Tools of Financial Analysis and Control

STOCKHOLDERS REPORT

Definition:

The annual report and other reports given to stockholders to inform them of the company's financial
standing and developments.

• Large and small corporations engage in the annual ritual of drafting the stockholder's report.

• The report places the company's achievements on display for shareholders, while highlighting
future plans and disclosing the financial well-being of the company.

• The content of the report varies by industry and company; however, companies include similar
content concerning the financial health of the business, new products to be launched, the
outlook for the coming year and information regarding research and development.

-CEO’s Letter

 The chief executive officer of the company greets the stockholders in an introductory letter
setting the tone of the report.
 If the company has done well, the letter will briefly highlight the revenues, earnings per share,
margins and cash flow, as well as the investment and return to shareholders.
 If the year brought heavy losses to the company, the CEO's letter will highlight progress and put
the setbacks into their context

Financial Well-Being

Stockholders have a right to know the overall financial conditions of the company in which they have
invested; therefore, the annual report contains the consolidated financial statements regarding the
company's income, cash flow performance, short- and long-term debt and financial position.

The section also contains information concerning the accounting practices, including the calculation of
revenue and the use of estimation in the preparation of the report. The financial portion discusses risks
and contingencies that can affect the finances of a company, such as pending lawsuits or claim.

FINANCIAL STATEMENT ANALYSIS

• Financial statement analysis is the process of analyzing a company's financial statements for
decision-making purposes.

• External stakeholders use it to understand the overall health of an organization as well as to

evaluate financial performance and business value.

• Internal constituents use it as a monitoring tool for managing the finances.

ANALYZING FINANCIAL STATEMENTS

The financial statements of a company record important financial data on every aspect of a
business’s activities. As such they can be evaluated based on past, current, and projected performance.
1. BALANCE SHEET

A balance sheet is designed to communicate the “book value” of a company. It’s a simple accounting of
all the company’s assets, liabilities, and shareholders’ equity, and offers analysts a quick snapshot of
how a company is performing and expects to perform.

Most balance sheets follow this basic formula:

Assets = Liabilities + Shareholders’ Equity

An Asset is anything the company owns which has a quantifiable value. This may include physical
property (vehicles, real estate, unsold inventory, etc.), as well as non-physical property (patents,
trademarks, etc.)

Liabilities refer to money the company owes to a debtor. This may include outstanding payroll expenses,
debt payments, rent and utility payments, money owed to suppliers, taxes, bonds payable, and more.

Shareholders’ equity is a term that generally refers to the net worth of a company. It reflects the
amount of money that would be left if all assets were sold, and all liabilities paid. This money belongs to
the shareholders, whether they are a private owner or public investors.

2. INCOME STATEMENT

An income statement is a report that a company generates in order to communicate how much money
it has earned over a period of time. They’re often found as quarterly and annual reports.

3. CASH FLOW STATEMENT

• A cash flow statement is a report that details how a company receives and spends its cash.
These are also called cash inflows and outflows.

• A company can only operate as long as it has the money to cover its expenses.

• Cash flow reflects a company’s ability to operate in both the short- and the long-term, and is
used by investors, creditors, and regulators to determine whether a company is in good financial
standing.
 Cash flow statements are typically split into three sections:

• Operating activities, which details cash flow generated from the company delivering upon its
goods or services, including both revenue and expenses

• Investing activities, which details cash flow generated from the buying or selling of assets, such
as real estate, vehicles, and equipment (using free cash and not debt)

• Financing activities, which details cash flow from both debt and equity financing

4. STATEMENT OF OWNERS EQUITY

The statement of Owners equity is a financial statement that details changes in the equity held
by shareholders, whether those shareholders be public or private investors.

A statement of Owners equity will typically report changes in the number of shares and value of
common and preferred stock, as well as details about whether or not the company has
purchased back any stock previously held by shareholders (called treasury stock) and other data
points

The Interrelationships of the 4 Financial Statements

Statement of Cash Flows
For the year ended December 31, 20x2
(000)
Net cash flows from operating activities $ 1,470
Net cash used by investing activities $ (4,100)
Net cash provided by financing activities $ 2,750
Increase in cash balance $ 120
Beginning cash balance (12/31/x1) $ 100
BALANCE SHEET Ending cash balance (12/31/x2) $ 220 BALANCE SHEET
As of December 31, 20x1 As of December 31, 20x2
(000) (000)
Assets Income Statement Assets
Cash $ 100 For the year ended December 31, 20x2 Cash $ 220
Other Current Assets $ 1,300 (000) Other Current Assets $ 1,195
Long-term Investments $ 3,000 Revenues $ 5,880 Long-term Investments $ 4,000
Long-term Assets $ 10,000 Expenses $ 4,795 Long-term Assets $ 11,500
Intangible Assets $ 1,600 Net Income $ 1,085 Intangible Assets $ 1,700
Total Assets $ 16,000 Total Assets $ 18,615

