Chapter 11: Financial Statement Analysis

To calculate how many days' sales were in receivables at any time...

1. Obtain daily sales amounts for the period ending. 2. Add daily sales amounts (working backward by day) until the sum equals the total accounts receivable. 3. Count the number of days' sales that had to be included to reach this total.

Average ROI based on operating income (U.S).

10% to 15%.

Dividend payout ratio average.

30% to 50%.

Turnover is frequently calculated for...

Accounts receivable, inventories, plant and equipment, total operating assets and total assets.

Extra dividends.

Additional dividends that may be declared and paid after an especially profitable year.

Interpretation of P/E ratios.

Average P/E ratio: between 12 and 18. An above-average P/E ratio indicates that the common stock price is high relative to the firm's current earnings (investors anticipate favorable future developments e.g. increased earnings per share or higher dividends per share). Low P/E ratios indicate poor earnings expectations.

Calculation: number of days' sales in inventories.

Average day's cost of goods sold = average cost of goods sold / 365. Days' sales in inventory = inventory at year-end / average day's cost of goods sold.

Calculation: number of days' sales in accounts receivable.

Average day's sales = annual sales / 365. Days' sales in accounts receivable = accounts receivable at year-end / average day's sales.

Financial leverage, ROE and ROI.

Because the cost of debt is a fixed charge regardless of the amount of earnings, leverage also magnifies the return to owners relative to the return on assets (ROI).

Average ROE (U.S).

Between 12% and 20%.

Average ROI based on net income for most U.S companies.

Between 7% and 10%.

Book value per share of common stock and explanation.

Common stockholder's equity / number of shares of common stock outstanding. If there is preferred stock in the capital structure of the firm, the liquidating value of the preferred stock is subtracted from total stockholders' equity to get the common stockholders' equity.

Inventory turnover.

Cost of goods sold / average inventories.

Why do debt and preferred stock provide financial leverage.

Debt and preferred stock provide leverage because the interest cost (or dividend rate) is fixed. When debt is issued, the interest rate is set and remains unchanged for the life of the debt issue.

Two financial leverage measures.

Debt ratio and debt/equity ratio.

Dividend payout ratio and use.

Dividend payout ratio = annual dividend per share / earnings per share. Reflects dividend policy of company. Permits the investor to project dividends from a firm's earnings prospects.

Dividend yield.

Dividend yield = annual dividend per share / market price per share of stock.

Times interest earned ratio and evaluation.

Earnings before interest and taxes / interest expense. The greater the ratio, the more confidence the debtholders can be about the firm's prospects for continuing to have enough earnings to cover interest expense. Ratio of 5 or higher is considered relatively low risk.

Turnover, number of days' sales in accounts receivable and efficiency.

In general, the higher the turnover or the fewer the number of days' sales in accounts receivable, the greater the efficiency.

Warnings that liquidity/profitability may be weakening.

Increase in the age of accounts receivable, an increase in inventory relative to sales, or a reduction in plant and equipment turnover.

What can affect the comparability of turnover between companies?

Inventory cost flow assumptions and depreciation methods.

Using the dividend yield.

Investors can accept a low current dividend yield from a common stock if they believe that the firm is reinvesting the earnings retained for use in the business at a relatively high ROI because investors anticipate that future earnings will permit higher future dividends. In the case of preferred stock, investors will compare the yield to that available on other fixed-income investments with comparable risk to determine whether or not to continue holding the preferred stock as an investment.

Four categories of ratios used in financial statement analysis.

Liquidity, activity, profitability and debt or financial leverage.

Price/earnings ratio AKA earnings multiple and its use.

Market price of a share of common stock / earnings per share of common stock. Used to evaluate the market price of a company's common stock relative to other companies and the market as a whole. Diluted earnings per share is commonly used.

Preferred dividend coverage ratio.

Net income / preferred dividend requirement.

Two other activity measures that permit assessment of the efficiency of asset management.

Number of days' sales in accounts receivable and number of days' sales in inventory. The sooner accounts receivable can be collected, the sooner cash is available and the less cash needs to be borrowed to pay for liabilities. Also, the lower that inventories can be maintained relative to sales, the less inventory needs to be financed with debt or stockholder's equity and the greater the return on investment.

ROE, ROI key notes.

Return on investment measures the efficiency with which management has used the operating assets to generate operating income. Note that the return on investment calculation is based on earnings before interest and taxes (operating income) and total assets, rather than net income and total assets. Earnings before interest and taxes (operating income) are used because the interest expense reflects a financing decision, not an operating result, and income taxes are beyond the control of operating management. Thus, ROI becomes an evaluation of the operating activities of the firm. Return on equity measures the rate of return that net income provides to the owners/ stockholders. ROI and ROE differ for the firm without financial leverage only because income taxes have been excluded from ROI but have been included in ROE.

Significance of the P/E ratio.

Return on investment will be realized in two ways: (1) The firm will pay cash dividends, and (2) the market price of the firm's stock will increase. The change in market value is usually called a capital gain or loss. A number of factors can cause the market price to change. One of the most significant of these is the prospect for future cash dividends. Both present and future cash dividends are a function of earnings. So, the market price of a company's common stock reflects investors' expectations about the firm's future earnings. The greater the probability of increased earnings, the more investors are willing to pay for a claim to those earnings. Relating market price and earnings per share in a ratio is a way to express investors' expectations without confusing the issue by focusing on just market price per share.

Accounts receivable turnover.

Sales / average accounts receivable.

Plant and equipment turnover.

Sales / average plant and equipment.

Dividend yield and preferred stock.

Since preferred dividends are linked to the par value per share, the dividend yield for preferred shareholders decreases as the market price per share increases.

Regular dividends.

Stable or gradually changing (i.e., quarterly, semiannual or annual).

Effect of inventory cost flow assumption on working capital.

The balance sheet carrying value of inventories depends on the method used. In periods of rising prices, FIFO will report a relatively higher asset value for inventories than LIFO.

LIFO reserve.

The difference between the inventory valuation as reported under LIFO and FIFO.

Focus of activity measures.

The relationship between asset levels and sales (i.e., turnover). Turnover = sales / average assets.

What is financial leverage?

The use of debt to finance the assets of the entity. Adds risk to the operation of the firm because if it does not generate enough cash to pay principal and interest payments, creditors may force the firm into bankruptcy.

Debt ratio and average level.

Total liabilities / total liabilities and stockholder's equity. Most nonfinancial firms will have a debt ratio below 50%.

Debt equity ratio and average level.

Total liabilities / total stockholder's equity. Normally, less than 1.