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A Framework for Financial Statement Analysis Chapter 11

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Why Financial Statements Are Analyzed In order for financial information to be useful, it must be interpreted.

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Why Financial Statements Are Analyzed A comprehensive set of ratios allows the user to make sense of all the financial information reported in the financial statements.

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Users of Financial Information Users of financial information may be current or future users.

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Users of Financial Information –Investors –Managers –Customers –Potential suppliers and creditors –Government regulators –Employee unions –Public interest and community groups Some of the users of financial information are the following:

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Sources of Financial Information The major source of financial information is a firm's annual report.

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The following are elements of most annual reports: Management discussion and analysis Independent auditor's report Primary financial statements Secondary financial statements Notes to the financial statements

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Other Sources of Information Reports filed with regulatory agencies (special, quarterly, and annual) Business periodicals (magazines, newspapers, newsletters) Investment advisory services (Standard & Poor, Moody's, etc.)

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Basis of Comparison When analyzing financial reports, one of the first decisions is to identify the basis of comparison.

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Data may be compared with the following: The firm's own data from prior years Data from another firm in the same industry Data from another firm in which the analyst may invest Industry averages Benchmarks or targets

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Restatements May Be Necessary The statements may need to be restated when significant unusual events have occurred which would distort comparisons.

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Restatements May Be Necessary Such events include, among others, mergers or acquisitions, discontinued operations, changes in accounting principles, and extraordinary items.

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More Comparability Is Better Comparability is enhanced when firms' size, capital structure, and product mix are similar.

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A summary of the steps: Identify the purpose and objectives of analysis.

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A summary of the steps: Review the financial statements, notes, and audit opinion to identify any unusual events or characteristics and to become familiar with the nature of the firm’s operation.

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A summary of the steps: Determine whether any restatements due to mergers, discontinued operations, etc., are necessary to enhance comparability of the firm’s financial statements.

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A summary of the steps: Determine whether the firm’s size, capital structure, and product mix are sufficiently comparable (between firms or time periods) to proceed with the ratio calculations.

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Financial Statement Analysis Ratios & Framework The analyst usually performs horizontal and vertical analyses of the financial statements.

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Financial Statement Analysis Ratios & Framework Horizontal analysis focuses on changes or growth, year to year, for each major element on the income statement and the balance sheet.

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Financial Statement Analysis Ratios & Framework Vertical analysis examines the percentage composition of the income statement and the balance sheet: It uses common-size financial statements for this analysis.

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Categories of Financial Ratios Ratios are usually grouped into broad categories.

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Categories of Financial Ratios Four widely used major headings are liquidity, profitability, capital structure, and investor.

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Liquidity Ratios Liquidity ratios indicate the short- term solvency of the firm.

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Liquidity Ratios They also indicate how effectively the firm is managing its working capital.

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Liquidity Ratios The following are commonly used liquidity ratios:

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Liquidity Ratios The following are commonly used liquidity ratios:

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Liquidity Ratios The following are commonly used liquidity ratios:

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Liquidity Ratios The following are commonly used liquidity ratios:

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Liquidity Ratios The following are commonly used liquidity ratios:

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Profitability Ratios Profitability ratios measure how profitable a firm is.

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Profitability Ratios This is very important for investors who want to invest in a firm which can return their investment to them.

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Profitability Ratios The following are commonly used profitability ratios:

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Profitability Ratios The following are commonly used profitability ratios:

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Profitability Ratios The following are commonly used profitability ratios:

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Profitability Ratios The following are commonly used profitability ratios:

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Profitability Ratios The following are commonly used profitability ratios:

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Profitability Ratios The following are commonly used profitability ratios:

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Capital Structure Ratios Capital structure ratios help in assessing a firm's strategies for financing its assets.

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Capital Structure Ratios Capital structure indicates the relative amounts of debt and equity capital.

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Capital Structure Ratios Percentage composition analysis is the starting point for any analysis of capital structure.

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Capital Structure Ratios Percentage composition analysis describes the relative amounts of capital obtained from each major source of financing.

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Capital Structure Ratios Current liabilities, long-term debt, deferred taxes and other similar liabilities, and shareholders' equity all will be divided by the total of total liabilities and shareholders' equity.

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Capital Structure Ratios Percentage composition analysis is the starting point for any analysis of capital structure.

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Capital Structure Ratios Percentage composition analysis is the starting point for any analysis of capital structure.

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Capital Structure Ratios Percentage composition analysis is the starting point for any analysis of capital structure.

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Capital Structure Ratios Percentage composition analysis is the starting point for any analysis of capital structure.

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Capital Structure Ratios The following capital structure ratios are also computed:

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Capital Structure Ratios The following capital structure ratios are also computed:

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Investor Ratios Investor ratios all relate to an external dimension of ownership interest. Most indicate how a firm is performing with regard to the market value of its shares.

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Investor Ratios The following are commonly used investor ratios:

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Investor Ratios The following are commonly used investor ratios:

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Investor Ratios The following are commonly used investor ratios:

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Financial Statement Analysis Framework The financial statement analysis framework includes the following steps.

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Financial Statement Analysis Framework Identify the purpose and objectives of the analysis.

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Financial Statement Analysis Framework Review the financial statements, notes and audit opinion.

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Financial Statement Analysis Framework Determine whether restatements are necessary to enhance the comparability of the statements.

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Financial Statement Analysis Framework Determine whether the firm's size, capital structure, and product mix are appropriate to proceed with the ratio calculations.

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Financial Statement Analysis Framework Conduct horizontal and vertical analyses of each financial statement, with special emphasis on the income statement.

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Financial Statement Analysis Framework Calculate the basic liquidity ratios.

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Financial Statement Analysis Framework Calculate profitability ratios based on net income and on cash flow from operating activities. Evaluate trends.

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Financial Statement Analysis Framework Evaluate the firm's capital structure with special emphasis on trends in the percentage composition ratios.

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Financial Statement Analysis Framework Examine the firm's market performance using the investor ratios.

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Financial Statement Analysis Framework Examine any inconsistencies in the ratio results, review notes, and recalculate the ratios.

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Limitations of Financial Statement Analyses Financial statement analysis is limited due to several items.

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Limitations of Financial Statement Analyses GAAP presents some limits.

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Limitations of Financial Statement Analyses GAAP presents some limits. Managers often have the ability to select favorable accounting methods.

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Limitations of Financial Statement Analyses Many major factors affecting profitability and survival of the firm are not included in the financial statements.

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Limitations of Financial Statement Analyses Many major factors affecting profitability and survival of the firm are not included in the financial statements. –A perfect example is human resources.

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Limitations of Financial Statement Analyses Many major factors affecting profitability and survival of the firm are not included in the financial statements. –While employees are often a firm's most important asset, a value for employees does not appear on the balance sheet.

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Limitations of Financial Statement Analyses "Real" events are often hard to distinguish from the effects of alternative accounting methods or principles.

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Limitations of Financial Statement Analyses Financial statement analysis relies on past numbers, and the past may not be a reliable indication of the future.

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A Framework for Financial Statement Analysis End of Chapter 11

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