The Analysis of Financial Statements
BA 617
Module 7
Step One
Who is the user?
Different users have different information
needs.
Potential Financial Statement
Users:
Creditors
Investors
Managers
What types of questions do each of
these users seek answers to?
Creditors
Why does the firm want/need to borrow
funds?
What is the firm’s capital structure? How
leveraged are they?
How will they pay it back? What kind of
cash flows are being generated by
operations?
Investors
How has the firm performed/what are
future expectations?
How much RISK is inherent in the capital
structure?
What are expected returns from the firm?
What is firm’s competitive position?
Managers
Need all info creditors and investors need
PLUS:
What operating areas have contributed to
success and which have not?
What are strengths/weaknesses of
company’s financial position?
What changes are indicated to improve
future performance?
Caution!!!
Keep in mind: management PREPARES
financial statements
Analyst should be alert to potential for
management to influence reporting to
make data more “appealing”
May want to supplement analysis with
information apart from Annual Report
prepared by management
Steps 2 and 3
Where to look for data...
Financial statements (and notes)
Auditor’s report
MD&A
Supplementary schedules
All of the above are in Annual Report -can also look further...
Other Data Sources
10K and 10Q reports filed with SEC
Computerized data bases
– Info on industry norms/ratios
– Info on particular companies/industries/mutual
funds
Articles in popular/business press
Ever-expanding websites
ValueLine
Username and Password
Available to Mercer students
only!
USERID: 156339
Password: stocks
Great Analysis Tool
http://edgarscan.pwcglobal.com/recruit/other.html
Try out the benchmarking assistant!
More sources of info
SIC Manual
Industry Averages and Comparison with
Competitors
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The Dept of Commerce Financial Report
Robert Morris Associates Annual Statement Studies
Standard & Poor’s Industry Surveys
Almanac of Business and Industrial Financial Ratios
D&B Industry Norms and Key Business Ratios
Compact Disclosure
Step 4
Basic Tools
Common size financial statements
Financial ratios
Trend analysis
Structural analysis
Industry comparisons
Common sense and judgment (often the
hardest to use!)
Common Size Statements
Common size income statement
– expresses each income statement category
as a percentage of net sales
Common size balance sheet
– expresses each item on balance sheet as a
percentage of total assets or equities
Both statements facilitate structural
analysis of the firm
Financial Ratio Categories
Liquidity Ratios
– measure a firm’s ability to meet cash needs
as they arise
Activity Ratios
– measure the liquidity of specific assets and
the efficiency of managing assets
Ratio Categories (continued)
Leverage Ratios
– measure the extent of a firm’s financing with
debt relative to equity and its ability to cover
interest and other fixed charges
Profitability Ratios
– measure the overall performance of a firm
and its efficiency in managing assets,
liabilities and equity
Caution!!!!!!
Ratios are valuable, BUT…..
– They do not provide answers in an of themselves and
are not predictive
– They should be used with other elements of financial
analysis
– There are no “rules of thumb” that apply to
interpretation of ratios
KEEPING THIS IN MIND, LET’S TAKE A LOOK
AT SOME OF THE RATIOS….
Liquidity Ratios
Current Ratio
– Current Assets/Current Liabilities
– Measures ability to meet short-term cash needs
Quick or Acid Test Ratio
– Current Assets-Inventory/Current Liabilities
– Measure ability to meet short-term cash needs
more rigorously
Liquidity Ratios (continued)
Cash Flow Liquidity Ratio
– Cash+Marketable Securities+Cash Flow from
Operating Activities/Current Liabilities
– Focuses on ability of the firm to generate
operating cash flows as a source of liquidity
Activity Ratios
Average Collection Period
– Accounts Receivable/Average Daily Sales
– Helps gauge liquidity of accounts receivable (ability
to collect cash from customers)
Accounts Receivable Turnover
– Net Sales/Accounts Receivable
– Another measure of efficiency of firm’s collection and
credit policies
Activity Ratios (continued)
Inventory Turnover
– Cost of Goods Sold/Inventory
– Measures efficiency of inventory management
Fixed Asset and Total Asset Turnover
– Net Sales/Net PP&E (Fixed Asset T/O)
– Net Sales/Total Assets (Total Asset T/O)
– Both assess effectiveness in generating sales from
investment in assets
Leverage: Debt Ratios
Debt Ratio
– Total Liabilities/Total Assets
Long-Term Debt to Total Capitalization
– Long-term Debt/Long-term Debt + Stockholders’
Equity
Debt to Equity Ratio
– Total Liabilities/Stockholders’ Equity
All three measure extent of firm’s financing with
debt
Leverage: Coverage Ratios
Proportion and amount of debt in capital
structure is important to analyst
Tradeoff between risk and return
Use of debt involves risk -- commitment to
fixed charges
Fixed charges must be COVERED -following are some ratios to assess
coverage…...
