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Financial Statements Analysis The Basics

William F. Messier, Jr. SDA BOCCONI MBA 29

Learning Objectives
After studying this chapter, you should be able to:
Locate and use the many sources of information about company performance. x Analyze the components of a company using trend analysis and other techniques.
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Sources of Information About Companies
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Financial statement analysis - using financial statements to assess a company’s performance Information about publicly traded companies comes in many forms and may be found in many places.
• • • • Annual reports SEC filings and databases Company press releases Articles that appear in the financial press

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Sources of Information About Companies
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The annual report is important to investors because of its completeness and its reliability due to the audit performed by an independent auditor.
• The annual report includes:
– – – – – – – Financial statements Footnotes to the financial statements A summary of accounting principles used Management’s discussion and analysis of the financial results The auditor’s report Comparative financial data for a series of years Narrative information about the company

Sources of Information About Companies
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Publicly traded companies must also prepare reports for the government agencies (e.g., Securities and Exchange Commission - SEC).
• Form 10-K - presents financial statement data in greater detail than the financial statements in annual reports • Form 10-Q - includes quarterly financial statements that provide more timely but less complete information than annual reports

Sources of Information About Companies
Company press releases provide the basis for articles in the financial press such as The Wall Street Journal (Europe/Asia), Financial Times, and other business magazines. x Services such as Value Line, Moody’s Investors Services, Standard and Poor’s Industrial Surveys, and Dun & Bradstreet provide useful information to investors.
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Sources of Information About Companies
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The Internet is changing the way that people make investments.
• Many investors now buy and sell securities without the help of a broker. • Much of the market information is available electronically, usually for free from various sources. • Visit the web sites of Pirelli, Recordati, or Luxottica and note how much information is shown in various places – investor relations.

Financial Statement Analysis
Applying analytical techniques to financial statements and other relevant data to produce information useful for decision making.

Some Features Of Financial Statement Analysis
Not simply a probing for more detail x More appropriately described as a process of • Synthesis • Summarization • Study of relationships • Comparative analyses
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Objectives of Financial Statement Analysis
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Although different investors demand different returns, they all use financial statement analysis for common reasons.
• To predict their expected returns • To assess the risks associated with those returns

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Financial statement analysis focuses on past performance to predict future performance.

Objectives of Financial Statement Analysis
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Creditors want to know about short-term liquidity and long-term solvency.
• Short-term liquidity - an organization’s ability to meet current payments as they become due • Long-term solvency - an organization’s ability to generate enough cash to repay long-term debts as they mature

Objectives of Financial Statement Analysis
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Equity investors are more concerned with returns in the form of dividends and increased market price of the stock.
• These investors are naturally more interested in profitability. • Profits spur both dividends and increased stock prices.

Evaluating Trends and Components of the Business
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Evaluating trends and components of a business are two ways of looking at financial information.
• Trend analysis involves comparing financial trends from one year to another. • Evaluating components of a business can be done in more than one way.
– Relationships among elements of the financial statements may be examined. – Components may also be thought of as separate business units or segments. These components may be examined.

Trend Analysis
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Trends are predictable patterns that have been observed in the past and are expected to continue into the future.
• A pattern must be identified, and expectations of whether the trend will continue must be formed. • Trends can be shown as changes in amounts from year to year or as percentage changes from year to year.

Trend Analysis
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The euro amount of the change is simply the current year minus the previous year. The percentage change is computed as follows:

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Amount of change % Change = ×100 Prior year amount

Trend Analysis
STELLAR CORPORATION Income Statements for the Years Ended December 31, 2002 and 2001 2002 Sales Expenses: Wages expense Rent expense Utilities expense Depreciation expense Total expenses Net Income €98,600 45,800 12,000 6,500 5,000 69,300 €29,300
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2001 €89,500 42,900 12,000 6,450 5,900 67,250 €22,250
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Increase (Decrease) €9,100 2,900 0 50 (900) 2,050 €7,050
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% Increase (Decrease) 10.2% 6.8 0.0 0.8 (15.3) 3.0 31.7

Trend Analysis
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Changes in euro amounts and percentage terms help to expose patterns.
• Understanding these patterns is most important. • The answers to why items changed tell a lot about how a company is run, how it will perform in the future, and whether or not it would be a good investment.

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Analysts generally look at several years’ worth of financial information to discover trends.

Common-Size Statements
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Common-size statements - financial statements expressed in component percentages
• The income statement is expressed as a percentage of sales.
– This makes it easy to compare percentages to those of other companies because percentages are a common index.

• The balance sheet is expressed as a percentage of total assets.
– This is often referred to as component percentages because they measure each component as a percentage of the total.

Common-Size Statements
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For the income statement, sales is set at 100% and each other element is expressed as a percentage of the sales figure. For the balance sheet, the total assets amount is set at 100%, and each other element is expressed as a percentage of the total assets figure.

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Common-Size Statements
STELLAR CORPORATION Income Statements for the Years Ended December 31, 2002 and 2001
2002 Sales Expenses Wages expense Rent expense Utilities expense Depreciation expense Total expenses Net income € 98,600 45,800 12,000 6,500 5,000 69,300 € 29,300 100% 46% 12% 7% 5% 70% 30% 2001 € 89,500 42,900 12,000 6,450 5,900 67,250 € 22,250 100% 48% 13% 7% 7% 75% 25%

Management’s Discussion and Analysis
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Management’s discussion and analysis - a required section of the annual report that concentrates on explaining the major changes in the income statement, liquidity, and capital resources
• Management’s discussion often includes a discussion of trends and analysis of components.

