Chapter 5: Using Financial Statement Information

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Chapter 5Using Financial Statement Information
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Control and Prediction

• Financial accounting numbers are useful in two
  fundamental ways
• They help investors and creditors influence and
  monitor the business decisions of a companys
  managers.
• They help to predict a companys future earnings
  and cash flows.

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Book Value vs. True Value

• Financial statements do not reflect the companys
  prospects within its business environment
• Statements are backward looking, not focusing on
  the future prospects.
• Financial statements are inherently limited
• Statements leave out some current and historical
  information such as human resources and the
  effects of inflation.
• Management prepares the financial statements in a
  biased manner
• Managers often choose accounting methods and
  estimates that make them look good.

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Framework for Financial Statement Analysis
Book Value
Add adjustments for (1) business environment
(2) unrecorded events (3) management bias
True Value
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Five Steps of Financial Statement Analysis

• Assessing the business environment.
• Reading and studying the financial statements and
  footnotes.
• Assessing earnings quality.
• Analyzing the financial statements.
• Predicting future earnings and/or cash flow.

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Assessing the Business Environment

• What is the nature of the companys operations?
• What strategy is being employed to generate
  profits?
• What is the companys industry?
• Who are the major players? Competition?
• What are the relationships between the company
  and its customers and suppliers?
• How are the companys sales and profits affected
  by changes in the economy?

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Reading and Studying the Financial Statements and
Notes

• Read the audit report.
• Identify significant transactions
• major acquisitions, discontinuance or disposal of
  a business segment, unresolved litigation, major
  write-downs of receivables or inventories, etc.
• Read the financial statements and footnotes.

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Assessing Earnings Quality

• Earnings quality may be affected by a number of
  strategies managers use to influence accounting
  numbers. Four major strategies are discussed
• Overstating operating performance
• Taking a bath
• Creating hidden reserves
• Employing off-balance-sheet financing

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Assessing Earnings Quality

• Overstating operating performance through the
  acceleration of recognition of revenue - shift
  the timing of revenue from a future period to the
  current period, through legitimate or
  questionable activities.
• Overstating operating performance through the
  allocation and estimation of expenses - shift the
  recognition of expenses through the use of
  taking a bath and creating hidden reserves.

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Assessing Earnings Quality

• Taking a bath (also called big bath) - large
  losses and expenses this year may increase income
  in future years.
• Rationale if the current year is going to be
  disappointing to investors anyway, increase the
  loss to make next year look better. For example
  
• Excessive write downs of equipment will lead to
  lower depreciation expense in future years.
• Excessive write down of inventory will lead to
  lower cost of goods sold next year.

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Assessing Earnings Quality

• Creating hidden reserves - expenses may be
  shifted from one year to another year by
  overestimating expense accrual.
• Excessive bad debt expense or warranty expense in
  the current year will lead to reduced estimates
  in future years, as the reserve is used up.
• Note that these reserves have nothing to do
  with cash reserves they simply reserve some of
  the income to future periods.

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Assessing Earnings Quality

• Employing off-balance-sheet financing - this
  relates to certain economic transactions that are
  not reflected in the balance sheet.
• Managers prefer to keep certain liabilities off
  the balance sheet when GAAP permits it, primarily
  because of potential debt covenant violations,
  and because of the effect on certain ratios.
• Examples include
• treatment of leases as operating leases (Radio
  Shack)
• unconsolidated investments (Enrons
  partnerships) which do not separate assets from
  liabilities.

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Analyzing the Financial Statements

• Comparisons across time
• Comparisons within the industry
• Comparisons within the financial statements
  common-size statements and ratio analysis
• Profitability ratios
• Leverage ratios
• Solvency ratios
• Asset turnover ratios
• Market ratios

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Comparisons Across Time

• Financial accounting numbers can be made more
  meaningful if they are compared across time.
• GAAP require side-by-side comparison of the
  current and the preceding years in published
  financial reports.

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Comparisons Within the Industry

• Financial accounting numbers can also be made
  more meaningful if they are compared to those of
  similar companies.
• Comparison of financial accounting numbers with
  industry averages is also helpful.
• Sources of industry information include
• Dun Bradstreet
• Robert Morris Associates
• Moody
• Standard Poor

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Comparisons Within the Financial Statements

• Common-size financial statements
• Ratio analysis
• Profitability ratios
• Leverage ratios
• Solvency ratios
• Asset turnover ratios
• Market ratios

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Common-Size Income Statement for La-Z-Boy, Inc.
(Figure 5-2)
Income Statement (in millions) 2003
2002 Net sales 2,112 100 2,154
100 Cost of sales (1,617) 77 (1,692)
79 Expenses and charges (459) 21
(400) 18 Net income 36 2
62 3 On the income statement, cost of
goods sold, expenses, and net income are often
expressed as percentages of net sales. On the
balance sheet, assets and liabilities can be
expressed as percentages of total assets.
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Profitability Ratios

• These ratios are designed to measure a firms
  earnings power.
• Net income, the primary measure of the overall
  success of a company, is compared to other
  measures of financial activity or condition to
  assess performance as a percent of some level of
  activity or investment.

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Profitability Ratios
Return on Net Income Equity Average
Stockholders Equity This ratio measures the
effectiveness at managing capital provided by the
shareholders.
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Profitability Ratios
Return on Net Income Interest Expense (1-tax
rate) Assets Average
Total Assets This ratio measures the
effectiveness at managing capital provided by all
investors (stockholders and creditors).
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Profitability Ratios
Return on Net Income Interest Expense (1-tax
rate) Sales Net
Sales This ratio provides an indication of a
companys ability to generate and market
profitable products and control its costs also
called the Profit Margin.
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Leverage Ratios

• Leverage refers to using borrowed funds to
  generate returns for stockholders.
• Leverage is desirable because it creates returns
  for stockholders without using any of their
  money.
• Leverage increases risk by committing the company
  to future cash obligations.

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Leverage Ratios
Common Net Income Equity Net Income Interest
Expense (1-tax rate) Leverage This ratio
compares the return available to the stockholders
to returns available to all capital providers.
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Leverage Ratios
Capital Average Total Assets Structure Ave
rage Stockholders Equity Leverage This ratio
measures the extent to which a company relies on
borrowings (liabilities).
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Leverage Ratios
Debt to Equity Average Total Liabilities
Ratio Average Stockholders Equity This
ratio compares liabilities to stockholders
equity and is another measure of capital
structure leverage.
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Leverage Ratios
Long-term Long-Term Debt Debt Ratio
Total Assets This ratio measures the
importance of long-term debt as a source of asset
financing.
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Solvency Ratios

• Solvency refers to a companys ability to meet
  its current debts as they come due.
• There is pressure on companies with high levels
  of leverage to manage their solvency.

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Solvency Ratios
Current Current Assets Ratio Current
Liabilities This ratio measures solvency in
the sense that current assets can be used to meet
current liabilities.
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Solvency Ratios
Quick Cash Marketable Securities A/R
Ratio Current Liabilities Similar to the
current ratio, this ratio provides a more
stringent test of a companys solvency.
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Solvency Ratios
Interest Net Income Tax Expense Interest
Expense Coverage Interest Expense This ratio
compares the annual funds available to meet
interest to the annual interest expense.
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Solvency Ratios
Accounts Cost of Goods Sold Payable
Average Accounts Payable Turnover This ratio
measures the extent to which accounts payable is
used as a form of financing.
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Asset Turnover Ratios

• Asset turnover ratios are typically computed for
  total assets, accounts receivable, inventory, and
  fixed assets.
• These ratios measure the speed with which assets
  move through operations or reflect the number of
  times during a given period that these specific
  assets are acquired, used, and replaced.

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Asset Turnover Ratios
Receivables Net Credit Sales Turnover Average
Accounts Receivable This ratio reflects the
number of times the trade receivables were
recorded, collected, and recorded again during
the period.
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Asset Turnover Ratios
Inventory Cost of Goods Sold Turnover Average
Inventory This ratio measures the speed with
which inventories move through operations.
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Asset Turnover Ratios
Fixed Assets Sales Turnover Average Fixed
Assets This ratio measures the speed with which
fixed assets are used up.
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Asset Turnover Ratios
Total Asset Sales Turnover Average Total
Assets This ratio measures the speed with which
all assets are used up in operations.
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Market Ratios

• These additional ratios are used by the financial
  community to assess company performance.

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Market Ratios
Earnings Net Income per Average Number of
Common Shares Share Outstanding This ratio,
according to the financial press, is the primary
measure of a companys performance. It
calculates the amount of income that is earned
for each shareholder.
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Market Ratios
Price/Earnings Market Price per Share
Ratio Earnings per Share This ratio is
used by many analysts to assess the investment
potential of common stocks.
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Market Ratios
Dividend Yield Dividends per Share
Ratio Market Price per Share This ratio
indicates to cash return on the stockholders
investment.
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Market Ratios
Stock Market Price1 - Market Price0
Dividends Price Market Price0 Return This
ratio measures the pretax performance of an
investment in a share of common stock.
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Solvency Assessment (Figure 5A-3)
Ability to Generate Cash
Cash Requirements
Operating Performance
Operating Revenue Sale of Goods Sale of
Service Creation of Operating Receivables (timing
difference) Cash Inflows from Operations
Operating Costs Cost of Goods Sold Operating
Expense Creation of Operating Payables (timing
difference) Cash Outflows from Operations
Financial Flexibility
and Liquidity
Ability to create short-term debt Ability to
create long-term debt Ability to issue
equity Ability to liquidate assets
Payments for short-term debt Payments for
long-term debt Payments for dividends Payments
for asset replacement
Timing of Cash Inflows
Timing of Cash Outflows