1 Analysis of Financial Statements Financial Statements and Reports Income statement Balance sheet...

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Analysis of Financial Statements

Financial Statements and ReportsIncome statementBalance sheetStatement of retained earningsStatement of cash flows

Ratio AnalysisRatio Analysis—DuPont ApproachUses and Limitations of Ratio Analysis

What financial statements do corporations publish, and what information does each provide?

How do investors utilize financial statements?

What is ratio analysis and why are the results important to both managers and investors?

What are some potential problems associated with financial statement analysis?

What is the most important factor in financial statement analysis?

Financial Statements and Reports

Financial reporting is used to disclose information about the firmFinancial statements provided tostockholders/creditorsSECIRSManagement

Annual report—includesa general discussion about the firm’s activities

during the past year and expectations in the near future

financial statements of the firm for the most recent years

Income Statement

Provides a summary of the revenues recognized and the expenses incurred during a particular operating period.

Matching principle—revenues are recognized when sales occur (earned) and expenses are realized when they are incurred.

Accrual accounting versus cash flows

Balance Sheet

Records the financial position of the firm at a particular point in time by showing the assets—that is, the investments—and the liabilities and equity—that is, the financing—of the firm.

Historical costs

Balance Sheet

Cash versus other assets—only cash represents actual funds that can be invested

Liabilities versus stockholders’ equity— liabilities represent debt, whereas equity represents ownership

Preferred versus common stock—all corporations have one type of stock called common stock; some firms have equity called preferred stock

Balance Sheet

Common equity accounts:

common stock = number of shares outstanding times the par value of each share

paid-in capital = amount above the par value for which common stock was issued

retained earnings = income the firm earned in the past that was “retained” and reinvested in assets

Statement of Retained Earnings

Shows the change in the retained earnings and common equity accounts since the last balance sheet was constructed.

Statement of Cash Flows

Reports the effect of the firm’s activities—operating, investing, and financing—over some period on its cash position

Statement of Cash Flows

Income versus cash flows—revenues and expenses are recognized when incurred, not when cash is received or paid

Non-cash items—some non-cash items appear on the income statement, such as depreciation

Accounting profit—net income, or the “bottom line” on the income statement; net income and cash flows generally are highly correlated

Operating cash flows—cash flows generated from the normal operating activities of the firm

Statement of Cash FlowsSimple rules to follow when constructing a statement of cash flows:

Sources of Cash Uses of Cash Liability Account Liability Account

(e.g., borrow more) (e.g., payoff loans)

Equity Account Equity Account

(e.g., issue stock) (e.g., pay a dividend)

Asset Account Asset Account(e.g., sell inventory) (e.g., purchase

equipment)

Eagle, Inc. Income Statement

Sales $80,000Variable operating costs (60,000)Fixed costs, excluding depreciation (12,000)Depreciation ( 2,000)EBIT = NOI 6,000Interest ( 1,000)Earnings before taxes (EBT) 5,000Taxes (40%) ( 2,000)Net income $ 3,000Dividends 2,000Addition to retained earnings 1,000

Eagle, Inc. Balance SheetCurrent Current

Year Year

Cash & securities $ 2,000 Accounts payable$ 4,000

Accounts receivable 6,000 Accruals 5,000

Inventory 7,000 Notes payable 1,000

Current assets 15,000 Current liabilities10,000

Net fixed assets 10,000 Long-term debt 6,000

Total assets $25,000 Total liabilities 16,000

Common stock 6,000

Retained earnings 3,000

Owners’ equity 9,000

Total liabilities & equity $25,000

CurrentPrevious CurrentPrevious

Year Year Year Year

Cash & securities $ 2,000 $1,000 Accounts payable$ 4,000$ 2,000

Accounts receivable 6,000 5,000 Accruals 5,0004,000

Inventory 7,000 8,000 Notes payable 1,000 2,000

Current assets 15,000 14,000 Current liabilities10,0008,000

Net fixed assets 10,000 9,000 Long-term debt 6,000 7,000

Total assets $25,000$23,000 Total liabilities 16,00015,000

Common stock 6,0006,000

Retained earnings 3,000 2,000

Owners’ equity 9,0008,000

Total liabilities & equity $25,000

$23,000

Eagle, Inc. Balance Sheet—Changes in Assets

Current Previous Year Year Change

Cash & securities $ 2,000 $ 1,000Accounts receivable 6,000 5,000Inventory 7,000 8,000 Current assets 15,000 14,000Net fixed assets 10,000 9,000 Total assets $25,000 $23,000

