1 Financial Statement Analysis CHAPTER F12 © 2007 Pearson Custom Publishing

2 Identify the three major categories of users of financial statement analysis and describe the objectives of each. Learning Objective 1: © 2007 Pearson Custom Publishing

3 Financial Statement Analysis Financial statement analysis is just what you would think it is: analyzing the information presented in a firm’s financial statements. Financial statement analysis is just what you would think it is: analyzing the information presented in a firm’s financial statements. Two major techniques are trend analysis and ratio analysis. Two major techniques are trend analysis and ratio analysis. © 2007 Pearson Custom Publishing

4 Who Performs Financial Statement Analysis? Financial statement analysis is routinely performed by: Financial statement analysis is routinely performed by: 1) Creditors (short term and long term) 1) Creditors (short term and long term) 2) Equity investors (current and potential) 2) Equity investors (current and potential) 3) Company management 3) Company management © 2007 Pearson Custom Publishing

5 Objectives of Creditors Short-term creditors, both trade creditors and lending institutions, are primarily concerned with the firm’s ability to pay its bills in a timely fashion. Short-term creditors, both trade creditors and lending institutions, are primarily concerned with the firm’s ability to pay its bills in a timely fashion. Long-term creditors are concerned with the firm’s long-term ability to repay any loan amounts (including bonds) as well as the interest on that debt. Long-term creditors are concerned with the firm’s long-term ability to repay any loan amounts (including bonds) as well as the interest on that debt. © 2007 Pearson Custom Publishing

6 Investors are concerned with many things, but probably the most important consideration is the company’s ability to generate income in the future. Investors are concerned with many things, but probably the most important consideration is the company’s ability to generate income in the future. Profitable operations for the company usually translate into dividends and stock price appreciation for the investors. Profitable operations for the company usually translate into dividends and stock price appreciation for the investors. Objectives of Equity Investors © 2007 Pearson Custom Publishing

7 Members of management have the responsibility of leading the firm through the day-to-day activities. The results of these activities are reflected in the financial statements. Members of management have the responsibility of leading the firm through the day-to-day activities. The results of these activities are reflected in the financial statements. Thus, management has two main concerns regarding financial statement analysis: 1) to present the information in the most favorable light, and 2) to monitor the overall performance. Thus, management has two main concerns regarding financial statement analysis: 1) to present the information in the most favorable light, and 2) to monitor the overall performance. Objectives of Management © 2007 Pearson Custom Publishing

8 Gather information to evaluate the political climate and general economic conditions and describe the ways in which each can affect business. Learning Objective 2: © 2007 Pearson Custom Publishing

9 Gathering Background Information - A First Step To properly analyze the firm’s financial statements, it is necessary to understand the environment in which the firm operates. In particular: To properly analyze the firm’s financial statements, it is necessary to understand the environment in which the firm operates. In particular: the general economic conditions or expectations, the general economic conditions or expectations, the political events and political climate, and the political events and political climate, and the industry outlook. the industry outlook. © 2007 Pearson Custom Publishing

10 General Economic Conditions and Expectations Another factor to consider in predicting the future financial performance of a company would be the current condition of the general economy and your expectations about the future of the economy. Another factor to consider in predicting the future financial performance of a company would be the current condition of the general economy and your expectations about the future of the economy. Companies in certain industries would be affected more than others when an economic downturn (or upswing) occurs. Companies in certain industries would be affected more than others when an economic downturn (or upswing) occurs. © 2007 Pearson Custom Publishing

11 Political Events and Political Climate Additional external factors that will have an influence on a company’s financial performance are the political events and the general political climate. Additional external factors that will have an influence on a company’s financial performance are the political events and the general political climate. Congressional actions often affect the financial performance through changes in the tax code, environmental actions, or reductions in governmental spending. Congressional actions often affect the financial performance through changes in the tax code, environmental actions, or reductions in governmental spending. © 2007 Pearson Custom Publishing

12 Industry Outlook A third external factor is the general outlook for the industry in which the firm operates. A third external factor is the general outlook for the industry in which the firm operates. For example, technology-based companies were hot in the late 1990s but many failed by 2001, while the increase in the federal defense budget has increased steadily since For example, technology-based companies were hot in the late 1990s but many failed by 2001, while the increase in the federal defense budget has increased steadily since Can you guess what industry will be the most successful in 2017? Can you guess what industry will be the most successful in 2017? © 2007 Pearson Custom Publishing

