Analysis and Interpretation of Financial Statements

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Analysis and Interpretation of Financial
Statements
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Financial Statement Analysis

• The application of analytical tools and
  techniques to financial statement data.
• Allows users to focus on how numbers are related
  and how they have changed over time

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Objective of Financial StatementAnalysis

• External users rely on general purpose financial
  statements
• Make predictions about an organization as an aid
  in making decisions
• Users highlight important trends or changes

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Risk and Return

• Users try to balance the risk of an investment
  with its expected return
• Generally the greater the risk, the higher the
  return
• Financial statement analysis is one source of
  information for assessing risk and return

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Sources of External Information

• Public companies must publish an annual financial
  report
• Government reports
• SEC 10K, 10Q
• Financial service information
• Moodys, Dow-Jones
• Financial newspapers and periodicals
• Wall Street Journal

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Financial Analysis Tools

• Horizontal analysis
• Vertical analysis
• Ratio analysis

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Horizontal Analysis Amounts and Percentages of
Change

• Amount of change later year amount - Earlier
  year amount
• Percentage change Amount of change / Earlier
  year amount
• Look for significant change

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Horizontal Analysis Trend Percentages

• Set all amounts in base year at 100
• Compute percentages for a number of years
• Divide each statement amount by respective amount
  in base year
• Shows degree of increase or decrease in
  individual statement items
• Used to explain changes in operating performance

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Vertical Analysis

• Shows how each item in a financial statement
  compares to the total of that statement
• Balance sheet
• Set both total assets and total equities at 100
• Income statement
• Set net sales at 100

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Vertical Analysis

• Identify significant dollar and percentage
  changes
• Explain the changes
• Identify whether they are favorable of unfavorable

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Ratio Analysis

• Shows the relative size of one financial
  statement component to another.
• Effective only when used in combination with
  other ratios, analysis, and information

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Ratio Analysis

• Short-term liquidity
• Long-term solvency
• Profitability
• Market performance

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Short-term Profitability

• Current ratio
• Quick ratio
• Accounts receivable turnover
• Days sales in receivables
• Inventory turnover

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Current Ratio

• Common measure of liquidity
• Ability to pay debts as they come due
• Rule of thumb 21
• Consider other factors

Current Assets
Current Liabilities
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Quick Ratio (Acid Test)

• More strict measure of short-term liquidity
• Numerator includes only quick current assets
• Assets readily converted to cash

Cash Short-term investments Net Current
Receivables
Current liabilities
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Accounts Receivable Turnover

• How many times we turn accounts receivable into
  cash during a period

Net sales
Average net accounts receivable
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Days Sales in Receivables

• How many days sales remain uncollected in
  accounts receivable

Net sales
Net sales per day
365 days
Average net accounts receivable
Net sales per day
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Inventory Turnover

• Number of times the company sells and replaces
  its inventory during the period
• Holding inventory results in financing and
  storage costs

Cost of goods sold
Average inventory
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Long-term Solvency

• Debt ratio
• Times Interest Earned

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Debt Ratio

• Shows amount of total assets creditors provide
• Higher levels of debt financing means company has
  a higher risk of not meeting interest and
  principal payments

Total liabilities
Total assets
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Times Interest Earned

• Number of times the company earned interest
  expense with current income
• Creditors want to know the firms ability to pay
  annual interest charges

Net income Income tax expense Interest
expense
Interest expense
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Profitability

• Profit margin
• Total asset turnover
• Return on total assets
• Return on owners equity
• Earning per share

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Profit Margin

• Percentage each sales dollar contributes to net
  income

Net income
Net sales
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Total Asset Turnover

• Measures the efficiency of the company is using
  its investment in assets to generate sales

Net sales
Average total assets
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Return on Total Assets

• Measures the amount a company earns on each
  dollar of investment in assets

Net income
Average total assets
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Return on Owners Equity

• Measures the earnings in relation to the owners
  investment in the company

Net income - Preferred dividends
Average owners equity
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Earnings Per Share

• Measures the net income available to each share
  of common stock
• Discussed in depth in Chapter 14

Net income - Preferred dividends
Weighted average number of common shares
outstanding during the year
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Market Performance

• Price/Earnings (P/E) ratio
• Dividend yield

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Price/Earning (P/E) Ratio

• Number of times earnings per share the stock is
  currently selling for in the market

Market price per share of common stock
Earnings per share
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Dividend Yield

• Measure of dividend-paying performance of a
  company
• Investors buy stock for two reasons
• Receive cash dividends
• Sell stock at a higher price

Dividends per share
Market price per share
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Limitations of Financial Analysis Tools

• Historical nature of accounting information
• Changing economic conditions
• Comparisons with industry averages
• Seasonal factors
• Quality of reported income

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