Financial Statements

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Financial Statements Analysis

• FIL 240
• Prepared by Keldon Bauer

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Financial Statement Fundamentals

• Publicly traded companies must file an annual
  (10-K) report with the SEC.
• The purpose of the 10-K is to report to owners on
  the status of their investment.
• The 10-K report contains both verbal and
  quantitative information about the performance of
  the firm.

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Financial Statement Fundamentals
Financial Sections Include

• Income Statement (usually 3 years)
• Balance Sheet (usually 2 years)
• Statement of Retained Earnings
• Statement of Cash Flows
• Key operating statistics for 5-10 years
• The purpose is both informative and marketing

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The Balance Sheet

• The balance sheet is an attempt to show the
  sources of investment funds and their uses in the
  firm at the present time.
• Accountants should be looking out for the
  interests of the investor.
• Conservatism.
• Lower of cost or market.

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The Balance Sheet

• Assets are listed in order of liquidity
• Ease of conversion to cash
• Without significant loss of value
• The less liquid an item on the balance sheet is,
  the less reliably it reflects its current value
  over time.
• Standard practice of inventory accounting,
  depreciation, etc. do not reflect actual value.

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The Balance Sheet

• Balance Sheet Identity
• Assets Liabilities Stockholders Equity
• Uses Debt Sources Equity Sources
• The amount the firm owes on its liabilities is
  usually exactly what is on its balance sheet.
• The value of the equity is never what appears on
  the balance sheet.
• Equity is what is used to balance the identity.

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Market versus Book Value

• The balance sheet provides the book value of the
  assets, liabilities and equity.
• Market value is the price at which the assets,
  liabilities or equity can actually be bought or
  sold.
• Market value and book value are often very
  different. Why?
• Which is more important to the decision-making
  process?

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Income Statement

• The income statement acts as a basis of change in
  the equity section of the balance sheet.
• You either pay equity investors back with income,
  or increase their book value (reinvest).
• You generally report revenues first and then
  deduct any expenses for the period.
• Matching principle GAAP requires revenue to be
  recognized when it accrues and match the expenses
  required to generate the revenue.

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Ratio Analysis

• Financial ratios are the vital signs of the
  business.
• They are used to assess the health of the
  business.
• When they are off the norm, they should be taken
  together with all known information to get a
  correct diagnosis.
• Norms should be seen as a normal range, not just
  one number.

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Ratio Analysis

• Ratios also allow for better comparison through
  time or between companies
• As we look at each ratio, ask yourself what the
  ratio is trying to measure and why is that
  information important
• Ratios are used both internally and externally

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Categories of Financial Ratios

• Short-term solvency or liquidity ratios
• Activity Ratios
• Debt Ratios
• Profitability ratios
• Market value ratios

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Liquidity Ratios

• Relate short-term sources of and uses for cash.
• Current Ratio

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Liquidity Ratios

• Quick (Acid Test) Ratio

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Asset Management Ratios

• Purpose is to assess how well the firm is
  managing assets
• Inventory turnover ratio (IT)

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Asset Management Ratios

• Accounts receivable turnover (ART)

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Asset Management Ratios

• Accounts payable turnover (APT)

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Asset Management Ratios

• Total Asset Turnover (TAT)
• Measure of asset use efficiency
• Interpret in industry context.

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Debt Ratios

• Relate debt to equity sources of investment funds
  .
• Debt Ratio

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Leverage Ratios

• Equity Multiplier

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Coverage Ratios

• Measure of ability to meet debt contracts.
• Times Interest Earned (TIE) Ratio

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Leverage Ratios

• EBITDA Ratio

• Cant calculate example, CMLTD is not disclosed.

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Profitability - Standardizing

• Common-Size Balance Sheets
• Compute all accounts as a percent of total assets
• Common-Size Income Statements
• Compute all line items as a percent of sales
• Standardized statements make it easier to compare
  financial information, particularly as the
  company grows
• They are also useful for comparing companies of
  different sizes, particularly within the same
  industry

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Profitability Ratios

• Whats the bottom line?
• Gross Profit Margin (GPM)

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Profitability Ratios

• Operating Profit Margin (OPM)

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Profitability Ratios

• Whats the bottom line?
• Net Profit Margin (NPM)

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Profitability Ratios

• Earnings per Share (EPS)

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Profitability Ratios

• Return on Total Assets (ROA)
• This is a measure of the return on assets owned.
• Therefore, it is a measure of return to all
  invested funds.

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Profitability Ratios

• Return on Common Equity (ROE)
• This is a measure of return to the equity holder
  (whether or not they get a dividend).

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Using the Du Pont Identity

• ROE PM TAT EM
• Profit margin is a measure of the firms
  operating efficiency how well does it control
  costs
• Total asset turnover is a measure of the firms
  asset use efficiency how well does it manage
  its assets
• Equity multiplier is a measure of the firms
  financial leverage

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Market Value Ratios

• Price Earnings (P/E) Ratio

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Market Value Ratios

• Market /Book (M/B) Ratio

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Benchmarking

• Ratios are not very helpful by themselves they
  need to be compared to something
• Time-Trend Analysis
• Used to see how the firms performance is
  changing through time
• Internal and external uses
• Peer Group Analysis
• Compare to similar companies or within industries
• SIC and NAICS codes

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Time-Series Analysis

• Evaluation of the firms financial performance
  over time using financial ratios.
• Look for trends.

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Interpretation

• The firm needs to take advantage of opportunities
  for maximizing shareholder wealth.
• That means you need to understand the real
  problem, not just the symptoms.
• Students typically describe symptoms
• Take a system wide approach.
• What is the root problems?