Chapter 5: Using Financial Statement Information

Control and Prediction Financial accounting numbers are useful in two fundamental ways: They help investors and creditors influence and monitor the business decisions of a company’s managers. They help to predict a company’s future earnings and cash flows.

Book Value vs. True Value Financial statements do not reflect the company’s prospects within its business environment Statements are backward looking, not focusing on the future prospects. Financial statements are inherently limited Statements leave out some current and historical information such as human resources and the effects of inflation. Management prepares the financial statements in a biased manner Managers often choose accounting methods and estimates that make them look good.

Framework for Financial Statement Analysis Book Value Add adjustments for: (1) business environment (2) unrecorded events (3) management bias = True Value

Five Steps of Financial Statement Analysis Assessing the business environment. Reading and studying the financial statements and footnotes. Assessing earnings quality. Analyzing the financial statements. Predicting future earnings and/or cash flow.

Assessing the Business Environment What is the nature of the company’s operations? What strategy is being employed to generate profits? What is the company’s industry? Who are the major players? Competition? What are the relationships between the company and its customers and suppliers? How are the company’s sales and profits affected by changes in the economy?

Reading and Studying the Financial Statements and Notes Read the audit report. Identify significant transactions major acquisitions, discontinuance or disposal of a business segment, unresolved litigation, major write-downs of receivables or inventories, etc. Read the financial statements and footnotes.

Assessing Earnings Quality Earnings quality may be affected by a number of strategies managers use to influence accounting numbers. Four major strategies are discussed: Overstating operating performance Taking a bath Creating hidden reserves Employing off-balance-sheet financing

Assessing Earnings Quality Overstating operating performance through the acceleration of recognition of revenue - shift the timing of revenue from a future period to the current period, through legitimate or questionable activities. Overstating operating performance through the allocation and estimation of expenses - shift the recognition of expenses through the use of “taking a bath” and “creating hidden reserves.”

Assessing Earnings Quality Taking a bath (also called “big bath”) - large losses and expenses this year may increase income in future years. Rationale: if the current year is going to be disappointing to investors anyway, increase the loss to make next year look better. For example: Excessive write downs of equipment will lead to lower depreciation expense in future years. Excessive write down of inventory will lead to lower cost of goods sold next year.

Assessing Earnings Quality Creating hidden reserves - expenses may be shifted from one year to another year by overestimating expense accrual. Excessive bad debt expense or warranty expense in the current year will lead to reduced estimates in future years, as the “reserve” is used up. Note that these “reserves” have nothing to do with cash reserves; they simply reserve some of the “income” to future periods.

Assessing Earnings Quality Employing off-balance-sheet financing - this relates to certain economic transactions that are not reflected in the balance sheet. Managers prefer to keep certain liabilities off the balance sheet when GAAP permits it, primarily because of potential debt covenant violations, and because of the effect on certain ratios. Examples include: treatment of leases as operating leases (Radio Shack) unconsolidated investments (Enron’s “partnerships”) which do not separate assets from liabilities.

Analyzing the Financial Statements Comparisons across time Comparisons within the industry Comparisons within the financial statements: common-size statements and ratio analysis Profitability ratios Leverage ratios Solvency ratios Asset turnover ratios Market ratios

Comparisons Across Time Financial accounting numbers can be made more meaningful if they are compared across time. GAAP require side-by-side comparison of the current and the preceding years in published financial reports.

Comparisons Within the Industry Financial accounting numbers can also be made more meaningful if they are compared to those of similar companies. Comparison of financial accounting numbers with industry averages is also helpful. Sources of industry information include: Dun & Bradstreet Robert Morris Associates Moody Standard & Poor

Comparisons Within the Financial Statements Common-size financial statements Ratio analysis Profitability ratios Leverage ratios Solvency ratios Asset turnover ratios Market ratios

Common-Size Income Statement for La-Z-Boy, Inc. (Figure 5-2) Income Statement (in millions) 2003 % 2002 % Net sales $2,112 100 $2,154 100 Cost of sales (1,617) 77 (1,692) 79 Expenses and charges (459) 21 (400) 18 Net income $ 36 2 $ 62 3 On the income statement, cost of goods sold, expenses, and net income are often expressed as percentages of net sales. On the balance sheet, assets and liabilities can be expressed as percentages of total assets.

Profitability Ratios These ratios are designed to measure a firm’s earnings power. Net income, the primary measure of the overall success of a company, is compared to other measures of financial activity or condition to assess performance as a percent of some level of activity or investment.

