Objective of Financial Statement Analysis Mark Kolta
Financial Statement Analysis ď‚—The
application of analytical tools and
techniques to financial statement data. ď‚—Allows
users to focus on how numbers
are related and how they have changed over time
Objective of Financial Statement Analysis ď‚—External
users rely on general purpose
financial statements ď‚—Make
predictions about an organization as
an aid in making decisions ď‚—Users
highlight important trends or changes
Risk and Return ď‚—Users
try to balance the risk of an
investment with its expected return ď‚—Generally
the greater the risk, the higher
the return ď‚—Financial
statement analysis is one source
of information for assessing risk and return
Sources of External Information Public
companies must publish an annual financial report Government reports ◦ SEC 10K, 10Q Financial
service information
◦ Moody’s, Dow-Jones Financial
newspapers and periodicals
◦ Wall Street Journal
Financial Analysis Tools Horizontal Vertical Ratio
analysis
analysis
analysis
Horizontal Analysis: Amounts and Percentages of Change Amount
of change = later year amount -
Earlier year amount Percentage
change = Amount of
change / Earlier year amount Look
for significant change
Horizontal Analysis: Trend Percentages Set
all amounts in base year at 100% Compute percentages for a number of years ◦ Divide each statement amount by respective amount in base year Shows
degree of increase or decrease in individual statement items Used to explain changes in operating performance
Vertical Analysis Shows
how each item in a financial statement compares to the total of that statement Balance sheet ◦ Set both total assets and total equities at 100% Income
statement
◦ Set net sales at 100%
Vertical Analysis Identify
significant dollar and percentage changes Explain the changes Identify whether they are favorable of unfavorable
Ratio Analysis ď‚—Shows
the relative size of one financial
statement component to another. ď‚—Effective
only when used in
combination with other ratios, analysis, and information.
Ratio Analysis ◦ Short-term liquidity ◦ Long-term solvency ◦ Profitability ◦ Market performance
Short-term Profitability Current Quick
ratio
ratio
Accounts Days’
receivable turnover
sales in receivables
Inventory
turnover
Current Ratio Common
measure of liquidity
◦ Ability to pay debts as they come due ◦ Rule of thumb 2:1 ◦ Consider other factors
Current Assets Current Liabilities
Quick Ratio (Acid Test) More
strict measure of short-term liquidity Numerator includes only quick current assets ◦ Assets readily converted to cash
Cash + Short-term investments + Net Current Receivables Current liabilities
Accounts Receivable Turnover ď‚—How
many times we turn accounts receivable into cash during a period Net sales Average net accounts receivable
Days’ Sales in Receivables How
many days’ sales remain uncollected in accounts receivable Net sales
Net sales per day = 365 days Average net accounts receivable Net sales per day
Inventory Turnover ď‚—Number
of times the company sells and replaces its inventory during the period ď‚—Holding inventory results in financing and storage costs Cost of goods sold Average inventory
Long-term Solvency Debt
ratio
Times
Interest Earned
Debt Ratio ď‚—Shows
amount of total assets creditors provide ď‚—Higher levels of debt financing means company has a higher risk of not meeting interest and principal payments Total liabilities Total assets
Times Interest Earned Number
of times the company earned interest expense with current income Creditors want to know the firm’s ability to pay annual interest charges Net income + Income tax expense + Interest expense Interest expense
Profitability Profit
margin
Total
asset turnover
Return
on total assets
Return
on owners’ equity
Earning
per share
Profit Margin ď‚—Percentage
each sales dollar contributes to net income Net income Net sales
Total Asset Turnover ď‚—Measures
the efficiency of the company is using its investment in assets to generate sales Net sales Average total assets
Return on Total Assets ď‚—Measures
the amount a company earns on each dollar of investment in assets Net income Average total assets
Return on Owners’ Equity Measures
the earnings in relation to the owners’ investment in the company
Net income - Preferred dividends Average owner’s equity
Earnings Per Share ď‚—Measures
the net income available to each share of common stock ď‚—Discussed in depth in Chapter 14 Net income - Preferred dividends Weighted average number of common shares outstanding during the year
Market Performance ď‚—Price/Earnings ď‚—Dividend
yield
(P/E) ratio
Price/Earning (P/E) Ratio ď‚—Number
of times earnings per share the stock is currently selling for in the market
Market price per share of common stock Earnings per share
Dividend Yield Measure
of dividend-paying performance of a company Investors buy stock for two reasons ◦ Receive cash dividends ◦ Sell stock at a higher price
Dividends per share Market price per share
Limitations of Financial Analysis Tools Historical
nature of accounting information Changing economic conditions Comparisons with industry averages Seasonal factors Quality of reported income
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