understanding financial statements seventh edition lyn m. fraser aileen ormiston insert book cover

Understanding Understanding Financial Statements Financial Statements Seventh Seventh EDITIONEDITION

Lyn M. Fraser Lyn M. Fraser

Aileen OrmistonAileen Ormiston Insert BOOK COVER

(C) 2004 Prentice Hall, Inc.(C) 2004 Prentice Hall, Inc.

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The Analysis of The Analysis of Financial StatementsFinancial Statements

Chapter 5

This chapter will develop tools and techniques for the interpretation of financial information


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Objectives of AnalysisObjectives of Analysis

Specify the objectives of the analysisSpecify the objectives of the analysis

Focus on WHO is the financial statement Focus on WHO is the financial statement useruser

Remember--the identity of the user Remember--the identity of the user helps define what information is helps define what information is needed needed

First order of business is toFirst order of business is to


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Objectives of AnalysisObjectives of Analysis ContinuedContinued

CreditorsCreditors

InvestorsInvestors

ManagementManagement

Potential Financial Statement Users:Potential Financial Statement Users:

What types of questions do each of these What types of questions do each of these users seek answers to? seek answers to?


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CreditorsCreditors

A creditor is ultimately concerned A creditor is ultimately concerned with the ability of an existing or with the ability of an existing or prospective borrower to make prospective borrower to make interest and principal payments interest and principal payments on borrowed funds on borrowed funds


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CreditorsCreditors Continued Continued

What is the borrowing cause?What is the borrowing cause? What is the firm’s capital What is the firm’s capital

structure?structure? What will be the source of debt What will be the source of debt

repayment? repayment?

Questions raised in a credit analysis should include:


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InvestorsInvestors

The ultimate objective is to The ultimate objective is to determine whether the determine whether the investment is sound investment is sound


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InvestorsInvestors Continued Continued

How has the firm performed/what How has the firm performed/what are future expectations?are future expectations?

How much risk is inherent in the How much risk is inherent in the existing capital structure?existing capital structure?

What are expected returns?What are expected returns? What is firm’s competitive What is firm’s competitive

position?position?

The investment analyst poses questions as:


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ManagementManagement

CreditorsCreditorsInvestorsInvestors

EmployeesEmployeesGeneral publicGeneral public

RegulatorsRegulatorsFinancial press Financial press

Management relates to all questions raised by:


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ManagementManagement Continued Continued

How well the firm has How well the firm has performed and why?performed and why?

What operating areas have What operating areas have contributed to success and contributed to success and which have not?which have not?

Looks to Financial Statement Data to Determine:


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ManagementManagement Continued Continued

What are strengths/weaknesses What are strengths/weaknesses of company’s financial position?of company’s financial position?

What changes are indicated to What changes are indicated to improve future performance? improve future performance?

Looks to Financial Statement Data to Determine:


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Caution!!!Caution!!! Keep in mind: management Keep in mind: management

PREPARES financial statementsPREPARES financial statements Analyst should be alert to potential Analyst should be alert to potential

for management to influence for management to influence reporting to make data more reporting to make data more “appealing”“appealing”

May want to supplement analysis May want to supplement analysis with information apart from Annual with information apart from Annual Report prepared by managementReport prepared by management


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Sources of InformationSources of Information

Proxy StatementProxy StatementMD&AMD&A

Supplementary schedulesSupplementary schedulesForm 10-K and Form 10-QForm 10-K and Form 10-Q

The analyst will want to consider the following resources:


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Other Sources of Other Sources of InformationInformation Computerized data basesComputerized data bases

Info on industry norms/ratiosInfo on industry norms/ratios Info on particular Info on particular

companies/industries/ mutual fundscompanies/industries/ mutual funds

Articles in popular/business press Articles in popular/business press Ever-expanding websites Ever-expanding websites


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Tools and TechniquesTools and Techniques

Common-size financial statementsCommon-size financial statements

Financial ratiosFinancial ratios

Trend analysisTrend analysis

Structural analysisStructural analysis

These include:These include:

Most important:Most important:Common sense and judgment


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Common-Size Common-Size Financial StatementsFinancial Statements

Express each account on the Express each account on the balance sheetbalance sheet as a percentage as a percentage of total assets and each of total assets and each account on the account on the income income statementstatement as a percentage of as a percentage of net sales net sales


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Key Financial RatiosKey Financial Ratios

