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CHAPTER 14CHAPTER 14

Analyzing Financial Statements:

A Managerial Perspective

Learning objective 1: Explain why managers analyze financial statements

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Why Managers Analyze Why Managers Analyze Financial StatementsFinancial Statements

Managers analyze financial statements for a variety of reasons including: Control of operations Assess the financial stability of

vendors, customers, and other business partners

Assess the appearance of the company to investors and creditors

Learning objective 1: Explain why managers analyze financial statements

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Control of OperationsControl of Operations Analysis of financial statements help

management gain insight into whether their goals have been achieved

Assume successful implementation of plan will be reflected in financial information- If financial information is inconsistent

with a successful implementation an investigation will be launched

Learning objective 1: Explain why managers analyze financial statements

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Assessment of Vendors, Assessment of Vendors, Customers, and Other PartnersCustomers, and Other Partners Management takes same approach to

review the financial stability of vendors, customers, and other strategic partners

Analysis of financial statements used to identify, qualify, and monitor potential partners- Important when developing

relationships to determine whether vendor or customer’s business is viable and will continue operations

Learning objective 1: Explain why managers analyze financial statements

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Assessment of Vendors, Assessment of Vendors, Customers, and Other PartnersCustomers, and Other Partners Managers analyze financial

statements to assess whether: Vendors are stable and will continue

in existence Customers need to be able to pay

amounts owed on a timely basis Potential partners are in financial

difficulty

Learning objective 1: Explain why managers analyze financial statements

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Assessment of Appearance to Assessment of Appearance to Investors and CreditorsInvestors and Creditors

Accrual income v. cash flows- Describe the differences between net

income and cash flow from operating activities to help readers Managers need to analyze statements

from the perspective of investors and creditors- Need to be prepared in order to

answer questions

Learning objective 1: Explain why managers analyze financial statements

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Why do managers analyze financial statements?

a. To evaluate and control operationsb. To evaluate vendors and customersc. To anticipate questions from

shareholders and creditorsd. All of the above

Answer: dAll of the above

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

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Horizontal and Vertical Horizontal and Vertical AnalysesAnalyses

Horizontal analysis- Analysis of the dollar value and

percentage changes in financial statement amounts across time

Vertical analysis- Also called common size analysis- Analysis of financial statement

amounts in comparison to a base amount, e.g. total assets

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Horizontal AnalysisHorizontal Analysis

Horizontal analysis Calculate amount of change for

each item on the balance sheet or income statement

Calculate percent change-Amount of change divided by old amount

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

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Horizontal AnalysisHorizontal Analysis

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

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Horizontal AnalysisHorizontal Analysis

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

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Prepare a horizontal analysis of the following condensed balance sheet

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Liabilities and Equity2010 2009

Current Liabilities 575,000 535,000 Long Term Liabilities 800,000 830,000 Common Stock 1,050,000 1,000,000 Retained Earnings 2,375,000 2,200,000 Total Liabilities and Equity 4,800,000 4,565,000

Liabilities and Equity

Current Liabilities 575,000 - 535,000 = 40,000 40,000 / 535,000 = 7.5%Long Term Liabilities 800,000 - 830,000 = (30,000) (30,000) / 830,000 = -3.6%Common Stock 1,050,000 - 1,000,000 = 50,000 50,000 / 1,000,000 = 5.0%Retained Earnings 2,375,000 - 2,200,000 = 175,000 175,000 / 2,200,000 = 8.0%

Change % Change

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Vertical AnalysisVertical Analysis Analysis of the balance sheet and

income statement in comparison to a base amount

Divide each amount by the base amount to calculate percentage- For the balance sheet the base

amount is total assets- For the income statement the

base amount is net sales

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

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Vertical AnalysisVertical Analysis

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

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Vertical AnalysisVertical Analysis

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

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Horizontal analysis analyzes:a. Comparable companiesb. Changes in expenses as a percentage

of salesc. Changes in expenses as a percent of

total assetsd. Changes in balances from one year to

another

Answer: dChanges in balances from one year to another

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

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Prepare a vertical analysis of the following condensed income statement

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Sales 1,500,000 Cost of Goods Sold 900,000 Gross Margin 600,000 SG&A 225,000 Operating Income 375,000 Interest Expense 115,000 Income Tax Expense 75,000 Net Income 185,000

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Prepare a vertical analysis of the following condensed income statement

Learning objective 2: Perform horizontal and vertical analyses of the balance sheet and the income statement

