## Analysis and Interpretation of Financial Statements

Read this chapter, which discusses how to analyze financial statements and demonstrates the use of ratios and the horizontal and vertical analysis tools that everyone from creditors to investors, vendors, and top management use when they want to identify the strengths and weaknesses in an organization. Analysis tools can help you compare companies of different sizes, companies in different industries, and the same company over time.

### Ratio analysis

Logical relationships exist between certain accounts or items in a company's financial statements. These accounts may appear on the same statement or on two different statements. We set up the dollar amounts of the related accounts or items in fraction form called ratios. These ratios include: (1) liquidity ratios; (2) equity, or longterm solvency, ratios; (3) profitability tests; and (4) market tests.

Liquidity ratios indicate a company's short-term debt-paying ability. Thus, these ratios show interested parties the company's capacity to meet maturing current liabilities.

Current (or working capital) ratio Working capital is the excess of current assets over current liabilities. The ratio that relates current assets to current liabilities is the current (or working capital) ratio. The current ratio indicates the ability of a company to pay its current liabilities from current assets and, thus, shows the strength of the company's working capital position.

You can compute the current ratio by dividing current assets by current liabilities:

$\text { Current ratio }=\dfrac{\text { Current assets }}{\text { Current liabilities }}$

The ratio is usually stated as a number of dollars of current assets to one dollar of current liabilities (although the dollar signs usually are omitted). Thus, for Synotech in 2010, when current assets totaled USD 2,846.7 million and current liabilities totaled USD 2,285.2 million, the ratio is 1.25:1, meaning that the company has USD 1.25 of current assets for each USD 1.00 of current liabilities.

The current ratio provides a better index of a company's ability to pay current debts than does the absolute amount of working capital. To illustrate, assume that we are comparing Synotech to Company B. For this example, use the following totals for current assets and current liabilities:

 Synotech Company B Current assets (a) $2,846.7$120.0 Current liabilities (b) 2,285.2 53.2 Working capital (a – b) $561.5$ 66.8 Current ratio (a/b) 1.25:1 2.26:1

Synotech has eight times as much working capital as Company B. However, Company B has a superior debtpaying ability since it has USD 2.26 of current assets for each USD 1.00 of current liabilities.

Short-term creditors are particularly interested in the current ratio since the conversion of inventories and accounts receivable into cash is the primary source from which the company obtains the cash to pay short-term creditors. Long-term creditors are also interested in the current ratio because a company that is unable to pay short-term debts may be forced into bankruptcy. For this reason, many bond indentures, or contracts, contain a provision requiring that the borrower maintain at least a certain minimum current ratio. A company can increase its current ratio by issuing long-term debt or capital stock or by selling noncurrent assets.

A company must guard against a current ratio that is too high, especially if caused by idle cash, slow-paying customers, and/or slow-moving inventory. Decreased net income can result when too much capital that could be used profitably elsewhere is tied up in current assets.

Refer to Exhibit 133. The Synotech data in Column (4) indicate that current liabilities are increasing more rapidly than current assets. We could also make such an observation directly by looking at the change in the current ratio. Synotech's current ratios for 2010 and 2009 follow:

 December 31 (USD millions) 2010 2009 Amount of increase Net sales (a) $10,498.8$10,029.8 $469.0 Net accounts receivable: January 1$ 1,340.3 $1,259.5$80.8 December 31 1,277.30 1,340.30 (63) Total (b) $2,617.6$ 2,599.8 $17.8 Synotech's working capital decreased by USD 167.1 million, or 22.9 per cent (USD 167.1/USD 728.6), and its current ratio decreased from 1.35:1 to 1.25:1. Together, these figures reflect that its current liabilities increased faster than its current assets. Acid-test (quick) ratio The current ratio is not the only measure of a company's short-term debt-paying ability. Another measure, called the acid-test (quick) ratio, is the ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities. Analysts exclude inventories and prepaid expenses from current assets to compute quick assets because they might not be readily convertible into cash. The formula for the acid-test ratio is: $\text { Acid }-\text { test ratio }=\dfrac{\text { Quick assets }}{\text { Current liabilities }}$ Short-term creditors are particularly interested in this ratio, which relates the pool of cash and immediate cash inflows to immediate cash outflows. The acid-test ratios for 2010 and 2009 for Synotech are:  December 31 (USD millions) 2010 2009 Amount of increase or (decrease) Quick assets (a)$1,646.6 $1,648.3$(1.7) Current liabilities (b) 2,285.6 2,103.8 181.8 Net quick assets (a – b) $(639.0)$(455.5) $(183.5) Acid-test ratio (a/b) .72:1 .78:1 In deciding whether the acid-test ratio is satisfactory, investors consider the quality of the marketable securities and receivables. An accumulation of poor-quality marketable securities or receivables, or both, could cause an acidtest ratio to appear deceptively favorable. When referring to marketable securities, poor quality means securities likely to generate losses when sold. Poor-quality receivables may be uncollectible or not collectible until long past due. The quality of receivables depends primarily on their age, which can be assessed by preparing an aging schedule or by calculating the accounts receivable turnover. (Covered in Chapter 9.) Cash flow liquidity ratio Another approach to measuring short-term liquidity is the cash flow liquidity ratio. The numerator, as an approximation of cash resources, consists of (1) cash and marketable securities, or liquid current assets, and (2) net cash provided by operating activities, or the cash generated from the company's operations. This reflects the company's ability to sell inventory and collect accounts receivable. The formula for the cash flow liquidity ratio is: $\dfrac{\text { Cash also marketable securities + Net cash provided by operating activities }} {\text{Current liabilities}}$ For 2010, Synotech has USD 298.0 million in cash and cash equivalents, USD 71.3 million in marketable securities, USD 2,285.2 million in current liabilities, and USD 1,101.0 million in cash provided by operating activities (taken from the statement of cash flows in its annual report). Its cash flow liquidity ratio is: $\dfrac{\text { USD } 298.0+\text { USD } 71.3+\text { USD } 1,101.0}{\text { USD } 2,285: 2}=.64 \text { time }$ This indicates that the company is going to have to rely on some other sources of funding to pay its current liabilities. The company's liquid current assets will only cover about two-thirds of the current liabilities. Possibly net cash provided by operations will be substantially higher in 2011. Accounts receivable turnover Turnover is the relationship between the amount of an asset and some measure of its use. Accounts receivable turnover is the number of times per year that the average amount of receivables is collected. To calculate this ratio, divide net credit sales (or net sales) by average net accounts receivable; that is, accounts receivable after deducting the allowance for uncollectible accounts: $\text { Accounts receivable turnover }=\dfrac{\text { Net credit sales }(\text { net sales })}{\text { Average net accounts receivable }}$ When a ratio compares an income statement item (like net credit sales) with a balance sheet item (like net accounts receivable), the balance sheet item should be an average. Ideally, analysts calculate average net accounts receivable by averaging the end-of-month balances or end-of-week balances of net accounts receivable outstanding during the period. The greater the number of observations used, the more accurate the resulting average. Often, analysts average only the beginning-of-year and end-of-year balances because this information is easily obtainable from comparative financial statements. Sometimes a formula calls for the use of an average balance, but only the year-end amount is available. Then the analyst must use the year-end amount. In theory, the numerator of the accounts receivable turnover ratio consists of only net credit sales because those are the only sales that generate accounts receivable. However, if cash sales are relatively small or their proportion to total sales remains fairly constant, analysts can obtain reliable results by using total net sales. In most cases, the analyst may have to use total net sales because the separate amounts of cash sales and credit sales are not reported on the income statement.  December 31 (USD millions) 2010 2009 Amount of increase Net sales (a)$10,498.8 $10,029.8$469.0 Net accounts receivable: January 1 $1,340.3$1,259.5 $80.8 December 31 1,277.30 1,340.30 (63) Total (b)$2,617.6 $2,599.8$17.8 Average net receivables (c) (b/2 = c) $1,308.8$1,299.9 Turnover of accounts receivable (a/c) 8.02 7.72

