Understanding Financial Statements EIGHTH EDITION

1. Understanding Financial Statements EIGHTH EDITION Lyn M. Fraser Aileen Ormiston

2. The Analysis of Financial Statements Ratios are tools and their value is limited when used alone. The more tools used, the better the analysis. For example, you can’t use the same golf club for every shot and expect to be a good golfer. The more you practice with each club, however, the better able you will be to gauge which club to use on one shot. So to, we need to be skilled with the financial tools we use. - Diane Morrison - CEO, R.E.C. Inc. (C) 2007 Prentice Hall, Inc.

3. The Analysis of Financial Statements(cont.) This chapter will develop tools and techniques for the interpretation of financial statement information (C) 2007 Prentice Hall, Inc.

4. Objectives of Analysis Remember--the identity of the user helps define what information is needed Objectives will vary depending on the • perspective of the financial statement user • specific questions that are addressed by the analysis (C) 2007 Prentice Hall, Inc.

5. Objectives of Analysis(cont.) Creditors Investors Management Potential Financial Statement Users: What types of questions do each of these users seek answers to? (C) 2007 Prentice Hall, Inc.

6. Creditors A creditor is ultimately concerned with the ability of an existing or prospective borrower to make interest and principal payments on borrowed funds (C) 2007 Prentice Hall, Inc.

7. Creditors(cont.) • What is the borrowing cause? • What is the firm’s capital structure? • What will be the source of debt repayment? Questions raised in a credit analysis should include: (C) 2007 Prentice Hall, Inc.

8. Investors An investor attempts to arrive at an estimation of a company’s future earnings stream in order to attach a value to the securities being considered for purchase or liquidation (C) 2007 Prentice Hall, Inc.

9. Investors(cont.) The investment analyst poses questions as: • How has the firm performed/what are future expectations? • How much risk is inherent in the existing capital structure? • What are expected returns? • What is firm’s competitive position? (C) 2007 Prentice Hall, Inc.

10. Management Management relates to all questions raised by: Creditors Investors Employees General public Regulators Financial press (C) 2007 Prentice Hall, Inc.

11. Management(cont.) • How well the firm has performed and why? • What operating areas have contributed to success and which have not? Looks to financial statement data to determine: (C) 2007 Prentice Hall, Inc.

12. Management(cont.) • What are strengths/weaknesses of company’s financial position? • What changes should be implemented to improve future performance? Looks to financial statement data to determine: (C) 2007 Prentice Hall, Inc.

13. 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 other sources of information apart from the Annual Report prepared by management (C) 2007 Prentice Hall, Inc.

14. Sources of Information The analyst will want to consider the following resources: Proxy Statement Auditor’s Report MD&A Supplementary schedules Form 10-K and Form 10-Q (C) 2007 Prentice Hall, Inc.

15. Other Sources of Information • Computerized data bases • Info on industry norms/ratios • Info on particular companies/industries • Ever-expanding financial and investment websites • Articles in popular/business press (C) 2007 Prentice Hall, Inc.

16. Tools and Techniques These include: Common-size financial statements Financial ratios Trend analysis Structural analysis Industry comparisons Most important: Common sense and judgment (C) 2007 Prentice Hall, Inc.

17. Common-Size Financial Statements Express each account on the • balance sheet as a percentage of total assets • income statement as a percentage of net sales (C) 2007 Prentice Hall, Inc.

18. Key Financial Ratios Standardize financial data in terms of mathematical relationships expressed in the form of Percentages Times Days (C) 2007 Prentice Hall, Inc.

19. Key Financial Ratios(cont.) • Liquidity Ratios Measure a firm’s ability to meet cash needs as they arise Four Categories of key financial ratios: (C) 2007 Prentice Hall, Inc.

20. Key Financial Ratios(cont.) • Activity Ratios Measure the liquidity of specific assets and the efficiency of managing assets Four Categories of key financial ratios: (C) 2007 Prentice Hall, Inc.

21. Key Financial Ratios (cont.) Four Categories of key financial ratios: • 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 (C) 2007 Prentice Hall, Inc.

22. Key Financial Ratios(cont.) Four Categories of key financial ratios: • Profitability Ratios Measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity (C) 2007 Prentice Hall, Inc.

23. Cautions! Ratios are valuable analytical tools and serve as screening devices, BUT. . . • They do not provide answers in and of themselves • They are not predictive (C) 2007 Prentice Hall, Inc.

24. Cautions! (cont.) • Ratios should be used with other elements of financial analysis • There are no “rules of thumb” that apply to the interpretation of ratios (C) 2007 Prentice Hall, Inc.

25. Cautions!(cont.) Keeping this in mind, let’s take a look at some of the ratios. . . . (C) 2007 Prentice Hall, Inc.

26. Liquidity Ratios: Short-Term Solvency Measures ability to meet short-term cash needs Current Ratio Current assets Current liabilities (C) 2007 Prentice Hall, Inc.

27. Liquidity Ratios: Short-Term Solvency (cont.) Measures ability to meet short-term cash needs more rigorously by eliminating inventory Quick or Acid-Test Ratio Current assets - Inventory Current liabilities (C) 2007 Prentice Hall, Inc.

28. Liquidity Ratios: Short-Term Solvency (cont.) Cash Flow Liquidity Ratio Focuses on ability of the firm to generate operating cash flows as a source of liquidity Cash + Marketable securities + CFO * Current liabilities *Cash flow from operating activities (C) 2007 Prentice Hall, Inc.

