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FINANCIAL STATEMENT ANALYSIS

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        THE IMPORTANCE OF ANALYSIS

         As you know, this website provides a substantial amount of material about accounting principles, and anyone wishing to study it with due diligence can learn valuable insights about accounting.  Does the mere fact that this website exists mean that everyone with internet access now knows about accounting principles?  Obviously not.  Does it mean that everyone who happens to "click by" will learn about accounting?  Again, no.  By analogy, the same can be said about financial information.  Companies, especially public companies, spend substantial amounts of money preparing and presenting financial statements that are readily available (the reports for U.S. public companies are freely available at www.sec.gov).  Does this mean that everyone with internet access now has in-depth knowledge about these companies?  For that matter, if you print the annual report of a company that you find interesting, does this really help you?  My point is that some degree of study is required to benefit from information.

        It is important for you to know that CPAs and the SEC provide safeguards to protect the integrity of reported information, but this is entirely different than suggesting that reporting companies are necessarily good investments.  For example, a company could report that its revenue stream is in decline, expenses are on the rise, and significant debt is coming due without a viable plan for making the payments.  The financial statements may fully report this predicament with perfect integrity, painting a rather gloomy picture.  But, if financial statement users choose to ignore that report, only they are to blame.

        The moral of the preceding point is that you must be very thorough in examining the financial statements of companies in which you are considering making an investment.  It is not sufficient to merely determine that reports exist and look nice; you must study them, drill down in the detail, and think carefully about what you are observing.  Sometimes, the evaluation of complex situations can be assisted by utilization of key metrics or ratios.  For example, a doctor will consider your health in conjunction with measurements of your blood pressure, heart rate, cholesterol level, etc.  Likewise, you measure a company's health by considering certain important ratios.

        The following ratios have been presented throughout this book, and are summarized below:

    LIQUIDITY AND DEBT SERVICE RATIOS

    Current Ratio

    Current Assets/
    Current Liabilities

    A measure of liquidity; the ability
     to meet near-term obligations

    Quick Ratio

    (Cash + Short-term Investments + Accounts Receivable)/
    Current Liabilities
    A narrow measure of liquidity; the ability
     to meet near-term obligations
    Debt to Total Assets Ratio
    Total Debt/
    Total Assets
    Percentage of assets financed by
     long-term and short-term debt
    Debt to Total Equity Ratio
    Total Debt/
    Total Equity
    Proportion of financing
     that is debt-related
    Times Interest Earned Ratio
    Income Before Income Taxes and Interest/
    Interest Charges
    Ability to meet
     interest obligations

    TURNOVER RATIOS

    Accounts Receivable Turnover Ratio

    Net Credit Sales/
    Average Net Accounts Receivable

    Frequency of collection cycle;
     to monitor credit policies

    Inventory Turnover Ratio

    Cost of Goods Sold/
    Average Inventory

    Frequency of inventory rotation;
     to monitor inventory management
    PROFITABILITY RATIOS

    Net Profit on Sales Ratio

    Net Income/
    Net Sales

    Profitability on sales;
     for comparison and trend analysis

    Gross Profit Margin Ratio

    Gross Profit/
    Net Sales

    Gross profit rate;
     for comparison and trend analysis

    Return on Assets Ratio

    (Net Income + Interest Expense)/
    Average Assets

    Asset utilization in
     producing returns

    Return on Equity Ratio

    (Net Income - Preferred Dividends)/
    Average Common Equity

    Effectiveness of equity investment
     in producing returns

    OTHER INDICATORS

    EPS

     Income Available to Common/
    Weighted-Average Number of Common Shares
    Amount of earnings attributable
     to each share of common stock

    P/E

    Market Price Per Share/
    Earnings Per Share
    The price of the stock in relation
     to earnings per share

    Dividend Rate/Yield

    Annual Cash Dividend/
    Market Price Per Share
    Direct yield to investors through
     dividend payments

    Dividend Payout Ratio

    Annual Cash Dividend/
    Earnings Per Share
    Proportion of earnings distributed
     as dividends

    Book Value

    "Common" Equity/
    Common Shares Outstanding
    The amount of stockholders' equity
     per common share outstanding

        COMPREHENSIVE ILLUSTRATION:  At this point, it may be helpful to consider these ratios as they relate to a comprehensive illustration.  Presented below are financial statements for Emerson Corporation.  Study them carefully.  Then, examine the ratio calculations for Emerson Corporation that can be found immediately following the financial statements.

