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**Financial Statement Analysis**

Chapter 23

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**Overview of Statement Analysis**

Clarify The Decision Focus Examine the Auditor’s Report Examine Accounting Policies Recast the Financial Statements Seek Comparative Information Apply Analytical Techniques Objective Financial Statements Accounting Policies Auditor’s Report Comparative Information Recast FS

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**Clarify the Decision Focus**

The starting point is to be clear about what decisions are to be made as a result of the financial statement analysis Possible decisions are: share investment decisions lending decisions contractual decisions regulatory decisions Each type of decision will require a somewhat different approach to the analysis and a different set of priorities

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**Clarify the Decision Focus (cont.)**

For example, a prospective investor in common shares will be concerned with the long-run profitability of the company (solvency and stability) Trade creditors will be primarily interested in the short-run liquidity (while still being interested in the long-term survival possibilities of the company) This difference in focus is illustrated by the fact that many creditors will continue to extend credit to a company with declining profitability that no objective investor would buy shares in

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**Examine the Auditor’s Report**

The auditor’s report should be reviewed with an eye to qualifications and to comments regarding accounting policies, if any The auditor’s report serves as an assurance that accounting policies are within the very broad framework of GAAP or a disclosed basis of accounting, that the statements are fairly stated (not materially misstated), and that an audit was performed using Generally Accepted Auditing Standards

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**Examine the Auditor’s Report (cont.)**

A public company must be audited and normally will have an unqualified audit opinion, which is often referred to as a “clean opinion” When an auditor is in serious disagreement with a company’s management about the suitability of its accounting policies and believes that the statements are misleading, the auditor will issue a reservation of opinion or an adverse opinion

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**Examine the Auditor’s Report (cont.)**

If a private company does not have an audit, an auditor may nevertheless be retained for a review engagement, in which a full audit is not performed but the auditor does review the financial statements for consistency with GAAP (or with disclosed basis of accounting) and for reasonableness of presentation

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**Examine Accounting Policies**

The essential first step in statement analysis is to fully understand the financial statements Meaningful analysis requires they be understood within the framework of management’s reporting objectives and accounting policies Clues to the accounting policies being used by management are found in the notes to the financial statements The policy note may give only sketchy information, but the notes relating to individual financial statement components may provide more useful information

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**Recast the Financial Statements**

It is often necessary for users to recast the financial statements to suit their needs before applying other analytical approaches Situations that suggest a needed restatement include the following: the income statement is revised to remove non-recurring gains and losses the income statement and balance sheet are revised to remove the effects of future income tax liabilities and assets

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**Recast the Financial Statements (cont.)**

the income statement and balance sheet are revised to reflect a different policy on capitalization of certain costs: capitalized costs are shifted to the income statement in the year they occurred, and amortization is removed expenditures charged directly to the income statement are removed, capitalized, and amortization is added.

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**Recast the Financial Statements (cont.)**

necessary recurring reinvestments are reclassified on the cash flow statement from investing activities to operations interest expense and taxes are removed from net income to yield a measure commonly referred to as EBIT (earnings before interest and taxes) loans to and from shareholders are reclassified as owners’ equity retractable preferred shares are reclassified as long-term debt

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**Seek Comparative Information**

Data is useless unless there is some basis for comparison Sometimes the comparison is with a mental data base accumulated by the analyst over years of experience in analyzing similar companies For less experienced analysts, empirical comparisons are necessary There are two bases for comparison: cross sectional longitudinal

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**Seek Comparative Information (cont.)**

Cross sectional comparisons analyze a company in relation to other companies in the same year Comparisons of this type frequently appear in articles in the business press that compare the recent performance of one company with its competitors Longitudinal comparisons look at a company over time, comparing this year’s performance with earlier years A comparison is often made to other companies or to general economic returns during the same time span

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**Apply Analytical Techniques**

The basic tool of numerical analysis is ratios A ratio is one number divided by another Two commonly cited types of ratios are vertical analysis or common-size analysis horizontal analysis or trend analysis

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**Apply Analytical Techniques (cont.)**

Vertical analysis (or common-size analysis): involves calculating financial statement components as a percentage of a total, such as balance sheet amounts as a percent of total assets Vertical analysis is useful for removing the effects of absolute changes in amounts; changes in the relative composition of balance sheet and income statement components become more readily apparent

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**Apply Analytical Techniques (cont.)**

Horizontal analysis (or trend analysis): involves calculating individual financial statement components over several years as an index number, with a base year set at 100 Horizontal analysis is used to determine the relative change in amounts between years Obvious calculations include the trend of sales over time and the trend of net income over time

