1. Chapter 5: Using Financial Statement Information

2. Control and Prediction
Financial accounting numbers are useful in two fundamental ways:
They help investors and creditors influence and monitor the business decisions of a company’s managers.
They help to predict a company’s future earnings and cash flows.

3. Book Value vs. True Value
Financial statements do not reflect the company’s prospects within its business environment
Statements are backward looking, not focusing on the future prospects.
Financial statements are inherently limited
Statements leave out some current and historical information such as human resources and the effects of inflation.
Management prepares the financial statements in a biased manner
Managers often choose accounting methods and estimates that make them look good.

4. Framework for Financial Statement Analysis
Book Value
Add adjustments for:
(1) business environment
(2) unrecorded events
(3) management bias
= True Value

5. Five Steps of Financial Statement Analysis
Assessing the business environment.
Reading and studying the financial statements and footnotes.
Assessing earnings quality.
Analyzing the financial statements.
Predicting future earnings and/or cash flow.

6. Assessing the Business Environment
What is the nature of the company’s operations?
What strategy is being employed to generate profits?
What is the company’s industry?
Who are the major players? Competition?
What are the relationships between the company and its customers and suppliers?
How are the company’s sales and profits affected by changes in the economy?

7. Reading and Studying the Financial Statements and Notes
Read the audit report.
Identify significant transactions
major acquisitions, discontinuance or disposal of a business segment, unresolved litigation, major write-downs of receivables or inventories, etc.
Read the financial statements and footnotes.

8. Assessing Earnings Quality
Earnings quality may be affected by a number of strategies managers use to influence accounting numbers. Four major strategies are discussed:
Overstating operating performance
Taking a bath
Creating hidden reserves
Employing off-balance-sheet financing

9. Assessing Earnings Quality
Overstating operating performance through the acceleration of recognition of revenue - shift the timing of revenue from a future period to the current period, through legitimate or questionable activities.
Overstating operating performance through the allocation and estimation of expenses - shift the recognition of expenses through the use of “taking a bath” and “creating hidden reserves.”

10. Assessing Earnings Quality
Taking a bath (also called “big bath”) - large losses and expenses this year may increase income in future years.
Rationale: if the current year is going to be disappointing to investors anyway, increase the loss to make next year look better. For example:
Excessive write downs of equipment will lead to lower depreciation expense in future years.
Excessive write down of inventory will lead to lower cost of goods sold next year.

11. Assessing Earnings Quality
Creating hidden reserves - expenses may be shifted from one year to another year by overestimating expense accrual.
Excessive bad debt expense or warranty expense in the current year will lead to reduced estimates in future years, as the “reserve” is used up.
Note that these “reserves” have nothing to do with cash reserves; they simply reserve some of the “income” to future periods.

12. Assessing Earnings Quality
Employing off-balance-sheet financing - this relates to certain economic transactions that are not reflected in the balance sheet.
Managers prefer to keep certain liabilities off the balance sheet when GAAP permits it, primarily because of potential debt covenant violations, and because of the effect on certain ratios.
Examples include:
treatment of leases as operating leases (Radio Shack)
unconsolidated investments (Enron’s “partnerships”) which do not separate assets from liabilities.

13. Analyzing the Financial Statements
Comparisons across time
Comparisons within the industry
Comparisons within the financial statements: common-size statements and ratio analysis
Profitability ratios
Leverage ratios
Solvency ratios
Asset turnover ratios
Market ratios

14. Comparisons Across Time
Financial accounting numbers can be made more meaningful if they are compared across time.
GAAP require side-by-side comparison of the current and the preceding years in published financial reports.

15. Comparisons Within the Industry
Financial accounting numbers can also be made more meaningful if they are compared to those of similar companies.
Comparison of financial accounting numbers with industry averages is also helpful.
Sources of industry information include:
Dun & Bradstreet
Robert Morris Associates
Moody
Standard & Poor

16. Comparisons Within the Financial Statements
Common-size financial statements
Ratio analysis
Profitability ratios
Leverage ratios
Solvency ratios
Asset turnover ratios
Market ratios

17. Common-Size Income Statement for La-Z-Boy, Inc. (Figure 5-2)
Income Statement (in millions) % %
Net sales $2, $2,
Cost of sales (1,617) (1,692) 79
Expenses and charges (459) (400) 18
Net income $ $
On the income statement, cost of goods sold, expenses, and net income are often expressed as percentages of net sales.
On the balance sheet, assets and liabilities can be expressed as percentages of total assets.

18. Profitability Ratios
These ratios are designed to measure a firm’s earnings power.
Net income, the primary measure of the overall success of a company, is compared to other measures of financial activity or condition to assess performance as a percent of some level of activity or investment.

