1. UNDERSTANDING FINANCIAL STATEMENTS
THE ANALYSIS OF FINANCIAL STATEMENTS
Fraser & Ormiston
Chapter 5

2. Overview of Financial Analysis
First order of business is to SPECIFY THE OBJECTIVES OF THE ANALYSIS
Focus on WHO is the financial statement user
Remember -- the identity of the user helps define what information is needed

3. Potential Financial Statement Users:
Creditors
Investors
Managers
What types of questions do each of these users seek answers to?

4. Creditors Why does the firm want/need to borrow funds?
What is the firm’s capital structure? How leveraged are they?
How will they pay it back? What kind of cash flows are being generated by operations?

5. Investors How has the firm performed/what are future expectations?
How much RISK is inherent in the capital structure?
What are expected returns from the firm?
What is firm’s competitive position?

6. Managers Need all info creditors and investors need PLUS:
What operating areas have contributed to success and which have not?
What are strengths/weaknesses of company’s financial position?
What changes are indicated to improve future performance?

7. Caution!!! Keep in mind: management PREPARES financial statements
Analyst should be alert to potential for management to influence reporting to make data more “appealing”
May want to supplement analysis with information apart from Annual Report prepared by management

8. Where to look for data... Financial statements (and notes)
Auditor’s report
MD&A
Supplementary schedules
All of the above are in Annual Report -- can also look further...

9. Other Data Sources 10K and 10Q reports filed with SEC
Computerized data bases
Info on industry norms/ratios
Info on particular companies/industries/mutual funds
Articles in popular/business press
Ever-expanding websites

10. Basic Tools Common size financial statements Financial ratios
Trend analysis
Structural analysis
Industry comparisons
Common sense and judgment (often the hardest to use!)

11. Common Size Statements
Common size income statement
expresses each income statement category as a percentage of net sales
Common size balance sheet
expresses each item on balance sheet as a percentage of total assets or equities
Both statements facilitate structural analysis of the firm

12. Financial Ratio Categories
Liquidity Ratios
measure a firm’s ability to meet cash needs as they arise
Activity Ratios
measure the liquidity of specific assets and the efficiency of managing assets

13. Ratio Categories (continued)
Leverage Ratios
measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges
Profitability Ratios
measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity

14. Caution!!!!!! Ratios are valuable, BUT…..
They do not provide answers in an of themselves and are not predictive
They should be used with other elements of financial analysis
There are no “rules of thumb” that apply to interpretation of ratios
KEEPING THIS IN MIND, LET’S TAKE A LOOK AT SOME OF THE RATIOS….

15. Liquidity Ratios Current Ratio Quick or Acid Test Ratio
Current Assets/Current Liabilities
Measures ability to meet short-term cash needs
Quick or Acid Test Ratio
Current Assets-Inventory/Current Liabilities
Measure ability to meet short-term cash needs more rigorously

16. Liquidity Ratios (continued)
Cash Flow Liquidity Ratio
Cash+Marketable Securities+Cash Flow from Operating Activities/Current Liabilities
Focuses on ability of the firm to generate operating cash flows as a source of liquidity

17. Activity Ratios Average Collection Period Accounts Receivable Turnover
Accounts Receivable/Average Daily Sales
Helps gauge liquidity of accounts receivable (ability to collect cash from customers)
Accounts Receivable Turnover
Net Sales/Accounts Receivable
Another measure of efficiency of firm’s collection and credit policies

18. Activity Ratios (continued)
Inventory Turnover
Cost of Goods Sold/Inventory
Measures efficiency of inventory management
Fixed Asset and Total Asset Turnover
Net Sales/Net PP&E (Fixed Asset T/O)
Net Sales/Total Assets (Total Asset T/O)
Both assess effectiveness in generating sales from investment in assets

19. Leverage: Debt Ratios Debt Ratio
Total Liabilities/Total Assets
Long-Term Debt to Total Capitalization
Long-term Debt/Long-term Debt + Stockholders’ Equity
Debt to Equity Ratio
Total Liabilities/Stockholders’ Equity
All three measure extent of firm’s financing with debt

20. Leverage: Coverage Ratios
Proportion and amount of debt in capital structure is important to analyst
Tradeoff between risk and return
Use of debt involves risk -- commitment to fixed charges
Fixed charges must be COVERED -- following are some ratios to assess coverage…...

