Building Blocks In Financial Forecasting

Analyzing Financial Statements for Financial Fitness Learning Objectives After studying the material in this chapter, you will be able to: 1. 2. 3. 4. 5. 6. Explain what financial statement analysis is and why it is important. Compare horizontal analysis and vertical analysis. List the basic components of ratio analysis. Distinguish between trend analysis and industry comparison. Calculate a comprehensive set of financial ratios and interpret them. Explain the limitations of ratio analysis. Accounting can be thought of as the art of creating scorecards for business operations. It translates raw data into a set of objective numbers integrated into financial statements that provide information about the firm’s profits, performance, problems and future prospects. Financial analysis is the study of the relationships among these financial numbers; it helps users to identify the major strengths and weaknesses of a business enterprise. I. Who Uses Financial Analysis The techniques of financial analysis are important to two groups: internal management and external users, such as investors and banks. A. INTERNAL MANAGERS Internal managers analyze the financial statements to determine whether the company is earning an adequate return on its assets. They also use financial ratios as “flags” to indicate potential areas of strength or weakness. Many financial analysts use rule-ofthumb measurements for key financial ratios. For example, most analysts feel that a current ratio (current assets divided by current liabilities) of two to one is acceptable for most businesses. However, while a company may meet or even surpass this ratio, the financial statements might indicate that an increasing proportion of the current assets consist of accounts receivable that have been outstanding for more than 30 days. Slow payments might require management to change its credit policy by shortening the credit period or by implementing a more effective cash-collection policy. Internal management also uses this “number-crunching” process to decide how much inventory is to be held at any one time or whether to merge with or acquire another company. B. EXTERNAL USERS External uses include investors, creditors, unions, and prospective employees. Investors might use the financial statements to study whether there is an adequate profit margin or a favorable return on assets. The financial health of the company, as perceived by investors, will affect the market price of the company’s stock, cost of financing, and bond rating. For creditors, financial statements indicate a company’s ability to repay a loan. A union will study the financial statements to evaluate their wage and pension demands when their old contract with management expires. Finally, students and other job seekers might analyze a company’s financial statements to determine career opportunities. C. HORIZONTAL AND VERTICAL ANALYSIS Financial statement analysis includes horizontal analysis (percentage change over the years) and vertical analysis (percentage relationship within one year). Sources of financial information include a company’s annual financial report, SEC filings, financial reference books put out by such firms as Dun & Bradstreet, trade publications, and financial newspapers such as the Wall Street Journal. An analyst also studies industry norms. This measurement indicates how a company is performing in comparison with other companies in the same industry. Unfortunately, there are limitations to the use of this method. First, one company in the same industry might be involved in manufacturing and selling a product in large quantities at the wholesale level, while another enterprise might only sell at the retail level to the public. Second, each enterprise might use a different accounting method for financial reporting purposes. For example, one company might value its ending inventory according to the FIFO method, while a competitor might use LIFO. In addition, the two companies might use a different accounting method for recording depreciation. The cumulative effect of the use of different accounting methods might make a comparison