Synotech's accounts receivable turnover ratios for 2010 and 2009 follow. Net accounts receivable on 2009 January 1, totaled USD 1,259.5 million.

The accounts receivable turnover ratio provides an indication of how quickly the company collects receivables. The accounts receivable turnover ratio for 2010 indicates that Synotech collected, or turned over, its accounts receivable slightly more than eight times. The ratio is better understood and more easily compared with a company's credit terms if we convert it into a number of days, as is illustrated in the next ratio.

Number of days' sales in accounts receivable The number of days' sales in accounts receivable ratio is also called the average collection period for accounts receivable. Calculate it as follows:

$\text { Number of days' sales per accounts receivable }=\dfrac{\text { Number of days per year }(365)}{\text { Accounts receivable turnover }}$

The turnover ratios for Synotech show that the number of days' sales in accounts receivable decreased from about 47 days (365/7.72) in 2009 to 46 days (365/8.02) in 2010. The change means that the average collection period for the company's accounts receivable decreased from 47 to 46 days.

The number of days' sales in accounts receivable ratio measures the average liquidity of accounts receivable and indicates their quality. Generally, the shorter the collection period, the higher the quality of receivables. However, the average collection period varies by industry; for example, collection periods are short in utility companies and much longer in some retailing companies. A comparison of the average collection period with the credit terms extended customers by the company provides further insight into the quality of the accounts receivable. For example, receivables with terms of 2/10, n/30 and an average collection period of 75 days need to be investigated further. It is important to determine why customers are paying their accounts much later than expected.

Inventory turnover A company's inventory turnover ratio shows the number of times its average inventory is sold during a period. You can calculate inventory turnover as follows:

$\text { Inventory turnover }=\dfrac{\text { Cost of goods sold }}{\text { Average inventory }}$

When comparing an income statement item and a balance sheet item, measure both in comparable dollars. Notice that we measure the numerator and denominator in cost rather than sales dollars. (Earlier, when calculating accounts receivable turnover, we measured both numerator and denominator in sales dollars.) Inventory turnover relates a measure of sales volume to the average amount of goods on hand to produce this sales volume.

Synotech's inventory on 2009 January 1, was USD 856.7 million. The following schedule shows that the inventory turnover decreased slightly from 5.85 times per year in 2009 to 5.76 times per year in 2010. To convert these turnover ratios to the number of days it takes the company to sell its entire stock of inventory, divide 365 by the inventory turnover. Synotech's average inventory sold in about 63 and 62 (365/5.76 and 365/5.85) in 2010 and 2009, respectively.

 December 31 (USD millions) 2010 2009 Amount of increase or (decrease) Cost of goods sold (a) Merchandise inventory: $5,341.3$5,223.7 $117.6 January 1$929.8 $856.7$ 73.1 December 31 924.8 929.8 (5.0) Total (b) $1,854.6$1,786.5 $68.1 Average inventory (c) (b/2 = c)$927.3 $893.3 Turnover of inventory (a/c) 5.76 5.85 Other things being equal, a manager who maintains the highest inventory turnover ratio is the most efficient. Yet, other things are not always equal. For example, a company that achieves a high inventory turnover ratio by keeping extremely small inventories on hand may incur larger ordering costs, lose quantity discounts, and lose sales due to lack of adequate inventory. In attempting to earn satisfactory income, management must balance the costs of inventory storage and obsolescence and the cost of tying up funds in inventory against possible losses of sales and other costs associated with keeping too little inventory on hand. #### An accounting perspective:Business insight Cabletron Systems develops, manufactures, installs, and supports a wide range of standards-based LAN and WAN connectivity hardware and software products. For the year ended 2009 December 31, both its number of day's sales in accounts receivable and its inventory turnover rate increased as compared to the prior year. In its 2009 annual report, the company explained these increases as follows: Accounts receivable, net of allowance for doubtful accounts, were USD 210.9 million, or 66 days of sales outstanding, at 2009 December 31 compared to USD 228.4 million at 2008 December 31, or 54 days sales outstanding. The increase in days of sales outstanding was a result of the timing of sales and related collections. Worldwide inventories were USD 98.1 million at 2009 December 31 or 63 days of inventory, compared to USD 85.0 million, or 37 days of inventory, at 2008 December 31. The increase of days in inventory was due to the increase in finished goods inventory purchased to protect against an anticipated shortage of supply components. Total assets turnover Total assets turnover shows the relationship between the dollar volume of sales and the average total assets used in the business. We calculate it as follows: $\text { Total assets turnover }=\dfrac{\text { Net sales }}{\text { Average total assets }}$ This ratio measures the efficiency with which a company uses its assets to generate sales. The larger the total assets turnover, the larger the income on each dollar invested in the assets of the business. For Synotech, the total asset turnover ratios for 2010 and 2009 follow. Total assets as of 2009 January 1, were USD 7,370.9 million.  (USD millions) 2010 2009 Amount of increase Net sales (a) Total assets:$10,498.8 $10,029.8$469.0 January 1 $9,170.8$7,370.9 $1,799.9 December 31 9,481.8 9,170.8 311.0 Total (b)$18,652.6 $16,541.7$2,110.9 Average total assets (c) (b/2 = c) $9,331.8$8,270.9 Turnover of total assets (a/c) 1.13:1 1.21:1

