1. Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws
Chapter 5
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

2. Chapter 5: Illustrates a comprehensive analysis
Integrates material from previous chapters
Adds new resources
Offers a toolbox of analytical techniques
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

3. From the Tools & Techniques Presented. . .
Readers can choose what to use to meet specific objectives
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

4. The 1st Step in Evaluating a Firm’s Financial Reports is to. . .
Specify the objectives of the analysis
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

5. An Investor Decides whether to buy, hold, or sell a firm’s security
Uses a company’s historical financial information to estimate future potential & value
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

6. A Creditor Determines borrowing need
Assesses firm’s ability to service debt
Evaluates source of debt repayment
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

7. Managers & Directors
Address questions relevant to investors & creditors
Satisfy other user groups:
employees
competitors
suppliers
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

8. Managers & Directors Continued:
Consider responses to financial reports by:
general public
regulators
financial press
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

9. Financial Reporting Environment
Is often adversarial:
management wants to present most positive picture possible
users want picture that represents financial reality
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

10. Sources of Information
Primary Sources
Four financial statements
Financial statement notes
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

11. Sources of Information Continued:
10-K report:
annual report filed with SEC
10-Q reports:
quarterly (unaudited) reports filed with SEC
Proxy statement:
required by SEC prior to shareholders meetings
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

12. Sources of Information Continued:
Auditor’s Reports
“Independent” reports expressing opinion about fairness of financial statement presentation
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

13. Sources of Information Continued:
Management Discussion & Analysis
Section in annual report monitored by SEC which covers firm’s:
liquidity
capital resources
operations
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

14. Sources of Information Continued:
Supplementary Schedules
Selected financial data on:
segments (unrelated lines of business)
operations outside U.S.
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

15. Sources of Information Continued:
Resources:
computerized search systems & data bases
comparative statistical ratios
research provided by independent services
financial press
financial analysis spreadsheet packages
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

16. More Resources Common size balance sheet:
expresses all items as a percentage of total assets
Common size income statement:
expresses all items as percentage of total sales
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

17. More Resources Continued:
Summary Analysis of Cash Flows:
Separates cash inflows & outflows in dollar & percentage terms
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

18. Tools & Techniques Financial Ratios
Standardize financial statement data
Mathematical relationships expressed in percent or times
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

19. Tools & Techniques Continued:
Trend analysis
evaluates financial data over several accounting periods
Structural analysis
considers the internal composition of a firm
Industry comparisons
relate one firm with averages compiled for industry in which it operates
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

20. Tools & Techniques Continued:
What’s most important?
Common sense & judgement
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

21. Financial Ratios Use as screening devices
Use with caution: they don’t supply answers
Use with other analytical tools
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

22. Financial Ratios Continued:
Look behind ratio that is out of line to determine cause
There is no standardized set of ratios or definitions
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

23. Liquidity Ratios Measure short-run solvency:
the ability of firm to meet debt payments as they come due
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

24. Liquidity Ratios Continued:
Current ratio:
Current assets Current liabilities
Quick ratio:
Current assets - inventory Current liabilities
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

25. Liquidity Ratios Continued:
Cash flow liquidity ratio:
Cash + Market Securities + Cash flow from operations
Current liabilities
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

26. Liquidity Ratios Continued:
Average collection period:
Accounts receivable Average daily sales
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

27. Liquidity Ratios Continued:
Days inventory held:
Inventory Average daily cost of sales
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

28. Liquidity Ratios Continued:
Days payable outstanding:
Accounts payable Average daily cost of sales
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

29. Net Trade Cycle Average collection period + days inventory held
- days payable outstanding
Measures normal cash conversion cycle of firm
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

30. Activity Ratios
Measures liquidity of assets & asset management efficiency
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

31. Activity Ratios Continued:
Accounts receivable turnover:
Net sales Accounts receivable
Inventory turnover:
Cost of goods sold Inventory
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

32. Activity Ratios Continued:
Payables turnover:
Cost of goods sold Accounts payable
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

33. Activity Ratios Continued:
Fixed asset turnover:
Net sales Net property, plant, equipment
Total asset turnover:
Net sales Total assets
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

34. Leverage Ratios Measures debt financing & debt coverage
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

35. Leverage Ratios Continued:
Debt ratio:
Total liabilities Total assets
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

36. Leverage Ratios Continued:
Long-term debt to total capitalization:
Long-term debt Long-term debt + stockholders’ equity
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

37. Leverage Ratios Continued:
Debt to equity:
Total liabilities Stockholders’ equity
Times interest earned:
Operating profit Interest expense
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

38. Leverage Ratios Continued:
Cash interest coverage:
Cash flow from operations + interest paid + taxes paid Interest paid
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

39. Leverage Ratios Continued:
Fixed charge coverage:
Operating profit + rent expense Interest expense + rent expense
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

40. Leverage Ratios Continued:
Cash flow adequacy:
Cash flow from operations
Capital expenditures + debt repayments + dividends paid
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

41. Profitability Ratios Measures overall efficiency & performance
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

42. Profitability Ratios Continued:
Gross profit margin:
Gross profit Net sales
Operating profit margin:
Operating profit Net sales
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

43. Profitability Ratios Continued:
Net profit margin:
Net profit Net sales
Cash flow margin:
Cash flow from operations
Net sales
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

44. Profitability Ratios Continued:
Return on assets (investment):
Net profit Total assets
Return on equity:
Net profit Stockholders’ equity
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

45. Financial Leverage: Use of Debt
Magnifies returns to shareholders when company earns more than after-tax cost of debt
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

46. Financial Leverage: Double-edged Sword
Produces negative effects on returns when company earns less than after-tax cost of debt
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

47. Profitability Ratios Continued:
Cash return on assets:
Cash flow from operations
Total assets
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

48. Net income Weighted average number of common shares outstanding
Market Ratios
Basic earnings per share:
Net income Weighted average number of common shares outstanding
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

49. Market Ratios Continued:
Dividend yield:
Cash dividends per share Year-end market price of common stock
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

50. Market Ratios Continued:
Price to earnings ratio:
Market price of common stock Basic earnings per share
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

51. Additional Information that is Useful
Financial data provided for operating segment (unrelated lines of business)
Financial data provided for operations outside of U.S.
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

52. Comprehensive Analysis
Includes many steps & interrelated pieces
No one step or piece should be interpreted in isolation from the other parts
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

53. Final Steps of Analysis
Integrate the separate steps & pieces
Reach overall conclusions about the firm’s
financial condition
performance
future prospects
Make sound financial decisions
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

54. Caution Flags Changes in top company management
Key financial ratios indicating deteriorating trends and/or weakness relative to industry competitors
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

55. More Caution Flags Cash flow from operating activities are: declining
negative
volatile
not tracking with net income
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

56. Even More Caution Flags
Lack of profitability in key operating areas
Low price to earnings ratio relative to competitors
Firm’s earnings less than after-tax cost of debt
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

57. Final Caution Flags Operating profits declining when debt is rising
Deteriorating trends in operating segments
Assuming authors are wealthy because they make wise business decisions
Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing