CHAPTER 2
ANALYSIS OF
FINANCIAL
STATEMENTS
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1
Learning Outcomes
LO.1 Describe the basic financial information
that is produced by corporations and
explain how the firm’s stakeholders use
such information.
LO.2 Describe the financial statements that
corporations publish and the
information that each statement
provides.
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2
Learning Outcomes (cont.)
LO.3 Describe how ratio analysis should be
conducted and why the results of such
an analysis are important to both
managers and investors.
LO.4 Discuss potential problems (caveats)
associated with financial statement
analysis.
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3
Relevant Accounting Principles
and Concepts
○ Accrual principle. This is the concept that accounting transactions
should be recorded in the accounting periods when they actually occur,
rather than in the periods when there are cash flows associated with
them. This is the foundation of the accrual basis of accounting. It is
important for the construction of financial statements that show what
actually happened in an accounting period, rather than being artificially
delayed or accelerated by the associated cash flows. For example, if you
ignored the accrual principle, you would record an expense only when
you paid for it, which might incorporate a lengthy delay caused by the
payment terms for the associated supplier invoice.
○ Conservatism principle. This is the concept that you should record
expenses and liabilities as soon as possible, but to record revenues and
assets only when you are sure that they will occur. This introduces a
conservative slant to the financial statements that may yield lower
reported profits, since revenue and asset recognition may be delayed
for some time. Conversely, this principle tends to encourage the
recordation of losses earlier, rather than later. This concept can be taken
too far, where a business persistently misstates its results to be worse
than is realistically the case.
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4
Relevant Accounting Principles
and Concepts
○ Consistency principle. This is the concept that, once you
adopt an accounting principle or method, you should
continue to use it until a demonstrably better principle
or method comes along. Not following the consistency
principle means that a business could continually jump
between different accounting treatments of its
transactions that makes its long-term financial results
extremely difficult to discern.
○ Cost principle. This is the concept that a business
should only record its assets, liabilities, and equity
investments at their original purchase costs. This
principle is becoming less valid, as a host of accounting
standards are heading in the direction of adjusting
assets and liabilities to their fair values.
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5
Relevant Accounting Principles
and Concepts
○ Economic entity principle. This is the concept that the transactions of a
business should be kept separate from those of its owners and other
businesses. This prevents intermingling of assets and liabilities among
multiple entities, which can cause considerable difficulties when the
financial statements of a fledgling business are first audited.
○ Full disclosure principle. This is the concept that you should include in or
alongside the financial statements of a business all of the information
that may impact a reader's understanding of those statements. The
accounting standards have greatly amplified upon this concept in
specifying an enormous number of informational disclosures.
○ Going concern principle. This is the concept that a business will remain
in operation for the foreseeable future. This means that you would be
justified in deferring the recognition of some expenses, such as
depreciation, until later periods. Otherwise, you would have to
recognize all expenses at once and not defer any of them.
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6
Relevant Accounting Principles
and Concepts
○ Matching principle. This is the concept that, when you record revenue, you
should record all related expenses at the same time. Thus, you charge inventory
to the cost of goods sold at the same time that you record revenue from the
sale of those inventory items. This is a cornerstone of the accrual basis of
accounting. The cash basis of accounting does not use the matching the
principle.
○ Materiality principle. This is the concept that you should record a transaction in
the accounting records if not doing so might have altered the decision making
process of someone reading the company's financial statements. This is quite a
vague concept that is difficult to quantify, which has led some of the more
picayune controllers to record even the smallest transactions.
○ Monetary unit principle. This is the concept that a business should only record
transactions that can be stated in terms of a unit of currency. Thus, it is easy
enough to record the purchase of a fixed asset, since it was bought for a specific
price, whereas the value of the quality control system of a business is not
recorded. This concept keeps a business from engaging in an excessive level of
estimation in deriving the value of its assets and liabilities.
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7
Relevant Accounting Principles
and Concepts
○ Reliability principle. This is the concept that only those transactions that
can be proven should be recorded. For example, a supplier invoice is
solid evidence that an expense has been recorded. This concept is of
prime interest to auditors, who are constantly in search of the evidence
supporting transactions.
○ Revenue recognition principle. This is the concept that you should only
recognize revenue when the business has substantially completed the
earnings process. So many people have skirted around the fringes of this
concept to commit reporting fraud that a variety of standard-setting
bodies have developed a massive amount of information about what
constitutes proper revenue recognition.
