lectures, study notes, study guides on financial statement analysis, Study notes of Financial Management

Download lectures, study notes, study guides on financial statement analysis and more Study notes Financial Management in PDF only on Docsity! Chapter 3: Financial Statement Analysis Purpose of the Chapter:  How analysts use historical financial statements in financial statement analysis.  Calculate and interpret operating, credit, and investment ratios.  Prepare a trend analysis of a company’s financial ratios.  How analysts use financial statement analysis to help prepare a valuation forecast.  The cautions analysts must consider when using financial statement analysis. Financial statement analysis are used to weigh and evaluate the operating performance of a firm. It access the profitability of the business firm, the firm’s ability to meet its obligations, safety of the investment in the business and effectiveness of management in running the firm. Tools and techniques in analysing financial statement. 1. Horizontal Analysis – involves comparing figures in two or more consecutive period. The difference between the figures of the two periods is calculated and the percentage of change from one period to the next, with the earliest period as the base. Example: 2017 2018 %change Sales 10,000 15,000 50% Increases are usually reflected with a positive % of change and decreases are usually reflected with a negative () % of change. a. Trend Analysis – a more advance form of Horizontal Analysis. Trend Analysis needs at least 5 – 10 years of experience in order to determine the trend for a particular account, unusual changes are not reflected in the trend. The firm will then compare the financial statement for a given year, based on the trend with that of the actual financial statement of the firm. Analysis: Net Income Decreases by 42.29% as a result of decrease in sales of 5%, though Cost of Goods Sold decreases by 1.49% it didn’t equal the decrease of 5% in sales (possible scenarios are: The volume of sale decreases and cost to produce one unit increases or Selling Price decreases as a result of decreasing the cost of goods sold) and Total operating expenses decreases by 3.49%. 2. Vertical Analysis – involves comparing figures in financial statements of a single period. The base for income statement is the revenue/sales and the base for balance sheet is the total assets/ total liabilities and equity. Vertical Analysis are effective when comparing two or more companies. Example: A firm’s salaries expense is 60% of revenue while another firm’s salaries expense is 70% of revenue. At the bottom of the analysis, note that net income, as a percentage of sales, declined by 2.62 percentage points (6.67 percent to 4.05 percent). As a dollar amount, net income declined by 14,096 (33,333 to 19,237). Management should consider both the percentage change and the dollar amount change. 3. Ratio Analysis – different ratios are computed to access the performance of the firm. Financial statement ratios are categorized into four (3). a. Liquidity ratios – allows the firm to measure its ability to pay its current obligations. b. Solvency ratios – allows the firm to measure its ability to pay long-term obligations. It access the firm’s ability to exist in the long run (going concern). c. Profitability ratios – allows the firm to measure its ability to earn an adequate return on sales, total assets and invested capital. It allows the firm to access if its capital is earning effectively through operations. Usually the firm’s rate of return is compared to a highest risk-free rate of return of an investment that is available in the market Liquidity Ratios: 1. Current ratio – also called the working capital ratio, measures the number of times that the current liabilities can be paid with the available current liabilities. Working Capital = Current Assets – Current Liabilities Formula is: Current Ratio = Current Assets Current Liabilities Example: If Current Assets is 1,000,000 and Current Liabilities is 200,000. Then: Current Ratio = 1,000,000= 5 200,000 Which means that the current liabilities can be paid 5 times until the current assets are exhausted. Current Ratio roughly defines the short term debt-paying ability of the firm 2. Acid test ratio – also called the quick asset ratio, because not all asset can pay current liabilities, like prepaid expenses, quick asset considers only the part of current liabilities that are nearly converted into cash. The quick assets are: Cash and cash equivalent, trading securities and receivables. Formula is: Acid test ratio = Cash & Cash Equivalent + Trading Securities + Receivables Current Liabilities Example: If Cash is 150,000, Short term Investment is 200,000 and Accounts Receivable is 400,000 and