List the users of financial statement. 2. Explain the importance of financial statement analysis. 3. List basic financial statement analytical procedures. 5. Apply financial statement analysis to assess the solvency of a business.
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PP for Chapter 6 - Financial Statement Analysis - Final
List the users of financial statement. 2. Explain the importance of financial statement analysis. 3. List basic financial statement analytical procedures. 5. Apply financial statement analysis to assess the solvency of a business.
List the users of financial statement. 2. Explain the importance of financial statement analysis. 3. List basic financial statement analytical procedures. 5. Apply financial statement analysis to assess the solvency of a business.
1 1 Accounting: A Malaysian Perspective, 4 th ed (Adapted from Accounting 22 nd ed) Warren, Reeve and Duchac Financial Statement Analysis 6 2 Click to edit Master title style 2 2 1. List the users of financial statement. 2. Explain the importance of financial statement analysis. 3. List basic financial statement analytical procedures. 4. Apply financial statement analysis to assess the solvency of a business. 5. Apply financial statement analysis to stress the profitability of a business. After studying this chapter, you should be able to: 3 Click to edit Master title style 3 3 Objective 1 6-1 List the users of financial statement.
4 Click to edit Master title style 4 4 1. Internal stakeholders a. Management team b. Existing shareholders c. Employees at all levels
2. External stakeholders a. Creditors (suppliers and banks) b. Inland revenue board (IRB) c. Potential shareholders d. Public at large
Two groups of financial statements users: 6-1 5 Click to edit Master title style 5 5 Users have different expectation on financial statements: User Example of use Management team and existing shareholders
Assess firms financial performance, growth, and future planning Employees Assess stability of the firm they are currently working with Creditors Evaluate credit worthiness and solvency of the firm Inland revenue board Compute taxable income of the company and avoiding tax evasion practice Potential shareholders Facilitate investment decisions Public at large Environmental awareness and corporate social responsibilities 6-1 6 Click to edit Master title style 6 6 Describe importance of financial statements Objective 2 6-2 7 Click to edit Master title style 7 7 1. Indicate financial positions of the company for certain period 2. Provide comparative analysis of the firm performance in relative to their competitors 3. Benchmark firm performance with an overall industry performance 4. Assess firm financial performance and operating efficiency by linking one type of financial information to another (ratio analysis) 6-2 8 Click to edit Master title style 8 8 List basic financial statement analytical procedures: Horizontal Analysis Vertical Analysis Common-size statements Objective 3 6-3 9 Click to edit Master title style 9 9 The percentage analysis of increases and decreases in related items in comparative financial statements is called horizontal analysis. 6-3 10 Click to edit Master title style 10 10 Increase (Decrease) Mercu Tanda Sdn Bhd Comparative Balance Sheet December 31, 2008 and 2007
2008 2007 Amount Percent Comparative Balance Sheets 6-3 11 Click to edit Master title style 11 11 Comparative Schedule of Current Assets Mercu Tanda Sdn Bhd Comparative Schedule of Current Assets December 31, 2008 and 2007 Increase (Decrease) Cash $ 90,500 $ 64,700 $ 25,800 39.9% Marketable securities 75,000 60,000 15,000 25.0% Accounts receivable (net) 115,000 120,000 (5,000) (4.2%) Inventories 264,000 283,000 (19,000) (6.7%) Prepaid expenses 5,500 5,300 200 3.8% Total current assets $550,000 $533,000 $17,000 3.2% 2008 2007 Amount Percent 6-3 12 Click to edit Master title style 12 12 Mercu Tanda Sdn Bhd Comparative Income Statement For the Year Ended December 31, 2008 and 2007 Sales $1,530,500 $1,234,000 $296,500 24.0% Sales returns and allowances 32,500 34,000 (1,500) (4.4%) Net sales $1,498,000 $1,200,000 $298,000 24.8% Cost of goods sold 1,043,000 820,000 223,000 27.2% Gross profit $ 455,000 $ 380,000 $ 75,000 19.7% Selling expenses $ 191,000 $ 147,000 $ 44,000 29.9% Administrative expenses 104,000 97,400 6,600 6.8% Total operating expenses $ 295,000 $ 244,400 $ 50,600 20.7% Income from operations $ 160,000 $ 135,600 $ 24,400 18.0% Other income 8,500 11,000 (2,500) (22.7%) $ 168,500 $ 146,600 $ 21,900 14.9% Other expense (interest) 6,000 12,000 (6,000) (50.0%) Income before income tax $ 162,500 $ 134,600 $ 27,900 20.7% Income tax expense 71,500 58,100 13,400 23.1% Net income $ 91,000 $ 76,500 $ 14,500 19.0%
2008 2007 Amount Percent Increase (Decrease) Comparative Income Statement 6-3 13 Click to edit Master title style 13 13 Comparative RE Statement A percentage analysis that shows the relationship of each component to the total within a single statement is called vertical analysis. Mercu Tanda Sdn Bhd Comparative Retained Earnings Statement December 31, 2008 and 2007 Increase (Decrease) Retained earnings, Jan. 1$137,500$100,000$37,500 37.5% Net income for year 91,000 76,500 14,500 19.0% Total $228,500 $176,500 $52,000 29.5%) Dividends: On preferred stock $ 9,000$ 9,000 On common stock 40,000 30,000 10,000 33.3% Total $ 49,000 $ 39,000 $10,000 25.6% Total current assets $179,500 $137,500 $42,000 30.5% 2008 2007 Amount Percent 6-3 14 Click to edit Master title style 14 14 A percentage analysis used to show the relationship of each component to the total within a single statement is called vertical analysis. 6-3 15 Click to edit Master title style 15 15 In a vertical analysis of the balance sheet, each asset item is stated as a percent of the total assets. Each liability and stockholders equity item is stated as a percent of the total liabilities and stockholders equity. e.g. Current asset (2008): =(Total current asset / Total asset) x 100 = $550,000/$1,139,500 = 48.3% 6-3 16 Click to edit Master title style 16 16 Mercu Tanda Sdn Bhd Comparative Balance Sheet For the Years Ended December 31, 2008 and 2007 Assets Current assets $ 550,000 48.3% $ 533,000 43.3% Long-term investments 95,000 8.3 177,500 14.4 Property, plant, & equip. (net) 444,500 39.0 470,000 38.2 Intangible assets 50,000 4.4 50,000 4.1 Total assets $1,139,500 100.0% $1,230,500 100.0% Liabilities Current liabilities $ 210,000 18.4% $ 243,000 19.7% Long-term liabilities 100,000 8.8 200,000 16.3 Total liabilities $ 310,000 27.2% $ 443,000 36.0% Stockholders Equity Preferred 6% stock, $100 par $ 150,000 13.2% $ 150,000 12.2% 2.2% Common stock, $10 par 500,000 43.9 500,000 40.6 Retained earnings 179,500 15.7 137,500 11.2 Total stockholders equity $ 829,500 72.8% $ 787,500 64.0% Total liab. & Stockholders equity $1,139,500 100.0% $1,230,500 100.0% Amount Percent Amount Percent 2008 2007 Total assets $1,139,500 100.0%$1,230,500100.0% Total liab. & stockholders equity $1,139,500 100.0% $1,230,500100.0% 6-3 17 Click to edit Master title style 17 17 In a vertical analysis of the income statement, each item is stated as a percent of net sales. As an example, lets see how the percent of 12.8% was calculated for 2008 selling expenses. e.g. Percentage of selling expense (2008): =(Selling expense/Net sales) x 100 =($191,000 / $1,498,000) x 100 = 12.8%
6-3 18 Click to edit Master title style 18 18 Sales $1,530,500 102.2% $1,234,000 102.8% Sales returns and allow. 32,500 2.2 34,000 2.8 Net sales $1,498,000 100.0% $1,200,000 100.0% Cost of goods sold 1,043,000 69.6 820,000 68.3 Gross profit $ 455,000 30.4% $ 380,000 31.7% Selling expenses $ 191,000 12.8% $ 147,000 12.3% Administrative expenses 104,000 6.9 97,400 8.1 Total operating expenses $ 295,000 19.7% $ 244,400 20.4% Income from operations $ 160,000 10.7 $ 135,600 11.3% Other income 8,500 0.6 11,000 0.9 $ 168,500 11.3% $ 146,600 12.2% Other expense (interest) 6,000 0.4 12,000 1.0 Income before income tax $ 162,500 10.9% $ 134,600 11.2% Income tax expense 71,500 4.8 58,100 4.8 Net income $ 91,000 6.1% $ 76,500 6.4%
2008 2007 Amount Percent Amount Percent Mercu Tanda Sdn Bhd Comparative Income Statement For the Years Ended December 31, 2008 and 2007 6-3 19 Click to edit Master title style 19 19 In a common-sized statements, all items are expressed as a percentage. Common-sized statements are useful in comparing the current period with prior periods, individual businesses, or one business with industry percentages. 6-3 20 Click to edit Master title style 20 20 Mercu Tanda Sdn Bhd and Megah Sdn Bhd Condensed Common-size Income Statement For the year Ended December 31, 2008 Mercu Tanda Megah 6-3 21 Click to edit Master title style 21 21 Apply financial statement analysis to assess the solvency of a business:
