Lecture 3 : Analyzing Financial Statements

MGMT640 - Financial Decision Making for Managers Lecture 3 : Analyzing Financial Statements Learning Objectives: 1. Identify the three perspectives from which financial statements can be analyzed. 2. Understand how common-size financial statements are helpful in financial statement analysis and be able to prepare a common-size balance sheet and a common-size income statement. 3. Discuss how financial ratios facilitate financial analysis, and be able to compute and use them to analyze a firm's performance. 4. Explain what benchmarks are, describe how they are prepared, and discuss why they are important in financial statement analysis. 5. Identify the major limitations in using ratios for financial statement analysis Welcome to Lesson 3: During this lesson, we will focus on analyzing financial statements. Let's begin by exploring the background of financial statement analysis. Perspectives in Financial Statement Analysis Internal and external users rely on a company's financial statements to get an in-depth understanding of the company's financial position. For internal users such as managers, the financial statements offer information necessary to plan, evaluate, and control operations. External users, such as investors and creditors, use the financial statements to gauge the future profitability and liquidity of a company. We just defined three groups of stakeholders who benefit from financial statement analysis: management, investors, and creditors. Let’s discuss how each of these three groups benefits from analyzing financial information. From the stockholder, or the investor's, perspective, financial statement analysis is essential as it provides information on the company’s profitability and on their prospects for earning a return on their investment by receiving dividends and/or increasing the market value of their stock holdings. Management’s interest in financial statement analysis is not all that different from the stockholder’s interest. Strong organizational performance will help the management team keep their jobs! Management also uses the financial statements to make investing, financing, and working capital decisions based on the trends they identify in the financial statements. From a creditor's perspective, financial statement analysis provides key information on the organization's ability to repay loans and make interest payments. Creditors often focus on the current debt load and the organization's short-term and long-term obligations. Creditors will often spend the 1 most time analyzing cash flows to ensure the organization has the necessary cash flow to meet all of its current and future debt requirements. When beginning to analyze financial statements, the first step is to consider whose perspective is being analyzed; stockholders, management, or creditors? This is important, as we have discussed, because these stakeholders have different reasons for analyzing the statements. Performing Financial Statement Analysis: Common-size Financial Statements To start, the analysis should be based on reports that have been audited, if at all possible. This will help to ensure the highest level of accuracy and reliability in the financial information. In addition, the analysis should include information from the past three to five years in order to conduct what is called a trend analysis. The trend analysis will show any trends in the performance of the organization over time. Another helpful analytical technique is to compare the financial statements of the company to those of its greatest competitor. This will help to show how the organization compares in financial health to its competitors. This is known as a benchmark analysis. Common-size, or standardized, financial statements are often used in financial statement analysis. It is important to note that common-size financial statements are NOT GAAP! They are simply a tool to compare balance sheets and income statements over time or between companies of varying sizes. A common-size balance sheet is prepared by dividing every line item on the balance sheet by the total assets figure. This will result in the balance sheet accounts being represented as a percentage of total assets. A common-size income statement is prepared by dividing every line item on the income statement by the total sales figure. This will result in the income statement accounts being represented as a percentage of sales. Common-size financial statements allow the stakeholder to make more meaningful comparisons. For example, it is more meaningful to note that advertising expense represented 3% of total sales for Company A but 12% of total sales for Company B rather than comparing the actual dollars of advertising expense incurred for each company. Financial Ratios Measuring the liquidity, leverage, and profitability of a company is not a matter of how many dollars the company has in the form of assets, liabilities, and equity. The key is the proportions in which such items occur in relation to one another. A company is analyzed by looking at ratios rather than just dollar amounts. Financial ratios are determined by dividing one number by another, and are usually expressed as a percentage. They enable business owners to examine the relationships between seemingly unrelated items and thus gain useful information for decision-making. Financial ratios are simple to calculate, easy to use, and provide a wealth of information that cannot be obtained elsewhere. There are many different types of ratios that can be computed depending on the purpose of the analysis: 1. Profitability ratios focus on the financial performance of the company. Common profitability ratios include: a. The gross profit margin is defined as: Gross Profit/Sales 2 The gross profit margin indicates the percentage of sales revenue that is left to pay operating expenses, creditor