Understanding financial statements
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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

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Fraser & Ormiston

Chapter 5

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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

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Potential Financial Statement Users:

  • Creditors

  • Investors

  • Managers

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

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  • 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?

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  • 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?

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  • 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?

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  • 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

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Where to look for data...

  • Financial statements (and notes)

  • Auditor’s report

  • MD&A

  • Supplementary schedules

  • All of the above are in Annual Report -- can also look further...

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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

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Basic Tools

  • Common size financial statements

  • Financial ratios

  • Trend analysis

  • Structural analysis

  • Industry comparisons

  • Common sense and judgment (often the hardest to use!)

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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

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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

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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

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  • 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


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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

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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

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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

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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

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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

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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…...

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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

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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

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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

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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!)

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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

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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

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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

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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

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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…...

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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?

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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?...

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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?

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Steps (continued)

  • Evaluate financial statements (number-crunching 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

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Steps (concluded)

  • Summarize findings

  • Reach conclusions about the firm relevant to your established objectives


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  • 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...

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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

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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)