© Copyrright Doug Hillman 2000 Analysis and Interpretation of ...

1© Copyrright Doug Hillman 2000

Analysis and Interpretation of

Financial Statements


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


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


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


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


Financial Analysis Tools

Horizontal analysis Vertical analysis Ratio analysis


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


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


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%


Vertical Analysis

Identify significant dollar and percentage changes

Explain the changes Identify whether they are favorable of

unfavorable


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


Ratio Analysis

Short-term liquidity Long-term solvency Profitability Market performance


Short-term Profitability

Current ratio Quick ratio Accounts receivable turnover Days’ sales in receivables Inventory turnover


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


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


Accounts Receivable Turnover

How many times we turn accounts receivable into cash during a period

Net sales

Average net accounts receivable


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


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


Long-term Solvency

Debt ratio Times Interest Earned


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


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


Profitability

Profit margin Total asset turnover Return on total assets Return on owners’ equity Earning per share


Profit Margin

Percentage each sales dollar contributes to net income

Net income

Net sales


Total Asset Turnover

Measures the efficiency of the company is using its investment in assets to generate sales

Net sales

Average total assets


Return on Total Assets

Measures the amount a company earns on each dollar of investment in assets

Net income

Average total assets


Return on Owners’ Equity

Measures the earnings in relation to the owners’ investment in the company

Net income - Preferred dividends

Average owner’s equity


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


Market Performance

Price/Earnings (P/E) ratio Dividend yield


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


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


Limitations of Financial Analysis Tools

Historical nature of accounting information

Changing economic conditions Comparisons with industry averages Seasonal factors Quality of reported income

© Copyrright Doug Hillman 2000 Analysis and Interpretation of ...

Economy & Finance

income statement

charges net income

net income available

quick current assets

total assets creditors

financial statement

financial statement

sales dollar