978-0078025679 Chapter 5 Lecture Note

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

CHAPTER 5

ESSENTIALS OF FINANCIAL STATEMENT ANALYSIS

CHAPTER OVERVIEW

Financial ratios, along with common size and trend statements, provide analysts with powerful

tools for tracking a company’s performance over time, for making comparisons among different

companies, and for assessing compliance with contractual benchmarks.

Alternative accounting methods can produce very different balance sheet and income

statement figures. As a result, numerous financial ratios can be affected. Analysts must be alert

to this possibility and know how to recognize when difference in GAAP accounting methods

that a company uses, rather than economic fundamentals, can affect the analysis. In addition,

analysts must be vigilant about the possibility that accounting distortions are present and can

complicate the interpretation of financial ratios, percentage relations, and trend indices.

These and other accounting influences complicate financial analysis and the interpretation of

ratio differences. That is why the effects of accounting method choices, inflation, and other

potential distortions of reported financial statement numbers are examined in this and

subsequent chapters.

CHAPTER OUTLINE

I. BASIC APPROACHES

A. Time-series analysis helps identify financial trends over time for a single company or

business unit.

B. Cross-sectional analysis helps identify similarities and differences across

companies or business units at a single moment in time.

Teaching Tip: Benchmark comparison measures a firm’s performance or health against

some predetermined standard. In time-series analysis, the benchmark may be the change in

performance or health each year. In cross-sectional analysis, the benchmark may be the

performance or health of a particular competitor or industry averages.

C. Financial Statement Analysis and Accounting Quality:

1. Both the selection of alternative accounting methods and management’s

discretion in applying those rules can distort the quality of the reported

information and the analyst’s view of the company.

a. For example, capital leases “pass through the filter” and are reported as both

assets and liabilities on the balance sheet but operating leases are “filtered

out” and so disclosed in supplemental notes that accompany the financial

statements, with the periodic lease payment shown as rent expense on the

income statement.

b. Managers who want to keep equipment leases off the balance sheet can make

certain that lease contracts meet the GAAP requirements for operating leases.

c. Managers also have discretion over accounting estimates and timing of

business transactions.

2. Analysts need to know how to adjust reported financial accounting numbers in order

to mitigate distortions caused by management’s accounting choices and discretion

so that underlying economic trends can be analyzed. In addition, raw data needed

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

for a complete picture is sometimes filtered by GAAP. Analysts should be able to

“get behind the numbers” in order to see the full picture.

3. Business segment reporting allows financial statement users to compare like

business units and to understand the contribution of individual business units to the

overall company profits. Transfer pricing issues may distort these results.

4. Conflicts of interest (e.g. management versus investors or lenders) poses a challenge to the

quality of financial reports.

5. When related-party transactions occur, GAAP requires disclosure of the relationship, a

description of the transaction, and the dollar amount involved.

II. A CASE IN POINT: GETTING BEHIND THE NUMBERS AT WHOLE FOODS

MARKET

A. Informed financial statement analysis begins with knowledge of the company and its

industry.

1. Whole Foods earnings grew because of increased sales at existing stores plus

sales from newly opened stores.

2. Exhibit 5.1 shows the comparative income statements at Whole Foods.

B. Analysis: A “cause-of-change analysis” quantifies and shows the effects of

individual changes on the change in net income. It shows which factors most influenced the

change in net income.

Teaching Tip: Cause-of-Change Analysis: Refer to the model in the text and demonstrate

its usefulness by changing one component of the model (holding all other inputs constant)

at a time using two periods of comparison. With each change, point out its effect on net

income until every component of the model has been analyzed.

C. Common–Size and Trend Analysis Income Statements provide a convenient way to

organize financial statement information so that major financial components and

changes are easily recognized.

1. Common-size income statements recast each statement item as a percentage

of sales for that period as shown in Exhibit 5.4.

2. Trend statements recast each statement item as a percentage of that item in a base

year as shown in Exhibit 5.4.

3. Common-size and trend income statements reveal changes in sales, margins,

and pre-tax profit.

4. Trend statements provide a clearer indication of growth and decline than do

common-size statements.

D. Common-Size and Trend Analysis Balance Sheets highlight changes in asset mix

and financial structure, respectively.

1. Common-size balance sheets recast each asset item as a percentage of total assets

as shown in Exhibit 5.7.

2. Trend balance sheets recast each balance sheet item as a percentage of that item as

compared to the base year amount. See Exhibit 5.7.

