Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws Chapter 5 Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Chapter 5: Illustrates a comprehensive analysis Integrates material from previous chapters Adds new resources Offers a toolbox of analytical techniques Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

From the Tools & Techniques Presented. . . Readers can choose what to use to meet specific objectives Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

The 1st Step in Evaluating a Firm’s Financial Reports is to. . . Specify the objectives of the analysis Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

An Investor Decides whether to buy, hold, or sell a firm’s security Uses a company’s historical financial information to estimate future potential & value Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

A Creditor Determines borrowing need Assesses firm’s ability to service debt Evaluates source of debt repayment Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Managers & Directors Address questions relevant to investors & creditors Satisfy other user groups: employees competitors suppliers Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Managers & Directors Continued: Consider responses to financial reports by: general public regulators financial press Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Financial Reporting Environment Is often adversarial: management wants to present most positive picture possible users want picture that represents financial reality Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Sources of Information Primary Sources Four financial statements Financial statement notes Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Sources of Information Continued: 10-K report: annual report filed with SEC 10-Q reports: quarterly (unaudited) reports filed with SEC Proxy statement: required by SEC prior to shareholders meetings Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Sources of Information Continued: Auditor’s Reports “Independent” reports expressing opinion about fairness of financial statement presentation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Sources of Information Continued: Management Discussion & Analysis Section in annual report monitored by SEC which covers firm’s: liquidity capital resources operations Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Sources of Information Continued: Supplementary Schedules Selected financial data on: segments (unrelated lines of business) operations outside U.S. Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Sources of Information Continued: Resources: computerized search systems & data bases comparative statistical ratios research provided by independent services financial press financial analysis spreadsheet packages Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

More Resources Common size balance sheet: expresses all items as a percentage of total assets Common size income statement: expresses all items as percentage of total sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

More Resources Continued: Summary Analysis of Cash Flows: Separates cash inflows & outflows in dollar & percentage terms Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Tools & Techniques Financial Ratios Standardize financial statement data Mathematical relationships expressed in percent or times Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Tools & Techniques Continued: Trend analysis evaluates financial data over several accounting periods Structural analysis considers the internal composition of a firm Industry comparisons relate one firm with averages compiled for industry in which it operates Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Tools & Techniques Continued: What’s most important? Common sense & judgement Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Financial Ratios Use as screening devices Use with caution: they don’t supply answers Use with other analytical tools Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Financial Ratios Continued: Look behind ratio that is out of line to determine cause There is no standardized set of ratios or definitions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Liquidity Ratios Measure short-run solvency: the ability of firm to meet debt payments as they come due Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Liquidity Ratios Continued: Current ratio: Current assets Current liabilities Quick ratio: Current assets - inventory Current liabilities Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Liquidity Ratios Continued: Cash flow liquidity ratio: Cash + Market Securities + Cash flow from operations Current liabilities Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Liquidity Ratios Continued: Average collection period: Accounts receivable Average daily sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Liquidity Ratios Continued: Days inventory held: Inventory Average daily cost of sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Liquidity Ratios Continued: Days payable outstanding: Accounts payable Average daily cost of sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Net Trade Cycle Average collection period + days inventory held - days payable outstanding Measures normal cash conversion cycle of firm Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Activity Ratios Measures liquidity of assets & asset management efficiency Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Activity Ratios Continued: Accounts receivable turnover: Net sales Accounts receivable Inventory turnover: Cost of goods sold Inventory Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Activity Ratios Continued: Payables turnover: Cost of goods sold Accounts payable Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Activity Ratios Continued: Fixed asset turnover: Net sales Net property, plant, equipment Total asset turnover: Net sales Total assets Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Leverage Ratios Measures debt financing & debt coverage Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Leverage Ratios Continued: Debt ratio: Total liabilities Total assets Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Leverage Ratios Continued: Long-term debt to total capitalization: Long-term debt Long-term debt + stockholders’ equity Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Leverage Ratios Continued: Debt to equity: Total liabilities Stockholders’ equity Times interest earned: Operating profit Interest expense Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Leverage Ratios Continued: Cash interest coverage: Cash flow from operations + interest paid + taxes paid Interest paid Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Leverage Ratios Continued: Fixed charge coverage: Operating profit + rent expense Interest expense + rent expense Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Leverage Ratios Continued: Cash flow adequacy: Cash flow from operations Capital expenditures + debt repayments + dividends paid Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Profitability Ratios Measures overall efficiency & performance Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Profitability Ratios Continued: Gross profit margin: Gross profit Net sales Operating profit margin: Operating profit Net sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Profitability Ratios Continued: Net profit margin: Net profit Net sales Cash flow margin: Cash flow from operations Net sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Profitability Ratios Continued: Return on assets (investment): Net profit Total assets Return on equity: Net profit Stockholders’ equity Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Financial Leverage: Use of Debt Magnifies returns to shareholders when company earns more than after-tax cost of debt Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Financial Leverage: Double-edged Sword Produces negative effects on returns when company earns less than after-tax cost of debt Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Profitability Ratios Continued: Cash return on assets: Cash flow from operations Total assets Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Net income Weighted average number of common shares outstanding Market Ratios Basic earnings per share: Net income Weighted average number of common shares outstanding Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Market Ratios Continued: Dividend yield: Cash dividends per share Year-end market price of common stock Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Market Ratios Continued: Price to earnings ratio: Market price of common stock Basic earnings per share Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Additional Information that is Useful Financial data provided for operating segment (unrelated lines of business) Financial data provided for operations outside of U.S. Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Comprehensive Analysis Includes many steps & interrelated pieces No one step or piece should be interpreted in isolation from the other parts Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Final Steps of Analysis Integrate the separate steps & pieces Reach overall conclusions about the firm’s financial condition performance future prospects Make sound financial decisions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Caution Flags Changes in top company management Key financial ratios indicating deteriorating trends and/or weakness relative to industry competitors Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

More Caution Flags Cash flow from operating activities are: declining negative volatile not tracking with net income Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Even More Caution Flags Lack of profitability in key operating areas Low price to earnings ratio relative to competitors Firm’s earnings less than after-tax cost of debt Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

Final Caution Flags Operating profits declining when debt is rising Deteriorating trends in operating segments Assuming authors are wealthy because they make wise business decisions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing