Chapter 18 Financial Statement Analysis

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Chapter 18Financial Statement Analysis
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Objectives ofFinancial Statement Analysis

• Financial statement analysis comprises all the
  techniques employed by users of financial
  statements to show important relationships in the
  financial statements.
• Users of financial statements fall into two broad
  categories internal and external.
• The main focus in this chapter is on the external
  users of financial statements and the analytical
  techniques they employ.

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Internal Users

• Managements primary objective is to increase
  the wealth of the owners or stockholders of the
  business.
• Managements main responsibility is to carry out
  plans to achieve the financial performance
  objectives.
• Management develops monthly, quarterly, and
  annual reports that compare actual performance
  with objectives for key financial measures.

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External Users

• Creditors make loans in the form of trade
  accounts, notes, or bonds.
• Investors buy capital stock, from which they hope
  to receive dividends and an increase in value.
• Both groups face risks and for both the goal is
  to achieve a return that makes up for the risk.

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External Users and Risk

• In general, the greater the risk taken, the
  greater the return required as compensation.
• Any one loan or any one investment can turn out
  badly.
• As a result, most creditors and investors put
  their funds into a portfolio, or a group of loans
  or investments.
• The portfolio allows creditors and investors to
  average both the returns and the risks.

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Uses ofFinancial Statement Analysis

• It is in making individual investment or loan
  decisions that financial statement analysis is
  most useful.
• Creditors and investors use financial statement
  analysis in two general ways.
• 1. To judge past performance and current
  position.
• 2. To judge future potential and the
  risk connected with that potential.

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Discussion

• Q. What role does risk play in making loans
  and investments?
• A. Risk refers to the uncertainty of future
  events. Risk is associated with the ease of
  predicting the future performance of a loan or
  investment. The more confident a creditor or
  investor is in predicting future liquidity or
  profitability, the less risk is associated with
  the loan or investment.

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Assessment of Past Performance and Current
Position

• Past performance is often a good indication of
  future performance.
• Current position indicates what assets are owned
  and how much is owed.
• Future potential includes the potential
  debt-paying ability of the company.
• The riskiness of an investment depends on how
  easy it is to predict future profitability or
  liquidity.

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Standards forFinancial Statement Analysis

• Decision makers must judge whether the
  relationships they have found are favorable
  or unfavorable.

• Three commonly used standards of comparison are

• 1. Rule-of-thumb measures.
• 2. A companys past performance.
• 3. Industry norms.

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Rule-of-Thumb Measures

• The credit-rating firm of Dun Bradstreet, in
  its Industry Norms and Key Business Ratios,
  offers such rules of thumb as the following
• Current debt to tangible net worth.
• Inventory to net working capital.
• Rule-of-thumb measures must be used with great
  care.

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Past Performance of the Company

• An improvement over rule-of-thumb measures is the
  comparison of financial measures or ratios of the
  same company over a period of time.
• This standard gives the analyst a basis for
  judging whether the measure or ratio is getting
  better or worse.

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Past Performance of the Company

• It may also be helpful in showing possible future
  trends.
• Since trends reverse at times, such projections
  must be made with care.
• Another problem with trend analysis is that the
  past may not be a useful measure of adequacy.

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Industry Norms

• One way of making up for the limitations of using
  past performance as a standard is to use industry
  norms.
• Industry norms tell how the company being
  analyzed compares with other companies in the
  same industry.

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Industry Norms

• There are three limitations to using industry
  norms as standards.
• 1. Two companies that seem to be in the same
  industry may not be strictly comparable.

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Industry Norms

• 2. Most large companies today operate in more
  than one industry.
• There are simply no other companies that are
  similar enough.
• A requirement by FASB presented in Statement No.
  131, states that diversified companies must
  report revenues, income from operations, and
  identifiable assets for each of their operating
  segments.

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Industry Norms

• Depending on specific criteria, segment
  information may be reported for operations in
  different industries or in different geographical
  areas, or for major customers.

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Industry Norms

• 3. Companies in the same industry with similar
  operations may use different acceptable
  accounting procedures.
• Industry norms probably offer the best available
  standards for judging current performance as long
  as they are used with care.

