Analysis of Financial Statements

1. Analysis of Financial Statements • Financial Statements and Reports • Income statement • Balance sheet • Statement of retained earnings • Statement of cash flows • Ratio Analysis • Ratio Analysis—DuPont Approach • Uses and Limitations of Ratio Analysis

2. Analysis of Financial Statements • What financial statements do corporations publish, and what information does each provide? • How do investors utilize financial statements? • What is ratio analysis and why are the results important to both managers and investors? • What are some potential problems associated with financial statement analysis? • What is the most important factor in financial statement analysis?

3. Financial Statements and Reports • Financial reporting is used to disclose information about the firm • Financial statements provided to • stockholders/creditors • SEC • IRS • Management • Annual report—includes • a general discussion about the firm’s activities during the past year and expectations in the near future • financial statements of the firm for the most recent years

4. Income Statement • Provides a summary of the revenues recognized and the expenses incurred during a particular operating period. • Matching principle—revenues are recognized when sales occur (earned) and expenses are realized when they are incurred. • Accrual accounting versus cash flows

5. Balance Sheet • Records the financial position of the firm at a particular point in time by showing the assets—that is, the investments—and the liabilities and equity—that is, the financing—of the firm. • Historical costs

6. Balance Sheet • Cash versus other assets—only cash represents actual funds that can be invested • Liabilities versus stockholders’ equity— liabilities represent debt, whereas equity represents ownership • Preferred versus common stock—all corporations have one type of stock called common stock; some firms have equity called preferred stock

7. Balance Sheet Common equity accounts: • common stock = number of shares outstanding times the par value of each share • paid-in capital = amount above the par value for which common stock was issued • retained earnings = income the firm earned in the past that was “retained” and reinvested in assets

8. Statement of Retained Earnings Shows the change in the retained earnings and common equity accounts since the last balance sheet was constructed.

9. Statement of Cash Flows Reports the effect of the firm’s activities—operating, investing, and financing—over some period on its cash position

10. Statement of Cash Flows • Income versus cash flows—revenues and expenses are recognized when incurred, not when cash is received or paid • Non-cash items—some non-cash items appear on the income statement, such as depreciation • Accounting profit—net income, or the “bottom line” on the income statement; net income and cash flows generally are highly correlated • Operating cash flows—cash flows generated from the normal operating activities of the firm

11. Statement of Cash Flows Simple rules to follow when constructing a statement of cash flows: Sources of CashUses of Cash Liability AccountLiability Account (e.g., borrow more)(e.g., payoff loans) Equity AccountEquity Account (e.g., issue stock)(e.g., pay a dividend) Asset AccountAsset Account (e.g., sell inventory)(e.g., purchase equipment)

12. Eagle, Inc. Income Statement Sales$80,000 Variable operating costs(60,000) Fixed costs, excluding depreciation(12,000) Depreciation( 2,000) EBIT = NOI6,000 Interest( 1,000) Earnings before taxes (EBT)5,000 Taxes (40%)( 2,000) Net income $ 3,000 Dividends2,000 Addition to retained earnings1,000 Sales$80,000 Variable operating costs(60,000) Fixed costs, excluding depreciation(12,000) Depreciation( 2,000) EBIT = NOI6,000 Interest( 1,000) Earnings before taxes (EBT)5,000 Taxes (40%)( 2,000) Net income $ 3,000 Dividends2,000 Addition to retained earnings1,000 Sales$80,000 Variable operating costs(60,000) Fixed costs, excluding depreciation(12,000) Depreciation ( 2,000) EBIT = NOI6,000 Interest( 1,000) Earnings before taxes (EBT)5,000 Taxes (40%)( 2,000) Net income $ 3,000 Dividends2,000 Addition to retained earnings1,000

13. Eagle, Inc. Balance Sheet Current Current Year Year Cash & securities$ 2,000Accounts payable$ 4,000 Accounts receivable6,000Accruals5,000 Inventory 7,000Notes payable 1,000 Current assets15,000 Current liabilities10,000 Net fixed assets 10,000Long-term debt 6,000 Total assets$25,000 Total liabilities16,000 Common stock6,000 Retained earnings 3,000 Owners’ equity9,000 Total liabilities & equity$25,000 CurrentPrevious CurrentPrevious Year Year Year Year Cash & securities$ 2,000$1,000Accounts payable$ 4,000$ 2,000 Accounts receivable6,0005,000Accruals5,0004,000 Inventory 7,000 8,000Notes payable 1,000 2,000 Current assets15,00014,000 Current liabilities10,0008,000 Net fixed assets 10,000 9,000Long-term debt 6,000 7,000 Total assets$25,000$23,000 Total liabilities16,00015,000 Common stock6,0006,000 Retained earnings 3,000 2,000 Owners’ equity9,0008,000 Total liabilities & equity$25,000$23,000

14. Eagle, Inc. Balance Sheet—Changes in Assets CurrentPrevious Year Year Change Cash & securities$ 2,000$ 1,000 Accounts receivable6,0005,000 Inventory 7,000 8,000 Current assets15,00014,000 Net fixed assets 10,000 9,000 Total assets$25,000$23,000 CurrentPrevious Year Year Cash & securities$ 2,000$ 1,000 Accounts receivable6,0005,000 Inventory 7,000 8,000 Current assets15,00014,000 Net fixed assets 10,000 9,000 Total assets$25,000$23,000 Source Use -- 1,000 (1,000) 3,000 X X X Sources of CashUses of Cash  Asset AccountAsset Account 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

15. Eagle, Inc. Balance Sheet—Changes in Liabilities and Equity CurrentPrevious Year Year Accounts payable$ 4,000$ 2,000 Accruals5,0004,000 Notes payable 1,000 2,000 Current liabilities10,0008,000 Long-term debt 6,000 7,000 Total liabilities16,00015,000 Common stock6,0006,000 Retained earnings 3,000 2,000 Owners’ equity9,0008,000 Total liabilities & equity$25,000$23,000 Change 2,000 1,000 (1,000) (1,000) 0 -- Source Use X X X X -- -- Sources of CashUses of Cash Liability/Equity AccountLiability/Equity Account

16. Eagle, Inc. Statement of Cash Flows Cash Flows from Operations: Net income (NI)$3,000 Adjustments to NI Depreciation 2,000  Inventory1,000 Accounts payable 2,000  Accruals1,000 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 cash1,000 Cash at beginning of year1,000 Cash at end of year $2,000

17. Financial Statements:Accounting Alternatives In many instances, the same business activity can be recorded using one of several accepted accounting methods—for example, LIFO versus FIFO for inventory valuation.

18. 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).

19. What Information Do Investors Use from Financial Statements? • Net working capital (NWC) = Current assets - Current liabilities • Operating cash flow (OCF) = NOI (1-Tax rate) + Depreciation & amortization expense • Free cash flow (FCF) = OCF – Investments • Economic Value Added (EVA) = NOI (1 - T) - [(Invested capital) X (After-tax cost of funds)

20. Financial Statement (Ratio) Analysis Used to evaluate how financial positions: • Change on a year-to-year basis for a single firm. • Compare among firms, even if they differ in size.

21. Ratio (Financial Statement) Analysis Used by: • Managers inside the firm • Stockholders and creditors—existing and potential—outside the firm

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

23. 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

24. Current ratio Shows the relationship between current assets and current liabilities; a higher value suggests greater liquidity, and vice versa:

25. Quick (Acid Test) Ratio Similar to the current ratio, except the value of inventories is subtracted from current assets (CA) in the numerator; inventories represent the least liquid of the current assets:

26. 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

27. Inventory Turnover Shows how many times during a period—for example, one year—the amount of average inventory is turned over due to sales activities.

28. Days Sales Outstanding (DSO) Indicates the average time it takes customers to pay for credit purchases—that is, the length of time it takes the firm to collect for credit sales.

29. Fixed Assets Turnover Indicates how efficiently the firm uses its fixed assets (excludes current assets) to produce revenues

30. Total Assets Turnover Similar to the fixed assets turnover, except the value of total assets (includes current assets) is used.

31. Debt Management Ratios • 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 Indicate how the firm’s financial position is affected by the amount of debt it has

32. Debt Ratio Indicates the capital structure of the firm; measures the percent debt used by the firm for the purposes of financing assets.

33. Times-Interest-Earned (TIE) Ratio Indicates whether the firm generates sufficient operating income (not cash) to meet its interest obligations each year.

34. Fixed Charge Coverage Ratio Like the times-interest-earned ratio, except all fixed payments related to financing are included.

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

36. Net Profit Margin Shows what percent of sales revenues is left after expenses related to operations and the effects of financing and taxes.

37. Return on Total Assets (ROA) Measures the return on investment earned by the firm; ROA represents a return on all invested funds (both debt and equity).

38. Return on Equity (ROE) Similar to ROA, ROE is a measure of the return on the original funds provided by common stockholders (equity only).

39. 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.

40. Price/Earnings (P/E) Ratio Indicates how much investors pay for each dollar of income generated by the firm.

41. Market/Book Value Ratio Indicates the relationship between the selling price of the common stock and its book value.

42. 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).

43. Du Pont Equation/Method • Shows the relationship between the return on investment (ROA) and both the total assets turnover and the net profit margin so as to give more detail where weaknesses or strengths exist. • For example, if ROA is relatively low, it might be due to a low profit margin, a slow turnover of assets, or both.

44. = x ROA Net profit margin Total assets turnover Net income Sales = x Sales Total assets Du Pont Equation

45. Uses and Limitations of Ratio Analysis • Classifying a very large, multidivisional firm into a single industry often is difficult. • Using a single norm, or “target,” ratio for comparisons might be misleading. • Values on balance sheets are historical costs, so ratios might not portray a “true” picture. • Seasonality in operations might cause ratios to differ significantly at different times of the year.

46. Uses and Limitations of Ratio Analysis • Sometimes firms try to make financial statements look better by using “window dressing” techniques. • If firms use different accounting methods, comparisons between firms can be difficult. • Do not make general conclusions about the firm’s financial position by examining only one or a few ratios; ratio analysis should be comprehensive. • The most important part of ratio analysis is the judgment used when interpreting the results, not the computation of the ratios.

47. Analysis of Financial Statements • What financial statements do corporations publish? • Balance sheet, income statement, statement of cash flows, and statement of retained earnings • How do investors utilize financial statements? • Debt holders estimate future cash flows to determine whether the debt contracts will be honored • Stockholders estimate future cash flows to determine the value of the firm’s common stock.

48. Analysis of Financial Statements • What is ratio analysis and why are the results important to both managers and investors? • Ratio analysis is used to evaluate a firm’s current financial position and, based on the results, to forecast the firm’s future financial position. • What are some potential problems associated with financial statement analysis? • Seasonality, alternative accounting methods, and historical costs are a few factors that make evaluation of financial statements difficult.

49. Analysis of Financial Statements • What is the most important factor in financial statement analysis? • To form general impressions about a firm’s financial position, judgment must be used when interpreting financial ratios