Liabilities and Owner's Equity Statement of Changes in Owner's Equity Liabilities and Owner's Equity
Current Liabilities $ 1,000 For the year ended December 31, 20x2 Current Liabilities $ 740
Long-term Liabilities $ 4,950 (000) Long-term Liabilities $ 6,940
Joe Owner, capital, 1/1/x2 $ 10,050
Joe Owner, Capital $ 10,050 Plus: Investments by owner $ - Joe Owner, Capital $ 10,935
Plus: Net Income $ 1,085
Total Liabilities and Equity $ 16,000 Less: Withdrawals by owner $ 200 Total Liabilities and Equity $ 18,615
Joe Owner, capital, 12/31/x2 $ 10,935
ANALYSIS TOOLS
changes are measured against a base year
with the ff formula:

Current year amount — Base year amount

———————————————————————
Base year amount
=

HORIZONTAL ANALYSIS OF BALANCE SHEET

 HORIZONTAL ANALYSIS OF INCOME STATEMENT

HORIZONTAL ANALYSIS OF RETAINED EARNINGS STATEMENT

The change in Jan 1 retained earnings is calculated as follows: 39.4% = 525,000-376,500

376,500

Financial statement elements are measured as a

percent of the total
 Balance Sheet Income Statement
Elements are a percent of total Elements are a percent of total sales
assets

VERTICAL ANALYSIS OF A BALANCE SHEET

VERTICAL ANALYSIS OF AN INCOME STATEMENT

LIQUIDITY RATIOS
 - Measures of short-term ability of the enterprise to pay its maturing obligations and to
meet unexpected needs for cash; Reveals a company’s ability to generate profits
Types of Liquidity Ratios
1. Current Ratio
Current Ratio = Current Assets / Current Liabilities
The current ratio is the simplest liquidity ratio to calculate and interpret. Anyone can easily find
the current assets and current liabilities line items on a company’s balance sheet. Divide current
assets by current liabilities, and you will arrive at the current ratio.

2. Quick Ratio
Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities
The quick ratio is a stricter test of liquidity than the current ratio. Both are similar in the sense
that current assets is the numerator, and current liabilities is the denominator.
However, the quick ratio only considers certain current assets. It considers more liquid assets
such as cash, accounts receivables, and marketable securities. It leaves out current assets such
as inventory and prepaid expenses because the two are less liquid. So, the quick ratio is more of
a true test of a company’s ability to cover its short-term obligations.

3. Cash Ratio
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
The cash ratio takes the test of liquidity even further. This ratio only considers a company’s
most liquid assets – cash and marketable securities. They are the assets that are most readily
available to a company to pay short-term obligations.
In terms of how strict the tests of liquidity are, you can view the current ratio, quick ratio, and
cash ratio as easy, medium, and hard.

Important Notes
Since the three ratios vary by what is used in the numerator of the equation, an acceptable
ratio will differ between the three. It is logical because the cash ratio only considers cash and
marketable securities in the numerator, whereas the current ratio considers all current assets.
Therefore, an acceptable current ratio will be higher than an acceptable quick ratio. Both will be
higher than an acceptable cash ratio. For example, a company may have a current ratio of 3.9, a
quick ratio of 1.9, and a cash ratio of 0.94. All three may be considered healthy by analysts and
investors, depending on the company.

Importance of Liquidity Ratios

1. Determine the ability to cover short-term obligations
Liquidity ratios are important to investors and creditors to determine if a company can cover
their short-term obligations, and to what degree. A ratio of 1 is better than a ratio of less than
1, but it isn’t ideal.
Creditors and investors like to see higher liquidity ratios, such as 2 or 3. The higher the ratio is,
the more likely a company is able to pay its short-term bills. A ratio of less than 1 means the
company faces a negative working capital and can be experiencing a liquidity crisis.

2. Determine creditworthiness
Creditors analyze liquidity ratios when deciding whether or not they should extend credit to a
company. They want to be sure that the company they lend to has the ability to pay them back.
Any hint of financial instability may disqualify a company from obtaining loans.

