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# Lesson 10 Understanding and Using Financial Statements

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## Lesson 10 Understanding and Using Financial Statements Presentation Transcript

• Lesson 10 Understanding and Using Financial Statements Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Yat-sen University
• Demand and supply of financial analysis
• Basic analytical procedures
• Analysis methods
• Comprehensive analysis of financial ratios
• The limitations of financial analysis
Outline
• What’s wrong with accounting information?
• Demand and supply of financial analysis Investors Managers Employees Customers auditors Government/regulatory agencies Demand
• Internal analysts
• Intermediaries
• Financial analysts
• Bond rating agencies
Supply
• Basic analytical procedures Conclude Contrive analysis scheme Analyze data Determine objective Collect data
• Techniques of Financial Statement Analysis
• Horizontal analysis
• Comparative financial statements are presented side by side
• Trend analysis
• Vertical analysis
• Common-size financial statement
• Ratio analysis
• Horizontal analysis Increase or Decrease December 31 X Company Comparative Balance Sheet December 31, 2004 and 2005 - - - - Asset Liabilities and Stockholders Equity Percentage Amount 2005 2004
• Trend Analysis Comparing a company’s financial condition and performance across time
• Vertical analysis
• Vertical analysis is used to show the relationship of the component parts to the total in a single statement
• In the vertical analysis of the balance sheet, each asset or equity item is stated as a percent of total assets;
• In the vertical analysis of the income statement, each item is stated as a percent of net sales;
• A example of vertical analysis Year ended 1.34 0.61 0.89 Net income 0.06 0.03 0.02 Income taxes 1.40 0.64 0.81 Income before taxes 13.00 13.75 14.20 Total expenses -0.81 0.15 0.20 Interest expenses 2.40 2.59 2.71 Administrative expenses 11.41 11.01 11.29 Selling expenses 11.40 14.39 15.01 Gross profit on sales 87.88 85.61 854.96 Less: Cost of goods sold 100.00 100.00 100.00 Net Sales 2001 2002 2003
• Ratio Analysis Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements Profitability analysis Activity analysis Liquidity analysis Long-term debt-paying ability analysis Market Strength
• Profitability analysis Gross income Net sales Operating margin Net income average stockholders’ equity Return on net assets Net income Average long-term debt+average owner’s equity Return on long-term capital Net income Average total assets Return on total assets
• A compare of company profitability
• Activity analysis Asset turnover total revenue average total assets Accounts receivable turnover Sales revenue Average accounts receivable Average collection period of accounts receivable 365(days) Accounts receivable turnover Inventory turnover Cost of goods sold Average inventory
• A compare of company efficiency ratios
• Liquidity analysis Current ratio Current assets Current Liabilities Quick ratio Quick assets Current liabilities Cash ratio Cash+ Short-term investment Current liabilities
• A compare of company Liquidity ratios
• Long-term debt-paying ability analysis Debt-equity ratio Total liabilities Total owner’s equity Debt-to-total asset Total liabilities Total Asset Times interest earned Net income +interest expense +taxes Interest expense
• A compare of Long-term debt-paying ability
• Market Strength Earning per share Net income shares of common stock outstanding Price-earnings ratio Market price per share Earnings per share Dividend yield Dividend per share Market price per share
• A compare of market strength
• Dupond Analysis Net income Net Sales ROE=Net Margin X Asset Turnover X Leverage Factor Net income owner’s equity Sales Assets Assets Owner’s equity
• Dupon analysis for five firms 6.25% 1.32 4.74% 1.12 4.24% E 7.04% 3.64 1.94% 1.36 1.42% D 6.52% 1.96 3.34% 0.86 3.87% C 5.11% 1.82 2.80% 0.12 22.83% B 11.31% 2.43 4.65% 0.56 8.36% A ROE Leverage Factor ROA Asset Turnover Net Margin Firm
• Why ratio analysis is useful?
• They facilitate inter-company comparison;
• They downplay the impact of size and allow evaluation over time or across entities without undue concern for the effects of size difference;
• They serve as benchmarks for targets such as financing ratios and debt burden;
• They help provide an informed basis for making investment-related decisions by comparing an entity’s financial performance to another;
• ……
• How is ratio analysis limited?
• It is restricted to information reported in the financial statements;
• It is based on past performance.
• Comparability is hampered when accounting policies are not uniform across an industry;
• The past may not predict the future;
• How is ratio analysis limited? (cont)
• Trends and relationships must be carefully evaluated with reference to industry norms, budgets, and strategic decisions;
• Because of some potential problems in standard, comparison must be careful;
• Standards of comparison for financial statement analysis Prior years’ results Industry averages Internal projections or budget May include inefficiencies or reflect different operating policies than in effect in the current year. May not be representative or desirable for this firm. May not be available; may be based on different or budgets operating policies than in effect in the current year. Standard of comparison Potential problem
• What should an analyst keep in mind about financial analysis?
• An overview of all ratios can provide important information concerning the strategic decisions of a company and the nature of its business;
• However, accounting information can only provide so much data. An analyst must proceed with caution;
• Summary
• Users of financial statements often gain a clearer picture of the economic condition of an entity by the analysis of accounting information;
• The analytical measures obtained from financial statements are usually expressed as ratios or percentages;
• Summary
• Financial analysis techniques work best when they are used to confirm or refute other information. When using analytical tools to evaluate a company, the analyst should keep in mind the limitations of analysis
• Discussion questions
• What is the advantage of using comparative statements for financial analysis rather than statements for a single date or period?
• What does an increase in the number of days’ sales in receivables ordinarily indicate about the credit and collection policy of the firm?
• Why would the dividend yield differ significantly from the rate earned on common stockholders’ equity?
• The End of Lesson 10