Objective 4 6-4 22 Click to edit Master title style 22 22 Using measures to assess a businesss ability to pay its current liabilities is called current position analysis. Such analysis is of special interest to short-term creditors. 6-4 23 Click to edit Master title style 23 23 Ratios used to assess current position analysis: Working capital Current ratio Quick ratio Accounts receivable turnover Number of Days Sales in Receivables Inventory turnover Number of days sales in inventory 6-4 24 Click to edit Master title style 24 24 The ability of a business to meet its financial obligations (debts) is called solvency. The ability of a business to earn income is called profitability. 6-4 25 Click to edit Master title style 25 25 Ratios used in assessing business solvency: Ratio of Fixed Assets to Long-Term Liabilities Ratio of Liabilities to Stockholders Equity Number of Times Interest Charges Earned 6-4 26 Click to edit Master title style 26 26 Working Capital The excess of current assets of a business over its current liabilities is called working capital. The working capital is often used in evaluating a companys ability to meet currently maturing debts. Working capital: Total current assets total current liabilities 6-4 27 Click to edit Master title style 27 27 Working capital (a b) $340,000 Current asset: Cash $ 90,500 Marketable securities 75,000 Accounts receivable (net) 115,000 Inventories 264,000 Prepaid expenses 5,500 a. Total current assets $550,000 b. Current liabilities 210,000 Mercu Tanda Sdn Bhd 6-4 28 Click to edit Master title style 28 28 Current Ratio The current ratio, sometimes called the working capital ratio or bankers ratio, is computed by dividing the total current assets by the total current liabilities. Current ratio: Total current assets total current liabilities 6-4 29 Click to edit Master title style 29 29 Current ratio (a/b) 2.6 2.2 a. Current assets $550,000 $533,000 b. Current liabilities 210,000 243,000 Working capital (a b) $340,000 $290,000 2008 2007 Mercu Tanda Sdn Bhd 6-4 30 Click to edit Master title style 30 30 Quick Ratio A ratio that measures the instant debt- paying ability of a company is called the quick ratio or acid-test ratio. Quick ratio: total quick assets total current liabilities 6-4 31 Click to edit Master title style 31 31 2008 2007 Quick ratio (a/b) 1.3 1.0 Quick assets: Cash $ 90,500 $ 64,700 Marketable securities 75,000 60,000 Accounts receivable (net) 115,000 120,000 a. Total quick assets $280,500 $244,700 b. Current liabilities $210,000 $243,000 Mercu Tanda Sdn Bhd Quick assets are cash and other current assets that can be quickly converted to cash. 6-4 32 Click to edit Master title style 32 32 Accounts Receivable Turnover The relationship between sales and accounts receivable may be stated as the accounts receivable turnover. The ratio is to assess the efficiency of the firm in collecting receivables and in the managing of credit. A/R turnover: Net sales average Accounts receivable 6-4 33 Click to edit Master title style 33 33 Accounts receivable turnover (a/b) 12.7 9.2 a. Net sales $1,498,000 $1,200,000 Accounts receivable (net): Beginning of year $ 120,000 $ 140,000 End of year 115,500 120,000 Total $ 235,000 $ 260,000 b. Average (Total/2) $ 117,500 $ 130,000 2008 2007 Mercu Tanda Sdn Bhd 6-4 34 Click to edit Master title style 34 34 Number of Days Sales in Receivables The number of days sales in receivables is an estimate of the length of time (in days) the accounts receivable have been outstanding. Comparing this measure with the credit terms provides information on the efficiency in collecting receivables. Formula: Average Accounts receivable Average daily sales on account 6-4 35 Click to edit Master title style 35 35 Number of days sales in receivables (a/b) 28.6 39.5 a. Average (Total/2) $ 117,500 $ 130,000 Net sales $1,498,000 $1,200,000 b. Average daily sales on account (Sales/365) $ 4,104 $ 3,288 2008 2007 Mercu Tanda Sdn Bhd 6-4 36 Click to edit Master title style 36 36 Inventory Turnover The relationship between the volume of goods (merchandise) sold and inventory may be stated as the inventory turnover. The purpose of this ratio is to assess the efficiency of the firm in managing its inventory. Formula: Cost of goods sold average inventories 6-4 37 Click to edit Master title style 37 37 2008 2007 Inventory turnover (a/b) 3.8 2.8 a. Cost of goods sold $1,043,000 $ 820,000 Inventories: Beginning of year $ 283,000 $ 311,000 End of year 264,000 283,000 Total $ 547,000 $ 594,000 b. Average (Total/2) $ 273,500 $ 297,000 Mercu Tanda Sdn Bhd 6-4 38 Click to edit Master title style 38 38 Formula: Average inventories average daily COGS Number of Days Sales in Inventories The number of days sales in inventories is an estimate of the length of time (in days) required to sell the inventories. This ratio provides information on the efficiency in converting inventories to sales. 