13 Locate sources of information about specific industries. Learning Objective 3: © 2007 Pearson Custom Publishing

14 Sources of Industry Information Library Sources: Library Sources: Standard and Poor’s Industry Survey Standard and Poor’s Industry Survey Mergent Industry Review Mergent Industry Review Value Line Industry Survey Value Line Industry Survey Business Press: Business Press: Wall Street Journal Wall Street Journal Business Week Business Week Fortune Fortune Forbes Forbes Internet Sources: (Beware of the integrity of the source.) Internet Sources: (Beware of the integrity of the source.) Trade Associations Trade Associations © 2007 Pearson Custom Publishing

15 Describe the purpose of trend analysis and ratio analysis and explain the three primary characteristics it helps users evaluate. Learning Objective 4: © 2007 Pearson Custom Publishing

16 Trend Analysis Trend analysis is a particular type of financial statement analysis where key financial figures are analyzed over time to see if there is a pattern of change. Trend analysis is a particular type of financial statement analysis where key financial figures are analyzed over time to see if there is a pattern of change. Trend analysis can often be effectively illustrated through the use of graphs or charts. Trend analysis can often be effectively illustrated through the use of graphs or charts. © 2007 Pearson Custom Publishing

17 Ratio Analysis Ratio analysis is a particular type of financial statement analysis where the relationship between two or more items from the financial statements is analyzed. Ratio analysis is a particular type of financial statement analysis where the relationship between two or more items from the financial statements is analyzed. A particular ratio might include information from various sources, including information not typically contained in the financial statements, such as market price of a stock. A particular ratio might include information from various sources, including information not typically contained in the financial statements, such as market price of a stock. © 2007 Pearson Custom Publishing

18 Profitability ratios Profitability ratios Liquidity ratios Liquidity ratios Solvency ratios Solvency ratios Major Categories of Ratio Analysis © 2007 Pearson Custom Publishing

19 Calculate financial ratios designed to measure a company’s profitability, liquidity, and solvency. Learning Objective 5: © 2007 Pearson Custom Publishing

20 Measuring Profitability Profitability refers to the company’s ability to generate income. Profitability ratios are used to measure a firm’s past performance and to aid in the prediction of future profits. Profitability refers to the company’s ability to generate income. Profitability ratios are used to measure a firm’s past performance and to aid in the prediction of future profits. Most business people agree that long-term profits are more important than short-term profits, yet most of the commonly used ratios focus on short-term profitability. Most business people agree that long-term profits are more important than short-term profits, yet most of the commonly used ratios focus on short-term profitability. © 2007 Pearson Custom Publishing

21 Measuring Profitability Commonly used measures include: Commonly used measures include: Return on assets ratio Return on assets ratio Profit margin before income tax Profit margin before income tax Total asset turnover Total asset turnover Profit margin after income tax Profit margin after income tax Return on equity Return on equity Return before taxes on equity Return before taxes on equity © 2007 Pearson Custom Publishing

22 Return on Assets Ratio Net income before income taxes Total assets One measure of return on investment. This is a measurement of how efficiently the company’s assets are used to generate profits. One measure of return on investment. This is a measurement of how efficiently the company’s assets are used to generate profits. © 2007 Pearson Custom Publishing

23 Return on Assets Ratio The return on assets can be broken down into two component parts: The return on assets can be broken down into two component parts: the profit margin before income tax, and the profit margin before income tax, and the total asset turnover. the total asset turnover. This might be abbreviated as follows: This might be abbreviated as follows: ROA = Margin X Turnover ROA = Margin X Turnover © 2007 Pearson Custom Publishing

24 Profit Margin Before Income Tax Ratio Net income before taxes Net income before taxes Sales Sales This ratio measures the income produced as a percentage from each dollar of sales revenue. This ratio measures the income produced as a percentage from each dollar of sales revenue. © 2007 Pearson Custom Publishing

25 Total Asset Turnover Ratio Sales Total assets Sales Total assets An analysis of the amount of sales (instead of income) generated through the effective use of the investment in assets. An analysis of the amount of sales (instead of income) generated through the effective use of the investment in assets. © 2007 Pearson Custom Publishing

26 4 Compare the return on assets for the following two firms: A jewelry store with a 30% profit margin and an asset turnover of.6, and a grocery store with a 4% profit margin and an asset turnover of 5.0: 4 Jewelry: 30% X.6 = 18% ROA  Grocery: 4% X 5.0 = 20% ROA ROA Comparisons © 2007 Pearson Custom Publishing

