Analysis of Financial Statements

After reading this chapter, students should be able to: Explain why ratio analysis is usually the first step in the analysis of a companys financial statements. List the five groups of ratios, specify which ratios belong in each group, and explain what information each group gives us about the firms financial position. State what trend analysis is, and why it is important. escribe how the u !ont chart is used, and how it may be modified to include the effect of financial leverage.

Explain "benchmar#ing$ and its purpose. List several limitations of ratio analysis. %dentify some of the problems with &'E that can arise when firms use it as a sole measure of performance. %dentify some of the (ualitative factors that must be considered when evaluating a companys financial performance.

Financial Statements and Reports Annual &eport: *early record of a publicly held company+s financial condition. %t includes a description of the firm+s operations, as well as balance sheet, income statement, and cash flow statement information. SE, rules re(uire that it be distributed to all shareholders. A more detailed version is called a )-./. %ncome Statement: 0Statement of 'perations, !rofit and Loss Statement1 A statement showing the revenues, expenses, and income 0the difference between revenues and expenses1 of a corporation over some period of time. 2alance Sheet: Also called the statement of financial condition, it is a summary of a company+s assets, liabilities, and owners+ e(uity at a specific point in time. Statement of &etained Earnings: A statement of all transactions affecting the balance of a company+s retained earnings account. Accounting Income versus Cash Flow ,ash 3low 3rom 'perations: A firm+s net cash inflow resulting directly from its regular operations calculated as the sum of net income plus noncash expenses 0mainly depreciation1 that are deducted in calculating net income. Statement of ,ash 3lows: A statement reporting the impact of a firms operating, investing, and financing activities on cash flows over an accounting period. Ratio Analysis &atio analysis of a firms financial statements is of interest to shareholders, creditors, and the firms management. Stoc#holders are interested in the firms current and future level of ris# and return, which directly affect the stoc# price. 4he firms creditors are primarily interested in the short.term li(uidity of the company and in its ability to ma#e interest and principal payments. %nternal management is concerned with all aspects of the firms financial performance. 4herefore, they attempt to produce financial ratios that will be considered favorable to both owners and creditors. Additionally,

management uses ratios to monitor the firms performance from period to period. 6nexpected changes or variances are identified to isolate developing problem areas. Li(uidity &atios: &atios that measure a firm+s ability to meet its short. term financial obligations on time. ). ,urrent &atio: %ndicator of short.term debt.paying ability. etermined by dividing current assets by current liabilities. 4he higher the ratio, the more li(uid the company. 5. 7uic# &atio: A stricter indication of a company+s financial strength 0or wea#ness1. ,alculated by ta#ing current assets less inventories, divided by current liabilities. 4his ratio provides information regarding the firm+s li(uidity and ability to meet its obligations. Also called the Acid 4est ratio. Asset 8anagement &atios: &atios that measure how effectively a firm is managing its assets. ). %nventory 4urnover: 4he ratio of cost of goods sold to inventory, which measures the speed at which inventory is produced and sold. Low turnover is an unhealthy sign, indicating excess stoc#s and9or poor sales. 5. ays Sales 'utstanding 0Average ,ollection !eriod1: 4he ratio of accounts receivables to average sales per day, or the total amount of credit extended per dollar of daily sales. :. 3ixed Asset 4urnover: 4he ratio of sales to net fixed assets. 8easures how effectively the firm uses its plant and e(uipment to generate revenues. ;. 4otal Assets 4urnover: ,alculated by dividing sales by total assets. %ndicates the efficiency with which the firm uses its assets to generate sales. ebt 8anagement &atios: 4he more debt a firm a firm uses in relation to its total assets, the greater the firms financial leverage. 3inancial leverage refers to the magnification of ris# and return introduced through the use of fixed.cost financing such as debt 0and preferred stoc#1. 4he more fixed.cost debt, or financial leverage, a firm uses, the greater will be its ris# and its expected return.