6-4 39 Click to edit Master title style 39 39 Number of days sales in inventory (a/b) 95.7 132.2 a. Average (Total/2) $ 273,500 $ 297,000 Cost of goods sold $1,043,000 $ 820,000 b. Average daily cost of goods sold (COGS/365 days) $2,858 $2,247 2008 2007 Number of Days Sales in Inventory Mercu Tanda Sdn Bhd 6-4 40 Click to edit Master title style 40 40 Ratio of Fixed Assets to Long-Term Liabilities The ratio of fixed assets to long-term liabilities is a solvency measure that indicates the margin of safety of the note holders or bondholders. It also indicates the ability of the business to borrow additional funds on a long-term basis. Formula: Fixed assets (net) long term liabilities 6-4 41 Click to edit Master title style 41 41 2008 2007 Ratio of fixed assets to long-term liabilities (a/b) 4.4 2.4 a. Fixed assets (net) $444,500 $470,000 b. Long-term liabilities $100,000 $200,000 Mercu Tanda Sdn Bhd 6-4 42 Click to edit Master title style 42 42 Ratio of Liabilities to Stockholders Equity The relationship between the total claims of the creditors and ownersthe ratio of liabilities to stockholders equityis a solvency measure that indicates the margin of safety for creditors. Formula: total liabilities total stockholders equity 6-4 43 Click to edit Master title style 43 43 Ratio of liabilities to stockholders equity (a/b) 0.4 0.6 a. Total liabilities $310,000 $443,000 b. Total stockholders equity $829,500 $787,500
2008 2007 Mercu Tanda Sdn Bhd 6-4 44 Click to edit Master title style 44 44 Number of Times Interest Charges Earned Corporations in some industries normally have high ratios of debt to stockholders equity. For such corporations, the relative risk of the debt- holders is normally measured as the number of times interest charges are earned (during the year), sometimes called the fixed charge coverage ratio. Formula: (Income before tax + interest expense) interest expense
6-4 45 Click to edit Master title style 45 45 2008 2007 Income before income tax $162,500 $134,600 a. Add interest expense 6,000 12,000 b. Amount available to meet interest charges $168,500 $146,600 Number of times interest charges earned (b/a) 28.1 12.2 Mercu Tanda Sdn Bhd 6-4 46 Click to edit Master title style 46 46 Apply financial statement analysis to assess the profitability of a business Objective 5 6-4 47 Click to edit Master title style 47 47 Profitability is the ability of an entity to earn profits. This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available as reported in the balance sheet. Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet. 6-4 48 Click to edit Master title style 48 48 Ratios used to assess the profitability of a business include: Ratio of Net Sales to Assets Rate Earned on Total Assets Rate Earned on Stockholders Equity Leverage Rate Earned on Common Stockholders Equity Earnings per Share on Common Stock Price earning ratio Dividends per Share Dividend yield 6-4 49 Click to edit Master title style 49 49 Ratio of Net Sales to Assets The ratio of net sales to assets is a profitability measure that shows how effectively a firm utilizes its assets. Formula: Net sales average total asset * (*exclude long term investment)
6-4 50 Click to edit Master title style 50 50 2008 2007 a. Net sales $1,498,000 $1,200,000 Total assets: Beginning of year $1,053,000 $1,010,000 End of year 1,044,500 1,053,000 Total $2,097,500 $2,063,000 b. Average (Total/2) $1,048,750 $1,031,500
Excludes long-term investments Mercu Tanda Sdn Bhd 6-4 51 Click to edit Master title style 51 51 2008 2007 a. Net sales $1,498,000 $1,200,000 Total assets: Beginning of year $1,053,000 $1,010,000 End of year 1,044,500 1,053,000 Total $2,097,500 $2,063,000 b. Average (Total/2) $1,048,750 $1,031,500
Ratio of net sales to assets (a/b) 1.4 1.2 Mercu Tanda Sdn Bhd 6-4 52 Click to edit Master title style 52 52 Rate Earned on Total Assets The rate earned on total assets measures the profitability of total assets, without considering how the assets are financed. Formula: Net income + interest expense Average total assets
