Analysis and Interpretation of Financial Statements

Financial Statement Analysis The application of analytical tools and techniques to financial statement data. Allows users to focus on how numbers are related and how they have changed over time

The application of analytical tools and techniques to financial statement data.

Allows users to focus on how numbers are related and how they have changed over time

Objective of Financial StatementAnalysis External users rely on general purpose financial statements Make predictions about an organization as an aid in making decisions Users highlight important trends or changes

External users rely on general purpose financial statements

Make predictions about an organization as an aid in making decisions

Users highlight important trends or changes

Risk and Return Users try to balance the risk of an investment with its expected return Generally the greater the risk, the higher the return Financial statement analysis is one source of information for assessing risk and return

Users try to balance the risk of an investment with its expected return

Generally the greater the risk, the higher the return

Financial statement analysis is one source of information for assessing risk and return

Sources of External Information Public companies must publish an annual financial report Government reports SEC 10K, 10Q Financial service information Moody’s, Dow-Jones Financial newspapers and periodicals Wall Street Journal

Public companies must publish an annual financial report

Government reports

SEC 10K, 10Q

Financial service information

Moody’s, Dow-Jones

Financial newspapers and periodicals

Wall Street Journal

Financial Analysis Tools Horizontal analysis Vertical analysis Ratio analysis

Horizontal analysis

Vertical analysis

Ratio analysis

Horizontal Analysis: Amounts and Percentages of Change Amount of change = later year amount - Earlier year amount Percentage change = Amount of change / Earlier year amount Look for significant change

Amount of change = later year amount - Earlier year amount

Percentage change = Amount of change / Earlier year amount

Look for significant change

Horizontal Analysis: Trend Percentages Set all amounts in base year at 100% Compute percentages for a number of years Divide each statement amount by respective amount in base year Shows degree of increase or decrease in individual statement items Used to explain changes in operating performance

Set all amounts in base year at 100%

Compute percentages for a number of years

Divide each statement amount by respective amount in base year

Shows degree of increase or decrease in individual statement items

Used to explain changes in operating performance

Vertical Analysis Shows how each item in a financial statement compares to the total of that statement Balance sheet Set both total assets and total equities at 100% Income statement Set net sales at 100%

Shows how each item in a financial statement compares to the total of that statement

Balance sheet

Set both total assets and total equities at 100%

Income statement

Set net sales at 100%

Vertical Analysis Identify significant dollar and percentage changes Explain the changes Identify whether they are favorable of unfavorable

Identify significant dollar and percentage changes

Explain the changes

Identify whether they are favorable of unfavorable

Ratio Analysis Shows the relative size of one financial statement component to another. Effective only when used in combination with other ratios, analysis, and information

Shows the relative size of one financial statement component to another.

Effective only when used in combination with other ratios, analysis, and information

Ratio Analysis Short-term liquidity Long-term solvency Profitability Market performance

Short-term liquidity

Long-term solvency

Profitability

Market performance

Short-term Profitability Current ratio Quick ratio Accounts receivable turnover Days’ sales in receivables Inventory turnover

Current ratio

Quick ratio

Accounts receivable turnover

Days’ sales in receivables

Inventory turnover

Current Ratio Common measure of liquidity Ability to pay debts as they come due Rule of thumb 2:1 Consider other factors Current Assets Current Liabilities

Common measure of liquidity

Ability to pay debts as they come due

Rule of thumb 2:1

Consider other factors

Quick Ratio (Acid Test) More strict measure of short-term liquidity Numerator includes only quick current assets Assets readily converted to cash Cash + Short-term investments + Net Current Receivables Current liabilities

More strict measure of short-term liquidity

Numerator includes only quick current assets

Assets readily converted to cash

Accounts Receivable Turnover How many times we turn accounts receivable into cash during a period Net sales Average net accounts receivable

How many times we turn accounts receivable into cash during a period

Days’ Sales in Receivables How many days’ sales remain uncollected in accounts receivable Net sales per day = Net sales 365 days Average net accounts receivable Net sales per day

How many days’ sales remain uncollected in accounts receivable

Inventory Turnover Number of times the company sells and replaces its inventory during the period Holding inventory results in financing and storage costs Cost of goods sold Average inventory

Number of times the company sells and replaces its inventory during the period

Holding inventory results in financing and storage costs

Long-term Solvency Debt ratio Times Interest Earned

Debt ratio

Times Interest Earned

Debt Ratio Shows amount of total assets creditors provide Higher levels of debt financing means company has a higher risk of not meeting interest and principal payments Total liabilities Total assets

Shows amount of total assets creditors provide

Higher levels of debt financing means company has a higher risk of not meeting interest and principal payments

Times Interest Earned Number of times the company earned interest expense with current income Creditors want to know the firm’s ability to pay annual interest charges Net income + Income tax expense + Interest expense Interest expense

Number of times the company earned interest expense with current income

Creditors want to know the firm’s ability to pay annual interest charges

Profitability Profit margin Total asset turnover Return on total assets Return on owners’ equity Earning per share

Profit margin

Total asset turnover

Return on total assets

Return on owners’ equity

Earning per share

Profit Margin Percentage each sales dollar contributes to net income Net income Net sales

Percentage each sales dollar contributes to net income

Total Asset Turnover Measures the efficiency of the company is using its investment in assets to generate sales Net sales Average total assets

Measures the efficiency of the company is using its investment in assets to generate sales

Return on Total Assets Measures the amount a company earns on each dollar of investment in assets Net income Average total assets

Measures the amount a company earns on each dollar of investment in assets

Return on Owners’ Equity Measures the earnings in relation to the owners’ investment in the company Net income - Preferred dividends Average owner’s equity

Measures the earnings in relation to the owners’ investment in the company

Earnings Per Share Measures the net income available to each share of common stock Discussed in depth in Chapter 14 Net income - Preferred dividends Weighted average number of common shares outstanding during the year

Measures the net income available to each share of common stock

Discussed in depth in Chapter 14

Market Performance Price/Earnings (P/E) ratio Dividend yield

Price/Earnings (P/E) ratio

Dividend yield

Price/Earning (P/E) Ratio Number of times earnings per share the stock is currently selling for in the market Market price per share of common stock Earnings per share

Number of times earnings per share the stock is currently selling for in the market

Dividend Yield Measure of dividend-paying performance of a company Investors buy stock for two reasons Receive cash dividends Sell stock at a higher price Dividends per share Market price per share

Measure of dividend-paying performance of a company

Investors buy stock for two reasons

Receive cash dividends

Sell stock at a higher price

Limitations of Financial Analysis Tools Historical nature of accounting information Changing economic conditions Comparisons with industry averages Seasonal factors Quality of reported income

Historical nature of accounting information

Changing economic conditions

Comparisons with industry averages

Seasonal factors

Quality of reported income