Analysis of Financial Statements

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Analysis of Financial Statements

  1. 1. Financial Statements and Reports Financial reporting is used to disclose information about the firm Financial statements provided to  stockholders/creditors  SEC  IRS  Management Annual report—includes  a general discussion about the firm’s activities during the past year and expectations in the near future  financial statements of the firm for the most recent years 1
  2. 2. Income Statement Provides a summary of the revenues recognized and the expenses incurred during a particular operating period. Matching principle—revenues are recognized when sales occur (earned) and expenses are realized when they are incurred. Accrual accounting versus cash flows 2
  3. 3. Balance Sheet Records the financial position of the firm at a particular point in time by showing the assets—that is, the investments—and the liabilities and equity—that is, the financing—of the firm. Historical costs 3
  4. 4. Balance Sheet Cash versus other assets—only cash represents actual funds that can be invested Liabilities versus stockholders’ equity— liabilities represent debt, whereas equity represents ownership Preferred versus common stock—all corporations have one type of stock called common stock; some firms have equity called preferred stock 4
  5. 5. Balance Sheet Common equity accounts: common stock = number of shares outstanding times the par value of each share paid-in capital = amount above the par value for which common stock was issued retained earnings = income the firm earned in the past that was ―retained‖ and reinvested in assets 5
  6. 6. Statement of Retained Earnings Shows the change in the retained earnings and common equity accounts since the last balance sheet was constructed. 6
  7. 7. Statement of Cash Flows Reports the effect of the firm’s activities—operating, investing, and financing—over some period on its cash position 7
  8. 8. Statement of Cash Flows Income versus cash flows—revenues and expenses are recognized when incurred, not when cash is received or paid Non-cash items—some non-cash items appear on the income statement, such as depreciation Accounting profit—net income, or the ―bottom line‖ on the income statement; net income and cash flows generally are highly correlated Operating cash flows—cash flows generated from the normal operating activities of the firm 8
  9. 9. Statement of Cash Flows Simple rules to follow when constructing a statement of cash flows: Sources of Cash Uses of Cash  Liability Account  Liability Account (e.g., borrow more) (e.g., payoff loans)  Equity Account  Equity Account (e.g., issue stock) (e.g., pay a dividend)  Asset Account  Asset Account (e.g., sell inventory) (e.g., purchase equipment) 9
  10. 10. Eagle, Inc. Income Statement Sales $80,000 Variable operating costs (60,000) Fixed costs, excluding depreciation (12,000) Depreciation ( 2,000) EBIT = NOI 6,000 Interest ( 1,000) Earnings before taxes (EBT) 5,000 Taxes (40%) ( 2,000) Net income $ 3,000 Dividends 2,000 Addition to retained earnings 1,000 10
  11. 11. Eagle, Inc. Balance Sheet Current Previous Current Previous Year Year Year Year Cash & securities $ 2,000 $1,000 Accounts payable $ 4,000 $ 2,000 Accounts receivable 6,000 5,000 Accruals 5,000 4,000 Inventory 7,000 8,000 Notes payable 1,000 2,000 Current assets 15,000 14,000 Current liabilities 10,000 8,000 Net fixed assets 10,000 9,000 Long-term debt 6,000 7,000 Total assets $25,000 $23,000 Total liabilities 16,000 15,000 Common stock 6,000 6,000 Retained earnings 3,000 2,000 Owners’ equity 9,000 8,000 Total liabilities & equity $25,000 $23,000 11
  12. 12. Eagle, Inc. Balance Sheet— Changes in Assets Current Previous Year Year Change Source Use Cash & securities $ 2,000 $ 1,000 -- Accounts receivable 6,000 5,000 1,000 X Inventory 7,000 8,000 (1,000) X Current assets 15,000 14,000 Net fixed assets 10,000 9,000 3,000 X Total assets $25,000 $23,000 Fixed assets if no of Cash or sales = $9,000 Cash Sources purchases Uses of - $2,000 = $7,000  Asset Account Depreciation = $2,000  Asset Account Change in fixed assets = $10,000 - $7,000 = $3,000 12