of net income and fixed-asset valuation of little importance. II. Financial Statement Analysis The financial community uses several methods for evaluating the financial health of an enterprise. These methods include trend analysis, horizontal and vertical analysis, and ratio analysis. A. TREND ANALYSIS Trend analysis indicates in which direction a company is headed. Trend percentages are computed by taking a base year and assigning its figures as a value of 100. Figures generated in subsequent years are expressed as percentages of base-year numbers. EXAMPLE 4.1 The Hotspot Appliance Corporation showed the following figures for a five-year period: 20x5 Net sales Cost of goods sold Gross profit $910 573 $337 20x4 $875 510 $365 20x3 $830 483 $347 20x2 $760 441 $319 20x1 $775 460 $315 A schedule showing trend percentages is given below. Net sales Cost of goods sold Gross profit 20x5 117 125 107 20x4 20x3 113 107 111 105 116 110 20x2 98 96 101 20x1 100 100 100 With 20x1 taken as the base year, its numbers are divided into those from subsequent years to yield comparative percentages. For example, net sales in 20x1 ($775,000) is divided into 20x5’s net-sales figure ($910,000). Net sales show an upward trend after a downturn in 20x2. Cost of goods sold shows a sharp increase between 20x4 and 20x5 after a small drop in costs between 20x1 and 20x2. There appears to be a substantial drop in gross profit between 20x4 and 20x5, which is attributable to the increased cost of goods sold. Trend percentages show horizontally the degree of increase or decrease, but they do not indicate the reason for the changes. They do serve to indicate unfavorable developments that will require further investigation and analysis. A significant change may have been caused by a change in the application of an accounting principle or by controllable internal conditions, such as a decrease in operating efficiency. B. HORIZONTAL ANALYSIS Horizontal analysis improves an analyst’s ability to use dollar amounts when evaluating financial statements. It is more useful to know that sales have increased 25% than to know that sales increased by $50,000. Horizontal analysis requires that you: (1) compute the change in dollars from the earlier base year, and (2) divide the dollar amount of the change by the base period amount. EXAMPLE 4. 2 The comparative income statement of the Ogel Supply Corporation as of December 31, 20x2, appears as follows: Net sales Cost of goods sold Gross profit Operating expenses: Selling expenses General expenses Total operating expenses Income from operations Interest expense Income before income taxes Income tax expense Net income 20x2 20x1 $990,000 $884,000 574,000 503,000 $416,000 $381,000 $130,000 $117,500 122,500 120,500 $252,500 $238,000 163,500 143,000 24,000 26,000 $139,500 $117,000 36,360 $103,140 28,030 $ 88,970 The following is a detailed horizontal analysis statement. Net sales Cost of goods sold Gross profit Operating expenses: Selling expenses General expenses Total operating expenses Income from operations Interest expense Income before income taxes Income tax expense Net income 20x2 20x1 $990,000 $884,000 574,000 503,000 416,000 381,000 130,000 122,500 252,500 163,500 24,000 139,500 36,360 $103,140 117,500 120,500 238,000 143,000 26,000 117,000 28,030 $ 88,970 Increase (Decrease) Amount $106,000 71,000 35,000 Percent 12.0 14.1 9.2 12,500 2,000 14,500 20,500 (2,000) 22,500 8,330 $ 14,170 10.6 1.7 6.1 14.3 (7.7) 19.2 29.7 15.9 EXAMPLE 4.3 The comparative balance sheet of the Ogel Supply Corporation as of December 31, 20x2, appears as follows: ASSETS Current assets: Cash Accounts receivable, net Inventories Prepaid expenses Total currents assets Property, plant & equipment, net Total assets LIABILITIES Current liabilities: Notes payable Accounts payable Total current liabilities Long-term debt Total liabilities STOCKHOLDERS’ EQUITY Common stock, no-par Retained earnings Total stockholders’ equity Total liabilities &stockholders’ equity 20x2 20x1 $ 60,000 $ 30,000 113,000 79,000 107,100 106,900 5,700 6,100 $285,800 $222,000 660,000 665,000 $945,800 $887,000 $ 40,000 100,600 $140,600 400,000 $540,600 $ 33,000 57,500 $ 