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Financial Statement Analysis: Objectives and Techniques for Investors and Creditors

This chapter explores the essential objectives of financial statement analysis from the perspectives of investors and creditors. Investors focus on profitability, dividends, and future stock prices, while creditors prioritize liquidity and solvency. The chapter covers various analytical techniques, including trend analysis, horizontal and vertical analysis, common-size statements, and ratio analysis. These methods help stakeholders evaluate financial health by comparing actual changes and percentages over time and against industry averages. Understanding these tools is crucial for making informed financial decisions.

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Financial Statement Analysis: Objectives and Techniques for Investors and Creditors

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  1. Chapter 16 “How Well Am I Doing?” Financial Statement Analysis

  2. Objectives • Objectives differ for investors and creditors • Investors - concerned with profitability, dividends and future stock prices • Creditors - concerned with liquidity and solvency • Short-term creditors - also concerned with short-term liquidity and solvency • Risks are evaluated

  3. Financial Statement Analysis • Trend Analysis • Horizontal Analysis • Trend percentages • Vertical Analysis • Percentages • Common-size statements • Ratio Analysis

  4. Horizontal Analysis • Compare year to year • Actual dollar change • Percentage change: Actual dollar change • Base year • Trend Analysis: Annual amount • Base year • Compare percentage changes and trend analyses to industry averages

  5. Vertical Analysis • Compare figures within the same year • Income statement - all items divided by net sales: Cost of goods sold/Net sales, Operating expenses/Net sales, Net income/Net sales, etc. • Balance sheet - all items divided by total assets: Cash/Total assets, Accounts payable/total assets, etc.

  6. Vertical Analysis • Common-size statements • Balance sheet: • Only percentages shown. • All items divided by total assets to get percentages • Income Statement: • Only percentages shown • All items divided by net sales to get percentages • Benchmark - compare figures to key competitors • Compare to industry averages

  7. Industry Averages • Ratios and trend percentages will vary by industry • Check a particular company’s ratios to the industry averages • Sources: EDGAR, Almanac of Business and Industrial Financial Ratios, AMA Annual Statement Studies, FreeEdgar, Hoover’s Online, Industry Norms & Key Business Ratios, Mergent Industrial Manual and Mergent Bank and Finance Manual, Standard & Poor’s Industry Survey, YahooFinance.com

  8. Ratio Analysis • Categories depend on who is analyzing financial statements • Common Stockholders • Short-term Creditors • Long-term Creditors

  9. Common Stockholders • Earnings per share (Basic and diluted) • Price/earnings ratio (Market price/EPS) • Dividend payout (Divs. Per share/EPS) • Dividend yield (Divs. per share/Mkt price) • Return on total assets (Net income + interest expense x (1-tax rate)/Avrg.assets) • Return on stockholders’ equity (Net income - pref. divs./Average common S/E • Book value per share

  10. Financial Leverage • Acquiring assets with funds that have been obtained from creditors or from preferred stockholders at a fixed rate of return. • Positive financial leverage: ROE > ROA • Negative financial leverage: ROE < ROA

  11. Short-term Creditors • Working capital (CA-CL) • Current ratio(CA/CL) • Acid-test (quick) ratio (Quick assets/CL) • Accounts receivable turnover (Credit sales/Average receivables) • Inventory turnover (COGS/Avg. Inventory)

  12. Long-term Creditors • Times-interest earned (Operating income/interest expense) • Debt-to-equity ratio (Total liabs/total assets)

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