Financial Statement Analysis

Financial Statement Analysis

Objectives • Review the components of the financial statement package. • Discuss the information contained in the financial statements and how it can be used to evaluate a firm. • Discuss the types of questions can financial ratios answer. • Discuss the relationship between the notion of market efficiency and financial statement analysis. FINA 4397 - Financial Statement Analysis

Introduction to Financial Statement Analysis • A major source of information regarding a a firm’s operating performance and its resources is the firm’s financial statement package. • Analyzing a set of financial statements involves using ratios of key financial statement items and other tools to gain insight into the profitability and risk of a firm. • Financial statement analysis can help us to better understand the business risk and the financial risk of a firm. FINA 4397 - Financial Statement Analysis

Principal Financial Statements • Financial statements are intended to provide information on the operating performance and financial health of a business during a specified period of time. • In the US, financial statements are required to adhere to GAAP (although GAAP does allow some flexibility). • One goal is to make the financial statements of one firm comparable across time and to the financial statements of other firms. FINA 4397 - Financial Statement Analysis

Principal Financial Statements, cont. • GAAP requires firms to present balance sheets for the two most recent years and income statements and statements of cash flows for the three most recent years in a set of financial statements. • In addition, firms are required to present notes to the financial statements that provide information on the accounting methods used by the firm to construct the financial statements. FINA 4397 - Financial Statement Analysis

The Balance Sheet • The balance sheet is a statement of financial position that presents details of the resources of a firm and the claims on those resources as of a specific point in time (i.e., on March 31, 20XX). • It is a “static” statement. • The asset side of a balance sheet reports the effects of a firm’s past investment decisions while the liabilities and shareholders’ equity side reports the effects of a firm’s past financing decisions. FINA 4397 - Financial Statement Analysis

The Balance Sheet, cont. • The balance sheet is governed by the accounting identity: • Assets are resources that have the potential for providing a firm with future economic benefits. • Liabilities are obligations to pay for benefits or services received in the past. • Shareholders’ Equity represents a residual claim on the firm (in book value terms). FINA 4397 - Financial Statement Analysis

The Balance Sheet, cont. • It is important to note that most (if not all in some cases) assets and liabilities are reported on a firm’s balance sheet are at historical cost (less some adjustments). • It is very rare that historical cost equals market value. • Examples: • Machinery: historical cost less depreciation • Accounts Receivables: historical value less an allowance for doubtful accounts • Inventory: lower of cost or market FINA 4397 - Financial Statement Analysis

The Balance Sheet, cont. • It is also important to note that the balance sheet may not report all assets and liabilities of a firm. • Only assets and liabilities meeting certain criteria set out by GAAP are required to be reported on the balance sheet. • The footnotes are a source of information for these other off-balance sheet “assets” and “liabilities.” FINA 4397 - Financial Statement Analysis

The Balance Sheet – Assets • Assets are resources under a firm’s control that have the potential to provide the firm with future economic benefit(s). • i.e., the ability to generate future cash inflows (accounts receivables, inventories, etc.) or decrease future cash outflows (i.e., prepayments, etc.) • Assets are usually presented in order of their “liquidity” (cash, cash equivalents, accounts receivables, inventories, etc.). FINA 4397 - Financial Statement Analysis

The Balance Sheet – Assets, cont. • Assets can be • Monetary Assets • cash, cash receivables, etc. • Monetary assets are reported at the amount of cash the firm expects to receive in the future. • Non-monetary • inventories, PP&E, etc. • GAAP generally requires reporting non-monetary assets at their historical cost (historical cost is objective and verifiable). FINA 4397 - Financial Statement Analysis

The Balance Sheet – Assets, cont. • Assets can be (cont.) • Current Assets • Cash and other assets (A/R, inventory, prepayments, etc.) expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. • Non-current/Long-term Assets • Assets not classified as current (PP&E, some prepayments, etc.). FINA 4397 - Financial Statement Analysis

The Balance Sheet – Liabilities • A liability represents a firm’s obligation to make payments of cash, goods, or services in a reasonably definite amount at a reasonably definite time in the future for benefits or services received in the past. • Liabilities are generally monetary (require a payment of a fixed amount of cash) but can be non-monetary. FINA 4397 - Financial Statement Analysis

