Fraser-Ormiston 9e PPT Ch06

Understanding
Financial Statements
NINTH EDITION
Lyn M. Fraser
Aileen Ormiston
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1

Copyright Notice
All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic,
mechanical, photocopying, recording, or otherwise,
without the prior written permission of the publisher.
Printed in the United States of America.
Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-2

Chapter 6: The Analysis of
Financial Statements
Ratios are tools, and their value is limited when
used alone. The more tools used, the better the
analysis. For example, you can’t use the same
golf club for every shot and expect to be a good
golfer. The more you practice with each club,
however, the better able you will be to gauge
which club to use on one shot. So to, we need to
be skilled with the financial tools we use.
- Diane Morrison
Chief Executive Officer, R.E.C. Inc.
Objectives of Analysis
Objectives will vary depending on the
• perspective of the financial
statement user
• specific questions that are
addressed by the analysis
The identity of the user helps define
what information is needed.
Creditors
A creditor is ultimately concerned with
the ability of an existing or
prospective borrower to make interest
and principal payments on borrowed
funds.

Creditors
Questions raised in a credit analysis
should include
• What is the borrowing cause?
• What is the firm’s capital structure?
• What will be the source of debt
repayment?

Investors
An investor attempts to arrive at an
estimation of a company’s future
earnings stream in order to attach a
value to the securities being
considered for purchase or
liquidation.

Investors
The investment analyst poses questions
such as:
• What is the company’s performance
record?
• What are the future expectations?
• How much risk is inherent in the existing
capital structure?
• What are expected returns?
• What is firm’s competitive position?
Objectives for Analysis
Management
Management relates to all questions
raised by creditors and investors.
Management must also consider its
employees, the general public,
regulators, and the financial press.

Management
Looks to financial statement data to
determine
• How well has the firm performed and why?
• What operating areas have contributed to
success and which have not?
• What are strengths and weaknesses of the
company’s financial position?
• What changes should be implemented to
improve future performance?
Financial statements
• provide insight into the company’s
current status
• lead to the development of policies
and strategies for the future

Management prepares financial statements.
Analyst should be alert to potential for
management to influence reporting to
make data more appealing to creditors,
investors, and other users.
It may be helpful to supplement analysis with
other material in the annual report and
other sources of information apart from the
annual report.
Sources of Information
Financial statement user has access
to a wide range of data sources.
Objective of analysis dictates the
approach and resources used.
Beginning point should be financial
statements and the notes.

Sources of Information
The analyst will want to consider the
following resources:
• Proxy statement
• Auditor’s report
• Management discussion and analysis
• Supplementary schedules
• From 10-K and From 10-Q
• Other Sources
Other Sources of Information
• Computerized databases
− Enhance analytical process
− Provide time-saving features
• Computerized financial statement

analysis packages
− Perform ratio calculations
− Other analytical tools

Other Sources of Information
It is important to review the annual
reports of suppliers, customers, and
competitors.
Many internet sites charge subscription
fees to access information, but public
and university libraries often subscribe,
making this information free to the
public.
Tools and Techniques
• Common-size financial statements
• Key financial ratios
• Trend analysis
• Structural analysis
• Industry comparisons
• Common sense and judgment

Common-Size Financial
Statements
Express each account on the
• balance sheet as a percentage of total
assets
• income statement as a percentage of
net sales

Key Financial Ratios
Five categories of ratios
• Liquidity ratios
• Activity ratios
• Leverage ratios
• Profitability ratios
• Market ratios

Ratios are valuable analytical tools and
serve as screening devices, but they
• do not provide answers in and of
themselves
• are not predictive
• should be used with other elements of
financial analysis

Liquidity Ratios
Liquidity ratios measure a firm’s ability to
meet cash needs as they arise. Liquidity
ratios include
• current ratio
• quick or acid-test ratio
• cash flow liquidity ratio
• average collection period
• days inventory held
• days payable outstanding

Liquidity Ratios
Short-Term Solvency
Current Ratio
Measures the ability of a firm to meet

debt requirements as they come due
Current assets
Current liabilities

Liquidity Ratios
Short-Term Solvency
Quick or Acid-Test Ratio
Measures ability to meet short-term cash
needs more rigorously by eliminating
inventory
Current assets - Inventory

Current liabilities
Liquidity Ratios
Short-Term Solvency
Cash Flow Liquidity Ratio
Focuses on ability of the firm to
generate operating cash flows as a
source of liquidity
Cash + Marketable securities + CFO *
Current liabilities
*Cash flow from operating activities
Liquidity Ratios
Short-Term Solvency
Average Collection Period
Helps gauge liquidity of accounts
receivable (ability to collect cash from
customers) and may help provide
information about a company’s credit
policies
Net accounts receivable
Average daily sales
Liquidity Ratios
Short-Term Solvency
Days Inventory Held
Measures the efficiency of the firm in

managing its inventory
Inventory
Average daily cost of sales

Liquidity Ratios
Short-Term Solvency
Days Payable Outstanding
Offers insight into a firm’s pattern of
payments to suppliers
Accounts payable
Average daily cost of sales

