Financial Statement Analysis

Chapter 18

Basics of Analysis: Transforming data into useful information. 

Purpose of Analysis: To help users make better business decisions.

Internal users: internal auditors, consultants, budget officers, and market researchers

External users: shareholders, lenders, directors, customers, suppliers, regulators, lawyers and the press

The common goal of all users is to evaluate:

1. Past and current performance.
2. Current financial position.
3. Future performance and risk.

Building Blocks of Analysis: The four areas of inquiry or building blocks are:

1. Liquidity and efficiency: ability to meet short-term obligations and to efficiently generate revenues.
2. Solvency: ability to generate future revenues and meet long-term obligations.
3. Profitability: ability to provide financial rewards sufficient to attract and retain financing.
4. Market: ability to generate positive market expectations.

Information for Analysis:

1. Income statement
2. Balance sheet
3. Statement of changes in equity
4. Statement of cash flows

Standards for Comparisons:

Used to determine if analysis measures suggest good, bad, or average performance.

Standards (benchmarks) are the following types of comparisons:

1. Intra-company: based on own prior performance and relationships between its financial items.
2. Competitor (or Intercompany): compared to one or more direct competitors (often best).
3. Industry: published industry statistics

(available from services like Dun & Bradstreet, Standard and Poor's, and Moody's).

4. Guidelines (rules-of-thumb): general standards developed from past experiences.

Tools of Analysis

1. Horizontal analysis: Comparison of a company's financial condition and performance across time
2. Vertical analysis: Comparison of a company's financial condition and performance to a base amount
3. Ratio analysis: Determination of key relations among financial statement items

Common-Size Graphics Graphical analysis are those that visually highlight comparison information.

Liquidity and Efficiency

1. Liquidity refers to the availability of resources to meet short-term cash requirements.
2. Efficiency refers to how productive a company is in using its assets.
3. Ratios in this block:
1. Working capital: the excess of current assets less current liabilities.
2. Current ratio: current assets divided by current liabilities; ability to pay short-term obligations.
3. Acid-test ratio: quick assets divided by current liabilities.
4. Accounts receivable turnover:

credit sales divided by average accounts receivable; time to collect its accounts.

5. Merchandise turnover: cost of goods sold divided by average inventory;

the number of times a company's average inventory is sold during an accounting period.

6. Days' sales uncollected: A / R divided by net credit sales multiplied by 365 days;

measures how frequently a company collects its accounts receivable.

7. Days' sales in inventory: ending inventory divided by cost of goods sold multiplied by 365; measures how many days it will take to convert the inventory into accounts receivable/cash.
8. Total asset turnover: net sales divided by average total assets;

describes the ability to use assets to generate sales.

9. Accounts payable turnover: cost of goods sold divided by average accounts payable; describes how much time it takes for a company to meet its obligations to suppliers.

Solvency

1. Solvency refers to ability to cover long-term obligations. 
2. Capital structure is one of the most important components of solvency analysis.

Capital structure refers to sources of financing share and/or debt.

Ratios in this block:

1. Debt ratio: total liabilities divided by total assets multiplied by 100%.
2. Equity ratio: total equity divided by total assets multiplied by 100%.
3. Debt-to-equity ratio: total liabilities divided by total equity. 
4. Pledged assets to secured liabilities ratio: pledged assets divided by secured liabilities.
5. Times interest earned:

income before interest expense and income taxes divided by interest expense;

reflects the risk of repayments with interest to creditors.

Profitability

1. Profitability refers to ability to generate an adequate return on invested capital.
2. Return is judged by assessing earnings relative to the level and sources of financing.
3. Ratios in this block:
1. Profit margin: net income divided by net sales multiplied by 100%;

describes the ability to earn a net income from sales.

2. Gross profit ratio: Gross profit divided by net sales multiplied by 100%.
3. Return on total assets: net income divided by average total assets multiplied by 100%;

comprises profit margin and total asset turnover.

4. Return on common shareholders' equity:

net income less preferred dividends divided by av. Common s/h' equity multiplied by 100%;

measures the success of a company in earning net income for its owners.

5. Book value per share: common shares equity divided by common shares outstanding.

Market

1. Market measures are useful for analyzing corporations with publicly traded stock.
2. Market measures use share price in their computation.
3. Ratios in this block:
1. Price-earnings ratio: market price per share divided by earnings per share;

used to evaluate the profitability of alternative common stock investments.

2. Dividend yield: annual cash dividends paid per share divided by market price per share; used to compare the dividend paying performance of different investment alternatives.