Financial Statement Analysis

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Course Review Finance for HR Executives
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Learning Objectives

• Upon completion of this course, you should be
  able to
• Develop an understanding of financial statements
  and their relationship to internal management.
• Acquire a basic knowledge of finance concepts and
  practices
• Develop fundamental budgeting and control skills
• Demonstrate an understanding of the
  inter-relationships between HR and Finance.
• Use the basic financial ratios to guide your
  thinking.
• Demonstrate the ability to assimilate and
  communicate HR knowledge, ideas and innovation
  using financial terms and models.

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Sources of InformationAbout Companies

• Financial statement analysis - using financial
  statements to assess a companys performance
• Information about publicly traded companies comes
  in many forms and may be found in many places.
• Annual reports
• SEC filings and databases
• Company press releases
• Articles that appear in the financial press

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Sources of InformationAbout Companies

• The annual report is important to investors
  because of its completeness and its reliability
  due to the audit performed by an independent
  auditor.
• The annual report includes
• Financial statements
• Footnotes to the financial statements
• A summary of accounting principles used
• Managements discussion and analysis of the
  financial results
• The auditors report
• Comparative financial data for a series of years
• Narrative information about the company

5
Sources of InformationAbout Companies

• Publicly traded companies must also prepare
  reports for the Securities and Exchange
  Commission (SEC).
• Form 10-K - presents financial statement data in
  greater detail than the financial statements in
  annual reports
• Form 10-Q - includes quarterly financial
  statements that provide more timely but less
  complete information than annual reports

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Sources of InformationAbout Companies

• Company press releases provide the basis for
  articles in the financial press such as The Wall
  Street Journal and Business Week.
• Services such as Value Line,
  Moodys Investors Services,
  Standard and Poors Industrial Surveys, and
  Dun Bradstreet provide useful information to
  investors.

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Sources of InformationAbout Companies

• The Internet is changing the way that people make
  investments.
• Many investors now buy and sell securities
  without the help of a broker.
• Much of the market information
  is available electronically,
  usually for free
  from various sources.

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Sources of InformationAbout Companies

• Large investors often require pro forma
  statements which are carefully formulated
  expressions of predicted results.
• Any investor should take the time to gather as
  much information about potential investments as
  possible.
• There are many sources of information for
  investors to use.

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Objectives of FinancialStatement Analysis

• Although different investors demand different
  returns, they all use financial statement
  analysis for common reasons.
• To predict their expected returns
• To assess the risks associated with those returns
• Financial statement analysis focuses on past
  performance to predict future performance.

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Objectives of FinancialStatement Analysis

• Creditors want to know about short-term liquidity
  and long-term solvency.
• Short-term liquidity - an organizations ability
  to meet current payments as they become due
• Long-term solvency - an organizations ability to
  generate enough cash to repay long-term debts as
  they mature

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Objectives of FinancialStatement Analysis

• Equity investors are more concerned with returns
  in the form of dividends and increased market
  price of the stock.
• These investors are naturally more interested in
  profitability.
• Profits spur both dividends and
  increased stock prices.

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Evaluating Trends and Components of the Business

• Evaluating trends and components of a business
  are two ways of looking at financial information.
• Trend analysis involves comparing financial
  trends from one year to another.
• Evaluating components of a business can be done
  in more than one way.
• Relationships among elements of the financial
  statements may be examined.
• Components may also be thought of as separate
  business units or segments. These components may
  be examined.

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Trend Analysis

• Trends are predictable patterns that have been
  observed in the past and are expected to continue
  into the future.
• A pattern must be identified, and expectations of
  whether the trend will continue must be formed.
• Trends can be shown as changes in amounts from
  year to year or as percentage changes from year
  to year.

