The Analysis of Financial Statements Ratios are tools and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison - CEO, R.E.C. Inc. (C) 2007 Prentice Hall, Inc.

Objectives of Analysis Objectives will vary depending on the perspective of the financial statement user specific questions that are addressed by the analysis Remember--the identity of the user helps define what information is needed (C) 2007 Prentice Hall, Inc.

Creditors A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds (C) 2007 Prentice Hall, Inc.

Creditors (cont.) Questions raised in a credit analysis should include: What is the borrowing cause? What is the firm’s capital structure? What will be the source of debt repayment? (C) 2007 Prentice Hall, Inc.

Investors An investor attempts to arrive at an estimation of a company’s future earnings stream in order to attach a value to the securities being considered for purchase or liquidation (C) 2007 Prentice Hall, Inc.

Investors (cont.) The investment analyst poses questions as: How has the firm performed/what are future expectations? How much risk is inherent in the existing capital structure? What are expected returns? What is firm’s competitive position? (C) 2007 Prentice Hall, Inc.

Management Looks to financial statement data to determine: How well the firm has performed and why? What operating areas have contributed to success and which have not? What are strengths/weaknesses of company’s financial position? What changes should be implemented to improve future performance? (C) 2007 Prentice Hall, Inc.

Caution!!! Keep in mind: Management PREPARES financial statements Analyst should be alert to potential for management to influence reporting to make data more “appealing” May want to supplement analysis with other sources of information apart from the Annual Report prepared by management (C) 2007 Prentice Hall, Inc.

Sources of Information The analyst will want to consider the following resources: Proxy Statement Auditor’s Report MD&A Supplementary schedules Form 10-K and Form 10-Q (C) 2007 Prentice Hall, Inc.

Other Sources of Information Computerized data bases Info on industry norms/ratios Info on particular companies/industries Ever-expanding financial and investment websites Articles in popular/business press (C) 2007 Prentice Hall, Inc.

Tools and Techniques These include: Common-size financial statements Financial ratios Trend analysis Structural analysis Industry comparisons Most important: Common sense and judgment (C) 2007 Prentice Hall, Inc.

Common-Size Financial Statements Express each account on the balance sheet as a percentage of total assets income statement as a percentage of net sales (C) 2007 Prentice Hall, Inc.

Key Financial Ratios Standardize financial data in terms of mathematical relationships expressed in the form of Percentages Times Days (C) 2007 Prentice Hall, Inc.

Key Financial Ratios (cont.) Liquidity (Short-term liquidity) Activity Leverage (Long-term solvency) Profitability Market (C) 2007 Prentice Hall, Inc.

Key Financial Ratios (cont.) Five Categories of key financial ratios: Liquidity Ratios Measure a firm’s ability to meet cash needs as they arise (C) 2007 Prentice Hall, Inc.

Key Financial Ratios (cont.) Five Categories of key financial ratios: Activity Ratios Measure the liquidity of specific assets and the efficiency of managing assets (C) 2007 Prentice Hall, Inc.

Key Financial Ratios (cont.) Five Categories of key financial ratios: Leverage Ratios (Long-term solvency) Measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges (C) 2007 Prentice Hall, Inc.

Key Financial Ratios (cont.) Five Categories of key financial ratios: Profitability Ratios Measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity (C) 2007 Prentice Hall, Inc.

Cautions! Ratios are valuable analytical tools and serve as screening devices, BUT. . . They do not provide answers in and of themselves They are not predictive Ratios should be used with other elements of financial analysis There are no “rules of thumb” that apply to the interpretation of ratios (C) 2007 Prentice Hall, Inc.

Liquidity Ratios: Short-Term Solvency Current Ratio Measures ability to meet short-term cash needs Current assets Current liabilities (C) 2007 Prentice Hall, Inc.

Liquidity Ratios: Short-Term Solvency (cont.) Quick or Acid-Test Ratio Measures ability to meet short-term cash needs more rigorously by eliminating inventory Current assets - Inventory Current liabilities (Cash+short-term investments + A/R) current liabilities (C) 2007 Prentice Hall, Inc.

Liquidity Ratios: Short-Term Solvency (cont.) Cash Flow Liquidity Ratio Focuses on ability of the firm to generate operating cash flows as a source of liquidity Cash + Marketable securities + CFO * Current liabilities *Cash flow from operating activities (C) 2007 Prentice Hall, Inc.