Each dollar of total assets produced USD 1.21 of sales in 2009 and USD 1.13 of sales in 2010. In other words, between 2009 and 2010, the company had a decrease of USD .08 of sales per dollar of investment in assets.

Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a company.

Equity (stockholders' equity) ratio The two basic sources of assets in a business are owners (stockholders) and creditors; the combined interests of the two groups are total equities. In ratio analysis, however, the term equity generally refers only to stockholders' equity. Thus, the equity (stockholders' equity) ratio indicates the proportion of total assets (or total equities) provided by stockholders (owners) on any given date. The formula for the equity ratio is:

$\text { Equity ratio }=\dfrac{\text { Stockholders' equity }}{\text { Total assets ( total equities })}$

Synotech's liabilities and stockholders' equity from Exhibit 133 follow. The company's equity ratio increased from 22.0 per cent in 2009 to 25.7 per cent in 2010. Exhibit 133 shows that stockholders increased their proportionate equity in the company's assets due largely to the retention of earnings (which increases retained earnings).

 2010 2009 December 31 December 31 (USD millions) Amount Per cent Amount Per cent Current liabilities $2,285.2 24.1%$2,103.8 22.9% Long-term liabilities 4,755.8 50.2 5,051.3 55.1 Total liabilities $7,041.0 74.3$7,155.1 78.0 Total stockholders' equity 2,440.8 25.7 2,015.7 22.0 Total equity (equal to total assets) $9,481.8 100%$9,170.8 100.0%

The equity ratio must be interpreted carefully. From a creditor's point of view, a high proportion of stockholders' equity is desirable. A high equity ratio indicates the existence of a large protective buffer for creditors in the event a company suffers a loss. However, from an owner's point of view, a high proportion of stockholders' equity may or may not be desirable. If the business can use borrowed funds to generate income in excess of the net after-tax cost of the interest on such funds, a lower percentage of stockholders' equity may be desirable.

To illustrate the effect of higher leveraging (i.e. a larger proportion of debt), assume that Synotech could have financed an increase in its productive capacity with USD 40 million of 6 per cent bonds instead of issuing 5 million additional shares of common stock. The effect on income for 2010 would be as follows, assuming a federal income tax rate of 40 per cent:

 Net income as presently stated (Exhibit 134) $762,000,000 Deduct additional interest on debt (0.06 x$40 million) 2,400,000 $759,600,000 Add reduced taxes due to interest deduction (.4 x 2,400,000) 960,000 Adjusted net income$760,560,000

As shown, increasing leverage by issuing bonds instead of common stock reduces net income. However, there are also fewer shares of common stock outstanding. Assume the company has 183 million shares of common stock outstanding. Earnings per share (EPS) with the additional debt would be USD 4.16 (or USD 760,560,000/183 million shares), and EPS with the additional stock would be USD 4.05 (or USD 762,000,000/188 million shares).

Since investors place heavy emphasis on EPS amounts, many companies in recent years have introduced large portions of debt into their capital structures to increase EPS, especially since interest rates have been relatively low in recent years.

We should point out, however, that too low a percentage of stockholders' equity (too much debt) has its dangers. Financial leverage magnifies losses per share as well as EPS since there are fewer shares of stock over which to spread the losses. A period of business recession may result in operating losses and shrinkage in the value of assets, such as receivables and inventory, which in turn may lead to an inability to meet fixed payments for interest and principal on the debt. As a result, the company may be forced into liquidation, and the stockholders could lose their entire investments.

Stockholders' equity to debt (debt to equity) ratio Analysts express the relative equities of owners and creditors in several ways. To say that creditors held a 74.3 per cent interest in the assets of Synotech on 2010 December 31, is equivalent to saying stockholders held a 25.7 per cent interest. Another way of expressing this relationship is the stockholders' equity to debt ratio:

$\text { Stockholders' equity for debt ratio }=\dfrac{\text { Stockholders 'equity }}{\text { Total debt }}$

Such a ratio for Synotech would be .28:1 (or USD 2,015.7 million/USD 7,155.1 million) on 2009 December 31, and .35:1 (or USD 2,440.8 million/USD 7,041.0 million) on 2010 December 31. This ratio is often inverted and called the debt to equity ratio. Some analysts use only long-term debt rather than total debt in calculating these ratios. These analysts do not consider short-term debt to be part of the capital structure since it is paid within one year.

Profitability is an important measure of a company's operating success. Generally, we are concerned with two areas when judging profitability: (1) relationships on the income statement that indicate a company's ability to recover costs and expenses, and (2) relationships of income to various balance sheet measures that indicate the company's relative ability to earn income on assets employed. Each of the following ratios utilizes one of these relationships.

Rate of return on operating assets The best measure of earnings performance without regard to the sources of assets is the relationship of net operating income to operating assets, the rate of return on operating assets. This ratio shows the earning power of the company as a bundle of assets. By disregarding both nonoperating assets and nonoperating income elements, the rate of return on operating assets measures the profitability of the company in carrying out its primary business functions. We can break the ratio down into two elements—the operating margin and the turnover of operating assets.

