UNDERSTANDING FINANCIAL STATEMENTS

1. UNDERSTANDING FINANCIAL STATEMENTS THE ANALYSIS OF FINANCIAL STATEMENTS Fraser & Ormiston Chapter 5

2. 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

3. Potential Financial Statement Users: • Creditors • Investors • Managers • What types of questions do each of these users seek answers to?

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

5. 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 firm’s competitive position?

6. 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 company’s financial position? • What changes are indicated to improve future performance?

7. 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

8. Where to look for data... • Financial statements (and notes) • Auditor’s report • MD&A • Supplementary schedules • All of the above are in Annual Report -- can also look further...

9. 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

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

11. 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

12. Financial Ratio Categories • Liquidity Ratios • measure a firm’s ability to meet cash needs as they arise • Activity Ratios • measure the liquidity of specific assets and the efficiency of managing assets

13. Ratio Categories (continued) • Leverage Ratios • measure the extent of a firm’s 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

14. 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, LET’S TAKE A LOOK AT SOME OF THE RATIOS….

15. 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

16. 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

17. 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 firm’s collection and credit policies

18. 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

19. 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 firm’s financing with debt

20. 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…...

21. 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

22. Coverage Ratios (continued) • Cash Flow Adequacy • Cash Flow from Operating Activities/ Average Annual Long-Term Debt Maturities • Measures firm’s 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

23. 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 firm’s ability to translate sales dollars into profits

24. 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!)

25. 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

26. Profitability Ratios (continued) • Cash Return on Assets • Cash Flow from Operating Activities / Total Assets • Useful comparison to return on investment • Indicates firm’s ability to generate cash from utilizing its assets

27. 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

28. 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

29. 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…...

30. 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?

31. 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?...

32. Steps (continued) • Develop knowledge of firm and quality of management (unless you buy an awful lot of stock, you can’t 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?

33. Steps (continued) • Evaluate financial statements (number-crunching 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

34. 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?

35. 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...

36. 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

37. 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!