27 Profit Margin After Income Tax Ratio Net income after taxes Sales Net income after taxes Sales Use after-tax income instead of before- tax. Some people argue that since taxes are a normal expense, the effect of income taxes should be included. Use after-tax income instead of before- tax. Some people argue that since taxes are a normal expense, the effect of income taxes should be included. © 2007 Pearson Custom Publishing

28 Return on Equity Ratio Net income after taxes Equity Net income after taxes Equity This ratio measures the profitability on the amount of investment by the company owners rather than the total investment in assets. This ratio measures the profitability on the amount of investment by the company owners rather than the total investment in assets. © 2007 Pearson Custom Publishing

29 Return Before Taxes on Equity Ratio Net income before taxes Equity Net income before taxes Equity We are measuring the earnings generated for the owners before considering the cost of taxes. We are measuring the earnings generated for the owners before considering the cost of taxes. © 2007 Pearson Custom Publishing

30 Measuring Liquidity Liquidity (in this context) refers to the company’s ability to generate cash as needed to pay its short-term obligations. Liquidity (in this context) refers to the company’s ability to generate cash as needed to pay its short-term obligations. Short-term creditors (current and potential) are particularly concerned with a company’s liquidity measures. Short-term creditors (current and potential) are particularly concerned with a company’s liquidity measures. Liquidity measures focus on the “liquidity of the assets” available to the company. Liquidity measures focus on the “liquidity of the assets” available to the company. © 2007 Pearson Custom Publishing

31 Measuring Liquidity Commonly used measures include: Commonly used measures include: Current ratio Current ratio Quick ratio Quick ratio Receivables turnover Receivables turnover Inventory turnover Inventory turnover © 2007 Pearson Custom Publishing

32 Current Ratio Current assets Current liabilities Current assets Current liabilities This ratio is a comparison of the level of current assets available to pay the current liabilities. This is a very widely used ratio. This ratio is a comparison of the level of current assets available to pay the current liabilities. This is a very widely used ratio. © 2007 Pearson Custom Publishing

33 Quick Ratio Cash + Accounts & notes receivable Current liabilities Also called the acid-test ratio, this is a more stringent measure of liquidity. The focus is placed on the “quick assets,” those that can be quickly turned into cash. Also called the acid-test ratio, this is a more stringent measure of liquidity. The focus is placed on the “quick assets,” those that can be quickly turned into cash. © 2007 Pearson Custom Publishing

34 Receivables Turnover Ratio Sales Accounts receivable Sales Accounts receivable A measurement of how quickly a company collects their accounts receivable. The higher the turnover, the more quickly the receivables are being collected. A measurement of how quickly a company collects their accounts receivable. The higher the turnover, the more quickly the receivables are being collected. © 2007 Pearson Custom Publishing

35 Inventory Turnover Ratio Cost of sales Inventory Cost of sales Inventory A measurement of how many times total merchandise inventory is purchased and sold during an accounting period. A measurement of how many times total merchandise inventory is purchased and sold during an accounting period. © 2007 Pearson Custom Publishing

36 Measuring Solvency Solvency refers to the ability to meet long- term obligations resulting from debt. Solvency refers to the ability to meet long- term obligations resulting from debt. These measurements are similar to the liquidity measures, except the focus is on all assets and liabilities rather than the current assets and liabilities. These measurements are similar to the liquidity measures, except the focus is on all assets and liabilities rather than the current assets and liabilities. These measures are of interest to long-term creditors, stockholders, and management. These measures are of interest to long-term creditors, stockholders, and management. © 2007 Pearson Custom Publishing

37 Measuring Solvency Commonly used measures include: Commonly used measures include: Debt ratio Debt ratio Debt to equity ratio Debt to equity ratio Coverage ratio Coverage ratio © 2007 Pearson Custom Publishing

38 Debt Ratio Total liabilities Total assets Total liabilities Total assets Measures the percentage of a company’s assets that is financed by debt, rather than equity. Measures the percentage of a company’s assets that is financed by debt, rather than equity. Debt % + Equity % = 100% Debt % + Equity % = 100%

