Understanding Financial Statements EIGHTH EDITION

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Understanding Financial Statements EIGHTH
EDITION

• Lyn M. Fraser
• Aileen Ormiston

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The Analysis of Financial Statements
Ratios are tools and their value is limited when
used alone. The more tools used, the better the
analysis. For example, you cant use the same
golf club for every shot and expect to be a good
golfer. The more you practice with each club,
however, the better able you will be to gauge
which club to use on one shot. So to, we need to
be skilled with the financial tools we use.

- Diane Morrison - CEO, R.E.C. Inc.
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The Analysis of Financial Statements (cont.)
This chapter will develop tools and techniques
for the interpretation of financial statement
information
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Objectives of Analysis

• Objectives will vary depending on the
• perspective of the financial statement user
• specific questions that are addressed
• by the analysis

• Remember--the identity of the user helps define
  what information is needed

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Objectives of Analysis (cont.)
Potential Financial Statement Users

• Creditors
• Investors
• Management

What types of questions do each of these
users seek answers to?
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Creditors

• A creditor is ultimately concerned with the
  ability of an existing or prospective borrower to
  make interest and principal payments on borrowed
  funds

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Creditors (cont.)
Questions raised in a credit analysis should
include

• What is the borrowing cause?
• What is the firms capital structure?
• What will be the source of debt repayment?

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Investors

• An investor attempts to arrive at an estimation
  of a companys future earnings stream in order to
  attach a value to the securities being considered
  for purchase or liquidation

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Investors (cont.)
The investment analyst poses questions as

• How has the firm performed/what are future
  expectations?
• How much risk is inherent in the existing capital
  structure?
• What are expected returns?
• What is firms competitive position?

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Management
Management relates to all questions raised by

• Creditors
• Investors
• Employees
• General public
• Regulators
• Financial press

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Management (cont.)
Looks to financial statement data to determine

• How well the firm has performed and why?
• What operating areas have contributed to success
  and which have not?

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Management (cont.)
Looks to financial statement data to determine

• What are strengths/weaknesses of companys
  financial position?
• What changes should be implemented to improve
  future performance?

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Caution!!!

• Keep in mind Management PREPARES financial
  statements
• Analyst should be alert to potential for
  management to influence reporting to make data
  more appealing
• May want to supplement analysis with other
  sources of information apart from the Annual
  Report prepared by management

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Sources of Information
The analyst will want to consider the following
resources

• Proxy Statement
• Auditors Report
• MDA
• Supplementary schedules
• Form 10-K and Form 10-Q

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Other Sources of Information

• Computerized data bases
• Info on industry norms/ratios
• Info on particular companies/industries
• Ever-expanding financial and investment websites
• Articles in popular/business press

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Tools and Techniques
These include

• Common-size financial statements
• Financial ratios
• Trend analysis
• Structural analysis
• Industry comparisons

Most important Common sense and judgment
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Common-Size Financial Statements

• Express each account on the
• balance sheet as a percentage of total assets
• income statement as a percentage of net sales

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Key Financial Ratios

• Standardize financial data in terms of
  mathematical relationships expressed in the form
  of

Percentages Times Days
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Key Financial Ratios (cont.)
Four Categories of key financial ratios

• Liquidity Ratios
• Measure a firms ability to meet cash needs as
  they arise

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Key Financial Ratios (cont.)
Four Categories of key financial ratios

• Activity Ratios
• Measure the liquidity of specific assets and the
  efficiency of managing assets

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Key Financial Ratios (cont.)
Four Categories of key financial ratios

• Leverage Ratios
• Measure the extent of a firms financing with
  debt relative to equity and its ability to cover
  interest and other fixed charges

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Key Financial Ratios (cont.)
Four Categories of key financial ratios

• Profitability Ratios
• Measure the overall performance of a firm and its
  efficiency in managing assets, liabilities and
  equity

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Cautions!

• Ratios are valuable analytical tools and serve as
  screening devices, BUT. . .
• They do not provide answers in and of themselves
• They are not predictive

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Cautions! (cont.)

• Ratios should be used with other elements of
  financial analysis
• There are no rules of thumb that apply to the
  interpretation of ratios

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Cautions! (cont.)

• Keeping this in mind, lets take a look at some
  of the ratios. . . .

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Liquidity Ratios Short-Term Solvency
Current Ratio

• Measures ability to meet short-term cash needs

Current assets Current liabilities
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Liquidity Ratios Short-Term Solvency (cont.)
Quick or Acid-Test Ratio

• Measures ability to meet short-term cash needs
  more rigorously by eliminating inventory

Current assets - Inventory Current liabilities
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Liquidity Ratios Short-Term Solvency (cont.)
Cash Flow Liquidity Ratio

• Focuses on ability of the firm to generate
  operating cash flows as a source of liquidity

Cash Marketable securities CFO Current
liabilities
Cash flow from operating activities
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Liquidity Ratios Short-Term Solvency (cont.)
Average Collection Period

• Helps gauge liquidity of accounts receivable
  (ability to collect cash from customers) and may
  help provide information about a companys credit
  policies

Net accounts receivable Average daily sales
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Liquidity Ratios Short-Term Solvency (cont.)
Days Inventory Held

• Measures the efficiency of the firm in managing
  its inventory

Inventory Average daily cost of sales
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Liquidity Ratios Short-Term Solvency (cont.)
Days Inventory Held Example of ratio
comparisons for two companies in the Electronic
Computers industry

• Current Yr. Prior Year 2 Yrs. Prior
• 5 days 5 days 4 days

Current Yr. Prior Year 2 Yrs. Prior
23 days 22 days 15 days

Data from SEC website, www.sec.gov
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Liquidity Ratios Short-Term Solvency (cont.)
Days Payable Outstanding

• Offers insight into a firms pattern of payments
  to suppliers

Accounts payable Average daily cost of sales
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Cash Conversion Cycle or Net Trade Cycle
The normal cycle of a firm that consists of

• Buying or manufacturing inventory, with some
  purchases on credit
• Selling inventory, with some sales on credit
• Collecting the cash

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Cash Conversion Cycle or Net Trade Cycle (cont.)
Helps the analyst understand why cash flow
generation has improved or deteriorated by
analyzing

• Key balance sheet accounts that affect cash flow
  from operating activities
• Accounts Receivable
• Inventory
• Accounts Payable

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Cash Conversion Cycle or Net Trade Cycle (cont.)
Calculated as follows

• Average collection period
• Plus
• Days inventory held
• Minus
• Days payable outstanding
• Equals
• Cash conversion or net trade cycle

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Activity Ratios Asset Liquidity, Asset
Management Efficiency
Accounts Receivable Turnover

• Another measure of efficiency of firms
  collection and credit policies

Net sales Net accounts receivable
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Activity Ratios Asset Liquidity, Asset
Management Efficiency (cont.)
Inventory Turnover

• Another measure of firms efficiency in managing
  its inventory

Cost of goods sold Inventory
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Activity Ratios Asset Liquidity, Asset
Management Efficiency (cont.)
Payables Turnover

• Another way to gain insight into a firms pattern
  of payment to suppliers

Cost of goods sold Accounts payable
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Activity Ratios Asset Liquidity, Asset
Management Efficiency (cont.)
Fixed Asset Turnover

• Assesses effectiveness in generating sales from
  investments in fixed assets

Net sales Net property, plant, equipment
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Activity Ratios Asset Liquidity, Asset
Management Efficiency (cont.)
Total Asset Turnover

• Assesses effectiveness in generating sales from
  investments in all assets

Net sales Total assets
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Leverage Ratios Debt Financing and Coverage
Debt Ratio

• Considers the proportion of all assets that are
  financed with debt

Total liabilities Total assets
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Leverage Ratios Debt Financing and Coverage
(cont.)
Debt Ratio Example of ratio comparisons for two
companies in the Grain Mills industry

• Current Yr. Prior Year
• 62.31 69.93

Current Yr. Prior Year
79.08 85.77
Data from SEC website, www.sec.gov
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Leverage Ratios Debt Financing and Coverage
(cont.)
Long-term Debt to Total Capitalization

• Reveals the extent to which long-term debt is
  used for the firms permanent financing (both
  long-term debt and equity)

Longterm debt Long-term debt Stockholders
equity
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Leverage Ratios Debt Financing and Coverage
(cont.)
Debt to Equity

• Measures the riskiness of the firms capital
  structure in terms of the relationship between
  the funds supplied by creditors (debt) and
  investors (equity)

Total liabilities Stockholders equity
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Leverage Ratios Debt Financing and Coverage
(cont.)
Times Interest Earned

• Indicates how well operating earnings cover fixed
  interest expenses

Operating profit Interest expense
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Leverage Ratios Debt Financing and Coverage
(cont.)
Cash Interest Coverage

• Measures how many times interest payments can be
  covered by cash flow from operations before
  interest and taxes

CFO interest paid taxes paid Interest paid
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Leverage Ratios Debt Financing and Coverage
(cont.)
Fixed Charge Coverage

• Broader measure of how well operating earnings
  cover fixed charges

Operating profit Rent expense Interest expense
Rent expense
Rent expense operating lease payments
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Leverage Ratios Debt Financing and Coverage
(cont.)
Cash Flow Adequacy

• Measures firms ability to cover capital
  expenditures, long-term debt payments and
  dividends each year