  13. 13. Eagle, Inc. Balance Sheet— Changes in Liabilities and Equity Current Previous Year Year Change Source Use Accounts payable $ 4,000 $ 2,000 2,000 X Accruals 5,000 4,000 1,000 X Notes payable 1,000 2,000 (1,000) X Current liabilities 10,000 8,000 Long-term debt 6,000 7,000 (1,000) X Total liabilities 16,000 15,000 Common stock 6,000 6,000 0 -- -- Retained earnings 3,000 2,000 -- Owners’ equity 9,000 8,000 Total liabilities & equity $25,000 $23,000 Sources of Cash Uses of Cash  Liability/Equity Account  Liability/Equity Account 13
  14. 14. Eagle, Inc. Statement of Cash Flows Cash Flows from Operations: Cash Flows from Financing Activities: Net income (NI) $3,000  Notes payable (1,000) Adjustments to NI  Long-term bonds (1,000) Depreciation 2,000 Dividend payment (2,000)  Inventory 1,000 Net CF from financing $(4,000)  Accounts payable 2,000  Accruals 1,000 Net Change in cash 1,000  Accounts receivable (1,000) Cash at beginning of year 1,000 Net CF from operations $8,000 Cash at end of year $2,000 Cash Flows from Long-Term Investing: Acquisition of assets (3,000) 14
  15. 15. Financial Statements: Accounting Alternatives In many instances, the same business activity can be recorded using one of several accepted accounting methods— for example, LIFO versus FIFO for inventory valuation. 15
  16. 16. Financial Statements: Time Dimension Balance sheet—a ―snapshot‖ of where the firm is at a specific point in time (stock statement). Income statement and statement of cash flows—shows the results of the firm’s activities over a period of time (flow statement). 16
  17. 17. What Information Do Investors Use from Financial Statements? Net working capital (NWC) = Current assets - Current liabilities Operating cash flow (OCF) = NOI (1-Tax rate) + Depreciation & amortization expense Free cash flow (FCF) = OCF – Investments Economic Value Added (EVA) = NOI (1 - T) - [(Invested capital) X (After-tax cost of funds)] 17
  18. 18. Financial Statement (Ratio) Analysis Used to evaluate how financial positions: Change on a year-to-year basis for a single firm. Compare among firms, even if they differ in size. 18
  19. 19. Ratio (Financial Statement) Analysis Used by: Managers inside the firm Stockholders and creditors—existing and potential—outside the firm 19
  20. 20. Ratio (Financial Statement) Analysis General categories of analysis: Liquidity Asset management Debt management Profitability Market value 20
  21. 21. Liquidity Ratios Provide an indication of how well the firm can meet its current obligations Help measure the liquidity position of the firm Too little, or too much liquidity could be considered a ―bad sign‖  too little liquidity—suggests the firm will have problems paying its current obligations in the future  too much liquidity—might suggest the firm is not investing its funds wisely 21
  22. 22. Current ratio Shows the relationship between current assets and current liabilities; a higher value suggests greater liquidity, and vice versa: Current assets Current ratio = Current liabilitie s 22
  23. 23. Quick (Acid Test) Ratio Similar to the current ratio, except the value of inventories is subtracted from current assets (CA) in the numerator; inventories represent the least liquid of the current assets: CA - Inventorie s Quick,or acid-test,ratio= CL 23
  24. 24. Asset Management Ratios Provide an indication of how well the firm manages its assets (efficiency) Show how often the firm is ―turning over‖ its assets to generate funds Generally, when assets are not turned over quickly enough, it is because sales have slowed or current assets, such as inventory and receivables, are too high If assets are turned over too quickly, it could mean that the firm is not producing enough 24
  25. 25. Inventory Turnover Shows how many times during a period—for example, one year—the amount of average inventory is turned over due to sales activities. Cost of goods sold Inventory turnover = Inventories 25
  26. 26. Days Sales Outstanding (DSO) Indicates the average time it takes customers to pay for credit purchases—that is, the length of time it takes the firm to collect for credit sales. Dayssales Receivable s = outstandin (DSO) Averagesales per day g Receivable s = Annual sales 360 26
  27. 27. Fixed Assets Turnover Indicates how efficiently the firm uses its fixed assets (excludes current assets) to produce revenues Sales Fixed assets turnover ratio = Net fixed assets 27
  28. 28. Total Assets Turnover Similar to the fixed assets turnover, except the value of total assets (includes current assets) is used. Sales Total assets turnover ratio = Total assets 28