Sales 1,500,000 1,500,000 / 1,500,000 = 100.0%Cost of Goods Sold 900,000 900,000 / 1,500,000 = 60.0%Gross Margin 600,000 600,000 / 1,500,000 = 40.0%SG&A 225,000 225,000 / 1,500,000 = 15.0%Operating Income 375,000 375,000 / 1,500,000 = 25.0%Interest Expense 115,000 115,000 / 1,500,000 = 7.7%Income Tax Expense 75,000 75,000 / 1,500,000 = 5.0%Net Income 185,000 185,000 / 1,500,000 = 12.3%

Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

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Earnings ManagementEarnings Management Accounting numbers can be

manipulated to make performance appear stronger

Allegations of impropriety have been leveled against:- Cendant- Computer Associates- Enron- Kroger- Lucent- Sunbeam- Waste Management

Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

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Earnings ManagementEarnings Management Why do managers manipulate

earnings?- Managers often are evaluated and

rewarded based on the level of earnings

- Managers can benefit from inflated stock prices

A red flag for earnings management is a substantial difference between reported earnings and operating cash flow- Fictitious sales will not produce cash- Understated expenses need to be paid

Learning objective 3: Discuss earnings management and the importance of comparing net income to cash flow from operations

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Cash Flow versus EarningsCash Flow versus Earnings

Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

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Other Sources of Financial Other Sources of Financial PerformancePerformance

Management discussion and analysisManagement provides financial statement users with explanations of financial results

Credit reportsNumber of firms (e.g. Dun & Bradstreet) provides information on a company’s credit history

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Other Sources of Financial Other Sources of Financial PerformancePerformance

News articles Includes announcements regarding major

company changes which may indicate problems

Many on-line services are available in which to conduct a search of news articles:

- Lexis-Nexis provides information for a fee- Yahoo! Finance provides free information- Search the internet using ticker symbol

Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

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Management Discussion & Management Discussion & Analysis (MD&A) ExampleAnalysis (MD&A) Example

Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

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In connection with a company’s annual report, MD&A stands for:

a. Management discussion and analysisb. More depreciation and amortizationc. Monthly depreciation and

amortizationd. Monthly discounts and advertising

Answer: aManagement discussion and analysis

Learning objective 4: Understand how MD&A, credit reports, and news articles can be used to gain insight into a company’s current and future financial performance

Learning objective 5: Calculate and interpret profitability ratios

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Ratio AnalysisRatio AnalysisProfitability ratios - Reveals a company’s ability to

generate profitsTurnover ratios - Reveals the company’s efficiency

with regard to the use of its assetsDebt-related ratios - Reveals a company’s ability to re-pay

its obligations

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Profitability RatiosProfitability Ratios

Learning objective 5: Calculate and interpret profitability ratios

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Profitability Ratio FormulasProfitability Ratio Formulas

Learning objective 5: Calculate and interpret profitability ratios

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Turnover RatiosTurnover Ratios

Learning objective 6: Calculate and interpret turnover ratios

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Turnover Ratio FormulasTurnover Ratio Formulas

Learning objective 6: Calculate and interpret turnover ratios

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The efficient use of assets is indicated by:

a. Turnover ratiosb. Debt-related ratiosc. The ratio of debt to equityd. The ratio of current assets to

current liabilities

Answer: aTurnover ratios

Learning objective 6: Calculate and interpret turnover ratios

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Debt-Related RatiosDebt-Related Ratios

Learning objective 7: Calculate and interpret debt-related ratios

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Debt-Related RatiosDebt-Related Ratios

Learning objective 7: Calculate and interpret debt-related ratios

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Too Much DebtToo Much Debt

Learning objective 7: Calculate and interpret debt-related ratios

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The ratio times interest earned can be used to evaluate:

a. The amount of debt versus equity financingb. The extent to which interest income

exceeds interest expensec. The extent to which interest expense

exceeds interest incomed. The likelihood that a company will be able

to make required interest payments

Answer: dThe likelihood that a company will be able to make required interest payments

Learning objective 7: Calculate and interpret debt-related ratios

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Ratio – Too High or Low?Ratio – Too High or Low?

Learning objective 7: Calculate and interpret debt-related ratios

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Comparative Ratio DataComparative Ratio Data

Learning objective 7: Calculate and interpret debt-related ratios

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Strategic PartnersStrategic Partners

Learning objective 7: Calculate and interpret debt-related ratios

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