interest, and income taxes after deducting cost of goods sold. b. The operating profit margin is defined as: Income from Operations/Sales This operating profit margin indicates the percentage of sales revenue left to cover interest and income taxes expenses after deducting cost of goods sold and operating expenses. c. The net profit margin is defined as: Net Income/Sales The net profit ratio is the percentage of sales revenue retained by the company after payment of operating expenses, interest expenses, and income taxes. It is an index of performance that can be used to compare the company to others in the same industry. d. EBIT Return on Assets e. The return on assets (ROA) ratio is defined as: Net Income/ Total Assets ROA is designed to measure the efficiency with which all of a company’s assets are used to produce income from operations. f. The return on equity (ROE) ratio is defined as: Net Income/Owners' Equity. ROE indicates how well the company is utilizing its equity investment. ROE is considered to be one of the best indicators of profitability. It is also a good figure to compare against competitors or an industry average. Experts suggest that companies usually need at least 10-14 percent ROE in order to fund future growth. If this ratio is too low, it can indicate poor management performance or a highly conservative business approach. On the other hand, a high ROE can mean that management is doing a good job, or that the firm is undercapitalized. 2. Efficiency ratios, also known as asset turnover ratios, focus on how effectively management generates sales from its long-lived assets. Common efficiency ratios include: a. Inventory Turnover b. Days’ Sales in Inventory c. Accounts Receivable Turnover d. Days’ Sales Outstanding e. Total Asset Turnover f. Fixed Asset Turnover 3. Liquidity ratios measure the organization's ability to meet short-term debt requirements without jeopardizing the organization's cash flow. Common liquidity ratios include: a. Current Ratio b. Quick Ratio c. The current ratio is defined as: Current Assets/Current Liabilities. 3 The current ratio measures the ability of an entity to pay its near-term obligations. Though the ideal current ratio depends to some extent on the type of business, a general rule of thumb is that it should be at least 2:1. A lower current ratio means that the company may not be able to pay its bills on time, while a higher ratio means that the company has money in cash or safe investments that could be put to better use in the business. d. The quick ratio or acid-test ratio is defined as: Quick Assets (cash, marketable securities, and receivables) / Current Liabilities. The quick ratio provides a stricter definition of the company's ability to make payments on current obligations. Ideally, this ratio should be 1:1. If it is higher, the company may keep too much cash on hand or have a poor collection program for accounts receivable. If it is lower, it may indicate that the company relies too heavily on inventory to meet its obligations. 4. Leverage, or solvency, ratios are concerned with the organization's ability to meet its long-term obligations on a continuing basis. There are two types of leverage ratios: debt ratios and coverage ratios. a. Debt ratios describe the company’s use of debt in its capital structure. Common debt ratios include: b. Total Debt Ratio c. Debt-to-Equity Ratio d. Equity Multiplier e. The debt-to-equity ratio is defined as: Total Liabilities / Owners' Equity. This ratio indicates the relative mix of the company's investor-supplied capital. A company is generally considered safer if it has a low debt-to-equity ratio; that is, a higher proportion of owner-supplied capital. Though, a very low ratio can indicate excessive caution. In general, debt should be between 50 and 80 percent of equity. f. Coverage ratios analyze the ability of the company to meet its debt obligations. Common coverage ratios include: g. Times Interest Earned h. Cash Coverage Ratio i. Times Interest Earned ratio is defined as: Income from Operations/Interest Expense This ratio indicates the amount by which income from operations could decline before a default on interest may result. Note that income from operations is used, so that income before deduction of creditor payments in the form of income taxes and interest is incorporated into the calculation. Another term for the numerator in this ratio is EBIT. 5. Market-value performance ratios explore how the stock market values an investment in the company’s stock. Common market-value performance ratios include: 4 a. Earnings per Share (EPS) b. Price-Earnings (P/E) Ratio c. Earnings per Share is defined as: Net Income/Number of Common Shares Outstanding EPS indicates the amount of return that has been earned by each outstanding share of common stock. d. Price-Earnings ratio is defined as: Market Price per Share/Earnings per Share This ratio is used as an indicator of the market’s expectation of a company’s future performance. It is a way to express the earnings performance of the common shares of stock. When using ratios for financial statement evaluation, there are several factors to consider. The usefulness of the ratios will depend on the accounting data that has been acquired in the past. The ratios are only beneficial if strong, financial data has been reported in the past. It is also important for those conducting the analysis to be neutral and not make any judgment regarding the organization. They should let the numbers speak for themselves! Financial statement evaluation is important for a variety of reasons, as we have discussed. It is essential for each stakeholder to understand what they are hoping to determine, and to use the right ratios to find this information. There are no short-cuts to financial statement analysis! Determining the financial health of the organization should be a top priority! 5