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• Purpose of Analysis; Financial statement analysis helps users make better decisions
• Financial Statements Are Designed for Analysis• Tools of Analysis– Dollar and Percentage Changes– Trend analysis is used to reveal patterns in data
covering successive periods– Component Percentages• Horizontal Analysis, Vertical Analysis
• Common Size Statements 1
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Chapter
14FINANCIAL STATEMENT
ANALYSISRATIO ANALYSIS
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Past perform ance topresent perform ance.
Other com panies toyour com pany.
Along w ith dollar and percentage changes,trend percentages, and com ponent percentages,
ratios can be used to com pare:
A ratio is a sim ple m athem atical expressionof the relationship betw een one item and another.
Ratios
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NORTON CORPORATION2003
Cash 30,000$ Accounts receivable, net Beginning of year 17,000 End of year 20,000 Inventory Beginning of year 10,000 End of year 15,000 Total current assets 65,000 Total current liabilities 42,000 Total liabilities 103,917 Total assets Beginning of year 300,000 End of year 346,390 Revenues 494,000
NORTON CORPORATION2003
Cash 30,000$ Accounts receivable, net Beginning of year 17,000 End of year 20,000 Inventory Beginning of year 10,000 End of year 15,000 Total current assets 65,000 Total current liabilities 42,000 Total liabilities 103,917 Total assets Beginning of year 300,000 End of year 346,390 Revenues 494,000
Use this information to calculate the
liquidity ratios for Norton
Corporation.
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Working capital Working capital is the excess of current assets over current liabilities.
Working capital Working capital is the excess of current assets over current liabilities.
Working Capital
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CurrentRatio
Current Assets Current Liabilities
=
CurrentRatio
$65,000 $42,000
= = 1.55 : 1
This ratio measures the short-term debt-paying ability of the
company.
This ratio measures the short-term debt-paying ability of the
company.
Current Ratio
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Quick assets are cash, marketable securities, and receivables.
Quick assets are cash, marketable securities, and receivables.
This ratio is like the currentratio but excludes current assets such as inventories that may be
difficult to quickly convert into cash.
This ratio is like the currentratio but excludes current assets such as inventories that may be
difficult to quickly convert into cash.
Quick Assets Current Liabilities
=QuickRatio
Quick Ratio
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Quick Assets Current Liabilities
=QuickRatio
$50,000 $42,000
= 1.19 : 1=QuickRatio
This ratio is like the currentratio but excludes current assets such as inventories that may be
difficult to quickly convert into cash.
This ratio is like the currentratio but excludes current assets such as inventories that may be
difficult to quickly convert into cash.
Quick Ratio
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A measure of creditor’s long-term risk. A measure of creditor’s long-term risk.
The smaller the percentage of assets that are financed by debt, the smaller the risk
for creditors.
A measure of creditor’s long-term risk. A measure of creditor’s long-term risk.
The smaller the percentage of assets that are financed by debt, the smaller the risk
for creditors.
Debt Ratio
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Ratios help usersunderstand
financial relationships.
Ratios provide forquick com parison
of com panies.
U ses
M anagem ent m ay enterinto transactions m erely
to im prove the ratios.
Ratios do not help w ithanalysis of the com pany's
progress tow ardnonfinancial goals.
Lim ita tions
Uses and Limitations of Financial Ratios
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An income statement can be prepared in either a multiple-step or single-step format.
An income statement can be prepared in either a multiple-step or single-step format.
The single-step format is simpler.The multiple-step format provides
more detailed information.
The single-step format is simpler.The multiple-step format provides
more detailed information.
Measures of Profitability
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Proper Heading {Gross Margin {Operating Expenses {
{Non- operating Items
Income Statement (Multiple-Step) ExampleIncome Statement (Multiple-Step) Example
Remember to compute EPS.
Remember to compute EPS.
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Proper Heading {Income Statement (Single-Step) ExampleIncome Statement (Single-Step) Example
Expenses & Losses {
Revenues & Gains {
Remember to compute EPS.
Remember to compute EPS.
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Use this information to calculate the profitability
ratios for Norton Corporation.
NORTON CORPORATION
2003Number of common shares outstanding all of 2003 27,400 Net income 53,690$ Shareholders' equity Beginning of year 180,000 End of year 234,390 Revenues 494,000 Cost of sales 140,000 Total assets Beginning of year 300,000 End of year 346,390
NORTON CORPORATION
2003Number of common shares outstanding all of 2003 27,400 Net income 53,690$ Shareholders' equity Beginning of year 180,000 End of year 234,390 Revenues 494,000 Cost of sales 140,000 Total assets Beginning of year 300,000 End of year 346,390
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This ratio is generally consideredthe best overall measure of a
company’s profitability.
This ratio is generally consideredthe best overall measure of a
company’s profitability.