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Trend Analysis

• The dollar amount of the change is simply the
  current year minus the previous year.
• The percentage change is computed as follows

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Trend Analysis

• STELLAR CORPORATION
• Income Statements
• for the Years Ended December 31, 2002 and 2001
• Increase Increase
• 2002 2001 (Decrease)
  (Decrease)
• Sales 98,600 89,500 9,100
  10.2
• Expenses
• Wages expense 45,800 42,900
  2,900 6.8
• Rent expense 12,000 12,000
  0 0.0
• Utilities expense 6,500 6,450 50
  0.8
• Depreciation expense 5,000 5,900
  (900) (15.3)
• Total expenses 69,300 67,250
  2,050 3.0
• Net Income 29,300 22,250 7,050
  31.7
• 
  

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Trend Analysis

• Changes in dollar amounts and percentage terms
  help to expose patterns.
• Understanding these patterns is most important.
• The answers to why items changed tell a lot about
  how a company is run, how it will perform in the
  future, and whether or not it would be a good
  investment.
• Analysts generally look at several years worth
  of financial information to discover trends.

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Common-Size Statements

• Common-size statements - financial statements
  expressed in component percentages
• The income statement is expressed as a percentage
  of sales.
• This makes it easy to compare percentages to
  those of other companies because percentages are
  a common index.
• The balance sheet is expressed as a percentage of
  total assets.
• This is often referred to as component
  percentages because they measure each component
  as a percentage of the total.

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Common-Size Statements

• For the income statement, sales is set at 100
  and each other element is expressed as a
  percentage of the sales figure.
• For the balance sheet, the total assets amount is
  set at 100, and each other element is expressed
  as a percentage of the total assets figure.

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Common-Size Statements

• STELLAR CORPORATION
• Income Statements
• for the Years Ended December 31, 2002 and 2001

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Managements Discussionand Analysis

• Managements discussion and analysis - a required
  section of the annual report that concentrates on
  explaining the major changes in the income
  statement, liquidity, and capital resources
• Managements discussion often
  includes a discussion of trends and
  analysis of components.

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Segment Reporting

• Many large companies are involved in more than
  one type of business activity or market.
• Each individual type of business activity or
  market may be considered a segment.
• The FASB requires information on a business
  segment to be reported based on the way it is
  reported to management.
• The information is reported consistent with the
  way the company manages the business.

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Segment Reporting

• When analyzing segment data, two things should be
  considered.
• Evaluating segment data forces us to ask
  important questions that help us to truly
  understand the business.
• Truly understanding the business means not only
  understanding what is sold and how much is made
  but also interpreting how financial reports
  summarize dynamic changes in the business.

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Financial Ratios

• The cornerstone of financial statement analysis
  is the use of ratios.
• Financial ratios are sometimes grouped into four
  categories
• Short-term liquidity ratios
• Long-term solvency ratios
• Profitability ratios
• Market price and dividends ratios

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Financial Ratios

• Short-term liquidity ratios

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Financial Ratios

• Long-term solvency ratios

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Financial Ratios

• Profitability ratios

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Financial Ratios

• Market price and dividend ratios

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Evaluating Financial Ratios

• Financial ratios are evaluated using three types
  of comparisons.
• Time-series comparisons - comparisons of a
  companys financial ratios with its own
  historical ratios
• Benchmarks - general rules of thumb specifying
  appropriate levels for financial ratios
• Cross-sectional comparisons - comparisons of a
  companys financial ratios with the ratios of
  other companies or with industry averages

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Ratios

• Financial analysis using ratios is useful to
  investors because the ratios capture critical
  dimensions of the economic performance of the
  company.
• Managers use ratios to guide, measure, and reward
  workers.
• Often companies base employee bonuses on a
  specific financial ratio or a combination of some
  other performance measure and a financial ratio.

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Ratios

• Ratios mean different things to different groups.
• A creditor might think that a high current ratio
  is good because it means that the company has the
  cash to pay the debt.
• However, a manager might think that a high
  current ratio is undesirable because it could
  mean that the company is carrying too much
  inventory or is allowing its receivables to get
  too high.