90,500 410,000 $500,500 $200,000 $200,000 205,200 186,500 $405,200 $386,500 $945,800 $887,000 The following is a detailed horizontal analysis statement. ASSETS Current assets: Cash Accounts receivable, net Inventories Prepaid expenses Total current assets Property, plant, & equipment, net Total assets LIABILITIES Current liabilities: Note payable Accounts payable Total current liabilities Long-term debt Total liabilities STOCKHOLDERS’ EQUITY Common stock, no-par Retained earnings Total stockholders’ equity Total liabilities & stockholders’ equity 20x2 20x1 $ 60,000 $ 30,000 113,000 79,000 107,100 106,900 5,700 6,100 $285,800 $222,000 660,000 665,000 $945,800 $887,000 $ 40,000 100,600 $140,600 400,000 $540,600 Increase (Decrease) Amount $ 33,000 57,500 $ 90,500 410,000 $500,500 $200,000 $200,000 205,200 186,500 $405,200 $386,500 $945,800 $887,000 Percent $ 30,000 34,000 200 (400) $ 63,800 (5,000) $ 58,800 100.0 43.0 0.0 (7.0) 28.7 .1 6.6 $ 7,000 43,100 $ 50,100 (10,000) $ 40,100 21.2 75.0 55.4 (2.4) 8.1 $ -018,700 $ 18,700 $ 58,800 0.0 10.0 5.0 6.6 C. VERTICAL ANALYSIS Vertical analysis shows the percentage relationship of each item on the financial statement to a total figure representing 100 percent. Each income statement account is compared to net sales. For example, if net sales is $100,000 and net income after taxes is $8,000, then the company’s net income is $8,000 divided by $100,000, or 8% of the net sales figure. Vertical analysis also reveals the internal structure of the business. This means that if total assets are $750,000 and cash shows a year-end balance of $75,000, then cash represents 10% of the total assets of the business year-end. Vertical analysis shows the mix of assets that generate the income as well as the sources of capital provided by either current or noncurrent liabilities, or by the sale of preferred and common stock. A company’s vertical percentages should be compared to those of its competitors or to industry averages to determine the company’s relative position in the marketplace. Like horizontal analysis, vertical analysis is not the end of the process. The analyst must be prepared to examine problem areas indicated by horizontal and vertical analysis. EXAMPLE 4.4 The comparative income statement of the Ogel Supply Corporation at December 31,20x2, appears as follows: Net sales Cost of goods sold Gross profit Operating expenses: Selling expenses General expenses Total operating expenses Income from operations Interest expense Income before income taxes Income tax expense Net income 20x2 20x1 $990,000 $884,000 574,000 503,000 $416,000 $381,000 $130,000 122,500 $252,500 $163,500 24,000 $139,500 36,360 $103,140 $117,500 120,500 $238,000 $143,000 26,000 $117,000 28,030 $ 88,970 The following is a detailed vertical analysis statement. Net sales Cost of goods sold Gross profit Operating expenses: Selling expenses General expenses Total operating expenses Income from operations Interest expense Income before income taxes Income tax expense Net income 20x2 Amount Percent $990,000 100.0 574,000 58.0 $416,000 42.0 $130,000 122,500 $252,500 $163,500 24,000 $139,500 36,360 $103,140 13.1 12.4 25.5 16.5 2.4 14.1 3.7 10.4 Amount $884,000 503,000 $381,000 20x1 Percent 100.0 57.0 43.0 $117,500 120,500 $238,000 $143,000 26,000 $117,000 28,030 $ 88,970 13.3 13.6 26.9 16.1 2.9 13.2 3.2 10.0 EXAMPLE 4.5 The comparative balance sheet of the Ogel Supply Corporation at December 31, 20x2, appears as follows: 20x2 ASSETS Current assets: Cash Accounts receivable, net Inventories Prepaid expenses Total currents assets Property, plant and equipment, net Total assets LIABILITIES Current liabilities: Notes payable Accounts payable Total current liabilities Long-term debt Total liabilities STOCKHOLDERS’ EQUITY Common stock, no-par Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity 20x1 $ 60,000 $ 30,000 113,000 79,000 107,100 106,900 5,700 6,100 $285,800 $222,000 660,000 665,000 $945,800 $887,000 $ 40,000 100,600 $140,600 400,000 $540,600 $ 33,000 57,500 $ 90,500 410,000 $500,500 $200,000 $200,000 205,200 186,500 $405,200 $386,500 $945,800 $887,000 Prepare a detailed vertical analysis statement. ASSETS Current