Standardize financial data in terms of Standardize financial data in terms of mathematical relationships mathematical relationships expressed in the form of expressed in the form of percentages or times percentages or times


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Key Financial RatiosKey Financial Ratios ContinuedContinued

1.1. Liquidity RatioLiquidity Ratio

Measures a firm’s ability to meet Measures a firm’s ability to meet cash needs as they arise cash needs as they arise

Four Categories of ratios:


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Four Categories of RatiosFour Categories of Ratios ContinuedContinued

2.2. Activity RatioActivity Ratio

Measures the liquidity of specific Measures the liquidity of specific assets and the efficiency of assets and the efficiency of managing assetsmanaging assets


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Four Categories of RatiosFour Categories of Ratios ContinuedContinued

3.3. Leverage RatioLeverage Ratio

Measures the extent of a firm’s Measures the extent of a firm’s financing with debt relative to financing with debt relative to equity and its ability to cover equity and its ability to cover interest and other fixed charges interest and other fixed charges


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4.4. Profitability RatioProfitability Ratio

Measures the overall performance Measures the overall performance of a firm and its efficiency in of a firm and its efficiency in managing assets, liabilities and managing assets, liabilities and equity equity

Four CategoriesCategories of Ratios Continued


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Caution!Caution!

Ratios are valuable, BUT. . .Ratios are valuable, BUT. . .

They do not provide answers in and They do not provide answers in and of themselves and are not of themselves and are not predictive predictive


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More Cautions!More Cautions!

Ratios should be used with Ratios should be used with other elements of financial other elements of financial analysisanalysis

There are no “rules of thumb” There are no “rules of thumb” that apply to interpretation of that apply to interpretation of ratios ratios


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More Cautions!More Cautions! Continued Continued

Keeping this in mind, let’s take a Keeping this in mind, let’s take a look at some of the ratios. . . . look at some of the ratios. . . .


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Liquidity Ratios: Liquidity Ratios: Short-Term SolvencyShort-Term Solvency

Measures ability to meet short-Measures ability to meet short-term cash needs term cash needs

Current RatioCurrent Ratio

sliabilitieCurrent

assetsCurrent


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Liquidity Ratios: Liquidity Ratios: Short-Term SolvencyShort-Term Solvency ContinuedContinued

Measures ability to meet short-term Measures ability to meet short-term cash needs more rigorouslycash needs more rigorously

Quick or Acid-Test Ratio

sliabilitieCurrent

Inventory - assetsCurrent


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Focuses on ability of the firm to Focuses on ability of the firm to generate operating cash flows generate operating cash flows as a source of liquidityas a source of liquidity

Cash Flow Liquidity Ratio

*Cash flow from operating activities sliabilitieCurrent

*CFO securities Marketable Cash


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Helps gauge liquidity of accounts Helps gauge liquidity of accounts receivable (ability to collect receivable (ability to collect cash from customers)cash from customers)

Average Collection Period

salesdaily Average

receivable Accounts


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Is the average number of days it takes Is the average number of days it takes to sell inventory to customersto sell inventory to customers

Days Inventory Held

sales ofcost daily Average

Inventory


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Is the average number of days it takes Is the average number of days it takes to pay accounts payables in cashto pay accounts payables in cash

Days Payable Outstanding

sales ofcost daily Average

payable Accounts


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Net Trade CycleNet Trade Cycle

Buying or manufacturing Buying or manufacturing inventory, with some purchases inventory, with some purchases on crediton credit

Selling inventory, with some sales Selling inventory, with some sales on crediton credit

Collecting the cash Collecting the cash

Is the normal cycle of a firm Is the normal cycle of a firm that consists of:that consists of:


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Net Trade CycleNet Trade Cycle Continued Continued

Average collection periodAverage collection period

PlusPlus

Days inventory heldDays inventory held

MinusMinus

Days payable outstandingDays payable outstanding

EqualsEquals

Net trade cycleNet trade cycle


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Activity Ratios: Assets Activity Ratios: Assets Liquidity, Asset Liquidity, Asset Management EfficiencyManagement Efficiency

Another measure of efficiency of firm’s Another measure of efficiency of firm’s collection and credit policiescollection and credit policies

Accounts Receivable TurnoverAccounts Receivable Turnover

receivable Accounts

salesNet


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Activity Ratios: Assets Activity Ratios: Assets Liquidity, Asset Management Liquidity, Asset Management EfficiencyEfficiency Con’t Con’t

