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Chapter 5_ Instructor and Student Version.ppt


									       Chapter 5:

Using Financial Statement

         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.

       Book Value vs. True Value
 Financial statements do not reflect the
  company’s prospects within its business
   – 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.
       Framework for
Financial Statement Analysis

          Book Value

    Add adjustments for:
    (1) business environment
    (2) unrecorded events
    (3) management bias

          = True Value
            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

       Assessing the Business
 What is the nature of the company’s
 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?
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

      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
    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.”

      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
   – Excessive write downs of equipment will
     lead to lower depreciation expense in future
   – Excessive write down of inventory will lead
     to lower cost of goods sold next year.
     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.

      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
   – unconsolidated investments (Enron’s
     “partnerships”) which do not separate assets
     from liabilities.

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

    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.

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

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

 Common-Size Income Statement
  for La-Z-Boy, Inc. (Figure 5-2)
Income Statement (in millions)  2003 %       2002   %
   Net sales                   $2,112 100   $2,154 100
   Cost of sales               (1,617) 77   (1,692) 79
   Expenses and charges          (459) 21     (400) 18
   Net income                  $ 36     2   $ 62     3

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.

           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

         Profitability Ratios

Return on              Net Income
 Equity        Average Stockholders’ Equity

This ratio measures the effectiveness at
managing capital provided by the shareholders.

                 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).

                  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.

           Leverage Ratios
 Leverage refers to using borrowed
  funds to generate returns for
 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.

                    Leverage Ratios
Common                   Net Income
Equity       Net Income + Interest Expense (1-tax rate)

This ratio compares the return available to the
stockholders to returns available to all capital providers.

               Leverage Ratios
Capital              Average Total Assets
Structure         Average Stockholders’ Equity

This ratio measures the extent to which a company
relies on borrowings (liabilities).

                   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.

             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.

           Solvency Ratios

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

               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.

                 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.

                   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.

                Solvency Ratios
Accounts            Cost of Goods Sold
Payable           Average Accounts Payable

This ratio measures the extent to which accounts
payable is used as a form of financing.

       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.

          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.

         Asset Turnover Ratios
Inventory         Cost of Goods Sold
Turnover           Average Inventory

This ratio measures the speed with which
inventories move through operations.

            Asset Turnover Ratios
Fixed Assets           Sales
  Turnover        Average Fixed Assets

This ratio measures the speed with which fixed assets
are used up.

          Asset Turnover Ratios
Total Asset             Sales
 Turnover         Average Total Assets

This ratio measures the speed with which all assets
are used up in operations.

              Market Ratios

   These additional ratios are used by the
    financial community to assess company

                 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.

                    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.

                 Market Ratios
Dividend Yield       Dividends per Share
    Ratio           Market Price per Share

This ratio indicates to cash return on the
stockholders’ investment.

                    Market Ratios
Stock       Market Price1 - Market Price0 + Dividends
Price                    Market Price0

This ratio measures the pretax performance of an
investment in a share of common stock.

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

  Timing of Cash Inflows             Timing of Cash Outflows

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