Profitability Ratios Return on Net Income Equity Average Stockholders’ Equity This ratio measures the effectiveness at managing capital provided by the shareholders.

Profitability Ratios Return on Net Income + Interest Expense (1-tax rate) Assets Average Total Assets This ratio measures the effectiveness at managing capital provided by all investors (stockholders and creditors).

Profitability Ratios Return on Net Income + Interest Expense (1-tax rate) Sales Net Sales This ratio provides an indication of a company’s ability to generate and market profitable products and control its costs; also called the Profit Margin.

Leverage Ratios Leverage refers to using borrowed funds to generate returns for stockholders. Leverage is desirable because it creates returns for stockholders without using any of their money. Leverage increases risk by committing the company to future cash obligations.

Leverage Ratios Common Net Income Equity Net Income + Interest Expense (1-tax rate) Leverage This ratio compares the return available to the stockholders to returns available to all capital providers.

Leverage Ratios Capital Average Total Assets Structure Average Stockholders’ Equity Leverage This ratio measures the extent to which a company relies on borrowings (liabilities).

Leverage Ratios Debt to Equity Average Total Liabilities Ratio Average Stockholders’ Equity This ratio compares liabilities to stockholders’ equity and is another measure of capital structure leverage.

Leverage Ratios Long-term Long-Term Debt Debt Ratio Total Assets This ratio measures the importance of long-term debt as a source of asset financing.

Solvency Ratios Solvency refers to a company’s ability to meet its current debts as they come due. There is pressure on companies with high levels of leverage to manage their solvency.

Solvency Ratios Current Current Assets Ratio Current Liabilities This ratio measures solvency in the sense that current assets can be used to meet current liabilities.

Solvency Ratios Quick Cash + Marketable Securities + A/R Ratio Current Liabilities Similar to the current ratio, this ratio provides a more stringent test of a company’s solvency.

Solvency Ratios Interest Net Income + Tax Expense + Interest Expense Coverage Interest Expense This ratio compares the annual funds available to meet interest to the annual interest expense.

Solvency Ratios Accounts Cost of Goods Sold Payable Average Accounts Payable Turnover This ratio measures the extent to which accounts payable is used as a form of financing.

Asset Turnover Ratios Asset turnover ratios are typically computed for total assets, accounts receivable, inventory, and fixed assets. These ratios measure the speed with which assets move through operations or reflect the number of times during a given period that these specific assets are acquired, used, and replaced.

Asset Turnover Ratios Receivables Net Credit Sales Turnover Average Accounts Receivable This ratio reflects the number of times the trade receivables were recorded, collected, and recorded again during the period.

Asset Turnover Ratios Inventory Cost of Goods Sold Turnover Average Inventory This ratio measures the speed with which inventories move through operations.

Asset Turnover Ratios Fixed Assets Sales Turnover Average Fixed Assets This ratio measures the speed with which fixed assets are used up.

Asset Turnover Ratios Total Asset Sales Turnover Average Total Assets This ratio measures the speed with which all assets are used up in operations.

Market Ratios These additional ratios are used by the financial community to assess company performance.

Market Ratios Earnings Net Income per Average Number of Common Shares Share Outstanding This ratio, according to the financial press, is the primary measure of a company’s performance. It calculates the amount of income that is earned for each shareholder.

Market Ratios Price/Earnings Market Price per Share Ratio Earnings per Share This ratio is used by many analysts to assess the investment potential of common stocks.

Market Ratios Dividend Yield Dividends per Share Ratio Market Price per Share This ratio indicates to cash return on the stockholders’ investment.

Market Ratios Stock Market Price1 - Market Price0 + Dividends Return This ratio measures the pretax performance of an investment in a share of common stock.

Solvency Assessment (Figure 5A-3) Ability to Generate Cash Cash Requirements Operating Performance Operating Revenue Sale of Goods Sale of Service Creation of Operating Receivables (timing difference) Cash Inflows from Operations Operating Costs Cost of Goods Sold Operating Expense Creation of Operating Payables (timing difference) Cash Outflows from Operations Financial Flexibility and Liquidity Ability to create short-term debt Ability to create long-term debt Ability to issue equity Ability to liquidate assets Payments for short-term debt Payments for long-term debt Payments for dividends Payments for asset replacement Timing of Cash Inflows Timing of Cash Outflows