○ Time period principle. This is the concept that a business should report
the results of its operations over a standard period of time. This may
qualify as the most glaringly obvious of all accounting principles, but is
intended to create a standard set of comparable periods, which is useful
for trend analysis.
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8
The Annual Report
○ Discussion of Operations
❑
Usually a letter from the chairman
○ Financial Reporting
❑
Basic financial statements
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9
Three Basic Financial Statements
○ The Balance Sheet
○ The Income Statement
○ Statement of Cash Flows
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10
The Balance Sheet
○ Represents a picture taken on a specific date
that shows a firm’s assets (investments) and
how those assets are financed (debt or
equity).
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11
The Balance Sheet (cont.)
○ Cash and equivalents versus other assets
❑
All assets are stated in dollars—only cash and
equivalents represent money that can be spent
○ Accounting alternatives—e.g., FIFO versus
LIFO, accelerated depreciation versus
straight-line depreciation
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12
The Balance Sheet (cont.)
○ Breakdown of the common equity account
❑
❑
❑
Common stock at par
Paid-in capital
Retained earnings
Combined into Common
stock account if the stock
has no par value.
○ Book values often do not equal market
values.
○ The time dimension
❑
A “snapshot” of the firm’s financial position at a
particular point in time; i.e., on a specific date
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13
Unilate Textiles
Dec. 31 Balance Sheets ($ millions)
2016
Percent of
Amount Total Assets
2015
Percent of
Amount Total Assets
Assets
Cash and equivalents
Accounts receivables
Inventory
Total current assets
Net plant and equipment
Total assets
$ 15.0
180.0
270.0
$465.0
380.0
$845.0
1.8%
21.3
32.0
55.0%
45.0
100.0%
$ 40.0
160.0
200.0
$400.0
350.0
$750.0
5.4%
21.3
26.7
53.3%
46.7
100.0%
Liabilities and Equity
Accounts payable
Accruals
Notes payable
Total current liabilities
Long–term bonds
Total liabilities (debt)
Common stock (25 million shares)
Retained earnings
Total common equity
Total liabilities and equity
$ 30.0
60.0
40.0
$130.0
300.0
$430.0
130.0
285.0
$415.0
$845.0
3.6%
7.1
4.7
15.4%
35.5
50.9%
15.4
33.7
49.1%
100.0%
$ 15.0
55.0
35.0
$105.0
255.0
$360.0
130.0
260.0
390.0
$750.0
2.0%
7.3
4.7
14.0%
34.0
48.0%
17.3
34.7
52.0
100.0%
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14
Unilate Textiles: Balance Sheets
December 31
($ millions, except per share data)
Additional information:
Book value per share
= (Common equity)/Shares
Market value per share (stock price)
Net working capital
= Current assets – Current liabilities
Net worth
= Total assets – Total liabilities
Breakdown of net plant and equipment account:
Gross plant and equipment
Less: Accumulated depreciation
Net plant and equipment
2016
2015
$16.60
$23.00
$15.60
$25.00
$335.0
$295.0
415.0
390.0
$680.0
(300.0)
$380.0
$600.0
250.0
$350.0
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15
The Income Statement
○ Presents the results of business operations
during a specified period of time.
○ Summarizes the revenues generated and
the expenses incurred during a particular
accounting period, such as one fiscal year.
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16
Unilate Textiles: Income Statements
Years Ending December 31 ($ millions)
Net sales
Variable operating costs (82% of sales)
Gross profit
Fixed operating costs, less depreciation
Earnings before interest, taxes, deprec.,
and amortization (EBITDA)
Depreciation
Net Operating income (NOI) =
Earnings b/f interest and taxes (EBIT)
Interest
Earnings before taxes (EBT)
Taxes (40%)
Net income
Preferred dividends
Earnings available to common stockholders (EAC)
Common dividends
Addition to retained earnings
2016
Percent of
Amount Total Sales
2015
Percent of
Amount Total Sales
$1,500.0
(1,230.0)
$ 270.0
( 90.0)
100.0%
82.0
18.0
6.0
$1,435.0
(1,176.7)
$ 258.3
( 85.0)
100.0%
82.0
18.0
5.9
$ 180.0
( 50.0)
12.0
3.3
173.3
( 40.0)
12.1
2.8
$ 130.0
( 40.0)
$ 90.0
( 36.0)
$ 54.0
0.0
$ 54.0
( 29.0)
$ 25.0
8.8
2.7
6.0
2.4
3.6
133.3
35.0)
98.3
39.3)
59.0
0.0
59.0
27.0)
32.0
9.3
2.4
6.9
2.7
4.1
(
(
$
(
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17
Unilate Textiles: Income Statements
Years Ending December 31 ($)
2016
2015
Earnings per share
= (Net income)/Shares
$2.16
$2.36
Dividends per share
= (Common dividends)/Shares
$1.16
$1.08
Per share data (25,000,000 shares):
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18
Statement of Cash Flows
○ Reports the effect of the firm’s activities—
operating, investing, and financing—over
some period on its cash position.