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Discussion

• Q. Why would a financial analyst compare the
  ratios of Steelco, a steel company, with the
  ratios of other companies in the steel industry?
  What factors might invalidate such a comparison?

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A.
Discussion (continued)

• A financial analyst might compare the ratios
  of Steelco with those of other steel companies to
  determine how Steelcos performance ranks in the
  industry. This type of analysis might not be
  valid if Steelco has characteristics that make it
  different from other steel companies.

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Sources of Information
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Reports Published by the Company

• The annual report of a publicly held corporation
  is an important source of financial information.

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Reports Published by the Company

• The main parts of an annual report are
• Managements analysis of the past years
  operations.
• The financial statements.
• The notes to the statements, including the
  principal accounting procedures used by the
  company.
• The auditors report.
• A summary of operations for a five- or ten-year
  period.

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Reports Published by the Company

• Most publicly held companies also publish interim
  financial statements each quarter.

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SEC Reports

• Publicly held corporations must file annual
  reports, quarterly reports, and current reports
  with the Securities and Exchange Commission (SEC).

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SEC Reports

• The SEC calls for several standard forms, two of
  which are
• The annual report (Form 10-K) that contains more
  information than the published annual report.
• The quarterly report (Form 10-Q) presents
  important facts about interim financial
  performance.

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Business Periodicals andCredit and
InvestmentAdvisory Services

• Financial analysts must keep up with current
  events in the financial world.
• Sources of financial information include The
  Wall Street Journal, Forbes, Barron's, Fortune,
  and the Commercial and Financial Chronicle.

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Business Periodicals andCredit and
InvestmentAdvisory Services

• The publications of Moodys Investors Service,
  Inc. and Standard Poors are useful for further
  details about the financial history of companies.
• Data on industry norms, average ratios and
  relationships, and credit ratings are available
  from the Dun Bradstreet Corp.

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Discussion

• Q. For each of the following pieces of
  information, indicate whether the best source
  would be
• Reports published by the company.
• SEC reports.
• Business periodicals.
• Credit and investment advisory services.

1. Current market value of a companys stock. 2.
Managements analysis of the past years
operations. 3. Objective assessment of a
companys financial performance. 4. Most complete
body of financial disclosures. 5. Current events
affecting the company.
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Discussion

• Q. For each of the following pieces of
  information, indicate whether the best source
  would be
• Reports published by the company.
• SEC reports.
• Business periodicals.
• Credit and investment advisory services.

1. Current market value of a companys stock
c 2. Managements analysis of the past years
operations a 3. Objective assessment of a
companys financial performance d 4. Most
complete body of financial disclosures b 5.
Current events affecting the company c
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Tools and Techniques of Financial Analysis

• Few numbers are very significant when looked at
  individually.
• It is the relationship between various numbers or
  their change from year to year that is important.
• The tools of financial analysis are intended to
  show relationships and changes.

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Horizontal Analysis

• GAAP require the presentation of comparative
  financial statements that give financial
  information for the current year and the previous
  year.
• Horizontal analysis begins with the computation
  of changes from the previous year to the current
  year. The base year is the first year considered.
  
• Horizontal analysis uses both dollar amounts and
  percentages.

Amount of Change Base Year Amount
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Trend Analysis

• Changes are calculated for several successive
  years instead of for two years.
• Trend analysis is important because it may point
  to basic changes in the nature of a business.
• Trend analysis uses an index number to show
  changes in related items over a period of time.

( )
Index 100 x
Index Year Amount Base Year Amount
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Vertical Analysis

• Percentages are used to show the relationship
  of the different parts to a total in a single
  statement.
• The accountant sets a total figure in the
  statement equal to 100 and computes each
  components percentage of that total.
• The statement of percentages is called a
  common-size statement.
• Vertical analysis is useful for comparing the
  importance of specific components in the
  operation of a business.

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Common-Size Balance Sheets Presented Graphically
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Common-Size Income Statements Presented
Graphically
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Ratio Analysis

• Ratios are guides or shortcuts that are useful
  in
• Evaluating a companys financial position and
  operations.
• Making comparisons with results in previous years
  or with other companies.
• The primary purpose of ratios is to point out
  areas needing further investigation.

