Mark Kolta - Objective of Financial Statement Analysis

Objective of Financial Statement Analysis Mark Kolta

Financial Statement Analysis ď‚—The

application of analytical tools and

techniques to financial statement data. ď‚—Allows

users to focus on how numbers

are related and how they have changed over time

Objective of Financial Statement Analysis ď‚—External

users rely on general purpose

financial statements ď‚—Make

predictions about an organization as

an aid in making decisions ď‚—Users

highlight important trends or changes

Risk and Return ď‚—Users

try to balance the risk of an

investment with its expected return ď‚—Generally

the greater the risk, the higher

the return ď‚—Financial

statement analysis is one source

of information for assessing risk and return

Sources of External Information Public

companies must publish an annual financial report Government reports ◦ SEC 10K, 10Q Financial

service information

◦ Moody’s, Dow-Jones Financial

newspapers and periodicals

◦ Wall Street Journal

Financial Analysis Tools Horizontal Vertical Ratio

analysis

analysis

analysis

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

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

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%

Vertical Analysis Identify

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

Ratio Analysis ď‚—Shows

the relative size of one financial

statement component to another. ď‚—Effective

only when used in

combination with other ratios, analysis, and information.

Ratio Analysis ◦ Short-term liquidity ◦ Long-term solvency ◦ Profitability ◦ Market performance

Short-term Profitability Current Quick

ratio

ratio

Accounts Days’

receivable turnover

sales in receivables

Inventory

turnover

Current Ratio Common

measure of liquidity

◦ Ability to pay debts as they come due ◦ Rule of thumb 2:1 ◦ Consider other factors

Current Assets Current Liabilities

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

Accounts Receivable Turnover ď‚—How

many times we turn accounts receivable into cash during a period Net sales Average net accounts receivable

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

Inventory Turnover ď‚—Number

of times the company sells and replaces its inventory during the period ď‚—Holding inventory results in financing and storage costs Cost of goods sold Average inventory

Long-term Solvency Debt

ratio

Times

Interest Earned

Debt Ratio ď‚—Shows

amount of total assets creditors provide ď‚—Higher levels of debt financing means company has a higher risk of not meeting interest and principal payments Total liabilities Total assets

Times Interest Earned Number

of times the company earned interest expense with current income Creditors want to know the firm’s ability to pay annual interest charges Net income + Income tax expense + Interest expense Interest expense

Profitability Profit

margin

Total

asset turnover

Return

on total assets

Return

on owners’ equity

Earning

per share

Profit Margin ď‚—Percentage

each sales dollar contributes to net income Net income Net sales

Total Asset Turnover ď‚—Measures

the efficiency of the company is using its investment in assets to generate sales Net sales Average total assets

Return on Total Assets ď‚—Measures

the amount a company earns on each dollar of investment in assets Net income Average total assets

Return on Owners’ Equity Measures

the earnings in relation to the owners’ investment in the company

Net income - Preferred dividends Average owner’s equity

Earnings Per Share ď‚—Measures

the net income available to each share of common stock ď‚—Discussed in depth in Chapter 14 Net income - Preferred dividends Weighted average number of common shares outstanding during the year

Market Performance ď‚—Price/Earnings ď‚—Dividend

yield

(P/E) ratio

Price/Earning (P/E) Ratio ď‚—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

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

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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