Chapter 11 Analysis of Financial Statements

1. Chapter 11 Analysis of Financial Statements

2. Financial Statements and Reports The Income Statement • The income statement provides a financial summary of a company’s operating results during a specified period. • Although they are prepared annually for reporting purposes, they are generally computed monthly by management and quarterly for tax purposes.

3. Penny Ltd. Income Statement Sales €80,000 Variable operating costs (60,000) Fixed costs, excluding depreciation (12,000) Depreciation ( 2,000) EBIT = NOI 6,000 Interest ( 1,000) Earnings before taxes (EBT) 5,000 Taxes (40%) ( 2,000) Net income € 3,000 Dividends 2,000 Addition to retained earnings 1,000

4. Financial Statements and Reports The Balance Sheet • The balance sheet presents a summary of a firm’s financial position at a given point in time. • Assets indicate what the firm owns, equity represents the owners’ investment, and liabilities indicate what the firm has borrowed.

5. Penny Ltd. Balance Sheet Current Current Year Year Cash & securities € 2,000 Accounts payable € 4,000 Accounts receivable 6,000 Accruals 5,000 Inventory 7,000 Notes payable 1,000 Current assets 15,000 Current liabilities 10,000 Net fixed assets 10,000 Long-term debt 6,000 Total assets €25,000 Total liabilities 16,000 Common stock 6,000 Retained earnings 3,000 Owners’ equity 9,000 Total liabilities & equity €25,000

6. Penny Ltd. Balance Sheet—Changes in Assets Current Previous Year Year Change Cash & securities € 2,000 €1,000 Accounts receivable 6,000 5,000 Inventory 7,000 8,000 Current assets 15,000 14,000 Net fixed assets 10,000 9,000 Total assets €25,000 €23,000 Source Use 1,000 (1,000) 1,000 X X X Fixed assets if no purchases or sales = €9,000 - €2,000 = €7,000 Depreciation = €2,000 Change in fixed assets = €10,000 - €7,000 = €3,000 Sources of CashUses of Cash  Asset Account  Asset Account

7. Penny Ltd. Balance Sheet—Changes in Liabilities and Equity Current Previous Year Year Accounts payable € 4,000 € 2,000 Accruals 5,000 4,000 Notes payable 1,000 2,000 Current liabilities 10,000 8,000 Long-term debt 6,000 7,000 Total liabilities 16,000 15,000 Common stock 6,000 6,000 Retained earnings 3,000 2,000 Owners’ equity 9,000 8,000 Total liabilities & equity €25,000 €23,000 Change 2,000 (1,000) (1,000) 1,000 Source Use X X X X Sources of CashUses of Cash  Liability/Equity Account  Liability/Equity Account

8. Financial Statements and Reports Statement of Cash Flows • The statement of cash flows provides a summary of the cash flows over the period of concern, typically the year just ended. • This statement not only provides insight into a company’s investment, financing and operating activities, but also ties together the income statement and previous and current balance sheets.

9. Penny Ltd. Statement of Cash Flows Cash Flows from Operations: Net income (NI) €3,000 Adjustments to NI Depreciation 2,000  Inventory 1,000  Accounts payable 2,000  Accruals 1,000  Accounts receivable (1,000) Net CF from operations €8,000 Cash Flows from Long-Term Investing: Acquisition of assets (3,000) Cash Flows from Financing Activities:  Notes payable (1,000)  Long-term bonds (1,000) Dividend payment (2,000) Net CF from financing €(4,000) Net Change in cash 1,000 Cash at beginning of year 1,000 Cash at end of year €2,000

10. Notes to the Financial Statements • Notes to the financial statements provide detailed information on the accounting policies, procedures, calculations, and transactions underlying various entries in the financial statements. • Common issues include revenue recognition, income taxes, breakdowns of fixed asset accounts, debt and lease terms, and contingencies.

11. Financial Statements:Time Dimension • Balance sheet—a “snapshot” of where the firm is at a specific point in time (stock statement). • Income statement and statement of cash flows—shows the results of the firm’s activities over a period of time (flow statement).

12. Ratio (Financial Statement) Analysis General categories of analysis: • Liquidity • Asset management • Debt management • Profitability • Market value

13. Liquidity Ratios Provide an indication of how well the firm can meet its current obligations • Help measure the liquidity position of the firm • Too little, or too much liquidity could be considered a “bad sign” • too little liquidity—suggests the firm will have problems paying its current obligations in the future • too much liquidity—might suggest the firm is not investing its funds wisely

14. Liquidity Ratios Current ratio = total current assets total current liabilities Quick ratio = Total Current Assets - Inventory total current liabilities

15. Asset Management Ratios Provide an indication of how well the firm manages its assets (efficiency) • Show how often the firm is “turning over” its assets to generate funds • Generally, when assets are not turned over quickly enough, it is because sales have slowed or current assets, such as inventory and receivables, are too high • If assets are turned over too quickly, it could mean that the firm is not producing enough

16. Asset Management Ratios Inventory Turnover = Cost of Goods Sold Inventory DSO =Days Sales Outstanding = Receivables Average sales per day Fixed assets turnover ratio = Sales Net fixed assets Total Asset Turnover = Sales Total Assets

17. Debt Management Ratios Indicate how the firm’s financial position is affected by the amount of debt it has • financial leverage refers to the use of debt • leverage helps to magnify returns, on both the positive and the negative sides, because debt represents a fixed obligation

18. Debt Management Ratios Debt Ratio = Total Liabilities/Total Assets Times Interest Earned = EBIT/Interest charges Fixed charge coverage ratio = EBIT + Lease Pymts Interest + Lease Pymts + {(Princ Pymts + PSD) x [1/(1-t)]}

19. Profitability ratios Indicate how the firm’s management of its liquidity position, assets, and debt has affected normal operating activities.

20. Profitability Ratios Profit Margin on Sales = Net Income/ Sales Return on Total Assets = Net Income/ Total Assets Return on Common Equity = Net Income available to common stockholders / Common equity

21. Market Value Ratios Measures that consider the value of the firm’s stock in the financial markets—that is, how well investors perceive that the firm is creating value.

22. Market Value Ratios P/E = Market Price Per Share of Common Stock Earnings Per Share M/B = Market Price Per Share of Common Stock Book Value Per Share of Common Stock

23. Trend and Comparative Analyses • Ratios should be evaluated • At a point in time in comparison to a norm, such as an industry average, to determine the firm’s current financial position (comparative analysis). • Over time to determine whether the firm’s current financial position is improving or deteriorating (trend analysis).

24. Using Financial Ratios Types of Ratio Comparisons