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.
Financial Statement Analysis Ratios & Framework
• Horizontal analysis focuses on changes or growth, year to year, for each major element on the income statement and the balance sheet.
Financial Statement Analysis Ratios & Framework
• 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 • The following are commonly used
liquidity ratios:
Quick ratio =Cash+ Cash equivalents + Accounts receivable
Current liabilities
Liquidity Ratios • The following are commonly used
liquidity ratios:
Average sales per day = Sales revenue365
Liquidity Ratios • The following are commonly used
liquidity ratios:
Cost of goods sold per day = Cost of goods sold365
Liquidity Ratios • The following are commonly used
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
Profitability Ratios • The following are commonly used
profitability ratios:
Operating income percentage =Operating income +
Extraordinary losses - unusual gainsSales revenue
Profitability Ratios • The following are commonly used
profitability ratios:
Return on equity = Net incomeAverage shareholders' equity
Profitability Ratios • The following are commonly used
profitability ratios:
Return on assets = Net income +
(Interest expense [1 - Tax rate])Sales revenue
×
Profitability Ratios • The following are commonly used
profitability ratios:
Cash return on assets =Cash flow from operating activities +
interest paidAverage total assets
Profitability Ratios • The following are commonly used
profitability ratios:
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
Capital Structure Ratios • Percentage composition analysis is the
starting point for any analysis of capital structure.
Percentage composition = Long term debt Total liabilities +Shareholders equity
Capital Structure Ratios • Percentage composition analysis is the
starting point for any analysis of capital structure.
Percentage composition = Deferred taxes +Other similar liabilities
Total liabilities +Shareholders equity
Capital Structure Ratios • Percentage composition analysis is the
starting point for any analysis of capital structure.
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 • The following are commonly used
investor ratios:
Market to book value = Market price per shareBook value per share
Investor Ratios • The following are commonly used
investor ratios:
Price to earnings = Market price per shareEarnings per share
Financial Statement Analysis Framework
• The financial statement analysis framework includes the following steps.
Financial Statement Analysis Framework
• Identify the purpose and objectives of the analysis.
Financial Statement Analysis Framework
• Review the financial statements, notes and audit opinion.
Financial Statement Analysis Framework
• Determine whether restatements are necessary to enhance the comparability of the statements.
Financial Statement Analysis Framework
• Determine whether the firm's size, capital structure, and product mix are appropriate to proceed with the ratio calculations.
Financial Statement Analysis Framework
• Conduct horizontal and vertical analyses of each financial statement, with special emphasis on the income statement.
Financial Statement Analysis Framework
• Calculate the basic liquidity ratios.
Financial Statement Analysis Framework
• Calculate profitability ratios based on net income and on cash flow from operating activities. Evaluate trends.
Financial Statement Analysis Framework
• Evaluate the firm's capital structure with special emphasis on trends in the percentage composition ratios.
Financial Statement Analysis Framework
• Examine the firm's market performance using the investor ratios.
Financial Statement Analysis Framework
• 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.
Limitations of Financial Statement Analyses
• GAAP presents some limits.
Limitations of Financial Statement Analyses
• GAAP presents some limits. • Managers often have the ability to
select favorable accounting methods.
Limitations of Financial Statement Analyses
• Many major factors affecting profitability and survival of the firm are not included in the financial statements.
Limitations of Financial Statement Analyses
• Many major factors affecting profitability and survival of the firm are not included in the financial statements. – A perfect example is human resources.
Limitations of Financial Statement Analyses
• 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.
Limitations of Financial Statement Analyses
• "Real" events are often hard to distinguish from the effects of alternative accounting methods or principles.
Limitations of Financial Statement Analyses
• 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
Top Related