Current Liabilities is 200,000. Then: Acid test ratio = 150,000 + 200,000 + 400,000 = 3.75 200,000 Acid test ratio is stricter than current ratio. Acid test ratio does not include inventory and prepaid expense, because inventory needs to be sold then collected first before it can be used to pay debts and prepaid expenses will never be converted to cash while short term investments can be immediately sold through active market and accounts receivable can be used to finance short term debt through pledging and factoring. Example: If Total Liabilities is 300,000 and Total Assets is 400,000. Then: Debt Ratio = 300,000 = 75% 400,000 Debt Ratio shows the percentage of ownership of creditors to the total asset, in the example in shows that 75% of the total asset belongs to the creditors 4. Equity Ratio – Indicates the percentage of total assets provided by the owners or stockholders. Formula is: Equity ratio = Total Equity Total Assets Example: If Total Equity is 100,000 and Total Assets is 400,000. Then: Equity Ratio = 100,000 = 75% 400,000 Equity Ratio shows the percentage of ownership of shareholders to the total asset, in the example in shows that 25% of the total asset belongs to the shareholders. Equity Ratio + Debt Ratio = 100% Profitability Ratio: 1. Rate of Return – also known as return on investment Formula is: Rate of Return = Net Income Investment 2. Return on Sales – measures the percentage of each peso revenue that results in net income Formula is: Return on Sales = Net Income Net Sales 3. Return on Asset – it measures how assets were efficiently used to produce the sales or revenue Formula is: Return on Asset = Net Income Average Total Asset 4. Return on Owners’ Equity – measures the percentage of net income to capital Formula is: Return on Equity = Net Income Average Equity 5. Return on Common Equity – measures the percentage of return to common equity after deducting the dividends for preference stock. Formula is: Rate on Common Equity = Net Income – Preferred Dividends Average Common Stockholders’ Equity 6. Basic Earnings Power Ratio - ratio is a measure that calculates the earning power of a business before the effect of the business' income taxes and its financial leverage. Formula is: Basic Earnings Power Ratio = Net Income Before Interest and Taxes Average Common Stockholders’ Equity 7. Earnings per share Formula is: Earnings per share = Net Income – Preferred Dividends Weighted Average Number of Common Shares 8. Market Tests – relationship of price, dividends and earnings, market test shows if shares of stocks are worth purchasing or not. a. Price-earnings ratio – relationship price to earnings, it shows how many years would it take for the shareholder to recover the price paid for the shares using the earnings received from the same shares, lower price-earnings ratio is desirable, while high price- earnings ratio indicates that the shares are overpriced. Formula is: Price-Earnings Ratio (P/E) = Price per share Earnings Per Share b. Dividend yield – relationship of dividends to the price per share, it shows the percentage of the price that was recovered through dividends. High dividend yield is desirable. Formula is: Dividend Yield = Dividend per share Price per Share c. Dividend payout – percentage of earnings that is distributed as dividends. Formula is: Dividend payout = Common Dividend Per Share Earnings Per Share Exercise 1: True or False 1. The purpose of financial statement analysis is not only to understand the historical results of financial statements but also to use that information to forecast the future. 2. Operating ratios measure a firm’s ability to repay its obligations. 3. One of the common credit ratios is the return on capital ratio. 4. The revenue growth rate is a ratio that measures the expansion or contraction of the business. 5. A ratio is most meaningful when the numerator and denominator are related to each other. 6. When an interest coverage ratio is computed, the lower the result, the better the firm’s ability to make interest payments. 7. The MB ratio is a popular metric used to determine the relationship between the market price of a stock and its earnings power as measured by earnings per share. 8. The only ratio that measures return on investment is the return on common equity. 9. The benchmark used in cross-sectional analysis is the prior performance of the firm currently undergoing analysis. 10. A firm “cannibalizes” its revenue when it adds additional store locations into an area in which the firm already has existing stores. 11. The benchmark used in trend analysis is a given firm’s performance over a period of time. 12. When analyzing revenue growth in trend analysis, often the analyst will not only look at overall revenue growth rates but also at revenue growth by business segment. 