Cash flow from operating activities Capital
expenditures debt repayments dividends paid
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Profitability Ratios Overall Efficiency and
Performance
Gross Profit Margin

• Measures ability to translate sales into profit
  after consideration of cost of products sold

Gross profit Net sales
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Profitability Ratios Overall Efficiency and
Performance (cont.)
Operating Profit Margin

• Measures ability to translate sales into profit
  after consideration of operating expenses

Operating profit Net sales
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Profitability Ratios Overall Efficiency and
Performance (cont.)
Net Profit Margin

• Measures ability to translate sales into profit
  after consideration of all expenses and revenues,
  including interest, taxes and nonoperating items

Net earnings Net sales
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Profitability Ratios Overall Efficiency and
Performance (cont.)
Cash Flow Margin

• Measures ability to translate sales into cash
  (with which to pay bills!)

Cash flow from operating activities Net sales
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Profitability Ratios Overall Efficiency and
Performance (cont.)
Return on Total Assets (ROA) or Return on
Investment (ROI)

• Measures overall efficiency of firm in managing
  investment in assets and generating profits

Net earnings Total assets
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Profitability Ratios Overall Efficiency and
Performance (cont.)
Return on Equity (ROE)

• Measures rate of return on stockholders
  investment

Net earnings Stockholders equity
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Profitability Ratios Overall Efficiency and
Performance (cont.)
Cash Return on Assets

• Measures firms ability to generate cash from the
  utilization of its assets
• Useful comparison to ROA

Cash flow from operating activities Total assets
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Market Ratios
Four market ratios of particular interest to the
investor are

• Earnings per common share
• Price-to-earnings
• Dividend payout
• Dividend yield

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Market Ratios (cont.)
Earnings per Common Share

• Provides the investor with a common denominator
  to gauge investment returns

Net earnings Average shares outstanding
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Market Ratios (cont.)
Price-to-Earnings

• Relates earnings per common share to the market
  price at which the stock trades, expressing the
  multiple that the stock market places on a
  firms earnings

Market price of common stock Earnings per share
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Market Ratios (cont.)
Dividend Payout

• Determined by the formula cash dividends per
  share divided by earnings per share

Dividends per share Earnings per share
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Market Ratios (cont.)
Dividend Yield

• Shows the relationship between cash dividends and
  market price

Dividends per share Market price of common stock
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Analyzing the Data

• Now that some of the tools of financial
  analysis have been illustrated, where does one go
  from here?
• Taking a general approach to financial statement
  analysis, one might proceed as follows. . .

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Five Steps of a Financial Statement Analysis
Step 1
Establish objectives of the analysis

• Who are you and why are you interested in this
  company?
• What questions would you like to have answered?
• What info is vital to the decision at hand?

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Five Steps of a Financial Statement Analysis
(cont.)
Step 2

• Study the industry in which the firm operates and
  relate industry climate to current and projected
  economic developments

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Five Steps of a Financial Statement Analysis
(cont.)
Step 3
Develop knowledge of the firm and the quality of
management

• How well does this firm appear to be run?
• Are they taking advantage of opportunities?
• Are they innovative, forward-looking, etc?

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Five Steps of a Financial Statement Analysis
(cont.)
Step 4
Evaluate financial statementstools include

• Common-size financial statements
• Key financial ratios
• Trend analysis
• Structural analysis
• Comparison with industry competitors

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Five Steps of a Financial Statement Analysis
(cont.)
Step 4
Evaluate financial statementsareas include

• Short-term liquidity
• Operating efficiency
• Capital structure and long-term solvency
• Profitability
• Market ratios
• Segmental analysis (when relevant)
• Quality of financial reporting

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Five Steps of a Financial Statement Analysis
(cont.)
Step 5
Summarize findings based on analysis

• Reach conclusions about the firm relevant to your
  established objectives

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Relating the RatiosThe Du Pont System

• Is helpful to complete the evaluation of a firm
  by considering the interrelationship among the
  individual ratios

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Relating the RatiosThe Du Pont System (cont.)

• The Du Pont System helps the analyst see how the
  firms decisions and activities over the course
  of an accounting period interact to produce an
  overall return to the firms shareholders, the
  return on equity

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Relating the RatiosThe Du Pont System (cont.)
The summary ratios used are the following
(1) Net profit margin
(2) Total asset turnover
(3) Return on investment
Net income Net sales Net
income Net sales X Total assets
Total assets
(3) Return on investment
(4) Financial leverage
(5) Return on equity
Net income Total assets
Net income Total assets X Stockholder equity
Stockholder equity
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What we have accomplished
Turned
Maze
Auditors Report
MDA
Notes
Statement of Cash Flows
Income Statement
Statement of Shareholders Equity
Balance Sheet
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Financial StatementsAn Overview
into
Map