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Understanding Financial Statements EIGHTH EDITION Lyn M. Fraser Aileen Ormiston The Analysis of Financial Statements

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the analysis of financial statements
The Analysis of Financial Statements

Ratios 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 financial statements cont
The Analysis of Financial Statements(cont.)

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

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objectives of analysis
Objectives of Analysis

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

Objectives will vary depending on the

  • perspective of the financial statement user
  • specific questions that are addressed

by the analysis

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objectives of analysis cont
Objectives of Analysis(cont.)

Creditors

Investors

Management

Potential Financial Statement Users:

What types of questions do each of these

users seek answers to?

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creditors
Creditors

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

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creditors cont
Creditors(cont.)
  • What is the borrowing cause?
  • What is the firm’s capital structure?
  • What will be the source of debt repayment?

Questions raised in a credit analysis should include:

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investors
Investors

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

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investors cont
Investors(cont.)

The investment analyst poses questions as:

  • How has the firm performed/what are future expectations?
  • How much risk is inherent in the existing capital structure?
  • What are expected returns?
  • What is firm’s competitive position?

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management
Management

Management relates to all questions raised by:

Creditors

Investors

Employees

General public

Regulators

Financial press

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management cont
Management(cont.)
  • How well the firm has performed and why?
  • What operating areas have contributed to success and which have not?

Looks to financial statement data to determine:

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management cont12
Management(cont.)
  • What are strengths/weaknesses of company’s financial position?
  • What changes should be implemented to improve future performance?

Looks to financial statement data to determine:

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caution
Caution!!!
  • 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 other sources of information apart from the Annual Report prepared by management

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sources of information
Sources of Information

The analyst will want to consider the following resources:

Proxy Statement

Auditor’s Report

MD&A

Supplementary schedules

Form 10-K and Form 10-Q

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other sources of information
Other Sources of Information
  • Computerized data bases
    • Info on industry norms/ratios
    • Info on particular companies/industries
  • Ever-expanding financial and investment websites
  • Articles in popular/business press

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tools and techniques
Tools and Techniques

These include:

Common-size financial statements

Financial ratios

Trend analysis

Structural analysis

Industry comparisons

Most important:

Common sense and judgment

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common size financial statements
Common-Size Financial Statements

Express each account on the

  • balance sheet as a percentage of total assets
  • income statement as a percentage of net sales

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key financial ratios
Key Financial Ratios

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

Percentages

Times

Days

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key financial ratios cont
Key Financial Ratios(cont.)
  • Liquidity Ratios

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

Four Categories of key financial ratios:

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key financial ratios cont20
Key Financial Ratios(cont.)
  • Activity Ratios

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

Four Categories of key financial ratios:

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key financial ratios cont21
Key Financial Ratios (cont.)

Four Categories of key financial ratios:

  • 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

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slide22

Key Financial Ratios(cont.)

Four Categories of key financial ratios:

  • Profitability Ratios

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

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cautions
Cautions!

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

  • They do not provide answers in and of themselves
  • They are not predictive

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cautions cont
Cautions! (cont.)
  • Ratios should be used with other elements of financial analysis
  • There are no “rules of thumb” that apply to the interpretation of ratios

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cautions cont25
Cautions!(cont.)

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

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liquidity ratios short term solvency
Liquidity Ratios: Short-Term Solvency

Measures ability to meet short-term cash needs

Current Ratio

Current assets

Current liabilities

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liquidity ratios short term solvency cont
Liquidity Ratios: Short-Term Solvency (cont.)

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

Quick or Acid-Test Ratio

Current assets - Inventory

Current liabilities

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liquidity ratios short term solvency cont28
Liquidity Ratios: Short-Term Solvency (cont.)

Cash Flow Liquidity Ratio

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

Cash + Marketable securities + CFO *

Current liabilities

*Cash flow from operating activities

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liquidity ratios short term solvency cont29
Liquidity Ratios: Short-Term Solvency (cont.)

Average Collection Period

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

Net accounts receivable

Average daily sales

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liquidity ratios short term solvency cont30
Liquidity Ratios: Short-Term Solvency (cont.)

Measures the efficiency of the firm in managing its inventory

Days Inventory Held

Inventory

Average daily cost of sales

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liquidity ratios short term solvency cont31
Liquidity Ratios: Short-Term Solvency (cont.)