E. Common-Size and Trend Analysis Cash Flow Statements are constructed by

dividing each cash flow item by sales for the year as shown in Exhibit 5.11.

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

F. Conclusions:

1. Financial statements help the analyst gain a sharper understanding of the

company’s economic condition and its prospects for the future.

2. Informed financial statement analysis begins with knowledge of the company its

industry.

3. Cause–of–change analysis helps identify the various reasons a particular quantity,

such as net income, changed from one period to another.

4. Common-size and trend statements provide a convenient way to organize

financial statement information so that major financial components and changes

can be easily recognized.

G. Whole Foods Summary:

1. Whole Foods is a growing retail company that must devote resources to expand its

store base.

2. Financial statement readers should always be on alert for changes in the

contribution made by non-operating items to overall net income.

3. Whole Foods’ income statement shows that sales increased 45.7% over three

years due to an increase in sales as well as due to growth in sales per store.

4. Whole Foods’ asset mix in 2012 remained relatively similar to that in 2009.

5. Whole Foods altered its financial structure over the four-year period. The

company reduced its reliance on capital (common stock) and increased its reliance

on long-term debt.

6. Whole Foods used a combination of methods that seemed to reflect almost no

change in net cash flows even though various components of cash flows had

major variations over time.

III. PROFITABILITY, COMPETITION, AND BUSINESS STRATEGY

A. Financial Ratios and Profitability Analysis: Financial ratios are powerful tools that

analysts use to evaluate profit performance and to assess credit risk.

Most evaluations of profit performance begin with the return on assets (ROA) ratio.

1. ROA =

2. Analysts can isolate a company’s sustainable profits by removing

nonrecurring (special items) items from reported earnings.

3. After-tax interest expense is eliminated from the profit calculation so that

profitability comparisons over time are not clouded by differences in financial

structure.

4. Adjustments can be made to eliminate distortions to both earnings and assets for

items such as the capital and operating lease example mentioned earlier.

5. A company can increase its ROA in two different ways:

a. By increasing the operating profit margin.

b. By increasing the intensity of asset utilization.

c. In other words, ROA can be thought of as:

6. Profit margin x Asset turnover, or

b.

7. Analysts can decompose ROA further to isolate where cost reductions have been

Earnings before interest (EBI)

Average assets

Earnings before interest (EBI)

Sales

x

Sales

Average assets

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

achieved or are needed, or to isolate efficiency gains in current or long-term asset

management.

8. The current asset turnover ratio helps analysts spot efficiency gains from

improved accounts receivable and inventory management.

9. The long-term asset turnover ratio captures information about PP&E utilization.

B. ROA and Competitive Advantage:

1. Several factors can explain why companies operating in the same industry—and

that therefore are confronting similar economic conditions—earn markedly

different rates of return on their assets.

2. Companies that consistently earn higher rates of return are said to have a

competitive advantage. Competitive advantage can result from:

a. Developing unique products or services.

b. Providing consistent quality or excellent customer service and convenience.

c. Innovative production technologies, distribution channels, or sales and

marketing efforts.

3. Competition in an industry continually works to drive down the rate of return on

assets toward the competitive floor (i.e., the rate of return that would be earned in

a “perfectly competitive” industry).

4. Rates of return higher than the industry floor stimulate more competition as

existing companies innovate and expand their market reach or as new companies

enter the industry, leading to the erosion of profitability and advantage.

5. According to most observers, there are only two strategies for achieving

superior performance in any business.

a. One strategy is product and service differentiation in order to focus

customer attention on “unique” product or service attributes to gain

customer loyalty and attractive profit margins.

b. The other strategy is low-cost leadership that focuses customer attention on

product pricing. The goal is to underprice the competition, achieve highest

sales volumes, and still make a profit on each sale.

c. Few companies actually pursue one strategy to the exclusion of the other.

Rather, they try to develop brand loyalty while controlling cost.

6. Differences in business strategies give rise to differences in cost structures and risk

factors. Operational risk factors are reflected in differences of operating margins,

earnings, and asset utilization; whereas, financial risk factors are determined by

methods of financing.

IV. RETURN ON COMMON EQUITY AND FINANCIAL LEVERAGE

A. Profitability and credit risk both influence the return that common shareholders earn on

their investment in the company.

B. Return on common equity (ROCE) = .

This ratio measures a company’s performance in using capital provided by shareholders to

generate earnings.

