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

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

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

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?

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?

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?

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

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...

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

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

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

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

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

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….

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

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

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

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

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

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…...

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

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

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

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!)

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

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

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

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

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…...

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?

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?...

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?

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

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?

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...

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

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!