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Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws

Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws. Chapter 5. Chapter 5:. Illustrates a comprehensive analysis Integrates material from previous chapters Adds new resources Offers a toolbox of analytical techniques. From the Tools & Techniques Presented. . .

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Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws

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  1. Understanding the Corporate Annual Report: Nuts, Bolts, and a Few Loose Screws Chapter 5 Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  2. Chapter 5: • Illustrates a comprehensive analysis • Integrates material from previous chapters • Adds new resources • Offers a toolbox of analytical techniques Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  3. From the Tools & Techniques Presented. . . • Readers can choose what to use to meet specific objectives Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  4. The 1st Step in Evaluating a Firm’s Financial Reports is to. . . • Specify the objectives of the analysis Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  5. An Investor • Decides whether to buy, hold, or sell a firm’s security • Uses a company’s historical financial information to estimate future potential & value Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  6. A Creditor • Determines borrowing need • Assesses firm’s ability to service debt • Evaluates source of debt repayment Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  7. Managers & Directors • Address questions relevant to investors & creditors • Satisfy other user groups: • employees • competitors • suppliers Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  8. Managers & Directors Continued: • Consider responses to financial reports by: • general public • regulators • financial press Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  9. Financial Reporting Environment • Is often adversarial: • management wants to present most positive picture possible • users want picture that represents financial reality Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  10. Sources of Information Primary Sources • Four financial statements • Financial statement notes Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  11. Sources of Information Continued: • 10-K report: • annual report filed with SEC • 10-Q reports: • quarterly (unaudited) reports filed with SEC • Proxy statement: • required by SEC prior to shareholders meetings Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  12. Sources of Information Continued: Auditor’s Reports • “Independent” reports expressing opinion about fairness of financial statement presentation Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  13. Sources of Information Continued: Management Discussion & Analysis • Section in annual report monitored by SEC which covers firm’s: • liquidity • capital resources • operations Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  14. Sources of Information Continued: Supplementary Schedules • Selected financial data on: • segments (unrelated lines of business) • operations outside U.S. Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  15. Sources of Information Continued: • Resources: • computerized search systems & data bases • comparative statistical ratios • research provided by independent services • financial press • financial analysis spreadsheet packages Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  16. More Resources • Common size balance sheet: • expresses all items as a percentage of total assets • Common size income statement: • expresses all items as percentage of total sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  17. More Resources Continued: • Summary Analysis of Cash Flows: • Separates cash inflows & outflows in dollar & percentage terms Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  18. Tools & Techniques Financial Ratios • Standardize financial statement data • Mathematical relationships expressed in percent or times Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  19. Tools & Techniques Continued: • Trend analysis • evaluates financial data over several accounting periods • Structural analysis • considers the internal composition of a firm • Industry comparisons • relate one firm with averages compiled for industry in which it operates Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  20. Tools & Techniques Continued: What’s most important? Common sense & judgement Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  21. Financial Ratios • Use as screening devices • Use with caution: they don’t supply answers • Use with other analytical tools Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  22. Financial Ratios Continued: • Look behind ratio that is out of line to determine cause • There is no standardized set of ratios or definitions Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  23. Liquidity Ratios • Measure short-run solvency: • the ability of firm to meet debt payments as they come due Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  24. Liquidity Ratios Continued: • Current ratio: Current assets Current liabilities • Quick ratio: Current assets - inventory Current liabilities Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  25. Liquidity Ratios Continued: • Cash flow liquidity ratio: Cash + Market Securities + Cash flow from operations Current liabilities Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  26. Liquidity Ratios Continued: • Average collection period: Accounts receivable Average daily sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  27. Liquidity Ratios Continued: • Days inventory held: Inventory Average daily cost of sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  28. Liquidity Ratios Continued: • Days payable outstanding: Accounts payable Average daily cost of sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  29. Net Trade Cycle Average collection period + days inventory held - days payable outstanding • Measures normal cash conversion cycle of firm Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  30. Activity Ratios • Measures liquidity of assets & asset management efficiency Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  31. Activity Ratios Continued: • Accounts receivable turnover: Net sales Accounts receivable • Inventory turnover: Cost of goods sold Inventory Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  32. Activity Ratios Continued: • Payables turnover: Cost of goods sold Accounts payable Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  33. Activity Ratios Continued: • Fixed asset turnover: Net sales Net property, plant, equipment • Total asset turnover: Net salesTotal assets Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  34. Leverage Ratios • Measures debt financing & debt coverage Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  35. Leverage Ratios Continued: • Debt ratio: Total liabilities Total assets Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  36. Leverage Ratios Continued: • Long-term debt to total capitalization: Long-term debt Long-term debt + stockholders’ equity Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  37. Leverage Ratios Continued: • Debt to equity: Total liabilities Stockholders’ equity • Times interest earned: Operating profit Interest expense Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  38. Leverage Ratios Continued: • Cash interest coverage: Cash flow from operations+ interest paid + taxes paid Interest paid Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  39. Leverage Ratios Continued: • Fixed charge coverage: Operating profit + rent expense Interest expense + rent expense Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  40. Leverage Ratios Continued: • Cash flow adequacy: Cash flow from operations Capital expenditures + debt repayments + dividends paid Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  41. Profitability Ratios • Measures overall efficiency & performance Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  42. Profitability Ratios Continued: • Gross profit margin: Gross profit Net sales • Operating profit margin: Operating profit Net sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  43. Profitability Ratios Continued: • Net profit margin: Net profit Net sales • Cash flow margin: Cash flow from operations Net sales Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  44. Profitability Ratios Continued: • Return on assets (investment): Net profit Total assets • Return on equity: Net profit Stockholders’ equity Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  45. Financial Leverage: Use of Debt • Magnifies returns to shareholders when company earns more than after-tax cost of debt Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  46. Financial Leverage: Double-edged Sword • Produces negative effects on returns when company earns less than after-tax cost of debt Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  47. Profitability Ratios Continued: • Cash return on assets: Cash flow from operations Total assets Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  48. Market Ratios • Basic earnings per share: Net income Weighted average number of common shares outstanding Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  49. Market Ratios Continued: • Dividend yield: Cash dividends per share Year-end market price of common stock Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

  50. Market Ratios Continued: • Price to earnings ratio: Market price of common stock Basic earnings per share Fraser/Ormiston: Understanding the Corporate Annual Report (C) 2002 Prentice Hall Business Publishing

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