Financial Statements according to GAAP Income Statement (Statement of Operations) –Shows profitability for a period of time –A summary statement of revenues, expenses, gains, and losses –Must follow GAAP (financial accounting standards) –Subject to much judgment by management and CPAs –Traditionally, bottom-line earnings from income statements represented primary stock price drivers –Currently, the move is on in the accounting profession to distinguish appropriately between earnings and “quality” earnings

The Balance Sheet (Financial Position) Determines Solvency Position of an organization on a given date –Assets (Resources): Future economic value owned or controlled by the organization Current:--Cash and near cash assets Non-current—Relatively permanent assets used to generate revenue –Liabilities (Debts): Future claims by outsiders on assets of the organization Current—Due in the near future Long-term—Due at least one year from the balance sheet date –Stockholders’ Equity—Owners’ claim to organization resources

Statement of Cash Flows Summarizes cash inflows and (outflows) for a period of time –Includes all cash inflows (outflows) regardless of source or use –Categories of cash flows Operating Activities: Shows cash flows from operating income (from income statement) Investing Activities: Shows cash flows to investments and from sales of investments Financing Activities: Shows cash flows from borrowing and sales of original equity issues and subsequent pay back of loans, equity re-acquisitions, and dividends

Sources of Financial Analysis Tools Finance and Accounting Texts Dess-Lumpkin Text pp Stickney-Brown Text (5th Ed) Handout Link in your tentative schedule (Best Source) –Uses averages instead of end-of-year figures where appropriate and cost of goods sold instead of sales in inventory turnover calculations –Emphasizes DuPont Model for R.O.I. calculations –More cash flow analyses included

Financial Statement Analysis Profitability Analysis –Return on Investment (ROI) Return / Average Investment –DuPont Model Return / Sales X Sales / Average Investment Sales Margin X Asset Turnover –Return on Equity (ROE) Return / Average Stockholders’ Equity –Others: PE Ratio; Dividend Yield; Dividend Payout –Also be sure to compare your company stock price trend with some of the major price indices.

Why We Use Averages in Denominators Assume Total Assets at Beginning of Year = $500 –At July 1, we acquire $500 in new plant assets –Net income (return on investment) for year is $50 If we use asset value at end of year –ROI =.05 ($50/ $1,000) If we use average asset value –ROI =.067 ($50/ ($ ,000)/2 Use of average assets gives a more accurate annual return on your investment (The $50 was earned during the last six months of the year)

Advantage of Using DuPont Model Identifies cause of change in ROI from year to year Uses the product of two intermediate calculations for sales margin (efficiency measure) and asset turnover (effective utilization of assets to generate revenue) Assume the following information as an example Year 01: Net Income-$50; Average Assets-$800; Sales-$1,000 Year 02: Net Income-$50; Average Assets-$1,000; Sales-$2,000

Calculation of ROI Both Methods Year 01 Year 02 Regular $50/$800 =.0625 $50/$1,000=.05 DuPont 50/1,000 * 1,000/800 50/2,000 * 2000/ * 1.25 =.025 * 2 =

Liquidity Analysis Working Capital –Working Capital =$Current Assets –$ Current Liabilities –Current Ratio = Current Assets / Current Liabilities –Acid Test Ratio = Cash, Temporary Investments and Receivables / Current Liabilities Cash and Equivalents –Cash Flow Adequacy –Debt Coverage (Debt Payback) –Operations Index –Others include Reinvestment ratio, cash flow to sales, and cash flow return on average assets

Activity and Efficiency Measures Property-Plant-Equipment Turnover Inventory Turnover (Day’s sales in inventory) Accounts Receivable Turnover (Days sales in accounts receivable)

Financial Leverage Analysis Debt Ratio Debt to Equity Ratio Times Interest Earned Times Interest Covered by Cash Flow from Operating Activities Wisely used outside capital injections greatly improve owners’ return on equity Unwise use of outside capital adds burdensome fixed costs and contribute to increased risk of the organization

WHY FINANCIAL ANALYSIS? Solvency Evaluation (Short-range and Long-range) Changes in Company Value (Owner’s net worth) Earnings and Quality of Earnings Trend Management Efficiency Utilization and Control of Organization Resources (Assets) Cash Generation Efficiency of Organization Risk Assessment