Accounting For Managers

Professor ZHOU Ning

SCHOOL OF ECONOMICS AND MANAGEMENT
BEIHANG UNIVERSITY

zning80@buaa.edu.cn
 Chapter 13

Financial Statement Analysis

The objectives of Chapter 13

 Business objectives
 Overall measures
 Profitability ratios
 Investment utilization ratios
 Financial condition ratios
 Dividend policy
 Growth measures
 Making comparisons
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 Relationship to previous material
 Focus has been:
 What goes into 3 basic financial statements
 Income Statement,
 Balance sheet,
 Statement of Cash Flows.
 Now focus is:
 How statements are analyzed by
management, investors, and creditors.
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 Objective of a Business

 Create value for its shareholders while

maintaining a sound financial position.
 Return on investment.
 Sound financial position.
 Other important objectives include:
 Employee satisfaction.
 Social responsibility.
 Ethical considerations.

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 Overview
 GAAP does not define ratios.
 Multiple equally valid approaches to ratios and
analysis.
 Managers (e.g. division manager, sales manager)
should be measured to items that they control.
 Investors and top management are most
interested in overall performance or broadest
measures of performance.
 Understanding less broad measures of performance may
give additional insight into overall performance
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 Structure of the analysis

 From broadest to more specific levels.

 Principal value of financial analysis:
 Suggests questions not answers.
 Ratio comparisons start with supposition
that all other things are equal (they
rarely are).

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Categories of ratios which measure:

 Overall performance.
 Profitability.
 Investment utilization.
 Financial condition.
 Dividend policy.

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 Making comparisons

 Finding the appropriate standard is difficult.

 A high ratio (e.g. current ratio, ROI) may
be good or bad. It can’t be viewed in
isolation.
 Is a high CR good or bad?
 Is a high ROI always good?
 Values of ratios compared across time 
longitudinal analysis, or trend analysis.
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 Overall Measures
(1)

 Possible definitions of investment: assets, owners’

equity, invested capital.
 Possible definitions of return:
 net income,
 net income -preferred dividends,
 net income + interest expense (1-tax rate).
 Use income generated from pool of funds before
considering cost of funds in pool.

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 Overall Measures

(2)
Tangible assets
 How well management is using a pool of capital .
 Before considering financing decisions. Some
analysts ignore interest adjustment.
 Measures how an enterprise uses its funds.
 May be used to evaluate individual business units in
a large company when managers do not influence
financing decision (i.e. how assets are financed).

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 Overall Measures

(3)
Or,

 Common shareholders’ equity = total

shareholders’ equity - preferred stock.
 Reflects return on funds invested by
shareholders.
 Of interest to current and prospective
shareholders.
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 Overall Measures
(4)

 Invested capital = permanent capital = capital

employed = long-term liabilities + shareholders’
equity = working capital + non-current assets.
 Return on funds entrusted to the firm for relatively
long time.

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 Variations

 Average or weighted average

investment is more representative (e.g.
(beginning + ending)  2).
 Tangible assets instead of total assets.
 To determine tax rate, can use total tax
rate or tax rate excluding deferred
taxes.

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 Relationship of ROE to Profit Margin,
Asset TO & Leverage

 ROE can be viewed as:

 Pretax profitx margin percentage ＊ Asset Turnover
ratio ＊ Financial leverage ratio ＊ Tax retention rate.
 ROE = (Pretax profit/sales revenue) ＊ (sales revenues
/ total assets) ＊ (Total assets/Shareholders’ equity) ＊
(1- Tax rate)
 How do we improve ROE?

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Relationship of ROE to Profit Margin,
Asset TO & Leverage

 F company BS
 F company IS
 F company CF

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 Illustration 13-1
factors affecting return in investment

*numbers based on 2006 data in F company 13-17

 Overall Measures

(5)

 Market price per share/EPS

 Market price is not controlled by company;
reflects all information available to the market.
 Reflects how investors judge future performance
or prospects of the company.
 Commonly compared to other companies in
same industry.
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 Profitability measures

 Common size financial statements =

Vertical analysis:
 Express each item on the income

statement as a percentage of net sales.

