© copyrright doug hillman 2000 analysis and interpretation of
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1© Copyrright Doug Hillman 2000
Analysis and Interpretation of
Financial Statements
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Financial Statement Analysis
The application of analytical tools and techniques to financial statement data.
Allows users to focus on how numbers are related and how they have changed over time
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Objective of Financial StatementAnalysis
External users rely on general purpose financial statements
Make predictions about an organization as an aid in making decisions
Users highlight important trends or changes
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Risk and Return
Users try to balance the risk of an investment with its expected return
Generally the greater the risk, the higher the return
Financial statement analysis is one source of information for assessing risk and return
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Sources of External Information
Public companies must publish an annual financial report
Government reports› SEC 10K, 10Q
Financial service information› Moody’s, Dow-Jones
Financial newspapers and periodicals› Wall Street Journal
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Financial Analysis Tools
Horizontal analysis Vertical analysis Ratio analysis
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Horizontal Analysis: Amounts and Percentages
of Change
Amount of change = later year amount - Earlier year amount
Percentage change = Amount of change / Earlier year amount
Look for significant change
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Horizontal Analysis: Trend Percentages
Set all amounts in base year at 100% Compute percentages for a number of years
› Divide each statement amount by respective amount in base year
Shows degree of increase or decrease in individual statement items
Used to explain changes in operating performance
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Vertical Analysis Shows how each item in a financial
statement compares to the total of that statement
Balance sheet
› Set both total assets and total equities at 100%
Income statement
› Set net sales at 100%
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Vertical Analysis
Identify significant dollar and percentage changes
Explain the changes Identify whether they are favorable of
unfavorable
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Ratio Analysis
Shows the relative size of one financial statement component to another.
Effective only when used in combination with other ratios, analysis, and information
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Ratio Analysis
Short-term liquidity Long-term solvency Profitability Market performance
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Short-term Profitability
Current ratio Quick ratio Accounts receivable turnover Days’ sales in receivables Inventory turnover
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Current Ratio
Common measure of liquidity
› Ability to pay debts as they come due
› Rule of thumb 2:1
› Consider other factors
Current Assets
Current Liabilities
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Quick Ratio (Acid Test)
More strict measure of short-term liquidity
Numerator includes only quick current assets
› Assets readily converted to cash
Cash + Short-term investments + NetCurrent Receivables
Current liabilities
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Accounts Receivable Turnover
How many times we turn accounts receivable into cash during a period
Net sales
Average net accounts receivable
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Days’ Sales in Receivables
How many days’ sales remain uncollected in accounts receivable
Net sales per day =Net sales
365 days
Average net accounts receivable
Net sales per day
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Inventory Turnover
Number of times the company sells and replaces its inventory during the period
Holding inventory results in financing and storage costs
Cost of goods sold
Average inventory
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Long-term Solvency
Debt ratio Times Interest Earned
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Debt Ratio
Shows amount of total assets creditors provide
Higher levels of debt financing means company has a higher risk of not meeting interest and principal payments
Total liabilities
Total assets
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Times Interest Earned
Number of times the company earned interest expense with current income
Creditors want to know the firm’s ability to pay annual interest charges
Net income + Income tax expense + Interest expense
Interest expense
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Profitability
Profit margin Total asset turnover Return on total assets Return on owners’ equity Earning per share
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Profit Margin
Percentage each sales dollar contributes to net income
Net income
Net sales
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Total Asset Turnover
Measures the efficiency of the company is using its investment in assets to generate sales
Net sales
Average total assets
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Return on Total Assets
Measures the amount a company earns on each dollar of investment in assets
Net income
Average total assets
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Return on Owners’ Equity
Measures the earnings in relation to the owners’ investment in the company
Net income - Preferred dividends
Average owner’s equity
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Earnings Per Share
Measures the net income available to each share of common stock
Discussed in depth in Chapter 14
Net income - Preferred dividends
Weighted average number of common shares outstanding during the year
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Market Performance
Price/Earnings (P/E) ratio Dividend yield
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Price/Earning (P/E) Ratio
Number of times earnings per share the stock is currently selling for in the market
Market price per share of common stock
Earnings per share
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Dividend Yield
Measure of dividend-paying performance of a company
Investors buy stock for two reasons
› Receive cash dividends
› Sell stock at a higher price
Dividends per share
Market price per share
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Limitations of Financial Analysis Tools
Historical nature of accounting information
Changing economic conditions Comparisons with industry averages Seasonal factors Quality of reported income