Return On Assets (ROA)
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Use this information to calculate the profitability
ratios for Norton Corporation.
NORTON CORPORATION
2003Number of common shares outstanding all of 2003 27,400 Net income 53,690$ Shareholders' equity Beginning of year 180,000 End of year 234,390 Revenues 494,000 Cost of sales 140,000 Total assets Beginning of year 300,000 End of year 346,390
NORTON CORPORATION
2003Number of common shares outstanding all of 2003 27,400 Net income 53,690$ Shareholders' equity Beginning of year 180,000 End of year 234,390 Revenues 494,000 Cost of sales 140,000 Total assets Beginning of year 300,000 End of year 346,390
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This measure indicates how well the company employed the owners’
investments to earn income.
This measure indicates how well the company employed the owners’
investments to earn income.
Return On Equity (ROE)
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Can beaudited orunaudited.
Annual andquarterlyfinancialreports.
Reports filedw ith the SEC bypublicly ow ned
com panies.
Internet andother freesources.
Detailedanalyses by
financialanalysts.
Sources of Financial Information
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More Examples of Ratios in Different Perspective
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Solvency AnalysisSolvency AnalysisSolvency AnalysisSolvency Analysis Solvency is the ability of a business to
meet its financial obligations (debts) as they are due.
Solvency analysis focuses on the ability of a business to pay or otherwise satisfy its current and noncurrent liabilities.
This ability is normally assessed by examining balance sheet relationships.
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Current Position AnalysisCurrent Position Analysis
Current assets $550,000 $533,000Current liabilities 210,000 243,000Working capital $340,000 $290,000
Current ratioCurrent ratio 2.6 2.6 2.2 2.2
Working Capital and Current RatioWorking Capital and Current RatioWorking Capital and Current RatioWorking Capital and Current Ratio
Use: To indicate the ability to meet currently maturing obligations.
Use: To indicate the ability to meet currently maturing obligations.
2006 2005
Divide current
assets by current
liabilities
Divide current
assets by current
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Quick RatioQuick RatioQuick RatioQuick Ratio
Use: To indicate instant debt-paying ability.Use: To indicate instant debt-paying ability.
2006 2005Quick assets:
Cash $ 90,500 $ 64,700Marketable securities 75,000 60,000Accounts receivable (net) 115,000 120,000 Total $280,500 $244,700
Current liabilities $210,000 $243,000Quick ratioQuick ratio 1.3 1.3 1.0 1.0
Current Position AnalysisCurrent Position Analysis
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Accounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable Turnover
Net sales on account $1,498,000 $1,200,000Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000End of year 115,500 120,000Total $ 235,000 $ 260,000
Average (Total ÷ 2) $ 117,500 $ 130,000
2006 2005
Accounts Receivable AnalysisAccounts Receivable Analysis
Net sales on accountAverage accounts
receivable
Net sales on accountAverage accounts
receivable
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Use: To assess the efficiency in collecting receivables and in the management of credit.
Use: To assess the efficiency in collecting receivables and in the management of credit.
Net sales on account $1,498,000 $1,200,000Accounts receivable (net):
Beginning of year $ 120,000 $ 140,000End of year 115,500 120,000Total $ 235,000 $ 260,000
Average $ 117,500 $ 130,000
Accounts receivable turnoverAccounts receivable turnover 12.7 12.7 9.2 9.2
2006 2005
Accounts Receivable AnalysisAccounts Receivable Analysis
Accounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable TurnoverAccounts Receivable Turnover
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Number of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in Receivables
Accounts receivable (net),end of year $ 115,000 $ 120,000
Net sales on account $1,498,000 $1,200,000Average daily sales on
account (sales ÷ 365) $ 4,104 $ 3,288
2006 2005
Accounts Receivable AnalysisAccounts Receivable Analysis
Accounts receivable, end of year
Average daily sales on account
Accounts receivable, end of year
Average daily sales on account
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Number of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in ReceivablesNumber of Days’ Sales in Receivables
Use: To assess the efficiency in collecting receivables and in the management of credit.
Use: To assess the efficiency in collecting receivables and in the management of credit.
Number of days’ sales inNumber of days’ sales in receivables 28.0 36.5receivables 28.0 36.5
Accounts receivable (net),end of year $ 115,000 $ 120,000
Net sales on account $1,498,000 $1,200,000Average daily sales on
account (sales ÷ 365) $ 4,104 $ 3,288
2006 2005
Accounts Receivable AnalysisAccounts Receivable Analysis
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Inventory TurnoverInventory TurnoverInventory TurnoverInventory Turnover2006 2005
Cost of goods sold $1,043,000 $ 820,000Inventories:
Beginning of year $ 283,000 $ 311,000End of year 264,000 283,000Total $ 547,000 $ 594,000
Average (Total ÷ 2) $ 273,500 $ 297,000
Inventory AnalysisInventory Analysis
Cost of goods sold
Average inventory
Cost of goods sold
Average inventoryInventory turnover =
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Inventory TurnoverInventory TurnoverInventory TurnoverInventory Turnover
Use: To assess the efficiency in the management of inventory.
