1 Financial Statements and Reports Financial reporting is used to disclose information about the firm Financial statements provided to stockholders/creditors SEC IRS Management Annual report—includes a general discussion about the firm’s activities during the past year and expectations in the near future financial statements of the firm for the most recent years
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Financial Statements and Reports
Financial reporting is used to disclose information about the firmFinancial statements provided tostockholders/creditorsSECIRSManagement
Annual report—includesa general discussion about the firm’s activities
during the past year and expectations in the near future
financial statements of the firm for the most recent years
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Income Statement
Provides a summary of the revenues recognized and the expenses incurred during a particular operating period.
Matching principle—revenues are recognized when sales occur (earned) and expenses are realized when they are incurred.
Accrual accounting versus cash flows
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Balance Sheet
Records the financial position of the firm at a particular point in time by showing the assets—that is, the investments—and the liabilities and equity—that is, the financing—of the firm.
Historical costs
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Balance Sheet
Cash versus other assets—only cash represents actual funds that can be invested
Fixed assets if no purchases or sales = $9,000 - $2,000 = $7,000Depreciation = $2,000Change in fixed assets = $10,000 - $7,000 = $3,000
Sources of Cash Uses of Cash Asset Account Asset Account
Source Use
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Eagle, Inc. Balance Sheet—Changes in Liabilities and Equity
CurrentPrevious
Year Year
Accounts payable $ 4,000$ 2,000
Accruals 5,0004,000
Notes payable 1,000 2,000
Current liabilities 10,0008,000
Long-term debt 6,000 7,000
Total liabilities 16,00015,000
Common stock 6,0006,000
Retained earnings 3,000 2,000
Owners’ equity 9,0008,000
Total liabilities & equity$25,000$23,000
Change2,0001,000(1,000)
(1,000)
0--
Source UseXX
X
X
-- --
Sources of Cash Uses of Cash Liability/Equity Account Liability/Equity Account
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Eagle, Inc. Statement of Cash Flows
Cash Flows from Operations:Net income (NI) $3,000
Adjustments to NI
Depreciation 2,000 Inventory 1,000
Accounts payable 2,000
Accruals 1,000
Accounts receivable(1,000)Net CF from operations $8,000
Cash Flows from Long-Term Investing:Acquisition of assets (3,000)
Cash Flows from Financing Activities: Notes payable (1,000)
Long-term bonds (1,000)
Dividend payment (2,000)
Net CF from financing $(4,000)
Net Change in cash 1,000Cash at beginning of year 1,000Cash at end of year $2,000
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Financial Statements:Accounting Alternatives
In many instances, the same business activity can be recorded using one of several accepted accounting methods—for example, LIFO versus FIFO for inventory valuation.
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Financial Statements:Time Dimension
Balance sheet—a “snapshot” of where the firm is at a specific point in time (stock statement).
Income statement and statement of cash flows—shows the results of the firm’s activities over a period of time (flow statement).
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What Information Do Investors Use from Financial Statements?
Net working capital (NWC)= Current assets - Current liabilities
Economic Value Added (EVA)= NOI (1 - T) - [(Invested capital) X (After-tax cost of funds)]
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Financial Statement (Ratio) Analysis
Used to evaluate how financial positions:
Change on a year-to-year basis for a single firm.
Compare among firms, even if they differ in size.
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Ratio (Financial Statement) Analysis
Used by:
Managers inside the firm
Stockholders and creditors—existing and potential—outside the firm
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Ratio (Financial Statement) Analysis
General categories of analysis:
Liquidity
Asset management
Debt management
Profitability
Market value
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Liquidity Ratios
Help measure the liquidity position of the firm
Too little, or too much liquidity could be considered a “bad sign”too little liquidity—suggests the firm will have
problems paying its current obligations in the future
too much liquidity—might suggest the firm is not investing its funds wisely
Provide an indication of how well the firm can meet its current obligations
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Current ratio
Shows the relationship between current assets and current liabilities; a higher value suggests greater liquidity, and vice versa:
sliabilitieCurrent
assetsCurrent = ratioCurrent
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Quick (Acid Test) Ratio
Similar to the current ratio, except the value of inventories is subtracted from current assets (CA) in the numerator; inventories represent the least liquid of the current assets:
LC
sInventorie - AC = ratio test,acid-or Quick,
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Asset Management Ratios
Show how often the firm is “turning over” its assets to generate funds
Generally, when assets are not turned over quickly enough, it is because sales have slowed or current assets, such as inventory and receivables, are too high
If assets are turned over too quickly, it could mean that the firm is not producing enough
Provide an indication of how well the firm manages its assets (efficiency)
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Inventory Turnover
Shows how many times during a period—for example, one year—the amount of average inventory is turned over due to sales activities.
sInventorie
sold goods ofCost =turnover Inventory
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Days Sales Outstanding (DSO)
Indicates the average time it takes customers to pay for credit purchases—that is, the length of time it takes the firm to collect for credit sales.
