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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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understanding financial statements



Fraser & Ormiston

Chapter 5

overview of financial analysis
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
Potential Financial Statement Users:
  • Creditors
  • Investors
  • Managers
  • What types of questions do each of these users seek answers to?
  • 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?
  • 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?
  • 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?
  • 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
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...
other data sources
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
Basic Tools
  • 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 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
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
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
  • 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
liquidity 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
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
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
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
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
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
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 continued22
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
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
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 continued25
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 continued26
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
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
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
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
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
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 continued32
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 continued33
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
steps concluded
Steps (concluded)
  • Summarize findings
  • Reach conclusions about the firm relevant to your established objectives
  • 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
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
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)