CHAPTER 14 Analyzing Financial Statements: A Managerial Perspective

Why Managers Analyze Financial Statements Managers analyze financial statements for a variety of reasons including: Control of operations Assess the financial stability of vendors, customers, and other business partners Assess the appearance of the company to investors and creditors Learning objective 1: Explain why managers analyze financial statements

Control of Operations Analysis of financial statements help management gain insight into whether their goals have been achieved Assume successful implementation of plan will be reflected in financial information - If financial information is inconsistent with a successful implementation an investigation will be launched Learning objective 1: Explain why managers analyze financial statements

Assessment of Vendors, Customers, and Other Partners Management takes same approach to review the financial stability of vendors, customers, and other strategic partners Analysis of financial statements used to identify, qualify, and monitor potential partners - Important when developing relationships to determine whether vendor or customer’s business is viable and will continue operations Learning objective 1: Explain why managers analyze financial statements

Assessment of Vendors, Customers, and Other Partners Managers analyze financial statements to assess whether: Vendors are stable and will continue in existence Customers need to be able to pay amounts owed on a timely basis Potential partners are in financial difficulty Learning objective 1: Explain why managers analyze financial statements

Assessment of Appearance to Investors and Creditors Accrual income v. cash flows - Describe the differences between net income and cash flow from operating activities to help readers Managers need to analyze statements from the perspective of investors and creditors - Need to be prepared in order to answer questions Learning objective 1: Explain why managers analyze financial statements

Review 1 Why do managers analyze financial statements? Answer: d To evaluate and control operations To evaluate vendors and customers To anticipate questions from shareholders and creditors All of the above Answer: d Learning objective 1: Explain why managers analyze financial statements

Horizontal and Vertical Analyses Horizontal analysis Analysis of the dollar value and percentage changes in financial statement amounts across time Vertical analysis - Also called common size analysis - Analysis of financial statement amounts in comparison to a base amount, e.g. total assets Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Horizontal Analysis Horizontal analysis Calculate amount of change for each item on the balance sheet or income statement Calculate percent change -Amount of change divided by old amount Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Horizontal Analysis Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Horizontal Analysis Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Exercise 1 Prepare a horizontal analysis of the following condensed balance sheet Slide 14-13 Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Vertical Analysis Analysis of the balance sheet and income statement in comparison to a base amount Divide each amount by the base amount to calculate percentage - For the balance sheet the base amount is total assets - For the income statement the base amount is net sales Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Vertical Analysis Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Vertical Analysis Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Review 2 Horizontal analysis analyzes: Comparable companies Changes in expenses as a percentage of sales Changes in expenses as a percent of total assets Changes in balances from one year to another Answer: d Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Exercise 2 Prepare a vertical analysis of the following condensed income statement Slide 14-18 Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Exercise 2 Prepare a vertical analysis of the following condensed income statement Slide 14-19 Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Earnings Management Accounting numbers can be manipulated to make performance appear stronger Allegations of impropriety have been leveled against: - Cendant - Computer Associates - Enron - Kroger - Lucent - Sunbeam - Waste Management Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

Earnings Management Why do managers manipulate earnings? - Managers often are evaluated and rewarded based on the level of earnings Managers can benefit from inflated stock prices A red flag for earnings management is a substantial difference between reported earnings and operating cash flow - Fictitious sales will not produce cash - Understated expenses need to be paid Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

Cash Flow versus Earnings Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

Other Sources of Financial Performance Management discussion and analysis Management provides financial statement users with explanations of financial results Credit reports Number of firms (e.g. Dun & Bradstreet) provides information on a company’s credit history Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

Other Sources of Financial Performance News articles Includes announcements regarding major company changes which may indicate problems Many on-line services are available in which to conduct a search of news articles: - Lexis-Nexis provides information for a fee - Yahoo! Finance provides free information - Search the internet using ticker symbol Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

Management Discussion & Analysis (MD&A) Example Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

Review 3 In connection with a company’s annual report, MD&A stands for: Management discussion and analysis More depreciation and amortization Monthly depreciation and amortization Monthly discounts and advertising Answer: a Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

Ratio Analysis Profitability ratios - Reveals a company’s ability to generate profits Turnover ratios - Reveals the company’s efficiency with regard to the use of its assets Debt-related ratios - Reveals a company’s ability to re-pay its obligations Learning objective 5: Calculate and interpret profitability ratios

Profitability Ratios Learning objective 5: Calculate and interpret profitability ratios

Profitability Ratio Formulas Learning objective 5: Calculate and interpret profitability ratios

Turnover Ratios Learning objective 6: Calculate and interpret turnover ratios

Turnover Ratio Formulas Learning objective 6: Calculate and interpret turnover ratios

Review 4 The efficient use of assets is indicated by: Answer: a Turnover ratios Debt-related ratios The ratio of debt to equity The ratio of current assets to current liabilities Answer: a Learning objective 6: Calculate and interpret turnover ratios

Debt-Related Ratios Learning objective 7: Calculate and interpret debt-related ratios

Debt-Related Ratios Learning objective 7: Calculate and interpret debt-related ratios

Too Much Debt Learning objective 7: Calculate and interpret debt-related ratios

Review 5 The ratio times interest earned can be used to evaluate: The amount of debt versus equity financing The extent to which interest income exceeds interest expense The extent to which interest expense exceeds interest income The likelihood that a company will be able to make required interest payments Answer: d Learning objective 7: Calculate and interpret debt-related ratios

Ratio – Too High or Low? Learning objective 7: Calculate and interpret debt-related ratios

Comparative Ratio Data Learning objective 7: Calculate and interpret debt-related ratios

Strategic Partners Learning objective 7: Calculate and interpret debt-related ratios

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