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Chapter 12
Financial Statement Analyses
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Recap

 Dividend
▪ Key dates, journal entries
▪ Stock dividend

 Statement of cash flows

▪ Why focus on cash?
▪ Three activities
▪ Indirect method for operating cash flows
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Indirect Method

Why add back Depreciation and Amortization?

 Remember the journal entry for depreciation expense:

Dr. Depreciation Expense (+E, -SE) XXXX

Cr. Accumulated Depreciation (+xA) XXXX

 Recording this entry:

▪ Reduced Net Income
▪ Did not affect cash
▪ Did not affect non-cash current assets or liabilities
 If we want to reconcile Net Income to the change in cash, we need to remove the
effects of depreciation and amortization expense (by adding them back)
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Indirect Method

Why subtract Gains and add back Losses from the sale of PPE and other investing
items?
 Remember the journal entry for sales of PP&E (at a gain):
Dr. Cash (+A) XXXX
Dr. Accumulated Depreciation (-xA) XXXX
Cr. Gain on Sale of PP&E(+R, +SE) XXXX
Cr. PP&E (-A) XXXX
 Recording this entry:
▪ Increased Net Income
▪ Increased Cash (BUT this is an INVESTING Cash Flow!)
The cash inflow related to “gain” is already included in investing cash flows. Thus, we need to
subtract the gain from NI.
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Indirect Method

Why add decreases and subtract increases in non-cash current assets?

Example: Accounts Receivable
Sale for Cash Sale on Account Cash Collection
Cash A/R Cash
Journal Entry
Revenue Revenue A/R
Effect on Net Income Increase Increase No Effect
Effect on Cash Increase No Effect Increase
Effect on Non-Cash
No Effect Increase Decrease
Current Assets
Subtract the Increase in Add the Decrease in
Adjustment None Non-Cash Assets from NI Non-Cash Assets to NI
to Get to Cash to Get to Cash
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Indirect Method

Why add increases and subtract decreases in current liabilities?

Example: Wages Payable
Cash Purchases Purchase on Account Cash Collection
Expense Wages Expense Wages payable
Journal Entry
Cash Wages Payable Cash
Effect on Net Income Decrease Decrease No Effect
Effect on Cash Decrease No Effect Decrease
Effect on Current
No Effect Increase Decrease
Liabilities
Add the Increase in Subtract the Decrease in
Adjustment None Current Liabilities to Current Liabilities to NI
NI to Get to Cash to Get to Cash
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Agenda

 Evaluate the company’s ability to generate cash flow

 Horizontal and Vertical Analysis
 Financial Ratio Analysis
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 Cash from operation less than Net Income.

 Major source of cash is the sale of PPE.
 Enix paid off more long-term debt than it did new borrowing.
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Analyzing SCF

 Analysts find that the statements of cash flows are more useful in finding weaknesses
rather than gauging successes. Why?
 A shortage of cash can throw a company into bankruptcy. On the other hand, lots of
cash doesn’t guarantee success.
 Signs of a healthy company
▪ Operations are the major source of cash
▪ Investing activities include more purchases than sales of long-term assets
▪ Financing activities are not dominated by new loans and borrowings
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Useful Metrics

How much cash a company can “free up” for new opportunities?
 Free Cash Flow
▪ FCF=Net cash provided by operating activities – Cash payment for investments in PPE

▪ The amount of cash available from operations after paying for capital expenditures
(typically investments in new PPE).
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 Cash Realization Ratio

𝐶𝐹𝑂
▪ CRR=
𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡

▪ How much of net profit is reflected in actual cash generated from operations
▪ If the net profit of Sintel was 1052 and 560 for 2020 and 2021. What was the cash
realization ratio?

▪ A number greater than 1 is considered a good ability to realize cash from profits.
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Agenda

 Evaluate the company’s ability to generate cash flow

 Horizontal and Vertical Analysis
 Financial Ratio Analysis
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Big Picture

As a shareholder or potential
investor, how would you evaluate
Nestlé’s financial performance and
financial position? What analysis
techniques can we use for financial
analysis?

Nestlé now has over 2,000 brands under its umbrella, from coffee,
snacks, baby food, and bottled water, to ice cream, pet care, and
weight management products.
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Big Picture

The best place to start financial analysis is with a solid understanding of a

company's business strategy. To evaluate how well a company is doing, you must
know what managers are trying to do.

Product Cost
Differentiation Leadership

Cars

Supermarket

Airlines
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Big Picture

 Financial analysis involves more than math. Big Picture

 Understanding the business and the industry is important.
▪ Reading and research
▪ Business press, magazines, and other publications.
 Horizon of your analysis? More than one year
 Coverage of your analysis? More than one company
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Horizontal Analysis
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Horizontal Analysis

Absolute magnitude might not be as useful as percentage change.

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Horizontal Analysis

 The study of the percentage changes from year to year.