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Ratio Analysis Ratio analysis: compares the proportional relationship between different items within a single year’s financial statements There are literally dozens of ratios that can be computed from a single year’s financial statements The important task for an analyst is to focus on the ratios that have primary meaning for the decision at hand

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Ratio Analysis (cont.) There are many ways of grouping ratios but we will group our ratios as follows: profitability ratios efficiency ratios solvency ratios liquidity ratios

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Profitability Ratios Profitability ratios: those that compare a measure of earnings (the numerator) to a measure of investment (the denominator) Some types of profitability ratios: capital employed or total capitalization return on long-term capital, before taxes return on long-term capital, after taxes return on total assets, before taxes return on total assets, after taxes return on gross assets, after tax

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**Exhibit 23-5 Summary of Profitability Ratios**

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**Exhibit 23-5 Summary of Profitability Ratios**

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**Components of Profitability Ratios**

Ratios are based on accounting numbers that are the result of the company’s accounting policies and that include the effects of many estimates made by management Despite the fact that ratios can be computed to many decimals, they really are very approximate measures that must be interpreted with extreme caution

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Efficiency Ratios Efficiency ratios: ratios that attempt to measure selected aspects of the company’s operational efficiency e.g., inventory turnover or the accounts receivable collection period Efficiency ratios must be used with great caution by an external analyst because the balance sheet amounts may not be typical of the balances throughout the period

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**Efficiency Ratios (cont.)**

Some types of efficiency ratios are: asset turnover ratios accounts receivable turnover inventory turnover the average collection period of accounts receivable accounts receivable aging schedule

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**Exhibit 23-6 Summary of Eficiency Ratios**

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**Exhibit 23-6 Summary of Eficiency Ratios**

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Solvency Ratios Solvency ratio: the basic objective is to assess the ability of the company to make both the interest and principal payments on its long-term debt Ratios can be further classified as: leveraged ratios debt service ratios

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**Solvency Ratios (Cont.)**

Leveraged ratios: measure the relative amount of the company’s financing that was obtained through debt Leverage: the extent to which a company uses fixed term obligations to finance its assets The most basic measure of leverage is debt-to-equity ratio

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**Solvency Ratios (cont.)**

Debt service ratios: test the ability of the company to generate sufficient cash flow from operations to pay the debt interest or the debt interest plus principal payments A traditional ratio used in solvency analysis is the times interest earned ratio A broader debt service ratio is times debt service earned that includes the amount of interest to be paid, and the amount of principle payments to be made

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**Exhibit 23-7 Summary of Solvency Ratios**

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**Exhibit 23-7 Summary of Solvency Ratios**

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Liquidity Ratios Liquidity ratios: ratios that test the company’s ability to cover its short-term obligations with its existing monetary assets Some types of liquidity ratios are: current ratio quick ratio defensive-interval ratio

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**Exhibit 23-8 Summary of Liquidity Ratios**

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**Consolidated Statements**

Many Canadian corporations, whether incorporated federally or provincially, operate through a series of subsidiaries Canadian GAAP provides that the primary statement for a company with subsidiaries is the consolidated financial statements, wherein all of the assets, liabilities, revenues, and expenses of all of the companies in the group are combined Investors in the parent want to see consolidated statements Creditors want to see separate company statements

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**Multi-Industry Corporations**

Many corporations engage in several lines of business Because they have a broad spectrum of activities, they cannot be classified as being in a specific industry Since industry comparisons are a common aspect of financial statement analysis (and particularly of ratio analysis), the inability to slot many corporations into a specific industry classification may appear to create a problem for the analyst

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**Multi-Industry Corporations (cont.)**

Risks often differ by industry Public companies are required to provide segment reporting as supplementary information in their annual financial statements The volume of activity is reported both by industry and by geographic region

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**Conclusion: Observations on Ratio Analysis**

Ratios are only as good as the underlying data Analyze the correct set of financial statements: consolidated or separate-legal-entity Financial statements adjust to suit the analyst’s needs before meaningful ratio analysis can be performed There is no assurance that the industry averages (or quartiles) are “right” or are based on similar accounting policies and measurements

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**Conclusion: Observations on Ratio Analysis (cont.)**

Assessments of profitability, solvency, and liquidity are not really industry-dependent, but they do depend to some extent on an analysis of risk for each line of business There is no point in computing masses of ratios; it is more important to identify one or two key ratios in each category that are relevant Given the many estimates and approximations underlying both the numerator and denominator of all ratios, it is absurd to calculate them to more than two significant digits

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Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University Chapter 15 Financial Statement Analysis.

Prepared by: C. Douglas Cloud Professor Emeritus of Accounting Pepperdine University Chapter 15 Financial Statement Analysis.

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