Use: To assess the efficiency in the management of inventory.
2006 2005Cost of goods sold $1,043,000 $ 820,000Inventories:
Beginning of year $ 283,000 $ 311,000End of year 264,000 283,000Total $ 547,000 $ 594,000
Average (Total ÷ 2) $ 273,500 $ 297,000
Inventory turnoverInventory turnover 3.8 3.8 2.8 2.8
Inventory AnalysisInventory Analysis
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Number of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in Inventory
2006 2005Inventories, end of year $ 264,000 $283,000Cost of goods sold $1,043,000 $820,000Average daily cost of
goods sold (COGS ÷ 365) $ 2,858 $ 2,247
Inventory AnalysisInventory Analysis
Inventories, end of year
Average daily cost of goods sold
Inventories, end of year
Average daily cost of goods sold
Number of Days’ Sales in Inventory
=
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Number of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in InventoryNumber of Days’ Sales in Inventory
Use: To assess the efficiency in the management of inventory.
Use: To assess the efficiency in the management of inventory.
Inventories, end of year $ 264,000 $283,000Cost of goods sold $1,043,000 $820,000Average daily cost of
goods sold (COGS ÷ 365) $ 2,858 $ 2,247
Number of days’ sales Number of days’ sales
in inventoryin inventory 92.4 92.4 125.9 125.9
Inventory AnalysisInventory Analysis
2006 2005
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Use: To indicate the margin of safety to long-term creditors.
Use: To indicate the margin of safety to long-term creditors.
2006 2005
Fixed assets (net) $444,500 $470,000Long-term liabilities $100,000 $200,000
Ratio of fixed assets toRatio of fixed assets to
long-term liabilitieslong-term liabilities 4.4 4.4 2.4 2.4
Ratio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term LiabilitiesRatio of Fixed Assets to Long-Term Liabilities
Long-Term CreditorsLong-Term Creditors
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Ratio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ EquityRatio of Liabilities to Stockholders’ Equity
Use: To indicate the margin of safety to creditors.
Use: To indicate the margin of safety to creditors.
Total liabilities $310,000 $443,000Total stockholders’ equity $829,500 $787,500Ratio of liabilities toRatio of liabilities to
stockholders’ equitystockholders’ equity 0.37 0.37 0.56 0.56
Long-Term CreditorsLong-Term Creditors
2006 2005
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Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned
2006 2005
Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000
Long-Term CreditorsLong-Term Creditors
Income beforeincome tax + interest expense
Interest expense
Income beforeincome tax + interest expense
Interest expense
Number of Times Interest
Charges Earned=
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Number of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges EarnedNumber of Times Interest Charges Earned
Use: To assess the risk to debtholders in terms of number of times interest charges were earned.
Use: To assess the risk to debtholders in terms of number of times interest charges were earned.
2006 2005
Income before income tax $ 900,000 $ 800,000Add interest expense 300,000 250,000Amount available for interest $1,200,000 $1,050,000
Number of times earnedNumber of times earned 4.0 4.0 4.2 4.2
Long-Term CreditorsLong-Term Creditors
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Profitability AnalysisProfitability AnalysisProfitability AnalysisProfitability Analysis
Profitability is the ability of an entity to earn profits.
This ability to earn profits depends on the effectiveness and efficiency of operations as well as resources available.
Profitability analysis focuses primarily on the relationship between operating results reported in the income statement and resources reported in the balance sheet.
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Ratio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to Assets2006 2005
Net sales $1,498,000 $1,200,000Total assets:
Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000
Average (Total ÷ 2) $1,048,750 $1,031,500
The Common StockholderThe Common Stockholder
Excludes long-term investmentsExcludes long-term investments
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The Common StockholderThe Common Stockholder
Use: To assess the effectiveness of the use of assets.
Use: To assess the effectiveness of the use of assets.
Ratio of net sales to assets 1.4 1.2Ratio of net sales to assets 1.4 1.2
Ratio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to AssetsRatio of Net Sales to Assets2006 2005
Net sales $1,498,000 $1,200,000Total assets:
Beginning of year $1,053,000 $1,010,000End of year 1,044,500 1,053,000Total $2,097,500 $2,063,000
Average (Total ÷ 2) $1,048,750 $1,031,500
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Rate Earned on Total AssetsRate Earned on Total AssetsRate Earned on Total AssetsRate Earned on Total Assets
Use: To assess the profitability of the assets.Use: To assess the profitability of the assets.