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Discussion

• Q. What is the difference between horizontal and
  vertical analysis?
• A. Horizontal analysis is a year-to-year analysis
  of the components of a series of financial
  statements. Vertical analysis, on the other hand,
  is concerned with the relationship of items
  within a single financial statement.

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Evaluating Liquidity

• Liquidity is a company's ability to pay bills
  when they are due and to meet unexpected needs
  for cash.
• All ratios that relate to liquidity involve
  working capital or some part of it.
• Current ratio.
• Quick ratio.
• Receivable turnover.
• Average days sales uncollected.
• Inventory turnover.
• Average days inventory on hand.

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Liquidity

• Current Ratio Current Assets
• Current Liabilities
• Quick Ratio Cash Marketable Securities
  Receivables
• Current Liabilities
• Receivable Turnover Net Sales
• Average Accounts Receivable
• Inventory Turnover Cost of Goods Sold
• Average Inventory

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Liquidity

• Average Days Inventory Days in Year
• on hand Inventory Turnover
• Payable Turnover Cost of Goods Sold /- Change
  in Inventory
• Average Accounts Payable
• Average Days Payable Days in Year
• Payables Turnover

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Evaluating Profitability

• The objective of profitability relates to a
  company's ability to earn a satisfactory income.
• A company's profitability is closely linked to
  its liquidity because earnings ultimately produce
  cash flow.
• Profitability ratios include
• Profit margin.
• Asset turnover.
• Return on assets.
• Return on equity.

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Profitability

• Profit Margin Net Income
• Net Sales
• Asset Turnover Net Sales
• Average Total Assets
• Return on Assets Net Income
• Average Total Assets
• Return on Equity Net Income
• Average Stockholders Equity

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EvaluatingLong-Term Solvency

• Long-term solvency has to do with a companys
  ability to survive for many years. The aim of
  long-term solvency analysis is to detect early
  signs that a company is on the road to bankruptcy.

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EvaluatingLong-Term Solvency

• Early signs that a company is on the road to
  bankruptcy include
• Declining profitability and liquidity ratios.
• Unfavorable debt to equity ratio.
• Unfavorable interest coverage ratio.

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Long-Term Solvency

• Debt to Equity Ratio Total Liabilities
• Stockholders Equity
• Measures capital structure and leverage.
• Failure to honor debt can result in bankruptcy,
  so debt is risky.
• BUT debt provides flexible financing
• It can be temporary.
• Interest is tax deductible.
• It leverages stockholders investments if the
  company earns a return on assets greater than the
  cost of interest.

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Long-Term Solvency (continued)

• Interest Coverage Ratio Income Before Income
  Taxes Interest Expense
• Interest
  Expense
• Measures creditors protection from default on
  interest payments.

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EvaluatingCash Flow Adequacy

• Because cash flows are needed to pay debts when
  they are due, cash flow measures are closely
  related to the objectives of liquidity and
  long-term solvency.
• Net cash flows from operating activities.
• Cash flow yield.
• Cash flows to sales.
• Cash flows to assets.
• Free cash flow.

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Cash Flow Adequacy

• Cash Flow Yield Net Cash Flows from Operating
  Activities
• Net Income
• Cash Flows to Sales Net Cash Flows from
  Operating Activities Net Sales
• Cash Flows to Assets Net Cash Flows from
  Operating Activities Average Total Assets
• Free Cash Flow N.C.F. from O.A. Dividends
  Net Capital Expenditures

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Evaluating Market Strength

• Market price is the price at which people are
  willing to buy or sell the stock.
• Market price provides information about how
  investors view the potential return and risk
  connected with owning the companys stock.

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Evaluating Market Strength

• Market price by itself is not very informative.
• Market price must be related to earnings by
  considering the price/earnings ratio and the
  dividends yield.

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Market Strength Ratios

• Price/Earnings Ratio Market Price per Share
• Earnings per Share
• Measures investor confidence in a company.
• Is useful for comparing the value placed on a
  companys shares in relation to the overall
  market.
• Dividends Yield Dividends per Share
• Market Price per Share
• Measures a stocks current return to an investor.

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Discussion

• Q. What is the difference between liquidity
  and solvency?
• A. Liquidity is a firms ability to meet its
  current obligations, whereas solvency is a firms
  ability to meet all its maturing obligations as
  they come due, without losing the ability to
  continue operations.