1 Financial Statement Analysis CHAPTER F12 © 2007 Pearson Custom Publishing

1

Financial Statement Financial Statement AnalysisAnalysis

CHAPTER F12

© 2007 Pearson Custom © 2007 Pearson Custom PublishingPublishing

2

Identify the three major Identify the three major categories of users of categories of users of financial statement financial statement

analysis and describe analysis and describe the objectives of each.the objectives of each.

Learning Objective 1:


3

Financial Statement Financial Statement AnalysisAnalysis

Financial statement analysisFinancial statement analysis is just is just what you would think it is: analyzing the what you would think it is: analyzing the information presented in a firm’s financial information presented in a firm’s financial statements.statements.

Two major techniques are Two major techniques are trend analysistrend analysis and and ratio analysis.ratio analysis.

© 2007 Pearson Custom Publishing© 2007 Pearson Custom Publishing

4

Who Performs Who Performs Financial Statement Financial Statement

Analysis?Analysis? Financial statement analysis is routinely Financial statement analysis is routinely

performed by:performed by: 1) Creditors (short term and long term)1) Creditors (short term and long term) 2) Equity investors (current and 2) Equity investors (current and

potential)potential) 3) Company management3) Company management


5

Objectives of Objectives of CreditorsCreditors

Short-term creditorsShort-term creditors, both trade creditors , both trade creditors and lending institutions, are primarily and lending institutions, are primarily concerned with the firm’s ability to pay its concerned with the firm’s ability to pay its bills in a timely fashion.bills in a timely fashion.

Long-term creditorsLong-term creditors are concerned with are concerned with the firm’s long-term ability to repay any the firm’s long-term ability to repay any loan amounts (including bonds) as well as loan amounts (including bonds) as well as the interest on that debt.the interest on that debt.


6

Investors are concerned with many things, Investors are concerned with many things, but probably the most important but probably the most important consideration is the company’s ability to consideration is the company’s ability to generate income in the future.generate income in the future.

Profitable operations for the company Profitable operations for the company usually translate into dividends and stock usually translate into dividends and stock price appreciation for the investors.price appreciation for the investors.

Objectives of Equity Objectives of Equity InvestorsInvestors


7

Members of management have the Members of management have the responsibility of leading the firm through the responsibility of leading the firm through the day-to-day activities. The results of these day-to-day activities. The results of these activities are reflected in the financial activities are reflected in the financial statements.statements.

Thus, management has two main concerns Thus, management has two main concerns regarding financial statement analysis: 1) to regarding financial statement analysis: 1) to present the information in the most favorable present the information in the most favorable light, and 2) to monitor the overall light, and 2) to monitor the overall performance.performance.

Objectives of Objectives of ManagementManagement


8

Gather information to Gather information to evaluate the political evaluate the political climate and general climate and general

economic conditions and economic conditions and describe the ways in describe the ways in which each can affect which each can affect

business.business.



9

Gathering Background Gathering Background Information - A First StepInformation - A First Step

To properly analyze the firm’s financial To properly analyze the firm’s financial statements, it is necessary to understand statements, it is necessary to understand the environment in which the firm operates. the environment in which the firm operates. In particular:In particular: the general economic conditions or the general economic conditions or

expectations,expectations, the political events and political climate, andthe political events and political climate, and the industry outlook.the industry outlook.


10

General Economic General Economic Conditions and Conditions and ExpectationsExpectations

Another factor to consider in predicting the Another factor to consider in predicting the future financial performance of a company future financial performance of a company would be the current condition of the would be the current condition of the general economy and your expectations general economy and your expectations about the future of the economy.about the future of the economy.

Companies in certain industries would be Companies in certain industries would be affected more than others when an affected more than others when an economic downturn (or upswing) occurs.economic downturn (or upswing) occurs.


11

Political Events and Political Events and Political ClimatePolitical Climate

Additional external factors that will have an Additional external factors that will have an influence on a company’s financial influence on a company’s financial performance are the political events and the performance are the political events and the general political climate.general political climate.

Congressional actions often affect the Congressional actions often affect the financial performance through changes in financial performance through changes in the tax code, environmental actions, or the tax code, environmental actions, or reductions in governmental spending.reductions in governmental spending.


12

Industry OutlookIndustry Outlook

A third external factor is the general outlook for A third external factor is the general outlook for the industry in which the firm operates. the industry in which the firm operates.

