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Understanding Understanding Financial Statements Financial Statements

EIGHTHEIGHTH EDITION EDITION

Lyn M. Fraser Lyn M. Fraser

Aileen OrmistonAileen Ormiston

(C) 2007 Prentice Hall, Inc.(C) 2007 Prentice Hall, Inc.

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The Analysis of The Analysis of Financial StatementsFinancial StatementsRatios are tools and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison

- CEO, R.E.C. Inc.


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The Analysis of The Analysis of Financial StatementsFinancial Statements (cont.)(cont.)

This chapter will develop tools and techniques for the interpretation of financial statement information


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Objectives of AnalysisObjectives of Analysis

Remember--the identity of the user helps Remember--the identity of the user helps define what information is needed define what information is needed

Objectives will vary depending on the Objectives will vary depending on the perspective of theperspective of the financial statement userspecific questions that are addressed

by the analysis


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Objectives of AnalysisObjectives of Analysis

(cont.)(cont.)

CreditorsCreditors

InvestorsInvestors

ManagementManagement

Potential Financial Statement Users:Potential Financial Statement Users:

What types of questions do each of these What types of questions do each of these users seek answers to? seek answers to?


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CreditorsCreditors

A creditor is ultimately concerned A creditor is ultimately concerned with the ability of an existing or with the ability of an existing or prospective borrower to make prospective borrower to make interest and principal payments interest and principal payments on borrowed funds on borrowed funds


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CreditorsCreditors (cont.)(cont.)

What is the borrowing cause?What is the borrowing cause? What is the firm’s capital What is the firm’s capital

structure?structure? What will be the source of debt What will be the source of debt

repayment? repayment?

Questions raised in a credit analysis should include:


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InvestorsInvestors

An investor attempts to arrive at an An investor attempts to arrive at an estimation of a company’s future estimation of a company’s future earnings stream in order to earnings stream in order to attach a value to the securities attach a value to the securities being considered for purchase or being considered for purchase or liquidation liquidation


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InvestorsInvestors (cont.)(cont.)

How has the firm performed/what How has the firm performed/what are future expectations?are future expectations?

How much risk is inherent in the How much risk is inherent in the existing capital structure?existing capital structure?

What are expected returns?What are expected returns? What is firm’s competitive What is firm’s competitive

position?position?

The investment analyst poses questions as:


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ManagementManagement

CreditorsCreditors

InvestorsInvestors

EmployeesEmployees

General publicGeneral public

RegulatorsRegulators

Financial press Financial press

Management relates to all questions raised by:


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ManagementManagement (cont.)(cont.)

How well the firm has How well the firm has performed and why?performed and why?

What operating areas have What operating areas have contributed to success and contributed to success and which have not?which have not?

Looks to financial statement data to determine:


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ManagementManagement (cont.)(cont.)

What are strengths/weaknesses What are strengths/weaknesses of company’s financial position?of company’s financial position?

What changes should be What changes should be implemented to improve future implemented to improve future performance? performance?

Looks to financial statement data to determine:


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Caution!!!Caution!!! Keep in mind: Management Keep in mind: Management

PREPARES financial statementsPREPARES financial statements Analyst should be alert to potential for Analyst should be alert to potential for

management to influence reporting to management to influence reporting to make data more “appealing”make data more “appealing”

May want to supplement analysis with May want to supplement analysis with other sources of information apart other sources of information apart from the Annual Report prepared by from the Annual Report prepared by managementmanagement


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Sources of InformationSources of Information

Proxy StatementProxy Statement

Auditor’s ReportAuditor’s Report

MD&AMD&A

Supplementary schedulesSupplementary schedules

Form 10-K and Form 10-QForm 10-K and Form 10-Q

The analyst will want to consider the following resources:


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Other Sources of Other Sources of InformationInformation Computerized data basesComputerized data bases

Info on industry norms/ratiosInfo on industry norms/ratios Info on particular Info on particular

companies/industriescompanies/industries

Ever-expanding financial and Ever-expanding financial and investment websites investment websites

Articles in popular/business press Articles in popular/business press


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Tools and TechniquesTools and Techniques

