Financial Statement Analysis I

1
Financial Statement Analysis I

• Overview
• Retrospective vs. Prospective Analysis
• Time-Series vs. Cross-Sectional Analysis
• Data Analysis - Raw Data, Common Size
• Ratios - ROA, ROE, Leverage, Turnover
  Ratios, Short Term Liquidity Ratios

2
Financial Statement Analysis

• (1) Understand the business
• Understand
• how the company runs.
• the risks of the business.
• the economic factors that impact the short and
  long-run health of the co.
• the range of businesses in which a co. is
  involved. (Outlined in the first sections of the
  annual statements.)

3
Financial Statement Analysis

• (2) Read the financial statements
• (a) The auditors report- a professional
  opinion, by an independent third party, on the
  fairness of the numbers and disclosures reported
  in the financial stmts. - opinion on whether
  the financial stmts. present info fairly
  according to GAAP. - not a guarantee of the
  accuracy of financial stmt. info or whether its
  good or bad. Its the responsibility of the
  reader to interpret the info provided.

4
Financial Statement Analysis

• (2) Read the financial statements
• (b) The major financial statements
• Do the results make sense for the type of
  activities the co. is involved in?
• Look for unusual account titles and unusually
  large amounts. New accounts may mean a new
  line of business with risks that differ from the
  established business.
• Try to determine if items are continuing or
  noncontinuing.

5
Financial Statement Analysis

• (2) Read the financial statements
• (c) The notes to the financial statements
• provide a place for more details and discussion
  about items on the financial stmts.
• summarize the significant accounting policies
  used by the co. (generally in the first note).
• (3) Proceed with detailed analysis.

6
Financial Statement Analysis

• Retrospective vs. Prospective Analysis
• Most analyses are prospective (forward-looking).
• Retrospective data (the results and trends of
  past operations) can be used to predict the
  future.
• In conjunction, you should know the economics of
  a co. well enough to understand when the economic
  environment has changed significantly enough to
  make retrospective data meaningless in
  predictions.

7
Financial Statement Analysis

• Time-Series vs. Cross-Sectional Analysis
• Time-Series Analysis
• looks for patterns over time.
• assumption that there is some predictability into
  the future.
• 5 or 10 year summaries are commonly provided by
  co.s in annual reports.
• Cross-Sectional Analysis
• compares same period data from one co. vs.
  another (usually in the same industry).
• consider that (1) different co.s use different
  assumptions, (2) different industries have
  slightly different accounting principles and (3)
  different countries have differing acctg methods
  and standards.

8
Financial Statement Analysis

• Data to be used
• (1) Raw Financial Data
• appear directly in the financial stmts.
• can be used in time-series analyses (e.g. two
  periods of data are usually shown. Also, 5 or 10
  year summaries) or
• cross-sectional analyses (e.g. a summary of
  revenues of co.s in the same industry).
• annual stmts. may also contain non-financial data
  (e.g. s of employees, units of sales volume).

9
Financial Statement Analysis

• Data to be used
• (1) Common Size Data
• Useful for comparing data items within a
  financial stmt.
• All line items are expressed as a age of a base
  number. (e.g. in a common size income stmt., all
  line items are expressed as a age of net
  revenues.)
• In the case of the income stmt., it allows
  expenses and profit margins to be compared to net
  revenues.
• Can be used in time-series analyses and
  cross-sectional analyses (allows comparison of
  co.s of different sizes.)

10
Financial Statement Analysis

• Data to be used
• (1) Ratio Data
• reveal info about relationships between financial
  stmts. Compares one data element from one stmt.
  with an element in another or with an element in
  the same stmt.
• can be used in time-series analyses and
  cross-sectional analyses.

11
Financial Statement Analysis

• Ratios
• Performance Ratios
• complement raw data and common size financial
  stmt info. and draw out some of the relationships
  between the income stmt and the balance sheet.
• 3 types of return on investment (ROI)- Return
  on Equity (ROE) - captures the return to
  shareholders.- Interest received by debtholders
  (not discussed in detail in this course).-
  Return on Assets (ROA) - captures the return
  generated by the investment in assets.
  Investment s are obtained from both debtholders
  and shareholders.
• Turnover ratios - accounts receivable, inventory,
  and accounts payable.

12
Financial Statement Analysis

• Performance Ratios ROA
• Provides info about how well the assets used in
  the co. are managed. ROA Income Before
  Interest
• Average Total Assets
• Should be computed prior to any payments or
  returns to debtholders or shareholders.
• Therefore, interest is added back to net income
  and any tax savings due to interest expense are
  deducted.

13
Financial Statement Analysis

• Performance Ratios ROA
• ROA Net IncomeInterest Expense x(1-Tax Rate)
• Average Total Assets
• Use to compare trends over time and versus other
  corporations.
• Be aware, when comparing to other co.s, that
  different co.s can use different amortization
  policies and different inventory assumptions that
  will impact both the total assets figure and net
  income.

