Lesson 10 Understanding and Using Financial Statements

1. Lesson 10Understanding and Using Financial Statements Task Team of FUNDAMENTAL ACCOUNTING School of Business, Sun Yat-sen University

2. Outline • Demand and supply of financial analysis • Basic analytical procedures • Analysis methods • Comprehensive analysis of financial ratios • The limitations of financial analysis

3. What’s wrong with accounting information?

4. Demand Supply Investors Managers Employees Customers auditors Government/regulatory agencies • Internal analysts • Intermediaries • Financial analysts • Bond rating agencies Demand and supply of financial analysis

5. Determine objective Contrive analysis scheme Collect data Analyze data Conclude Basic analytical procedures

6. Techniques of Financial Statement Analysis • Horizontal analysis • Comparative financial statements are presented side by side • Trend analysis • Vertical analysis • Common-size financial statement • Ratio analysis

7. Horizontal analysis

8. Trend Analysis Comparing a company’s financial condition and performance across time

9. Vertical analysis • Vertical analysis is used to show the relationship of the component parts to the total in a single statement • In the vertical analysis of the balance sheet, each asset or equity item is stated as a percent of total assets; • In the vertical analysis of the income statement, each item is stated as a percent of net sales;

10. A example of vertical analysis

11. Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements Long-term debt-paying ability analysis Profitability analysis Liquidity analysis Activity analysis Market Strength Ratio Analysis

12. Profitability analysis

13. A compare of company profitability

14. Asset turnover total revenue average total assets Accounts receivable turnover Sales revenue Average accounts receivable Average collection period of accounts receivable 365(days) Accounts receivable turnover Inventory turnover Cost of goods sold Average inventory Activity analysis

15. A compare of company efficiency ratios

16. Current ratio Current assets Current Liabilities Quick ratio Quick assets Current liabilities Cash ratio Cash+ Short-term investment Current liabilities Liquidity analysis

17. A compare of company Liquidity ratios

18. Debt-equity ratio Total liabilities Total owner’s equity Debt-to-total asset Total liabilities Total Asset Times interest earned Net income +interest expense +taxes Interest expense Long-term debt-paying abilityanalysis

19. A compare of Long-termdebt-paying ability

20. Earning per share Net income shares of common stock outstanding Price-earnings ratio Market price per share Earnings per share Dividend yield Dividendper share Market price per share Market Strength

21. A compare of market strength

22. ROE=Net MarginX Asset TurnoverX Leverage Factor Assets Owner’s equity Net income Net Sales Sales Assets Net income owner’s equity Dupond Analysis

23. Dupon analysis for five firms

24. Why ratio analysis is useful? • They facilitate inter-company comparison; • They downplay the impact of size and allow evaluation over time or across entities without undue concern for the effects of size difference; • They serve as benchmarks for targets such as financing ratios and debt burden; • They help provide an informed basis for making investment-related decisions by comparing an entity’s financial performance to another; • ……

25. How is ratio analysis limited? • It is restricted to information reported in the financial statements; • It is based on past performance. • Comparability is hampered when accounting policies are not uniform across an industry; • The past may not predict the future;

26. How is ratio analysis limited? (cont) • Trends and relationships must be carefully evaluated with reference to industry norms, budgets, and strategic decisions; • Because of some potential problems in standard, comparison must be careful;

27. Standard of comparison Potential problem May include inefficiencies or reflect different operating policies than in effect in the current year. Prior years’ results May not be representative or desirable for this firm. Industry averages May not be available; may be based on different or budgets operating policies than in effect in the current year. Internal projections or budget Standards of comparison for financial statement analysis

28. What should an analyst keep in mind about financial analysis? • An overview of all ratios can provide important information concerning the strategic decisions of a company and the nature of its business; • However, accounting information can only provide so much data. An analyst must proceed with caution;

29. Summary • Users of financial statements often gain a clearer picture of the economic condition of an entity by the analysis of accounting information; • The analytical measures obtained from financial statements are usually expressed as ratios or percentages;

30. Summary • Financial analysis techniques work best when they are used to confirm or refute other information. When using analytical tools to evaluate a company, the analyst should keep in mind the limitations of analysis

31. Discussion questions • What is the advantage of using comparative statements for financial analysis rather than statements for a single date or period? • What does an increase in the number of days’ sales in receivables ordinarily indicate about the credit and collection policy of the firm? • Why would the dividend yield differ significantly from the rate earned on common stockholders’ equity?

32. The End of Lesson 10