1. Understanding Financial Statements Seventh EDITION
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BOOK COVER
Lyn M. Fraser
Aileen Ormiston

2. The Analysis of Financial Statements
This chapter will develop tools and techniques for the interpretation of financial information
Chapter 5
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3. Objectives of Analysis
First order of business is to
Specify the objectives of the analysis
Focus on WHO is the financial statement user
Remember--the identity of the user helps define what information is needed
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4. Objectives of Analysis Continued
Potential Financial Statement Users:
Creditors
Investors
Management
What types of questions do each of these
users seek answers to?
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5. Creditors
A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds
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6. Creditors Continued
Questions raised in a credit analysis should include:
What is the borrowing cause?
What is the firm’s capital structure?
What will be the source of debt repayment?
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7. Investors
The ultimate objective is to determine whether the investment is sound
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8. Investors Continued The investment analyst poses questions as:
How has the firm performed/what are future expectations?
How much risk is inherent in the existing capital structure?
What are expected returns?
What is firm’s competitive position?
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9. Management Creditors Investors Employees General public Regulators
Management relates to all questions raised by:
Creditors
Investors
Employees
General public
Regulators
Financial press
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10. Management Continued Looks to Financial Statement Data to Determine:
How well the firm has performed and why?
What operating areas have contributed to success and which have not?
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11. Management Continued Looks to Financial Statement Data to Determine:
What are strengths/weaknesses of company’s financial position?
What changes are indicated to improve future performance?
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12. Caution!!! Keep in mind: management PREPARES financial statements
Analyst should be alert to potential for management to influence reporting to make data more “appealing”
May want to supplement analysis with information apart from Annual Report prepared by management
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13. Sources of Information
The analyst will want to consider the following resources:
Proxy Statement
MD&A
Supplementary schedules
Form 10-K and Form 10-Q
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14. Other Sources of Information
Computerized data bases
Info on industry norms/ratios
Info on particular companies/industries/ mutual funds
Articles in popular/business press
Ever-expanding websites
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15. Tools and Techniques These include: Most important:
Common-size financial statements
Financial ratios
Trend analysis
Structural analysis
Most important:
Common sense and judgment
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16. Common-Size Financial Statements
Express each account on the balance sheet as a percentage of total assets and each account on the income statement as a percentage of net sales
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17. Key Financial Ratios
Standardize financial data in terms of mathematical relationships expressed in the form of percentages or times
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18. Key Financial Ratios Continued
Four Categories of ratios:
Liquidity Ratio
Measures a firm’s ability to meet cash needs as they arise
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19. Four Categories of Ratios Continued
Activity Ratio
Measures the liquidity of specific assets and the efficiency of managing assets
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20. Four Categories of Ratios Continued
Leverage Ratio
Measures the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges
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21. Four Categories of Ratios Continued
Profitability Ratio
Measures the overall performance of a firm and its efficiency in managing assets, liabilities and equity
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22. Caution! Ratios are valuable, BUT. . .
They do not provide answers in and of themselves and are not predictive
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23. More Cautions!
Ratios should be used with other elements of financial analysis
There are no “rules of thumb” that apply to interpretation of ratios
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24. More Cautions! Continued
Keeping this in mind, let’s take a look at some of the ratios
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25. Liquidity Ratios: Short-Term Solvency
Current Ratio
Measures ability to meet short-term cash needs
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26. Liquidity Ratios: Short-Term Solvency Continued
Quick or Acid-Test Ratio
Measures ability to meet short-term cash needs more rigorously
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27. Liquidity Ratios: Short-Term Solvency Continued
Cash Flow Liquidity Ratio
Focuses on ability of the firm to generate operating cash flows as a source of liquidity
*Cash flow from operating activities
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28. Liquidity Ratios: Short-Term Solvency Continued
Average Collection Period
Helps gauge liquidity of accounts receivable (ability to collect cash from customers)
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29. Liquidity Ratios: Short-Term Solvency Continued
Days Inventory Held
Is the average number of days it takes to sell inventory to customers
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30. Liquidity Ratios: Short-Term Solvency Continued
Days Payable Outstanding
Is the average number of days it takes to pay accounts payables in cash
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31. Net Trade Cycle Is the normal cycle of a firm that consists of:
Buying or manufacturing inventory, with some purchases on credit
Selling inventory, with some sales on credit
Collecting the cash
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32. Net Trade Cycle Continued
Average collection period
Plus
Days inventory held
Minus
Days payable outstanding
Equals
Net trade cycle
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33. Activity Ratios: Assets Liquidity, Asset Management Efficiency
Accounts Receivable Turnover
Another measure of efficiency of firm’s collection and credit policies
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34. Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t
Inventory Turnover
Measures efficiency of inventory management
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35. Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t
Payables Turnover
Another measure of efficiency of inventory management
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36. Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t
Fixed Asset Turnover
Assesses effectiveness in generating sales from investment in fixed assets
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37. Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t
Total Asset Turnover
Assesses effectiveness in generating sales from investment in total assets
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38. Leverage Ratios: Debt Financing and Coverage
Debt Ratio
Measures the extent of firm’s financing with debt
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39. Leverage Ratios: Debt Financing and Coverage Con’t.
Long-term Debt to Total Capitalization
Measures the extent of firm’s financing with long-term debt
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40. Leverage Ratios: Debt Financing and Coverage Con’t
Debt to Equity
Measures the extent of firm’s financing with debt
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41. Leverage Ratios: Debt Financing and Coverage Con’t
Times Interest Earned
Indicates how well operating earnings cover fixed interest charges
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42. Leverage Ratios: Debt Financing and Coverage Con’t
Cash Interest Coverage
Measures how many times interest payments can be covered by cash flow from operations before interest and taxes
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43. Leverage Ratios: Debt Financing and Coverage Con’t
Fixed Charge Coverage
Broader measure of how well operating earnings cover fixed charges
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44. Leverage Ratios: Debt Financing and Coverage Con’t
Cash Flow Adequacy
Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year
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45. Profitability Ratios: Overall Efficiency and Performance
Gross Profit Margin
Measures profit generated after consideration of cost of products sold
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46. Profitability Ratios: Overall Efficiency and Performance Con’t.
Operating Profit Margin
Measures profit generated after consideration of operating expenses
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47. Profitability Ratios: Overall Efficiency and Performance Con’t.
Net Profit Margin
Measures profit generated after consideration of all expenses and revenues
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48. Profitability Ratios: Overall Efficiency and Performance Con’t.
Cash Flow Margin
Measures ability to translate sales into cash (with which to pay bills!)
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49. Profitability Ratios: Overall Efficiency and Performance Con’t.
Return on Total Assets (ROA) or Return on Investment (ROI)
Measures overall efficiency of firm in managing investment in assets and generating profits
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50. Profitability Ratios: Overall Efficiency and Performance Con’t.
Return on Equity (ROE)
Measures rate of return on stockholders’ investment
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51. Profitability Ratios: Overall Efficiency and Performance Con’t.
Cash Return on Assets
Useful comparison to return on investment
Indicates firm’s ability to generate cash from utilizing its assets
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52. Analyzing the Data
Now that some of the “tools” of financial analysis have been illustrated, where does one go from here?
Taking a general approach to financial statement analysis, one might proceed as follows. . .
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53. Five Steps of a Financial Statement Analysis
Establish objectives of the analysis
Who are you and why are you interested in this company?
What questions would you like to have answered?
What info is vital to the decision at hand?
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54. Five Steps of a Financial Statement Analysis Con’t.
Study the industry in which the firm operates and relate industry climate to current and projected economic developments
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55. Five Steps of a Financial Statement Analysis Con’t
Develop knowledge of firm and quality of management
How well does this firm seem to be run?
Are they taking advantage of opportunities?
Are they innovative, forward-looking, etc?
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56. Five Steps of a Financial Statement Analysis Con’t
Evaluate financial statements
Tools: Common-size financial statements, key financial ratios, trend analysis, structural analysis, and comparison with industry competitors
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57. Five Steps of a Financial Statement Analysis Con’t
Step 4 Continued
Evaluate financial statements
Major Areas: Short term liquidity, operating efficiency capital structure and long-term solvency, profitability, market ratios, and segmental analysis (when relevant)
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58. Five Steps of a Financial Statement Analysis Con’t
Summarize findings
Reach conclusions about the firm relevant to your established objectives
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59. Relating the Ratios —The Du Pont System
It is helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios
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60. Relating the Ratios —The Du Pont System Continued
The Du Pont System helps the analyst see how the firm’s decisions and activities over the course of an accounting period interact to produce an overall return to the firm’s shareholders, the return on equity
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61. Relating the Ratios —The Du Pont System Continued
The summary ratios are:
(1)
Net profit margin
(2)
Total asset turnover
(3)
Return on investment
(3)
Return on investment
(4)
Financial leverage
(5)
Return on equity
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62. Four Market Ratios Earnings per common share Price-to-earnings
Dividend payout
Dividend yield
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63. Market Ratios Continued
Earnings per Common Share
Provides the investor with a common denominator to gauge investment returns
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64. Market Ratios Continued
Price-to-Earnings
Relates earnings per common share to the market price at which the stock trades, expressing the “multiple” that the stock market places on a firm’s earnings
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65. Market Ratios Continued
Dividend Payout
This ratio is determined by the formula cash dividends per share divided by earnings per share
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66. Market Ratios Continued
Dividend Yield
Shows that relationship between cash dividends and market price
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67. What we have accomplished
Turned
Maze
Auditor’s Report
MD&A
Notes
Statement of Cash Flows
Income Statement
Statement of Shareholders’ Equity
Balance Sheet
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68. Financial Statements An Overview
into
Map
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