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Financial Statement Analysis Essentials: Principles, Ratios, and Limitations

Understand the key principles of financial statements, analysis methods like ratio analysis, limitations of accounting data, depreciation impact, and DuPont system for identifying financial weaknesses. Learn to interpret ratios and comparison techniques.

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Financial Statement Analysis Essentials: Principles, Ratios, and Limitations

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  1. Chapter 10 Analysis of Financial Statements

  2. General Accounting Principles • Reliability • Understandability • Comparability

  3. Primary Financial Statements • The balance sheet enumerates • Assets • Liabilities • Equity

  4. Assets • Current: cash and equivalents, accounts receivable, and inventory • Long-term: land, buildings, machinery, and equipment • Hidden assets

  5. Liabilities • Current • .Accounts Payable • Accruals • Notes payable • Long-term

  6. Equity • Preferred stock • Common stock • Additional paid-in capital • Retained earnings • Book value • Book value per share

  7. The Income Statement • Enumerates • Revenues • Expenses • To determine • Income (earnings) • Earnings per share

  8. Analysis of Cash Flow: Statement of Cash Flows • Enumerates • sources of funds • uses of funds • Determines change in the cash position • Emphasis on the firm’s ability to generate cash

  9. Cash Inflows • A decrease in an asset • An increase in a liability • An increase in equity

  10. Cash Outflows • An increase in an asset • A decrease in a liability • A decrease in equity

  11. Limitations of Accounting Data • Nonmeasureable items are excluded • Aggregations • Biased estimates of data • Insufficient challenges by auditors

  12. Depreciation • Allocation of the cost of plant and equipment over time • Non-cash expense • Impact on taxes and cash flow

  13. Depreciation • Straight-line depreciation • Equal allocation each year • Accelerated depreciation • Larger proportion during the early years

  14. Modified Accelerated Cost Recovery System (MACRS) • Asset classified by years 3, 5, 7, 10, 15, 20 years • The half-year convention

  15. Corporate Losses • Offset earnings from other years • Carry back 3 years then • Carry forward

  16. Ratio Analysis • Builds on a firm's financial statements • Easy to understand • Used by both equity investors and creditors

  17. Ratio Analysis • Facilitates Comparisons • Over time: time-series analysis • Across firms: cross-sectional analysis

  18. An Application of Ratio Analysis • The following ratios use Pier I Imports 2002 financial statements

  19. Current Ratio • Current assets / current liabilities • $605.1 / $208.4 = 2.90

  20. Quick Ratio • (Current assets - inventory) / current liabilities • ($605.1 - $275.4) / $208.4 = 1.58

  21. Inventory Turnover • Sales / average inventory • $1,548.9 / $293.1 = 5.3

  22. Receivables Turnover • Sales / accounts receivable • $1,548.6 / $6,205 = 249.6 • Answer is not meaningful

  23. Receivables Turnover • For Southern Company$10,155 / $1,132 = 8.97 • Interpretation: 8.97 is about nine times a year or every six weeks.

  24. Average Collection Period(days sales outstanding) • For Southern Company • Accounts receivable / sales per day • $1,132 / $28,208 = 40 days

  25. Fixed Asset Turnover • Sales / fixed assets • $1,159 / $209.9 = 7.38

  26. Total Asset Turnover • Sales / total assets • $1,159 / $862.7 = 1.80

  27. Gross Profit Margin • (revenues - cost of goods sold) / sales • $649.8 / $1,549 = 41.96%

  28. Operating Profit Margin • Operating earnings / sales • $158.8 / $1,549 = 10.26%

  29. Net Profit Margin • Earnings after taxes / sales • $100.2 / $1,549 = 6.47%

  30. Return on Assets • Earnings after taxes / total assets • $100.2 / $862.7 = 11.6%

  31. Return on Equity • Earnings after taxes / equity • $100.2 / $585.6 = 17.1%

  32. Return on Common Equity • Adjusts for preferred stock • If no preferred, ratio is same as return on equity

  33. Basic Earning Power • EBIT / total assets • $158.8 / $862.7 = 18.47%

  34. Debt Ratio • Debt / total assets • $277.0 / $862.7 = 32.1%

  35. Debt to Equity Ratio • Debt / equity • $277.0 / $585.7 = 47.3%

  36. DuPont System of Analysis • Combines • Net profit margin • Turnover • Leverage • Helps identify source of weakness

  37. DuPont System of Analysis

  38. Times-interest-earned • Earnings before interest and taxes / interest • $158,813 / $-184 = -863.1 • Interest earned exceeded interest paid.

  39. Ratio Comparisons • Ratios of firms within an industry • tend to have similar numerical values • differences in numerical values are reasons for further analysis

  40. Problems for Interpretation • Different definitions for the same ratio • Historical data may be outmoded • Non-recurring items • Internet sources differ

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