Using your text and at least one scholarly source, prepare a two to three page paper, in APA format, and evaluate the three m

Chapter 8

Analysis

Learning Objectives

• Convert financial statements to common-sized financial statements and perform trend analysis.

• Perform liquidity analysis by evaluating working capital, the current ratio, and the quick ratio.

• Perform debt service analysis via the debt-to-assets, debt-to-equity, and times-interest- earned ratios.

• Evaluate accounts receivable and inventory turnover.

• Analyze trends in profitability through examining margins and rates of return.

• Calculate earnings per share and book value per share.

Reza Estakhrian/Iconica/Getty Images

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CHAPTER 8Introduction

Chapter Outline

Introduction 8.1 Common-Size Financial Statements

Vertical Analysis Horizontal Analysis

8.2 Ratio Analysis 8.3 Liquidity Analysis 8.4 Debt Service Analysis 8.5 Activity Analysis

Accounts Receivable Turnover Inventory or Supplies Turnover

8.6 Profitability Analysis Margin Ratios Return-on-Assets Ratio Return-on-Equity Ratio

8.7 Recap and Summary Illustration

Introduction

By now, you have developed an appreciation for the basic principles and practices used to develop key financial reports. As noted many times, financial statements are intended to benefit investors and creditors in their quest to make informed decisions about buying stock from or lending money to a company. They can also be used by executives and managers to determine trends and find trouble spots that need changes to improve the financial health of the organization. The focus now turns to the analytical process by which information extracted from an accounting system can be examined in a thoughtful and systematic fashion.

Users of financial statements often engage in comparative analysis; that is, they have choices. They can make either equity investments or loans, and they likely have multiple firms to choose from. Executives and managers can use this analysis to identify possible issues and make changes to pricing, purchasing, staffing, credit rules, and many other aspects of a business to improve profitability and liquidity. Clearly, the goal is to maximize anticipated returns based on the risk level that they are willing to entertain. Common-size financial statements and ratio analysis are tools that can facilitate this process.

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CHAPTER 8Section 8.1 Common-Size Financial Statements

8.1 Common-Size Financial Statements

The concept of common-size financial statements relates to converting the dollar amounts within financial statements to percentage terms. The purpose of the scaling process is to facilitate comparisons across firms and/or time. There are many ways in which this scaling can occur. The following examples will illustrate a few of the possible scenarios and are sufficient to provide you with a conceptual understanding that you can then adapt to almost any type of evaluation.

Exhibit 8.1 is a comparative income statement for ABC Medical Clinic for 2 consecutive years. This is the traditional format that you are already well acquainted with.

Exhibit 8.1: A comparative income statement

The 20X3 income statement reveals a profit of $48,000, based on $250,000 in sales. Net income doubled from the prior year’s $24,000 amount; sales did not. Although it is appar- ent that income increased significantly, it is not readily apparent why. The cause for the doubling in income can be clarified via both vertical and horizontal analyses.

Vertical Analysis A vertical analysis of income results when each expense category is expressed as a per- centage of sales. In other words, each item within the vertical column of data is expressed in relation to (as a percentage of) the top item in the column: sales. For example, to calcu- late Cost of Goods Sold, you would divide $100,000 (CGS) by $250,000 5 0.4. Then you convert that to a percentage by multiplying 0.4 by 100 5 40%. The vertical analysis in Exhibit 8.2 reveals how each line item component of income relates to revenue, on a per- centage basis.

Sales

Cost of goods sold

Gross profit

Operating expenses

Income before tax

Income taxes

Net income

20X3 20X2

ABC Medical Clinic Income Statement

For the Years Ending December 31

$ 250,000

100,000

$ 150,000

80,000

$ 70,000

22,000

$ 48,000

$ 225,000

95,000

$ 130,000

88,000

$ 42,000

18,000

$ 24,000

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CHAPTER 8Section 8.1 Common-Size Financial Statements

Exhibit 8.2: An income statement showing a vertical analysis

By reviewing this vertical analysis of income, you can readily see that cost of goods sold is about 40% of sales. The remaining gross profit of around 60% is allocated to operating expenses, taxes, and net income. On a relative basis, you can also tell that most expenses were at a fairly steady percentage of sales for both years, with a noted exception for the decrease in operating expenses; indeed, a large portion of the increase in income appears to be due to the reduction in the operating expense proportion.