6-4 53 Click to edit Master title style 53 53 2008 2007 Rate earned on total assets (a/b) 8.2% 7.3% Net income $ 91,000 $ 76,500 Plus interest expense 6,000 12,000 a. Total $ 97,000 $ 88,500 Total assets: Beginning of year $1,230,500 $1,187,500 End of year 1,139,500 1,230,500 Total $2,370,000 $2,418,000 b. Average (Total/2) $1,185,000 $1,209,000 Mercu Tanda Sdn Bhd 6-4 54 Click to edit Master title style 54 54 Rate Earned on Stockholders Equity The rate earned on stockholders equity measure emphasizes the rate of income earned on the amount invested by the stockholders. Formula: Net income Average stockholders equity
6-4 55 Click to edit Master title style 55 55 Rate earned on stockholders equity (a/b) 11.3% 10.0% a. Net income $ 91,000 $ 76,500 Stockholders equity: Beginning of year $ 787,500 $ 750,000 End of year 829,500 787,500 Total $1,617,000 $1,537,500 b. Average (Total/2) $ 808,500 $ 768,750 2008 2007 Mercu Tanda Sdn Bhd 6-4 56 Click to edit Master title style 56 56 The difference in the rate earned on stockholders equity and the rate earned on total assets is called leverage. Leverage Formula: Rate earned on stockholders equity rate earned on total asset
6-4 57 Click to edit Master title style 57 57 73 10 % 5% 0% Rate earned on total assets Rate earned on stockholders equity 8.2% 11.3% Leverage 3.1% 2008 7.3% 10.0% Leverage 2.7% 2007 Exhibit 8 Leverage 6-4 58 Click to edit Master title style 58 58 The rate earned on common stockholders equity focuses only on the rate of profits earned on the amount invested by the common stockholders. Rate Earned on Common Stockholders Equity Formula: Net income preferred dividend Average common stockholders equity
6-4 59 Click to edit Master title style 59 59 2008 2007 Net income $ 91,000 $ 76,500 Less preferred dividends 9,000 9,000 a. Remaindercommon stock $ 82,000 $ 67,500 Common stockholders equity: Beginning of year $ 637,500 $ 600,000 End of year 679,500 637,500 Total $1,317,000 $1,237,500 b. Average (Total/2) $ 658,500 $ 618,750 Rate earned on common stockholders equity (a/b) 12.5% 10.9% Mercu Tanda Sdn Bhd 6-4 60 Click to edit Master title style 60 60 Earnings per Share on Common Stock One of the profitability measures often quoted by the financial press is earning per share (EPS) on common stock. It is also normally reported in the income statement in corporate annual reports. Formula: Net income preferred dividend number of shares in common stock
6-4 61 Click to edit Master title style 61 61 2008 2007 Earnings per share on common stock (a/b) $1.64 $1.35 Net income $ 91,000 $ 76,500 Preferred dividends 9,000 9,000 a. Remainderidentified with common stock $ 82,000 $ 67,500 b. Shares of common stock 50,000 50,000 Mercu Tanda Sdn Bhd 6-4 62 Click to edit Master title style 62 62 Price-Earnings Ratio Another profitability measure quoted by the financial press is the price-earnings (P/E) ratio on common stock. The price-earnings ratio is an indicator of a firms future earnings prospects. Formula: Share market price earning/share of common stock
6-4 63 Click to edit Master title style 63 63 2008 2007 Price-earnings ratio on common stock 25 20 Market price per share of common stock $41.00 $27.00 Earnings per share on common stock 1.64 1.35 Mercu Tanda Sdn Bhd 6-4 64 Click to edit Master title style 64 64 Dividends per Share Dividends per share can be reported with earnings per share to indicate the relationship between dividends and earnings. Comparing these two per share amounts indicates the extent to which the corporation is retaining its earnings for use in operations. 6-4 65 Click to edit Master title style 65 65 86 Dividends Earnings $0.80 $1.64 2008 $0.60 $1.35 2007 Per share $2.00 $1.50 $1.00 $0.50 $0.0 0 Exhibit 9: Dividends and Earning per Share of Common Stock Mercu Tanda Sdn Bhd 6-4 66 Click to edit Master title style 66 66 The dividend yield on common stock is a profitability measure that shows the rate of return to common stockholders in terms of cash dividends. Dividend Yield Formula: Dividend per share market price per share
6-4 67 Click to edit Master title style 67 67 2008 2007 Dividend yield on common stock 2.0% 2.2% Dividends per share of common stock $ 0.80 $ 0.60 Market price per share of common stock 41.00 27.00 Mercu Tanda Sdn Bhd 6-4