assets: Cash Accounts receivable, net Inventories Prepaid expenses Total currents assets Property, plant and equipment, net Total assets LIABILITIES Current liabilities: Notes payable Accounts payable Total current liabilities Long-term debt Total liabilities STOCKHOLDERS’ EQUITY Common stock, no-par Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity 20x2 Amount $ 60,000 113,000 107,100 5,700 $285,800 Percent 20x1 Amount Percent 6.3 $ 30,000 11.9 79,000 11.3 106,900 0.6 6,100 30.1 $222,000 3.4 8.9 12.1 .7 25.1 660,000 $945,800 69.9 100.0 100.0 $ 40,000 100,600 $140,600 400,000 $540,600 4.2 10.6 14.8 42.3 57.1 $200,000 205,200 $405,200 21.1 $200,000 21.7 186,500 42.8 $386,500 $945,800 100.0 665,000 $887,000 $ 33,000 57,500 $ 90,500 410,000 $500,500 $887,000 74.9 3.7 6.5 10.2 46.2 56.4 22.6 21.0 43.6 100.0 After completing the statement analysis, the financial analyst will consult with management to discuss problem areas, possible solutions, and the company’s prospects for the future. III. Ratio Analysis Ratios provide a convenient and useful way of expressing a relationship between numbers. For example, management is always interested in its ability to pay its current liabilities as they become due. A. LIQUIDITY ANALYSIS Ratios used to determine the debt-paying ability of the company include the current ratio and the acid-test or quick ratio. A term also frequently used in financial statement analysis is working capital. 1. Current Ratio The current ratio is a valuable indicator of a company’s ability to meet its current obligations as they become due. The ratio is computed by using the following formula: Current Assets Current Liabilities EXAMPLE 4.6 Assume that in Example 4.3 the Ogel Supply Corporation showed the following current assets and current liabilities for the years ended December 31, 20x2, and December 31, 20x1: 20x2 20x1 ASSETS Current assets: Cash $ 60,000 $ 30,000 Accounts receivable, net 113,000 79,000 Inventories 107,100 106,900 Prepaid expenses 5,700 6,100 Total currents assets $285,800 $222,000 LIABILITIES Current liabilities: Notes payable $ 40,000 $ 33,000 Accounts payable 100,600 57,500 Total current liabilities $140,600 $ 90,500 The current ratios for 20x2 and 20x1 are: Total current assets Total current liabilities 20x2 $285,800 $140,600 = 2.0 20x1 $222,000 $90,500 = 2.5 The change from 2.5 to 2.0 indicates that Ogel has a diminished ability to pay its current liabilities as they mature. However, a current ratio of 2.0 to 1 is still considered a “secure” indicator of a company’s ability to meet its current obligations incurred in operating the business. 2. Acid-Test or Quick Ratio Unlike the current ratio, the acid-test or quick ratio places emphasis on the relative convertibility of the current assets into cash. The ratio places greater emphasis on receivables than on inventory, since the inventory may not be readily convertible into cash. This method also assumes that prepaid expenses have minimal resale value. The ratio is computed by using the following formula: Cash + Short-Term Investments + Accounts Receivable, Net Current Liabilities EXAMPLE 4.7 Assumed that in Example 4.3 the Ogel Supply Corporation showed the following current assets and current liabilities for the years ended December 31, 20x2, and December 31, 20x1: Current assets: Cash Accounts receivable, net Inventories Prepaid expenses Total currents assets Current liabilities: Notes payable Accounts payable Total current liabilities 20x2 20x1 $ 60,000 $ 30,000 113,000 79,000 107,100 106,900 5,700 6,100 $285,800 $222,000 $ 40,000 100,600 $140,600 $ 33,000 57,500 $ 90,500 The acid-test or quick ratios for 20x2 and 20x1 are: 20x2 Current assets: Cash Accounts receivable, net Total currents assets Current liabilities: Notes payable Accounts payable Total current liabilities $ 60,000 $ 30,000 113,000 79,000 $173,000 $109,000 $ 40,000 100,600 $140,600 20x2 Total acid-test assets Total current liabilities 20x1 $173,000 $140,600 =1.2 $ 33,000 57,500 $ 90,500 20x1 $109,000 $90,500 =1.2 The ratios are unchanged. This shows that, despite a significant increase in both the acid-test or quick assets and current liabilities, Ogel still maintains the same ability to meet its current obligations as they mature. 