Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1 Understanding Financial Statements NINTH EDITION Lyn M. Fraser Aileen Ormiston

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-2 Copyright Notice All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-3 Chapter 6: The Analysis of Financial Statements Ratios are tools, and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison Chief Executive Officer, R.E.C. Inc.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-4 Objectives of Analysis Objectives will vary depending on the perspective of the perspective of the financial statement user specific questions that are addressed by the analysis The identity of the user helps define what information is needed.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-5 Objectives of Analysis Creditors A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-6 Objectives of Analysis Creditors What is the borrowing cause? What is the borrowing cause? What is the firm’s capital structure? What is the firm’s capital structure? What will be the source of debt repayment? What will be the source of debt repayment? Questions raised in a credit analysis should include

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-7 Objectives of Analysis Investors An investor attempts to arrive at an estimation of a company’s future earnings stream in order to attach a value to the securities being considered for purchase or liquidation.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-8 Objectives of Analysis Investors What is the company’s performance record? What is the company’s performance record? What are the future expectations? What are the future expectations? How much risk is inherent in the existing capital structure? How much risk is inherent in the existing capital structure? What are expected returns? What are expected returns? What is firm’s competitive position? What is firm’s competitive position? The investment analyst poses questions such as:

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-9 Objectives for Analysis Management Management relates to all questions raised by creditors and investors. Management must also consider its employees, the general public, regulators, and the financial press.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-10 Objectives of Analysis Management How well has the firm performed and why? How well has the firm performed and why? What operating areas have contributed to success and which have not? What operating areas have contributed to success and which have not? What are strengths and weaknesses of the company’s financial position? What are strengths and weaknesses of the company’s financial position? What changes should be implemented to improve future performance? What changes should be implemented to improve future performance? Looks to financial statement data to determine

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-11 Objectives of Analysis Financial statements provide insight into the company’s current status provide insight into the company’s current status lead to the development of policies and strategies for the future lead to the development of policies and strategies for the future

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-12 Objectives of Analysis Management prepares financial statements. Analyst should be alert to potential for management to influence reporting to make data more appealing to creditors, investors, and other users. It may be helpful to supplement analysis with other material in the annual report and other sources of information apart from the annual report.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-13 Sources of Information Financial statement user has access to a wide range of data sources. Objective of analysis dictates the approach and resources used. Beginning point should be financial statements and the notes.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-14 Sources of Information The analyst will want to consider the following resources: Proxy statement Auditor’s report Management discussion and analysis Supplementary schedules From 10-K and From 10-Q Other Sources

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-15 Other Sources of Information Computerized databases Computerized databases − Enhance analytical process − Provide time-saving features Computerized financial statement analysis packages Computerized financial statement analysis packages − Perform ratio calculations − Other analytical tools

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-16 Other Sources of Information It is important to review the annual reports of suppliers, customers, and competitors. Many internet sites charge subscription fees to access information, but public and university libraries often subscribe, making this information free to the public.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-17 Tools and Techniques Common-size financial statements Common-size financial statements Key financial ratios Key financial ratios Trend analysis Trend analysis Structural analysis Structural analysis Industry comparisons Industry comparisons Common sense and judgment Common sense and judgment

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-18 Common-Size Financial Statements Express each account on the balance sheet as a percentage of total assets balance sheet as a percentage of total assets income statement as a percentage of net sales income statement as a percentage of net sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-19 Key Financial Ratios Five categories of ratios Liquidity ratios Liquidity ratios Activity ratios Activity ratios Leverage ratios Leverage ratios Profitability ratios Profitability ratios Market ratios Market ratios

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-20 Key Financial Ratios Ratios are valuable analytical tools and serve as screening devices, but they do not provide answers in and of themselves do not provide answers in and of themselves are not predictive are not predictive should be used with other elements of financial analysis should be used with other elements of financial analysis

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-21 Key Financial Ratios Liquidity Ratios Liquidity ratios measure a firm’s ability to meet cash needs as they arise. Liquidity ratios include current ratio current ratio quick or acid-test ratio quick or acid-test ratio cash flow liquidity ratio cash flow liquidity ratio average collection period average collection period days inventory held days inventory held days payable outstanding days payable outstanding

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-22 Liquidity Ratios Short-Term Solvency Measures the ability of a firm to meet debt requirements as they come due Current Ratio Current assets Current liabilities

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-23 Liquidity Ratios Short-Term Solvency Measures ability to meet short-term cash needs more rigorously by eliminating inventory Quick or Acid-Test Ratio Current assets - Inventory Current liabilities

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-24 Liquidity Ratios Short-Term Solvency Focuses on ability of the firm to generate operating cash flows as a source of liquidity Cash Flow Liquidity Ratio *Cash flow from operating activities Cash + Marketable securities + CFO * Current liabilities