Segment Reporting
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Many large companies are involved in more than one type of business activity or market.
• Each individual type of business activity or market may be considered a segment.

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The FASB requires information on a business segment to be reported based on the way it is reported to management.
• The information is reported consistent with the way the company manages the business.

Segment Reporting
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When analyzing segment data, two things should be considered.
• Evaluating segment data forces us to ask important questions that help us to truly understand the business. • Truly understanding the business means not only understanding what is sold and how much is made but also interpreting how financial reports summarize dynamic changes in the business.

Prominence of Earnings Per Share
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Earnings per share is a basic reporting element in the financial statements. Some issues tend to complicate the calculation of earnings per share.
• Use of a weighted-average number of shares of common stock • Outstanding shares of nonconvertible preferred stock • Changes in capitalization structure such as stock splits and stock dividends

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Weighted-Average Shares and Preferred Stock
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If all shares outstanding are common shares, the biggest complication is the use of a weightedaverage number of shares of common stock. The following formula is used in this case.

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Net income Earning per share = of common stock Weighted - average number of shares

Weighted-Average Shares and Preferred Stock
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Earnings per share is calculated as net income divided by weighted-average number of shares outstanding during the period.
• The weighted-average number of shares is based on the number of months that the shares were outstanding during the year.

Weighted-Average Shares and Preferred Stock
Online, Inc., has 750,000 shares of common stock outstanding at the beginning of the calendar year, and 200,000 additional shares were issued on October 1. What is the weighted-average number of shares outstanding during the year?

Weighted-Average Shares and Preferred Stock
The weighted-average number of shares is computed as follows:
750,000 x weighting of 12/12 = 750,000 200,000 x weighting of 3/12 = 50,000 800,000
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OR 750,000 x 9/12 = 562,500 950,000 x 3/12 = 237,500 800,000
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Weighted-Average Shares and Preferred Stock
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Another complication arises if there are shares of nonconvertible preferred stock outstanding.
• The dividends on preferred stock for the current period, whether or not paid, should be deducted in calculating EPS because those dividends are not available to be paid to common shareholders.

Earning per share Net income - Preferred dividends = of common stock Weighted - average number of shares

Basic and Diluted EPS
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When a company has convertible securities, stock options outstanding, or other financial instruments that can be converted to common shares, the calculation of EPS becomes even more complicated.
• When convertible securities exist, EPS is calculated using the assumption that any and all convertible shares are turned into common stock at the beginning of the period.

Basic and Diluted EPS
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The presence of convertible securities increases the number of common shares to the highest possible number considering the convertible securities and stock options outstanding.
• If the number or shares outstanding is increased, earnings per share is decreased. • These convertible securities are said to dilute (reduce) earnings per share.

Disclosure of Nonrecurring Items
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Financial statement analysis focuses on normal recurring items of the financial statements, not nonrecurring items. Four major categories of nonrecurring items:
• • • • Special items Extraordinary items Discontinued operations Accounting changes

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Special Items
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Special items - expenses that are large enough and unusual enough to warrant separate disclosure
• Companies generally have flexibility in deciding when to treat something as a special item. • Special items appear as separate line items among operating expenses on the income statement. • Any necessary discussion must be included in the footnotes to the financial statements.

Extraordinary Items
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Extraordinary items - items that are unusual in nature and infrequent in occurrence that are shown separately, net of tax, in the income statement
• Unusual in nature means that an item is different from the typical or normal operating activities of a business. • Infrequent in occurrence means that an event should not be expected to recur often.

Discontinued Operations
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Discontinued operations - the termination (closing or sale) of a business segment reported separately, net of tax, in the income statement
• Any gain or loss from the actual disposal of the segment must be disclosed along with the results of operations (income or loss) for that segment during the period before the disposal.

Accounting Changes
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Accounting changes occur when the standard setters require a new way of accounting for a particular item.
• For example, when the IASB changes its rules, it often requires a major one-time recognition (revenue or expense). • Accounting changes are shown separately and are shown net of tax.

Income Statement Presentation
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The presentation of nonrecurring items on the income statement is as follows:
Income from continuing operations before income taxes Deduct income taxes Income from continuing operations Discontinued operations, net of tax Income before extraordinary items Extraordinary items, net of tax Income before cumulative effect of an accounting change Cumulative effect of an accounting change, net of tax Net income

International Considerations
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Financial statement analysis may be complicated by several factors when companies carry on operations in different countries.
• • • • Differences in accounting methods Language in which the results are reported Currency in which results are reported Different securities markets, tax structures, and local customs

Price-Earnings Ratios and Growth
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The P-E ratio is helpful for relating the price of a stock to the earnings it is generating.
• Value investors look for stocks with low P-E ratios because they feel these stocks are undervalued. • Growth investors feel that stocks with high P-E ratios are likely to be high growth stocks.
– The price is high because investors see strong growth ahead.

Price-Earnings Ratios and Growth
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One way to relate P-E ratios to growth is the price-earnings growth (PEG) ratio.
• It is a tool to help focus attention on certain stocks and to help moderate knee-jerk reactions to other ratios.

P-E ratio Price-earnings = growth ratio Earnings growth rate

Always Remember When Reading Financial Statements The statements are one possible interpretation of the financial situation of the company x That interpretation was decided by management x Always consider how reasonable you believe the given interpretation to be x Remember the notion of Conservative vs. Favorable Accounting
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Financial Statements Analysis The Basics

ANY QUESTIONS?