Current Previous Year Year

Cash & securities $ 2,000 $ 1,000Accounts receivable 6,000 5,000Inventory 7,000 8,000 Current assets 15,000 14,000Net fixed assets 10,000 9,000 Total assets $25,000 $23,000

1,000(1,000)

Fixed assets if no purchases or sales = $9,000 - $2,000 = $7,000Depreciation = $2,000Change in fixed assets = $10,000 - $7,000 = $3,000

Sources of Cash Uses of Cash Asset Account Asset Account

Source Use

Eagle, Inc. Balance Sheet—Changes in Liabilities and Equity

CurrentPrevious

Year Year

Accounts payable $ 4,000$ 2,000

Accruals 5,0004,000

Notes payable 1,000 2,000

Current liabilities 10,0008,000

Long-term debt 6,000 7,000

Total liabilities 16,00015,000

Common stock 6,0006,000

Retained earnings 3,000 2,000

Owners’ equity 9,0008,000

Total liabilities & equity$25,000$23,000

Change2,0001,000(1,000)

(1,000)

Source UseXX

Sources of Cash Uses of Cash Liability/Equity Account Liability/Equity Account

Eagle, Inc. Statement of Cash Flows

Cash Flows from Operations:Net income (NI) $3,000

Adjustments to NI

Depreciation 2,000 Inventory 1,000

Accounts payable 2,000

Accruals 1,000

Accounts receivable(1,000)Net CF from operations $8,000

Cash Flows from Long-Term Investing:Acquisition of assets (3,000)

Cash Flows from Financing Activities: Notes payable (1,000)

Long-term bonds (1,000)

Dividend payment (2,000)

Net CF from financing $(4,000)

Net Change in cash 1,000Cash at beginning of year 1,000Cash at end of year $2,000

Financial Statements:Accounting Alternatives

In many instances, the same business activity can be recorded using one of several accepted accounting methods—for example, LIFO versus FIFO for inventory valuation.

Financial Statements:Time Dimension

Balance sheet—a “snapshot” of where the firm is at a specific point in time (stock statement).

Income statement and statement of cash flows—shows the results of the firm’s activities over a period of time (flow statement).

What Information Do Investors Use from Financial Statements?

Net working capital (NWC)= Current assets - Current liabilities

Operating cash flow (OCF)= NOI (1-Tax rate) + Depreciation & amortization expenseFree cash flow (FCF)= OCF – Investments

Economic Value Added (EVA)= NOI (1 - T) - [(Invested capital) X (After-tax cost of funds)

Financial Statement (Ratio) Analysis

Used to evaluate how financial positions:

Change on a year-to-year basis for a single firm.

Compare among firms, even if they differ in size.

Ratio (Financial Statement) Analysis

Used by:

Managers inside the firm

Stockholders and creditors—existing and potential—outside the firm

Ratio (Financial Statement) Analysis

General categories of analysis:

Liquidity

Asset management

Debt management

Profitability

Market value

Liquidity Ratios

Help measure the liquidity position of the firm

Too little, or too much liquidity could be considered a “bad sign”too little liquidity—suggests the firm will have

problems paying its current obligations in the future

too much liquidity—might suggest the firm is not investing its funds wisely

Provide an indication of how well the firm can meet its current obligations

Current ratio

Shows the relationship between current assets and current liabilities; a higher value suggests greater liquidity, and vice versa:

sliabilitieCurrent

assetsCurrent = ratioCurrent

Quick (Acid Test) Ratio

Similar to the current ratio, except the value of inventories is subtracted from current assets (CA) in the numerator; inventories represent the least liquid of the current assets:

sInventorie - AC = ratio test,acid-or Quick,

Asset Management Ratios

Show how often the firm is “turning over” its assets to generate funds

Generally, when assets are not turned over quickly enough, it is because sales have slowed or current assets, such as inventory and receivables, are too high

If assets are turned over too quickly, it could mean that the firm is not producing enough

Provide an indication of how well the firm manages its assets (efficiency)

Inventory Turnover

Shows how many times during a period—for example, one year—the amount of average inventory is turned over due to sales activities.

sInventorie

sold goods ofCost =turnover Inventory

Days Sales Outstanding (DSO)

Indicates the average time it takes customers to pay for credit purchases—that is, the length of time it takes the firm to collect for credit sales.

