Analyzing financial statements Accounting ii

How a business discloses information about how it is doing financially Financial Statements How a business discloses information about how it is doing financially Government (SEC) requires certain reports for public companies (including an auditor’s report) Investors – use to make investment decisions SEC = Securities and Exchange Commission – government commission that regulates securities (stock) markets and protects investors.

Public v. Private Companies Public – stock is traded on a major stock exchange (AMEX, NASDAQ). Can sell stock to raise money (capital), but must answer to stockholders. Must disclose financial information

Public v. Private Private – privately held; owners are usually the founders of the company or their descendants, or a group of private investors. Can’t sell stock to raise cash, but do not have to answer to stockholders and do not have to disclose financial information.

Annual Reports Companies must file an annual report with the SEC 10-K (quarterly reports are less detailed – 10-Q) Available on-line

Financial statements Balance Sheet – Assets = Liabilities + Owner’s Equity Income Statement -- Profits = Revenue - Expenses

Analyzing Financial Statements Horizontally – between companies and across industries Vertically – using ratios (mathematical expressions that relate one number to another Trend – time–series analysis; look at historical data; compare data over time

Apples to apples (e.g., similar companies) Horizontally Apples to apples (e.g., similar companies) “Benchmarking” – comparing to other companies

Vertically Activity Liquidity Solvency Profitability

How efficiently a company uses its assets Inventory turnover Activity How efficiently a company uses its assets Inventory turnover Asset turnover “Turnover” relates a IS item to a Balance Sheet item

Inventory turnover COGS_____ Average Inventory The higher the ratio, the faster the rate that inventory is sold; less company resources are tied up inventory COGS = cost of goods sold (expense item)

Formula = net revenue / average total assets Asset Turnover Formula = net revenue / average total assets How efficiently a business uses its total assets to generate revenue Low turnover = inefficient OR capital intensive (rather than labor intensive Capital intensive business – require a lot of capital to operate, e.g., airlines, auto manufacturers, drillers; Labor intensive - require a lot of labor to operate (restaurants, hotels, agriculture, mining). Net revenue: Capital costs are considered fixed, while labor is variable

Liabilities Liquidity Current Ratio Formula: Current Assets / Current Liabilities Indicates if the company can pay off short-term liabilities by liquidating current assets

Solvency Calculate Working Capital – Formula: Current Assets – Current Liabilities

Profitability Gross Profit Ratio (Margin) Formula = Gross Profit (income) /Net Income Revenues = all the money a company brought in during the time period Gross Profit = Revenue - COGS COGS = cost of goods sold; -- expenses most directly related to creating revenue

Profitability Operating Profit Ratio (Margin) = Operating Income / Net revenue Operating Income = gross income less operating expenses (e.g., administrative expenses – “overhead” – can’t be attributed to single product units Looks at sales v. management-controlled costs; should be consistent

Profitability Net Profit Ratio (Margin) = Net Income (“bottom line”) / Revenue Shows the ability to translate sales into earnings – should be consistent

Return on Equity Formula: Net Income / average stockholder’s equity (for the same time period) Looks at level of income attributed to shareholders, against their investment

Return on Assets Net Income / Total Assets Measures how efficiently the company uses its assets. A high ratio means that the company is able to operate efficiently