The Analysis of Financial Statements

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• The Analysis of Financial Statements
• BA 617
• Module 7

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Step One
Establish the objectives of the analysis!

• Who is the user?
• Different users have different information needs.

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Potential Financial Statement Users

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

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Creditors

• Why does the firm want/need to borrow funds?
• What is the firms capital structure? How
  leveraged are they?
• How will they pay it back? What kind of cash
  flows are being generated by operations?

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Investors

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

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Managers

• Need all info creditors and investors need PLUS
• What operating areas have contributed to success
  and which have not?
• What are strengths/weaknesses of companys
  financial position?
• What changes are indicated 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 information
  apart from Annual Report prepared by management

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Steps 2 and 3
Study the industry
Develop knowledge of firm
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Where to look for data...

• Financial statements (and notes)
• Auditors report
• MDA
• Supplementary schedules
• All of the above are in Annual Report -- can also
  look further...

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Other Data Sources

• 10K and 10Q reports filed with SEC
• Computerized data bases
• Info on industry norms/ratios
• Info on particular companies/industries/mutual
  funds
• Articles in popular/business press
• Ever-expanding websites

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More sources of info

• SIC Manual
• Industry Averages and Comparison with Competitors
• The Dept of Commerce Financial Report
• Robert Morris Associates Annual Statement Studies
• Standard Poors Industry Surveys
• Almanac of Business and Industrial Financial
  Ratios
• DB Industry Norms and Key Business Ratios
• Compact Disclosure

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Step 4
Evaluate financial statements
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Basic Tools

• Common size financial statements
• Financial ratios
• Trend analysis
• Structural analysis
• Industry comparisons
• Common sense and judgment (often the hardest to
  use!)

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Common Size Statements

• Common size income statement
• expresses each income statement category as a
  percentage of net sales
• Common size balance sheet
• expresses each item on balance sheet as a
  percentage of total assets or equities
• Both statements facilitate structural analysis of
  the firm

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Financial Ratio Categories

• Liquidity Ratios
• measure a firms ability to meet cash needs as
  they arise
• Activity Ratios
• measure the liquidity of specific assets and the
  efficiency of managing assets

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Ratio Categories (continued)

• Leverage Ratios
• measure the extent of a firms financing with
  debt relative to equity and its ability to cover
  interest and other fixed charges
• Profitability Ratios
• measure the overall performance of a firm and its
  efficiency in managing assets, liabilities and
  equity

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Caution!!!!!!

• Ratios are valuable, BUT..
• They do not provide answers in an of themselves
  and are not predictive
• They should be used with other elements of
  financial analysis
• There are no rules of thumb that apply to
  interpretation of ratios
• KEEPING THIS IN MIND, LETS TAKE A LOOK AT SOME
  OF THE RATIOS.

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Liquidity Ratios

• Current Ratio
• Current Assets/Current Liabilities
• Measures ability to meet short-term cash needs
• Quick or Acid Test Ratio
• Current Assets-Inventory/Current Liabilities
• Measure ability to meet short-term cash needs
  more rigorously

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Liquidity Ratios (continued)

• Cash Flow Liquidity Ratio
• CashMarketable SecuritiesCash Flow from
  Operating Activities/Current Liabilities
• Focuses on ability of the firm to generate
  operating cash flows as a source of liquidity

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Activity Ratios

• Average Collection Period
• Accounts Receivable/Average Daily Sales
• Helps gauge liquidity of accounts receivable
  (ability to collect cash from customers)
• Accounts Receivable Turnover
• Net Sales/Accounts Receivable
• Another measure of efficiency of firms
  collection and credit policies

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Activity Ratios (continued)

• Inventory Turnover
• Cost of Goods Sold/Inventory
• Measures efficiency of inventory management
• Fixed Asset and Total Asset Turnover
• Net Sales/Net PPE (Fixed Asset T/O)
• Net Sales/Total Assets (Total Asset T/O)
• Both assess effectiveness in generating sales
  from investment in assets

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Leverage Debt Ratios

• Debt Ratio
• Total Liabilities/Total Assets
• Long-Term Debt to Total Capitalization
• Long-term Debt/Long-term Debt Stockholders
  Equity
• Debt to Equity Ratio
• Total Liabilities/Stockholders Equity
• All three measure extent of firms financing with
  debt

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Leverage Coverage Ratios

• Proportion and amount of debt in capital
  structure is important to analyst
• Tradeoff between risk and return
• Use of debt involves risk -- commitment to fixed
  charges
• Fixed charges must be COVERED -- following are
  some ratios to assess coverage...