  29. 29. Debt Management Ratios Indicate how the firm’s financial position is affected by the amount of debt it has financial leverage refers to the use of debt leverage helps to magnify returns, on both the positive and the negative sides, because debt represents a fixed obligation 29
  30. 30. Debt Ratio Indicates the capital structure of the firm; measures the percent debt used by the firm for the purposes of financing assets. Total debt Total liabilities Debt ratio= = Total assets Total assets 30
  31. 31. Times-Interest-Earned (TIE) Ratio Indicates whether the firm generates sufficient operating income (not cash) to meet its interest obligations each year. EBIT Times-interest- earned ratio = Interestcharges Operatingincome = Interestcharges 31
  32. 32. Fixed Charge Coverage Ratio Like the times-interest-earned ratio, except all fixed payments related to financing are included. Fixed charge EBIT Lease payments coverage ratio Interest Lease Sinkingfund payments ch arg es payments 1 tax rate Funds available to cover financing obligations Fixed financing obligations 32
  33. 33. Profitability ratios Indicate how the firm’s management of its liquidity position, assets, and debt has affected normal operating activities. 33
  34. 34. Net Profit Margin Shows what percent of sales revenues is left after expenses related to operations and the effects of financing and taxes. Net income Net profit margin = Sales 34
  35. 35. Return on Total Assets (ROA) Measures the return on investment earned by the firm; ROA represents a return on all invested funds (both debt and equity). Net income Return on totalassets (ROA) = Total assets 35
  36. 36. Return on Equity (ROE) Similar to ROA, ROE is a measure of the return on the original funds provided by common stockholders (equity only). Return on Income available common stockholde to rs Equity(ROE) Common equity Net income P referred dividends Common equity 36
  37. 37. Market Value Ratios Measures that consider the value of the firm’s stock in the financial markets—that is, how well investors perceive that the firm is creating value. 37
  38. 38. Price/Earnings (P/E) Ratio Indicates how much investors pay for each dollar of income generated by the firm. Marketprice per share Price/earn ings ratio= Earningsper share EarningsPer Incomeavailable to commonstockholde rs = Share (EPS) Number of commonsharesoutstanding 38
  39. 39. Market/Book Value Ratio Indicates the relationship between the selling price of the common stock and its book value. Market val per share ue Market/ bookvalue Book value share per Market val per share ue Common equity Number of common shares outstanding 39
  40. 40. Trend and Comparative Analyses Ratios should be evaluated At a point in time in comparison to a norm, such as an industry average, to determine the firm’s current financial position (comparative analysis). Over time to determine whether the firm’s current financial position is improving or deteriorating (trend analysis). 40
  41. 41. Du Pont Equation/Method Shows the relationship between the return on investment (ROA) and both the total assets turnover and the net profit margin so as to give more detail where weaknesses or strengths exist. For example, if ROA is relatively low, it might be due to a low profit margin, a slow turnover of assets, or both. 41
  42. 42. Du Pont Equation ROA Net profit margin x Total assets turnover Net income Sales x Sales Total assets Net income Total assets 42
  43. 43. Uses and Limitations of Ratio Analysis Classifying a very large, multidivisional firm into a single industry often is difficult. Using a single norm, or ―target,‖ ratio for comparisons might be misleading. Values on balance sheets are historical costs, so ratios might not portray a ―true‖ picture. Seasonality in operations might cause ratios to differ significantly at different times of the year. 43
  44. 44. Uses and Limitations of Ratio Analysis Sometimes firms try to make financial statements look better by using ―window dressing‖ techniques. If firms use different accounting methods, comparisons between firms can be difficult. Do not make general conclusions about the firm’s financial position by examining only one or a few ratios; ratio analysis should be comprehensive. The most important part of ratio analysis is the judgment used when interpreting the results, not the computation of the ratios. 44

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