For example, technology-based companies were For example, technology-based companies were hot in the late 1990s but many failed by 2001, hot in the late 1990s but many failed by 2001, while the increase in the federal defense budget while the increase in the federal defense budget has increased steadily since 2001. has increased steadily since 2001.

Can you guess what industry will be the most Can you guess what industry will be the most successful in 2017?successful in 2017?


13

Locate sources of Locate sources of information about information about specific industries.specific industries.



14

Sources of Industry Sources of Industry InformationInformation

Library Sources: Library Sources: Standard and Poor’s Industry SurveyStandard and Poor’s Industry Survey Mergent Industry ReviewMergent Industry Review Value Line Industry SurveyValue Line Industry Survey

Business Press: Business Press: Wall Street JournalWall Street Journal Business WeekBusiness Week FortuneFortune ForbesForbes

Internet Sources: (Beware of the integrity of the Internet Sources: (Beware of the integrity of the source.)source.) Trade AssociationsTrade Associations


15

Describe the purpose of Describe the purpose of trend analysis and ratio trend analysis and ratio analysis and explain the analysis and explain the

three primary three primary characteristics it helps characteristics it helps

users evaluate.users evaluate.



16

Trend AnalysisTrend Analysis

Trend analysisTrend analysis is a particular type of is a particular type of financial statement analysis where key financial statement analysis where key financial figures are analyzed over time financial figures are analyzed over time to see if there is a pattern of change.to see if there is a pattern of change.

Trend analysis can often be effectively Trend analysis can often be effectively illustrated through the use of graphs or illustrated through the use of graphs or charts.charts.


17

Ratio AnalysisRatio Analysis Ratio analysisRatio analysis is a particular type of is a particular type of

financial statement analysis where the financial statement analysis where the relationship between two or more items relationship between two or more items from the financial statements is analyzed.from the financial statements is analyzed.

A particular ratio might include information A particular ratio might include information from various sources, including information from various sources, including information not typically contained in the financial not typically contained in the financial statements, such as market price of a stock.statements, such as market price of a stock.


18

Profitability ratiosProfitability ratios Liquidity ratios Liquidity ratios Solvency ratiosSolvency ratios

Major Categories of Major Categories of Ratio AnalysisRatio Analysis


19

Calculate financial Calculate financial ratios designed to ratios designed to

measure a company’s measure a company’s profitability, liquidity, profitability, liquidity,

and solvency.and solvency.



20

Measuring Measuring ProfitabilityProfitability

Profitability refers to the company’s ability to Profitability refers to the company’s ability to generate income. Profitability ratios are generate income. Profitability ratios are used to measure a firm’s past performance used to measure a firm’s past performance and to aid in the prediction of future profits.and to aid in the prediction of future profits.

Most business people agree that long-term Most business people agree that long-term profits are more important than short-term profits are more important than short-term profits, yet most of the commonly used profits, yet most of the commonly used ratios focus on short-term profitability.ratios focus on short-term profitability.


21

Measuring Measuring ProfitabilityProfitability

Commonly used measures include:Commonly used measures include: Return on assets ratioReturn on assets ratio Profit margin before income taxProfit margin before income tax Total asset turnoverTotal asset turnover Profit margin after income taxProfit margin after income tax Return on equityReturn on equity Return before taxes on equityReturn before taxes on equity


22

Return on Assets Return on Assets RatioRatio

Net income before income taxesNet income before income taxes Total assets Total assets

One measure of One measure of return on return on investment.investment. This is a measurement of This is a measurement of how efficiently the company’s assets how efficiently the company’s assets are used to generate profits.are used to generate profits.


23

Return on Assets Return on Assets RatioRatio

The return on assets can be broken down The return on assets can be broken down into two component parts:into two component parts: the the profit margin before income taxprofit margin before income tax, and, and the the total asset turnovertotal asset turnover..

This might be abbreviated as follows:This might be abbreviated as follows: ROA = Margin X TurnoverROA = Margin X Turnover


24

Profit Margin Before Profit Margin Before Income Tax RatioIncome Tax Ratio

Net income before taxesNet income before taxes

SalesSales

This ratio measures the income produced This ratio measures the income produced as a percentage from each dollar of sales as a percentage from each dollar of sales revenue.revenue.


25

Total Asset Turnover Total Asset Turnover RatioRatio

Sales Sales Total assetsTotal assets

An analysis of the amount of sales An analysis of the amount of sales (instead of income) generated through (instead of income) generated through the effective use of the investment in the effective use of the investment in assets.assets.