Days Inventory Held: Example of ratio

comparisons for two companies in the

Electronic Computers industry*

Current Yr. Prior Year2 Yrs. Prior

5 days 5 days 4 days

Current Yr. Prior Year2 Yrs. Prior

23 days 22 days 15 days

*Data from SEC website, www.sec.gov

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liquidity ratios short term solvency cont32
Liquidity Ratios: Short-Term Solvency (cont.)

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

Days Payable Outstanding

Accounts payable

Average daily cost of sales

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cash conversion cycle or net trade cycle
Cash Conversion Cycle or Net Trade Cycle

The normal cycle of a firm that consists of:

  • Buying or manufacturing inventory, with some purchases on credit
  • Selling inventory, with some sales on credit
  • Collecting the cash

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cash conversion cycle or net trade cycle cont
Cash Conversion Cycle or Net Trade Cycle(cont.)

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

Key balance sheet accounts that affect cash flow from operating activities

  • Accounts Receivable
  • Inventory
  • Accounts Payable

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cash conversion cycle or net trade cycle cont35
Cash Conversion Cycle or Net Trade Cycle(cont.)

Calculated as follows:

Average collection period

Plus

Days inventory held

Minus

Days payable outstanding

Equals

Cash conversion or net trade cycle

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activity ratios asset liquidity asset management efficiency
Activity Ratios: Asset Liquidity, Asset Management Efficiency

Accounts Receivable Turnover

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

Net sales

Net accounts receivable

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activity ratios asset liquidity asset management efficiency cont
Activity Ratios: Asset Liquidity, Asset Management Efficiency(cont.)

Another measure of firm’s efficiency in managing its inventory

Inventory Turnover

Cost of goods sold

Inventory

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activity ratios asset liquidity asset management efficiency cont38
Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.)

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

Payables Turnover

Cost of goods sold

Accounts payable

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activity ratios asset liquidity asset management efficiency cont39
Activity Ratios: Asset Liquidity, Asset Management Efficiency(cont.)

Assesses effectiveness in generating sales from investments in fixed assets

Fixed Asset Turnover

Net sales

Net property, plant, equipment

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activity ratios asset liquidity asset management efficiency cont40
Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.)

Assesses effectiveness in generating sales from investments in all assets

Total Asset Turnover

Net sales

Total assets

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leverage ratios debt financing and coverage
Leverage Ratios: Debt Financing and Coverage

Debt Ratio

Considers the proportion of all assets that are financed with debt

Total liabilities

Total assets

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leverage ratios debt financing and coverage cont
Leverage Ratios: Debt Financing and Coverage (cont.)

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

Current Yr. Prior Year

62.31% 69.93%

Current Yr. Prior Year

79.08% 85.77%

*Data from SEC website, www.sec.gov

(C) 2007 Prentice Hall, Inc.

leverage ratios debt financing and coverage cont43
Leverage Ratios: Debt Financing and Coverage (cont.)

Long-term Debt to Total Capitalization

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

Long–term debt

Long-term debt + Stockholders’ equity

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leverage ratios debt financing and coverage cont44
Leverage Ratios: Debt Financing and Coverage(cont.)

Debt to Equity

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

Total liabilities

Stockholders’ equity

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leverage ratios debt financing and coverage cont45
Leverage Ratios: Debt Financing and Coverage(cont.)

Indicates how well operating earnings cover fixed interest expenses

Times Interest Earned

Operating profit

Interest expense

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leverage ratios debt financing and coverage cont46
Leverage Ratios: Debt Financing and Coverage(cont.)

Cash Interest Coverage

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

CFO + interest paid + taxes paid

Interest paid

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leverage ratios debt financing and coverage cont47
Leverage Ratios: Debt Financing and Coverage(cont.)

Broader measure of how well operating earnings cover fixed charges

Fixed Charge Coverage

Operating profit + Rent expense

Interest expense + Rent expense

*Rent expense = operating lease payments

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leverage ratios debt financing and coverage cont48
Leverage Ratios: Debt Financing and Coverage (cont.)

Cash Flow Adequacy

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

Cash flow from operating activities

Capital expenditures + debt repayments + dividends paid

(C) 2007 Prentice Hall, Inc.

profitability ratios overall efficiency and performance
Profitability Ratios: Overall Efficiency and Performance

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

Gross Profit Margin

Gross profit

Net sales

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profitability ratios overall efficiency and performance cont
Profitability Ratios: Overall Efficiency and Performance (cont.)