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ebt &atio: 4otal debt divided by total assets. 4he percentage of funds provided by creditors. 5. 4imes %nterest Earned: Earnings before interest and taxes, divided by interest payments. 8easures the firms ability to ma#e contractual interest payments 0also called the %nterest ,overage &atio1. :. 3ixed.,harge ,overage &atio: A measure of a firm+s ability to meet its fixed.charge obligations: the ratio of earnings before interest and taxes plus long.term lease payments to interest charges paid plus long.term lease payments plus sin#ing fund payments90).tax rate1. 4his is a stricter measure of the firms ability to meet fixed financial obligations since it includes lease and sin#ing fund payments 0some analysts also include preferred stoc# dividends in this ratio1. !rofitability &atios: Show the effect of li(uidity, asset management, and debt management on operating results. 4hey focus on the profitability of the firm. !rofit margins measure performance with relation to sales. &ate of return ratios measure performance relative to some measure of si<e of the investment. ). =et !rofit 8argin on Sales: 4he ratio of earnings available to common stoc#holders to net sales. 8easures the percentage of each sales dollar remaining after all costs and expenses, including interest and taxes, have been deducted. 5. &eturn on 4otal Assets 0&'A1: 4he ratio of net income to total assets. 8easures the firms overall effectiveness in generating profits with its available assets. :. &eturn on ,ommon E(uity &'E1: 4he ratio of net income to common e(uity. 8easures the return earned on the owners 0common stoc#holders1 investment in the firm. 8ar#et >alue &atios: &elate the firms stoc# price to its earnings and boo# value. ). !rice9Earnings 0!9E1 &atio: Shows the ?multiple? of earnings at which a stoc# sells. etermined by dividing current stoc# price by current earnings per share 0ad@usted for stoc# splits1. Earnings per share for the !9E ratio are determined by dividing earnings for past )5 months 0four

(uarters1 by the number of common shares outstanding. Aigher ?multiple? means investors have higher expectations for future growth, and have bid up the stoc#+s price. 5. 8ar#et92oo# &atio: 4he ratio of a stoc#s mar#et price to its boo# value. An indication of how investors regard the company. A stoc#s boo# value is the ratio of stoc#holder e(uity to the number of common shares outstanding. 2oo# value per share should not be thought of as an indicator of economic worth, since it reflects accounting valuation 0and not necessarily mar#et valuation1. The DuPont System of Analysis 4he u!ont system of analysis merges the income statement and balance sheet into two summary measures of profitability: &eturn on 4otal Assets 0&'A1 and &eturn on E(uity 0&'E1. 4he u!ont E(uation &'A B =et !rofit 8argin on Sales x 4otal Assets 4urnover &'A B =et %ncome9Sales x Sales94otal Assets Extended u!ont E(uation &'E B =et !rofit 8argin x 4otal Assets 4urnover x E(uity 8ultiplier &'E B =. %.9Sales x Sales94otal Assets x 4otal Assets9,ommon E(uity Note ebt &atio B 4otal ebt94otal Assets B C) . 0) 9 E(uity 8ultiplier1D

Note E(uity 8ultiplier B ) 9 C) . 04otal ebt94otal Assets1D Types of Ratio Comparisons 4rend Analysis: Also termed time.series analysis. Evaluation of the firms financial performance over time to help determine or predict the improvement or deterioration in its financial situation. ,omparative Analysis: Also termed cross.sectional analysis. %nvolves comparing the firms ratios to those of other firms in the same industry or to

industry averages. 2enchmar#ing is a type of cross.sectional analysis in which the firms ratios are compared to those of a #ey competitor or group of competitors, primarily to identify areas for improvement. !ses and "imitations of Ratio Analysis ). 5. :. ;. E. F. G. H. ifficult to develop a meaningful set of industry average ratios for comparative purposes due to the fact that most large firms operate a number of divisions in different industries. Striving for "average$ performance is not a target for most firms. %nflation can distort firms balance sheets. Assets are carried at their historical cost. Seasonal factors can distort a ratio analysis. Average account figures should be used for all ratios when possible to alleviate this problem. 8anagement sometimes employ "window dressing$ techni(ues to artificially present better ratios. ifferent accounting practices can distort comparisons. ifficult to generali<e about whether a particular ratio is good or bad. Even with a comprehensive ratio analysis, it is difficult to tell whether the company is, on balance, strong or wea#. 4he most important and difficult input to a successful ratio analysis is the @udgement used when interpreting the results to reach an overall conclusion about the firms financial position.