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Ratios

• Because financial ratios may be interpreted
  differently by different users, the users of the
  financial ratios must understand
• the company and the business before
  drawing conclusions.

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Operating Performance andFinancial Performance

• Measures of profitability are affected by both
  financing and operating decisions.
• Financial management is concerned with where the
  company gets cash and how it uses that cash.
• Operating management is concerned with the
  day-to-day activities that generate revenues and
  expenses.
• Ratios that assess operating efficiency should
  not be affected by financial management
  performance.

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Operating Performance

• Rate of return on investment - evaluates the
  overall success of an investment by comparing
  what the investment returns with the amount of
  investment initially made

Rate of return on investment
34
Operating Performance

• Income may be defined differently for alternative
  purposes.
• Net earnings
• Pretax income from operations
• Earnings before interest and taxes (EBIT)
• Invested capital may also be defined differently.
• Stockholders equity
• Total capital provided by both debt and equity
  sources

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Operating Performance

• Operating performance is best measured by pretax
  operating rate of return on total assets, often
  referred to as return on total assets.

Pretax operating rate of return on total assets
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Operating Performance

• The right side of the previous equation is
  actually composed of two more important ratios.
• This equation may also be expressed as

Pretax operating rate of return on total assets
Operating income percentage on sales
Total asset turnover

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Operating Performance

• The expanded expression of pretax operating rate
  of return on total assets highlights that
  operating income percentage and asset turnover
  will each increase the rate of return on assets.
• Using these two ratios allows manipulation of
  either one to determine what happens to the rate
  of return under different scenarios.

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Operating Performance

Operating Income
Operating Income on Sales

Sales
Pretax Return on Total Assets
x
Sales

Total Asset Turnover
Average Total Assets
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Operating Performance

• This decomposition of return on total assets can
  also be applied to the return on equity.
• This is often referred to as the DuPont analysis.

or
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Financial Performance

• Debt and equity financing must be balanced in
  order to achieve good financial performance.
• Firms must choose how much debt is appropriate.
• The firms must also choose how to split their
  debt between short-term debt and long-term debt.
• The prudent use of debt is a major part of
  intelligent financial management.

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Financial Performance

• Short-term debt must be repaid or refinanced in a
  short period of time.
• If a company has trouble repaying the debt, it
  will also generally have trouble refinancing the
  debt.
• Naturally, lenders like healthy borrowers, not
  troubled borrowers.

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Financial Performance

• Long-term debt or equity are generally used to
  finance long-term investments.
• Debt financing is more attractive than equity
  financing because
• Interest payments are deductible for income tax
  purposes, but dividends are not deductible.
• The ownership rights to voting and profits are
  kept by the present shareholders.

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Trading on the Equity

• Capitalization (capital structure) - the total of
  a companys long-term financing
• Owners equity plus long-term debt
• Trading on the equity (financial leverage,
  leveraging) - using borrowed money at fixed
  interest rates with the objective of enhancing
  the rate of return on common equity

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Trading on the Equity

• There are costs and benefits to the shareholders
  from leveraging.
• Costs
• Interest payments
• Increased risk
• Benefits
• Larger returns to the common shareholders, as
  long as overall income is large enough to cover
  the increased interest payments

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Trading on the Equity

• General comments about leveraging
• A debt-free, or unleveraged, company has
  identical return on assets (ROA) and return on
  equity (ROE).
• When a company has a ROA greater than the
  interest rate it is paying its lenders, ROE
  exceeds ROA.
• This is called favorable financial leverage.
• When a company is unable to earn at least the
  interest rate on the money borrowed, the return
  on equity will be lower than it would be for a
  debt-free company.
• The more stable the income, the less dangerous it
  is to trade on the equity.

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Economic Value Added

• The idea behind economic value added (EVA) is
  that a company must earn more than it must pay
  for capital if it is to increase in value.
• Capital is considered both debt and equity.
• The cost of capital in EVA is a weighted average
  of interest cost and the returns required by
  equity investors.
• If a company has positive EVA, the company is
  adding value if a company has negative EVA, the
  company is losing value and might be better off
  liquidating.

