Your SlideShare is downloading. ×
0
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
coba.drury.edu
Upcoming SlideShare
Loading in...5
×

Thanks for flagging this SlideShare!

Oops! An error has occurred.

×
Saving this for later? Get the SlideShare app to save on your phone or tablet. Read anywhere, anytime – even offline.
Text the download link to your phone
Standard text messaging rates apply

coba.drury.edu

911

Published on

0 Comments
1 Like
Statistics
Notes
  • Be the first to comment

No Downloads
Views
Total Views
911
On Slideshare
0
From Embeds
0
Number of Embeds
0
Actions
Shares
0
Downloads
56
Comments
0
Likes
1
Embeds 0
No embeds

Report content
Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
No notes for slide

Transcript

  • 1. Understanding Financial Statements EIGHTH EDITION Lyn M. Fraser Aileen Ormiston
  • 2. The Analysis of Financial Statements Ratios are tools and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison - CEO, R.E.C. Inc.
  • 3. The Analysis of Financial Statements (cont.) This chapter will develop tools and techniques for the interpretation of financial statement information
  • 4. Objectives of Analysis <ul><li>Remember--the identity of the user helps define what information is needed </li></ul><ul><li>Objectives will vary depending on the </li></ul><ul><li>perspective of the financial statement user </li></ul><ul><li>specific questions that are addressed </li></ul><ul><li>by the analysis </li></ul>
  • 5. Objectives of Analysis (cont.) <ul><li>Creditors </li></ul><ul><li>Investors </li></ul><ul><li>Management </li></ul>Potential Financial Statement Users: What types of questions do each of these users seek answers to?
  • 6. Creditors <ul><li>A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds </li></ul>
  • 7. Creditors (cont.) <ul><li>What is the borrowing cause? </li></ul><ul><li>What is the firm’s capital structure? </li></ul><ul><li>What will be the source of debt repayment? </li></ul>Questions raised in a credit analysis should include:
  • 8. Investors <ul><li>An investor attempts to arrive at an estimation of a company’s future earnings stream in order to attach a value to the securities being considered for purchase or liquidation </li></ul>
  • 9. Investors (cont.) <ul><li>How has the firm performed/what are future expectations? </li></ul><ul><li>How much risk is inherent in the existing capital structure? </li></ul><ul><li>What are expected returns? </li></ul><ul><li>What is firm’s competitive position? </li></ul>The investment analyst poses questions as:
  • 10. Management <ul><li>Creditors </li></ul><ul><li>Investors </li></ul><ul><li>Employees </li></ul><ul><li>General public </li></ul><ul><li>Regulators </li></ul><ul><li>Financial press </li></ul>Management relates to all questions raised by:
  • 11. Management (cont.) <ul><li>How well the firm has performed and why? </li></ul><ul><li>What operating areas have contributed to success and which have not? </li></ul>Looks to financial statement data to determine:
  • 12. Management (cont.) <ul><li>What are strengths/weaknesses of company’s financial position? </li></ul><ul><li>What changes should be implemented to improve future performance? </li></ul>Looks to financial statement data to determine:
  • 13. Caution!!! <ul><li>Keep in mind: Management PREPARES financial statements </li></ul><ul><li>Analyst should be alert to potential for management to influence reporting to make data more “appealing” </li></ul><ul><li>May want to supplement analysis with other sources of information apart from the Annual Report prepared by management </li></ul>
  • 14. Sources of Information <ul><li>Proxy Statement </li></ul><ul><li>Auditor’s Report </li></ul><ul><li>MD&amp;A </li></ul><ul><li>Supplementary schedules </li></ul><ul><li>Form 10-K and Form 10-Q </li></ul>The analyst will want to consider the following resources:
  • 15. Other Sources of Information <ul><li>Computerized data bases </li></ul><ul><ul><li>Info on industry norms/ratios </li></ul></ul><ul><ul><li>Info on particular companies/industries </li></ul></ul><ul><li>Ever-expanding financial and investment websites </li></ul><ul><li>Articles in popular/business press </li></ul>