360sales Annual
sReceivable =
dayper sales Average
sReceivable = (DSO) goutstandin
sales Days
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Fixed Assets Turnover
Indicates how efficiently the firm uses its fixed assets (excludes current assets) to produce revenues
assets fixedNet
Sales = ratio turnover assets Fixed
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Total Assets Turnover
Similar to the fixed assets turnover, except the value of total assets (includes current assets) is used.
assets Total
Sales = ratio turnover assets Total
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Debt Management Ratios
financial leverage refers to the use of debt
leverage helps to magnify returns, on both the positive and the negative sides, because debt represents a fixed obligation
Indicate how the firm’s financial position is affected by the amount of debt it has
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Debt Ratio
Indicates the capital structure of the firm; measures the percent debt used by the firm for the purposes of financing assets.
assets Total
sliabilitie Total =
assets Total
debt Total = ratioDebt
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Times-Interest-Earned (TIE) Ratio
Indicates whether the firm generates sufficient operating income (not cash) to meet its interest obligations each year.
chargesInterest
income Operating =
chargesInterest
EBIT = ratio earnedinterest-Times-
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Fixed Charge Coverage Ratio
Like the times-interest-earned ratio, except all fixed payments related to financing are included.
sobligation financing Fixed
sobligation financingcover toavailable Funds
paymentsLease
esargchInterest
payments LeaseEBITratio eragecov
charge Fixed
ratetax 1payments fund Sinking
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Profitability ratios
Indicate how the firm’s management of its liquidity position, assets, and debt has affected normal operating activities.
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Net Profit Margin
Shows what percent of sales revenues is left after expenses related to operations and the effects of financing and taxes.
Sales
incomeNet =margin profit Net
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Return on Total Assets (ROA)
Measures the return on investment earned by the firm; ROA represents a return on all invested funds (both debt and equity).
assets Total
incomeNet = (ROA) assets on totalReturn
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Return on Equity (ROE)
Similar to ROA, ROE is a measure of the return on the original funds provided by common stockholders (equity only).
equity Common
dividends Preferred incomeNet
equityCommon
rsstockholdecommon toavailable Income(ROE) Equity
on turnRe
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Market Value Ratios
Measures that consider the value of the firm’s stock in the financial markets—that is, how well investors perceive that the firm is creating value.
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Price/Earnings (P/E) Ratio
Indicates how much investors pay for each dollar of income generated by the firm.
goutstandin sharescommon ofNumber
rsstockholdecommon toavailable Income =
(EPS) SharePer Earnings
shareper Earnings
shareper price Market = ratio ingsPrice/earn
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Market/Book Value Ratio
Indicates the relationship between the selling price of the common stock and its book value.
goutstandin sharescommon of Number
equityCommon
shareper ueMarket val
shareper Book value
shareper ueMarket val valuebook/Market
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Trend and Comparative Analyses
Ratios should be evaluated
At a point in time in comparison to a norm, such as an industry average, to determine the firm’s current financial position (comparative analysis).
Over time to determine whether the firm’s current financial position is improving or deteriorating (trend analysis).
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Du Pont Equation/Method
Shows the relationship between the return on investment (ROA) and both the total assets turnover and the net profit margin so as to give more detail where weaknesses or strengths exist.
For example, if ROA is relatively low, it might be due to a low profit margin, a slow turnover of assets, or both.
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Du Pont Equation
assets Total
Sales
Sales
income Net x
turnoverassets Total margin profit Net ROA x
assets Total
income Net
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Classifying a very large, multidivisional firm into a single industry often is difficult.
Using a single norm, or “target,” ratio for comparisons might be misleading.
Values on balance sheets are historical costs, so ratios might not portray a “true” picture.
Seasonality in operations might cause ratios to differ significantly at different times of the year.
Uses and Limitations of Ratio Analysis
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Uses and Limitations of Ratio Analysis
Sometimes firms try to make financial statements look better by using “window dressing” techniques.
If firms use different accounting methods, comparisons between firms can be difficult.
Do not make general conclusions about the firm’s financial position by examining only one or a few ratios; ratio analysis should be comprehensive.
The most important part of ratio analysis is the judgment used when interpreting the results, not the computation of the ratios.