Operating Profit Margin

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

Operating profit

Net sales

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profitability ratios overall efficiency and performance cont51
Profitability Ratios: Overall Efficiency and Performance (cont.)

Net Profit Margin

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

Net earnings

Net sales

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profitability ratios overall efficiency and performance cont52
Profitability Ratios: Overall Efficiency and Performance (cont.)

Cash Flow Margin

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

Cash flow from operating activities

Net sales

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profitability ratios overall efficiency and performance cont53
Profitability Ratios: Overall Efficiency and Performance (cont.)

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

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

Net earnings

Total assets

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profitability ratios overall efficiency and performance cont54
Profitability Ratios: Overall Efficiency and Performance (cont.)

Measures rate of return on stockholders’ investment

Return on Equity (ROE)

Net earnings

Stockholders’ equity

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profitability ratios overall efficiency and performance cont55
Profitability Ratios: Overall Efficiency and Performance (cont.)

Cash Return on Assets

  • Measures firm’s ability to generate cash from the utilization of its assets
  • Useful comparison to ROA

Cash flow from operating activities

Total assets

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market ratios
Market Ratios

Four market ratios of particular interest

to the investor are

  • Earnings per common share
  • Price-to-earnings
  • Dividend payout
  • Dividend yield

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market ratios cont
Market Ratios (cont.)

Provides the investor with a common denominator to gauge investment returns

Earnings per Common Share

Net earnings

Average shares outstanding

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market ratios cont58
Market Ratios (cont.)

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

Price-to-Earnings

Market price of common stock

Earnings per share

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market ratios cont59
Market Ratios (cont.)

Dividend Payout

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

Dividends per share

Earnings per share

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market ratios cont60
Market Ratios (cont.)

Shows the relationship between cash dividends and market price

Dividend Yield

Dividends per share

Market price of common stock

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analyzing the data
Analyzing the Data

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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five steps of a financial statement analysis
Five Steps of a Financial Statement 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?

Step 1

Establish objectives of the analysis

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five steps of a financial statement analysis cont
Five Steps of a Financial Statement Analysis(cont.)

Step 2

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

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five steps of a financial statement analysis cont64
Five Steps of a Financial Statement Analysis(cont.)
  • How well does this firm appear to be run?
  • Are they taking advantage of opportunities?
  • Are they innovative, forward-looking, etc?

Step 3

Develop knowledge of the firm and the quality of management

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five steps of a financial statement analysis cont65
Five Steps of a Financial Statement Analysis(cont.)

Step 4

  • Common-size financial statements
  • Key financial ratios
  • Trend analysis
  • Structural analysis
  • Comparison with industry competitors

Evaluate financial statements–toolsinclude:

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five steps of a financial statement analysis cont66
Five Steps of a Financial Statement Analysis(cont.)

Step 4

  • Short-term liquidity
  • Operating efficiency
  • Capital structure and long-term solvency
  • Profitability
  • Market ratios
  • Segmental analysis (when relevant)
  • Quality of financial reporting

Evaluate financial statements–areas include:

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five steps of a financial statement analysis cont67
Five Steps of a Financial Statement Analysis(cont.)
  • Reach conclusions about the firm relevant to your established objectives

Step 5

Summarize findings based on analysis

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relating the ratios the du pont system
Relating the Ratios—The Du Pont System

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

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relating the ratios the du pont system cont
Relating the Ratios—The Du Pont System(cont.)

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

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relating the ratios the du pont system cont70
Relating the Ratios—The Du Pont System(cont.)

The summary ratios used are the following:

(1)

Net profit margin

(2)

Total asset turnover

(3)

Return on investment

Net income Net sales Net income

Net sales X Total assets = Total assets

(3)

Return on investment

(4)

Financial leverage

(5)

Return on equity

Net income Total assets Net income

Total assets X Stockholder equity = Stockholder equity

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what we have accomplished
What we have accomplished

Turned

Maze

Auditor’s Report

MD&A

Notes

Statement of Cash Flows

Income Statement

Statement of Shareholders’ Equity

Balance Sheet

(C) 2007 Prentice Hall, Inc.

financial statements an overview
Financial StatementsAn Overview

into

Map

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