C. Components of ROCE:

Net income – Preferred dividends

Average common shareholders’ equity

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

1. ROCE = ROA x common earnings leverage x financial structure leverage, or

2. ROCE =

a. The common earnings leverage ratio shows the proportion of EBI that

belongs to common shareholders.

b. The financial structure leverage ratio measures the degree to which the

company uses common shareholders’ capital to finance assets.

V. GLOBAL VANTAGE POINT

A. How earnings are determined may be different for firms using U.S. GAAP than for

firms that follow IFRS, adding to comparability issues. Analysts will generally recognize

potential differences and make adjustments for more informative comparisons. Some examples

of these differential treatments include:

1. Firms following IFRS may reverse prior year impairment charges while firms

using U.S. GAAP may not.

2. Recognition of compensation expense under SFAS 123R for firms that grant

employee stock compensation

VI. LIQUIDITY, SOLVENCY, AND CREDIT ANALYSIS

A. Credit risk refers to the risk of nonpayment of a debt by the borrower.

1. Ability to repay debt is determined by capacity to generate cash from operations,

asset sales, or external financial markets in excess of cash needs.

2. Willingness to pay depends on which competing cash need is viewed as the most

pressing at the moment.

3. The statement of cash flows is an important source of information for

analyzing a company’s credit risk. Financial ratios are also useful for this

purpose.

4. Credit risk analysis using financial ratios typically involves an assessment of

liquidity and solvency. Liquidity refers to the short-term ability to generate

cash for working capital needs and immediate debt repayment needs.

Solvency refers to the long-term ability to generate cash to satisfy plant

capacity needs, fuel growth, and repay debt when due.

B. Short-Term Liquidity

1. Liquidity refers to the company’s short-term ability to generate cash for working

capital needs and immediate debt repayment needs.

2. Solvency refers to the long-term ability to generate cash internally or from external

sources in order to satisfy plant capacity needs, fuel growth, and repay debt when

due.

C. Short-term liquidity:

1. Current ratio = ,

current assets

current liabilities

___EBI_____

average assets

net income available to common shareholders

EBI

average assets

average common shareholder’s equity

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

This ratio reflects cash as well as amounts that will be converted into cash in the normal

operating cycle.

2. Quick ratio = …

Inventory is not included, providing a more short-run reflection of liquidity, since few

businesses can instantaneously convert their inventories into cash.

3. Activity ratios tell users how efficiently the company is using its assets by

highlighting causes for cash flow mismatches.

a. Accounts receivable turnover = .

This ratio tells users the proportion of yearly sales that the average receivables

balance represents. This ratio will be correspondingly larger for firms with

cash sales that are a larger proportion of total sales.

b.

Days accounts receivable outstanding = .

This ratio tells users the average collection period for accounts receivable. This

should be compared to the credit period allowed by the company.

c. Inventory turnover = .

This ratio tells users the proportion of sales that the average inventory balance

represents. A higher ratio may indicate:

i. More efficient operations, or

ii. Adoption of a low-cost leadership strategy.

d. Days inventory held = .

This ratio tells users the average number of days that inventory is held in storage.

e. Accounts payable turnover = .

This ratio, and its counterpart that follows, helps analysts understand the

company’s pattern of payment to suppliers.

f. Days accounts payable outstanding = .

g. Add days receivable outstanding and days inventory held, then subtract days

accounts payable outstanding to get a measure of the mismatching of cash

inflows and outflows. This ratio determines the amount of “working capital”

financing needed by a company and is useful to determine liquidity needs

when a company expands or contracts its volume of goods or services.

D. Long-Term Solvency:

1. Debt ratios provide information about the amount of long-term debt in a

company’s financial structure.

cash + receivables + short term investments

current liabilities

net sales

average accounts receivable

365 days

accounts receivable turnover

cost of goods sold

average inventory

365 days

inventory turnover

inventory purchases

average accounts payable

365 days

accounts payable turnover

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

2. Long-term debt to assets = ,

This ratio reflects the proportion of each asset dollar financed with long-term debt.

3. Long-term debt to assets = .

The adjustment to remove intangible assets is intended to remove “soft” assets, i.e.

those that are difficult to value reliably.

4. Interest coverage = .

While debt ratios are useful for understanding the financial structure of a company,

they provide no information about its ability to generate a stream of inflows sufficient

to make principal and interest payments. The interest coverage ratio is commonly used

for this purpose.