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Coverage Ratios (continued)

• Times Interest Earned
• Operating Profit/Interest Expense
• Indicates how well operating earnings cover fixed
  interest charges
• Fixed Charge Coverage
• Operating Profit Lease Payments/Interest
  Expense Lease Payments
• Broader measure of how well operating earnings
  cover fixed charges

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Coverage Ratios (continued)

• Cash Flow Adequacy
• Cash Flow from Operating Activities/ Average
  Annual Long-Term Debt Maturities
• Measures firms ability to cover long-term debt
  maturities each year
• Rationale is that over the long-run operating
  cash flows must be adequate to cover investing
  activities financed with debt

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Profitability Ratios

• Gross Profit Margin
• Gross Profit/Net Sales
• Operating Profit Margin
• Operating Profit/Net Sales
• Net Profit Margin
• Net Earnings/Net Sales
• All measure firms ability to translate sales
  dollars into profits

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Profitability Ratios (continued)

• Cash Flow Margin
• Cash Flow from Operating Activities / Net
  Sales
• Measures ability to translate sales into cash
  (with which to pay bills!)

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Profitability Ratios (continued)

• Return on Investment (or Return on Assets -- same
  thing, different words!)
• Net Earnings/Total Assets
• Return on Equity
• Net Earnings/Stockholders Equity
• Both measure overall efficiency of firm in
  managing investment in assets and generating
  return to stockholders

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Profitability Ratios (continued)

• Cash Return on Assets
• Cash Flow from Operating Activities / Total
  Assets
• Useful comparison to return on investment
• Indicates firms ability to generate cash from
  utilizing its assets

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Other Ratios You Hear About..

• Earnings per Common Share
• Net Earnings/Average Common Shares Outstanding
• Indicates return on a per share basis
• Price to Earnings
• Market Price of Common Stock/Earnings per Common
  Share
• Expresses a multiple the stock market places on
  earnings

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Other Ratios (continued)

• Dividend Payout
• Dividends per Share/Earnings per Share
• Shows percentage of earnings paid out to
  stockholders
• Dividend Yield
• Dividends per Share/Market Price of Common Share
• Shows rate earned by shareholders from dividends
  relative to current stock price

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Analyzing the Company

• Now that some of the tools of financial
  analysis have been illustrated, where does one go
  from here?

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Step 5
Summarize Findings
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Red Flags

• Changes in top company management
• Key financial ratios indicating deteriorating
  trends and/or weaknesses relative to industry
  competitors
• Cash flow from operations declining, negative,
  volatile, or not tracking with net income.
• Lack of profitability in key operating areas.

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More Red Flags

• Price to earnings ratio low relative to
  competitors
• Firms earnings less than after-tax cost of debt
• Declining operating profits when debt is rising
• Deteriorating trends in operating segments

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Accomplishments

• Reviewed all the basic financial statements and
  know what they are
• Practiced the rudiments of financial analysis
• If nothing else, hopefully gained an appreciation
  of what information is available and how one
  might use it...

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A Final Note

• Financial analysis is only as good as the
  information upon which it is based -- hence we
  need to be concerned about honest,
  straightforward, comprehensible financial
  reporting
• Financial analysis is only valuable to me if it
  answers MY questions -- I need to THINK about
  what I need/would like to know BEFORE I crunch
  numbers

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A Final Final Note (really!)

• Analyzing financial information can be fun (as
  well as profitable)
• You can never know too much about a company you
  plan to have a relationship with (as an investor,
  a creditor, a manager, an employee)