13. Cause-of-action analysis is a special kind of evaluation in which the reasons for a change in a specific item over some period are identified. 14. In cross-sectional analysis, we compare two or more companies using financial ratios, and we may also compare the companies’ ratios to an industry average. 15. In doing ratio analysis, we must recognize that different firms provide different levels of disclosure. Exercise 2: Multiple Choice 16. In financial analysis, ratios are used to help us learn about the firm’s: a. profitability b. growth and potential for growth c. resource needs d. All of the above answers are correct. 17. A ratio that is used to evaluate a firm’s operating margin percentage is classified as: a. a specialty ratio b. an investment ratio c. a credit ratio d. an operating ratio 18. A ratio that measures income taxes to revenues is: a. relatively meaningless since it tells us little about the income tax rate or the profitability of the firm b. an excellent metric since it compares the effective rate of income tax to the profitability of the firm c. classified as a common investment ratio d. complimentary to the return on common equity ratio 19. The only operating ratio that uses the cost of sales in its numerator is the: a. market-to-book ratio b. quick ratio c. inventory turnover ratio d. days payables outstanding ratio 20. An operating ratio, such as the inventory turnover ratio, varies greatly by industry. An example of a business with a high inventory turnover ratio is a: a. watch repair shop b. grocery store c. jewelry retailer 32. A firm has the following operating income rates for the last four years: 2000, 9.0%; 2001, 8.9%; 2002, 9.1%; 2003, 8.8%. From a standpoint of trend analysis, what conclusion might an analyst reach regarding the firm’s revenue growth? a. The trend analysis indicates the firm’s operating income has been flat over time. b. The trend analysis indicates the firm’s operating income has materially declined over time and is cause for investor concern. c. The trend analysis indicates the firm’s operating income has been increasing at a fiscally healthy rate over time. d. The conclusion is indeterminable from the information given. 33. There are two key ratios that measure operating profitability. The numerator for the __________ ratio uses income while the __________ ratio uses revenues less cost of goods sold in its computation. a. gross margin percentage; operating margin percentage b. operating margin percentage; gross margin percentage c. quick; operating margin percentage d. current; gross margin percentage 34. The analyst must exercise caution when using ratios as part of the analysis of a firm. The fact that ratios often vary across industries is an example of what is called: a. an accounting method discrepancy b. an industry and business difference c. a business environment change d. an ambiguous ratio definition 35. Select the answer that best fits this statement, “Analysts define ratios differently.” a. What some analysts call trend analysis others call cross-sectional analysis. b. What some analysts call the current ratio is called the quick ratio by others. c. The numerator used in the return on capital ratio may vary. d. The income statement is restated in non-GAAP terms. 36. Ratios often aid analysts to project the future. Such projections require the adjustment of certain items found on the financial statements. One such item that should be adjusted in such a projection is: a. removing an extraordinary item from the income statement b. removing revenue from the income statement c. the earnings-per-share calculation when there are no dilutive or anti-dilutive items d. the reconciliation of cash on the balance sheet Problems 1. Following are data about Blite Company Average total assets P150,000 Average owner’s equity 60,000 Net income after interest but before tax 10,000 Bonds payable, 8% 50,000 Income tax rate 35% Calculate the following ratios. 1. Times interest earned 2. Return on equity 3. Return on assets 4. Basic earnings power ratio 2. Below are data about Loi Merchandising Company: Sales P500,000 Cost of goods sold 200,000 Average inventory 20,000 Average receivable 30,000 Compute the following: a. Inventory turnover b. Receivable turnover c. Collection period of accounts receivable d. Average age of inventory e. Operating cycle 3. Estrada Inc. is concerned about the level of its advertising and office salaries expense. Selected statement of comprehensive income data from 2016 – 2018 appear below: 2018 2017 2016 Sales P140,000 P60,000 P37,500 Gross Profit 89,600 37,200 22,500 Advertising Expense 7,000 3,300 2,250 Office Salaries 22,400 9,000 4,500 Profit 30,800 13,800 9,000 4. The following information was taken from the statement of