Cash Conversion Cycle or
Net Trade Cycle
The normal cycle of a firm that consists
of
• buying or manufacturing inventory,
with some purchases on credit
• selling inventory, with some sales on
credit and creation of accounts
receivable
• collecting the cash
Net Trade Cycle
Helps the analyst understand why cash
flow generation has improved or
deteriorated by analyzing key balance
sheet accounts that affect cash flow from
operating activities:
• Accounts Receivable
• Inventory
• Accounts Payable
Net Trade Cycle
Calculated as follows
Average collection period
plus
Days inventory held
minus
Days payable outstanding
equals
Cash conversion or net trade cycle
Activity Ratios
Activity ratios measure the liquidity of
specific assets and the efficiency of
managing assets. Activity ratios include
• accounts receivable turnover
• inventory turnover
• accounts payable turnover
• fixed asset turnover
• total asset turnover
Activity Ratios: Asset Liquidity,
Asset Management Efficiency
Accounts Receivable Turnover
Measures efficiency of firm’s collection

and credit policies
Net sales
Net accounts receivable

Inventory Turnover
Measures firm’s efficiency in managing
its inventory
Cost of goods sold

Inventory

Accounts Payables Turnover
Helps to gain insight into a firm’s pattern
of payment to suppliers
Cost of goods sold
Accounts payable

Fixed Asset Turnover
Assesses effectiveness in generating sales
from investments in fixed assets
Net sales
Net property, plant, equipment

Total Asset Turnover
Assesses effectiveness in generating sales
from investments in all assets
Net sales
Total assets

Leverage Ratios
Leverage ratios measure the extent of a
firm’s financing with debt relative to
equity and its ability to cover interest
and other fixed charges.

Leverage Ratios
Leverage ratios include
• Debt ratio
• Long-term debt to total capitalization
• Debt to equity
• Times interest earned
• Fixed charge coverage
• Cash flow adequacy

Leverage Ratios
Debt Financing and Coverage
Debt Ratio
Considers the proportion of all assets

that are financed with debt
Total liabilities
Total assets

Leverage Ratios
Long-term Debt to Total Capitalization
Reveals the extent to which long-term
debt is used for the firm’s permanent
financing (both long-term debt and
equity)
Long–term debt
Long-term debt + Stockholders’ equity
Leverage Ratios:
Debt Financing and Coverage (cont.)
Debt to Equity
Measures the riskiness of the firm’s
capital structure in terms of the
relationship between the funds supplied
by creditors (debt) and investors
(equity)
Total liabilities
Stockholders’ equity
Leverage Ratios
Times Interest Earned
Indicates how well operating earnings
cover fixed interest expenses
Operating profit
Interest expense

Leverage Ratios
Cash Interest Coverage
Measures how many times interest
payments can be covered by cash flow
from operations before interest and
taxes
CFO + interest paid + taxes paid

Interest paid
Leverage Ratios
Fixed Charge Coverage
Broader measure of how well operating
earnings cover fixed charges
Operating profit + Rent expense

Interest expense + Rent expense
*Rent expense = operating lease payments

Leverage Ratios
Cash Flow Adequacy
Measures firm’s ability to cover capital
expenditures, long-term debt payments
and dividends each year
Cash flow from operating activities

Capital expenditures + debt repayments
+ dividends paid
Profitability Ratios
Profitability ratios measure the overall
performance of a firm and its
efficiency in managing assets,
liabilities, and equity.

Profitability ratios include
• gross profit margin
• operating profit margin
• net profit margin
• cash flow margin
• return on total assets (ROA) or return on
investment (ROI)
• return on equity (ROE)
• cash return on assets
Overall Efficiency and Performance
Gross Profit Margin
Measures ability of a company to control
costs of inventories or manufacturing of
products and to pass along price
increases through sales to customers
Gross profit
Net sales
Operating Profit Margin
Measures overall operating efficiency
and incorporates all of the expenses
associated with ordinary business
activities
Operating profit
Net sales
Net Profit Margin
Measures profitability after

consideration of all revenue and
expense, including interest, taxes, and
nonoperating items
Net earnings
Net sales
Cash Flow Margin
Measures ability to translate sales into

cash

Net sales

Return on Total Assets (ROA) or Return
on Investment (ROI)
Measures overall efficiency of firm in

managing investment in assets and
generating profits
Net earnings
Total assets
Return on Equity (ROE)
Measures rate of return on stockholders’

investment
Net earnings
Stockholders’ equity

Cash Return on Assets
Measures firm’s ability to generate cash
from the utilization of its assets