26

Compare the return on assets for the following two firms: A jewelry store with a 30% profit margin and an asset turnover of .6, and a grocery store with a 4% profit margin and an asset turnover of 5.0:

Jewelry: 30% X .6 = 18% ROA Grocery: 4% X 5.0 = 20% ROA

ROA ComparisonsROA Comparisons


27

Profit Margin After Profit Margin After Income Tax RatioIncome Tax Ratio

Net income after taxesNet income after taxes Sales Sales

Use after-tax income instead of before-Use after-tax income instead of before-tax. Some people argue that since taxes tax. Some people argue that since taxes are a normal expense, the effect of are a normal expense, the effect of income taxes should be included.income taxes should be included.


28

Return on Equity Return on Equity RatioRatio

Net income after taxesNet income after taxes Equity Equity

This ratio measures the profitability on This ratio measures the profitability on the amount of investment by the the amount of investment by the company owners rather than the total company owners rather than the total investment in assets.investment in assets.


29

Return Before TaxesReturn Before Taxeson Equity Ratioon Equity Ratio

Net income before taxesNet income before taxes Equity Equity

We are measuring the earnings generated We are measuring the earnings generated for the owners before considering the cost for the owners before considering the cost of taxes.of taxes.


30

Measuring LiquidityMeasuring Liquidity Liquidity (in this context) refers to the Liquidity (in this context) refers to the

company’s ability to generate cash as company’s ability to generate cash as needed to pay its short-term obligations.needed to pay its short-term obligations.

Short-term creditors (current and Short-term creditors (current and potential) are particularly concerned with potential) are particularly concerned with a company’s liquidity measures.a company’s liquidity measures.

Liquidity measures focus on the “liquidity Liquidity measures focus on the “liquidity of the assets” available to the company.of the assets” available to the company.


31

Measuring LiquidityMeasuring Liquidity

Commonly used measures include:Commonly used measures include: Current ratioCurrent ratio Quick ratioQuick ratio Receivables turnoverReceivables turnover Inventory turnoverInventory turnover


32

Current RatioCurrent Ratio

Current assets Current assets Current liabilitiesCurrent liabilities

This ratio is a comparison of the level This ratio is a comparison of the level of current assets available to pay the of current assets available to pay the current liabilities. This is a very widely current liabilities. This is a very widely used ratio.used ratio.


33

Quick RatioQuick Ratio

Cash + Accounts & notes receivableCash + Accounts & notes receivable Current liabilities Current liabilities

Also called the Also called the acid-test ratio,acid-test ratio, this is a this is a more stringent measure of liquidity. The more stringent measure of liquidity. The focus is placed on the “quick assets,” those focus is placed on the “quick assets,” those that can be quickly turned into cash.that can be quickly turned into cash.


34

Receivables Turnover Receivables Turnover RatioRatio

Sales Sales Accounts receivable Accounts receivable

A measurement of how quickly a A measurement of how quickly a company collects their accounts company collects their accounts receivable. The higher the turnover, the receivable. The higher the turnover, the more quickly the receivables are being more quickly the receivables are being collected.collected.


35

Inventory Turnover Inventory Turnover RatioRatio

Cost of sales Cost of sales Inventory Inventory

A measurement of how many times total A measurement of how many times total merchandise inventory is purchased and merchandise inventory is purchased and sold during an accounting period. sold during an accounting period.


36

Measuring SolvencyMeasuring Solvency Solvency refers to the ability to meet long-Solvency refers to the ability to meet long-

term obligations resulting from debt. term obligations resulting from debt. These measurements are similar to the These measurements are similar to the

liquidity measures, except the focus is on all liquidity measures, except the focus is on all assets and liabilities rather than the current assets and liabilities rather than the current assets and liabilities.assets and liabilities.

These measures are of interest to long-term These measures are of interest to long-term creditors, stockholders, and management.creditors, stockholders, and management.


37

Measuring SolvencyMeasuring Solvency

Commonly used measures include:Commonly used measures include: Debt ratioDebt ratio Debt to equity ratioDebt to equity ratio Coverage ratioCoverage ratio


38

Debt RatioDebt Ratio

Total liabilities Total liabilities Total assets Total assets

Measures the percentage of a Measures the percentage of a company’s assets that is financed by company’s assets that is financed by debt, rather than equity. debt, rather than equity.

Debt % + Equity % = 100%Debt % + Equity % = 100%

39

Debt to Equity Debt to Equity RatioRatio

Total liabilities Total liabilities Net worth Net worth

Net worth is the same as owners’ Net worth is the same as owners’ equity; it is equal to Assets - Liabilities. equity; it is equal to Assets - Liabilities. This ratio highlights the relationship This ratio highlights the relationship between creditors’ claims and owners’ between creditors’ claims and owners’ claims to assets.claims to assets.