(1)

(2)

a measure of overall profitability

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 Profitability measures

(3)

 Class discussion:
 Company ABC has an EPS of $5 per share,
Company XYZ has an EPS of $10 per share.
 Is one a better company or investment
than the other? Is one more profitable
than the other?
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 Investment utilization measures

 How well are assets managed.

 Profitability measures focus on Income
Statement.
 Investment utilization measures involve
balance sheet and income statement
amounts.

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Investment utilization measures
Investment turnover
(1)

(2)

(3)

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 Investment utilization measures

 Capital intensity: less encompassing

than investment turnover.

(4)

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 Investment utilization measures
Working capital measurers
(5)

 Cash expenses = total expenses - depreciation

- other non-cash expenses

(6)

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 Investment utilization measures
Working capital measurers
(7)

(8)

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 Investment utilization measures
Working capital measurers
(9)

(10)

 Working capital= current assets-current liabilities

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 Investment utilization measures

Working capital measurers

 Cash conversion cycle:
 Receivables conversion period (i.e. days’ receivables)

+ inventory conversion period (i.e. days’ inventory)

- payment deferral period (i.e. days’ payables) =
operating cycle - payment deferral period.
 A measure of liquidity.
 Indicates time interval for which additional

short-term financing might be needed to

support a spurt in sales.
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 Financial condition ratios

(1)

 Liquidity.

 Solvency.

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 Liquidity

 Ability to meet current obligations.

 Tests for size and relationship between current
liabilities and current assets.
 Liquidity measures:
(2)

(3)

 Monetary current assets = current assets - inventory - prepaid assets.

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 Solvency

 Ability to meet interest costs and repayment

schedules associated with long-term debt.
 Solvency measures
(4)

(5)

(6)
Total invested capital = long-term debt + shareholders’ equity 13-30
 Solvency Measures (Continued)

(7)

(8)

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 Dividend policy

(1)

(2)

 Provides info on how growth is financed.

 Less dividends paid means more earnings

are retained to fund growth.

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 Dividend yield vs. interest yield on bonds

 Not a valid comparison.

 Investor’s return on bonds kept to
maturity:
 Interest (adjusted for amortization of
premium/discount).
 Investor’s return on common stock:
 Dividends + change in share price.
 Function of expected future earnings.
 Earnings reinvested in business.
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 Growth measures
 Key accounting items for which growth is
computed: sales, net income, earnings per
share.
 Averageyeras
Items growth
2006 =2005
(growth
2004 per
2003 year
2002 for2001
n
Net years)/n
sales $6,295 $6,191 $5,787 $5,181 $4,652 $4,349
Year-to-year basis 1.68% 6.98% 11.70% 11.37% 6.97%
Average growth rate 7.74%

 Compound growth rate = based on present

value concepts.
 May be misleading due to abnormally high
or low beginning or ending year.
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 Implied growth rate

 Estimates potential to grow its sales and

profits without an injection of new capital
(1)

(2)

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 Bases for comparison
 Experience. A feel for what is right or reasonable.
 Budget. A target developed within the company.
Factors to be considered:
 How carefully was budget constructed?
 What circumstances are different now?
 Historical standards. Prior period’s results adjusted
for changes in accounting methods.
 External benchmarks. Competitor, industry average.

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 Comments on Ratio Analysis

 Helps paint a picture.

 Try to overcome tendency to look at
numbers rather than underlying reasons.
 Starting point; identifies questions not
answers.

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Summary of Ratio

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Summary of Ratio

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Summary of Ratio

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 Summary of Chapter 13

 Business objectives
 Overall measures
 Profitability ratios
 Investment utilization ratios
 Financial condition ratios
 Dividend policy
 Growth measures
 Making comparisons
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Assignments of Chapter 13

 Problem 13-1～13-7
 Case 13-1

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Thank you

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