3. Working Capital Working capital is the excess of current assets over current liabilities. Working capital items are those that are flowing through the business in a regular pattern and may be diagrammed as follows: Inventory Accounts Receivable Cash Accounts Payable EXAMPLE 4.8 Assumed that in Example 4.3 the Ogel Supply Corporation showed the following current assets and current liabilities for the years ended December 31, 20x2, and December 31, 20x1: Current assets: Cash Accounts receivable, net Inventories Prepaid expenses Total currents assets Current liabilities: Notes payable Accounts payable Total current liabilities 20x2 20x1 $ 60,000 113,000 $ 30,000 79,000 107,100 106,900 5,700 6,100 $285,800 $222,000 $ 40,000 100,600 $140,600 $ 33,000 57,500 $ 90,500 20x2 20x1 Working capital for 20x2 and 20x1 is: Total currents assets Total current liabilities Working capital $285,800 $222,000 $140,600 $ 90,500 $145,200 $131,500 The change from $131,500 to $145,200 indicates that Ogel has increased its working capital, which Ogel must now decide whether it is making effective use of. For example, should any excess working capital be used to purchase short-term income-producing investments? 4. Accounts-Receivable Ratios Accounts-receivable ratios are composed of the accounts receivable turnover and the collection period, which is the number of days the receivables are held. 5. Accounts-Receivable Turnover The accounts-receivable turnover is the number of times accounts receivable are collected during the year. The turnover equals net credit sales (if not available, then total sales) divided by the average accounts receivable. Average accounts receivable is usually determined by adding the beginning accounts receivable to the ending accounts receivable and dividing by two. However, average accounts receivable may be arrived at with greater accuracy on a quarterly or monthly basis, particularly for a seasonal business. Unfortunately, this information is typically known only to management. Using data for the shortest time period will provide the most reliable ratio. The higher the accounts-receivable turnover, the more successfully the business collects cash. However, an excessively high ratio may signal an excessively stringent credit policy, with management not taking advantage of the potential profit by selling to customers with greater risk. Note that here, too, before changing its credit policy, management has to consider the profit potential versus the inherent risk in selling to more marginal customers. For example, bad debt losses will increase when credit policies are liberalized to include riskier customers. The formula for determining the accounts-receivable turnover is expressed as follows: Net Credit Sales Average Net Accounts Receivable EXAMPLE 4.9 Assumed that in Example 4.3 the Ogel Supply Corporation showed the following accounts-receivable totals for the years ended December 31, 20x2, and December 31, 20x1: 20x2 Current assets: Accounts receivable, net 113,000 20x1 79,000 Assuming sales of $990,000 for 20x2, calculate the accounts-receivable turnover for 20x2. Average accounts receivable = Sales Average accounts receivable ($113,000+$79,000) /2 = $990,000 = $96,000 = 10.3 $96,000 6. Day-Sales-in-Receivables The days-sales-in-receivables determines how many days’ sales remain in accounts receivable. The determination is a two-step process. First, divide the net sales by 365 days to determine the sales amount for an average day. Then divide this figure into the average net accounts receivable. EXAMPLE 4.10 In Example 4.9 it was determined that the Ogel Supply Corporation’s accounts receivable turnover was 10.3. Use this figure to calculate the days-sales-in-receivables for 20x2. Step one: Net sales 365 days = $990,000 365 = $2,712 Step two: Average net accounts receivable $96,000 = One day’s sales = 35.4 days $2,712 7. Inventory Ratios A company with excess inventory is tying up funds that could be invested elsewhere for a return. Inventory turnover is a measure of the number of times a company sells its average level of