▪ Compute the amount of change
▪ Divide the amount of change by the base period amount.
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Horizontal Analysis
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Horizontal Analysis

 Trend Analysis
▪ A form of horizontal analysis. 𝐴𝑛𝑦 𝑦𝑒𝑎𝑟 ′ 𝑠 𝑎𝑚𝑜𝑢𝑛𝑡
𝑇𝑟𝑒𝑛𝑑 % =
▪ Select a base year 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 ′ 𝑠 𝑎𝑚𝑜𝑢𝑛𝑡

▪ The amount for each following year is stated as a percentage of the base amount.

Operating profit has been lower than 2012. Low of 81% in 2014 but steadily
climbed back.
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Vertical Analysis

 Also called component analysis

 Shows the relationship of financial-statement items relative to a total.
 All items on the financial statements are reported as a percentage of the base.

For each CHF sales in

2016, Nestle made about
10% in net profit.
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Common-Size Financial Statements

 Report only percentages, no dollar amount.

 Benchmarking against industry peers/industry average.
 Assist in comparison of different companies
CHF EUR USD
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Agenda

 Evaluate the company’s ability to generate cash flow

 Horizontal and Vertical Analysis
 Financial Ratio Analysis
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Financial Ratio Analysis

 Financial ratios are a major tool of financial analysis.

 Expresses one relevant accounting number to another relevant accounting number
through division.
 Compare ratios to:
▪ Industry averages
▪ Prior year ratios
▪ Competitors’ ratios
 In this class, we discuss the following ratios
▪ Efficiency Ratios
▪ Financial Strength Ratios
▪ Profitability Ratios
▪ Investment Ratios
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Efficiency Ratios

 The ability to sell inventory and collect receivables.

Ratio Computation Information Provided

Indicates the speed at which an entity is able to

1. Inventory turnover convert cash from its inventory and receivables

Indicates the salability of inventory—the

2. Accounts receivable number of times a company sells its average
turnover level of inventory during a year.

3. Payable Turnover Measures the ability to use assets to generate

revenue.

4. Cash conversion cycle Measures the frequency of payments to trade

creditors.

5. Asset turnover Measures the ability to collect cash from

customers.
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Inventory Turnover

Cost of Goods Sold

Inventory Turnover =
Average Inventory
Average Inventory = (Beginning Inventory + Ending Inventory)/2

 This ratio reflects how many times average inventory was produced and sold during
the period.
 A higher ratio indicates that inventory moves more quickly thus reducing storage and
obsolescence costs.
365
Average days to sell =
(Inventory resident period) Inventory Turnover
 Average time it takes the company to produce and deliver inventory
to customer.
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Inventory Turnover

(1) (2) (3) (4)

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Quick Question

Tinker's cost of goods sold in the year of sale (2019) was $750,000 and 2018 cost
of goods sold was $770,000. The inventory at the end of 2019 was $188,000 and at
the end of 2018 the inventory was $208,000.
Tinker's inventory turnover during 2019 was closest to:
A. 3.99
B. 3.79
C. 3.84
D. 3.89
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Financial Strength Ratio

 Indicators of an entity’s abilities to meet its financial obligations.

 Measure liquidity (short term) and solvency (long term).
Measures the number of times operating
income can cover interest expense.

Indicates percentage of assets financed

with liabilities or debt.

Shows the ability to pay all current

liabilities if they come due immediately.
Sometimes calculated as (current assets –
inventory) divided by current liabilities.

Measures the ability to pay current

liabilities with current assets.
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Working Capital

 Working Capital = Current Assets – Current Liabilities

 Working capital is a measure of a company’s liquidity and short-term
financial health.
 If working capital is too bloated, there may be inefficient use of assets (e.g.
excess inventory).
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Current Ratio

 A firm’s ability to pay current obligations

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑹𝒂𝒕𝒊𝒐 =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔

 A higher ratio means that there may be more assets with which current liabilities
could be repaid (should be > 1). However, if this ratio is too large, assets could
be inefficiently utilized. Industry comparison is important.
 Alternatively, Quick Ratio = Quick Assets/Current Liabilities
(Quick Assets: cash, cash equivalents such as marketable securities, and accounts receivable)

 How to improve current ratio? Repay short-term obligations, sell fixed assets,
get more long-term debt, issue shares, etc.

100 90
≈ 1.11 → = 1.125
90 80
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Examples

 Current Assets (CA)=100; Current Liabilities (CL)=80; Current Ratio?

▪ Current ratio=100/80 = 1.25

 What if firm wants to increase current ratio?

▪ A) can improve operations, thus increasing CA and improving current ratio
▪ B) can simply pay off some CL right before year end (will only work if CR > 1); What is the
current ratio if pay off $20 of A/P?
▪ Current ratio = (100-20)/(80-20)=80/60 = 1.33

 Would paying off accounts payable affect any other ratios?