Operating margin reflects the percentage of each dollar of net sales that becomes net operating income. Net operating income excludes nonoperating income elements such as extraordinary items, cumulative effect on prior years of changes in accounting principle, losses or gains from discontinued operations, interest revenue, and interest expense. Another name for net operating income is "income before interest and taxes" (IBIT). The formula for operating margin is:

$\text { Operating margin }=\dfrac{\text { Net operatingincome }}{\text { Net sales }}$

Turnover of operating assets shows the amount of sales dollars generated for each dollar invested in operating assets. Operating assets are all assets actively used in producing operating revenues. Typically, we use year-end operating assets, even though in theory an average would be better. Nonoperating assets are owned by a company but not used in producing operating revenues, such as land held for future use, a factory building rented to another company, and long-term bond investments. Analysts do not use these nonoperating assets in evaluating earnings performance. Nor do they use total assets that include nonoperating assets not contributing to the generation of sales. The formula for the turnover of operating assets is:

$\text { Turnover of operating assets }=\dfrac{\text { Net sales }}{\text { Operating assets }}$

The rate of return on operating assets of a company is equal to its operating margin multiplied by turnover of operating assets. The more a company earns per dollar of sales and the more sales it makes per dollar invested in operating assets, the higher is the return per dollar invested. To find the rate of return on operating assets, use the following formulas:

$\text { Operating margin } \times \text { Turnover of operating assets }=\text { Rate of return on operating assets }$

or

$\text { Rate of return on operating assets }=\dfrac{\text { Net operating income }}{\text { Net sales }} \times \dfrac{\text { Net sales }}{\text { Operating assets }}$

Because net sales appears in both ratios (once as a numerator and once as a denominator), we can cancel it out, and the formula for rate of return on operating assets becomes:

$\text { Rate of return on operating assets }=\dfrac{\text { Net operating income }}{\text { Operating assets }}$

For analytical purposes, the formula should remain in the form that shows margin and turnover separately, since it provides more information.

The rates of return on operating assets for Synotech for 2010 and 2009 are:

 (USD millions) 2010 2009 Amount of increase or (decrease) Net operating income (a)* $1,382.4$682.7 $699.7 Net sales (b)$10,498.8 $10,029.8$469.0 Operating assets (c)  † $9,481.8$9,170.8 $311.0 Operating margin (a/b) 13.17% 6.81% Turnover of operating assets (b/c) 1.11 times 1.09 times Rate of return on operating assets (a/c) 14.58% 7.44% *Calculated as income before income taxes plus net interest expense. This method excludes nonoperating items. †When companies have no nonoperating assets, total assets are used in the calculation Net income to net sales (return on sales) ratio Another measure of a company's profitability is the net income to net sales ratio, calculated as follows: $\text { Net income by net sales }=\dfrac{\text { Net income }}{\text { Net sales }}$ This ratio measures the proportion of the sales dollar that remains after deducting all expenses. The computations for Synotech for 2010 and 2009 are: #### An accounting perspective:Business insight Companies that are to survive in the economy must attain some minimum rate of return on operating assets. However, they can attain this minimum rate of return in many different ways. To illustrate, consider a grocery store and a jewelry store, each with a rate of return of 8 per cent on operating assets. The grocery store normally would attain this rate of return with a low margin and a high turnover, while the jewelry store would have a high margin and a low turnover, as shown here:  Margin x Turnover = Rate of return on operating assets Grocery store 1% x 8.0 times = 8% Jewelry store 20 x 0.4 = 8  (USD millions) 2010 2009 Amount of increase or (decrease) Net income (a)$ 762.0 $206.4$555.6 Net sales (b) $10,498.$10,029. $469.0 8 8 Ratio of net income to net sales (a/b) 7.26% 2.06% Although the ratio of net income to net sales indicates that the net amount of profit increased on each sales dollar, exercise care in using and interpreting this ratio. The net income includes all nonoperating items that may occur only in a particular period; therefore, net income includes the effects of such things as extraordinary items, changes in accounting principle, effects of discontinued operations, and interest charges. Thus, a period that contains the effects of an extraordinary item is not comparable to a period that contains no extraordinary items. Also, since interest expense is deductible in the determination of net income while dividends are not, the methods used to finance a company's assets affect net income. Return on average common stockholders' equity From the stockholders' point of view, an important measure of the income-producing ability of a company is the relationship of return on average common stockholders' equity, also called rate of return on average common stockholders' equity, or simply the return on equity (ROE). Although stockholders are interested in the ratio of operating income to operating assets as a measure of management's efficient use of assets, they are even more interested in the return the company earns on each dollar of stockholders' equity. The formula for return on average common stockholders' equity if no preferred stock is outstanding is: $\text { Return on average common stockholders' equity }=\dfrac{\text { Net income }}{\text { Average common stockholders'equity }}$ When a company has preferred stock outstanding, the numerator of this ratio becomes net income minus the annual preferred dividends, and the denominator becomes the average book value of common stock. As described in Chapter 12, the book value of common stock is equal to total stockholders' equity minus (1) the liquidation value (usually equal to par value) of preferred stock and (2) any dividends in arrears on cumulative preferred stock. Thus, the formula becomes: $\text { Return on average common stockholders' equity }=\dfrac{\text { (Net income }-\text { Preferred stock dividends) }}{\text { Average book value of commonstock }}$ Synotech has preferred stock outstanding. The ratios for the company follow. Total common stockholders' equity on 2009 January 1, was USD 1,697.4 million. Preferred dividends were USD 25.7 million in 2010 and USD 25.9 million in 2009.  (USD millions) 2010 2009 Amount of increase or (decrease) Net income – Preferred stock dividends$ 736.3 $180.5$ 555.8 (a) Total common stockholders' equity (book value of common stock):* January 1 $1,531.5$1,697.4 $(165.9) December 31 1,969.6 1,531.5 438.1 Total (b)$3,501.1 $3,228.9$272.2 Average common stockholders' equity (c) (b/2 = c): $1,750.6$1,614.5 Return on common stockholders' equity (a/c) 42.06% 11.18% *Total stockholders' equity – par value of preferred stock

The stockholders would regard the increase in the ratio from 11.18 per cent to 42.06 per cent favorably. This ratio indicates that for each dollar of capital invested by a common stockholder, the company earned approximately 42 cents in 2010.