inventory during the year. A high turnover indicates an ability to sell the inventory, while a low number indicates an inability. A low inventory turnover may lead to inventory obsolescence and high storage and insurance costs. The formula for determining inventory turnover is: Cost of Goods sold Average Inventory EXAMPLE 4.11 Assume that in Example 4.3 the Ogel Supply Corporation showed the following inventory amounts for the years ended December 31, 20x2, and December 31, 20x1: Current assets: Inventories 20x2 107,100 20x1 106,900 If cost of goods sold is $574,000 for 20x2, calculate the inventory turnover for 20x2. Average inventories = ($107,100 + $106,900) / 2 Cost of goods sold Average inventories = $574,000 $107,000 = = $107,000 5.4 8. Operating Cycle The operating cycle is the time needed to turn cash into inventory, inventory into receivables, and receivables back into cash. For a retailer, it is the time from purchase of inventory to collection of cash. Thus, the operating cycle of a retailer is equal to the sum of the number of days’ sales in inventory and the number of days’ sales in receivables. The days’ sales in inventory equals 365 (or another period chosen by the analyst) divided by the inventory turnover. The days’ sales in receivables equals 365 (or other number) divided by the accounts receivable turnover. 9. Interrelationship of Liquidity and Activity to Earnings There is a trade-off between liquidity risk and return. Liquidity risk is reduced by holding more current assets than noncurrent assets. There will be less of a return, however, because the return rate on current assets (i.e., marketable securities) is usually less than the return rate on productive fixed assets. Further, excessive liquidity may mean that management has not been aggressive enough in finding attractive capital-investment opportunities. There should be a balance between liquidity and return. High profitability does not automatically mean a strong cash flow. Cash problems may exist even with a high net income due to maturing debt and the need for asset replacement, among other reasons. For instance, it is possible that a growth business may have a decline in liquidity because cash is needed to finance an expanded sales base. B. MEASURING A COMPANY’S ABILITY TO PAY ITS LONG-TERM DEBT A corporation with a large amount of debt runs a greater risk of insolvency than one with a large amount of preferred or common stock outstanding. The reason is that payment of interest is mandatory, while the payment of dividends is discretionary with the corporation’s board of directors. Individuals and banks that purchase the long-term notes and bonds issued by an enterprise take a special interest in a business’s ability to repay its debt plus interest. Two key methods used to measure a company’s ability to pay its legal obligations as they become due are the debt ratio and the times-interestearned ratio. 1. Debt Ratio The debt ratio indicates how much of the company’s assets were obtained by the issuance of debt. If the ratio is 1, it means that all of the firm’s assets were financed by the issuance of debt. If the ratio is 0.6, it means that 60% of the company’s assets were financed by debt. The formula for the debt ratio is: Total Liabilities Total Assets EXAMPLE 4.12 Assume that in Example 4.3 the Ogel Supply Corporation showed the following current assets and current liabilities for the years ended December 31, 20x2, and December 31, 20x1: 20x2 ASSETS Current assets: Cash Accounts receivable, net Inventories Prepaid expenses Total currents assets Property, plant, and equipment, net Total assets 20x1 $ 60,000 $ 30,000 113,000 79,000 107,100 106,900 5,700 6,100 $285,800 $222,000 660,000 665,000 $945,800 LIABILITIES Current liabilities: Notes payable Accounts payable Total current liabilities Long-term debt Total liabilities $ 40,000 100,600 $140,600 400,000 $540,600 $887,000 $ 33,000 57,500 $ 90,500 410,000 $500,500 The debt ratios for 20x2 and 20x1 are: 20x2 Total liabilities Total assets $540,600 $945,800 = 0.57 20x1 $500,500 $887,000 = 0.56 The ratios indicate that Ogel debt position has increased. 