▪ Accounts Payable Turnover would increase (COGS/Avg. A/P)
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Quick Question

Smith Corporation entered into the following transactions:

• Purchased inventory on account.
• Collected an account receivable.
• Purchased equipment using cash.
Which of the following statements about Smith's transactions is correct?
A. The inventory purchase on account increased working capital.
B. Collecting an account receivable increases working capital.
C. The equipment purchase decreases working capital.
D. The inventory purchase on account decreases working capital.
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Profitability Ratios

 Fundamental goal of a business

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Gross Margin

 Also called gross profit, equal to the excess of sales revenue over cost of goods sold.
 “Gross” profit because other operating expenses have not yet been subtracted.

If the cost of goods sold is $8,000, the gross margin is $5,000, total other operating
expense is $4,000. The revenue is_____.

A. $13,000
B. $3,000
C. $9,000
D. $12,000
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Gross Profit Percentage

 Gross Profit (Margin) Percentage： 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡

𝑆𝑎𝑙𝑒𝑠

975845/2008846=48.58%
1073955/2132992=50.35%
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Investment Ratio

 Measure return on share investment

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Dividend Yield

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅𝒔 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆 (𝑫𝑷𝑺)

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒚𝒊𝒆𝒍𝒅 =
𝒔𝒉𝒂𝒓𝒆 𝒑𝒓𝒊𝒄𝒆

 𝑒.𝑔., 𝑀𝑆 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑=$1.47/$61.78=2.38%

 Dividend Yield is a great way to compare dividends across companies. It puts
them all on an equal footing.

2016 Dividend Comparison With Competitors 2016 Dividend Yield Comparison With Competitors
IBM HP Cisco IBM HP Cisco
$5.50 $0.57 $0.89 3.94% 1.67% 3.40%
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Earnings Per Share (EPS)

Net Income
EPS = Average Number of Shares Outstanding

 Example: Dunkin’s income for 2016 was $195,576,000 and the average number of
common shares outstanding was 92,039,248.
$195,576,000
EPS = 92,039,248 Shares ≈ $2.12 per share
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Earnings Per Share (EPS)

2016 EPS Comparison With Competitors

YUM! Brands Dunkin Panera
$ 2.52 $ 2.12 $ 6.18

 Is it really fair to compare EPS across firms?

▪ Different number of shares outstanding
▪ Doesn’t account for differences in the price paid for the shares

 Then, what should we do? Dunkin historical EPS

▪ Look at historical trends 2016 2017 2018
$ 2.12 $ 3.80 $ 2.71

▪ P/E ratio (= stock price / EPS) P/E Comparison With Competitors

YUM! Brands Dunkin Panera
29.68 26.03 47.31
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Quick Question

Which of the following statements correctly describes either the dividend yield or the
earnings per share?
A. The dividend yield decreases when net income increases.
B. Earnings per share is a measure per share of both common and preferred stock.
C. The dividend yield increases when the market price per share decreases.
D. Earnings per share decreases when dividends per share decrease.
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Other Issues

 Financial ratios are useful but not a cure-all.

 A sudden change in certain ratios might indicate problems. Need to analyze the whole
situation to learn what caused the change.
 Also need to consider external factors, industry, legislation, accounting principles, etc.
 Some red flags
▪ Earnings problem: Operating profit/net income decreased/was negative in consecutive years?
▪ Cash flow problem: Operating cash flows consistently lower than net income? Major source of cash flows?
▪ Debt problem: Debt ratio compared to major competitors?
▪ Inventory problem: Inventory turnover slows down (building up inventory)?
▪ …
 Still interested? Take ACCT4213 Financial Statement Analysis and Valuation
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Additional Exercise

 The following transactions were selected from among those completed by Bennett
Retailers in November and December:
Nov 20 Sold 20 items of merchandise to Customer B at an invoice price of
$5,500 (total); terms 3/10, n/30.
25 Sold two items of merchandise to Customer C, who charged the
$400 (total) sales price on her Visa credit card. Visa charges Bennett
Retailers a 2 percent credit card fee.
28 Sold 10 identical items of merchandise to Customer D at an invoice
price of $9,000 (total); terms 3/10, n/30.
29 Customer D returned one of the items purchased on the 28th; the
item was defective and credit was given to the customer.
Dec 6 Customer D paid the account balance in full.
15 Customer B paid in full for the invoice of November 20.

 Compute net sales for the two months ended December 31.
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A Few Words

 Thank you for the great semester!

▪ Smart and hardworking
▪ Young and promising
 Hopefully, you have gained something from the course. (Accounting/non-accounting)
 Wish you all the best!
Course and Teaching Evaluation (CTE)
Step 1: Locate the Online CTE Questionnaire email in your student email account

Step 2: Click the URL, fill in the questionnaire and submit it in 15 minutes

Thank you!