 Company 1 Company 2 Return on assets 12.0% 12.0% Return on stockholders' equity 6.4 8.0

Sometimes, two companies have the same return on assets but have different returns on stockholders' equity, as shown here:

The difference of 1.6 per cent in Company 2's favor is the result of Company 2's use of borrowed funds, particularly long-term debt, in its capital structure. Use of these funds (or preferred stock with a fixed return) is called trading on the equity. When a company is trading profitably on the equity, it is generating a higher rate of return on its borrowed funds than it is paying for the use of the funds. The excess, in this case 1.6 per cent, is accruing to the benefit of the common stockholders, because their earnings are being increased.

Companies that magnify the gains from this activity for the stockholders are using leverage. Using leverage is a risky process because losses also can be magnified, to the disadvantage of the common stockholders. We discussed trading on the equity and leverage in Chapter 15.

Cash flow margin The cash flow margin measures a company's overall efficiency and performance. The cash flow margin indicates the ability of a company to translate sales into cash. Measuring the amount of cash a company generates from every dollar of sales is important because a company needs cash to service debt, pay dividends, and invest in new capital assets. The formula for the cash flow margin is:

$\text { Cash flow margin }=\dfrac{\text { Net cash provided by operating activities }}{\text { Net sales }}$

Thus, we calculate Synotech's 2010 cash flow margin as follows:

$\dfrac{\text { USD 1,101.0 million net cash provided by operating activities }}{\text { USD } 10,498.8 \text { million net sales }}=10.49 \text { per cent }$

Earnings per share of common stock Probably the measure used most widely to appraise a company's operations is earnings per share (EPS) of common stock. EPS is equal to earnings available to common stockholders divided by the weighted average number of shares of common stock outstanding. The financial press regularly publishes actual and forecasted EPS amounts for publicly traded corporations, together with period-toperiod comparisons. The Accounting Principles Board noted the significance attached to EPS by requiring that such amounts be reported on the face of the income statement.52 (Chapter 13 illustrates how earnings per share should be presented on the income statement.)

The calculation of EPS may be fairly simple or highly complex depending on a corporation's capital structure. A company has a simple capital structure if it has no outstanding securities (e.g. convertible bonds, convertible preferred stocks, warrants, or options) that can be exchanged for common stock. If a company has such securities outstanding, it has a complex capital structure. Discussion of EPS for a corporation with a complex capital structure is beyond the scope of this text.

A company with a simple capital structure reports a single basic EPS amount, which is calculated as follows:

$\text { EPS of common stock }=\dfrac{\text { Earnings available for common stockholders }}{\text { Weighted }-\text { average number of common shares outstanding }}$

The amount of earnings available to common stockholders is equal to net income minus the current year's preferred dividends, whether such dividends have been declared or not.

Determining the weighted-average number of common shares The denominator in the EPS fraction is the weighted-average number of common shares outstanding for the period. If the number of common shares outstanding did not change during the period, the weighted-average number of common shares outstanding would, of course, be the number of common shares outstanding at the end of the period. The balance in the Common Stock account of Synotech (Exhibit 133) was USD 219.9 million on 2010 December 31. The common stock had a USD 1.20 par value. Assuming no common shares were issued or redeemed during 2010, the weighted-average number of common shares outstanding would be 183.2 million (or USD 219.9 million/USD 1.20 per share). (Normally, common treasury stock reacquired and reissued are also included in the calculation of the weighted-average number of common shares outstanding. We ignore treasury stock transactions to simplify the illustrations.)

If the number of common shares changed during the period, such a change increases or decreases the capital invested in the company and should affect earnings available to stockholders. To compute the weighted-average number of common shares outstanding, we weight the change in the number of common shares by the portion of the year that those shares were outstanding. Shares are outstanding only during those periods that the related capital investment is available to produce income.

To illustrate, assume that during 2009 Synotech's common stock balance increased by USD 14.0 million (11.7 million shares). Assume that the company issued 9.5 million of these shares on 2009 April 1, and the other 2.2 million shares on 2009 October 1. The computation of the weighted-average number of common shares outstanding would be:

 171.5 million shares x 1 year 171.500 million 9.5 million shares x ¾ year (April – December) 7.125 million 2.2 million shares x ¼ year (October – December) 0.55 Weighted-average number of common shares outstanding 179.125 million

An alternate method looks at the total number of common shares outstanding, weighted by the portion of the year that the number of shares was outstanding, as follows:

 171.5 million shares x ¼ year (January – March) 42.875 million 181.0 million shares x ½ year (April – September) 90.500 million 183.2 million shares x 1/3 year (October – December) 45.800 million Weighted-average number of shares outstanding 179.175 million

Another alternate method is:

 171.5 million shares x 3 months =   514.5 million share-months 181.0 million shares x 6 months =   1,086.0 million share-months 183.2 million shares x 3 months =   549.6 million share-months 12 months     2,150.1 million share-months 2,150.1 million share-months/12 months = 179.175 million

Note that all three methods yield the same result. In 2010, the balance in the common stock account did not change as it had during 2009. Therefore, the weighted-average number of common shares outstanding during 2010 is equal to the number of common shares issued, 183.2 million. The EPS of common stock for the Synotech are:

 (USD millions) 2010 2009 Amount of increase or (decrease) Net income-preferred dividends (a) USD 736.3 USD 180.50 USD 555.80 Average number of shares of common stock (b) 183.2 179.13 4.03 EPS of common stock (a,b) USD 4.02 USD 1.01

Synotech's stockholders would probably view the increase of approximately 298.0 per cent ([USD 4.02 - USD 1.01]/USD 1.01) in EPS from USD 1.01 to USD 4.02 favorably.

EPS and stock dividends or splits Increases in shares outstanding as a result of a stock dividend or stock split do not require weighting for fractional periods. Such shares do not increase the capital invested in the business and, therefore, do not affect income. All that is required is to restate all prior calculations of EPS using the increased number of shares. For example, assume a company reported EPS for 2010 as USD 1.20 (or USD 120,000/100,000 shares) and earned USD 180,000 in 2011. The only change in common stock over the two years was a two-for-one stock split on 2011 December 1, which doubled the shares outstanding to 200,000. The firm would restate EPS for 2010 as USD 0.60 (or USD 120,000/200,000 shares) and as USD 0.90 (USD 180,000/200,000 shares) for 2011.