2. Times-Interest-Earned Ratio The times-interest-earned ratio measures a company’s ability to pay its interest obligations. For example, a times-interest-earned ratio of 5 means that the company earned enough to pay its annual interest obligation five times. EXAMPLE 4.13 Assume that in Example 4.2 the Ogel Supply Corporation showed the following income from operations and interest expense for the years ended December 31, 20x2, and December 31, 20x1: 20x2 20x1 Interest expense Income from operations $ 24,000 $ 26,000 163,500 143,000 The times-interest-earned ratios for 20x2 and 20x1 are: 20x2 Income from operations Interest expense $163,500 $ 24,000 = 6.8 20x1 $143,000 $ 26,000 = 5.5 The ratios indicate that Ogel will have little difficulty paying its interest obligations. Ogel might even consider borrowing more money. C. PROFITABILITY RATIOS These ratios measure the profitability of the company. The primary ratios are rate of return on net sales, rate of return on total assets, and rate of return on total stockholders' equity. 1. Rate of Return on Net Sales The formula for calculating the rate of return on net sales is as follows: Net Income Net Sales This ratio reveals the profit margin of the business. It tells how much earnings are associated with each sales dollar. EXAMPLE 4.14 Assume that in Example 4.2 the Ogel Supply Corporation showed the following net income and net sales figures for the years ended December 31, 20x2, and December 31, 20x1: 20x2 Net sales Net income 20x1 $990,000 $884,000 103,140 88,970 The rates of return on net sales for 20x2 and 20x1 are: 20x2 Net sales Net income $103,140 $990,000 = 10.4% 20x1 $ 88,970 $884,000 = 10.1% The increase in the rate of return indicates that the company is more profitable on each sales dollar obtained. 2. Rate of Return on Total Assets The rate of return measures the ability of the company to earn a profit on its total assets. In making the calculation, interest expense must be added back to the net income, since both creditors and investors have financed the company’s operations. The formula is: Net Income + Interest Expense Average Total Assets where average total assets = total assets (beginning) + total assets (ending) / 2 EXAMPLE 4.15 Assume that in Example 4.2 the Ogel Supply Corporation showed the following net income and net sales figures for the years ended December 31, 20x2, and December 31, 20x1: 20x2 Net income Interest expense Total assets 20x1 $103,140 $ 88,970 24,000 26,000 945,800 887,000 The rate of return on total assets for 20x2 is: Average total assets = $103,140 + $24,000 ($945,800 + $887,000) / 2 = $127,140 $916,400 = 13.9% 3. Rate of Return on Common Stockholders' Equity The rate of return on common stock shows the relationship between net income and the common stockholders’ investment in the company. To compute this rate, preferred dividends must be subtracted from net income. This leaves net income available to the common shareholders. The formula for computing the rate of return on common stock is: Net Income - Preferred Dividends Average Common Stockholders’ Equity EXAMPLE 4.16 Assume that in Examples 4.2 and 4.3 the Ogel Supply Corporation showed the following net income for 20x2, and total stockholders’ equity for the years ended December 31, 20x2, and December 31, 20x1: 20x2 Net income Total stockholders' equity 20x1 $103,140 $ 88,970 405,200 386,500 The rate of return on total common stockholders' equity for 20x2 is: = Average common stockholders' equity ($405,200 + $386,500) / 2 Net income Average common stockholders' equity = $103,140 - 0 $395,850 = = 395,850 26.1% The return on the common stockholders’ equity is 26.1%, which is 12.2% higher than the return on assets, which is 13.9%. The company is borrowing at a lower rate to earn a higher rate. The practice is called trading on equity, or leverage, and is directly related to the debt ratio. However, should revenues drop, the interest on debt must still be paid. Thus, in times of operating losses, excessive debt can hurt profitability. 