Analysis and Interpretation of Financial Statements

1. Analysis and Interpretation of Financial Statements

2. Financial Statement Analysis • The application of analytical tools and techniques to financial statement data. • Allows users to focus on how numbers are related and how they have changed over time

3. Objective of Financial StatementAnalysis • External users rely on general purpose financial statements • Make predictions about an organization as an aid in making decisions • Users highlight important trends or changes

4. Risk and Return • Users try to balance the risk of an investment with its expected return • Generally the greater the risk, the higher the return • Financial statement analysis is one source of information for assessing risk and return

5. Sources of External Information • Public companies must publish an annual financial report • Government reports • SEC 10K, 10Q • Financial service information • Moody’s, Dow-Jones • Financial newspapers and periodicals • Wall Street Journal

6. Financial Analysis Tools • Horizontal analysis • Vertical analysis • Ratio analysis

7. Horizontal Analysis: Amounts and Percentages of Change • Amount of change = later year amount - Earlier year amount • Percentage change = Amount of change / Earlier year amount • Look for significant change

8. Horizontal Analysis: Trend Percentages • Set all amounts in base year at 100% • Compute percentages for a number of years • Divide each statement amount by respective amount in base year • Shows degree of increase or decrease in individual statement items • Used to explain changes in operating performance

9. Vertical Analysis • Shows how each item in a financial statement compares to the total of that statement • Balance sheet • Set both total assets and total equities at 100% • Income statement • Set net sales at 100%

10. Vertical Analysis • Identify significant dollar and percentage changes • Explain the changes • Identify whether they are favorable of unfavorable

11. Ratio Analysis • Shows the relative size of one financial statement component to another. • Effective only when used in combination with other ratios, analysis, and information

12. Ratio Analysis • Short-term liquidity • Long-term solvency • Profitability • Market performance

13. Short-term Profitability • Current ratio • Quick ratio • Accounts receivable turnover • Days’ sales in receivables • Inventory turnover

14. Current Ratio • Common measure of liquidity • Ability to pay debts as they come due • Rule of thumb 2:1 • Consider other factors Current Assets Current Liabilities

15. Quick Ratio (Acid Test) • More strict measure of short-term liquidity • Numerator includes only quick current assets • Assets readily converted to cash Cash + Short-term investments + Net Current Receivables Current liabilities

16. Accounts Receivable Turnover • How many times we turn accounts receivable into cash during a period Net sales Average net accounts receivable

17. Days’ Sales in Receivables • How many days’ sales remain uncollected in accounts receivable Net sales Net sales per day = 365 days Average net accounts receivable Net sales per day

18. Inventory Turnover • Number of times the company sells and replaces its inventory during the period • Holding inventory results in financing and storage costs Cost of goods sold Average inventory

19. Long-term Solvency • Debt ratio • Times Interest Earned

20. Debt Ratio • Shows amount of total assets creditors provide • Higher levels of debt financing means company has a higher risk of not meeting interest and principal payments Total liabilities Total assets

21. Times Interest Earned • Number of times the company earned interest expense with current income • Creditors want to know the firm’s ability to pay annual interest charges Net income + Income tax expense + Interest expense Interest expense

22. Profitability • Profit margin • Total asset turnover • Return on total assets • Return on owners’ equity • Earning per share

23. Profit Margin • Percentage each sales dollar contributes to net income Net income Net sales

24. Total Asset Turnover • Measures the efficiency of the company is using its investment in assets to generate sales Net sales Average total assets

25. Return on Total Assets • Measures the amount a company earns on each dollar of investment in assets Net income Average total assets

26. Return on Owners’ Equity • Measures the earnings in relation to the owners’ investment in the company Net income - Preferred dividends Average owner’s equity

27. Earnings Per Share • Measures the net income available to each share of common stock • Discussed in depth in Chapter 14 Net income - Preferred dividends Weighted average number of common shares outstanding during the year

28. Market Performance • Price/Earnings (P/E) ratio • Dividend yield

29. Price/Earning (P/E) Ratio • Number of times earnings per share the stock is currently selling for in the market Market price per share of common stock Earnings per share

30. Dividend Yield • Measure of dividend-paying performance of a company • Investors buy stock for two reasons • Receive cash dividends • Sell stock at a higher price Dividends per share Market price per share

31. Limitations of Financial Analysis Tools • Historical nature of accounting information • Changing economic conditions • Comparisons with industry averages • Seasonal factors • Quality of reported income