○ Examines investment decisions (uses of
cash) and financing decisions (sources of
cash)
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19
Statement of Cash Flows
Simple rules to follow when constructing a statement
of cash flows:
Sources of Cash
 Liability Account
(e.g., borrow more)
 Equity Account
(e.g., issue stock)
 Asset Account
(e.g., sell inventory)
Uses of Cash
 Liability Account
(e.g., payoff loans)
 Equity Account
(e.g., pay a dividend)
 Asset Account
(e.g., purchase equipment)
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20
Unilate Textiles: Cash Sources and Uses,
2016 ($ millions)
Account Balances as of:
12/31/16 12/31/15
Balance Sheet Effects (Adjustments)
Cash and marketable securities
Accounts receivable
Inventory
Gross plant and equipment
Accounts payable
Accruals
Notes payable
Long-term bonds
Common stock (11 million shares)
Total balance sheet effects
$ 15.0
180.0
200.0
680.0
30.0
60.0
40.0
300.0
130.0
$ 40.0
160.0
270.0
600.0
15.0
55.0
35.0
255.0
130.0
Change
Sources
Uses
---$ 20.0
70.0
80.0
$15.0
5.0
5.0
45.0
$70.0 $170.0
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21
Unilate Textiles: Statement of Cash Flows
for the Period Ending December 31, 2016
Cash Flows
Cash Flows from Operating Activities
Net income
Additions (adjustments) to net income
Depreciation
Increase in accounts payable
Increase in accruals
Subtractions (adjustments) from net income
Increase in accounts receivable
Increase in inventory
Net cash flow from operations
Cash Flows from Long-Term Investing Activities
Acquisition of fixed assets
Cash Flows from Financing Activities
Increase in notes payable
Increase in bonds
Dividend payment
Net cash flow from financing
Net change in cash
Cash at the beginning of the year
Cash at the end of the year
Net Amounts
$ 54.0
50.0
15.0
5.0
(20.0)
(70.0)
$ 34.0
$ (80.0)
$ 5.0
45.0
(29.0)
$ 21.0
$ (25.0)
40.0
$ 15.0
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22
Statement of Retained Earnings
○ Changes in the common equity accounts between
balance sheet dates.
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23
Unilate Textiles:
Statement of Retained Earnings
for the Period Ending December 31, 2016
Balance of retained earnings, December 31, 2015
Add: 2016 net income
Less: 2016 dividends paid to stockholders
Balance of retained earnings, December 31, 2016
$260.0
54.0
(29.0)
$285.0
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24
Financial Statement (Ratio)
Analysis
○ Financial ratios are simply accounting
numbers translated into relative values.
○ Ratios are designed to show relationships
between financial statement accounts
within firms and between firms, no matter
their sizes.
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25
The Purpose of Ratio Analysis
○ Provides an idea of how well the company is
doing.
○ Standardizes numbers; facilitates comparisons.
○ Used to highlight weaknesses and strengths.
○ Provides an indication of the future financial
health of the firm—this is the primary
purpose for conducting ratio analysis.
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26
Five Major Categories of Ratios
○ Liquidity: Is the firm able to meet its current
obligations?
○ Asset management: Is the firm effectively
managing its assets (investments)?
○ Debt management: Does the firm have the
right mix of debt and equity (financing)?
Can the firm “handle” more debt?
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27
Five Major Categories of Ratios
(cont.)
○ Profitability: How do the combined effects
of liquidity, asset, and debt management
affect profits?
○ Market values: What do investors think
about the firm’s future financial prospects?