4. Earnings per Share Earnings per share (EPS) is computed by dividing net income less the preferred dividends by the number of common shares outstanding. The preferred-share dividend must be subtracted because it represents a prior claim to dividends that must be paid before any payments of dividends can be made to the common shareholders. If there is no preferred stock, earnings per share equals net income divided by common shares outstanding. EXAMPLE 4.17 Assume that in Examples 4.2 and 4.3 the Ogel Supply Corporation showed the following net income for 20x2 and 20x1, and that 10,000 common shares were outstanding for the years ended December 31, 20x2, and December 31, 20x1: 20x2 Net income $103,140 20x1 $ 88,970 Calculate the earnings per share for 20x2 and 20x1. Net income Common shares outstanding 20x2 $103,140 - 0 10,000 = $10.31 20x1 $88,970 - 0 10,000 = $8.90 D. EVALUATING STOCK AS AN INVESTMENT Investors purchase stock to earn a return on their investment. This return consists of both gains from the sale of appreciated stock and from dividends. Two ratios used to analyze the value of a stock include the price-earnings ratio and the book value per share of stock. 1. Price-Earnings Ratio The price-earnings ratio equals the market price per share divided by the earnings per share. A high price-earnings ratio is generally favorable because it indicates that the investing public looks at the company in a positive light. However, too high a price- earnings ratio could mean a poor investment because the stock may be overvalued, while a low price-earnings ratio stock could be a good investment if it’s a case of the stock being undervalued. EXAMPLE 4.18 Assume that for the years 20x2 and 20x1 the market price per share of common stock for Ogel Corporation was as follows: 20x2 $130.00 Market price per share 20x1 $95.00 Using the earnings per share of $10.31 for 20x2 (from Example 4.17) and $8.90 for 20x1, the price/earnings ratio for each year can be calculated as follows. 20x2 Market price per share Earnings per share of common stock $130.00 $10.31 = 20x1 $95.00 12.6 $8.90 = 10.7 The increase in the price-earnings multiple indicates that the stock market had a higher opinion of the business in 20x2, possibly due to the company’s increased profitability. 2. Book Value Per Share The book value per share equals the net divided by the shares outstanding. Net preferred stock. The comparison of book provides a clue as to how investors regard value per share is as follows: assets available to common stockholders assets equals stockholders’ equity minus value per share to market price per share the firm. The formula for calculating book Total Stockholders Equity - Preferred Equity Number of Shares of Common Stock Outstanding EXAMPLE 4.19 Assume that for the year's 20x2 and 20x1 the stockholders’ equity of Ogel Corporation was as follows: 20x2 $405,200 Total stockholders' equity 20x1 $386,500 If there are 10,000 shares of common stock outstanding at December 31 of each year, the book value per share for each year would be: 20x2 Total stockholders' equity Common shares outstanding $405,200 10,000 = 20x1 $386,500 $40.52 10,000 = $38.65 IV. Limitations of Ratio Analysis Some of the limitations of ratio analysis are as follows: (1) Many large businesses are involved with multiple lines of business, making it difficult to identify the industry to which a specific company belongs. A comparison of its ratios with other corporations may thus be meaningless. (2) Accounting and operating practices differ among companies, which can distort the ratios and make comparisons meaningless. For example, the use of different inventory-valuation methods would affect inventory and assetturnover ratios. (3) Industry averages published by financial advisory services are only approximations. Therefore the company may have to look at the ratios of its major competitors if such ratios are available. (4) Financial statements are based on historical costs and do not consider inflation. (5) Management may hedge or exaggerate its financial figures. Hence certain ratios will not be accurate indicators. (6) A ratio does not describe the quality of its components. For example, the current ratio may be high but inventory may consist of obsolete merchandise. (7) Ratios are static and do not take into account future trends.