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-25 Liquidity Ratios Short-Term Solvency Helps gauge liquidity of accounts receivable (ability to collect cash from customers) and may help provide information about a company’s credit policies Average Collection Period Net accounts receivable Average daily sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-26 Liquidity Ratios Short-Term Solvency Measures the efficiency of the firm in managing its inventory Days Inventory Held Inventory Average daily cost of sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-27 Liquidity Ratios Short-Term Solvency Offers insight into a firm’s pattern of payments to suppliers Days Payable Outstanding Accounts payable Average daily cost of sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-28 Cash Conversion Cycle or Net Trade Cycle buying or manufacturing inventory, with some purchases on credit buying or manufacturing inventory, with some purchases on credit selling inventory, with some sales on credit and creation of accounts receivable selling inventory, with some sales on credit and creation of accounts receivable collecting the cash collecting the cash The normal cycle of a firm that consists of

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-29 Cash Conversion Cycle or Net Trade Cycle Helps the analyst understand why cash flow generation has improved or deteriorated by analyzing key balance sheet accounts that affect cash flow from operating activities: Accounts Receivable Accounts Receivable Inventory Inventory Accounts Payable Accounts Payable

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-30 Cash Conversion Cycle or Net Trade Cycle Average collection period plus Days inventory held minus Days payable outstanding equals Cash conversion or net trade cycle Calculated as follows

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-31 Key Financial Ratios Activity Ratios Activity ratios measure the liquidity of specific assets and the efficiency of managing assets. Activity ratios include accounts receivable turnover accounts receivable turnover inventory turnover inventory turnover accounts payable turnover accounts payable turnover fixed asset turnover fixed asset turnover total asset turnover total asset turnover

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-32 Activity Ratios: Asset Liquidity, Asset Management Efficiency Measures efficiency of firm’s collection and credit policies Accounts Receivable Turnover Net sales Net accounts receivable

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-33 Activity Ratios: Asset Liquidity, Asset Management Efficiency Measures firm’s efficiency in managing its inventory Inventory Turnover Cost of goods sold Inventory

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-34 Activity Ratios: Asset Liquidity, Asset Management Efficiency Helps to gain insight into a firm’s pattern of payment to suppliers Accounts Payables Turnover Cost of goods sold Accounts payable

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-35 Activity Ratios: Asset Liquidity, Asset Management Efficiency Assesses effectiveness in generating sales from investments in fixed assets Fixed Asset Turnover Net sales Net property, plant, equipment

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-36 Activity Ratios: Asset Liquidity, Asset Management Efficiency Assesses effectiveness in generating sales from investments in all assets Total Asset Turnover Net sales Total assets

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-37 Key Financial Ratios Leverage Ratios Leverage ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-38 Key Financial Ratios Leverage Ratios Leverage ratios include Debt ratio Debt ratio Long-term debt to total capitalization Long-term debt to total capitalization Debt to equity Debt to equity Times interest earned Times interest earned Fixed charge coverage Fixed charge coverage Cash flow adequacy Cash flow adequacy

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-39 Leverage Ratios Debt Financing and Coverage Considers the proportion of all assets that are financed with debt Debt Ratio Total liabilities Total assets

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-40 Leverage Ratios Debt Financing and Coverage Reveals the extent to which long-term debt is used for the firm’s permanent financing (both long-term debt and equity) Long-term Debt to Total Capitalization Long–term debt Long-term debt + Stockholders’ equity

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-41 Leverage Ratios: Debt Financing and Coverage (cont.) Measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity) Debt to Equity Total liabilities Stockholders’ equity

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-42 Leverage Ratios Debt Financing and Coverage Indicates how well operating earnings cover fixed interest expenses Times Interest Earned Operating profit Interest expense

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-43 Leverage Ratios Debt Financing and Coverage Measures how many times interest payments can be covered by cash flow from operations before interest and taxes Cash Interest Coverage CFO + interest paid + taxes paid Interest paid

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-44 Leverage Ratios Debt Financing and Coverage Broader measure of how well operating earnings cover fixed charges Fixed Charge Coverage *Rent expense = operating lease payments Operating profit + Rent expense Interest expense + Rent expense

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-45 Leverage Ratios Debt Financing and Coverage Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year Cash Flow Adequacy Cash flow from operating activities Capital expenditures + debt repayments + dividends paid

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-46 Profitability ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity. Key Financial Ratios Profitability Ratios

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-47 Profitability ratios include gross profit margin gross profit margin operating profit margin operating profit margin net profit margin net profit margin cash flow margin cash flow margin return on total assets (ROA) or return on investment (ROI) return on total assets (ROA) or return on investment (ROI) return on equity (ROE) return on equity (ROE) cash return on assets cash return on assets Key Financial Ratios Profitability Ratios