5. Operating cash flows to total liabilities = .

This ratio shows the ability of a company to generate cash flows from operations

in order to service both short-term and long-term borrowings.

D. Cash Flow Analysis:

1. A company’s obligation to make interest and principal payments cannot be

satisfied out of earnings because accrual earnings includes many noncash accruals

and deferrals.

2. Cash Flow from Operations – The cash flows from operating activities indicate the

amount of cash the company was able to generate from its ongoing core business

activities.

a. A business that spends more cash on its operating activities than it generates

must find ways to finance the operating cash shortfall.

b. None of the available options can be sustained for prolonged periods of time.

3. The cash flows from investing activities represent cash inflows and cash outflows

related to investment and disinvestment in long-term assets.

a. Emerging companies require substantial investments in property,

plant, and equipment at a stage when operating cash flows are

typically negative.

b. Established growth companies also require substantial fixed asset investments

to further expand their market presence. Operating cash flows for established

growth companies can be positive or negative.

c. Capital expenditures for mature companies are limited to the amount

needed to sustain current levels of operation.

d. Changes in a company’s capital expenditures or fixed asset sales over time

must be carefully analyzed.

4. The cash flows from financing activities show cash inflows and cash outflows

related to changes in long-term liabilities and equity accounts.

a. The most significant source of external financing for most companies is

debt.

i. The advantage of debt financing is that interest on debt is tax

operating income before taxes and interest

interest expense

long – term debt

total assets

cash flow from continuing operations

avg. current liabilities + long – term debt

long – term debt

tangible assets

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

deductible.

ii. The disadvantage is that highly leveraged firms have a greater

risk of bankruptcy.

b. A change in dividend policy may be a “signal” from management

about its expectations of future operating cash flows levels

E. Financial Ratios and Default Risk

1. In a case of default (nonpayment of required payment), lenders can respond in

several ways: a. Adjust the loan payment schedule to better suit the company (borrower)

b. Modify the payment schedule with increased interest rate or additional

collateral

c. Petition a court to judge the borrower insolvent – ultimate form of

default

3. Credit analysis helps lenders assess a borrower’s default risk.

Financial ratios help in two ways:

a. Help lenders quantify potential borrower’s default risk (before

loan is granted)

b. Early warning device to alert lenders to changes in borrower’s

credit risk (after loan is granted)

4. Credit risk assessment often begins with the statement of cash

flows because it shows the company’s operating cash flows along

with its financing investment needs. A low credit risk company

generates operating cash flows substantially in excess of what are

required to sustain its business activities.

5. The Altman Z-score model uses a combination of five financial ratios to

estimate a company’s default ratio.

6. Footnote disclosures provide the data that analysts use to adjust financial

statements to provide for a better comparison of company results of operations

and financial position.

7. Analysts must be wary and try to assess the “meaning behind the numbers.”

APPENDIX

VII. SEGMENT REPORTING

A. Definition of a Reportable Segment – an operating segment is a component of a

public entity that earns revenue and incurs expenses within or outside the entity and

produces discrete financial information that is reviewed and used by the chief

operating officer, president, or group of officers responsible for reviewing entity

activities and allocating resources. The management approach is used where the

information is disclosed in the same manner as it is internally for operations.

B. Criteria for aggregating operating segments require that firms must disclose

information for segments meeting any of the following quantitative thresholds:

a. Determine the grouping of segments (based on similar characteristics)

b. Revenue equals or exceeds 10% of total revenue (internal and external)

c. Operating profit/loss (in absolute value terms) equals or exceeds 10% of the

greater of (in absolute value terms) combined segment operating profit of

those segments with profits and combined segment operating losses of

those segments with losses.

d. Assets equal or exceed 10% of total segment assets.

C. Further…

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

a. Reportable segments must represent 75% of the revenue reported on the

income statement

D. Required Disclosures

a. How a firm determines its reportable segments and describe its products

and services for each segment in addition to other income statement and

balance sheet related items (see the list in textbook).

b. U.S. GAAP requires minimal enterprise-wide disclosures related to

industry and geographic location if not included in the disclosure

CHAPTER QUIZ

1. A useful tool in financial statement analysis is the common-size financial statement. What

does this tool enable the financial analyst to do?

a.. Evaluate financial statements of companies within a given industry of approximately the

same value.

b. Determine which companies in the same industry are at approximately the same

stage of development.

c. Compare the mix of assets, liabilities, owners’ equity, revenue, and expenses within a

given industry without respect to relative size.

d.. Ascertain the relative potential of companies of similar size in different industries.

