Now that we have learned several techniques that are useful in better understanding an enterprise’s financial statements, we will do a comprehensive analysis of a company.
This illustration draws from material presented in ‘this as well as. from information presented earlier in the text.
We take a comprehensive look at the analysis of financial statements from the perspectives of three important commonwealths stockholders, long-term creditors, and-short-term creditors.
The basic information for our analysis is, contained in a set of condensed two-year comparative financial statements for Sea cliff Company shown below and on the following pages.
Summarized statement data, together with computations of dollar increases and decreases, and component percentages where applicable, have been compiled,
For convenience. in this illustration, relatively small dollar amounts have been used in the Wycliffe Company financial statements.
Analysis by Common Stockholders
Common stockholders and potential investors in common stock look first at a company’s earnings record.
Their investment is in shares of stock, so earnings per share and dividends per share are of particular interest. Earnings per Share of Common Stock As indicated in Chapter 12, earnings per share of common stock are computed by dividing the income applicable to the common stock by the weighted-average number of shares of common stock outstanding during the year.
Any preferred dividend requirements must be subtracted from net income to determine income applicable to common stock, as shown in the following computations for Sea-cliff Company:Notice that earnings per share have decreased by $7.05 in 2001, representing a decline of nearly 35% from their level in 2000 ($7.05 $20.25 = 34.8%). Common stockholders consider a decline in earnings per share to be an unfavorable development.
A decline in earnings per share generally represents a decline in the profitability of the company and creates doubt as to the company’s prospects for future growth.
With such a significant decline in earnings per’ share, we should expect to see a substantial decline in the market value of Sea-cliff”s common stock during 2001. [For purposes of our illustration, we assume the common stock had a market value of $160 at December 31, 2000, and of $132 at the end of 200 1. This drop of $28 per share represents a 17’12% decline in the market value .of every common stockholder’s investment ($28 decline $160 = 17.5%).] Price-Earnings Ratio The relationship between the market price of common stock and earnings per share is so widely recognized that it is expressed as a ratio, called the price-earnings ratio (or pie ratio). The pIe ratio is determined by dividing the market price per share by the annual earnings per share.
The average pIe ratio of the 30 stocks included in the Dow Jones Industrial Average has varied widely in recent years, ranging from a low of about lOjo a high of about 18. The outlook for future earnings is the major factor influencing a company’s pIe ratio.
Companies with track records of rapid growth may sell at pIe ratios of perhaps 20 to I. or even higher.
Companies with “flat” earnings or earnings expected to decline in future. years often sell at price-earnings ratios below, say, 10 to I. . At the end of 2000, Seacliff”s pIeratiovas approximately 810 J ($160 -;-.$20.25 = 7.9), suggesting that investors were expecting earnings to decline in 200 I. At December 31,2001, the price-earnings ratio was 10 to J ($132 -:- $13.20 = 10,0). A pIe ratio in this range suggests that investors expect future earnings to stabilize around the current level. Dividend Yield Dividends are of prime importance to some stockholders, but a secondary factor to others.
Some stockholders invest primarily to receive regular cash Income, while others invest.in stocks ~rincipally with the expectation of rising market prices. If a corporation is profitable and retains its earnings for expansion of the business, the expanded operations should produce an increase in the net income of the company and thus lend to make each share of stock more valuable.
In comparing the merits of alternative investment opportunities, we should relate earnings and dividends per share to the market value of the stock. Dividends per share divided by market price per share determine the yield rate of a company’s stock.
Icelandic yield is especially important to those investors whose objective is to maximize the dividend revenue from their investments. For Sea cliff;: dividend yield was 3.1% in 2000 ($5/$160) and 3.6% in 2001 ($4.80/$132).
Summary of Earnings aid Dividend Data for Sacrifice The relationships of Sea-cliff”s per-share earnings and dividends to its year-end stock prices are summarized below:The decline in market value during 2001 presumably reflects the decreases in both earnings, and dividends per share. Investors appraising this stock at December 31, 200 I, should consider whether a preregistration of 10 and a dividend yield of 3.6% represent a satisfactory situation in the light of alternative investment opportunities.
These investors will also place considerable weight on estimates of the company’s prospective future earnings and the probable effect of such estimated earnings on the market price of the stock and on dividend payments. Revenue and Expense Analysis The trend of earnings of Sea cliff Company is unfavorable, and stockholders will want to know the reasons for the decline in net income.
The comparative income statement on page 631 shows that despite’ a 20% increase in net sales, net income fell from $90,000 in 2000 to $75,000 in 2001, a decline of 16.7%. As a percentage of net sales, net income fell from 12% to only 8:3%. The primary causes of this decline were ,the increases in selling expenses (56.0%), in general and administrative expenses (32.6% j, and in the cost of goods sold (26.2%), all of ~hich exceeded the 20% increase in net sales.
Let us assume that further investigation reveals Seacliff Company decided in 2001 to reduce its sales prices in an ‘effort to generate greater sales volume. This would explain the decrease in gross profit rate from 44% to 41.1% of net sales. Since the dollar amount
of gross profit increased $40,000 in 2001, the strategy of reducing sales prices to’ increase volume would have been successful if there had been little or no increase in operating expenses. However, operating expenses rose by $73,000, resulting in a $33,000 decrease in operating income
The next step is to find which expenses increased and why. An investor may be handicapped here, because detailed operating expenses are not usually shown in published financial statements. Some conclusions, however, can be reached on the basis of even the condensed information available in the comparative income statement for Seacliff Company shown on page 631.
The substantial increase in selling expenses presumably reflects greater selling :erfor( during 2001 in an attempt to improve sales volume. However, the fact that selling expenses increased $42,000 while gross profit increased only $40,000 indicates that the cost of this increased sales effort was not justified in terms 01′ result.
Even more disturbing is [he increase in general and administrative expenses, Sor(,wthin administrative expenses might be expected to accompany increased .nume, but because some of the expenses are fixed. the growth generally should be less than proportional to any increase in sales. The increase in general and administrative expensesfrom 12.7St to 14% of sales would be of serious concern to informed investors
Management generally has greater control over operating expenses than over revenue. The operating” expense ratio is often used as a measure of management’s ability to control its operating expenses.
The unfavorable trend in this ratio for Seacliff Company is . shown as follows:If management were able to increase the sates volume while at the same time inilig the gros« profit rate and decreasing the operating expense ratio. the effect on net income could be quite dramatic.
For example. if in the year 2002 Seaclilf Company can increase its sales by I I% to $1.000,000. increase its gross profit rate from 41.1 to 44%. and reduce the operating expense ratio from 27 to 24%. its operating income will increase from $127,000 to $200,000($1.000,000 – $560.000 -$240.0(0). an increase of over 57%. Return on investment UWI} The rate of return on investment (often called ROO is a measure of management’s cfficicncy in using available resources. Regardless of the size. of the organization. capital is a scarce resource. and must be used efficiently.’ In judging the performance of branch managers or of company-wide management. it is reasonable to raise the question:
What rate or return have you earned on the resources under your control? The concept of return on investment can he applied to a number of situations: for example. evaluating a branch. a total business. a product line, 01′ an individual investment.