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Understanding Financial Statements Seventh EDITION Lyn M. Fraser Aileen Ormiston Insert BOOK COVER The Analysis of Financial Statements This chapter will develop tools and techniques for the interpretation of financial information Chapter 5 (C) 2004 Prentice Hall, Inc. 5-2 Objectives of Analysis First order of business is to Specify the objectives of the analysis Focus on WHO is the financial statement user Remember--the identity of the user helps define what information is needed (C) 2004 Prentice Hall, Inc. 5-3 Objectives of Analysis Continued Potential Financial Statement Users: Creditors Investors Management What types of questions do each of these users seek answers to? (C) 2004 Prentice Hall, Inc. 5-4 Creditors A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds (C) 2004 Prentice Hall, Inc. 5-5 Creditors Continued Questions raised in a credit analysis should include: What is the borrowing cause? What is the firm’s capital structure? What will be the source of debt repayment? (C) 2004 Prentice Hall, Inc. 5-6 Investors The ultimate objective is to determine whether the investment is sound (C) 2004 Prentice Hall, Inc. 5-7 Investors Continued The investment analyst poses questions as: How has the firm performed/what are future expectations? How much risk is inherent in the existing capital structure? What are expected returns? What is firm’s competitive position? (C) 2004 Prentice Hall, Inc. 5-8 Management Management relates to all questions raised by: Creditors Investors Employees General public Regulators Financial press (C) 2004 Prentice Hall, Inc. 5-9 Management Continued Looks to Financial Statement Data to Determine: How well the firm has performed and why? What operating areas have contributed to success and which have not? (C) 2004 Prentice Hall, Inc. 5-10 Management Continued Looks to Financial Statement Data to Determine: What are strengths/weaknesses of company’s financial position? What changes are indicated to improve future performance? (C) 2004 Prentice Hall, Inc. 5-11 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 (C) 2004 Prentice Hall, Inc. 5-12 Sources of Information The analyst will want to consider the following resources: Proxy Statement MD&A Supplementary schedules Form 10-K and Form 10-Q (C) 2004 Prentice Hall, Inc. 5-13 Other Sources of Information Computerized data bases Info on industry norms/ratios Info on particular companies/industries/ mutual funds Articles in popular/business press Ever-expanding websites (C) 2004 Prentice Hall, Inc. 5-14 Tools and Techniques These include: Common-size financial statements Financial ratios Trend analysis Structural analysis Most important: Common sense and judgment (C) 2004 Prentice Hall, Inc. 5-15 Common-Size Financial Statements Express each account on the balance sheet as a percentage of total assets and each account on the income statement as a percentage of net sales (C) 2004 Prentice Hall, Inc. 5-16 Key Financial Ratios Standardize financial data in terms of mathematical relationships expressed in the form of percentages or times (C) 2004 Prentice Hall, Inc. 5-17 Key Financial Ratios Continued Four Categories of ratios: 1. Liquidity Ratio Measures a firm’s ability to meet cash needs as they arise (C) 2004 Prentice Hall, Inc. 5-18 Four Categories of Ratios Continued 2. Activity Ratio Measures the liquidity of specific assets and the efficiency of managing assets (C) 2004 Prentice Hall, Inc. 5-19 Four Categories of Ratios Continued 3. Leverage Ratio Measures the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges (C) 2004 Prentice Hall, Inc. 5-20 Four Categories of Ratios Continued 4. Profitability Ratio Measures the overall performance of a firm and its efficiency in managing assets, liabilities and equity (C) 2004 Prentice Hall, Inc. 5-21 Caution! Ratios are valuable, BUT. . . They do not provide answers in and of themselves and are not predictive (C) 2004 Prentice Hall, Inc. 5-22 More Cautions! Ratios should be used with other elements of financial analysis There are no “rules of thumb” that apply to interpretation of ratios (C) 2004 Prentice Hall, Inc. 5-23 More Cautions! Continued Keeping this in mind, let’s take a look at some of the ratios. . . . (C) 2004 Prentice Hall, Inc. 5-24 Liquidity Ratios: Short-Term Solvency Current Ratio Measures ability to meet short-term cash needs Current assets Current liabilitie s (C) 2004 Prentice Hall, Inc. 5-25 Liquidity Ratios: Short-Term Solvency Continued Quick or Acid-Test Ratio Measures ability to meet short-term cash needs more rigorously Current assets - Inventory Current liabilitie s (C) 2004 Prentice Hall, Inc. 5-26 Liquidity Ratios: Short-Term Solvency Continued Cash Flow Liquidity Ratio Focuses on ability of the firm to generate operating cash flows as a source of liquidity Cash Marketable securities CFO * Current liabilitie s *Cash flow from operating activities (C) 2004 Prentice Hall, Inc. 5-27 Liquidity Ratios: Short-Term Solvency Continued Average Collection Period Helps gauge liquidity of accounts receivable (ability to collect cash from customers) Accounts receivable Average daily sales (C) 2004 Prentice Hall, Inc. 5-28 Liquidity Ratios: Short-Term Solvency Continued Days Inventory Held Is the average number of days it takes to sell inventory to customers Inventory Average daily cost of sales (C) 2004 Prentice Hall, Inc. 5-29 Liquidity Ratios: Short-Term Solvency Continued Days Payable Outstanding Is the average number of days it takes to pay accounts payables in cash Accounts payable Average daily cost of sales (C) 2004 Prentice Hall, Inc. 5-30 Net Trade Cycle Is the normal cycle of a firm that consists of: Buying or manufacturing inventory, with some purchases on credit Selling inventory, with some sales on credit Collecting the cash (C) 2004 Prentice Hall, Inc. 5-31 Net Trade Cycle Continued Average collection period Plus Days inventory held Minus Days payable outstanding Equals Net trade cycle (C) 2004 Prentice Hall, Inc. 5-32 Activity Ratios: Assets Liquidity, Asset Management Efficiency Accounts Receivable Turnover Another measure of efficiency of firm’s collection and credit policies Net sales Accounts receivable (C) 2004 Prentice Hall, Inc. 5-33 Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t Inventory Turnover Measures efficiency of inventory management Cost of goods sold Inventory (C) 2004 Prentice Hall, Inc. 5-34 Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t Payables Turnover Another measure of efficiency of inventory management Cost of goods sold Accounts payable (C) 2004 Prentice Hall, Inc. 5-35 Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t Fixed Asset Turnover Assesses effectiveness in generating sales from investment in fixed assets Net sales Net property, plant, equipment (C) 2004 Prentice Hall, Inc. 5-36 Activity Ratios: Assets Liquidity, Asset Management Efficiency Con’t Total Asset Turnover Assesses effectiveness in generating sales from investment in total assets Net sales Total assets (C) 2004 Prentice Hall, Inc. 5-37 Leverage Ratios: Debt Financing and Coverage Debt Ratio Measures the extent of firm’s financing with debt Total liabilitie s Total assets (C) 2004 Prentice Hall, Inc. 5-38 Leverage Ratios: Debt Financing and Coverage Con’t. Long-term Debt to Total Capitalization Measures the extent of firm’s financing with long-term debt Long - term debt Long - term debt Stockholde rs' equity (C) 2004 Prentice Hall, Inc. 5-39 Leverage Ratios: Debt Financing and Coverage Con’t Debt to Equity Measures the extent of firm’s financing with debt Total liabilitie s Stockholde rs' equity (C) 2004 Prentice Hall, Inc. 5-40 Leverage Ratios: Debt Financing and Coverage Con’t Times Interest Earned Indicates how well operating earnings cover fixed interest charges Operating profit Interest expense (C) 2004 Prentice Hall, Inc. 5-41 Leverage Ratios: Debt Financing and Coverage Con’t Cash Interest Coverage Measures how many times interest payments can be covered by cash flow from operations before interest and taxes CFO interest paid taxes paid Interest paid (C) 2004 Prentice Hall, Inc. 5-42 Leverage Ratios: Debt Financing and Coverage Con’t Fixed Charge Coverage Broader measure of how well operating earnings cover fixed charges Operating profit Rent expense Interest expense Rent expense (C) 2004 Prentice Hall, Inc. 5-43 Leverage Ratios: Debt Financing and Coverage Con’t Cash Flow Adequacy Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year Cash flow from operating activities Capital expenditur es debt repayments dividends paid (C) 2004 Prentice Hall, Inc. 5-44 Profitability Ratios: Overall Efficiency and Performance Gross Profit Margin Measures profit generated after consideration of cost of products sold Gross profit Net sales (C) 2004 Prentice Hall, Inc. 5-45 Profitability Ratios: Overall Efficiency and Performance Con’t. Operating Profit Margin Measures profit generated after consideration of operating expenses Operating profit Net sales (C) 2004 Prentice Hall, Inc. 5-46 Profitability Ratios: Overall Efficiency and Performance Con’t. Net Profit Margin Measures profit generated after consideration of all expenses and revenues Net earnings Net sales (C) 