The Balance Sheet – Liabilities, cont. • Liabilities can be • Current Liabilities • Obligations whose liquidation is reasonably expected to require the use of existing resources classified as current assets or the creation of other current liabilities. • Non-current/Long-term Liabilities • Obligations not classified as current. FINA 4397 - Financial Statement Analysis

The Balance Sheet – Shareholders’ Equity • The shareholders’ equity in a firm is the firm’s owners’ residual interest or claim on the firm. • The accounting identity can be re-written as • Therefore, the valuation of assets and liabilities in the balance sheet determines the book value of the shareholders’ equity. FINA 4397 - Financial Statement Analysis

The Balance Sheet – Shareholders’ Equity, cont. • The shareholders’ equity portion of the balance sheet is commonly presented in three parts. • Capital Stock: the par value of shares issued • Additional Paid-In Capital: excess amounts paid in (by shareholders) in excess of the par value of the shares issued • Retained Earnings: the firm’s undistributed earnings FINA 4397 - Financial Statement Analysis

The Balance Sheet - Conclusion • In summary, the balance sheet views resources from two perspectives: • As a list of the specific form in which the firm holds the resources (i.e., cash, inventory, etc.). • As a list of the persons or entities that provided the funding to obtain those resources (and thus the persons who have a claim on those resources, i.e. debt holders and equity holders). The balance sheet presents the equality of investing and financing. FINA 4397 - Financial Statement Analysis

The Income Statement • The income statement is sometimes titled the Statement of Operations, Statement of Earnings, or the Statement of Income. • The income statement presents details on the operating profitability of a firm over a particular time period (i.e., performance for the year ending on March 31, 20XX). • It is a “dynamic” statement. FINA 4397 - Financial Statement Analysis

The Income Statement, cont. • GAAP requires publicly traded firms to use an accrual basis of accounting (as opposed to a cash basis) in measuring operating performance. • Accrual basis accounting records revenues when they are earned and expenses when they are incurred (regardless of when actual cash flows occur). • Cash basis accounting records revenues when cash is received and expenses when cash is paid. • It is this accrual concept that links the balance sheet and the income statement. FINA 4397 - Financial Statement Analysis

The Income Statement, cont. • The bottom line: • Revenues measure the inflows of net assets from selling goods and providing services. • Expenses measure the outflows of net assets that a firm uses in the process of generating revenues. • Gains and losses arise from the sale of assets that aren’t directly related to the firm’s business. FINA 4397 - Financial Statement Analysis

The Income Statement, cont. • The goal of the income statement is to give a measure of operating performance that matches the firm’s outputs with the firm’s inputs. • But, keep in mind, because the accrual basis of accounting is required • revenues reflect sales for cash and sales for credit, and • expenses reflect purchases made in cash and purchases made on credit. • Therefore, net income includes cash and non-cash elements. FINA 4397 - Financial Statement Analysis

The Statement of Cash Flows • The statement of cash flows reports for a period of time the net cash flows (inflows less outflows) from three principal business activities of a firm: (1) cash flows from operating activities (2) cash flows from investing activities (3) cash flows from financing activities • As this statement reports on the actual cash flows for a period, it can be used to disentangle the effects of the accrual basis of accounting (where non-cash items affect reported net income). FINA 4397 - Financial Statement Analysis

The Statement of Cash Flows, cont. • Question: Why is the statement of cash flows so important to a financial analyst? • Answer: Cash flows are vital to a firm’s survival. The statement of cash flows integrates the information contained in the balance sheet and income statement in a manner that allows an analyst to determine what the sources and uses of cash were for a firm for the specified time period. FINA 4397 - Financial Statement Analysis

Cash Flows from Operating Activities • This section of the statement of cash flows lists the sources and uses of cash that arise from the normal operations of a firm: • Operating activities involve the cash effects of transactions that enter into the determination of net income (i.e., income statement items). FINA 4397 - Financial Statement Analysis

Cash Flows from Investing Activities • This section of the statement of cash flows lists the sources and uses of cash that arise from the investing activities of a firm (generally related to long-term assets). • Investing activities include: • buying and selling debt of OTHER firms, • collecting principal payments on debt of other firms, • buying and selling securities of OTHER firms, and • buying and selling property, plant, and equipment. FINA 4397 - Financial Statement Analysis

Cash Flows from Financing Activities • This section of the statement of cash flows lists the sources and uses of cash that arise from the financing activities of a firm (generally related to long-term liabilities and equity). • Financing activities include: • sales and repurchases of the firm’s equity, • dividends to the firm’s stockholders, and • issuances and retirements of the firm’s debt. FINA 4397 - Financial Statement Analysis

The Statement of Cash Flows, cont. • The purpose of the statement of cash flows is to describe how the firm generated and used cash during the reporting period. • The “bottom line” of the statement of cash flows reports the change in the firm’s cash balance from the beginning of the reporting period to the end of the reporting period. FINA 4397 - Financial Statement Analysis

The Notes to the Financial Statements • The notes to the financial statements generally explain the items presented in the main body of the statements. • Examples of notes include: • descriptions of the accounting policies used in measuring the elements reported in the statements or • explanations of uncertainties or contingencies. • The notes to the financial statements are an integral part of the financial statements and should be viewed as such. FINA 4397 - Financial Statement Analysis

Common Size Financial Statements • Often, it may be difficult to compare two firms because they differ in size (in terms of sales levels or total asset levels). • To resolve this problem, an analyst can create “common size” financial statements. • A common size balance sheet states all numbers as a percentage of total assets. • A common size income statement states all numbers as a percentage of sales. FINA 4397 - Financial Statement Analysis

Common Size Financial Statements, cont. • However, interpretation of common size financial statements must be made with care. • One item in a common size statement is not independent of the other items (all items are presented as relative values to some base amount). • The dollar amount of any one item might increase over the period but the item’s relative size can decrease at the same time. FINA 4397 - Financial Statement Analysis

Percentage Change Statements • A percentage change statement will present the percentage changes of individual items from the previous period to the current period. • Again, care must be taken in interpreting the numbers in a percentage change statement. For instance, FINA 4397 - Financial Statement Analysis

A Final (??) Comment on the Financial Statement Package • It is always important to remember who the authors of a financial statement package are (the firm’s managers) and what their incentives/motivations are (make the firm look good). • Only the actual financial statements and accompanying notes are independently viewed by a team of auditors! • More often than not, quarterly financial information is un-audited. FINA 4397 - Financial Statement Analysis

Economic vs. Accounting Earnings • Keep in mind that the financial statement package is only an approximation of reality though. • If the world were certain, we could measure economic earnings as where the market value of net assets is equal to the present value of their future cash flows discounted at the risk-free rate. FINA 4397 - Financial Statement Analysis

Economic vs. Accounting Earnings, cont. • Unfortunately (or fortunately depending on your taste) we live in an uncertain world. • We cannot say, with certainty, what will happen tomorrow most of the time. • Therefore, we cannot say, with certainty, what an asset’s market price should be. • In this world of uncertainty, no matter how we record earnings, they are only a proxy for economic income. FINA 4397 - Financial Statement Analysis

Economic vs. Accounting Earnings, cont. • Because of this uncertainty, analysts have developed different proxies for economic earnings. • Distributable earnings – the value of dividends that could be paid without changing the value of the firm. • Sustainable income – the level of income that can be maintained given the firm’s stock of capital investment. • Permanent earnings – the amount that can normally be earned given the firm’s assets. FINA 4397 - Financial Statement Analysis

Economic vs. Accounting Earnings, cont. • But, the accounting framework we’ve begun to describe gives us another measure – Accounting Earnings. • The accrual accounting system does not directly provide a measure equivalent to those previously discussed. • It is the analyst’s task to use the accounting information to determine the numbers he/she wants/needs to value a firm. FINA 4397 - Financial Statement Analysis