Horizontal Analysis A horizontal analysis can be used to compare data from within two or more periods, side by side. In other words, it is intended to show the change in certain accounts from two separate accounting periods. Horizontal analysis can be very helpful in looking for trends in a company’s income. Consider Exhibit 8.3 and the comments that follow.

Exhibit 8.3: An income statement showing a horizontal analysis

Sales

Cost of goods sold

Gross profit

Operating expenses

Income before tax

Income taxes

Net income

100.00% 100.00%

40.00% 42.22%

60.00% 57.78%

32.00% 39.11%

28.00% 18.67%

8.80% 8.00%

19.20% 10.67%

ABC Medical Clinic Income Statement

Vertical Common-Size Report For the Years Ending December 31

20X3 20X2

Sales

Cost of goods sold

Gross profit

Operating expenses

Income before tax

Income taxes

Net income

+ 11%

+ 5%

+ 15%

– 9%

+ 67%

+ 22%

+ 100%

ABC Medical Clinic Income Statement

Horizontal Common-Size Report 20X3 Change Over 20X2

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CHAPTER 8Section 8.1 Common-Size Financial Statements

The horizontal analysis in Exhibit 8.3 shows that sales increased by only 11%, but gross profit increased by 15%. This is reflective of the slightly reduced cost of goods sold per- centage. Operating expenses decreased by 9%, notwithstanding the increase in overall sales. The impacts of the slight improvement in gross profit, coupled with the decrease in operating expenses, resulted in a dramatic rise in income. This type of analysis is not complex or brilliant, but it is illuminating. It will definitely cause you to focus on changes that need to be monitored closely.

Vertical and horizontal analyses are also applicable to balance sheet presentations. These analyses can be used to pinpoint shifts in key business elements, such as a buildup of inventory, capital investments, changing debt levels, and so forth. Many of these impor- tant trends are additionally monitored by ratios that are discussed later in this chapter. But the common-size financial statements can cause important trends or problems to “pop off the page” and be noticed. You can almost think of this technique as radar, constantly scan- ning financial reports for emerging storm clouds! Examine the balance sheets in Exhibits 8.4, 8.5, and 8.6 and see what trends that you can identify.

Exhibit 8.4: A comparative balance sheet

Cash

Accounts receivable

Inventory

Investments

Land

Buildings (net)

Equipment (net)

Total assets

Accounts payable

Notes payable

Total liabilities

Common stock

Retained earnings

Total equity

Total liabilities and equity

$ 80,000

135,000

210,000

500,000

190,000

624,000

400,000

$ 2,139,000

$ 85,000

810,000

$ 895,000

$ 500,000

744,000

$ 1,244,000

$ 2,139,000

$ 100,000

225,000

175,000

600,000

190,000

610,000

435,000

$ 2,335,000

$ 143,000

790,000

$ 933,000

$ 500,000

902,000

$ 1,402,000

$ 2,335,000

Base Hospital Corporation Comparative Balance Sheets December 31, 20X5 and 20X6

20X6 20X5

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CHAPTER 8Section 8.1 Common-Size Financial Statements

Exhibit 8.5: A balance sheet showing a vertical analysis

Exhibit 8.6: A balance sheet showing a horizontal analysis

4.28%

9.64%

7.49%

23.70%

8.14%

26.12%

18.63%

100.00%

3.97%

37.87%

41.84%

23.38%

34.78%

58.16%

100.00%

Base Hospital Corporation Balance Sheet

December 31, 20X6 and 20X5

Cash

Accounts receivable

Inventory

Investments

Land

Buildings (net)

Equipment (net)