Total assets
Market Ratios
Market ratios measure returns to
stockholders and the value the
marketplace puts on a company’s stock.
Market ratios include
• earnings per common share
• price-to-earnings
• dividend payout
• dividend yield
Market Ratios
Earnings per Common Share
Earnings per Common Share
Provides the investor with a common
denominator to gauge investment
returns
Net earnings
Average shares outstanding
Market Ratios
Price-to-Earnings
Price-to-Earnings
Relates earnings per common share to
the market price at which the stock
trades, expressing the “multiple” that
the stock market places on a firm’s
earnings
Market price of common stock
Earnings per share
Market Ratios
Dividend Payout
Dividend Payout
Determined by the formula cash
dividends per share divided by earnings
per share
Dividends per share

Earnings per share
Market Ratios
Dividend Yield
Dividend Yield
Shows the relationship between cash
dividends and market price
Dividends per share

Market price of common stock

Analyzing the Data
There are five broad areas that would typically
constitute a fundamental analysis of financial
statements:
• Background on the firm, industry, economy,
and outlook
• Short-term liquidity
• Operating efficiency
• Capital structure and long-term solvency
• Profitability

Background: Economy,
Industry, and Firm
Economic developments and the actions of
competitors affect the ability of any
business enterprise to perform successfully.
It is necessary to evaluate the environment in
which the firm conducts business.
This process involves blending hard facts with
guess and estimates.

Short-Term Liquidity
Especially important to creditors, suppliers,
management, and others who are
concerned with the ability of a firm to meet
near-term demands for cash
Should include analysis of selected financial
ratios and a comparison with industry
averages
Predicts the future ability of the firm to meet
prospective needs for cash
Operating Efficiency
Turnover ratios measure the operating
efficiency of a firm.
The efficiency in managing a company’s
accounts receivable, inventory, and
accounts payable is discussed in the
short-term liquidity analysis.

Capital Structure and
Long-Term Solvency
Analytical process includes an
evaluation of the amount and
proportion of debt in a firm’s capital
structure as well as the ability to
service debt.
Debt financing implies risk and
leverage.

Profitability
Analysis of how well the firm has
performed in terms of profitability,
beginning with the evaluation of
several key ratios

Relating the Ratios
The Du Pont System
Helpful to complete the evaluation of a firm by
considering the interrelationship among the
individual ratios
Looks at how the various pieces of financial
measurement work together to produce an
overall return
Helps analyst see how the firm’s decisions and
activities over the course of an accounting
period interact to produce overall return to
shareholders

Relating the Ratios
The Du Pont System
The summary ratios used are the following:
(1) (2) (3)
Net profit margin Total asset turnover Return on investment
Net income Net sales Net income

Net sales X Total assets = Total assets
(3) (4) (5)
Return on investment Financial leverage Return on equity
Net income Total assets Net income

Total assets X Stockholder equity = Stockholder equity
Relating the Ratios
The Du Pont System
The first three ratios reveal that return
on investment is a product of the net
profit margin and the total asset
turnover.
The second three ratios show how the
return on equity is the product of
return on investment and financial
leverage.
Relating the Ratios
The Du Pont System
By reviewing this series of relationships, the
analyst can identify strengths and
weaknesses as well as trace potential
causes of problems in the overall financial
condition and performance of the firm.
Analyst can evaluate changes in condition and
performance.
Evaluation can then focus on specific areas
contributing to changes.

Projections and
Pro Forma Statements
Pro forma financial statements are
projections based on a set of
assumptions regarding
• future revenues
• expenses
• level of investment in assets
• financing methods and costs
• working capital management

Projections and
Pro Forma Statements
Pro forma financial statements are used
primarily for long-range planning and
long-term credit decisions.
Many firms have made up their own
definitions of pro forma statements,
which should not be confused with
the pro forma statement described
above.
Summary of Analysis
Analysis of any firm’s financial statements
consists of a mixture of steps and pieces
that interrelate and affect each other.
No one part of the analysis should be
interpreted in isolation.
The last step of analysis is to integrate the
separate pieces into a whole, leading to
conclusions about the business enterprise.

Fraser-Ormiston 9e PPT Ch06

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Fraser-Ormiston 9e PPT Ch06

Uploaded by

Copyright:

Available Formats

Understanding

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 1

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-2

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-5

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-6

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-7

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-9

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-11

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-13

• Computerized financial statement

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-15

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-17

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-18

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-19

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-20

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-21

Measures the ability of a firm to meet

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-22

Current assets - Inventory

Measures the efficiency of the firm in

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-26

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-27

Measures efficiency of firm’s collection

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-32

Cost of goods sold

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-33

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-34

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-35

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-36

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-37

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-38

Considers the proportion of all assets

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-39

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-42

CFO + interest paid + taxes paid

Operating profit + Rent expense

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-44

Cash flow from operating activities

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-46

Measures profitability after

Measures ability to translate sales into

Cash flow from operating activities

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-51

Measures overall efficiency of firm in

Measures rate of return on stockholders’

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-53

Cash flow from operating activities

Dividends per share

Dividends per share

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-59

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-60

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-61

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-63

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-64

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-65

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-66

Net income Net sales Net income

Net income Total assets Net income

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-69

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-70

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-72

You might also like