Coverage Ratios (continued)
Times Interest Earned
– Operating Profit/Interest Expense
– Indicates how well operating earnings cover
fixed interest charges
Fixed Charge Coverage
– Operating Profit + Lease Payments/Interest
Expense + Lease Payments
– Broader measure of how well operating
earnings cover fixed charges
Coverage Ratios (continued)
Cash Flow Adequacy
– Cash Flow from Operating Activities/ Average
Annual Long-Term Debt Maturities
– Measures firm’s ability to cover long-term debt
maturities each year
– Rationale is that over the long-run operating
cash flows must be adequate to cover
investing activities financed with debt
Profitability Ratios
Gross Profit Margin
– Gross Profit/Net Sales
Operating Profit Margin
– Operating Profit/Net Sales
Net Profit Margin
– Net Earnings/Net Sales
All measure firm’s ability to translate sales
dollars into profits
Profitability Ratios (continued)
Cash Flow Margin
– Cash Flow from Operating Activities /
Net
Sales
– Measures ability to translate sales into cash
(with which to pay bills!)
Profitability Ratios (continued)
Return on Investment (or Return on Assets
-- same thing, different words!)
– Net Earnings/Total Assets
Return on Equity
– Net Earnings/Stockholders’ Equity
Both measure overall efficiency of firm in
managing investment in assets and
generating return to stockholders
Profitability Ratios (continued)
Cash Return on Assets
– Cash Flow from Operating Activities /
Total
Assets
– Useful comparison to return on investment
– Indicates firm’s ability to generate cash from
utilizing its assets
Other Ratios You Hear About..
Earnings per Common Share
– Net Earnings/Average Common Shares
Outstanding
– Indicates return on a per share basis
Price to Earnings
– Market Price of Common Stock/Earnings per
Common Share
– Expresses a multiple the stock market places
on earnings
Other Ratios (continued)
Dividend Payout
– Dividends per Share/Earnings per Share
– Shows percentage of earnings paid out to
stockholders
Dividend Yield
– Dividends per Share/Market Price of Common
Share
– Shows rate earned by shareholders from dividends
relative to current stock price
Analyzing the Company
Now that some of the “tools” of financial
analysis have been illustrated, where does
one go from here?
Step 5
Red Flags
Changes in top company management
Key financial ratios indicating deteriorating
trends and/or weaknesses relative to
industry competitors
Cash flow from operations declining,
negative, volatile, or not tracking with net
income.
Lack of profitability in key operating areas.
More Red Flags
Price to earnings ratio low relative to
competitors
Firm’s earnings less than after-tax cost of
debt
Declining operating profits when debt is
rising
Deteriorating trends in operating segments
Accomplishments
Reviewed all the basic financial
statements and know what they are
Practiced the rudiments of financial
analysis
If nothing else, hopefully gained an
appreciation of what information is
available and how one might use it...
A Final Note
Financial analysis is only as good as the
information upon which it is based -hence we need to be concerned about
honest, straightforward, comprehensible
financial reporting
Financial analysis is only valuable to me if
it answers MY questions -- I need to
THINK about what I need/would like to
know BEFORE I crunch numbers
A Final Final Note (really!)
Analyzing financial information can be fun
(as well as profitable)
You can never know too much about a
company you plan to have a relationship
with (as an investor, a creditor, a manager,
an employee)