  • 16. Tools and Techniques <ul><li>Common-size financial statements </li></ul><ul><li>Financial ratios </li></ul><ul><li>Trend analysis </li></ul><ul><li>Structural analysis </li></ul><ul><li>Industry comparisons </li></ul>These include: Most important: Common sense and judgment
  • 17. Common-Size Financial Statements <ul><li>Express each account on the </li></ul><ul><li>balance sheet as a percentage of total assets </li></ul><ul><li>income statement as a percentage of net sales </li></ul>
  • 18. Key Financial Ratios <ul><li>Standardize financial data in terms of mathematical relationships expressed in the form of </li></ul>Percentages Times Days
  • 19. Key Financial Ratios (cont.) <ul><li>Liquidity Ratios </li></ul><ul><li>Measure a firm’s ability to meet cash needs as they arise </li></ul>Four Categories of key financial ratios:
  • 20. Key Financial Ratios (cont.) <ul><li>Activity Ratios </li></ul><ul><li>Measure the liquidity of specific assets and the efficiency of managing assets </li></ul>Four Categories of key financial ratios:
  • 21. Key Financial Ratios (cont.) <ul><li>Leverage Ratios </li></ul><ul><li>Measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges </li></ul>Four Categories of key financial ratios:
  • 22. <ul><li>Profitability Ratios </li></ul><ul><li>Measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity </li></ul>Key Financial Ratios (cont.) Four Categories of key financial ratios:
  • 23. Cautions! <ul><li>Ratios are valuable analytical tools and serve as screening devices, BUT. . . </li></ul><ul><li>They do not provide answers in and of themselves </li></ul><ul><li>They are not predictive </li></ul>
  • 24. Cautions! (cont.) <ul><li>Ratios should be used with other elements of financial analysis </li></ul><ul><li>There are no “rules of thumb” that apply to the interpretation of ratios </li></ul>
  • 25. Cautions! (cont.) <ul><li>Keeping this in mind, let’s take a look at some of the ratios. . . . </li></ul>
  • 26. Liquidity Ratios: Short-Term Solvency <ul><li>Measures ability to meet short-term cash needs </li></ul>Current Ratio Current assets Current liabilities
  • 27. Liquidity Ratios: Short-Term Solvency (cont.) <ul><li>Measures ability to meet short-term cash needs more rigorously by eliminating inventory </li></ul>Quick or Acid-Test Ratio Current assets - Inventory Current liabilities
  • 28. Liquidity Ratios: Short-Term Solvency (cont.) <ul><li>Focuses on ability of the firm to generate operating cash flows as a source of liquidity </li></ul>Cash Flow Liquidity Ratio *Cash flow from operating activities Cash + Marketable securities + CFO * Current liabilities
  • 29. Liquidity Ratios: Short-Term Solvency (cont.) <ul><li>Helps gauge liquidity of accounts receivable (ability to collect cash from customers) and may help provide information about a company’s credit policies </li></ul>Average Collection Period Net accounts receivable Average daily sales
  • 30. Liquidity Ratios: Short-Term Solvency (cont.) <ul><li>Measures the efficiency of the firm in managing its inventory </li></ul>Days Inventory Held Inventory Average daily cost of sales
  • 31. Liquidity Ratios: Short-Term Solvency (cont.) <ul><li>Current Yr. Prior Year 2 Yrs. Prior </li></ul><ul><li>5 days 5 days 4 days </li></ul>Days Inventory Held: Example of ratio comparisons for two companies in the Electronic Computers industry* Current Yr. Prior Year 2 Yrs. Prior 23 days 22 days 15 days *Data from SEC website, www.sec.gov
  • 32. Liquidity Ratios: Short-Term Solvency (cont.) <ul><li>Offers insight into a firm’s pattern of payments to suppliers </li></ul>Days Payable Outstanding Accounts payable Average daily cost of sales
  • 33. Cash Conversion Cycle or Net Trade Cycle <ul><li>Buying or manufacturing inventory, with some purchases on credit </li></ul><ul><li>Selling inventory, with some sales on credit </li></ul><ul><li>Collecting the cash </li></ul>The normal cycle of a firm that consists of:
  • 34. Cash Conversion Cycle or Net Trade Cycle (cont.) <ul><li>Key balance sheet accounts that affect cash flow from operating activities </li></ul><ul><li>Accounts Receivable </li></ul><ul><li>Inventory </li></ul><ul><li>Accounts Payable </li></ul>Helps the analyst understand why cash flow generation has improved or deteriorated by analyzing:
  • 35. Cash Conversion Cycle or Net Trade Cycle (cont.) <ul><li>Average collection period </li></ul><ul><li>Plus </li></ul><ul><li>Days inventory held </li></ul><ul><li>Minus </li></ul><ul><li>Days payable outstanding </li></ul><ul><li>Equals </li></ul><ul><li>Cash conversion or net trade cycle </li></ul>Calculated as follows:
  • 36. Activity Ratios: Asset Liquidity, Asset Management Efficiency <ul><li>Another measure of efficiency of firm’s collection and credit policies </li></ul>Accounts Receivable Turnover Net sales Net accounts receivable
  • 37. Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) <ul><li>Another measure of firm’s efficiency in managing its inventory </li></ul>Inventory Turnover Cost of goods sold Inventory
  • 38. Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) <ul><li>Another way to gain insight into a firm’s pattern of payment to suppliers </li></ul>Payables Turnover Cost of goods sold Accounts payable
  • 39. Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) <ul><li>Assesses effectiveness in generating sales from investments in fixed assets </li></ul>Fixed Asset Turnover Net sales Net property, plant, equipment
  • 40. Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) <ul><li>Assesses effectiveness in generating sales from investments in all assets </li></ul>Total Asset Turnover Net sales Total assets
  • 41. Leverage Ratios: Debt Financing and Coverage <ul><li>Considers the proportion of all assets that are financed with debt </li></ul>Debt Ratio Total liabilities Total assets
  • 42. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Current Yr. Prior Year </li></ul><ul><li>62.31% 69.93% </li></ul>Debt Ratio: Example of ratio comparisons for two companies in the Grain Mills industry* Current Yr. Prior Year 79.08% 85.77% *Data from SEC website, www.sec.gov
  • 43. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Reveals the extent to which long-term debt is used for the firm’s permanent financing (both long-term debt and equity) </li></ul>Long-term Debt to Total Capitalization Long–term debt Long-term debt + Stockholders’ equity
  • 44. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity) </li></ul>Debt to Equity Total liabilities Stockholders’ equity
  • 45. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Indicates how well operating earnings cover fixed interest expenses </li></ul>Times Interest Earned Operating profit Interest expense
  • 46. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Measures how many times interest payments can be covered by cash flow from operations before interest and taxes </li></ul>Cash Interest Coverage CFO + interest paid + taxes paid Interest paid
  • 47. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Broader measure of how well operating earnings cover fixed charges </li></ul>Fixed Charge Coverage *Rent expense = operating lease payments Operating profit + Rent expense Interest expense + Rent expense
  • 48. Leverage Ratios: Debt Financing and Coverage (cont.) <ul><li>Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year </li></ul>Cash Flow Adequacy Cash flow from operating activities Capital expenditures + debt repayments + dividends paid
  • 49. Profitability Ratios: Overall Efficiency and Performance <ul><li>Measures ability to translate sales into profit after consideration of cost of products sold </li></ul>Gross Profit Margin Gross profit Net sales
  • 50. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures ability to translate sales into profit after consideration of operating expenses </li></ul>Operating Profit Margin Operating profit Net sales
  • 51. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures ability to translate sales into profit after consideration of all expenses and revenues, including interest, taxes and nonoperating items </li></ul>Net Profit Margin Net earnings Net sales
  • 52. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures ability to translate sales into cash (with which to pay bills!) </li></ul>Cash Flow Margin Cash flow from operating activities Net sales
  • 53. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures overall efficiency of firm in managing investment in assets and generating profits </li></ul>Return on Total Assets (ROA) or Return on Investment (ROI) Net earnings Total assets