14
Financial Statement Analysis

• Performance Ratios ROA
• ROA can also be expressed as Net
  IncomeInterest Expense x(1-Tax Rate)
• Sales Revenue X Sales
  Revenue
• Average Total Assetsi.e. Profit Margin
  Ratio x Total Asset Turnover
• Changes in the Profit Margin Ratio would indicate
  a change in the profitability of the product and
  may indicate changes in the cost structure or
  pricing policy.
• Changes in the Total Asset Turnover would
  indicate changes in sales volume or in asset
  investment.

15
Financial Statement Analysis

• Performance Ratios ROE
• ROE Net Income - Preferred Dividends
• Average Common Shareholders Equity
• Calculated from the common shareholders
  viewpoint. Therefore, preferred dividends are
  deducted from net income (This is what is left
  over for common shareholders.

16
Financial Statement Analysis

• Financial Leverage
• Means that some of the funds obtained to invest
  in assets came from debtholders as well as
  shareholders.
• The shareholders can improve their return (ROE)
  if the co. can borrow funds at an after-tax
  borrowing rate that is less than the after-tax
  ROA (see exhib. s 12-5 to 12-9)
• The risk of leveraging a co. is that the reverse
  will be true.

17
Financial Statement Analysis

• Financial Leverage
• There is a limit to the s that a co. can
  borrow. As the co. adds more debt, the fixed
  interest payments increase. This increases the
  risk to lenders that they wont get paid.
  Therefore, they demand higher interest rates.
  When the average borrowing rate equals or exceeds
  the ROA, it becomes unattractive to borrow more
  funds.
• The optimal capital structure is the point at
  which ROE is maximized.

18
Financial Statement Analysis

• Ratios
• Turnover Ratios
• provide some quantitative measures of the
  lead/lag relationships between revenue and
  expense recognition and their related cash flows.

19
Financial Statement Analysis

• Turnover Ratios Accounts Receivable
  Turnover Ratio
• Measures how often the accounts receivable are
  turned over (i.e. fully paid and replaced by
  new accounts.)
• Sales on Account
• Average Accounts Receivable
• Acceptable numbers vary with industry and credit
  policies.
• Trends over time should be considered.

20
Financial Statement Analysis

• Number of Days To Collect Accounts Receivable
• Measures the number of days it takes to collect
  sales on account.
• _________365______________
• Accounts Receivable Turnover
• Acceptable numbers would approximate the normal
  credit terms of the company.
• Trends over time should be considered.

21
Financial Statement Analysis

• Turnover Ratios - Inventory Turnover Ratio
• Provides information about how fast the physical
  inventory turns over. Inventory Turnover
• Cost of Goods Sold
• Average Inventory
• If LIFO is used, numbers can be very distorted.
  However, very few co.s in Canada use LIFO.

22
Financial Statement Analysis

• Days Inventory Held
• Measures the average number of days from
  original purchase to sale of product.
• ____________365_____________
• Inventory Turnover
• Acceptable numbers would vary according to the
  industry. e.g. If the product is perishable
  (food), days would be short (approx. one week).
• Trends over time should be considered.

23
Financial Statement Analysis

• Turnover Ratios Accounts Payable
  Turnover Ratio
• Measures how often the accounts payable are
  turned over (i.e. fully paid and replaced by
  new accounts.)
• Credit Purchases
• Average Accounts Payable
• Problem is that credit purchases dont appear
  directly in the financial stmts.
• May be able to estimate credit purchases based on
  cash paid to suppliers on the CFS.
• Acceptable numbers vary with industry and
• Trends over time should be considered.

24
Financial Statement Analysis

• Turnover Ratios Accounts Payable
  Turnover Ratio
• Alternative calculation (for a retailer)
• Cost of Goods Sold
• Average Accounts Payable
• Problem for manufacturers is that many more items
  than credit purchases affect cost of goods sold.
• Acceptable numbers vary with industry and
• Trends over time should be considered.

25
Financial Statement Analysis

• Days to Pay
• Measures the average number of days it takes to
  pay suppliers.
• ____________365_____________
• Accounts Payable Turnover
• Acceptable numbers would approximate the normal
  payment terms negotiated by the co.
• Trends over time should be considered.

26
Financial Statement Analysis

• Short-term Liquidity Ratios Current Ratio
• Measures the ability of a company to pay its
  short-term obligations.
• Current Assets
• Current Liabilities
• Must be greater than 11. Rule of thumb is 21.
  (varies with industry.)

27
Financial Statement Analysis

• Short-term Liquidity Ratios Quick Ratio
• Again, measures the ability of a company to pay
  its short-term obligations. But, omits
  inventories (which may not be very liquid,
  depending on the industry or business) and
  prepaids (since prepaids dont convert to cash).
• Cash Accts Recble Marketable Securities
• Current Liabilities
• Rule of thumb is 11. (varies with industry.)