2. In financial statement analysis, the expression of all financial statement figures as a

percentage of base-year figures is called:

a.. Horizontal common-size analysis.

b. Vertical common-size analysis.

c. Cross-sectional analysis.

d.. Ratio analysis.

3. The relationship of the total debt to the total equity of a corporation is a measure of:

a.. Liquidity.

b. Creditor risk.

c. Profitability.

d.. Solvency.

4. In comparing the current ratios of two companies, why is it invalid to assume that the

company with the higher current ratio is the better company?

a. The current ratio includes assets other than cash.

b. The two companies may include different current assets and liabilities in working capital.

c. A high current ratio may indicate inadequate inventory on hand.

d. A high current ratio may indicate inefficient use of various assets and liabilities.

5. Selected data from Orvosh Corporation’s year–end financial statements are presented below.

The difference between average and ending inventory is immaterial.

Current ratio 2.0

Quick ratio 1.5

Current liabilities $120,000

Inventory turnover (based on cost of goods sold) 8 times

Gross profit margin 40%

Orvosh’s net sales for the year were:

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

a. $240,000.

b. $480,000.

c. $800,000.

d.. $1,200,000.

6. Return on assets (ROA):

a. Will increase as long as operating profit margin increases.

b. Will decrease as long as asset turnover decreases.

c. Is not useful in helping analysts isolate achieved cost reductions.

d. Is useful in helping analysts isolate efficiency gains in asset management.

7. Increasing the average age of property, plant, and equipment on hand:

a. Increases the return on assets and increases the return on common equity.

b. Increases the return on assets and has no effect on the return on common equity.

c. Decreases the return on assets and decreases the return on common equity.

d. Has no effect on either the return on assets or the return on common equity.

8. A firm that earns a 12% return on the investment of proceeds of debt that costs 9%:

a. Increases return on assets and increases return on common equity.

b. Increases return on assets, but does not affect return on common equity.

c. Does not affect return on assets, but increases return on common equity.

d. Does not affect either return on assets or return on common equity.

9. Which of the following characterizes best how the statement of cash flows is useful in

assessing the credit risk of a firm?

a. The ability to repay debt is determined by capacity to generate cash from operations,

which is shown on the statement of cash flows.

b. The ability to repay debt is determined by capacity to generate cash from asset sales,

which is shown in the investing section of the statement of cash flows.

c. The ability to repay debt is determined by capacity to generate cash from external

markets, which is shown in the financing section of the statement of cash flows.

d. All of the above.

10. Which of the following is true about long-term solvency?

a. Debt ratios provide information about the amount of debt in a firm’s capital structure.

b. Debt ratios are useful in assessing a firm’s ability to generate a stream of inflows

sufficient to make principal and interest payments.

c. The interest coverage ratio is useful in assessing whether a firm has an optimal level of

debt in its capital structure.

d. The operating section of the statement of cash flows only provides information on a

firm’s ability to service its short–term debt.

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

QUIZ ANSWERS:

1. c. A common-size financial statement presents the items in a financial statement as

percentages of a common base. The items in a balance sheet are usually stated in

percentages of total assets. The items in the income statement are usually expressed as a

percentage of sales. Thus, comparisons among firms in the same industry are made possible

despite differences in size.

Financial Reporting and Analysis 6e Essentials of Financial Statement Analysis

RECOMMENDED EXHIBITS

1. Figure 5.1—The Financial Reporting Filter and the Analyst’s Task

2. Exhibit 5.3 – Whole Foods Market Cause-of-Change Analysis

3. Exhibit 5.4 – Whole Foods Markets Common-Size and Trend Analysis of Income

4. Exhibit 5.6 – Whole Foods Markets Comparative Balance Sheets

5. Exhibit 5.7 – Whole Foods Markets Common-Size and Trend Analysis of Assets

6. Exhibit 5.8 – Whole Foods Markets Common-Size and Trend Analysis of Liabilities and

Shareholders’ Equity

7. Exhibit 5.10—Whole Foods Markets comparative cash flow statements.

8. Exhibit 5.11 – Whole Foods Markets Common-Size and Trend Analysis of Selected Cash

Flow Items

9. Exhibit 5.14—Asset Turnover Decomposition

10. Exhibit 5.16 – Profitability and Financial Leverage

11. Exhibit 5.21 – G.T. Wilson Company – Selected Financial Statistics