables turnover ratio
Low - a company is having trouble collecting its A/R High - a company can quickly turn over its receivables into cash
What does the inventory turnover ratio measure?
Measures how many times, on average, a company sells its entire inventory during the year.
Example of horizontal analysis) Calculate Net income relative to net sales
Net Income/Net sales
What is solvency?
Refers to a companies ability to pay for its long-term liabilities
What is asset turnover
Sales volume in relation to the investment is assets
What is important to know when comparing an income statement account to a balance sheet account?
Since the income statement account is measured over a PERIOD of time and a balance sheet account is measured at a POINT in time, we need to take the average of beginning and ending balances of the balance sheet account
What is debt to equity ratio?
The ability of creditors to force bankruptcy
What is a discontinued operation?
a business, or a component of a business, that the organization has already discontinued or plans to discontinue We report any gains or losses on discontinued operations in the current year, separately from gains and losses on the portion of the business that will continue.
Return on assets
average income/total assets Note: higher ratio, more profitability
What is the current ratio?
compares current assets to current liabilities
What is the average days in inventory?
converting the inventory turnover ratio into days 365/inventory turnover ratio Note: the lower the better, companies try to minimize the number of days they hold inventory
What is profit margin?
earnings on each dollar of sales
What is the return on equity?
earnings on each dollar of stockholders equity
What is gross profit ratio?
indicates the portion of each dollar of sales above its cost of goods sold.
What do profitability ratios measure?
measure the earnings or operating effectiveness of a company.
What is return on assets?
measures the income the company earns on each dollar invested in assets.
Receivables turnover ratio
net credit sales/average accounts receivable note: the higher the better
Return on equity
net income/average stockholders equity Note: higher ratio, more profitability
Profit margin
net income/net sales Note: higher ratio, more profitability
Asset turnover
net sales/average total assets Note: higher ratio, more profitability
What is liquidity?
refers to having sufficient cash (or other assets easily convertible to cash) to pay its current liabilities
Quality of earnings
refers to the ability of reported earnings to reflect the company's true earnings, as well as the usefulness of reported earnings to predict future earnings.
What does risk analysis help us determine?
the risk and profitability of a company it is important for determining company value
Debt to equity ratio
total liabilities/total Stockholders equity