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28
Liquidity Ratios
○ Current ratio
○ Quick (Acid test) ratio
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29
Unilate’s Current Ratio
Current Ratio =
Current Assets
Current Liabilities
$465.0 = 3.6 times
$130.0
Industry average = 4.1 times
=
o Unilate’s current ratio is below the industry average,
which suggests it is not as liquid (able to pay its bills) as
the average firm in its industry.
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30
Unilate’s Quick
(Acid Test) Ratio
Quick Ratio = Current Assets- Inventories
Current Liabilities
= $465.0 - $270.0 = $195.0 = 1.5 times
$130.0
$130.0
Industry average = 2.1 times
o Unilate’s quick ratio is below the industry average, which
suggests its lower-than-average liquidity might be the
result of large amounts of inventory.
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31
Unilate’s Liquidity Position—
Conclusion
○ Liquidity ratios indicates that Unilate’s
liquidity position is fairly poor.
○ Suggests the firm might have difficulty in
the future paying its bills from operations.
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32
Asset Management Ratios
○
○
○
○
Inventory Turnover Ratio
Days Sales Outstanding (DSO)
Fixed Assets Turnover Ratio
Total Assets Turnover Ratio
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33
Unilate’s Inventory Turnover Ratio
Cost of goods sold
Inventory turnover =
Inventory
$1,230.0
. times
= 4.6
=
$270.0
Industry average = 7.4 times
o Unilate’s inventory turnover ratio is below the industry
average, which suggests it might be holding excess
inventory compared to the average firm in the industry.
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34
Unilate’s Days Sales Outstanding
(DSO) Ratio
Receivables
Receivables
DSO =
=
Daily Sales
 Annual Sales 


360


$180.0
$180.0
=
=
= 43.2 days
 $1,500.0  $4.167
 360 
Industry average = 32.1 days
o Unilate’s DSO is higher than the industry average, which
suggests it is not collecting its receivables as quickly as it
should.
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35
Unilate’s Fixed Assets (FA)
Turnover Ratio
Sales
Fixed assets turnover =
Net fixed assets
$1,500.0
= 3.9 times
=
$380.0
Industry Average
= 4.0 times
o Unilate’s FA turnover ratio is about the same as the
industry average, which suggests it using its fixed assets
about as efficiently as other firms in the industry.
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36
Unilate’s Total Assets (TA)
Turnover Ratio
Sales
Total assets turnover =
Total assets
$1,500.0
=
$845.0
Industry Average
= 1.8 times
= 2.1 times
o Unilate’s TA turnover ratio is below the industry average,
which suggests it is not using all of its assets as efficiently
as other firms in the industry.
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37
Unilate’s Asset Management Ratios—
Conclusion
○ Most asset turnover ratios are below the
industry average, which means the age of
the assets is longer than other firms in the
industry.
○ Unilate does not appear to be operating as
efficiently as the average firm in its industry.
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38
Debt Management Ratios
○ Debt Ratio
○ Times-Interest-Earned Ratio
○ Fixed Charge Coverage Ratio
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39
Unilate’s Debt Ratio
Debt Ratio = Total liabilities
Total assets
= $430.0 = 0.509 = 50.9%
$845.0
Industry Average = 42.0%
o Unilate’s debt ratio is above the industry average, which
suggests it is using more debt to finance its assets than
the average firm in the industry.
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40
Unilate’s Times-Interest-Earned
(TIE) Ratio
TIE =
EBIT
Interest charges
$130.0
= 3.3 times
=
$40.0
Industry Average = 6.5 times
o Unilate’s TIE ratio is well below the industry average,
which suggests it is not as able to service its debt (i.e.,
pay interest) as the average firm in the industry.
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41
Unilate’s Fixed Charge Coverage
(FCC) Ratio
EBIT + Lease payments
FCC =
 Interest  +  Lease  +  Sinking fund payment 

 charges   payments  
1 − Tax rate

$130.0 + $10.0
$140.0
=
=
= 2.2 times
$8.0
$40.0 + $10.0 +  1−0.4  $63.3
Industry Average = 5.8 times
o Unilate’s FCC ratio is well below the industry average,
which suggests it is not as able to cover its fixed financing
charges as the average frim in the industry.
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42
Unilate’s Debt Position—
Conclusion
○ The debt ratio is higher than the industry,
and the coverage ratios are lower than the
industry.