  • 54. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures rate of return on stockholders’ investment </li></ul>Return on Equity (ROE) Net earnings Stockholders’ equity
  • 55. Profitability Ratios: Overall Efficiency and Performance (cont.) <ul><li>Measures firm’s ability to generate cash from the utilization of its assets </li></ul><ul><li>Useful comparison to ROA </li></ul>Cash Return on Assets Cash flow from operating activities Total assets
  • 56. Market Ratios <ul><li>Earnings per common share </li></ul><ul><li>Price-to-earnings </li></ul><ul><li>Dividend payout </li></ul><ul><li>Dividend yield </li></ul>Four market ratios of particular interest to the investor are
  • 57. Market Ratios (cont.) <ul><li>Provides the investor with a common denominator to gauge investment returns </li></ul>Earnings per Common Share Net earnings Average shares outstanding
  • 58. Market Ratios (cont.) <ul><li>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 </li></ul>Price-to-Earnings Market price of common stock Earnings per share
  • 59. Market Ratios (cont.) <ul><li>Determined by the formula cash dividends per share divided by earnings per share </li></ul>Dividend Payout Dividends per share Earnings per share
  • 60. Market Ratios (cont.) <ul><li>Shows the relationship between cash dividends and market price </li></ul>Dividend Yield Dividends per share Market price of common stock
  • 61. Analyzing the Data <ul><li>Now that some of the “tools” of financial analysis have been illustrated, where does one go from here? </li></ul><ul><li>Taking a general approach to financial statement analysis, one might proceed as follows. . . </li></ul>
  • 62. Five Steps of a Financial Statement Analysis <ul><li>Who are you and why are you interested in this company? </li></ul><ul><li>What questions would you like to have answered? </li></ul><ul><li>What info is vital to the decision at hand? </li></ul>Establish objectives of the analysis Step 1
  • 63. Five Steps of a Financial Statement Analysis (cont.) <ul><li>Study the industry in which the firm operates and relate industry climate to current and projected economic developments </li></ul>Step 2
  • 64. Five Steps of a Financial Statement Analysis (cont.) <ul><li>How well does this firm appear to be run? </li></ul><ul><li>Are they taking advantage of opportunities? </li></ul><ul><li>Are they innovative, forward-looking, etc? </li></ul>Step 3 Develop knowledge of the firm and the quality of management
  • 65. Five Steps of a Financial Statement Analysis (cont.) <ul><li>Common-size financial statements </li></ul><ul><li>Key financial ratios </li></ul><ul><li>Trend analysis </li></ul><ul><li>Structural analysis </li></ul><ul><li>Comparison with industry competitors </li></ul>Step 4 Evaluate financial statements– tools include:
  • 66. Five Steps of a Financial Statement Analysis (cont.) <ul><li>Short-term liquidity </li></ul><ul><li>Operating efficiency </li></ul><ul><li>Capital structure and long-term solvency </li></ul><ul><li>Profitability </li></ul><ul><li>Market ratios </li></ul><ul><li>Segmental analysis (when relevant) </li></ul><ul><li>Quality of financial reporting </li></ul>Step 4 Evaluate financial statements– areas include:
  • 67. Five Steps of a Financial Statement Analysis (cont.) <ul><li>Reach conclusions about the firm relevant to your established objectives </li></ul>Step 5 Summarize findings based on analysis
  • 68. Relating the Ratios —The Du Pont System <ul><li>Is helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios </li></ul>
  • 69. Relating the Ratios —The Du Pont System (cont.) <ul><li>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 </li></ul>
  • 70. Relating the Ratios —The Du Pont System (cont.) The summary ratios used are the following: (1) Net profit margin (2) Total asset turnover (3) Return on investment (3) Return on investment (4) Financial leverage (5) Return on equity Net income Net sales Net income Net sales X Total assets = Total assets Net income Total assets Net income Total assets X Stockholder equity = Stockholder equity
  • 71. What we have accomplished Auditor’s Report Statement of Cash Flows MD&amp;A Statement of Shareholders’ Equity Balance Sheet Notes Income Statement Turned Maze
  • 72. Financial Statements An Overview into Map

×