Humanities and International Exchange Faculty Shanghai Second Polytechnic University Lesson 6 Understanding and Using Financial Statements

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 2  Demand and supply of financial analysis  Basic analytical procedures  Analysis methods  Comprehensive analysis of financial ratios  The limitations of financial analysis Outline

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 3 What’s wrong with accounting information?

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 4 Demand and supply of financial analysis InvestorsManagersEmployeesCustomersauditors Government/regulatory agencies InvestorsManagersEmployeesCustomersauditors DemandDemand Internal analysts Internal analysts Intermediaries Intermediaries Financial analysts Bond rating agencies Internal analysts Internal analysts Intermediaries Intermediaries Financial analysts Bond rating agencies SupplySupply

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 5 Basic analytical procedures ConcludeConcludeContriveanalysis scheme schemeContriveanalysis AnalyzedataAnalyzedataDetermineobjectiveDetermineobjectiveCollectdataCollectdata

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 6 Techniques of Financial Statement Analysis  Horizontal analysis Comparative financial statements are presented side by side  Trend analysis  Vertical analysis Common-size financial statement  Ratio analysis

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 7 Horizontal analysis X Company Comparative Balance Sheet December 31, 2004 and 2005 December 31 Increase or Decrease AmountPercentage Asset Liabilities and Stockholders Equity ----

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 8 Comparing a company’s financial condition and performance across time Trend Analysis

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 9 Vertical analysis  Vertical analysis is used to show the relationship of the component parts to the total in a single statement In the vertical analysis of the balance sheet, each asset or equity item is stated as a percent of total assets; In the vertical analysis of the income statement, each item is stated as a percent of net sales;

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 10 A example of vertical analysis Year ended Net Sales Less: Cost of goods sold Gross profit on sales Selling expenses Administrative expenses Interest expenses Total expenses Total expenses Income before taxes Income taxes Net income

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 11 Ratio Analysis Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements Profitability analysis Activity analysis Liquidity analysis Long-term debt-paying ability analysis MarketStrengthMarketStrength

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 12 Profitability analysis Return on total assets Net income Average total assets Return on long- term capital Net income Average long-term debt+average owner’s equity Return on net assets Net income average stockholders’ equity Operating margin Gross income Net sales

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 13 A compare of company profitability

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 14 Activity analysis Asset turnover total revenue average total assets average total assets Accounts receivable turnover Sales revenue Average accounts receivable Average accounts receivable Average collection period of accounts receivable 365(days) Accounts receivable turnover Inventory turnover Cost of goods sold Average inventory

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 15 A compare of company efficiency ratios

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 16 Liquidity analysis Current ratio Current assets Current Liabilities Current Liabilities Quick ratio Quick assets Current liabilities Current liabilities Cash ratio Cash+ Short-term investment Current liabilities

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 17 A compare of company Liquidity ratios

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 18 Long-term debt-paying ability analysis Debt-equity ratio Total liabilities Total owner’s equity Total owner’s equity Debt-to-total asset Total liabilities Total Asset Times interest earned Net income +interest expense +taxes Interest expense

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 19 A compare of Long-term debt-paying ability

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 20 Market Strength Earning per share Net income shares of common stock outstanding shares of common stock outstanding Price- earnings ratio Market price per share Earnings per share Dividend yield Dividend per share Market price per share

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 21 A compare of market strength

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 22 Dupond Analysis Net income Net Sales Net income Net Sales ROE=Net Margin X Asset Turnover X Leverage Factor Net income owner’s equity Net income owner’s equity SalesAssetsSalesAssets Assets Owner’s equity Assets

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 23 Dupon analysis for five firms FirmNetMarginAssetTurnoverROALeverageFactorROE A8.36% % % B22.83% % % C3.87% % % D1.42% % % E4.24% % %

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 24 Why ratio analysis is useful?  They facilitate inter-company comparison;  They downplay the impact of size and allow evaluation over time or across entities without undue concern for the effects of size difference;  They serve as benchmarks for targets such as financing ratios and debt burden;  They help provide an informed basis for making investment-related decisions by comparing an entity’s financial performance to another;  ……

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 25 How is ratio analysis limited?  It is restricted to information reported in the financial statements;  It is based on past performance.  Comparability is hampered when accounting policies are not uniform across an industry;  The past may not predict the future;

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 26 How is ratio analysis limited? (cont)  Trends and relationships must be carefully evaluated with reference to industry norms, budgets, and strategic decisions;  Because of some potential problems in standard, comparison must be careful;

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 27 Standards of comparison for financial statement analysis Prior years’ results Industry averages Internal projections or budget May include inefficiencies or reflect different operating policies than in effect in the current year. May not be representative or desirable for this firm. May not be available; may be based on different or budgets operating policies than in effect in the current year. Standard of comparison Potential problem

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 28 What should an analyst keep in mind about financial analysis?  An overview of all ratios can provide important information concerning the strategic decisions of a company and the nature of its business;  However, accounting information can only provide so much data. An analyst must proceed with caution;

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 29 Summary  Users of financial statements often gain a clearer picture of the economic condition of an entity by the analysis of accounting information;  The analytical measures obtained from financial statements are usually expressed as ratios or percentages;

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 30 Summary  Financial analysis techniques work best when they are used to confirm or refute other information. When using analytical tools to evaluate a company, the analyst should keep in mind the limitations of analysis

Humanities and International Exchange Faculty Shanghai Second Polytechnic University 31 Discussion questions  What is the advantage of using comparative statements for financial analysis rather than statements for a single date or period?  What does an increase in the number of days’ sales in receivables ordinarily indicate about the credit and collection policy of the firm?  Why would the dividend yield differ significantly from the rate earned on common stockholders’ equity?

Humanities and International Exchange Faculty Shanghai Second Polytechnic University The End of Lesson 6