Common-size financial statementsCommon-size financial statements

Financial ratiosFinancial ratios

Trend analysisTrend analysis

Structural analysisStructural analysis

Industry comparisonsIndustry comparisons

These include:These include:

Most important:Most important:Common sense and judgment


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Common-Size Common-Size Financial StatementsFinancial Statements

Express each account on the Express each account on the balance sheetbalance sheet as a percentage as a percentage

of total assets of total assets income statementincome statement as a as a

percentage of net sales percentage of net sales


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Key Financial RatiosKey Financial Ratios

Standardize financial data in terms Standardize financial data in terms of mathematical relationships of mathematical relationships expressed in the form of expressed in the form of

PercentagesPercentages

TimesTimes

DaysDays


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Key Financial RatiosKey Financial Ratios (cont.)(cont.)

1.1. Liquidity RatiosLiquidity Ratios

Measure a firm’s ability to meet Measure a firm’s ability to meet cash needs as they arise cash needs as they arise

Four Categories of key financial ratios:


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Key Financial RatiosKey Financial Ratios (cont.)(cont.)

2.2. Activity RatiosActivity Ratios

Measure the liquidity of specific Measure the liquidity of specific assets and the efficiency of assets and the efficiency of managing assetsmanaging assets



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Key Financial RatiosKey Financial Ratios (cont.) (cont.)

3.3. Leverage RatiosLeverage Ratios

Measure the extent of a firm’s Measure the extent of a firm’s financing with debt relative to financing with debt relative to equity and its ability to cover equity and its ability to cover interest and other fixed charges interest and other fixed charges



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4.4. Profitability RatiosProfitability Ratios

Measure the overall performance of Measure the overall performance of a firm and its efficiency in a firm and its efficiency in managing assets, liabilities and managing assets, liabilities and equity equity

Key Financial Ratios (cont.)



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Cautions!Cautions!

Ratios are valuable analytical tools Ratios are valuable analytical tools and serve as screening devices, and serve as screening devices, BUT. . .BUT. . .

They do not provide answers in They do not provide answers in and of themselves and of themselves

They are not predictive They are not predictive


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Cautions! Cautions! (cont.)(cont.)

Ratios should be used with Ratios should be used with other elements of financial other elements of financial analysisanalysis

There are no “rules of thumb” There are no “rules of thumb” that apply to the interpretation that apply to the interpretation of ratios of ratios


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Cautions!Cautions! (cont.)(cont.)

Keeping this in mind, let’s take a Keeping this in mind, let’s take a look at some of the ratios. . . . look at some of the ratios. . . .


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Liquidity Ratios: Liquidity Ratios: Short-Term SolvencyShort-Term Solvency

Measures ability to meet short-Measures ability to meet short-term cash needs term cash needs

Current RatioCurrent Ratio

Current assetsCurrent assets

Current liabilitiesCurrent liabilities


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Liquidity Ratios: Liquidity Ratios: Short-Term SolvencyShort-Term Solvency (cont.) (cont.)

Measures ability to meet short-term Measures ability to meet short-term cash needs more rigorously by cash needs more rigorously by eliminating inventory eliminating inventory

Quick or Acid-Test Ratio

Current assets - InventoryCurrent assets - Inventory



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Focuses on ability of the firm to Focuses on ability of the firm to generate operating cash flows generate operating cash flows as a source of liquidityas a source of liquidity

Cash Flow Liquidity Ratio

*Cash flow from operating

activities

Cash + Marketable securities + Cash + Marketable securities + CFO *CFO *



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Helps gauge liquidity of accounts Helps gauge liquidity of accounts receivable (ability to collect receivable (ability to collect cash from customers) and may cash from customers) and may help provide information about help provide information about a company’s credit policiesa company’s credit policies

Average Collection Period

Net accounts receivableNet accounts receivable

Average daily salesAverage daily sales


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Measures the efficiency of the firm Measures the efficiency of the firm in managing its inventoryin managing its inventory

Days Inventory Held

InventoryInventory

Average daily cost of salesAverage daily cost of sales


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Current Yr. Current Yr. Prior YearPrior Year 2 Yrs. Prior2 Yrs. Prior

5 days 5 days 4 days5 days 5 days 4 days

Days Inventory Held: Example of ratio comparisons for two companies in the Electronic Computers industry*