Measures efficiency of inventory Measures efficiency of inventory managementmanagement

Inventory Turnover

Inventory

sold goods ofCost


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Another measure of efficiency of Another measure of efficiency of inventory managementinventory management

Payables Turnover

payable Accounts

sold goods ofCost


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Assesses effectiveness in generating Assesses effectiveness in generating sales from investment in fixed assetssales from investment in fixed assets

Fixed Asset Turnover

equipment plant, property,Net

salesNet


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Assesses effectiveness in generating sales Assesses effectiveness in generating sales from investment in total assetsfrom investment in total assets

Total Asset Turnover

assets Total

salesNet


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Leverage Ratios: Leverage Ratios: Debt Financing and Debt Financing and CoverageCoverage

Measures the extent of firm’s Measures the extent of firm’s financing with debtfinancing with debt

Debt Ratio

assets Total

sliabilitie Total


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Leverage Ratios: Leverage Ratios: Debt Financing and CoverageDebt Financing and Coverage Con’t. Con’t.

Measures the extent of firm’s Measures the extent of firm’s financing with long-term debtfinancing with long-term debt

Long-term Debt to Total Capitalization

equity rs'Stockholde debt term-Long

debt term-Long


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Leverage Ratios: Leverage Ratios: Debt Financing and CoverageDebt Financing and Coverage Con’t Con’t

Measures the extent of firm’s Measures the extent of firm’s financing with debtfinancing with debt

Debt to Equity

equity rs'Stockholde

sliabilitie Total


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Leverage Ratios: Leverage Ratios: Debt Financing and CoverageDebt Financing and Coverage Con’tCon’t

Indicates how well operating earnings Indicates how well operating earnings cover fixed interest chargescover fixed interest charges

Times Interest Earned

expenseInterest

profit Operating


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Measures how many times interest Measures how many times interest payments can be covered by payments can be covered by cash flow from operations cash flow from operations before interest and taxesbefore interest and taxes

Cash Interest Coverage

paidInterest

paid taxes paidinterest CFO


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Broader measure of how well operating Broader measure of how well operating earnings cover fixed chargesearnings cover fixed charges

Fixed Charge Coverage

expenseRent expenseInterest

expenseRent profit Operating


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Measures firm’s ability to cover capital Measures firm’s ability to cover capital expenditures, long-term debt expenditures, long-term debt payments and dividends each yearpayments and dividends each year

Cash Flow Adequacy

paid dividends

repaymentsdebt esexpenditur Capital

activities operating from flowCash


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Profitability Ratios: Profitability Ratios: Overall Efficiency and Overall Efficiency and PerformancePerformance

Measures profit generated after Measures profit generated after consideration of cost of products soldconsideration of cost of products sold

Gross Profit Margin

salesNet

profit Gross


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Profitability Ratios: Profitability Ratios: Overall Efficiency and PerformanceOverall Efficiency and Performance Con’t.Con’t.

Measures profit generated after Measures profit generated after consideration of operating expensesconsideration of operating expenses

Operating Profit Margin

salesNet

profit Operating


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Measures profit generated after Measures profit generated after consideration of all expenses consideration of all expenses and revenuesand revenues

Net Profit Margin

salesNet

earningsNet


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Measures ability to translate sales into Measures ability to translate sales into cash (with which to pay bills!)cash (with which to pay bills!)

Cash Flow Margin

salesNet



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Measures overall efficiency of firm Measures overall efficiency of firm in managing investment in in managing investment in assets and generating profitsassets and generating profits

Return on Total Assets (ROA) or Return on Investment (ROI)

assets Total

earningsNet


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Measures rate of return on Measures rate of return on stockholders’ investmentstockholders’ investment

Return on Equity (ROE)

equity rsStockholde

earningsNet


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Useful comparison to return on Useful comparison to return on investmentinvestment

Indicates firm’s ability to generate Indicates firm’s ability to generate cash from utilizing its assetscash from utilizing its assets

Cash Return on Assets

assets Total



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Analyzing the DataAnalyzing the Data

Now that some of the “tools” of Now that some of the “tools” of financial analysis have been financial analysis have been illustrated, where does one go from illustrated, where does one go from here?here?

Taking a general approach to financial Taking a general approach to financial statement analysis, one might statement analysis, one might proceed as follows. . . proceed as follows. . .


