FINANCIAL FINANCIAL ACCOUNTING ACCOUNTING A U s e r P e r s p e c t i v e Third Canadian Edition A U s e r P e r s p e c t i v e Third Canadian Edition Hoskin  Fizzell

2 Financial Statement Analysis 12 C h a p t e r

3 You must have a grasp of You must have a grasp of – Operating activities – Underlying economics – Risks involved – Crucial economic factors to the health of the company Understanding the Business

4 Read the description of the business in the annual report Read the description of the business in the annual report Review additional information about the company and the industry Review additional information about the company and the industry Read the financial statements, including Read the financial statements, including – Auditor’s report – Notes to the financial statements Understanding the Business

5 Use the reported financial results, retrospective data, to Use the reported financial results, retrospective data, to Make a forward-looking, prospective, analysis Make a forward-looking, prospective, analysis Prospective Analysis

6 Examines information from different time periods in the life of the company Examines information from different time periods in the life of the company Looks for patterns in the data over time Looks for patterns in the data over time Assumes that there is predictability in the time series Assumes that there is predictability in the time series Time-Series Analysis

7 Compares data from one company to another for the same time period Compares data from one company to another for the same time period Usually compares companies in the same industry Usually compares companies in the same industry Cross-Sectional Analysis

8 Raw financial data Raw financial data Common size data Common size data Ratio data Ratio data Data to Be Used

9 The data that appear directly in the financial statements The data that appear directly in the financial statements Useful in a time-series analysis Useful in a time-series analysis Raw Financial Data

10 Elements of the raw data are compared with other elements Elements of the raw data are compared with other elements Statement of earnings Statement of earnings – All line items are expressed as percentages of net revenues Can be used for analysis of the balance sheet and the cash flow statement Can be used for analysis of the balance sheet and the cash flow statement Common Size Data

11 Common Size Statements of Earnings

12 Useful for making comparisons of data items within a given financial statement Useful for making comparisons of data items within a given financial statement General categories General categories – Performance – Short-term liquidity – Long-term liquidity Ratio Data

13 Return on investment (ROI) Return on investment (ROI) – Measures investment performance Return on equity (ROE) Return on equity (ROE) – Measures return to shareholders Return on assets (ROA) Return on assets (ROA) – Measures investment in assets Performance Ratios

14 ROA = Net income + [Interest expense x (1-Tax rate)] Average total assets = Income before interest Average total assets Return on Assets

15 ROE = Net income - Preferred dividends Average common shareholders’ equity Return on Equity

16 Financial leverage Financial leverage – Some of the funds obtained to invest in assets came from debtholders rather than from shareholders High leverage High leverage – Larger proportion of debt to equity Leverage

17 Provide measures of the lead/lag relationships that exist between revenue and expense recognition and the related cash flows Provide measures of the lead/lag relationships that exist between revenue and expense recognition and the related cash flows – Accounts receivable turnover – Inventory turnover – Accounts payable turnover Turnover Ratios

18 Accounts receivable turnover = Sales on account Average accounts receivable Days to collect = 365 Accounts receivable turnover Accounts Receivable

19 Inventory turnover = Cost of goods sold Average inventory Days inventory held = 365 Inventory turnover Inventory

20 Accounts payable turnover = Credit purchases Average accounts payable Days to pay = 365 Accounts payable turnover Accounts Payable

21 Understanding liquidity requires knowledge of the leads/lags in the company’s cash-to- cash cycle Understanding liquidity requires knowledge of the leads/lags in the company’s cash-to- cash cycle – Current ratio – Quick ratio Short-term Liquidity Ratios

22 Current Ratio Current Liabilities Current Assets = Current Ratio

23 Quick Ratio Current Liabilities Cash + Accounts receivable + Marketable securities = Quick Ratio

24 The ability of the company to pay its obligations in the long term The ability of the company to pay its obligations in the long term – Debt-equity ratio – Times interest ratio Long-term Liquidity Ratios

25 Debt/Equity= Total liabilities + shareholders’ equity Total liabilities Debt-Equity Ratio

26 Times interest earned = Interest (including capitalized interest) Income before interest and taxes Times Interest Earned

27 Basic earnings per share = Weighted average number of common shares outstanding Net income - Preferred dividends Earnings Per Share

28 Price/ earnings = Earnings per share Stock market price per share Price/Earnings Ratio

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