21. Coverage Ratios (continued)
Times Interest Earned
Operating Profit/Interest Expense
Indicates how well operating earnings cover fixed interest charges
Fixed Charge Coverage
Operating Profit + Lease Payments/Interest Expense + Lease Payments
Broader measure of how well operating earnings cover fixed charges

22. Coverage Ratios (continued)
Cash Flow Adequacy
Cash Flow from Operating Activities/ Average Annual Long-Term Debt Maturities
Measures firm’s ability to cover long-term debt maturities each year
Rationale is that over the long-run operating cash flows must be adequate to cover investing activities financed with debt

23. Profitability Ratios Gross Profit Margin Operating Profit Margin
Gross Profit/Net Sales
Operating Profit Margin
Operating Profit/Net Sales
Net Profit Margin
Net Earnings/Net Sales
All measure firm’s ability to translate sales dollars into profits

24. Profitability Ratios (continued)
Cash Flow Margin
Cash Flow from Operating Activities / Net Sales
Measures ability to translate sales into cash (with which to pay bills!)

25. Profitability Ratios (continued)
Return on Investment (or Return on Assets -- same thing, different words!)
Net Earnings/Total Assets
Return on Equity
Net Earnings/Stockholders’ Equity
Both measure overall efficiency of firm in managing investment in assets and generating return to stockholders

26. Profitability Ratios (continued)
Cash Return on Assets
Cash Flow from Operating Activities / Total Assets
Useful comparison to return on investment
Indicates firm’s ability to generate cash from utilizing its assets

27. Other Ratios You Hear About..
Earnings per Common Share
Net Earnings/Average Common Shares Outstanding
Indicates return on a per share basis
Price to Earnings
Market Price of Common Stock/Earnings per Common Share
Expresses a multiple the stock market places on earnings

28. Other Ratios (continued)
Dividend Payout
Dividends per Share/Earnings per Share
Shows percentage of earnings paid out to stockholders
Dividend Yield
Dividends per Share/Market Price of Common Share
Shows rate earned by shareholders from dividends relative to current stock price

29. Analyzing the Company
Now that some of the “tools” of financial analysis have been illustrated, where does one go from here?
Taking a general approach to financial statement analysis, one might proceed as follows…...

30. Steps of a F/S Analysis Establish objectives of the analysis
Who are you and why are you interested in this company?
What questions would you like to have answered?
What info is vital to the decision at hand?

31. Steps (continued)
Study the industry in which the firm operates and relate industry climate to current and projected economic developments
individual company does not operate in a vacuum
are we dealing with a growth industry? a dying industry? a changing industry?...

32. Steps (continued)
Develop knowledge of firm and quality of management (unless you buy an awful lot of stock, you can’t DO much about the latter!)
how well does this firm seem to be run?
are they taking advantage of opportunities?
are they innovative, forward-looking, etc?

33. Steps (continued)
Evaluate financial statements (number-crunching time!) using basic tools
Focus on major areas:
short-term liquidity
capital structure/long-term solvency
operating efficiency/profitability
market ratios
segmental analysis if relevant

34. Steps (concluded) Summarize findings
Reach conclusions about the firm relevant to your established objectives
NOW, WHAT HAVE WE ACCOMPLISHED AS WE HAVE “WADED” THROUGH THE LAST FIVE CHAPTERS?

35. Accomplishments TRIED to turn a maze into a map
Reviewed all the basic financial statements and know what they are
Practiced the rudiments of financial analysis
If nothing else, hopefully gained an appreciation of what information is available and how one might use it...

36. A Final Note
Financial analysis is only as good as the information upon which it is based -- hence we need to be concerned about honest, straightforward, comprehensible financial reporting
Financial analysis is only valuable to me if it answers MY questions -- I need to THINK about what I need/would like to know BEFORE I crunch numbers

37. A Final Final Note (really!)
Analyzing financial information can be fun (as well as profitable)
You can never know too much about a company you plan to have a relationship with (as an investor, a creditor, a manager, an employee)
GO FIND THE INFORMATION AND USE IT INTELLIGENTLY -- YOU CAN DO IT!