2. CHAPTER 14
Analyzing Financial Statements:
A Managerial Perspective

3. Why Managers Analyze Financial Statements
Managers analyze financial statements for a variety of reasons including:
Control of operations
Assess the financial stability of vendors, customers, and other business partners
Assess the appearance of the company to investors and creditors
Learning objective 1: Explain why managers analyze financial statements

4. Control of Operations
Analysis of financial statements help management gain insight into whether their goals have been achieved
Assume successful implementation of plan will be reflected in financial information
- If financial information is inconsistent with a successful implementation an investigation will be launched
Learning objective 1: Explain why managers analyze financial statements

5. Assessment of Vendors, Customers, and Other Partners
Management takes same approach to review the financial stability of vendors, customers, and other strategic partners
Analysis of financial statements used to identify, qualify, and monitor potential partners
- Important when developing relationships to determine whether vendor or customer’s business is viable and will continue operations
Learning objective 1: Explain why managers analyze financial statements

6. Assessment of Vendors, Customers, and Other Partners
Managers analyze financial statements to assess whether:
Vendors are stable and will continue in existence
Customers need to be able to pay amounts owed on a timely basis
Potential partners are in financial difficulty
Learning objective 1: Explain why managers analyze financial statements

7. Assessment of Appearance to Investors and Creditors
Accrual income v. cash flows
- Describe the differences between net
income and cash flow from
operating activities to help readers
Managers need to analyze statements from the perspective of investors and creditors
- Need to be prepared in order to answer questions
Learning objective 1: Explain why managers analyze financial statements

8. Review 1 Why do managers analyze financial statements? Answer: d
To evaluate and control operations
To evaluate vendors and customers
To anticipate questions from shareholders and creditors
All of the above
Answer: d
Learning objective 1: Explain why managers analyze financial statements

9. Horizontal and Vertical Analyses
Horizontal analysis
Analysis of the dollar value and percentage changes in financial statement amounts across time
Vertical analysis
- Also called common size analysis
- Analysis of financial statement amounts in comparison to a base amount, e.g. total assets
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

10. Horizontal Analysis Horizontal analysis
Calculate amount of change for each item on the balance sheet or income statement
Calculate percent change
-Amount of change divided by old amount
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

11. Horizontal Analysis
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

12. Horizontal Analysis
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

13. Exercise 1
Prepare a horizontal analysis of the following condensed balance sheet
Slide 14-13
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

14. Vertical Analysis
Analysis of the balance sheet and income statement in comparison to a base amount
Divide each amount by the base amount to calculate percentage
- For the balance sheet the base amount is total assets
- For the income statement the base amount is net sales
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

15. Vertical Analysis
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

16. Vertical Analysis
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

17. Review 2 Horizontal analysis analyzes: Comparable companies
Changes in expenses as a percentage of sales
Changes in expenses as a percent of total assets
Changes in balances from one year to another
Answer: d
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

18. Exercise 2
Prepare a vertical analysis of the following condensed income statement
Slide 14-18
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

19. Exercise 2
Prepare a vertical analysis of the following condensed income statement
Slide 14-19
Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

20. Earnings Management
Accounting numbers can be manipulated to make performance appear stronger
Allegations of impropriety have been leveled against:
- Cendant
- Computer Associates
- Enron
- Kroger
- Lucent
- Sunbeam
- Waste Management
Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

21. Earnings Management Why do managers manipulate earnings?
- Managers often are evaluated and rewarded based on the level of earnings
Managers can benefit from inflated stock prices
A red flag for earnings management is a substantial difference between reported earnings and operating cash flow
- Fictitious sales will not produce cash
- Understated expenses need to be paid
Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

22. Cash Flow versus Earnings
Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

23. Other Sources of Financial Performance
Management discussion and analysis
Management provides financial statement users with explanations of financial results
Credit reports
Number of firms (e.g. Dun & Bradstreet) provides information on a company’s credit history
Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

24. Other Sources of Financial Performance
News articles
Includes announcements regarding major company changes which may indicate problems
Many on-line services are available in which to conduct a search of news articles:
- Lexis-Nexis provides information for a
fee
- Yahoo! Finance provides free information
- Search the internet using ticker symbol
Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

25. Management Discussion & Analysis (MD&A) Example
Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

26. Review 3
In connection with a company’s annual report, MD&A stands for:
Management discussion and analysis
More depreciation and amortization
Monthly depreciation and amortization
Monthly discounts and advertising
Answer: a
Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

27. Ratio Analysis Profitability ratios
- Reveals a company’s ability to generate profits
Turnover ratios
- Reveals the company’s efficiency with regard to the use of its assets
Debt-related ratios
- Reveals a company’s ability to re-pay its obligations
Learning objective 5: Calculate and interpret profitability ratios

28. Profitability Ratios
Learning objective 5: Calculate and interpret profitability ratios

29. Profitability Ratio Formulas
Learning objective 5: Calculate and interpret profitability ratios

30. Turnover Ratios
Learning objective 6: Calculate and interpret turnover ratios

31. Turnover Ratio Formulas
Learning objective 6: Calculate and interpret turnover ratios

32. Review 4 The efficient use of assets is indicated by: Answer: a
Turnover ratios
Debt-related ratios
The ratio of debt to equity
The ratio of current assets to current liabilities
Answer: a
Learning objective 6: Calculate and interpret turnover ratios

33. Debt-Related Ratios
Learning objective 7: Calculate and interpret debt-related ratios

34. Debt-Related Ratios
Learning objective 7: Calculate and interpret debt-related ratios

35. Too Much Debt
Learning objective 7: Calculate and interpret debt-related ratios

36. Review 5 The ratio times interest earned can be used to evaluate:
The amount of debt versus equity financing
The extent to which interest income exceeds interest expense
The extent to which interest expense exceeds interest income
The likelihood that a company will be able to make required interest payments
Answer: d
Learning objective 7: Calculate and interpret debt-related ratios

37. Ratio – Too High or Low?
Learning objective 7: Calculate and interpret debt-related ratios

38. Comparative Ratio Data
Learning objective 7: Calculate and interpret debt-related ratios

39. Strategic Partners
Learning objective 7: Calculate and interpret debt-related ratios

40. Copyright
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