A Framework for Financial Statement Analysis Chapter 11

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

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.

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

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:

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

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

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.)

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

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

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

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

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

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

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.

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.

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.

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

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.

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.

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

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

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

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

Liquidity Ratios The following are commonly used liquidity ratios:

Liquidity Ratios The following are commonly used liquidity ratios:

Liquidity Ratios The following are commonly used liquidity ratios:

Liquidity Ratios The following are commonly used liquidity ratios:

Liquidity Ratios The following are commonly used liquidity ratios:

Profitability Ratios Profitability ratios measure how profitable a firm is.

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

Profitability Ratios The following are commonly used profitability ratios:

Profitability Ratios The following are commonly used profitability ratios:

Profitability Ratios The following are commonly used profitability ratios:

Profitability Ratios The following are commonly used profitability ratios:

Profitability Ratios The following are commonly used profitability ratios:

Profitability Ratios The following are commonly used profitability ratios:

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

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

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

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

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.

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

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

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

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

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

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

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.

Investor Ratios The following are commonly used investor ratios:

Investor Ratios The following are commonly used investor ratios:

Investor Ratios The following are commonly used investor ratios:

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

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

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

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

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

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

Financial Statement Analysis Framework Calculate the basic liquidity ratios.

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

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

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

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

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

Limitations of Financial Statement Analyses GAAP presents some limits.

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

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

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.

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.

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

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

A Framework for Financial Statement Analysis End of Chapter 11