UNDERSTANDING FINANCIAL STATEMENTS

THE ANALYSIS OF FINANCIAL STATEMENTS

Fraser & Ormiston Chapter 5

Overview of Financial Analysis

First order of business is to SPECIFY THE OBJECTIVES OF THE ANALYSIS Focus on WHO is the financial statement user Remember -- the identity of the user helps define what information is needed

Potential Financial Statement Users:

Creditors Investors Managers What types of questions do each of these users seek answers to?

Creditors
Why does the firm want/need to borrow funds? What is the firms capital structure? How leveraged are they? How will they pay it back? What kind of cash flows are being generated by operations?

Investors
How has the firm performed/what are future expectations? How much RISK is inherent in the capital structure? What are expected returns from the firm? What is firms competitive position?

Managers
Need all info creditors and investors need PLUS: What operating areas have contributed to success and which have not? What are strengths/weaknesses of companys financial position? What changes are indicated to improve future performance?

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 information apart from Annual Report prepared by management

Where to look for data...

Financial statements (and notes) Auditors report MD&A Supplementary schedules

All of the above are in Annual Report -can also look further...

Other Data Sources

10K and 10Q reports filed with SEC Computerized data bases
Info on industry norms/ratios Info on particular companies/industries/mutual funds

Articles in popular/business press Ever-expanding websites

Basic Tools
Common size financial statements Financial ratios Trend analysis Structural analysis Industry comparisons Common sense and judgment (often the hardest to use!)

Common Size Statements

Common size income statement
expresses each income statement category as a percentage of net sales

Common size balance sheet

expresses each item on balance sheet as a percentage of total assets or equities

Both statements facilitate structural analysis of the firm

Financial Ratio Categories

Liquidity Ratios
measure a firms ability to meet cash needs as they arise

Activity Ratios
measure the liquidity of specific assets and the efficiency of managing assets

Ratio Categories (continued)

Leverage Ratios
measure the extent of a firms financing with debt relative to equity and its ability to cover interest and other fixed charges

Profitability Ratios
measure the overall performance of a firm and its efficiency in managing assets, liabilities and equity

Caution!!!!!!
Ratios are valuable, BUT..
They do not provide answers in an of themselves and are not predictive They should be used with other elements of financial analysis There are no rules of thumb that apply to interpretation of ratios

KEEPING THIS IN MIND, LETS TAKE A LOOK AT SOME OF THE RATIOS.

Liquidity Ratios
Current Ratio
Current Assets/Current Liabilities Measures ability to meet short-term cash needs

Quick or Acid Test Ratio

Current Assets-Inventory/Current Liabilities Measure ability to meet short-term cash needs more rigorously

Liquidity Ratios (continued)

Cash Flow Liquidity Ratio
Cash+Marketable Securities+Cash Flow from Operating Activities/Current Liabilities Focuses on ability of the firm to generate operating cash flows as a source of liquidity

Activity Ratios
Average Collection Period
Accounts Receivable/Average Daily Sales Helps gauge liquidity of accounts receivable (ability to collect cash from customers)

Accounts Receivable Turnover

Net Sales/Accounts Receivable Another measure of efficiency of firms collection and credit policies

Activity Ratios (continued)

Inventory Turnover
Cost of Goods Sold/Inventory Measures efficiency of inventory management

Fixed Asset and Total Asset Turnover

Net Sales/Net PP&E (Fixed Asset T/O) Net Sales/Total Assets (Total Asset T/O) Both assess effectiveness in generating sales from investment in assets

Leverage: Debt Ratios

Debt Ratio
Total Liabilities/Total Assets

Long-Term Debt to Total Capitalization

Long-term Debt/Long-term Debt + Stockholders Equity

Debt to Equity Ratio

Total Liabilities/Stockholders Equity

All three measure extent of firms financing with debt

Leverage: Coverage Ratios

Proportion and amount of debt in capital structure is important to analyst Tradeoff between risk and return Use of debt involves risk -- commitment to fixed charges Fixed charges must be COVERED -following are some ratios to assess coverage...