financial position of Blanche Corporation: Cash P13,250 Accounts Receivable (net) 33,000 Merchandise Inventory 40,000 Prepaid Expenses 9,950 Accounts Payable 25,200 Accrued Payables 1,800 Notes Payable (due in 6 months) 10,000 Calculate the working capital, current ratio and quick ratio 5. The following data are available from Gumban’s annual report: Beginning Merchandise Inventory P 245,000 Ending Merchandise Inventory 375,000 Beginning Accounts Receivable 250,000 Ending Accounts Receivable 297,000 Cost of Goods Sold 2,480,000 Cash Sales 1,000,000 Total Sales 5,100,000 Gumban’s Credit Terms Net 30 days Required: 1. Calculate inventory turnover and accounts receivable turnover 2. In your opinion, is Gumban doing a good job in receivables? Explain. Horizontal analysis 6. Kline Corporation had net income of P2 million in 2016. Using the 2016 financial elements as the base data, net income decreased by 70 percent in 2017 and increased by 175 percent in 2018. The respective net income reported by Kline Corporation for 2017 and 2018 are: A. P 600,000 and P5,500,000 C. P1,400,000 and P3,500,000 B. P5,500,000 and P 600,000 D. P1,400,000 and P5,500,000 7. Assume that Axle Inc. reported a net loss of P50,000 in 2016 and net income of P250,000 in 2017. The increase in net income of P300,000: A. can be stated as 0% C. cannot be stated as a percentage B. can be stated as 100% increase D. can be stated as 200% increase Liquidity ratios 8. The following financial data have been taken from the records of Ratio Company: Accounts receivable P200,000 Accounts payable 80,000 Bonds payable, due in 10 years 500,000 Cash 100,000 Interest payable, due in three months 25,000 Inventory 440,000 Land 800,000 Notes payable, due in six months 250,000 What will happen to the ratios below if Ratio Company uses cash to pay 50 percent of its accounts payable? A. B. C. D. Current ratio Increase Decrease Increase Decrease Acid-test ratio Increase Decrease Decrease Increase Question Nos. 9 through 11 are based on the data taken from the balance sheet of Nomad Company at the end of the current year: Accounts payable P145,000 Accounts receivable 110,000 Accrued liabilities 4,000 Cash 80,000 Income tax payable 10,000 Inventory 140,000 Marketable securities 250,000 Notes payable, short-term 85,000 Prepaid expenses 15,000 9. The amount of working capital for the company is: A. P351,000 C. P211,000 B. P361,000 D. P336,000 10. The company’s current ratio as of the balance sheet date is: A. 2.67:1 C. 2.02:1 B. 2.44:1 D. 1.95:1 11. The company’s acid-test ratio as of the balance sheet date is: A. 1.80:1 C. 2.02:1 B. 2.40:1 D. 1.76:1 Activity ratios Receivables turnover 12. Pine Hardware Store had net credit sales of P6,500,000 and cost of goods sold of P5,000,000 for the year. The Accounts Receivable balances at the beginning and end of the year were P600,000 and P700,000, respectively. The receivables turnover was A. 7.7 times. C. 9.3 times. B. 10.8 times. D. 10.0 times. Based on the data presented above, what is the number of times bond interest charges were earned (round to one decimal point)? A. 3.7 C. 4.5 B. 4.4 D. 3.5 26. The following data were abstracted from the records of Johnson Corporation for the year: Sales P1,800,000 Bond interest expense 60,000 Income taxes 300,000 Net income 400,000 How many times was bond interest earned? A. 7.67 C. 12.67 B. 11.67 D. 13.67 Net income 27. The times interest earned ratio of Mikoto Company is 4.5 times. The interest expense for the year was P20,000, and the company’s tax rate is 40%. The company’s net income is: A. P22,000 C. P54,000 B. P42,000 D. P66,000 Profitability Ratios Return on Common Equity 28. Selected information for Ivano Company as of December 31 is as follows: 2016 2017 Preferred stock, 8%, par P100, nonconvertible, noncumulative P250,000 P250,000 Common stock 600,000 800,000 Retained earnings 150,000 370,000 Dividends paid on preferred stock for the year 20,000 20,000 Net income for the year 120,000 240,000 Ivano’s return on common stockholders’ equity, rounded to the nearest percentage point, for 2017 is A. 17% C. 21% B. 19% D. 23% Dividend yield 29. The following information is available for Duncan Co.: 2016 Dividends per share of common stock P 1.40 Market price per share of common stock 17.50 Which of the following statements is correct? A. The dividend yield is 8.0%, which is of interest to investors seeking an increase in market price of their stocks. B. The dividend yield is 8.0%, which is of special interest to investors seeking current returns on their investments. C. The dividend yield is 12.5%, which is of interest to bondholders. D. The dividend yield is 8.0 times the market price, which is important in solvency analysis. Market Test Ratios Market/Book value ratio Price per share 30. What is the market price of a share of stock for a firm with 100,000 shares outstanding, a book value of equity of P3,000,000, and a market/book ratio of 3.5? A. P8.57 C. P85.70 B. P30.00 D. P105.00 P/E ratio 31. Orchard Company’s capital stock at December 31 consisted of the following:  Common stock, P2 par value; 100,000 shares authorized, issued, and outstanding.  