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Financial Statement Analysis

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This document outlines what constitutes Financial Analysis to study a company's Balance Sheet, Profit and Loss accounts, Cash Flow Statements. It also provides guidance to do Ratio Analysis.

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Financial Statement Analysis

  1. 1. Financial Statement c o m t . Analysis e tr e Financial Policy and Planning R I sN © nristreet.com
  2. 2. Outline c o m t . Meaning of Financial Statements and Financial e Statement Analysis e Significance of Financial Statements r Types of Financial Statements t s  Income Statement I  Balance Sheet  Cash Flow Statement R  Statement of Retained EarningsN Ratio Analysis including Du Pont Analysis Limitations of Financial Statement Analysis © nristreet.com
  3. 3. Focus c o m t . The focus will be on financial statement analysis and e its use in corporate finance. e financial statement analysis from managerial tr perspective and not from an investor and/or s creditor’s perspective. I How to use financial statement analysis to ensure R that shareholder wealth is maximized and the stock price continues to rise?N © nristreet.com
  4. 4. Meaning of FinancialStatements c o m t .  Financial statements are summaries of the e operating, financing, and investment activities e of a firm. r  According to the Financial Accounting t Standards Board (FASB), the financial s statements of a firm should provide sufficient I information that is useful to  investors and R  creditorsN  in making their investment and credit decisions in an informed way. © nristreet.com
  5. 5. c o m t . The financial statements are expected to be prepared in e accordance with a set of standards known as generally e accepted accounting principles (GAAP). r The financial statements of publicly traded firms must be t audited at least annually by independent public s accountants. I The auditors are expected to attest to the fact that these R financial statements of a firm have been prepared in accordance with GAAP.N © nristreet.com
  6. 6. m Significance of Financial c o Statements  e t . Wall Street analysts and other sophisticated investors prefer such financial disclosure documents as 10-Ks, which contain e more detailed information about the company r  Financial statements summarize and provide an overview of t events relating to the functioning of a firm. s  Financial statement analysis helps identify I  a firm’s strengths and  weaknesses R  so that management can take advantage of a firm’s strengths and make plans to counter weaknesses ofN the firm.  The strengths must be understood if they are to be used to proper advantage and weaknesses must be recognized if corrective action needs to be taken © nristreet.com
  7. 7. c o m t . For example, are inventories adequate to support the projected e level of sales? Does the firm have too heavy an investment in account e receivable? tr Does large account receivable reflect a lax collection policy? s To ensure efficient operations of a firm’s manufacturing facility, does the firm have too much or too little invested in plant and I equipment? R Financial statement analysis provides answers to all of these questions.N © nristreet.com
  8. 8. mTypes of Financial Statements and oReports t . The Income Statement c e The Balance Sheet r e The Statement of Retained s t Earnings I The Statement of Cash FlowsN R © nristreet.com
  9. 9. The Income Statement c o m t .  An income statement is a summary of the revenues and e expenses of a business over a period of time, usually either e one month, three months, or one year. r  Summarizes the results of the firm’s operating and financing t decisions during that time. s  Operating decisions of the company apply to production and I marketing such as sales/revenues, cost of goods sold, administrative and general expenses (advertising, office R salaries)  Provides operating income/earnings before interest andN taxes (EBIT) © nristreet.com
  10. 10. c o m t . Results of financing decisions are reflected in the e remainder of the income statement. e When interest expenses and taxes are subtracted r from EBIT, the result is net income available to t shareholders. s Net income does not necessarily equal actual cash I flow from operations and financing.N R © nristreet.com
  11. 11. mThe Balance Sheet . c o t A summary of the assets, liabilities, and equity of a business at a particular point in time, usually at the end of the firm’s fiscal year. eAssets = Liabilities + Equity e(Resources of the (Obligations of (ownership left over rbusiness enterprise) the business) Residual) tFixed Assets Long-term Common stock outstanding s(Plant, Machinery, Equipment (Notes, bonds, & Additional paid-in capitalBuildings) Capital Lease Retained Earnings ICurrent Assets Obligation)(Cash, Marketable Securities, Current Liabilities RAccount Receivable, Inventories) (Accounts Payable, Wages and salaries, Short-term loansN Any portion of long-term Indebtedness due in one-year) © nristreet.com
  12. 12. mTHE STATEMENT OF CASH oFLOWS t . c The statement is designed to show how the firm’s operations have e affected its cash position and to help answer questions such as these: e  Is the firm generating the cash needed to purchase additional fixed assets r for growth? t  Is the growth so rapid that external financing is required both to maintain s operations and for investment in new fixed assets? I  Does the firm have excess cash flows that can be used to repay debt or to R invest in new products?N © nristreet.com
  13. 13. mRATIO ANALYSIS . c o t  Financial statements report both on a firm’s e position at a point in time and on its operations e over some past period. r  From management’s viewpoint, financial t statement analysis is useful both as a way to s  anticipate future conditions and I  more important, as a starting point for planning R actions  that will influence the future course of events orN  to show whether a firm’s position has been improving or deteriorating over time. © nristreet.com
  14. 14. c o m t . Ratio analysis begins e  with the calculation of a set of financial ratios e  designed to show the relative strengths and r  weaknesses of a company as compared to t  Other firms in the industry s  Leadings firms in the industry I  The previous year of the same firm R Ratio analysis helps to show whether the firm’s position has been improving or deterioratingN Ratio analysis can also help plan for the future © nristreet.com
  15. 15. m Types of Ratios . c o t  Liquidity Ratios e Current Ratio Quick Ratio/Acid Test Ratio e  Asset Management Ratios r Inventory Turnover Ratio Days Sales Outstanding t Fixed Assets Turnover Ratio s Total Assets Turnover Ratio  Debt Management Ratio I Total Debt to Total Assets Ratio Times Interest Covered Ratio R  Profitability Ratios Profit Margin on SalesN Return on Assets Return on Equity Basic Earning Power Ratio © nristreet.com
  16. 16. Liquidity Ratio c o m t . A liquid asset is one that can be easily e converted into cash at a fair market value e Liquidity question deals with this question tr  Will the firm be able to meet its current s obligations? I Two measures of liquidity R  Current RatioN  Quick/Acid Test Ratio © nristreet.com
  17. 17. Asset Management Ratios c o m t . Asset management ratio measures how effectively e the firm is managing/using its assets e Do we have too much investment in assets or too tr little investment in assets in view of current and s projected sales levels? I What happens if the firm has R  Too much investment in assetsN  Too little investment in assets © nristreet.com
  18. 18. Asset Management Ratios c o m t . Inventory Turnover Ratio e  Measures the efficiency of Inventory Management e  A high ratio indicates that inventory does not remain in r warehouses or on shelves, but rather turns over rapidly t into sales I s Two cautions Market prices for sales and inventories at cost R   Sales over the year and inventory at the end of the yearN © nristreet.com
  19. 19. Asset Management Ratio c o m t . Days Sales Outstanding (DSO) e  To appraise the quality of accounts receivables e  Average length of time that the firm must wait after making r a sale before receiving cash from customers t  Measures effectiveness of a firm credit policy s  Indicates the level of investment needed in receivables to I maintain firm’s sales level R What happens if this ratio is  Too high, orN  Too low © nristreet.com
  20. 20. Asset Management Ratios c o m t . Fixed Assets Turnover Ratio e  Measures efficiency of long-term capital r e investment t  How effectively a firm is using its plant and s machinery to generate sales? I  How much fixed assets are needed to achieve a R particular level of sales?N Cautions © nristreet.com
  21. 21. Asset Management Ratio c o m t . Total Asset Turnover Ratio e  Measure efficiency of total assets for the company r e as a whole or for a division of the firm t  Core competency R I sN © nristreet.com
  22. 22. Debt Management Ratio c o m t . Implications of use of borrowings e  Creditors look to Stockholders’ equity as a safety r e margin t  Interest on borrowings is a legal liability of the firm s Interest is to be paid out of operating income I   Debt magnifies return and risk to common R stockholdersN © nristreet.com
  23. 23. c o m t . Total Debt to Total Assets Ratio e  Measures percentage of assets being financed r e through borrowings t  Too high a number means increased risk of s bankruptcy I Leverage R  What percentage of total assets are beingN financed through equity? © nristreet.com
  24. 24. c o m t . Times Earned Interest (TIE) e  Measure the extent to which operating income r e can decline before the firm is unable to meet its t annual interest costs s  Failure to pay interest can result in legal action by I creditors with possible bankruptcy for the firmN R © nristreet.com
  25. 25. Profitability Ratios c o m t . Net result of a number of policies and e decisions r e Show the combined effect of liquidity, asset t management, and debt management on I s operating resultsN R © nristreet.com
  26. 26. c o m t . Net Profit Margin on Sales e  Relates net income available to common stockholders to sales Basic Earning Power e  Relates EBIT to Total Assets r  Useful for comparing firms with different tax situations and t different degrees of financial leverage s Return on Assets (ROA) I  Relates net income available to common stockholders to total assets R Return on Common Equity (ROE)  Relates net income available to common stockholders toN common stockholders equity © nristreet.com
  27. 27. m PROBLEMS IN FINANCIAL o STATEMENT ANALYSIS t . c Developing and Using Comparative Data e Distortion of Comparative Data e r Notes to Financial Statements t Interpretation of Results s I Differences in Accounting Treatment Window Dressing R Effects of InflationN © nristreet.com

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