1 © Copyrright Doug Hillman 2000 Analysis and Interpretation of Financial Statements

2 © Copyrright Doug Hillman 2000 Financial Statement Analysis l The application of analytical tools and techniques to financial statement data. l Allows users to focus on how numbers are related and how they have changed over time

3 © Copyrright Doug Hillman 2000 Objective of Financial StatementAnalysis l External users rely on general purpose financial statements l Make predictions about an organization as an aid in making decisions l Users highlight important trends or changes

4 © Copyrright Doug Hillman 2000 Risk and Return l Users try to balance the risk of an investment with its expected return l Generally the greater the risk, the higher the return l Financial statement analysis is one source of information for assessing risk and return

5 © Copyrright Doug Hillman 2000 Sources of External Information l Public companies must publish an annual financial report l Government reports ›SEC 10K, 10Q l Financial service information ›Moody’s, Dow-Jones l Financial newspapers and periodicals ›Wall Street Journal

6 © Copyrright Doug Hillman 2000 Financial Analysis Tools l Horizontal analysis l Vertical analysis l Ratio analysis

7 © Copyrright Doug Hillman 2000 Horizontal Analysis: Amounts and Percentages of Change l Amount of change = later year amount - Earlier year amount l Percentage change = Amount of change / Earlier year amount l Look for significant change

8 © Copyrright Doug Hillman 2000 Horizontal Analysis: Trend Percentages l Set all amounts in base year at 100% l Compute percentages for a number of years ›Divide each statement amount by respective amount in base year l Shows degree of increase or decrease in individual statement items l Used to explain changes in operating performance

9 © Copyrright Doug Hillman 2000 Vertical Analysis l Shows how each item in a financial statement compares to the total of that statement l Balance sheet ›Set both total assets and total equities at 100% l Income statement ›Set net sales at 100%

10 © Copyrright Doug Hillman 2000 Vertical Analysis l Identify significant dollar and percentage changes l Explain the changes l Identify whether they are favorable of unfavorable

11 © Copyrright Doug Hillman 2000 Ratio Analysis l Shows the relative size of one financial statement component to another. l Effective only when used in combination with other ratios, analysis, and information

12 © Copyrright Doug Hillman 2000 Ratio Analysis l Short-term liquidity l Long-term solvency l Profitability l Market performance

13 © Copyrright Doug Hillman 2000 Short-term Profitability l Current ratio l Quick ratio l Accounts receivable turnover l Days’ sales in receivables l Inventory turnover

14 © Copyrright Doug Hillman 2000 Current Ratio l Common measure of liquidity ›Ability to pay debts as they come due ›Rule of thumb 2:1 ›Consider other factors Current Assets Current Liabilities

15 © Copyrright Doug Hillman 2000 Quick Ratio (Acid Test) l More strict measure of short-term liquidity l Numerator includes only quick current assets ›Assets readily converted to cash Cash + Short-term investments + Net Current Receivables Current liabilities

16 © Copyrright Doug Hillman 2000 Accounts Receivable Turnover l How many times we turn accounts receivable into cash during a period Net sales Average net accounts receivable

17 © Copyrright Doug Hillman 2000 Days’ Sales in Receivables l How many days’ sales remain uncollected in accounts receivable Net sales per day = Net sales 365 days Average net accounts receivable Net sales per day

18 © Copyrright Doug Hillman 2000 Inventory Turnover l Number of times the company sells and replaces its inventory during the period l Holding inventory results in financing and storage costs Cost of goods sold Average inventory

19 © Copyrright Doug Hillman 2000 Long-term Solvency l Debt ratio l Times Interest Earned

20 © Copyrright Doug Hillman 2000 Debt Ratio l Shows amount of total assets creditors provide l Higher levels of debt financing means company has a higher risk of not meeting interest and principal payments Total liabilities Total assets

21 © Copyrright Doug Hillman 2000 Times Interest Earned l Number of times the company earned interest expense with current income l Creditors want to know the firm’s ability to pay annual interest charges Net income + Income tax expense + Interest expense Interest expense

22 © Copyrright Doug Hillman 2000 Profitability l Profit margin l Total asset turnover l Return on total assets l Return on owners’ equity l Earning per share

23 © Copyrright Doug Hillman 2000 Profit Margin l Percentage each sales dollar contributes to net income Net income Net sales

24 © Copyrright Doug Hillman 2000 Total Asset Turnover l Measures the efficiency of the company is using its investment in assets to generate sales Net sales Average total assets

25 © Copyrright Doug Hillman 2000 Return on Total Assets l Measures the amount a company earns on each dollar of investment in assets Net income Average total assets

26 © Copyrright Doug Hillman 2000 Return on Owners’ Equity l Measures the earnings in relation to the owners’ investment in the company Net income - Preferred dividends Average owner’s equity

27 © Copyrright Doug Hillman 2000 Earnings Per Share l Measures the net income available to each share of common stock l Discussed in depth in Chapter 14 Net income - Preferred dividends Weighted average number of common shares outstanding during the year

28 © Copyrright Doug Hillman 2000 Market Performance l Price/Earnings (P/E) ratio l Dividend yield

29 © Copyrright Doug Hillman 2000 Price/Earning (P/E) Ratio l 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

30 © Copyrright Doug Hillman 2000 Dividend Yield l Measure of dividend-paying performance of a company l Investors buy stock for two reasons ›Receive cash dividends ›Sell stock at a higher price Dividends per share Market price per share

31 © Copyrright Doug Hillman 2000 Limitations of Financial Analysis Tools l Historical nature of accounting information l Changing economic conditions l Comparisons with industry averages l Seasonal factors l Quality of reported income