Liquidity Ratios (C) 2007 Prentice Hall, Inc.

Activity Ratios: Asset Liquidity, Asset Management Efficiency Accounts Receivable Turnover Another measure of efficiency of firm’s collection and credit policies (C) 2007 Prentice Hall, Inc.

Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Inventory Turnover Another measure of firm’s efficiency in managing its inventory (C) 2007 Prentice Hall, Inc.

Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Payables Turnover Another way to gain insight into a firm’s pattern of payment to suppliers (C) 2007 Prentice Hall, Inc.

Cash Conversion Cycle or Net Trade Cycle The normal cycle of a firm that consists of: Buying or manufacturing inventory, with some purchases on credit Selling inventory, with some sales on credit Collecting the cash (C) 2007 Prentice Hall, Inc.

Cash Conversion Cycle or Net Trade Cycle (cont.) Helps the analyst understand why cash flow generation has improved or deteriorated by analyzing: Key balance sheet accounts that affect cash flow from operating activities Accounts Receivable Inventory Accounts Payable (C) 2007 Prentice Hall, Inc.

Cash Conversion Cycle or Net Trade Cycle (cont.) Calculated as follows: Average collection period Plus Days inventory held Minus Days payable outstanding Equals Cash conversion or net trade cycle (C) 2007 Prentice Hall, Inc.

Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Fixed Asset Turnover Assesses effectiveness in generating sales from investments in fixed assets Net sales Net property, plant, equipment (Average) (C) 2007 Prentice Hall, Inc.

Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Total Asset Turnover Assesses effectiveness in generating sales from investments in all assets Net sales Total assets (Average) (C) 2007 Prentice Hall, Inc.

Activity Ratios- Summary (C) 2007 Prentice Hall, Inc.

Activity Ratios- Summary (C) 2007 Prentice Hall, Inc.

Leverage Ratios: Debt Financing and Coverage Debt Ratio Considers the proportion of all assets that are financed with debt Total liabilities Total assets (C) 2007 Prentice Hall, Inc.

Leverage Ratios: Debt Financing and Coverage (cont.) Long-term Debt to Total Capitalization Reveals the extent to which long-term debt is used for the firm’s permanent financing (both long-term debt and equity) Long–term debt Long-term debt + Stockholders’ equity (C) 2007 Prentice Hall, Inc.

Leverage Ratios: Debt Financing and Coverage (cont.) Debt to Equity Measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity) Total liabilities Stockholders’ equity (C) 2007 Prentice Hall, Inc.

Leverage Ratios: Debt Financing and Coverage (cont.) Times Interest Earned Indicates how well operating earnings cover fixed interest expenses Operating profit Interest expense (C) 2007 Prentice Hall, Inc.

Leverage Ratios: Debt Financing and Coverage (cont.) Cash Interest Coverage Measures how many times interest payments can be covered by cash flow from operations before interest and taxes CFO + interest paid + taxes paid Interest paid (C) 2007 Prentice Hall, Inc.

Leverage Ratios: Debt Financing and Coverage (cont.) Fixed Charge Coverage Broader measure of how well operating earnings cover fixed charges Operating profit + Rent expense Interest expense + Rent expense *Rent expense = operating lease payments (C) 2007 Prentice Hall, Inc.

Leverage Ratios: Debt Financing and Coverage (cont.) Cash Flow Adequacy Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year Cash flow from operating activities Capital expenditures + debt repayments + dividends paid (C) 2007 Prentice Hall, Inc.

Leverage Ratios: Debt Financing and Coverage Summary (C) 2007 Prentice Hall, Inc.

Profitability Ratios: Overall Efficiency and Performance Gross Profit Margin Measures ability to translate sales into profit after consideration of cost of products sold Gross profit Net sales (C) 2007 Prentice Hall, Inc.

Profitability Ratios: Overall Efficiency and Performance (cont.) Operating Profit Margin Measures ability to translate sales into profit after consideration of operating expenses Operating profit Net sales (C) 2007 Prentice Hall, Inc.

Profitability Ratios: Overall Efficiency and Performance (cont.) Net Profit Margin Measures ability to translate sales into profit after consideration of all expenses and revenues, including interest, taxes and nonoperating items Net earnings Net sales (C) 2007 Prentice Hall, Inc.

Profitability Ratios: Overall Efficiency and Performance (cont.) Cash Flow Margin Measures ability to translate sales into cash (with which to pay bills!) Cash flow from operating activities Net sales (C) 2007 Prentice Hall, Inc.