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Income Tax Effects

• If all things are equal, debt financing is less
  costly to a corporation than equity financing
  because interest payments are deductible for
  income tax purposes.
• Dividends paid on stock are not deductible.
• Also, dividend rates on stock are generally
  higher than interest rates on debt because of the
  increased risk associated with stock.

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Income Tax Effects

• General comments on debt financing versus equity
  financing
• Because interest is deductible for income tax
  purposes, net income attributable to common
  shareholders can be higher if debt is used
  because taxes are lower.
• Book net income is higher if equity financing is
  used because there are no interest payments to be
  deducted as expenses.
• Failure to pay interest is an act of bankruptcy,
  which gives creditors the right to control the
  company failure to pay dividends has less severe
  consequences.

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Measuring Safety

• Investors in debt securities want assurance that
  the company in which they have invested will be
  able to make the scheduled interest and principal
  payments.
• These investors want to avoid the trouble of
  recovering their investments through bankruptcy
  of the company.
• They would much rather a steady stream of income
  from a healthy company.

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Measuring Safety

• Interest coverage (times interest earned) - a
  ratio that focuses on the interest-paying ability
  of a company

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Measuring Safety

• A rule of thumb for debt investors is that the
  interest coverage should be at least five
  times even in the poorest year in a
  span of 7 to 10 years.
• The tax deductibility feature of interest is a
  major reason why debt financing is used more than
  equity financing using preferred stock.

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Prominence of Earnings Per Share

• Earnings per share is a basic reporting element
  in the financial statements.
• Some issues tend to complicate the calculation of
  earnings per share.
• Use of a weighted-average number
  of shares of common stock
• Outstanding shares of nonconvertible
  preferred stock
• Changes in capitalization structure such as stock
  splits and stock dividends

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Weighted-Average Shares and Preferred Stock

• If all shares outstanding are common shares, the
  biggest complication is the use of a
  weighted-average number of shares of common
  stock.
• The following formula is used in this case.

Earning per share of common stock
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Weighted-Average Sharesand Preferred Stock

• Earnings per share is calculated as net income
  divided by weighted-average number of shares
  outstanding during the period.
• The weighted-average number of shares is based on
  the number of months that the shares were
  outstanding during the year.

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Weighted-Average Sharesand Preferred Stock

• Online, Inc., has 750,000 shares of common stock
  outstanding at the beginning of the calendar
  year, and 200,000 additional shares were issued
  on October 1. What is the weighted-average
  number of shares outstanding during the year?

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Weighted-Average Sharesand Preferred Stock

• The weighted-average number of shares is
  computed as follows
• 750,000 x weighting of 12/12 750,000
• 200,000 x weighting of 3/12 50,000
• 800,000
• 
  
• OR
• 750,000 x 9/12 562,500
• 950,000 x 3/12
  237,500
• 800,000
• 
  

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Weighted-Average Sharesand Preferred Stock

• Another complication arises if there are shares
  of nonconvertible preferred stock outstanding.
• The dividends on preferred stock for the current
  period, whether or not paid, should be deducted
  in calculating EPS because those dividends are
  not available to be paid to common shareholders.

Earning per share of common stock
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Basic and Diluted EPS

• When a company has convertible securities, stock
  options outstanding, or other financial
  instruments that can be converted to common
  shares, the calculation of EPS becomes even more
  complicated.
• When convertible securities exist, EPS is
  calculated using the assumption that any and all
  convertible shares are turned into common stock
  at the beginning of the period.

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Basic and Diluted EPS

• The presence of convertible securities increases
  the number of common shares to the highest
  possible number considering the convertible
  securities and stock options outstanding.
• If the number or shares outstanding is increased,
  earnings per share is decreased.
• These convertible securities are said to dilute
  (reduce) earnings per share.

