Financial Statement Analysis

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CHAPTER 13

• Financial Statement Analysis

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Financial Statement Analysis

• External users and analysts rely on
  publicly-available information to perform
  financial analysis
• Such information is contained in corporate annual
  report

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Annual Report Contents
FOUR BASIC FINANCIAL STATEMENTS
FOOTNOTES TO THE FINANCIAL STATEMENTS
SUMMARY OF ACCOUNTING METHODS

MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
STATEMENTS
AUDITORS REPORT
COMPARATIVE FINANCIAL DATA FOR A SERIES OF YEARS
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Tools to Evaluate Financial Information

• Horizontal Analysis
• Vertical Analysis
• Ratio Analysis

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Horizontal Analysis

• Examines percentage change in each item on the
  financial statements
• Compares current years dollar amount with prior
  years dollar amount
• Expresses the change in
• Dollars
• Percentage
• Look at Exhibit 13-3, Pg. 610

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Horizontal - Trend Percentages

• Specialized form of horizontal analysis
• Shows trend of financial statement items over
  longer time periods such as 5 or 10 years

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Vertical Analysis

• Vertical Analysis

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Vertical Analysis

• Compares each item on the financial statement to
  a key, or base, item
• Base-item dollar amount always set to 100
• Produces common-size statements
• Income statement
• Net sales 100
• Balance sheet
• Total assets 100
• Look at exhibit 13-4, Pg 612 and 13-5, Pg 613

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Benchmarking Against the Industry Average

• Benchmarking is a term used to describe the
  process of comparing a companys activities to a
  standard of excellence achieved by industry
  leaders

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Benchmarking Against Key Competitors

• A company also can compare its common-size
  financials to those of its industrys leaders
• Determine where it differs
• Design and implement business processes to bring
  financial results in line with these benchmark
  entities

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Using Ratios to Make Business Decisions

• Ratio Analysis

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Using Ratios to Make Business Decisions

• Ratios - the relationship between two items on
  financial statements - permit users to calculate
  a variety of financial comparisons
• These ratios can be compared to
• Prior years financial results
• Industry averages
• Benchmark entities ratios

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Using Ratios to Make Business Decisions

• Ratios measure an entitys ability to
• Pay current liabilities
• Sell inventory and collect receivables
• Pay long-term debt
• Generate profits from operations
• Sustain shareholder wealth

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Ratios in Chapter 13

• Overview, pp. 630
• Decision guidelines lists all ratios

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Ratio analysis

• The current ratio is a ratio of the current
  assets to the current liabilities. Acceptable
  current ratios vary from industry to industry,
  but the norm for most companies is between 1.6
  and 1.9. 
• There are five categories of current assets that
  are listed in order of their liquidity Cash,
  Short-term Investments, Receivables, Inventory,
  and Prepaid Expenses.

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Ratio analysis

• The acid-test (quick) ratio measures the quick
  assetscash, short-term investments, and
  receivablesto current liabilities. This ratio
  excludes inventory and prepaid expenses because
  these current assets are the least liquid current
  assets.
• Certain ratios measure the firms ability to sell
  inventory and collect receivables, a key factor
  in a firms success.

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Ratio analysis

• Inventory turnover measures how many times a year
  the company sells its average level of inventory.
  A high turnover indicates relative ease of
  selling inventory, while a low turnover indicates
  relative difficulty of selling inventory.
• Accounts receivable turnover measures how quickly
  the firm collects cash from credit customers. The
  higher the ratio, the more quickly a firm
  collects its receivables.
• Days sales in receivables is the number of days
  sales that remain uncollected.

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Ratio analysis

• Suppose you were analyzing Company A and Company
  B and the two companies reported the following
• Company A Company B
• Current assets 10,000 10,000,000
• Current liabilities 5,000 9,995,000
• Working capital 5,000 5,000
• Both companies have identical working capital,
  but which company has a better ability to pay its
  short-term debt?
• Company A, because the ratio of the current
  assets to current liabilities is higher for
  Company A. Working capital is not a ratio it
  does not calculate the relative size of the
  current assets to current liabilities. The
  current ratio provides a better understanding of
  the two companies liquidity.
• Current ratio of A is 2 (10,000 ? 5,000)
  Current ratio of B is 1.001 (10,000,000 ?
  9,995,000)

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Ratio analysis

• Not all ratios apply to all companies. For
  example, inventory turnover would not be
  applicable to a service company
• Sharp changes in ratios indicate that something
  significant has happened, but the manager must
  analyze the change to determine what has occurred
  and what corrective action must be taken.

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Analyzing the Companys Stock as an Investment

• Financial analysts use several ratios to assess
  value of stock investments
• Price/earnings ratio
• Dividend yield
• Book value (covered in chapter 9)

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Earnings Per Share

• Most widely quoted of all financial statistics
• Computed by dividing net income available to
  common stockholders by the number of common
  shares outstanding during the year
• Net Income Preferred Dividends
• Number of common shares outstanding

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Price/Earnings Ratio

• Decision to buy, hold, or sell stock
• Relationship between a stocks market price and
  its earnings per share
• Measures the number of times one share of stock
  sells above the current periods reported
  earnings
• Widely published in The Wall Street Journal

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Price/Earnings Ratio

• Suppose the market value of Asian Art, Inc.,
  common stock is 15.75 on the last day of its
  fiscal year
• The income statement reports EPS of .92
• What is Asian Arts price/earnings ratio?

Calculating the P/E ratio Market value of
stock Earnings per share
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Price/Earnings Ratio Example

• Market value of stock
• Earnings per share
• 15.75
• .92
• 17.12

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Dividend Yield

• Ratio of dividends per share of stock to the
  stocks market value
• Indicates the percentage of a stocks market
  value returned to the stockholder in the form
  of dividends
• Assists investors who desire a steady flow of
  dividend revenue in their decisions to invest in
  a particular stock

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Dividend Yield

• Annual dividends per share
• Stocks market value per share
• Example If Asian Art paid a total of 1.25 in
  dividends per share, what would be its dividend
  yield, assuming the same market value for its
  stock (15.75)?

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Dividend Yield

• Annual dividends per share
• Stocks market value per share
• 1.25
• 15.75
• .079

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Limitations of Financial Analysis

• No one ratio or years worth of financial
  information should be relied upon to provide a
  complete assessment of a corporations financial
  condition
• Ratio analysis is most helpful when calculated
  over a broad time frame and when used in
  conjunction with other relevant information that
  can affect a company, such as legislation,
  competition, and scandals.
• Analysts should
• Examine trends over time
• Benchmark to industry and key competitors
• Seek answers about why ratios are different

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End of Lecture