Objective of Financial Statement Analysis Mark Kolta

Financial Statement Analysis ď&#x201A;&#x2014;The

application of analytical tools and

techniques to financial statement data. ď&#x201A;&#x2014;Allows

users to focus on how numbers

are related and how they have changed over time

Objective of Financial Statement Analysis ď&#x201A;&#x2014;External

users rely on general purpose

financial statements ď&#x201A;&#x2014;Make

an aid in making decisions ď&#x201A;&#x2014;Users

highlight important trends or changes

Risk and Return ď&#x201A;&#x2014;Users

try to balance the risk of an

investment with its expected return ď&#x201A;&#x2014;Generally

the greater the risk, the higher

the return ď&#x201A;&#x2014;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&#x201A;&#x2014;Shows

the relative size of one financial

statement component to another. ď&#x201A;&#x2014;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&#x201A;&#x2014;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&#x201A;&#x2014;Number

of times the company sells and replaces its inventory during the period ď&#x201A;&#x2014;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&#x201A;&#x2014;Shows

amount of total assets creditors provide ď&#x201A;&#x2014;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&#x201A;&#x2014;Percentage

each sales dollar contributes to net income Net income Net sales

Total Asset Turnover ď&#x201A;&#x2014;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&#x201A;&#x2014;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&#x201A;&#x2014;Measures

the net income available to each share of common stock ď&#x201A;&#x2014;Discussed in depth in Chapter 14 Net income - Preferred dividends Weighted average number of common shares outstanding during the year

Market Performance ď&#x201A;&#x2014;Price/Earnings ď&#x201A;&#x2014;Dividend

yield

(P/E) ratio

Price/Earning (P/E) Ratio ď&#x201A;&#x2014;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

Thanks

# Mark Kolta - Objective of Financial Statement Analysis

Allows users to focus on how numbers are related and how they have changed over time.

# Mark Kolta - Objective of Financial Statement Analysis

Allows users to focus on how numbers are related and how they have changed over time.