Basic EPS and diluted EPS In the merger wave of the 1960s, corporations often issued securities to finance their acquisitions of other companies. Many of the securities issued were calls on common or possessed equity kickers. These terms mean that the securities were convertible to, or exchangeable for, shares of their issuers' common stock. As a result, many complex problems arose in computing EPS. Until 1997, APB Opinion No. 15 provided guidelines for solving these problems. In 1997, FASB Statement No. 128, "Earnings per Share" replaced APB Opinion No. 15. A company with a complex capital structure must present at least two EPS calculations, basic EPS and diluted EPS. Because of the complexities involved in the calculations, we reserve further discussion of these two EPS calculations for an intermediate accounting text.

Times interest earned ratio Creditors, especially long-term creditors, want to know whether a borrower can meet its required interest payments when these payments come due. The times interest earned ratio, or interest coverage ratio, is an indication of such an ability. It is computed as follows:

$\text { Time interest earned ratio }=\dfrac{\text { Income beforeinterest including taxes }(\text { IBIT })}{\text { Interest expense }}$

The ratio is a rough comparison of cash inflows from operations with cash outflows for interest expense. Income before interest and taxes (IBIT) is the numerator because there would be no income taxes if interest expense is equal to or greater than IBIT. (To find income before interest and taxes, take net income from continuing operations and add back the net interest expense and taxes.) Analysts disagree on whether the denominator should be (1) only interest expense on long-term debt, (2) total interest expense, or (3) net interest expense. We will use net interest expense in the Synotech illustration.

For Synotech, the net interest expense is USD 236.9 million. With an IBIT of USD 1,382.4 million, the times interest earned ratio is 5.84, calculated as:

$\dfrac{ USD 1,382.4}{ USD 236.9}=5.84 \text { time }$

The company earned enough during the period to pay its interest expense almost 6 times over.

Low or negative interest coverage ratios suggest that the borrower could default on required interest payments. A company is not likely to continue interest payments over many periods if it fails to earn enough income to cover them. On the other hand, interest coverage of 5 to 10 times or more suggests that the company is not likely to default on interest payments.

Times preferred dividends earned ratio Preferred stockholders, like bondholders, must usually be satisfied with a fixed-dollar return on their investments. They are interested in the company's ability to make preferred dividend payments each year. We can measure this ability by computing the times preferred dividends earned ratio as follows:

$\text { Time preferred dividends earned ratio }=\dfrac{\text { Net income }}{\text { Annual preferred dividends }}$

Synotech has a net income of USD 762.0 million and preferred dividends of USD 25.7 million. The number of times the annual preferred dividends are earned for 2010 is:

$\dfrac{\operatorname{USD} 762.0}{\operatorname{USD} 25.7}=29.65: 1 \quad, \text { or } 29.65 \text { times }$

The higher this rate, the higher is the probability that the preferred stockholders will receive their dividends each year.

Analysts compute certain ratios using information from the financial statements and information about the market price of the company's stock. These tests help investors and potential investors assess the relative merits of the various stocks in the marketplace.

The yield on a stock investment refers to either an earnings yield or a dividends yield.

Earnings yield on common stock You can calculate a company's earnings yield on common stock as follows:

$\text{Earnings yield on common stock} = \dfrac{\text{EPS}}{\text{Current market price per share of common stock}}$

Assume Synotech has common stock with an EPS of USD 5.03 and that the quoted market price of the stock on the New York Stock Exchange is USD 110.70. The earnings yield on common stock would be:

$\dfrac{ USD 5.03}{ USD 110.7}=4.54 \text { per cent }$

Price-earnings ratio When inverted, the earnings yield on common stock is the price-earnings ratio. To compute the price-earnings ratio:

$\text { Price }-\text { earnings ratio }=\dfrac{\text { Current market price per share of commonstock }}{\text { EPS }}$

$\dfrac{\text{USD} 110.7}{\text{USD 5.03}}=22.01: 1$

Investors would say that this stock is selling at 22 times earnings, or at a multiple of 22. These investors might have a specific multiple in mind that indicates whether the stock is underpriced or overpriced. Different investors have different estimates of the proper price-earnings ratio for a given stock and also different estimates of the future earnings prospects of the company. These different estimates may cause one investor to sell stock at a particular price and another investor to buy at that price.

Payout ratio on common stock Using dividend yield, investors can compute the payout ratio on common stock. Assume that Synotech's dividends per share were USD 1.80 and earnings per share were USD 5.03. To calculate payout ratio on common stock, divide the dividend per share of common stock by EPS. The payout ratio of stock in 2010 is:

$\text{Payout ratio on common stock} =\dfrac{\text { Dividend per share of common stock }}{\text { EPS }}$

$\dfrac{\operatorname{USD} 1.80}{\operatorname{USD} 5.03}=\text{35.8 per cent}$

A payout ratio of 35.8 per cent means that the company paid out 35.8 per cent of its earnings in the form of dividends. Some investors are attracted by the stock of companies that pay out a large percentage of their earnings. Other investors are attracted by the stock of companies that retain and reinvest a large percentage of their earnings. The tax status of the investor has a great deal to do with this preference. Investors in high tax brackets often prefer to have the company reinvest the earnings with the expectation that this reinvestment results in share price appreciation.

Dividend yield on common stock The dividend paid per share of common stock is also of much interest to common stockholders. When the current annual dividend per share of common stock is divided by the current market price per share of common stock, the result is called the dividend yield on common stock. Synotech's 2010 December 31, common stock price was USD 110.70 per share. Its dividends per share were USD 1.80. The company's dividend yield on common stock was:

$\text { Dividend yield on of common stock }=\dfrac{\text { Dividend per share of common stock }}{\text { Current market price per share of commonstock }}$

$\dfrac{\text{USD 1.80}}{\text{USD 110.7}}=1.63 \text { per cent }$

Dividend yield on preferred stock Preferred stockholders, as well as common stockholders, are interested in dividend yields. The computation of the dividend yield on preferred stock is similar to the common stock dividend yield computation. Assume that Synotech's dividend per share of preferred stock is USD 5.10 with a current market price of USD 84.00 per share. We compute the dividend yield on preferred stock as follows:

$\text { Dividend yield on preferred stock }=\dfrac{\text { Dividend per share of preferredstock }}{\text { Current market price per share of preferred stock }}$

$\dfrac{ \text{USD 5.10}}{\text{USD 84.00}}=6.07 \text { per cent }$

Through the use of dividend yield rates, we can compare different preferred stocks having different annual dividends and different market prices.

