Using Financial Statement Information Presentations for Chapter 5 by Glenn Owen.

Using Financial Using Financial Statement InformationStatement Information

Presentations for Chapter 5 by Glenn Owen

Key PointsKey Points Using financial accounting numbers to influence management

decisions and predict future events. Five steps of financial statement analysis. Assessing the business environment. Assessing earnings quality and persistence. Analyzing financial statements. Difficulties involved in using annual report information to

identify mispriced securities. Difficulties involved in using financial statements

to compare the performance of companies operating in different countries.

Control and PredictionControl and PredictionFinancial accounting numbers are useful in

two fundamental ways:– They help investors and creditors influence and monitor

the business decisions of a company’s managers– They help to predict a company’s future earnings and

cash flows

Book Value vs. True ValueBook Value vs. True Value

Business environment– Statements are backward looking, not focusing on the

future prospects.

Unrecorded events– Statements leave out some current and historical

information such as human resources and the effects of inflation.

Management bias– Managers often choose accounting methods

and estimates that make them look good.

Five Steps of Five Steps of Financial Statement AnalysisFinancial Statement Analysis

Assessing the business environment.Reading and studying the financial

statements and footnotes.Assessing earnings quality.Analyzing the financial statements.Predicting future earnings

and/or cash flow.

Assessing the Business Assessing the Business EnvironmentEnvironment

What is the nature of the company’s operations? What strategy is being employed to generate profits? What is the company’s industry? Who are the major players? Competition? What are the relationships between the

company and its customers and suppliers? How are the company’s sales and

profits affected by changes in the economy?

Reading and Studying the Financial Reading and Studying the Financial Statements and NotesStatements and Notes

Read the audit report.Identify significant transactions

– major acquisitions, discontinuance or disposal of a business segment, unresolved litigation, major write-downs of receivables or inventories, etc.

Read the financial statements and footnotes.

Assessing Earnings QualityAssessing Earnings Quality

Overstating operating performanceTaking a bathCreating hidden reservesEmploying off-balance-sheet financingEarnings quality and unrecorded events

Analyzing the Financial Analyzing the Financial StatementsStatements

Comparisons across timeComparisons within the industryComparisons within the financial statements:

common-size statements and ratio analysis– Profitability ratios– Leverage ratios– Solvency ratios– Asset turnover ratios– Market ratios

Comparisons Across TimeComparisons Across Time

Financial accounting numbers can be made more meaningful if they are compared across time.

GAAP require side-by-side comparison of the current and the preceding years in published financial reports.

Comparisons Within Comparisons Within the Industrythe Industry

Financial accounting numbers can also be made more meaningful if they are compared to those of similar companies.

Comparison of financial accounting numbers with industry averages is also helpful.

Sources of industry information include:– Dun & Bradstreet– Robert Morris Associates– Moody– Standard & Poor

Comparisons Within Comparisons Within the Financial Statementsthe Financial Statements

Common-size financial statementsRatio analysis

– Profitability ratios– Leverage ratios– Solvency ratios– Asset turnover ratios– Other ratios

Common-Size Income Common-Size Income Statement for LA-Z-Boy, Inc.Statement for LA-Z-Boy, Inc.

2000 % 1999 % Net sales $1,717 100 1,288 100 Cost of sales (1,284) 75 (947) 74 Expenses (345) 20 (275) 21 Net income $88 5 $ 66 5

On the income statement, cost of goods sold, expenses, and net income are often expressed as percentages of net sales.

On the balance sheet, assets and liabilities can be expressed as percentages of total assets.

Profitability RatiosProfitability RatiosThese ratios are designed to measure a

firm’s earnings power.Net income, the primary measure of the

overall success of a company, is compared to other measures of financial activity or condition to assess performance as a percent of some level of activity or investment.

The return on equity ratio measures the effectiveness The return on equity ratio measures the effectiveness at managing capital provided by at managing capital provided by ownersowners..

Profitability RatiosProfitability Ratios

Return on equity

Net Income Average Stockholder’s Equity

The return on assets ratio measures the effectiveness The return on assets ratio measures the effectiveness at managing capital provided by all at managing capital provided by all investorsinvestors..


Return on assets

Net Income + [Interest Expense (1 -Tax Rate )]

Average Total Assets

Return on sales (profit margin)

Net Income + [Interest Expense (1 -Tax Rate )]

Net Sales


The return on sales ratio provides an indication of The return on sales ratio provides an indication of a company’s ability to generate and market a company’s ability to generate and market profitable products and control its costs.profitable products and control its costs.

Leverage RatiosLeverage RatiosLeverage refers to using borrowed funds to

generate returns for stockholders.Leverage is desirable because it creates

returns for stockholders without using any of their money.

Leverage increases risk by committing the company to future cash obligations

Common equity leverage

Net Income Net Income +

[Interest Expense (1 -Tax Rate )]

This ratio compares the return available to the This ratio compares the return available to the stockholders to returns available to all capital providers.stockholders to returns available to all capital providers.

Leverage RatiosLeverage Ratios

This ratio measures the extent to which a company This ratio measures the extent to which a company relies on borrowings (liabilities).relies on borrowings (liabilities).

Capital structure leverage

Average Total Assets Average Stockholders' Equity


This ratio compares liabilities to stockholders’ equity This ratio compares liabilities to stockholders’ equity and is another measure of capital structure leverage.and is another measure of capital structure leverage.

Debt/equity ratio

Average Liabilities Average Stockholders' Equity


Long-term debt ratio

Long-Term Liabilities Total Assets

This ratio measures the importance of long-term debt This ratio measures the importance of long-term debt as a source of asset financing.as a source of asset financing.


Solvency RatiosSolvency RatiosSolvency refers to a company’s ability to

meet its current debts as they come due.There is pressure on companies with high

levels of leverage to manage their solvency.

Current ratio Current Assets Current Liabilities

Solvency RatiosSolvency Ratios

This ratio measures solvency in the sense that This ratio measures solvency in the sense that current assets can be used to meet current liabilitiescurrent assets can be used to meet current liabilities


Quick ratio Cash + Marketable Securities + Net Accounts Receivable

Current Liabilities

Similar to the current ratio, this ratio provides a Similar to the current ratio, this ratio provides a more stringent test of a company’s solvency.more stringent test of a company’s solvency.


Interest coverage

Net Income + Tax Expense + Interest Expense Interest Expense

This ratio compares the annual funds available to This ratio compares the annual funds available to meet interest to the annual interest expense.meet interest to the annual interest expense.

Accounts payable turnover

Cost of Goods Sold Average Accounts Payable

This ratio measures the extent to which accounts This ratio measures the extent to which accounts payable is used as a form of financing.payable is used as a form of financing.


Asset Turnover RatiosAsset Turnover RatiosAsset turnover ratios are typically computed

for total assets, accounts receivable, inventory, and fixed assets.

These ratios measure the speed with which assets move through operations or reflect the number of times during a given period that these specific assets are acquired, used, and replaced.

Asset Turnover RatiosAsset Turnover Ratios

Receivables turnover

Net Credit Sales Average Accounts Receivable

This ratio reflects the number of times the trade This ratio reflects the number of times the trade receivables were recorded, collected, and recorded receivables were recorded, collected, and recorded again during the period.again during the period.


Inventory turnover

Cost of Goods Sold Average Inventory

This ratio measures the speed with which inventories This ratio measures the speed with which inventories move through operations.move through operations.


Fixed assets turnover

Sales Average Fixed Assets

This ratio measures the speed with which fixed assets This ratio measures the speed with which fixed assets are used up.are used up.


Total asset turnover

Sales Average Total Assets

This ratio measures the speed with which all assets are This ratio measures the speed with which all assets are used up in operations.used up in operations.

Other RatiosOther RatiosThese additional ratios are used by the

financial community to assess company performance.

Other RatiosOther Ratios

Earnings per share

Net Income Average Number of Common

Shares Outstanding

This ratio, according to the financial press, is the This ratio, according to the financial press, is the primary measure of a company’s performance.primary measure of a company’s performance.


Price/earnings ratio

Market Price per Share Earnings per Share

This ratio is used by many analysts to assess the This ratio is used by many analysts to assess the investment potential of common stocks.investment potential of common stocks.


Dividend yield ratio

Dividends per Share Market Price per Share

This ratio indicates to cash return on the This ratio indicates to cash return on the stockholders’ investment.stockholders’ investment.


Stock price return

Market Price 1 - Market Price 0 + Dividends

Market Price 0

This ratio measures the pretax performance of an This ratio measures the pretax performance of an investment in a share of common stock.investment in a share of common stock.

Solvency AssessmentSolvency AssessmentAbility to Generate Cash Cash Requirements

Operating Performance

Financial Flexibility


Operating PerformanceOperating Revenue

Sale of GoodsSale of Service

Creation of Operating Receivables(timing difference)Cash Inflows from Operations






Operating CostsCost of Goods SoldOperating Expense

Creation of Operating Payables(timing difference)Cash Outflows from Operations








Financial FlexibilityAbility to create short-term debtAbility to create long-term debtAbility to issue equityAbility to liquidate assets Liquidity







Financial FlexibilityAbility to create short-term debtAbility to create long-term debtAbility to issue equityAbility to liquidate assets

Payments for short-term debtPayments for long-term debtPayments for dividendsPayments for asset replacement







Financial FlexibilityAbility to create short-term debtAbility to create long-term debtAbility to issue equityAbility to liquidate assets

Payments for short-term debtPayments for long-term debtPayments for dividendsPayments for asset replacement

Liquidity

Timing of Cash Inflows Timing of Cash Outflows

C O P Y R I G H T

C o p y r i g h t © 2 0 0 3 , J o h n W i l e y & S o n s , I n c . A l l r i g h t s r e s e r v e d .R e p r o d u c t i o n o r t r a n s l a t i o n o f t h i s w o r k b e y o n d t h a t p e r m i t t e d i n S e c t i o n 1 1 7 o f t h e 1 9 7 6 U n i t e d S t a t e s C o p y r i g h t A c t w i t h o u t t h ee x p r e s s w r i t t e n p e r m i s s i o n o f t h e c o p y r i g h t o w n e r i s u n l a w f u l . R e q u e s t f o r f u r t h e r i n f o r m a t i o n s h o u l d b e a d d r e s s e d t o t h e P e r m i s s i o n s D e p a r t m e n t , J o h n W i l e y & S o n s , I n c . T h e p u r c h a s e r m a y m a k e b a c k - u p c o p i e s f o r h i s / h e r o w n u s e o n l y a n d n o t f o r d i s t r i b u t i o n o r r e s a l e . T h e P u b l i s h e r a s s u m e s n o r e s p o n s i b i l i t yf o r e r r o r s , o m i s s i o n s , o r d a m a g e s , c a u s e d b y t h e u s e o f t h e s e p r o g r a m s o r f r o m t h e u s e o f t h e i n f o r m a t i o n c o n t a i n e d h e r e i n .

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Using Financial Statement Information Presentations for Chapter 5 by Glenn Owen.

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