2004 Prentice Hall, Inc. 5-47 Profitability Ratios: Overall Efficiency and Performance Con’t. Cash Flow Margin Measures ability to translate sales into cash (with which to pay bills!) Cash flow from operating activities Net sales (C) 2004 Prentice Hall, Inc. 5-48 Profitability Ratios: Overall Efficiency and Performance Con’t. Return on Total Assets (ROA) or Return on Investment (ROI) Measures overall efficiency of firm in managing investment in assets and generating profits Net earnings Total assets (C) 2004 Prentice Hall, Inc. 5-49 Profitability Ratios: Overall Efficiency and Performance Con’t. Return on Equity (ROE) Measures rate of return on stockholders’ investment Net earnings Stockholde rs equity (C) 2004 Prentice Hall, Inc. 5-50 Profitability Ratios: Overall Efficiency and Performance Con’t. Cash Return on Assets Useful comparison to return on investment Indicates firm’s ability to generate cash from utilizing its assets Cash flow from operating activities Total assets (C) 2004 Prentice Hall, Inc. 5-51 Analyzing the Data Now that some of the “tools” of financial analysis have been illustrated, where does one go from here? Taking a general approach to financial statement analysis, one might proceed as follows. . . (C) 2004 Prentice Hall, Inc. 5-52 Five Steps of a Financial Statement Analysis Step 1 Establish objectives of the analysis Who are you and why are you interested in this company? What questions would you like to have answered? What info is vital to the decision at hand? (C) 2004 Prentice Hall, Inc. 5-53 Five Steps of a Financial Statement Analysis Con’t. Step 2 Study the industry in which the firm operates and relate industry climate to current and projected economic developments (C) 2004 Prentice Hall, Inc. 5-54 Five Steps of a Financial Statement Analysis Con’t Step 3 Develop knowledge of firm and quality of management How well does this firm seem to be run? Are they taking advantage of opportunities? Are they innovative, forward-looking, etc? (C) 2004 Prentice Hall, Inc. 5-55 Five Steps of a Financial Statement Analysis Con’t Step 4 Evaluate financial statements Tools: Common-size financial statements, key financial ratios, trend analysis, structural analysis, and comparison with industry competitors (C) 2004 Prentice Hall, Inc. 5-56 Five Steps of a Financial Statement Analysis Con’t Step 4 Continued Evaluate financial statements Major Areas: Short term liquidity, operating efficiency capital structure and long-term solvency, profitability, market ratios, and segmental analysis (when relevant) (C) 2004 Prentice Hall, Inc. 5-57 Five Steps of a Financial Statement Analysis Con’t Step 5 Summarize findings Reach conclusions about the firm relevant to your established objectives (C) 2004 Prentice Hall, Inc. 5-58 Relating the Ratios —The Du Pont System It is helpful to complete the evaluation of a firm by considering the interrelationship among the individual ratios (C) 2004 Prentice Hall, Inc. 5-59 Relating the Ratios —The Du Pont System Continued 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 (C) 2004 Prentice Hall, Inc. 5-60 Relating the Ratios —The Du Pont System Continued The summary ratios are: (1) Net profit margin Net income Sales (3) Return on investment Net income Assets (C) 2004 Prentice Hall, Inc. (2) Total asset turnover (3) Return on investment Sales Assets Net income Assets (4) Financial leverage Assets Equity (5) Return on equity Net income Equity 5-61 Four Market Ratios 1. 2. 3. 4. Earnings per common share Price-to-earnings Dividend payout Dividend yield (C) 2004 Prentice Hall, Inc. 5-62 Market Ratios Continued Earnings per Common Share Provides the investor with a common denominator to gauge investment returns Net earnings Average shares outstandin g (C) 2004 Prentice Hall, Inc. 5-63 Market Ratios Continued Price-to-Earnings 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 Market price of common stock Earnings per share (C) 2004 Prentice Hall, Inc. 5-64 Market Ratios Continued Dividend Payout This ratio is determined by the formula cash dividends per share divided by earnings per share Dividends per share Earnings per share (C) 2004 Prentice Hall, Inc. 5-65 Market Ratios Continued Dividend Yield Shows that relationship between cash dividends and market price Dividends per share Market price of common stock (C) 2004 Prentice Hall, Inc. 5-66 What we have accomplished Turned Maze Statement of Cash Flows Balance Sheet (C) 2004 Prentice Hall, Inc. MD&A Income Statement Notes Auditor’s Report Statement of Shareholders’ Equity 5-67 Financial Statements An Overview into Map (C) 2004 Prentice Hall, Inc. 5-68