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Analysis of Financial Statements

Analysis of Financial Statements. Chapter 7. Requests for permission to make copies of any part of the work should be mailed to: Thomson/South-Western 5191 Natorp Blvd. Mason, OH 45040. Financial Statements and Reports. Annual Report

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Analysis of Financial Statements

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  1. Analysis of Financial Statements Chapter 7 Requests for permission to make copies of any part of the work should be mailed to: Thomson/South-Western5191 Natorp Blvd.Mason, OH 45040

  2. Financial Statements and Reports • Annual Report • a report issued annually by a corporation to its stockholders • management’s opinion of the past year’s operations and the firm’s future prospects

  3. Financial Statements and Reports • Annual Report • basic financial statements • income statement • balance sheet • statement of retained earnings • statement of cash flows

  4. Financial Statements and Reports • Income Statement • a statement summarizing the firm’s revenues and expenses over an accounting period, generally a quarter or a year

  5. Financial Statements and Reports • Balance Sheet • a statement of the firm’s financial position at a specific point in time

  6. Financial Statements and Reports • Balance Sheet - points worth noting • Cash versus other assets • Liabilities versus stockholders equity • Preferred versus common stock • Breakdown of common equity account • common stock • paid in capital • retained earnings

  7. Financial Statements and Reports • Balance Sheet - points worth noting • Accounting alternatives • FIFO (first-in, first-out) • LIFO (last-in, first-out) • Accelerated or straight-line depreciation • The time dimension • balance sheet is at a point in time

  8. Financial Statements and Reports • Statement of Retained Earnings • a statement reporting changes in the firm’s retained earnings as a result of the income generated and retained during the year • the balance sheet figure for retained earnings is the sum of the earnings retained for each year the firm has been in business

  9. Financial Statements and Reports • Accounting income versus cash flow • Cash Flows • the cash receipts and the cash disbursements, as opposed to the revenues and expenses reported for computation of net income, generated by a firm during some specified period

  10. Financial Statements and Reports • Accounting income versus cash flow • Accounting profit • a firm’s net income as reported on its income statement • Operating cash flows • those cash flows that arise from normal operations • the difference between cash collections and cash expenses

  11. Financial Statements and Reports • Statement of cash flows • a statement reporting the impact of a firm’s operating, investing, and financing activities on cash flows over an accounting period

  12. Financial Statements and Reports • Statement of cash flows • sources of cash • increase in liability or equity account • decrease in an asset account • uses of cash • decrease in a liability or equity account • increase in an asset account

  13. Argile Textiles: Cash Sources & Uses 2007

  14. Argile Textiles: Statement of Cash Flows (for the period ending Dec. 31, 2007)

  15. Ratio Analysis • Liquid asset • an asset that can be easily converted into cash without significant loss of its original value • Liquidity ratios • ratios that relates the firm’s cash and other assets to its current liabilities

  16. Ratio Analysis • Current ratio • indicates the extent to which current liabilities are covered by assets expected to be converted into cash in the near future

  17. Ratio Analysis • Quick (acid test) Ratio • deducts inventories from current assets and divides the remainder by current liabilities • a variation of the current ratio

  18. Ratio Analysis • Asset management ratios • ratios that measure how effectively a firm is managing its assets

  19. Ratio Analysis • Inventory Turnover Ratio

  20. Ratio Analysis • Days Sales Outstanding(DSO)

  21. Ratio Analysis • Fixed Assets Turnover Ratio

  22. Ratio Analysis • Total Assets Turnover Ratio

  23. Ratio Analysis • Debt management ratios • analyze the company’s use of debt • Financial leverage • the use of debt financing

  24. Ratio Analysis • Debt ratio

  25. Ratio Analysis • Times-Interest-Earned (TIE) Ratio

  26. Ratio Analysis • Fixed Charge Coverage Ratio

  27. Ratio Analysis • Profitability ratios • ratios showing the effect of liquidity, asset management, and debt management on operating results

  28. Ratio Analysis • Net profit margin on sales

  29. Ratio Analysis • Return on Total Assets (ROA)

  30. Ratio Analysis • Return On common Equity (ROE)

  31. Ratio Analysis • Market Value Ratios • ratios that relate the firm’s stock price to its earnings and book value per share

  32. Ratio Analysis • Earnings per share (EPS)

  33. Ratio Analysis • Price/Earnings (P/E) Ratio

  34. Ratio Analysis • Book value per share

  35. Ratio Analysis • Market/Book (M/B) Ratio

  36. Ratio Analysis • Trend analysis • an analysis of a firm’s financial ratios over time • used to determine improvement or deterioration in its financial situation

  37. Ratio Analysis • Summary of ratio analysis: The Du Pont Chart • a chart designed to show the relationships among return on investment, asset turnover, the profit margin, and leverage

  38. Ratio Analysis • Du Pont Equation

  39. Ratio Analysis • Comparative ratio analysis • an analysis based on a comparison of a firm’s ratios with those of other firms in the same industry

  40. Uses and Limitations of Ratio Analysis • Large firms operate divisions in different industries • difficult to develop meaningful industry averages • If the goal is to be better than average, industry averages are not the target • focus on the industry leaders’ ratios

  41. Uses and Limitations of Ratio Analysis • Inflation distorts balance sheets • depreciation and inventory costs affect income statements • comparative analysis of firm over time • comparing firms of different ages

  42. Uses and Limitations of Ratio Analysis • Seasonal factors distort ratios • use monthly averages as base for inventory and receivables instead of one particular month • Window dressing techniques • make financial statements appear better than they actually are • borrowing “long-term” to be repaid quickly distorts liquidity ratios

  43. Uses and Limitations of Ratio Analysis • Different accounting practices • distorts comparisons • inventory valuation • depreciation methods

  44. Uses and Limitations of Ratio Analysis • Difficult to generalize about “good” or “bad” ratios • high current ratio can indicate strong liquidity or excessive cash • high fixed assets turnover can indicate efficient use or undercapitalized

  45. Uses and Limitations of Ratio Analysis • Firm may have some “good” ratios and others that look “bad” • difficult to tell whether overall the company is strong or weak • statistical procedures can analyze the net effects of a set of ratios

  46. End of Chapter 7 Analysis of Financial Statements

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