3. Determine investment worthiness

For investors, they will analyze a company using liquidity ratios to ensure that a company is
financially healthy and worthy of their investment. Working capital issues will put restraints on
the rest of the business as well. A company needs to be able to pay its short-term bills with
some leeway.
Low liquidity ratios raise a red flag, but “the higher, the better” is only true to a certain extent.
At some point, investors will question why a company’s liquidity ratios are so high. Yes, a
company with a liquidity ratio of 8.5 will be able to confidently pay its short-term bills, but
investors may deem such a ratio excessive. An abnormally high ratio means the company holds
a large amount of liquid assets.
For example, if a company’s cash ratio was 8.5, investors and analysts may consider that too
high. The company holds too much cash on hand, which isn’t earning anything more than the
interest the bank offers to hold their cash. It can be argued that the company should allocate
the cash amount towards other initiatives and investments that can achieve a higher return.
With liquidity ratios, there is a balance between a company being able to safely cover its bills
and improper capital allocation. Capital should be allocated in the best way to increase the
value of the firm for shareholders.

PROFITABILITY RATIOS
- Measures of the income or operating success of an enterprise for a given period of time;
Reveals the company’s efficiency with regard to the use of its assets.

PROFITABILITY RATIOS

PROFITABILITY RATIO FORMULAS

TURNOVER RATIOS

• Asset Turnover

• Measures how efficiently assets are utilized

• Accounts Receivable Turnover

• Measures the number of times each year receivables are collected

• Days’ Sales in Receivables

• Measures the average number of days necessary to collect credit sales

• Inventory Turnover

• Measures the number of times each year inventory is sold

• Days’ Sales in Inventory

• Measures the average number of days necessary to sell all inventory

TURNOVER RATIO FORMULAS

DEBT-RELATED RATIOS

• Current Ratio

• Measures a company’s ability to meet short-term obligations

• Acid-Test Ratio (Quick Ratio)

• More stringent measure of the current ratio

 • Debt-to-Equity Ratio

• Assesses the company’s debt position

• Times Interest Earned

• Measures a company’s ability to re-pay long-term debt

DEBT-RELATED RATIOS

Summary of Ratio Formulas

SOLVENCY RATIOS
- Measures of the ability of the enterprise to survive over a long period of time; Reveals a
company’s ability to pay off its long-term debts with its current assets.

What are the types of solvency ratio?

The most common types of solvency ratio are the debt-to-equity ratio and the times-interest-earned
ratio.

Debt-to-Assets Ratio

The debt-to-assets ratio measures how much of the firm's asset base is financed using debt.1 You
calculate this by dividing a company's debt by its assets. If a firm's debt-to-assets ratio is 0.5, that means,
for every $1 of debt, there are $2 worth of assets.

Debt-to-Assets Ratio = Debt/ Assets

Equity Ratio

This ratio is calculated by dividing total equity by total assets.2 This tells analysts how effectively a
company funds its assets with shareholder equity, as opposed to debt. The higher the ratio, the less
debt is needed to fund asset acquisition.

Equity Ratio = Equity/ Assets

Interest-Coverage Ratio

This measures a company's ability to meet its long-term debt obligations. It's calculated by dividing
corporate income, or "earnings," before interest and income taxes (commonly abbreviated EBIT) by
interest expense related to long-term debt. A ratio of 1.5 or less is generally considered a troubling
number.

Interest-Coverage Ratio = EBIT/ Interest Expenses

How Solvency Ratios Work

If one of the ratios shows limited solvency, that should raise a red flag for analysts. If several of these
ratios point to low solvency, that's a major issue, especially if the broader economic climate is fairly
upbeat. A company that struggles with solvency when things are good is unlikely to fare well in a
stressful economic environment.

For business owners, it should spur an effort to reduce debt, increase assets, or both. For a potential
investor, these are serious indications of problems ahead, and a troubling sign about the direction the
stock price could take. Traders may even take this as a sign to short the stock, though traders would
consider many other factors beyond solvency before making such a decision.

Difference Between Solvency Ratios and Liquidity Ratios

Solvency ratios assess the company's long-term health by evaluating long-term debt and the interest on
that debt; liquidity ratios assess the company's short-term ability to meet current obligations and turn
assets into cash quickly.

A company with high liquidity could easily rise to meet sudden financial emergencies, but that doesn't
tell an analyst how easily a company can honor all of its debt obligations on a decades-long timeline.
Conversely, a company with solid solvency is on stable ground for the long-term, but it's unclear how it
would fair under a sudden cash crunch.

By using both solvency ratios and liquidity ratios, analysts can determine how well a company can meet
any sudden cash needs without sacrificing its long-term stability.