Financial Statement Analysis • Financial statement analysis in general focuses on five primary categories: • the firm’s internal liquidity, • the firm’s operating performance, • an analysis of firm risk, • an analysis of growth potential, and • external market liquidity. • The common approach is to start with ratio analysis. • We will only highlight a handful of key ratios. FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity • Internal liquidity ratios indicate the ability of the firm to meet future short-term financial obligations. • The probability of financial distress decreases as the relative liquidity of a firm’s assets increases. • Liquidity means “nearness to cash,” i.e., cash is the most liquid asset a firm can have, a machine might be very illiquid if it is difficult to sell to generate cash. • The focus is on the current portion of the balance sheet. FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – The Current Ratio • The current ratio is calculated as: • The analyst must consider how much inventory the company carries in assessing this ratio. • Problem: • The effect on the current ratio of an equivalent increase in current assets and current liabilities depends on whether or not the current ratio was previously greater than or less than one. • Can be greatly affected by economic conditions. FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – The Quick Ratio • Sometimes, inventories and some other current assets may not be very liquid (i.e., easily converted into cash). • Therefore, they shouldn’t be considered in assessing a firm’s ability to meet its current obligations since they don’t really add to this ability. • The quick ratio is calculated as: FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – The Cash Ratio • An even more conservative measure is the cash ratio. This ratio assumes that only cash and marketable securities should be considered in evaluating a firm’s ability to meet its current obligations. • The cash ratio is calculated as: FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – Accounts Receivables Turnover • The rate at which A/R turn gives an indication of how quickly a firm’s receivables are converted into cash. • The A/R turnover ratio is calculated as: FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – Accounts Receivables Turnover • This rate implies an average A/R collection period: i.e., if the Average A/R collection period is 10, this implies that on average it takes the firm 10 days to collect cash from sales on credit. • Potential problem: Where do we get credit sales from? FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – Accounts Receivables Turnover, cont. • Firms might extend credit to induce sales, how might this affect receivables turnover? • Firms make a trade-off in deciding the desirable receivables turnover rate. • Receivables turnover too high – strict credit policies, may be refusing credit to the creditworthy • Receivables turnover too low – lax credit policies, may be extending too much credit to the non-creditworthy. Large deviations from the industry average A/R collection period may be a red flag. FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – Inventory Turnover • The rate at which inventories turn gives an indication of how soon they will be sold. • The inventory turnover ratio is calculated as: FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – Inventory Turnover, cont. • This rate implies an average inventory processing time: • Question: What would you expect Wal-Mart’s average processing time to be? What would you expect a jeweler’s average processing time to be? • These ratios vary widely by industry. Be careful when comparing across industries. FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – Inventory Turnover, cont. • Increasing inventory turnover ratios might indicate more efficient inventory control systems. • A JIT inventory system will increase the inventory turnover rate to infinity. • Firms make a trade-off in deciding the desirable inventory turnover rate. • Inventory turnover too high – potential inventory shortages, may have to turn away customers and lose sales • Inventory turnover too low – excess inventory on hand, increased carrying costs, inventory obsolescence FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – Inventory Valuation • These ratios are affected by inventory valuation method. • Three common inventory valuation methods: • Average cost – values each unit of inventory at the same cost, a weighted average of all inventory units EVER purchased. • First-In-First-Out (FIFO) – assumes goods are sold in order of their purchase by the firm. • Last-In-First-Out (LIFO) – assumes goods are sold in reverse order of their purchase by the firm. FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – Inventory Valuation, cont. • What we are measuring is cost flow and NOT the actual flow of goods. • Inventory valuation is a cost allocation mechanism. • If input prices are • Constant: FIFO = Average = LIFO • Rising: FIFO < Average < LIFO • Declining: FIFO > Average > LIFO • In making a comparison across firms, if the two firms don’t use the same valuation method the comparison is NOT reasonable. FINA 4397 - Financial Statement Analysis

Evaluating Internal Liquidity – Inventory Valuation, cont. • FIFO has good balance sheet effects but poor income statement effects. • On the B/S, inventory is listed closer to replacement cost. • On the I/S, COGS reflects possibly old input prices. • LIFO has good income statement effects but poor balance sheet effects. • On the I/S, COGS reflects more recent input prices. • On the B/S, inventory is listed at old replacement costs. FINA 4397 - Financial Statement Analysis

Financial Statement Analysis