UNDERSTANDING FINANCIAL STATEMENTS
THE ANALYSIS OF
FINANCIAL STATEMENTS
Fraser & Ormiston
Chapter 5
Overview of Financial 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
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
Where to look for data...
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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
Basic Tools
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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?
• Taking a general approach to financial
statement analysis, one might proceed
as follows…...
Steps of a F/S Analysis
• 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?
Steps (continued)
• Study the industry in which the firm
operates and relate industry climate to
current and projected economic
developments
– individual company does not operate in a
vacuum
– are we dealing with a growth industry? a
dying industry? a changing industry?...
Steps (continued)
• Develop knowledge of firm and quality
of management (unless you buy an
awful lot of stock, you can’t DO much
about the latter!)
– how well does this firm seem to be run?
– are they taking advantage of opportunities?
– are they innovative, forward-looking, etc?
Steps (continued)
• Evaluate financial statements (numbercrunching time!) using basic tools
• Focus on major areas:
– short-term liquidity
– capital structure/long-term solvency
– operating efficiency/profitability
– market ratios
– segmental analysis if relevant
Steps (concluded)
• Summarize findings
• Reach conclusions about the firm
relevant to your established objectives
• NOW, WHAT HAVE WE
ACCOMPLISHED AS WE HAVE
“WADED” THROUGH THE LAST FIVE
CHAPTERS?
Accomplishments
• TRIED to turn a maze into a map
• 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)
• GO FIND THE INFORMATION AND
USE IT INTELLIGENTLY -- YOU CAN
DO IT!