1. Interpreting Financial Statements
Chapter 13
Interpreting Financial Statements
This chapter is important to all business majors. We will look in detail at ways to analyze a set of financial statements to gain new perspectives on the performance and financial position of a company. Let’s get started by looking at some cautions about the use or misuse of financial statement analysis.

2. Building Blocks of Analysis
C1/C 2
Ability to meet short-term obligations and to efficiently generate revenues
Ability to generate future revenues and meet long-term obligations
Liquidity and Efficiency
Solvency
We have many analytical tools we can use to analyze the financial statements of a company. These techniques help us to better understand the company, allows us to transform and analyze data, and also helps to reduce uncertainty associated with financial information.
Financial analysis is used by many people within the organization. Managers find financial analysis helpful in planning and controlling operations. External users of financial statements are also interested in the results of comprehensive financial analysis. Shareholders, creditors, and customers all want to learn as much as possible about the financial health of a company.
As we complete this chapter by showing you how to calculate key business ratios, we will organize the ratios into four unique groups. Measures of liquidity and efficiency are most important to short-term creditors. Measures of solvency help people assess the ability of the company to generate revenues in the long-run. These measures are especially important to long-term creditors. Measures of profitability are important to managers and outsiders as well. Everyone with an interest in the company is concerned about the long-term profitability of its operations. Market prospects are most important to owners of the company’s common shares.
Basic information for our analysis comes from the financial statements and the notes to those statements. In some cases, we may need to develop supplemental information to complete our analysis.
When we complete our analysis, it is essential to compare the results we obtained to those of our competitors, other companies in our same industry, and general financial market guidelines.
Ability to provide financial rewards sufficient to attract and retain financing
Ability to generate positive market expectations
Market Prospects
Profitability
13-2

3. Ratio Analysis
p. 573 of text book

4. Liquidity and Efficiency - ability to pay ST obligations & Generate revenues
Current
Ratio
Inventory Turnover
Acid-test
Ratio
Days’ Sales Uncollected
Accounts Receivable Turnover
Now that we have the basic information we need, let’s calculate some of the company’s important ratios. On the next slide, we provide supplemental information that we will need.
Days’ Sales in Inventory
Total Asset Turnover
13-4

5. Solvency - ability to generate future revenues & meet LT obligations
P 3
Solvency - ability to generate future revenues & meet LT obligations
Debt
Ratio
Equity
Ratio
Pledged Assets to Secured Liabilities
Let’s focus now on solvency ratios.
Times Interest Earned
13-5

6. P 3
Profitability - ability to provide financial rewards sufficient to attract & retain financing.
Profit
Margin
Basic Earnings per Share
Gross Margin
Book Value per Common Share
The next category of ratios deals with profitability measures.
Return on Total Assets
Return on Common Stockholders’ Equity
13-6

7. Price/Earnings (PE) ratio
Market Prospects
P 3
Price/Earnings (PE) ratio
Dividend Yield
Ability to generate positive market expectations and interest in the company’s stock.
As a shareholder, we often need information about the market prospects of our investment. Good ratios to look at for this purpose is the price earnings ratio and the dividend yield.
Here is some supplemental information we will need to calculate the market prospect ratios. The supplemental information includes information about the closing market price of the common stock and the annual cash dividend.
13-7

8. Comparative Income Statements For the Years Ended December 31, 2015
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 2015
Common-size
Percents*
2015
2014
Revenues
520,000 $
480,000
100.0%
Costs and expenses:
Cost of sales
360,000
315,000
69.2%
65.6%
Selling and admin.
128,600
126,000
24.7%
26.3%
Interest expense
6,400
7,000
1.2%
1.5%
Income before taxes
25,000
32,000
4.8%
6.7%
Income taxes (30%)
7,500
9,600
1.4%
2.0%
Net income
17,500
22,400
3.4%
4.7%
Net income per share
0.79
1.01
Avg. # common shares
22,200
* Rounded to first decimal point.
P 2
Let’s go back and look at the comparative income statements of Clover Corporation and complete our common size calculations.
We will express all line-items on the income statement as a percent of total sales. We begin by setting total sales equal to one hundred percent.
We begin the calculation by determining the cost of goods sold percentages. For 2009, divide cost of goods sold of three hundred sixty thousand dollars by sales of five hundred twenty thousand dollars, and multiply by one hundred percent. For 2009, cost of goods sold was sixty nine point two percent of total sales. Before moving to the next slide, calculate the gross margin percent for each year as well as the percentages for the other line items. It will be good practice.
13-8

9. P 2
Common-Size Graphics
This is a graphical analysis of Clover Corporation’s common-size income statement for 2015.
This graph shows a common size income statement for All percentages are expressed in term of sales revenue. For example, cost of sales was sixty nine point two percent of total sales in Some business managers prefer to view charts rather than the raw numbers. We constructed this chart using Excel.
13-9

10. Standards for Comparison
When interpreting measures, we need to decide whether the measures indicate good, bad, or average performance. We can use the following to make that judgment:
Intracompany
Competitor
Industry
Guidelines (rule of thumb)
When interpreting measures from financial statement analysis, we need to decide whether measures indicate good, back, or average performance. To make such judgments, we need standards or benchmarks for comparisons that include the following:
Intracompany– The company under analysis can provide standards based on prior performance and relationships between financial statement items. Next, we can use competitor benchmarks for comparison purposes. One or more direct competitors can be analyzed for the comparison to see how the company measures up to others in their industry. We can also use industry statistics – such as those that are available from Dun and Bradstreet, Standard & Poor’s and Moody’s. Finally, we can use general rules of thumb to help assess performance. For example, we know that the level of 2:1 is generally a positive benchmark for the current ratio.
The more experience one gains in performing such analyses, the easier it becomes to interpret the results. Like anything else, practice goes a long way in this area.
13-10