®1999 South-Western College Publishing 1 Chapter 21 Financial Statement Analysis.

1® 1999 South-Western College Publishing

Chapter 21Financial Statement Analysis


Importance of Financial Accounting

• Three General Approaches to ValuationThree General Approaches to Valuation

1.1. DCF approachDCF approach

2.2. Relative valuation approachRelative valuation approach

– ““Going concern” valuationsGoing concern” valuations

3.3. Liquidation or “break-up” valueLiquidation or “break-up” value

• All use information from financial statementsAll use information from financial statements


Sources of Information• Annual reportsAnnual reports

– Company websitesCompany websites• Value LineValue Line• Wall Street JournalWall Street Journal• SECSEC

– EDGAREDGAR– 10K & 10Q reports10K & 10Q reports

• InternetInternet– NYSE (www.nyse.com)NYSE (www.nyse.com)– Nasdaq (www.nasdaq.com)Nasdaq (www.nasdaq.com)– Text (www.mhhe.com/cj)Text (www.mhhe.com/cj)


Financial Accounting Concepts

• Accountants follow specific rules for:Accountants follow specific rules for:

– CollectingCollecting

– OrganizingOrganizing

– ReportingReporting

• Financial InformationFinancial Information

• Assumptions and concepts forming framework for Assumptions and concepts forming framework for rules are as listed on next sliderules are as listed on next slide


Basic Concepts(Exhibit 21-1)

• Business entityBusiness entity• Going concernGoing concern• MonetaryMonetary• Accounting periodAccounting period• ConsistencyConsistency• Historical costHistorical cost• RealizationRealization

• Matching Costs and Matching Costs and RevenuesRevenues

• Dual aspectDual aspect• Reliability of evidenceReliability of evidence• DisclosureDisclosure• ConservatismConservatism• MaterialityMateriality• Substance over formSubstance over form


Three Basic Statements

• Balance SheetBalance Sheet

• Income StatementIncome Statement

• Statement of Cash FlowsStatement of Cash Flows


Balance Sheet

• Fundamental Identity:Fundamental Identity:– Assets = Liabilities + EquityAssets = Liabilities + Equity– As of a specific dateAs of a specific date

• Look for PatternsLook for Patterns• Investigate ChangesInvestigate Changes• AssetsAssets

– Inventory ValuationInventory Valuation– Plant and EquipmentPlant and Equipment– IntangiblesIntangibles

• LiabilitiesLiabilities• EquityEquity


Balance Sheet Questions

• What is the Size of the Firm?What is the Size of the Firm?

• Are Most Assets Current or Fixed?Are Most Assets Current or Fixed?

• How is the Capital to be Invested?How is the Capital to be Invested?

• What is the Firm’s Capital Structure?What is the Firm’s Capital Structure?

• Do Significant Patterns Emerge Over Time?Do Significant Patterns Emerge Over Time?


Investigate Changes

• Changes can be a SignalChanges can be a Signal

– Is Something Wrong?Is Something Wrong?

• Look at the Explanation in the Notes to the Look at the Explanation in the Notes to the Financial StatementsFinancial Statements


Inventory Valuation• How are inventories carried on the balance sheet?How are inventories carried on the balance sheet?

– See the Notes to the Financial StatementsSee the Notes to the Financial Statements• FIFOFIFO

– Overstates inventories during inflationOverstates inventories during inflation• LIFOLIFO

– Most popularMost popular– Understates inventory during inflationUnderstates inventory during inflation

• Average CostAverage Cost– Spreads cost fluctuations over timeSpreads cost fluctuations over time


Intangibles• GoodwillGoodwill• PatentsPatents• CopyrightsCopyrights• TrademarksTrademarks• FranchisesFranchises• LicensesLicenses• Organization and Development ExpensesOrganization and Development Expenses• Key accounting distinction:Key accounting distinction:

– Intangibles developed in-house (expensed immediately) orIntangibles developed in-house (expensed immediately) or– Purchased from outside (capitalized, then amortized)?Purchased from outside (capitalized, then amortized)?


