Financial Statement Analysis for

							     CHAPTER 13
Financial Statement Analysis
    Financial Statement Analysis
   External users and
    analysts rely on
    publicly-available
    information to
    perform financial
    analysis
   Such information is
    contained in
    corporate annual
    report
       Annual Report Contents
 FOUR BASIC FINANCIAL STATEMENTS

   FOOTNOTES TO THE FINANCIAL      1
         STATEMENTS
                                   2
 SUMMARY OF ACCOUNTING METHODS
                                   3
 MANAGEMENT’S DISCUSSION AND       4
ANALYSIS OF FINANCIAL STATEMENTS
                                   5
        AUDITOR’S REPORT           6

COMPARATIVE FINANCIAL DATA FOR A
       SERIES OF YEARS
    Tools to Evaluate Financial
            Information

               Horizontal Analysis

1

2               Vertical Analysis
3

                 Ratio Analysis
        Horizontal Analysis
 Examines percentage change in
  each item on the financial
  statements
 Compares current year’s dollar
  amount with prior year’s dollar
  amount
 Expresses the change in
     Dollars
     Percentage
     Look at Exhibit 13-3, Pg. 610
Horizontal - Trend Percentages
   Specialized form
    of horizontal
    analysis
   Shows trend of
    financial
    statement items
    over longer time
    periods such as 5
    or 10 years
    Vertical Analysis




2         Vertical Analysis
               Vertical Analysis
 Compares each item on the financial
  statement to a key, or base, item
 Base-item dollar amount always set to 100%
 Produces ―common-size‖ statements
 Income statement
       Net sales = 100%
   Balance sheet
     Total assets = 100%
     Look at exhibit 13-4, Pg 612 and 13-5, Pg 613
Benchmarking Against the
    Industry Average



  Benchmarking is a term used to
describe the process of comparing a
company’s activities to a standard of
  excellence achieved by industry
              leaders
Benchmarking Against Key
      Competitors

 A company also can compare its
  common-size financials to those of
  its industry’s leaders
 Determine where it differs
 Design and implement business
  processes to bring financial results in
  line with these benchmark entities
    Using Ratios to Make Business
              Decisions




3
                 Ratio Analysis
Using Ratios to Make Business
          Decisions
 Ratios - the relationship between two
  items on financial statements - permit
  users to calculate a variety of financial
  comparisons
 These ratios can be compared to:
 Prior years’ financial results
 Industry averages
 Benchmark entities’ ratios
Using Ratios to Make Business
          Decisions

 Ratios measure an entity’s ability to:
  Pay current liabilities
  Sell inventory and collect receivables
  Pay long-term debt
  Generate profits from operations
  Sustain shareholder wealth
      Ratios in Chapter 13

Overview,
 pp. 630
Decision
 guidelines
 lists all ratios
             Ratio analysis
 The current ratio is a ratio of the current
  assets to the current liabilities. Acceptable
  current ratios vary from industry to
  industry, but the norm for most companies
  is between 1.6 and 1.9.
 There are five categories of current
  assets that are listed in order of their
  liquidity: Cash, Short-term Investments,
  Receivables, Inventory, and Prepaid
  Expenses.
             Ratio analysis
 The acid-test (quick) ratio measures the
  quick assets—cash, short-term
  investments, and receivables—to current
  liabilities. This ratio excludes inventory and
  prepaid expenses because these current
  assets are the least liquid current assets.
 Certain ratios measure the firm’s ability to
  sell inventory and collect receivables, a
  key factor in a firm’s success.
                Ratio analysis
   Inventory turnover measures how many times
    a year the company sells its average level of
    inventory. A high turnover indicates relative ease
    of selling inventory, while a low turnover
    indicates relative difficulty of selling inventory.
   Accounts receivable turnover measures how
    quickly the firm collects cash from credit
    customers. The higher the ratio, the more
    quickly a firm collects its receivables.
   Days’ sales in receivables is the number of
    days’ sales that remain uncollected.
                Ratio analysis
Suppose you were analyzing Company A and Company B
  and the two companies reported the following:
  Company A                    Company B
  Current assets $10,000       $10,000,000
  Current liabilities 5,000       9,995,000
  Working capital $ 5,000      $       5,000

Both companies have identical working capital, but which
  company has a better ability to pay its short-term debt?
Company A, because the ratio of the current assets to
  current liabilities is higher for Company A. Working
  capital is not a ratio; it does not calculate the relative
  size of the current assets to current liabilities. The
  current ratio provides a better understanding of the two
  companies’ liquidity.
Current ratio of A is 2 ($10,000  $5,000) Current ratio of
  B is 1.001 ($10,000,000  $9,995,000)
            Ratio analysis
 Not all ratios apply to all companies. For
  example, inventory turnover would not be
  applicable to a service company
 Sharp changes in ratios indicate that
  something significant has happened, but
  the manager must analyze the change to
  determine what has occurred and what
  corrective action must be taken.
Analyzing the Company’s Stock
       as an Investment
                  Financial analysts
                   use several ratios
                   to assess value of
                   stock investments:
                  Price/earnings
                   ratio
                  Dividend yield
                  Book value
                   (covered in
                   chapter 9)
        Earnings Per Share

   Most widely quoted of all
    financial statistics
   Computed by dividing net income
    available to common stockholders by the
    number of common shares outstanding
    during the year
   = Net Income – Preferred Dividends
        Number of common shares
              outstanding
       Price/Earnings Ratio

   Decision to buy, hold, or sell
    stock
   Relationship between a stock’s market
    price and its earnings per share
   Measures the number of times one
    share of stock sells above the current
    period’s reported earnings
   Widely published in The Wall Street
    Journal
          Price/Earnings Ratio
                               Suppose the
                                market value of
                                Asian Art, Inc.,
Calculating the P/E ratio
                                common stock is
                                $15.75 on the last
 Market value of stock
                                day of its fiscal
  Earnings per share
                                year
                               The income
                                statement reports
                                EPS of $.92
                               What is Asian Art’s
                                price/earnings
                                ratio?
Price/Earnings Ratio Example
      Market value of stock
       Earnings per share

             $15.75
              $.92

            = 17.12
            Dividend Yield
 Ratio of dividends per share of stock to the
  stock’s market value
 Indicates the percentage of a stock’s
  market value ―returned‖ to the stockholder
  in the form of dividends
 Assists investors who desire a steady flow
  of dividend revenue in their decisions to
  invest in a particular stock
             Dividend Yield

          Annual dividends per share
         Stock’s market value per share

   Example: If Asian Art paid a total of $1.25
    in dividends per share, what would be its
    dividend yield, assuming the same market
    value for its stock ($15.75)?
     Dividend Yield
 Annual dividends per share
Stock’s market value per share

           $1.25
           $15.75

           = .079
Limitations of Financial Analysis
 No one ratio or year’s worth of financial
  information should be relied upon to provide a
  complete assessment of a corporation’s financial
  condition
 Ratio analysis is most helpful when calculated
  over a broad time frame and when used in
  conjunction with other relevant information that
  can affect a company, such as legislation,
  competition, and scandals.
Analysts should:
 Examine trends over time
 Benchmark to industry and key competitors
 Seek answers about why ratios are different
End of
Lecture