Total assets

Accounts payable

Notes payable

Total liabilities

Common stock

Retained earnings

Total equity

Total liabilities and equity

3.74%

6.31%

9.82%

23.38%

29.17%

8.88%

18.70%

100.00%

3.97%

37.87%

41.84%

23.38%

34.78%

58.16%

100.00%

20X520X6

20X6

125.00%

166.67%

83.33%

120.00%

100.00%

97.76%

108.75%

109.16%

168.24%

97.53%

104.25%

109.16%

109.16%

109.16%

109.16%

Base Hospital Corporation Balance Sheet

Horizontal Common-Size Report December 31, 20X6 and 20X5

Cash

Accounts receivable

Inventory

Investments

Land

Buildings (net)

Equipment (net)

Total assets

Accounts payable

Notes payable

Total liabilities

Common stock

Retained earnings

Total equity

Total liabilities and equity

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CHAPTER 8Section 8.3 Liquidity Analysis

Common-size financial statements are often reported on investment research websites, in reports prepared by financial statement analysts, and others. The company itself typically does not present them. It is essential that financial statement users and others do their own research and analysis, and converting published financial statements to common- size reports is an excellent starting point.

8.2 Ratio Analysis

An automobile is a complex machine. Think of all the data you must monitor to know that it is functioning correctly. Tire pressure, speed, water temperature, voltage, rpm, and so forth are factors that you may constantly monitor. Numbers that are out of the normal operating range can serve as early warning signs that something is going wrong. For instance, if the water temperature gauge is rising above 200 degrees, you may suspect that trouble is coming; perhaps your car is losing water from a broken hose. So you fix the minor problem before it becomes major and requires a costly solution. In the same way, executives, managers, investors, and creditors may develop their own ratios and keep a watchful eye for trouble. The ratios are divisible into categories related to liquidity meas- ures, debt service, turnover, and profitability. In addition, a host of other measures may be of great interest.

8.3 Liquidity Analysis

Executives, managers, investors, and creditors must be vigilant to monitor a company’s liquidity, or ability to meet short-term obligations as they mature. A company with a strong balance sheet and robust sales can still find itself in deep trouble by running out of cash. This can happen when resources become bound up in receivables, inventory, and plant assets. Therefore, management, investors, and creditors will all follow a company’s liquidity trends and condition. Two ratios, the current and quick ratios, are particularly intended to signal the potential for liquidity challenges.

First, to understand liquidity better, you also need to become familiar with the concept of working capital. It is the amount of current assets minus current liabilities. Assume that Ashcroft Clinics has current assets of $1,000,000 and current liabilities of $400,000; the working capital is $600,000. Normally, one hopes to find that a company has a signifi- cantly positive amount of working capital. Having positive working capital can provide some comfort that the company has sufficient access to assets that are readily convertible to cash and will therefore be able to meet liabilities as they come due.

The preceding generalization is sometimes not true, however. A firm’s current assets could be invested in slow-moving inventory. These goods would be of little value in meet- ing obligations. Indeed, the obligations may have arisen upon purchase of the goods. The seller of the goods would hardly be interested in receiving them back; they expect to be paid in cash. Conversely, some businesses manage cash flow very effectively. They may provide goods and services and have little invested in inventory or receivables. Most medical practices have very little invested in inventory, but may have a long waiting time to get paid cash on receivables because insurance companies can be slow payers. Careful budgeting needs to be conducted to ensure that enough cash is available to pay the bills even if payments on receivables are slow.

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CHAPTER 8Section 8.3 Liquidity Analysis

How much working capital is enough? The answer to this question is partially answered by giving consideration to the issues raised in the preceding paragraphs. However, you also need to know about the size of the business. A small business may function well with $100,000 of working capital, while a large business may run short with $100,000,000 of working capital. Therefore, working capital is sensitive to the size of the business. You must also give consideration to the industry in which a business operates. An automobile manufacturer can be expected to have significant amounts of inventory, and this leads to an ordinary condition of a large amount of current assets and working capital. On the other hand, inventory may be totally lacking in service businesses, and they may have a much-reduced level of working capital as a result. Some medical facilities may face primarily inventory issues, others may face both inventory and receivables issues, and a third group may only face issues related to receivables. A practice that must keep a lot of supplies on hand, such as a dialysis center or cancer treatment center that must keep expensive medicines or medical supplies well stocked, may need access to more working capital, as the centers wait for cash payment from insurance companies. A small medical practice may not have inventory concerns, but slow-paying insurance companies could create a cash flow problem.