2006 2005
Rate earned on total assets 8.2% 7.3%Rate earned on total assets 8.2% 7.3%
Net income $ 91,000 $ 76,500Plus interest expense 6,000 12,000
Total $ 97,000 $ 88,500Total assets:
Beginning of year $1,230,500 $1,187,500End of year 1,139,500 1,230,500Total $2,370,000 $2,418,000Average (Total ÷ 2) $1,185,000 $1,209,000
The Common StockholderThe Common Stockholder
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Rate Earned on Stockholders’ EquityRate Earned on Stockholders’ EquityRate Earned on Stockholders’ EquityRate Earned on Stockholders’ Equity
Use: To assess the profitability of the investment by stockholders.
Use: To assess the profitability of the investment by stockholders.
Rate earned on stockholders’Rate earned on stockholders’equity 11.3% 10.0% equity 11.3% 10.0%
Net income $ 91,000 $ 76,500Stockholders’ equity:
Beginning of year $ 787,500 $ 750,000End of year 829,500 787,500Total $1,617,000 $1,537,500Average (Total ÷ 2) $ 808,500 $ 768,750
2006 2005
The Common StockholderThe Common Stockholder
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Leverage10%
5%
0%
Rate earned on total assets
Rate earned on stockholders’ equity
8.2%
11.3%
Leverage 3.1%
2006
7.3%
10.0%Leverage
2.7%
2005
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Rate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ Equity
2006 2005
The Common StockholderThe Common Stockholder
Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Remainder—common stock $ 82,000 $ 67,500Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000End of year 679,500 637,500Total $1,317,000 $1,237,500Average (Total ÷ 2) $ 658,500 $ 618,750
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Use: To assess the profitability of the investment by common stockholders.
Use: To assess the profitability of the investment by common stockholders.
2006 2005
Rate earned on commonRate earned on common stockholders’ equity 12.5% 10.9%stockholders’ equity 12.5% 10.9%
Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Remainder—common stock $ 82,000$ 82,000 $ 67,500$ 67,500Common stockholders’ equity:
Beginning of year $ 637,500 $ 600,000End of year 679,500 637,500Total $1,317,000 $1,237,500Average (Total ÷ 2) $ 658,500$ 658,500 $ 618,750 $ 618,750
The Common StockholderThe Common StockholderRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ EquityRate Earned on Common Stockholders’ Equity
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Earnings Per Share on Common StockEarnings Per Share on Common StockEarnings Per Share on Common StockEarnings Per Share on Common Stock
2006 2005
Earnings per share on common stock $1.64 $1.35Earnings per share on common stock $1.64 $1.35
Net income $ 91,000 $ 76,500Less preferred dividends 9,000 9,000Remainder—common stock $ 82,000 $ 67,500Shares of common stock 50,000 50,000
Use: To assess the profitability of the investment by common stockholders.
Use: To assess the profitability of the investment by common stockholders.
The Common StockholderThe Common Stockholder
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Price-Earnings RatioPrice-Earnings RatioPrice-Earnings RatioPrice-Earnings Ratio
Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings.
Use: To indicate future earnings prospects, based on the relationship between market value of common stock and earnings.
2006 2005
Price-earnings ratio on common stock 25 20Price-earnings ratio on common stock 25 20
Market price per share of common $41.00 $27.00Earnings per share on common ÷ 1.64 ÷ 1.35
The Common StockholderThe Common Stockholder
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Dividends and Earnings Per Share
Dividends Earnings
$0.80
$1.64
2006
$0.60
$1.35
2005
Per share
$2.00$2.00
$1.50$1.50
$1.00$1.00
$0.50$0.50
$0.00
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Dividend Yield on Common StockDividend Yield on Common StockDividend Yield on Common StockDividend Yield on Common Stock
Use: To indicate the rate of return to common stockholders in terms of dividends.
Use: To indicate the rate of return to common stockholders in terms of dividends.
2006 2005
Dividend yield on common stock 1.95% 2.22% Dividend yield on common stock 1.95% 2.22%
Dividends per share of common $ 0.80 $ 0.60Market price per share of common ÷ 41.00 ÷ 27.00
The Common StockholderThe Common Stockholder
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Corporate Annual ReportsCorporate Annual ReportsCorporate Annual ReportsCorporate Annual Reports
In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report.
The MDA includes an analysis of the results of operations and discusses management’s
opinion about future performance. It compares the prior year’s income statement with the current year’s. It also contains an analysis of the firm’s financial condition.
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Corporate Annual ReportsCorporate Annual ReportsCorporate Annual ReportsCorporate Annual Reports
In addition to financial statements, the annual report includes a management discussion analysis (MDA) and an independent auditors’ report.
Before issuing annual statements, all publicly held corporations are required to have an independent audit of their financial statements. The CPAs who conduct the audit render an opinion as
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