Presentation on theme: "UNDERSTANDING FINANCIAL STATEMENTS"— Presentation transcript:
1 UNDERSTANDING FINANCIAL STATEMENTS THE ANALYSIS OF FINANCIAL STATEMENTSFraser & OrmistonChapter 5
2 Overview of Financial Analysis First order of business is to SPECIFY THE OBJECTIVES OF THE ANALYSISFocus on WHO is the financial statement userRemember -- the identity of the user helps define what information is needed
3 Potential Financial Statement Users: CreditorsInvestorsManagersWhat 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 reportMD&ASupplementary schedulesAll of the above are in Annual Report -- can also look further...
9 Other Data Sources 10K and 10Q reports filed with SEC Computerized data basesInfo on industry norms/ratiosInfo on particular companies/industries/mutual fundsArticles in popular/business pressEver-expanding websites
10 Basic Tools Common size financial statements Financial ratios Trend analysisStructural analysisIndustry comparisonsCommon sense and judgment (often the hardest to use!)
11 Common Size Statements Common size income statementexpresses each income statement category as a percentage of net salesCommon size balance sheetexpresses each item on balance sheet as a percentage of total assets or equitiesBoth statements facilitate structural analysis of the firm
12 Financial Ratio Categories Liquidity Ratiosmeasure a firm’s ability to meet cash needs as they ariseActivity Ratiosmeasure the liquidity of specific assets and the efficiency of managing assets
13 Ratio Categories (continued) Leverage Ratiosmeasure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed chargesProfitability Ratiosmeasure 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 predictiveThey should be used with other elements of financial analysisThere are no “rules of thumb” that apply to interpretation of ratiosKEEPING 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 LiabilitiesMeasures ability to meet short-term cash needsQuick or Acid Test RatioCurrent Assets-Inventory/Current LiabilitiesMeasure ability to meet short-term cash needs more rigorously
16 Liquidity Ratios (continued) Cash Flow Liquidity RatioCash+Marketable Securities+Cash Flow from Operating Activities/Current LiabilitiesFocuses 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 SalesHelps gauge liquidity of accounts receivable (ability to collect cash from customers)Accounts Receivable TurnoverNet Sales/Accounts ReceivableAnother measure of efficiency of firm’s collection and credit policies
18 Activity Ratios (continued) Inventory TurnoverCost of Goods Sold/InventoryMeasures efficiency of inventory managementFixed Asset and Total Asset TurnoverNet 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 AssetsLong-Term Debt to Total CapitalizationLong-term Debt/Long-term Debt + Stockholders’ EquityDebt to Equity RatioTotal Liabilities/Stockholders’ EquityAll three measure extent of firm’s financing with debt
20 Leverage: Coverage Ratios Proportion and amount of debt in capital structure is important to analystTradeoff between risk and returnUse of debt involves risk -- commitment to fixed chargesFixed charges must be COVERED -- following are some ratios to assess coverage…...
21 Coverage Ratios (continued) Times Interest EarnedOperating Profit/Interest ExpenseIndicates how well operating earnings cover fixed interest chargesFixed Charge CoverageOperating Profit + Lease Payments/Interest Expense + Lease PaymentsBroader measure of how well operating earnings cover fixed charges
22 Coverage Ratios (continued) Cash Flow AdequacyCash Flow from Operating Activities/ Average Annual Long-Term Debt MaturitiesMeasures firm’s ability to cover long-term debt maturities each yearRationale is that over the long-run operating cash flows must be adequate to cover investing activities financed with debt
24 Profitability Ratios (continued) Cash Flow MarginCash Flow from Operating Activities / Net SalesMeasures 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 AssetsReturn on EquityNet Earnings/Stockholders’ EquityBoth measure overall efficiency of firm in managing investment in assets and generating return to stockholders
26 Profitability Ratios (continued) Cash Return on AssetsCash Flow from Operating Activities / Total AssetsUseful comparison to return on investmentIndicates firm’s ability to generate cash from utilizing its assets
27 Other Ratios You Hear About.. Earnings per Common ShareNet Earnings/Average Common Shares OutstandingIndicates return on a per share basisPrice to EarningsMarket Price of Common Stock/Earnings per Common ShareExpresses a multiple the stock market places on earnings
28 Other Ratios (continued) Dividend PayoutDividends per Share/Earnings per ShareShows percentage of earnings paid out to stockholdersDividend YieldDividends per Share/Market Price of Common ShareShows rate earned by shareholders from dividends relative to current stock price
29 Analyzing the CompanyNow 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 developmentsindividual company does not operate in a vacuumare 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 toolsFocus on major areas:short-term liquiditycapital structure/long-term solvencyoperating efficiency/profitabilitymarket ratiossegmental analysis if relevant
34 Steps (concluded) Summarize findings Reach conclusions about the firm relevant to your established objectivesNOW, 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 arePracticed the rudiments of financial analysisIf nothing else, hopefully gained an appreciation of what information is available and how one might use it...
36 A Final NoteFinancial analysis is only as good as the information upon which it is based -- hence we need to be concerned about honest, straightforward, comprehensible financial reportingFinancial 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!