Profitability Ratios: Overall Efficiency and Performance (cont.) Return on Total Assets (ROA) or Return on Investment (ROI) Measures overall efficiency of firm in managing investment in assets and generating profits Net earnings Total assets (Average) (C) 2007 Prentice Hall, Inc.

Relating the Ratios —The Du Pont System Is helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios (C) 2007 Prentice Hall, Inc.

Relating the Ratios —The Du Pont System (cont.) The Du Pont System helps the analyst see how the firm’s decisions and activities over the course of an accounting period interact to produce an overall return to the firm’s shareholders, the return on equity (C) 2007 Prentice Hall, Inc.

Relating the Ratios —The Du Pont System (cont.) The summary ratios used are the following: (1) Net profit margin (2) Total asset turnover (3) Return on investment Net income Net sales Net income Net sales X Total assets = Total assets (3) Return on investment (4) Financial leverage (5) Return on equity Net income Total assets Net income Total assets X Stockholder equity = Stockholder equity (C) 2007 Prentice Hall, Inc.

Profitability Ratios: Overall Efficiency and Performance (cont.) Return on Equity (ROE) Measures rate of return on stockholders’ investment Net earnings Stockholders’ equity (Average) (C) 2007 Prentice Hall, Inc.

Profitability Ratios: Overall Efficiency and Performance (cont.) Cash Return on Assets Measures firm’s ability to generate cash from the utilization of its assets Useful comparison to ROA Cash flow from operating activities Total assets (Average) (C) 2007 Prentice Hall, Inc.

Profitability Ratios-Summary (C) 2007 Prentice Hall, Inc.

Profitability Ratios-Summary (C) 2007 Prentice Hall, Inc.

Market Ratios Four market ratios of particular interest to the investor are Earnings per common share Price-to-earnings Dividend payout Dividend yield (C) 2007 Prentice Hall, Inc.

Average shares outstanding Market Ratios (cont.) Earnings per Common Share Provides the investor with a common denominator to gauge investment returns Net earnings Average shares outstanding (C) 2007 Prentice Hall, Inc.

Market price of common stock Market Ratios (cont.) Price-to-Earnings Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings Market price of common stock Earnings per share (C) 2007 Prentice Hall, Inc.

Market Ratios (cont.) Dividend Payout Determined by the formula cash dividends per share divided by earnings per share Dividends per share Earnings per share (C) 2007 Prentice Hall, Inc.

Market price of common stock Market Ratios (cont.) Dividend Yield Shows the relationship between cash dividends and market price Dividends per share Market price of common stock (C) 2007 Prentice Hall, Inc.

Market Ratios (C) 2007 Prentice Hall, Inc.

Five Steps of a Financial Statement Analysis Establish objectives of the analysis Who are you and why are you interested in this company? What questions would you like to have answered? What info is vital to the decision at hand? (C) 2007 Prentice Hall, Inc.

Five Steps of a Financial Statement Analysis (cont.) Study the industry in which the firm operates and relate industry climate to current and projected economic developments (C) 2007 Prentice Hall, Inc.

Five Steps of a Financial Statement Analysis (cont.) Develop knowledge of the firm and the quality of management How well does this firm appear to be run? Are they taking advantage of opportunities? Are they innovative, forward-looking, etc? (C) 2007 Prentice Hall, Inc.

Five Steps of a Financial Statement Analysis (cont.) Evaluate financial statements–tools include: Common-size financial statements Key financial ratios Trend analysis Structural analysis Comparison with industry competitors (C) 2007 Prentice Hall, Inc.

Five Steps of a Financial Statement Analysis (cont.) Evaluate financial statements–areas include: Short-term liquidity Operating efficiency Capital structure and long-term solvency Profitability Market ratios Segmental analysis (when relevant) Quality of financial reporting (C) 2007 Prentice Hall, Inc.

Five Steps of a Financial Statement Analysis (cont.) Summarize findings based on analysis Reach conclusions about the firm relevant to your established objectives (C) 2007 Prentice Hall, Inc.

What we have accomplished Turned Maze Auditor’s Report MD&A Notes Statement of Cash Flows Income Statement Statement of Shareholders’ Equity Balance Sheet (C) 2007 Prentice Hall, Inc.

Financial Statements An Overview Map (C) 2007 Prentice Hall, Inc.