○ Unilate probably will find it difficult to
borrow additional funds until its poor debt
position is improved.
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43
Profitability Ratios
○ Net Profit Margin
○ Return on Total Assets (ROA)
○ Return on Common Equity (ROE)
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44
Unilate’s Profit Margin Ratio
Profit margin =
=
Net Profit
Sales
$54.0 =
0.036 = 3.6%
$1,500
Industry Average = 4.9%
o Unilate’s profit margin is below the industry average,
which suggests it is not generating as much income per
dollar of sales as the average firm in the industry.
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
45
Unilate’s Return on Total Assets
(ROA)
Net income
ROA =
Total assets
$54.0
= 0.064 = 6.4%
=
$845.0
Industry Average = 10.3%
o Unilate’s ROA is below the industry average, which
suggests it is not generating the same return on its
investment in assets as other firms in the industry.
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46
Unilate’s Return on Common
Equity (ROE)
Net income
ROE =
Common equity
$54.0 = 0.130 = 13.0%
=
$415.0
Industry Average = 17.7%
o Unilate’s ROE is below the industry average, which
suggests it is not generating as much return for
stockholders as other firms in the industry.
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47
Unilate’s Profitability Position—
Conclusion
○ The operating results have suffered because
of the poor liquidity position, poor asset
management, and a poor debt position.
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48
Market Value Ratios
○ Price/Earnings Ratio
○ Market/Book Ratio
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
49
Unilate’s Price/Earnings (P/E)
Ratio
P/E Ratio =
Price per share
Earnings per share
$23.00
=
$2.16
= 10.6 times
Industry Average = 15.0 times
o Unilate’s P/E ratio is below the industry average, which
suggests that investors consider it to be a riskier
investment than other firms in the industry.
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
50
Unilate’s Market/Book (M/B)
Ratio
$23.00
$16.00
=
Market/Book Ratio =
Market price per share
Book value per share
1.4 times
=
Industry Average = 2.5 times
o Unilate’s M/B ratio is below the industry average, which
suggests that investors value its stock lower than other
firms in the industry.
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51
Unilate’s Market Value—
Conclusion
○ Investors are not excited about the future
prospects of the company.
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52
Summary of Ratio Analysis:
The DuPont Analysis—ROA
ROA = Net Profit Margin X Total Assets Turnover
=
Net Income
Sales
X
Sales _
Total Assets
=
$54.0 _
$1,500.0
X
$1,500.0
$845.0
=
3.6%
X
1.775
= 6.4%
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53
Summary of Ratio Analysis:
The DuPont Analysis—ROE
ROE =
ROA
= Net Income
Total assets
X Equity multiplier
Total
assets
_
X
Common equity
=
$54.0
$845.0
X
$845.0
$415.0
=
6.4%
X
2.036
=
13.0%
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54
Summary of Ratio Analysis:
The DuPont Analysis—ROE (cont.)
ROE = (Profit margin X TA Turnover) X Equity multiplier
= Net Income
Sales
=
$54.0 _
$1,500.0
=
3.6%
=
13.0%
Sales _ X Total assets _
X
Total assets
Common equity
X $1,500.0
$845.0
X
$845.0
$415.0
X
X
2.036
1.775
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
55
DuPont Equation Provides
Overview
○ Firm’s profitability (measured by ROA)
○ Firm’s expense control (measured by profit
margin)
○ Firm’s asset utilization (measured by total
assets turnover)
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56
Limitations (Caveats) of Financial
Statement Analysis
○ Comparison with industry averages is
difficult if the firm operates many different
divisions.
○ The industry average might not be the
“magical” number that every firm should try
to achieve.
○ Inflation distorts balance sheets.
○ Seasonal factors can distort ratios.
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distributed with a certain product or service or otherwise on a password-protected website for classroom use.
57
Limitations (Caveats) of Financial
Statement Analysis
○ “Window dressing” can make ratios look
better than they really are.
○ Different operating and accounting practices
distort comparisons.
○ Sometimes hard to tell whether a ratio is
“good” or “bad.”
○ Difficult to tell whether company is, on
balance, in strong or weak position.
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58
Financial Statement Analysis—
Conclusion
○ The most important, as well as the most
difficult, ingredient of successful financial
statement analysis is the judgment that is
used to reach final conclusions about a
firm’s future financial position.
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59