Current Yr. Current Yr. Prior YearPrior Year 2 Yrs. 2 Yrs. PriorPrior 23 days 22 days 15 23 days 22 days 15 days days *Data from SEC website, *Data from SEC website, www.sec.gov


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Offers insight into a firm’s pattern Offers insight into a firm’s pattern of payments to suppliersof payments to suppliers

Days Payable Outstanding

Accounts payableAccounts payable

Average daily cost of salesAverage daily cost of sales


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Cash Conversion Cycle or Cash Conversion Cycle or Net Trade CycleNet Trade Cycle

Buying or manufacturing Buying or manufacturing inventory, with some purchases inventory, with some purchases on crediton credit

Selling inventory, with some sales Selling inventory, with some sales on crediton credit

Collecting the cash Collecting the cash

The normal cycle of a firm that The normal cycle of a firm that consists of:consists of:


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Cash Conversion Cycle or Cash Conversion Cycle or Net Trade CycleNet Trade Cycle (cont.)(cont.)

Key balance sheet accounts that affect Key balance sheet accounts that affect cash flow from operating activitiescash flow from operating activities

Accounts ReceivableAccounts Receivable InventoryInventory Accounts PayableAccounts Payable

Helps the analyst understand why Helps the analyst understand why cash cash flow generation has flow generation has improved or improved or deteriorated by deteriorated by analyzing:analyzing:


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Cash Conversion Cycle or Cash Conversion Cycle or Net Trade CycleNet Trade Cycle (cont.)(cont.)

Average collection periodAverage collection periodPlusPlus

Days inventory heldDays inventory heldMinusMinus

Days payable outstandingDays payable outstandingEqualsEquals

Cash conversion or net trade cycleCash conversion or net trade cycle

Calculated as follows:Calculated as follows:


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Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Liquidity, Asset Management EfficiencyManagement Efficiency

Another measure of efficiency of Another measure of efficiency of firm’s collection and credit policiesfirm’s collection and credit policies

Accounts Receivable TurnoverAccounts Receivable Turnover

Net salesNet sales

Net accounts receivableNet accounts receivable


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Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.)(cont.)

Another measure of firm’s efficiency Another measure of firm’s efficiency in managing its inventoryin managing its inventory

Inventory Turnover

Cost of goods soldCost of goods sold

InventoryInventory


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Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.) (cont.)

Another way to gain insight into a firm’s Another way to gain insight into a firm’s pattern of payment to supplierspattern of payment to suppliers

Payables Turnover

Cost of goods soldCost of goods sold

Accounts payableAccounts payable


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Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.)(cont.)

Assesses effectiveness in generating Assesses effectiveness in generating sales from investments in fixed sales from investments in fixed assetsassets

Fixed Asset Turnover

Net salesNet sales

Net property, plant, equipmentNet property, plant, equipment


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Activity Ratios: Asset Activity Ratios: Asset Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency (cont.) (cont.)

Assesses effectiveness in generating sales Assesses effectiveness in generating sales from investments in all assetsfrom investments in all assets

Total Asset Turnover

Net salesNet sales

Total assetsTotal assets


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Leverage Ratios: Leverage Ratios: Debt Financing and Debt Financing and CoverageCoverage

Considers the proportion of all assets Considers the proportion of all assets that are financed with debtthat are financed with debt

Debt Ratio

Total liabilitiesTotal liabilities



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Leverage Ratios: Leverage Ratios: Debt Financing and Coverage Debt Financing and Coverage (cont.)(cont.)

Current Yr. Current Yr. Prior YearPrior Year 62.31% 69.93%62.31% 69.93%

Debt Ratio: Example of ratio comparisons for two companies in the Grain Mills industry*

Current Yr. Current Yr. Prior YearPrior Year

79.08% 85.77%79.08% 85.77%

*Data from SEC website, *Data from SEC website, www.sec.gov


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Leverage Ratios: Leverage Ratios: Debt Financing and Coverage Debt Financing and Coverage (cont.) (cont.)

Reveals the extent to which long-Reveals the extent to which long-term debt is used for the firm’s term debt is used for the firm’s permanent financing (both permanent financing (both long-term debt and equity)long-term debt and equity)

Long-term Debt to Total Capitalization

Long–term debtLong–term debt

Long-term debt + Stockholders’ Long-term debt + Stockholders’ equityequity


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Leverage Ratios: Leverage Ratios: Debt Financing and CoverageDebt Financing and Coverage

(cont.)(cont.)

Measures the riskiness of the firm’s Measures the riskiness of the firm’s capital structure in terms of the capital structure in terms of the relationship between the funds relationship between the funds supplied by creditors (debt) and supplied by creditors (debt) and investors (equity)investors (equity)

Debt to Equity

Total liabilitiesTotal liabilities

Stockholders’ equityStockholders’ equity


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(cont.)(cont.)

Indicates how well operating earnings Indicates how well operating earnings cover fixed interest expensescover fixed interest expenses

Times Interest Earned

Operating profitOperating profit

Interest expenseInterest expense


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(cont.)(cont.)

Measures how many times interest Measures how many times interest payments can be covered by payments can be covered by cash flow from operations cash flow from operations before interest and taxesbefore interest and taxes

Cash Interest Coverage

CFO + interest paid + taxes paidCFO + interest paid + taxes paid

Interest paidInterest paid


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(cont.)(cont.)

Broader measure of how well operating Broader measure of how well operating earnings cover fixed chargesearnings cover fixed charges

Fixed Charge Coverage

*Rent expense = operating lease payments

Operating profit + Rent expenseOperating profit + Rent expense

Interest expense + Rent expenseInterest expense + Rent expense


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Leverage Ratios: Leverage Ratios: Debt Financing and CoverageDebt Financing and Coverage (cont.)(cont.)

Measures firm’s ability to cover capital Measures firm’s ability to cover capital expenditures, long-term debt expenditures, long-term debt payments and dividends each yearpayments and dividends each year

Cash Flow Adequacy

Cash flow from operating activitiesCash flow from operating activities

Capital expenditures + debt Capital expenditures + debt repayments + dividends paidrepayments + dividends paid


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Profitability Ratios: Profitability Ratios: Overall Efficiency and Overall Efficiency and PerformancePerformance

Measures ability to translate sales Measures ability to translate sales into profit after consideration of into profit after consideration of cost of products soldcost of products sold

Gross Profit Margin

Gross profitGross profit

Net salesNet sales


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Profitability Ratios: Profitability Ratios: Overall Efficiency and PerformanceOverall Efficiency and Performance (cont.)(cont.)

Measures ability to translate sales Measures ability to translate sales into profit after consideration of into profit after consideration of operating expensesoperating expenses

Operating Profit Margin

Operating profitOperating profit

Net salesNet sales


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Measures ability to translate sales Measures ability to translate sales into profit after consideration into profit after consideration of all expenses and revenues, of all expenses and revenues, including interest, taxes and including interest, taxes and nonoperating itemsnonoperating items

Net Profit Margin

Net earningsNet earnings

Net salesNet sales


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Measures ability to translate sales into Measures ability to translate sales into cash (with which to pay bills!)cash (with which to pay bills!)

Cash Flow Margin

Cash flow from operating Cash flow from operating activitiesactivities

Net salesNet sales


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Measures overall efficiency of firm Measures overall efficiency of firm in managing investment in in managing investment in assets and generating profitsassets and generating profits

Return on Total Assets (ROA) or Return on Investment (ROI)




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Measures rate of return on Measures rate of return on stockholders’ investmentstockholders’ investment

Return on Equity (ROE)


Stockholders’ equityStockholders’ equity


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Measures firm’s ability to generate Measures firm’s ability to generate cash from the utilization of its assetscash from the utilization of its assets

Useful comparison to ROAUseful comparison to ROA

Cash Return on Assets

Cash flow from operating Cash flow from operating activitiesactivities



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Market RatiosMarket Ratios

1.1. Earnings per common shareEarnings per common share2.2. Price-to-earningsPrice-to-earnings3.3. Dividend payoutDividend payout4.4. Dividend yieldDividend yield

Four market ratios of particular interest to the investor are


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Market RatiosMarket Ratios (cont.) (cont.)