360sales Annual

sReceivable =

dayper sales Average

sReceivable = (DSO) goutstandin

sales Days

Fixed Assets Turnover

Indicates how efficiently the firm uses its fixed assets (excludes current assets) to produce revenues

assets fixedNet

Sales = ratio turnover assets Fixed

Total Assets Turnover

Similar to the fixed assets turnover, except the value of total assets (includes current assets) is used.

assets Total

Sales = ratio turnover assets Total

Debt Management Ratios

financial leverage refers to the use of debt

leverage helps to magnify returns, on both the positive and the negative sides, because debt represents a fixed obligation

Indicate how the firm’s financial position is affected by the amount of debt it has

Debt Ratio

Indicates the capital structure of the firm; measures the percent debt used by the firm for the purposes of financing assets.

assets Total

sliabilitie Total =

assets Total

debt Total = ratioDebt

Times-Interest-Earned (TIE) Ratio

Indicates whether the firm generates sufficient operating income (not cash) to meet its interest obligations each year.

chargesInterest

income Operating =

chargesInterest

EBIT = ratio earnedinterest-Times-

Fixed Charge Coverage Ratio

Like the times-interest-earned ratio, except all fixed payments related to financing are included.

sobligation financing Fixed

sobligation financingcover toavailable Funds

paymentsLease

esargchInterest

payments LeaseEBITratio eragecov

charge Fixed

ratetax 1payments fund Sinking

Profitability ratios

Indicate how the firm’s management of its liquidity position, assets, and debt has affected normal operating activities.

Net Profit Margin

Shows what percent of sales revenues is left after expenses related to operations and the effects of financing and taxes.

incomeNet =margin profit Net

Return on Total Assets (ROA)

Measures the return on investment earned by the firm; ROA represents a return on all invested funds (both debt and equity).

assets Total

incomeNet = (ROA) assets on totalReturn

Return on Equity (ROE)

Similar to ROA, ROE is a measure of the return on the original funds provided by common stockholders (equity only).

equity Common

dividends Preferred incomeNet

equityCommon

rsstockholdecommon toavailable Income(ROE) Equity

on turnRe

Market Value Ratios

Measures that consider the value of the firm’s stock in the financial markets—that is, how well investors perceive that the firm is creating value.

Price/Earnings (P/E) Ratio

Indicates how much investors pay for each dollar of income generated by the firm.

goutstandin sharescommon ofNumber

rsstockholdecommon toavailable Income =

(EPS) SharePer Earnings

shareper Earnings

shareper price Market = ratio ingsPrice/earn

Market/Book Value Ratio

Indicates the relationship between the selling price of the common stock and its book value.

goutstandin sharescommon of Number

equityCommon

shareper ueMarket val

shareper Book value

shareper ueMarket val valuebook/Market

Trend and Comparative Analyses

Ratios should be evaluated

At a point in time in comparison to a norm, such as an industry average, to determine the firm’s current financial position (comparative analysis).

Over time to determine whether the firm’s current financial position is improving or deteriorating (trend analysis).

Du Pont Equation/Method

Shows the relationship between the return on investment (ROA) and both the total assets turnover and the net profit margin so as to give more detail where weaknesses or strengths exist.

For example, if ROA is relatively low, it might be due to a low profit margin, a slow turnover of assets, or both.

Du Pont Equation

assets Total

income Net x

turnoverassets Total margin profit Net ROA x

assets Total

income Net

Classifying a very large, multidivisional firm into a single industry often is difficult.

Using a single norm, or “target,” ratio for comparisons might be misleading.

Values on balance sheets are historical costs, so ratios might not portray a “true” picture.

Seasonality in operations might cause ratios to differ significantly at different times of the year.

Uses and Limitations of Ratio Analysis

Sometimes firms try to make financial statements look better by using “window dressing” techniques.

If firms use different accounting methods, comparisons between firms can be difficult.

Do not make general conclusions about the firm’s financial position by examining only one or a few ratios; ratio analysis should be comprehensive.

The most important part of ratio analysis is the judgment used when interpreting the results, not the computation of the ratios.

What financial statements do corporations publish?Balance sheet, income statement, statement of

cash flows, and statement of retained earnings

How do investors utilize financial statements?Debt holders estimate future cash flows to

determine whether the debt contracts will be honored

Stockholders estimate future cash flows to determine the value of the firm’s common stock.

What is ratio analysis and why are the results important to both managers and investors?Ratio analysis is used to evaluate a firm’s current

financial position and, based on the results, to forecast the firm’s future financial position.

What are some potential problems associated with financial statement analysis?Seasonality, alternative accounting methods, and

historical costs are a few factors that make evaluation of financial statements difficult.

What is the most important factor in financial statement analysis?To form general impressions about a firm’s

financial position, judgment must be used when interpreting financial ratios

1 Analysis of Financial Statements Financial Statements and Reports Income statement Balance sheet...

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