Using Financial Statement Information Presentations for Chapter 5 by Glenn Owen

Key Points Using financial accounting numbers to influence management decisions and predict future events. Five steps of financial statement analysis. Assessing the business environment. Assessing earnings quality and persistence. Analyzing financial statements. Difficulties involved in using annual report information to identify mispriced securities. Difficulties involved in using financial statements to compare the performance of companies operating in different countries.

Control and Prediction Financial accounting numbers are useful in two fundamental ways: – They help investors and creditors influence and monitor the business decisions of a company’s managers – They help to predict a company’s future earnings and cash flows

Book Value vs. True Value Business environment – Statements are backward looking, not focusing on the future prospects. Unrecorded events – Statements leave out some current and historical information such as human resources and the effects of inflation. Management bias – Managers often choose accounting methods and estimates that make them look good.

Five Steps of Financial Statement Analysis Assessing the business environment. Reading and studying the financial statements and footnotes. Assessing earnings quality. Analyzing the financial statements. Predicting future earnings and/or cash flow.

Assessing the Business Environment What is the nature of the company’s operations? What strategy is being employed to generate profits? What is the company’s industry? Who are the major players? Competition? What are the relationships between the company and its customers and suppliers? How are the company’s sales and profits affected by changes in the economy?

Reading and Studying the Financial Statements and Notes Read the audit report. Identify significant transactions – major acquisitions, discontinuance or disposal of a business segment, unresolved litigation, major write-downs of receivables or inventories, etc. Read the financial statements and footnotes.

Assessing Earnings Quality Overstating operating performance Taking a bath Creating hidden reserves Employing off-balance-sheet financing Earnings quality and unrecorded events

Analyzing the Financial Statements Comparisons across time Comparisons within the industry Comparisons within the financial statements: common-size statements and ratio analysis – Profitability ratios – Leverage ratios – Solvency ratios – Asset turnover ratios – Market ratios

Comparisons Across Time Financial accounting numbers can be made more meaningful if they are compared across time. GAAP require side-by-side comparison of the current and the preceding years in published financial reports.

Comparisons Within the Industry Financial accounting numbers can also be made more meaningful if they are compared to those of similar companies. Comparison of financial accounting numbers with industry averages is also helpful. Sources of industry information include: – Dun & Bradstreet – Robert Morris Associates – Moody – Standard & Poor

Comparisons Within the Financial Statements Common-size financial statements Ratio analysis – Profitability ratios – Leverage ratios – Solvency ratios – Asset turnover ratios – Other ratios

Common-Size Income Statement for LA-Z-Boy, Inc % 1999 % Net sales $1, , Cost of sales (1,284) 75 (947) 74 Expenses (345) 20 (275) 21 Net income $88 5 $ 66 5 On the income statement, cost of goods sold, expenses, and net income are often expressed as percentages of net sales. On the balance sheet, assets and liabilities can be expressed as percentages of total assets.

Profitability Ratios These ratios are designed to measure a firm’s earnings power. Net income, the primary measure of the overall success of a company, is compared to other measures of financial activity or condition to assess performance as a percent of some level of activity or investment.

The return on equity ratio measures the effectiveness at managing capital provided by owners. Profitability Ratios

The return on assets ratio measures the effectiveness at managing capital provided by all investors. Profitability Ratios

The return on sales ratio provides an indication of a company’s ability to generate and market profitable products and control its costs.

Leverage Ratios Leverage refers to using borrowed funds to generate returns for stockholders. Leverage is desirable because it creates returns for stockholders without using any of their money. Leverage increases risk by committing the company to future cash obligations

This ratio compares the return available to the stockholders to returns available to all capital providers. Leverage Ratios

This ratio measures the extent to which a company relies on borrowings (liabilities). Leverage Ratios

This ratio compares liabilities to stockholders’ equity and is another measure of capital structure leverage. Leverage Ratios

This ratio measures the importance of long-term debt as a source of asset financing. Leverage Ratios

Solvency Ratios Solvency refers to a company’s ability to meet its current debts as they come due. There is pressure on companies with high levels of leverage to manage their solvency.

Solvency Ratios This ratio measures solvency in the sense that current assets can be used to meet current liabilities

Solvency Ratios Similar to the current ratio, this ratio provides a more stringent test of a company’s solvency.

Solvency Ratios This ratio compares the annual funds available to meet interest to the annual interest expense.

This ratio measures the extent to which accounts payable is used as a form of financing. Solvency Ratios

Asset Turnover Ratios Asset turnover ratios are typically computed for total assets, accounts receivable, inventory, and fixed assets. These ratios measure the speed with which assets move through operations or reflect the number of times during a given period that these specific assets are acquired, used, and replaced.

Asset Turnover Ratios This ratio reflects the number of times the trade receivables were recorded, collected, and recorded again during the period.

Asset Turnover Ratios This ratio measures the speed with which inventories move through operations.

Asset Turnover Ratios This ratio measures the speed with which fixed assets are used up.

Asset Turnover Ratios This ratio measures the speed with which all assets are used up in operations.

Other Ratios These additional ratios are used by the financial community to assess company performance.

Other Ratios This ratio, according to the financial press, is the primary measure of a company’s performance.

Other Ratios This ratio is used by many analysts to assess the investment potential of common stocks.

Other Ratios This ratio indicates to cash return on the stockholders’ investment.

Other Ratios This ratio measures the pretax performance of an investment in a share of common stock.

Solvency Assessment Ability to Generate CashCash Requirements Operating Performance Financial Flexibility

Solvency Assessment Ability to Generate CashCash Requirements Operating Performance Operating Revenue Sale of Goods Sale of Service Creation of Operating Receivables (timing difference) Cash Inflows from Operations Financial Flexibility

Solvency Assessment Ability to Generate CashCash Requirements Operating Performance Operating Revenue Sale of Goods Sale of Service Creation of Operating Receivables (timing difference) Cash Inflows from Operations Operating Costs Cost of Goods Sold Operating Expense Creation of Operating Payables (timing difference) Cash Outflows from Operations Financial Flexibility

Solvency Assessment Ability to Generate CashCash Requirements Operating Performance Operating Revenue Sale of Goods Sale of Service Creation of Operating Receivables (timing difference) Cash Inflows from Operations Operating Costs Cost of Goods Sold Operating Expense Creation of Operating Payables (timing difference) Cash Outflows from Operations Financial Flexibility Ability to create short-term debt Ability to create long-term debt Ability to issue equity Ability to liquidate assets Liquidity

Solvency Assessment Ability to Generate CashCash Requirements Operating Performance Operating Revenue Sale of Goods Sale of Service Creation of Operating Receivables (timing difference) Cash Inflows from Operations Operating Costs Cost of Goods Sold Operating Expense Creation of Operating Payables (timing difference) Cash Outflows from Operations Financial Flexibility Ability to create short-term debt Ability to create long-term debt Ability to issue equity Ability to liquidate assets Payments for short-term debt Payments for long-term debt Payments for dividends Payments for asset replacement

Solvency Assessment Ability to Generate CashCash Requirements Operating Performance Operating Revenue Sale of Goods Sale of Service Creation of Operating Receivables (timing difference) Cash Inflows from Operations Operating Costs Cost of Goods Sold Operating Expense Creation of Operating Payables (timing difference) Cash Outflows from Operations Financial Flexibility Ability to create short-term debt Ability to create long-term debt Ability to issue equity Ability to liquidate assets Payments for short-term debt Payments for long-term debt Payments for dividends Payments for asset replacement Liquidity Timing of Cash InflowsTiming of Cash Outflows