Analysis and Interpretation of Financial Statements www.AssignmentPoint.com
Financial Statement Analysis The application of analytical tools and techniques to financial statement data. Allows users to focus on how numbers are related and how they have changed over time www.AssignmentPoint.com
Objective of Financial StatementAnalysis External users rely on general purpose financial statements Make predictions about an organization as an aid in making decisions Users highlight important trends or changes www.AssignmentPoint.com
Risk and Return Users try to balance the risk of an investment with its expected return Generally the greater the risk, the higher the return Financial statement analysis is one source of information for assessing risk and return www.AssignmentPoint.com
Sources of External Information Public companies must publish an annual financial report Government reports SEC 10K, 10Q Financial service information Moody’s, Dow-Jones Financial newspapers and periodicals Wall Street Journal www.AssignmentPoint.com
Financial Analysis Tools Horizontal analysis Vertical analysis Ratio analysis www.AssignmentPoint.com
Horizontal Analysis: Amounts and Percentages of Change Amount of change = later year amount - Earlier year amount Percentage change = Amount of change / Earlier year amount Look for significant change www.AssignmentPoint.com
Horizontal Analysis: Trend Percentages Set all amounts in base year at 100% Compute percentages for a number of years Divide each statement amount by respective amount in base year Shows degree of increase or decrease in individual statement items Used to explain changes in operating performance www.AssignmentPoint.com
Vertical Analysis Shows how each item in a financial statement compares to the total of that statement Balance sheet Set both total assets and total equities at 100% Income statement Set net sales at 100% www.AssignmentPoint.com
Vertical Analysis Identify significant dollar and percentage changes Explain the changes Identify whether they are favorable of unfavorable www.AssignmentPoint.com
Ratio Analysis Shows the relative size of one financial statement component to another. Effective only when used in combination with other ratios, analysis, and information www.AssignmentPoint.com
Ratio Analysis Short-term liquidity Long-term solvency Profitability Market performance www.AssignmentPoint.com
Short-term Profitability Current ratio Quick ratio Accounts receivable turnover Days’ sales in receivables Inventory turnover www.AssignmentPoint.com
Current Ratio Current Assets Current Liabilities Common measure of liquidity Ability to pay debts as they come due Rule of thumb 2:1 Consider other factors Current Assets Current Liabilities www.AssignmentPoint.com
Quick Ratio (Acid Test) More strict measure of short-term liquidity Numerator includes only quick current assets Assets readily converted to cash Cash + Short-term investments + Net Current Receivables Current liabilities www.AssignmentPoint.com
Accounts Receivable Turnover How many times we turn accounts receivable into cash during a period Net sales Average net accounts receivable www.AssignmentPoint.com
Days’ Sales in Receivables How many days’ sales remain uncollected in accounts receivable Net sales Net sales per day = 365 days Average net accounts receivable Net sales per day www.AssignmentPoint.com
Inventory Turnover Cost of goods sold Average inventory Number of times the company sells and replaces its inventory during the period Holding inventory results in financing and storage costs Cost of goods sold Average inventory www.AssignmentPoint.com
Long-term Solvency Debt ratio Times Interest Earned www.AssignmentPoint.com
Debt Ratio Total liabilities Total assets Shows amount of total assets creditors provide Higher levels of debt financing means company has a higher risk of not meeting interest and principal payments Total liabilities Total assets www.AssignmentPoint.com
Net income + Income tax expense Times Interest Earned Number of times the company earned interest expense with current income Creditors want to know the firm’s ability to pay annual interest charges Net income + Income tax expense + Interest expense Interest expense www.AssignmentPoint.com
Profitability Profit margin Total asset turnover Return on total assets Return on owners’ equity Earning per share www.AssignmentPoint.com
Profit Margin Net income Net sales Percentage each sales dollar contributes to net income Net income Net sales www.AssignmentPoint.com
Total Asset Turnover Net sales Average total assets Measures the efficiency of the company is using its investment in assets to generate sales Net sales Average total assets www.AssignmentPoint.com
Return on Total Assets Net income Average total assets Measures the amount a company earns on each dollar of investment in assets Net income Average total assets www.AssignmentPoint.com
Return on Owners’ Equity Measures the earnings in relation to the owners’ investment in the company Net income - Preferred dividends Average owner’s equity www.AssignmentPoint.com
Earnings Per Share Net income - Preferred dividends Measures the net income available to each share of common stock Discussed in depth in Chapter 14 Net income - Preferred dividends Weighted average number of common shares outstanding during the year www.AssignmentPoint.com
Market Performance Price/Earnings (P/E) ratio Dividend yield www.AssignmentPoint.com
Price/Earning (P/E) Ratio Number of times earnings per share the stock is currently selling for in the market Market price per share of common stock Earnings per share www.AssignmentPoint.com
Dividend Yield Dividends per share Market price per share Measure of dividend-paying performance of a company Investors buy stock for two reasons Receive cash dividends Sell stock at a higher price Dividends per share Market price per share www.AssignmentPoint.com
Limitations of Financial Analysis Tools Historical nature of accounting information Changing economic conditions Comparisons with industry averages Seasonal factors Quality of reported income www.AssignmentPoint.com