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-48 Profitability Ratios Overall Efficiency and Performance Measures ability of a company to control costs of inventories or manufacturing of products and to pass along price increases through sales to customers Gross Profit Margin Gross profit Net sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-49 Profitability Ratios Overall Efficiency and Performance Measures overall operating efficiency and incorporates all of the expenses associated with ordinary business activities Operating Profit Margin Operating profit Net sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-50 Profitability Ratios Overall Efficiency and Performance Measures profitability after consideration of all revenue and expense, including interest, taxes, and nonoperating items Net Profit Margin Net earnings Net sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-51 Profitability Ratios Overall Efficiency and Performance Measures ability to translate sales into cash Cash Flow Margin Cash flow from operating activities Net sales

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-52 Profitability Ratios Overall Efficiency and Performance Measures overall efficiency of firm in managing investment in assets and generating profits Return on Total Assets (ROA) or Return on Investment (ROI) Net earnings Total assets

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-53 Profitability Ratios Overall Efficiency and Performance Measures rate of return on stockholders’ investment Return on Equity (ROE) Net earnings Stockholders’ equity

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-54 Profitability Ratios Overall Efficiency and Performance Measures firm’s ability to generate cash from the utilization of its assets Cash Return on Assets Cash flow from operating activities Total assets

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-55 Key Financial Ratios Market Ratios Market ratios measure returns to stockholders and the value the marketplace puts on a company’s stock. Market ratios include earnings per common share earnings per common share price-to-earnings price-to-earnings dividend payout dividend payout dividend yield dividend yield

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-56 Market Ratios Earnings per Common Share Provides the investor with a common denominator to gauge investment returns Earnings per Common Share Net earnings Average shares outstanding

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-57 Market Ratios Price-to-Earnings Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings Price-to-Earnings Market price of common stock Earnings per share

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-58 Market Ratios Dividend Payout Determined by the formula cash dividends per share divided by earnings per share Dividend Payout Dividends per share Earnings per share

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-59 Market Ratios Dividend Yield Shows the relationship between cash dividends and market price Dividend Yield Dividends per share Market price of common stock

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-60 Analyzing the Data There are five broad areas that would typically constitute a fundamental analysis of financial statements: Background on the firm, industry, economy, and outlook Background on the firm, industry, economy, and outlook Short-term liquidity Short-term liquidity Operating efficiency Operating efficiency Capital structure and long-term solvency Capital structure and long-term solvency Profitability Profitability

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-61 Background: Economy, Industry, and Firm Economic developments and the actions of competitors affect the ability of any business enterprise to perform successfully. It is necessary to evaluate the environment in which the firm conducts business. This process involves blending hard facts with guess and estimates.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-62 Short-Term Liquidity Especially important to creditors, suppliers, management, and others who are concerned with the ability of a firm to meet near-term demands for cash Should include analysis of selected financial ratios and a comparison with industry averages Predicts the future ability of the firm to meet prospective needs for cash

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-63 Operating Efficiency Turnover ratios measure the operating efficiency of a firm. The efficiency in managing a company’s accounts receivable, inventory, and accounts payable is discussed in the short-term liquidity analysis.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-64 Capital Structure and Long-Term Solvency Analytical process includes an evaluation of the amount and proportion of debt in a firm’s capital structure as well as the ability to service debt. Debt financing implies risk and leverage.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-65 Profitability Analysis of how well the firm has performed in terms of profitability, beginning with the evaluation of several key ratios

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-66 Relating the Ratios The Du Pont System Helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios Looks at how the various pieces of financial measurement work together to produce an overall return Helps analyst see how the firm’s decisions and activities over the course of an accounting period interact to produce overall return to shareholders

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-67 Relating the Ratios The Du Pont System The summary ratios used are the following: (1) Net profit margin (2) Total asset turnover (3) Return on investment (3) Return on investment (4) Financial leverage (5) Return on equity Net income Net sales Net income Net sales X Total assets = Total assets Net sales X Total assets = Total assets Net income Total assets Net income Total assets X Stockholder equity = Stockholder equity

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-68 Relating the Ratios The Du Pont System The first three ratios reveal that return on investment is a product of the net profit margin and the total asset turnover. The second three ratios show how the return on equity is the product of return on investment and financial leverage.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-69 Relating the Ratios The Du Pont System By reviewing this series of relationships, the analyst can identify strengths and weaknesses as well as trace potential causes of problems in the overall financial condition and performance of the firm. Analyst can evaluate changes in condition and performance. Evaluation can then focus on specific areas contributing to changes.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-70 Projections and Pro Forma Statements Pro forma financial statements are projections based on a set of assumptions regarding future revenues future revenues expenses expenses level of investment in assets level of investment in assets financing methods and costs financing methods and costs working capital management working capital management

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-71 Projections and Pro Forma Statements Pro forma financial statements are used primarily for long-range planning and long-term credit decisions. Many firms have made up their own definitions of pro forma statements, which should not be confused with the pro forma statement described above.

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall6-72 Summary of Analysis Analysis of any firm’s financial statements consists of a mixture of steps and pieces that interrelate and affect each other. No one part of the analysis should be interpreted in isolation. The last step of analysis is to integrate the separate pieces into a whole, leading to conclusions about the business enterprise.