F/S Analysis

A Framework for Financial Statement Analysis

Chapter 11

Why Financial Statements Are Analyzed

• In order for financial information to be useful, it must be interpreted.

Why Financial Statements Are Analyzed

• A comprehensive set of ratios allows the user to make sense of all the financial information reported in the financial statements.

Users of Financial Information

• Users of financial information may be current or future users.

Users of Financial Information

–  Investors –  Managers –  Customers –  Potential suppliers

and creditors

–  Government regulators

–  Employee unions –  Public interest and

community groups

• Some of the users of financial information are the following:

Sources of Financial Information

• The major source of financial information is a firm's annual report.

The following are elements of most annual reports:

• Management discussion and analysis • Independent auditor's report • Primary financial statements • Secondary financial statements • Notes to the financial statements

Other Sources of Information

• Reports filed with regulatory agencies (special, quarterly, and annual)

• Business periodicals (magazines, newspapers, newsletters)

• Investment advisory services (Standard & Poor, Moody's, etc.)

Basis of Comparison • When analyzing financial reports, one

of the first decisions is to identify the basis of comparison.

Data may be compared with the following:

• The firm's own data from prior years • Data from another firm in the same

industry • Data from another firm in which the

analyst may invest • Industry averages • Benchmarks or targets

Restatements May Be Necessary

• The statements may need to be restated when significant unusual events have occurred which would distort comparisons.

Restatements May Be Necessary

• Such events include, among others, mergers or acquisitions, discontinued operations, changes in accounting principles, and extraordinary items.

More Comparability Is Better

• Comparability is enhanced when firms' size, capital structure, and product mix are similar.

A summary of the steps: • Identify the purpose and objectives of

analysis.

A summary of the steps: • Review the financial statements, notes,

and audit opinion to identify any unusual events or characteristics and to become familiar with the nature of the firm’s operation.

A summary of the steps: • Determine whether any restatements

due to mergers, discontinued operations, etc., are necessary to enhance comparability of the firm’s financial statements.

A summary of the steps: • Determine whether the firm’s size,

capital structure, and product mix are sufficiently comparable (between firms or time periods) to proceed with the ratio calculations.

Financial Statement Analysis Ratios & Framework

• The analyst usually performs horizontal and vertical analyses of the financial statements.


• Horizontal analysis focuses on changes or growth, year to year, for each major element on the income statement and the balance sheet.


• Vertical analysis examines the percentage composition of the income statement and the balance sheet: It uses common-size financial statements for this analysis.

Categories of Financial Ratios

• Ratios are usually grouped into broad categories.

Categories of Financial Ratios

• Four widely used major headings are liquidity, profitability, capital structure, and investor.

Liquidity Ratios • Liquidity ratios indicate the short-term

solvency of the firm.

Liquidity Ratios • They also indicate how effectively the

firm is managing its working capital.

Liquidity Ratios • The following are commonly used

liquidity ratios:

Current ratio = Current assetsCurrent liabilities


liquidity ratios:

Quick ratio =Cash+ Cash equivalents + Accounts receivable

Current liabilities


liquidity ratios:

Average sales per day = Sales revenue365


liquidity ratios:

Cost of goods sold per day = Cost of goods sold365


liquidity ratios:

Number of days' sales in ending inventory =

Ending inventoryCost of goods sold per day

Profitability Ratios • Profitability ratios measure how

profitable a firm is.

Profitability Ratios • This is very important for investors

who want to invest in a firm which can return their investment to them.

Profitability Ratios • The following are commonly used

profitability ratios:

Gross profit percentage = Gross profitNet sales revenue



Operating income percentage =Operating income +

Extraordinary losses - unusual gainsSales revenue



Return on equity = Net incomeAverage shareholders' equity



Return on assets = Net income +

(Interest expense [1 - Tax rate])Sales revenue

×



Cash return on assets =Cash flow from operating activities +

interest paidAverage total assets



Quality of income =Cash flow from operating activities

Net income

Capital Structure Ratios • Capital structure ratios help in

assessing a firm's strategies for financing its assets.

Capital Structure Ratios • Capital structure indicates the relative

amounts of debt and equity capital.

Capital Structure Ratios • Percentage composition analysis is

the starting point for any analysis of capital structure.

Capital Structure Ratios • Percentage composition analysis

describes the relative amounts of capital obtained from each major source of financing.

Capital Structure Ratios • Current liabilities, long-term debt,

deferred taxes and other similar liabilities, and shareholders' equity all will be divided by the total of total liabilities and shareholders' equity.

Capital Structure Ratios • Percentage composition analysis is the

starting point for any analysis of capital structure.

Percentage composition = Current liabilities Total liabilities +Shareholders equity



Percentage composition = Long term debt Total liabilities +Shareholders equity



Percentage composition = Deferred taxes +Other similar liabilities

Total liabilities +Shareholders equity



Percentage composition = Shareholders' equity Total liabilities +Shareholders equity

Capital Structure Ratios • The following capital structure ratios

are also computed:

Financial leverage = Total liabilitiesTotal assets

Capital Structure Ratios • The following capital structure ratios

are also computed:

Times interest earned =Earnings before interest and Taxes

Interest expense

Investor Ratios • Investor ratios all relate to an external

dimension of ownership interest. • Most indicate how a firm is

performing with regard to the market value of its shares.

Investor Ratios • The following are commonly used

investor ratios:

Earnings per share = Net incomeWeighted average number of shares outstanding


investor ratios:

Market to book value = Market price per shareBook value per share


investor ratios:

Price to earnings = Market price per shareEarnings per share

Financial Statement Analysis Framework

• The financial statement analysis framework includes the following steps.


• Identify the purpose and objectives of the analysis.


• Review the financial statements, notes and audit opinion.


• Determine whether restatements are necessary to enhance the comparability of the statements.


• Determine whether the firm's size, capital structure, and product mix are appropriate to proceed with the ratio calculations.


• Conduct horizontal and vertical analyses of each financial statement, with special emphasis on the income statement.


• Calculate the basic liquidity ratios.


• Calculate profitability ratios based on net income and on cash flow from operating activities. Evaluate trends.


• Evaluate the firm's capital structure with special emphasis on trends in the percentage composition ratios.


• Examine the firm's market performance using the investor ratios.


• Examine any inconsistencies in the ratio results, review notes, and recalculate the ratios.

Limitations of Financial Statement Analyses

• Financial statement analysis is limited due to several items.


• GAAP presents some limits.


• GAAP presents some limits. • Managers often have the ability to

select favorable accounting methods.


• Many major factors affecting profitability and survival of the firm are not included in the financial statements.


• Many major factors affecting profitability and survival of the firm are not included in the financial statements. – A perfect example is human resources.


• Many major factors affecting profitability and survival of the firm are not included in the financial statements. – While employees are often a firm's most

important asset, a value for employees does not appear on the balance sheet.


• "Real" events are often hard to distinguish from the effects of alternative accounting methods or principles.


• Financial statement analysis relies on past numbers, and the past may not be a reliable indication of the future.

A Framework for Financial Statement Analysis

End of Chapter 11

F/S Analysis

Documents

Transcript of F/S Analysis