Provides the investor with a Provides the investor with a common denominator to common denominator to gauge investment returnsgauge investment returns

Earnings per Common Share


Average shares outstandingAverage shares outstanding


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Relates earnings per common share to the Relates earnings per common share to the market price at which the stock trades, market price at which the stock trades, expressing the “multiple” that the stock expressing the “multiple” that the stock market places on a firm’s earningsmarket places on a firm’s earnings

Price-to-Earnings

Market price of common stockMarket price of common stock

Earnings per shareEarnings per share


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Determined by the formula cash Determined by the formula cash dividends per share divided by dividends per share divided by earnings per shareearnings per share

Dividend Payout

Dividends per shareDividends per share

Earnings per shareEarnings per share


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Shows the relationship between cash Shows the relationship between cash dividends and market pricedividends and market price

Dividend Yield

Dividends per shareDividends per share

Market price of common stockMarket price of common stock


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Analyzing the DataAnalyzing the Data

Now that some of the “tools” of Now that some of the “tools” of financial analysis have been financial analysis have been illustrated, where does one go from illustrated, where does one go from here?here?

Taking a general approach to financial Taking a general approach to financial statement analysis, one might statement analysis, one might proceed as follows. . . proceed as follows. . .


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Five Steps of a Financial Five Steps of a Financial Statement AnalysisStatement Analysis

Who are you and why are you Who are you and why are you interested in this company?interested in this company?

What questions would you like to What questions would you like to have answered?have answered?

What info is vital to the decision at What info is vital to the decision at hand? hand?

Establish objectives of the analysis

Step 1


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Five Steps of a Financial Five Steps of a Financial Statement AnalysisStatement Analysis (cont.)(cont.)

Study the industry in which the firm Study the industry in which the firm operates and relate industry operates and relate industry climate to current and projected climate to current and projected economic developments economic developments

Step 2Step 2


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How well does this firm appear to be run?How well does this firm appear to be run? Are they taking advantage of Are they taking advantage of

opportunities?opportunities? Are they innovative, forward-looking, etc?Are they innovative, forward-looking, etc?

Step 3

Develop knowledge of the firm and the quality of management


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Common-size financial statementsCommon-size financial statements Key financial ratiosKey financial ratios Trend analysisTrend analysis Structural analysisStructural analysis Comparison with industry competitorsComparison with industry competitors

Step 4

Evaluate financial statements–tools include:


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Short-term liquidityShort-term liquidity Operating efficiencyOperating efficiency Capital structure and long-term Capital structure and long-term

solvencysolvency ProfitabilityProfitability Market ratiosMarket ratios Segmental analysis (when relevant)Segmental analysis (when relevant) Quality of financial reportingQuality of financial reporting

Step 4 Evaluate financial statements–areas include:


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Reach conclusions about the Reach conclusions about the firm relevant to your firm relevant to your established objectives established objectives

Step 5

Summarize findings based on analysis


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Relating the RatiosRelating the Ratios—The Du Pont System—The Du Pont System

Is helpful to complete the evaluation Is helpful to complete the evaluation of a firm by considering the of a firm by considering the interrelationship among the interrelationship among the individual ratios individual ratios


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(cont.)(cont.)

The Du Pont System helps the The Du Pont System helps the analyst see how the firm’s analyst see how the firm’s decisions and activities over decisions and activities over the course of an accounting the course of an accounting period interact to produce an period interact to produce an overall return to the firm’s overall return to the firm’s shareholders, the return on shareholders, the return on equity equity


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(cont.)(cont.)The summary ratios used are the following:

(1)Net profit margin

(2)Total asset turnover

(3)Return on investment

(3)Return on investment

(4)Financial leverage

(5)Return on equity

Net income Net sales Net incomeNet income Net sales Net income

Net sales X Total assets = Total assetsNet sales X Total assets = Total assets

Net income Total assets Net Net income Total assets Net incomeincome

Total assets X Stockholder equity = Stockholder Total assets X Stockholder equity = Stockholder equityequity


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What we have What we have accomplishedaccomplished

Auditor’s Report

Statement of Cash Flows

MD&A

Statement of Shareholders’ EquityBalance Sheet

Note

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Inco

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TurnedMaze


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Financial StatementsFinancial StatementsAn OverviewAn Overviewinto Map

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