Cash flow per share of common stock Investors calculate the cash flow per share of common stock ratio as follows:

$\text { Cash flow per share of common stock }=\dfrac{\text { Net cash provided by operating activities }}{\text { Average number of shares of common stock outstanding }}$

Currently, FASB Statement No. 95 does not permit the use of this ratio for external reporting purposes. However, some mortgage and investment banking firms do use this ratio to judge the company's ability to pay dividends and pay liabilities. The cash flow per share of common stock ratio for Synotech is as follows:

 Fiscal Year 2010 2009 Cash provided by operating activities (a) $1,101.0$972.3 Average shares outstanding (b) (assumed) 146.6 145.2 Cash flow per share of common stock (a)/(b) $7.51$6.70

Final considerations in financial statement analysis

Standing alone, a single financial ratio may not be informative. Investors gain greater insight by computing and analyzing several related ratios for a company. Exhibit 135 summarizes the ratios presented in this chapter, and Exhibit 136 presents them graphically.

Financial analysis relies heavily on informed judgment. As guides to aid comparison, percentages and ratios are useful in uncovering potential strengths and weaknesses. However, the financial analyst should seek the basic causes behind changes and established trends.

#### An accounting perspective:Uses of technology

Most companies calculate some of the ratios we have discussed, if not all of them. To efficiently and effectively perform these calculations, accountants use computers. Some programs that gather information in the preparation of financial statements calculate the ratios at the end of a period. Accountants also create spreadsheets to perform this task. Remember, to interpret the numbers correctly, investors and management must compare these ratios with the industry in which the company operates.

 Liquidity ratios Formula Significance Current, or working capital, ratio Current assets + Current liabilities Test of debt-paying ability Acid-test (quick) ratio Quick assets (cash + marketable securities + net receivables) + Current liabilities Test of immediate debt-paying ability Cash flow liquidity ratio (Cash and marketable securities + Net cash provided by operating activities) + Current liabilities Test of short-term, debt-paying ability Accounts receivable turnover Net credit sales (or net sales) + Average net accounts receivable Test of quality of accounts receivable Number of days' sales in accounts accounts receivable) Number of days in year (365) + Accounts receivable (average collection period of receivable turnover Test of quality of accounts receivable Inventory turnover Cost of goods sold + Average inventory Test of whether or not a sufficient volume of business is being generated relative to inventory Total assets turnover Net sales + Average total assets Test of whether or not the volume of business generated is adequate relative to amount of capital invested in the business Equity, or Long-term Solvency, Ratios Equity (stockholders' equity) ratio Stockholders' equity + Total assets (or total equities) Index of long-run solvency and safety Stockholders' equity to debt (debt to equity) ratio Stockholders' equity + Total debt Measure of the relative proportion of stockholders' and of creditors' equities Profitability Tests Rate of return on operating assets Net operating income + Operating assets or Operating margin x Turnover operating assets Measure of managerial Net income to net sales (return on sales) Net income + Net sales Indicator of the amount of net profit on each dollar of sales Return on average common stockholders' equity Net income + Average common stockholders' equity Measure of what a given company earned for its stockholders from all sources as a percentage of common stockholders' investment Cash flow margin Net cash provided by operating activities + Net Measure of the ability of a firm to sales translate sales into cash EPS of common stock Earnings available to common stockholders' +  Weighted-average number of common shares outstanding Measure of the return to investors Times interest earned ratio Income before interest and taxes + Interest Test of the likelihood that expense creditors will continue to receive their interest payments Time preferred dividends earned ratio Net income + Annual preferred dividends Test of the likelihood that preferred stockholders will receive their dividend each year Market Tests Earnings yield on common stock EPS + Current market price per share of common stock Comparison with other common stocks Price-earnings ratio Current market price per share of common stock + EPS Index of whether a stock is relatively cheap or expensive based on the ratio Pay cut ratio on common stock Dividend per share of common stock + EPS Index of whether company pays out a large percentage of earnings as dividends or reinvests most of its earnings Dividend yield on common stock Dividend per share of common stock + Current market price per share of common stock Comparisons with other common stocks Dividend yield on preferred stock Dividend per share of preferred stock + Current market price per share of preferred stock Comparison with other preferred stocks Cash flow per share of common stock Net cash provided by operating activities +   Average number of share of common stock   outstanding Test of ability to pay dividends and liabilities

Exhibit 135: Summary of ratios

Analysts must be sure that their comparisons are valid - especially when the comparisons are of items for different periods or different companies. They must follow consistent accounting practices if valid interperiod comparisons are to be made. Comparable intercompany comparisons are more difficult to secure. Accountants cannot do much more than disclose the fact that one company is using FIFO and another is using LIFO for inventory and cost of goods sold computations. Such a disclosure alerts analysts that intercompany comparisons of inventory turnover ratios, for example, may not be comparable.

Also, when comparing a company's ratios to industry averages provided by an external source such as Dun &

Bradstreet, the analyst should calculate the company's ratios in the same manner as the reporting service. Thus, if Dun & Bradstreet uses net sales (rather than cost of goods sold) to compute inventory turnover, so should the analyst. Net sales is sometimes preferable because all companies do not compute and report cost of goods sold amounts in the same manner.

Facts and conditions not disclosed by the financial statements may, however, affect their interpretation. A single important event may have been largely responsible for a given relationship. For example, competitors may put a new product on the market, making it necessary for the company under study to reduce the selling price of a product suddenly rendered obsolete. Such an event would severely affect the percentage of gross margin to net sales. Yet there may be little chance that such an event will happen again.

Analysts must consider general business conditions within the industry of the company under study. A corporation's downward trend in earnings, for example, is less alarming if the industry trend or the general economic trend is also downward.

Investors also need to consider the seasonal nature of some businesses. If the balance sheet date represents the seasonal peak in the volume of business, for example, the ratio of current assets to current liabilities may be much lower than if the balance sheet date is in a season of low activity.

Potential investors should consider the market risk associated with the prospective investment. They can determine market risk by comparing the changes in the price of a stock in relation to the changes in the average price of all stocks.

Potential investors should realize that acquiring the ability to make informed judgments is a long process and does not occur overnight. Using ratios and percentages without considering the underlying causes may lead to incorrect conclusions.

Relationships between financial statement items also become more meaningful when standards are available for comparison. Comparisons with standards provide a starting point for the analyst's thinking and lead to further investigation and, ultimately, to conclusions and business decisions. Such standards consist of (1) those in the analyst's own mind as a result of experience and observations, (2) those provided by the records of past performance and financial position of the business under study, and (3) those provided about other enterprises. Examples of the third standard are data available through trade associations, universities, research organizations (such as Dun & Bradstreet and Robert Morris Associates), and governmental units (such as the Federal Trade Commission).

In financial statement analysis, remember that standards for comparison vary by industry, and financial analysis must be carried out with knowledge of specific industry characteristics. For example, a wholesale grocery company would have large inventories available to be shipped to retailers and a relatively small investment in property, plant, and equipment, while an electric utility company would have no merchandise inventory (except for repair parts) and a large investment in property, plant, and equipment.

Even within an industry, variations may exist. Acceptable current ratios, gross margin percentages, debt to equity ratios, and other relationships vary widely depending on unique conditions within an industry. Therefore, it is important to know the industry to make comparisons that have real meaning.

Exhibit 136: Graphic depiction of financial statement analysis utilizing financial rations

The bankruptcies of companies like General Motors and Lehman Brothers, with the resulting significant losses to employees, stockholders, and other members of the general public, have caused important changes in corporate governance, standards of accounting, and auditing procedures and standards. These changes have come about as a result of self-regulation, oversight by the Public Company Accounting Oversight Board, regulation by the Securities and Exchange Commission, regulation by the stock exchanges, and legislation passed by Congress, and by some combination of these actions. Further changes are likely.

Financial statements are likely to become more "transparent". This means they will reveal more clearly the results of operations and the financial condition of the company. There is likely to be an increased focus on the balance sheet and on the quality and measurement of assets and the extent and nature of liabilities as well as on a proper identification of other risks. The quality of earnings will continue to be of paramount importance. There have been too many situations where companies have had to restate their earnings for prior years because they did not properly disclose material facts or properly implement the revenue recognition and/or expense recognition principles that were covered in Chapter 5.

The Enron situation was the focus of a massive investigation that led to significant changes in corporate governance, accounting rules, and auditing procedures. Enron was formed in 1985 and became a major player in the energy industry. Its stock reached a high of about USD 90 per share in August 2000. Top executives began selling stock shortly thereafter, while at least for a short period during the ensuing fall in the stock's price, employees were prevented from doing so. In October of 2001, the disclosure of off-balance sheet partnerships, with attendant liabilities for Enron, resulted in a USD 1.2 billion write-off in stockholder's equity. In November of 2001, Enron revealed that it had overstated earnings by USD 586 million since 1997. In December 2001, Enron filed for bankruptcy. Enron stock became almost worthless, selling for under USD 1. Employees of Enron not only lost their jobs, but many also lost their retirement savings because they consisted largely of Enron stock. Individual and pension fund investors as a group lost billions of dollars. The state of Florida's pension fund lost about USD 340 million. Enron's external auditor, Arthur Andersen & Co., was accused of shredding documents pertaining to Enron after the US Justice Department confirmed its investigation and was indicated in March of 2002 for that action.

External auditors, internal auditors, audit committee members, and members of Boards of Directors are likely to ask much tougher questions of management. They are also more likely to investigate questionable transactions.

Audit committees may be required to publicly disclose their activities that were performed to carry out their duties.

Management's letter to the stockholders contained in the annual report, and usually signed by the CEO, contains the views of management regarding current operations, operating results, and plans for the future. This letter is likely to become even more important in the future than it is now. There could be financial penalties if this letter is purposely misleading in that its contents are not supported by the financial statements or they misrepresent significant facts. To the extent these letters are more conservative rather than being unrealistic, individuals analyzing financial statements will be able to rely on their content to a greater extent in the future. The SarbanesOxley Act of 2002 in the US sets more stringent standards for financial reporting for public companies and their managers. Boards, and independent auditors, along with strict penalties for non-compliance.

Financial statement analysis is going to have increasing importance. There will be more focus on the cash flow statement, covered in Chapter 16, and its "cash flow from operating activities", since this amount is considered by some to be "cash earnings". Some consider this amount to be less susceptible to manipulation than is net income.

Management may disclose in an accounting policy statement, its policies regarding their business practices and those accounting policies that were followed in preparing the financial statements. Conflicts of interest will be identified and discouraged.

Professional financial analysts, such as those working for stock brokerage firms and those employed to help evaluate possible merger and acquisition candidates, typically go "beyond the numbers" in analyzing a company. They usually visit the company, interview management, and assess the physical facilities and plans for the future. They are interested in evaluating such factors as the competence and integrity of management. Professional financial analysts form an overall impression of the company by giving all of the data and other information the "smell test". In other words, does everything seem legitimate or are there possible significant hidden factors that have not yet been identified which makes one think that something is not right.

The future looks bright.  Needed changes will be made to maintain public confidence in financial reporting.

Protecting the public interest should be paramount in the future.

This chapter concludes our coverage of financial accounting. It is likely you will continue on with studies in managerial accounting. It is important to realize that it is impossible to completely separate financial and managerial accounting information into neat packages. Managers use both the published financial statements and managerial accounting information in making decisions. Also, some of the concepts covered in managerial accounting (e.g. job costing and process costing) have a direct impact on the formal financial statements. Many accountants are attracted to managerial accounting because it is not constrained by having to conform to generally accepted accounting principles. Instead, management accountants can provide to management whatever information in whatever form management requests.

#### An accounting perspective:Uses of technology

The Journal of Accountancy periodically publishes articles on Internet resources to encourage greater use of technology by accountants. One of the best in this category is called “Smart Stops on the Web”, a series authored by Megan Pinkston. (For example, see this one from 2007): http://www.journalofaccountancy.com/Issues/2007/Jun/SmartStopsOnTheWebArticle.

You may want to investigate this article and some of the others in the series and then visit some of the websites they list. There is no doubt that the Internet will only grow in importance in the future. The more you know about it, the more marketable you will be upon graduation.