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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
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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?
Analysis of Financial Statements
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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
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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
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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
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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
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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
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Statement of Retained Earnings
Shows the change in the retained earnings and common equity accounts since the last balance sheet was constructed.
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Statement of Cash Flows
Reports the effect of the firm’s activities—operating, investing, and financing—over some period on its cash position
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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
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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)
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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
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
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
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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
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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)
3,000
XX
X
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
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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)
0--
Source UseXX
X
X
-- --
Sources of Cash Uses of Cash Liability/Equity Account Liability/Equity Account
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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
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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.
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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).
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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)
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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.
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Ratio (Financial Statement) Analysis
Used by:
Managers inside the firm
Stockholders and creditors—existing and potential—outside the firm
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Ratio (Financial Statement) Analysis
General categories of analysis:
Liquidity
Asset management
Debt management
Profitability
Market value
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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
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Current ratio
Shows the relationship between current assets and current liabilities; a higher value suggests greater liquidity, and vice versa:
sliabilitieCurrent
assetsCurrent = ratioCurrent
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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:
LC
sInventorie - AC = ratio test,acid-or Quick,
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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)
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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
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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
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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
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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
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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
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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
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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-
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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
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Profitability ratios
Indicate how the firm’s management of its liquidity position, assets, and debt has affected normal operating activities.
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Net Profit Margin
Shows what percent of sales revenues is left after expenses related to operations and the effects of financing and taxes.
Sales
incomeNet =margin profit Net
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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
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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
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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.
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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
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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
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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).
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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.
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Du Pont Equation
assets Total
Sales
Sales
income Net x
turnoverassets Total margin profit Net ROA x
assets Total
income Net
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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
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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.
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Analysis of Financial Statements
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.
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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.
Analysis of Financial Statements
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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
Analysis of Financial Statements