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Five Steps of a Five Steps of a Financial Statement Financial Statement AnalysisAnalysis

Who are you and why are you Who are you and why are you interested in this company?interested in this company?

What questions would you like to What questions would you like to have answered?have answered?

What info is vital to the decision at What info is vital to the decision at hand? hand?

Establish objectives of the analysis

Step 1


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Five Steps of a Five Steps of a Financial Statement AnalysisFinancial Statement Analysis Con’t.Con’t.

Study the industry in which the firm Study the industry in which the firm operates and relate industry operates and relate industry climate to current and projected climate to current and projected economic developments economic developments

Step 2Step 2


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Five Steps of a Five Steps of a Financial Statement AnalysisFinancial Statement Analysis Con’tCon’t

How well does this firm seem to be run?How well does this firm seem to be run? Are they taking advantage of Are they taking advantage of

opportunities?opportunities? Are they innovative, forward-looking, Are they innovative, forward-looking,

etc?etc?

Step 3

Develop knowledge of firm and quality of management


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Five Steps of a Five Steps of a Financial Statement AnalysisFinancial Statement Analysis Con’t Con’t

Tools: Common-size financial Tools: Common-size financial statements, key financial ratios, statements, key financial ratios, trend analysis, structural trend analysis, structural analysis, and comparison with analysis, and comparison with industry competitorsindustry competitors

Step 4

Evaluate financial statements


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Major Areas: Short term liquidity, Major Areas: Short term liquidity, operating efficiency capital operating efficiency capital structure and long-term solvency, structure and long-term solvency, profitability, market ratios, and profitability, market ratios, and segmental analysis (when relevant)segmental analysis (when relevant)

Step 4 Continued

Evaluate financial statements


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Reach conclusions about the Reach conclusions about the firm relevant to your firm relevant to your established objectives established objectives

Step 5

Summarize findings


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Relating the RatiosRelating the Ratios—The Du Pont System—The Du Pont System

It is helpful to complete the It is helpful to complete the evaluation of a firm by evaluation of a firm by considering the interrelationship considering the interrelationship among the individual ratios among the individual ratios


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Relating the RatiosRelating the Ratios—The Du Pont System—The Du Pont System ContinuedContinued

The Du Pont System helps the The Du Pont System helps the analyst see how the firm’s analyst see how the firm’s decisions and activities over decisions and activities over the course of an accounting the course of an accounting period interact to produce an period interact to produce an overall return to the firm’s overall return to the firm’s shareholders, the return on shareholders, the return on equity equity


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Relating the RatiosRelating the Ratios—The Du Pont System—The Du Pont System ContinuedContinued

The summary ratios are:

Assets

incomeNet

Assets

Sales

Sales

incomeNet

Equity

incomeNet

Equity

Assets

Assets

incomeNet

(1)Net profit margin

(2)Total asset turnover

(3)Return on investment

(3)Return on investment

(4)Financial leverage

(5)Return on equity


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Four Market RatiosFour Market Ratios

1.1. Earnings per common shareEarnings per common share

2.2. Price-to-earningsPrice-to-earnings

3.3. Dividend payoutDividend payout

4.4. Dividend yieldDividend yield


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Market RatiosMarket Ratios Continued Continued

Provides the investor with a Provides the investor with a common denominator to common denominator to gauge investment returnsgauge investment returns

Earnings per Common Share

goutstandin shares Average

earningsNet


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Relates earnings per common share to the Relates earnings per common share to the market price at which the stock trades, market price at which the stock trades, expressing the “multiple” that the stock expressing the “multiple” that the stock market places on a firm’s earningsmarket places on a firm’s earnings

Price-to-Earnings

shareper Earnings

stockcommon of priceMarket


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This ratio is determined by the formula This ratio is determined by the formula cash dividends per share divided by cash dividends per share divided by earnings per shareearnings per share

Dividend Payout

shareper Earnings

shareper Dividends


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Shows that relationship between Shows that relationship between cash dividends and market pricecash dividends and market price

Dividend Yield

stockcommon of priceMarket

shareper Dividends


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What we have What we have accomplishedaccomplished

Auditor’s Report

Statement of Cash Flows

MD&A

Statement of Shareholders’ EquityBalance Sheet

Note

s

Inco

me S

tate

ment

TurnedMaze


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Financial StatementsFinancial StatementsAn OverviewAn Overviewinto Map

understanding financial statements seventh edition lyn m. fraser aileen ormiston insert book cover

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