Analysis and Interpretation of Financial Statements Tools and concepts

2008International Business Program Financial Accounting 1 Learning Objectives Tools and concepts, uses, limitations Purposes of financial analysis Types – trends and cross sectional Liquidity and solvency analyses Operating performance analyses Investment analyses

2008International Business Program Financial Accounting 2 Financial Analysis and Interpretation Tools and concepts –What are tools?

2008International Business Program Financial Accounting 3 Financial Analysis and Interpretation Tools and concepts (continued) –What are tools? Items used to achieve some purpose They are NOT end results!!!!!!!!!!!!!!!!!! They are not precise They are only as good as the raw material from which they are derived Accounting information is based on estimates so tools are estimates

2008International Business Program Financial Accounting 4 Financial Analysis and Interpretation Tools and concepts (continued) –What are concepts?

2008International Business Program Financial Accounting 5 Financial Analysis and Interpretation Tools and concepts (continued) –What are concepts? Notions; general ideas Are NOT precise measurements!!!! Are NOT exact formulas to be memorized!!! Are EXAMPLES of what users of financial reports use in practice

2008International Business Program Financial Accounting 6 Financial Analysis and Interpretation Purpose of financial analysis and interpretation –Primary focus on investors; others find useful (e.g. creditors) –Primary interest is in value Have views of enterprise been borne out? Expectations about future

2008International Business Program Financial Accounting 7 Financial Analysis and Interpretation Two basic types of tools and approaches –Trends – same enterprise over time –Cross sectional – at single point in time, often in comparison with other enterprises –Users use combinations which vary among situations

2008International Business Program Financial Accounting 8 Financial Analysis and Interpretation Two basic types of tools and approaches - trends and cross sectional (continued) Lecture focuses on cross sectional –Why?

2008International Business Program Financial Accounting 9 Financial Analysis and Interpretation Two basic types of tools and approaches - trends and cross sectional (continued) Lecture focuses on cross sectional – Why? Trends adequately covered in textbook BUT, textbook has only EXAMPLES!!!! Trend follows logically after cross-sectional

2008International Business Program Financial Accounting 10 Financial Analysis and Interpretation Liquidity and solvency –What do terms mean?

2008International Business Program Financial Accounting 11 Financial Analysis and Interpretation Liquidity and solvency-meaning? –Liquidity – net liquid assets current –“Liquid” varies Generally cash and equivalents Assets becoming cash shortly ‘shortly’ varies. –Solvency–pay amounts when due –Can be un-liquid but solvent!!!!!!!!!!

2008International Business Program Financial Accounting 12 Financial Analysis and Interpretation Liquidity and solvency tools at point in time –Current ratio –Quick ratio –Cash ratio Many slight variations in computation

2008International Business Program Financial Accounting 13 Financial Analysis and Interpretation Liquidity and solvency tools— turnovers –Working capital to Sales-variations –Inventory turnover and days –Trade receivables turnover and days –Trade payables turnover and days

2008International Business Program Financial Accounting 14 Financial Analysis and Interpretation Liquidity and solvency tools—long term solvency and risk (gearing) –Debt ratio Debt ÷ total assets Debt ÷ liabilities + owners’ equity –Debt to owners’ equity –Assume debt and equity separate!!!

2008International Business Program Financial Accounting 15 Financial Analysis and Interpretation Operating performance –Return on investment (ROI) –Concept, not a computation –Relation of profit (can be estimated many ways) to invested capital (can be estimated many ways)

2008International Business Program Financial Accounting 16 Financial Analysis and Interpretation Operating performance –Possible ways to estimate profits Net income Income before minority interests Operating income (EBIT) EBITDA – discredited; not allowed to be reported in some countries (e.g. USA)

2008International Business Program Financial Accounting 17 Financial Analysis and Interpretation Operating performance (continued) –Return on assets (ROA or ROTA) Relates profit (computed various ways) to ASSETS Generally, how well enterprises uses its resources Use of EBIT in textbook is EXAMPLE

2008International Business Program Financial Accounting 18 Financial Analysis and Interpretation Operating performance –ROTA (continued) –Major strength is ability to decompose Margin on sales (income ÷ sales) Asset turnover (sales ÷ assets) –Widely used Anglo-Saxon concept

2008International Business Program Financial Accounting 19 Financial Analysis and Interpretation Operating performance – (continued) –Return on Equity (ROE) Income ÷ Owners’ equity EAT in text is an EXAMPLE!!!! Minority interest often excluded from both numerator and denominator

2008International Business Program Financial Accounting 20 Financial Analysis and Interpretation Operating performance – ROE (continued) –Indicator of use of shareholders’ investment –Indicator of increase in shareholder value

2008International Business Program Financial Accounting 21 Financial Analysis and Interpretation Operating performance – ROE (continued) –Compare with ROA to assess consequences of gearing –Assumes that owners’ equity can be separated from debt!!!!!!!!!!!!!!

2008International Business Program Financial Accounting 22 Financial Analysis and Interpretation Investment ratios –Earnings per share (EPS) Very complex computations Focus on understanding and interpreting, not computing Assumes owners’ equity is separate from debt Useful only if shares widely held

2008International Business Program Financial Accounting 23 Financial Analysis and Interpretation Investment ratios-EPS (continued) –Basic – profit ÷ average shares –Eliminate minority interest and preference dividends –Average shares adjusted for bonus and splits

2008International Business Program Financial Accounting 24 Financial Analysis and Interpretation Investment ratios-EPS (continued) –Diluted – assumes all possible future shares from conversions and options become issued –Worst case scenario –Hypothetical!!!!!!!!!!!!!!!

2008International Business Program Financial Accounting 25 Financial Analysis and Interpretation Investment ratios-others –Price earnings –Dividend ratios –Market to book See textbook Not widely used in Europe (but may be in the future)