40

Coverage RatioCoverage Ratio

Earnings before interest and income taxesEarnings before interest and income taxes Interest expenseInterest expense

Also called the Also called the times interest earned ratio, times interest earned ratio, it is ait is an indication of the company’s ability to n indication of the company’s ability to make interest payments. Lenders pay close make interest payments. Lenders pay close attention to this ratio.attention to this ratio.


41

Evaluate a company’s Evaluate a company’s ratios using a ratios using a

comparison to industry comparison to industry averages.averages.



42

Using the RatiosUsing the Ratios

After calculating the ratios for a particular After calculating the ratios for a particular company, you might want to do some or company, you might want to do some or all of the following:all of the following: Compare ratios to industry averages,Compare ratios to industry averages, Look for company trends,Look for company trends, Consider the industry environment, andConsider the industry environment, and Draw conclusionsDraw conclusions


43

Use ratio values from Use ratio values from consecutive time consecutive time

periods to evaluate the periods to evaluate the profitability, liquidity, profitability, liquidity,

and solvency of a and solvency of a business.business.



44

Using the RatiosUsing the Ratios

After comparing the ratios for a company After comparing the ratios for a company to the industry, you should prepare a to the industry, you should prepare a trend analysis of the ratio numbers. trend analysis of the ratio numbers.

Small changes in the ratios over time Small changes in the ratios over time may indicate improvement or danger may indicate improvement or danger signs of decline in financial health.signs of decline in financial health.


45

Ratio Trend AnalysisRatio Trend Analysis

What would the following ratio trend analysis What would the following ratio trend analysis indicate to you about the financial condition of the indicate to you about the financial condition of the company?company?

20062006 20072007 20082008 20092009 Profit after taxes ratioProfit after taxes ratio 5.5%5.5% 5.7%5.7% 5.9%5.9%

6.3%6.3% Current ratioCurrent ratio 2.02.0 1.91.9 1.71.7 1.41.4 Debt ratioDebt ratio 42%42% 47%47% 56%56% 65%65%


46

Explain the purpose of Explain the purpose of the North American the North American

Industry Classification Industry Classification System and specify System and specify what an NAICS code what an NAICS code

indicates.indicates.



47

NAICSNAICS

NAICS is a classification system instituted by NAICS is a classification system instituted by the federal government to gather useful the federal government to gather useful industrial data from tax returns and SEC industrial data from tax returns and SEC filings. filings.

Each industry has its own classification Each industry has its own classification numbers.numbers.

The 452990 code represents discount The 452990 code represents discount general merchandise stores with centralized general merchandise stores with centralized checkout.checkout.


48

NAICSNAICS

The NAICS information allows analysts to The NAICS information allows analysts to compare companies that are as alike as compare companies that are as alike as possible. possible.

Published ratios are grouped by NAICS Published ratios are grouped by NAICS codes to facilitate meaningful comparison.codes to facilitate meaningful comparison.


49

State the limitations State the limitations of ratio analysis.of ratio analysis.



50

Limitations of Ratio Limitations of Ratio AnalysisAnalysis

As informative as ratio analysis can be, it As informative as ratio analysis can be, it also has some inherent limitations:also has some inherent limitations:

1) Attempting to predict the future using past 1) Attempting to predict the future using past results is problematic at best. Past results are results is problematic at best. Past results are not always indicative of future performance.not always indicative of future performance.

2) The financial statements used as the basis 2) The financial statements used as the basis of the ratios are based on the accounting of the ratios are based on the accounting principle of historical cost.principle of historical cost.


51

3) Figures from the balance sheet used in the 3) Figures from the balance sheet used in the calculation of the ratios are year-end values, which calculation of the ratios are year-end values, which may or may not be representative.may or may not be representative.

4) Comparing the ratios of companies in different 4) Comparing the ratios of companies in different industries is difficult because of industry industries is difficult because of industry peculiarities.peculiarities.

5) There are no hard-and-fast rules telling the 5) There are no hard-and-fast rules telling the analyst what numbers to use to calculate the ratios.analyst what numbers to use to calculate the ratios.

Limitations of Ratio Limitations of Ratio AnalysisAnalysis


52

The End of Chapter 12

Documents

1 Financial Statement Analysis CHAPTER F12 © 2007 Pearson Custom Publishing