Analysts may scale the evaluation of working capital to a ratio that relates current assets to current liabilities. The current ratio reveals the relative amount of working capital by dividing current assets by current liabilities:

Current Ratio 5 Current Assets/Current Liabilities.

Based on the information provided in Table 8.1, Ashcroft’s current ratio is 2.5:1 ($1,000,000 4 $400,000). This ratio does not seem to indicate any particular problem with liquidity. One thing you do need to consider is that companies may be able to manipulate their cur- rent ratio. For instance, suppose Ashcroft’s bank required them to maintain at least a 3:1 current ratio. Using existing resources, how could this be accomplished? The answer is easier than you might think. If Ashcroft used $100,000 of cash to immediately pay $100,000 of taxes payable, total current assets would be reduced to $900,000, and total current lia- bilities would be reduced to $300,000. This changes the ratio to the target of 3:1. While this might help the current ratio, it could actually restrict the company’s financial flexibility by immediately forgoing part of its cash supply. Although ratios may be subject to short- term manipulation, they are nonetheless highly indicative of business performance, and this limitation should not dissuade you from proper use of these popular techniques for financial statement analysis.

Table 8.1: Ashcroft’s current assets and liabilities

Current Assets Current Liabilities

Cash $ 150,000 Accounts payable $ 50,000

Accounts receivable 250,000 Wages payable 125,000

Inventory 400,000 Interest payable 85,000

Prepaid assets 200,000 Taxes payable 140,000

$1,000,000 $400,000

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CHAPTER 8Section 8.4 Debt Service Analysis

It was already pointed out that current assets include inventory and prepaids that are of little use in satisfying current debts. Therefore, it is also a helpful to calculate a more stringent liquidity measure known as the quick ratio. This ratio is calculated by dividing quick assets by current liabilities. Quick assets are cash and other assets that are readily and quickly converted to cash. The latter includes short-term investments and accounts receivable. The following formula is used to calculate the quick ratio:

Quick Ratio 5 (Cash 1 Accounts Receivable)/Current Liabilities.

Ashcroft’s quick ratio is 1:1 ($400,000 of cash and receivables divided by $400,000 of cur- rent liabilities). By removing the inventory and prepaids, you may gain greater insight into the ability of a firm to be truly ready to meet maturing financial obligations.

Before moving on the next category of ratios, consider that obligations that are not yet reflected as current liabilities may also be looming. Suppose the company has a contract that requires it to make monthly payments to a janitorial firm. The commitment is real, but the future services have not yet been received. Thus, neither the expense nor liability is as yet reported. Still, these types of contractual commitments may entail a firm a duty to pay and are sometimes reported in notes to the financial statements. This example provides further evidence that ratio analysis must be used with caution. An informed investor or creditor should thoroughly research not only the ratios but also all available information. An as executive or manager, you would have information about ongoing obligations, such as a janitorial contract, so it can be easier for you to do this analysis using expected future expenses or incomes not yet shown on the income statement. Usually this is done using a budget versus actual spreadsheet, which would show the expected expenses budgeted for the year versus the actual expenses already incurred. Budgeting will be examined in greater detail in Chapter 12.

8.4 Debt Service Analysis

The current and quick ratios provide insight on immediate liquidity issues. There is another set of issues related to a company’s broader solvency, or the ability to satisfy long-term structural debt. Even if debt is not due to be repaid in the near term, interest payments must be made. Then, at the time of a long-term obligation’s maturity, it must be paid or refinanced. Thus, users of financial statements have developed another family of ratios and analysis techniques designed to evaluate a company’s ability to service its debt. One such ratio is the debt-to-total-assets ratio. This ratio evaluates the proportion of the asset pool that is financed with debt:

Debt-to-Total-Assets Ratio 5 Total Debt/Total Assets.

