Financial Statement Analysis

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• Chapter 11
• Financial Statement Analysis

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Financial Statement Analysis

• In addition to the financial statements, annual
  reports contain the following
• Notes to the financial statements, including a
  summary of the accounting methods used
• Managements discussion and analysis (MDA) of
  the financial results
• The auditors report
• Comparative financial data for a series of years

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Horizontal Analysis
Horizontal analysis compares one value across
several periods. First, a base year must be
chosen as the basis for comparison. The
difference between each year and the base year is
expressed as a percentage of the base year. For
example, the sales for 2003 represent an
increase of 18.6 over the base year 2000.
2003 2002 2001
2000 Sales 41,500 37,850 36,300
35,000 18.6 8.1 3.7
Base year
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Vertical Analysis

• This kind of analysis compares each item in a
  financial statement to a base number set to 100.
• Every item on the financial statement is then
  reported as a percentage of that base.

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Vertical Analysis
2002 Sales 38,303 1
00.0 Cost of goods sold 19,688
51.4 Gross margin 18,615 48.6 Total
operating expenses 13,209
34.5 Operating income 5,406 14.1 Other
income 2,187 5.7 Income before
taxes 7,593 19.8 Income taxes
2,827 7.4 Net income 4,766 12.4
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Ratio Analysis

• Ratios are standard measures that enable analysts
  to compare companies of different sizes.
• A ratio by itself does not give much information.
  
• To be useful, a ratio must be compared to other
  ratios from previous periods, compared to ratios
  of other companies in the industry, or compared
  to industry averages.
• Ratio classification
• Liquidity Can a company pay the bills as they
  come due?
• Solvency Can the company survive over a long
  period of time?
• Profitability Can a company earn a satisfactory
  rate of return?
• Market indicators Is the stock a good
  investment?

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Liquidity Measuring Ability to Pay Current
Liabilities
The current ratio and acid-test ratio measure a
companys ability to pay current liabilities with
current assets.
Current ratio Total current assets Total
current liabilities Acid-test ratio (Cash
Short-term investments Net current receivables)
Total current liabilities Working capital is
not a ratio Current assets Current liabilities
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Liquidity Ratios
Inventory turnover ratio - ratio measures how
quickly a company is turning over its inventory.
A high number indicates an ability to quickly
sell inventory. Accounts receivable turnover
ratio - measures a companys ability to collect
the cash from its credit customers.
Inventory turnover Cost of goods sold Average
inventory Accounts receivable turnover Net
credit sales Average accounts receivable
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Solvency Measuring Ability to Pay Long-term Debt

• The debt to equity ratio compares the amount of
  debt a company has with the amount the owners
  have invested in the company.
• Times interest earned ratio compares the amount
  of income that has been earned in an accounting
  period to the interest obligation for the same
  period.

Debt-to-equity ratio Total liabilities Total
equity Times interest earned ratio Net income
interest expense Interest expense
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Measuring Profitability
Return on assets - measures a companys success
in using its assets to earn income for those who
are financing the business. Return on equity
measures how much income is earned with the
common shareholders investment in the company.
Return on assets Net income interest expense
Average total assets Rate of return on common
stockholders equity (Net income preferred
dividends) Average common stockholders equity
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Measuring Profitability
Gross margin ratio - measures percentage of sales
price that is gross profit. A small shift usually
indicates a big change in the profitability of
the companys sales. Earnings per share - gives
the amount of net income per share of common
stock. It is one of the most widely-used measures
of a companys profitability.
Gross margin ratio Gross margin
Sales Earnings per share of common stock (Net
income Preferred dividends) Number of shares
of common stock outstanding
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Market Indicators

• Price/earnings ratio - the ratio of market price
  per share to earnings per share. This ratio
  indicates the market price for 1 of earnings.
• Dividend yield - gives the percentage of a
  stocks market value returned as dividends to
  stockholders each period.

Price/Earnings Ratio Market price per share of
Common stock Earnings per share Dividend per
share of common (or preferred) stock Market
price per share of common (or preferred) stock