29. Liquidity Ratios: Short-Term Solvency (cont.) Average Collection Period Helps gauge liquidity of accounts receivable (ability to collect cash from customers) and may help provide information about a company’s credit policies Net accounts receivable Average daily sales (C) 2007 Prentice Hall, Inc.

30. Liquidity Ratios: Short-Term Solvency (cont.) Measures the efficiency of the firm in managing its inventory Days Inventory Held Inventory Average daily cost of sales (C) 2007 Prentice Hall, Inc.

31. Liquidity Ratios: Short-Term Solvency (cont.) Days Inventory Held: Example of ratio comparisons for two companies in the Electronic Computers industry* Current Yr. Prior Year2 Yrs. Prior 5 days 5 days 4 days Current Yr. Prior Year2 Yrs. Prior 23 days 22 days 15 days *Data from SEC website, www.sec.gov (C) 2007 Prentice Hall, Inc.

32. Liquidity Ratios: Short-Term Solvency (cont.) Offers insight into a firm’s pattern of payments to suppliers Days Payable Outstanding Accounts payable Average daily cost of sales (C) 2007 Prentice Hall, Inc.

33. Cash Conversion Cycle or Net Trade Cycle The normal cycle of a firm that consists of: • Buying or manufacturing inventory, with some purchases on credit • Selling inventory, with some sales on credit • Collecting the cash (C) 2007 Prentice Hall, Inc.

34. Cash Conversion Cycle or Net Trade Cycle(cont.) Helps the analyst understand why cash flow generation has improved or deteriorated by analyzing: Key balance sheet accounts that affect cash flow from operating activities • Accounts Receivable • Inventory • Accounts Payable (C) 2007 Prentice Hall, Inc.

35. Cash Conversion Cycle or Net Trade Cycle(cont.) Calculated as follows: Average collection period Plus Days inventory held Minus Days payable outstanding Equals Cash conversion or net trade cycle (C) 2007 Prentice Hall, Inc.

36. Activity Ratios: Asset Liquidity, Asset Management Efficiency Accounts Receivable Turnover Another measure of efficiency of firm’s collection and credit policies Net sales Net accounts receivable (C) 2007 Prentice Hall, Inc.

37. Activity Ratios: Asset Liquidity, Asset Management Efficiency(cont.) Another measure of firm’s efficiency in managing its inventory Inventory Turnover Cost of goods sold Inventory (C) 2007 Prentice Hall, Inc.

38. Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Another way to gain insight into a firm’s pattern of payment to suppliers Payables Turnover Cost of goods sold Accounts payable (C) 2007 Prentice Hall, Inc.

39. Activity Ratios: Asset Liquidity, Asset Management Efficiency(cont.) Assesses effectiveness in generating sales from investments in fixed assets Fixed Asset Turnover Net sales Net property, plant, equipment (C) 2007 Prentice Hall, Inc.

40. Activity Ratios: Asset Liquidity, Asset Management Efficiency (cont.) Assesses effectiveness in generating sales from investments in all assets Total Asset Turnover Net sales Total assets (C) 2007 Prentice Hall, Inc.

41. Leverage Ratios: Debt Financing and Coverage Debt Ratio Considers the proportion of all assets that are financed with debt Total liabilities Total assets (C) 2007 Prentice Hall, Inc.

42. Leverage Ratios: Debt Financing and Coverage (cont.) Debt Ratio: Example of ratio comparisons for two companies in the Grain Mills industry* Current Yr. Prior Year 62.31% 69.93% Current Yr. Prior Year 79.08% 85.77% *Data from SEC website, www.sec.gov (C) 2007 Prentice Hall, Inc.

43. Leverage Ratios: Debt Financing and Coverage (cont.) Long-term Debt to Total Capitalization Reveals the extent to which long-term debt is used for the firm’s permanent financing (both long-term debt and equity) Long–term debt Long-term debt + Stockholders’ equity (C) 2007 Prentice Hall, Inc.

44. Leverage Ratios: Debt Financing and Coverage(cont.) Debt to Equity Measures the riskiness of the firm’s capital structure in terms of the relationship between the funds supplied by creditors (debt) and investors (equity) Total liabilities Stockholders’ equity (C) 2007 Prentice Hall, Inc.

45. Leverage Ratios: Debt Financing and Coverage(cont.) Indicates how well operating earnings cover fixed interest expenses Times Interest Earned Operating profit Interest expense (C) 2007 Prentice Hall, Inc.

46. Leverage Ratios: Debt Financing and Coverage(cont.) Cash Interest Coverage Measures how many times interest payments can be covered by cash flow from operations before interest and taxes CFO + interest paid + taxes paid Interest paid (C) 2007 Prentice Hall, Inc.

47. Leverage Ratios: Debt Financing and Coverage(cont.) Broader measure of how well operating earnings cover fixed charges Fixed Charge Coverage Operating profit + Rent expense Interest expense + Rent expense *Rent expense = operating lease payments (C) 2007 Prentice Hall, Inc.

48. Leverage Ratios: Debt Financing and Coverage (cont.) Cash Flow Adequacy Measures firm’s ability to cover capital expenditures, long-term debt payments and dividends each year Cash flow from operating activities Capital expenditures + debt repayments + dividends paid (C) 2007 Prentice Hall, Inc.

49. Profitability Ratios: Overall Efficiency and Performance Measures ability to translate sales into profit after consideration of cost of products sold Gross Profit Margin Gross profit Net sales (C) 2007 Prentice Hall, Inc.

50. Profitability Ratios: Overall Efficiency and Performance (cont.) Operating Profit Margin Measures ability to translate sales into profit after consideration of operating expenses Operating profit Net sales (C) 2007 Prentice Hall, Inc.