10% noncumulative, nonconvertible preferred stock, P100 par value; 1,000 shares authorized, issued, and outstanding. Orchard’s common stock, which is listed on a major stock exchange, was quoted at P4 per share on December 31. Orchard’s net income for the year ended December 31 was P50,000. The yearly preferred dividend was declared. No capital stock transactions occurred. What was the price earnings ratio on Orchard’s common stock at December 31? A. 6 to 1 C. 10 to 1 B. 8 to 1 D. 16 to 1 32. On December 31, 2016 and 2017, Renegade Corporation had 100,000 shares of common stock and 50,000 shares of noncumulative and nonconvertible preferred stock issued and outstanding. Additional information: Stockholders’ equity at 12/31/07 P4,500,000 Net income year ended 12/31/07 1,200,000 Dividends on preferred stock year ended 12/31/07 300,000 Market price per share of common stock at 12/31/07 144 The price-earnings ratio on common stock at December 31, 2017, was A. 10 to 1 C. 14 to 1 B. 12 to 1 D. 16 to 1 Payout ratio 33. Selected financial data of Alexander Corporation for the year ended December 31, 2017, is presented below: Operating income P900,000 Interest expense (100,000) Income before income taxes 800,000 Income tax (320,000) Net income 480,000 Preferred stock dividend (200,000) Net income available to common stockholders 280,000 Common stock dividends were P120,000. The payout ratio is: A. 42.9 percent C. 25.0 percent B. 66.7 percent D. 71.4 percent P/E ratio & Payout ratio Use the following information for question Nos. 33 and 34: Terry Corporation had net income of P200,000 and paid dividends to common stockholders of P40,000 in 2017. The weighted-average number of shares outstanding in 2017 was 50,000 shares. Terry Corporation’s common stock is selling for P60 per share in the local stock exchange. 34. Terry Corporation’s price-earnings ratio is A. 3.8 times C. 18.8 times B. 15 times D. 6 times 35. Terry Corporation’s payout ratio for 2017 is A. P4 per share C. 20.0 percent B. 12.5 percent D. 25.0 percent Integrated ratios Liquidity & activity ratios Inventory 36. The current assets of Mayon Enterprise consists of cash, accounts receivable, and inventory. The following information is available: Credit sales 75% of total sales Inventory turnover 5 times Working capital P1,120,000 Current ratio 2.00 to 1 Quick ratio 1.25 to 1 Average Collection period 42 days Working days 360 The estimated inventory amount is: A. 840,000 C. 720,000 B. 600,000 D. 550,000 37. The following data were obtained from the records of Salacot Company: Current ratio (at year end) 1.5 to 1 Inventory turnover based on sales and ending inventory 15 times Inventory turnover based on cost of goods sold and ending inventory10.5 times Gross margin for 2017 P360,000 What was Salacot Company’s December 31, 2017 balance in the Inventory account? A. P120,000 C. P 80,000 B. P 54,000 D. P 95,000 Net sales 38. Selected data from Mildred Company’s year-end financial statements are presented below. The difference between average and ending inventory is immaterial. Current ratio 2.0 Quick ratio 1.5 Current liabilities P120,000 Inventory turnover (based on cost of sales) 8 times Gross profit margin 40% Mildred’s net sales for the year were A. P 800,000 C. P 480,000 B. P 672,000 D. P1,200,000 Gross margin 39. Selected information from the accounting records of the Blackwood Co. is as follows: Net A/R at December 31, 2016 P 900,000 Net A/R at December 31, 2017 P1,000,000 Accounts receivable turnover 5 to 1 Inventories at December 31, 2016 P1,100,000 Inventories at December 31, 2017 P1,200,000 Inventory turnover 4 to 1 What was the gross margin for 2017? A. P150,000 C. P300,000 B. P200,000 D. P400,000 Market Test Ratio Dividend yield 40. Recto Co. has a price earnings ratio of 10, earnings per share of P2.20, and a pay out ratio of 75%. The dividend yield is A. 25.0% C. 7.5% B. 22.0% D. 10.0% 41. The following were reflected from the records of Salvacion Company: Earnings before interest and taxes P1,250,000 Interest expense 250,000 Preferred dividends 200,000 Payout ratio 40 percent Shares outstanding throughout 2016 Preferred 20,000 Common 25,000 Income tax rate 40 percent Price earnings ratio 5 times The dividend yield ratio is A. 0.50 C. 0.40 B. 0.12 D. 0.08 Comprehensive 42. The balance sheets of Magdangal Company at the end of each of the first two years of operations indicate the following: