ACCOUNTING FINANCIAL ACCOUNTING ANAIYSIS.ppt

ACCOUNTING FINANCIAL ACCOUNTING ANAIYSIS

1. Financial Statements
Analysis

2. What is Financial Statement Analysis?
Financialstatementanalysisisaprocesswhich
examinespastandcurrentfinancialdataforthe
purposeofevaluatingperformanceandestimating
futurerisksandpotential.
Financialstatementanalysisisusedbyinvestors,
creditors,banklendingofficers,etc
Theseanalyseswillhelptomeasure:
Efficiency
Profitability
Financialsoundnessand
Futureprospectsofthebusinessunits

3. Objectives Of Financial Statement Analysis
Themajorobjectivesoffinancialstatementanalysisareas
follows
1.AssessmentofPastPerformance
Pastperformanceisagoodindicatoroffutureperformance.
Investorsorcreditorsareinterestedinthetrendofpastsales,
costofgoodsold,operatingexpenses,netincome,cashflows
andreturnoninvestment.Thesetrendsofferameansforjudging
management'spastperformanceandarepossibleindicatorsof
futureperformance.
2.Assessmentofcurrentposition
Financialstatementanalysisshowsthecurrentpositionofthe
firmintermsofthetypesofassetsownedbyabusinessfirmand
thedifferentliabilitiesdueagainsttheenterprise.

4. 3.Predictionofprofitabilityandgrowth
prospects
Financialstatementanalysishelpsin
assessingandpredictingtheearning
prospectsandgrowthratesoffirms.
4.Predictionofbankruptcyandfailure
Financialstatementanalysisisan
importanttoolinassessingandpredicting
bankruptcyandprobabilityofbusiness
failure.

5. 5.Assessmentoftheoperationalefficiency
Financialstatementanalysishelpstoassess
theoperationalefficiencyofthemanagement
ofacompany.
Theactualperformanceofthefirmwhichare
revealedinthefinancialstatementscanbe
comparedwithsomestandardssetearlierand
thedeviationofanybetweenstandardsand
actualperformancecanbeusedasthe
indicatorofefficiencyofthemanagement

6. Techniques and Tools of Financial
statement analysis
Differenttechniquesareemployedforanalysingand
interpretingthefinancialstatements.
Techniquesofanalysisoffinancialstatementsare
mainlyclassifiedintothreecategories.
1.Cross-sectionalanalysis
Itisalsoknownasinterfirmcomparison.This
analysishelpsinanalysingfinancialcharacteristics
ofanenterprisewithfinancialcharacteristicsof
anothersimilarenterpriseinthataccountingperiod.

7. 2.Timeseriesanalysis
Itisalsocalledasintra-firmcomparison.Accordingtothis
method,therelationshipbetweendifferentitemsoffinancial
statementisestablished,comparisonsaremadeand
resultsobtained.
ThebasisofcomparisonmaybeComparisonofthe
financialstatementsofdifferentyearsofthesamebusiness
unit.
3.CombinationofCross-sectional&timeseries
analysis
Thisanalysisisintendedtocomparethefinancial
characteristicsoftwoormoreenterprisesformultiple
accountingperiod.Itispossibletoextendsucha
comparisonovertheyear.Thisapproachismosteffective
inanalysingoffinancialstatements.

8. A number of tools or methods or devices are used to
study the relationship between financial statements.
The most important tools which are commonly used
for analysing and interpreting financial statements are
the following:
Tools of Financial Statement Analysis
Dollar & Percentage Changes
Trend Percentages
Component Percentages
Ratios

9. Thedollaramountofanychangeisthe
differencebetweentheamountfora
comparisonyearandtheamountforabase
year.
Thepercentagechangeiscomputedby
dividingtheamountofthedollarchangeby
theamountforthebaseyear.
Dollar and Percentage Changes

10. Dollar Change:
Analysis Period
Amount
Base Period
Amount
Dollar
Change
= –
Percentage Change:
Dollar Change
Base Period
Amount
Percent
Change
= ÷%
Dollar and Percentage Changes

11. Let’slookattheassetsectionofABC
Corporation’scomparativebalance
sheetandincomestatementfor2003
and2002onthenextslide.
Computethedollarchangeandthe
percentageforcash.
Dollar and Percentage Changes
Example

12. ABC CORPORATION
Comparative Balance Sheets
December 31,
2003 2002
Dollar
Change
Percent
Change*
Assets
Current assets:
Cash and equivalents 12,000$ 23,500$ ? ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000$ 164,700$
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment160,000$ 125,000$
Total assets 315,000$ 289,700$
* Percent rounded to one decimal point.

13. ABC CORPORATION
Comparative Balance Sheets
December 31,
2003 2002
Dollar
Change
Percent
Change*
Assets
Current assets:
Cash and equivalents 12,000$ 23,500$ (11,500)$ ?
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000$ 164,700$
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment160,000$ 125,000$
Total assets 315,000$ 289,700$
* Percent rounded to one decimal point. $12,000 –$23,500 = $(11,500)

14. ABC CORPORATION
Comparative Balance Sheets
December 31,
2003 2002
Dollar
Change
Percent
Change*
Assets
Current assets:
Cash and equivalents 12,000$ 23,500$ (11,500)$ -48.9%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000$ 164,700$
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment160,000$ 125,000$
Total assets 315,000$ 289,700$
* Percent rounded to one decimal point. ($11,500 ÷$23,500) ×100% = 48.94%
Complete the
analysis for the
other assets.

15. ABC CORPORATION
Comparative Balance Sheets
December 31,
2003 2002
Dollar
Change
Percent
Change*
Assets
Current assets:
Cash and equivalents 12,000$ 23,500$ (11,500)$ -48.9%
Accounts receivable, net 60,000 40,000 20,000 50.0%
Inventory 80,000 100,000 (20,000) -20.0%
Prepaid expenses 3,000 1,200 1,800 150.0%
Total current assets 155,000$ 164,700$ (9,700) -5.9%
Property and equipment:
Land 40,000 40,000 - 0.0%
Buildings and equipment, net 120,000 85,000 35,000 41.2%
Total property and equipment160,000$ 125,000$ 35,000 28.0%
Total assets 315,000$ 289,700$ 25,300$ 8.7%
* Percent rounded to one decimal point.

16. ABC CORPORATION
Comparative Balance Sheets
December 31,
2003
2003 2002
Dollar
change
Percentag
e change
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable 67,000$ 44,000$ 23,000$ 52.3%
Notes payable 3,000 6,000 (3,000)$ -50.0%
Total current liabilities 70,000$ 50,000$ 20,000$ 40.0%
Long-term liabilities: -$
Bonds payable, 8% 75,000 80,000 (5,000)$ -6.3%
Total liabilities 145,000$ 130,000$ 15,000$ 11.5%
Shareholders' equity:
Preferred stock 20,000 20,000 -$ 0.0%
Common stock 60,000 60,000 -$ 0.0%
Additional paid-in capital 10,000 10,000 -$ 0.0%
Total paid-in capital 90,000$ 90,000$ -$ 0.0%
Retained earnings 80,000 69,700 10,300$ 14.8%
Total shareholders' equity 170,000$ 159,700$ 10,300$ 6.4%
Total liabilities and shareholders' equity315,000$ 289,700$ 25,300$ 8.7%
* Percent rounded to first decimal point.

17. Interpretation
(i)Thecomparativebalancesheetofthecompanyrevealsthat
during2003therehasbeenanincreaseinfixedassetsof
$35,000i.e.28.2%andLongtermliabilitiestooutsidershave
relativelydecreasedby$6,000,i.e.-6.3%,.Equitysharecapital
hasnochange,butretainingearningsofthecompanyincreases
by$10,800,i.e.14.8%.
Thisfactindicatesthatthesourcesoffinanceofthecompanyto
purchasefixedassetsareshorttermdebtsandcompany’s
retainingearnings.
(ii)Thecurrentassetshavedecreasedby$9,700i.e.-5.9%,
whereasthecurrentliabilitieshaveincreasedby$20,000i.e.
40.0%.Thisfurtherconfirmsthatthecompanyhasusedshort-
termfinancestoacquirefixedassets.
(iii)RetainedEarningshaveincreasedfrom$69,700to
$80,000,($10,300i.e.14.8%)whichshowsthatthecompanyhas
utilizedRetainedearningsforacquiringoffixedassets.

18. Thechangeinfinancialstatementitems
fromabaseyeartofollowingyearsare
oftenexpressedastrendpercentagesto
showtheextentanddirectionofchange.
Twostepsarenecessarytocomputetrend
percentages.
1.Selectbaseyearandassignaweightof100%
foreachiteminthebaseyear
2.Expresseachitemfollowingyearsasa
percentageofitsbaseyearamount.
Trend Analysis

19. Trend
Percent
Analysis Period Amount
Base Period Amount
100%= ×
Trend Analysis
Trend analysis is used to reveal patterns in data
covering successive period.

20. 1999 is the base period so
its amounts will equal
100%.
Berry Products
Income Information
For the Years Ended December 31, Item 2003 2002 2001 2000 1999
Revenues 400,000$ 355,000$ 320,000$ 290,000$ 275,000$
Cost of sales285,000 250,000 225,000 198,000 190,000
Gross profit 115,000 105,000 95,000 92,000 85,000 Item 2003 2002 2001 2000 1999
Revenues 105% 100%
Cost of sales 104% 100%
Gross profit 108% 100% Item 2003 2002 2001 2000 1999
Revenues 145% 129% 116% 105% 100%
Cost of sales 150% 132% 118% 104% 100%
Gross profit 135% 124% 112% 108% 100% (290,000275,000)100%=105%
(198,000190,000)100%=104%
(92,00085,000)100%=108%
Trend Analysis -Example

22. Indicate the relative size of each item included in a total.
Examinetherelativesizeofeachiteminthefinancialstatements
bycomputingcomponent(orcommon-sized)percentages.
Component
Percent
100%
Analysis Amount
Base Amount
= ×
Financial StatementBase Amount
Balance Sheet Total Assets
Income Statement Revenues
Component Percentages

23. ABC CORPORATION
Comparative Balance Sheets
December 31,
Common-size
Percents*
2003 2002 2003 2002
Assets
Current assets:
Cash and equivalents 12,000$ 23,500$ 3.8% 8.1%
Accounts receivable, net 60,000 40,000
Inventory 80,000 100,000
Prepaid expenses 3,000 1,200
Total current assets 155,000$ 164,700$
Property and equipment:
Land 40,000 40,000
Buildings and equipment, net 120,000 85,000
Total property and equipment160,000$ 125,000$
Total assets 315,000$ 289,700$ 100.0%100.0%
* Percent rounded to first decimal point.
Complete the common-size analysis for the other
assets. ($12,000 ÷$315,000) ×100% = 3.8%
($23,500 ÷$289,700) ×100% = 8.1%

24. ABC CORPORATION
Comparative Balance Sheets
December 31,

Common-size
Percents*
2003 2002 2003 2002
Assets
Current assets:
Cash and equivalents 12,000$ 23,500$ 3.8% 8.1%
Accounts receivable, net 60,000 40,000 19.0% 13.8%
Inventory 80,000 100,000 25.4% 34.5%
Prepaid expenses 3,000 1,200 1.0% 0.4%
Total current assets 155,000$ 164,700$ 49.2% 56.9%
Property and equipment:
Land 40,000 40,000 12.7% 13.8%
Buildings and equipment, net 120,000 85,000 38.1% 29.3%
Total property and equipment160,000$ 125,000$ 50.8% 43.1%
Total assets 315,000$ 289,700$ 100.0%100.0%
* Percent rounded to first decimal point.

25. CLOVER CORPORATION
Comparative Balance Sheets
December 31,
Common-size
Percents*
2003 2002 2003 2002
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable 67,000$ 44,000$
Notes payable 3,000 6,000
Total current liabilities 70,000$ 50,000$
Long-term liabilities:
Bonds payable, 8% 75,000 80,000
Total liabilities 145,000$ 130,000$
Shareholders' equity:
Preferred stock 20,000 20,000
Common stock 60,000 60,000
Additional paid-in capital 10,000 10,000
Total paid-in capital 90,000$ 90,000$
Retained earnings 80,000 69,700
Total shareholders' equity 170,000$ 159,700$
Total liabilities and shareholders' equity315,000$ 289,700$
* Percent rounded to first decimal point.
Complete the common-size analysis for the liabilities and equity
accounts. ABC CORPORATION
Comparative Balance Sheets
December 31,

Common-size
Percents*
2003 2002 2003 2002
Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable 67,000$ 44,000$ 21.3% 15.2%
Notes payable 3,000 6,000 1.0% 2.1%
Total current liabilities 70,000$ 50,000$ 22.2% 17.3%
Long-term liabilities:
Bonds payable, 8% 75,000 80,000 23.8% 27.6%
Total liabilities 145,000$ 130,000$ 46.0% 44.9%
Shareholders' equity:
Preferred stock 20,000 20,000 6.3% 6.9%
Common stock 60,000 60,000 19.0% 20.7%
Additional paid-in capital 10,000 10,000 3.2% 3.5%
Total paid-in capital 90,000$ 90,000$ 28.6% 31.1%
Retained earnings 80,000 69,700 25.4% 24.1%
Total shareholders' equity 170,000$ 159,700$ 54.0% 55.1%
Total liabilities and shareholders' equity315,000$ 289,700$ 100.0%100.0%
* Percent rounded to first decimal point.

26. ABC CORPORATION
Comparative Income Statements
For the Years Ended December 31,
Common-size
Percents*
2003 2002 2003 2002
Revenues 520,000$ 480,000$ 100.0%100.0%
Costs and expenses:
Cost of sales 360,000 315,000 69.2% 65.6%
Selling and admin. 128,600 126,000 24.7% 26.3%
Interest expense 6,400 7,000 1.2% 1.5%
Income before taxes 25,000$ 32,000$ 4.8% 6.7%
Income taxes (30%) 7,500 9,600 1.4% 2.0%
Net income 17,500$ 22,400$ 3.4% 4.7%
Net income per share 0.79$ 1.01$
Avg. # common shares 22,200 22,200
* Rounded to first decimal point.

27. Ratios
Aratioisasimplemathematicalexpressionofthe
relationshipbetweenoneitemandanother.
Alongwithdollarandpercentagechanges,trend
percentages,andcomponentpercentages,ratioscanbe
usedtocompare:
Other companies to your company.
Past performance to present performance.

28. NORTON CORPORATION
2003
Cash 30,000$
Accounts receivable, net
Beginning of year 17,000
End of year 20,000
Inventory
Beginning of year 10,000
End of year 15,000
Total current assets 65,000
Total current liabilities 42,000
Total liabilities 103,917
Total assets
Beginning of year 300,000
End of year 346,390
Revenues 494,000 A. Liquidity Ratios
Use this information to calculate the liquidity
ratios for Norton Corporation.

29. Dec. 31, 2003
Current assets 65,000$
Current liabilities (42,000)
Net Working capital 23,000$ Gross working capital is total current assets of
firms.
Net Working capital is the excess of current assets
over current liabilities.
Working Capital

30. Current
Ratio
Current Assets
Current Liabilities
=
This ratio measures the short-term debt-
paying ability of the company.
Current Ratio
=Current
Ratio
$65,000
$42,000
=
1.55 : 1

31. Quick assetsare cash, marketable securities, and
receivables.
Thisratioislikethecurrentratiobutexcludescurrentassets
suchasinventoriesthatmaybedifficulttoquicklyconvertinto
cash.
Quick Assets
Current Liabilities
=
Quick
Ratio
Quick Ratio

32. Quick Assets
Current Liabilities
=
Quick
Ratio
$50,000
$42,000
=1.19 : 1=
Quick
Ratio
Thisratioislikethecurrentratiobut
excludescurrentassetssuchasinventories
thatmaybedifficulttoquicklyconvertinto
cash.
Quick Ratio

33. B. Activity (Asset management) Ratios
Assetmanagementratiosmeasurehoweffectivelyafirmismanagingits
assets.
Ifacompanyhasexcessiveinvestmentsinassets,thenitsoperating
capitalwillbeundulyhigh,whichwillreduceitsfreecashflowand
ultimatelyitsstockprice.
Ontheotherhand,ifacompanydoesnothaveenoughassetsthenit
willlosesales,whichwillhurtprofitability,freecashflow,andthestock
price.
Therefore,itisimportanttohavetherightamountinvestedinassets.
Activityratiosinclude
i.InventoryTurnover
ii.AverageCollectionPeriod
iii.FixedAssetturnover
iv.TotalAssetturnover

34. MicroDrive Balance Sheet

35. MicroDrive Income Statement

36. Measuresfirm’sefficiencyinmanagingitsinventory.
Itmeasureshowfasttheinventoryisturnedovertoproducetheyears
sales.
Inventory turnover ratio = Sales/Inventories
=$3,000/$615 = 4.9,
Industry average = 9.0
Asaroughapproximation,eachitemofMicroDrive’sinventoryissold
outandrestocked,or“turnedover,”4.9timesperyear,muchlower
thantheindustryaverage.
ThissuggeststhatMicroDriveisholdingtoomuchinventory.
Highlevelsofinventoryaddtonetoperatingworkingcapital(NOWC),
whichreducesFCF,whichleadstolowerstockprices.
Inaddition,MicroDrive’slowinventoryturnoverratiomakesus
wonderwhetherthefirmisactuallyholdingobsoletegoodsnotworth
theirstatedvalue.
i. Inventory Turnover

37. Inventory turnover
Notethatsalesoccurovertheentireyear,whereasthe
inventoryfigureismeasuredatasinglepointintime.
Forthisreason,itisbettertouseanaverageinventory
measure.
Ifthefirm’sbusinessishighlyseasonal,oriftherehas
beenastrongupwardordownwardsalestrendduring
theyear,thenitisespeciallyusefultomakesomesuch
adjustment.
37

38. AlsocalledAccountsReceivableTurnoverorDaysSalesOutstanding.
Showstheaveragelengthoftimethatafirmmustwaitaftermakingasale,butbefore
receivingcash.
Measuresefficiencyoffirm’scollectionandcreditpolicies.
DSO = Receivables / (Annual sales /365)
=375 /(3000/365)
= 45.6 days = 46 days
Micro Drive has 46 DSO, well above the 36-day industry average
MicroDrive’ssalestermscallforpaymentwithin30days.
Thefactthat46daysofsalesareoutstandingindicatesthatcustomers,onaverage,are
notpayingtheirbillsontime.
Aswithinventory,highlevelsofaccountsreceivablecausehighlevelsofNOWC,which
hurtsFCFandstockprice.
Acustomerwhoispayinglatemaywellbeinfinancialtrouble,inwhichcaseMicro
Drivemayhaveahardtimeevercollectingthereceivable.
38
ii. Average Collection Period

39. Assesseshoweffectivelyafirmusesitsplantand
equipmenttogeneratesales.
=$3,000/$1,000=3.0;Industryaverage=3.0
MicroDrive’sratioof3.0isequaltotheindustryaverage,
indicatingthatthefirmisusingitsfixedassetsaboutas
intensivelyasareotherfirmsinitsindustry.
Therefore,MicroDriveseemstohaveabouttheright
amountoffixedassetsinrelationtootherfirms.
Apotentialproblemcanexistwheninterpretingthefixed
assetsturnoverratiowhencomparingcompabiesof
differentages.
39-
iii. Fixed Asset Turnover
Net sales
Net property, plant, equipment

40. Assesseseffectivenessingeneratingsalesfrom
investmentsinallassets.
Totalassetturnover=$3,000/$2,000=1.5;Industryaverage=1.8
MicroDrive’sratioissomewhatbelowtheindustry
average,indicatingthatthecompanyisnotgeneratinga
sufficientvolumeofbusinessgivenitstotalasset
investment.
Salesshouldbeincreased,someassetsshouldbesold,or
acombinationofthesestepsshouldbetaken.
40
iv. Total Asset Turnover
Net sales
Total assets

41. C. DEBT MANAGEMENT/ Financial Leverage Ratios
Leverageratiosmeasuretheextentofafirm’sfinancing
withdebtrelativetoequityanditsabilitytocoverinterest
andotherfixedcharge.
Theextenttowhichafirmusesdebtfinancing,or
financialleverage,hasthreeimportantimplications:
CommonLeverageratiosinclude:
Debt ratio
Times interest earned
Fixed charge coverage
41

42. Theratiooftotalliabilitiestototalassetsis
calledthedebtratio,orsometimesthetotal
debtratio.
Considerstheproportionofallassetsthatare
financedwithdebt.
Itmeasuresthepercentageoffundsprovided
bycurrentliabilitiesandlong-termdebt:
Considerthefollowingexample.
42
i. Debt Ratio
Total liabilities
Total assets

43. Debtratio=Totalliabilities/Totalassets
=$310+$754
$2,000
=53.2%;Industryaverage=40.0%
Creditorspreferlowdebtratiosbecausethelowertheratio,the
greaterthecushionagainstcreditors’lossesintheeventofliquidation.
Stockholders,ontheotherhand,maywantmoreleveragebecauseit
magnifiestheirreturn.
MicroDrive’sdebtratiois53.2%butitsdebtratiointhepreviousyear
was47.6%,whichmeansthatcreditorsarenowsupplyingmorethan
halfthetotalfinancing.
Inadditiontoanupwardtrend,thelevelofthedebtratioiswellabove
theindustryaverage.
Creditorsmaybereluctanttolendthefirmmoremoneybecausea
highdebtratioisassociatedwithagreaterriskofbankruptcy.
43

44. Somesourcesreportthedebt-to-equityratio,definedas:
Debt-to-equityratio=Totalliabilities/(Totalassets−Total
liabilities)
=$310+$754/($2,000−($310+$754)
= 1.14;Industry average = 0.67
Thedebt-to-equityratioandthedebtratiocontainthesameinformation
butpresentthatinformationslightlydifferently.
Thedebt-to-equityratioshowsthatMicroDrivehas$1.14ofdebtfor
everydollarofequity,whereasthedebtratioshowsthat53.2%ofMicro
Drive’sfinancingisintheformofliabilities.
44

45. Indicateshowwelloperatingearningscoverfixedinterest
expenses,alsocalledtheinterestcoverageratio.
Times-interest-earned (TIE) ratio for Micro Drive
=$283.8/$88 =3.2 times,Industry average = 6.0
TheTIEratiomeasurestheextenttowhichoperating
incomecandeclinebeforethefirmisunabletomeetits
annualinterestcosts.
Failuretomeetthisobligationcanbringlegalactionbythe
firm’screditors,possiblyresultinginbankruptcy.
45
ii. Times Interest Earned (TIE)
Earning Before Interest and Tax (EBIT)
Interest expense

46. Times Interest Earned ratio
NotethatEarningsBeforeInterestandTaxes(EBIT),
ratherthanNetIncome,isusedinthenumerator.
Becauseinterestispaidwithpre-taxdollars,thefirm’s
abilitytopaycurrentinterestisnotaffectedbytaxes.
MicroDrive’sinterestiscovered3.2times.
Theindustryaverageis6,soMicroDriveiscoveringits
interestchargesbyarelativelylowmarginofsafety.
Thus,theTIEratioreinforcestheconclusionfromour
analysisofthedebtratiothatMicroDrivewouldface
difficultiesifitattemptedtoborrowadditionalfunds.
46

47. Broadermeasureofhowwelloperatingearningscover
FixedChargesbyincludingleasepaymentsandSinking
fundobligations.
TheTIEratioisusefulforassessingacompany’sabilityto
meetinterestchargesonitsdebt,butthisratiohastwo
shortcomings:
1.Interestisnottheonlyfixedfinancialcharge-companiesmustalso
reducedebtonschedule,andmanyfirmsleaseassets
andthusmustmakeleasepayments.
Iftheyfailtorepaydebtormeetleasepayments,theycanbeforced
intobankruptcy.
2.EBITdoesnotrepresentallthecashflowavailabletoservicedebt,
especiallyifafirmhashighdepreciationand/oramortizationcharges.
TheEBITDAcoverageratioaccountsforthese
deficiencies.
47
iii. Fixed Charge or EBITDA Coverage ratio

48. EBITDA coverage ratio for Micro Drive = $383.8 + $28
$88 + $20 + $28
= $411.8
$136
= 3.0 times, Industry average = 4.3
MicroDrivehad$383.8millionofearningsbeforeinterest,taxes,depreciation,and
amortization(EBITDA).
Also,leasepaymentsof$28millionweredeductedwhilecalculatingEBITDA.
That$28millionwasavailabletomeetfinancialcharges;hence
itmustbeaddedback,bringingthetotalavailabletocoverfixedfinancialchargesto
$411.8million.
Fixedfinancialchargesconsistedof$88millionofinterest,$20millionofsinkingfund
payments,and$28millionforleasepayments,foratotalof$136million.
Therefore,MicroDrivecovereditsFixedFinancialChargesby3.0times.
However,ifEBITDAdeclinesthenthecoveragewillfall.
Moreover,MicroDrive’sratioiswellbelowtheindustryaverage,soagainthecompany
seemstohavearelativelyhighlevelofdebt.
48

49. TheEBITDAcoverageratioismostusefulforrelatively
short-termlenderssuchasbanks,whichrarelymake
loans(exceptrealestate-backedloans)forlongerthan
about5years.
Overarelativelyshortperiod,depreciation-generated
fundscanbeusedtoservicedebt.
Overalongertime,thosefundsmustbereinvestedto
maintaintheplantandequipmentorelsethecompany
cannotremaininbusiness.
Therefore,banksandotherrelativelyshort-termlenders
focusontheEBITDAcoverageratio,whereaslong-term
bondholdersfocusontheTIEratio.
49

50. An income statement can be prepared in either a
multiple-step or single-step format.
The single-step format is simpler.
The multiple-step format provides more
detailed information.
Measures of Profitability

51. Central Company
Income Statement
For the Year Ended 12/31/03
Sales, net 785,250$
Cost of goods sold 351,800
Gross margin 433,450$
Operating expenses:
Selling expenses 197,350$
General & Admin. 78,500
Depreciation 17,500 293,350
Income from Operations 140,100$
Other revenues & gains:
Interest income 62,187$
Gain 24,600 86,787
Other expenses:
Interest 27,000$
Loss 9,000 (36,000)
Income before taxes 190,887$
Income taxes 62,500
Net income 128,387$ Proper Heading{
Gross
Margin{
Operating
Expenses{
{
Non-
operating
Items
Income Statement (Multiple-Step) Example
Remember to
compute EPS.

52. Central Company
Income Statement
For the Year Ended 12/31/03
Revenues and gains:
Sales, net 785,250$
Interest income 62,187
Gain on sale of plant assets 24,600
Total revenues and gains 872,037$
Expenses and losses:
Cost of goods sold 351,800$
Selling Expenses 197,350
General and Admin. Exp. 78,500
Depreciation 17,500
Interest 27,000
Income taxes 62,500
Loss: sale of investment 9,000
Total expenses & losses 743,650
Operating income 128,387$ Proper Heading{
Income Statement (Single-Step) Example
Expenses &
Losses{
Revenues &
Gains{
Remember to
compute EPS.

53. Use this
information
to calculate
the
profitability
ratios for
Norton
Corporation.NORTON CORPORATION
2003
Number of common
shares outstanding all of
2003 27,400
Net income from operation 53,690$
Shareholders' equity
Beginning of year 180,000
End of year 234,390
Revenues 494,000
Cost of sales 140,000
Total assets
Beginning of year 300,000
End of year 346,390

54. This ratio is generally considered
the best overall measure of a
company’s profitability.ROA =
Operating
income
÷Average total assets
= 53,690$ ÷($300,000 + $346,390) ÷ 2
= 16.61%
Return On Assets (ROA)

55. ROE =
Operating
income
÷
Average total stockholders'
equity
= 53,690$ ÷($180,000 + $234,390) ÷ 2
= 25.91% This measure indicates how well the company employed the
owners’ investments to earn income.
Return On Equity (ROE)