1. Analysis and Interpretation of Financial Statements

2. Financial Statement Analysis
The application of analytical tools and techniques to financial statement data.
Allows users to focus on how numbers are related and how they have changed over time

3. Objective of Financial StatementAnalysis
External users rely on general purpose financial statements
Make predictions about an organization as an aid in making decisions
Users highlight important trends or changes

4. Risk and Return
Users try to balance the risk of an investment with its expected return
Generally the greater the risk, the higher the return
Financial statement analysis is one source of information for assessing risk and return

5. Sources of External Information
Public companies must publish an annual financial report
Government reports
SEC 10K, 10Q
Financial service information
Moody’s, Dow-Jones
Financial newspapers and periodicals
Wall Street Journal

6. Financial Analysis Tools
Horizontal analysis
Vertical analysis
Ratio analysis

7. Horizontal Analysis: Amounts and Percentages of Change
Amount of change = later year amount - Earlier year amount
Percentage change = Amount of change / Earlier year amount
Look for significant change

8. Horizontal Analysis: Trend Percentages
Set all amounts in base year at 100%
Compute percentages for a number of years
Divide each statement amount by respective amount in base year
Shows degree of increase or decrease in individual statement items
Used to explain changes in operating performance

9. Vertical Analysis
Shows how each item in a financial statement compares to the total of that statement
Balance sheet
Set both total assets and total equities at 100%
Income statement
Set net sales at 100%

10. Vertical Analysis Identify significant dollar and percentage changes
Explain the changes
Identify whether they are favorable of unfavorable

11. Ratio Analysis
Shows the relative size of one financial statement component to another.
Effective only when used in combination with other ratios, analysis, and information

12. Ratio Analysis Short-term liquidity Long-term solvency Profitability
Market performance

13. Short-term Profitability
Current ratio
Quick ratio
Accounts receivable turnover
Days’ sales in receivables
Inventory turnover

14. Current Ratio Current Assets Current Liabilities
Common measure of liquidity
Ability to pay debts as they come due
Rule of thumb 2:1
Consider other factors
Current Assets
Current Liabilities

15. Quick Ratio (Acid Test)
More strict measure of short-term liquidity
Numerator includes only quick current assets
Assets readily converted to cash
Cash + Short-term investments + Net
Current Receivables
Current liabilities

16. Accounts Receivable Turnover
How many times we turn accounts receivable into cash during a period
Net sales
Average net accounts receivable

17. Days’ Sales in Receivables
How many days’ sales remain uncollected in accounts receivable
Net sales
Net sales per day =
365 days
Average net accounts receivable
Net sales per day

18. Inventory Turnover Cost of goods sold Average inventory
Number of times the company sells and replaces its inventory during the period
Holding inventory results in financing and storage costs
Cost of goods sold
Average inventory

19. Long-term Solvency Debt ratio Times Interest Earned

20. Debt Ratio Total liabilities Total assets
Shows amount of total assets creditors provide
Higher levels of debt financing means company has a higher risk of not meeting interest and principal payments
Total liabilities
Total assets

21. Net income + Income tax expense
Times Interest Earned
Number of times the company earned interest expense with current income
Creditors want to know the firm’s ability to pay annual interest charges
Net income + Income tax expense
+ Interest expense
Interest expense

22. Profitability Profit margin Total asset turnover
Return on total assets
Return on owners’ equity
Earning per share

23. Profit Margin Net income Net sales
Percentage each sales dollar contributes to net income
Net income
Net sales

24. Total Asset Turnover Net sales Average total assets
Measures the efficiency of the company is using its investment in assets to generate sales
Net sales
Average total assets

25. Return on Total Assets Net income Average total assets
Measures the amount a company earns on each dollar of investment in assets
Net income
Average total assets

26. Return on Owners’ Equity
Measures the earnings in relation to the owners’ investment in the company
Net income - Preferred dividends
Average owner’s equity

27. Earnings Per Share Net income - Preferred dividends
Measures the net income available to each share of common stock
Discussed in depth in Chapter 14
Net income - Preferred dividends
Weighted average number of common
shares outstanding during the year

28. Market Performance Price/Earnings (P/E) ratio Dividend yield

29. Price/Earning (P/E) Ratio
Number of times earnings per share the stock is currently selling for in the market
Market price per share of common stock
Earnings per share

30. Dividend Yield Dividends per share Market price per share
Measure of dividend-paying performance of a company
Investors buy stock for two reasons
Receive cash dividends
Sell stock at a higher price
Dividends per share
Market price per share

31. Limitations of Financial Analysis Tools
Historical nature of accounting information
Changing economic conditions
Comparisons with industry averages
Seasonal factors
Quality of reported income