Miles CMA Review - Class Notes to Wiley CMA Learning System Part 2, Section A Section A Financial Statement Analysis A.1) Basic Financial Statement Analysis 1) Common Size Statements A.2) Financial Ratios 1) Working Capital Analysis - Liquidity/Solvency Ratios I) Capital Structure Analysis A.3) Profitability Analysis 1) Earnings per Share II) _ Sustainable Equity Growth II) Return on Capital Investment IV) Revenue Analysis V) __ Income Measurement Analysis VI) _ Limitations of Ratio Analysis A.4) Special Issues 1) Economic Profit and Accounting Profit I) Earnings Quality II) _ Effects of changing prices and inflation IV) _ Fair Value Standards V) Accounting for foreign currency VI) __ Differences in financial results: IFRS vs. GAAPMiles CMA Review - Class Notes to Wiley CMA Learning System Part 2, Section A Section A: Financial Statement Analysis Financial statements summarize the past performance of an organization, but they can also provide users with valuable insights into future performance. Financial statement analysis is performed by stockholders and creditors, and is an important tool for management accountants and financial analysts to use to better understand their company’s competitive position. Financial statements can be analyzed to identify trends in key financial data, compare financial performance across companies, and to calculate financial ratios that can be used to assess a company's current performance as well as its prospects for the future. In addition, the management accountant should be familiar with the analytical techniques used by external investors to evaluate their company This section features four topics: Topic A1: Basic Financial Statement Analysis Topic A2: Financial Performance Metrics - Financial Ratios Topic A3: Profitability Analysis Topic Ad: Analytical Issues in Financial AccountingMiles CMA Review - Class Notes to Wiley CMA Learning System Part 2, Section A A.1) Basic Financial Statement Analysis In order to evaluate companies, financial analysts examine financial statements in different ways: they may create variants of financial statements, such as common-size statements, and consider other issues that may affect the company’s performance. Moreover, a financial analyst is expected to be able to prepare base year statements to enable trend analysis and review the growth rates of the various elements of the financial statement. In addition, the cash flow statement, a requirement under FASB, provides useful information regarding the financial performance of a company. This topic looks at: 1) Common-size statements Il). Statement of cash flows 1) Common Size Statements > CGHARSREEEISEEIRGREE ecast all items in a particular financial statement as a% of a selected (usually the largest and most important) item on the statement for F/S analysis ‘* These can be used in several ways: ¥ Tocompare elements in a single year’s financial statements Y To analyze trends across a number of years for one business Y To compare businesses of differing sizes within an industry (such as Wal-Mart to Target) ¥ To compare the company’s performance and position with an industry average * The analyst must use judgment to resolve the issue of actual comparability between individual companies in different industries where common-size statements reflect the fundamental differences in conducting business in these industries ‘© Comparing common-size statements of companies within an industry or with common-size composite statistics of that industry can bring to light variations in account structure or distribution that require the analyst to explore and explain the reasons for differences a3Miles CMA Review - Class Notes to Wiley CMA Learning System Part 2, Section A > Vertical Common-Size Statements - In vertical common-size statements, a base amount (generally total assets on the balance sheet and net sales on the income statement) will be valued at 100%, and the elements within that statement are expressed as a percentage of the total. Common-size statements can be created for both the balance sheet and the income statement [Vertical Common-size Balance Sheet| Y Generally, Vertical Common-size Balance Sheet for Company XYZ Assets Total Current Assets $350,000 70% Net Fixed Assets 150,000 30% $500,000 GD abilities & Equity abies: Total Curren tabs $200,000 «0% Long Term Lsblties 50.000 10% Total abies $250,000 son Shareholders’ Equity: Common Stock, pa value 25.000 om Additonal paldincaptal 100,000 20% Retained Earnings 125,000 258 Total shareholders’ Equity 250.000 Sox Total labltes & Equity $500,000 Go Generally, Y Analysis of common-size income statements is useful because each item in itis related to the central value of sales, Most expense items (except fixed costs) are affected to some extent by sales volume. Therefore, it is helpful to know what proportion of the sales dollar each of the various costs and expenses represents Y Eg., Vertical Common-size Income Statement for Company ABC ‘sales $250,000 Cost of goods sold 120,000 28% Gross Margin ‘$130,000 52% General & Administrative Expenses 85,000 30% Selling Expenses 10,000 4 BIT ‘$35,000 14% AdMiles CMA Review - Class Notes to Wiley CMA Learning System Part 2, Section A + Wertical Commimen Size Stateiment|serOss IMGUSEHES - Typically, companies within the same industry display similar traits in their common sized statements, but companies in different industries display different traits v Eg, Tanfaciurer | —Retaler | Phammaceuteal | Financed rom Cash & Cash Equivalents Bm 2 33% a Marketable Secures 23% T3% Accounts/Notes ReceNaBle 23% 16% nae Inventories 34% 3% Prepaid and Others 4% 63% Trvestmets| Be 73% | High S| Property, Pant & EquipmenOltsourced 67% 78.2% 0.7% Goodwill intangibles 25% 5% Other Assets z Total Assets CITY aod Tabittes& Equity Shore-erm Payables cr a Team Short-term Debt Tae eae Other Current abies 145% Tong-term Debt a BK 5.0% 33% Other Lbs 40% 2 ina 3.5 Total Liabilities 53.8% 3.3% 52.0% | High 95.5% Total uty 46.2% 28.7% 25.0% | Low 45% Total bile & Equty 100.0%. 300.0% 300.0% 100.0% In => Accounts receivable makes up a very low percentage of the total assets for the retailer primarily because a retailer has most of its sales in cash or on credit cards. On the other hand, as expected, Inventories are a significant portion of the total assets for the retailer, much more so than in any other industry. Moreover, companies in the financial industry (such as a bank or stock broker) possess little or no inventory => Investments are the most significant account for companies in the financial industry, but this account is small or non- existent for retailers. The business model of financial firms, and in particular investment banks, isto hold investments that yield a high return. Therefore, investment represents about 70% of the total assets. Leaders in the pharmaceutical industry typically have investments in smaller companies in their respective industries, although the investment amount accounts for a much smaller proportion of their total assets than for financial companies => Plant, property & equipment was traditionally a large investment for manufacturers, but recently decreasing with advent of "lean manufacturing”. However, these may represent a significant proportion of assets for retailers who own, rather than lease, their stores => Financing for manufacturers, retailers and pharmaceutical companies are @ mix of debt and ‘equity. However, financial firms have financing obtained largely (about 75%) from short-term ‘obligations (mainly demand deposits), and only about 5% form equity-holders AsMiles CMA Review - Class Notes to Wiley CMA Learning System Part 2, Section A AS company over a period of years. This analysi jorizontal Common-Size Statements} A horizontal common-size statement, also called a Variation > [Horizontal Common-size Statements] or ‘compares key financial statement values or relationships for the same sets the base year at a value of 100% and then shows subsequent years in relation to increases or decreases over the base year Compare across periods Horizontal or trend analysis helps the analyst examine relationships to detect strengths and weaknesses, such as a faster growth in cost of sales compared to sales, as shown in the example below. The purpose of horizontal analysis is primarily to direct attention to the accounts that require further investigation Eg, Yearo sales $200,000 base year Muller o> Cost of Sales $100,000 Base year Multiplier Gross Margin $100,000 Gross Margin % 50% Interpretation Year $210,000 105% $110,000, 110% $100,000 $120,000 48% Gross Margin% lesser than base year Year2 $250,000 125% $130,000 130% 48% Year3 Yeara $260,000 $300,000 130% 150% $150,000 $160,000 150% 160% $110,000 $140,000 42% 47% Cost of Sales growing faster than Sales, leading toa