A variation of this ratio is the debt-to-equity ratio that compares total debt to total equity:

Debt-to-Equity Ratio 5 Total Debt/Total Equity.

Both of these ratios are carefully monitored by investors and analysts. Generalizing, it is difficult to go broke when a business has manageable debt loads, as reflected by small values for these ratios. However, comparative analysis requires careful consideration of the industry in which a business operates. Some industries, like public utilities, are

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CHAPTER 8Section 8.4 Debt Service Analysis

customarily financed by large pools of debt financing. Their regulated rates are generally set at a level that is high enough to provide comfort about their debt-serving ability. This is true despite those businesses being highly leveraged with debt. Medical organizations require significant debt loads to pay for the expensive facilities and medical equipment needed to provide services. Given these capital expenditures, debt loads can be high in this industry as well.

At other times, even a small amount of debt can become a problem when a business’s future looks bleak. Banks and other creditors may be interested in getting their money back and may be unwilling to renew or extend debt financing that would otherwise be a routine transaction. Another challenge in interpreting the ratios is when a company has a large amount of intangible assets. Those assets can be difficult or impossible to convert to cash. Nevertheless, they impact the ratio calculations in a way that paints a picture of financial health. You are likely getting the message again: Ratio analysis is helpful in assessing a company, but only when done with great care.

The times-interest-earned ratio is also used to evaluate debt service capacity. It shows how many times that a company’s income stream will cover its interest obligation:

Times-Interest-Earned Ratio 5 Income Before Income Taxes and Interest/Interest Charges.

When this number drops to a small value, it signals that the company’s operating results may become insufficient to cover interest obligations. When that happens, creditors may force foreclosure of assets or other remedies that threaten the company’s ability to exist. For example, a creditor may require an organization to secure the debt with additional collateral.

The following list provides facts for Brynn Corporation, followed by calculations of these key debt service indicators.

Total assets $800,000

Total liabilities 200,000

Total equity 600,000

Net income 60,000

Income taxes 40,000

Interest expense 20,000

Brynn’s debt-to-total-assets ratio is 0.25, calculated by dividing $200,000 in debt by $800,000 in assets. The debt-to-equity ratio is 0.333, calculated by dividing $200,000 in debt by $600,000 in equity. The times-interest-earned factor is 6, calculated as $120,000 (income before interest and taxes: $60,000 1 $40,000 1 $20,000) divided by $20,000 in interest. You may wonder why back taxes and interest are included in calculating the lat- ter ratio. The reason is that the interest reduces both income and taxes, and knowing how many times interest can be paid before incurring those costs is necessary.

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CHAPTER 8Section 8.5 Activity Analysis

8.5 Activity Analysis

Some analysis is used to measure the level of activity and how that activity impacts the company’s liquidity and profitability. Two key activities we review here are accounts receivable turnover, which measures how quickly bills are paid, and supplies or inventory turnover, which measures how long supplies or inventory sit on the shelves.

One of the more dreadful problems a business can encounter is selling on credit and then not being able to collect amounts due, which can be common in the healthcare industry, as providers wait for insurance reimbursements. A similar problem is building up inventory and being unable to sell it at all. Either of these situations can eventually prove fatal to a business. Management must take great care to avoid this outcome. Executives, managers, investors, and creditors can sometimes get an advance hint about such problems by per- forming turnover analysis.

Accounts Receivable Turnover First, focus on accounts receivable. You already know that much attention is devoted to accounting for bad debts. A company must minimize bad debts by monitoring credit poli- cies, considering the credit history of potential customers, and being certain not to aban- don good sense in trying to attract new patients. Many healthcare organizations require that co-payments and deductibles be paid at the time of service to avoid collection prob- lems related to patient bills. When the out-of-pocket costs are too high, some practices will even assist patients with an application to a medical credit account to enable the collec- tion of payment at time of service. Other businesses require customers to prepare a credit application, check credit references, and obtain credit reports. Some types of businesses require a security deposit or bank guarantee to reduce credit risk, but this is rare in the healthcare industry.