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Disclosure of Nonrecurring Items

• Financial statement analysis focuses on normal
  recurring items of the financial statements, not
  nonrecurring items.
• Four major categories of nonrecurring items
• Special items
• Extraordinary items
• Discontinued operations
• Accounting changes

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Special Items

• Special items - expenses that are large enough
  and unusual enough to warrant separate disclosure
• Companies generally have flexibility in deciding
  when to treat something as a special item.
• Special items appear as separate line items among
  operating expenses on the income statement.
• Any necessary discussion must be included in the
  footnotes to the financial statements.

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Extraordinary Items

• Extraordinary items - items that are unusual in
  nature and infrequent in occurrence that are
  shown separately, net of tax, in the income
  statement
• Unusual in nature means that an item is different
  from the typical or normal operating activities
  of a business.
• Infrequent in occurrence means that an event
  should not be expected to recur often.

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Extraordinary Items

• Examples of extraordinary items are the financial
  effects of natural disasters such as earthquakes
  or hurricanes and government expropriations.
• Whether an item is extraordinary sometimes
  depends on where the event occurs.
• For example, losses from damage resulting from a
  hurricane on the coast of Louisiana would not be
  considered extraordinary, but losses from damage
  resulting from a hurricane in South Dakota would
  be extraordinary.

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Extraordinary Items

• Extraordinary items must be shown separately on
  the income statement.
• They must also be shown net of tax, which means
  that the amount on the income
  statement includes any tax effect
  the item might have.

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Discontinued Operations

• Discontinued operations - the termination
  (closing or sale) of a business segment reported
  separately, net of tax, in the income statement
• Any gain or loss from the actual disposal of the
  segment must be disclosed along with
  the results of operations (income or
  loss) for that segment
  during the period
  before the disposal.

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Accounting Changes

• Accounting changes occur when the FASB requires a
  new way of accounting for a particular item.
• When the FASB changes its rules, it often
  requires a major one-time recognition (revenue or
  expense).
• Accounting changes are shown separately and are
  shown net of tax.

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Accounting Changes

• The presentation of nonrecurring items on the
  income statement is as follows
• Income from continuing operations before income
  taxes
• Deduct income taxes
• Income from continuing operations
• Discontinued operations, net of tax
• Income before extraordinary items
• Extraordinary items, net of tax
• Income before cumulative effect of an
  accounting change
• Cumulative effect of an accounting change,
  net of tax
• Net income

68
International Considerations

• Financial statement analysis may be complicated
  by several factors when companies carry on
  operations in different countries.
• Differences in accounting methods
• Language in which the results are reported
• Currency in which results are reported
• Different securities markets, tax structures,
  and local customs

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Price-Earnings Ratios and Growth

• The P-E ratio is helpful for relating the price
  of a stock to the earnings it is generating.
• Value investors look for stocks with low P-E
  ratios because they feel these stocks are
  undervalued.
• Growth investors feel that stocks with high P-E
  ratios are likely to be high growth stocks.
• The price is high because investors see strong
  growth ahead.

70
Price-Earnings Ratios and Growth

• One way to relate P-E ratios to growth is the
  price-earnings growth (PEG) ratio.
• It is a tool to help focus attention on certain
  stocks and to help moderate knee-jerk reactions
  to other ratios.

P-E ratio
Price-earnings growth ratio

Earnings growth rate
71
Relating Cash Flowand Net Income

• Four possible combinations of net income and cash
  flows exists.
• Relationship 1 2 3 4
• Cash flow from operations
• Net income

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Relating Cash Flowand Net Income

• Four possible situations
• Situation 1 confirms the profitability of the
  company.
• Situation 2 can occur where a company has large
  non-cash expenses such as depreciation.
• Situation 3 is often an indication of trouble but
  may also be an indication of a rapidly growing
  company.
• Situation 4 confirms the lack of profitability of
  the company.