    Emerson

    RATIOS FOR EMERSON CORPORATION
    AS OF DECEMBER 31, 20X5

    Additional facts:  No dividends were due or paid on the $300,000 of preferred stock which was issued in exchange for a building in late 20X5.  Average common equity is assumed to be $2,095,000 ((($2,910,000 - $300,000) + $1,580,000)/2).  Assume most other balance sheet items change uniformly throughout the year (e.g., average receivables = ($600,000 + $850,000)/2 = $725,000, etc.).  The year end market value of the common was $10 per share, and the cash dividend was paid on shares outstanding at the end of the year ($50,000/910,000 shares = $0.055 per share). 

    Current Ratio

    Current Assets/
    Current Liabilities

    $1,730,000/$290,000 = 5.97

    Quick Ratio

    (Cash + Short-term Investments + Accounts Receivable)/
    Current Liabilities
    $1,550,000/$290,000 = 5.34
    Debt to Total Assets Ratio Total Debt/
    Total Assets
    $1,190,000/$4,100,000 = 0.29
    Debt to Total Equity Ratio Total Debt/
    Total Equity
    $1,190,000/$2,910,000 = 0.41
    Times Interest Earned Ratio Income Before Income Taxes and Interest/
    Interest Charges
    $1,400,000/$100,000 = 14

    Accounts Receivable Turnover Ratio

    Net Credit Sales/
    Average Net Accounts Receivable

    $3,250,000/$725,000 = 4.48

    Inventory Turnover Ratio

    Cost of Goods Sold/
    Average Inventory

    $1,160,000/$200,000 = 5.8

    Net Profit on Sales Ratio

    Net Income/
    Net Sales

    $1,000,000/$3,250,000 = 31%

    Gross Profit Margin Ratio

    Gross Profit/
    Net Sales

    $2,090,000/$3,250,000 = 64%

    Return on Assets Ratio

    (Net Income + Interest Expense)/
    Average Assets

    $1,100,000/$3,865,000 = 28%

    Return on Equity Ratio

    (Net Income - Preferred Dividends)/
    Average Common Equity

    $1,000,000/$2,095,000 = 48%

    EPS

     Income Available to Common/
    Weighted-Average Number of Common Shares
    $1,000,000/905,000 = $1.11

    P/E

    Market Price Per Share/
    Earnings Per Share
    $10/$1.11 = 9

    Dividend Rate/Yield

    Annual Cash Dividend/
    Market Price Per Share
    $0.055/$10 = 0.55 %

    Dividend Payout Ratio

    Annual Cash Dividend/
    Earnings Per Share
    $0.055/$1.11 = 5.0%

    Book Value

    "Common" Equity/
    Common Shares Outstanding
    $2,610,000/910,000 = $2.87

         In examining the ratios of Emerson, it would appear that the company is doing fairly well.  Its liquidity suggests no problem in meeting obligations, the debt is at a manageable level, receivables and inventory appear to be turning reasonably well, and profits are good.

        TREND ANALYSIS:  Financial statement data are often reproduced in percentage terms.  For example, Emerson's cash is 17% of total assets ($700,000/$4,100,000).  Such percentage data can be monitored closely, year after year.  This provides sharp investors and managers with a keen sense of subtle shifts that can foretell changes in the underlying business environment.



    ACCOUNTING FORUM


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