19. Profitability Ratios Return on Net Income
Equity Average Stockholders’ Equity
This ratio measures the effectiveness at managing capital provided by the shareholders.

20. Profitability Ratios
Return on Net Income + Interest Expense (1-tax rate)
Assets Average Total Assets
This ratio measures the effectiveness at managing capital provided by all investors (stockholders and creditors).

21. Profitability Ratios
Return on Net Income + Interest Expense (1-tax rate)
Sales Net Sales
This ratio provides an indication of a company’s ability to generate and market profitable products and control its costs; also called the Profit Margin.

22. Leverage Ratios
Leverage refers to using borrowed funds to generate returns for stockholders.
Leverage is desirable because it creates returns for stockholders without using any of their money.
Leverage increases risk by committing the company to future cash obligations.

23. Leverage Ratios Common Net Income
Equity Net Income + Interest Expense (1-tax rate)
Leverage
This ratio compares the return available to the stockholders to returns available to all capital providers.

24. Leverage Ratios Capital Average Total Assets
Structure Average Stockholders’ Equity
Leverage
This ratio measures the extent to which a company relies on borrowings (liabilities).

25. Leverage Ratios Debt to Equity Average Total Liabilities
Ratio Average Stockholders’ Equity
This ratio compares liabilities to stockholders’ equity and is another measure of capital structure leverage.

26. Leverage Ratios Long-term Long-Term Debt Debt Ratio Total Assets
This ratio measures the importance of long-term debt as a source of asset financing.

27. Solvency Ratios
Solvency refers to a company’s ability to meet its current debts as they come due.
There is pressure on companies with high levels of leverage to manage their solvency.

28. Solvency Ratios Current Current Assets Ratio Current Liabilities
This ratio measures solvency in the sense that current assets can be used to meet current liabilities.

29. Solvency Ratios Quick Cash + Marketable Securities + A/R
Ratio Current Liabilities
Similar to the current ratio, this ratio provides a more stringent test of a company’s solvency.

30. Solvency Ratios Interest Net Income + Tax Expense + Interest Expense
Coverage Interest Expense
This ratio compares the annual funds available to meet interest to the annual interest expense.

31. Solvency Ratios Accounts Cost of Goods Sold
Payable Average Accounts Payable
Turnover
This ratio measures the extent to which accounts payable is used as a form of financing.

32. Asset Turnover Ratios
Asset turnover ratios are typically computed for total assets, accounts receivable, inventory, and fixed assets.
These ratios measure the speed with which assets move through operations or reflect the number of times during a given period that these specific assets are acquired, used, and replaced.

33. Asset Turnover Ratios Receivables Net Credit Sales
Turnover Average Accounts Receivable
This ratio reflects the number of times the trade receivables were recorded, collected, and recorded again during the period.

34. Asset Turnover Ratios Inventory Cost of Goods Sold
Turnover Average Inventory
This ratio measures the speed with which inventories move through operations.

35. Asset Turnover Ratios Fixed Assets Sales Turnover Average Fixed Assets
This ratio measures the speed with which fixed assets are used up.

36. Asset Turnover Ratios Total Asset Sales Turnover Average Total Assets
This ratio measures the speed with which all assets are used up in operations.

37. Market Ratios
These additional ratios are used by the financial community to assess company performance.

38. Market Ratios Earnings Net Income per Average Number of Common Shares
Share Outstanding
This ratio, according to the financial press, is the primary measure of a company’s performance. It calculates the amount of income that is earned for each shareholder.

39. Market Ratios Price/Earnings Market Price per Share
Ratio Earnings per Share
This ratio is used by many analysts to assess the investment potential of common stocks.

40. Market Ratios Dividend Yield Dividends per Share
Ratio Market Price per Share
This ratio indicates to cash return on the stockholders’ investment.

41. Market Ratios Stock Market Price1 - Market Price0 + Dividends
Return
This ratio measures the pretax performance of an investment in a share of common stock.

42. Solvency Assessment (Figure 5A-3)
Ability to Generate Cash
Cash Requirements
Operating Performance
Operating Revenue
Sale of Goods
Sale of Service
Creation of Operating Receivables
(timing difference)
Cash Inflows from Operations
Operating Costs
Cost of Goods Sold
Operating Expense
Creation of Operating Payables
(timing difference)
Cash Outflows from Operations
Financial Flexibility
and Liquidity
Ability to create short-term debt
Ability to create long-term debt
Ability to issue equity
Ability to liquidate assets
Payments for short-term debt
Payments for long-term debt
Payments for dividends
Payments for asset replacement
Timing of Cash Inflows
Timing of Cash Outflows