Coverage Ratios (continued)

Times Interest Earned
Operating Profit/Interest Expense Indicates how well operating earnings cover fixed interest charges

Fixed Charge Coverage

Operating Profit + Lease Payments/Interest Expense + Lease Payments Broader measure of how well operating earnings cover fixed charges

Coverage Ratios (continued)

Cash Flow Adequacy
Cash Flow from Operating Activities/ Average Annual Long-Term Debt Maturities Measures firms ability to cover long-term debt maturities each year Rationale is that over the long-run operating cash flows must be adequate to cover investing activities financed with debt

Profitability Ratios
Gross Profit Margin
Gross Profit/Net Sales

Operating Profit Margin

Operating Profit/Net Sales

Net Profit Margin

Net Earnings/Net Sales

All measure firms ability to translate sales dollars into profits

Profitability Ratios (continued)

Cash Flow Margin
Cash Flow from Operating Activities / Net Sales Measures ability to translate sales into cash (with which to pay bills!)

Profitability Ratios (continued)

Return on Investment (or Return on Assets -- same thing, different words!)
Net Earnings/Total Assets

Return on Equity
Net Earnings/Stockholders Equity

Both measure overall efficiency of firm in managing investment in assets and generating return to stockholders

Profitability Ratios (continued)

Cash Return on Assets
Cash Flow from Operating Activities / Total Assets Useful comparison to return on investment Indicates firms ability to generate cash from utilizing its assets

Other Ratios You Hear About..

Earnings per Common Share
Net Earnings/Average Common Shares Outstanding Indicates return on a per share basis

Price to Earnings
Market Price of Common Stock/Earnings per Common Share Expresses a multiple the stock market places on earnings

Other Ratios (continued)

Dividend Payout
Dividends per Share/Earnings per Share Shows percentage of earnings paid out to stockholders

Dividend Yield
Dividends per Share/Market Price of Common Share Shows rate earned by shareholders from dividends relative to current stock price

Analyzing the Company

Now that some of the tools of financial analysis have been illustrated, where does one go from here? Taking a general approach to financial statement analysis, one might proceed as follows...

Steps of a F/S Analysis

Establish objectives of the analysis
Who are you and why are you interested in this company? What questions would you like to have answered? What info is vital to the decision at hand?

Steps (continued)
Study the industry in which the firm operates and relate industry climate to current and projected economic developments
individual company does not operate in a vacuum are we dealing with a growth industry? a dying industry? a changing industry?...

Steps (continued)
Develop knowledge of firm and quality of management (unless you buy an awful lot of stock, you cant DO much about the latter!)
how well does this firm seem to be run? are they taking advantage of opportunities? are they innovative, forward-looking, etc?

Steps (continued)
Evaluate financial statements (numbercrunching time!) using basic tools Focus on major areas:
short-term liquidity capital structure/long-term solvency operating efficiency/profitability market ratios segmental analysis if relevant

Steps (concluded)
Summarize findings Reach conclusions about the firm relevant to your established objectives
NOW, WHAT HAVE WE ACCOMPLISHED AS WE HAVE WADED THROUGH THE LAST FIVE CHAPTERS?

Accomplishments
TRIED to turn a maze into a map Reviewed all the basic financial statements and know what they are Practiced the rudiments of financial analysis If nothing else, hopefully gained an appreciation of what information is available and how one might use it...

A Final Note
Financial analysis is only as good as the information upon which it is based -hence we need to be concerned about honest, straightforward, comprehensible financial reporting Financial analysis is only valuable to me if it answers MY questions -- I need to THINK about what I need/would like to know BEFORE I crunch numbers

A Final Final Note (really!)

Analyzing financial information can be fun (as well as profitable) You can never know too much about a company you plan to have a relationship with (as an investor, a creditor, a manager, an employee) GO FIND THE INFORMATION AND USE IT INTELLIGENTLY -- YOU CAN DO IT!