Income Statement• Basic formatBasic format

– FlowFlow of revenues, expenses, and earnings of revenues, expenses, and earnings– Profit and loss (P&L) statementProfit and loss (P&L) statement

• RevenuesRevenues– ““Top line”Top line”

• COGSCOGS• ExpensesExpenses

– R&DR&D– DepreciationDepreciation

• Net IncomeNet Income– ““Bottom line”Bottom line”– ““Net profits after taxes”Net profits after taxes”


Costs Of Goods Sold

COGS = Beginning Inventory +COGS = Beginning Inventory +

Purchases -Purchases -

Ending InventoryEnding Inventory


Income Statement Questions• What were the Primary Sources of: What were the Primary Sources of:

– Income?Income?– COGSCOGS??– Expenses?Expenses?

• What is the Value of What is the Value of R&DR&D??• Does Does R&D R&D Produce Income?Produce Income?• What is the True Earning Power of the Firm?What is the True Earning Power of the Firm?• What is the Trend in Revenues, Market Share, and What is the Trend in Revenues, Market Share, and

Profits?Profits?


Statement Of Cash Flows (CFs)• ComponentsComponents

– Operating activitiesOperating activities• Directly related to earnings activitiesDirectly related to earnings activities

– Investing activitiesInvesting activities• Buying or selling assets (or securities) Buying or selling assets (or securities) • Activities related to lending moneyActivities related to lending money• Asset side (LHS) of B/SAsset side (LHS) of B/S

– Financing activitiesFinancing activities• Activities related to borrowing moneyActivities related to borrowing money• Transactions related to owners’ equityTransactions related to owners’ equity• RHS of B/SRHS of B/S


Methods For Reporting CFs

• DirectDirect– Cash receipts and paymentsCash receipts and payments– Shows how cash moves through a firmShows how cash moves through a firm

• IndirectIndirect– Adjusts net income for noncash itemsAdjusts net income for noncash items– Reconciles net income with cash from Reconciles net income with cash from

operationsoperations– Most popular methodMost popular method


Percentage Financial Statements

• Common Sized StatementCommon Sized Statement

• Balance SheetBalance Sheet

– % of total assets% of total assets

• Income StatementIncome Statement

– % of net sales% of net sales

• Reveal ChangesReveal Changes


Earnings Per Share (EPS)• Used to Estimate Future Earnings AbilityUsed to Estimate Future Earnings Ability• How Accurate are How Accurate are EPSEPS??

– How does the reported How does the reported EPSEPS differ from the actual differ from the actual earnings ability of the firm?earnings ability of the firm?

• Adjusting for Nonrecurring ItemsAdjusting for Nonrecurring Items• Quality of EarningsQuality of Earnings

– Low qualityLow quality• EPSEPS numbers differ greatly numbers differ greatly

– High qualityHigh quality


Assessing High Quality Earnings

• Conservative AccountingConservative Accounting• Earnings are DistributedEarnings are Distributed• Stable EarningsStable Earnings• Recent Earnings Good Forecast of FutureRecent Earnings Good Forecast of Future• Related to Ongoing BusinessRelated to Ongoing Business• Reflect Prudent, Realistic ViewReflect Prudent, Realistic View• No Balance Sheet SurprisesNo Balance Sheet Surprises• Earnings are From OperationsEarnings are From Operations• Earnings are DomesticEarnings are Domestic• Earnings are UnderstandableEarnings are Understandable


Assessing LowQuality Earnings

• Liberal AccountingLiberal Accounting• Earnings are not RealizedEarnings are not Realized• Volatile EarningsVolatile Earnings• Recent Earnings Poor Forecast of FutureRecent Earnings Poor Forecast of Future• Nonrepeatable EarningsNonrepeatable Earnings• Not Economically RealisticNot Economically Realistic• Overstated Balance SheetOverstated Balance Sheet• Earnings are From FinancingEarnings are From Financing• Earnings are OffshoreEarnings are Offshore• Complex EarningsComplex Earnings


Ratio Analysis

• Financial TrendsFinancial Trends– Between firms (cross-sectional)Between firms (cross-sectional)– For a given firm over time (cross-temporal)For a given firm over time (cross-temporal)

• Profitability RatiosProfitability Ratios• Liquidity RatiosLiquidity Ratios• Debt RatiosDebt Ratios• Other RatiosOther Ratios


Profitability Ratios

• Return on Equity (Return on Equity (ROEROE))

• Earnings Per Share (Earnings Per Share (EPSEPS))

• Net Profit MarginNet Profit Margin

• Return on Assets (Return on Assets (ROAROA))

• Return on Total Invested CapitalReturn on Total Invested Capital


Liquidity Ratios

• Quick RatioQuick Ratio

• Current RatioCurrent Ratio

• Days’ Sales in InventoryDays’ Sales in Inventory

• CashCash

• Inventory TurnoverInventory Turnover


Debt Ratios

• Fixed Charge CoverageFixed Charge Coverage

• Times Interest EarnedTimes Interest Earned

• Debt to EquityDebt to Equity

• Degree of Financial Leverage (Degree of Financial Leverage (DFLDFL))

• Debt to AssetsDebt to Assets


Other Ratios

• P/E P/E RatioRatio– ““Earnings multiplier”Earnings multiplier”– Combines market and accounting valueCombines market and accounting value

• M/BM/B Ratio Ratio– > 1 implies stock is overpriced> 1 implies stock is overpriced– < 1 implies stock is underpriced < 1 implies stock is underpriced – Combine market and accounting valueCombine market and accounting value– Related to Related to MVAMVA


Some Things to Look For

• Recommendations from:Recommendations from:• Graham and DoddGraham and Dodd

– ““Security AnalysisSecurity Analysis””– ““Bible” of value investingBible” of value investing– Provide specific guidelinesProvide specific guidelines

• Peter LynchPeter Lynch– ““One Up on Wall StreetOne Up on Wall Street””– More recent classicMore recent classic– More general, less detailedMore general, less detailed


Graham & Dodd

1.1. P/E less than half the reciprocal of the AAA P/E less than half the reciprocal of the AAA bond yieldbond yield

2.2. P/E less than 40% of ave. P/E over last 5 yearsP/E less than 40% of ave. P/E over last 5 years

3.3. Dividend yld. greater than 2/3 of AAA bond Dividend yld. greater than 2/3 of AAA bond yieldyield

4.4. Price less than 2/3 of BV per sharePrice less than 2/3 of BV per share

5.5. Price less than 2/3 of net current assetsPrice less than 2/3 of net current assets


Graham & Dodd

6.6. Debt-to-equity ratio less than oneDebt-to-equity ratio less than one

7.7. Current ratio greater than twoCurrent ratio greater than two

8.8. Total debt less than twice net current assetsTotal debt less than twice net current assets

9.9. Ten-year compound annual growth rate in EPS Ten-year compound annual growth rate in EPS greater than 7%greater than 7%

10.10. No more than 2 years out of past 10 with No more than 2 years out of past 10 with earnings declines greater than 5% in magnitudeearnings declines greater than 5% in magnitude


Peter Lynch

1.1. Growth in stock price less than growth in EPSGrowth in stock price less than growth in EPS

2.2. P/E ratio vs. growth in EPS (+ div. yld.)P/E ratio vs. growth in EPS (+ div. yld.)

3.3. ““Real” price of a stock after adjusting for “net Real” price of a stock after adjusting for “net cash” (or “cash beyond debt”)cash” (or “cash beyond debt”)

4.4. Ratio of free cash flow to share priceRatio of free cash flow to share price

5.5. Debt-to-equity ratio Debt-to-equity ratio


Peter Lynch

6.6. Inventory growth vs. sales growthInventory growth vs. sales growth

7.7. Pension fund assetsPension fund assets

8.8. Percent of sales for key productsPercent of sales for key products

9.9. Net profit margin before taxesNet profit margin before taxes

10.10. Dividends Dividends

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®1999 South-Western College Publishing 1 Chapter 21 Financial Statement Analysis.

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