Managing accounts receivable turnover can be critical in a healthcare environment, where there could be several payers for one patient: The patient pays his or her share, an insur- ance company pays another portion, and a third party (such as secondary insurer) pays another portion. For example, a patient will pay his or her share, the primary payer will pay its share, and possibly a secondary insurer policy may pay its share. Another example could be multiple billings for the same patient, such as a billing for the physician’s fees, a second billing for laboratory testing, and a third billing for radiology. Multiple billings can be common in the healthcare industry.

The collection rate, particularly from insurers, must also be monitored. A large sum of money is sometimes nested in accounts receivable, and liquidity is impacted if receivables are not actively managed. The accounts-receivable-turnover ratio is a useful tool in this regard. It shows the number of times a firm’s receivables are converted to cash during a year. This tool is useful in signaling if a company is having trouble collecting receivables on a timely basis. If the turnover pace is slowing, it may signal impending collection risks or a general business slowdown. It is also helpful for comparing one business to another because it provides insight into the degree to which credit is extended and monitored. Net credit sales (the amount due from insurers in account receivables) are divided by the average net accounts receivable:

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CHAPTER 8Section 8.5 Activity Analysis

Accounts-Receivable-Turnover Ratio 5 Net Credit Sales/Average Net Accounts Receivable.

One method for finding the average net accounts receivable balance is to divide the sum of the beginning and ending receivables balances by 2. For example, assume that Zollinger had annual net credit sales of $10,000,000; beginning accounts receivable of $600,000; and ending accounts receivable of $1,000,000. Zollinger’s turnover ratio is calculated as follows:

12.5 5 $10,000,000/[($600,000 1 $1,000,000)/2].

A derivative calculation is the days outstanding ratio. It reveals how many days sales are carried in the receivables category. Zollinger’s days outstanding are 29.2, calculated as follows:

365 Days/Accounts-Receivable-Turnover Ratio 5 Days Outstanding Ratio

365/12.5 5 29.2.

The significance of values like 12.5 or 29.2 can only be considered in context. They must be compared to industry trends and prior years as well as credit terms used by the company. Changes in values may provide signs of looming problems, such as a weakening economy or bad business decision making.

Inventory or Supplies Turnover Inventory-turnover ratios are very similar in nature. Inventory can be expensive for healthcare facilities, and much of it, such as medications, is subject to obsolescence, dam- age, and spoilage. In healthcare, inventory often is found on the income statement as a supplies expense. It is costly to store and involves a potentially huge commitment of financial capital. It is a delicate balance to maintain levels to adequately support key cus- tomers but avoid overstock. Equilibrium in inventory levels is delicate and easily lost. The inventory-turnover ratio is used to maintain focus on proper inventory management and to signal failings in this regard. This ratio reveals the number of times that a firm’s inven- tory balance is turned over or sold during a particular year.

For example, The Home Depot turns its inventory about six to seven times per year, which is a turnover ratio of 6 to 7. This means the “average” item of inventory will sit on the shelf for slightly less than 60 days before finding a buyer. By itself, this datum is interesting, but, when used to compare activity from year to year, it can signal improving or worsen- ing economic conditions. It can also be compared to other companies, like Lowe’s, which has a slightly lower inventory turnover ratio of 5 to 6. In other words, The Home Depot usually turns its inventory faster than Lowe’s. The inventory-turnover ratio is calculated via the following formula:

Inventory-Turnover Ratio 5 Cost of Goods Sold/Average Inventory.

Notice that this calculation bears a striking resemblance to the accounts-receivable- turnover ratio. The average inventory balance can be found by dividing the sum of the beginning and ending inventory balances by 2. When a company’s average inventory is

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CHAPTER 8Section 8.6 Profitability Analysis

$2,500,000 and cost of goods sold is $25,000,000, the inventory turnover ratio is 10. This means that the inventory stock is turning over about once every 36.5 days (365 divided by 10). The meaningfulness of this information must again be considered in context. A car dealer might be very pleased with this number, whereas a vegetable supplier might find this to be disastrously poor. Probably more important than fixating on the value is observ- ing the trend in this number. The objective is to detect emerging challenges that might be signified by changes in these numbers. Further, if you are comparing …