39 Debt to Equity Ratio Total liabilities Net worth Total liabilities Net worth Net worth is the same as owners’ equity; it is equal to Assets - Liabilities. This ratio highlights the relationship between creditors’ claims and owners’ claims to assets. Net worth is the same as owners’ equity; it is equal to Assets - Liabilities. This ratio highlights the relationship between creditors’ claims and owners’ claims to assets. © 2007 Pearson Custom Publishing

40 Coverage Ratio Earnings before interest and income taxes Interest expense Earnings before interest and income taxes Interest expense Also called the times interest earned ratio, it is an indication of the company’s ability to make interest payments. Lenders pay close attention to this ratio. Also called the times interest earned ratio, it is an indication of the company’s ability to make interest payments. Lenders pay close attention to this ratio. © 2007 Pearson Custom Publishing

41 Evaluate a company’s ratios using a comparison to industry averages. Learning Objective 7: © 2007 Pearson Custom Publishing

42 Using the Ratios After calculating the ratios for a particular company, you might want to do some or all of the following: After calculating the ratios for a particular company, you might want to do some or all of the following: Compare ratios to industry averages, Compare ratios to industry averages, Look for company trends, Look for company trends, Consider the industry environment, and Consider the industry environment, and Draw conclusions Draw conclusions © 2007 Pearson Custom Publishing

43 Use ratio values from consecutive time periods to evaluate the profitability, liquidity, and solvency of a business. Learning Objective 8: © 2007 Pearson Custom Publishing

44 Using the Ratios After comparing the ratios for a company to the industry, you should prepare a trend analysis of the ratio numbers. After comparing the ratios for a company to the industry, you should prepare a trend analysis of the ratio numbers. Small changes in the ratios over time may indicate improvement or danger signs of decline in financial health. Small changes in the ratios over time may indicate improvement or danger signs of decline in financial health. © 2007 Pearson Custom Publishing

45 Ratio Trend Analysis What would the following ratio trend analysis indicate to you about the financial condition of the company? What would the following ratio trend analysis indicate to you about the financial condition of the company? Profit after taxes ratio5.5%5.7%5.9%6.3% Profit after taxes ratio5.5%5.7%5.9%6.3% Current ratio Current ratio Debt ratio42%47%56%65% Debt ratio42%47%56%65% © 2007 Pearson Custom Publishing

46 Explain the purpose of the North American Industry Classification System and specify what an NAICS code indicates. Learning Objective 6: © 2007 Pearson Custom Publishing

47 NAICS NAICS is a classification system instituted by the federal government to gather useful industrial data from tax returns and SEC filings. NAICS is a classification system instituted by the federal government to gather useful industrial data from tax returns and SEC filings. Each industry has its own classification numbers. Each industry has its own classification numbers. The code represents discount general merchandise stores with centralized checkout. The code represents discount general merchandise stores with centralized checkout. © 2007 Pearson Custom Publishing

48 NAICS The NAICS information allows analysts to compare companies that are as alike as possible. The NAICS information allows analysts to compare companies that are as alike as possible. Published ratios are grouped by NAICS codes to facilitate meaningful comparison. Published ratios are grouped by NAICS codes to facilitate meaningful comparison. © 2007 Pearson Custom Publishing

49 State the limitations of ratio analysis. Learning Objective 9: © 2007 Pearson Custom Publishing

50 Limitations of Ratio Analysis As informative as ratio analysis can be, it also has some inherent limitations: As informative as ratio analysis can be, it also has some inherent limitations: 1) Attempting to predict the future using past results is problematic at best. Past results are not always indicative of future performance. 1) Attempting to predict the future using past results is problematic at best. Past results are not always indicative of future performance. 2) The financial statements used as the basis of the ratios are based on the accounting principle of historical cost. 2) The financial statements used as the basis of the ratios are based on the accounting principle of historical cost. © 2007 Pearson Custom Publishing

51 3) Figures from the balance sheet used in the calculation of the ratios are year-end values, which may or may not be representative. 3) Figures from the balance sheet used in the calculation of the ratios are year-end values, which may or may not be representative. 4) Comparing the ratios of companies in different industries is difficult because of industry peculiarities. 4) Comparing the ratios of companies in different industries is difficult because of industry peculiarities. 5) There are no hard-and-fast rules telling the analyst what numbers to use to calculate the ratios. 5) There are no hard-and-fast rules telling the analyst what numbers to use to calculate the ratios. Limitations of Ratio Analysis © 2007 Pearson Custom Publishing

52 The End of Chapter 12